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EX-23 - CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM - MOUNTAIN NATIONAL BANCSHARES INCd463925dex23.htm
EX-32.1 - CERTIFICATE - MOUNTAIN NATIONAL BANCSHARES INCd463925dex321.htm
EX-31.1 - CERTIFICATE - MOUNTAIN NATIONAL BANCSHARES INCd463925dex311.htm
EX-32.2 - CERTIFICATE - MOUNTAIN NATIONAL BANCSHARES INCd463925dex322.htm
EX-31.2 - CERTIFICATE - MOUNTAIN NATIONAL BANCSHARES INCd463925dex312.htm
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-K

(Mark One)

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2011

or

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from             to             

Commission file number: 000-49912

 

 

MOUNTAIN NATIONAL BANCSHARES, INC.

(Exact name of registrant as specified in its charter)

 

Tennessee   75-3036312

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

300 East Main Street, Sevierville, Tennessee   37862
(Address of principal executive offices)   (Zip code)

(865) 428-7990

(Registrant’s telephone number, including area code)

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

None

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

Common Stock, $1.00 par value

 

 

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 Securities Exchange Act of 1934 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  ¨    No  x

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data 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 (of for such shorter period that the registrant was required to submit and post such files).    Yes  ¨    No  x

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 the 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 the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer   ¨    Accelerated filer   ¨
Non-accelerated filer   ¨  (Do not check if a smaller reporting company)    Smaller reporting company   x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the 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: $15,131,763.

There were 2,631,611 shares of Common Stock outstanding as of December 31, 2012.

 

 

DOCUMENTS INCORPORATED BY REFERENCE

None.

 

 

 


Table of Contents

MOUNTAIN NATIONAL BANCSHARES, INC.

Annual Report on Form 10-K

For the Fiscal Year Ended December 31, 2011

Table of Contents

 

Item

Number

       Page
Number
 
  Part I   

1.

  Business      1   

1A.

  Risk Factors      26   

2.

  Properties      40   

3.

  Legal Proceedings      42   

4.

  Mine Safety Disclosures      42   
  Part II   

5.

  Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities      42   

7.

  Management’s Discussion and Analysis of Financial Condition and Results of Operations      44   

8.

  Financial Statements and Supplementary Data      86   

9.

  Changes in and Disagreements with Accountants on Accounting and Financial Disclosure      87   

9A.

  Controls and Procedures      87   

9B.

  Other Information      90   


Table of Contents
  Part III   

10.

  Directors, Executive Officers and Corporate Governance      90   

11.

  Executive Compensation      95   

12.

  Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters      102   

13.

  Certain Relationships and Related Transactions, and Director Independence      105   

14.

  Principal Accountant Fees and Services      106   
  Part IV   

15.

  Exhibits, Financial Statement Schedules      107   
  Signatures      111   


Table of Contents

PART I

ITEM 1. BUSINESS

Forward-Looking Statements

Certain of the statements made herein under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and elsewhere, are “forward-looking statements” within the meaning and subject to the protections of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”).

Forward-looking statements include statements with respect to our beliefs, plans, objectives, goals, expectations, anticipations, assumptions, estimates, intentions, and future performance, and involve known and unknown risks, uncertainties and other factors, which may be beyond our control, and which may cause the actual results, performance or achievements of Mountain National Bancshares, Inc. (“Mountain National” or the “Company”) to be materially different from future results, performance or achievements expressed or implied by such forward-looking statements.

All statements other than statements of historical fact are statements that could be forward-looking statements. You can identify these forward-looking statements through our use of words such as “may,” “will,” “anticipate,” “assume,” “should,” “indicate,” “seek,” “attempt,” “would,” “believe,” “contemplate,” “expect,” “estimate,” “continue,” “plan,” “point to,” “project,” “could,” “intend,” “target,” “potential” and other similar words and expressions of the future. These forward-looking statements may not be realized due to a variety of factors, including, without limitation, those set forth in Item 1A. Risk Factors below and the following factors:

 

   

the effects of greater than anticipated deterioration in economic and business conditions (including in the residential and commercial real estate construction and development segment of the economy) nationally and in our local market;

 

   

deterioration in the financial condition of borrowers resulting in significant increases in loan losses and provisions for those losses;

 

   

increased levels of non-performing and repossessed assets;

 

   

lack of sustained growth in the economy in the Sevier County and Blount County, Tennessee area;

 

   

government monetary and fiscal policies as well as legislative and regulatory changes, including changes in banking, securities and tax laws and regulations;

 

   

the risks of changes in interest rates on the levels, composition and costs of deposits, loan demand, and the values of loan collateral, securities, and interest sensitive assets and liabilities;

 

   

the effects of competition from a wide variety of local, regional, national and other providers of financial, and investment services;

 

   

the failure of assumptions underlying the establishment of reserves for possible loan losses and other estimates due to our inability to properly classify loans and identify loans as collateral dependent;

 

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the risks of divestitures, including, without limitation, the related time and costs of implementing such transactions and the possible failure to achieve expected gains and/or expense savings from such transactions;

 

   

the effects of failing to comply with our regulatory commitments, including those contained in the consent order our bank subsidiary entered into on October 27, 2011 (the “Consent Order”);

 

   

our and our bank subsidiary’s ability to maintain our capital levels above those levels that would result in our bank subsidiary being closed;

 

   

our ability to raise sufficient amounts of capital to enable our bank subsidiary to achieve the capital commitments it has made to its primary regulators;

 

   

the inability to comply with regulatory capital requirements, including those resulting from recently proposed changes to capital methodologies and required capital maintenance levels;

 

   

changes in accounting policies, rules and practices;

 

   

changes in technology or products that may be more difficult, or costly, or less effective, than anticipated;

 

   

the effects of war or other conflicts, acts of terrorism or other catastrophic events that may affect general economic conditions;

 

   

the effects on deposit liabilities and liquidity as a result of the restrictions on our bank subsidiary’s ability to pay interest on deposits above certain national rate caps as a result of our bank subsidiary entering into the Consent Order;

 

   

results of regulatory examinations;

 

   

the remediation efforts related to the Company’s material weakness in internal control over financial reporting;

 

   

the ability to raise additional capital or return the Company and Bank to a profitable status;

 

   

the prepayment of FDIC insurance premiums and higher FDIC assessment rates;

 

   

the effects of negative publicity, including as a result of our announcing that our bank subsidiary had entered into the Consent Order and that the Company had entered into a written agreement with the Federal Reserve Bank of Atlanta (the “FRB-Atlanta”);

 

   

the effectiveness of the Company’s activities in improving, resolving or liquidating lower quality assets;

 

   

the Company’s recording of a further allowance related to its deferred tax asset; and

 

   

other factors and information described in this report and in any of our other reports that we make with the Securities and Exchange Commission (the “Commission”) under the Exchange Act.

All written or oral forward-looking statements that are made by or are attributable to us are expressly qualified in their entirety by this cautionary notice. Except as required by the federal securities laws we do not undertake to update, revise or correct any of the forward-looking statements after the date of this report, or after the respective dates on which such statements otherwise are made.

 

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The Company

Mountain National is a bank holding company registered with the Board of Governors of the Federal Reserve System (“Federal Reserve”) under the Bank Holding Company Act of 1956, as amended (the “BHC Act”). The Company provides a full range of banking services through its banking subsidiary, Mountain National Bank (the “Bank”).

For the purposes of the discussions in this report, the words “we,” “us,” and “our” refer to the combined entities of the Company and the Bank unless otherwise indicated or evident. The Company’s main office is located at 300 East Main Street, Sevierville, Tennessee 37862. The Company was incorporated as a business corporation in March 2002 under the laws of the State of Tennessee for the purpose of acquiring 100% of the issued and outstanding shares of common stock of the Bank. Effective July 1, 2002, the Company and the Bank entered into a reorganization pursuant to which the Company acquired 100% of the outstanding shares of the Bank and the shareholders of the Bank became the shareholders of the Company. In June 2003, the Company received approval from the FRB-Atlanta to become a bank holding company.

At December 31, 2011, the assets of the Company consisted primarily of its ownership of the capital stock of the Bank.

The Company is authorized to engage in any activity permitted by law to a corporation, subject to applicable federal and state regulatory restrictions on the activities of bank holding companies. The Company’s holding company structure provides it with greater flexibility than the Bank would otherwise have relative to expanding and diversifying its business activities through newly formed subsidiaries or through acquisitions. While management of the Company has no present plans to engage in any other business activities, management may from time to time study the feasibility of establishing or acquiring subsidiaries to engage in other business activities to the extent permitted by law.

The Bank

The Bank is organized as a national banking association. The Bank applied to the Office of the Comptroller of the Currency (the “OCC”), and the Federal Deposit Insurance Corporation, (the “FDIC”), on February 16, 1998, to become an insured national banking association. The Bank received approval from the OCC to organize as a national banking association on June 16, 1998 and commenced business on November 23, 1998. The Bank’s principal business is to accept demand and savings deposits from the general public and to make residential mortgage, commercial and consumer loans.

Our Banking Business

General. Our banking business consists primarily of traditional commercial banking operations, including taking deposits and originating loans. We conduct our banking activities from our main office located in Sevierville, Tennessee and through eight additional branch offices in Sevier County, Tennessee, as well as a regional headquarters and two branch offices in Blount County, Tennessee. Sevier County is adjacent to Knox County, Tennessee and the Knoxville SMSA, and Blount County is also adjacent to Knox County and part of the Knoxville

 

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SMSA. Both Sevier County and Blount County are adjacent to the Great Smokey Mountains National Park and have a significant portion of their respective communities dependent upon the tourism and resort industries. Blount County also benefits from economic growth of the Knoxville SMSA.

We offer a variety of retail banking services. We seek savings and other time and demand deposits from consumers and businesses in our primary market area by offering a full range of deposit accounts, including savings, demand deposit, retirement, including individual retirement accounts, or “IRA’s,” and professional and checking accounts, as well as certificates of deposit. We use the deposit funds we receive to originate mortgage, commercial and consumer loans, and to make other authorized investments. In addition, we currently maintain 18 full-service ATMs throughout our market area. Because the Bank is a member of a number of payment systems networks, Bank customers may also access banking services through ATMs and point of sale terminals throughout the world. In addition to traditional deposit-taking and lending services, we also provide a variety of checking accounts, savings programs, night depository services, safe deposit facilities and credit card plans.

The banking industry is significantly affected by prevailing economic conditions, as well as government policies and regulations concerning, among other things, monetary and fiscal affairs, the housing industry and financial institutions. Deposits at commercial banks are influenced by economic conditions, including interest rates and competing investment instruments, levels of personal income and savings, among others. Lending activities are also influenced by a number of economic factors, including demand for and supply of housing and commercial properties, conditions in the construction industry, local economic and seasonal factors and availability of funds. Our primary sources of funding for lending activities include savings and demand deposits, income from investments, loan principal payments and borrowings. For additional information relating to our deposits and loans, refer to “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

Market Areas. Our primary market areas are Sevier and Blount Counties, contiguous counties located in eastern Tennessee. We intend to continue our focus on these primary market areas in the future. Additionally, even with our current market area focus, some of our business may come from other areas contiguous to our primary market area.

Lending Activities

General. We concentrate on developing a diversified loan portfolio consisting of first mortgage loans secured by residential properties, loans secured by commercial properties and other commercial and consumer loans.

Real Estate Lending. We originate permanent and construction loans having terms in the case of the permanent loans of up to 30 years that are typically secured by residential real estate comprised of single-family dwellings and multi-family dwellings of up to four units. All of our residential real estate loans consist of conventional loans that are not insured or guaranteed by government agencies. We also originate and hold in our portfolio traditional fixed-rate mortgage loans in appropriate circumstances.

 

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Consumer Lending. We originate consumer loans that typically fall into the following categories:

 

   

loans secured by junior liens on real estate, including home improvement and home equity loans, which have an average maturity of about three years and generally are limited to 80% of appraised value, and home equity lines of credit;

 

   

loans secured by personal property, such as automobiles, recreational vehicles or boats, which typically have 36 to 60 month maturities;

 

   

loans to our depositors secured by their time deposit accounts or certificates of deposit;

 

   

unsecured personal loans and personal lines of credit; and

 

   

credit card loans.

Consumer loans generally entail greater risk than residential mortgage loans, particularly in the case of consumer loans that are unsecured or that are secured by rapidly depreciating assets such as automobiles. Where consumer loans are unsecured or secured by depreciating assets, the absence of collateral or the insufficiency of any repossessed collateral to serve as an adequate source of repayment of the outstanding loan balance poses greater risk of loss to us. When a deficiency exists between the outstanding balance of a defaulted loan and the value of collateral repossessed, the borrower’s financial instability and life situations that led to the default (which may include job loss, divorce, illness or personal bankruptcy, among other things) often do not warrant substantial further collection efforts. Furthermore, the application of various federal and state laws, including federal bankruptcy and state insolvency laws, may limit the amount that we can recover in the event a consumer defaults on an unsecured or undersecured loan.

Construction Lending. We offer single-family residential construction loans to borrowers for construction of one-to-four family residences in our primary market area, although volume has reduced substantially. Generally, we limit our construction lending to construction-permanent loans and make these loans to individuals building their primary residences. We also originate construction loans to selected local builders for construction of single-family dwellings.

Our construction loans may have fixed or adjustable interest rates and are underwritten in accordance with the same standards that we apply to permanent mortgage loans, with the exception that our construction loans generally provide for disbursement of the loan amount in stages during a construction period of up to 12 months, during which period the borrower is required to make monthly payments of accrued interest on the outstanding loan balance. We typically require a maximum loan-to-value ratio of 80% on construction loans we originate. While our construction loans generally convert to permanent loans following construction, the construction loans we extend to builders generally require repayment in full upon the completion of construction, or, alternatively, may be assumed by the borrower.

Construction lending affords us the opportunity to earn higher interest rates and fees with shorter terms to maturity than does single-family permanent mortgage lending. Construction lending, however, is generally considered to involve a higher degree of risk than single-family permanent mortgage lending because of the inherent difficulty in estimating both a property’s

 

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value at completion of the project and the projected cost of the project. If the estimate of construction cost proves to be inaccurate, we may be required to advance funds beyond the amount originally committed to complete the project. If the estimate of value upon completion proves inaccurate, we may be confronted at, or prior to, the maturity of the loan with collateral of insufficient value to assure full repayment. Construction projects may also be jeopardized by downturns in the economy or demand in the area where the project is being undertaken, disagreements between borrowers and builders and by the failure of builders to pay subcontractors.

Commercial Lending. We originate secured and unsecured loans for commercial, corporate, business and agricultural purposes, and we engage in commercial real estate activities consisting of loans for hotels, motels, restaurants, retail store outlets and service providers such as insurance agencies. Currently, we concentrate our commercial lending efforts on originating loans to small businesses for purposes of providing working capital, capital improvements, and construction and leasehold improvements. These loans typically have one-year maturities, if they are unsecured loans, or, in the case of small business loans secured by real estate, have an average maturity of approximately two years.

Commercial lending, while generally considered to involve a higher degree of credit risk than long-term financing of residential properties, generally provides higher yields and greater interest rate sensitivity than do residential mortgage loans. Commercial loans are generally adjustable rate loans or loans that have short-term maturities of one to five years. The higher risks inherent in commercial lending include risks specific to the business venture, delays in leasing the collateral and excessive collateral dependency, vacancy, delays in obtaining or inability to obtain permanent financing and difficulties we may experience in exerting influence over or acquiring the collateral following a borrower’s default. Moreover, commercial loans often carry larger loan balances to single borrowers or groups of related borrowers than do residential real estate loans. With respect to commercial real estate lending, the borrower’s ability to make principal and interest payments on loans secured by income-producing properties is typically dependent on the successful operation of the related real estate project and thus may be subject to a greater extent to adverse conditions in the real estate market or in the economy generally. We attempt to mitigate the risks inherent in commercial lending by, among other things, securing our loans with adequate collateral and extending commercial loans only to persons located in our primary market area.

Creditworthiness and Collateral. We require each prospective borrower to complete a detailed loan application which we use to evaluate the applicant’s creditworthiness. All loan applications are reviewed and approved or disapproved in accordance with guidelines established by the Bank’s Board of Directors. We also require that loan collateral be appraised by an in house evaluation or by independent appraisers approved by the Bank’s Board of Directors and require borrowers to maintain fire and casualty insurance on collateral in accordance with guidelines established by the Bank’s Board of Directors. Title insurance is required for most real property collateral.

Loan Originations. We originate loans primarily for our own portfolio but, subject to market conditions, we may sell certain loans we originate in the secondary market. Initially, most of our loans are originated based on referrals and to walk-in customers. We also use various methods of local advertising to stimulate originations.

 

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Secondary Market Activities. We engage in secondary mortgage market activities, principally the sale of certain residential mortgage loans on a servicing-released basis, subject to market conditions. Secondary mortgage market activities permit us to generate fee income and sale income to supplement our principal source of income - net interest income resulting from the interest margin between the yield on interest-earning assets like loans and investment securities and the interest paid on interest-bearing liabilities such as savings deposits, time deposit certificates and funds borrowed by the Bank.

From time to time we originate a limited number of permanent, conventional residential mortgage loans that we sell on a servicing-released basis to private institutional investors such as savings institutions, banks, life insurance companies and pension funds. We originate these loans on terms and conditions similar to those required for sale to the Federal Home Loan Mortgage Corporation (“FHLMC”), the Federal National Mortgage Association (“FNMA”), the Federal Housing Administration (“FHA”) and the Veterans Administration (“VA”), except that we occasionally offer these loans with higher dollar limits than are permissible for FHLMC or FNMA-eligible loans.

The loan-to-value ratios we require for the residential mortgage loans we originate are determined based on guidelines established by the Bank’s Board of Directors pursuant to applicable law.

Income from Lending Activities. Our lending activities generate interest and loan origination fee income. Loan origination fees are calculated as a percentage of the principal amount of the mortgage loans we originate and are charged to the borrower by the Bank for originating the loan. We also receive loan fees and charges related to existing loans, which include late charges and assumption fees.

Loan Delinquencies and Defaults. When a borrower fails to make a required loan payment for 30 days, we classify the loan as delinquent. If the delinquency exceeds 90 days and is not cured through the Bank’s normal collection procedures, we institute more formal recovery efforts. If a foreclosure action is initiated and the loan is not reinstated, paid in full or refinanced, the property is sold at a judicial or trustee sale at which, in some instances, the Bank acquires the property. Thereafter, such acquired property is recorded in the Bank’s records as “other real estate owned” (“OREO”) until the property is sold. In some cases, we may finance sales of OREO, which may involve our origination of “loans to facilitate” that typically involve a lower down payment, a lower interest rate and/or a longer term.

Investment Activities

Our investment securities portfolio is an integral part of our total assets and liabilities management strategy. We use our investments, in part, to further our interest rate risk management objective of reducing our sensitivity to interest-rate fluctuations. Our primary objective in making investment determinations with respect to our securities portfolio is to achieve a high degree of maturity and rate matching between these assets and our interest-bearing liabilities. In order to achieve this goal, we concentrate our investments, which constituted approximately 19% of our total assets at December 31, 2011, in U.S. government securities or other securities of similar low risk. The U.S. government and other investment-grade securities in which we invest typically have maturities ranging from 30 days to 30 years.

 

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Sources of Funds

General. Deposits are the primary source of funds we use to support our lending activities and other general business activities. Other sources of funds include loan repayments, loan sales and borrowings. Although deposit activity is significantly influenced by fluctuations in interest rates and general market conditions, loan repayments are a relatively stable source of funds. We also use short-term borrowings to compensate in periods where our normal funding sources are insufficient to satisfy our funding needs. We use long-term borrowings to support extended activities and to extend the term of our liabilities.

Deposits. We offer a variety of programs designed to attract both short-term and long-term deposits from the general public in our market areas. These programs include savings accounts, NOW accounts, demand deposit accounts, money market deposit accounts, fixed-rate and variable-rate certificate of deposit accounts of varying maturities, retirement accounts and certain other accounts. We particularly focus on promoting long-term deposits, such as IRA accounts and certificates of deposit. Additionally, we historically have used brokered deposits that are comparable to our traditional certificates of deposit; however, management has significantly to reduced its reliance on this source of wholesale funding as required by the consent order (the “Consent Order”), as discussed in more detail below under Bank Regulation.

Borrowings. The Bank became a member of the Federal Home Loan Bank of Cincinnati (the “FHLB of Cincinnati”) in December 2001. The FHLB of Cincinnati functions as a central reserve bank that provides credit for member institutions. As a member, the Bank is required to own capital stock in the FHLB of Cincinnati. Membership in the FHLB of Cincinnati entitles the Bank, provided certain standards related to creditworthiness have been met, to apply for advances on the security of the FHLB of Cincinnati stock it holds as well as on the security of certain of its residential mortgage loans, commercial loans and other assets (principally, its investment securities that are obligations of, or guaranteed by, the United States). The FHLB of Cincinnati makes advances to the Bank pursuant to several different credit programs. Each credit program has its own interest rate and range of maturities. Interest rates on FHLB of Cincinnati advances are generally variable and adjust to reflect actual conditions existing in the credit markets. The uses for which we may employ funds received pursuant to FHLB of Cincinnati advances are prescribed by the various lending programs, which also prescribe borrowing limitations. Acceptable uses prescribed by the FHLB of Cincinnati have included expansion of residential mortgage lending and funding short-term liquidity needs. Depending on the particular credit program under which we borrow, borrowing limitations are generally based on the FHLB of Cincinnati’s assessment of our creditworthiness. The FHLB of Cincinnati is required to review the credit limitations and standards to which we are subject at least once every six months.

Financing. In August of 1998, the Bank completed an offering of common stock which yielded proceeds of $12,000,000. On November 7, 2003, the Company completed the sale, through its wholly owned statutory trust subsidiary, MNB Capital Trust I, of $5,500,000 of trust preferred securities, which we refer to as “Capital Securities I,” which mature on December 31, 2033, and have a liquidation amount of $50,000 per Capital Security. Interest on the Capital Securities I is to be paid quarterly on the last day of each March, June, September and December and is reset quarterly based on the three-month LIBOR plus 305 basis points. The Company used the net proceeds from the offering of Capital Securities I to pay off an outstanding line of credit.

 

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On June 20, 2006, the Company completed the sale, through its wholly owned statutory trust subsidiary, MNB Capital Trust II, of $7,500,000 of trust preferred securities, which we refer to as “Capital Securities II,” which mature on July 7, 2036, and have a liquidation amount of $1,000 per Capital Security. Interest on the Capital Securities II is to be paid quarterly on the seventh day of each January, April, July and October and is reset quarterly based on the three-month LIBOR plus 160 basis points. The Company used the net proceeds from the offering of Capital Securities II to increase regulatory capital for the Company and for operating funds for the Bank.

On December 14, 2010, the Company exercised its rights to defer regularly scheduled interest payments on all of its issues of junior subordinated debentures relating to outstanding trust preferred securities. The regular scheduled interest payments will continue to be accrued for payment in the future and reported as an expense for financial statement purposes. During the period in which it is deferring the payment of interest on its subordinated debentures, the Company may not pay any dividends on its common stock.

Competition

We face significant competition in our primary market areas from a number of sources, including eight commercial banks and one savings institution in Sevier County and twelve commercial banks and one savings institution in Blount County. As of June 30, 2011, there were 60 commercial bank branches and three savings institutions branches located in Sevier County and 56 commercial bank branches and one savings institution branch located in Blount County.

The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 and other federal and state laws have resulted in increased competition from both conventional banking institutions and other businesses offering financial services and products. Mortgage banking firms, finance companies, real estate investment trusts, insurance companies, leasing companies and certain government agencies provide additional competition for loans and for certain financial services. We also compete for deposit accounts with a number of other financial intermediaries, including securities brokerage firms, money market mutual funds, government and corporate securities and credit unions. The primary criteria on which institutions compete for deposits and loans are interest rates, loan origination fees and range of services offered.

During our operating history, we have been successful in hiring a staff with significant local bank experience that shares our commitment to providing our customers with the highest levels of customer service. While focusing on customer service, we are also able to offer our customers most of the banking services offered by our local competitors, including Internet banking, investment services and sweep accounts.

Employees

We currently employ a total of 143 employees, including 138 full time employees. We are not a party to any collective bargaining agreements with our employees, and we consider relations with our employees to be good.

 

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Seasonality

Due to the predominance of the tourism industry in Sevier County, a significant portion of our commercial loan portfolio is concentrated within that industry. The predominance of the tourism industry also makes our business more seasonal in nature than may be the case with banks and financial institutions in other market areas. Deposit growth generally slows during the first quarter each year and then increases during each of the last three quarters. The tourism industry in Sevier County has remained relatively stable during the past couple of years, particularly with respect to overnight rentals and hospitality services, and management does not anticipate any significant changes in that trend in the future.

Supervision and Regulation

Bank holding companies and banks are extensively regulated under federal and state law. These laws and regulations are generally intended to protect depositors and borrowers, not shareholders. In July 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) was signed into law, incorporating numerous financial institution regulatory reforms. Many of these reforms have been implemented over the course of 2011 through regulations adopted by various federal banking and securities regulations, and additional regulations are expected to be implemented in 2012 and beyond. This law has begun to significantly change the current bank regulatory structure and affect the lending, deposit, investment, trading and operating activities of financial institutions and their holding companies, including the Company and the Bank. A broad range of new rules and regulations by various federal agencies have been adopted (with more to come) and, consequently, many details and much of the impact of this act may not be known for many months or years.

This discussion is qualified in its entirety by reference to the particular statutory and regulatory provisions referred to below and is not intended to be a complete description of the statutes or regulations applicable to the Company’s and the Bank’s business. Supervision, regulation, and examination of the Company and the Bank and their respective subsidiaries by the bank regulatory agencies are intended primarily for the protection of bank depositors rather than holders of Company capital stock. Any change in applicable law or regulation may have a material effect on the Company’s business.

Bank Holding Company Regulation

The Company, as a bank holding company, is subject to supervision and regulation by the Board of Governors of the Federal Reserve under the BHC Act. Bank holding companies are generally limited to the business of banking, managing or controlling banks, and other activities that the Federal Reserve determines to be so closely related to banking, or managing or controlling banks, as to be a proper incident thereto. The Company is required to file with the Federal Reserve periodic reports and such other information as the Federal Reserve may request. The Federal Reserve examines the Company and may examine non-bank subsidiaries the Company may acquire.

 

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The BHC Act requires prior Federal Reserve approval for, among other things, the acquisition by a bank holding company of direct or indirect ownership or control of more than 5% of the voting shares or substantially all the assets of any bank, or for a merger or consolidation of a bank holding company with another bank holding company. With certain exceptions, the BHC Act prohibits a bank holding company from acquiring direct or indirect ownership or control of voting shares of any company which is not a bank or bank holding company, and from engaging directly or indirectly in any activity other than banking or managing or controlling banks or performing services for its authorized subsidiaries. A bank holding company, may, however, engage in or acquire an interest in a company that engages in activities which the Federal Reserve has determined by regulation or order to be so closely related to banking or managing or controlling banks as to be a proper incident thereto.

The Gramm-Leach-Bliley Act of 1999 (the “GLB Act”) substantially revised the statutory restrictions separating banking activities from certain other financial activities. Under the GLB Act, bank holding companies that are “well-capitalized” and “well-managed”, as defined in Federal Reserve Regulation Y, which have and maintain “satisfactory” Community Reinvestment Act (“CRA”) ratings, and meet certain other conditions, can elect to become “financial holding companies.” Financial holding companies and their subsidiaries are permitted to acquire or engage in previously impermissible activities such as insurance underwriting, securities underwriting, travel agency activities, broad insurance agency activities, merchant banking, and other activities that the Federal Reserve determines to be financial in nature or complementary thereto. In addition, under the merchant banking authority added by the GLB Act and Federal Reserve regulation, financial holding companies are authorized to invest in companies that engage in activities that are not financial in nature, as long as the financial holding company makes its investment with the intention of limiting the term of its investment and does not manage the company on a day-to-day basis, and the invested company does not cross-market with any of the financial holding company’s controlled depository institutions. Financial holding companies continue to be subject to the overall oversight and supervision of the Federal Reserve, but the GLB Act applies the concept of functional regulation to the activities conducted by subsidiaries. For example, insurance activities would be subject to supervision and regulation by state insurance authorities. While the Company has no present plans to become a financial holding company, it may elect to do so in the future in order to exercise the broader activity powers provided by the GLB Act. The GLB Act also includes consumer privacy provisions, and the federal bank regulatory agencies have adopted extensive privacy rules implementing the GLB Act.

The Company is a legal entity separate and distinct from the Bank. Various legal limitations restrict the Bank from lending or otherwise supplying funds to the Company. The Company and the Bank are subject to Section 23A of the Federal Reserve Act and Federal Reserve Regulation W thereunder. Section 23A defines “covered transactions,” which include extensions of credit, and limits a bank’s covered transactions with any affiliate to 10% of such bank’s capital and surplus. All covered and exempt transactions between a bank and its affiliates must be on terms and conditions consistent with safe and sound banking practices, and banks and their subsidiaries are prohibited from purchasing low-quality assets from the bank’s affiliates. Finally, Section 23A requires that all of a bank’s extensions of credit to its affiliates be appropriately secured by acceptable collateral, generally United States government or agency securities. The Company and the Bank also are subject to Section 23B of the Federal Reserve Act, which generally limits covered and other transactions among affiliates to be on terms, including credit standards, that are substantially the same or at least as favorable to the bank or its subsidiary as those prevailing at the time for similar transactions with unaffiliated companies.

 

 

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The Dodd-Frank Act expands the affiliate transaction rules of the federal law to broaden the definition of affiliate and to apply such rules to securities lending, repurchase agreements, and derivative activities that the Bank may have with an affiliate, as well as to strengthen collateral requirements and limit FRB exemptive authority. The definition of “extension of credit” for transactions with executive officers, directors, and principal shareholders is also being expanded to include credit exposure arising from a derivative transaction, a repurchase or reverse repurchase agreement, and securities lending or borrowing transactions.

The BHC Act, as amended by the Dodd-Frank Act, permits acquisitions of banks by bank holding companies, such that, if well-capitalized and well managed, Mountain National and any other bank holding company located in Tennessee may acquire a bank located in any other state, and, if well-capitalized and well managed, any bank holding company located outside Tennessee may lawfully acquire any bank based in another state, subject to certain deposit-percentage, age of bank charter requirements, and other restrictions. Federal law also permits national and state-chartered banks to branch interstate through acquisitions of banks in other states. Under Tennessee law, in order for an out-of-state bank or bank holding company to establish a branch in Tennessee, the bank or bank holding company must purchase an existing bank, bank holding company, or branch of a bank in Tennessee which has been in existence for at least three years. De novo interstate branching is permitted under Tennessee law on a reciprocal basis. The Bank is eligible to be acquired by any bank or bank holding company, whether inter-or intrastate, since it has been in existence for more than three years.

Under the Dodd-Frank Act and previously under Federal Reserve policy a bank holding company is required to act as a source of financial strength and to take measures to preserve and protect its bank subsidiaries in situations where additional investments in a troubled bank may not otherwise be warranted. In addition, under the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (“FIRREA”), where a bank holding company has more than one bank or thrift subsidiary, each of the bank holding company’s subsidiary depository institutions are responsible for any losses to the FDIC as a result of an affiliated depository institution’s failure. As a result, a bank holding company may be required to loan money to its subsidiaries in the form of capital notes or other instruments that qualify as capital under regulatory rules. However, any loans from the holding company to such subsidiary banks likely will be unsecured and subordinated to such bank’s depositors and perhaps to other creditors of the bank.

Bank Regulation

The Bank is subject to supervision, regulation, and examination by the OCC which monitors all areas of the operations of the Bank, including reserves, loans, mortgages, issuances of securities, payment of dividends, establishment of branches, capital adequacy, and compliance with laws. The Bank is a member of the FDIC and, as such, its deposits are insured by the FDIC to the maximum extent provided by law. See “FDIC Insurance Assessments”.

 

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While the OCC has authority to approve branch applications, national banks are required by the National Bank Act to adhere to branching laws applicable to state chartered banks in the states in which they are located. With prior regulatory approval, Tennessee law permits banks based in the state to either establish new or acquire existing branch offices throughout Tennessee and in other states on a reciprocal basis. Mountain National and any other national or state-chartered bank generally may branch across state lines by merging with banks in other states if allowed by the applicable states’ laws. Tennessee law, with limited exceptions, currently permits branching across state lines either through interstate merger or branch acquisition. Tennessee, however, only permits an out-of-state bank, short of an interstate merger, to branch into Tennessee through branch acquisition if the home state of the out-of-state bank permits Tennessee-based banks to acquire branches there.

The OCC has adopted a series of revisions to its regulations, including expanding the powers exercisable by operating subsidiaries of the Bank. These changes also modernize and streamline corporate governance, investment and fiduciary powers. The OCC also has the ability to preempt state laws purporting to regulate the activities of national banks.

The OCC has adopted the Federal Financial Institutions Examination Council’s (“FFIEC”) rating system and assigns each financial institution a confidential composite rating based on an evaluation and rating of six essential components of an institution’s financial condition and operations including Capital Adequacy, Asset Quality, Management, Earnings, Liquidity and Sensitivity to market risk, as well as the quality of risk management practices. For most institutions, the FFIEC has indicated that market risk primarily reflects exposures to changes in interest rates. When regulators evaluate this component, consideration is expected to be given to: (i) management’s ability to identify, measure, monitor, and control market risk; (ii) the institution’s size; (iii) the nature and complexity of its activities and its risk profile; and (iv) the adequacy of its capital and earnings in relation to its level of market risk exposure. Market risk is rated based upon, but not limited to, an assessment of the sensitivity of the financial institution’s earnings or the economic value of its capital to adverse changes in interest rates, foreign exchange rates, commodity prices, or equity prices; management’s ability to identify, measure, monitor, and control exposure to market risk; and the nature and complexity of interest rate risk exposure arising from non-trading positions.

In February 2010, the Bank agreed to an OCC requirement to maintain a minimum Tier 1 capital to average assets ratio of 9% and a minimum total capital to risk-weighted assets ratio of 13%. The OCC imposed this requirement to maintain capital at higher levels than those required by applicable federal regulations because the OCC believed that the Bank’s capital levels were less than satisfactory given the level of credit risk in the Bank, specifically the high level of nonperforming assets and provision for loan losses.

In October 2011, the Bank accepted a Stipulation and Consent (the “Consent”) of the Bank to the issuance of the Consent Order by the OCC.

Under the terms of the Consent Order, the Bank agreed to take the following actions:

 

   

Maintain a Board committee to oversee the Bank’s compliance with the Consent Order;

 

   

Develop, within 60 days of the date of the Consent Order, a strategic plan covering at least a three-year period that establishes objectives for the Bank’s overall risk profile, earnings performance, growth, balance sheet mix, off-balance sheet activities, liability structure, capital adequacy, reduction in volume of nonperforming assets, product line development, and market segments that the Bank intends to promote or develop, together with strategies to achieve those objectives;

 

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Develop and implement, within 60 days of the date of the Consent Order, a capital plan that increases the Bank’s Total risk-based capital ratio and Tier 1 capital ratio to at least 12% and 9%, respectively;

 

   

Prepare and submit, within 90 days of the date of the Consent Order, a written assessment of the capabilities of certain of the Bank’s officers and, if the Board of Directors of the Bank determines an officer’s performance needs improvement, implement a written program to improve the officer’s performance, skills and abilities;

 

   

Ensure adherence to the Bank’s written program to reduce and manage the high level of credit risk in the Bank, and at least quarterly prepare a written assessment of the Bank’s credit risk and the Bank’s adherence to the program;

 

   

Implement and adhere to a written program designed to protect the Bank’s interest in those assets criticized as “doubtful”, “substandard” or “special mention”;

 

   

Not extend, directly or indirectly, any additional credit to any borrower whose loans or other extensions of credit are criticized and whose aggregate loans and extensions of credit exceed $250,000, unless the Board of Directors of the Bank makes certain determinations;

 

   

Establish, within 60 days of the date of the Consent Order, an effective independent and ongoing independent loan review program to review, at least semi-annually, the Bank’s loan portfolio, to assure timely identification and categorization of problem credits;

 

   

Maintain and adhere to a written policy and procedures for the maintenance of an adequate Allowance for Loan and Lease Losses;

 

   

Adopt, implement and ensure adherence to an independent, risk-based audit program of all Bank operations and ensure immediate actions are undertaken to remedy deficiencies cited in audit reports;

 

   

Revise and maintain, within 60 days of the date of the Consent Order, a comprehensive liability risk management program; and

 

   

Agree to certain limitations on third party contracts.

If the Bank fails to comply with the requirements of the Consent Order, the OCC may impose additional limitations, restraints, commitments or conditions on the Bank. As noted below under “Capital,” the Bank’s ratio of Tier 1 capital to average assets was 2.10% and its ratio of total capital to risk-weighted assets ratio was 4.35% at December 31, 2011 and thus failed to satisfy either of the capital ratios required by the Consent Order. Failure to satisfy such requirement could result in further enforcement action by the OCC. All actions are continuous and subject to review and revision by the OCC.

On November 16, 2011, the Company entered into a Written Agreement (the “Agreement”) with the FRB-Atlanta. Pursuant to the terms of the Written Agreement, the Company has agreed with the FRB-Atlanta that: (i) its board of directors shall take appropriate steps to fully utilize the Company’s financial and managerial resources to serve as a source of strength to the Bank, including, but not limited to, taking steps to ensure that the Bank complies with the Formal Agreement entered into with the OCC on June 2, 2009 and any other supervisory action taken by the OCC; (ii) the Company shall not declare or pay any dividends

 

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without the prior written approval of the FRB-Atlanta and the Director of the Division of Banking Supervision and Regulation of the Board of Governors of the Federal Reserve System (the “Director”); (iii) the Company shall not directly or indirectly take dividends or any other form of payment representing a reduction in capital from the Bank without the prior written approval of the FRB-Atlanta; (iv) the Company and its nonbank subsidiaries shall not make any distributions of interest, principal, or other sums on subordinated debentures or trust preferred securities without the prior written approval of the FRB-Atlanta and the Director; (v) the Company and its nonbank subsidiaries shall not, directly or indirectly, incur, increase, or guarantee any debt without the prior written approval of the FRB-Atlanta; (vi) the Company shall not, directly or indirectly, purchase or redeem any shares of its stock without the prior written approval of the FRB-Atlanta; and (vii) within 60 days of this Agreement, the Company shall submit to the FRB-Atlanta an acceptable written plan to maintain sufficient capital at the Company on a consolidated basis. The Company is also required to comply with certain notice and approval requirements in connection with director and senior executive officer appointments and is subject to certain restrictions on indemnification and severance payments. In addition, the Company must submit quarterly progress reports to the FRB-Atlanta.

The GLB Act requires banks and their affiliated companies to adopt and disclose privacy policies regarding the sharing of personal information they obtain from their customers with third parties. The GLB Act also permits bank subsidiaries to engage in “financial activities” through subsidiaries similar to those permitted to financial holding companies. See the discussion regarding the GLB Act in “Bank Holding Company Regulation” above.

Community Reinvestment Act

The Company and the Bank are subject to the CRA and the federal banking agencies’ regulations. Under the CRA, all banks and thrifts have a continuing and affirmative obligation, consistent with their safe and sound operation to help meet the credit needs for their entire communities, including low and moderate income neighborhoods. The CRA requires a depository institution’s primary federal regulator, in connection with its examination of the institution, to assess the institution’s record of assessing and meeting the credit needs of the communities served by that institution, including low- and moderate-income neighborhoods. The regulatory agency’s assessment of the institution’s record is made available to the public. Further, such assessment is required of any institution which has applied to: (i) charter a national bank; (ii) obtain deposit insurance coverage for a newly-chartered institution; (iii) establish a new branch office that accepts deposits; (iv) relocate an office; (v) merge or consolidate with, or acquire the assets or assume the liabilities of, a federally regulated financial institution, or (vi) expand other activities, including engaging in financial services activities authorized by the GLB Act. A less than satisfactory CRA rating will slow, if not preclude, expansion of banking activities and prevent a company from becoming a financial holding company. The Bank has a satisfactory CRA rating.

The GLB Act and federal bank regulations have made various changes to the CRA. Among other changes, CRA agreements with private parties must be disclosed and annual CRA reports must be made to a bank’s primary federal regulator. A bank holding company will not be permitted to become or remain a financial holding company and no new activities authorized under the GLB Act may be commenced by a holding company or by a bank financial subsidiary

 

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if any of its bank subsidiaries received less than a “satisfactory” CRA rating in its latest CRA examination. Under current OCC regulations, the Bank has intermediate small bank status. The requirements for an intermediate small bank to meet its CRA objectives are more stringent than those for a small bank, but less so than those for large banks.

The Dodd-Frank Act also creates a new Bureau of Consumer Financial Protection (the “CFPB”) that will take over responsibility for the federal consumer financial protection laws. The CFPB will be an independent bureau within the FRB and will have broad rule-making, supervisory and examination authority to set and enforce rules in the consumer protection area over financial institutions that have assets of $10.0 billion or more. The Dodd-Frank Act also gives the CFPB expanded data collecting powers for fair lending purposes for both small business and mortgage loans, as well as expanded authority to prevent unfair, deceptive and abusive practices. The consumer complaint function will also be consolidated into the CFPB.

Several major regulatory and legislative initiatives adopted and revised by the Dodd-Frank Act, have had, and could continue to have, significant future impacts on our business and financial results. Amendments to Regulation E, which implement the Electronic Fund Transfer Act (the “EFTA”), involve changes to the way banks may charge overdraft fees by limiting our ability to charge an overdraft fee for ATM and one-time debit card transactions that overdraw a consumer’s account, unless the consumer affirmatively consents to payment of overdrafts for those transactions. Additional amendments to the EFTA include the “Durbin Act,” which limits debit card interchange fees that banks may charge merchants.

The Bank is also subject to, among other things, the provisions of the Equal Credit Opportunity Act (the “ECOA”) and the Fair Housing Act (the “FHA”), both of which prohibit discrimination based on race or color, religion, national origin, sex, and familial status in any aspect of a consumer or commercial credit or residential real estate transaction. In 1994, the Department of Housing and Urban Development, the Department of Justice (the “DOJ”), and the federal banking agencies issued an Interagency Policy Statement on Discrimination in Lending in order to provide guidance to financial institutions in determining whether discrimination exists, how the agencies will respond to lending discrimination, and what steps lenders might take to prevent discriminatory lending practices. The DOJ has also increased its efforts to prosecute what it regards as violations of the ECOA and FHA.

Sarbanes-Oxley Act

We are required to comply with various corporate governance and financial reporting requirements under the Sarbanes-Oxley Act of 2002, as well as rules and regulations adopted by the SEC and the Public Company Accounting Oversight Board thereunder. In particular, we are required to include management reports on internal controls as part of our annual reports that we file with the SEC, pursuant to Section 404 of the Sarbanes-Oxley Act. We have spent significant amounts of time and money on compliance with these rules and anticipate a similar burden going forward. Our failure to comply with these internal control rules may materially adversely affect our reputation, our ability to obtain the necessary certifications to our financial statements, and the values of our securities.

 

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Payments of Dividends

The Company is a legal entity separate and distinct from the Bank. The prior approval of the OCC is required if the total of all dividends declared by a national bank (such as the Bank) in any calendar year will exceed the sum of such bank’s net profits for the year and its retained net profits for the preceding two calendar years, less any required transfers to surplus. Federal law also prohibits any national bank from paying dividends that would be greater than such bank’s undivided profits after deducting statutory bad debts in excess of such bank’s allowance for possible loan losses.

In addition, the Company and the Bank are subject to various general regulatory policies and requirements relating to the payment of dividends, including requirements to maintain adequate capital above regulatory minimums. The appropriate federal regulatory authority is authorized to determine under certain circumstances relating to the financial condition of a national or state member bank or a bank holding company that the payment of dividends would be an unsafe or unsound practice and to prohibit payment thereof. The OCC and the Federal Reserve have indicated that paying dividends that deplete a national or state member bank’s capital base to an inadequate level would be an unsound and unsafe banking practice. The OCC and the Federal Reserve have each indicated that depository institutions and their holding companies should generally pay dividends only out of current operating earnings.

Given the losses experienced by the Bank during 2010 and 2011, the Bank may not, without the prior approval of the OCC, pay any dividends to the Company until such time that current year profits exceed the net losses and dividends of the prior two years. Moreover, the Bank and the Company are prohibited from paying dividends without the consent of their primary regulators pursuant to the terms of the Consent Order and the Agreement, respectively. Generally, federal regulatory policy discourages payment of holding company or bank dividends if the holding company or its subsidiaries are experiencing losses. Accordingly, until such time as it may receive dividends from the Bank, the Company must service its interest payment on its subordinated indebtedness from its available cash balances, if any.

On December 14, 2010, the Company exercised its rights to defer regularly scheduled interest payments on all of its issues of junior subordinated debentures relating to outstanding trust preferred securities. The regular scheduled interest payments will continue to be accrued for payment in the future and reported as an expense for financial statement purposes. During the period in which it is deferring the payment of interest on its subordinated debentures, the Company may not pay any dividends on its common stock. The Company may defer the payment of dividends on its subordinated debentures for up to 20 consecutive quarters without the failure to pay such dividends constituting an event of default. Thereafter, the failure to pay such dividends would, unless all accrued and unpaid dividends are paid, constitute an event of default which would allow the holders of such subordinated debentures, or the associated trust preferred securities, to accelerate the principal payable thereunder, which could result in the Company’s bankruptcy. In a bankruptcy, the Company’s common shareholders’ investment in the Company would be worthless.

 

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Supervisory guidance from the Federal Reserve Board indicates that bank holding companies that are experiencing financial difficulties generally should eliminate, reduce or defer dividends on Tier 1 capital instruments including trust preferred securities, preferred stock or common stock, if the holding company needs to conserve capital for safe and sound operation and to serve as a source of strength to its subsidiaries. Pursuant to the Agreement, the Company agreed with the FRB-Atlanta that it will not (1) declare or pay dividends on the Company’s common or preferred stock, or (2) incur any additional indebtedness without, in each case, the prior written approval of the FRB-Atlanta.

Capital

The Federal Reserve and the OCC have risk-based capital guidelines for bank holding companies and national banks, respectively. These guidelines require a minimum ratio of capital to risk-weighted assets (including certain off-balance-sheet activities, such as standby letters of credit) of 8%. At least half of the total capital must consist of common equity, retained earnings, noncumulative perpetual preferred stock and a limited amount of cumulative perpetual preferred stock, less goodwill and other specified intangible assets (“Tier 1 capital”). Additionally, qualified trust preferred securities, for certain eligible companies, and other restricted capital elements such as minority interests in the equity accounts of consolidated subsidiaries are permitted to be included as Tier 1 capital up to 25% of core capital, net of goodwill and intangibles. Following passage of the Dodd-Frank Act, trust preferred and cumulative preferred securities will no longer be deemed Tier 1 capital for bank holding companies, but trust preferred securities issued by bank holding companies with under $15 billion in total assets at December 31, 2009 will be grandfathered in and continue to count as Tier 1 capital. However, the proposed Basel III capital reforms ignore the grandfathering for smaller community banks and phase out trust preferred securities from Tier 1 capital over a ten year period. If these proposed rules are adopted, as proposed, the trust preferred securities we have issued will begin to be excluded from our calculation of Tier 1 capital. Voting common equity must be the predominant form of capital. The remainder may consist of non-qualifying preferred stock, qualifying subordinated, perpetual, and/or mandatory convertible debt, up to 45% of pretax unrealized holding gains on available for sale equity securities with readily determinable market values that are prudently valued, and a limited amount of any loan loss allowance (“Tier 2 capital” and, together with Tier 1 capital, “Total Capital”).

In addition, the Federal Reserve and the OCC have established minimum leverage ratio guidelines for bank holding companies and national banks, which provide for a minimum leverage ratio of Tier 1 capital to adjusted average quarterly assets (“leverage ratio”) equal to 3%, plus an additional cushion of 1.0% to 2.0%, if the institution has less than the highest regulatory rating. The guidelines also provide that institutions experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels without significant reliance on intangible assets. Higher capital may be required in individual cases depending upon a bank holding company’s risk profile. All bank holding companies and banks are expected to hold capital commensurate with the level and nature of their risks, including the volume and severity of their problem loans. Lastly, the Federal Reserve’s guidelines indicate that the Federal Reserve will continue to consider a “tangible Tier 1 leverage ratio” (deducting all intangibles) in evaluating proposals for expansion or new activity.

 

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The Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”), among other things, requires the federal banking agencies to take “prompt corrective action” regarding depository institutions that do not meet minimum capital requirements. FDICIA establishes five capital tiers: “well capitalized”, “adequately capitalized”, “undercapitalized”, “significantly undercapitalized”, and “critically undercapitalized”. A depository institution’s capital tier will depend upon how its capital levels compare to various relevant capital measures and certain other factors, as established by regulation.

All of the federal banking agencies have adopted regulations establishing relevant capital measures and relevant capital levels. The relevant capital measures are the Total Capital ratio, Tier 1 capital ratio, and the leverage ratio. Under the regulations, a national bank will be (i) well capitalized if it has a Total Capital ratio of 10% or greater, a Tier 1 capital ratio of 6% or greater, and a leverage ratio of at least 5%, and is not subject to any written agreement, order, capital directive, or prompt corrective action directive by a federal bank regulatory agency to meet and maintain a specific capital level for any capital measure, (ii) adequately capitalized if it has a Total Capital ratio of 8% or greater, a Tier 1 capital ratio of 4% or greater, and a leverage ratio of 4% or greater (3% in certain circumstances), (iii) undercapitalized if it has a Total Capital ratio of less than 8%, or a Tier 1 capital ratio of less than 4% (3% in certain circumstances), (iv) significantly undercapitalized if it has a total capital ratio of less than 6% or a Tier I capital ratio of less than 3%, or a leverage ratio of less than 3%, or (v) critically undercapitalized if its tangible equity is equal to or less than 2% of average quarterly tangible assets.

On June 7, 2012, the federal bank regulatory agencies issued a series of proposed rules that would revise their risk-based and leverage capital requirements and their method for calculating risk-weighted assets to make them consistent with the agreements that were reached by the Basel Committee on Banking Supervision in “Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems” (“Basel III”) and certain provisions of the Dodd-Frank Act. The proposed rules would apply to all depository institutions, top-tier bank holding companies with total consolidated assets of $500 million or more, and top-tier savings and loan holding companies (“banking organizations”). Among other things, the proposed rules establish a new common equity tier 1 minimum capital requirement of 4.5% and a higher minimum tier 1 capital requirement of 6.0% and assign higher risk weightings (150%) to exposures that are more than 90 days past due or are on nonaccrual status and certain commercial real estate facilities that finance the acquisition, development or construction of real property. Additionally, the U.S. implementation of Basel III contemplates that, for banking organizations with less than $15 billion in assets, the ability to treat trust preferred securities as tier 1 capital would be phased out over a ten-year period. The proposed rules also required unrealized gains and losses on certain securities holdings to be included for purposes of calculating regulatory capital requirements. The proposed rules limit a banking organization’s capital distributions and certain discretionary bonus payments if the banking organization does not hold a “capital conservation buffer” consisting of a specified amount of common equity tier 1 capital in addition to the amount necessary to meet its minimum risk-based capital requirements. The proposed rules indicated that the final rule would become effective on January 1, 2013, and the changes set forth in the final rules will be phased in from January 1, 2013 through January 1, 2019. However, the agencies have recently indicated that, due to the volume of public comments received, the final rule would not be in effect on January 1, 2013.

 

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When fully phased in on January 1, 2019, Basel III requires banks to maintain the following new standards and introduces a new capital measure “Common Equity Tier 1”, or “CET1”. Basel III increases the CET1 to risk-weighted assets to 4.5%, and introduces a capital conservation buffer of an additional 2.5% of common equity to risk-weighted assets, raising the target CET1 to risk-weighted assets ratio to 7%. It requires banks to maintain a minimum ratio of Tier 1 capital to risk weighted assets of at least 6.0%, plus the capital conservation buffer effectively resulting in Tier 1 capital ratio of 8.5%. Basel III increases the minimum total capital ratio to 8.0% plus the capital conservation buffer, increasing the minimum total capital ratio to 10.5%. Basel III also introduces a non-risk adjusted tier 1 leverage ratio of 3%, based on a measure of total exposure rather than total assets, and new liquidity standards.

Failure to meet statutorily mandated capital guidelines or more restrictive ratios separately established for a financial institution (like those contained in the Consent Order) could subject a bank or bank holding company to a variety of enforcement remedies, including issuance of a capital directive, the termination of deposit insurance by the FDIC, a prohibition on accepting or renewing brokered deposits, limitations on the rates of interest that the institution may pay on its deposits and other restrictions on its business. As described above, significant additional restrictions can be imposed on FDIC-insured depository institutions that fail to meet applicable capital requirements.

During the first quarter of 2010, the Bank agreed to an OCC requirement to maintain a minimum Tier 1 capital to average assets ratio of 9% and a minimum total capital to risk-weighted assets ratio of 13%. This Individual Minimum Capital Requirement was replaced by the Consent Order, which requires the Bank to maintain a minimum Tier 1 capital to average assets ratio of 9% and a minimum total capital to risk-weighted assets ratio of 12% and was effective November 22, 2011. The 9% ratio was the same as in the Bank’s IMCR while the 12% ratio was a slight reduction from the 13% required under the IMCR.

As of December 31, 2010, the consolidated capital ratios of the Company and Bank were as follows:

 

     Regulatory
Minimum to
be Adequately
Capitalized
    Regulatory
Minimum to
be Well
Capitalized
    Company     Bank  

Tier 1 capital ratio

     4.0     6.0     11.87     11.97

Total capital ratio

     8.0     10.0     13.27     13.23

Leverage ratio

     3.0-5.0     5.0     8.34     8.41

 

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As of December 31, 2011, the consolidated capital ratios of the Company and Bank were as follows:

 

     Regulatory     Regulatory     Required of     Required of              
     Minimum to     Minimum to     Bank by     Company by              
     be Adequately     be Well     Consent     Written              
     Capitalized*     Capitalized*     Order     Agreement*     Company     Bank  

Tier 1 capital ratio

     4.0     6.0     N/A        4.0     -0.68     3.07

Total capital ratio

     8.0     10.0     12.0     8.0     -0.68     4.35

Leverage ratio

     3.0-5.0     5.0     9.0     4.0     -0.47     2.10

 

* The Bank would not be considered adequately capitalized or well capitalized if it achieves the ratios noted in the table above for those respective categories due to its stipulation to the Consent Order. Additionally, while under the Consent Order, the Bank cannot be considered well capitalized. The Company has not submitted an acceptable written plan to maintain sufficient capital under the Written Agreement and the ratios noted above are the required ratios for the Company to meet the regulatory adequately capitalized or well capitalized ratios if it were not subject to the Written Agreement.

FDICIA

FDICIA directs that each federal banking regulatory agency prescribe standards for depository institutions and depository institution holding companies relating to internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth compensation, a maximum ratio of classified assets to capital, minimum earnings sufficient to absorb losses, a minimum ratio of market value to book value for publicly traded shares, and such other standards as the federal regulatory agencies deem appropriate.

FDICIA generally prohibits an FDIC-depository institution from making any capital distribution (including payment of a dividend) or paying any management fee to its holding company if the depository institution would thereafter be undercapitalized. Undercapitalized depository institutions are subject to growth limitations and are required to submit capital restoration plans. A depository institution’s parent holding company must guarantee the capital plan, up to an amount equal to the lesser of 5% of the depository institution’s total assets at the time it became undercapitalized or the amount of the capital deficiency when the institution fails to comply with the plan. The federal banking agencies may not accept a capital plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institution’s capital. If a depository institution fails to submit an acceptable plan, it is treated as if it is significantly undercapitalized.

Significantly undercapitalized depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become adequately capitalized, requirements to reduce total assets and cessation of receipt of deposits from correspondent banks. Critically undercapitalized depository institutions are subject to appointment of a receiver or conservator generally within 90 days of the date on which they became critically undercapitalized.

 

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FDICIA also contains a variety of other provisions that may affect the operations of the Company and the Bank, including reporting requirements, regulatory standards for real estate lending, “truth in savings” provisions, the requirement that a depository institution give 90 days’ prior notice to customers and regulatory authorities before closing any branch, and a prohibition on the acceptance or renewal of brokered deposits by depository institutions that are not well capitalized or are adequately capitalized and have not received a waiver from the FDIC.

The Company is considered “critically undercapitalized” and the Bank is considered “significantly undercapitalized.” The board of directors agreed to execute a stipulation and consent to the issuance of the Consent Order by the OCC in October 2011. As such brokered deposits are currently restricted and the Company and Bank are subject to certain other restrictions and requirements and the Bank is required to seek approval of the FDIC before it can accept, renew or roll over brokered deposits. See “Item 1A-Risk Factors” and “Item 7-Management’s Discussion and Analysis of Financial Condition and Results of Operations” for a more detailed discussion. In addition, the Bank generally will not be able to offer interest rates on deposits more than 75 basis points above the FDIC determined “national rate.”

Enforcement Policies and Actions

The Federal Reserve and the OCC monitor compliance with laws and regulations. Violations of laws and regulations, or other unsafe and unsound practices, may result in these agencies imposing fines or penalties, cease and desist orders, or taking other enforcement actions. Under certain circumstances, these agencies may enforce these remedies directly against officers, directors, employees and others participating in the affairs of a bank or bank holding company.

Fiscal and Monetary Policy

Banking is a business that depends on interest rate differentials. In general, the difference between the interest paid by a bank on its deposits and its other borrowings, and the interest received by a bank on its loans and securities holdings, constitutes the major portion of a bank’s earnings. Thus, the financial results of the Company and the Bank are subject to the influence of economic conditions generally, both domestic and foreign, and also to the monetary and fiscal policies of the United States and its agencies, particularly the Federal Reserve. The Federal Reserve regulates the supply of money through various means, including open market dealings in United States government securities, the discount rate at which banks may borrow from the Federal Reserve, and the reserve requirements on deposits. The nature and timing of any changes in such policies and their effect on Mountain National and its subsidiary cannot be predicted. During 2008, the Federal Reserve reduced the target federal funds rate seven times for a total of 4.00 - 4.25%. The year-end target federal funds rate was expressed as a range from 0.00 - 0.25%. During 2008, the Federal Reserve also reduced the discount rate eight times for a total of 4.25%. The Federal Reserve increased the discount rate 0.25% during the first quarter of 2010. The target federal funds rate in effect at December 31, 2008 was unchanged throughout 2010 and 2011.

 

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FDIC Insurance Assessments

The Deposit Insurance Fund (“DIF”) of the FDIC insures deposit accounts in the Bank up to a maximum amount per separately insured depositor. Under the Dodd-Frank Act, the maximum amount of federal deposit insurance coverage has been permanently increased from $100,000 to $250,000 per depositor, per institution. On November 9, 2010, the FDIC issued a final rule to implement a provision of the Dodd-Frank Act that provides temporary unlimited deposit insurance coverage for noninterest-bearing transaction accounts at all FDIC-insured depository institutions. Institutions cannot opt out of this coverage, nor will the FDIC charge a separate assessment for the insurance. On December 29, 2010, President Obama signed into law an amendment to the Federal Deposit Insurance Act to include Interest on Lawyers Trust Accounts (“IOLTA”) within the definition of noninterest-bearing transaction accounts. This amendment will provide IOLTAs with the same temporary, unlimited insurance coverage afforded to noninterest-bearing transaction accounts under the Dodd-Frank Act. This unlimited coverage for noninterest-bearing transaction accounts became effective on December 31, 2010 and expired on December 31, 2012. The expiration of the program could, along with concerns of depositors regarding the financial condition of the Bank, cause depositors of the Bank to withdraw deposits in excess of FDIC–insured levels. The withdrawal of these deposits could cause stress on the Bank’s liquidity. Furthermore, the withdrawal of these deposits could negatively impact the Bank’s aggregate cost of funds by reducing the percentage of Bank’s non-interest bearing deposits to total deposits.

The FDIC did not extend its Transaction Account Guarantee Program beyond its sunset date of December 31, 2010, which provided a full guarantee of certain Negotiable Order of Withdrawal accounts (“NOW accounts”). The FDIC insures NOW accounts up to the standard maximum deposit insurance amount as noted above.

FDIC-insured depository institutions are required to pay deposit insurance premiums based on the risk an institution poses to the DIF. In order to restore reserves and ensure that the DIF will be able to adequately cover losses from future bank failures, the FDIC approved new deposit insurance rules in November 2009. These new rules required insured depository institutions to prepay their estimated quarterly risk-based assessments for all of 2010, 2011, and 2012. On December 30, 2009, the Bank prepaid its assessment in the amount of approximately $4 million related to years 2010 through 2012. As of December 31, 2011 the remaining balance of our prepaid FDIC assessment was approximately $1.8 million. Continuing declines in the DIF may result in the FDIC imposing additional assessments in the future, which could adversely affect the Company’s capital levels and earnings.

As required by the Dodd-Frank Act, on February 7, 2011, the FDIC finalized new rules which would redefine the assessment base as “average consolidated total assets minus average tangible equity.” The new rate schedule and other revisions to the assessment rules became effective April 1, 2011, for use in calculating the June 2011 assessments which were due in September 2011. The FDIC’s final rules also eliminated risk categories and debt ratings from the assessment calculation for large banks (over $10 billion) and instead used scorecards that the FDIC believes better reflect risks to the DIF.

 

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In addition to DIF assessments, all FDIC-insured depository institutions must pay an annual assessment to provide funds for the repayment of debt obligations of the Financing Corporation (“FICO”). The FICO is a government-sponsored entity that was formed to borrow the money necessary to carry out the closing and ultimate disposition of failed thrift institutions by the Resolution Trust Corporation. The FICO assessments are set quarterly.

During the two years ended December 31, 2011 and 2010, the Bank paid approximately $36,000 and $65,000, respectively, in FICO assessments. The Bank paid approximately $1,651,000 during 2011 for FDIC deposit insurance premiums.

Other Laws and Regulations

The International Money Laundering Abatement and Anti-Terrorism Funding Act of 2001 specifies “know your customer” requirements that obligate financial institutions to take actions to verify the identity of the account holders in connection with opening an account at any U.S. financial institution. Banking regulators will consider compliance with this Act’s money laundering provisions in acting upon acquisition and merger proposals, and sanctions for violations of this Act can be imposed in an amount equal to twice the sum involved in the violating transaction, up to $1 million.

Under the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the “USA PATRIOT Act”), financial institutions are subject to prohibitions against specified financial transactions and account relationships as well as to enhanced due diligence and “know your customer” standards in their dealings with foreign financial institutions and foreign customers. For example, the enhanced due diligence policies, procedures, and controls generally require financial institutions to take reasonable steps:

 

   

to conduct enhanced scrutiny of account relationships to guard against money laundering and report any suspicious transaction;

 

   

to ascertain the identity of the nominal and beneficial owners of, and the source of funds deposited into, each account as needed to guard against money laundering and report any suspicious transactions;

 

   

to ascertain for any foreign bank, the shares of which are not publicly traded, the identity of the owners of the foreign bank, and the nature and extent of the ownership interest of each such owner; and

 

   

to ascertain whether any foreign bank provides correspondent accounts to other foreign banks and, if so, the identity of those foreign banks and related due diligence information.

The USA PATRIOT Act requires financial institutions to establish anti-money laundering programs, and sets forth minimum standards for these programs, including:

 

   

the development of internal policies, procedures, and controls;

 

   

the designation of a compliance officer;

 

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an ongoing employee training program; and

 

   

an independent audit function to test the programs.

In addition, the USA PATRIOT Act authorizes the Secretary of the Treasury to adopt rules increasing the cooperation and information sharing between financial institutions, regulators, and law enforcement authorities regarding individuals, entities and organizations engaged in, or reasonably suspected based on credible evidence of engaging in, terrorist acts or money laundering activities.

The Dodd-Frank Act, certain aspects of which have been described above, have had, and are expected to continue to have, a broad impact on the financial services industry, imposing significant regulatory and compliance changes, including the designation of certain financial companies as systemically significant, the imposition of increased capital, leverage, and liquidity requirements, and numerous other provisions designed to improve supervision and oversight of, and strengthen safety and soundness within, the financial services sector. Additionally, the Dodd-Frank Act establishes a new framework of authority to conduct systemic risk oversight within the financial system to be distributed among new and existing federal regulatory agencies, including the Financial Stability Oversight Council, the Federal Reserve, the OCC and the FDIC.

The following items provide a brief description of certain provisions of the Dodd-Frank Act that may have an effect on us:

• The Dodd-Frank Act made permanent the general $250,000 deposit insurance limit for insured deposits. The Dodd-Frank Act also extended until December 31, 2012, federal deposit coverage for the full net amount held by depositors in non-interest bearing transaction accounts. Amendments to the FDICIA also revised the assessment base against which an insured depository institution’s deposit insurance premiums paid to DIF are calculated. Under the amendments, the assessment base is no longer the institution’s deposit base, but rather its average consolidated total assets less its average tangible equity. Additionally, the Dodd-Frank Act made changes to the minimum designated reserve ratio of the DIF, increasing the minimum from 1.15 percent to 1.35 percent of the estimated amount of total insured deposits, and eliminating the requirement that the FDIC pay dividends to depository institutions when the reserve ratio exceeds certain thresholds.

• The Dodd-Frank Act generally enhances the restrictions on transactions with affiliates under Section 23A and 23B of the Federal Reserve Act, including an expansion of the definition of “covered transactions” and an increase in the amount of time for which collateral requirements regarding covered credit transactions must be satisfied. Insider transaction limitations are expanded through the strengthening of loan restrictions to insiders and the expansion of the types of transactions subject to the various limits, including derivatives transactions, repurchase agreements, reverse repurchase agreements and securities lending or borrowing transactions. Restrictions are also placed on certain asset sales to and from an insider to an institution, including requirements that such sales be on market terms and, in certain circumstances, approved by the institution’s board of directors.

 

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• The Dodd-Frank Act authorized the establishment of the CFPB, which has the power to issue rules governing all financial institutions that offer financial services and products to consumers. The CFPB has the authority to monitor markets for consumer financial products to ensure that consumers are protected from abusive practices. Financial institutions are subject to increased compliance and enforcement costs associated with regulations established by the CFPB.

• The Dodd-Frank Act addressed many investor protection, corporate governance and executive compensation matters that will affect most U.S. publicly traded companies, including ours, in certain circumstances. The Dodd-Frank Act (1) granted stockholders of U.S. publicly traded companies an advisory vote on executive compensation; (2) enhanced independence requirements for compensation committee members; (3) required companies listed on national securities exchanges to adopt incentive-based compensation clawback policies for executive officers; (4) prohibited uninstructed broker votes on election of directors, executive compensation matters (including say on pay advisory votes), and other significant matters, and (5) required disclosure on board leadership structure.

Many of the requirements of the Dodd-Frank Act remain to be implemented over time and most will be subject to regulations implemented over the course of several years. Given the uncertainty associated with the manner in which the provisions of the Dodd-Frank Act that remain to be implemented will be implemented by the various regulatory agencies and through regulations, the full extent of the impact such requirements will have on our operations is unclear. The changes resulting from the Dodd-Frank Act may impact the profitability of our business activities, require changes to certain of our business practices, impose upon us more stringent capital, liquidity and leverage requirements or otherwise adversely affect our business. These changes may also require us to invest significant management attention and resources to evaluate and make any changes necessary to comply with new statutory and regulatory requirements. Failure to comply with the new requirements may negatively impact our results of operations and financial condition. While we cannot predict what effect any presently contemplated or future changes in the laws or regulations or their interpretations would have on us, these changes could be materially adverse to our investors.

ITEM 1A. RISK FACTORS

We have incurred significant losses in the last two years and could continue to sustain losses if our asset quality declines.

We incurred substantial losses in 2010 and 2011, resulting primarily from substantially higher provisions for loan losses related to real estate related loans, reductions in net interest income and, in 2010, the establishment of a reserve for a significant portion of our deferred tax asset. A significant portion of our loans are real estate based or made to real estate based borrowers, and the credit quality of such loans has deteriorated and could deteriorate further if real estate market conditions continue to decline or fail to stabilize in our market areas. We have sustained losses, and could continue to sustain losses if we incorrectly assess the creditworthiness of our borrowers or fail to detect or respond to further deterioration in asset quality in a timely manner.

 

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Our business is highly dependent upon conditions in the local real estate market and has been adversely impacted by adverse developments in those markets.

Adverse market or economic conditions in East Tennessee have disproportionately increased the risk our borrowers will be unable to timely make their loan payments. The market value of the real estate securing loans as collateral has been adversely affected by unfavorable changes in market and economic conditions. As of December 31, 2011, approximately 89.9% of our loans were secured by real estate. Of this amount, approximately 38.6% were commercial real estate loans, 33.2% were residential real estate loans and 18.1% were construction and development loans. We have experienced increased payment delinquencies, foreclosures or losses caused by adverse market or economic conditions in our markets and such conditions are expected to continue to adversely affect the value of our assets, our revenues, results of operations and financial condition.

We have entered into a consent order with, and are subject to a capital requirement from, the OCC.

The board of directors stipulated to the issuance of the Consent Order by the OCC in October 2011. The consent order includes, among other provisions, the requirement that the Bank maintain a minimum Tier 1 to average assets ratio of 9% and a minimum total risk-based ratio of 12%. Because the Bank’s capital levels are below those required to be considered adequately capitalized and because the Bank is subject to the Consent Order, the Bank is required to seek approval of the FDIC before it can accept, renew or roll over brokered deposits or pay interest on deposits above certain federally established rates. The Bank’s regulators have considerable discretion in whether to grant required approvals, and we may not be able to obtain approvals if requested.

Additionally, if the Bank fails to comply with the requirements of the consent order, it may be subject to further regulatory action. The OCC also has broad authority to take additional actions against the Bank, including assessing civil fines and penalties, issuing additional consent or cease and desist orders, removing officers and directors, and requiring us to sell or merge the Bank.

An inability to improve our regulatory capital position could adversely affect our operations and future prospects.

Our ability to remain in operation as a financial institution is dependent on our ability to raise sufficient capital to improve our regulatory capital position. At December 31, 2011, the Bank was classified as “significantly undercapitalized,” which restricts its operations. As a result of its reduced capital levels and the terms of the Consent Order, the Bank is required to submit a capital restoration plan to the OCC that details the manner in which the Bank will restore its capital levels to those required to meet the requirements of the Consent Order. The Bank has submitted numerous capital restoration plans to the OCC but none of these plans have yet been approved by the OCC because the OCC was unable to determine that the capital restoration plans were based on realistic assumptions or were likely to succeed in restoring the Bank’s capital. If we are unable to find a merger partner or anyone to buy us, and we are also unable to raise sufficient capital to meet the capital commitments the Bank has made to the OCC in the Consent

 

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Order, the Bank may be closed. Because of the significant losses we have suffered in each of the last four years and the significant negative impact of those losses on our capital position, the price that a potential buyer might pay to acquire the Bank in connection with a merger with us is likely to be significantly lower than the price our shareholders paid to acquire our stock. Accordingly, if we sell the Bank or sell stock in the Company to an investor or merge with a buyer, you are likely to suffer significant dilution.

Certain conditions give rise to substantial doubt about our ability to continue as a going concern.

The Company has incurred significant recurring net losses, primarily from higher provisions for loan losses and expenses associated with the administration and disposition of nonperforming assets. These losses have adversely impacted capital and liquidity at the Bank and liquidity at the Company. At December 31, 2011, regulatory capital at the Bank was below the amount specified in the regulatory Consent Order and the Company’s total shareholder’s equity was in a deficit position. Failure to raise capital to the amount specified in the Consent Order and otherwise comply with the regulatory orders may result in additional enforcement actions and/or receivership of the Bank.

Our independent registered public accounting firm in its audit report for fiscal year 2011 has expressed substantial doubt about our ability to continue as a going concern. Continued operations depend on our ability to satisfy regulatory capital requirements. Our consolidated audited financial statements were prepared under the assumption that we will continue our operations on a going concern basis, which contemplates the realization of assets and the discharge of liabilities in the normal course of business. Our consolidated financial statements do not include any adjustments that might be necessary if we are unable to continue as a going concern. If we cannot continue as a going concern, our shareholders will lose some or all of their investment.

Our inability to accept, renew or roll over brokered deposits without the prior approval of the FDIC could adversely affect our liquidity.

As of November 30, 2012, we had approximately $8.4 million in brokered certificates of deposit which represented approximately 2.14% of our total deposits, all of which mature in the next twelve months. The Bank may not accept, renew or roll over brokered deposits without prior approval of the FDIC. Funding sources for the maturing brokered deposits include, among other sources: our cash account at the FRB-Atlanta; growth, if any, of core deposits from current and new retail and commercial customers; scheduled repayments on existing loans; and the possible pledge or sale of investment securities. Because the Bank is not considered “well capitalized” and because it is subject to the Consent Order, it is not permitted to offer to pay interest on deposits at rates that are more than 75 basis points above the “national rate” unless the FDIC determines we are in a “high rate area.” These interest rate limitations may limit the ability of the Bank to increase or maintain core deposits from current and new deposit customers. The limitations on our ability to accept, renew or roll over brokered deposits, or pay more than 75 basis points above the “national rate” could adversely affect our liquidity.

 

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As the Bank’s capital levels decline, the amount that it can lend any one borrower is reduced.

As the Bank’s capital levels decline, the amount that it can lend any one borrower is reduced. At December 31, 2011, the Bank’s legal lending limit under applicable regulations (based upon the maximum legal lending limits of 15% of capital, surplus and the allowance for loan loss) was $3,857,000. As the Bank’s capital levels have declined, its legal lending limit has been reduced. At September 30, 2012, that limit had increased slightly to $3,931,000. If the legal lending limit is reduced below the level of credit, including lines of credit that the Bank has extended to a borrower, it can no longer renew or continue undrawn credit lines or make additional loans or advances to its largest borrower relationships, and its ability to renew outstanding loans to such customers is extremely limited. Additionally, if the Bank seeks to reduce the amount of credit that it has extended to a particular borrower because of a reduction in its legal lending limit, the borrower may decide to move its loan relationships to another financial institution with legal lending limits high enough to accommodate the borrower’s relationships. A loss of loan customers as a result of being subject to lower lending limits, could negatively impact the Bank’s liquidity and results of operations.

If our allowance for loan losses is not sufficient to cover actual loan losses, additional provisions will be necessary.

If loan customers with significant loan balances fail to repay their loans according to the terms of these loans, our losses will continue. We make various assumptions and judgments about the collectability of our loan portfolio, including the creditworthiness of our borrowers and the value of any collateral securing the repayment of our loans. We maintain an allowance for loan losses in an attempt to cover probable incurred losses inherent to the risks associated with lending. In determining the size of this allowance, we rely on an analysis of our loan portfolio based on volume and types of loans, internal loan classifications, trends in classifications, volume and trends in delinquencies, nonaccruals and charge-offs, loss experience of various loan categories, national and local economic conditions, other factors and other pertinent information. If our assumptions are inaccurate, our current allowance may not be sufficient to cover probable incurred loan losses, and additional provisions may be necessary which would decrease our earnings.

In addition, federal regulators periodically review our loan portfolio and may require us to increase our provision for loan losses or recognize loan charge-offs. Their conclusions about the quality of a particular borrower of ours or our entire loan portfolio may be different than ours. Any increase in our allowance for loan losses or loan charge-offs as required by these regulatory agencies could have a negative effect on our operating results. Moreover, additions to the allowance may be necessary based on changes in economic and real estate market conditions, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of our management’s control. These additions may require increased provision expense which would negatively impact our results of operations.

 

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We have increased levels of other real estate owned, primarily as a result of foreclosures, and we anticipate higher levels of foreclosed real estate expense.

As we have begun to resolve non-performing real estate loans, we have increased the level of foreclosed properties, primarily those acquired from builders and from residential land developers. Foreclosed real estate expense consists of three types of charges: maintenance costs, valuation adjustments to appraisal values and gains or losses on disposition. These charges will likely remain at above historical levels as our level of other real estate owned remains elevated, and also if local real estate values continue to decline, negatively affecting our results of operations.

Our loan portfolio includes a meaningful amount of real estate construction and development loans, which have a greater credit risk than residential mortgage loans.

The percentage of real estate construction and development loans in the Company’s portfolio was approximately 18.1% of total loans at December 31, 2011, and these loans make up approximately 48.9% of our non-performing loans at December 31, 2011. This type of lending is generally considered to have relatively high credit risks because the principal is concentrated in a limited number of loans with repayment dependent on the successful completion and operation of the related real estate project. Consequently, the credit quality of many of these loans has deteriorated as a result of the current adverse conditions in the real estate market. Throughout 2010 and 2011, the number of newly constructed homes or lots sold in our market areas continued to decline, negatively affecting collateral values and contributing to increased provision expense and higher levels of non-performing assets. A continued reduction in residential real estate market prices and demand could result in further price reductions in home and land values adversely affecting the value of collateral securing the construction and development loans that we hold. These adverse economic and real estate market conditions may lead to further increases in non-performing loans and other real estate owned, increased losses and expenses from the management and disposition of non-performing assets, increases in provision for loan losses, and increases in operating expenses as a result of the allocation of management time and resources to the collection and work out of loans, all of which would negatively impact our financial condition and results of operations.

We are geographically concentrated in Sevier County and Blount County, Tennessee, and changes in local economic conditions, particularly the tourism industry, impact our profitability.

We operate primarily in Sevier County and Blount County, Tennessee, and substantially all of our loan customers and most of our deposit and other customers live or have operations in Sevier and Blount Counties. Accordingly, our success significantly depends upon the growth in population, income levels, deposits and housing starts in both counties, along with the continued attraction of business ventures to the area. Economic conditions in our area weakened during 2008 and 2009 and remained weak throughout 2010, 2011 and 2012, negatively affecting our operations, particularly the real estate construction and development segment of our loan portfolio. We cannot assure you that economic conditions in our market will improve during 2013 or thereafter, and continued weak economic conditions could cause us to continue to further reduce our asset size, affect the ability of our customers to repay their loans and generally affect our financial condition and results of operations.

 

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Due to the predominance of the tourism industry in Sevier County, Tennessee, which is adjacent to the Great Smoky Mountains National Park and the home of the Dollywood theme park, a significant portion of the Bank’s commercial loan portfolio is concentrated within that industry. The predominance of the tourism industry also makes our business more seasonal in nature than may be the case with banks in other market areas. The Bank maintains twelve primary concentrations of credit by industry, of which seven are directly related to the tourism industry. At December 31, 2011, approximately $156 million in loans, representing approximately 50.1% of our total loans, were to businesses and individuals whose ability to repay depends to a significant extent on the tourism industry in the markets we serve. We also have additional loans that would be considered related to the tourism industry in addition to the seven categories included in the industry concentration amounts noted above. The tourism industry in Sevier County has remained relatively stable during recent years and we do not anticipate any significant changes in this trend; however, if the tourism industry does experience an economic slowdown and, as a result, borrowers in this industry are unable to perform their obligations under their existing loan agreements, owe could incur additional losses.

We are less able than a larger institution to spread the risks of unfavorable local economic conditions across a large number of diversified economies. Moreover, we cannot give any assurance that we will benefit from any market growth or return of more favorable economic conditions in our primary market areas if they do occur.

A portion of our loan portfolio is secured by homes that are being built for sale as vacation homes or as second homes for out of market investors or homes that are used to generate rental income.

A significant portion of our borrowers rely to some extent upon rental income to service real estate loans secured by rental properties, or they rely upon sales of the property for construction and development loans secured by homes that have been built for sale to investors living outside of our market area as investment properties, second homes or as vacation homes. If tourism levels in our market area or the rates that visitors are willing to pay for lodging were to decline significantly, the rental income that some of our borrowers utilize to service their obligations to us may decline as well and these borrowers may have difficulty meeting their obligations to us which would adversely impact our results of operations. In addition, sales of vacation homes and second homes to investors living outside of our market area have slowed and are expected to remain at reduced levels at least throughout the next twelve months. Borrowers that are developers or builders whose loans are secured by these vacation and second homes and whose ability to repay their obligations to us is dependent on the sale of these properties have had, and may continue to have, difficulty meeting their obligations to us if these properties are not sold timely or at values in excess of their loan amount which could adversely impact our results of operations.

 

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If the value of real estate in our markets were to decline further or if appraisals do not accurately reflect real estate values, a significant portion of our loan portfolio could become under-collateralized, which could have a material adverse effect on us.

In addition to considering the financial strength and cash flow characteristics of borrowers, we often secure loans with real estate collateral. At December 31, 2011, approximately 90% of our loans had real estate as a primary or secondary component of collateral. The real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower but may deteriorate in value during the time the credit is extended. If the value of real estate in our markets were to decline further, a significant portion of our loan portfolio could become under-collateralized. As a result, if we are required to liquidate the collateral securing a loan to satisfy the debt during a period of reduced real estate values, our earnings and capital could be adversely affected.

Also, in considering whether to make a loan secured by real property, we generally require an appraisal of the property. However, an appraisal is only an estimate of the value of the property at the time the appraisal is made, and, as real estate values in our market area have experienced changes in value in relatively short periods of time, this estimate might not accurately describe the net value of the real property collateral after the loan has been closed. If the appraisal does not reflect the amount that may be obtained upon any sale or foreclosure of the property, we may not realize an amount equal to the indebtedness secured by the property. The valuation of the property may negatively impact the continuing value of such loan and could adversely affect our operating results and financial condition.

Negative publicity about financial institutions, generally, or about us or the Bank, specifically, could damage the Bank’s reputation and adversely impact its liquidity, business operations or financial results.

Reputation risk, or the risk to our business from negative publicity, is inherent in our business. Negative publicity can result from the actual or alleged conduct of financial institutions, generally, or us or the Bank, specifically, in any number of activities, including leasing and lending practices, corporate governance, and actions taken by government regulators in response to those activities. Negative publicity can adversely affect our ability to keep and attract customers and can expose us to litigation and regulatory action, any of which could negatively affect our liquidity, business operations or financial results.

The costs and effects of litigation, investigations or similar matters, or adverse facts and developments related thereto, could materially affect our business, operating results and financial condition.

We may be involved from time to time in a variety of litigation, investigations or similar matters arising out of our business. Our insurance may not cover all claims that may be asserted against it and indemnification rights to which we are entitled may not be honored, and any claims asserted against us, regardless of merit or eventual outcome, may harm our reputation. Should the ultimate judgments or settlements in any litigation or investigation significantly exceed our insurance coverage, they could have a material adverse effect on our business, financial condition and results of operations. In addition, premiums for insurance covering the financial and banking sectors are rising. We may not be able to obtain appropriate types or levels of insurance in the future, nor may we be able to obtain adequate replacement policies with acceptable terms or at historic rates, if at all.

 

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We may be required to pay significantly higher FDIC premiums or remit special assessments that could adversely affect our earnings.

The downgrade in our regulatory condition caused our assessment to materially increase. In addition, market developments have significantly depleted the insurance fund of the FDIC and reduced the ratio of reserves to insured deposits. As a result, the entire industry may be required to pay significantly higher premiums or additional special assessments that could adversely affect our earnings. It is possible that the FDIC may impose additional special assessments in the future as part of its restoration plan.

We reported material weaknesses in our internal control over financial reporting, and if we are unable to improve our internal controls, our financial results may not be accurately reported.

Management’s assessment of the effectiveness of our internal control over financial reporting as of December 31, 2011 identified material weaknesses in its internal control over financial reporting, as described in “Item 9A-Controls and Procedures.” These material weaknesses, or difficulties encountered in implementing new or improved controls or remediation, could prevent us from accurately reporting our financial results, result in material misstatements in our financial statements or cause us to fail to meet our reporting obligations. Failure to comply with Section 404 of the Sarbanes-Oxley Act of 2002 could negatively affect our business, the price of our common stock and market confidence in our reported financial information.

Negative developments in the U.S. and local economy and in local real estate markets have adversely impacted our operations and results and may continue to adversely impact our results in the future.

Economic conditions in the markets in which we operate deteriorated significantly between early 2008 and 2011. As a result, we incurred losses in 2009, 2010 and 2011, resulting primarily from provisions for loan losses related to declining collateral values in our construction and development loan portfolio. Although economic conditions showed signs of stabilization in our markets during 2011 with the exception of real estate values for certain types of properties, we believe that we will continue to experience a challenging and volatile economic environment for the next twelve months. Accordingly, we expect that our results of operations will continue to be negatively impacted in 2012. There can be no assurance that the economic conditions that have adversely affected the financial services industry, and the capital, credit and real estate markets generally or us in particular, will improve, materially or at all, in which case we could continue to experience losses, write-downs of assets, capital and liquidity constraints or other business challenges.

 

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The December 31, 2012 expiration of the FDIC’s Transaction Account Guarantee Program could stress the Bank’s liquidity and negatively impact the Bank’s cost of funds.

Under the FDIC’s Transaction Account Guarantee Program, certain non-interest bearing transaction accounts, including those of consumers and businesses, are insured by the FDIC over and above the customary $250,000 limit. This program expired on December 31, 2012. The expiration of the program could, along with concerns of depositors regarding the financial condition of the Bank, cause depositors of the Bank to withdraw deposits in excess of FDIC –insured levels. The withdrawal of these deposits could cause stress on the Bank’s liquidity. Furthermore, the withdrawal of these deposits could negatively impact the Bank’s aggregate cost of funds by reducing the percentage of Bank’s non-interest bearing deposits to total deposits.

Environmental liability associated with commercial lending could result in losses.

In the course of business, we may acquire, through foreclosure, properties securing loans it has originated or purchased which are in default. Particularly in commercial real estate lending, there is a risk that hazardous substances could be discovered on these properties. In this event, we, or the Bank, might be required to remove these substances from the affected properties at our sole cost and expense. The cost of this removal could substantially exceed the value of affected properties. We may not have adequate remedies against the prior owner or other responsible parties and could find it difficult or impossible to sell the affected properties. These events could have a material adverse effect on our business, results of operations and financial condition.

Competition with other banking institutions could adversely affect our profitability.

We face significant competition in our primary market areas from a number of sources, currently including eight commercial banks and one savings institution in Sevier County and twelve commercial banks and one savings institution in Blount County. As of June 30, 2011, there were 60 commercial bank branches and three savings institutions branches located in Sevier County and 56 commercial bank branches and one savings institution branch located in Blount County.

Liquidity needs could adversely affect our results of operations and financial condition.

We rely on dividends from the Bank as our primary source of funds, and currently, as a result of the Bank’s losses in 2010 and 2011 and the terms and conditions of the Consent Order, the Bank may not, without the prior approval of the OCC, pay any dividends to the Company. The Bank relies on customer deposits and loan repayments as its primary source of funds. While scheduled loan repayments are a relatively stable source of funds, they are subject to the ability of borrowers to repay the loans. The ability of borrowers to repay loans can be adversely affected by a number of factors, including changes in economic conditions, adverse trends or events affecting business industry groups, reductions in real estate values or markets, business closings or lay-offs, inclement weather, natural disasters, and international instability. Additionally, deposit levels may be affected by a number of factors, including rates paid by competitors, general interest rate levels, returns available to customers on alternative investments, and general economic conditions. Prior to the issuance of the Consent Order, we relied to a significant degree

 

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on national time deposits and brokered deposits. As a result of entering into the Consent Order, the Bank is prohibited from accepting, renewing or rolling over brokered deposits. As a result, the level of brokered deposits that we have has been reduced. We continue to be focused on improving our asset and liability liquidity. However, actions to improve liquidity may adversely affect our profitability. We may be required from time to time to rely on secondary sources of liquidity to meet withdrawal demands or otherwise fund operations. Such sources include FHLB of Cincinnati advances and federal funds lines of credit from correspondent banks. The availability of these sources has been restricted because of the Bank’s financial performance. While we believe that these sources are currently adequate, there can be no assurance they will be sufficient to meet future liquidity demands. We may be required to continue to reduce our asset size, slow or discontinue capital expenditures or other investments or liquidate assets should such sources not be adequate.

Fluctuations in interest rates could reduce our profitability.

Changes in interest rates may affect our level of interest income, the primary component of our gross revenue, as well as the level of our interest expense, our largest recurring expenditure. Interest rate fluctuations are caused by many factors which, for the most part, are not under our direct control. For example, national monetary policy plays a significant role in the determination of interest rates. Additionally, competitor pricing and the resulting negotiations that occur with our customers also impact the rates we collect on loans and the rates we pay on deposits.

As interest rates change, we expect that we will periodically experience “gaps” in the interest rate sensitivities of our assets and liabilities (usually deposits and borrowings), meaning that either our interest-bearing liabilities will be more sensitive to changes in market interest rates than our interest-earning assets (usually loans and investment securities), or vice versa. In either event, if market interest rates should move contrary to our position, this “gap” may work against us, and our earnings may be negatively affected. As a result of the Bank being subject to the Consent Order we generally will not be able to offer interest rates on deposits more than 75 basis points above the FDIC determined “national rate.” This could negatively affect our ability to attract deposits during a rising interest rate environment as the FDIC national rate may not increase at the same rate as other types of deposits available to the Bank.

Changes in the level of interest rates also may negatively affect our ability to originate real estate loans, the value of our assets and our ability to realize gains from the sale of our assets, all of which ultimately affect our earnings.

Our common stock is currently traded on the over-the-counter, or OTC, bulletin board and has substantially less liquidity than the average stock quoted on a national securities exchange.

Although our common stock is publicly traded on the OTC bulletin board, our common stock has substantially less daily trading volume than the average trading market for companies quoted on the Nasdaq Global Market, or any national securities exchange. A public trading market having the desired characteristics of depth, liquidity and orderliness depends on the presence in the marketplace of willing buyers and sellers of our common stock at any given time. This presence depends on the individual decisions of investors and general economic and market conditions over which we have no control.

 

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The market price of our common stock has fluctuated significantly, and may fluctuate in the future. These fluctuations may be unrelated to our performance. General market or industry price declines or overall market volatility in the future could adversely affect the price of our common stock, and the current market price may not be indicative of future market prices.

Our business is dependent on technology, and an inability to invest in technological improvements may adversely affect our results of operations and financial condition.

The financial services industry is undergoing rapid technological changes with frequent introductions of new technology-driven products and services. In addition to better serving customers, the effective use of technology increases efficiency and enables financial institutions to reduce costs. We have made significant investments in data processing, management information systems and internet banking accessibility. Our future success will depend in part upon our ability to create additional efficiencies in our operations through the use of technology. Many of our competitors have substantially greater resources to invest in technological improvements. There can be no assurance that our technological improvements will increase our operational efficiency or that we will be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to our customers.

Consumer protection initiatives related to the foreclosure process could affect our remedies as a creditor.

Consumer protection initiatives related to the foreclosure process, including voluntary and/or mandatory programs intended to permit or require lenders to consider loan modifications or other alternatives to foreclosure, could increase our credit losses or increase our expense in pursuing our remedies as a creditor.

National or state legislation or regulation may increase our expenses and reduce earnings.

Federal bank regulators are increasing regulatory scrutiny, and additional restrictions (including those originating from the Dodd-Frank Act) on financial institutions have been proposed or adopted by regulators and by Congress. Changes in tax law, federal legislation, regulation or policies, such as bankruptcy laws, deposit insurance, consumer protection laws, and capital requirements, among others, can result in significant increases in our expenses and/or charge-offs, which may adversely affect our earnings. Changes in state or federal tax laws or regulations can have a similar impact. Many state and municipal governments, including the State of Tennessee, are under financial stress due to the economy. As a result, these governments could seek to increase their tax revenues through increased tax levies which could have a meaningful impact on our results of operations. Furthermore, financial institution regulatory agencies are expected to continue to be very aggressive in responding to concerns and trends identified in examinations, including the continued issuance of additional formal or

 

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informal enforcement or supervisory actions. These actions, whether formal or informal, could result in our agreeing to limitations or to take actions that limit our operational flexibility, restrict our growth or increase our capital or liquidity levels. Failure to comply with any formal or informal regulatory restrictions, including informal supervisory actions, could lead to further regulatory enforcement actions. Negative developments in the financial services industry and the impact of recently enacted or new legislation in response to those developments could negatively impact our operations by restricting our business operations, including our ability to originate or sell loans, and adversely impact our financial performance. In addition, industry, legislative or regulatory developments may cause us to materially change our existing strategic direction, capital strategies, compensation or operating plans.

Implementation of the various provisions of the Dodd-Frank Act has resulted in an increase in our operating costs and may continue to cause additional increases, and implementation of those provisions of the Dodd-Frank Act that are not yet implemented could have a material effect on our business, financial condition or results of operations.

On July 21, 2010, President Obama signed the Dodd-Frank Act. This landmark legislation includes, among other things, (i) the creation of a Financial Services Oversight Counsel to identify emerging systemic risks and improve interagency cooperation; (ii) the elimination of the Office of Thrift Supervision and the transfer of oversight of federally chartered thrift institutions and their holding companies to the Office of the Comptroller of the Currency and the Federal Reserve; (iii) the creation of a Consumer Financial Protection Agency authorized to promulgate and enforce consumer protection regulations relating to financial products that would affect banks and non-bank finance companies; (iv) the establishment of new capital and prudential standards for banks and bank holding companies; (v) the termination of investments by the U.S. Treasury under TARP; (vi) enhanced regulation of financial markets, including the derivatives, securitization and mortgage origination markets; (vii) the elimination of certain proprietary trading and private equity investment activities by banks; (viii) the elimination of barriers to de novo interstate branching by banks; (ix) a permanent increase of the previously implemented temporary increase of FDIC deposit insurance to $250,000; (x) the authorization of interest-bearing transaction accounts; and (xi) changes in how the FDIC deposit insurance assessments will be calculated and an increase in the minimum designated reserve ratio for the Deposit Insurance Fund.

Certain provisions of the legislation are not immediately effective or are subject to required studies and implementing regulations. Further, community banks with less than $10 billion in assets (like us) are exempt from certain provisions of the legislation. Although certain regulations implementing portions of the Dodd-Frank Act have been promulgated, we are still unable to predict how this significant new legislation may be interpreted and enforced or how implementing regulations and supervisory policies may affect us. There can be no assurance that these or future reforms will not significantly increase our compliance or operating costs or otherwise have a significant impact on our business, financial condition and results of operations.

The short-term and long-term impact of the changing regulatory capital requirements and anticipated new capital rules is uncertain.

On June 7, 2012, the Federal Reserve, FDIC and OCC approved proposed rules that would substantially amend the regulatory risk-based capital rules applicable to the Company and the Bank. The proposed rules implement the “Basel III” regulatory capital reforms and changes required by the Dodd-Frank Act. The proposed rules were subject to a public comment period that has expired and there is no date set for the adoption of final rules.

 

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Various provisions of the Dodd-Frank Act increase the capital requirements of bank holding companies, such as the Company. The leverage and risk-based capital ratios of these entities may not be lower than the leverage and risk-based capital ratios for insured depository institutions. The proposed rules include new minimum risk-based capital and leverage ratios, which would be phased in during 2013 and 2014, and would refine the definition of what constitutes “capital” for purposes of calculating those ratios. The proposed new minimum capital level requirements applicable to the Company and the Bank under the proposals would be: (i) a new common equity Tier 1 capital ratio of 4.5%; (ii) a Tier 1 capital ratio of 6% (increased from 4%); (iii) a total capital ratio of 8% (unchanged from current rules); and (iv) a Tier 1 leverage ratio of 4% for all institutions. The proposed rules would also establish a “capital conservation buffer” of 2.5% above the new regulatory minimum capital ratios, and would result in the following minimum ratios: (i) a common equity Tier 1 capital ratio of 7.0%, (ii) a Tier 1 capital ratio of 8.5%, and (iii) a total capital ratio of 10.5%. The new capital conservation buffer requirement would be phased in beginning in January 2016 at 0.625% of risk-weighted assets and would increase each year until fully implemented in January 2019. Moreover, the proposed reforms seek to eliminate trust preferred securities from Tier 1 capital over a ten-year period. An institution would be subject to limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses if its capital level falls below the buffer amount. These limitations would establish a maximum percentage of eligible retained income that could be utilized for such actions. Additionally, the U.S. implementation of Basel III contemplates that, for banking organizations with less than $15 billion in assets, the ability to treat trust preferred securities as tier 1 capital would be phased out over a ten-year period.

While the proposed Basel III changes and other regulatory capital requirements will likely result in generally higher regulatory capital standards, it is difficult at this time to predict when or how any new standards will ultimately be applied to the Company and the Bank.

In addition, in the current economic and regulatory environment, regulators of banks and bank holding companies have become more likely to impose capital requirements on bank holding companies and banks that are more stringent than those required by applicable existing regulations (like those contained in the Consent Order or the Agreement).

The application of more stringent capital requirements for the Company and the Bank could, among other things, result in lower returns on invested capital, require the raising of additional capital, and result in additional regulatory actions if we were to be unable to comply with such requirements. Furthermore, the imposition of liquidity requirements in connection with the implementation of Basel III could result in our having to lengthen the term of our funding, restructure our business models, and/or increase our holdings of liquid assets. Implementation of changes to asset risk weightings for risk based capital calculations, items included or deducted in calculating regulatory capital and/or additional capital conservation buffers could result in management modifying its business strategy and could limit our ability to make distributions, including paying dividends.

 

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If the federal funds rate remains at current extremely low levels, our net interest margin, and consequently our net earnings, may be negatively impacted.

Because of significant competitive deposit pricing pressures in our market and the negative impact of these pressures on our cost of funds, coupled with the fact that a significant portion of our loan portfolio has variable rate pricing that moves in concert with changes to the Federal Reserve Board of Governors’ federal funds rate (which is at an extremely low rate as a result of current economic conditions), our net interest margin continues to be negatively affected. Because of these competitive pressures, we have been unable to lower the rate that we pay on interest-bearing liabilities to the same extent and as quickly as the yields we charge on interest-earning assets. Additionally, the amount of non-accrual loans and other real estate owned has been and may continue to be elevated. As a result, our net interest margin, and consequently our profitability, has been and may continue to be negatively impacted.

We have a significant deferred tax asset and cannot give any assurance that it will be fully realized.

During 2010, the Company reached a three-year pre-tax cumulative loss position. Under GAAP, a cumulative loss position is considered significant negative evidence which makes it very difficult for the Company to rely on future earnings as a reliable source of future taxable income to realize deferred tax assets. We recorded a valuation allowance against our deferred tax assets as of December 31, 2011 totaling approximately $22 million and had net deferred tax assets of zero because we believe that it is not more likely than not that all of these assets will be realized. In determining the amount of the valuation allowance, we considered the reversal of deferred tax liabilities and the ability to carryback losses to prior years. This process required significant judgment by management about matters that are by nature uncertain. We may need to increase our valuation allowance because of changes in the amounts of deferred tax assets and liabilities, which could have a material adverse effect on our results of operations and financial condition.

Holders of the Company’s junior subordinated debentures have rights that are senior to those of the Company’s common shareholders.

At December 31, 2011, we had outstanding trust preferred securities from special purpose trusts and accompanying junior subordinated debentures totaling $13 million. Payments of the principal and interest on the trust preferred securities of these trusts are conditionally guaranteed by us. Further, the accompanying junior subordinated debentures we issued to the trusts are senior to our shares of common stock and preferred stock. As a result, we must make payments on the junior subordinated debentures before any dividends can be paid on our common stock and, in the event of our bankruptcy, dissolution or liquidation, the holders of the junior subordinated debentures must be satisfied before any distributions can be made on our common stock. We have the right to defer distributions on our junior subordinated debentures (and the related trust preferred securities) for up to five years, during which time no dividends may be paid on our common stock. Because of the losses the Bank incurred since 2009 and under the terms of the Consent Order, it is not permitted to pay dividends to us without the consent of the OCC. As a result, we must use cash on hand to pay our obligations on the subordinated debentures related to our trust preferred securities. Furthermore, under the terms of the Agreement that we entered into with the FRB-Atlanta, we are not permitted to pay dividends on our indebtedness without the consent of the FRB-Atlanta.

 

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On December 14, 2010, the Company exercised its rights to defer regularly scheduled interest payments on all of its issues of junior subordinated debentures relating to outstanding trust preferred securities. The regular scheduled interest payments will continue to be accrued for payment in the future and reported as an expense for financial statement purposes. During the period in which it is deferring the payment of interest on its subordinated debentures, the Company may not pay any dividends on its common stock and the Company’s subsidiaries may not pay dividends on the subsidiaries’ common stock owned by entities other than the Company and its subsidiaries. The Company may defer the payment of dividends on its subordinated debentures for up to 20 consecutive quarters without the failure to pay such dividends constituting an event of default. Thereafter, the failure to pay such dividends would, unless all accrued and unpaid dividends are paid, constitute an event of default which would allow the holders of such subordinated debentures, or the associated trust preferred securities, to accelerate the principal payable thereunder, which could result in the Company’s bankruptcy. In a bankruptcy, the Company’s common shareholders’ investment in the Company would be worthless.

If a change in control or change in management is delayed or prevented, the market price of our common stock could be negatively affected.

Certain federal and state regulations may make it difficult, and expensive, to pursue a tender offer, change in control or takeover attempt that our board of directors opposes. As a result, our shareholders may not have an opportunity to participate in such a transaction, and the trading price of our stock may not rise to the level of other institutions that are more vulnerable to hostile takeovers.

An investment in the Company’s common stock is not an insured deposit.

Our common stock is not a bank deposit and, therefore, is not insured against loss by the FDIC, any other deposit insurance fund or by any other public or private entity. Investment in our common stock is inherently risky for the reasons described in this “Risk Factors” section and elsewhere in this report and is subject to the equity market forces like other common stocks. As a result, if you acquire our stock, you could lose some or all of your investment.

ITEM 2. PROPERTIES

The Bank currently operates from its main office in Sevierville, Tennessee, its Blount County regional headquarters in Maryville, Tennessee, and ten branch offices located in Gatlinburg, Pigeon Forge, Seymour, Kodak and Maryville, Tennessee. The main office, which is located at 300 East Main, Sevierville, Tennessee 37862, contains approximately 24,000 square feet and is owned by the Bank.

The Blount County regional headquarters opened for business during the first quarter of 2009 and is located at 1820 W. Broadway, Maryville, Tennessee. The building contains approximately 12,000 square feet and is owned by the Bank.

 

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The first Gatlinburg branch was built in 1999 and is located at 960 E. Parkway. It contains approximately 4,800 square feet. The Bank leases the land at this location. The lease expires in 2013 and includes renewal options for twelve additional five-year terms.

The second Gatlinburg branch is a walk-up branch leased by the Bank located at 745 Parkway, which lies in the heart of the Gatlinburg tourist district. The lease expires in 2015 and includes one five-year renewal option through 2020.

The Pigeon Forge branch, owned by the Bank, contains approximately 3,800 square feet and is located at 3104 Teaster Lane, Pigeon Forge, Tennessee.

The second Pigeon Forge branch, owned by the Bank, contains approximately 3,800 square feet and is located at 242 Wears Valley Road, Pigeon Forge, Tennessee.

The Seymour branch, owned by the Bank, contains approximately 3,800 square feet and is located on Chapman Highway, Seymour, Tennessee.

The Kodak branch, owned by the Bank, contains approximately 3,800 square feet and is located on Winfield Dunn Parkway – Highway 66, Sevierville, Tennessee.

The Collier Drive branch, owned by the Bank, contains approximately 3,800 square feet and is located at 470 Collier Drive, Sevierville, Tennessee.

The West Maryville branch, owned by the Bank, contains approximately 4,800 square feet and is located at 2403 US Highway 411 South, Maryville, Tennessee.

The Justice Center branch is located on land leased by the Bank at 1002 E. Lamar Alexander Parkway, Maryville, Tennessee. The branch contains approximately 3,900 square feet. The lease expires in 2013 and includes renewal options for six additional five-year terms.

The Newport Highway branch opened for business during the second quarter of 2009 and is located at 305 New Riverside Drive, Sevierville, Tennessee on land owned by the Bank. The branch contains approximately 3,800 square feet.

The Operations Center, owned by the Bank, contains approximately 40,000 square feet and is located on Red Bank Road in Sevierville, Tennessee. We completed construction of a 16,000 square foot addition, which is included in the 40,000 square foot total, during the first quarter of 2009.

In addition to our thirteen existing locations including the Operations Center, we hold one property in Knox County, Tennessee, which we intend to use as a future branch site.

Management believes that the physical facilities maintained by the Bank are suitable for its current operations and that all properties are adequately covered by insurance.

 

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ITEM 3. LEGAL PROCEEDINGS

Other than the matter discussed below, at December 31, 2011, the Company is not aware of any material pending legal proceedings to which the Company or the Bank is a party or to which any of their properties are subject, other than ordinary routine legal proceedings incidental to the business of the Bank.

During the third quarter of 2012, former President and CEO Dwight B. Grizzell filed a lawsuit regarding the cancellation of his Executive Salary Continuation Agreement. A full liability for the Salary Continuation Agreement was recorded at December 31, 2011, but it was reversed in 2012 when a cancellation agreement was executed April 12, 2012. After receiving notice of the lawsuit, the Bank recorded a contingent liability by restoring the previously recorded liability balance pending outcome of this action. The lawsuit was filed in Chancery Court for Sevier County, Tennessee on July 26, 2012, Dwight B. Grizzell vs. Mountain National Bancshares, Inc. and Mountain National Bank.

ITEM 4. MINE SAFETY DISCLOSURES

None.

PART II

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

There is not a large market for the Company’s shares, which are quoted on the OTC Bulletin Board under the symbol “MNBT” and are not traded on any national exchange. Trading is generally limited to private transactions and, therefore, there is limited reliable information available as to the number of trades or the prices at which our stock has traded. Management has reviewed the limited information available regarding the range of prices at which the Company’s common stock has been sold.

 

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The following table sets forth, for the calendar periods indicated, the range of high and low reported sales prices. This data is provided for information purposes only and should not be viewed as indicative of the actual or market value of our common stock:

 

     Market Price Range
Per Share
 

Year/Period

   High      Low  

2011:

   $ 4.15       $ 0.50   

First Quarter

     4.15         3.60   

Second Quarter

     4.00         1.70   

Third Quarter

     2.20         0.75   

Fourth Quarter

     1.10         0.50   

2010:

   $ 8.10       $ 4.00   

First Quarter

     8.10         5.75   

Second Quarter

     6.75         5.10   

Third Quarter

     5.75         5.00   

Fourth Quarter

     5.00         4.00   

These quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission, and may not represent actual transactions.

As of December 31, 2011, the Company had approximately 2,000 holders of record of its common stock. The Company has no other class of securities issued or outstanding. Dividends from the Bank are the Company’s primary source of funds to pay dividends on its capital stock. Under the National Bank Act, the Bank may, in any calendar year, without the approval of the OCC, pay dividends to the extent of net profits for that year, plus retained net profits for the preceding two years (less any required transfers to surplus). Given the losses incurred by the Bank in 2010 and 2011, as of January 1, 2011, the Bank may not, without the prior approval of the OCC, pay any dividends to the Company until such time that current year profits exceed the net losses and dividends of the prior two years. Moreover, the Bank and the Company are prohibited from paying dividends without the consent of their primary regulators pursuant to the terms of the Consent Order and the Agreement, respectively. Effective November 16, 2011, the Company shall not declare or pay any dividends without the prior written approval of the FRB and the Director of the Division of Banking Supervision and Regulation of the Board of Governors of the Federal Reserve System. The need to maintain adequate capital in the Bank also limits dividends that may be paid to the Company. The OCC and Federal Reserve have the general authority to limit the dividends paid by insured banks and bank holding companies, respectively, if such payment may be deemed to constitute an unsafe or unsound practice. If, in the particular circumstances, the OCC determines that the payment of dividends would constitute an unsafe or unsound banking practice, the OCC may, among other things, issue a cease and desist order prohibiting the payment of dividends. Additional information regarding restrictions on the ability of the Bank to pay dividends to the Company is contained in this report under “Item 1 - Business- Supervision and Regulation.”

 

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Issuer Purchases of Equity Securities

The Company made no repurchases of its Common Stock during the fourth quarter of 2011.

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

To better understand financial trends and performance, our management analyzes certain key financial data in the following pages. This analysis and discussion reviews our results of operations for the two-year period ended December 31, 2011, and our financial condition at December 31, 2010 and 2011. We have provided comparisons of financial data as of and for the fiscal years ended December 31, 2010 and 2011, to illustrate significant changes in performance and the possible results of trends revealed by that historical financial data. The following discussion should be read in conjunction with our consolidated audited financial statements, including the notes thereto, and the selected consolidated financial data presented elsewhere in this Annual Report on Form 10-K.

Going Concern

The board of directors agreed to execute a stipulation and consent to the issuance of a Consent Order by the OCC in October 2011. The Company entered into a written agreement with the FRB-Atlanta in November 2011. The Consent Order requires, among other things, that the Bank maintain a minimum Tier 1 to average assets ratio of 9% and a minimum total risk-based ratio of 12%. As a result, the Bank will be required to seek approval of the FDIC before it can accept, renew or roll over brokered deposits or pay interest on deposits above certain federally established rates. The Bank’s regulators have considerable discretion in whether to grant required approvals, and we may not be able to obtain approvals if requested.

There can be no assurance that our actions will successfully resolve all of the concerns of the federal banking regulatory authorities regarding our condition. The events and uncertainties discussed in Note 2 to our consolidated financial statements raise substantial doubt about the Company’s ability to continue as a going concern. The consolidated financial statements do not include any adjustments that might result from the outcome of these uncertainties.

Overview

We conduct our business, which consists primarily of traditional commercial banking operations, through our wholly owned subsidiary, Mountain National Bank. Through the Bank we offer a broad range of traditional banking services from our corporate headquarters in Sevierville, Tennessee, our regional headquarters in Maryville, TN, and through ten additional branches in Sevier County and Blount County, Tennessee. Our banking operations primarily target individuals and small businesses in Sevier and Blount Counties and the surrounding area. The retail nature of the Bank’s commercial banking operations allows for diversification of depositors and borrowers, and we believe that the Bank is not dependent upon a single or a few customers. But, due to the predominance of the tourism industry in Sevier County, a significant portion of the Bank’s commercial loan portfolio is concentrated within that industry, including

 

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the residential real estate segment of that industry. The predominance of the tourism industry also makes our business more seasonal in nature, particularly with respect to deposit levels, than may be the case with banks in other market areas. The tourism industry in Sevier County has remained relatively stable during the past couple of years, particularly with respect to overnight rentals and hospitality services, and management does not anticipate any significant changes in that trend in the future.

Critical Accounting Policies

Our accounting and reporting policies are in accordance with accounting principles generally accepted in the United States of America and conform to general practices accepted within the banking industry. Our significant accounting policies are described in the notes to our consolidated financial statements. Certain accounting policies require management to make significant estimates and assumptions that have a material impact on the carrying value of certain assets and liabilities, and we consider these to be critical accounting policies. The estimates and assumptions used are based on historical experience and other factors that management believes to be reasonable under the circumstances. Actual results could differ significantly from these estimates and assumptions, which could have a material impact on the carrying value of assets and liabilities at the balance sheet dates and on our results of operations for the reporting periods.

We believe the following are the critical accounting policies that require the most significant estimates and assumptions and that are particularly susceptible to a significant change in the preparation of our financial statements.

Valuation of Investment Securities

Management conducts regular reviews to assess whether the values of our investments are impaired and whether any such impairment is other than temporary. The determination of whether other-than-temporary impairment has occurred involves significant assumptions, estimates and judgments by management. Changing economic conditions – global, regional or related to industries of specific issuers – could adversely affect these values.

We recorded no other-than-temporary impairment of our investment securities during 2010 and 2011.

Allowance and Provision for Loan Losses

The allowance and provision for loan losses are based on management’s assessments of amounts that it deems to be adequate to absorb probable incurred losses inherent in our existing loan portfolio. The allowance for loan losses is established through a provision for losses based on management’s evaluation of current economic conditions, volume and composition of the loan portfolio, the fair market value or the estimated net realizable value of underlying collateral, historical charge-off experience, the level of nonperforming and past due loans, and other indicators derived from reviewing the loan portfolio. The evaluation includes a review of all loans on which full collection may not be reasonably assumed. This evaluation is based on the provisions of U.S. GAAP and, as such, management believes the allowance for loan losses is appropriate at each balance sheet date according to the requirements of U.S. GAAP. Should the

 

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factors that are considered in determining the allowance for loan losses change over time, or should management’s estimates prove incorrect, a different amount may be reported for the allowance and the associated provision for loan losses. For example, because economic conditions in our market area underwent an unexpected and adverse change in 2009, 2010 and 2011, we had to increase our allowance for loan losses by taking a charge against earnings in the form of additional provisions for loan losses in 2010 and 2011.

Valuation of Other Real Estate Owned

Real estate properties acquired through or in lieu of loan foreclosure are initially recorded at the fair value less estimated selling cost at the date of foreclosure. The fair value of other real estate is generally based on current appraisals, comparable sales, and other estimates of value obtained principally from independent sources. Any write-downs based on the asset’s fair value at the date of acquisition are charged to the allowance for loan losses. Valuations are periodically performed by management, and any subsequent write-downs are recorded as a charge to operations, if necessary, to reduce the carrying value of a property to fair value less cost to sell. Other real estate owned also includes excess Bank property not utilized when subdividing land acquired for the construction of Bank branches. Costs of significant property improvements are capitalized. Costs relating to holding property are expensed.

Deferred Tax Asset Valuation

A valuation allowance is recognized for a deferred tax asset if, based on the weight of available evidence, it is more-likely-than-not that some portion or the entire deferred tax asset will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. In making such judgments, significant weight is given to evidence that can be objectively verified. As a result of its increased credit losses, the Company entered into a three-year cumulative pre-tax loss position during 2010. A cumulative loss position is considered significant negative evidence in assessing the realizability of a deferred tax asset which is difficult to overcome. The Company’s estimate of the realization of its deferred tax assets was based on the scheduled reversal of deferred tax liabilities and taxable income available in prior carry back years. We did not consider future taxable income in determining the realizability of our deferred tax assets, and as such, recorded a valuation allowance to reduce our net deferred tax asset to zero. If the Company’s profitability returns and continues to a point that is considered sustainable, some or all of the valuation allowance may be reversed. The timing of the reversal of the valuation allowance is dependent on an assessment of future events and will be based on the circumstances that exist as of that future date.

Results of Operations for the Years Ended December 31, 2011 and 2010

General Discussion of Our Results

Our principal source of revenue is net interest income at the Bank. Net interest income is the difference between:

 

   

income received on interest-earning assets, such as loans and investment securities; and

 

   

payments we make on our interest-bearing sources of funds, such as deposits and borrowings.

 

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The level of net interest income is determined primarily by the average balances, or volume, of interest-earning assets and interest-bearing liabilities and the various rate spreads between the interest-earning assets and the Company’s funding sources. Changes in our net interest income from period to period result from, among other things:

 

   

increases or decreases in the volumes of interest-earning assets and interest-bearing liabilities;

 

   

increases or decreases in the average rates earned and paid on those assets and liabilities;

 

   

our ability to manage our interest-earning asset portfolio, which includes loans;

 

   

the availability and costs of particular sources of funds, such as non-interest bearing deposits; and

 

   

our ability to “match” liabilities to fund assets of similar maturities at a profitable spread of rates earned on assets over rates paid on liabilities.

In 2011 and 2010, our other principal sources of revenue were service charges on deposit accounts and credit/debit card related income.

 

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Net Loss

The following is a summary of our results of operations (dollars in thousands except per share amounts):

 

     Years Ended December 31,     Dollar Change     Percent Change  
     2011     2010     2011 to 2010     2011 to 2010  

Interest income

   $ 20,591      $ 23,456      $ (2,865     -12.21

Interest expense

     7,940        10,702        (2,762     -25.81
  

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income

     12,651        12,754        (103     -0.81

Provision for loan losses

     33,597        7,727        25,870        334.80
  

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income (loss) after provision for loan losses

     (20,946     5,027        (25,973     -516.67

Noninterest income

     (936     5,750        (6,686     -116.28

Noninterest expense

     17,982        17,490        492        2.81
  

 

 

   

 

 

   

 

 

   

 

 

 

Net loss before income taxes

     (39,864     (6,713     (33,151     493.83

Income tax expense (benefit)

     (606     3,738        (4,344     -116.21
  

 

 

   

 

 

   

 

 

   

 

 

 

Net loss

   $ (39,258   $ (10,451   $ (28,807     275.64
  

 

 

   

 

 

   

 

 

   

 

 

 

Total revenues

   $ 19,655      $ 29,206       

Total expenses

     58,913        39,657       

Basic loss per share

     (14.92     (3.97    

Diluted loss per share

     (14.92     (3.97    

The net loss for 2011 was primarily attributable to the provision for loan losses, the continued compression in the Company’s net interest margin and the significant write down of the recorded value of the Bank’s other real estate. The provision for loan losses reflects the continued elevated levels of net loans charged-off and increased probable losses as a result of the slowdown in economic conditions, primarily with respect to the real estate construction and development segment of our portfolio and is discussed in more detail under “Provision for Loan Losses.” Total average loans, our largest interest earning-asset, decreased approximately $60,034,000 during 2011. More significantly, the average balance of nonaccrual loans decreased approximately $17,742,000 during the year from approximately $53,005,000 at December 31, 2010 to approximately $35,263,000 at December 31, 2011. The interest associated with these loans that was excluded and reversed from income throughout 2011 was a significant factor contributing to the decrease in interest income and the continued compression of our net interest margin. Nonaccrual loans and interest income are discussed in more detail under “Allowance for Loan Losses” and “Net Interest Income.” During 2010 and continuing through 2011, we established a valuation allowance against our deferred tax assets in order to adjust the net carrying amount to what we believe is currently realizable. The deferred tax valuation allowance and related tax expense is described in more detail under “Income Taxes.” The net loss during 2011 was lessened by the decrease in certain noninterest expense items which were primarily related to the decrease in salaries and employee benefits from personnel cutbacks. However, the FDIC assessment increased offsetting this reduction as described in more detail under “Noninterest Expenses.”

 

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Basic and diluted loss per share was ($14.92) and ($14.92), respectively, for 2011, compared to ($3.97) and ($3.97), respectively, for 2010 reflecting the increased net loss from 2010 to 2011. The average number of shares outstanding was unchanged during 2011.

The Bank’s net interest margin, the difference between the yields on earning assets, including loan fees, and the rate paid on funds to support those assets, increased 50 basis points from 2.34% at December 31, 2010, to 2.84% at December 31, 2011. The reduction of nonaccrual loans in 2011 and resulting lower average balance of loans in the portfolio is the primary reason for the Bank’s improved margin. See the section titled “Net Interest Income,” below for a more detailed discussion.

The following chart illustrates our net income (loss) for the periods indicated. The changes below were impacted by changes in rate as well as changes in volume:

 

     2011     2010  

First Quarter

   $ (3,379,037   $ 329,113   

Second Quarter

     (21,854,599     142,286   

Third Quarter

     (3,220,946     350,893   

Fourth Quarter

     (10,803,787     (11,273,470
  

 

 

   

 

 

 

Annual Total

   $ (39,258,369   $ (10,451,178
  

 

 

   

 

 

 

The following discussion and analysis describes, in greater detail, the specific changes in each income statement component.

Net Interest Income

Average Balances, Interest Income, and Interest Expense

The following table contains condensed average balance sheets for the years indicated. In addition, the amount of our interest income and interest expense for each category of interest earning assets and interest-bearing liabilities and the related average interest rates, net interest spread and net yield on average interest earning assets are included.

 

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Average Balance Sheet and Analysis of Net Interest Income

for the Years Ended December 31, 2011 and 2010

(in thousands, except rates)

 

     Average Balance      Income/Expense      Yield/Rate  
     2011      2010      2009      2011      2010      2009      2011     2010     2009  

Interest-earning assets:

                        

Loans (1)(2)

   $ 337,560       $ 397,594       $ 415,522       $ 18,094       $ 20,674       $ 25,072         5.36     5.20     6.03

Investment Securities: (3)

                        

Available for sale

     89,212         111,784         151,729         2,215         2,456         5,994         2.48     2.20     3.95

Held to maturity

     1,347         1,362         2,156         63         61         87         4.68     4.48     4.04

Equity securities

     4,350         3,837         3,895         171         189         191         3.93     4.93     4.90
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

Total securities

     94,909         116,983         157,780         2,449         2,706         6,272         2.58     2.31     3.98

Federal funds sold and other

     13,602         29,310         13,295         48         76         25         0.35     0.26     0.19
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

Total interest-earning assets

     446,071         543,887         586,597         20,591         23,456         31,369         4.62     4.31     5.35

Nonearning assets

     80,166         74,544         72,816                   
  

 

 

    

 

 

    

 

 

                 

Total Assets

   $ 526,237       $ 618,431       $ 659,413                   
  

 

 

    

 

 

    

 

 

                 

Interest-bearing liabilities:

                        

Interest bearing deposits:

                        

Interest bearing demand deposits

     106,166         119,547         150,384         964         1,309         1,856         0.91     1.09     1.23

Savings deposits

     23,072         22,790         17,340         156         245         241         0.68     1.08     1.39

Time deposits

     256,762         302,494         304,715         4,217         6,283         8,151         1.64     2.08     2.67
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

Total interest bearing deposits

     386,000         444,831         472,439         5,337         7,837         10,248         1.38     1.76     2.17

Securities sold under agreements to repurchase

     891         1,535         4,284         15         24         91         1.68     1.56     2.12

Federal Home Loan Bank advances and other borrowings

     55,200         61,657         68,442         2,250         2,497         2,627         4.08     4.05     3.84

Subordinated debt

     13,403         13,403         13,403         339         344         392         2.53     2.57     2.92
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

Total interest-bearing liabilities

     455,494         521,426         558,568         7,941         10,702         13,358         1.74     2.05     2.39

Noninterest-bearing deposits

     47,660         46,237         45,761         —           —           —            
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

        

Total deposits and interest-bearings liabilities

     503,154         567,663         604,329         7,941         10,702         13,358         1.58     1.89     2.21
           

 

 

    

 

 

    

 

 

        

Other liabilities

     2,230         2,890         3,143                   

Shareholders’ equity

     20,853         47,878         51,941                   
  

 

 

    

 

 

    

 

 

                 
   $ 526,237       $ 618,431       $ 659,413                   
  

 

 

    

 

 

    

 

 

                 

Net interest income

            $ 12,650       $ 12,754       $ 18,011          
           

 

 

    

 

 

    

 

 

        

Net interest spread (4)

                       2.88     2.26     2.96

Net interest margin (5)

                       2.84     2.34     3.07

 

(1) Interest income from loans includes total fee income of approximately $740,000, $889,000 and $1,134,000 for the years ended December 31, 2011, 2010 and 2009, respectively.
(2) For the purpose of these computations, non-accrual loans are included in average loans.
(3) Tax-exempt income from investment securities is not presented on a tax-equivalent basis.
(4) Yields realized on interest-earning assets less the rates paid on interest-bearing liabilities.
(5) Net interest margin is the result of net interest income divided by average interest-earning assets for the period.

 

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The large volume of nonaccrual loans as well as a securities portfolio that, at certain times during 2011, contained comparatively low-rate investments resulted in the continued compression of our net interest margin. Rate and volume variances during 2011 caused the decrease in interest expense to largely offset the decrease in interest income so that the overall net interest income is approximately the same in 2011 when compared to 2010. The Company’s net interest margin increased by 50 basis points in 2011 compared to 2010. Yields on our loan portfolio increased by 16 basis points in 2011 compared to 2010, largely due to the charge-off of nonaccrual loans and the resulting decrease in average loans in the same period. As discussed in more detail under “Securities,” we were able to redistribute our portfolio from lower to higher yielding investments in 2011 after shifting a significant portion of our investment portfolio to shorter-term securities in preparation for their liquidation in 2010. This redistribution caused the yield on our investment securities portfolio to increase 27 basis points during 2011 when compared to 2010. In addition to the very slight increase in yields earned on our average earning assets, we also experienced a decrease in our funding costs. Rates paid on our interest-bearing deposits decreased by 38 basis points in 2011 compared to 2010, reflecting the continued effects of a decreasing interest rate environment and the continued maturity and roll-off of brokered deposits.

Average balances of our earning assets decreased by approximately $98 million in 2011 compared to 2010, primarily due to a reduction in average loans and average securities which decreased approximately $60 million and $22 million, respectively, in 2011. The liquidity created by the reduction in securities and loans was used to fund the withdrawal of brokered deposits and other time deposits during the year as discussed in more detail under “Deposits.” The remaining funds were used to pre-pay an FHLB advance and invested in federal funds sold.

Our net interest margin, the difference between the yield on earning assets, including loan fees, and the rate paid on funds to support those assets, averaged 2.84% during 2011 versus 2.34% in 2010, an increase of 50 basis points. The increase in our net interest margin reflects an increase in the average spread in 2011 between the rates we earned on our interest-earning assets, which had a slight increase in overall yield of 31 basis points to 4.62% at December 31, 2011, as compared to 4.31% at December 31, 2010, and the rates we paid on interest-bearing liabilities, which had a decrease of 31 basis points in the overall rate to 1.74% at December 31, 2011, versus 2.05% at December 31, 2010. Our interest-earning assets include approximately $122,000,000 in loans tied to prime that re-price more quickly than our interest-bearing liabilities, particularly time deposits and borrowings with a fixed rate and term. During the declining and low interest rate environments experienced in 2010 and 2011, our net interest margin has remained compressed as our interest-sensitive assets and liabilities re-price at their expected speeds. Additionally, the approximately $4 million decrease in average nonaccrual loans and increase in the average rate earned on our investment securities portfolio positively impacted our net interest margin. The negative effect of nonaccrual loans on our net interest margin will continue as long as and to the extent that the balance of nonaccrual loans is elevated. When market interest rates begin to increase, our net interest margin will likely remain compressed until interest rates exceed the established rate floors for loans.

 

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The interest income we earn on loans is the largest component of net interest income and the Bank’s net interest margin. The average balance of our loan portfolio decreased approximately $60.0 million during 2011. This significant decrease, offset in part by the slightly higher yield we earned on loans in 2011, resulted in an approximately $2.6 million reduction in loan related interest income in 2011. While management separately deals with the nonperforming loans that accounted for a portion of the decline in yield and income during 2011, measures to offset the impact of the ongoing depressed rate environment, including certain terms and conditions applicable to performing loans such as repricing frequency, rate floors and fixed interest rates, have been used by the Bank in an attempt to reduce the impact of low interest rates.

Interest income on investment securities only slightly decreased by approximately $0.3 million from 2010 to 2011 due to the approximately $22.1 million decrease in volume of securities owned offset by the 27 basis point increase in the yield earned on these securities. The change in the types of securities held during 2010 as compared to 2011 was the primary cause of the slight decline in the dollar amount of interest income even though the volume decrease was significant. Due to the liquidation of public funds during 2010, the average balance of short term U. S. Treasury securities and U. S. Agency discount notes, which earn interest at levels significantly below the securities held during 2011, greatly exceeded the average balance of these same investments during 2011.

The decrease in interest expense during 2011 as compared to 2010 was primarily due to the general decrease in interest rates paid on deposits, primarily demand deposit accounts and time deposits (including brokered deposits). The decreases in the average balance of time deposits of approximately $46 million and interest-bearing demand deposits of approximately $13 million also contributed to the decrease in interest expense from 2010 to 2011. Since the bank did not purchase any federal funds in 2011, the average rate paid on combined FHLB advances and other borrowings during 2011 was slightly higher than the average rate paid during 2010. The rates paid to borrow federal funds are based on current market rates and are significantly lower than the average rates paid on our FHLB borrowings which are generally fixed rates obtained at various times under different market conditions. FHLB advances are typically subject to prepayment penalties that severely limit any interest rate advantages gained from early payment if current market rates are lower than rates applicable to outstanding advances. In spite of the 2011 average rate increase, interest expense on borrowed funds decreased approximately $261,000, reflecting the approximately $7,101,000 decrease in average borrowed funds. Interest expense on subordinated debt remained approximately the same in 2011 in comparison to 2010. The rate on this debt is priced at a spread above 3-month LIBOR.

Even as our cost of interest-bearing deposits has declined due to the actions of the Federal Open Markets Committee (“FOMC”) in recent years, the local competition for deposits, in some instances, has and could continue to cause interest rates paid on deposits to remain above market levels during 2011. Interest rate limitations may limit the ability of the Bank to increase or maintain core deposits from current and new deposit customers. Because the Bank is not considered “well-capitalized” and because it is subject to the Consent Order, it is not permitted to offer to pay interest on deposits at rates that are more than 75 basis points above the “national rate” unless the FDIC determines we are in a high rate area.

 

 

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Rate and Volume Analysis

The following table sets forth the extent to which changes in interest rates and changes in volume of interest-earning assets and interest-bearing liabilities have affected our interest income and interest expense during the years indicated. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (1) change in volume (change in volume multiplied by previous year rate); (2) change in rate (change in rate multiplied by current year volume); and (3) a combination of change in rate and change in volume. The changes in interest income and interest expense attributable to both volume and rate have been allocated proportionately to the change due to volume and the change due to rate.

ANALYSIS OF CHANGES IN NET INTEREST INCOME

FOR THE YEARS ENDED DECEMBER 31, 2011 AND 2010

(dollars in thousands)

 

     2011 Compared to 2010  
     Increase (decrease)  
     due to change in  
     Rate     Volume     Total  

Income from interest-earning assets:

      

Interest and fees on loans

   $ 663      $ (3,243   $ (2,580

Interest on securities

     465        (722     (257

Interest on Federal funds sold and other

     (37     9        (28
  

 

 

   

 

 

   

 

 

 

Total interest income

     1,091        (3,956     (2,865
  

 

 

   

 

 

   

 

 

 

Expense from interest-bearing liabilities:

      

Interest on interest-bearing deposits

     (262     (172     (434

Interest on time deposits

     (1,199     (867     (2,066

Interest on other borrowings

     58        (319     (261
  

 

 

   

 

 

   

 

 

 

Total interest expense

     (1,403     (1,358     (2,761
  

 

 

   

 

 

   

 

 

 

Net interest income

   $ 2,494      $ (2,598   $ (104

Provision for Loan Losses

The provision for loan losses represents a charge to earnings necessary to establish an allowance for loan losses and is based on management’s evaluation of economic conditions, volume and composition of the loan portfolio, historical charge-off experience, the level of nonperforming and past due loans, and other indicators derived from reviewing the loan portfolio. Management performs such reviews quarterly and makes appropriate adjustments to the level of the allowance for loan losses as a result of these reviews.

 

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As discussed in more detail under “Discussion of Financial Condition – Allowance for Loan Losses,” management determined it was necessary to significantly increase the allowance for loan loss account in 2011 through the provision for loan losses. Although total loans decreased approximately $64,000,000 during 2011, the continuing increased level of provision for loan loss expense during 2011, as well as 2010, was due to increased charge-offs and delinquencies, related primarily to deterioration in the real estate segment of the Company’s loan portfolio, particularly construction and land development, as well as increased probable losses as the result of the slowdown in economic conditions. Continuing reductions in property values and the reduced volume of sales of developed and undeveloped land has led to an increase of impaired loans determined to be collateral dependent. As the collateral value for these loans secured by land has declined significantly during 2011 and into 2012, related charge-offs and provision expense have been incurred and these charge-offs were more than would have normally been recorded due to a liquidation strategy adopted by management during the second quarter of 2011 pursuant to which management, with the concurrence of the Board of Directors, determined that accelerating the liquidation of collateral dependent loans would be a part of the strategy to reduce the Bank’s non-performing assets. This strategy is described in more detail below under “Past Due Loans and Non-Performing Assets”. Management has continued its ongoing review of the loan portfolio with particular emphasis on construction and land development loans and we believe we have identified and, in our estimation, adequately provided for losses present in the loan portfolio. However, due to the necessarily approximate and imprecise nature of the allowance for loan loss estimate, certain projected scenarios may not occur as anticipated. Additionally, further deterioration of factors relating to the loan portfolio, such as conditions in the local and national economy and the local real estate market, could have an added adverse impact and require additional provision expense and higher allowance levels.

Noninterest Income

The following table presents the major components of noninterest income for 2011 and 2010 (dollars in thousands).

 

     Years Ended December 31,      Dollar Change  
     2011     2010      2011 to 2010  

Service charges on deposit accounts

   $ 1,442      $ 1,642       $ (200

Other fees and commissions

     1,475        1,473         2   

Gain on sale of mortgage loans

     107        191         (84

Gain on sale of securities, net

     198        1,511         (1,313

Gain (loss) on other real estate, net

     (4,980     35         (5,015

Other noninterest income

     822        898         (76
  

 

 

   

 

 

    

 

 

 

Total noninterest income

   $ (936   $ 5,750       $ (6,686
  

 

 

   

 

 

    

 

 

 

The principal components of noninterest income during both 2010 and 2011 were service charges on deposits, fees associated with credit/debit cards included in “other fees and commissions”, and income resulting from the increase in the cash surrender value of bank owned life insurance (“BOLI”). Additionally, during 2010 and 2011, we sold approximately $104,000,000 and $11,350,000, respectively, of our available-for-sale investment securities in order to reposition our bond portfolio for asset liability management purposes. As a result of the sale of these securities, during 2010 we realized an approximately $1,500,000 net gain while in

 

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2011 we realized an approximately $198,000 net gain. Also during 2011, we recorded an approximately $5,000,000 net loss on OREO, which includes valuation adjustments as well as gains and losses on disposal. We recorded a small net gain on OREO in 2010. The reduction in service charges on deposit accounts was primarily the result of a decrease in overdraft fees. During 2010 these fees began decreasing due, in part, to regulatory changes that became effective during 2010 which are discussed in the following paragraph, as well as general consumer behavior. The other fees and commissions remained approximately the same in 2010 and 2011 and include credit/debit card fees.

In November 2009, the Federal Reserve Board issued a final rule that, effective July 1, 2010, prohibited financial institutions from charging customers fees for paying overdrafts on automated teller machine and debit card transactions, unless a consumer consents, or opts in, to the overdraft service for those types of transactions. Consumers must be provided a notice that explains the financial institution’s overdraft services, including the fees associated with the service, and the consumers’ choices. This rule had a negative impact on insufficient funds income during 2010 and 2011.

Noninterest Expenses

The following table presents the major components of noninterest expense for 2011 and 2010 (dollars in thousands).

 

     Years Ended December 31,      Dollar Change     Percent Change  
     2011      2010      2011 to 2010     2011 to 2010  

Salaries and employee benefits

   $ 8,055       $ 8,322       $ (267     -3.21

Occupancy expenses

     1,799         1,759         40        2.27

FDIC assessment expense

     1,800         1,161         639        55.04

Other operating expenses

     6,328         6,248         80        1.28
  

 

 

    

 

 

    

 

 

   

 

 

 

Total noninterest expense

   $ 17,982       $ 17,490       $ 492        2.81
  

 

 

    

 

 

    

 

 

   

 

 

 

The largest component of our noninterest expense continues to be the cost of salaries and employee benefits, which decreased by approximately $267,000 during 2011. Additionally, there was an increase in FDIC assessment expense in 2011 compared to 2010 and a decrease in other operating expenses related to an FHLB pre-payment penalty of approximately $350,000 recorded during 2010. Offsetting this decrease in other operating expenses was an increase in consultant/advisory and legal fees in 2011 of approximately $273,000, primarily related to the Company’s pursuit of capital development opportunities as well as the Bank’s efforts to comply with the formal written agreement and the Consent Order.

 

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Income Taxes

Our provision for income taxes and effective tax rates for 2011 and 2010 were as follows:

Provision for Income Taxes and Effective Tax Rates

(dollars in thousands)

 

     Provision     Effective  
     Expense/(Benefit)     Tax Rates  

2011

   $ (606     1.52

2010

   $ 3,738        -55.68

The effective income tax rate for the year ended December 31, 2011 was approximately 1.52%, compared to an income tax benefit rate of (55.68%) for the year ended December 31, 2010. Our income tax expense (benefit) rate for 2010 was impacted by income tax expense related to changes in the unrealized gains and losses on investment securities available for sale. This expense was recorded through accumulated other comprehensive income and decreased our deferred tax valuation allowance. Our income tax expense rate for 2010 was principally impacted by the recognition of a valuation allowance during 2010 as more fully discussed in “Note 8. Income Taxes.” Establishing a valuation allowance required us to record a significant tax expense which, when applied to a pretax loss, caused a negative effective tax rate. Additionally, tax exempt income has the effect of increasing a taxable loss, therefore increasing effective tax rates as a percentage of pretax income. This is the opposite effect on tax rates when a company has pretax income.

During 2010 and 2011, the effective tax rate was positively impacted by the continuing tax benefits generated from MNB Real Estate, Inc., which is a real estate investment trust subsidiary formed during the second quarter of 2005. The income generated from tax-exempt municipal bonds and bank owned life insurance also improved our effective tax rate in both years. Additionally, during 2006, the Bank became a partner in Appalachian Fund for Growth II, LLC with three other Tennessee banking institutions. This partnership has invested in a program that generated a federal tax credit in the amount of approximately $200,000 per year during 2010 and 2011.

 

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Discussion of Financial Condition

General Discussion of Our Financial Condition

The following is a summary comparison of selected major components of our financial condition for the periods ended December 31, 2011 and 2010 (dollars in thousands):

 

     2011     2010     $ change     % change  

Cash and equivalents

   $ 42,768      $ 32,576      $ 10,192        31.29

Loans

     310,796        374,355        (63,559     -16.98

Allowance for loan losses

     14,863        10,942        3,921        35.83

Investment securities

     96,410        87,635        8,775        10.01

Premises and equipment

     31,548        32,601        (1,053     -3.23

Other real estate owned

     11,023        13,141        (2,118     -16.12

Total assets

     502,646        557,207        (54,561     -9.79

Noninterest-bearing demand deposits

     50,761        47,639        3,122        6.55

Interest-bearing demand and savings deposits

     132,537        130,779        1,758        1.34

Time deposits

     248,839        271,173        (22,334     -8.24
  

 

 

   

 

 

   

 

 

   

 

 

 

Total deposits

     432,137        449,591        (17,454     -3.88

Federal Home Loan Bank advances

     55,200        55,200        —          0.00

Subordinated debentures

     13,403        13,403        —          0.00

Total liabilities

     504,983        521,532        (16,549     -3.17

Accumulated other comprehensive income (loss)

     80        (1,065     1,145        107.51

Total shareholders’ equity

   $ (2,337   $ 35,674      $ (38,011     -106.55

Loans

At December 31, 2010 and 2011, loans comprised 77.4% and 72.6% of our total earning assets, respectively. The decrease in loans of approximately $63,559,000 was the result of the charge off of approximately $30,086,000, foreclosed properties moved to ORE totaling approximately $10,325,000 and approximately $23,148,000 in payoffs and payments received in each case during 2011.

 

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Loan Portfolio. Our loan portfolio consisted of the following loan categories and amounts as of the dates indicated:

 

     At December 31,  
     2011      2010      2009      2008      2007  
     (in thousands)  

Commercial, financial, agricultural

   $ 27,296       $ 24,944       $ 30,387       $ 37,632       $ 35,929   

Real estate - construction, development

     56,325         83,543         99,771         142,370         150,844   

Real estate - mortgage

     222,962         260,738         270,622         231,999         201,011   

Consumer and other

     4,213         5,130         6,924         8,428         9,890   

Less allowance for loan losses

     14,863         10,942         11,353         5,292         3,974   

Loans, net

   $ 295,933       $ 363,413       $ 396,351       $ 415,137       $ 393,700   

Commercial and consumer loans tend to be more risky than loans that are secured by real estate; however, the Bank seeks to control this risk with adherence to quality underwriting standards. Still, as reflected in our 2010 and 2011 results of operations and described in more detail under “Allowance for Loan Losses,” real estate construction and development loans do involve risk and if the underlying collateral, which in the case of acquisition and development loans may involve large parcels of real property, is not equal to the value of the loan, we may suffer losses if the borrower defaults on its obligation to us.

The Bank originates commercial and consumer loans. For each type of loan within these categories the underwriting policies and procedures are substantially the same. The Bank’s loan underwriting guidelines for commercial credit require verification of cash flow and income from financial statements and federal income tax returns prior to a loan’s origination. In addition, credit reports are obtained, including credit scores, for all loan guarantors prior to a loan’s origination. For consumer credit, before originating a loan, sources of income are verified from the borrower’s most recent federal tax returns and credit bureau reports, including credit scores. The Bank does not engage in subprime lending which is generally defined as lending to borrowers with credit scores below a certain threshold. The Bank does not extend credit under programs such as low doc/no doc loans whereby a borrower can obtain a loan based primarily on loan to value ratios in real estate pledged as collateral being at or below a certain level and all other customary documentation requirements are waived. The Bank does not engage in hybrid lending.

The credit underwriting process, which utilizes a trained credit analyst for more complex credits, seeks to consider all of a borrower’s contingent credit liabilities. All loans are underwritten as if fully drawn and amortized over periods ranging from sixty months to two hundred forty months at the current interest rate offered on the loan. Additionally, a stress test is applied to all current and contingent debt by increasing the interest rate 200 basis points. Debt-to-income ratios are calculated for consumer loans with the general guideline requiring the ratio to be 40% or less. Debt service coverage ratios are calculated for commercial loans and must exceed a one to one coverage ratio. Loan to value ratios for loans secured by real estate generally range from 70% to 90% at the time of a loan’s origination, dependent upon the type of collateral pledged. The Company has not made material changes to its underwriting policies and procedures during the most recent fiscal year.

 

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Maturities and Sensitivities of Loan Portfolio to Changes in Interest Rates. Total loans as of December 31, 2011 are classified in the following table according to maturity or scheduled repricing:

 

     One year
or less
     Over one
year
through
three years
     Over three
years
through
five years
     Over five
years
 
     (in thousands)  

Commercial, financial, agricultural

   $ 15,072       $ 5,572       $ 3,486       $ 3,166   

Real estate - construction, development

     29,214         20,089         3,139         3,883   

Real estate - mortgage

     105,076         71,969         26,131         19,786   

Consumer and other

     3,098         709         240         166   

Total

   $ 152,460       $ 98,339       $ 32,996       $ 27,001   

In an effort to maintain pricing leverage on a significant portion of its loan portfolio, the Company has historically structured loans with maturities of one year or less. Accordingly, approximately 49% of our loans mature in one year or less. Loans that are not paid in full within the one year maturity are generally renewed at maturity on terms at least as favorable to the Company as at origination. Of our loans maturing more than one year after December 31, 2011, approximately $72,035,000 had fixed rates of interest and approximately $82,252,000 had variable rates of interest. At December 31, 2011, loans to sub-dividers/developers were 15.6% of total loans and loans to franchise hotels & motels were 13.1% of total loans. No other concentrations of credit exceeded ten percent of our total loans.

 

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Past Due Loans and Non-Performing Assets

The following table presents performing loans that were past due at least 30 days but less than 90 days as of December 31, 2011 and 2010:

 

     December 31,  
     2011     2010  
     Balance      % of
total
loans
    Balance      % of
total
loans
 
     ($ in thousands)  

Construction, land development and other land loans

   $ 1,141         0.37   $ 265         0.07

Commercial real estate

     4,658         1.50     541         0.14

Consumer real estate

     2,958         0.95     1,130         0.30

Commercial loans

     2,922         0.94     —           0.00

Consumer loans

     60         0.02     68         0.02
  

 

 

      

 

 

    

Total

   $ 11,739         3.78   $ 2,004         0.54
  

 

 

      

 

 

    

Due to management’s ongoing efforts to identify and liquidate certain impaired loans, delinquent loans at December 31, 2011 were significantly higher than delinquent loans at December 31, 2010. This liquidation process involves a foreclosure process on loans secured by real estate and can be delayed based on legal actions taken by borrowers including bankruptcy. Developers that do not have adequate cash flow or cash reserves to sustain the required interest payments on their loans during this period of economic stress have been unable to continue their developments. Also, reduced cash flows for operating businesses have caused borrowers that do not have adequate cash reserves to become delinquent. A significant portion of loans classified consumer real estate are secured with nightly rental cabins and not the borrower’s primary residence and these properties have also seen a decline in cash flow. As a result, the Bank has classified a significant portion of these loans as non-performing assets. Higher levels of delinquent loans could result in higher levels of impaired loans and non-performing assets, which may negatively impact the Company’s results of operations.

The Company’s non-performing assets consist of loans past due 90 days or more and still accruing, nonaccrual loans and OREO. Loans that have been restructured and remain on accruing status are not included in non-performing assets. The following table presents the Bank’s non-performing assets for the periods indicated:

 

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     Past due
90 days
or more and
still accruing
     % of
total
loans
    Nonaccrual
loans
     % of
total
loans
    Other real
estate
owned
     Total
non-
performing
assets
 
     ($ in thousands)  

As of December 31, 2011

               

Construction, land development and other land loans

   $ —           0.00   $ 17,720         5.70   $ 2,738       $ 20,207   

Commercial real estate

     —           0.00     8,512         2.74     5,248         13,760   

Consumer real estate

     770         0.25     9,031         2.91     3,037         12,838   

Commercial loans

     200         0.06     —           0.00     —           200   

Consumer loans

     —           0.00     —           0.00     —           —     
  

 

 

      

 

 

      

 

 

    

 

 

 

Total

   $ 970         0.31   $ 35,263         11.35   $ 11,023       $ 47,005   
  

 

 

      

 

 

      

 

 

    

 

 

 

Total non-performing loans to total loans

             11.66     

Total non-performing assets to total loans plus other real estate owned

  

       14.61     

As of December 31, 2010

               

Construction, land development and other land loans

   $ —           0.00   $ 27,929         7.46   $ 2,595       $ 30,524   

Commercial real estate

     413         0.11     6,362         1.70     2,107         8,882   

Consumer real estate

     —           0.00     18,647         4.98     8,439         27,086   

Commercial loans

     —           0.00     67         0.02     —           67   

Consumer loans

     19         0.01     —           0.00     —           19   
  

 

 

      

 

 

      

 

 

    

 

 

 

Total

   $ 432         0.12   $ 53,005         14.16   $ 13,141       $ 66,578   
  

 

 

      

 

 

      

 

 

    

 

 

 

Total non-performing loans to total loans

             14.27     

Total non-performing assets to total loans plus other real estate owned

  

       17.18     

As of December 31, 2009

               

Construction, land development and other land loans

   $ 43         0.01   $ 21,596         5.30   $ 5,834       $ 27,473   

Commercial real estate

     —           0.00     11,003         2.70     1,093         12,096   

Consumer real estate

     —           0.00     7,864         1.93     7,648         15,512   

Commercial loans

     —           0.00     75         0.02     —           75   

Consumer loans

     25         0.01     10         0.00     —           35   
  

 

 

      

 

 

      

 

 

    

 

 

 

Total

   $ 68         0.02   $ 40,548         9.95   $ 14,575       $ 55,191   
  

 

 

      

 

 

      

 

 

    

 

 

 

Total non-performing loans to total loans

             9.96     

 

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Loans past due ninety days or more and still accruing and nonaccrual loans at December 31, 2011, 2010 and 2009 consisted primarily of construction and land development loans and commercial and consumer real estate loans. Of the approximately $35,263,000 nonaccrual loans at December 31, 2011, approximately $17,720,000, or 50.3% are construction and land development loans while commercial real estate and consumer real estate make up approximately $8,512,000 and $9,031,000, or 24.1% and 25.6%, respectively, at that date. Loans past due ninety days or more and still accruing are not considered material for each of the three years presented in the table above. There was a significant decline in nonaccrual loans during 2011 for both the construction and land development loans and consumer real estate loans after both of these categories had increased from 2009 to 2010. Construction and land development loans on nonaccrual reduced approximately $10,209,000 from approximately $27,929,000 to approximately $17,720,000 at December 31, 2010 and 2011, respectively. Consumer real estate loans on nonaccrual reduced approximately $9,616,000 from approximately $18,647,000 to approximately $9,031,000 at December 31, 2010 and 2011, respectively. These declines were primarily due to management’s problem loan liquidation strategy described in more detail below.

Notwithstanding the general favorable trends in tourism in Sevier County, residential and commercial real estate sales continued to be weak during 2010 and 2011, following the same pattern that began during the second half of 2008 and continued throughout 2009. The reduced sales have negatively impacted past due, nonaccrual and charged-off loans. Price declines during 2010 and 2011 had an adverse impact on overall real estate values. These trends had the greatest effect on the construction and development and commercial real estate portfolios resulting in the continuing high levels of nonaccrual loans during 2010 and continuing during 2011. Many of the borrowers in these categories are dependent upon real estate sales to generate the cash flows used to service their debt. Since real estate sales have been depressed, many of these borrowers have experienced greater difficulty meeting their obligations, and to the extent that sales remain depressed, these borrowers may continue to have difficulty meeting their obligations.

The following table sets forth the reduction in interest income we experienced in 2010 and 2011 as a result of non-performance of certain loans during the year:

 

     2011      2010  
     ($ in thousands)  

Interest income that would have been recorded on nonaccrual loans under original terms

   $ 1,055       $ 3,164   

Interest income that was recorded on nonaccrual loans

     257         603   

The purpose of placing a loan on nonaccrual is to prevent the Bank from overstating its income. The decision to place a loan on nonaccrual is made by the Special Assets Department based on a monthly review. Management also reviews any loans placed on nonaccrual that are: (1) being maintained on a cash basis because of deterioration in the financial position of the borrower; or (2) for which payment in full of interest or principal is not expected.

 

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Generally, the Bank does not accrue interest on any loan when principal or interest are in default for 90 days or more unless the loan is well secured and in the process of collection. Consumer loans and residential real estate loans secured by 1-4 family dwellings are ordinarily not subject to those guidelines.

Management may restore a non-accruing loan to an accruing status when principal and interest is no longer due and unpaid, or it otherwise becomes both well secured and in the process of collection. All loans on non-accrual are reported on the Bank’s watch loan list.

The Bank’s OREO decreased approximately $2,118,000 during 2011. During the second quarter of 2011, management, with the concurrence of the Board of Directors, determined that accelerating the liquidation of OREO and collateral dependent loans would be a part of the strategy to reduce the Bank’s non-performing assets. Management’s goal was to accelerate the liquidation of existing OREO within three- to six-months of adopting the strategy and to accelerate the foreclosure of property securing collateral dependent loans and liquidate the acquired OREO within three- to six-months of foreclosure. This strategy was intended to reduce the Bank’s levels of delinquent loans and non-performing assets and increase liquidity and performing assets from the sale of the OREO. The responsibility for carrying out this strategy was assigned to the Special Assets Department. This department, which was significantly expanded during 2010 and 2011, is dedicated to oversight of non-performing assets. The Special Assets Department reports directly to the Bank’s Board of Directors and focuses on relationships that represent current and potential performance problems related to the Bank’s loan portfolio. The department also handles administration of the Bank’s OREO properties including incorporating new information and data as it becomes available and applying that information to the recorded value of these assets.

Prior to adopting this strategy, management established the recorded value of foreclosed real estate at discounts ranging from ten percent to twenty percent with limited exceptions. Those estimates reflected management’s estimate of concessions, including costs to sell, necessary to sell the property within timeframes consistent with those identified in the appraisals. For certain properties consisting primarily of five or more lots in a single development, the appraisal (“Bulk appraisal”) would incorporate a discounted value, including costs to sell, that estimated the price a buyer would pay to acquire all of the lots in a single transaction.

To effect the accelerated liquidation of OREO, management offered the properties for sale at prices the Special Assets Department believed would facilitate a sale in the targeted three- to six-month timeframe. Initially, those prices were estimated by this department on a property by property basis using the most recent independent appraisal and adjusting the value downward by an estimated cost to sell and based on input from realtors and the department’s observations of local market conditions. The resulting prices typically reflected a discount to the last appraised value that ranged from thirty percent to fifty percent of the appraised value, although certain properties were discounted more heavily. Subsequent to adopting the accelerated liquidation strategy, the offering price of real estate acquired through foreclosure was based on values provided by appraisers at or near the date of foreclosure. The reduction in offering prices associated with the accelerated liquidation strategy triggered a reduction in the carrying value of existing OREO of approximately $3,253,000 to $4,022,000, as noted in the table below, as of December 31, 2011. This reduction was recorded through a valuation allowance with a corresponding charge against earnings in the form of a loss on OREO for existing OREO

 

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properties or as a charge off to the allowance for loan losses for properties transferred to OREO after the strategy was adopted. The offering prices for substantially all of the Company’s OREO properties reflected the accelerated liquidation strategy at December 31, 2011. During the first quarter of 2012, the Board of Directors approved a change in strategy from accelerated liquidation to holding OREO for normal marketing periods and the discontinuance of the use of accelerated liquidation values for determination of the recorded value for OREO.

The following table sets forth a range of the reduction in earnings the Bank experienced at December 31, 2011 as a result of implementing the accelerated liquidation strategy (excludes OREO held by the Holding Company):

 

Range of

Recorded

Values as

   OREO
Balance by
Range
     Range
Category
Percentage
    Reduction in Recorded
Value Due to Use of
Accelerated Liquidation
Strategy
 

% of Appraisal

   Category      of Total     (A)     (B)  

50% or less

   $ 708,690         6.58   $ 614,810      $ 695,560   

> 50% < 60%

     2,584,651         23.99     1,370,589        1,608,729   

> 60% < 70%

     2,160,495         20.05     608,830        772,555   

> 70% < 80%

     2,908,603         27.00     363,147        555,997   

> 80% < 90%

     1,032,552         9.58     4,423        65,421   

> 90%

     638,327         5.93     (85,826     (53,326

Bulk Value

     739,805         6.87     377,123        377,123   
  

 

 

    

 

 

   

 

 

   

 

 

 

Total

   $ 10,773,123         100.00   $ 3,253,096      $ 4,022,059   
  

 

 

    

 

 

   

 

 

   

 

 

 

 

(A) Reduction in recorded value as a result of using accelerated disposal value compared to using appraised values using a normal marketing period, discounted 15% to 20%. Approximately $759,000 of the reduction was recorded through the valuation reserve and approximately $1,395,000 through the allowance for loan losses for transfers after the change in strategy
(B) Reduction in recorded value as a result of using accelerated disposal value compared to using appraised values using a normal marketing period, discounted 10% to 15%. Approximately $965,000 of the reduction was recorded through the valuation reserve and approximately $984,000 through the allowance for loan losses for transfers after the change in strategy
* Bulk properties are generally recorded at appraised value

The recorded investment in OREO ranged from approximately 36% to 100% of the appraised value at December 31, 2011. As noted in the table above, approximately $8,362,000, or 77.6%, of the Bank’s OREO had a recorded investment resulting from a discount of the appraised value of more than twenty percent at December 31, 2011. Had the accelerated liquidation strategy not been implemented during 2011, the gross balance in OREO would have been in a range of approximately $16,939,000 to approximately $17,708,000 and the balance in the valuation allowance would have been in a range of approximately ($2,154,000) to approximately ($1,948,000) resulting in a recorded investment in OREO of approximately $14,785,000 to approximately $15,760,000.

 

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Potential problem loans, which are not included in nonperforming loans, amounted to approximately $45,427,000, or 14.62% of total loans outstanding at December 31, 2011, compared to approximately $58,900,000, or 15.72% of total loans outstanding at December 31, 2010. These loans could lead to higher levels of impaired loans and non-performing assets. Potential problem loans represent those loans with a well-defined weakness and where information about possible credit problems of borrowers has caused management to have serious doubts about the borrower’s ability to comply with present repayment terms. This definition is believed to be substantially consistent with the standards established by the OCC, the Bank’s primary regulator, for loans classified as substandard or worse, excluding the impact of nonperforming loans. The decrease in potential problem loans was due primarily to the liquidation strategy implemented by management and the overall decline in loans during 2011. Loans past due 30 days or longer have been excluded from potential problem loans.

Allowance for Loan Losses

The allowance for loan losses is maintained at a level which, in management’s judgment, is adequate to absorb probable credit losses incurred in the loan portfolio. The amount of the allowance is based on management’s evaluation of the collectability of the loan portfolio, including the nature of the portfolio, credit concentrations, trends in historical loss experience, specific impaired loans, economic conditions and other risks inherent in the portfolio. Allowances for impaired loans are generally determined based on collateral values or the present value of estimated cash flows. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged off. The allowance is increased by a provision for loan losses, which is charged to expense and reduced by charge offs, net of recoveries. Changes to the allowance relating to impaired loans are charged or credited to the provision for loan losses. Based on an analysis of the credit quality of the loan portfolio prepared by the Bank’s risk officer, the CFO presents a quarterly analysis of the adequacy of the allowance for loan losses for review by our board of directors.

Within the allowance, there are specific and general loss components. The specific loss component is assessed for non-homogeneous loans that management believes to be impaired. A loan is considered impaired when, based on current information and events it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Loans, for which the terms have been modified, and for which the borrower is experiencing financial difficulties, are considered troubled debt restructurings, as discussed in more detail below, and classified as impaired. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record and the amount of the shortfall in relation to the principal and interest owed.

 

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Loans over $100,000 that are graded special mention or worse are individually evaluated for impairment. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment, and accordingly, they are not separately identified for impairment disclosures. Troubled debt restructurings are separately identified for impairment disclosures and are measured at the present value of estimated future cash flows using the loan’s effective rate at inception. If a troubled debt restructuring is considered to be a collateral dependent loan, the loan is reported, net, at the fair value of the collateral. For troubled debt restructurings, as discussed in more detail below, that subsequently default, the Company determines the amount of reserve in accordance with the accounting policy for the allowance for loan losses. For loans determined to be impaired, the loan’s carrying value is compared to its fair value using one of the following fair value measurement techniques: present value of expected future cash flows, observable market price, or fair value of the associated collateral less costs to sell. An allowance is established through a charge to earnings when the fair value is lower than the carrying value of that loan.

The general component of the allowance for loan losses covers non-classified and classified non-impaired loans. Management tracks the eight-quarter rolling loss ratio for loans in each of the following loan categories at December 31, 2011: construction and land development, commercial real estate, commercial, residential real estate, consumer and credit cards. These segments are described in more detail below. An allowance for loan losses is estimated for each of these segments by applying a loss factor to the balance of loans in the segment. The loss factor is comprised of the eight-quarter rolling loss ratio (the quantitative factor) and a single qualitative factor. The qualitative factor is based on the current level of classified loans in the segment relative to the eight-quarter weighted average level of classified loans in that segment. Generally, the qualitative factor increases as the level of classified loans at the end of the period increases relative to the eight-quarter weighted average level of classified loans and the qualitative factor decreases as the level of classified loans at the end of the period decreases relative to the eight-quarter weighted average level of classified loans.

The method of estimating the general component of the allowance for loans described above is an enhancement of the method previously used. Prior to the fourth quarter of 2011, material changes in loan risk classifications and charge-offs during the most recent quarter-end were addressed through the qualitative factors. As of year-end 2011, all charge offs and changes in loan classifications in the most recent quarter are included in the eight-quarter rolling average data discussed above.

Real estate and commercial and industrial loans comprise approximately 98.6% of loans at December 31, 2011. The Bank’s loan segments are as follows:

Construction and land development loans include loans to finance the process of improving land preparatory to erecting new structures or the on-site construction of industrial, commercial or residential buildings. Construction and land development loans also include loans secured by vacant land, except land known to be used or usable for agricultural purposes. Construction loans generally are made for relatively short terms. They generally are more vulnerable to changes in economic conditions. Further, the nature of these loans is such that they are more difficult to evaluate and monitor. The risk of loss on a construction loan is dependent largely upon the accuracy of the initial estimate of the property’s value upon completion of the project and the estimated cost (including interest) of the project. Periodic site inspections are made on construction loans.

 

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Commercial real estate loans include loans secured by non-residential real estate, including farmland and improvements thereon. Often these loans are made to single borrowers or groups of related borrowers, and the repayment of these loans largely depends on the results of operations and management of these properties. Adverse economic conditions may affect the repayment ability of these loans.

Commercial and industrial loans include loans for commercial or industrial purposes to business enterprises that are not secured by real estate. Commercial loans are typically made on the basis of the borrower’s ability to repay from the cash flow of the borrower’s business. Commercial loans are generally secured by accounts receivable, inventory and equipment. The collateral securing loans may depreciate over time, may be difficult to appraise and may fluctuate in value based on the success of the business. The Company seeks to minimize these risks through its underwriting standards.

Residential real estate loans include loans secured by residential real estate, including single-family and multi-family dwellings. Mortgage title insurance and hazard insurance are normally required. Adverse economic conditions in the Company’s market area may reduce borrowers’ ability to repay these loans and may reduce the collateral securing these loans.

Consumer loans include loans to individuals for household, family and other personal expenditures that are not secured by real estate. Consumer loans are generally secured by vehicles and other household goods. The collateral securing consumer loans may depreciate over time. The Company seeks to minimize these risks through its underwriting standards.

Credit Card loans include revolving lines of credit issued for commercial and consumer purposes. These lines are generally unsecured. Several factors including adverse economic conditions and unfavorable circumstances relative to individual customers may affect repayment of these loans.

Consumer loans, which comprised approximately 1.4% of loans at December 31, 2011, have an allowance established for non-classified and classified non-impaired loans based upon a five calendar year plus current year to date historical loss factor. This loss factor is also adjusted for certain environmental factors and is applied against the segregated categories that are determined by product type. The “other consumer” class of loans is comprised of both revolving credit and installment loans.

The allowance could also include an unallocated component. We believe that an unallocated amount could be warranted for inherent factors that cannot be practically assigned to individual loan categories, such as the estimable nature of the loss allocation measurement process and the volatility of the local economies in the markets we serve. An unallocated

 

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component was not considered necessary as of December 31, 2011 due to the enhancements described above and input from the most recent regular safety and soundness exam performed by the OCC, as discussed in more detail below. At year-end 2010, the unallocated component was $1,077,000 due, primarily, to the calculation used during that period not incorporating the most recent quarter end results. However, management considered these results and trends to determine the unallocated component.

As discussed at “Past Due Loans and Non-Performing Assets” above, the Company adopted a strategy in the second quarter of 2011 to accelerate the liquidation of certain impaired loans. The strategy involved an accelerated foreclosure of the real estate securing these loans and an accelerated disposal of the real estate, or allowing borrowers to utilize short sales, which is the sale of the real estate at a price less than the balance of the loan. Forgiveness of remaining debt after these foreclosures and short sales, a legal agreement not to pursue the borrower for any resulting deficiency balance, was used as an enticement for borrowers to agree to the terms allowing liquidation of certain loans. As discussed above, management offered the foreclosed properties for sale at prices management believed would facilitate a sale in a targeted three- to six-month timeframe. For the impaired loans, those prices were initially estimated by management on a property-by-property basis using the most recent appraisal and adjusting the value downward based on input from realtors and management’s observations of local market conditions. The reduction in offering prices associated with the strategy triggered a reduction in the estimated fair value of the collateral for substantially all of these collateral dependent loans.

The adoption of this strategy resulted in charge offs on and a reduction of the recorded investment in collateral dependent loans at December 31, 2011 in a range of approximately $2,628,000 to $3,017,000. This range is determined on a loan by loan basis by applying discounts to the appraised value of the collateral of ten to fifteen percent for the higher value in the range and discounts of fifteen to twenty percent for the lower value in the range through the allowance for loan loss. Properties with bulk appraisals are generally recorded at the appraised value. Total charge offs were approximately $17,700,000 on impaired collateral dependent loans that had a recorded investment of approximately $32,015,000 at December 31, 2011. During the first quarter of 2012, the Board of Directors approved the discontinuance of the use of accelerated liquidation values for determination of the fair value to be recorded for loans determined to be collateral dependent which may result in a reduction in the charge off to the ALLL for individual collateral dependent loans going forward.

Loans considered collateral dependent are also considered nonaccrual loans and are generally included in the nonperforming loan balances. Management has recorded partial charge offs on nonaccrual collateral dependent loans totaling approximately $14,906,000 as of December 31, 2011, and of this amount approximately $12,736,000 was charged off during 2011 and $2,170,000 was charged off prior to 2011.

Our allowance for loan losses is also subject to regulatory examinations and determinations as to adequacy, which may take into account such factors as the methodology used to calculate the allowance and the level of risk in the loan portfolio. During their routine examinations of banks, regulatory agencies may advise a bank to make additional provisions to its allowance for loan losses, which would negatively impact a bank’s results of operations, when the opinion of the regulators regarding credit evaluations and allowance for loan loss

 

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methodology differ materially from those of the Bank’s management. During the regular safety and soundness examination conducted by the Bank’s regulatory agency during the first quarter of 2012, significant increases were required for provisions to the allowance for loan losses based on loans determined to be collateral dependent by the OCC that had not been identified by the Special Assets Department. Based on these findings, the Bank recorded an additional charge off of approximately $5,788,000 and a resulting provision to the allowance for loan losses of approximately $5,333,000 for the fourth quarter of 2011. These changes have been recognized and incorporated into the results of operations as of December 31, 2011. The failure to timely identify these classified loans and to identify all collateral dependent loans is considered a material internal control weakness as more fully described in “Item 9A. Controls and Procedures.” Also, during the safety and soundness exam the OCC required the Bank to enhance its allowance for loan loss calculation, effective as of December 31, 2011.

Concentrations of credit risk typically involve loans to one borrower, an affiliated group of borrowers, borrowers engaged in or dependent upon the same industry, or a group of borrowers whose loans are secured by the same type of collateral. Our most significant concentration of credit risks lies in the high proportion of our loans to businesses and individuals dependent on the tourism industry and loans to sub-dividers and developers of land. The Bank assesses loan risk by primary concentrations of credit by industry and loans directly related to the tourism industry are monitored carefully. At December 31, 2011, approximately $156,000,000 in loans, or 50% of total loans, were to businesses and individuals whose ability to repay depends to a significant extent on the tourism industry in the markets we serve as compared to approximately $192,000,000 in loans, or 51% of total loans, at December 31, 2010. The most significant decreases in this category were overnight rentals by agency and sub-dividers and developers each of which decreased approximately $17,000,000.

While it is the Bank’s policy to charge off in the current period loans for which a loss is considered confirmed, there are additional risks of losses which cannot be quantified precisely or attributed to particular loans or classes of loans. Because the risk of loss includes unpredictable factors, such as the state of the economy and conditions affecting individual borrowers, management’s judgments regarding the appropriate size of the allowance for loan losses is necessarily approximate and imprecise, and involves numerous estimates and judgments that may result in an allowance that is insufficient to absorb all incurred loan losses.

Management is not aware, as of December 31, 2011, of any loans classified for regulatory purposes as loss, doubtful, substandard, or special mention that have not been identified and sufficiently provided for in the allowance for loan losses which (1) represent or result from trends or uncertainties which management reasonably expects will materially impact future operating results, liquidity, or capital resources, or (2) represent material credits about which management is aware of any information which causes management to have serious doubts as to the ability of such borrowers to comply with the loan repayment terms.

Individually impaired loans are loans that the Bank does not expect to collect all amounts due according to the contractual terms of the loan agreement and include any loans that meet the definition of a troubled debt restructuring (“TDR”), as discussed in more detail below. In some cases, collection of amounts due becomes dependent on liquidating the collateral securing the impaired loan. Collateral dependent loans do not necessarily result in the loss of principal or

 

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interest amounts due; rather the cash flow is disrupted until the underlying collateral can be liquidated. As a result, the Bank’s impaired loans may exceed nonaccrual loans which are placed on nonaccrual status when questions arise about the future collectability of interest due on these loans. The status of impaired loans is subject to change based on the borrower’s financial position.

Problem loans are identified and monitored by the Bank’s watch list report which is generated during the loan review process. This process includes review and analysis of the borrower’s financial statements and cash flows, delinquency reports and collateral valuations. The watch list includes all loans determined to be impaired. Management determines the proper course of action relating to these loans and receives monthly updates as to the status of the loans.

The following table presents impaired loans as of December 31, 2011 and December 31, 2010:

 

     December 31, 2011     December 31, 2010  
            % of            % of  
     Impaired      total     Impaired      total  
     Loans      loans     Loans      loans  
            ($ in thousands)         

Construction, land development and other land loans

   $ 18,018         5.80   $ 41,517         11.09

Commercial real estate

     20,283         6.53     21,529         5.75

Consumer real estate

     18,575         5.98     29,182         7.80

Other loans

     9         0.00     128         0.03
  

 

 

      

 

 

    

Total

   $ 56,885         18.30   $ 92,356         24.67
  

 

 

      

 

 

    

The decrease in impaired loans during 2011 was primarily related to management’s aggressive liquidation strategy noted above. There has been a continued weakening of the residential and commercial real estate market in the Bank’s market areas which has led to the continued elevation of impaired loans. Within this segment of the portfolio, the Bank has traditionally made loans to, among other borrowers, home builders and developers of land. These borrowers have continued to experience stress during the ongoing challenging economic climate due to a combination of declining demand for residential real estate, excessive volume of properties available and the resulting price and collateral value declines. In addition, housing starts in the Bank’s market areas continue to be at historically low levels. Continuation of the challenging economic climate will likely cause the Bank’s real estate mortgage loans, which include construction and land development loans, to continue to underperform and may result in increased levels of impaired loans and non-performing assets, which may negatively impact the Company’s results of operations.

Thirty-seven impaired loans with a recorded value of approximately $32,015,000 were considered to be collateral dependent at December 31, 2011. One of these loans had a specific reserve allocated in the ALLL of $200,000 resulting in a net recorded value of approximately $31,815,000 for collateral dependent loans. Approximately $27,095,000 of the collateral

 

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dependent loans is troubled debt restructurings discussed in more detail below. Collateral dependent loans are generally recorded at the lower of cost or the appraised value net of estimated selling costs. It is generally determined these loans will be repaid by the liquidation of the collateral securing the loans. Management obtains independent appraisals of the collateral securing collateral dependent loans at least annually, or more frequently during periods of significant devaluation of real estate, like those currently being experienced, from independent licensed real estate appraisers and the carrying amount of the loans that exceed the accelerated liquidation value, which includes estimated selling costs, is taken as a charge against the allowance for loan losses and may result in additional charges to the provision expense. During the first quarter of 2011, for any impaired loans for which the principal collateral is real estate, the Bank began obtaining a current appraisal at least every six months. Prior to obtaining appraisals semi-annually, the Bank was obtaining annual appraisals. The process of obtaining appraisals every six months continued until the fourth quarter of 2011 at which time the Special Assets Department made the determination the rapid decline in property values in the Bank’s market areas were no longer prevalent and appraisals are presently being ordered annually. However, loans secured by land have continued to experience significant declines in value and the lengthening of the appraisal period could result in increased charges to the ALLL and provision expense when new appraisals are received. The Company utilizes a third party independent advisor to review appraisals for consistency and to assist the Company in identifying deficiencies in the appraisals. In the event that the Company disputes the appraisal results, the Company notifies the appraiser of the defects in the appraisal and engages a second independent appraiser to perform a second appraisal, which appraisal results the Company uses.

Due to the weakening credit status of a borrower, we may elect to formally restructure certain loans to facilitate a repayment plan that minimizes the potential losses, if any, that we might incur. All restructured loans are classified as impaired loans and, if on nonaccruing status as of the date of restructuring, the loans are included in the nonperforming loan balances. Restructurings generally involve a reduced rate of interest that is below current market rates for a specified term usually ranging from one to two years. An additional concession could involve an extended amortization period up to thirty years. At the end of each loan’s revised maturity date, the Bank re-evaluates the credit to determine if additional time is required to enable the borrower to perform under normal credit underwriting standards.

Concessions could involve restructuring a loan into tranches with the primary note meeting all credit underwriting standards and secondary notes being classified as nonaccrual loans or being charged off through the ALLL. Generally, these types of restructurings require the borrower to demonstrate the ability to perform under the restructured loan agreement with the loan being designated nonaccrual until performance is considered likely to occur. These types of restructurings are not material at this time.

Restructurings are not generally utilized to prevent a loan from being placed on nonaccrual status. All restructured loans are included in the impaired loan category with loans in compliance with modified terms accounted for on the accrual basis with a specific reserve calculated using the discounted cash flow method. TDRs that are not in compliance with modified terms are also classified as nonaccrual loans and specific performance according to the contractual terms of the TDR is required prior to these loans being accounted for on an accrual basis.

 

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The following table presents troubled debt restructurings in compliance with modified terms and not in compliance with modified terms as December 31, 2011, 2010 and 2009:

 

     Troubled Debt Restructurings  
            December 31,         
     2011      2010      2009  
            (in thousands)         

In compliance with modified terms

     21,574         35,752         21,798   

30-89 days past due

     1,518         —           —     

Greater than 90 days past due

     —           —           —     

Nonaccrual

     28,832         46,691         15,534   
  

 

 

    

 

 

    

 

 

 

Total TDRs

   $ 51,924       $ 82,443       $ 37,332   

The overall decrease in TDRs from December 31, 2010 to December 31, 2011 was primarily due to management’s strategy to accelerate liquidation of certain impaired loans, as discussed above, including TDRs. Not included in nonperforming loans are loans that have been restructured that were performing as of the restructure date. The Company has $51,924,408, $82,442,903 and $37,332,034 outstanding to customers whose loans are classified as a troubled debt restructuring and the Company has committed to lend additional amounts totaling $643,037, $1,241,287 and $900,367 related to those loans, respectively, as of December 31, 2011, 2010 and 2009. The Company has allocated $2,192,909, $3,699,700 and $3,733,765 of specific reserves to customers whose loan terms have been modified in troubled debt restructurings, respectively, as of December 31, 2011, 2010 and 2009. At December 31, 2011, 2010 and 2009, there were $23,092,377, $35,751,985 and $21,797,811, respectively, of accruing restructured loans that remain in a performing status. At December 31, 2011, TDRs related primarily to construction and development loans totaling approximately $17,236,000, or 30.5% of impaired loans, 1-4 family residential loans totaling approximately $14,099,000, or 24.8% of impaired loans and commercial real estate loans totaling approximately $16,964,000, or 29.9% of impaired loans.

Our allowance for loan losses at December 31, 2011 was approximately $14,863,000, a net increase of approximately $3,921,000 for the year. The allowance for loan losses as a percentage of total loans, non-accrual loans and non-performing assets at December 31, 2011 was 4.8%, 42.1% and 31.6%, respectively, compared to 2.9%, 20.6% and 16.4%, respectively, at December 31, 2010. Net charge-offs during 2011 increased from approximately $8,138,000 in 2010 to approximately $29,676,000 in 2011, representing a net charge-off ratio of 4.2% in 2011 compared to 2.0% in 2010. Management continues to evaluate and adjust our allowance for loan losses, and presently believes the allowance for loan losses is adequate to provide for probable losses incurred in the loan portfolio. Management believes the loans, including those loans that were delinquent at December 31, 2011, that will result in additional charge-offs have been identified and adequate provision has been made in the allowance for loan loss balance. No assurance can be given that adverse economic circumstances, declines in real estate values or other events or changes in borrowers’ financial conditions, particularly borrowers in the real estate construction and development business, will not result in increased losses in the Bank’s loan portfolio or in the need for increases in the allowance for loan losses through additional provision expense in future periods.

 

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The following table summarizes our loan loss experience and related adjustments to the allowance for loan losses as of the dates and for the periods indicated:

 

     At December 31,  
     2011     2010     2009     2008     2007  
     ($ in thousands)  

Average balance of loans outstanding

   $ 350,062      $ 397,594      $ 415,522      $ 417,124      $ 373,237   

Balance of allowance for loan losses at beginning of year

     10,942        11,353        5,292        3,974        3,524   

Charge-offs:

          

Commercial, financial, agricultural

     171        225        328        198        43   

Real estate - construction, development

     14,569        5,439        3,054        686        158   

Real estate - mortgage

     15,082        2,652        2,220        41        250   

Consumer and other

     264        278        289        98        110   

Recoveries:

          

Commercial, financial, agricultural

     16        13        1        43        —     

Real estate - construction, development

     115        390        —          —          —     

Real estate - mortgage

     255        4        251        11        15   

Consumer and other

     24        49        27        12        14   

Net charge-offs

     29,676        8,138        5,612        957        532   

Additions to allowance charges to operations

     33,597        7,727        11,673        2,275        982   

Balance of allowance for loan losses at end of year

     14,863        10,942        11,353        5,292        3,974   

Ratio of net loan charge-offs during the year to average loans outstanding during the year

     8.48     2.05     1.35     0.23     0.14

Ratio of additions to allowance charges to operations to net charge off

     113.21     94.95     208.00     237.72     184.59

Ratio of allowance for loan losses as a percent of non-performing assets

     31.62     16.43     20.57     24.86     260.25

Ratio of allowance for loan losses as a percent of total loans

     4.78     2.92     2.78     1.26     1.00

As noted in the table above, there was an increase in all metrics relating to the allowance for loan losses, allowance charges to operations (provision expense) and net charge off during the period ended December 31, 2011 as compared to December 31, 2010. Net charge off as a percentage of average loans outstanding during the year increased from 2.05% to 8.48% from December 31, 2010 to December 31, 2011, due to the accelerated liquidation strategy discussed above. Provision expense increased from approximately $7,727,000, or 95.0% of net charge off, to approximately $33,597,000, or 113.2% of net charge off during the same period due to the strategy. The ratio of the allowance for loan losses as a percent of non-performing assets, even

 

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though an increase from 16.4% at December 31, 2010 to 31.62% at December 31, 2011, is considered to be a relatively low ratio from a historical perspective and would indicate the increase in the allowance for loan loss balance is directionally consistent with the overall level of non-performing assets and charge off.

The following table presents our allocation of the allowance for loan losses to the categories of loans in our loan portfolio as of the dates indicated:

 

    At December 31,  
    2011     2010     2009     2008     2007  
    ($ in thousands)  
          Loan           Loan           Loan           Loan           Loan  
          Category           Category           Category           Category           Category  
          as % of           as % of           as % of           as % of           as % of  
          Total           Total           Total           Total           Total  
    Amount     Loans     Amount     Loans     Amount     Loans     Amount     Loans     Amount     Loans  

Commercial

  $ 387        1.42   $ 396        0.13   $ 557        0.18   $ 1,289        0.41   $ 968        0.31

Real estate - construction, development

    3,572        6.34     3,614        1.16     5,844        1.88     2,131        0.69     1,600        0.51

Real estate - mortgage

    10,715        4.81     6,713        2.16     4,798        1.54     1,599        0.51     1,201        0.39

Consumer, other

    189        4.49     219        0.07     154        0.05     273        0.09     205        0.07
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $ 14,863        17.06   $ 10,942        3.52   $ 11,353        3.65   $ 5,292        1.70   $ 3,974        1.28

Securities

Our investment securities portfolio consists primarily of mortgage-backed securities and municipal securities. The investment securities portfolio is the second largest component of our earning assets and represented 25.4% of total earning assets and 19.2% of total assets at year-end 2011. As an integral component of our asset/liability management strategy, we manage our investment securities portfolio to maintain liquidity, balance interest rate risk and augment interest income. We also use our investment securities portfolio to meet pledging requirements for deposits and borrowings. The average yield on our investment securities portfolio during 2011 was 2.58% versus 2.31% for 2010, an increase of 27 basis points. Net unrealized gains (losses) on securities available for sale, included in accumulated other comprehensive income (loss), increased from a net unrealized loss of ($1,064,678) for the year ended December 31, 2010 to a net unrealized gain of $80,253 at December 31, 2011.

The approximately $8.7 million increase in investment securities during 2011 is primarily attributable to fluctuations in pledging requirements related to the Bank’s secured liabilities. In addition to meeting pledging requirements for borrowings, we also use our investment securities portfolio to secure public deposits. Municipal deposits, which are secured by a portion of the Bank’s investment securities and are currently required to be over-collateralized by such securities, decreased approximately $60 million during 2010 to approximately $40 million at December 31, 2010 and December 31, 2011, respectively. This resulted in a decrease in pledging requirements for municipal deposits of approximately $70 million from approximately $115 million to approximately $45 million at December 31, 2010 and December 31, 2011, respectively.

 

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Additionally, at December 31, 2010, we had approximately $31 million in mortgage-backed and municipal securities pledged as collateral for certain fed funds lines of credit and FHLB borrowings. The average yields on these investments generally exceeded the cost of the interest-bearing deposits that funded them during 2011. However, the cost of these deposits and the lower yield associated with these securities, when compared to loans, negatively impacted our net interest margin during 2011. Included in our investment securities portfolio as of December 31, 2011, was approximately $5,907,000 in tax-exempt municipal securities.

The carrying amounts of securities at the dates indicated are summarized as follows:

 

     At December 31,  
     2011      2010      2009  
            (in thousands)         

Securities available for sale:

        

U.S. Treasury and government agencies and corporations

   $ —         $ 250       $ 10,149   

Mortgage-backed securities - residential

     89,655         81,145         114,057   

Obligations of states and political subdivisions

     5,375         4,922         20,124   
  

 

 

    

 

 

    

 

 

 

Total

     95,030         86,317         144,330   

Securities held to maturity:

        

Obligations of states and political subdivisions

     1,380         1,318         2,204   

 

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The following table contains the contractual and projected maturity distribution, carrying value, and weighted-average yield to maturity of our investment securities.

 

     Maturity  
            Weighted            Weighted            Weighted            Weighted            Weighted  
            Average Tax     After 1      Average Tax     After 5      Average Tax            Average Tax            Average Tax  
     1 year      Equivalent     Year - 5      Equivalent     Years - 10      Equivalent     Over 10      Equivalent            Equivalent  
     or less      Yield     Years      Yield     Years      Yield     Years      Yield     Total      Yield  
                               (dollars in thousands)                            

Securities available for sale:

                         

Mortgage-backed securities - residential

     692         2.97     84,725         3.50     2,788         4.11     1,450         3.62     89,655         3.52

Obligations of states and political subdivisions

     —           —          265         2.27     2,737         3.13     2,373         6.24     5,375         4.46
  

 

 

    

 

 

   

 

 

      

 

 

      

 

 

      

 

 

    

Total available for sale

     692         2.97     84,990         3.50     5,525         3.62     3,823         5.25     95,030         3.57

Securities held to maturity:

                         

Obligations of states and political subdivisions

     —           —          —           —          756         4.65     624         4.72     1,380         4.68
  

 

 

    

 

 

   

 

 

      

 

 

      

 

 

      

 

 

    

Total held to maturity

     —           —          —           —          756         4.65     624         4.72     1,380         4.68

Total securities

     692         2.97     84,990         3.50     6,281         3.75     4,447         5.17     96,410         3.59

All securities we held exceeded 10% of total shareholders’ equity as of December 31, 2011. Projected maturities for mortgage-backed securities include industry estimates of payments and pre-payments based on the most recent history of each individual security and an overall projection for future performance of each security based on estimated future trends.

Deposits

Total deposits decreased during 2011 and the balances were distributed as follows:

 

     2011      2010      $ change     % change  

Noninterest-bearing demand deposits

   $ 50,761       $ 47,638       $ 3,123        6.56
  

 

 

    

 

 

    

 

 

   

 

 

 

Total noninterest-bearing deposits

     50,761         47,638         3,123        6.56

NOW accounts

     58,367         57,345         1,022        1.78

Money market accounts

     51,806         49,701         2,105        4.24

Savings

     22,364         23,734         (1,370     -5.77

Brokered deposits

     16,605         27,019         (10,414     -38.54

Time deposits

     232,235         244,154         (11,919     -4.88
  

 

 

    

 

 

    

 

 

   

 

 

 

Total interest-bearing deposits

     381,377         401,953         (20,576     -5.12

Total deposits

   $ 432,138       $ 449,591       $ (17,453     -3.88

 

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The balance in NOW accounts primarily consists of public funds deposits that are generally obtained through a bidding process under varying terms. Notable fluctuations in this category are fairly common and are dependent upon the cash flows of the various municipalities.

The increase in money market accounts is related to the seasonality of the tourism industry in the Bank’s market area. The Bank’s customers typically experience their strongest cash inflows during the third and fourth quarter of each year.

The decrease in certificates of deposit was the result of seasonal reductions and, to a lesser extent, migration of funds to non-interest bearing deposits upon maturity of the certificates.

Brokered deposits are certificates of deposit acquired from approved brokers on terms that are substantially similar to deposits acquired in the local market. As a result of the Bank agreeing to the terms of the Consent Order, the Bank may not accept, renew or roll over brokered deposits without prior approval of the FDIC. As of December 31, 2011, brokered deposits maturing in the next 12 months totaled approximately $8,260,000 with the balance of approximately $8,345,000 maturing during the following twelve months. Funding sources for the maturing brokered deposits include, among other sources, our cash account at the FRB-Atlanta, growth, if any, of core deposits from current and new retail and commercial customers, scheduled repayments on existing loans and the possible pledge or sale of investment securities. Because the Bank is not considered “well capitalized”, it is not permitted to offer to pay interest on deposits at rates that are more than 75 basis points above the “national rate” unless the FDIC determines we are in a “high rate area.” These interest rate limitations may limit the ability of the Bank to increase or maintain core deposits from current and new deposit customers.

Brokered deposits decreased approximately $10.4 million during 2011, and represented approximately 3.8% and 6.0% of total deposits at December 31, 2011 and 2010, respectively. The Bank significantly reduced its reliance on brokered deposits during 2010 and 2011. Management intends to seek to further reduce the level of brokered deposits during 2012 consistent with the terms of the Consent Order. The average cost of our brokered deposits at December 31, 2011 was 1.91%. During 2010, the average cost of these deposits was 1.70%. We have not and do not intend to replace any maturing brokered deposits during 2012.

 

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The average balances of deposit accounts by category and the average rates paid thereon are presented below for the periods indicated:

 

     2011     2010     2009  
     Amount      Rate     Amount      Rate     Amount      Rate  
     ($ in thousands)  

Noninterest-bearing demand deposits

   $ 47,660         0   $ 46,237         0   $ 45,761         0

Interest-bearing demand deposits

     106,166         0.91     119,547         1.09     150,384         1.23

Savings deposits

     23,072         0.68     22,790         1.08     17,340         1.39

Time deposits

     256,762         1.64     302,494         2.08     304,715         2.67
  

 

 

      

 

 

      

 

 

    

Total

   $ 433,660         $ 491,068         $ 518,200      
  

 

 

      

 

 

      

 

 

    

The balances in time certificates of deposit issued in amounts of $100,000 or more as of December 31, 2011, are shown below by time remaining until maturity:

 

     (dollars in thousands)  

Three months or less

   $ 16,459   

Over three months through six months

     20,300   

Over six months through 12 months

     34,669   

Over 12 months

     60,465   
  

 

 

 

Total

   $ 131,893   

The average balance of interest-bearing demand and savings deposits decreased approximately $13,099,000 during 2011. The average rate paid on these interest-bearing demand and savings deposits in 2011 was 0.87%, down from 1.09% in 2010.

Our total average cost of interest-bearing deposits (including demand, savings and certificate of deposit accounts) for 2011 was 1.38%, down from 1.76% in the prior year.

Shareholders’ Equity

At December 21, 2011, the Company’s shareholders’ deficit was approximately $2,336,668, compared to shareholders’ equity of approximately $35,674,170 at December 31, 2010. Accordingly, at December 31, 2011, the Company’s liabilities exceeded its assets, resulting in the Company’s common stock having no equity value. The decrease in shareholders’ equity was primarily the result of the 2011 net loss of approximately $39,258,000. Accumulated other comprehensive income (loss) represents the net unrealized gain (losses) on securities available-for-sale. The increase in accumulated comprehensive income from a net loss of $1,064,678 at December 31, 2010 to a net gain of $80,253 at December 31, 2011 offset some of the decrease in shareholders’ equity during 2011.

 

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Interest Rate Sensitivity Management

Interest rate risk is the risk to earnings or market value of equity from the potential movement in interest rates. The primary purpose of managing interest rate risk is to reduce the effects of interest rate volatility and achieve reasonable stability of earnings from changes in interest rates and preserve the value of our equity. Changes in interest rates affect, among other things, our net interest income, volume of loan production and the fair value of financial instruments and our loan portfolio. A key component of our interest rate risk management policy is the maintenance of an appropriate mix of assets and liabilities.

Our earnings are affected not only by general economic conditions, but also by the monetary and fiscal policies of the U.S. and its agencies, particularly the Federal Reserve. The monetary policies of the Federal Reserve can influence the overall growth of loans, investment securities, and deposits and the level of interest rates earned on assets and paid for liabilities. The nature and impact of future changes in monetary policies are generally not predictable.

It is our objective to manage assets and liabilities to control the impact of interest rate fluctuations on earnings and to provide a satisfactory, consistent level of profitability within the framework of established cash, loan, investment, borrowing, and capital policies. Certain officers within the Bank are charged with the responsibility for monitoring policies and procedures that are designed to ensure acceptable composition of the asset/liability mix.

The Bank’s asset/liability mix is monitored on a regular basis and a report reflecting the interest rate sensitive assets and interest rate sensitive liabilities is prepared and presented to our Board of Directors and management’s asset/liability committee on a quarterly basis. The key objective of our asset/liability management policy is to monitor and adjust the mix of interest rate sensitive assets and liabilities so as to minimize the impact of substantial movements in interest rates on earnings by matching rates and maturities of our interest-earning assets to those of our interest-bearing liabilities. An asset or liability is considered to be interest rate-sensitive if it will re-price or mature within the time period analyzed, usually one year or less.

We use interest rate sensitivity gap analysis to achieve the appropriate mix of interest rate-sensitive assets and liabilities. The interest rate-sensitivity gap is the difference between the interest-earning assets and interest-bearing liabilities scheduled to mature or reprice within a given time period. A gap is considered positive when the amount of interest rate-sensitive assets exceeds the amount of interest rate-sensitive liabilities. A gap is considered negative when the amount of interest rate-sensitive liabilities exceeds the amount of interest rate-sensitive assets. During a period of rising interest rates, a negative gap would tend to adversely affect net interest income, while a positive gap would tend to result in an increase in net interest income. Conversely, during a period of falling interest rates, a negative gap would tend to result in an increase in net interest income, while a positive gap would tend to adversely affect net interest income. If our assets and liabilities were equally flexible and moved concurrently, the impact of any increase or decrease in interest rates on net interest income would be minimal.

A simple interest rate “gap” analysis by itself may not be an accurate indicator of how net interest income will be affected by changes in interest rates. Accordingly, we also evaluate how the repayment of particular assets and liabilities is impacted by changes in interest rates. Income associated with interest-earning assets and costs associated with interest-bearing liabilities may

 

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not be affected uniformly by changes in interest rates. In addition, unpredictable variables such as the magnitude and duration of changes in interest rates may have a significant impact on net interest income. For example, although certain assets and liabilities may have similar maturities or periods of repricing, they may react in different degrees to changes in market interest rates. Interest rates on certain types of assets and liabilities fluctuate in advance of changes in general market rates, while interest rates on other types of assets and liabilities may lag behind changes in general market rates. In addition, certain assets, such as adjustable rate mortgage loans, have features (generally referred to as “interest rate caps”), that limit changes in interest rates. Prepayment and early withdrawal levels also could deviate significantly from those assumed in calculating the interest rate gap.

The following table summarizes our interest-sensitive assets and liabilities as of December 31, 2011. Adjustable rate loans are included in the period in which their interest rates are scheduled to adjust. Fixed rate loans are included in the periods in which they are anticipated to be repaid based on scheduled maturities and anticipated prepayments. Investment securities are included in the period in which they are scheduled to mature while mortgage backed securities are included according to expected repayment. Certificates of deposit are presented according to contractual maturity dates.

Analysis of Interest Sensitivity

As of December 31, 2011

(dollars in thousands)

 

     0 - 3     3 - 12     1 - 3     Over three        
     months     months     years     years     Total  

Federal funds sold

   $ 2,881      $ —        $ —        $ —        $ 2,881   

Federal Reserve Bank

     30,226        —          —          —          30,226   

Securities

     5,388        15,031        26,955        49,037        96,411   

Loans (1)

     59,656        92,804        98,339        59,997        310,796   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total interest-earning assets

     98,151        107,835        125,294        59,962        391,242   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Interest-bearing liabilities:

          

Interest-bearing demand deposits

     110,173        —          —          —          110,173   

Savings

     22,364        —          —          —          22,364   

Time deposits

     48,642        107,363        71,191        21,643        248,839   

Other borrowings

     —          5,200        5,000        45,000        55,200   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total interest-bearing liabilities

     181,179        112,563        76,191        66,643        436,576   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Interest rate sensitivity gap

   $ (83,028   $ (4,728   $ 49,103      $ (6,681   $ (45,334
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Cumulative interest rate sensitivity gap

   $ (83,028   $ (87,756   $ (38,653   $ (45,334  
  

 

 

   

 

 

   

 

 

   

 

 

   

Interest rate sensitivity gap ratio

     -84.59     -4.38     39.19     -11.14  

Cumulative interest rate sensitivity gap ratio

     -84.59     -42.60     -11.67     -11.59  

 

(1) Includes nonaccrual loans

 

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At December 31, 2011, the Bank’s cumulative one-year interest rate sensitivity gap ratio was (42.60%), which indicates that our interest-earning assets will re-price during this period at a rate slower than our interest-bearing liabilities. The effects of certain categories of interest-bearing liabilities, primarily interest-bearing demand deposits and overnight federal funds purchased, tend to be overstated in our gap analysis and we believe that the spread between our interest-earning assets and interest-bearing liabilities will not be affected as much by the repricing period for these deposits as they will by the current interest rate environment. Currently, due to the extended period of low interest rates, our short term interest-sensitive assets and liabilities are likely close to their floors. Certain longer term interest-sensitive assets and liabilities, particularly fixed rate loans, time deposits and long-term borrowings, have more potential for repricing adjustments as they mature and are replaced at current rate levels. Additionally, when interest rates increase, our cumulative interest rate sensitivity gap indicates that a larger volume of our interest-bearing liabilities will reprice more quickly than our interest-earning assets. This could cause further compression of our net interest margin until the volume of interest-sensitive assets earning higher rates of interest gets closer to the volume of interest-sensitive liabilities already bearing higher rates of interest.

Return on Assets and Equity

The following table summarizes our return on average assets and return on average equity as well as our dividend payout ratio for the years ended December 31, 2011, 2010 and 2009:

 

     For the Years Ended  
     At December 31,  
     2011     2010     2009  

Return on average assets

     -7.46     -1.69     -0.64

Return on average equity

     -188.26     -21.83     -8.14

Average equity as a percentage of average assets

     3.96     7.74     7.88

Cash dividend payout ratio

     0.00     0.00     0.00

Capital Adequacy and Liquidity

Our funding sources primarily include customer-based core deposits and customer repurchase accounts. The Bank, being situated in a market that relies on tourism as its principal industry, can be subject to periods of reduced deposit funding because tourism in Sevier County is seasonably slow in the winter months. The Bank has a cash management line of credit in the amount of $100 million from the FHLB of Cincinnati as well as a line of credit totaling approximately $3 million at December 31, 2011 from the Federal Reserve Discount Window that the Bank uses to meet short-term liquidity demands, none of which was borrowed as of that date. The borrowing capacity can be increased based on the amount of collateral pledged.

Capital adequacy is important to the Bank’s continued financial safety and soundness and growth. Our banking regulators have adopted risk-based capital and leverage guidelines to measure the capital adequacy of national banks. In addition, the Company’s and the Bank’s regulators may impose additional capital requirements on financial institutions and their bank subsidiaries, like the Company and the Bank, beyond those provided for statutorily, which standards may be in addition to, and require higher levels of capital, than the general capital

 

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adequacy guidelines. Under the terms of the Consent Order, the Bank was required to achieve by February 24, 2012 and thereafter maintain a Tier 1 leverage capital ratio of 9% and a total risk-based capital ratio of 12%. The 9% ratio is the same as that required by the OCC in an individual minimum capital requirement (“IMCR”) for the Bank effective in February 2010 and the 12% ratio is slightly below the 13% ratio required by the IMCR. As of December 31 2011, the Bank failed to satisfy these ratios, as well as the requirements for being considered “adequately capitalized,” as described below.

The Dodd-Frank Act contains a number of provisions dealing with capital adequacy of insured depository institutions and their holding companies, and for the most part will result in insured depository institutions and their holding companies being subject to more stringent capital requirements. Under the so-called Collins Amendment to the Dodd-Frank Act, federal regulators have established minimum leverage and risk-based capital requirements for, among other entities, banks and bank holding companies on a consolidated basis. These minimum requirements require that a bank holding company maintain a Tier 1 leverage ratio of not less than 4% and a total risk-based capital ratio of not less than 8%.

On June 7, 2012, the federal bank regulatory agencies issued a series of proposed rules that would revise their risk-based and leverage capital requirements and their method for calculating risk-weighted assets to make them consistent with the agreements that were reached by the Basel Committee on Banking Supervision in “Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems” (“Basel III”) and certain provisions of the Dodd-Frank Act. The proposed rules would apply to all depository institutions, top-tier bank holding companies with total consolidated assets of $500 million or more, and top-tier savings and loan holding companies (“banking organizations”). Among other things, the proposed rules establish a new common equity tier 1 minimum capital requirement of 4.5% and a higher minimum tier 1 capital requirement of 6.0% and assign higher risk weightings (150%) to exposures that are more than 90 days past due or are on nonaccrual status and certain commercial real estate facilities that finance the acquisition, development or construction of real property. Additionally, the U.S. implementation of Basel III contemplates that, for banking organizations with less than $15 billion in assets, the ability to treat trust preferred securities as tier 1 capital would be phased out over a ten-year period. The proposed rules also required unrealized gains and losses on certain securities holdings to be included for purposes of calculating regulatory capital requirements. The proposed rules limit a banking organization’s capital distributions and certain discretionary bonus payments if the banking organization does not hold a “capital conservation buffer” consisting of a specified amount of common equity tier 1 capital in addition to the amount necessary to meet its minimum risk-based capital requirements. The proposed rules indicated that the final rule would become effective on January 1, 2013, and the changes set forth in the final rules will be phased in from January 1, 2013 through January 1, 2019. However, the agencies have recently indicated that, due to the volume of public comments received, the final rule would not be in effect on January 1, 2013.

When fully phased in on January 1, 2019, Basel III requires banks to maintain the following new standards and introduces a new capital measure “Common Equity Tier 1”, or “CET1”. Basel III increases the CET1 to risk-weighted assets to 4.5%, and introduces a capital conservation buffer of an additional 2.5% of common equity to risk-weighted assets, raising the target CET1 to risk-weighted assets ratio to 7%. It requires banks to maintain a minimum ratio of

 

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Tier 1 capital to risk weighted assets of at least 6.0%, plus the capital conservation buffer effectively resulting in Tier 1 capital ratio of 8.5%. Basel III increases the minimum total capital ratio to 8.0% plus the capital conservation buffer, increasing the minimum total capital ratio to 10.5%. Basel III also introduces a non-risk adjusted tier 1 leverage ratio of 3%, based on a measure of total exposure rather than total assets, and new liquidity standards.

The table below sets forth the Bank’s capital ratios as of the periods indicated:

 

     December 31,  
     2011     2010  

Tier 1 Leverage

     2.10     8.41

Adequately capitalized regulatory minimum

     4.00     4.00

Required by Consent Order/IMCR*

     9.00     9.00

Tier 1 Risk-Based Capital

     3.07     11.97

Adequately capitalized regulatory minimum

     4.00     4.00

Total Risk-Based Capital

     4.35     13.23

Adequately capitalized regulatory minimum

     8.00     8.00

Required by Consent Order/IMCR*

     12.00     13.00

 

* The Bank was subject to the IMCR until October 2011 at which time it was replaced by the Consent Order

The table below sets forth the Company’s capital ratios as of the periods indicated:

 

     December 31,  
     2011     2010  

Tier 1 Leverage

     -0.47     8.34

Regulatory minimum

     4.00     4.00

Required by Written Agreement*

     4.00     4.00

Tier 1 Risk-Based Capital

     -0.68     11.87

Regulatory minimum

     4.00     4.00

Required by Written Agreement*

     4.00     4.00

Total Risk-Based Capital

     -0.68     13.27

Regulatory minimum

     8.00     8.00

Required by Written Agreement*

     8.00     8.00

 

* The Company has not submitted an acceptable written plan to maintain sufficient capital under the Written Agreement and the ratios noted above are the required ratios for the Company to meet regulatory minimum adequately capitalized ratios if it were not subject to the Written Agreement.

On October 27, 2011, the OCC issued the Consent Order that, among other things, required the Bank to attain on or before February 24, 2012 and thereafter maintain a minimum Tier 1 capital to average assets ratio of 9% and a minimum total capital to risk-weighted assets

 

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ratio of 12%. The 9% ratio was the same as in the Bank’s IMCR while the 12% ratio was a slight reduction from the 13% required under the IMCR. Prior to December 28, 2011, the Bank was required to submit to the OCC a capital plan to achieve these ratios, and if the OCC determines it has no supervisory objection to the capital plan, to implement it within five days. As noted above, the Bank’s ratio of Tier 1 capital to average assets was 2.10% and its ratio of total capital to risk-weighted assets was 4.35% at December 31, 2011 and thus substantially below the requirements of the Consent Order. The Bank’s Tier 1 capital at December 31, 2011 was approximately $35,583,000 below the amount needed to meet the agreed-upon Tier 1 capital to average assets ratio of 9%. The Bank’s total risk-based capital at December 31, 2011 was approximately $26,975,000 below the amount needed to meet the agreed-upon total capital to risk-weighted assets ratio of 12%.

In addition to the capital requirements established under the Consent Order, under the OCC’s prompt corrective action regulations, as discussed above, the Bank is treated as “significantly undercapitalized” because of its capital level. Accordingly, the Bank is subject to certain restrictions restricting payment of capital distributions or management fees, restricting asset growth, requiring prior approval of asset expansion proposals and limiting compensation paid to senior executive officers. In view of the substantial levels of capital required, the Board of Directors and management are exploring additional sources of capital and funding as well as the sale of control of the Company and/or the Bank to reach the required levels. In the current economic environment, however, there can be no assurance that it will be able to do so or, if it can, what the cost of doing so will be. If the Company is able to sell shares of its equity securities to generate additional capital, the price at which those securities would likely be sold would result in substantial dilution to the Company’s existing shareholders.

In November 2003, the Company formed a wholly owned Delaware statutory trust subsidiary, MNB Capital Trust I. This subsidiary issued approximately $5.5 million in trust preferred securities, guaranteed by the Company on a junior subordinated basis. In June 2006, the Company formed a wholly owned Delaware statutory trust subsidiary, MNB Capital Trust II. This subsidiary issued approximately $7.5 million in trust preferred securities, guaranteed by the Company on a junior subordinated basis. The Company obtained the proceeds from the trusts’ sale of trust preferred securities by issuing junior subordinated debentures to the trusts. Under the Financial Accounting Standards Board’s revised Interpretation No. 46 (“FIN 46R”), the trust subsidiaries must be deconsolidated with the Company for accounting purposes. As a result of this accounting pronouncement, the Federal Reserve adopted changes to its capital rules with respect to the regulatory capital treatment afforded to trust preferred securities. The Federal Reserve’s current rules permit qualified trust preferred securities and other restricted capital elements to be included as Tier 1 capital up to 25% of core capital, net of goodwill and intangibles. Additionally, following passage of the Dodd-Frank Act, trust preferred and cumulative preferred securities will no longer be deemed Tier 1 capital for bank holding companies, but trust preferred securities issued by bank holding companies with under $15 billion in total assets at December 31, 2009 are to be grandfathered in and continue to count as Tier 1 capital. However, the proposed Basel III capital reforms ignore the grandfathering for smaller community banks and phase out trust preferred securities from Tier 1 capital over a ten-year period. If these proposed rules are adopted, as proposed, the trust preferred securities we have issued will begin to be excluded from our calculation of Tier 1 capital.

 

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On December 14, 2010, the Company exercised its rights to defer regularly scheduled interest payments on all of its issues of junior subordinated debentures relating to outstanding trust preferred securities and interest payable as of December 31, 2011 totaled $431,753. The regular scheduled interest payments will continue to be accrued for payment in the future and reported as an expense for financial statement purposes.

Liquidity is the ability of a company to convert assets into cash or cash equivalents without significant loss. Our liquidity management involves maintaining our ability to meet the day-to-day cash flow requirements of our customers, whether they are depositors wishing to withdraw funds or borrowers requiring funds to meet their credit needs. Without proper liquidity management, we would not be able to perform the primary function of a financial intermediary and would, therefore, not be able to meet the production and growth needs of the communities we serve.

The primary function of asset and liability management is not only to assure adequate liquidity in order for us to meet the needs of our customer base, but also to maintain an appropriate balance between interest-sensitive assets and interest-sensitive liabilities so that we can also meet the investment objectives of our shareholders. For additional information relating to our interest rate sensitivity management, refer to the discussion above under the heading “Interest Rate Sensitivity Management.” Daily monitoring of the sources and uses of funds is necessary to maintain an acceptable cash position that meets both the needs of our customers and the objectives of our shareholders. In a banking environment, both assets and liabilities are considered sources of liquidity funding and both are therefore monitored on a daily basis.

Off-Balance Sheet Arrangements

Our only material off-balance sheet arrangements consist of commitments to extend credit and standby letters of credit issued in the ordinary course of business to facilitate customers’ funding needs or risk management objectives.

Commitments and Lines of Credit

In the ordinary course of business, the Bank has granted commitments to extend credit and standby letters of credit to approved customers. Generally, these commitments to extend credit have been granted on a temporary basis for seasonal or inventory requirements and have been approved by the Bank’s loan committee. These commitments are recorded in the financial statements as they are funded. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitment amounts expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.

 

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The following is a summary of the Bank’s commitments outstanding at December 31, 2011 and 2010.

 

     December 31,  
     2011      2010  
     ($ in thousands)  

Commitments to extend credit

   $ 25,855       $ 41,155   

Standby letters of credit

     6,851         5,288   
  

 

 

    

 

 

 

Totals

   $ 32,706       $ 46,443   

Commitments to extend credit include unused commitments for open-end lines secured by 1-4 family residential properties, commitments to fund loans secured by commercial real estate, construction loans, land development loans, and other unused commitments. Commitments to fund commercial real estate, construction, and land development loans decreased approximately $15,300,000 during 2011, reflecting current economic conditions in our market.

Effects of Inflation

Our consolidated financial statements and related data presented herein have been prepared in accordance with generally accepted accounting principles, which require the measurement of financial position and operational results in terms of historic dollars, without considering changes in the relative purchasing power of money over time due to inflation.

Inflation generally increases the costs of funds and operating overhead, and to the extent loans and other assets bear variable rates, the yields on such assets. Unlike most industrial companies, virtually all of the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates generally have a more significant effect on the performance of a financial institution than the effects of general levels of inflation. In addition, inflation affects financial institutions’ cost of goods and services purchased, the cost of salaries and benefits, occupancy expense, and similar items. Inflation and related increases in interest rates generally decrease the market value of investments and loans held and may adversely affect liquidity, earnings, and stockholders’ equity. Mortgage originations and refinancings tend to slow as interest rates increase, and likely will reduce the Bank’s volume of such activities and the income from the sale of residential mortgage loans in the secondary market.

Significant Accounting Changes

The information appearing under “Note 20. Recent Accounting Pronouncements” in the 2011 notes to the financial statements is incorporated herein by reference.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The consolidated financial statements of the Company, including notes thereto, and the reports of the Company’s independent registered public accounting firm are included in this Annual Report on Form 10-K beginning at page F-1 and are incorporated herein by reference.

 

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ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

None.

ITEM 9A. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

The Company maintains disclosure controls and procedures, as defined in rule 13a-15(e) promulgated under the Exchange Act, that are designed to ensure that information required to be disclosed in the Company’s reports and other information filed with the Commission, under the Exchange Act, is recorded, processed, summarized and reported within the time periods specified in the Commission’s rules and forms, and that such information is accumulated and communicated to the management, including the Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.

The Company carried out an evaluation, under the supervision and with the participation of management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Exchange Act Rule 13a-15. Based upon the foregoing, the Chief Executive Officer along with the Chief Financial Officer concluded that certain deficiencies identified in internal controls and procedures created material weaknesses and resulted in the Company’s disclosure controls and procedures not being effective to ensure that information required to be disclosed in the Company’s reports under the Exchange Act was recorded, summarized and reported within the time periods specified in the Commission’s rules and forms as of the end of the period covered by this report. Based on this determination of the existence of material weaknesses, which began during the fourth quarter of 2010 and continued during 2011, management identified certain areas requiring internal control and procedure improvements.

Management’s Annual Report on Internal Control over Financial Reporting

Management of the Company is responsible for establishing and maintaining effective internal control over financial reporting. Internal control is designed to provide reasonable assurance to the Company’s management and board of directors regarding the preparation of reliable published financial statements. Internal control over financial reporting includes self-monitoring mechanisms, and actions are taken to correct deficiencies as they are identified.

Because of inherent limitations in any system of internal control, no matter how well designed, misstatements due to error or fraud may occur and not be detected, including the possibility of the circumvention or overriding of controls. Accordingly, even effective internal control over financial reporting can provide only reasonable assurance with respect to financial statement preparation. Further, because of changes in conditions, internal control effectiveness may vary over time.

 

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Management assessed the Company’s internal control over financial reporting as of December 31, 2011. This assessment was based on criteria for effective internal control over financial reporting described in “Internal Control – Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment the Chief Executive Officer and Chief Financial Officer concluded that, as of December 31, 2011, the Company’s system of internal control over financial reporting was not effective. See “Changes in Internal Control over Financial Reporting” for further information.

This annual report does not include an attestation report of the Company’s independent registered public accounting firm regarding internal control over financial reporting because that requirement under Section 404 of the Sarbanes Oxley Act of 2002 was permanently removed for non-accelerated filers pursuant to the provisions of Section 989(G) set forth in the Dodd-Frank Act.

Changes in Internal Control over Financial Reporting

During Management’s assessment of the Company’s internal control over financial reporting at December 31, 2011, the following material deficiencies were noted: 1) Loans determined to be collateral dependent were not properly identified in a timely manner and detailed documentation of the recorded investment was not maintained; 2) Loan risk-grades were not properly determined in a timely manner which is necessary to manage the high level of credit risk in the Bank; 3) The allowance for loan loss calculation was deemed inadequate due to items one and two which caused the charge off relating to the fourth quarter of 2011 not being recognized and recorded in a timely manner and an enhancement to the methodology was required. These deficiencies could result in overstatement of loans and income and understatement of the provision for loan losses, charge off and the allowance for loan losses; 4) There was a lack of well-documented support for discounts taken on appraisals for collateral dependent loans and OREO; and 5) Inability of management to prepare financial reporting in a timely manner. The remediation plan for these internal control deficiencies is noted below. Other than the items noted below, during the fourth quarter of 2011 there were no other changes in the Company’s internal control over financial reporting that have materially affected, or that are reasonably likely to materially affect, the Company’s internal control over financial reporting.

During and subsequent to the fourth quarter of 2011, management took the following remediation actions regarding the above referenced internal control deficiencies:

 

  1)

During the first quarter of 2012, the Bank’s primary regulator, during its regular safety and soundness exam, determined several loans were not properly identified by the Bank as collateral dependent as of December 31, 2011. Collateral dependent loans require a charge off of the loan balance if the recorded investment in the loan exceeds the underlying collateral value net of cost to sell. To make the determination the proper recorded investment has been recorded, the current appraised value of the collateral must be obtained and a well documented analysis performed. Procedures should include a thorough review of the analysis performed including a determination that proper appraisal values are determined and used in the calculation. Findings of external auditors and consultants should be considered and incorporated into the determination of both collateral dependence and the calculation of any resulting change in the recorded investment for each loan. The Special Assets Department reports directly to the Bank’s board of directors and is in charge of complying with these requirements. Controls and

 

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  procedures have been developed and incorporated into the process to assure collateral dependent loans are properly identified and related charge offs recorded as of a reporting date. Procedures put in place in the Special Assets Department to comply with these requirements and the results of their efforts have been incorporated into the financial statements as of December&nbs