CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
This report contains statements that constitute "forward-looking statements"
within the meaning of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as amended, and the Private
Securities Litigation Reform Act of 1995. The words "believe," "estimate,"
"expect," "intend," "anticipate," "plan" and similar expressions and variations
thereof identify certain of such forward-looking statements which speak only as
of the dates on which they were made. We undertake no obligation to publicly
update or revise any forward-looking statements, whether as a result of new
information, future events, or otherwise. Readers are cautioned that any such
forward-looking statements are not guarantees of future performance and involve
risks and uncertainties, and that actual results may differ materially from
those indicated in the forward-looking statements as a result of various
factors. Factors that could cause actual results to differ from the results
discussed in the forward-looking statements include, but are not limited to:
economic conditions (both generally and more specifically in the markets in
which we operate); competition for our customers from other providers of
financial services; government legislation and regulation relating to the
banking industry (which changes from time to time and over which we have no
control) including but not limited to the Dodd-Frank Wall Street Reform and
Consumer Protection Act; changes in the value of real estate securing loans made
by the Bank; changes in interest rates; and material unforeseen changes in the
liquidity, results of operations, or financial condition of our customers. Other
risks, uncertainties and factors could cause our actual results to differ
materially from those projected in any forward-looking statements we make.
Critical Accounting Policies
Bank of the James Financial Group, Inc.'s ("Financial") financial statements are
prepared in accordance with accounting principles generally accepted in the
United States (GAAP). The financial information contained within our statements
is, to a significant extent, based on measures of the financial effects of
transactions and events that have already occurred. A variety of factors could
affect the ultimate value that is obtained either when earning income,
recognizing an expense, recovering an asset or relieving a liability. We use
historical loss ratios as one factor in determining the inherent loss that may
be present in our loan portfolio. Actual losses could differ significantly from
the historical factors that we use in estimating risk. In addition, GAAP itself
may change from one previously acceptable method to another method. Although the
economics of our transactions would be the same, the timing of events that would
impact our transactions could change.
The allowance for loan losses is management's estimate of the losses that may be
sustained in our loan portfolio. The allowance is based on two basic principles
of accounting: (i) ASC 450 "Contingencies", which requires that losses be
accrued when they are probable of occurring and are reasonably estimable and
(ii) ASC 310 "Impairment of a Loan", which requires that losses on impaired
loans be accrued based on the differences between the value of collateral,
present value of future cash flows or values that are observable in the
secondary market and the loan balance. Guidelines for determining allowances for
loan losses are also provided in the SEC Staff Accounting Bulletin No. 102 -
"Selected Loan Loss Allowance Methodology and Documentation Issues" and the
Federal Financial Institutions Examination Council's interagency guidance,
"Interagency Policy Statement on the Allowance for Loan and Lease Losses" (the
"FFIEC Policy Statement"). See "Management Discussion and Analysis Results of
Operations - Allowance for Loan Losses and Loan Loss Reserve" below for further
discussion of the allowance for loan losses.
Table of Contents
Financial is a bank holding company headquartered in Lynchburg, Virginia. Our
primary business is retail banking which we conduct through our wholly-owned
subsidiary, Bank of the James (which we refer to as the "Bank"). We conduct
three other business activities, mortgage banking through the Bank's Mortgage
division (which we refer to as "Mortgage"), investment services through the
Bank's Investment division (which we refer to as "Investment"), and insurance
activities through BOTJ Insurance, Inc., a subsidiary of the Bank, (which we
refer to as "Insurance").
The Bank is a Virginia banking corporation headquartered in Lynchburg, Virginia.
The Bank was incorporated under the laws of the Commonwealth of Virginia as a
state chartered bank in 1998 and began banking operations in July 1999. The Bank
was organized to engage in general retail and commercial banking business. The
Bank is a community-oriented financial institution that provides varied banking
services to individuals, small and medium-sized businesses, and professional
concerns in the Central Virginia, Region 2000 area, which encompasses the seven
jurisdictions of the Town of Altavista, Amherst County, Appomattox County, the
City of Bedford, Bedford County, Campbell County, and the City of Lynchburg. The
Bank strives to provide its customers with products comparable to statewide
regional banks located in its market area, while maintaining the prompt response
time and level of service of a community bank. Management believes this
operating strategy has particular appeal in the Bank's market area.
The Bank's principal office is located at 828 Main Street, Lynchburg, Virginia
24504 and its telephone number is (434) 846-2000. The Bank also maintains a
website at www.bankofthejames.com.
Our operating results depend primarily upon the Bank's net interest income,
which is determined by the difference between (i) interest and dividend income
on earning assets, which consist primarily of loans, investment securities and
other investments, and (ii) interest expense on interest-bearing liabilities,
which consist principally of deposits and other borrowings. The Bank's net
income also is affected by its provision for loan losses, as well as the level
of its non-interest income, including loan fees and service charges, and its
non-interest expenses, including salaries and employee benefits, occupancy
expense, data processing expenses, Federal Deposit Insurance Corporation
premiums, expense in complying with the Sarbanes-Oxley Act of 2002,
miscellaneous other expenses, franchise taxes, and income taxes.
The Bank intends to enhance its profitability by increasing its market share in
the Region 2000 area, providing additional services to its customers, and
The Bank now services its banking customers through the following nine full
service branch locations in the Region 2000 area.
• The main office located at 828 Main Street in Lynchburg (opened
October 2004) (the "Main Street Office"),
• A branch located at 615 Church Street in Lynchburg (opened July 1999)
(the "Church Street Branch"),
• A branch located at 5204 Fort Avenue in Lynchburg (opened November
2000) (the "Fort Avenue Branch"),
• A branch located on South Amherst Highway in Amherst County (opened
June 2002) (the "Madison Heights Branch"),
• A branch located at 17000 Forest Road in Forest (opened February 2005)
(the "Forest Branch"),
• A branch located at 4935 Boonsboro Road, Suites C and D in Lynchburg
(opened April 2006) (the "Boonsboro Branch"),
• A branch located at 164 South Main Street, Amherst, Virginia (opened
January 2007) (the "Amherst Branch"),
• A branch located at 1405 Ole Dominion Boulevard in the City of
Bedford, Virginia, located off of Independence Boulevard (opened
October 2008) (the "Bedford Branch"), and
• A branch located at 1110 Main Street, Altavista, Virginia (relocated
from temporary branch in June 2009) (the "Altavista Branch").
The Bank also has opened a limited-service branch located in the
Westminster-Canterbury facilities located at 501 VES Road, Lynchburg, Virginia
In addition, the Bank, through its Mortgage division, originates residential
mortgage loans through two offices-one located at the Forest Branch and the
other located at 1152 Hendricks Store Road, Moneta, Virginia.
The Investment division operates primarily out of its office located at the
Church Street Branch.
The Bank continuously evaluates areas located within Region 2000 to identify
additional viable branch locations. Based on this ongoing evaluation, the Bank
may acquire one or more additional suitable sites.
Subject to regulatory approval, the Bank anticipates opening additional branches
during the next two fiscal years. Although numerous factors could influence the
Bank's expansion plans, the following discussion provides a general overview of
the additional branch location that the Bank currently is considering.
Timberlake Road Area, Campbell County (Lynchburg), Virginia. As previously
disclosed, the Bank has purchased certain real property located at the
intersection of Turnpike and Timberlake Roads, Campbell County, Virginia. The
Bank does not anticipate opening a branch at this location prior to 2013. The
Bank has determined that the existing structure is not suitable for use as a
Rustburg, Virginia. In March, 2011 the Bank purchased certain real property near
the intersection of Routes 501 and 24 in Rustburg, Virginia. The structure on
the property is being demolished and removed. The Bank does not anticipate
opening a branch at this location prior to the first quarter of 2013. The Bank
has installed an ATM in a local municipal building in order to establish a
presence in this market until the branch has been established.
The Bank estimates that the cost of improvements, furniture, fixtures, and
equipment necessary to upfit the property will be between $900,000 and
$1,500,000 per location.
Although the Bank cannot predict with certainty the financial impact of each new
branch, management generally anticipates that each new branch will become
profitable within 12 to 18 months of operation.
Except as set forth herein, the Bank does not expect to purchase any significant
property or equipment in the upcoming 12 months. Future branch openings are
subject to regulatory approval.
OFF-BALANCE SHEET ARRANGEMENTS
The Bank is a party to various financial instruments with off-balance sheet risk
in the normal course of business to meet the financing needs of our customers.
These financial instruments include commitments to extend credit and standby
letters of credit. Such commitments involve, to varying degrees, elements of
credit risk and interest rate risk in excess of the amount recognized in the
balance sheets and could impact the overall liquidity and capital resources to
the extent customers accept and/or use these commitments.
The Bank's exposure to credit loss in the event of nonperformance by the other
party to the financial instrument for commitments to extend credit and standby
letters of credit is represented by the contractual amount of those instruments.
The Bank uses the same credit policies in making commitments and conditional
obligations as it does for on-balance sheet instruments. A summary of the Bank's
commitments is as follows:
June 30, 2012
Commitments to extend credit $ 55,724
Letters of Credit 1,719
Total $ 57,443
Commitments to extend credit are agreements to lend to a customer as long as
there is no violation of any condition established in the contract. Because many
of the commitments are expected to expire without being drawn upon, the total
commitment amounts do not necessarily represent future cash requirements. The
amount of collateral obtained, if deemed necessary by the Bank upon extension of
credit, is based on the Bank's credit evaluation of the customer.
Standby letters of credit are conditional commitments issued by the Bank to
guarantee the performance of a customer to a third party. Those letters of
credit are primarily issued to support public and private borrowing
arrangements. The credit risk involved in issuing letters of credit is
essentially the same as that involved in extending loans to customers.
Collateral is required in instances that the Bank deems necessary.
SUMMARY OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion represents management's discussion and analysis of the
financial condition of Financial as of June 30, 2012 and December 31, 2011 and
the results of operations of Financial for the three month and six month periods
ended June 30, 2012 and 2011. This discussion should be read in conjunction with
the financial statements included elsewhere herein.
All financial statements have been prepared in accordance with accounting
principles generally accepted in the United States of America.
Financial Condition Summary
June 30, 2012 as Compared to December 31, 2011
Total assets were $433,204,000 on June 30, 2012 compared with $427,436,000 at
December 31, 2011, an increase of 1.34%. The increase in total assets is due
primarily to an increase in Federal funds sold and securities available-for-sale
resulting from an increase in deposits, as explained in the following paragraph.
Total deposits increased from $374,234,000 as of December 31, 2011 to
$384,589,000 on June 30, 2012, an increase of 2.77%. This increase occurred
because of the Bank's increased efforts to obtain lower cost demand deposits and
the Bank's increased presence in the market.
Total loans increased to $324,909,000 on June 30, 2012 from $324,366,000 on
December 31, 2011. Loans, net of unearned income and allowance, increased to
$319,216,000 on June 30, 2012 from $318,754,000 on December 31, 2011, an
increase of 0.14%. The following summarizes the position of the Bank's loan
portfolio as of the dates indicated by dollar amount and percentages (dollar
amounts in thousands):
June 30, 2012 December 31, 2011
Amount Percentage Amount Percentage
Commercial $ 56,846 17.50 % $ 59,623 18.39 %
Commercial Real Estate 151,937 46.76 % 150,622 46.43 %
Consumer 71,283 21.94 % 72,488 22.34 %
Residential 44,843 13.80 % 41,633 12.84 %
Total loans $ 324,909 100.00 % $ 324,366 100.00 %
Total nonperforming assets, which consist of non-accrual loans and other real
estate owned ("OREO") decreased to $9,453,000 on June 30, 2012 from $13,628,000
on December 31, 2011. This decrease was primarily due to a decrease in
non-accrual (or nonperforming) loans. Non-accrual loans decreased 30.72% to
$7,190,000 on June 30, 2012 from $10,375,000 on December 31, 2011. The decrease
primarily resulted from the liquidation of real estate collateral associated
with several relationships, including one large commercial relationship. The
proceeds from the liquidations were used to curtail principal on a non-accrual
loan. As discussed in more detail below under "Results of Operations-Allowance
for Loan Losses", management has provided for the anticipated losses on these
loans in the loan loss reserve. If interest on non-accrual loans had been
accrued, such interest on a cumulative basis would have approximated $864,000
and $1,233,000, as of June 30, 2012 and December 31, 2011, respectively. Loan
payments received on non-accrual loans are first applied to principal. When a
loan is placed on non-accrual status there are several negative implications.
First, all interest accrued but unpaid at the time of the classification is
reversed and deducted from the interest income totals for the Bank. Second,
accruals of interest are discontinued until it becomes certain that both
principal and interest can be repaid. Third, there may be actual losses that
necessitate additional provisions for credit losses charged against earnings.
These loans were included in the non-performing loan totals listed above.
OREO represents real property acquired by the Bank for debts previously
contracted, including through foreclosure, deeds in lieu of foreclosure or
repossession. On December 31, 2011, the Bank was carrying 18 OREO properties on
its books at a value of $3,253,000. During the six months ended June 30, 2012,
the Bank acquired 16 additional OREO properties and disposed of 20 OREO
properties, and as of June 30, 2012 the Bank is carrying 14 OREO properties at a
value of $2,263,000. The OREO properties are available for sale and are being
actively marketed on the Bank's website and through other means.
The Bank had loans in the amount of $187,000 at June 30, 2012 classified as
performing Troubled Debt Restructurings ("TDRs") as compared to $783,000 at
December 31, 2011. This decrease was due entirely to the liquidation of
collateral associated with one commercial relationship with the proceeds from
the liquidation being used to pay off the TDR loans. None of these TDRs were
included in non-accrual loans. These loans have had their original terms
modified to facilitate payment by the borrower. The loans have been classified
as TDRs primarily due to a change to interest only payments and the maturity of
these modified loans is primarily less than one year.
Cash and cash equivalents increased to $27,286,000 on June 30, 2012 from
$23,340,000 on December 31, 2011. Cash and cash equivalents consist of cash due
from correspondents, cash in vault, and overnight investments (including federal
funds sold). This increase is in large part due to an increase in deposits in
excess of loans. The Bank invested a majority of the increase in deposits in fed
funds. Cash and cash equivalents can vary due to routine fluctuations in
deposits, including fluctuations in transactional accounts and professional
settlement accounts, both of which are subject to fluctuations.
Securities held-to-maturity decreased to $3,087,000 on June 30, 2012 from
$8,133,000 on December 31, 2011. During the six months ended June 30, 2012, the
Bank received $5,000,000 in proceeds from maturities and calls of
securities-held-to-maturity. Securities available-for-sale increased to
$55,674,000 on June 30, 2012, from $48,338,000December 31, 2011. During the six
months ended June 30, 2012 the Bank received $10,488,000 in proceeds from
maturities and/or calls of securities available-for-sale and $8,472,000 in
proceeds from the sale of securities available-for-sale. The Bank purchased
$25,400,000 in securities available-for sale during the same period. The
increase from December 31, 2011 in securities available-for-sale was primarily
due to the investment of funds received from an increase in deposit accounts.
Financial's investment in Federal Home Loan Bank of Atlanta (FHLBA) stock
totaled $1,109,000 at June 30, 2012 and $1,170,000 at December 31, 2011, a
non-material decrease of $61,000. FHLBA stock is generally viewed as a long-term
investment and because there is no market for the stock other than other Federal
Home Loan Banks or member institutions, FHLBA stock is viewed as a restricted
security. Therefore, when evaluating FHLBA stock for impairment, its value is
based on the ultimate recoverability of the par value rather than by recognizing
temporary declines in value.
Liquidity and Capital
At June 30, 2012, Financial, on a consolidated basis, had liquid assets of
$82,960,000 in the form of cash, interest-bearing and noninterest-bearing
deposits with banks, federal funds sold and available-for-sale investments.
Management believes that liquid assets were adequate at June 30, 2012.
Management anticipates that additional liquidity will be provided by the growth
in deposit accounts and loan repayments at the Bank. In addition, the Bank has
the ability to purchase federal funds on the open market and borrow from the
Federal Reserve Bank's discount window, if necessary.
Financial currently is conducting a private placement of unregistered debt
securities (the "2012 Offering") pursuant to which Financial is authorized to
issue up to $12,000,000 in principal of notes (the "2012 Notes"). As of June 30,
2012, Financial had issued 2012 Notes in the amount $9,627,000. Although
Financial is authorized to sell up to $12,000,000 in 2012 Notes, Financial has
determined that it will close the 2012 Offering at such time as it has sold
$10,000,000 in principal of 2012 Notes, or it terminates the offering, or,
whichever occurs first.
The 2012 Notes will not be and have not been registered under the Securities Act
of 1933 and may not be offered or sold in the United States absent registration
or an applicable exemption from registration requirements. The 2012 Notes will
bear interest at the rate of 6% per year with interest payable quarterly in
arrears. The first interest payment of $133,000 was due on July 1, 2012 and paid
on or about June 29, 2012. The notes mature on April 1, 2017, but are subject to
prepayment in whole or in part on or after April 1, 2013 at Financial's sole
discretion on 30 days written notice to the holders. Financial used $7,000,000
of the proceeds from the 2012 Offering to pay the 2009 Notes on their maturity.
Management is not aware of any trends, events or uncertainties that are
reasonably likely to have a material negative impact on Financial's short-term
or long-term liquidity.
At June 30, 2012, the Bank had a leverage ratio of 8.04%, a Tier 1 risk-based
capital ratio of 10.78% and a total risk-based capital ratio of 12.03%. As of
June 30, 2012 and December 31, 2011 the Bank's regulatory capital levels
exceeded those established for well-capitalized institutions. The following
table sets forth the minimum capital requirements and the Bank's capital
position as of June 30, 2012 and December 31, 2011:
Bank Level Only Capital Ratios
June 30, 2012 December 31,
Analysis of Capital (in 000's)
Tier 1 Capital:
Common stock $ 3,742 $ 3,742
Surplus 19,325 19,325
Retained earnings 11,449 10,394
Total Tier 1 capital $ 34,516 $ 33,461
Tier 2 Capital:
Allowance for loan losses $ 4,024 $
Total Tier 2 Capital: $ 4,024 $ 3,991
Total risk-based capital $ 38,540 $ 37,452
Risk weighted assets $ 320,288 $ 317,684
Average total assets $ 429,382 $ 427,680
Actual Regulatory Benchmarks
For Capital For Well
December 31, Adequacy Capitalized
June 30, 2012 2011 Purposes Purposes
Tier 1 capital to average
total assets ratio (leverage
ratio) 8.04 % 7.82 % 4.00 % 5.00 %
Tier 1 risk based capital
ratio 10.78 % 10.53 % 4.00 % 6.00 %
Total risk-based capital ratio 12.03 % 11.79 % 8.00 % 10.00 %
The above tables set forth the capital position and analysis for the Bank only.
Because total assets on a consolidated basis are less than $500,000,000,
Financial is not subject to the consolidated capital requirements imposed by the
Bank Holding Company Act. Consequently, Financial does not calculate its
financial ratios on a consolidated basis. If calculated, the capital ratios for
the Company on a consolidated basis would no longer be comparable to the capital
ratios of the Bank because the proceeds from the private placement of the 6%
capital notes due on April 1, 2017 do not qualify as equity capital on a
Results of Operations
Comparison of the Three and Six Months Ended June 30, 2012 and 2011
Financial had net income including all operating segments of $486,000 and
$846,000 for the three and six months ended June 30, 2012 compared to $319,000
and $754,000 for the for the comparable periods in 2011. The basic and diluted
earnings per common share for the three and six months ended June 30, 2012 were
$0.15 and $0.25, compared to basic and diluted earnings per share of $0.10 and
$0.23 for the three and six months ended June 30, 2011.
The increase in net income was due in large part to a decreased provision to the
allowance for loan loss reserve as discussed in more detail below (See
"Allowance for Loan Losses"), a decrease in interest expense, and an increase in
non-interest income. The increase was partially offset by an increase in
These operating results represent an annualized return on stockholders' equity
of 7.18% and 6.28% for the three and six months ended June 30, 2012, compared
with 4.81% and 5.76% for the same periods in 2011. The Company had an annualized
return on average assets for the three and six months ended June 30, 2012 of
0.45% and 0.40%, compared with 0.30% and 0.36% for three and six months ended
June 30, 2011.
See Non-Interest Income below for mortgage business segment discussion.
Interest Income, Interest Expense, and Net Interest Income
Interest income decreased to $4,645,000 and $9,331,000 for the three and six
months ended June 30, 2012 from $4,896,000 and $9,838,000 for the same periods
in 2011, a decrease of 5.13% and 5.15%, respectively. Interest income decreased
primarily because a) the average principal balance of the loan portfolio (net of
allowance for loan losses) decreased as compared to the comparable periods in
2011; and b) the average rate received on earning assets decreased to 4.73% and
4.76% for the three and six months ended June 30, 2012 as compared with 4.95%
and 5.03% for the comparable periods in 2011. The rate on total average earning
assets decreased largely because of a decrease in market rates of interest.
Although management cannot be certain, management expects that interest rates
will remain near historic lows for the remainder of 2012 and may continue to
negatively impact our interest income.
Interest expense decreased to $809,000 and $1,629,000 for the three and six
months ended June 30, 2012 from $1,090,000 and $2,325,000 for the same periods
in 2011, a decrease of 25.78% and 29.94%, respectively. This significant
decrease in interest expense resulted in large part from a decrease in the rate
paid on balances on deposits. The Bank's average rate paid on deposits was 0.74%
and 0.76% during the three and six month periods ended June 30, 2012 as compared
to 1.09% and 1.19% for the same periods in 2011. This resulted from management's
efforts to minimize the Bank's interest expense and maximize its net interest
The fundamental source of the Bank's revenue is net interest income, which is
determined by the difference between (i) interest and dividend income on
interest earning assets, which consist primarily of loans, investment securities
and other investments, and (ii) interest expense on interest-bearing
liabilities, which consist principally of deposits and other borrowings. Net
interest income for the three and six months ended June 30, 2012 was $3,836,000
and $7,702,000 compared with $3,806,000 and $7,513,000 for the same periods in
2011. The increase in net interest income for the three and six months ended
June 30, 2012 as compared with the comparable periods in 2011 was due the fact
that the rate paid on deposit accounts has decreased from the comparable periods
in 2011. The net interest margin was 3.91% and 3.95% for the three and six
months ended June 30, 2012, up from 3.85% and 3.84% for the same periods a year
Financial's net interest margin analysis and average balance sheets are shown in
Schedule I on page 48.
Non-interest income is comprised primarily of fees and charges on transactional
deposit accounts, mortgage loan origination fees, commissions on sales of
investments and the Bank's ownership interest in a title insurance agency.
Non-interest income exclusive of gains on sales of securities increased to
$714,000 and $1,344,000 for the three and six months ended June 30, 2012 from
$589,000 and $1,230,000 for the three and six months ended June 30, 2011. This
increase for the three and six months
ended June 30, 2012 as compared to the same periods last year was due primarily
to increases in all categories of non-operating income, including increases in
mortgage origination fees and service charges, fees, and commissions. Gains on
sales of securities decreased to $129,000 and $170,000 for the three and six
months ended June 30, 2012 as compared to $169,000 and $200,000 for the
comparable periods in 2011.
The Bank, through the Mortgage division, originates both conforming and
non-conforming consumer residential mortgage loans in the Region 2000 area. As
part of the Bank's overall risk management strategy, all of the loans originated
and closed by the Mortgage division are presold to major national mortgage
banking or financial institutions. The Mortgage division assumes no credit or
interest rate risk on these mortgages.
Management anticipates that residential mortgage rates will remain near the
current historic lows for the remainder of 2012. Management expects that low
rates coupled with the Mortgage division's reputation in Region 2000 will allow
us to maintain revenue at the Mortgage division. Revenue from mortgage
origination fees increased in the three month period ended June 30, 2012 as
compared to the same period for 2011. Revenue from mortgage origination fees
decreased in the six month period ended June 30, 2012 as compared to the same
period for 2011. Management believes that regulatory pressure may result in a
decreased number of competitors to the Mortgage division and this could result
in an increase in market share.
Our Investment division provides brokerage services through an agreement with a
third-party broker-dealer. Pursuant to this arrangement, the third party
broker-dealer operates a service center adjacent to one of the branches of the
Bank. The center is staffed by dual employees of the Bank and the broker-dealer.
Investment receives commissions on transactions generated and in some cases
ongoing management fees such as mutual fund 12b-1 fees. The Investment
division's financial impact on our consolidated revenue has been immaterial.
Although management cannot predict the financial impact of Investment with
certainty, management anticipates the Investment division's impact on
noninterest income will remain immaterial in 2012.
In the third quarter of 2008, we began providing insurance and annuity products
to Bank customers and others, through the Bank's Insurance subsidiary. The Bank
has one full-time and one part-time employee that are dedicated to selling
insurance products through Insurance. Insurance generates minimal revenue and
its financial impact on our consolidated revenue has been immaterial. Management
anticipates that Insurance's impact on noninterest income will remain immaterial
Non-interest expense for the three and six months ended June 30, 2012 increased
to $3,559,000 and $6,843,000, or 11.08% and 7.36%, respectively, from $3,204,000
and $6,374,000 for the comparable periods in 2011. This increase in non-interest
expense from the comparable period in 2011 can be attributed in large part to an
increase in compensation expense, discussed in more detail in the following
paragraph, and other real estate expenses. Other real estate expenses consist
primarily of insurance, maintenance, real estate taxes, and other expenses
related to property ownership.
Total personnel expense was $1,546,000 and $3,049,000 for the three and six
month periods ended June 30, 2012 as compared to $1,391,000 and $2,818,000 for
the same periods in 2011. Compensation for some employees of the Mortgage
division and the Investment division is commission-based and therefore subject
During the three months ended June 30, 2012, the FDIC premium expense increased
to $144,000 from $141,000 for the three months ended June 30, 2011. During the
six months ended June 30, 2012, the FDIC premium expense decreased to $288,000
from $370,000 for the three months ended June 30, 2011. FDIC assessment payments
have decreased in large part because the FDIC changed the formula used to
calculate the assessment in a way that favors banks whose liabilities consist
primarily of deposits.
Allowance for Loan Losses
The allowance for loan losses represents an amount that, in our judgment, will
be adequate to absorb any losses on existing loans that may become
uncollectible. The provision for loan losses increases the allowance, and loans
charged off, net of recoveries, reduce the allowance. The provision to the
allowance for loan losses is charged to earnings to bring the total allowance to
a level deemed appropriate by management and is based upon many factors,
including calculations of specific impairment of certain loans, general economic
conditions, actual and expected credit losses, loan performance measures,
historical trends and specific conditions of the individual borrower. Based on
the application of the loan loss calculation, the Bank provided $425,000 and
$1,175,000 to the allowance for loan loss for the three and six months ended
June 30, 2012 compared to a provision of $906,000 and $1,485,000 for the
comparable periods in 2011.
The decrease in the loan loss provision for the three and six months ended
June 30, 2012 as compared to the same periods in 2011 was due to the following
• The Bank's asset quality has improved as problem assets, including certain
commercial development loans and residential speculative housing construction
loans have decreased as the collateral for those loans has been liquidated.
Management's evaluation of these asset classes resulted in the decreased
provision in the quarter ended June 30, 2012.
• In light of the current economic environment, management continues its ongoing
assessment of specific impairment in the Bank's loan portfolio. The analysis
resulted in a decrease in the provision for the quarter ended June 30, 2012 as
compared to the same quarter in 2011.
• General reserves related to consumer loans collectively evaluated for
impairment have also decreased as a result of a decrease in historical
charge-offs associated with this loan segment.
Management believes that the current allowance for loan loss of $5,693,000 (or
1.75% of total loans) at June 30, 2012, as compared to $5,612,000 (or 1.73% of
total loans) as of December 31, 2011 remains adequate.
The following tables summarize the allowance activity for the periods indicated:
Allowance for Credit Losses
and Recorded Investment in Financing Receivables
(dollars in thousands)
Six months Ended June 30, 2012
Commercial Real Estate Consumer Residential Total
Allowance for Credit Losses:
Beginning Balance $ 892 $ 2,677 $ 1,486 $ 557 $ 5,612
Charge-offs (175 ) (631 ) (413 ) (12 ) (1,231 )
Recoveries 13 109 9 6 137
Provision 131 761 197 86 1,175
Ending Balance 861 2,916 1,279 637 5,693
Ending Balance: Individually
evaluated for impairment $ 428 $ 1,016 $ 487 $ 133 $ 2,064
Ending Balance: Collectively
evaluated for impairment 433 1,900 792 504 3,629
Totals: $ 861 $ 2,916 $ 1,279 $ 637 $ 5,693
Ending Balance: Individually
evaluated for impairment 5,152 14,127 990 3,005 23,274
Ending Balance: Collectively
evaluated for impairment 51,694 137,810 70,293 41,838 301,635
Totals: $ 56,846 $ 151,937 $ 71,283 $ 44,843 $ 324,909
Allowance for Credit Losses
Year Ended December 31, 2011
Commercial Real Estate Consumer Residential Total
Allowance for Credit Losses:
Beginning Balance $ 473 $ 2,897 $ 1,207 $ 890 $ 5,467
Charge-offs (702 ) (2,738 ) (817 ) (459 ) (4,716 )
Recoveries 16 3 31 4 54
Provision 1,105 2,515 1,065 122 4,807
Ending Balance 892 2,677 1,486 557 5,612
Ending Balance: Individually
evaluated for impairment $ 440 $ 1,058
$ 357 $ 128 $ 1,983
Ending Balance: Collectively
evaluated for impairment 452 1,619 1,129 429 3,629
Totals: $ 892 $ 2,677 $ 1,486 $ 557 $ 5,612
Ending Balance: Individually
evaluated for impairment 6,325 15,000 1,235 2,784 25,344
Ending Balance: Collectively
evaluated for impairment 53,298 135,622 71,253 38,849 299,022
Totals: $ 59,623 $ 150,622 $ 72,488 $ 41,633 $ 324,336
The following sets forth the reconciliation of the allowance for loan loss:
Three months ended Six months ended
June 30, June 30,
(in thousands) (in thousands)
2012 2011 2012 2011
Balance, beginning of period $ 6,006 $ 5,318 $ 5,612 $ 5,467
Provision for loan losses 425 906 1,175 1,485
Loans charged off (847 ) (1,266 ) (1,231 ) (2,005 )
Recoveries of loans charged off 109 12 137 23
Net Charge Offs (738 ) (1,254 ) (1,094 ) (1,982 )
Balance, end of period $ 5,693 $ 4,970 $ 5,693 $ 4,970
The Bank's internal risk rating system is in place to grade commercial and
commercial real estate loans. Category ratings are reviewed periodically by
lenders and the credit review area of the Bank based on the borrower's
individual situation. Additionally, internal and external monitoring and review
of credits are conducted on an annual basis.
Below is a summary and definition of the Bank's risk rating categories:
RATING 1 Excellent
RATING 2 Above Average
RATING 3 Satisfactory
RATING 4 Acceptable / Low Satisfactory
RATING 5 Monitor
RATING 6 Special Mention
RATING 7 Substandard
RATING 8 Doubtful
RATING 9 Loss
We segregate loans into the above categories based on the following criteria and
we review the characteristics of each rating at least annually, generally during
the first quarter. The characteristics of these ratings are as follows:
• "Pass." These are loans having risk ratings of 1 through 4. Pass loans are to
persons or business entities with an acceptable financial condition,
appropriate collateral margins, appropriate cash flow to service the existing
loan, and an appropriate leverage ratio. The borrower has paid all
obligations as agreed and it is expected that this type of payment history
will continue. When necessary, acceptable personal guarantors support the
• "Monitor." These are loans having a risk rating of 5. Monitor loans have
currently acceptable risk but may have the potential for a specific defined
weakness in the borrower's operations and the borrower's ability to generate
positive cash flow on a sustained basis. The borrower's recent payment
history may currently or in the future be characterized by late payments. The
Bank's risk exposure is mitigated by collateral supporting the loan. The
collateral is considered to be well-margined, well maintained, accessible and
• "Special Mention." These are loans having a risk rating of 6. Special Mention
loans have weaknesses that deserve management's close attention. If left
uncorrected, these potential weaknesses may result in deterioration of the
repayment prospects for the asset or in the bank's credit position at some
future date. Special Mention loans are not adversely classified and do not
expose an institution to sufficient risk to warrant adverse classification.
These loans do warrant more than routine monitoring due to a weakness caused
by adverse events.
• "Substandard." These are loans having a risk rating of 7. Substandard loans
are considered to have specific and well-defined weaknesses that jeopardize
the viability of the Bank's credit extension. The payment history for the
loan has been inconsistent and the expected or projected primary repayment
source may be inadequate to service the loan. The estimated net liquidation
value of the collateral pledged and/or ability of the personal guarantor(s)
to pay the loan may not adequately protect the Bank. There is a distinct
possibility that the Bank will sustain some loss if the deficiencies
associated with the loan are not corrected in the near term. A substandard
loan would not automatically meet our definition of impaired unless the loan
is significantly past due and the borrower's performance and financial
condition provides evidence that it is probable that the Bank will be unable
to collect all amounts due.
• "Doubtful." These are loans having a risk rating of 8. Doubtful rated loans
have all the weaknesses inherent in a loan that is classified substandard but
with the added characteristic that the weaknesses make collection or
liquidation in full, on the basis of currently existing facts, conditions,
and values, highly questionable and improbable. The possibility of loss is
• "Loss." These are loans having a risk rating of 9. Loss rated loans are not
considered collectible under normal circumstances and there is no realistic
expectation for any future payment on the loan. Loss rated loans are fully
The increase in the balance in the allowance for loan loss reserve as of
June 30, 2012 as compared to December 31, 2011 resulted from provisions being
higher than the net charge-offs during the first six months of 2012. The loan
loss reserve is determined as discussed above.
Net charge offs decreased to $738,000 and $1,094,000 for the three and six
months ended June 30, 2012 from $1,254,000 and $1,982,000 for the same periods
in 2011. Charged off loans, which are loans that management deems uncollectible,
are written against the loan loss reserve and constitute a realized loss. While
a charged off loan may subsequently be collected, such recoveries generally are
realized over an extended period of time.
For the three and six months ended June 30, 2012, Financial had an income tax
expense of $209,000 and $352,000, respectively. This represents an effective tax
rate of 30.10% and 29.90% for the respective periods.
On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act
(the "Dodd-Frank Reform Act") was signed into law. The Dodd-Frank Reform Act
represents a significant overhaul of many aspects of the regulation of the
financial services industry, although many of its provisions (e.g., the
interchange and trust preferred capital limitations) apply to companies that are
significantly larger than Financial. The Dodd-Frank Reform Act directs
applicable regulatory authorities to promulgate regulations implementing its
provisions, and its effect on Financial and on the financial services industry
as a whole will be clarified as those regulations are issued. Major elements of
the Dodd-Frank Reform Act include:
• A permanent increase in deposit insurance coverage to $250,000 per
account, permanent unlimited deposit insurance on noninterest-bearing
transaction accounts, and an increase in the minimum Deposit Insurance
Fund reserve requirement for banks having consolidated assets in excess of
$10 billion from 1.15% to 1.35%, with assessments to be based on assets as
opposed to deposits.
• New disclosure and other requirements relating to executive compensation
and corporate governance.
• Amendments to the Truth in Lending Act aimed at improving consumer
protections with respect to mortgage originations, including originator
compensation, minimum repayment standards, and prepayment considerations.
• The establishment of the Financial Stability Oversight Council, which will
be responsible for identifying and monitoring systemic risks posed by
financial firms, activities, and practices.
• The development of regulations to limit debit card interchange fees.
• The future elimination of trust preferred securities as a permitted
element of Tier 1 capital.
• The creation of a special regime to allow for the orderly liquidation of
systemically important financial companies, including the establishment of
an orderly liquidation fund.
• The development of regulations to address derivatives markets, including
clearing and exchange trading requirements and a framework for regulating
• Enhanced supervision of credit rating agencies through the Office of
Credit Ratings within the SEC.
• Increased regulation of asset-backed securities, including a requirement
that issuers of asset-backed securities retain at least 5% of the risk of
the asset-backed securities.
• The establishment of a Bureau of Consumer Financial Protection, within the
Federal Reserve, to serve as a dedicated consumer-protection regulatory
• On February 7, 2011, the FDIC issued a final rule redefining the
assessment base as required by Dodd-Frank. The final rule adopted a
separate risk-based assessment system for large insured depository
institutions (institutions with greater than $10 billion in assets). The
final rule applies to all insured depository institutions and is effective
on April 1, 2011.
Financial continues to evaluate the potential impact of the Dodd-Frank Reform
Table of Contents
Net Interest Margin Analysis
Average Balance Sheets
For the Quarter Ended June 30, 2012 and 2011
Average Interest Average Average Interest Average
Balance Income/ Rates Earned/ Balance Income/ Rates Earned/
Sheet Expense Paid Sheet Expense Paid
Loans, including fees (1) (2) $ 320,588 $ 4,170 5.22 % $ 325,460 $ 4,382 5.40 %
Loans held for sale 878 8 3.65 % 202 2 3.97 %
Federal funds sold 10,497 6 0.23 % 12,203 8 0.26 %
Securities (3) 59,741 432 2.90 % 56,951 481 3.39 %
Federal agency equities 1,829 29 6.36 % 2,007 23 4.60 %
CBB equity 116 - 0.00 % 116 - 0.00 %
Total earning assets 393,649 4,645 4.73 % 396,939 4,896 4.95 %
Allowance for loan losses (5,901 ) (5,325 )
Non-earning assets 44,499 37,700
Total assets $ 432,247 $ 429,314
LIABILITIES AND STOCKHOLDERS' EQUITY
Demand interest bearing $ 81,765 $ 65 0.32 % $ 63,851 $ 90 0.57 %
Savings 153,241 144 0.38 % 180,879 374 0.83 %
Time deposits 92,196 392 1.71 % 83,125 428 2.07 %
Total interest bearing deposits 327,202 601 0.74 % 327,855 892 1.09 %
Other borrowed funds
Repurchase agreements 28 - 0.00 % 8,156 18 0.89 %
Other borrowings 10,000 75 3.01 % 10,000 75 3.01 %
Capital Notes 8,865 133 6.00 % 7,000 105 6.00 %
Total interest-bearing liabilities 346,095 809 0.94 % 353,011 1,090 1.24 %
Non-interest bearing deposits 57,593 49,198
Other liabilities 1,393 515
Total liabilities 405,081 402,724