10-K 1 v337365_10k.htm 10-K

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


 

Form 10-K

(Mark One)

 

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

 

For the fiscal year ended December 31, 2012

 

or

 

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

 

1934

 

For the transition period from_____________ to_______________

 

Commission File Number 000-49929

 

Access National Corporation

(Exact name of registrant as specified in its charter)

 

Virginia 82-0545425
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)

 

1800 Robert Fulton Drive, Suite 300, Reston, Virginia 20191

(Address of principal executive offices) (Zip Code)

 

(703) 871-2100

(Registrant's telephone number, including area code)

 

Securities registered pursuant to Section 12(b) of the Act:
Title of each class Name of each exchange on which registered
Common Stock $0.835 par value The NASDAQ Stock Market LLC

 

Securities registered pursuant to Section 12(g) of the Act:

(Title of each class) None

 

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

 

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

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities 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 (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨

 

Indicate by checkmark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K x

 

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

 

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

 

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

 

The aggregate market value of the registrant’s common voting and non-voting common equity held by non-affiliates of the registrant, computed by reference to the price at which the stock was last sold on the NASDAQ Global Market as of the last business day of the registrant’s most recently completed second fiscal quarter, was approximately $98,279,618.

 

As of March 14, there were 10,325,104 shares of Common Stock, par value $0.835 per share, of Access National Corporation issued and outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Registrant’s Proxy Statement for the Corporation’s Annual Meeting of Shareholders to be held on May 21, 2013, are incorporated by reference in Part III of this Form 10-K.

 

 
 

 

Access National Corporation

FORM 10-K

INDEX

 

    Page
PART I      
       
Item 1   Business 2
Item 1A   Risk Factors 15
Item 1B   Unresolved Staff Comments 22
Item 2   Properties 22
Item 3   Legal Proceedings 22
Item 4   Mine Safety Disclosures 22
       
PART II      
       
Item 5   Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 23
Item 6   Selected Financial Data 25
Item 7   Management’s Discussion and Analysis of Financial Condition and Results of Operations 26
Item 7A   Quantitative and Qualitative Disclosures About Market Risk 42
Item 8   Financial Statements and Supplementary Data 43
Item 9   Changes in and Disagreements With Accountants on Accounting and Financial Disclosure 85
Item 9A   Controls and Procedures 85
Item 9B   Other Information 85
       
PART III      
       
Item 10   Directors, Executive Officers and Corporate Governance 86
Item 11   Executive Compensation 86
Item 12   Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 86
Item 13   Certain Relationships and Related Transactions, and Director Independence 86
Item 14   Principal Accountant Fees and Services 86
       
PART IV      
       
Item 15   Exhibits, Financial Statement Schedules 87
Signatures     89

 

1
 

 

PART I

 

In addition to historical information, the following report contains forward-looking statements that are subject to risks and uncertainties that could cause Access National Corporation’s actual results to differ materially from those anticipated. Readers are cautioned not to place undue reliance on these forward-looking statements, which reflect management’s analysis only as of the date of the report. For discussion of factors that may cause our actual future results to differ materially from those anticipated, please see “Item 1A – Risk Factors” and “Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations” herein.

 

ITEM 1 – BUSINESS

 

Access National Corporation (the “Corporation” or “ANC”) was organized June 15, 2002 under the laws of Virginia to operate as a bank holding company.  The Corporation has two active wholly owned subsidiaries:  Access National Bank (the “Bank” or “ANB”), and Access National Capital Trust II. Effective June 15, 2002, pursuant to an Agreement and Plan of Reorganization dated April 18, 2002 between the Corporation and the Bank, the Corporation acquired all of the outstanding stock of the Bank in a statutory share exchange transaction.

 

The Bank is the primary operating business of the Corporation. The Bank provides credit, deposit, mortgage services and wealth management services to middle market commercial businesses and associated professionals, primarily in the greater Washington, D.C. Metropolitan Area. The Bank was organized under federal law in 1999 as a national banking association to engage in a general banking business to serve the communities in and around Northern Virginia. Deposits with the Bank are insured to the maximum amount provided by the Federal Deposit Insurance Corporation (“FDIC”). The Bank offers a comprehensive range of financial services and products and specializes in providing customized financial services to small and medium sized businesses, professionals, and associated individuals. The Bank provides its customers with personal customized service utilizing the latest technology and delivery channels. The various operating and non-operating entities that support the Corporation’s business directly and indirectly are listed below:

 

    PARENT    
ENTITY /   COMPANY /   YEAR
ACTIVITY   SOLE MEMBER   ORGANIZED
         
Access National Corporation   N/A   2002

 

A Virginia corporation with common stock listed on the NASDAQ Global Market, and serves as the Bank’s holding company. The bank holding company is subject to regulatory oversight by the Federal Reserve System. Its primary purpose is to hold the common stock of the commercial bank subsidiary and support related capital activities.

 

Access National Bank   ANC   1999

 

Primary operating entity holding a national bank charter issued under the laws of the United States. Its principal activities are subject to regulation by the Office of the Comptroller of the Currency (the “Comptroller”). The Bank’s primary business is serving the credit, depository and cash management needs of businesses and associated professionals. Deposits of the Bank are insured by the FDIC.

 

Access National Mortgage Corporation   ANB   1985
(“ANMC” or the “Mortgage Corporation”)      

 

During 2011 the Bank closed the Mortgage Corporation and all mortgage banking activities were transferred to the Bank under a separate business division of the Bank (the “Mortgage Division”). The Mortgage Corporation ceased conducting new business on July 1, 2011 and was dissolved in the second quarter of 2012.

 

Access Real Estate L.L.C   ANB 2003

 

Access Real Estate was formed to acquire and hold title to real estate for the Corporation. Access Real Estate owns a 45,000 square foot, three story office building located at 1800 Robert Fulton Drive in Reston, Virginia that serves as the corporate headquarters for the Corporation, Bank, Mortgage Division, Access Real Estate, Capital Fiduciary Advisors, and Access Investment Services. Access Real Estate also owns vacant land in Fredericksburg that was purchased for future expansion of the Bank.

 

2
 

 

Access Capital Management Holding, L.L.C (“ACM”)   ANB   2011

 

ACM is a Virginia limited liability company whose sole member is ANB. ACM is the holding company for Capital Fiduciary Advisors, L.L.C. (“CFA”), Access Investment Services, L.L.C. (“AIS”), and Access Insurance Group, L.L.C. (“AIG”). ACM provides a full range of wealth management services to individuals.

 

Capital Fiduciary Advisors, L.L.C.   ACM   2011

 

CFA is a Registered Investment Advisor with the Securities and Exchange Commission (“SEC”) and provides wealth management services to high net worth individuals, businesses, and institutions. Activities are supervised by the Bank’s primary regulator, the Comptroller, as well as the SEC.

 

Access Investment Services, L.L.C.   ACM   2011

 

AIS is a limited liability company whose sole member is ACM. AIS provides financial planning services to clients along with access to a full range of investment products. Activities are supervised by the Bank’s primary regulator, the Comptroller, as well as the SEC.

 

Access Insurance Group, L.L.C.   ACM   2011

 

AIG is a limited liability company whose sole member is ACM. AIG is presently inactive and when activated will provide access to a wide variety of insurance products.

 

Access Capital Trust II   ANC   2003

 

A Delaware corporate trust established for the purpose of issuing trust preferred capital securities.

 

ACME Real Estate, L.L.C (“ACME” or “ACME Real Estate”)   ANB   2007

 

ACME is a Virginia limited liability company whose sole member is ANB. ACME is a real estate holding company whose

purpose is to hold title to the properties acquired by the Bank either through foreclosure or property deeded in lieu of

foreclosure. Activities are supervised by the Bank’s primary regulator, the Comptroller.

 

The principal products and services offered by the Bank are listed below:

 

BUSINESS BANKING SERVICES
Lending
  BUSINESS BANKING SERVICES
Cash Management
  PERSONAL BANKING
SERVICES
         
Accounts Receivable Lines of Credit
Accounts Receivable Collection
Accounts
Growth Capital Term Loans
Business Acquisition Financing
Partner Buyout Funding
Debt Re-financing
Franchise Financing
Equipment Financing
Commercial Mortgages
Commercial Construction Loans
SBA Preferred Lender Loans
  Online Banking
Checking Accounts
Money Market Accounts
Sweep Accounts
Zero Balance Accounts
Overnight Investments
Certificates of Deposit
Business Debit Cards
Lockbox Payment Processing
Payroll Services
Employer Sponsored Retirement Plans
  Personal Checking Accounts
Savings / Money Market
Accounts
Certificates of Deposit
Residential Mortgage Loans
Asset Secured Loans
Loans for Business Investment
Construction Loans
Lot & Land Loans
Investment Management
Financial Planning
Retirement Account Services
Qualified Plans

 

Bank revenues are derived from interest and fees received in connection with loans, deposits, and investments. Interest paid on deposits and borrowings are the major expenses, followed by administrative and operating expenses. Revenues from the Mortgage Division consist primarily of gains from the sale of loans and loan origination fees. Major expenses of the Mortgage Division consist of personnel, advertising, and other operating expenses. Revenue generated by the Bank (excluding the Mortgage Division) totaled $38.6 million in 2012. The Mortgage Division contributed $54.3 million; others contributed $2.7 million prior to inter-company eliminations. In 2012, the Bank’s pre-tax earnings amounted to 51.8% of the Corporation’s total income before taxes and the Mortgage Division and others contributed the remaining 48.2%.

 

3
 

 

The economy, interest rates, monetary and fiscal policies of the federal government, and regulatory policies have a significant influence on the Corporation, the Bank, the Mortgage Division, ACM, and the banking industry as a whole. The economy shows signs of gradual improvement with the national unemployment rate dropping from 8.3% in January, 2012 to 7.9% in January, 2013. The January 2013 statement of the Federal Open Market Committee (“FOMC”) projected the federal funds rate to remain at zero percent to 0.25% as long as the unemployment rate remains above 6.5%. The continued low rate environment will help to keep mortgage rates low, which is favorable for mortgage originations, but will continue to stress net interest margins.

 

The effect of the sequestration cuts which began on March 1, 2013 has yet to be determined as much is still unknown as to the length or depth of reductions that will impact our geographical area.

 

The Bank operates from five banking centers located in Virginia: Chantilly, Tyson’s Corner, Reston, Leesburg and Manassas, and online at www.accessnationalbank.com. Additional offices may be added from time to time based upon management’s constant analysis of the market and opportunities.

 

The Mortgage Division specializes in the origination of conforming and government insured residential mortgages to individuals in the greater Washington, D.C. Metropolitan Area, the surrounding areas of its branch locations, outside of its local markets via direct mail solicitation, and otherwise. The Mortgage Division has established offices throughout Virginia; in Fairfax, Reston, Roanoke, and McLean. Offices outside the state of Virginia include New Smyrna Beach in Florida, Nashville in Tennessee, Denver in Colorado, Indianapolis in Indiana, Atlanta in Georgia, and San Antonio in Texas. During 2012, the Mortgage Division closed its offices in Crofton, Maryland and Winchester, Massachusetts.

 

The following table details the geographic distribution of the real estate collateral securing mortgage loans originated by the Mortgage Division in the periods indicated. The individually named states are those in which the Mortgage Division had a physical presence during the periods described. In addition to making loans for purchases within its markets, the Mortgage Division makes loans to borrowers for second homes located elsewhere, as well as utilizes direct mail to solicit loans outside its local markets, which accounts for the “Other States” category. Percentages are of the total dollar value of originations, as opposed to the number of originations.

 

   Loan Origination By State
   Year Ended December 31,
   Offices  2012   2011   2010 
                
COLORADO  1   6.11%   4.56%   3.92%
FLORIDA  1   2.92%   2.40%   0.00%
GEORGIA  1   4.37%   4.90%   4.06%
INDIANA  1   12.75%   9.15%   8.22%
MASSACHUSETTS  0   0.00%   2.30%   2.69%
MARYLAND  4   7.54%   9.15%   8.85%
TENNESSEE  1   5.02%   5.23%   5.60%
TEXAS  1   5.18%   4.86%   4.45%
VIRGINIA  6   21.36%   20.12%   27.92%
   16   65.25%   62.67%   65.71%
Other States      34.75%   37.33%   34.29%
       100.00%   100.00%   100.00%

 

The Mortgage Division’s activities rely on insurance provided by the Department of Housing and Urban Development (“HUD”) and the Veterans Administration. In addition we underwrite mortgage loans in accordance with guidelines for programs under Fannie Mae and Freddie Mac that make these loans marketable in the secondary market.

 

The Corporation and its subsidiaries are headquartered in Fairfax County, Virginia and primarily focus on serving the greater Washington, D.C. Metropolitan Area.

 

Our Strategy – Historical and Prospective

 

Our view of the financial services marketplace is that community banks must be effective in select market niches that are underserved and should stay clear of competing with large national competitors on a head-to-head basis for broad based consumer business. We started by organizing a de novo national bank in 1999. The focus of the Bank was and is serving the small and medium sized businesses and their associated professionals in the greater Washington, D.C. Metropolitan Area. We find that large national competitors are ineffective at addressing this market; it is difficult to distinguish where a business’s financial needs stop and the personal financial needs of that business’s professionals start. We believe that emerging businesses and the finances of their owners are best served hand-in-hand.

 

4
 

 

Our core competency is judgmental discipline of commercial lending based upon our personnel and practices that help our clients strategize and grow their businesses from a financial perspective. As financial success takes hold in the business, personal goals and wealth objectives of the business owners become increasingly important. Our second competency is a derivative of the first. We have the personnel, skills and strategy and know how to provide private banking services that assist our individual clients to acquire assets, build wealth, and manage their resources. Mortgage banking and the related activities in our model go hand-in-hand with supplying effective private banking services. Unlike most banking companies, the heart of our Mortgage Division is ingrained into our commercial bank, serving the same clients side-by-side in a coordinated and seamless fashion. We believe that lending is not enough in today’s environment to attract and retain commercial and professional clients. The credit services must be backed up by competitive deposit and cash management products and operational excellence. We have made significant investments in skilled personnel and the latest technology to ensure we can deliver these services.

 

We generally expect to have fewer branch locations compared to similar size banking companies. We do not view our branch network as a significant determinant of our growth. Our marketing strategies focus on benefits other than branch location convenience.

 

The goal was and is to generate 70-80% of the Corporation’s net income from the core business of the Bank, with the rest of our consolidated net income to be generated from related fee income activities. Due to the low interest rate environment in 2012, the Mortgage Division’s contribution to net income exceeded expectations thereby reducing the net income generated by the core business of the Bank to 53% of the Corporation’s net income. We will consider entering other related fee income businesses that serve our target market as opportunities, market conditions, and our capacity dictate. See Note 17 to the consolidated financial statements for additional information on segment performance.

 

We expect to grow our Bank by continuing to hire and train our own skilled personnel. We provide a sound infrastructure that facilitates the success of businesses, their owners and key personnel, not only today but tomorrow and on into the ensuing decades. We will consider growth by careful acquisition; however, that is not our primary focus.

 

Lending Activities

 

The Bank’s lending activities involve commercial real estate loans both owner occupied and non-owner occupied, residential real estate loans, commercial loans, commercial and real estate construction loans, home equity loans, and consumer loans. These lending activities provide access to credit to small and medium sized businesses, professionals, and consumers in the greater Washington, D.C. Metropolitan Area. Loans originated by the Bank are classified as loans held for investment. The Mortgage Division originates residential mortgages and home equity loans that are held on average fifteen to forty-five days pending their sale primarily to mortgage banking subsidiaries of large financial institutions. The Bank is also approved to sell loans directly to Fannie Mae and Freddie Mac and is able to securitize loans that are insured by the Federal Housing Administration. In the past, when the Mortgage Division was a separate subsidiary of the Bank, the Bank would, in certain circumstances, purchase adjustable rate mortgage loans in the Bank’s market area directly from the Mortgage Corporation to supplement loan growth in the Bank’s portfolio.   The Bank did not retain any loans originated by the Mortgage Division for said purpose in 2012 but may retain loans in the future if management believes doing so would assist in achieving the Corporation’s strategic goals. Loans held in the Bank’s portfolio at December 31, 2012 resulting from the Mortgage Division’s inability to sell the loan to a third party totaled $1.7 million. The Mortgage Division also brokers certain loans that do not conform to their existing products.  Each of our principal loan types are described below.

 

At December 31, 2012 loans held for investment totaled $617.0 million compared to $569.4 million at year end 2011. The Bank continued to experience growth in both Commercial Real Estate Loans and Commercial Loans reflecting continued improvement in the local economic conditions.

 

The Bank’s lending activities are subject to a variety of lending limits imposed by federal law. While differing limits apply in certain circumstances based on the type of loan, in general, the Bank’s lending limit to any one borrower on loans that are not fully secured by readily marketable or other permissible collateral is equal to 15% of the Bank’s capital and surplus. Permissible collateral consists of: inventory, accounts receivable, general intangibles, equipment, real estate, marketable securities, cash, and vehicles. The Bank has established relationships with correspondent banks to participate in loans when loan amounts exceed the Bank’s legal lending limits or internal lending policies. At December 31, 2012 unsecured loans were comprised of $2.2 million in commercial loans and approximately $142 thousand in consumer loans and collectively equal approximately 0.4% of the loans held for investment portfolio.

 

5
 

 

We have an established credit policy that includes procedures for underwriting each type of loan and lending personnel have been assigned specific authorities based upon their experience. Loans in excess of an individual loan officer’s authority are presented to our Loan Committee for approval. The Loan Committee meets weekly to facilitate a timely approval process for our clients. Loans are approved based on the borrower’s capacity for credit, collateral and sources of repayment. Loans are actively monitored to detect any potential performance issues. We manage our loans within the context of a risk grading system developed by management based upon extensive experience in administering loan portfolios in our market. Payment performance is carefully monitored for all loans. When loan repayment is dependent upon an operating business or investment real estate, periodic financial reports, site visits, and select asset verification procedures are used to ensure that we accurately rate the relative risk of our assets. Based upon criteria that are established by management and the Board of Directors, the degree of monitoring is escalated or relaxed for any given borrower based upon our assessment of the future repayment risk.

 

The Bank does not currently hold any pay option adjustable rate mortgages, loans with teaser rates, subprime loans, Alt A loans or any other loans considered to be “high-risk loans” in its loans held for investment portfolio, and did not during 2012, 2011, or 2010. The Mortgage Division does not currently originate any subprime loans or Alt A loans, did not originate such loans in 2012, 2011 or 2010, and does not expect to offer these programs in the future.

 

Loan Portfolio – Loans Held for Investment.  The following outlines the composition of loans held for investment.

 

Commercial Real Estate Loans-Owner Occupied: Loans in this category represent 29.60% of our loan portfolio held for investment, as of December 31, 2012. This category represents loans supporting an owner occupied commercial property. Repayment is dependent upon the cash flows generated by operation of the commercial property. Loans are secured by the subject property and underwritten to policy standards. Policy standards approved by the Board of Directors from time to time set forth, among other considerations, loan to value limits, cash flow coverage ratios, and the general creditworthiness of the obligors.

 

Commercial Real Estate Loans-Non-Owner Occupied: Also known as Commercial Real Estate Loans-Income Producing. Loans in this category represent 17.38% of our loan portfolio held for investment, as of December 31, 2012. This category includes loans secured by commercial property that is leased to third parties and loans to non-profit organizations such as churches and schools. Also included in this category are loans secured by farmland and multifamily properties. Repayment is dependent upon the cash flows generated from rents or by the non-profit organization. Loans are secured by the subject property and underwritten to policy standards. Policy standards approved by the Board of Directors from time to time set forth, among other considerations, loan to value limits, cash flow coverage ratios, and the general creditworthiness of the obligors.

 

Residential Real Estate Loans: This category includes loans secured by first or second mortgages on one to four family residential properties, generally extended to existing consumers of other Bank products, and represents 23.43% of the loan portfolio, as of December 31, 2012. Of this amount, the following sub-categories exist as a percentage of the whole Residential Real Estate Loan portfolio: Home Equity Lines of Credit 20.13%; First Trust Mortgage Loans 68.71%; Loans Secured by a Junior Trust 11.16%.

 

Home Equity Loans are extended to borrowers in our target market. Real estate equity is the largest component of consumer wealth in our marketplace. Once approved, this consumer finance tool allows the borrowers to access the equity in their home or investment property and use the proceeds for virtually any purpose. Home Equity Loans are most frequently secured by a second lien on residential property. One to Four Family Residential First Trust Loan, or First Trust Mortgage Loan, proceeds are used to acquire or refinance the primary financing on owner occupied and residential investment properties. Junior Trust Loans, or Loans Secured by Second Trust Loans, are to consumers wherein the proceeds have been used for a stated consumer purpose. Examples of consumer purposes are education, refinancing debt, or purchasing consumer goods. The loans are generally extended in a single disbursement and repaid over a specified period of time.

 

Loans in the Residential Real Estate portfolio are underwritten to standards within a traditional consumer framework that is periodically reviewed and updated by our management and Board of Directors and includes analysis of: repayment source and capacity, value of the underlying property, credit history, savings pattern, and stability.

 

Commercial Loans: Commercial Loans represent 24.21% of our loan portfolio held for investment as of December 31, 2012. These loans are to businesses or individuals within our target market for business purposes. Typically the loan proceeds are used to support working capital and the acquisition of fixed assets of an operating business. These loans are underwritten based upon our assessment of the obligor’s(s’) ability to generate operating cash flow in the future necessary to repay the loan. To address the risks associated with the uncertainties of future cash flow, these loans are generally well secured by assets owned by the business or its principal shareholders and the principal shareholders are typically required to guarantee the loan.

 

6
 

 

Real Estate Construction Loans: Real Estate Construction Loans, also known as construction and land development loans, comprise 4.87% of our held for investment loan portfolio as of December 31, 2012. These loans generally fall into one of four circumstances: loans to construct owner occupied commercial buildings, loans to individuals that are ultimately used to acquire property and construct an owner occupied residence, loans to builders for the purpose of acquiring property and constructing homes for sale to consumers, and loans to developers for the purpose of acquiring land that is developed into finished lots for the ultimate construction of residential or commercial buildings. Loans of these types are generally secured by the subject property within limits established by the Board of Directors based upon an assessment of market conditions and up-dated from time to time. The loans typically carry recourse to principal borrowers. In addition to the repayment risk associated with loans to individuals and businesses, loans in this category carry construction completion risk. To address this additional risk, loans of this type are subject to additional administrative procedures designed to verify and ensure progress of the project in accordance with allocated funding, project specifications, and time frames.

 

Consumer Loans: Consumer Loans make up approximately 0.51% of our loan portfolio as of December 31, 2012. Most loans are well secured with assets other than real estate, such as marketable securities or automobiles. Very few loans are unsecured. As a matter of operation, management discourages unsecured lending. Loans in this category are underwritten to standards within a traditional consumer framework that is periodically reviewed and updated by our management and Board of Directors: repayment source and capacity, collateral value, credit history, savings pattern, and stability.

 

Loans Held for Sale (“LHFS”). Loans in this category are originated by the Mortgage Division and comprised of residential mortgage loans extended to consumers and underwritten in accordance with standards set forth by an institutional investor to whom we expect to sell the loan. Loan proceeds are used for the purchase or refinance of the property securing the loan. Loans and servicing are sold concurrently. The LHFS loans are closed in our name and carried on our books until the loan is delivered to and purchased by an investor, generally within fifteen to forty-five days. In 2012, we originated $1.1 billion of loans processed in this manner, up from $797.0 million in 2011. At December 31, 2012 loans held for sale totaled $111.5 million compared to $95.1 million at year end 2011. The amount of loans held for sale outstanding at the end of any given month fluctuates with the volume of loans closed during the month and the timing of loans purchased by investors.

 

Brokered Loans

 

Brokered loans are underwritten and closed by a third party lender. We are paid a fee for procuring and packaging brokered loans. In 2012, we originated a total volume of $1.8 million in residential mortgage loans under this type of delivery method compared to $34.6 million in 2011. Brokered loans accounted for .2% and 4.2% of the total loan volume of the Mortgage Division at December 31, 2012 and 2011, respectively. The risks associated with this activity are limited to losses or claims arising from fraud.

 

Deposits

 

Deposits are the primary source of funding loan growth. At December 31, 2012 deposits totaled $671.5 million compared to $645.0 million on December 31, 2011.

 

Market Area

 

The Corporation, the Bank, the Mortgage Division, and ACM are headquartered in Fairfax County and primarily serve the Northern Virginia region and the Greater Washington, D.C. Metropolitan Area. We believe that the economic conditions in Fairfax County provide a reasonable proxy for economic conditions across our primary market, the greater Washington, D.C. Metropolitan Area. Fairfax County is a diverse and thriving urban county. As per the 2011 Census, the population of the county was 1,100,692 making it the most populous jurisdiction in the Commonwealth of Virginia, with about 13.6% of Virginia's population. The proximity to Washington, D.C. and the influence of the federal government and its spending provides somewhat of a recession shelter for the area. Virginia receives a large amount of federal procurement dollars second only to California, and Fairfax County ranks the highest among the counties in Virginia receiving federal procurement money. Forbes Magazine has ranked Virginia number 1 or number 2 among the best states for businesses in each of the last 7 years due to a pro-business regulatory climate. The U.S. Census Bureau and the Fairfax County government provide the following information about current economic conditions and trends in Fairfax County.

 

The median sales price of new single-family homes in Fairfax County that sold in January through November, 2012 was $1,055,000, an increase of 20.1% compared to the 2011 median of $878,333.

 

The commercial office vacancy rate in Fairfax County at year end 2012 was 19.5%, up from 18.3% at year end 2011. The increase in vacancy rates is partially attributable to space vacated by the military and government as a result of the Defense Base Realignment and Closure Commission initiatives as well as uncertainty due to the fiscal cliff during 2012. Building permits in Fairfax County have continued to decline since 2010, from a 847 in 2010 to 799 in 2011 and 706 in 2012. While vacancy rates and building permits are common measures of the general health of the real estate industry, we have not discerned any material correlation between such measures and the performance of our loan portfolio.

 

At December 31, 2012 and 2011, the Bank had approximately $107.2 million and $105.0 million, respectively in non-owner occupied income producing commercial real estate loans. The properties securing these loans are generally small office buildings and industrial properties located in our trade area with less than ten tenants. Income producing property loans are underwritten with personal and business guarantees that provide secondary sources of repayment and mitigate market risk factors.

 

7
 

 

The unemployment rate for Fairfax County was 3.7% in December 2012 compared to 5.6% for the state of Virginia and 7.8% for the nation. At December 31, 2011 the unemployment rate for Fairfax County was 4.2%, 6.1% for the state of Virginia and 8.5% for the nation.

 

The median household income in Fairfax County was $108,439 in 2012 up from $105,241 in 2011 and $103,010 in 2010.

 

As mentioned previously, the effect of sequestration cuts which began on March 1, 2013 has yet to be determined as to the impact to our market area.

 

Competition

 

The Bank competes with virtually all banks and financial institutions which offer services in its market area. Much of this competition comes from large financial institutions headquartered outside the state of Virginia, each of which has greater financial and other resources to conduct large advertising campaigns and offer incentives. To attract business in this competitive environment, the Bank relies on personal contact by its officers and directors, local promotional activities, and the ability to provide personalized custom services to small and medium sized businesses and professionals. In addition to providing full service banking, the Bank offers and promotes alternative and modern conveniences such as internet banking, automated clearinghouse transactions, remote deposit capture, and courier services for commercial clients. Because federal regulation of financial institutions changes regularly and is the subject of constant legislative debate, we cannot foresee how federal regulation of financial institutions may change in the future. However, it is possible that current and future governmental regulatory and economic initiatives could impact the competitive landscape in the Bank’s markets.

 

Employees

 

At December 31, 2012 the Corporation had 305 employees, 109 of whom were employed by the Bank (excluding the Mortgage Division), 188 of whom were employed by the Mortgage Division, and 8 of whom were employed by the wealth management subsidiaries. None of the employees of the Corporation are subject to a collective bargaining agreement. Management considers employee relations to be good.

 

Supervision and Regulation

 

Set forth below is a brief description of the material laws and regulations that affect the Corporation. The description of these statutes and regulations is only a summary and does not purport to be complete. This discussion is qualified in its entirety by reference to the statutes and regulations summarized below. No assurance can be given that these statutes or regulations will not change in the future.

 

General. The financial crisis of 2008, the threat of collapse of numerous financial institutions, and other recent events have led to the adoption of numerous new laws and regulations that apply to and focus on financial institutions. As a result of these regulatory reforms, the Corporation is experiencing a period of rapidly changing regulations. These regulatory changes could have a significant impact on how the Corporation conducts its business. The specific implications of these new laws and regulations cannot yet be predicted and will depend to a large extent on the specific regulations that are adopted in the coming months and years. As a public company, the Corporation is subject to the periodic reporting requirements of the Securities and Exchange Act of 1934, as amended (the “Exchange Act”), which include, but are not limited to, the filing of annual, quarterly, and other reports with the SEC. The Corporation is also required to comply with other laws and regulations of the SEC applicable to public companies.

 

As a national bank, the Bank is subject to regulation, supervision, and regular examination by the Comptroller. The prior approval of the Comptroller or other appropriate bank regulatory authority is required for a national bank to merge with another bank or purchase the assets or assume the deposits of another bank. In reviewing applications seeking approval of merger and acquisition transactions, the bank regulatory authorities will consider, among other things, the competitive effect and public benefits of the transactions, the capital position of the combined organization, the risks to the stability of the U.S. banking or financial system, the applicant’s performance record under the Community Reinvestment Act (“CRA”) and fair housing initiatives, and the effectiveness of the subject organizations in combating money laundering activities. Each depositor’s account with the Bank is insured by the FDIC to the maximum amount permitted by law. The Bank is also subject to certain regulations promulgated by the FRB and applicable provisions of Virginia law, insofar as they do not conflict with or are not preempted by federal banking law.

 

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The regulations of the FDIC, the Comptroller, and FRB govern most aspects of the Corporation’s business, including deposit reserve requirements, investments, loans, certain check clearing activities, issuance of securities, payment of dividends, branching, deposit interest rate ceilings, and numerous other matters.

 

As a consequence of the extensive regulation of commercial banking activities in the United States, the Corporation’s business is particularly susceptible to changes in state and federal legislation and regulations, which may have the effect of increasing the cost of doing business, limiting permissible activities or increasing competition.

 

The Sarbanes-Oxley Act. When enacted in 2002, the Sarbanes-Oxley Act (SOX) provided for major reforms of the federal securities laws intended to protect investors by improving the accuracy and reliability of corporate disclosures. It impacts all companies with securities registered under the Exchange Act, including the Corporation. Section 404(a) of the SOX required public companies to include in their annual reports on Form 10-K an assessment from management of the effectiveness of the company’s internal control over financial reporting, and Section 404(b) of the SOX required the company’s auditor to attest to and report on management’s assessment. SOX sets out enhanced requirements for audit committees including independence and expertise, includes stronger requirements for auditor independence by limiting the types of non-audit services that auditors can provide, and contains additional and increased civil and criminal penalties for violations of securities laws. Effective with the filing of this annual report, the Corporation is required to file as an accelerated filer as our public float has exceeded the $75 million threshold.

 

The Bank Holding Company Act. The Corporation is a bank holding company within the meaning of the Bank Holding Company Act of 1956, and is registered as such with, and subject to the supervision of, the Board of Governors of the Federal Reserve System and the Federal Reserve Bank of Richmond (”FRB”). A bank holding company is required to obtain the approval of the FRB before making certain acquisitions or engaging in certain activities. Bank holding companies and their subsidiaries are also subject to restrictions on transactions with insiders and affiliates.

 

Generally, a bank holding company is required to obtain the approval of the FRB before it may acquire all or substantially all of the assets of any bank, and before it may acquire ownership or control of the voting shares of any bank if, after giving effect to the acquisition, the bank holding company would own or control more than 5% of the voting shares of such bank. The FRB’s approval is also required for the merger or consolidation of bank holding companies.

 

The Corporation is required to file periodic reports with the FRB and provide any additional information as the FRB may require. The FRB also has the authority to examine the Corporation and the Bank, as well as any arrangements between the Corporation and the Bank, with the cost of any such examinations to be borne by the Corporation. The FRB has the power to order any bank holding company or its subsidiaries to terminate any activity or to terminate its ownership or control of any subsidiary when the FRB has reasonable grounds to believe that continuation of such activity or ownership constitutes a serious risk to the financial soundness, safety or stability of any bank subsidiary of the bank holding company.

 

Banking subsidiaries of bank holding companies are also subject to certain restrictions imposed by federal law in dealings with their holding companies and other affiliates. Subject to certain restrictions set forth in the Federal Reserve Act, a bank can loan or extend credit to an affiliate, purchase or invest in the securities of an affiliate, purchase assets from an affiliate or issue a guarantee, acceptance or letter of credit on behalf of an affiliate, as long as the aggregate amount of such transactions of a bank and its subsidiaries with its affiliates does not exceed 10 percent of the capital stock and surplus of the bank on a per affiliate basis or 20 percent of the capital stock and surplus of the bank on an aggregate affiliate basis. In addition, such transactions must be on terms and conditions that are consistent with safe and sound banking practices. In particular, a bank and its subsidiaries generally may not purchase from an affiliate a low-quality asset, as defined in the Federal Reserve Act. These restrictions also prevent a bank holding company and its other affiliates from borrowing from a banking subsidiary of the bank holding company unless the loans are secured by marketable collateral of designated amounts. Additionally, the Corporation and its subsidiary are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit, sale or lease of property or furnishing of services.

 

A bank holding company is prohibited from engaging in or acquiring direct or indirect ownership or control of more than 5% of the voting shares of any company engaged in non-banking activities. A bank holding company may, however, engage in or acquire an interest in a company that engages in activities which the FRB has determined by regulation or order are so closely related to banking as to be a proper incident to banking. In making these determinations, the FRB considers whether the performance of such activities by a bank holding company would offer advantages to the public that outweigh possible adverse effects.

 

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The Dodd-Frank Act.   On July 21, 2010, the Dodd-Frank Act was signed into law. The Dodd-Frank Act implements far-reaching changes across the financial regulatory landscape, and among other things includes the following:

 

·Creates a new consumer financial protection bureau that will have rulemaking authority for a wide range of consumer protection laws that would apply to all banks and have broad powers to supervise and enforce consumer protection laws.

 

·Changes standards for Federal preemption of state laws related to federally chartered institutions and their subsidiaries.

 

·Permanently increases the deposit insurance coverage to $250 thousand and provided unlimited federal deposit insurance for noninterest-bearing demand transaction accounts at all insured depository institutions through December 31, 2012, and allows depository institutions to pay interest on business checking accounts starting July 2011.

 

·Changes the assessment base for federal deposit insurance from the amount of insured deposits to consolidated assets less tangible capital, eliminates the ceiling on the size of the Deposit Insurance Fund (“DIF’), and increases the floor of the size of the DIF.

 

·Many aspects of the Dodd-Frank Act are subject to rulemaking and will take effect over several years, making it difficult to anticipate the overall financial impact on the Corporation, its subsidiaries, its customers or the financial industry more generally. Provisions in the legislation that affect the payment of interest on demand deposits and interchange fees are likely to increase the costs associated with deposits as well as place limitations on certain revenues those deposits may generate. Provisions in the legislation that revoke the Tier 1 capital treatment of trust preferred securities and otherwise require revisions to the capital requirements of the Corporation and the Bank could require the Corporation and the Bank to seek other sources of capital in the future. Some of the rules that have been proposed and, in some cases, adopted to comply with the Dodd-Frank Act’s mandates are discussed further below.

 

Dividends. There are both federal and state regulatory restrictions on dividend payments by both the Bank and the Corporation that may affect the Corporation’s ability to pay dividends on its common stock. As a bank holding company, the Corporation is a separate legal entity from the Bank. Virtually all of the Corporation’s income results from dividends paid to the Corporation by the Bank. The amount of dividends that may be paid by the Bank depends upon the Bank’s net income and capital position and is limited by federal and state law, regulations, and policies. In addition to specific regulations governing the permissibility of dividends, both the FRB and the Virginia Bureau of Financial Institutions are generally authorized to prohibit payment of dividends if they determine that the payment of dividends by the Bank would be an unsafe and unsound banking practice. The Corporation meets all regulatory requirements and began paying dividends in February 2006. The Corporation paid dividends totaling $9.8 million in 2012, which includes the special, non-routine cash dividend of $0.70 per share discussed in more detail under “Item 5 - Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities”.

 

Capital Requirements. The FRB, the Comptroller, and the FDIC have adopted risk-based capital adequacy guidelines for bank holding companies and banks pursuant to the Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”) and the Basel III Capital Accords. These capital adequacy regulations are based upon a risk-based capital determination, whereby a bank holding company’s capital adequacy is determined in light of the risk, both on and off-balance sheet, contained in the company’s assets. Different categories of assets are assigned risk weightings and are counted at a percentage of their book value.

 

The regulations divide capital between Tier 1 capital (core capital) and Tier 2 capital. For a bank holding company, Tier 1 capital consists primarily of common stock, related surplus, non-cumulative perpetual preferred stock, minority interests in consolidated subsidiaries, and a limited amount of qualifying cumulative preferred securities. Goodwill and certain other intangibles are excluded from Tier 1 capital. Further, as long as the Corporation has total consolidated assets of less than $15 billion, the Corporation may include in Tier 1 and total capital the Corporation’s trust preferred securities that were issued before May 19, 2010. Tier 2 capital consists of an amount equal to the allowance for loan and lease losses up to a maximum of 1.25% of risk-weighted assets, limited other types of preferred stock not included in Tier 1 capital, hybrid capital instruments, and term subordinated debt. Investments in and loans to unconsolidated banking and finance subsidiaries that constitute capital of those subsidiaries are excluded from capital. The sum of Tier 1 and Tier 2 capital constitutes qualifying total capital. The guidelines generally require banks to maintain a total qualifying capital to weighted risk assets level of 8% (the “Risk-based Capital Ratio”). Of the total 8%, at least 4% of the total qualifying capital to risk weighted assets (the “Tier 1 Risk-based Capital Ratio”) must be Tier 1 capital.

 

The FRB, the Comptroller, and the FDIC have adopted leverage requirements that apply in addition to the risk-based capital requirements. Banks and bank holding companies are required to maintain a minimum leverage ratio of Tier 1 capital to average total consolidated assets (the “Leverage Ratio”) of at least 3% for the most highly-rated, financially sound banks and bank holding companies and a minimum Leverage Ratio of at least 4% for all other banks. The FDIC and the FRB define Tier 1 capital for banks in the same manner for both the Leverage Ratio and the Risk-based Capital Ratio. However, the FRB defines Tier 1 capital for bank holding companies in a slightly different manner. An institution may be required to maintain Tier 1 capital of at least 4% or 5%, or possibly higher, depending upon the activities, risks, rate of growth, and other factors deemed material by regulatory authorities. As of December 31, 2012, the Corporation and Bank both met all applicable capital requirements imposed by regulation.

 

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Under the FDICIA, there are five capital categories applicable to insured institutions, each with specific regulatory consequences. If the appropriate federal banking agency determines, after notice and an opportunity for hearing, that an insured institution is in an unsafe or unsound condition, it may reclassify the institution to the next lower capital category (other than critically undercapitalized) and require the submission of a plan to correct the unsafe or unsound condition. The Comptroller has issued regulations to implement these provisions. Under these regulations, the categories are:

 

a.     Well Capitalized — The institution exceeds the required minimum level for each relevant capital measure. A well capitalized institution is one (i) having a Risk-based Capital Ratio of 10% or greater, (ii) having a Tier 1 Risk-based Capital Ratio of 6% or greater, (iii) having a Leverage Ratio of 5% or greater and (iv) that is not subject to any order or written directive to meet and maintain a specific capital level for any capital measure.

 

b.     Adequately Capitalized — The institution meets the required minimum level for each relevant capital measure. No capital distribution may be made that would result in the institution becoming undercapitalized. An adequately capitalized institution is one (i) having a Risk-based Capital Ratio of 8% or greater, (ii) having a Tier 1 Risk-based Capital Ratio of 4% or greater and (iii) having a Leverage Ratio of 4% or greater or a Leverage Ratio of 3% or greater if the institution is rated composite 1 under the CAMELS (Capital, Assets, Management, Earnings, Liquidity, and Sensitivity to market risk) rating system.

 

c.     Undercapitalized — The institution fails to meet the required minimum level for any relevant capital measure. An undercapitalized institution is one (i) having a Risk-based Capital Ratio of less than 8% or (ii) having a Tier 1 Risk-based Capital Ratio of less than 4% or (iii) having a Leverage Ratio of less than 4%, or if the institution is rated a composite 1 under the CAMEL rating system, a Leverage Ratio of less than 3%.

 

d.     Significantly Undercapitalized — The institution is significantly below the required minimum level for any relevant capital measure. A significantly undercapitalized institution is one (i) having a Risk-based Capital Ratio of less than 6% or (ii) having a Tier 1 Risk-based Capital Ratio of less than 3% or (iii) having a Leverage Ratio of less than 3%.

 

e.     Critically Undercapitalized — The institution fails to meet a critical capital level set by the appropriate federal banking agency. A critically undercapitalized institution is one having a ratio of tangible equity to total assets that is equal to or less than 2%.

 

An institution which is less than adequately capitalized must adopt an acceptable capital restoration plan, is subject to increased regulatory oversight, and is increasingly restricted in the scope of its permissible activities. Each company having control over an undercapitalized institution must provide a limited guarantee that the institution will comply with its capital restoration plan. Except under limited circumstances consistent with an accepted capital restoration plan, an undercapitalized institution may not grow. An undercapitalized institution may not acquire another institution, establish additional branch offices or engage in any new line of business unless determined by the appropriate federal banking agency to be consistent with an accepted capital restoration plan, or unless the FDIC determines that the proposed action will further the purpose of prompt corrective action. The appropriate Federal banking agency may take any action authorized for a significantly undercapitalized institution if an undercapitalized institution fails to submit an acceptable capital restoration plan or fails in any material respect to implement a plan accepted by the agency. A critically undercapitalized institution is subject to having a receiver or conservator appointed to manage its affairs and for loss of its charter to conduct banking activities.

 

An insured depository institution may not pay a management fee to a bank holding company controlling that institution or any other person having control of the institution if, after making the payment, the institution, would be undercapitalized. In addition, an institution cannot make a capital distribution, such as a dividend or other distribution that is in substance a distribution of capital to the owners of the institution if following such a distribution the institution would be undercapitalized. Thus, if payment of such a management fee or the making of such would cause the Bank to become undercapitalized, it could not pay a management fee or dividend to the Corporation.

 

As of December 31, 2012, both the Corporation and the Bank were considered “well capitalized.”

 

Basel III Capital Framework. In June 2012, the federal bank regulatory agencies proposed (i) rules to implement the Basel III capital framework as outlined by the Basel Committee on Banking Supervision, and (ii) rules for calculating risk-weighted assets. The federal bank regulatory agencies have delayed the implementation of Basel III and the new risk-weighted assets calculations to consider comments received on the proposed rules. The timing for the agencies’ publication of revised proposed rules regarding or final rules to implement Basel III and the new risk-weighted assets calculation is uncertain. Basel III, when implemented by the federal banking agencies and fully phased-in, will require bank holding companies and their bank subsidiaries to maintain substantially more capital, with a greater emphasis on common equity.

 

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The Basel III capital framework is anticipated to, among other things, (i) introduce as a new capital measure "Common Equity Tier 1" (“CET1”), (ii) specify that Tier 1 capital consists of CET1 and "Additional Tier 1 capital" instruments meeting specified requirements, (iii) define CET1 narrowly by requiring that most adjustments to regulatory capital measures be made to CET1 and not to the other components of capital and (iv) expand the scope of the adjustments as compared to existing regulations.

 

When fully phased in Basel III would require banks to maintain (i) as a newly adopted international standard, a minimum ratio of CET1 to risk-weighted assets of at least 4.5%, plus a 2.5% "capital conservation buffer" (which is added to the 4.5% CET1 ratio as that buffer is phased in, effectively resulting in a minimum ratio of CET1 to risk-weighted assets of at least 7%), (ii) a minimum ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus the capital conservation buffer (which is added to the 6.0% Tier 1 capital ratio as that buffer is phased in, effectively resulting in a minimum Tier 1 capital ratio of 8.5% upon full implementation), (iii) a minimum ratio of Total (that is, Tier 1 plus Tier 2) capital to risk-weighted assets of at least 8.0%, plus the capital conservation buffer (which is added to the 8.0% total capital ratio as that buffer is phased in, effectively resulting in a minimum total capital ratio of 10.5% upon full implementation) and (iv) as a newly adopted international standard, a minimum leverage ratio of 3%, calculated as the ratio of Tier 1 capital to balance sheet exposures plus certain off-balance sheet exposures (computed as the average for each quarter of the month-end ratios for the quarter).

 

Basel III will provide for a "countercyclical capital buffer," generally designed to absorb losses during periods of economic stress and to be imposed when national regulators determine that excess aggregate credit growth becomes associated with a buildup of systemic risk. The buffer would be a CET1 add-on to the capital conservation buffer in the range of 0% to 2.5% when fully implemented (potentially resulting in total buffers of between 2.5% and 5%).

 

The Basel III capital framework is also expected to provide for a number of new deductions from and adjustments to CET1. These include, for example, the requirement that mortgage servicing rights, deferred tax assets dependent upon future taxable income and significant investments in non-consolidated financial entities be deducted from CET1 to the extent that any one such category exceeds 10% of CET1 or all such categories in the aggregate exceed 15% of CET1.

 

Implementation of the deductions and other adjustments to CET1 are currently expected to be phased-in over a five-year period (20% per year). The implementation of the capital conservation buffer will begin at 0.625% and be phased in over a four-year period (increasing by that amount each year until it reaches 2.5%).

 

In connection with proposing rules to adopt the Basel III capital framework, the federal banking agencies also proposed revisions to the general rules for calculating a banking organization’s total risk-weighted assets (the denominator for risk-based capital ratios) (such revisions, the “Standardized Approach”). If adopted as proposed, the Standardized Approach would modify the risk-weightings that are applied to many classes of assets held by community banks, including, importantly, the application of higher risk-weightings to certain “higher risk” mortgage loans and commercial real estate loans that are frequently held in a community bank’s loan portfolio.

 

The regulations ultimately implemented may be substantially different from the Basel III proposed rules that were issued in June 2012. Requirements to maintain higher levels of capital or to maintain higher levels of liquid assets could adversely impact the Corporation’s net income and return on equity.

 

Deposit Insurance. The Bank's deposits are insured up to applicable limits by the DIF of the FDIC. In November 2010, the FDIC issued a Final Rule implementing section 343 of the Dodd-Frank Act that provides for unlimited insurance coverage of certain noninterest-bearing accounts. Beginning December 31, 2010, through December 31, 2012, all noninterest-bearing transaction accounts were fully insured, regardless of the balance of the account, at all FDIC-insured institutions. The unlimited insurance coverage was available to all depositors, including consumers, businesses, and government entities. This unlimited insurance coverage was separate from, and in addition to, the insurance coverage provided to a depositor’s other deposit accounts held at an FDIC-insured institution. On December 31, 2012, the unlimited insurance coverage for noninterest-bearing transaction accounts expired. Depositors are now limited to the insurance thresholds established by the FDIC.

 

The FDIC has set a designated reserve ratio of 1.35% ($1.35 for each $100 of insured deposits) for the DIF to be reached by September 30, 2020 as required by the Dodd-Frank Act. The Federal Deposit Insurance Act of 2005 (“FDIC Act”) provides the FDIC Board of Directors the authority to set the designated reserve ratio between 1.15% and 1.50%. The FDIC must adopt a restoration plan when the reserve ratio falls below 1.15% and begin paying dividends when the reserve ratio exceeds 1.35%. The DIF reserve ratio calculated by the FDIC at June 30, 2012 was 0.32%, up from the 0.17% calculated at December 31, 2011 and the negative 0.12% calculated at December 31, 2010. The FDIC staff project the DIF reserve ratio will reach 1.15% by the end of 2018.

 

On November 12, 2009, the FDIC adopted a final rule requiring depository institutions to prepay their estimated quarterly insurance premium for fourth quarter 2009 and all of 2010, 2011 and 2012. The Bank prepaid $2.8 million of such premium on December 30, 2009 and $1.4 million remained as a prepaid balance at December 31, 2012. This amount is scheduled to be reduced further by our first and second quarter risk-based deposit insurance assessment with any remaining funds to be returned by the FDIC in June 2013.

 

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In February 2011, the FDIC approved a final rule that changes the assessment base from domestic deposits to average consolidated total assets minus average tangible equity (defined as Tier 1 capital); adopts a new large-bank pricing assessment scheme; and sets a target size for the DIF. The changes went into effect beginning with the second quarter of 2011 and were payable at the end of September 2011. As such, the first quarter of 2011 saw average annual assessment rates of approximately 17.6 cents per $100. The last three quarters of 2011 saw the average assessment rate drop to approximately 11.1 cents per $100. The rule, as mandated by the Dodd-Frank Act, finalizes a target size for the DIF at 2 percent of insured deposits. It also implements a lower assessment rate schedule when the fund reaches 1.15 percent and, in lieu of dividends, provides for a lower rate schedule when the reserve ratio reaches 2 percent and 2.5 percent.

 

Financial Holding Company Status. As provided by the Gramm-Leach-Bliley Act of 1999 (the “GLBA”) , a bank holding company may become eligible to engage in activities that are financial in nature or incidental or complimentary to financial activities by qualifying as a financial holding company. To qualify as a financial holding company, each insured depository institution controlled by the bank holding company must be well-capitalized, well-managed and have at least a satisfactory rating under the CRA. In addition, the bank holding company must file with the FRB a declaration of its intention to become a financial holding company. While the Corporation satisfies these requirements, the Corporation has not elected for various reasons to be treated as a financial holding company under the GLBA.

 

We do not believe that the GLBA has had a material adverse impact on the Corporation’s or the Bank’s operations. To the extent that it allows banks, securities firms and insurance firms to affiliate, the financial services industry may experience further consolidation. The GLBA may have the result of increasing competition that we face from larger institutions and other companies offering financial products and services, many of which may have substantially greater financial resources.

 

Confidentiality and Required Disclosures of Financial Information. The Corporation is subject to various laws and regulations that address the privacy of nonpublic personal financial information of consumers. The GLBA and certain other regulations issued thereunder protect against the transfer and use by financial institutions of consumer nonpublic personal information. A financial institution must provide to its customers, at the beginning of the customer relationship and annually thereafter, the institution’s policies and procedures regarding the handling of customers’ nonpublic personal financial information. These privacy provisions generally prohibit a financial institution from providing a customer’s personal financial information to unaffiliated third parties unless the institution discloses to the customer that the information may be so provided and the customer is given the opportunity to opt out of such disclosure.

 

The Corporation is subject to various laws and regulations that attempt to combat money laundering and terrorist financing. The Bank Secrecy Act requires all financial institutions to, among other things, create a system of controls designed to prevent money laundering, the financing of terrorism, and imposes recordkeeping and reporting requirements. The USA Patriot Act provides for the facilitation of information sharing among governmental entities and financial institutions for the purpose of combating terrorism and money laundering. Certain provisions of the USA PATRIOT Act impose the obligation to establish anti-money laundering programs. The Federal Bureau of Investigation (“FBI”) has sent, and will send, our banking regulatory agencies lists of the names of persons suspected of involvement in terrorist activities. The Bank has been requested, and will be requested, to search its records for any relationships or transactions with persons on those lists. If the Bank finds any relationships or transactions, it must file a suspicious activity report and contact the FBI. The Office of Foreign Assets Control (“OFAC”), which is a division of the U.S. Treasury, is responsible for helping to insure that United States entities do not engage in transactions with “enemies” of the United States, as defined by various Executive Orders and Acts of Congress. OFAC has sent, and will send, our banking regulatory agencies lists of names of persons and organizations suspected of aiding, harboring or engaging in terrorist acts, and publicly releases information on designations of persons and organizations suspected of engaging in these activities. If the Bank finds a name on any transaction, account or wire transfer that is on an OFAC list, it must freeze such account, file a suspicious activity report and notify the FBI.

 

Although these laws and programs impose compliance costs and create privacy and reporting obligations, these laws and programs do not materially affect the Bank’s products, services or other business activities.

 

Community Reinvestment Act.  The Bank is subject to the requirements of CRA. The CRA imposes on financial institutions an affirmative and ongoing obligation to meet the credit needs of their local communities, including low and moderate-income neighborhoods, consistent with the safe and sound operation of those institutions. A financial institution’s efforts in meeting community credit needs currently are evaluated as part of the examination process pursuant to three performance tests. These factors also are considered in evaluating mergers, acquisitions, and applications to open a branch or facility.

 

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Federal Home Loan Bank (“FHLB”) of Atlanta. The Bank is a member of the FHLB of Atlanta, which is one of twelve regional FHLBs that provide funding to their members for making housing loans as well as for affordable housing and community development lending. Each FHLB serves as a reserve or central bank for its members within its assigned region. It is funded primarily from proceeds derived from the sale of consolidated obligations of the FHLB System. It makes loans to members (i.e., advances) in accordance with policies and procedures established by the Board of Directors of the FHLB. As a member the Bank is required to purchase and maintain stock in the FHLB in an amount equal to 4.5% of aggregate outstanding advances in addition to the membership stock requirement of 0.15% of the Bank’s total assets. The FHLB has announced the membership stock requirement will reduce to 0.12% as of March 2013.

 

Mortgage Banking Regulation. The Mortgage Division is subject to the rules and regulations of, and examination by, HUD, the Federal Housing Administration, the Department of Veterans Affairs, and state regulatory authorities with respect to originating, processing, and selling mortgage loans. Those rules and regulations, among other things, establish standards for loan origination, prohibit discrimination, provide for inspections and appraisals of property, require credit reports on prospective borrowers, and, in some cases, restrict certain loan features and fix maximum interest rates and fees. In addition to other federal laws, mortgage origination activities are subject to the Equal Credit Opportunity Act, Truth-in-Lending Act, Home Mortgage Disclosure Act, Real Estate Settlement Procedures Act, and Home Ownership Equity Protection Act, and the regulations promulgated there under. These laws prohibit discrimination, require the disclosure of certain basic information to mortgagors concerning credit and settlement costs, limit payment for settlement services to the reasonable value of the services rendered, and require the maintenance and disclosure of information regarding the disposition of mortgage applications based on race, gender, geographical distribution, and income level.

 

Consumer Laws and Regulations. The Bank is also subject to certain consumer laws and regulations that are designed to protect consumers in transactions with banks. While the list set forth herein is not exhaustive, these laws and regulations include the Truth in Lending Act, the Truth in Savings Act, the Electronic Funds Transfer Act, the Expedited Funds Availability Act, the Equal Credit Opportunity Act, the Fair Credit Reporting Act, and the Fair Housing Act, among others. These laws and regulations mandate certain disclosure requirements and regulate the manner in which financial institutions transact business with customers. The Bank must comply with the applicable provisions of these consumer protection laws and regulations as part of its ongoing customer relations.

 

Temporary Liquidity Guarantee Program. On November 21, 2008, the Board of Directors of the FDIC adopted a final rule relating to the Temporary Liquidity Guarantee Program (“TLG Program”). The TLG Program was announced by the FDIC on October 14, 2008, preceded by the determination of systemic risk by the Secretary of the Department of Treasury (after consultation with the President), as an initiative to counter the system-wide crisis in the nation’s financial sector. Under the TLG Program the FDIC will (i) guarantee, through the earlier of maturity or December 31, 2012, certain newly issued senior unsecured debt issued by participating institutions on or after October 14, 2008, and before October 31, 2009 and (ii) provide full FDIC deposit insurance coverage for noninterest-bearing transaction deposit accounts, Negotiable Order of Withdrawal (“NOW”) accounts paying less than 0.5% interest per annum and Interest on Lawyers Trust Accounts held at participating FDIC insured institutions through June 30, 2010, extended by subsequent amendment from December 31, 2009. Coverage under the TLG Program was available for the first 30 days without charge. The fee assessment for coverage of senior unsecured debt ranges from 50 basis points to 125 basis points per annum, depending on the initial maturity of the debt and its date of issuance. The fee assessment for deposit insurance coverage on amounts in covered accounts exceeding $250,000 was an annualized 10 basis points through December 31, 2009 and was an annualized 15 basis points for coverage in 2010 for institutions in risk category 1. The Bank elected to participate in both guarantee programs. On February 11, 2009 the Bank issued $30.0 million in new senior unsecured debt at 2.74% maturing February 15, 2012 under the TLG Program. The proceeds to the Bank from the issuance of senior unsecured debt under the TLGP were used to repay FHLB short term borrowings and to provide additional liquidity. The Bank repaid the debt at maturity on February 15, 2012.

 

Incentive Compensation. The FRB, the Comptroller and the FDIC issued regulatory guidance intended to ensure that the incentive compensation policies of banking organizations do not undermine the safety and soundness of such organizations by encouraging excessive risk-taking.

 

The FRB will review, as part of the regular, risk-focused examination process, the incentive compensation arrangements of banking organizations, such as the Corporation, that are not “large, complex banking organizations.” The findings will be included in reports of examination and deficiencies will be incorporated into the organization's supervisory ratings. Enforcement actions may be taken against a banking organization if its incentive compensation arrangements, or related risk-management control or governance processes, pose a risk to the organization's safety and soundness and the organization is not taking prompt and effective measures to correct the deficiencies.

 

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The Dodd-Frank Act requires the SEC and the federal bank regulatory agencies to establish joint regulations or guidelines that require financial institutions with assets of at least $1 billion to disclose the structure of their incentive compensation practices and prohibit such institutions from maintaining compensation arrangements that encourage inappropriate risk-taking by providing excessive compensation or that could lead to material financial loss to the financial institution. The SEC and the federal bank regulatory agencies proposed such regulations in March 2011. If the regulations are adopted in the form initially proposed, they will impose limitations on the manner in which the Corporation may structure compensation for its executives only if the Corporation’s total consolidated assets exceed $1 billion. These proposed regulations incorporate the principles discussed in the Incentive Compensation Guidance.

 

Stress Testing. As required by the Dodd-Frank Act, the federal banking agencies have implemented stress testing requirements for certain financial institutions, including bank holding companies and state chartered banks, with more than $10 billion in total consolidated assets. Although these requirements do not apply to institutions with $10 billion or less in total consolidated assets, the federal banking agencies, including the Comptroller, emphasize that all banking organizations, regardless of size, should have the capacity to analyze the potential impact of adverse market conditions or outcomes on the organization’s financial condition. Based on existing regulatory guidance, the Corporation and the Bank will be expected to consider the institution’s interest rate risk management, commercial real estate concentrations and other credit-related information, and funding and liquidity management during this analysis of adverse outcomes.

 

ITEM 1A – RISK FACTORS

 

Risks Related to the Corporation’s Business

 

Our future success will depend on our ability to compete effectively in the highly competitive financial services industry in Northern Virginia.

 

We face substantial competition in all phases of our operations from a variety of different competitors. In particular, there is very strong competition for financial services in Northern Virginia and the greater Washington, D.C. Metropolitan Area in which we conduct a substantial portion of our business. We compete with commercial banks, credit unions, savings and loan associations, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market funds and other mutual funds, as well as other local and community, super-regional, national and international financial institutions that operate offices in our primary market areas and elsewhere. Our future growth and success will depend on our ability to compete effectively in this highly competitive financial services environment. Many of our competitors are well-established, larger financial institutions and many offer products and services that we do not. Many have substantially greater resources, name recognition and market presence that benefit them in attracting business. Some of our competitors are not subject to the same regulation as is imposed on bank holding companies and federally-insured national banks, including credit unions which do not pay federal income tax, and, therefore, have regulatory advantages over us in accessing funding and in providing various services. While we believe we compete effectively with these other financial institutions in our primary markets, we may face a competitive disadvantage as a result of our smaller size, smaller asset base, lack of geographic diversification and inability to spread our marketing costs across a broader market. If we have to raise interest rates paid on deposits or lower interest rates charged on loans to compete effectively, our net interest margin and income could be negatively affected. Failure to compete effectively to attract new or to retain existing clients may reduce or limit our net income and our market share and may adversely affect our results of operations, financial condition and growth.

 

Our profitability depends on interest rates generally, and we may be adversely affected by changes in government monetary policy or by fluctuations in interest rates.

 

Our profitability depends in substantial part on our net interest margin, which is the difference between the rates we receive on loans and investments and the rates we pay for deposits and other sources of funds. Our net interest margin depends on many factors that are partly or completely outside of our control, including competition, federal economic, monetary and fiscal policies, and economic conditions generally. Our net interest income will be adversely affected if market interest rates change so that the interest we pay on deposits and borrowings increases faster than the interest we earn on loans and investments.

 

Changes in interest rates, particularly by the Board of Governors of the FRB, which implements national monetary policy in order to mitigate recessionary and inflationary pressures, also affect the value of our loans. In setting its policy, the FRB may utilize techniques such as: (i) engaging in open market transactions in United States government securities; (ii) setting the discount rate on member bank borrowings; and (iii) determining reserve requirements. These techniques may have an adverse effect on our deposit levels, net interest margin, loan demand or our business and operations. In addition, an increase in interest rates could adversely affect borrowers’ ability to pay the principal or interest on existing loans or reduce their desire to borrow more money. This may lead to an increase in our non-performing assets, a decrease in loan originations, or a reduction in the value of and income from our loans, any of which could have a material and negative effect on our results of operations. We try to minimize our exposure to interest rate risk, but we are unable to completely eliminate this risk. Fluctuations in market rates and other market disruptions are neither predictable nor controllable and may have a material and negative effect on our business, financial condition and results of operations. In addition, the FRB’s Federal Open Market Committee has stated that it expects to keep the federal funds target rate at 0% - 0.25% through 2015 or until economic and labor conditions (as indicated by the unemployment rate) improve. Even though such a continuance of accommodative monetary policy could allow the Corporation to continue to reprice fixed-rate deposits to lower rates, sustained low interest rates could put further pressure on the yields generated by the Corporation’s loan portfolio and on the Corporation’s net interest margin.

 

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At December 31, 2012 approximately 71% of the loans held for investment were variable rate loans. A majority of these loans are based on the prime rate and will adjust upwards as the prime rate increases. While the variable rate structure on these loans reduces interest rate risk for the Bank, increases in rates may cause the borrower’s required payment to increase which, in turn, may increase the risk of payment default.

 

Because we make loans primarily to local small and medium sized businesses, our profitability depends significantly on local economic conditions, particularly real estate values, and the success of those businesses.

 

As a lender, we are exposed to the risk that our loan clients may not repay their loans according to their terms and any collateral securing payment may be insufficient to fully compensate us for the outstanding balance of the loan plus the costs we incur disposing of the collateral. Although we have collateral for most of our loans, that collateral can fluctuate in value and may not always cover the outstanding balance on the loan. With most of our loans concentrated in Northern Virginia, a decline in local economic conditions could adversely affect the values of our real estate collateral. Consequently, a decline in local economic conditions may have a greater effect on our net income and capital than on the net income and capital of larger financial institutions whose real estate loan portfolios are more geographically diverse.

 

In addition to assessing the financial strength and cash flow characteristics of each of our borrowers, the Bank often secures loans with real estate collateral. At December 31, 2012, approximately 75% of our Bank’s loans held for investment have real estate as a primary or secondary component of collateral. The real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower and may deteriorate in value during the time the credit is extended. If we are required to liquidate the collateral securing a loan to satisfy the debt during a period of reduced real estate values, our net income and capital could be adversely affected.

 

The effect of sequestration cuts to the federal budget which began on March 1, 2013 may have an adverse impact to our market area due to our proximity to the federal government and the concentration of business clientele working with or for the federal government. The ultimate impact is yet to be determined as much is still unknown as to the length or depth of reductions that will affect our business and geographical area.

 

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

 

We intend to continue to grow in our existing banking markets (internally and through additional offices) and to expand into new markets as appropriate opportunities arise. Our prospects must be considered in light of the risks, expenses and difficulties frequently encountered by companies that are experiencing growth. We cannot assure you we will be able to expand our market presence in our existing markets or successfully enter new markets, or that any expansion will not adversely affect our results of operations. Failure to manage our growth effectively could have a material adverse effect on our business, future prospects, financial condition or results of operations, and could adversely affect our ability to successfully implement our business strategy. Also, if our growth occurs more slowly than anticipated or declines, our operating results could be materially affected in an adverse way. Our ability to successfully grow will depend on a variety of factors, including the continued availability of desirable business opportunities, the competitive responses from other financial institutions in our market areas and our ability to manage our growth. While we believe we have the management resources and internal systems in place to successfully manage our future growth, there can be no assurance growth opportunities will be available or growth will be successfully managed.

 

Although we have made a limited number of acquisitions, we may face a broad range of risks in connection with future acquisitions that could result in those acquisitions not increasing shareholder value.

 

As a strategy, we have sought to increase the size of our business by pursuing business development opportunities, and we have grown rapidly since our incorporation. As part of that strategy, we have acquired three mortgage companies, a wealth management company, and a small equipment leasing company. We may acquire other financial institutions and mortgage companies, or parts of those entities, in the future. Acquisitions and mergers involve a number of risks, including:

 

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·the time and costs associated with identifying and evaluating potential acquisitions and merger partners;

 

·the estimates and judgments used to evaluate credit, operations, management and market risks with respect to the target entity may not be accurate;

 

·the time and costs of evaluating new markets, hiring experienced local management and opening new offices, and the time lags between these activities and the generation of sufficient assets and deposits to support the costs of the expansion;

 

·our ability to finance an acquisition and possible ownership or economic dilution to our current shareholders;

 

·the diversion of our management’s attention to the negotiation of a transaction, and the integration of the operations and personnel of the combining businesses;

 

·entry into new markets where we lack experience;

 

·the introduction of new products and services into our business;

 

·the incurrence and possible impairment of goodwill associated with an acquisition and possible adverse short-term effects on our results of operations; and

 

·the potential loss of key employees and clients.

 

We may incur substantial costs to expand, and we can give no assurance such expansion will result in the levels of profits we seek. There can be no assurance that integration efforts for any future mergers or acquisitions will be successful. Also, we may issue equity securities, including common stock and securities convertible into shares of our common stock, in connection with future acquisitions, which could cause ownership and economic dilution to our current shareholders. There is no assurance that, following any future merger or acquisition, our integration efforts will be successful or our company, after giving effect to the acquisition, will achieve profits comparable to or better than our historical experience.

 

Our allowance for loan losses could become inadequate and reduce our net income and capital.

 

We maintain an allowance for loan losses that we believe is adequate for absorbing any potential losses in our loan portfolio. Management conducts a periodic review and consideration of the loan portfolio to determine the amount of the allowance for loan losses based upon general market conditions, credit quality of the loan portfolio and performance of our clients relative to their financial obligations with us. The amount of future losses, however, is susceptible to changes in borrowers’ circumstances and economic and other market conditions, including changes in interest rates and collateral values that are beyond our control, and these future losses may exceed our current estimates. Our allowance for loan losses at December 31, 2012 was $12.5 million. Although we believe the allowance for loan losses is adequate to absorb probable losses in our loan portfolio, we cannot predict such losses or guarantee that our allowance will be adequate in the future. Excessive loan losses could have a material impact on our financial performance and reduce our net income and capital.

 

Our future liquidity needs could exceed our available liquidity sources, which could limit our asset growth and adversely affect our results of operations and financial condition.

 

We rely on dividends from the Bank as our primary source of funds. The primary sources of funds of the Bank are client deposits and loan repayments. While scheduled loan repayments are a relatively stable source of funds, they are subject to the ability of borrowers to repay the loans. The ability of borrowers to repay loans can be adversely affected by a number of factors, including changes in economic conditions, adverse trends or events affecting business industry groups, reductions in real estate values or markets, business closings or lay-offs, inclement weather, natural disasters and international instability. Additionally, deposit levels may be affected by a number of factors, including rates paid by competitors, general interest rate levels, regulatory capital requirements, returns available to clients on alternative investments and general economic conditions. Accordingly, we may be required from time to time to rely on secondary sources of liquidity to meet withdrawal demands or otherwise fund operations. Such sources include FHLB advances, sales of securities and loans, and federal funds lines of credit from correspondent banks, as well as out-of-market time deposits. While we believe that these sources are currently adequate, there can be no assurance they will be sufficient to meet future liquidity demands, particularly if we continue to grow and experience increasing loan demand. We may be required to slow or discontinue loan growth, capital expenditures or other investments or liquidate assets should such sources not be adequate.

 

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We are subject to extensive regulation that could limit or restrict our activities and adversely affect our net income.

 

We operate in a highly regulated industry, and both the Corporation and the Bank are subject to extensive regulation and supervision by the FRB, the Comptroller, and the FDIC. Our compliance with these regulations is costly and restricts certain of our activities, including payment of dividends, mergers and acquisitions, investments, loans and interest rates charged, interest rates paid on deposits and locations of offices. We are also subject to capitalization guidelines established by our regulators, which require us to maintain adequate capital to support our growth. Many of these regulations are intended to protect depositors and the FDIC’s DIF rather than our shareholders.

 

SOX, and the related rules and regulations promulgated by the SEC and NASDAQ that are applicable to us, have increased the scope, complexity and cost of corporate governance, reporting and disclosure practices, including the cost of completing our audit and maintaining our internal controls. As a result, we may experience greater compliance costs.

 

Congress and federal regulatory agencies continually review banking laws, regulations and policies for possible changes. Changes to statutes, regulations or regulatory policies, including changes in interpretation or implementation of statutes, regulations or policies, could affect the Corporation in substantial and unpredictable ways. Such changes could subject the Corporation to additional costs, limit the types of financial services and products the Corporation may offer and/or increase the ability of non-banks that are not subject to similar regulation to offer competing financial services and products, which could place these non-banks in stronger, more favorable competitive positions and which could adversely affect the Corporation’s growth and ability to operate profitably. Failure to comply with laws, regulations or policies could result in sanctions by regulatory agencies, civil money penalties and/or reputation damage, which could have a material adverse effect on the Corporation’s business, financial condition and results of operations.

 

The Dodd-Frank Act has increased the Corporation’s regulatory compliance burden and associated costs, placed restrictions on certain products and services, and limited its future capital raising strategies.  

 

A wide range of regulatory initiatives directed at the financial services industry has been proposed in recent years. One of those initiatives, the Dodd-Frank Act, was enacted in 2010 and mandates significant changes in the financial regulatory landscape that will impact all financial institutions, including the Corporation and the Bank.  The Dodd-Frank Act has increased the Corporation’s regulatory compliance burden and may have a material adverse effect on the Corporation by increasing the costs associated with regulatory examinations and compliance measures. However, it is too early to fully assess the impact of the Dodd-Frank Act and subsequent regulatory rulemaking processes on the Corporation’s and the Bank’s business, financial condition or results of operations.

 

Among the Dodd-Frank Act’s significant regulatory changes, the Act creates a new financial consumer protection agency that has the authority to impose new regulations and include its examiners in routine regulatory examinations conducted by the Comptroller. This agency, named the Consumer Financial Protection Bureau (“CFPB”), may reshape the consumer financial laws through rulemaking and enforcement of the Dodd-Frank Act’s prohibitions against unfair, deceptive and abusive business practices, which may directly impact the business operations of financial institutions offering consumer financial products or services, including the Corporation and the Bank.  This agency’s broad rulemaking authority includes identifying practices or acts that are unfair, deceptive or abusive in connection with any consumer financial transaction or consumer financial product or service.  Although the CFPB has jurisdiction over banks with $10 billion or greater in assets, rules, regulations and policies issued by the CFPB may also apply to the Corporation, the Bank and/or the Mortgage Division by virtue of the adoption of such policies and best practices by the FRB, Comptroller and FDIC.  The costs and limitations related to this additional regulatory agency and the limitations and restrictions that may be placed upon the Corporation with respect to its consumer product and service offerings have yet to be determined.  However, these costs, limitations and restrictions may produce significant, material effects on the Corporation’s business, financial condition and results of operations.

  

The Dodd-Frank Act also increases regulatory supervision and examination of bank holding companies and their banking and non-banking subsidiaries. These and other regulations included in the Dodd-Frank Act could increase the Corporation’s regulatory compliance burden and costs, restrict the financial products and services the Corporation can offer to its customers and restrict the Corporation’s ability to generate revenues from non-banking operations. The Dodd-Frank Act imposes more stringent capital requirements on bank holding companies, which may cause the Corporation to reevaluate elements of its business focus and shape future capital strategies.

 

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The Basel III capital framework could require higher levels of capital and liquid assets, which could adversely affect the Corporation’s net income and return on equity.

 

The Basel III capital framework, when implemented by the U.S. banking agencies and fully phased-in, would represent the most comprehensive overhaul of the U.S. banking capital framework in over two decades. The proposed Basel III capital framework and related changes to the standardized calculations of risk-weighted assets are complex and would create enormous compliance burdens, especially for community banks. These proposed regulations would require bank holding companies and their subsidiaries, such as the Corporation and the Bank, to maintain substantially more capital as a result of higher required capital levels and more demanding regulatory capital risk-weightings and calculations. The proposals would require all banks to substantially change the manner in which they collect and report information to calculate risk-weighted assets, and would likely increase risk-weighted assets at many banking organizations as a result of applying higher risk-weightings to many types of loans and securities. As a result, banks may be forced to limit originations of certain types of commercial and mortgage loans, thereby reducing the amount of credit available to borrowers and limiting opportunities to earn interest income from the loan portfolio.

 

If the proposed changes to bank capital levels and the calculation of risk-weighted assets are implemented without change, many banks could be required to access the capital markets on short notice and in relatively weak economic conditions, which could result in banks raising capital that significantly dilutes existing shareholders. Additionally, many community banks could be force to limit banking operations and activities, and growth of loan portfolios and interest income, in order to focus on retention of earnings to improve capital levels. The regulations ultimately applicable to the Corporation and the Bank may be substantially different from the proposed rules to implement the Basel III capital framework and revised calculations of risk-weighted assets. However, the final regulations may have a detrimental effect on the Corporation net income and return on equity and limit the products and services it provides to its customers.

 

Our hedging strategies do not completely eliminate risks associated with interest rates and we may incur losses due to changes in interest rates that are not effectively hedged.

 

We use various derivative financial instruments to provide a level of protection against interest rate risks, but no hedging strategy can protect us completely, and we cannot assure you that our hedging strategy and use of derivatives will offset the risks related to changes in interest rates. When rates change, we expect to record a gain or loss on derivatives that would be offset by an inverse change in the value of loans held for sale and mortgage-related securities. We utilize a third party consulting firm to manage our hedging activities and we typically hedge 80% of our loan pipeline and 100% of our loans being warehoused. The derivative financial instruments used to hedge the interest rate risk of our loan pipeline and warehoused loans are forward sales of 15 year and 30 year mortgage backed securities. The notional amount and fair value of these derivatives are disclosed in Note 8 of the financial statements on page 67.

 

The primary risks related to our hedging activities relate to incorrect assumptions regarding pull through and the amount of the pipeline being hedged. A hedging policy and hedging management committee are in place to control, monitor and manage risks associated with our hedging activity. The hedging policy quantifies risk tolerance thresholds that ensure the economic risk taken is not material to the Corporation’s financial condition or operating performance. See “Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations — Critical Accounting Policies” and “Item 7A - Quantitative and Qualitative Disclosures About Market Risk.”

 

The profitability of the Mortgage Division will be significantly reduced if we are not able to sell mortgages.

 

Currently, we generally sell all of the mortgage loans originated by the Mortgage Division. We only underwrite mortgages that we reasonably expect will have more than one potential purchaser. The profitability of our Mortgage Division depends in large part upon our ability to originate or purchase a high volume of loans and to quickly sell them in the secondary market. Thus, we are dependent upon (i) the existence of an active secondary market and (ii) our ability to sell loans into that market.

 

The Mortgage Division’s ability to sell mortgage loans readily is dependent upon the availability of an active secondary market for single-family mortgage loans, which in turn depends in part upon the continuation of programs currently offered by Fannie Mae and Freddie Mac and other institutional and non-institutional investors. These entities account for a substantial portion of the secondary market in residential mortgage loans. Some of the largest participants in the secondary market, including Fannie Mae and Freddie Mac, are government-sponsored enterprises with substantial market influence whose activities are governed by federal law. Any future changes in laws that significantly affect the activity of these government-sponsored enterprises and other institutional and non-institutional investors or any impairment of our ability to participate in such programs could, in turn, adversely affect our operations.

 

Fannie Mae and Freddie Mac have reported past substantial losses and a need for substantial amounts of additional capital. Such losses are due to these entities’ business models being tied extensively to the U.S. housing market which has been in a severe contraction. In response to the deteriorating financial condition of Fannie Mae and Freddie Mac from the U.S. housing market contraction, Congress and the U.S. Treasury have undertaken a series of actions to stabilize these entities. The Federal Housing Finance Agency, or FHFA, was established in July 2008 pursuant to the Regulatory Reform Act in an effort to enhance regulatory oversight over Fannie Mae and Freddie Mac. FHFA placed Fannie Mae and Freddie Mac into federal conservatorship in September 2008. Although the federal government has committed capital to Fannie Mae and Freddie Mac, there is no explicit guaranty of the obligations of these entities by the federal government and there can be no assurance that these government credit facilities and other capital infusions will be adequate for the needs of Fannie Mae and Freddie Mac. If the financial support is inadequate, these companies could continue to suffer losses and could fail to offer programs necessary to an active secondary market. If this were to occur, the Mortgage Division’s ability to sell mortgage loans readily could be hampered, and the profitability of the Bank could be significantly reduced.

 

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On February 11, 2011, the U.S. Treasury issued a White Paper titled “Reforming America's Housing Finance Market” (or the “White Paper”) that lays out, among other things, proposals to limit or potentially wind down the role that Fannie Mae and Freddie Mac play in the mortgage market. Any such proposals, if enacted, may have broad adverse implications for the residential mortgage market, the mortgage-backed securities market and the Mortgage Division’s business, operations and financial condition. Such proposals have been, and we expect them to continue to be, the subject of significant discussion, and it is not yet possible to determine whether such proposals will be enacted and, if so, when, what form any final legislation or policies might take and how proposals, legislation or policies emanating from the White Paper may impact the residential mortgage market, the mortgage-backed securities market and the Mortgage Division’s business, operations and financial condition. We are evaluating, and will continue to evaluate, the potential impact of the proposals set forth in the White Paper on our business and our financial position and results of operations.

 

Our net income may be adversely affected if representations and warranties related to loans sold by the Mortgage Division are breached and we must pay related claims.

 

The Mortgage Division makes representations and warranties that loans sold to investors meet their program’s guidelines and that the information provided by the borrowers is accurate and complete and that the loan documents are complete and executed by the borrowers. In the event of a default on a loan sold, the investor may make a claim for losses due to document deficiencies, program compliance, early payment default, and fraud or borrower misrepresentations. During the fourth quarter of 2012, the Mortgage Division reached a settlement arrangement with one of its investors wherein a payment of $750 thousand was made to release the Bank from known and unknown repurchase obligations associated with approximately $252 million of mortgage loans. During the fourth quarter of 2010, while the Mortgage Division was still operating as a separate company, settlement arrangements were reached with two additional investors and payments totaling $3.8 million were made to release the company from known and unknown repurchase obligations associated with approximately $3 billion of mortgage loans. The Mortgage Division maintains a reserve in other liabilities for potential losses on mortgage loans sold. Net income may be impacted if this reserve is insufficient to cover claims from the investors.

 

An economic downturn may adversely affect our operating results and financial condition because our small to medium sized business target market may have fewer financial resources to weather an economic downturn.

 

We target our commercial development and marketing strategy primarily to serve the banking and financial services needs of small and medium sized businesses. These businesses generally have fewer financial resources in terms of capital or borrowing capacity than larger entities. If general economic conditions negatively impact this economic sector in the markets in which we operate, our results of operations and financial condition may be adversely affected.

 

Negative public opinion could damage our reputation and the strength of our Access National brand and adversely impact our business, client relationships and net income.

 

Reputation risk, or the risk to our businesses’ (including our primary commercial banking business and secondary mortgage lending business) net income and capital from negative public opinion, is inherent in our business. Negative public opinion can result from our actual or alleged conduct in any number of activities, including lending practices, corporate governance and acquisitions, and from actions taken by government regulators and community organizations in response to those activities. Negative public opinion can adversely affect our ability to keep and attract clients and employees and can expose us to litigation and regulatory action.

 

Virtually all of our businesses operate under the “Access National” brand. Any actual or alleged conduct by one of our businesses could result in negative public opinion about our other businesses under the Access National brand. Because our businesses rely on and leverage the strength of the Access National brand any negative public opinion that tarnishes our Access National brand may negatively impact our business, client relationships and financial performance. Although we take steps to minimize our reputation risk in dealing with our clients and communities, due to the nature of the commercial banking and mortgage lending businesses we will always face some measure of reputational risk.

 

If recent government actions do not help stabilize the U.S. financial system, the financial condition of our target markets may suffer, which could adversely affect our business.

 

In response to the financial crises affecting the banking system and financial markets and going concern threats to investment banks and other financial institutions, various branches and agencies of the U.S. government have put in place laws, regulations, and programs to address capital and liquidity issues in the banking system. There can be no assurance, however, as to the actual impact that such laws, regulations, and programs will have on the financial markets.

 

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Among many other contributing factors, the recent recession was triggered by instability of financial institutions and large measures of volatility and fear in the financial markets. This financial instability led to an economic downturn which, in turn, has harmed the financial condition and performance of our small to medium sized business target market. If such laws, regulations, and programs fail to help stabilize the financial markets, or recent financial market conditions deteriorate rather than improve or remain steady, the financial condition of our small to medium sized business target market would suffer and could materially and adversely affect our business, financial condition, results of operations, and the trading price of our common stock.

 

Significant reductions in U.S. government spending may have an adverse effect on our local economy and customer base.

 

Fairfax County, Virginia receives more federal procurement dollars than any other jurisdiction in the nation. More broadly, the State of Virginia ranks second among states that benefit from federal procurement. We cannot predict any adverse implications of direct and indirect impact of government spending reductions on our financial performance.

 

We have substantial counterparty risk due to our transactions with financial institution counterparties and the soundness of such counterparties could adversely affect us.

 

Our ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial services institutions are interrelated as a result of trading, clearing, counterparty, or other relationships. We have exposure to many different counterparties, and we routinely execute transactions with counterparties in the financial services industry, including brokers, dealers, commercial banks, investment banks, and government sponsored enterprises. Many of these transactions expose us to credit risk in the event of default of our counterparty. In addition, our credit risk may be exacerbated when the collateral held by us cannot be realized or is liquidated at prices not sufficient to recover the full amount of the loan or other obligation due us. There is no assurance that any such losses would not materially and adversely affect our financial condition and results of operations.

 

Risks Associated With The Corporation’s Common Stock

 

Our ability to pay dividends is subject to regulatory restrictions, and we may be unable to pay future dividends.

 

Our ability to pay dividends is subject to regulatory restrictions and the need to maintain sufficient consolidated capital. Also, our only source of funds with which to pay dividends to our shareholders is dividends we receive from our Bank, and the Bank’s ability to pay dividends to us is limited by its own obligations to maintain sufficient capital and regulatory restrictions. If these regulatory requirements are not satisfied, we will be unable to pay dividends on our common stock. We have paid quarterly cash dividends since our first cash dividend on February 24, 2006. We cannot guarantee that dividends will not be reduced or eliminated in future periods.

 

Certain provisions under our articles of incorporation and applicable law may make it difficult for others to obtain control of our Corporation even if such a change in control may be favored by some shareholders.

 

Certain provisions in our articles of incorporation and applicable Virginia corporate and banking law may have the effect of discouraging a change of control of our company even if such a transaction is favored by some of our shareholders and could result in shareholders receiving a substantial premium over the current market price of our shares.  The primary purpose of these provisions is to encourage negotiations with our management by persons interested in acquiring control of our Corporation.  These provisions may also tend to perpetuate present management and make it difficult for shareholders owning less than a majority of the shares to be able to elect even a single director.

 

The ownership position of certain shareholders, directors and officers may permit them to exert a major influence on the election of directors and other corporate actions that require a shareholder vote, including change in control transactions.

 

As of December 31, 2012, our chairman of the board, executive officers and directors and one other principal shareholder collectively beneficially owned approximately 35% of the outstanding shares of our common stock. Our executive officers and directors collectively beneficially owned approximately 29% of our common stock and one other individual shareholder has declared beneficial ownership of an additional 5.7% of our common stock. This concentration of ownership may allow our directors, acting in their role as substantial shareholders, to exert a major influence over the election of their nominees as directors, especially if voting together with our officers and other significant shareholders. Our directors, officers, and major shareholders could exercise similar influence over other corporate actions that require a shareholder vote, including change in control transactions.

 

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The trading volume in the corporation’s common stock is less than that of other larger financial services companies.

 

Although the Corporation’s common stock is listed for trading on the NASDAQ Stock Exchange, the trading volume in its common stock is less than that of other, larger financial services companies. A public trading market having the desired characteristics of depth, liquidity and orderliness depends on the presence in the marketplace of willing buyers and sellers of the Corporation’s common stock at any given time. This presence depends on the individual decisions of investors and general economic and market conditions over which the Corporation has no control. Given the lower trading volume of the Corporation’s common stock, significant sales of the Corporation’s common stock, or the expectation of these sales, could cause the Corporation’s stock price to fall.

 

ITEM 1B - UNRESOLVED STAFF COMMENTS

 

None.

 

ITEM 2 - PROPERTIES

 

The Bank leases offices that are used in the normal course of business. The principal executive office of the Corporation, Bank, Access Real Estate, ACM and Mortgage Division is owned by Access Real Estate, a subsidiary of the Bank, and is located at 1800 Robert Fulton Drive, Reston, Virginia. The Bank leases offices in Chantilly, Tysons Corner, Leesburg, and Manassas, Virginia. The Mortgage Division leases offices in Fairfax, McLean, Reston, and Roanoke in Virginia as well as Rockville, Hagerstown and Annapolis in Maryland. The Mortgage Division also leases offices in Tennessee, Texas, Indiana, Georgia, Colorado, and Florida. During 2012, the Mortgage Division terminated its leases in Crofton, Maryland and Winchester, Massachusetts. All of the Mortgage Division’s leases with the exception of Roanoke are month to month leases and can be terminated with thirty days notice. Access Real Estate owns an undeveloped commercial lot in Fredericksburg that was purchased for future expansion of the Bank.

 

All of the owned and leased properties are in good operating condition and are adequate for the Corporation’s present and anticipated future needs.

 

ITEM 3 – LEGAL PROCEEDINGS

 

The Corporation, and the Bank are from time to time parties to legal proceedings arising in the ordinary course of business. Management is of the opinion that these legal proceedings will not have a material adverse effect on the Corporation’s financial condition or results of operations. From time to time the Bank and the Corporation may initiate legal actions against borrowers in connection with collecting defaulted loans. Such actions are not considered material by management unless otherwise disclosed.

 

Prior to discontinuing the operations of the Mortgage Corporation, a subpoena dated May 3, 2011 was received from the United States Attorney's Office (the "U.S. Attorney's Office") for the Southern District of New York. Correspondence accompanying the subpoena indicated that the U.S. Attorney's Office is investigating potential violations by the Mortgage Corporation of the statutes, regulations, and rules governing the Federal Housing Administration's direct endorsement lender program and potential violations of sections 215, 656, 657, 1005, 1006, 1007, 1014, or 1344 of Title 18 or section 287, 1001, 1032, 1341, or 1343 of Title 18 affecting a federally insured financial institution in contemplation of a possible civil proceeding under 12 U.S.C. Section 1833a.

 

The subpoena requires the Mortgage Corporation, through the Bank since the activities of the Mortgage Corporation have been transitioned into an operating division of the Bank, to produce certain documents and designate a knowledgeable witness to testify with respect to the matters set forth above. The Corporation and its subsidiaries have cooperated fully with this investigation.

 

The Corporation cannot determine the outcome of this investigation or any related civil proceeding. In addition, the Corporation cannot predict how long the investigation will take or whether it or any of its subsidiaries will be required to take any additional actions.

 

ITEM 4 – MINE SAFETY DISCLOSURES

 

None.

 

22
 

 

PART II

 

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

 

In July 2004, the Corporation’s common stock became listed on the NASDAQ Global Market of the NASDAQ Stock Market LLC and is quoted under the symbol of “ANCX”. Set forth below is certain financial information relating to the Corporation’s common stock price history. Prices reflect transactions executed on NASDAQ.

 

   2012       2011     
   High   Low   Dividends   High   Low   Dividends 
                         
First Quarter  $10.71   $8.66   $0.05   $7.19   $6.28   $0.02 
Second Quarter   13.56    10.42    0.06    7.99    6.79    0.03 
Third Quarter   14.39    12.71    0.06    8.86    7.23    0.04 
Fourth Quarter  $14.40   $11.03   $0.78   $9.49   $7.61   $0.04 

 

As of March 14, 2013, the Corporation had 10,325,104 outstanding shares of Common Stock, par value $0.835 per share, held by approximately 448 shareholders of record and the closing price for the Corporation’s common stock on the NASDAQ Global Market was $16.27.

 

The Corporation paid its twenty-ninth consecutive quarterly cash dividend on February 25, 2013 to shareholders of record as of February 11, 2013. Payment of dividends is at the discretion of the Corporation’s Board of Directors, and is also subject to various federal and state regulatory limitations. Future dividends are dependent upon the overall performance and capital requirements of the Corporation. See “Item 1 - Business - Supervision and Regulation - Dividends" for a discussion of regulatory requirements related to dividends. Our strategic objective with respect to dividends is to achieve and maintain a minimum payout ratio equal to 40% of core earnings.

 

In addition to the ordinary quarterly dividends paid in 2012, on November 20, 2012, the Corporation declared a special non-routine cash dividend of $0.70 per share to shareholders of record as of December 3, 2012, which was paid on December 17, 2012.

 

Issuer Purchases of Equity Securities for the Quarter Ended December 31, 2012

 

The following table details the Corporation’s purchases of its common stock during the fourth quarter pursuant to a Share Repurchase Program announced on March 20, 2007. On June 22, 2010 the number of shares authorized for repurchase under the Share Repurchase Program was increased from 2,500,000 to 3,500,000 shares. The Share Repurchase Program does not have an expiration date.

Issuer Purchases of Equity Securities
           (c) Total Number of   (d) Maximum Number 
           Shares Purchased as   of Shares that may 
   (a) Total Number of   (b) Average Price   Part of Publicly   yet be Purchased 
Period  Shares Purchased   Paid Per Share   Announced Plan   Under the Plan 
                 
October 1 - October 31, 2012   -   $-    -    830,235 
November 1 - November 30, 2012   -    -    -    830,235 
December 1 - December 31, 2012   -    -    -    830,235 
    -   $-    -    830,235 

 

Stock Performance

 

The following graph compares the Corporation’s cumulative total shareholder return on its common stock for the five year period ended December 31, 2012 with the cumulative return of a broad equity market index and the Standard & Poor’s 500 Index (“S&P 500 Index”). This presentation assumes $100 was invested in shares of the Corporation and each of the indices on December 31, 2007, and that dividends, if any, were immediately reinvested in additional shares. The graph plots the value of the initial $100 investment at one-year intervals from December 31, 2007 through December 31, 2012.

 

23
 

 

 

   Period Ending 
Index  12/31/07   12/31/08   12/31/09   12/31/10   12/31/11   12/31/12 
Access National Corporation   100.00    79.81    98.98    109.09    151.06    239.04 
S&P 500   100.00    63.00    79.68    91.68    93.61    108.59 
SNl Bank Index   100.00    57.06    56.47    63.27    49.00    66.13 

 

24
 

 

ITEM 6 – SELECTED FINANCIAL DATA

 

The following consolidated selected financial data is derived from the Corporation’s audited financial statements for the five years ended December 31, 2012. This information should be read in conjunction with the following Management’s Discussion and Analysis of Financial Condition and Results of Operations and the Consolidated Financial Statements and Notes thereto.

 

   Selected Financial Data 
   Year Ended December 31, 
   2012   2011   2010   2009   2008 
       (In Thousands, Except for Share and Per Share Data) 
Income Statement Data:                         
Net interest income  $31,551   $28,117   $25,029   $23,558   $21,052 
Provision for loan losses   1,515    1,149    2,816    6,064    5,423 
Noninterest income   54,794    36,429    34,660    56,966    30,813 
Noninterest expense   56,399    45,722    44,771    58,971    38,998 
Income taxes   10,708    6,287    4,526    5,854    2,700 
Net Income  $17,723   $11,388   $7,576   $9,635   $4,744 
                          
Per Share Data:                          
Earnings per share                         
Basic   1.73    1.11    0.72    0.93    0.46 
Diluted   1.71    1.10    0.72    0.92    0.46 
Cash dividends paid   0.95    0.13    0.04    0.04    0.04 
Book value at period end   8.85    8.13    6.96    6.43    5.66 
                          
Balance Sheet Data:                         
Total assets  $863,914   $809,758   $831,824   $666,879   $702,324 
Loans held for sale   111,542    95,126    82,244    76,232    84,312 
Loans held for investment   616,978    569,400    491,529    486,564    485,929 
Total investment securities (2)   80,711    85,824    124,307    43,095    85,119 
Total deposits   671,496    645,013    627,848    466,645    485,401 
Shareholders' equity   91,267    82,815    72,193    67,778    57,945 
Average shares outstanding, basic   10,253,656    10,277,801    10,503,383    10,391,348    10,298,631 
Average shares outstanding, diluted   10,363,267    10,344,325    10,525,258    10,432,857    10,423,555 
                          
Performance Ratios:                         
Return on average assets   2.15%   1.50%   0.98%   1.35%   0.76%
Return on average equity   19.68%   14.80%   10.85%   15.04%   8.34%
Net interest margin (1)   3.94%   3.82%   3.41%   3.42%   3.48%
                          
Efficiency Ratios:                         
Access National Bank   51.71%   52.92%   59.02%   60.41%   55.36%
Access National Mortgage Division   70.19%   80.78%   84.72%   77.40%   86.65%
Access National Corporation   65.32%   70.84%   75.01%   73.23%   75.19%
                          
Asset Quality Ratios:                         
Allowance to period end loans   2.03%   2.06%   2.14%   1.88%   1.54%
Allowance to non-performing loans   455.71%   175.12%   122.96%   129.79%   259.55%
Net charge-offs to average loans   0.13%   0.01%   0.30%   0.90%   1.12%

 

(1) Net interest income divided by total average earning assets.

(2) Excludes restricted stock.

 

Table continued on next page

 

25
 

 

ITEM 6 – SELECTED FINANCIAL DATA continued

 

   Year Ended December 31, 
   2012   2011   2010   2009   2008 
   (In Thousands, Except for Share and Per Share Data) 
Average Balance Sheet Data:                         
Total assets  $826,233   $758,994   $772,600   $714,970   $624,450 
Investment securities   105,520    105,042    107,940    69,758    68,861 
Loans held for sale   78,543    51,774    63,868    65,780    25,757 
Loans held for investment   583,724    520,062    475,726    490,393    484,764 
Allowance for loan losses   11,994    11,123    9,485    8,065    8,248 
Total deposits   672,693    565,450    572,139    519,477    450,873 
Junior subordinated debentures   6,186    6,186    6,186    6,186    6,186 
Total shareholders' equity   90,047    76,969    69,827    64,054    56,882 
                          
Capital Ratios:                         
Tier 1 risk-based capital   14.10%   14.33%   14.25%   13.47%   11.86%
Total risk-based capital   15.35%   15.59%   15.51%   14.73%   13.11%
Leverage capital ratio   11.50%   10.78%   9.56%   10.73%   9.71%

 

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

 

The following discussion and analysis is intended to provide an overview of the significant factors affecting the Corporation and its subsidiaries financial condition at December 31, 2012 and 2011and the results of operations for the years ended December 31, 2012, 2011 and 2010. The consolidated financial statements and accompanying notes should be read in conjunction with this discussion and analysis.

 

Forward-Looking Statements

 

In addition to historical information, this Annual Report on Form 10-K may contain forward-looking statements. For this purpose, any statements contained herein, including documents incorporated by reference, that are not statements of historical fact may be deemed to be forward-looking statements. Examples of forward-looking statements include discussions as to our expectations, beliefs, plans, goals, objectives and future financial or other performance or assumptions concerning matters discussed in this document. Forward-looking statements often use words such as “believes,” “expects,” “plans,” “may,” “will,” “should,” “projects,” “contemplates,” “ anticipates,” “forecasts,” “intends” or other words of similar meaning. You can also identify them by the fact that they do not relate strictly to historical or current facts. Forward-looking statements are subject to numerous assumptions, risks and uncertainties, and actual results could differ materially from historical results or those anticipated by such statements. Factors that could have a material adverse effect on the operations and future prospects of the Corporation include, but are not limited to, changes in: collateral values, especially in the real estate market; stagnation or continued deterioration in general business and economic conditions and in the financial markets; the impact of any policies or programs implemented pursuant to the Dodd-Frank Act or other legislation or regulation; unemployment levels; branch expansion plans; interest rates; general economic conditions; monetary and fiscal policies of the U.S. Government, including policies of the Comptroller, U.S. Treasury and the FRB; the economy of Northern Virginia, including governmental spending and real estate markets; the quality or composition of the loan or investment portfolios; demand for loan products; deposit flows; competition; and accounting principles, policies, and guidelines. These risks and uncertainties should be considered in evaluating the forward-looking statements contained herein, and readers are cautioned not to place undue reliance on such statements. Any forward-looking statement speaks only as of the date on which it is made, and we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which it is made. For additional discussion of risk factors that may cause our actual future results to differ materially from the results indicated within forward-looking statements, please see “Item 1A – Risk Factors” herein.

 

26
 

 

CRITICAL ACCOUNTING POLICIES

 

The Corporation’s consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States. In preparing the Corporation’s financial statements management makes estimates and judgments that affect the reported amounts of assets, liabilities, revenues, and expenses. Our significant accounting policies are presented in Note 1 to the consolidated financial statements. Management believes that the most significant subjective judgments that it makes include the following:

 

Allowance for Loan Losses

 

The allowance for loan losses is an estimate of the losses that may be sustained in our loan portfolio. The allowance is based on two basic principals of accounting: (i) Accounting Standards Codification (ASC) No. 450-10 Contingencies, which requires that losses be accrued when they are probable of occurring and estimable and (ii) ASC 310-10, Receivables, which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance.

 

An allowance for loan losses is established through a provision for loan losses based upon industry standards, known risk characteristics, and management’s evaluation of the risk inherent in the loan portfolio and changes in the nature and volume of loan activity. Such evaluation considers, among other factors, the estimated market value of the underlying collateral and current economic conditions. For further information about our practices with respect to allowance for loan losses, please see the subsection “Allowance for Loan Losses” below.

 

Other Than Temporary Impairment of Investment Securities

 

Securities in the Bank’s investment portfolio are classified as either held-to-maturity or available-for-sale. Securities classified as held-to-maturity are recorded at cost or amortized cost. Available-for-sale securities are carried at fair value. The estimated fair value of the available-for-sale portfolio fluctuates due to changes in market interest rates and other factors. Changes in estimated fair value are recorded in shareholders’ equity as a component of other comprehensive income. Securities are monitored to determine whether a decline in their value is other than temporary. Management evaluates the investment portfolio on a quarterly basis to determine the collectability of amounts due per the contractual terms of the investment security. A decline in the fair value of an investment below its amortized cost attributable to factors that indicate the decline will not be recovered over the anticipated holding period of the investment will cause the security to be considered other than temporarily impaired. Other than temporary impairments result in reducing the security’s carrying value by the amount of the estimated credit loss. The credit component of the other than temporary impairment loss is realized through the statement of income and the remainder of the loss remains in other comprehensive income. At December 31, 2012 there were no securities in the securities portfolio with other than temporary impairment.

 

Income Taxes

 

The Corporation uses the liability method of accounting for income taxes. This method results in the recognition of deferred tax assets and liabilities that are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. The deferred provision for income taxes is the result of the net change in the deferred tax asset and deferred tax liability balances during the year. This amount combined with the current taxes payable or refundable results in the income tax expense for the current year. Our evaluation of the deductibility or taxability of items included in the Corporation’s tax returns has not resulted in the identification of any material uncertain tax positions.

 

Fair Value

 

Fair values of financial instruments are estimated using relevant market information and other assumptions. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect the estimates. The fair value estimates of existing on and off-balance sheet financial instruments do not include the value of anticipated future business or the values of assets and liabilities not considered financial instruments. For additional information about our financial assets carried at fair value, refer to Note 16 to the consolidated financial statements.

 

Executive Summary

 

The Corporation completed its thirteenth year of operation and recorded net income of $17.7 million or $1.71 per diluted common share in 2012 compared to $11.4 million or $1.10 per diluted common share and $7.6 million or $0.72 per diluted common share in 2011 and 2010, respectively. The increase in net income over last year was due mainly to record performance during 2012 by the Mortgage Division. In 2012 we were able to reduce interest expense by $1.9 million or 27% as the target federal funds rate remained at 0.25% throughout 2012 which contributed to the lower interest expense. In 2012, gains realized from the sale of mortgage loans increased by $20.4 million or 58% from 2011, while noninterest expense increased by $10.7 million or 23%. The increase in net income during 2011 over 2010 was mainly due to record performance in the banking division. Interest expense reduced by $3.1 million or 30% compared to 2010 while the provision for loan losses reduced by $1.7 million or 59% signaling improvement in the loans held for investment portfolio.

 

27
 

 

At December 31, 2012, assets totaled $863.9 million compared to $809.8 million at December 31, 2011. Total loans held for investment were $617.0 million at December 31, 2012, compared to $569.4 million at December 31, 2011, an increase of $47.6 million. The growth in loans occurred in commercial real estate – owner occupied, residential real estate and commercial loans and is due in part to our focus on small to medium sized businesses and providing credit facilities in conjunction with the U.S. Small Business Administration’s (“SBA”) guaranteed loan program. The Bank continues to be one of the dominant SBA lenders in 7A loans in the greater Washington D.C. Metropolitan Area, as measured by dollar value of originations. The SBA lending activity is an important component of our focus on small businesses and expanding our core business relationships.

 

Investment securities totaled $80.7 million at December 31, 2012 compared to $85.8 million at December 31, 2011. The decrease in the investment portfolio is primarily attributable to securities that matured or were otherwise called and not reinvested. The funds not reinvested in investment securities were used to provide funding for the growth in our loan portfolio.

 

Deposits totaled $671.5 million at December 31, 2012 compared to $645.0 million at December 31, 2011. Noninterest-bearing deposit balances totaled approximately $164.2 million compared to $113.9 million at December 31, 2011, an increase of 44.2%. This increase is primarily due to new business relationships and increased balances of existing clients.

 

Non-performing assets (“NPA”) totaled approximately $2.7 million or 0.32% of total assets at December 31, 2012, down from $6.7 million or 0.83% of total assets at December 31, 2011. NPAs are comprised of non-accrual loans solely, as at December 31, 2012, and 2011, the Corporation did not have any other real estate owned. Included in non-accrual loans at December 31, 2012 is a restructured loan to one borrower which consisted of a commercial loan totaling $759 thousand. The allowance for loan losses totaled $12.5 million or 2.0% of total loans held for investment as of December 31, 2012, compared to $11.7 million or 2.1% at December 31, 2011.

 

The economy continues to show signs of improvement with unemployment rates declining, and we are beginning to see price appreciation in the local residential real estate market. Notwithstanding the foregoing, there is no guarantee that these positive trends will continue. Although we believe that the credit quality of our primary business and professional customers has stabilized and has begun to improve, we will continue to focus on improving the credit quality of our loan portfolio and reducing non-performing assets. The Corporation is optimistic going into 2013 with a strong capital base and being positioned for continued growth.

 

RESULTS OF OPERATIONS

 

Net income for 2012 totaled $17.7 million, or $1.71 per diluted common share compared to $11.4 million or $1.10 per diluted common share in 2011. Net income in 2012 was favorably impacted by a decrease in interest expense and increased gains from the sale of mortgage loans, partially offset by increases in noninterest expense, provision for loan losses and provision for income taxes. During 2012 average loans held for investment increased $63.7 million and average loans held for sale increased $26.8 million.

 

Net income for 2011 totaled $11.4 million, or $1.10 per diluted common share compared to $7.6 million or $0.72 per diluted common share in 2010. Net income in 2011 was favorably impacted by a decrease in interest expense, a decrease in the provision for loan losses and increased gains from the sale of mortgage loans, partially offset by increases in noninterest expense and provision for income taxes. During 2011 average loans held for investment increased $44.3 million and average loans held for sale decreased $12.1 million. Average interest-bearing balances and federal funds sold decreased $28.4 million from 2010 to 2011.

 

Net Interest Income

 

Net interest income is the amount of income generated by earning assets (primarily loans and investment securities) less the interest expense incurred on interest-bearing liabilities (primarily deposits) used to fund earning assets. Net interest income and margin are influenced by many factors, primarily the volume and mix of earning assets, funding sources, yields on earning assets and interest rate fluctuations. Net interest income totaled $31.6 million in 2012, up from $28.1 million in 2011. Average noninterest-bearing deposits increased $46.2 million in 2012. Net interest margin was 3.94% in 2012 and 3.82% in 2011, with the increase primarily due to the weighted average rate paid on interest-bearing liabilities decreasing 33 basis points to 0.90% in 2012 from 1.23% in 2011.

 

During 2012, total average earning assets increased by $65.0 million. Average loans held for investment increased by $63.7 million, or 12.2%, and average loans held for sale increased by $26.8 million, or 51.7%. These increases were offset by a decrease of $24.9 million or 42.8% in average interest-bearing balances and federal funds sold. On the funding side total average interest-bearing deposits and borrowings increased by only $3.5 million or 0.61%; however, a $57.5 million decrease in average total borrowings with a rate of 1.25% was more than enough to offset the $61.0 million increase in total average interest-bearing deposits with a rate of 0.86% to reduce the cost of these interest-bearing deposits and borrowings from 1.23% in 2011 to 0.90% in 2012. The combination of these changes produced an increase in net interest margin of 12 basis points.

 

28
 

 

Net interest income totaled $28.1 million in 2011, up from $25.0 million in 2010. A decrease in average interest-bearing deposits and borrowings of $37.2 million in 2011 coupled with a reduction in the rate of average interest-bearing deposits and borrowings of 0.43% in 2011 assisted in providing an increase in net interest margin from 3.41% in 2010 to 3.82% in 2011.

 

The table below, Yield on Average Earning Assets and Rates on Average Interest-Bearing Liabilities, summarizes the major components of net interest income for the past three years and also provides yields, rates, and average balances.

 

   Yield on Average Earning Assets and Rates on Average Interest-Bearing Liabilities 
   For the Year Ended 
   December 31, 2012   December 31, 2011   December 31, 2010 
   Average   Income /   Yield /   Average   Income /   Yield /   Average   Income /   Yield / 
   Balance   Expense   Rate   Balance   Expense   Rate   Balance   Expense   Rate 
   (Dollars In Thousands) 
Assets:                                             
Interest-earning assets:                                             
Securities  $105,378   $2,266    2.15%  $105,964   $2,216    2.09%  $107,685   $2,242    2.08%
Loans held for sale   78,543    2,953    3.76%   51,774    2,176    4.20%   63,868    2,982    4.67%
Loans(1)   583,724    31,418    5.38%   520,062    30,632    5.89%   475,726    29,709    6.24%
Interest-bearing balances and federal funds sold   33,272    79    0.24%   58,128    143    0.25%   86,531    210    0.24%
Total interest-earning assets   800,917    36,716    4.58%   735,928    35,167    4.78%   733,810    35,143    4.79%
Noninterest-earning assets:                                             
Cash and due from banks   11,848              12,066              10,927           
Premises, land and equipment   8,548              8,819              8,655           
Other assets   16,914              13,304              28,693           
Less: allowance for loan losses   (11,994)             (11,123)             (9,485)          
Total noninterest-earning assets   25,316              23,066              38,790           
Total Assets  $826,233             $758,994             $772,600           
                                              
Liabilities and Shareholders' Equity:                                             
Interest-bearing deposits:                                             
Interest-bearing demand deposits  $63,203   $171    0.27%  $48,349   $227    0.47%  $30,166   $183    0.61%
Money market deposit accounts   119,621    484    0.40%   111,090    628    0.57%   132,761    1,345    1.01%
Savings accounts   2,587    4    0.15%   2,853    6    0.21%   3,939    30    0.76%
Time deposits   340,935    3,870    1.14%   303,009    4,343    1.43%   331,162    6,075    1.83%
Total interest-bearing deposits   526,346    4,529    0.86%   465,301    5,204    1.12%   498,028    7,633    1.53%
Borrowings:                                             
FHLB Advances   11,141    65    0.58%   8,458    42    0.50%   11,413    429    3.76%
Securities sold under agreements to repurchase and federal funds purchased   26,744    38    0.14%   36,612    67    0.18%   29,202    105    0.36%
Other short-term borrowings   -    -    0.00%   20,681    114    0.55%   26,674    228    0.85%
FHLB Long-term borrowings   3,015    212    7.03%   6,196    219    3.53%   9,239    312    3.38%
FDIC Term Note   3,607    98    2.72%   30,081    1,191    3.96%   29,998    1,191    3.97%
Subordinated Debentures   6,186    223    3.60%   6,186    213    3.44%   6,186    216    3.49%
Total borrowings   50,693    636    1.25%   108,214    1,846    1.71%   112,712    2,481    2.20%
Total interest-bearing deposits and borrowings   577,039    5,165    0.90%   573,515    7,050    1.23%   610,740    10,114    1.66%
Noninterest-bearing liabilities:                                             
Demand deposits   146,347              100,149              74,111           
Other liabilities   12,800              8,361              17,922           
Total liabilities   736,186              682,025              702,773           
Shareholders' Equity   90,047              76,969              69,827           
Total Liabilities and Shareholders' Equity:  $826,233             $758,994             $772,600           
                                              
Interest Spread(2)             3.69%             3.55%             3.13%
                                              
Net Interest Margin(3)       $31,551    3.94%       $28,117    3.82%       $25,029    3.41%

 

(1) Loans placed on nonaccrual status are included in loan balances

(2) Interest spread is the average yield earned on earning assets, less the average rate incurred on interest-bearing liabilities.

(3) Net interest margin is net interest income, expressed as a percentage of average earning assets.

 

29
 

 

The following table shows fluctuations in net interest income attributable to changes in the average balances of assets and liabilities and the yields earned or rates paid for the years ended December 31:

 

   Volume and Rate Analysis 
   Years Ended December 31, 
   2012 compared to 2011   2011 compared to 2010   2010 compared to 2009 
   Change Due To:   Change Due To:   Change Due To: 
   Increase /           Increase /           Increase /         
   (Decrease)   Volume   Rate   (Decrease)   Volume   Rate   (Decrease)   Volume   Rate 
   (In Thousands) 
Interest Earning Assets:                                             
Investments  $50   $(12)  $62   $(26)  $(36)  $10   $(796)  $1,246   $(2,042)
Loans   1,563    4,880    (3,317)   117    1,898    (1,781)   (1,643)   (1,012)   (631)
Interest-bearing deposits   (64)   (60)   (4)   (67)   (70)   3    56    54    2 
                                              
Total increase (decrease) in interest income   1,549    4,808    (3,259)   24    1,792    (1,768)   (2,383)   288    (2,671)
                                              
Interest-Bearing Liabilities:                                             
Interest-bearing demand deposits   (56)   57    (113)   44    92    (48)   (95)   27    (122)
Money market deposit accounts   (144)   45    (189)   (717)   (193)   (524)   (58)   493    (551)
Savings accounts   (2)   (1)   (1)   (24)   (7)   (17)   (30)   (6)   (24)
Time deposits   (473)   501    (974)   (1,732)   (485)   (1,247)   (2,752)   384    (3,136)
Total interest-bearing deposits   (675)   602    (1,277)   (2,429)   (593)   (1,836)   (2,935)   898    (3,833)
FHLB Advances   23    15    8    (387)   (89)   (298)   (550)   (468)   (82)
Securities sold under agreements to repurchase   (29)   (16)   (13)   (38)   22    (60)   (10)   25    (35)
Other short-term borrowings   (114)   (57)   (57)   (114)   (44)   (70)   61    79    (18)
Long-term borrowings   (7)   (150)   143    (93)   (107)   14    (521)   (500)   (21)
FDIC Term note   (1,093)   (806)   (287)   -    3    (3)   123    134    (11)
Trust preferred   10    -    10    (3)   -    (3)   (22)   -    (22)
                                              
Total (decrease) increase in interest expense   (1,885)   (412)   (1,473)   (3,064)   (808)   (2,256)   (3,854)   168    (4,022)
                                              
Increase in net interest income  $3,434   $5,220   $(1,786)  $3,088   $2,600   $488   $1,471   $120   $1,351 

 

Provision for Loan Losses

 

The provision for loan losses charged to operating expense in 2012 was $1.5 million compared $1.1 million in 2011 and $2.8 million in 2010. The decrease in the provision for loan losses since 2010 reflects the improved credit quality of the loan portfolio and the decrease in nonperforming assets. The minor increase in the provision for loan losses between 2011 and 2012 is due to the growth in the loan portfolio rather than a decline in the credit quality of the loan portfolio. The amount of the provision is determined by management to restore the allowance for loan losses to a level believed to be adequate to absorb inherent losses in the loan portfolio based on evaluations as of December 31, 2012.

 

Noninterest Income

 

Noninterest income consists of revenue generated from gains on sale of loans, service fees on deposit accounts, and other charges and fees. The Mortgage Division provides the most significant contributions towards noninterest income and is subject to wide fluctuations due to the general interest rate environment and economic conditions. Total noninterest income was $54.8 million in 2012 compared to $36.4 million in 2011. Gains on the sale of loans originated by the Mortgage Division totaled $55.7 million in 2012 compared to $35.3 million in 2011 due to an increase in mortgage loan volume of $298.5 million from 2011 to 2012 as well as an increase in the gains recognized in the secondary market. Mortgage broker fee income declined $573 thousand in 2012, from $627 thousand in 2011 to $54 thousand in 2012 due to a management decision to decrease the amount of loans obtained through brokers. Other income reflects a loss of $1.7 million in 2012, up from a loss of $236 thousand in 2011 as a result of losses incurred on hedging activities associated with the origination of mortgage loans held for sale. When losses occur on instruments used to hedge interest rate risk the value of the loans being hedged increases proportionately and is recognized in gains on the sale of loans.

 

Total noninterest income was $36.4 million in 2011 compared to $34.7 million in 2010. Gains on the sale of loans originated by the Mortgage Division totaled $35.3 million in 2011 compared to $32.5 million in 2010. Mortgage loan volume decreased minimally from 2010 to 2011; however, the increase in gains recognized in the secondary market allowed for the increase in the gain on the sale of the loans. Other income decreased $87 thousand in 2011 as a result of losses incurred on hedging activities associated with the origination of mortgage loans held for sale.

 

30
 

 

Noninterest Expense

 

Noninterest expense totaled $56.4 million in 2012 compared to $45.7 million in 2011. Compensation and employee benefits, the largest component of noninterest expense, totaled $31.5 million in 2012 compared to $25.4 million in 2011, an increase of $6.1 million. The increase is due to a combination of increased staffing at the Bank, primarily in the lending area, and an increase in performance-based compensation in the Mortgage Division as a result of the increase in revenue generated in 2012. Other operating expense totaled $22.2 million in 2012, up from $17.4 million for the year ended December 31, 2011, an increase of $4.8 million. The increase is due mainly to increased management fees paid to mortgage branch managers, advertising and promotional expense, provision for loans held for sale and investor fees in the Mortgage Division as a result of its increased operations. A further breakdown of other operating expenses is provided for in Note 15 of the consolidated financial statements.

 

Noninterest expense totaled $45.7 million in 2011 compared to $44.8 million in 2010. Compensation and employee benefits, the largest component of noninterest expense, totaled $25.4 million in 2011 compared to $22.0 million in 2010, an increase of $3.4 million. The increase is due to a combination of increased staffing at the Bank, primarily in the lending area, additional personnel costs associated with the new wealth management subsidiaries and an increase in performance-based compensation in the Mortgage Division as a result of the increase in revenue generated in 2011. Other operating expense totaled $17.4 million in 2011, down from $20.1 million for the year ended December 31, 2010, a decrease of $2.7 million due mainly to a decrease in the provision for loans held for sale from 2010 to 2011.

 

Income Taxes

 

Income tax expense totaled $10.7 million in 2012 compared to $6.3 million in 2011 and $4.5 million in 2010, an increase of $4.4 million and $1.8 million, respectively. The increase in taxes is due to an increase of $10.8 million and $5.6 million in pre-tax earnings from 2011 and 2010, respectively. Note 7 to the consolidated financial statements shows the components of federal income tax.

 

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Quarterly Results (unaudited)

 

The following is a summary of the results of operations for each quarter of 2012, 2011 and 2010.

 

   First   Second   Third   Fourth   Total 
   Quarter   Quarter   Quarter   Quarter   YTD 
2012  (In Thousands, Except for Per Share Data) 
                     
Total interest income  $9,351   $9,002   $9,172   $9,191   $36,716 
Total interest expense   1,483    1,270    1,193    1,219    5,165 
Net interest income   7,868    7,732    7,979    7,972    31,551 
Provision for loan losses   718    472    150    175    1,515 
Net interest income after provision for loan losses   7,150    7,260    7,829    7,797    30,036 
Total noninterest income   12,101    13,732    12,725    16,236    54,794 
Total noninterest expense   13,763    14,411    14,064    14,161    56,399 
Income tax expense   2,050    2,691    2,358    3,609    10,708 
Net income  $3,438   $3,890   $4,132   $6,263   $17,723 
                          
Earnings Per Share:                         
Basic  $0.34   $0.38   $0.40   $0.61   $1.73 
Diluted  $0.33   $0.38   $0.40   $0.60   $1.71 
                     
   First   Second   Third   Fourth   Total 
   Quarter   Quarter   Quarter   Quarter   YTD 
2011  (In Thousands, Except for Per Share Data) 
                     
Total interest income  $8,570   $8,529   $8,876   $9,192   $35,167 
Total interest expense   2,003    1,682    1,670    1,695    7,050 
Net interest income   6,567    6,847    7,206    7,497    28,117 
Provision for loan losses   223    (2)   715    213    1,149 
Net interest income after provision for loan losses   6,344    6,849    6,491    7,284    26,968 
Total noninterest income   5,839    8,100    10,702    11,788    36,429 
Total noninterest expense   8,631    10,803    12,374    13,914    45,722 
Income tax expense   1,265    1,475    1,706    1,841    6,287 
Net income  $2,287   $2,671   $3,113   $3,317   $11,388 
                          
Earnings Per Share:                         
Basic  $0.22   $0.26   $0.30   $0.33   $1.11 
Diluted  $0.22   $0.26   $0.30   $0.32   $1.10 
                     
   First   Second   Third   Fourth   Total 
   Quarter   Quarter   Quarter   Quarter   YTD 
2010  (In Thousands, Except for Per Share Data) 
                     
Total interest income  $8,259   $8,658   $8,831   $9,395   $35,143 
Total interest expense   2,674    2,671    2,472    2,297    10,114 
Net interest income   5,585    5,987    6,359    7,098    25,029 
Provision for loan losses   198    548    575    1,495    2,816 
Net interest income after provision for loan losses   5,387    5,439    5,784    5,603    22,213 
Total noninterest income   6,023    7,277    10,410    10,950    34,660 
Total noninterest expense   9,503    10,042    12,269    12,957    44,771 
Income tax expense   691    996    1,489    1,350    4,526 
Net income  $1,216   $1,678   $2,436   $2,246   $7,576 
                          
Earnings Per Share:                         
Basic  $0.11   $0.16   $0.23   $0.22   $0.72 
Diluted  $0.11   $0.16   $0.23   $0.22   $0.72 

 

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FINANCIAL CONDITION

 

Summary

 

Total assets at December 31, 2012 were $863.9 million compared to $809.8 million in 2011, an increase of $54.1 million. The increase in total assets was due mainly to a combination of a $47.6 million increase in loans held for investment, a $16.4 million increase in loans held for sale and a $10.3 million increase in cash and due from banks that was offset by a $16.3 million decrease in interest-bearing deposits in other banks and federal funds sold and a $5.1 million decrease in securities.

 

The following discussions by major categories explain the changes in financial condition.

 

Cash and Due From Banks

 

Cash and due from banks represents cash and noninterest-bearing balances at other banks and cash letters in process of collection at the FRB. At December 31, 2012 cash and due from banks totaled $15.7 million compared to $5.4 million at December 31, 2011. The balance fluctuates depending on the volume of cash letters in process of collection at the FRB.

 

Interest-Bearing Deposits in Other Banks and Federal Funds Sold

 

At December 31, 2012 interest-bearing balances in other banks totaled $22.2 million compared to $38.5 million at December 31, 2011. These balances are maintained at the FRB and the FHLB of Atlanta and provide liquidity for managing daily cash inflows and outflows from deposits and loans. The reduction in interest-bearing deposits and federal funds sold was used to fund loan growth.

 

Investment Securities

 

The Corporation’s investment securities portfolio is comprised of U.S. Government Agency securities, municipal securities, CRA mutual fund, mortgage backed securities issued by U.S. government sponsored agencies and corporate bonds. The investment portfolio is used to provide liquidity and as a tool for managing interest sensitivity in the balance sheet, while generating income.

 

At December 31, 2012, securities totaled $80.7 million compared to $85.8 million at December 31, 2011, a decrease of $5.1 million. The decrease is attributable to maturities and bonds that were called and not reinvested in securities. The proceeds from the maturing and called securities were used to fund loan growth. The securities portfolio at December 31, 2012 is comprised of $35.8 million in securities classified as available-for-sale and $44.9 million in securities classified as held-to-maturity. Securities classified as available-for-sale are carried at fair market value. Unrealized gains and losses are recorded directly to a separate component of shareholders' equity. Held-to-maturity securities are carried at cost or amortized cost.

 

The following tables present the types, amounts and maturity distribution of the investment securities portfolio.

 

   Maturity Schedule of  Investment Securities 
   Year Ended December 31, 2012 
   After One Year   After Five Years   After Ten Years         
   But Within   But Within   and         
   Five Years   Ten Years   Over   Total 
   Amount   Yield   Amount   Yield   Amount   Yield   Amount   Yield 
   (Dollars In Thousands) 
Investment securities available-for-sale (1)                                        
US Government agency  $5,003    1.00%  $5,008    2.30%  $5,005    1.00%  $15,016    1.43%
Mortgage backed   -    -    3,745    1.54%   11,432    2.04%   15,177    1.92%
Corporate bonds   4,079    3.39%   -    -    -    -    4,079    3.39%
   $9,082    2.07%  $8,753    1.98%  $16,437    1.72%  $34,272    1.88%
                                         
Investment securities Held-to-maturity                                        
US Government agency  $24,981    1.24%  $5,000    1.75%  $14,971    3.02%  $44,952    1.89%
   $24,981    1.24%  $5,000    1.75%  $14,971    3.02%  $44,952    1.89%

 

(1) Excludes FRB Stock, and FHLB Stock, and CRA Mutual Fund

 

33
 

 

Loans

 

Loans held for investment totaled $617.0 million at December 31, 2012 compared to $569.4 million at December 31, 2011. During 2012, loan demand increased over 2011 as local economic conditions improved. Commercial real estate loans increased $13.3 million from year end December 31, 2011 while commercial loans increased $17.6 million from year end 2011. The Bank continues to be one of the dominant SBA 7a lenders, based on dollar volume of loans originated, in the Greater Washington D.C. Metropolitan Area. Residential real estate loans increased $16.0 million from 2011.

 

The Bank concentrates on providing banking services to small and medium sized businesses and professionals in our market area. As of December 31, 2012 we did not have any exposure to builders or developers in our commercial real estate portfolio. Our loan officers maintain a professional relationship with our clients and are responsive to their financial needs. They are directly involved in the community, and it is this involvement and commitment that leads to referrals and continued growth.

 

Loans held for sale totaled $111.5 million at December 31, 2012 compared to $95.1 million at December 31, 2011, an increase of $16.4 million. The level of loans held for sale fluctuates with the volume of loans originated during the month and the timing of loans purchased by investors. Loan origination volume including brokered loans totaled $1.1 billion in 2012 compared to $797.0 million in 2011 due primarily to an increase in re-financing activity as loan interest rates continued to decline throughout 2012.

 

The following tables present the major classifications and maturity distribution of loans held for investment at December 31:

 

   Composition of Loan Portfolio 
   Year Ended December 31, 
   2012   2011   2010   2009   2008 
   Amount   Percentage
of Total
   Amount   Percentage
of Total
   Amount   Percentage
of Total
   Amount   Percentage
of Total
   Amount   Percentage
of Total
 
   (Dollars In Thousands) 
Commercial real estate - owner occupied  $182,655    29.60%  $171,599    30.14%  $137,169    27.91%  $128,859    26.49%  $123,399    25.39%
Commercial real estate - non-owner occupied   107,213    17.38    104,976    18.44    80,830    16.44    91,442    18.79    95,140    19.58 
Residential real estate   144,521    23.43    128,485    22.56    137,752    28.02    150,792    30.99    153,740    31.64 
Commercial   149,389    24.21    131,816    23.15    94,798    19.29    72,628    14.93    69,537    14.31 
Real estate construction   30,038    4.87    29,705    5.22    38,093    7.75    41,508    8.53    42,600    8.77 
Consumer   3,162    0.51    2,819    0.49    2,887    0.59    1,335    0.27    1,513    0.31 
Total loans  $616,978    100.00%  $569,400    100.00%  $491,529    100.00%  $486,564    100.00%  $485,929    100.00%

 

   Loan Maturity Distribution 
   Year Ended December 31, 2012 
   Three Months or   Over Three Months   Over One Year   Over     
   Less   Through One Year   Through Five Years   Five Years   Total 
   (In Thousands) 
Commercial real estate - owner occupied  $16,389   $19,389   $95,523   $51,354   $182,655 
Commercial real estate - non-owner occupied   15,317    14,767    50,871    26,258    107,213 
Residential real estate   45,649    36,712    42,077    20,083    144,521 
Commercial   21,929    68,835    39,561    19,064    149,389 
Real estate construction   8,552    13,465    8,021    -    30,038 
Consumer and other   279    936    1,844    103    3,162 
Total  $108,115   $154,104   $237,897   $116,862   $616,978 
                          
Loans with fixed interest rates  $18,600   $12,553   $55,256   $91,543   $177,952 
Loans with floating interest rates   89,515    141,551    182,641    25,319    439,026 
Total  $108,115   $154,104   $237,897   $116,862   $616,978 

 

Allowance for Loan Losses

 

The allowance for loan losses totaled $12.5 million at December 31, 2012 compared to $11.7 million at year end 2011. The allowance for loan losses was equivalent to 2.0% of total loans held for investment at December 31, 2012 and 2.1% at December 31, 2011. Adequacy of the allowance is assessed and increased by provisions for loan losses charged to expense no less than quarterly. Charge-offs are taken when a loan is identified as uncollectible.

 

The methodology by which we systematically determine the amount of our allowance is set forth by the Board of Directors in our Loan Policy and implemented by management. The results of the analysis are documented, reviewed and approved by the Board of Directors no less than quarterly.

 

The level of the allowance for loan losses is determined by management through an ongoing, detailed analysis of historical loss rates and risk characteristics. During each quarter, management evaluates the collectability of all loans in the portfolio and ensures an accurate risk rating is assigned to each loan. The risk rating scale and definitions jointly adopted by the Federal banking regulators are used within the framework prescribed by the Bank’s Loan Policy. Any loan that is deemed to have potential or well defined weaknesses that may jeopardize collection in full is then analyzed to ascertain its level of weakness. If appropriate, the loan may be charged-off or a specific reserve may be assigned if the loan is deemed to be impaired.

 

34
 

 

During the risk rating verification process, each loan identified as inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged is considered impaired and is placed on non-accrual status. On these loans, management analyzes the potential impairment of the individual loan and may set aside a specific reserve. Any amounts deemed uncollectible during that analysis are charged-off.

 

For the remaining loans in each segment, management calculates the probability of loss as a group using the risk rating for each of the following loan types: Commercial Real Estate – owner occupied, Commercial Real Estate – non-owner occupied, Residential Real Estate, Commercial, Real Estate Construction, and Consumer. Management calculates the historical loss rate in each group by risk rating using a period of at least five years. This historical loss rate may then be adjusted based on management’s assessment of internal and external environmental factors. This adjustment is meant to account for changes between the historical economic environment and current conditions and for changes in the ongoing management of the portfolio which affects the loans’ potential losses.

 

Once complete, management compares the condition of the portfolio using several different characteristics as well as its experience to the experience of other banks in its peer group in order to determine if it is directionally consistent with others’ experiences in our area and line of business. Based on that analysis, management aggregates the probabilities of loss of the remaining portfolio based on the specific and general allowances and may provide additional amounts to the allowance for loan losses as needed. Since this process involves estimates, the allowance for loan losses may also contain an immaterial amount that is not allocated to a specific loan or to a group of loans but is deemed necessary to absorb additional losses in the portfolio.

 

Management and the Board of Directors subject the reserve adequacy and methodology to review on a regular basis to internal auditors and bank regulators, and such reviews have not resulted in any material adjustment to the reserve.

 

The following tables present an analysis of the allowance for loan losses for the periods indicated.

 

   Allowance for Loan Losses 
   Year Ended December 31, 
   2012   2011   2010   2009   2008 
   (In Thousands) 
Balance, beginning of year  $11,738   $10,527   $9,127   $7,462   $7,462 
                          
Provision for loan losses   1,515    1,149    2,816    6,064    5,423 
                          
Charge-offs:                         
Commercial real estate - owner occupied   429    344    624    584    1,125 
Commercial real estate - non-owner occupied   103    -    -    1,064    2,913 
Residential real estate   790    596    875    851    1,055 
Commercial   808    292    501    1,541    184 
Real estate construction   -    -    48    1,247    241 
Consumer   35    -    -    23    42 
Total charge-offs   2,165   1,232   2,048   5,310    5,560 
Recoveries:                         
Commercial real estate - owner occupied   -    405    20    159    - 
Commercial real estate - non-owner occupied   416    234    89    135    - 
Residential real estate   410    89    38    79    137 
Commercial   566    536    385    374    - 
Real estate construction   -    30    99    66    - 
Consumer and other   20    -    1    98    - 
Total recoveries   1,412    1,294    632    911    137 
Net (charge-offs) recoveries   (753)   62    (1,416)   (4,399)   (5,423)
                          
Balance, end of year  $12,500   $11,738   $10,527   $9,127   $7,462 

 

   Allocation of the Allowance for Loan Losses 
   Year Ended December 31, 
   2012   Percentage
of total
   2011   Percentage
of total
   2010   Percentage
of total
   2009   Percentage
of total
   2008   Percentage
of total
 
   (Dollars In Thousands) 
Commercial real estate - owner occupied  $3,701    29.61%  $3,634    30.96%  $3,134    29.77%  $2,533    27.75%  $1,633    21.88%
Commercial real estate - non-owner occupied   2,173    17.39    1,747    14.88    2,173    20.64    1,865    20.43    1,315    17.62 
Residential real estate   2,924    23.39    2,874    24.48    2,930    27.83    2,517    27.58    1,880    25.19 
Commercial   3,028    24.22    3,021    25.74    1,509    14.33    1,563    17.13    1,816    24.34 
Real estate construction   610    4.88    423    3.60    758    7.20    539    5.91    805    10.79 
Consumer   64    0.51    39    0.34    23    0.23    110    1.20    13    0.18 
Total  $12,500    100.00%  $11,738    100.00%  $10,527    100.00%  $9,127    100.00%  $7,462    100.00%

 

35
 

 

Non-performing Assets And Loans Past Due

 

The following table presents information with respect to non-performing assets and 90 day delinquencies as of the dates indicated.

 

   Non-performing Assets and Accruing Loans Past Due 90 Days or More 
   Year Ended December 31, 
   2012   2011   2010   2009   2008 
   (Dollars In Thousands) 
Non-accrual loans:                         
Commercial real estate - owner occupied  $-   $2,694   $6,345   $3,631   $22 
Commercial real estate - non-owner occupied   -    321    367    -    - 
Residential real estate   922    2,249    949    1,504    - 
Commercial   1,821    1,439    900    208    74 
Real estate construction   -    -    -    1,689    2,678 
Consumer   -    -    -    -    101 
Total non-accrual loans   2,743    6,703   8,561    7,032   2,875 
                          
Other real estate owned ("OREO")   -    -    1,859    5,111    4,455 
                          
Total non-performing assets  $2,743   $6,703   $10,420   $12,143   $7,330 
                          
Restructured loans included above in non-accrual loans  $759   $1,428   $958   $-   $- 
                          
Ratio of non-performing assets to:                         
Total loans plus OREO   0.44%   1.18%   2.11%   2.47%   1.49%
                          
Total assets   0.32%   0.83%   1.25%   1.82%   1.04%
                          
Accruing past due loans:                         
90 or more days past due  $-   $-   $333   $-   $- 

 

Non-accrual loans totaled $2.7 million at December 31, 2012 and were comprised of seven borrowers. The loans are carried at the current net realizable value after consideration of $507 thousand in specific reserves. Included in non-accrual loans at December 31, 2012 is a restructured commercial loan in the amount of $759 thousand. There were no restructured loans prior to 2010. The Bank considers restructurings of loans to troubled borrowers when it is deemed to be beneficial to the borrower and improves the prospects for complete recovery of the debt.

 

The accrual of interest is discontinued at the time a loan is 90 days delinquent unless the credit is well-secured and in process of collection. When a loan is placed on non-accrual, accrued and unpaid interest is reversed from interest income. Subsequent receipts on non-accrual loans are recorded as a reduction to the principal balance. Interest income is recorded only after principal recovery is complete.

 

The loss potential for each loan has been evaluated, and in management’s opinion, the risk of loss is adequately reserved against. Management actively works with the borrowers to maximize the potential for repayment and reports on the status to the Board of Directors monthly.

 

Deposits

 

Deposits totaled $671.5 million at December 31, 2012 and were comprised of noninterest-bearing demand deposits in the amount of $164.2 million, savings and interest-bearing deposits in the amount of $188.0 million, and time deposits in the amount of $319.3 million. Total deposits increased $26.5 million from December 31, 2011. Noninterest-bearing deposits increased $50.3 million from $113.9 million at December 31, 2011 to $164.2 million at December 31, 2012. This increase in noninterest-bearing accounts is due to a combination of 398 new accounts and increased balances in existing commercial accounts at year end. Savings and interest-bearing deposit accounts increased $6.0 million from $182.0 million at December 31, 2011 to $188.0 million at December 31, 2012. Time deposits decreased $29.8 million and totaled $319.3 million at December 31, 2012 compared to $349.1 million in 2011. The decrease in time deposits occurred primarily in deposits obtained through the Certificate of Deposit Account Registry Service (“CDARS”).

 

36
 

 

We use wholesale funding or brokered deposits to supplement traditional customer deposits for liquidity and to maintain our desired interest rate risk position. Together with FHLB borrowings we use brokered deposits to fund the short-term cash needs associated with the LHFS activities discussed under “Loans” as well as other funding needs. Brokered deposits totaled $215.1 million at December 31, 2012, which included $185.9 million in CDARS deposits as compared to $223.6 million at December 31, 2011, which included $192.3 million in CDARS deposits.

 

Through CDARS our depositors are able to obtain FDIC insurance of up to $69 million. The FDIC currently classifies CDARS deposits as brokered deposits, even though the deposits originate from our customers. These deposits are placed at other participating financial institutions to obtain FDIC insurance, and we receive a reciprocal amount in return from these financial institutions.

 

True brokered deposits have declined from $31.2 million at December 31, 2011 to $29.3 million at December 31, 2012. These deposits are not at premium rates and are frequently below retail interest rates. Brokered deposits are viewed by many as being volatile and unstable; however, unlike retail certificates of deposit, there are no early withdrawal options on brokered certificates of deposit for any reason other than death of the underlying depositors. Brokered deposits provide funding flexibility and can be renewed at maturity, allowed to roll off or increased or decreased without any impact on core deposit relationships.

 

We manage the roll over risk of all deposits by maintaining liquid assets in the form of interest-bearing balances at the FRB and FHLB as well as investment securities available-for-sale and loans held for sale. In addition we also maintain lines of credit with the FHLB, FRB, and correspondent banks. At December 31, 2012 there was $269.7 million available under these lines of credit.

 

Depositors have been reluctant to extend maturities on certificates of deposits due to the low interest rate environment which has resulted in an increase in certificates of deposits maturing in the one year or less category. We anticipate that we will renew these certificates of deposits depending on our current funding needs. Our Asset Liability Committee monitors the level of re-pricing assets and liabilities and establishes pricing guidelines to maintain net interest margins.

 

The daily average balances and weighted average rates paid on deposits for each of the years ended December 31, 2012, 2011, and 2010 are presented below.

 

   Average Deposits and Average Rates Paid 
   Year Ended December 31, 
   2012   2011   2010 
   Average   Income /   Yield /   Average   Income /   Yield /   Average   Income /   Yield / 
   Balance   Expense   Rate   Balance   Expense   Rate   Balance   Expense   Rate 
   (Dollars In Thousands) 
Interest-bearing demand deposits  $63,203   $171    0.27%  $48,349   $227    0.47%  $30,166   $183    0.61%
Money market deposit accounts   119,621    484    0.40%   111,090    628    0.57%   132,761    1,345    1.01%
Savings accounts   2,587    4    0.15%   2,853    6    0.21%   3,939    30    0.76%
Time deposits   340,935    3,870    1.14%   303,009    4,343    1.43%   331,162    6,075    1.83%
Total interest-bearing deposits  $526,346   $4,529    0.86%  $465,301   $5,204    1.12%  $498,028   $7,633    1.53%
Noninterest-bearing demand deposits   146,347              100,149              74,111           
Total deposits  $672,693             $565,450             $572,139           

 

The table below presents the maturity distribution of time deposits at December 31, 2012.

 

   Certificate of Deposit Maturity Distribution 
   Year Ended December 31, 2012 
   Three months   Over three   Over     
   or less   through twelve months   twelve months   Total 
   (In Thousands) 
Less than $100,000  $7,297   $26,299