10-Q 1 v318540_10q.htm FORM 10-Q

 

U.S. Securities and Exchange Commission

Washington, D.C. 20549

 

Form 10-Q

 

x Quarterly Report Under Section 13 or 15(d)

of the Securities Exchange Act of 1934

 

For the quarterly period ended June 30, 2012

 

¨ Transition Report Under Section 13 or 15(d)

of the Securities Exchange Act of 1934

 

For the transition period ended                                 

 

Commission File Number    000-33227

 

Southern Community Financial Corporation

(Exact name of registrant as specified in its charter)

 

North Carolina   56-2270620
(State or other jurisdiction of   (I.R.S. Employer Identification No.)
incorporation or organization)    
     
4605 Country Club Road    
Winston-Salem, North Carolina   27104
(Address of principal executive offices)   (Zip Code)

 

Registrant's telephone number, including area code (336) 768-8500

 

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 x No ¨

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes x No ¨

 

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

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

 

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

 

As of July 31, 2012 (the most recent practicable date), the registrant had outstanding 16,852,525 shares of Common Stock, no par value.

 

 
 

 

      Page No.
         
Part I. FINANCIAL INFORMATION      
         
Item 1 - Financial Statements (Unaudited)    
         
 

Consolidated Statements of Financial

Condition June 30, 2012 and December 31, 2011

  22  
         
 

Consolidated Statements of Operations

Three Months and Six Months Ended June 30, 2012 and 2011

  23  
         
 

Consolidated Statements of Comprehensive Income (Loss)

Three Months and Six Months Ended June 30, 2012 and 2011

  24  
         
 

Consolidated Statement of Changes in Stockholders’ Equity

Six Months Ended June 30, 2012

  25  
         
 

Consolidated Statements of Cash Flows

Six Months Ended June 30, 2012 and 2011

  26  
         
  Notes to Consolidated Financial Statements   27  
         
  Selected Financial Data   3  
         
Item 2 - Management’s Discussion and Analysis of Financial Condition and Results of Operations   4  
         
Item 3 - Quantitative and Qualitative Disclosures about Market Risk   61  
         
Item 4 - Controls and Procedures   61  
         
Part II. Other Information      
         
Item 1A - Risk Factors   62  
         
Item 6 - Exhibits   62  
         
Signatures     63  

 

 
 

 

Part I. Financial Information

SElected financial data

 

 

   At or for the Quarter Ended   % Change June 30, 2012 from 
   June 30,   December 31,   June 30,   December 31,   June 30, 
   2012   2011   2011   2011   2011 
   (Amounts in thousands, except per share data)         
Operating Data:                         
Interest income  $15,442   $16,602   $18,148    (7)%   (15)%
Interest expense   4,772    5,111    5,578    (7)   (14)
Net interest income   10,670    11,491    12,570    (7)   (15)
Provision for loan losses   2,300    3,400    3,700    (32)   (38)
Net interest income after provision for loan losses   8,370    8,091    8,870    3    (6)
Non-interest income   3,898    4,403    3,534    (11)   10 
Non-interest expense   11,177    11,497    11,255    (3)   (1)
Income before income taxes   1,091    997    1,149    9    (5)
Income tax expense (benefit)   -    -    -    -    - 
Net income  $1,091   $997   $1,149    9    (5)
Effective dividend on preferred stock   645    638    638    1    1 
Net income available to common shareholders  $446   $359   $511    24    (13)
                          
Net Income Per Common Share:                         
Basic  $0.03   $0.02   $0.03           
Diluted   0.03    0.02    0.03           
                          
Selected Performance Ratios:                         
Return on average assets   0.30%   0.26%   0.29%          
Return on average equity   4.44%   4.02%   5.00%          
Net interest margin (1)   3.15%   3.22%   3.43%          
Efficiency ratio (2)   76.72%   72.34%   69.89%          
                          
Asset Quality Ratios:                         
Nonperforming loans to period-end loans   6.01%   7.13%   6.42%          
Nonperforming assets to total assets (3)   5.18%   5.85%   5.75%          
Net loan charge-offs to average loans outstanding (annualized)   1.52%   2.29%   1.46%          
Allowance for loan losses to period-end loans   2.50%   2.53%   2.65%          
Allowance for loan losses to nonperforming loans   0.42X   0.36X   0.41X          
                          
Capital Ratios:                         
Total risk-based capital   14.87%   14.26%   13.41%         
Tier 1 risk-based capital   12.38%   11.75%   10.90%         
Leverage ratio   8.95%   8.47%   7.97%         
Equity to assets ratio   6.93%   6.50%   6.07%         
                          
Balance Sheet Data (End of Period):                         
Total assets   1,446,961    1,502,578    1,561,986    (4)   (7)
Loans   913,591    950,022    1,038,349    (4)   (12)
Deposits   1,126,701    1,183,172    1,247,888    (5)   (10)
Short-term borrowings   59,268    33,629    7,353    76    706 
Long-term borrowings   147,426    177,514    202,601    (17)   (27)
Stockholders’ equity   100,339    97,635    94,740    3    6 
                          
Other Data:                         
Weighted average shares                         
Basic   16,858,572    16,827,684    16,835,724           
Diluted   16,934,115    16,891,910    16,906,810           
Period end outstanding shares   16,854,775    16,827,075    16,831,375           
Number of banking offices   22    22    22           
Number of full-time equivalent employees   286    290    289           

 

(1) Net interest margin is net interest income divided by average interest-earning assets.

(2) Efficiency ratio is non-interest expense divided by the sum of net interest income and non-interest income.

(3) Nonperforming assets consist of nonaccrual loans, restructured loans and foreclosed assets, where applicable.

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

This Quarterly Report on Form 10-Q may contain certain forward-looking statements consisting of estimates with respect to our financial condition, results of operations and business that are subject to various factors which could cause actual results to differ materially from these estimates. These factors include, but are not limited to, general economic conditions, changes in interest rates, deposit flows, loan demand, real estate values and competition; changes in accounting principles, policies, or guidelines; changes in legislation or regulation; and other economic, competitive, governmental, regulatory, technological factors affecting our operations, pricing, products and services, and other factors discussed in our filings with the Securities and Exchange Commission.

 

Capital Bank Financial Corp. Acquisition

 

On March 26, 2012, Southern Community Financial Corporation, Winston-Salem, N.C. (“Southern Community”) entered into an Agreement and Plan of Merger (the “Agreement”) with Capital Bank Financial Corp. (“CBF”) and Winston 23 Corporation (“Winston”), a wholly-owned subsidiary of CBF, pursuant to which Southern Community will merge with Winston and become a wholly-owned subsidiary of CBF (the “Merger”). The Agreement and the transactions contemplated by it has been approved by the Board of Directors of both CBF and Southern Community.

 

Capital Bank Financial Corp. is a national bank holding company that was incorporated in the State of Delaware in 2009. CBF has raised approximately $900 million of equity capital with the goal of creating a regional banking franchise in the southeastern region of the United States. CBF has previously invested in First National of the South, Metro Bank of Dade Country, Turnberry Bank, TIB Financial Corporation, Capital Bank Corporation and Green Bankshares, Inc. CBF is the parent of Capital Bank, N.A., a national banking association with approximately $6.5 billion in total assets and 143 full-service banking offices throughout southern Florida and the Florida Keys, North Carolina, South Carolina, Tennessee and Virginia. CBF is also the parent company of Naples Capital Advisors, Inc., a registered investment advisor.

 

Subject to the terms and conditions set forth in the Agreement dated March 26, 2012 and as amended on June 25, 2012, each share of Southern Community Common Stock issued and outstanding at the effective time of the Merger will be converted into the right to receive $3.11 in cash, without interest and less any applicable withholding taxes.

 

Each outstanding option to purchase shares of Southern Community common stock will be vested prior to the Merger and be paid in cash equal to the difference between the exercise price of the option and $3.11 and each share of Southern Community restricted stock will vest immediately prior to the Merger and all restrictions will immediately lapse.

 

Southern Community shareholders will also be granted one non-transferable contingent value right (“CVR”) per share, with each CVR eligible to receive a cash payment equal to 75% of the excess, if any, of (i) $87 million over (ii) net charge-offs and net realized losses on Southern Community’s legacy loan portfolio and foreclosed assets for a period of five years from the closing date of the Merger, with a maximum payment of $1.30 per CVR. Payout of the CVR will be overseen by a special committee of the CBF Board. Southern Community shareholders may also receive an additional cash payment based on the terms of a potential repurchase by CBF of the securities issued by Southern Community to the United States Department of the Treasury.

 

Upon the closing of the Merger, Dr. William G. Ward, Sr., the Chairman of Southern Community’s Board of Directors, will join the Board of Directors of both CBF and its subsidiary bank (“Capital Bank”), and James G. Chrysson, the Vice Chairman of the Board of Southern Community, will join the Board of Capital Bank.

 

The obligations of Southern Community and CBF to consummate the merger are subject to certain conditions, including: (i) approval of the Merger by the shareholders of Southern Community; (ii) receipt of required regulatory approvals (and in CBF’s case, without the imposition of an unduly burdensome regulatory condition); (iii) the absence of any injunction or similar restraint enjoining or making illegal consummation of the Merger or any of the other transactions contemplated by the Agreement; (iv) the continuing material truth and accuracy of representations and warranties made by the parties in the Agreement; and (vi) the performance in all material respects by each of the parties of its covenants under the Agreement. Some of these conditions may be waived by the party for whose benefit they were included in the Agreement. CBF’s obligation to close is subject to certain additional conditions, including the absence of a material adverse effect on Southern Community and the amendment or waiver of certain of Southern Community’s compensation-related agreements.

 

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The Agreement may be terminated, before or after receipt of shareholder approval, in certain circumstances, including: (i) upon the mutual consent of the parties; (ii) failure to obtain any required regulatory approval; (iii) by either party if the Merger is not consummated on or before September 26, 2012 if such failure is not caused by material breach of the Agreement; (iv) by either party if there is a material breach of the other party’s representations, warranties, or covenants, and the breach or change that is not cured within 30 days following notice by the complaining party to the complaining party’s reasonable satisfaction; (v) by CBF if Southern Community’s Board fails to recommend that shareholders approve the Agreement and the Merger, changes such recommendation or breaches certain non-solicitation covenants with respect to third party proposals; or (vi) by either party if the shareholders of Southern Community fail to approve the Agreement.

 

Under certain circumstances, Southern Community will be obligated to pay CBF a termination fee of $4 million and reimburse CBF up to $1 million for all expenses incurred by it in connection with the Agreement and the transactions contemplated thereby.

 

On July 25, 2012, the Board terminated the employment of Messrs. Bauer and Clark effective September 22, 2012. Their employment agreements, which have now been terminated, contained change in control provisions that provided for a lump sum payment equal to three times the sum of the applicable officer’s base salary for the year of the change in control and the incentive compensation paid in the year prior to the change in control. As previously disclosed in Southern Community’s Form 10-K/A, Amendment No. 1 for the year ended December 31, 2011, the following would have been the estimated cost to the Company in the event of a change in control as of January 1, 2012, pursuant to the employment agreements and Salary Continuation Agreements and assuming that the Treasury’s investment in Southern Community was repaid in full, the Company was no longer under regulatory restrictions and not taking into account the amendments contemplated by the merger agreement. On behalf of Messrs. Bauer and Clark, the estimated cost to the Company would have been approximately $2,622,297 and $1,366,220, respectively. As a condition to the closing of the merger, both the amounts and the terms of potential change in control payments under the employment agreements with Messrs. Bauer and Clark were required to be amended. Since neither officer will be an employee of Southern Community at the time of the merger, amendments to their employment agreements will not be required to consummate the merger.

 

Regulatory Actions and Management’s Compliance Efforts

 

On February 25, 2011, the Bank entered into a Consent Order with the Federal Deposit Insurance Corporation (“FDIC”) and the North Carolina Commission of Banks (“NCCOB”). Under the terms of the Consent Order among other things, the Bank has agreed to:

 

·Strengthen Board oversight of the management and operations of the Bank;
·Comply with minimum capital requirements of 8% Tier 1 leverage capital and 11% total risk-based capital;
·Formulate and implement a plan to reduce the Bank’s risk exposure in assets classified “Substandard or Doubtful” in the FDIC’s most recent report of examination by 15% in 180 days, 35% in 360 days, 60% in 540 days and 75% in 720 days;
·Within 90 days, implement effective lending and collection policies;
·Not pay cash dividends without the prior written approval of the FDIC and the Commissioner; and
·Neither renew, rollover or accept any brokered deposits without obtaining a waiver from the FDIC.

 

On June 23, 2011, the Company entered into a Written Agreement with the Federal Reserve Bank of Richmond under which the Company agreed to, among other things:

 

·Not, directly or indirectly, do the following without the prior approval of the Federal Reserve:
¾Declare or pay dividends on its, common or preferred stock;
¾Make any distributions of interest or principal on trust preferred securities;
¾Incur, increase or guarantee any debt; and
¾Purchase or redeem any shares of its stock.
·Formulate and implement a written plan to maintain sufficient capital at the Company on a consolidated basis.

 

- 5 -
 

 

As previously reported, the Company suspended the payment of quarterly cash dividends on the preferred stock issued to the US Treasury and the Company elected to defer the payment of quarterly scheduled interest payments on both issues of junior subordinated debentures, relating to its outstanding trust preferred securities. The Company continues to account for the obligation for the preferred dividend to the US Treasury and the interest due on the subordinated debentures. Although the Company has suspended the declaration and payment of preferred stock dividends at the present time, net income (loss) available to common shareholders reflects the dividends as if declared because of their cumulative nature. As of June 30, 2012, the cumulative amount of dividends owed to the US Treasury and the cumulative amount of interest due on the subordinated debentures were $3.9 million and $4.3 million, respectively.

 

The Bank has already undertaken the following actions, among others, to comply with the Consent Order:

 

·The Bank has exceeded all minimum capital requirements of the Consent Order.
·As of June 30, 2012, the Bank reduced its risk exposure to adversely classified assets identified in the Bank’s June 30, 2010 Report of Examination by an amount (60%) exceeding its scheduled reduction of 35% by February 2012 and meeting, in advance, its August 2012 scheduled reduction of 60%.

 

To date, management believes that the Company’s compliance efforts have been satisfactory and within the scheduled time frames. Compliance efforts remain ongoing.

 

Summary of Second Quarter

 

Total assets decreased $54.4 million, or 3.6%, during the second quarter as loans continued to decline but at a much slower rate. Investment securities decreased by $89.8 million, or 22.3%, due to the Company’s active management of the investment portfolio. Loans outstanding decreased $17.8 million, or 1.9%, as loan pay downs continued to exceed weak loan demand. The allowance for loan losses decreased $1.2 million, or 5.1%, to $23.0 million during the quarter as the specific allowance requirements decreased $928 thousand to $1.7 million while the volume of impaired loans individually evaluated for impairment decreased $2.0 million. Foreclosed assets decreased $4.1 million as the $831 thousand in writedowns and $6.4 million in foreclosed assets sold exceeded the new foreclosed asset additions during the quarter of $3.1 million. The liquidity from the loan pay downs and sales of investment securities held at the Federal Reserve ended the quarter at an unusually high balance of $101.5 million. Total deposits were $1.13 billion at June 30, 2012, a decrease of $55.1 million, or 4.7%, from the prior quarter end. The decrease in deposits included decreases of $44.5 million in time deposits and $13.7 million in interest bearing transaction accounts while demand deposits increased $3.2 million. This decrease in time deposits consisted of $24.4 million in outflows of maturing brokered deposits and $20.1 million in customer certificates of deposits. Interest bearing transaction accounts also declined with decreases of $11.1 million in NOW accounts, $2.4 million in money market accounts and $214 thousand in savings accounts. The decrease in interest bearing transaction accounts combined with the decrease in higher cost customer certificates of deposit and brokered deposits minimized the two basis point decrease in the net interest margin for the quarter. We expect wholesale funding to continue to decrease as the Company seeks to grow its core deposits and not renew maturing brokered deposits. Borrowings decreased $2.9 million, or 1.4%, from the prior quarter due primarily to decreased customer repurchase agreement activity.

 

Net interest income decreased $248 thousand, or 2.3%, for the second quarter compared to the first quarter. The interest rate environment remained stable in the second quarter as the Federal Reserve maintained the federal funds target rate consistent with the prior quarter and changes in LIBOR rates were relatively minor. Total interest income decreased $403 thousand, or 2.5%, while the cost of funds decreased $155 thousand, or 3.2%, compared to the previous quarter. The sequential decrease in interest income was attributable to a $15.5 million decrease in average loan balances and a four basis point decline in the earning asset yields due to the shift in the earning asset mix from loans into lower yielding investments and overnight funds. Interest expense declined primarily due to reduced cost of deposits as interest bearing deposit balances dropped significantly and the continued downward repricing of deposits. The net interest margin decreased two basis points to 3.15% compared to 3.17% for the linked quarter and decreased 28 basis points when compared to 3.43% for the second quarter of 2011. Management expects that interest margin compression will continue in the near future due to, among other factors, (i) more competitive pricing for loans, (ii) a continuation of current balance sheet trends in loan portfolio reduction and earning asset mix shift, (iii) a reduction in the investment securities portfolio and corresponding increase in interest bearing balances held at the Federal Reserve and federal funds sold and (iv) less impactful opportunities to reduce the cost of funds due to the low current interest rate structure of deposits.

 

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The Company’s provision for loan losses of $2.3 million decreased from $2.9 million for the first quarter and decreased from $3.7 million for the second quarter of 2011. Net charge-offs of $3.5 million increased $600 thousand compared to $2.9 million in the first quarter. Annualized net charge-offs increased to 1.52% of average loans in second quarter 2012 from 1.22% of average loans for first quarter and year-over-year from 1.46% of average loans for the second quarter 2011. Nonperforming loans decreased to $55.1 million, or 6.01% of loans, at June 30, 2012 from $57.9 million, or 6.19% of loans, at March 31, 2012. Nonperforming assets decreased to $75.0 million, or 5.18% of total assets, at June 30, 2012 from $81.9 million, or 5.46% of total assets, at March 31, 2011. The allowance for loan losses of $23.0 million at June 30, 2012 represented 2.50% of total loans and 42% coverage of nonperforming loans at current quarter-end compared with 2.58% of total loans and 42% coverage of nonperforming loans at March 31, 2012. We believe the allowance is adequate for losses inherent in the loan portfolio at June 30, 2012.

 

Non-interest income of $3.9 million increased $466 thousand, or 13.6%, compared to $3.4 million for the prior quarter and increased $364 thousand, or 10.3%, compared to $3.5 million for the second quarter of 2011. The major sequential changes in non-interest income were increases of $601 thousand from gains on sale of investment securities, an increase of $126 thousand in wealth management income and an increase of $93 thousand in derivative activity. These increases were offset by a decrease in Small Business Investment Corporation (SBIC) income of $370 thousand. The year-over-year increase of $364 thousand in non-interest income was primarily due to increased gains on sale of investment securities of $340 thousand and an increase in SBIC income of $177 thousand; partially offsetting these year-over-year increases was a decrease of $218 thousand in service charges on deposit accounts.

 

Non-interest expense of $11.2 million in the second quarter of 2012 increased $542 thousand, or 5.1%, from the prior quarter and decreased by $78 thousand, or 0.7%, compared with the year ago period. Linked quarter expense increases were primarily due to increases of $225 in foreclosed asset related expenses and $673 thousand in merger related expense offset by increased gains in sales of foreclosed property of $110 thousand and decreases of $73 thousand in debit card rewards expense and $51 thousand in other outside services expense. Non-interest expense decreased $78 thousand year-over-year primarily from decreases in occupancy and equipment of $198 thousand, FDIC deposit insurance of $161 thousand and advertising of $150 thousand which were offset by an increase of $387 thousand in foreclosed asset related expenses.

 

Financial Condition at June 30, 2012 and December 31, 2011

 

During the six month period ending June 30, 2012, total assets declined $55.4 million, or 3.7%, to $1.45 billion. The Company continued to emphasize improving the funding mix and reducing brokered deposits during this time of asset shrinkage from slow loan demand. A decrease of $36.4 million in loans and $93.7 million in investment securities was offset by an increase of $78.6 million in interest bearing deposits and overnight funds. Investment securities that matured or were sold during the quarter remained in our interest bearing account at the Federal Reserve instead of being reinvested due to merger related considerations. Demand deposits increased $12.6 million during the six month period, reaching an all-time high of $148.0 million or 13.1% of total deposits. Money market, NOW and savings accounts increased $9.7 million. Time deposits decreased $78.8 million as a result of $60.2 million in brokered deposits not being renewed, while customer time deposits decreased $18.6 million. The decrease in customer time deposits was due to lower retention of maturing certificates of deposits at a time of declining deposit offering rates and the Bank’s less competitive pricing on time deposits.

 

Total loans decreased $36.4 million, or 3.8%, during the six month period with decreases in the following major categories: $14.7 million, or 8.5%, in consumer loans, $14.5 million, or 3.8%, in commercial real estate loans, $5.6 million, or 12.3%, in residential lots, $3.2 million or 3.4%, in home equity lines, $2.5 million or 2.9% in commercial and industrial loans and $2.3 million in other loans. Commercial lines of credit increased $3.4 million or 7.7% and residential construction increased $3.0 million or 2.9% during the quarter. Loans outstanding decreased during the period as a result of large loan payoffs and continued problem loan remediation although the amount of the decrease was much less than in prior quarters due to some improvement in new loan volume for the quarter. The allowance for loan losses decreased $1.2 million year to date with a provision of $5.2 million and net charge-offs of $6.4 million. Net charge-offs increased in the second quarter to $3.5 million from the first quarter total of $2.9 million while the provision decreased due to factors discussed in the Asset Quality section below. Year to date net charge-offs have decreased to $6.4 million for the current year from $9.9 million for the six month period of 2011. The reduced amount of provision and charge-offs during the second quarter reflected moderating economic conditions and continued improving trends in the Company’s asset quality.

 

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At June 30, 2012, the Company’s consolidated leverage ratio, Tier 1 risk-based capital ratio and total risk-based capital ratio were 8.95%, 12.38% and 14.87%, respectively. As of June 30, 2012, the Bank’s leverage ratio, Tier 1 risk-based capital ratio and total risk-based capital ratio were 9.66%, 13.36% and 14.62%, respectively. Our capital position remains in excess of our required regulatory capital ratios, including the capital requirements pursuant to the Consent Order. See Note 8 to the financial statements for an update on compliance with the Consent Order. Given the current regulatory environment and recent legislation, our regulatory burden could increase with a material impact on the Company and could include requirements for higher regulatory capital levels and various other restrictions. While regulatory capital requirements are considered, the Company also evaluates its capital needs based on other appropriate business considerations on an ongoing basis. Although raising additional capital has been considered and discussed in recent filings, management does not expect to seek additional sources of capital due to the pending merger with Capital Bank. At June 30, 2012, our stockholders’ equity totaled $100.3 million, an increase of $2.7 million compared to December 31, 2011. The increase is primarily the result of $1.9 million in net income and $769 thousand in other comprehensive income.

 

Results of Operations for the Three Months Ended June 30, 2012 and 2011

 

Net Income. Our net income from operations of $1.1 million and our net income available to common shareholders of $446 thousand for the three months ended June 30, 2012 decreased $58 thousand and $65 thousand, respectively, from the same three month period in 2011. Net income per share available to common shareholders was $0.03 per share, both basic and diluted, for the three months ended June 30, 2012 which were unchanged in comparison with the same period in 2011. Net interest income for the second quarter of 2012 was $10.7 million, down from $12.6 million, or a decrease of $1.9 million, or 15.1%, compared with the second quarter 2011, primarily due to a $108.6 million decrease in the average balance of interest earning assets. The net interest margin of 3.15% declined 28 basis points from the year ago period. The shift in the mix of earning assets from loans to lower yielding investments and overnight funds and the decreased loan yields due to pricing competition were the main influences on net interest income. The yield on interest earning assets decreased 39 basis points while the cost of funds decreased only nine basis points year-over-year. Due to the current unusually low interest rate environment, management’s ability to continue to reprice downward our deposits to achieve a meaningful reduction in our cost of funds is limited. A positive factor included in net income was the $1.4 million reduction in the provision for loan losses for the period. Non-interest income was $3.9 million during the second quarter of 2012, which represents an increase of 10.3% from non-interest income of $3.5 million reported in the comparable period in 2011. Non-interest expense declined $78 thousand year-over-year.

 

Net Interest Income. During the three months ended June 30, 2012, our net interest income was $10.7 million, a decrease of $1.9 million, or 15.1%, over the second quarter 2011. Interest income decreased $2.7 million from the reduced level of interest earning assets. This reduction in our interest income exceeded the $806 thousand decrease in interest expense from reduced interest bearing deposit volume and repricing of deposits.

 

The average yield on interest-earning assets in the second quarter of 2012 decreased 39 basis points to 4.56% compared to the second quarter 2011 due to the decline in yields for investment securities and the shift in mix from loans to lower yielding securities and overnight deposits. The lower interest rate environment has also impacted our funding costs. Deposits, such as money market and NOW accounts, are repriced at the discretion of management while time deposits can only be repriced as they mature. Over the past year, management repriced all of our deposits downward to continue to lower our funding cost while remaining competitive. Given the Bank’s excess liquidity levels and weak loan demand, management has focused on reducing its levels of time deposits and has continued to reprice deposit offering rates downward. Our cost of average interest bearing liabilities for the second quarter of 2012 decreased eight basis points to 1.58% compared to the second quarter of 2011. For the second quarter 2012, our net interest margin of 3.15% decreased 28 basis points from 3.43% for the second quarter of 2011.

 

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Average Yield/Cost Analysis

 

The following table contains information relating to the Company’s average balance sheet and reflects the average yield on assets and cost of liabilities for the periods indicated. Such annualized yields and costs are derived by dividing annualized income or expense by the average balances of assets or liabilities, respectively, for the periods presented. The average loan portfolio balances include nonaccrual loans.

 

   Three Months   Three Months 
   Ended June 30, 2012   Ended June 30, 2011 
   (Amounts in thousands) 
   Average
balance
   Interest
earned/paid
   Average
yield/cost
   Average
balance
   Interest
earned/paid
   Average
yield/cost
 
Interest-earning assets:                              
Loans  $931,809   $12,824    5.54%  $1,059,527   $15,003    5.68%
Investment securities available for sale   352,247    1,914    2.19%   304,750    2,490    3.28%
Investment securities held to maturity   51,591    690    5.39%   52,937    618    4.68%
Federal funds sold and overnight deposits   26,505    14    0.21%   53,581    37    0.28%
                               
Total interest earning assets   1,362,152    15,442    4.56%   1,470,795    18,148    4.95%
Other assets   105,434              11,660           
Total assets  $1,467,586             $1,482,455           
                               
Interest-bearing liabilities:                              
Deposits:                              
Money market, NOW and savings  $487,267   $521    0.43%  $497,711   $731    0.59%
Time deposits greater than $100K   213,213    604    1.14%   237,658    583    0.98%
Other time deposits   301,380    1,383    1.85%   394,895    1,978    2.01%
Short-term borrowings   62,252    424    2.75%   7,037    35    1.99%
Long-term borrowings   147,440    1,840    5.02%   210,592    2,251    4.29%
                               
Total interest bearing liabilities   1,211,552    4,772    1.58%   1,347,893    5,578    1.66%
                               
Demand deposits   144,867              132,559           
Other liabilities   12,419              9,794           
Stockholders' equity   98,748              92,209           
                               
Total liabilities and stockholders' equity  $1,467,586             $1,582,455           
                               
Net interest income and net interest spread       $10,670    2.98%       $12,570    3.29%
Net interest margin             3.15%             3.43%
Ratio of average interest-earning assets to average interest-bearing liabilities   112.43%             109.12%          

 

Provision for Loan Losses. The Company recorded a $2.3 million provision for loan losses for the quarter ended June 30, 2012, representing a decrease of $1.4 million from the $3.7 million provision for the second quarter of 2011. The level of provision for the quarter is reflective of the trends in the loan portfolio, including levels of nonperforming loans and other loan portfolio quality measures, and analyses of impaired loans as well as the level of net charge-offs during the period. The year-over-year decrease in the provision was based on management’s analysis and evaluation of the adequacy of the level of the allowance for loan losses. Provisions for loan losses are charged to income to bring our allowance for loan losses to a level deemed appropriate by management based on the factors discussed under “Asset Quality” below. On an annualized basis, our percentage of net loan charge-offs to average loans outstanding was 1.52% for the quarter ended June 30, 2012, compared with 1.46% for the quarter ended June 30, 2011.

 

Non-Interest Income. For the three months ended June 30, 2012, non-interest income increased $364 thousand, or 10.3%, to $3.9 million from $3.5 million for the same period in 2011 primarily as a result of increased gain on sales of investment securities of $340 thousand and SBIC income of $177 thousand. Insufficient fund, or NSF, charges continued their trend, decreasing $178 thousand, based on a reduction in transaction volumes and other service charges, including debit card charges, decreased $40 thousand. Wealth management fees and mortgage banking income increased $36 thousand and $33 thousand, respectively; while income from derivative activities and other non-interest income remained virtually unchanged.

 

- 9 -
 

 

Non-Interest Expense. For the three months ended June 30, 2012, non-interest expenses decreased $78 thousand or 0.7%, over the same period in 2011. Merger related expenses including investment banker fees, legal fees and CPA fees, which were not present in the second quarter of 2011, were $673 thousand. Expenses related to foreclosed assets continued to be significant including a year-over-year increase in foreclosed property writedowns of $528 thousand offset by reduced other expenses of $141 thousand. Gains on sales of foreclosed assets decreased $25 thousand due to a number of factors including the higher mix of residential lots being sold this year. Reduced legal and professional expenses included savings of $165 thousand in legal fees and $287 thousand in fees on other professional services. The reduced legal fees related to a decreased volume of problem asset remediation litigation and other work. FDIC deposit insurance premiums decreased $161 thousand primarily due to decreased levels of deposits and a change in the basis of the quarterly assessment calculation. Although the premiums decreased year-over year, the premiums remained high as a result of the previously announced Consent Order and will remain at the higher assessment rates until the Consent Order is no longer in effect. Salaries and employees benefits increased $79 thousand from increases in commissions on mortgage and wealth management production, employee insurance costs and payroll taxes. Occupancy and equipment expense decreased $198 thousand which included decreases of $48 thousand in furniture and equipment depreciation, software maintenance of $44 thousand and building repairs of $49 thousand. Other reductions in non-interest expense included, among other things, advertising of $150 thousand, debit card rewards program of $73 thousand and real estate appraisals of $68 thousand.

 

Provision for Income Taxes. The Company recorded no income tax expense or benefit for the quarter ending June 30, 2012 or for the second quarter 2011. The Company has now used all available net operating loss (NOL) carry backs and now has an NOL carry forward. No income tax expense is expected until income taxes on future earnings exceed the NOL carry forward of approximately $4.7 million.

 

Results of Operations for the Six Months Ended June 30, 2012 and 2011

 

Net Income. Our net income after preferred dividends for the six months ended June 30, 2012 was $616 thousand, compared to $23 thousand for the six months ended June 30, 2011. Net interest income decreased $3.8 million, or 15.0%, compared to the 2011 six month period as net interest margin declined 26 basis points due to decreased yields on loans and the shift in mix of earning assets from loans to lower yielding securities and overnight funds while continuing the downward repricing of deposits and borrowings. The provision for loan losses continued to be the most significant factor in improved profitability, decreasing $2.6 million, or 33.3%, compared to the prior year period. Non-interest income increased $893 thousand, or 13.9%, compared to the prior six month period with significant differences between the two periods discussed below. Non-interest expense decreased $926 million, or 4.1%, year-over-year. The largest increase in non-interest expense for the six month period was $673 thousand for merger related expenses; while the largest decrease was in FDIC deposit insurance expense which decreased $543 thousand.

 

Net Interest Income. During the six months ended June 30, 2012, our net interest income totaled $21.6 million, a year-over-year decrease of $3.8 million, or 15.0%. The primary reasons for this decrease were the $121.4 million reduction in the average balance of earning assets and the shift in the mix of earning assets from loans to lower yielding investment securities and overnight funds. The impact of these two factors was partially mitigated through the downward repricing of deposits and borrowings as well as an improved funding mix as previously mentioned. Our average yield on interest-earning assets decreased 39 basis points to 4.58% for the first six months of 2012 compared to the same period in 2011. Declining rates have also impacted our funding costs for the first six months of 2012, as funding costs decreased nine basis points to 1.59% from 1.68% for the comparable period a year ago. Average interest bearing liabilities decreased $148.7 million, or 10.8%, to $1.36 billion from $1.23 billion for the six month period ended June 2011. Average demand deposits increased $13.0 million, or 10.3%, year-over-year. For the six months ended June 30, 2012, our net interest spread decreased 30 basis points compared to the prior year at 3.29%; while our net interest margin was 3.16% compared to 3.42% for the prior year period.

 

- 10 -
 

 

Average Yield/Cost Analysis

 

The following table contains information relating to the Company’s average balance sheet and reflects the average yield on assets and cost of liabilities for the periods indicated. Such annualized yields and costs are derived by dividing income or expense by the average balances of assets or liabilities, respectively, for the periods presented. The average loan portfolio balances include non-accrual loans.

 

   Six Months   Six Months 
   Ended June 30, 2012   Ended June 30, 2011 
   (Amounts in thousands) 
   Average
balance
   Interest
earned/paid
   Average
yield/cost
   Average
balance
   Interest
earned/paid
   Average
yield/cost
 
Interest-earning assets:                              
Loans  $939,564   $26,040    5.57%  $1,085,468   $30,516    5.67%
Investment securities available for sale   358,358    3,951    2.22%   308,607    5,053    3.30%
Investment securities held to maturity   49,304    1,267    5.17%   49,337    1,167    4.77%
Federal funds sold and over night deposits   26,937    29    0.22%   52,180    111    0.43%
                               
Total interest earning assets   1,374,163    31,287    4.58%   1,495,592    36,847    4.97%
Other assets   105,213              110,988           
Total assets  $1,479,376             $1,606,580           
                               
Interest-bearing liabilities:                              
Deposits:                              
Money market, NOW and savings  $484,555   $1,036    0.43%  $519,414   $1,611    0.63%
Time deposits greater than $100K   215,553    1,210    1.13%   223,313    1,156    1.04%
Other time deposits   318,751    2,943    1.86%   414,487    4,148    2.02%
Short-term borrowings   61,514    836    2.74%   15,013    113    1.52%
Long-term borrowings   148,671    3,674    4.97%   205,542    4,418    4.33%
                               
Total interest bearing liabilities   1,229,044    9,699    1.59%   1,377,769    11,446    1.68%
                               
Demand deposits   140,198              127,155           
Other liabilities   11,809              9,572           
Stockholders' equity   98,325              92,084           
                               
Total liabilities and stockholders' equity  $1,479,376             $1,606,580           
                               
Net interest income and net interest spread       $21,588    2.99%       $25,401    3.29%
Net interest margin             3.16%             3.42%
Ratio of average interest-earning assets to average interest-bearing liabilities   111.81%             108.55%          

 

Provision for Loan Losses. The Company recorded a $5.2 million provision for loan losses for the six months ended June 30, 2012, representing a decrease of $2.6 million from the $7.8 million provision for the comparable period of 2011. The level of provision for the quarter is reflective of the trends in the loan portfolio, including loan growth, levels of non-performing loans and other loan portfolio quality measures, and analyses of impaired loans as well as the level of net charge-offs during the period. Provisions for loan losses are charged to income to bring our allowance for loan losses to a level deemed appropriate by management based on the factors discussed under “Asset Quality.” On an annualized basis, our percentage of net loan charge-offs to average loans outstanding was 1.37% for the six month period ended June 30, 2012, compared with 1.83% for the period ended June 30, 2011.

 

Non-Interest Income. For the six months ended June 30, 2012, the Company reported non-interest income of $7.3 million compared to $6.4 million for the first six months of 2011, an increase of $893 thousand, or 13.9%. SBIC income improved $725 thousand due to significant investment harvest gains in the current year. Gains from derivative activity increased $687 thousand, or 162.0%, for the period due to consistent activity in the current year compared to a $384 thousand mark to market charge on the ineffective trust preferred interest rate swap which was incurred during the prior year. Mortgage banking income increased $75 thousand, or 13.5%, as new loan origination activity improved during the 2012 period. Investment brokerage income increased $78 thousand during the 2012 period on increased brokerage transaction volume. The year-over-year decrease in service charges on deposits of $344 thousand was primarily attributable to a $346 thousand decrease in NSF fees, reflecting the trend of more customer transactions being completed electronically and fewer checks being written. Gains on sales of investment securities decreased $341 thousand, or 23.2%, year-over-year as management actively managed the investment portfolio and sold investment securities that met certain criteria.

 

- 11 -
 

 

Non-Interest Expense. For the six months ended June 30, 2012, the Company reported non-interest expense of $21.8 million compared to $22.7 million for the first six months of 2011, a decrease of $926 thousand, or 4.1%. FDIC deposit insurance premiums decreased $543 thousand primarily due to decreased levels of deposits and a change in the basis of the quarterly assessment calculation. Significant expense reductions of $359 thousand were realized in legal fees while other professional fees decreased an additional $486 thousand. Advertising expense decreased $152 thousand due to reduced advertisement of deposit rates. Merger related expenses including investment banker fees, legal fees and CPA fees, which were not present in the prior period, were $673 thousand. Expenses related to foreclosed assets continued to be significant including a year-over-year increase in foreclosed property writedowns of $379 thousand offset by reduced other expenses of $74 thousand. Gains on sales of foreclosed assets decreased $233 thousand due to a number of factors including the higher mix of residential lots being sold this year. Occupancy and equipment expense decreased $342 thousand compared to the prior period of 2011 due to reduced building maintenance, software maintenance and furniture and fixture leases and equipment depreciation. Other non-interest expense decreases for the period included debit card rewards of $78 thousand, contract employee services of $68 thousand, shareholder relations of $38 thousand and real estate appraisals of $32 thousand.

 

Provision for Income Taxes. The Company recorded no income tax expense or benefit for the six months ended June 30, 2012 or 2011. The Company has now used all available net operating loss (NOL) carry backs and now has a NOL carry forward. No income tax expense or benefit is expected until future earnings exceed the NOL carry forward.

 

Liquidity and Capital Resources

 

Market and public confidence in our financial strength and in the strength of financial institutions in general will largely determine our access to appropriate levels of liquidity. This confidence is significantly dependent on our ability to maintain sound asset quality and sufficient levels of capital resources to generate appropriate earnings and to maintain a consistent dividend policy.

 

Liquidity is defined as our ability to meet anticipated customer demands for funds under credit commitments and deposit withdrawals at a reasonable cost and on a timely basis. Management measures our liquidity position by giving consideration to both on- and off-balance sheet sources of funds and demands for funds on a daily and weekly basis.

 

Sources of liquidity include cash and cash equivalents, net of federal requirements to maintain reserves against deposit liabilities, unpledged investments available for sale, loan repayments, loan sales, deposits, and borrowings from the Federal Home Loan Bank, the Federal Reserve and from correspondent banks through overnight federal funds credit lines. In addition to deposit and borrowing withdrawals and maturities, the Company’s primary demand for liquidity is anticipated funding under credit commitments to customers.

 

We believe our liquidity is adequate to fund expected loan demand and current deposit and borrowing maturities particularly in light of the expected continued balance sheet shrinkage through loan remediation activities and continued slowdown in loan demand. During the six months ended June 30, 2012, $60.2 million of brokered deposits matured and were repaid. We expect an additional $13.0 million in brokered deposits to mature or be called by December 31, 2012. Under the provisions of the Consent Order, the Bank may not renew rollover or replace these brokered deposits at their call or maturity. Investment securities totaled $313.0 million at June 30, 2012, a decrease of $93.7 million from $406.7 million at December 31, 2011. As of June 30, 2012, there were $119.9 million in unpledged securities collateral. In addition, management has increased our overnight balances at the Federal Reserve Bank to $101.5 million at June 30, 2012 versus our reserve requirement of $5.6 million for the applicable period. Supplementing liquid assets and customer deposits as a source of funding, we have available a line of credit from a correspondent bank to purchase federal funds on a short-term basis of approximately $40.0 million. We also have the credit capacity from the Federal Home Loan Bank of Atlanta (FHLB) to borrow up to $361.1 million as of June 30, 2012 with lendable collateral value of $87.6 million and current outstanding borrowings of $76.5 million. At June 30, 2012, we had funding of $60.0 million in the form of term repurchase agreements with maturities from two to seven years under repurchase lines of credit from various institutions. The repurchases must be and are adequately collateralized. We also had short-term repurchase agreements with total outstanding balances of $24.3 million and $28.6 million at June 30, 2012 and December 31, 2011, respectively, $4.3 million of which were done as accommodations for our deposit customers. In addition to the investment securities, $3.0 million in cash is currently being held as collateral for one short term repurchase agreement. At June 30, 2012, our outstanding commitments to extend credit consisted of loan commitments of $141.5 million and amounts available under home equity credit lines, other credit lines and letters of credit of $85.6 million, $8.4 million and $5.5 million, respectively. We believe that our combined aggregate liquidity position from all sources is sufficient to meet the funding requirements of loan demand and deposit maturities and withdrawals in the near term.

 

- 12 -
 

 

Historically, we relied heavily on certificates of deposits as a source of funds. While the majority of these funds are from our local market area, the Bank utilized brokered and out-of-market certificates of deposits to diversify and supplement our deposit base. Under the Consent Order, as discussed above, the Bank is not permitted to accept, renew or rollover any brokered deposits. During the six months of 2012, brokered deposits decreased $60.2 million as maturing brokered deposits were not renewed. Year-over-year demand deposits increased $20.6 million, or 16.1%. Customer certificates of deposits decreased $29.6 million, or 6.8%, on a year-over-year basis; while money market, savings and NOW accounts decreased $4.8 million, or 1.0%. Customers’ certificates of deposit decreased significantly due to lower retention of maturing certificates of deposit at a time of declining deposit offering rates and the Bank’s less competitive pricing on time deposits. Certificates of deposits represented 36.0% of our total deposits at June 30, 2012, an increase from 34.9% at June 30, 2011.

 

Under the United States Treasury’s Capital Purchase Program (CPP), the Company issued $42.75 million in Cumulative Perpetual Preferred Stock, Series A, on December 5, 2008. In addition, the Company provided warrants to the Treasury to purchase 1,623,418 shares of the Company’s common stock at an exercise price of $3.95 per share. These warrants are immediately exercisable and expire ten years from the date of issuance. The preferred stock is non-voting, other than having class voting rights on certain matters, and pays cumulative dividends quarterly at a rate of 5% per annum for the first five years and 9% per annum thereafter. The preferred shares are redeemable at the option of the Company subject to regulatory approval. In February 2011, the Company suspended the payment of quarterly cash dividends to the US Treasury on this cumulative preferred stock. Although the Company has suspended the declaration and payment of preferred stock dividends at the present time, net income (loss) available to common shareholders reflects the dividends as if declared because of their cumulative nature. Interest on the past due payments is now also being accrued. As of June 30, 2012, the total amount of cumulative dividends and interest owed to the US Treasury was $3.9 million. As part of the merger with Capital Bank, it is expected that the Treasury’s investment in the Company’s preferred stock will be redeemed.

 

As a condition of the CPP, the Company must obtain consent from the United States Department of the Treasury to repurchase its common stock or to increase its cash dividend on its common stock from the September 30, 2008 quarterly level of $0.04 per common share. The Company has agreed to certain restrictions on executive compensation, including limitations on amounts payable to certain executives under severance arrangements and change in control provisions of employment contracts and clawback provisions in compensation plans, as part of the CPP. Under the American Recovery and Reinvestment Act of 2009, the Company is limited to using restricted stock as the form of payment to the top five highest compensated executives under any incentive or bonus compensation programs.

 

Through July 2006, the Company authorized the repurchase of up to 1.9 million shares of its common stock. Through December 5, 2008 (the date of our participation in the CPP), the Company had repurchased 1,858,073 shares at an average price of $6.99 per share under the three plans. During the first six months of 2012, there were no repurchases. Under the provisions of the CPP, the Company may not repurchase any of its common stock without the consent of the United States Treasury as long as the Treasury holds an investment in our preferred stock.

 

At June 30, 2012, the Company’s consolidated leverage ratio, Tier 1 risk-based capital ratio and total risk-based capital ratio were 8.95%, 12.38% and 14.87%, respectively, which exceeded the minimum requirements for a “well-capitalized” bank holding company. As of June 30, 2012, the Bank’s leverage ratio, Tier 1 risk-based capital ratio and total risk-based capital ratio were 9.66%, 13.36% and 14.62%, respectively. The Consent Order, as set forth above, requires the Bank to achieve and maintain minimum capital requirements of 8% Tier 1 (leverage) capital and 11% total risk-based capital. Our capital position remains in excess of our regulatory capital requirements pursuant to the Consent Order. In addition to utilizing balance sheet shrinkage through net loan run-off and the reduction in brokered deposits and ways to improve Bank profitability, the Company has considered various strategies, including: asset sales, plans for capital injections, taking action to restructure the risk weighting of assets, capital raising and strategic partnerships in order to achieve and maintain compliance with the terms of the Consent Order. Due to the pending merger with Capital Bank Financial Corp., management does not expect to seek additional sources of capital. As of June 30, 2012, the parent holding company had $5.5 million in cash available to be invested into the Bank to bolster capital levels.

 

- 13 -
 

 

Given the current regulatory environment and recent legislation such as the Dodd-Frank Act, our regulatory burden could increase with a material impact on the Company and could include requirements for higher regulatory capital levels and various other restrictions.

 

On March 24, 2009, the Company announced that its Board of Directors voted to suspend payment of a quarterly cash dividend to common shareholders.

 

Asset Quality

 

We consider asset quality to be of primary importance. We employ a formal internal loan review process to ensure adherence to the Board-approved Lending Policy. It is the responsibility of each lending officer to assign an appropriate risk grade to every loan originated. Credit Administration, through the loan review process, validates the accuracy of the initial and any revised risk grade assessment. In addition, as a given loan’s credit quality improves or deteriorates, it is the loan officer’s responsibility to change the borrower’s risk grade accordingly. Our policy in regard to past due loans normally requires a charge-off to the allowance for loan losses within a reasonable period after collection efforts and a thorough review have been completed. Further collection efforts are then pursued through various means including legal remedies. Loans carried in a nonaccrual status and probable losses are considered in the determination of the allowance for loan losses.

 

Our financial statements are prepared on the accrual basis of accounting, which means we recognize interest income on loans, unless we place a loan on nonaccrual basis. We account for loans on a nonaccrual basis when we have serious doubts about the collectability of principal or interest. Generally, our policy is to place a loan on nonaccrual status when the loan becomes past due 90 days. We also place loans on nonaccrual status in cases where we are uncertain whether the borrower can satisfy the contractual terms of the loan agreement. Amounts received on nonaccrual loans generally are applied first to principal and then to interest only after all principal has been collected. If a borrower brings their loan current, our general policy is to keep this loan in a nonaccrual status until this loan has remained current for six months. Restructured loans are those for which concessions, including the reduction of interest rates below a rate otherwise available to that borrower or the deferral of interest or principal have been granted due to the borrower’s weakened financial condition. We record interest on restructured loans at the restructured rates, as collected, when we anticipate that no loss of original principal will occur. Management also considers potential problem loans in the evaluation of the adequacy of the Bank’s allowance for loan losses. Potential problem loans are loans which are currently performing and are not included in nonaccrual or restructured loans as shown above, but about which we have doubts as to the borrower’s ability to comply with present repayment terms. Because these loans are at a heightened risk of becoming past due, reaching nonaccrual status or being restructured, they are being monitored closely.

 

- 14 -
 

 

Nonperforming Assets

 

In the tables and discussion below, the credit metrics for the current quarter and their sequential changes are illustrated reflecting: 1) a $2.8 million decrease in nonperforming loans; 2) $7.0 million decrease in nonperforming assets as foreclosed assets decreased $4.2 million returning to a near year end level; 3) a sequential increase in 30-89 delinquencies driven by one loan; 4) a significant decrease in criticized assets (Special Mention, Substandard and Doubtful); and 5) the continued reduction in the higher risk loan segments of aged speculative construction and land acquisition and development loans.

 

The following is a summary of nonperforming assets at the periods presented:

 

   June 30,   March 31,   December 31,   September 30,   June 30, 
   2012   2012   2011   2011   2011 
   (Amounts in thousands) 
                     
Nonaccrual loans  $34,443   $31,499   $38,715   $39,587   $45,381 
Restructured loans - nonaccruing   20,669    26,404    29,333    32,870    21,422 
Total nonperforming loans   55,112    57,903    68,048    72,457    66,803 
                          
Foreclosed assets   19,873    24,032    19,812    19,114    23,022 
                          
Total nonperforming assets  $74,985   $81,935   $87,860   $91,571   $89,825 
                          
Restructured loans in accruing status not included above  $24,107   $24,486   $24,202   $22,214   $15,471 

 

Nonperforming loans decreased to $55.1 million, or 6.01% of total loans, at June 30, 2012 compared to $57.9 million or 6.19% of total loans at March 31, 2012 and $68.0 million, or 7.13% of total loans, at December 31, 2011. This $12.9 million year to date decrease in nonperforming loans is due to the impact of: $6.4 million in net charge-offs $8.3 million in loans foreclosed upon and approximately $4.6 million in loan payoffs and pay downs which more than offset the $16.5 million in new additions to nonperforming loans year to date. Foreclosed assets increased $61 thousand for the first six months as $8.3 million in new foreclosed asset additions was offset by sales of foreclosed properties of $7.0 million and writedowns of $1.3 million. The increase in sales year to date was affected by the sale of three large commercial real estate properties during the second quarter.

 

The following table sets forth a breakdown of nonperforming loans at the periods presented, by loan segment.

 

   June 30,   March 31,   December 31,   September 30,   June 30, 
Nonperforming loans  2012   2012   2011   2011   2011 
   (Amounts in thousands) 
                     
Construction  $13,162   $12,887   $12,975   $16,412   $13,424 
Commercial real estate   17,429    19,234    26,484    31,035    28,730 
Commercial and industrial   4,228    3,292    4,977    5,524    3,917 
Residential lots   10,056    12,305    12,096    8,717    8,806 
Consumer   10,237    10,185    11,516    10,769    11,926 
Total nonperforming loans  $55,112   $57,903   $68,048   $72,457   $66,803 

 

- 15 -
 

 

The following table sets forth a breakdown, by loan class, of impaired loans that were individually evaluated for loss impairment at June 30, 2012. This table further shows, within each loan class, the evaluation results for those loans requiring a specific valuation allowance and those which did not.

 

   With Specific Allowance   No Specific Allowance         
   Unpaid           Unpaid       Total   Net 
   Principal   Recorded   Specific   Principal   Recorded   Recorded   of Specific 
   Balance   Investment   Allowance   Balance   Investment   Investment   Allowance 
   (Amounts in thousands) 
Commercial real estate  $12,394   $12,394   $673   $30,821   $20,743   $33,137   $32,464 
Commercial                                   
Commercial and industrial   815    815    524    4,034    3,086    3,901    3,377 
Commercial line of credit   397    397    167    1,070    939    1,336    1,169 
Residential real estate                                   
Residential construction   646    646    11    17,466    15,426    16,072    16,061 
Residential lot loans   -    -    -    15,075    10,076    10,076    10,076 
Raw land   -    -    -    2,716    114    114    114 
Home equity lines   1,007    1,007    250    435    403    1,410    1,160 
Consumer loans   2,509    2,282    74    7,081    6,514    8,796    8,722 
Total  $17,768   $17,541   $1,699   $78,698   $57,301   $74,842   $73,143 

 

The recorded investment in loans that were considered individually impaired, including all non-accrual loans and accruing troubled debt restructured loans, was $74.8 million and $87.1 million at June 30, 2012 and December 31, 2011, respectively. At June 30, 2012, the largest non-accrual balance of any one borrower was $8.0 million, with the average balance for the two hundred fourteen non-accrual loans being $258 thousand. Included in the table above, $52.4 million of the total $55.1 million of non-accrual loans and $22.4 million of the total $24.1 million of accruing troubled debt restructured loans were individually evaluated as they exceeded the evaluation scope of $200,000 per loan. The results of the individual evaluations indicated that $2.6 million in non-accrual loans and $14.9 million in accruing troubled debt restructured loans required specific allowances of $1.2 million and $526 thousand, respectively, for an aggregate specific allowance of $1.7 million. In the above table for these impaired loans individually evaluated for loss impairment, the unpaid principal balance represents the amount borrowers owe the Bank; while the recorded investment represents the amount of loans shown on the Bank’s books which are net of amounts charged off to date. For these impaired loans as of June 30, 2012, amounts charged off to date were $21.6 million, or 22.4% of the unpaid principal balances.

 

For loan modifications and in particular, troubled debt restructurings (TDRs), the Company generally utilizes its own loan modification programs whereby the borrower is provided one or more of the following concessions: interest rate reduction, extension of payment terms, forgiveness of principal or other modifications. The Company has a small residential mortgage portfolio without the need to utilize government sponsored loan modification programs. The primary factor in the pre-modification evaluation of a troubled debt restructuring is whether such an action will increase the likelihood of achieving a better result in terms of collecting the amount owed to the Bank.

 

As illustrated in one of the tables in Note 4 to the financial statements, during the six months ended June 30, 2012, the following concessions were made on 16 loans for $5.2 million (measured as a percentage of loan balances on TDRs):

 

·Reduced interest rate for 40% (3 loans for $2.0 million);
·Extension of payment terms for 50% (11 loans for $2.6 million); and
·Forgiveness of principal for 10% (2 loans for $531 thousand).

 

In cases where there was more than one concession granted, the modification was classified by the more dominant concession.

 

Of the total of 86 loans for $36.9 million which were modified as TDRs during the twelve months ended June 30, 2012, there were payment defaults (where the modified loan was past due thirty days or more) of $617 thousand, or 1.7%, during the six months ended June 30, 2012.

 

- 16 -
 

 

On these TDRs (86 loans for $36.9 million) during the twelve months ended June 30, 2012, the following represents the success or failure of these concessions during the past year:

 

·89.5% are paying as restructured;
·0.3% have been reclassified to nonaccrual;
·5.3% have defaulted and/or been foreclosed upon; and
·4.9% have paid in full.

 

For a further breakdown of the successes and failures of each type of concession/modification, see the table in Note 4 to the financial statements.

 

In addition to nonperforming loans and accruing TDRs, there were $102.6 million of loans at June 30, 2012 for which management has concerns regarding the ability of the borrowers to meet existing repayment terms, compared with $98.5 million at December 31, 2011. See “Credit Quality Indicators” below for a more detailed disclosure and discussion on the Bank’s distribution of credit risk grade classifications. Potential problem loans are primarily classified as substandard for regulatory purposes and reflect the distinct possibility, but not the probability, that the Company will not be able to collect all amounts due according to the contractual terms of the loan agreement. Although these loans have been identified as potential problem loans, they may never become delinquent, nonperforming or impaired. Additionally, these loans are generally secured by real estate or other assets, thus reducing the total exposure should they become nonperforming. Potential problem loans are considered in the determination of the adequacy of the allowance for loan losses.

 

The following table sets forth a breakdown of foreclosed assets at the periods presented, by nature of the property.

 

   June 30,   March 31,   December 31,   September 30,   June 30, 
Foreclosed assets  2012   2012   2011   2011   2011 
   (Amounts in thousands) 
Residential construction, land                         
development and other land  $9,210   $10,452   $9,854   $11,617   $14,360 
Commercial construction   -    1,196    1,196    1,196    1,196 
1 - 4 family residential properties   1,770    2,126    1,990    2,453    1,245 
Nonfarm nonresidential properties   8,893    10,258    6,772    3,808    6,221 
Multi-family properties   -    -    -    40    - 
Total foreclosed assets  $19,873   $24,032   $19,812   $19,114   $23,022 

 

Foreclosed assets decreased $4.2 million, or 17%, sequentially as strong sales of foreclosed properties of $6.4 million and writedowns of $831 thousand exceeded the $3.0 million in new foreclosed asset additions. During the quarter ended June 30, 2012, foreclosed property was affected by the sales of three large commercial real estate properties.

 

- 17 -
 

 

Credit Quality Indicators

 

We monitor credit risk migration and delinquency trends in the ongoing evaluation and assessment of credit risk exposure in the overall loan portfolio. The following table presents quarterly trends in loan delinquencies, in loans classified substandard or doubtful and in nonperforming loans.

 

   June 30,   March 31,   December 31,   September 30,   June 30, 
   2012   2012   2011   2011   2011 
   (Amounts in millions) 
   $   % of
Total
Loans
   $   % of
Total
Loans
   $   % of
Total
Loans
   $   % of
Total
Loans
   $   % of
Total
Loans
 
Loans delinquencies:                                                  
30 - 89 days past due  $6.2    0.68%  $4.5    0.48%  $5.2    0.55%  $4.5    0.46%  $4.3    0.41%
Loans classified substandard or doubtful  $180.2    19.64%  $176.8    18.90%  $185.7    19.46%  $205.6    20.72%  $210.0    20.19%
Nonperforming loans  $55.1    6.01%  $57.9    6.19%  $68.0    7.13%  $72.5    7.30%  $66.8    6.42%

 

Delinquency is viewed as one of the leading indicators for credit quality. The Company’s 30-89 day past due statistic increased sequentially by $1.7 million to $6.2 million, or 0.68% of total loans, at June 30, 2012. This sequential increase was driven by one loan for $2.9 million which matured during the second quarter and the borrower is in process of putting the underlying property on the market for sale. The borrower is expected to bring this loan current in the near term and keep it current until the property is liquidated and the loan is paid off. Absent this loan, the Company’s 30-89 day delinquency would be $3.3 million, or 0.36% of total loans, at June 30, 2012. The improvement in loan delinquencies is attributable to a continued strong involvement of commercial loan officers and their management in monthly collection efforts.

 

Another key indicator of credit quality is the distribution of credit risk grade classifications in the loan portfolio and the trends in the movement or migration of these risk grades or classifications. See Note 5 in the financial statements for a description of the Bank’s credit risk grade classifications. The Substandard (Grade 7) and Doubtful (Grade 8) classifications denote adversely classified loans, while the Special Mention (Grade 6) classification may provide an early warning indicator of deterioration in the credit quality of a loan portfolio. The following table is a summary of certain classified loans in our loan portfolio at the dates indicated.

 

   June 30,   March 31,   December 31,   September 30,   June 30, 
   2012   2012   2011   2011   2011 
   $   % of
Total
Loans
   $   % of
Total
Loans
   $   % of
Total
Loans
   $   % of
Total
Loans
   $   % of
Total
Loans
 
   (Amounts in millions) 
                                         
Special Mention  $61.7    6.8%  $86.8    9.3%  $96.1    10.1%  $100.0    10.1%  $104.1    10.0%
Substandard and Doubtful   180.2    19.7%   176.8    19.0%   185.7    19.6%   205.6    20.8%   210.0    20.2%
   $241.9    26.5%  $263.6    28.3%  $281.8    29.7%  $305.6    30.9%  $314.1    30.2%

 

Criticized loans (consisting of loans classified Special Mention, Substandard and Doubtful) decreased by $21.7 million, or 8%, during the second quarter of 2012 and decreased by $39.9 million, or 14% during the six months ended June 30, 2012. These reductions were due to ongoing loan remediation efforts partially mitigated by portfolio downgrades during the period. The $3.4 million, or 2%, increase in adversely classified loans was the result of downgrades of loans previously classified Special Mention.

 

- 18 -
 

 

The following table contains an indicator of the overall credit quality of each loan class, denoted by the weighted average risk grade, along with a further breakdown of the certain classified loans by loan class at June 30, 2012.

 

   Weighted        
   Average  Special   Substandard and 
   Risk Grade  Mention   Doubtful 
      (Amounts in thousands) 
Commercial real estate  4.91  $26,778   $72,947 
Commercial             
Commercial and industrial  4.83   4,872    19,271 
Commercial line of credit  4.55   3,101    5,481 
Residential real estate             
Residential construction  4.95   8,106    25,858 
Residential lots  6.19   3,655    26,474 
Raw land  5.14   200    3,168 
Home equity lines  3.65   1,251    5,024 
Consumer  4.51   13,698    21,974 
      $61,659   $180,199 

 

Compared with December 31, 2011, the above mentioned weighted average risk grades, within these loan classes and in the aggregate, have not changed significantly.

 

In addition to the financial strength of each borrower and cash flow characteristics of each project, the repayment of construction and development loans are particularly dependent on the value of the real estate collateral. Repayment of such loans is generally considered subject to greater credit risk than residential mortgage loans. Regardless of the underwriting criteria the Company utilizes, losses may be experienced as a result of various factors beyond our control, including, among other things, changes in market conditions affecting the value of the real estate collateral and problems affecting the credit of our borrowers.

 

Furthermore, we monitor certain performance and credit metrics related to these higher risk loan categories, including the aging of the underlying loans in these categories. As of June 30, 2012, speculative construction loans on our books more than twelve months amounted to $9.9 million, or 30.1%, of the total speculative residential construction loan portfolio of $32.9 million. This aged segment of the speculative residential construction loan portfolio has declined to 30.1% from 37.9% at December 31, 2011. This speculative residential construction portfolio has decreased from $33.3 million at December 31, 2011 and decreased from $37.7 million at June 30, 2011. Land acquisition and development loans on our books for more than twenty-four months at June 30, 2012 amounted to $34.8 million, or 79.5%, of that $43.8 million portfolio. The land acquisition and development portfolio has decreased from $46.0 million as of December 31, 2011 and decreased from $55.8 million as of June 30, 2011.

 

Analysis of Allowance for Loan Losses

 

Our allowance for loan losses (“ALLL”) is established through charges to earnings in the form of a provision for loan losses. We increase our allowance for loan losses by provisions charged to operations and by recoveries of amounts previously charged off and we reduce our allowance by loans charged off. In evaluating the adequacy of the allowance, we consider the growth, composition and industry diversification of the portfolio, historical loan loss experience, current delinquency levels, trends in past dues and classified assets, adverse situations that may affect a borrower’s ability to repay, estimated value of any underlying collateral, prevailing economic conditions and other relevant factors derived from our history of operations. Management is continuing to closely monitor the value of real estate serving as collateral for our loans, especially lots and land under development, due to continued concern that the low level of real estate sales activity will continue to have a negative impact on the value of real estate collateral. In addition, depressed market conditions have adversely impacted, and may continue to adversely impact, the financial condition and liquidity position of certain of our borrowers. Additionally, the value of commercial real estate collateral may come under further pressure from weak economic conditions and prevailing unemployment levels. The methodology and assumptions used to determine the allowance are continually reviewed as to their appropriateness given the most recent losses realized and other factors that influence the estimation process. The model assumptions and resulting allowance level are adjusted accordingly as these factors change.

 

- 19 -
 

 

The ALLL consists of two major components: specific valuation allowances and a general valuation allowance. The Bank’s format for the calculation of ALLL begins with the evaluation of individual loans considered impaired. For the purpose of evaluating loans for impairment, loans are considered impaired when it is considered probable that all amounts due under the contractual terms of the loan will not be collected when due (minor shortfalls in amount or timing excepted). The Bank has established policies and procedures for identifying loans that should be evaluated for impairment. Loans are reviewed through multiple means such as delinquency management, credit risk reviews, watch and criticized loan monitoring meetings and general account management. Loans that are outside of the Bank’s established criteria for evaluation may be considered for impairment testing when management deems the risk sufficient to warrant this approach. For loans determined to be impaired, the specific allowance is based on the most appropriate of the three measurement methods: present value of expected future cash flows, fair value of collateral, or the observable market price of a loan method. While management uses the best information available to make evaluations, future adjustments to the allowance may be necessary if conditions differ substantially from the assumptions used in making the evaluations. Once a loan is considered individually impaired, it is not included in other troubled loan analysis, even if no specific allowance is considered necessary.

 

In addition to the evaluation of loans for impairment, we calculate the loan loss exposure on the remaining loans (not evaluated for impairment) by applying the applicable historical loan loss experience of the loan portfolio to provide for probable losses in the loan portfolio through the general valuation allowance. These loss factors are based on an appropriate loss history for each major loan segment more heavily weighted for the most recent twelve months historical loss experience to reflect current market conditions. In addition, we assign additional general allowance requirements utilizing qualitative risk factors related to economic trends (such as the unemployment rate and changes in real estate values) and portfolio trends (such as delinquencies and concentration levels among others) that are pertinent to the underlying risks in each major loan segment in estimating the general valuation allowance. This methodology allows us to focus on the relative risk and the pertinent factors for the major loan segments of the Company. The Company incorporates certain refinements and improvements to its allowance for loan losses methodology from time to time. During 2011 and for the six months ended June 30, 2012, these refinements had a minimal effect on the total allowance for loan losses.

 

As discussed herein, management has undertaken various initiatives since mid-year 2010 in response to the challenging economic environment, increased nonperforming loans, weakened collateral positions, and increased foreclosed asset levels, including but not limited to:

 

·Restructuring interest only loan payment terms to require principal repayments;
·Refining the allowance for loan losses methodology to weight current period loss experience more heavily;
·Downgrading renewed and other higher risk loans to a substandard classification;
·Enhancing the internal controls surrounding troubled debt restructured (TDR) loan identification and monitoring;
·Charging off weakened credits;
·Increasing the staffing resources of our Credit Administration function, including problem asset management and loan review;
·Enhancing our internal and external loan review protocol; and
·Increasing the general valuation allowance component of our allowance for loan losses.

 

- 20 -
 

 

The following table shows, an analysis of the allowance for loan losses by loan segment, for the quarter ended June 30, 2012.

 

   Commercial       Residential             
   Real       Real             
   Estate   Commercial   Estate   HELOC   Consumer   Total 
Allowance for credit losses:  (Amounts in thousands) 
                         
Beginning balance  $8,925   $3,092   $7,861   $1,266   $3,037   $24,181 
Provision   1,410    574    76    34    206    2,300 
Charge-offs   (1,802)   (356)   (1,597)   (139)   (586)   (4,480)
Recoveries   321    112    433    7    80    953 
Ending balance  $8,854   $3,422   $6,773   $1,168   $2,737   $22,954 

 

The following table shows, by loan segment, an analysis of the allowance for loan losses for the six months ended June 30, 2012.

 

   Commercial       Residential             
   Real       Real             
   Estate   Commercial   Estate   HELOC   Consumer   Total 
Allowance for credit losses:  (Amounts in thousands) 
                         
Beginning balance  $9,076   $3,036   $7,258   $1,412   $3,383   $24,165 
Provision   2,778    1,390    1,202    (103)   (67)   5,200 
Charge-offs   (3,529)   (1,256)   (2,169)   (151)   (943)   (8,048)
Recoveries   529    252    482    10    364    1,637 
Ending balance  $8,854   $3,422   $6,773   $1,168   $2,737   $22,954 

 

The following table describes the allocation of the allowance for loan losses among various categories of loans and certain other information for the dates indicated. The allocation is made for analytical purposes only and is not necessarily indicative of the categories in which future losses may occur.

 

   At June 30, 2012   At March 31, 2012   At December 31, 2011   At September 30, 2011 
       % of       % of       % of       % of 
By Loan Class  Amount   Total ALLL   Amount   Total ALLL   Amount   Total ALLL   Amount   Total ALLL 
   (Amounts in thousands) 
Commercial real estate  $8,854    38.6%  $8,925    36.9%  $9,076    37.6%  $8,072    30.6%
Commercial                                        
Commercial and industrial   2,251    9.8%   1,741    7.2%   1,865    7.7%   2,504    9.5%
Commercial line of credit   1,171    5.1%   1,351    5.6%   1,171    4.8%   1,047    4.0%
Residential real estate                                        
Residential Construction   4,187    18.2%   4,827    20.0%   4,564    18.9%   5,559    21.0%
Residential lots   2,457    10.7%   2,821    11.7%   2,595    10.7%   4,295    16.3%
Raw land   129    0.6%   213    0.9%   99    0.5%   218    0.8%
Home equity lines   1,168    5.1%   1,266    5.2%   1,412    5.8%   1,665    6.3%
Consumer   2,737    11.9%   3,037    12.5%   3,383    14.0%   3,049    11.5%
                                         
   $22,954    100.0%  $24,181    100.0%  $24,165    100.0%  $26,409    100.0%

 

- 21 -
 

 

Item 1 - Financial Statements

 

SOUTHERN COMMUNITY FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (Unaudited)

 

   June 30,   December 31, 
   2012   2011* 
   (Amounts in thousands, except share data) 
Assets          
Cash and due from banks  $25,144   $23,356 
Federal funds sold and overnight deposits   101,784    23,198 
Investment securities          
Available for sale, at fair value   261,944    362,298 
Held to maturity, at amortized cost   51,009    44,403 
Federal Home Loan Bank stock   5,957    6,842 
           
Loans held for sale   4,032    4,459 
           
Loans   913,591    950,022 
Allowance for loan losses   (22,954)   (24,165)
Net Loans   890,637    925,857 
           
Premises and equipment, net   37,501    38,315 
Foreclosed assets   19,873    19,812 
Other assets   49,080    54,038 
           
Total Assets  $1,446,961   $1,502,578 
Liabilities and Stockholders’ Equity          
Deposits          
Non-interest bearing demand  $148,048   $135,434 
Money market, NOW and savings   485,569    475,900 
Time   493,084    571,838 
Total Deposits   1,126,701    1,183,172 
           
Short-term borrowings   59,268    33,629 
Long-term borrowings   147,426    177,514 
Other liabilities   13,227    10,628 
           
Total Liabilities   1,346,622    1,404,943 
           
Stockholders’ Equity          
Senior cumulative preferred stock (Series A), no par value, 1,000,000 shares authorized; 42,750 shares issued and outstanding at June 30, 2012 and December 31, 2011   42,091    41,870 
Common stock, no par value, 30,000,000 shares authorized; issued and outstanding 16,854,775 shares at June 30, 2012  and 16,827,075 shares at December 31, 2011   119,534    119,505 
Retained earnings (accumulated deficit)   (62,740)   (64,425)
Accumulated other comprehensive income   1,454    685 
Total Stockholders’ Equity   100,339    97,635 
           
Total Liabilities and Stockholders' Equity  $1,446,961   $1,502,578 

 

* Derived from audited consolidated financial statements

 

See accompanying notes.

 

- 22 -
 

 

SOUTHERN COMMUNITY FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)

 

   Three Months Ended   Six Months Ended 
   June 30,   June 30, 
   2012   2011   2012   2011 
   (Amounts in thousands, except per share and share data) 
Interest Income                    
Loans  $12,824   $15,003   $26,040   $30,516 
Investment securities available for sale   1,914    2,490    3,951    5,053 
Investment securities held to maturity   690    618    1,267    1,167 
Federal funds sold and overnight deposits   14    37    29    111 
                     
Total Interest Income   15,442    18,148    31,287    36,847 
Interest Expense                    
Money market, NOW and savings deposits   521    731    1,036    1,611 
Time deposits   1,987    2,561    4,153    5,304 
Borrowings   2,264    2,286    4,510    4,531 
                     
Total Interest Expense   4,772    5,578    9,699    11,446 
                     
Net Interest Income   10,670    12,570    21,588    25,401 
                     
Provision for Loan Losses   2,300    3,700    5,200    7,800 
                     
Net Interest Income After Provision for Loan Losses   8,370    8,870    16,388    17,601 
                     
Non-Interest Income                    
Service charges and fees on deposit accounts   1,363    1,581    2,725    3,069 
Income from mortgage banking activities   324    291    629    554 
Investment brokerage and trust fees   356    320    586    508 
Gain on sale of investment securities   864    524    1,127    1,468 
SBIC income and management fees   300    123    970    245 
Other   691    695    1,293    593 
Total Non-Interest Income   3,898    3,534    7,330    6,437 
                     
Non-Interest Expense                    
Salaries and employee benefits   4,647    4,568    9,333    9,314 
Occupancy and equipment   1,662    1,860    3,302    3,644 
FDIC deposit insurance   771    932    1,522    2,065 
Foreclosed asset related   1,023    636    1,821    1,515 
Merger related expense   673    -    673    - 
Other   2,401    3,259    5,161    6,200 
                     
Total Non-Interest Expense   11,177    11,255    21,812    22,738 
                     
Income Before Income Taxes   1,091    1,149    1,906    1,300 
                     
Income Tax (Benefit) Expense   -    -    -    - 
                     
Net Income   1,091    1,149    1,906    1,300 
                     
Effective Dividend on Preferred Stock   645    638    1,290    1,277 
                     
Net Income Available to Common Shareholders  $446   $511   $616   $23 
                     
Net Income Per Common Share                    
Basic  $0.03   $0.03   $0.04   $- 
Diluted   0.03    0.03    0.04    - 
                     
Weighted Average Common Shares Outstanding                    
Basic   16,858,572    16,835,724    16,849,841    16,829,898 
Diluted   16,934,115    16,906,810    16,921,561    16,897,702 

 

See accompanying notes.

 

- 23 -
 

 

SOUTHERN COMMUNITY FINANCIAL CORPORATION
Consolidated STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)

 

   Three Months Ended   Six Months Ended 
   June 30,   June 30, 
   2012   2011   2012   2011 
   (Amounts in thousands)         
                 
Net income  $1,091   $1,149   $1,906   $1,300 
                     
Other comprehensive income (loss):                    
Securities available for sale:                    
Unrealized holding gains on available for sale securities   2,296    3,387    3,280    2,798 
Tax effect   (885)   (1,306)   (1,264)   (1,079)
Reclassification of gains recognized in net income   (864)   (524)   (1,127)   (1,468)
Tax effect   333    202    434    566 
Net of tax amount   880    1,759    1,323    817 
Cash flow hedging activities:                    
Unrealized holding (gains) losses on cash flow hedging activities   (850)   (137)   (903)   (150)
Tax effect   328    52    349    57 
Reclassification of (gains) losses recognized in net income, net:                    
Reclassified into income   -    75    -    534 
Tax effect   -   (28)   -   (206)
Net of tax amount   (522)   (38)   (554)   235 
                     
Total other comprehensive income   358    1,721    769    1,052 
                     
Comprehensive income  $1,449   $2,870   $2,675   $2,352 

 

See accompanying notes.

 

- 24 -
 

 

SOUTHERN COMMUNITY FINANCIAL CORPORATION
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY (Unaudited)

 

   Preferred Stock   Common Stock   Retained
Earnings
   Accumulated
Other
   Total 
   Shares   Amount   Shares   Amount   (Accumulated
Deficit)
   Comprehensive
Income
   Stockholders'
Equity
 
           (Amounts in thousands, except share data) 
                             
Balance at December 31, 2011   42,750   $41,870    16,827,075   $119,505   $(64,425)  $685   $97,635 
Net income   -    -    -    -    1,906    -    1,906 
Other comprehensive income, net of tax   -    -    -    -    -    769    769 
Stock options exercised including income tax benefit of $0   -    -    200    -    -    -    - 
Restricted stock issued   -    -    27,500    26    -    -    26 
Stock-based compensation   -    -    -    3    -    -    3 
Preferred stock accretion of discount   -    221    -    -    (221)   -    - 
                                    
Balance at June 30, 2012   42,750   $42,091    16,854,775   $119,534   $(62,740)  $1,454   $100,339 

 

See accompanying notes.

 

- 25 -
 

 

SOUTHERN COMMUNITY FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

 

   Six Months Ended 
   June 30, 
   2012   2011 
   (Amounts in thousands) 
Cash Flows from Operating Activities          
Net income  $1,906   $1,300 
Adjustments to reconcile net income to net cash provided by (used in) operating activities:          
Depreciation and amortization   2,630    2,156 
Provision for loan losses   5,200    7,800 
Net proceeds from sales of loans held for sale   28,173    29,164 
Originations of loans held for sale   (27,117)   (24,243)
Gain from mortgage banking   (629)   (554)
Stock-based compensation   29    47 
Net increase in cash surrender value of life insurance   (511)   (542)
Realized gain on sale of available for sale securities, net   (1,127)   (1,468)
Realized loss on sale of premises and equipment   4    - 
(Gain) loss on economic hedges   (263)   424 
Deferred income taxes   (830)   - 
Realized gain on sales of foreclosed assets   (258)   (490)
Writedowns in carrying values of foreclosed assets   1,291    912 
Changes in assets and liabilities:          
Decrease in other assets   4,583    4,543 
Increase in other liabilities   3,085    1,126 
Total Adjustments   14,260    18,875 
           
Net Cash Provided by (Used in) Operating Activities   16,166    20,175 
           
Cash Flows from Investing Activities          
(Increase) decrease in federal funds sold   (78,586)   3,207 
Purchase of:          
Available-for-sale investment securities   (82,304)   (136,116)
Held-to-maturity investment securities   (8,552)   (7,829)
Proceeds from maturities and calls of:          
Available-for-sale investment securities   22,437    16,825 
Held-to-maturity investment securities   2,070    724 
Proceeds from sale of:          
Available-for-sale investment securities   162,182    124,052 
Proceeds from sales of Federal Home Loan Bank stock   885    871 
Net decrease in loans   21,740    68,917 
Capitalized cost in foreclosed assets   (55)   (230)
Purchases of premises and equipment   (526)   (270)
Proceeds from disposal of premises and equipment   10    - 
Proceeds from sales of foreclosed assets   7,241    7,041 
           
Net Cash Provided by (Used in) Investing Activities   46,542    77,192 
           
Cash Flows from Financing Activities          
Net increase (decrease) in transaction accounts and savings accounts   22,283    (75,125)
Net decrease in time deposits   (78,754)   (25,406)
Net decrease in short-term borrowings   (4,361)   (14,745)
Proceeds from long-term borrowings   -    20,000 
Repayment of long-term borrowings   (88)   (85)
           
Net Cash Provided by (Used in) Financing Activities   (60,920)   (95,361)
           
Net Increase (Decrease) in Cash and Due From Banks   1,788    2,006 
Cash and Due From Banks, Beginning of Period   23,356    16,584 
           
Cash and Due From Banks, End of Period  $25,144   $18,590 
           
Supplemental Cash Flow Information:          
Transfer of loans to foreclosed assets  $8,280   $12,941 

 

See accompanying notes.

- 26 -
 

 

Southern Community Financial Corporation
Notes to Consolidated Financial Statements (Unaudited)

 

Note 1 – Basis of Presentation

 

The consolidated financial statements include the accounts of Southern Community Financial Corporation (the “Company”), and its wholly-owned subsidiary, Southern Community Bank and Trust (the “Bank”). All intercompany transactions and balances have been eliminated in consolidation. In management’s opinion, the financial information, which is unaudited, reflects all adjustments (consisting solely of normal recurring adjustments) necessary for a fair presentation of the financial information as of and for the three-month and six-month periods ended June 30, 2012 and 2011, in conformity with accounting principles generally accepted in the United States of America.

 

The preparation of the consolidated financial statements and accompanying notes requires management of the Company to make estimates and assumptions relating to reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the period. Actual results could differ significantly from those estimates and assumptions. Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan losses. To a lesser extent, significant estimates are also associated with the valuation of securities, intangibles and derivative instruments and determination of stock-based compensation and income tax assets or liabilities. Operating results for the three-month and six-month periods ended June 30, 2012 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2012.

 

The organization and business of the Company, accounting policies followed by the Company and other relevant information are contained in the notes to the consolidated financial statements filed as part of the Company’s 2011 annual report on Form 10-K. This quarterly report should be read in conjunction with the annual report.

 

Per Share Data

 

Basic and diluted net income per common share is computed based on the weighted average number of shares outstanding during each period. Diluted net income per share reflects the potential dilution that could occur if stock options or warrants were exercised, resulting in the issuance of common stock that then shared in the net income of the Company.

 

Basic and diluted net income per share have been computed based upon the weighted average number of common shares outstanding or assumed to be outstanding as summarized below.

 

   Three Months Ended   Six Months Ended 
   June 30,   June 30, 
   2012   2011   2012   2011 
                 
Weighted average number of common shares used in computing basic net income per share   16,858,572    16,835,724    16,849,841    16,829,898 
                     
Effect of dilutive stock options   75,543    71,086    71,720    67,804 
                     
Weighted average number of common shares and dilutive potential common shares used in computing diluted net income per share   16,934,115    16,906,810    16,921,561    16,897,702 
                     
Net income available to common shareholders (in thousands)  $446   $511   $616   $23 
Basic   0.03    0.03    0.04    - 
Diluted   0.03    0.03    0.04    - 

 

- 27 -
 

 

Note 1 – Basis of Presentation (continued)

 

For the three months ended June 30, 2012 and 2011, net income for determining net income per common share was reported as net income less the dividend on preferred stock. Options and warrants to purchase shares that have been excluded from the determination of diluted earnings per share because they are antidilutive (the exercise price is higher than the current market price) amount to 485,950 and 597,452 shares for the three months ended June 30, 2012 and 2011, respectively, and 485,950 and 597,452 shares for the six months ended June 30, 2012 and 2011, respectively. These options, warrants, unvested shares of restricted stock and all other common stock equivalents were excluded from the determination of diluted earnings per share for the three months ended June 30, 2012 since the exercise price exceeded the average market price for the period.

 

Recently issued accounting pronouncements

 

In May 2011, the FASB has issued Accounting Standards Update No. 2011-04, Fair Value Measurement. The purpose of the standard is to clarify and combine fair value measurements and disclosure requirements for accounting principles generally accepted in the U.S. (GAAP) and international financial reporting standards (IFRS). The new standard provides amendments and wording changes used to describe certain requirements for measuring fair value and for disclosing information about fair value measurements. This guidance is effective for interim and annual reporting periods beginning after December 15, 2011, and should be applied prospectively to the beginning of the annual period of adoption. The Company adopted this statement during the quarter ended March 31, 2012, which resulted in additional disclosures related to fair value in Notes 11 and 12.

 

From time to time the FASB issues exposure drafts for proposed statements of financial accounting standards. Such exposure drafts are subject to comment from the public, to revisions by the FASB and to final issuance by the FASB as statements of financial accounting standards. Management considers the effect of the proposed statements and SEC Staff Accounting Bulletins on the consolidated financial statements of the Company and monitors the status of changes to and proposed effective dates of exposure drafts.

 

Note 2 – Acquisition Agreement with Capital Bank Financial Corp.

 

On March 26, 2012, the Company entered into an Agreement and Plan of Merger (the “Agreement”) with Capital Bank Financial Corp. (“CBF”) and Winston 23 Corporation (“Winston”), a wholly-owned subsidiary of CBF, pursuant to which Southern Community Financial Corporation (“Southern Community”) will merge with Winston and become a wholly-owned subsidiary of CBF (the “Merger”). The Agreement and the transactions contemplated by it has been approved by the Board of Directors of both CBF and Southern Community.

 

Capital Bank Financial Corp. is a national bank holding company that was incorporated in the State of Delaware in 2009. CBF has raised approximately $900 million of equity capital with the goal of creating a regional banking franchise in the southeastern region of the United States. CBF has previously invested in First National of the South, Metro Bank of Dade Country, Turnberry Bank, TIB Financial Corporation, Capital Bank Corporation and Green Bankshares, Inc. CBF is the parent of Capital Bank, N.A., a national banking association with approximately $6.5 billion in total assets and 143 full-service banking offices throughout southern Florida and the Florida Keys, North Carolina, South Carolina, Tennessee and Virginia. CBF is also the parent company of Naples Capital Advisors, Inc., a registered investment advisor.

 

Subject to the terms and conditions set forth in the Agreement dated March 26, 2012 and as amended on June 25, 2012, each share of Southern Community Common Stock issued and outstanding at the effective time of the Merger will be converted into the right to receive $3.11 in cash, without interest and less any applicable withholding taxes.

 

Each outstanding option to purchase shares of Southern Community common stock will be vested prior to the Merger and be paid in cash equal to the difference between the exercise price of the option and $3.11 and each share of Southern Community restricted stock will vest immediately prior to the Merger and all restrictions will immediately lapse.

 

- 28 -
 

 

Note 2 – Acquisition Agreement with Capital Bank Financial Corp. (continued)

 

Southern Community shareholders will also be granted one non-transferable contingent value right (“CVR”) per share, with each CVR eligible to receive a cash payment equal to 75% of the excess, if any, of (i) $87 million over (ii) net charge-offs and net realized losses on Southern Community’s legacy loan portfolio and foreclosed assets for a period of five years from the closing date of the Merger, with a maximum payment of $1.30 per CVR. Payout of the CVR will be overseen by a special committee of the CBF Board. Southern Community shareholders may also receive an additional cash payment based on the terms of a potential repurchase by CBF of the securities issued by Southern Community to the United States Department of the Treasury.

 

Upon the closing of the Merger, Dr. William G. Ward, Sr., the Chairman of Southern Community’s Board of Directors, will join the Board of Directors of both CBF and its subsidiary bank (“Capital Bank”), and James G. Chrysson, the Vice Chairman of the Board of Southern Community, will join the Board of Capital Bank.

 

The obligations of Southern Community and CBF to consummate the merger are subject to certain conditions, including: (i) approval of the Merger by the shareholders of Southern Community; (ii) receipt of required regulatory approvals (and in CBF’s case, without the imposition of an unduly burdensome regulatory condition); (iii) the absence of any injunction or similar restraint enjoining or making illegal consummation of the Merger or any of the other transactions contemplated by the Agreement; (iv) the continuing material truth and accuracy of representations and warranties made by the parties in the Agreement; and (vi) the performance in all material respects by each of the parties of its covenants under the Agreement. Some of these conditions may be waived by the party for whose benefit they were included in the Agreement. CBF’s obligation to close is subject to certain additional conditions, including the absence of a material adverse effect on Southern Community and the amendment or waiver of certain of Southern Community’s compensation-related agreements.

 

The Agreement may be terminated, before or after receipt of shareholder approval, in certain circumstances, including: (i) upon the mutual consent of the parties; (ii) failure to obtain any required regulatory approval; (iii) by either party if the Merger is not consummated on or before September 26, 2012 if such failure is not caused by material breach of the Agreement; (iv) by either party if there is a material breach of the other party’s representations, warranties, or covenants, and the breach or change that is not cured within 30 days following notice by the complaining party to the complaining party’s reasonable satisfaction; (v) by CBF if Southern Community’s Board fails to recommend that shareholders approve the Agreement and the Merger, changes such recommendation or breaches certain non-solicitation covenants with respect to third party proposals; or (vi) by either party if the shareholders of Southern Community fail to approve the Agreement.

 

Under certain circumstances, Southern Community will be obligated to pay CBF a termination fee of $4 million and reimburse CBF up to $1 million for all expenses incurred by it in connection with the Agreement and the transactions contemplated thereby.

 

On July 25, 2012, the Board terminated the employment of Messrs. Bauer and Clark effective September 22, 2012. Their employment agreements, which have now been terminated, contained change in control provisions that provided for a lump sum payment equal to three times the sum of the applicable officer’s base salary for the year of the change in control and the incentive compensation paid in the year prior to the change in control. As previously disclosed in Southern Community’s Form 10-K/A, Amendment No. 1 for the year ended December 31, 2011, the following would have been the estimated cost to the Company in the event of a change in control as of January 1, 2012, pursuant to the employment agreements and Salary Continuation Agreements and assuming that the Treasury’s investment in Southern Community was repaid in full, the Company was no longer under regulatory restrictions and not taking into account the amendments contemplated by the merger agreement. On behalf of Messrs. Bauer and Clark, the estimated cost to the Company would have been approximately $2,622,297 and $1,366,220, respectively. As a condition to the closing of the merger, both the amounts and the terms of potential change in control payments under the employment agreements with Messrs. Bauer and Clark were required to be amended. Since neither officer will be an employee of Southern Community at the time of the merger, amendments to their employment agreements will not be required to consummate the merger.

 

- 29 -
 

 

Note 3 – Investment Securities

 

The following is a summary of the securities portfolio by major classification at the dates presented.

 

   June 30, 2012 
   Amortized Cost   Gross Unrealized 
Gains
   Gross Unrealized 
Losses
   Fair Value 
   (Amounts in thousands) 
Securities available for sale:                    
US Government agencies  $19,681   $34   $-   $19,715 
Asset-backed securities                    
Residential mortgage-backed securities   155,698    2,406    66    158,038 
Collateralized mortgage obligations   26,895    392    594    26,693 
Small Business Administration loan pools   13,515    430    7    13,938 
Student loan pools   8,538    -    62    8,476 
Municipals   25,142    2,644    -    27,786 
Trust preferred securities   3,250    -    695    2,555 
Corporate bonds   4,213    -    469    3,744 
Other   1,000    -    1    999 
   $257,932   $5,906   $1,894   $261,944 
                     
Securities held to maturity:                    
Mortgage-backed securities                    
Residential mortgage-backed securities  $389   $26   $-   $415 
Small Business Administration loan pools   4,655    316    -    4,971 
Municipals   31,452    2,833    24    34,261 
Trust preferred securities   8,726    -    361    8,365 
Corporate bonds   5,787    -    741    5,046 
   $51,009   $3,175   $1,126   $53,058 

 

   December 31, 2011 
   Amortized Cost   Gross Unrealized
Gains
   Gross Unrealized
Losses
   Fair Value 
   (Amounts in thousands) 
Securities available for sale:                    
US Government agencies  $34,660   $69   $-   $34,729 
Asset-backed securities                    
Residential mortgage-backed securities   185,838    1,713    245    187,306 
Collateralized mortgage obligations   28,089    450    1,447    27,092 
Small Business Administration loan pools   67,507    637    76    68,068 
Student loan pools   8,903    -    1    8,902 
Municipals   26,981    2,239    -    29,220 
Trust preferred securities   3,250    -    929    2,321 
Corporate Bonds   4,213    -    554    3,659 
Other   1,000    1    -    1,001 
   $360,441   $5,109   $3,252   $362,298 
                     
Securities held to maturity:                    
Mortgage-backed securities                    
Residential mortgage-backed securities  $474   $34   $-   $508 
Small Business Administration loan pools   4,928    230    -    5,158 
Municipals   33,214    1,904    1    35,117 
Corporate bonds   5,787    -    1,056    4,731 
   $44,403   $2,168   $1,057   $45,514 

 

Residential mortgage-backed securities and collateralized mortgage obligations are primarily government sponsored (GSE) agency issued whose underlying collateral are prime residential mortgage loans. The Company’s municipal securities are composed of geographic concentrations of 97.3% North Carolina, 1.7% of Texas independent school districts and less than 1.0% in other states. As the Company’s investment policy limits the purchase of municipal securities to “A” rated or better, the municipal investment portfolio segment has 98.3% of this portfolio rated “A” or better.

 

- 30 -
 

 

 

Note 3 – Investment Securities (continued)

 

For the second quarter 2012 and 2011, sales of securities available for sale resulted in gross realized gains of $864 thousand and $926 thousand, respectively, and realized losses of none and $402 thousand, respectively for each period. These investment sales generated $100.2 million and $72.4 million in proceeds during these respective periods. For the six months ended June 30, 2012 and 2011, sales of securities available for sale resulted in gross realized gains of $1.2 million and $2.2 million, respectively, and realized losses of $38 thousand and $730 thousand, respectively, for each period. These investment sales generated $162.2 million and $124.1 million in proceeds during these respective periods.

 

The following table shows the gross unrealized losses and fair values for our investments and length of time that the individual securities have been in a continuous unrealized loss position.

 

   June 30, 2012 
   Less than 12 Months   12 Months or More   Total 
   Fair Value   Unrealized
losses
   Fair Value   Unrealized
losses
   Fair Value   Unrealized
losses
 
   (Amounts in thousands) 
Securities available for sale:                              
Asset-backed securities                              
Residential mortgage-backed securities  $18,036   $66   $-   $-   $18,036   $66 
Collateralized mortgage obligations   1,506    128    5,602    466    7,108    594 
Small Business Administration loan pools   2,544    5    993    2    3,537    7 
Student loan pools   8,477    62    -    -    8,477    62 
Trust preferred securities   -    -    2,553    695    2,553    695 
Corporate bonds   -    -    3,744    469    3,744    469 
Other   1,000    1    -    -    1,000    1 
                               
Total temporarily impaired  securities  $31,563   $262   $12,892   $1,632   $44,455   $1,894 
                               
Securities held to maturity:                              
Municipals  $942   $24   $-   $-   $942   $24 
Trust preferred securities   8,365    361    -    -    8,365    361 
Corporate bonds   -    -    5,046    741    5,046    741 
                               
Total temporarily impaired  securities  $9,307   $385   $5,046   $741   $14,353   $1,126 

  

   December 31, 2011 
   Less than 12 Months   12 Months or More   Total 
   Fair Value   Unrealized
losses
   Fair Value   Unrealized
losses
   Fair Value   Unrealized
losses
 
   (Amount in thousands) 
Securities available for sale:                              
Asset-backed securities                              
Residential mortgage-backed securities  $54,446   $245   $-   $-   $54,446   $245 
Collateralized mortgage obligations   12,248    1,447    -    -    12,248    1,447 
Small Business Administration loan pools   12,309    74    686    2    12,995    76 
Student loan pools   8,902    1    -    -    8,902    1 
Municipals   6    -    -    -    6    - 
Trust preferred securities   -    -    2,321    929    2,321    929 
Corporate bonds   -    -    3,659    554    3,659    554 
                               
Total temporarily impaired  securities  $87,911   $1,767   $6,666   $1,485   $94,577   $3,252 
                               
Securities held to maturity:                              
Municipals  $-   $-   $967   $1   $967   $1 
Corporate bonds   -    -    4,731    1,056    4,731    1,056 
                               
Total temporarily impaired  Securities  $-   $-   $5,698   $1,057   $5,698   $1,057 

 

- 31 -
 

 

Note 3 – Investment Securities (continued)

 

In evaluating investment securities for “other-than-temporary impairment” losses, management considers, among other things, (i) the length of time and the extent to which the investment is in an unrealized loss position, (ii) the financial condition and near term prospects of the issuer, and (iii) the intent and ability of the Company to retain its investment in the issuer for a sufficient period of time to allow for any anticipated recovery of unrealized loss. At June 30, 2012, there were six investment securities with aggregate fair values of $17.9 million in an unrealized loss position for at least twelve months including one trust preferred security valued at $2.6 million with a $695 thousand unrealized loss due to changes in the level of market interest rates. The security has a variable rate based on LIBOR which had declined steadily throughout 2009 and has stabilized during 2010, 2011 and the first six months of 2012. The fair value of this security increased from the prior quarter and the unrealized loss remained significant. Based on the nature of these securities and the continued timely receipt of scheduled payments, we believe the decline in value to be solely due to changes in interest rates and the general economic conditions and not deterioration in their credit quality. We have the intention and ability to hold these securities for a period of time sufficient to allow for their recovery in value or until maturity. The unrealized losses on the securities available for sale are reflected in other comprehensive income.

 

The amortized cost and fair values of securities available for sale and held to maturity at June 30, 2012 by contractual maturity are shown below. Actual expected maturities may differ from contractual maturities because issuers may have the right to call or prepay the obligation.

 

   Securities Available for Sale   Securities Held to Maturity 
   Amortized
Cost
   Fair Value   Amortized
Cost
   Fair Value 
   (Amount in thousands) 
                 
US Government Agencies                    
Due after one but through five years  $1,000   $1,001   $-   $- 
Due after ten years   18,681    18,713    -    - 
Municipals                    
Due within one year   103    103    -    - 
Due after one but through five years   444    445    1,318    1,398 
Due after five but through ten years   684    717    3,825    4,184 
Due after ten years   23,911    26,521    26,309    28,679 
Trust preferred securities                    
Due after ten years   3,250    2,555    8,726    8,365 
Corporate bonds                    
Due after five but through ten years   4,213    3,744    5,787    5,046 
Other                    
Due after five but through ten years   1,000    999    -    - 
Asset-backed securities                    
Residential mortgage-backed securities   155,698    158,038    389    415 
Collateralized mortgage obligations   26,895    26,693    -    - 
Small Business Administration loan pools   13,515    13,938    4,655    4,971 
Student loan pools   8,538    8,477    -    - 
                     
   $257,932   $261,944   $51,009   $53,058 

 

Federal Home Loan Bank Stock

 

As disclosed separately on our statements of financial condition, the Company has an investment in Federal Home Loan Bank of Atlanta (“FHLB”) stock of $6.0 million and $6.8 million at June 30, 2012 and December 31, 2011 respectively. The Company carries its investment in FHLB at its cost which is the par value of the stock. Based on current borrowings, the FHLB periodically repurchases excess stock from the Company at par value as the stock is not actively traded and does not have a quoted market price. After briefly suspending the payment of dividends, the FHLB paid a quarterly cash dividend to its members for the second quarter of 2009 and each quarter following including the most recent quarter. Management believes that the investment in FHLB stock was not impaired as of June 30, 2012.

 

- 32 -
 

 

Note 4 – Loans

 

Following is a summary of loans by loan class:

 

   At June 30, 2012   At December 31, 2011 
       Percent       Percent 
   Amount   of Total   Amount   of Total 
   (Amounts in thousands) 
Commercial real estate  $372,739    40.8%  $387,275    40.8%
Commercial                    
Commercial and industrial   82,816    9.1%   85,321    9.0%
Commercial line of credit   48,008    5.3%   44,574    4.7%
Residential real estate                    
Residential construction   104,927    11.5%   101,945    10.7%
Residential lots   39,607    4.3%   45,164    4.8%
Raw land   15,158    1.7%   17,488    1.8%
Home equity lines   91,900    10.1%   95,136    10.0%
Consumer   158,436    17.4%   173,119    18.2%
                     
Subtotal  $913,591    100%  $950,022    100%
Less: Allowance for loan losses   (22,954)        (24,165)     
Net Loans  $890,637        $925,857      

 

Construction loans are non-revolving extensions of credit secured by real property, the proceeds of which will be used to a) finance the preparation of land for construction of industrial, commercial, residential, or farm buildings; or b) finance the on-site construction of such buildings. Construction loans are approved based on a set of projections regarding cost, time to completion, time to stabilization or sale, and availability of permanent financing. Any one of these projections may vary from actual results. Therefore, construction loans are considered based not only on the expected merits of the project itself, but also on secondary and tertiary repayment sources of the project sponsor, project sponsor expertise and experience and independent evaluation of project viability. Personal guarantees are typically required. Sources of repayment for these types of loans may be pre-committed permanent loans from approved long-term lenders, sales of developed property, or an interim loan commitment from the Company until permanent financing is obtained. These loans are closely monitored by on-site inspections to ensure that loan commitments remain in-balance with work completed to date and that adequate funds remain available to ensure completion.

 

Commercial real estate loans are underwritten by evaluating and understanding the borrower’s ability to generate adequate cash flow to repay the subject debt within reasonable terms. These loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate. Commercial real estate lending typically involves higher loan amounts relative to equity sources of capitalization and higher debt service requirements relative to available cash flow. This heightened degree of financial and operating leverage can expose commercial real estate loans to increased sensitivity to changes in market and economic conditions. Repayment of these loans is generally largely dependent on the successful operation of the property securing the loan or the business conducted on the property securing the loan. Management monitors and evaluates commercial real estate loans based on collateral, geography, and secondary/tertiary sources of repayment of the property sponsors. Management tracks the level of owner-occupied commercial real estate loans versus non-owner occupied loans. Loans secured by owner-occupied properties are generally considered to be less sensitive to real estate market conditions, since the profitability and cash flow of the occupying business are aligned via common ownership.

 

Commercial and industrial loans are underwritten after evaluating and understanding the borrower’s ability to generate positive cash flow, operate profitably and prudently expand its business. Underwriting standards are designed to promote relationships to include a full range of loan, deposit, and cash management services. Underwriting processes include thorough examination of the borrower’s market, operating environment, and business model, to assess whether current and projected cash flows can reasonably be expected to present an acceptable source of repayment. Such repayments are generally sensitized with variances of growth/decline, profitability, and operating cycle changes. Secondary repayment sources, including collateral, are assessed. The level of control and monitoring over such secondary repayment sources may be impacted by the strength of the primary repayment source and the financial position of the borrower.

 

- 33 -
 

 

Note 4 – Loans (continued)

 

Residential lot loans are extensions of credit secured by developed tracts of land with appropriate entitlements to support construction of single family or multifamily residential buildings. Such loans were historically structured as time or term loans to finance the holding of the lot for future construction. Because the property is neither generating current income nor providing shelter, these loans have proven to be subject to a higher-than-average risk of abandonment. Extensions of credit for acquisition of finished lots are generally assessed based on the outside repayment sources readily available to the borrower in the current underwriting for such loans.

 

Consumer loans are originated utilizing a centralized approval process staffed by experienced consumer loan administration personnel. Policies and procedures are developed and maintained to ensure compliance with the Company’s risk management objectives and regulatory compliance requirements. This activity, coupled with relatively small loan amounts spread across many individual borrowers, minimizes risk. Additionally, trend and outlook reports are reviewed by management on a periodic basis, along with periodic review activity of particular regions and individual lenders. Loans are concentrated in home equity lines of credit and term loans secured by first or second liens on owner-occupied residential real estate.

 

Home Equity loans are consumer-purpose revolving or term loans secured by 1st or 2nd liens on owner-occupied residential real estate. Such loans are underwritten and approved on the same centralized basis as other consumer loans. Appropriate risk management and compliance practices are exercised to ensure that loan-to-value, lien perfection, and compliance risks are addressed and managed within the Bank’s established tolerances. The degree of utilization of revolving commitments within this asset class is reviewed monthly to identify changes in the behavior of this borrowing group.

 

Commercial lines of credit are underwritten according to the same standards applied to other commercial and industrial loans; with particular focus on the cash flow impact of the borrower’s operating cycle. Based on the risk profile of each borrower, an appropriate level of monitoring and servicing can be applied, such that higher risk categories involve more frequent monitoring and more involved control over the cash proceeds of asset conversion. Lower risk profiles may involve less restrictive controls and lighter servicing intensity.

 

Raw land loans are those secured by tracts of undeveloped raw land held for personal use or investment. Such properties are expected to be held for a period of not less than twenty-four months with no active development plan. Given the raw nature of the land, these loans are underwritten based on the ability of the borrower to service the indebtedness with sources of income unrelated to the property. Higher cash down payment and lower loan-to-value expectations are applied to such loans.

 

Loan origination fees and certain direct origination are capitalized and recognized as an adjustment to yield over the life of the related loan. Net unamortized deferred fees less related cost included in the above were $123 thousand at June 30, 2012 and $136 thousand at December 31, 2011.

 

Loans are placed in a nonaccrual status for all classes of loans when, in management’s opinion, the borrower may be unable to meet payments as they become due or payments are 90 days past due. Loans are returned to an accrual status when the borrower makes timely principal and interest payments for a period of at least six months and has demonstrated the ability to continue making scheduled payments until the loan is repaid in full.

 

The following is a summary of nonperforming assets at the periods presented:

 

   June 30,   December 31,   June 30, 
   2012   2011   2011 
   (Amounts in thousands) 
             
Nonaccrual loans  $34,443   $38,715   $45,381 
Restructured loans - nonaccruing   20,669    29,333    21,422 
Total nonperforming loans   55,112    68,048    66,803 
                
Foreclosed assets   19,873    19,812    23,022 
Total nonperforming assets  $74,985   $87,860   $89,825 
                
Restructured loans in accrual status not included above  $24,107   $24,202   $15,471 

 

- 34 -
 

 

Note 4 – Loans (continued)

 

For loan modifications and in particular, troubled debt restructurings (TDRs), the Company generally utilizes its own loan modification programs whereby the borrower is provided one or more of the following concessions: interest rate reduction, extension of payment terms, forgiveness of principal or other modifications. The primary factor in the pre-modification evaluation of a troubled debt restructuring is whether such an action will increase the likelihood of achieving a better result in terms of collecting the amount owed to the Bank.

 

As illustrated in the table below, during the three months ended June 30, 2012, the following concessions were made on 11 loans for $3.4 million (measured as a percentage of loan balances on TDRs):

 

·Reduced interest rate for 58% (2 loans for $2.0 million);
·Extension of payment terms for 29% (8 loans for $984 thousand); and
·Forgiveness of principal for 13% (1 loan for $435 thousand).

 

During the six months ended June 30, 2012, the following concessions were made on 16 loans for $5.2 million (measured as a percentage of loan balances on TDRs):

 

·Reduced interest rate for 40% (3 loans for $2.0 million);
·Extension of payment terms for 50% (11 loans for $2.6 million); and
·Forgiveness of principal for 10% (2 loans for $531 thousand).

 

In cases where there was more than one concession granted, the modification was classified by the more dominant concession.

 

- 35 -
 

 

Note 4 – Loans (continued)

 

The following table presents a breakdown of the types of concessions made by loan class for the three and six months ended June 30, 2012.

 

   Three months ended June 30, 2012   Six months ended June 30, 2012 
       Pre-Modification   Post-Modification       Pre-Modification   Post-Modification 
       Outstanding   Outstanding       Outstanding   Outstanding 
   Number of   Recorded   Recorded   Number of   Recorded   Recorded 
   Loans   Investment   Investment   Loans   Investment   Investment 
Below market interest rate                              
Commercial real estate   1   $1,957   $1,957    1   $1,957   $1,957 
Commercial and industrial   -    -    -    -    -    - 
Commercial line of credit   -    -    -         -    - 
Residential construction   -    -    -    -    -    - 
Home equity lines   1    46    46    1    46    46 
Residential lots   -    -    -    -    -    - 
Raw land   -    -    -    -    -    - 
Consumer   -    -    -    1    42    42 
Total   2    2,003    2,003    3    2,045    2,045 
                               
Extended payment terms                              
Commercial real estate   2    414    414    2    414    414 
Commercial and industrial   1    30    30    3    737    737 
Commercial line of credit   1    74    74    1    74    74 
Residential construction   -    -    -    1    902    902 
Home equity lines   -    -    -    -    -    - 
Residential lots   1    349    349    1    349    349 
Raw land   -    -    -    -    -    - 
Consumer   3    117    117    3    117    117 
Total   8    984    984    11    2,593    2,593 
                               
Forgiveness of principal                              
Commercial real estate   -    -    -    -    -    - 
Commercial and industrial   -    -    -    -    -    - 
Commercial line of credit   -    -    -    -    -    - 
Residential construction   1    435    345    1    435    345 
Home equity lines   -    -    -    -    -    - 
Residential lots   -    -    -    -    -    - 
Raw land   -    -    -    -    -    - 
Consumer   -    -    -    1    96    27 
Total   1    435    345    2    531    372 
                               
Total   11   $3,422   $3,332    16   $5,169   $5,010 

 

- 36 -
 

 

Note 4 – Loans (continued)

 

During the previous twelve months ended June 30, 2012, the Company modified 86 loans in the amount of $36.9 million. Of this total, there were payment defaults (where the modified loan was past due thirty days or more) of $198 thousand, or 0.5%, and $617 thousand, or 1.7%, respectively, during the three and six months ended June 30, 2012.

 

The following table presents loans that were modified as troubled debt restructurings within the previous 12 months and for which there was a payment default (past due 30 days or more) during the three and six months ended June 30, 2012.

 

   Three Months   Six Months 
   Ended June 30, 2012   Ended June 30, 2012 
   Number of   Recorded   Number of   Recorded 
   Loans   Investment   Loans   Investment 
Below market interest rate                    
Commercial real estate   -   $-    -   $- 
Commercial and industrial   -    -    -    - 
Commercial line of credit   -    -    -    - 
Residential construction   -    -    -    - 
Home equity lines   -    -    -    - 
Residential lots   -    -    1    10 
Raw land   -    -    -    - 
Consumer   -    -    -    - 
Total   -    -    1    10 
                     
Extended payment terms                    
Commercial real estate   1    22    2    158 
Commercial and industrial   1    4    1    4 
Commercial line of credit   -    -    -    - 
Residential construction   1    46    1    46 
Home equity lines   -    -    -    - 
Residential lots   1    43    1    43 
Raw land   -    -    -    - 
Consumer   2    83    3    356 
Total   6    198    8    607 
                     
Forgiveness of principal                    
Total   -    -    -    - 
                     
Total   6   $198    9   $617 

 

Of the total of 86 loans for $36.9 million which were modified during the twelve months ended June 30, 2012, the following represents their success or failure for the twelve months ended June 30, 2012:

 

· 89.5% are paying as restructured;
· 0.3% have been reclassified to nonaccrual;
· 5.3% have defaulted and/or foreclosed upon; and
· 4.9% has paid in full.

 

The following table presents the successes and failures of the types of modifications within the previous 12 months as of June 30, 2012.

 

   Paid in full   Paying as restructured   Converted to non-accrual   Foreclosure/Default 
   Number   Recorded   Number   Recorded   Number   Recorded   Number   Recorded 
Amounts in $ thousands  of Loans   Investment   of Loans   Investment   of Loans   Investment   of Loans   Investment 
Below market interest rate   1   $1,500    22   $16,465    2   $94    -   $- 
Extended payment terms   1    292    49    13,670    1    30    5    1,969 
Forgiveness of principal   -    -    3    1,763    -    -    -    - 
Other   -    -    2    1,142    -    -    -    - 
Total   2   $1,792    76   $33,040    3   $124    5   $1,969 

 

- 37 -
 

 

Note 4 – Loans (continued)

 

The following is a summary of the recorded investment in nonaccrual loans and impaired loans segregated by class of loans at the periods presented:

 

   June 30, 2012   December 31, 2011 
   Nonaccrual
Loans
   Impaired
Loans
   Nonaccrual
Loans
   Impaired
Loans
 
   (Amounts in thousands) 
Commercial real estate  $17,429   $33,137   $26,484   $39,297 
Commercial and industrial   2,799    3,901    3,548    3,899 
Commercial line of credit   1,429    1,337    1,429    1,004 
Residential construction   12,921    16,071    11,491    16,619 
Home equity lines   2,093    1,410    2,637    1,955 
Residential lots   10,056    10,076    12,096    12,095 
Raw land   241    114    1,484    1,484 
Consumer   8,144    8,796    8,879    10,753 
                     
Total  $55,112   $74,842   $68,048   $87,106 

 

The Company evaluates “impaired” loans, which includes nonperforming loans and accruing troubled debt restructured loans, having risk characteristics that are unique to an individual borrower on a loan-by-loan basis with balances above a specified level. For smaller loans, the allowance is calculated based on the credit grade utilizing historical loss experience and other qualitative factors. Included in the table below, $52.4 million out of the total of $55.1 million of nonperforming loans and $22.4 million out of the total of $24.1 million of accruing troubled debt restructured loans were individually evaluated which required a specific allowance of $1.2 million and $526 thousand, respectively, for a total specific ALLL of $1.7 million. The impaired loans with smaller balances ($2.7 million in nonperforming loans and $1.7 million in accruing troubled debt restructured loans) were collectively evaluated for impairment.

 

The following is a summary of loans individually or collectively evaluated for impairment, by segment, at June 30, 2012:

 

   Commercial       Residential             
   Real       Real             
   Estate   Commercial   Estate   HELOC   Consumer   Total 
   (Amounts in thousands) 
Ending balance: nonperforming loans individually evaluated for impairment  $15,983   $3,655   $25,093   $1,410   $6,254   $52,395 
                               
Accruing troubled debt restructured loans individually evaluated for impairment   17,154    1,583    1,168    -    2,542    22,447 
                               
Ending balance: total impaired loans individually evaluated for impairment   33,137    5,238    26,261    1,410    8,796    74,842 
                               
Ending balance: collectively  evaluated for impairment   339,602    125,586    133,431    90,490    149,640    838,749 
                               
Ending Balance  $372,739   $130,824   $159,692   $91,900   $158,436   $913,591 

 

- 38 -
 

Note 4 – Loans (continued)

 

The following is a summary of loans individually or collectively evaluated for impairment, by segment, at December 31, 2011:

 

   Commercial       Residential             
   Real       Real             
   Estate   Commercial   Estate   HELOC   Consumer   Total 
   (Amounts in thousands) 
Ending balance: nonperforming loans individually evaluated for impairment  $24,822   $3,889   $27,238   $1,955   $7,209   $65,113 
                               
Accruing troubled debt restructured loans individually evaluated for impairment   14,475    1,014    2,960    -    3,544    21,993 
                               
Ending balance: total impaired loans individually evaluated for impairment   39,297    4,903    30,198    1,955    10,753    87,106 
                               
Ending balance: collectively   evaluated for impairment   347,978    124,993    134,399    93,180    162,366    862,916 
                               
 Ending Balance  $387,275   $129,896   $164,597   $95,135   $173,119   $950,022 

 

The following is a breakdown of impaired loans individually evaluated for impairment, by class, with and without related specific allowance at June 30, 2012:

 

                   Quarter   Quarter   Year to Date   Year to Date 
   Unpaid   Partial           Average   Interest   Average   Interest 
   Principal   Charge Offs   Recorded   Related   Recorded   Income   Recorded   Income 
   Balance   To Date   Investment   Allowance   Investment   Recognized   Investment   Recognized 
   (Amounts in thousands)         
With no related allowance recorded:                                        
                                         
Commercial real estate  $30,821   $(10,078)  $20,743   $-   $22,270   $66   $23,188   $204 
Commercial                                        
Commercial and industrial   4,034    (948)   3,086    -    2,860    4    2,449    26 
Commercial line of credit   1,070    (131)   939    -    457    3    501    4 
Residential real estate                                        
Residential construction   17,466    (2,040)   15,426    -    13,567    24    13,039    42 
Residential lots   15,075    (4,999)   10,076    -    7,376    12    7,680    12 
Raw land   2,716    (2,602)   114    -    115    1    117    3 
Home equity lines   435    (32)   403    -    918    -    878      
Consumer   7,081    (567)   6,514    -    7,434    10    7,254    22 
Subtotal   78,698    (21,397)   57,301    -    54,997    120    55,106    313 
                                         
With an allowance recorded:                                        
                                         
Commercial real estate   12,394    -    12,394    673    11,841    147    12,126    294 
Commercial                                        
Commercial and industrial   815    -    815    524    792    -    544      
Commercial line of credit   397    -    397    167    695    -    571      
Residential real estate                                        
Residential construction   646    -    646    11    2,298    4    2,751    7 
Residential lots   -    -    -    -    5,710    5    4,825    11 
Raw land   -    -    -    -    -    -    272      
Home equity lines   1,007         1,007    250    926    -    911      
Consumer   2,509    (227)   2,282    74    2,130    38    2,479    75 
Subtotal   17,768    (227)   17,541    1,699    24,392    194    24,479    387 
                                         
Summary                                        
Commercial real estate   43,215    (10,078)   33,137    673    34,111    213    35,314    498 
Commercial   6,316    (1,079)   5,237    691    4,804    7    4,065    30 
Residential real estate   35,903    (9,641)   26,262    11    29,066    46    28,684    75 
Home equity lines   1,442    (32)   1,410    250    1,844    -    1,789    - 
Consumer   9,590    (794)   8,796    74    9,564    48    9,733    97 
                                         
Grand Totals  $96,466   $(21,624)  $74,842   $1,699   $79,389   $314   $79,585   $700 

 

- 39 -
 

 

Note 4 – Loans (continued)

 

As shown in the above table, the Company has previously taken partial charge-offs of $21.6 million on the $74.8 million in loans individually evaluated for impairment. In addition, the Company has set aside $1.7 million in specific allowance for $17.5 million of these loans.

 

The recorded investment in loans that were considered and collectively evaluated for impairment at June 30, 2012 and December 31, 2011 totaled $838.7 million and $862.9 million, respectively. The recorded investment in loans that were considered individually impaired at June 30, 2012 and December 31, 2011 totaled $74.8 million and $87.1 million, respectively. At June 30, 2012 and December 31, 2011, the recorded investment in impaired loans requiring a valuation allowance based on individual analysis was $17.5 million and $23.0 million, respectively, with a corresponding valuation allowance of $1.7 million and $1.6 million. No valuation allowance for the other impaired loans was considered necessary as a result of previously recognized partial charge-offs or adequate collateral coverage. No loans with deteriorated credit quality have been acquired by the Company to date.

 

The average recorded investment in impaired loans for the quarter ended June 30, 2012 and year ended December 31, 2011 was approximately $79.4 million and $84.7 million, respectively. For the three months ended June 30, 2012, the interest income recorded on accruing troubled debt restructured loans that were individually evaluated for impairment was $314 thousand. The interest income foregone for loans in a non-accrual status at June 30, 2012 and 2011 was $700 thousand and $2.1 million, respectively.

 

The following is a breakdown of impaired loans individually evaluated for impairment, by class, with and without related specific allowance at December 31, 2011:

 

                   Year to Date   Year to Date 
   Unpaid   Partial           Average   Interest 
   Principal   Charge Offs   Recorded   Related   Recorded   Income 
   Balance   To Date   Investment   Allowance   Investment   Recognized 
   (Amounts in thousands)     
With no related allowance recorded:                              
                               
Commercial real estate  $36,251   $(7,334)  $28,917   $-   $26,846   $358 
Commercial                              
Commercial and industrial   4,742