10-K 1 a08-2835_210k.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, 2007

 

 

 

 

 

OR

 

 

 

o

 

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 000-51281

 

Tennessee Commerce Bancorp, Inc.

(Exact name of registrant as specified in its charter)

 

Tennessee

 

62-1815881

(State or other jurisdiction

 

(I.R.S. Employer

of incorporation or organization)

 

Identification No.)

 

 

 

381 Mallory Station Road, Suite 207, Franklin,
Tennessee

 


37067

(Address of principal executive offices)

 

(Zip Code)

 

Registrant’s telephone number, including area code  (615) 599-2274

 

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

 

Common Stock, $0.50 par value per share

 

NASDAQ Global Market

(Title of each class)

 

(Name of each exchange of

 

 

which registered)

 

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

 

 

(Title of each class)

 

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

 

Indicate by check mark whether registrant (1) has filed reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes   x  No   o

 

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

 

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

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

(Do not check if a smaller reporting company)

 

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

 

The aggregate market value of the registrant’s voting stock held by non-affiliates of the registrant at June 30, 2007 was $96.5 million, based upon the average sale price on that date.

 

As of March 14, 2008, there were 4,731,696 shares of the registrant’s common stock outstanding.

 

Documents Incorporated by Reference:

 

Part III information is incorporated herein by reference, pursuant to Instruction G of Form 10-K, to registrant’s Definitive Proxy Statement for its 2008 Annual Meeting of shareholders to be held on June 25, 2008, which will be filed with the Commission no later than April 29, 2008 (the Proxy Statement). Certain Part II information required by Form 10-K is incorporated by reference to the registrant’s Annual Report to Shareholders, but the Annual Report to Shareholders shall not be deemed filed with the Commission.

 

 



 

TABLE OF CONTENTS

 

PART I

 

 

 

 

 

ITEM 1.

 

BUSINESS

1

ITEM 1A.

 

RISK FACTORS

10

ITEM 1B.

 

UNRESOLVED STAFF COMMENTS

15

ITEM 2.

 

PROPERTIES

15

ITEM 3.

 

LEGAL PROCEEDINGS

15

ITEM 4.

 

SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

15

 

 

 

 

PART II

 

 

 

 

 

ITEM 5.

 

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

16

ITEM 6.

 

SELECTED FINANCIAL DATA

17

ITEM 7.

 

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION

18

ITEM 7A.

 

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

38

ITEM 8.

 

FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

40

ITEM 9.

 

CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

40

ITEM 9A.

 

CONTROLS AND PROCEDURES

40

ITEM 9B.

 

OTHER INFORMATION

41

 

 

 

 

PART III

 

 

 

 

 

ITEM 10.

 

DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

42

ITEM 11.

 

EXECUTIVE COMPENSATION

42

ITEM 12.

 

SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

43

ITEM 13.

 

CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

43

ITEM 14.

 

PRINCIPAL ACCOUNTING FEES AND SERVICES

43

 

 

 

 

PART IV

 

 

 

 

 

ITEM 15.

 

EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

44

 

i



 

PART I

 

ITEM 1.                                                     BUSINESS

 

General

 

Tennessee Commerce Bancorp, Inc. (the “Corporation” or “we” or “us”) is a bank holding company formed as a Tennessee corporation to own the shares of Tennessee Commerce Bank (the “Bank”). The Bank commenced operations January 14, 2000, and is a full service financial institution located in Franklin, Tennessee, 15 miles south of Nashville. Franklin is in Williamson County, one of the most affluent and rapidly growing counties in the nation and the Bank conducts business from a single location in the Cool Springs commercial area of Franklin. The Bank had total assets at December 31, 2007 of $900 million. Although the Bank offers a full range of banking services and products, it operates with a focused “Business Bank” strategy.  The Business Bank strategy emphasizes banking services for small- to medium-sized businesses, entrepreneurs and professionals in the local market. The Bank competes by combining the personal service and appeal of a community bank institution with the sophistication and flexibility of a larger bank. This strategy distinguishes the Bank from its competitors in efforts to attract loans and deposits of local businesses. In addition, the Bank accesses a national market through a network of financial service companies and vendor partners that provide indirect funding opportunities for the Bank nationwide.

 

The Bank does not compete based on the traditional definition of “convenience” and does not have a branch network for that purpose. Business is conducted from a single office with no teller line, drive-through window or extended banking hours.  The Bank competes by providing responsive and personalized service to meet customer needs.  Convenience is created by technology and by a free courier service which transports deposits directly from the local business location to the Bank.  The Bank provides free electronic banking and cash management tools and on-site training for business customers.  The Bank competes for local consumer business by providing superior products, attractive deposit rates, free Internet Banking services and access to a third party regional automated teller machine (“ATM”) network. The Bank targets service, manufacturing and professional customers and avoids retail businesses with high transaction volume.

 

The Bank offers a full range of competitive retail and commercial banking services.  The deposit services offered include various types of checking accounts, savings accounts, money market investment accounts, certificates of deposits and retirement accounts.  Lending services include consumer installment loans, various types of mortgage loans, personal lines of credit, home equity loans, credit cards, real estate construction loans, commercial loans to small-and-medium size businesses and professionals, and letters of credit. The Bank issues VISA credit cards and is a merchant depository for cardholder drafts under VISA credit cards.  The Bank also offers check cards and debit cards.  The Bank offers its local customers courier services, access to third-party ATMs and state of the art electronic banking. The Bank has trust powers but does not have a trust department.

 

The Business Bank strategy is evident in differences between the financial statements of the Bank and more traditional financial institutions.   The Business Bank model creates a high degree of leverage.  By avoiding the investment and maintenance costs of a typical branch network, the Bank is able to maintain earning assets at a higher level than peer institutions.  Management targets a minimum earning asset ratio of 97% compared to the average of 90 to 92% for all banks insured by the Federal Deposit Insurance Corporation (“FDIC”). Assets of the Bank are centered in the loan portfolio which consists primarily of commercial and industrial loans.  Management targets a loan mix of 60% commercial loans and 40% real estate.  At December 31, 2007, the composition of the $794 million loan portfolio was 60.14% commercial, 36.50% secured by real estate (both commercial and consumer) and 0.50% in consumer and credit card loans.

 

The Bank offers a full range of loan products to local consumers and businesses.  Consumer products include secured and unsecured lines of credit, term loans and credit cards.  Loans secured by real estate include construction and acquisition loans in the form of 1st and 2nd mortgage term loans and home equity lines.  The Bank specializes in lending to businesses.  Customized business loans include lines of credit and term loans secured by accounts receivable, inventory, equipment, and real estate.  Commercial real estate products include acquisition and construction loans for business properties and term loan financing of commercial real estate.

 

1



 

In addition to lending in the local marketplace, the Bank generates assets in the national market by providing collateral-based loans to business borrowers located in other states through two types of indirect funding programs. In both programs, the transactions are originated by a third party, such as an equipment vendor or financial services company, who provides the Bank with a borrower’s financial information and arranges for a borrower’s execution of loan documentation. The Bank funds these transactions earning strong yields and has no servicing expense or residual risk in any transaction originated by these financial service companies and vendors. The Bank has management and personnel who are experienced in this type of transaction and are able to evaluate and partner effectively with the companies who originate these transactions. All indirect funding is secured by the business asset financed, and is subject to the Bank’s minimum credit score and documentation standards.  These national market transactions provide geographic and collateral diversity for the portfolio and represent approximately 35.72% of the total loan portfolio at December 31, 2007.

 

The two national market funding programs fund different size loans through two different networks. In the first type, the Bank uses an established network of financial service companies and vendor partners that provide the Bank funding opportunities to national middle-market and investment grade companies. At December 31, 2007, the average size of this type of loan in the loan portfolio was $289,000 and earned an average yield of 7.91%. Funding under this program represents approximately 16.44% of the $794 million total loan portfolio.  In the second program, the Bank partners with a second network of financial service companies and vendors located in Tennessee, Alabama, Georgia, California and Michigan. This program is for smaller transactions. These loans that finance business assets are less than $125,000 at origination. Management has installed a standardized credit approval process that delivers quick responsive service. At December 31, 2007, the average size of this type of loan in the loan portfolio was $45,000, and the average yield on these loans was 8.75%. Funding under this program represents approximately 19.28% of the $794 million total loan portfolio.

 

Management believes the Business Bank model is highly efficient.  The Bank targets the non-retail sector of the commercial market, which is characterized by lower levels of transactions and processing costs.  The commercial customer mix and the strategic outsourcing of certain administrative functions, such as data processing, allow the Bank to operate with a smaller, more highly trained staff.  Management targets an average asset per employee ratio of $7.5 million compared to the average of less than $3.4 million in assets per employee for Tennessee state-chartered banks at the end of September 30, 2007, as reported by SNL. The Bank also promotes the use of technology, both internally and externally, to maximize the efficiency of operations.  Management targets an operating efficiency ratio (total operating expense divided by total revenue) of 40% to 45%.

 

The Bank is subject to the regulatory authority of the Department of Financial Institutions of the State of Tennessee (“TDFI”) and the FDIC.

 

The Bank’s principal executive offices are located at 381 Mallory Station Road, Suite 207, Franklin, Tennessee 37067, and its telephone number is (615) 599-2274.

 

We were incorporated on March 22, 2000, for the purpose of acquiring 100% of the shares of the Bank by means of a share exchange, and becoming a registered bank holding company under the Federal Reserve Act.  The share exchange was completed on May 31, 2000.  The activities of the Corporation are subject to the supervision of the Board of Governors of the Federal Reserve System (“Federal Reserve Board”).  Our offices are the same as the principal office of the Bank.  On March 29, 2005, we formed a wholly owned subsidiary, Tennessee Commerce Bank Statutory Trust I (the “Trust”). The Bank and the Trust are our only subsidiaries. At this time, we have no plans to conduct any business apart from the activities of the Bank. The Bank commenced operations as a Tennessee state chartered bank on January 14, 2000, and is headquartered in Franklin, Tennessee.

 

Market Area and Competition

 

All phases of the Bank’s business are highly competitive.  The Bank is subject to intense competition from various financial institutions and other companies or firms that offer financial services.  The Bank competes for deposits with other commercial banks, savings and loan associations, credit unions and issuers of commercial paper and other securities, such as money-market and mutual funds.  In making loans, the Bank is expected to compete with other commercial banks, savings and loan associations, consumer finance companies, credit unions, leasing companies and other lenders.

 

2



 

The Bank’s primary market area is Davidson County and Williamson County in Tennessee.  In Davidson County, as of June 30, 2007, there were 25 banks and no savings and loan institutions, with at least 205 offices actively engaged in banking activities, including eight major state-wide financial institutions, according to SNL.  Total deposits held by banks in Davidson County as of June 30, 2007, were approximately $16.7 billion.  In Williamson County, as of June 30, 2007, there were 22 banks and two savings and loan institutions, with at least 83 offices actively engaged in banking activities, including eight major state-wide financial institutions.  Total deposits held by banks and savings and loan associations in Williamson County as of June 30, 2007, were approximately $4.6 billion, according to SNL.  In addition, there are numerous credit unions, finance companies, and other financial services providers.

 

Demographic information published by SNL Financial shows a total estimated population of 164,410 for Williamson County in 2007, which is a 29.83% increase from 126,638 in 2000. The estimated number of households in the county in 2007 was 58,965, up from 44,725 in 2000, averaging 2.79 persons per household. In 2007, the median household income was $88,854, while per capita income was $44,942.  At the end of 2007, the unemployment rate was 3.6%.

 

Demographic information published by SNL Financial shows an estimated population of 599,512 for Davidson County in 2007, which is a 5.2% increase over the population of 569,891 in 2000. The estimated number of households in the county in 2007 was 253,891, averaging 2.36 persons per household. In 2007, the median household income was $51,811, while per capita income was $30,129.  At the end of 2007, the unemployment rate was 4.1%.

 

Employees

 

At December 31, 2007, the Corporation employed no persons and the Bank employed 64 persons on a full-time basis. The Bank’s employees are not represented by any union or other collective bargaining agreement and management of the Bank believes its employee relations are satisfactory.

 

Supervision and Regulation

 

Bank Holding Company Regulation

 

We are a bank holding company within the meaning of the Bank Holding Company Act of 1956, as amended (the “Holding Company Act”), and are registered with the Federal Reserve Board. Our banking subsidiary is subject to restrictions under federal law which limit the transfer of funds by the Bank to the Corporation, whether in the form of loans, extensions of credit, investments or asset purchases. Such transfers by any subsidiary bank to its holding company or any non-banking subsidiary are limited in amount to 10% of the subsidiary bank’s capital and surplus and, with respect to the Corporation and the Bank, to an aggregate of 20% of the Bank’s capital and surplus.  Furthermore, such loans and extensions of credit are required to be secured in specified amounts.  The Holding Company Act also prohibits, subject to certain exceptions, a bank holding company from engaging in or acquiring direct or indirect control of more than 5% of the voting stock of any company engaged in non-banking activities.  An exception to this prohibition is for activities expressly found by the Federal Reserve Board to be so closely related to banking or managing or controlling banks as to be a proper incident thereto or financial in nature.

 

As a bank holding company, we are required to file with the Federal Reserve Board semiannual reports and such additional information as the Federal Reserve Board may require.  The Federal Reserve Board also makes examinations of us at its discretion.

 

According to Federal Reserve Board policy, bank holding companies are expected to act as a source of financial strength to each subsidiary bank and to commit resources to support each such subsidiary.  This support may be required at times when a bank holding company may not be able to provide such support.  Furthermore, in the event of a loss suffered or anticipated by the FDIC – either as a result of default of our banking subsidiary or related to FDIC assistance provided to a subsidiary in danger of default – our banking subsidiary may be assessed for the FDIC’s loss, subject to certain exceptions.

 

3



 

Various federal and state statutory provisions limit the amount of dividends the subsidiary banks can pay to their holding companies without regulatory approval.  The payment of dividends by any bank also may be affected by other factors, such as the maintenance of adequate capital for such subsidiary bank.  In addition to the foregoing restrictions, the Federal Reserve Board has the power to prohibit dividends by bank holding companies if their actions constitute unsafe or unsound practices.  The Federal Reserve Board has issued a policy statement on the payment of cash dividends by bank holding companies, which expresses the Federal Reserve Board’s view that a bank holding company experiencing earnings weaknesses should not pay cash dividends that exceed its net income or that could only be funded in ways that weaken the bank holding company’s financial health, such as by borrowing.  Furthermore, the TDFI also has authority to prohibit the payment of dividends by a Tennessee bank when it determines such payment to be an unsafe and unsound banking practice.

 

A bank holding company and its subsidiaries are also prohibited from acquiring any voting shares of, or interest in, any banks located outside of the state in which the operations of the bank holding company’s subsidiaries are located, unless the acquisition is specifically authorized by the statutes of the state in which the target is located.  Further, a bank holding company and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with the extension of credit or provision of any property or service.  Thus, an affiliate of a bank holding company may not extend credit, lease or sell property, or furnish any services or fix or vary the consideration for these on the condition that (i) the customer must obtain or provide some additional credit, property or services from or to its bank holding company or subsidiaries thereof or (ii) the customer may not obtain some other credit, property or services from a competitor, except to the extent reasonable conditions are imposed to assure the soundness of the credit extended.

 

In approving acquisitions by bank holding companies of banks and companies engaged in the banking-related activities described above, the Federal Reserve Board considers a number of factors, including the expected benefits to the public such as greater convenience, increased competition, or gains in efficiency, as weighed against the risks of possible adverse effects such as undue concentration of resources, decreased or unfair competition, conflicts of interest, or unsound banking practices.  The Federal Reserve Board is also empowered to differentiate between new activities and activities commenced through the acquisition of a going concern.

 

The Attorney General of the United States may, within 30 days after approval by the Federal Reserve Board of an acquisition, bring an action challenging such acquisition under the federal antitrust laws, in which case the effectiveness of such approval is stayed pending a final ruling by the courts.  Failure of the Attorney General to challenge an acquisition does not, however, exempt the holding company from complying with both state and federal antitrust laws after the acquisition is consummated or immunize the acquisition from future challenge under the anti-monopolization provisions of the Sherman Act.

 

Bank Regulation

 

The Bank is a Tennessee state-chartered bank and is subject to the regulations of and supervision by the FDIC as well as the Commissioner of the TDFI (the “Commissioner”), Tennessee’s state banking authority.  The Bank is also subject to various requirements and restrictions under federal and state law, including without limitation restrictions on permitted activities, requirements to maintain reserves against deposits, restrictions on the types and amounts of loans that may be granted and the interest that may be charged thereon and limitations on the types of investments that may be made and the types of services that may be offered.  Various consumer laws and regulations also affect the operations of the Bank.  In addition to the impact of regulation, commercial banks are affected significantly by the actions of the Federal Reserve Board as it attempts to control the money supply and credit availability in order to influence the economy.

 

The FDIC and the Commissioner periodically conduct examinations of the Bank.  If, as a result of an examination of the Bank, the FDIC determines that the financial condition, capital resources, asset quality, earnings prospects, management, liquidity or other aspects of the Bank’s operations are unsatisfactory or that the Bank or its management is violating or has violated any law or regulation, various remedies are available to the FDIC.  Such remedies include the power to enjoin “unsafe or unsound” practices, to require affirmative action to correct any conditions resulting from any violation or practice, to issue an administrative order that can be judicially enforced, to direct an increase in capital, to restrict the growth of the Bank, to assess civil monetary penalties, to remove officers and directors and ultimately to terminate a Bank’s deposit insurance.  The Commissioner has many of the same remedial powers, including the power to take possession of a bank whose capital becomes impaired.  As of December 31, 2007, the Bank was not the subject of any such action by the FDIC or the Commissioner.

 

The deposits of the Bank are insured by the FDIC in the manner and to the extent provided by law.  For this protection, the Bank pays a semiannual statutory assessment.

 

4



 

Although the Bank is not a member of the Federal Reserve System, it is nevertheless subject to certain regulations of the Federal Reserve Board.

 

Tennessee law contains limitations on the interest rates that may be charged on various types of loans and restrictions on the nature and amount of loans that may be granted and on the types of investments that may be made.  The operations of banks are also affected by various consumer laws and regulations, including those relating to equal credit opportunity and regulation of consumer lending practices.  All Tennessee banks must become and remain insured banks under the Federal Deposit Insurance Act (the “FDIA”).

 

Capital Requirements

 

The Federal Reserve Board has risk-based capital requirements for bank holding companies and member banks, and the FDIC adopted risk-based capital requirements for banks and bank holding companies effective after December 31, 1990. The risk-based capital guidelines are designed to make regulatory capital requirements more sensitive to differences in risk profile among banks to account for off-balance sheet exposure and to minimize disincentives for holding liquid assets.  Assets and off-balance sheet items are assigned to broad risk categories each with appropriate weights.  The resulting capital ratios represent capital as a percentage of total risk-weighted assets and off-balance sheet items.  The guidelines require all federally regulated banks to maintain a minimum risk-based total capital ratio of 8%, of which at least 4% must be Tier I Capital (as defined below).  Under the guidelines, the minimum ratio of total capital to risk-weighted assets (including certain off-balance sheet items, such as standby letters of credit) is 8%.  To be considered a “well capitalized” bank or bank holding company under the guidelines, a bank or bank holding company must have a total risk based capital ratio in excess of 10% (in addition to meeting other requirements).

 

At least half of the total capital of a bank is to be comprised of common equity, retained earnings and a limited amount of perpetual preferred stock, after subtracting goodwill and certain other adjustments (“Tier I Capital”).  The remainder may consist of perpetual debt, mandatory convertible debt securities, a limited amount of subordinated debt, other preferred stock not qualifying for Tier I Capital and a limited amount of loan loss reserves (“Tier II Capital”).  Under the risk-based capital requirements, total capital consists of Tier I Capital, which is generally common shareholders’ equity less goodwill, and Tier II Capital, which is primarily a portion of the allowance for loan losses and certain qualifying debt instruments.  In determining risk-based capital requirements, assets are assigned risk-weights of 0% to 100%, depending primarily on the regulatory assigned levels of credit risk associated with such assets.  Off-balance sheet items are considered in the calculation of risk-adjusted assets through conversion factors established by the regulators.  The framework for calculating risk-based capital requires banks and bank holding companies to meet the regulatory minimums of 4% Tier I Capital and 8% total risk-based capital.

 

The Federal Reserve Board and the FDIC have adopted a minimum leverage ratio of 3%.  Generally, banking organizations are expected to operate well above the minimum required capital level of 3% unless they meet certain specified criteria, including having the highest regulatory ratings. Most banking organizations are required to maintain a leverage ratio of 3%, plus an additional cushion of at least 1% to 2%.  State regulatory authorities and the FDIC encourage most community banks to maintain a leverage ratio of 6.5% to 7.0%. The FDIC has a regulation requiring certain banking organizations to maintain additional capital of 1% to 2% above a 3% minimum Tier I leverage capital ratio (ratio of Tier I Capital, less intangible assets, to total assets).  In order for an institution to operate at or near the minimum Tier I leverage capital requirement of 3%, the FDIC expects that such institution would have well-diversified risk, no undue rate risk exposure, excellent asset quality, high liquidity and good earnings.  In general, the Bank would have to be considered a strong banking organization, rated in the highest category under the bank rating system and have no significant plans for expansion.  Higher Tier I leverage capital ratios of up to 5% will generally be required if all of the above characteristics are not exhibited or if the institution is undertaking expansion, seeking to engage in new activities or otherwise faces unusual or abnormal risks.  The guidelines also provide that banking organizations experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels without significant reliance upon intangible assets.  The Bank’s Tier I leverage capital ratio at December 31, 2007 was 8.75%.

 

5



 

Under the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (“FIRREA”), failure to meet the capital guidelines could subject a banking institution to a variety of enforcement remedies available to federal regulatory authorities, including the termination of deposit insurance by the FDIC.  Institutions not in compliance with the capital guidelines are expected to be operating in compliance with a capital plan or agreement with the regulator.  If they do not do so, they are deemed to be engaging in an unsafe and unsound practice and may be subject to enforcement action.  In addition, failure by an institution to maintain capital of at least 2% of assets constitutes an unsafe and unsound practice and may subject the institution to enforcement action.  An institution’s failure to maintain capital of at least 2% of assets constitutes an unsafe and unsound condition justifying termination of FDIC insurance.

 

In 1999, the Basel Committee on Banking Supervision (“Basel Committee”) launched its efforts to develop an improved capital adequacy framework by issuing its proposals to revise the 1988 Basel Capital Accord.  In June 2004, the Basel Committee issued its final framework.  The new capital framework (“Basel II”) consists of minimum capital requirements, a supervisory review process and the effective use of market discipline.  Basel II seeks to ensure that a bank’s capital position is consistent with its overall risk profile and strategy, encourages early supervisory intervention when a bank’s capital position deteriorates and calls for detailed disclosure of a bank’s capital adequacy and how it evaluates its own capital adequacy.

 

In September 2006, the U.S. regulators published a revised Notice of Proposed Rulemaking (“NPR”) for Basel II.  The Final Rule on Advanced Capital Adequacy Framework—Basel II (the “Final Rule”), has been approved by all regulatory agencies and took effect on April 1, 2008. The Final Rule currently applies only to certain core banks with total assets of $250 billion or more, but allows non-core banks to opt in.  Under the Final Rule, the Bank is considered to be a non-core bank. For those non-core banks that do not opt in, a NPR was issued in December 2006, known as Basel IA, which proposed certain revisions to the current Basel I capital rules.

 

The agencies are currently developing a NPR that would provide non-core banks the option of adopting the Standardized Approach of the Basel II Framework.  The Basel II Standardized NPR is expected to replace the Basel IA NPR.

 

Payment of Dividends

 

The Corporation is a legal entity separate and distinct from its banking and other subsidiaries.  The principal source of cash flow of the Company, including cash flow to pay dividends on its stock or principal (premium, if any) and interest on debt securities, is dividends from the Bank.  There are state and federal statutory and regulatory limitations on the payment of dividends by the Bank to the Company, as well as by the Company to its shareholders.

 

Under the FDIA, the Bank may not make any capital distributions (including the payment of dividends) or pay any management fees to its holding company or pay any dividend if it is undercapitalized or if such payment would cause it to become undercapitalized.  In addition, the Bank is restricted from paying dividends under certain circumstance by the Tennessee Banking Act. The payment of dividends by any bank is dependent upon its earnings and financial condition and subject to the statutory power of certain federal and state regulatory agencies to act to prevent what they deem unsafe or unsound banking practices.  The payment of dividends could, depending upon the financial condition of the Bank, be deemed to constitute such an unsafe or unsound banking practice.  Under Tennessee law, the board of directors of a state bank may not declare dividends in any calendar year that exceeds the total of its retained net income of the preceding two (2) years without the prior approval of the TDFI.  The FDIA prohibits a state bank, the deposits of which are insured by the FDIC, from paying dividends if it is in default in the payment of any assessments due the FDIC.  The Bank is also subject to the minimum capital requirements of the FDIC which impact the Bank’s ability to pay dividends.  If the Bank fails to meet these standards, it may not be able to pay dividends or to accept additional deposits because of regulatory requirements.

 

If, in the opinion of the FDIC or the Federal Reserve Board, a depository institution or a holding company is engaged in or is about to engage in an unsafe or unsound practice (which, depending on the financial condition of the depository institution or holding company, could include the payment of dividends), such authority may require that such institution or holding company cease and desist from such practice.  The FDIC and the Federal Reserve Board have indicated that paying dividends that deplete a depository institution’s or holding company’s capital base to an inadequate level would be such an unsafe and unsound banking practice. Moreover, the Federal Reserve Board and the FDIC have issued policy statements which provide that bank holding companies and insured depository institutions generally should only pay dividends out of current operating earnings.

 

6



 

Under Tennessee law, the Corporation is not permitted to pay dividends if, after giving effect to such payment, it would not be able to pay its debts as they become due in the usual course of business or the Corporation’s total assets would be less than the sum of its total liabilities plus any amounts needed to satisfy any preferential rights if the Corporation was dissolving.  In addition, in deciding whether or not to declare a dividend of any particular size, the Corporation’s Board must consider the Corporation’s current and prospective capital, liquidity, and other needs.

 

The payment of dividends by the Corporation and the Bank may also be affected or limited by other factors, such as the requirement to maintain adequate capital above regulatory guidelines and debt covenants.

 

FIRREA

 

FIRREA provides that a depository institution insured by the FDIC can be held liable for any loss incurred by, or reasonably expected to be incurred by, the FDIC after August 9, 1989 in connection with (i) the default of a commonly controlled FDIC-insured depository institution or (ii) any assistance provided by the FDIC to a commonly controlled FDIC-insured depository institution in danger of default.  FIRREA provides that certain types of persons affiliated with financial institutions can be fined by the federal regulatory agency having jurisdiction over a depository institution with federal deposit insurance (such as the Bank) up to $1 million per day for each violation of certain regulations related (primarily) to lending to and transactions with executive officers, directors, principal shareholders and the interests of these individuals.  Other violations may result in civil money penalties of $5,000 to $30,000 per day or in criminal fines and penalties.  In addition, the FDIC has been granted enhanced authority to withdraw or to suspend deposit insurance in certain cases.

 

FDICIA

 

The Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”) requires, among other things, the federal banking regulators to take “prompt corrective action” in respect of FDIC-insured depository institutions that do not meet minimum capital requirements. FDICIA establishes five capital tiers: “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” and “critically undercapitalized.” Under applicable regulations, a FDIC-insured depository institution is well capitalized if it maintains a Leverage Ratio of at least 5%, a risk adjusted Tier 1 Capital Ratio of at least 6% and a Total Capital Ratio of at least 10% and is not subject to a directive, order or written agreement to meet and maintain specific capital levels.  An insured depository institution is adequately capitalized if it meets all of the minimum capital requirements as described above.  In addition, an insured depository institution will be considered undercapitalized if it fails to meet any minimum required measure, significantly undercapitalized if it is significantly below such measure and critically undercapitalized if it fails to maintain a level of tangible equity equal to not less than 2% of total assets.  An insured depository institution may be deemed to be in a capitalization category that is lower than is indicated by its actual capital position if it receives an unsatisfactory examination rating.

 

The capital-based prompt corrective action provisions of FDICIA and their implementing regulations apply to FDIC-insured depository institutions and are not directly applicable to holding companies that control such institutions.  However, the Federal Reserve Board has indicated that, in regulating bank holding companies, it will take appropriate action at the holding company level based on an assessment of the effectiveness of supervisory actions imposed upon subsidiary depository institutions pursuant to such provisions and regulations.

 

Undercapitalized depository institutions are subject to restrictions on borrowing from the Federal Reserve System.  In addition, undercapitalized depository institutions are subject to growth limitations and are required to submit capital restoration plans.  A depository institution’s holding company must guarantee the capital plan, up to an amount equal to the lesser of 5% of the depository institution’s assets at the time it becomes undercapitalized or the amount of the capital deficiency when the institution fails to comply with the plan.  The federal banking agencies may not accept a capital plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institution’s capital.  If a depository institution fails to submit an acceptable plan, it is treated as if it is significantly undercapitalized.

 

7



 

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

 

FDICIA contains numerous other provisions, including accounting, audit and reporting requirements, termination of the “too big to fail” doctrine except in special cases, limitations on the FDIC’s payment of deposits at foreign branches, new regulatory standards in such areas as asset quality, earnings and compensation and revised regulatory standards for, among other things, powers of state banks, real estate lending and capital adequacy.  FDICIA also requires that a depository institution provide 90 days prior notice of the closing of any branches.

 

Riegle-Neal Interstate Banking and Branching Efficiency Act

 

The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (“Interstate Act”), among other things and subject to certain conditions and exceptions, permits on an interstate basis (i) bank holding company acquisitions commencing one year after enactment of banks of a minimum age of up to five years as established by state law in any state, (ii) mergers of national and state banks after May 31, 1997 unless the home state of either bank has opted out of the interstate bank merger provision, (iii) branching de novo by national and state banks if the host state has opted-in to this provision of the Interstate Act, and (iv) certain bank agency activities after one year after enactment.  The Interstate Act contains a 30% intrastate deposit cap, except for the initial acquisition in the state, restriction that applies to certain interstate acquisitions unless a different intrastate cap has been adopted by the applicable state pursuant to the provisions of the Interstate Act and a 10% national deposit cap restriction.  Tennessee has opted-in to the Interstate Act.  Management cannot predict the extent to which the business of the Bank may be affected by the Interstate Act.  Tennessee has also adopted legislation allowing banks to acquire branches across state lines subject to certain conditions, including the availability of similar legislation in the other state.

 

Brokered Deposits and Pass-Through Insurance

 

The FDIC has adopted regulations under FDICIA governing the receipt of brokered deposits and pass-through insurance.  Under the regulations, a bank cannot accept or rollover or renew brokered deposits unless (i) it is well capitalized or (ii) it is adequately capitalized and receives a waiver from the FDIC.  A bank that cannot receive brokered deposits also cannot offer “pass-through” insurance on certain employee benefit accounts.  Whether or not it has obtained such a waiver, an adequately capitalized bank may not pay an interest rate on any deposits in excess of 75 basis points over certain index prevailing market rates specified by regulation.  There are no such restrictions on a bank that is well capitalized.  Because it believes that the Bank was well capitalized as of December 31, 2007, management of the Bank believes the brokered deposits regulation will have no material effect on the funding or liquidity of the Bank.

 

FDIC Insurance Premiums

 

The Bank is required to pay semiannual FDIC deposit insurance assessments to the Deposit Insurance Fund (“DIF”).  The FDIC merged the Bank Insurance Fund and the Savings Association Insurance Fund to form the DIF on March 31, 2006 in accordance with the Federal Deposit Insurance Reform Act of 2005.  The FDIC maintains the DIF by assessing depository institutions an insurance premium.  The amount each institution is assessed is based upon statutory factors that include the balance of insured deposits as well as the degree of risk the institution poses to the insurance fund.  The FDIC uses a risk-based premium system that assesses higher rates on those institutions that pose greater risks to the DIF.

 

Under the FDIA, insurance of deposits may be terminated by the FDIC upon a finding that the institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by a federal bank regulatory agency.

 

8



 

Gramm-Leach-Bliley Act

 

The Gramm-Leach-Bliley Act of 1999 (the “GLBA”) ratified new powers for banks and bank holding companies, especially in the areas of securities and insurance.  The GLBA also includes requirements regarding the privacy and protection of customer information held by financial institutions, as well as many other providers of financial services.  There are provisions providing for functional regulation of the various services provided by institutions among different regulators.  There are other provisions which limit the future expansion of unitary thrift holding companies.  Finally, among many other sections of the GLBA, there is some relief for small banks from the regulatory burden of the Community Reinvestment Act.  The regulatory agencies have been adopting many new regulations to implement the GLBA.

 

USA Patriot Act

 

The Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the “USA Patriot Act”) contains the International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001 (the “IMLAFA”).  The IMLAFA substantially broadened existing anti-money laundering legislation and the extraterritorial jurisdiction of the United States, imposed new compliance and due diligence obligations, created new crimes and penalties, compelled the production of documents located both inside and outside the United States, including those of foreign institutions that have a correspondent relationship in the United States, and clarified the safe harbor from civil liability to customers.  The U.S. Treasury Department has issued a number of regulations implementing the USA Patriot Act that apply certain of its requirements to financial institutions such as our banking subsidiary.  The regulations imposed new obligations on financial institutions to maintain appropriate policies, procedures and controls to detect, prevent and report money laundering and terrorist financing.  The Treasury Department is expected to issue a number of additional regulations which will further clarify the USA Patriot Act’s requirements.

 

The IMLAFA required all “financial institutions,” as defined therein, to establish anti-money laundering compliance and due diligence programs no later than April 2003.  Such programs must include, among other things, adequate policies, the designation of a compliance officer, employee training programs, and an independent audit function to review and test the program.  The Bank has established anti-money laundering compliance and due diligence programs which management believes comply with the IMLAFA.

 

Depositor Preference

 

The Omnibus Budget Reconciliation Act of 1993 provides that deposits and certain claims for administrative expenses and employee compensation against an insured depositary institution would be afforded a priority over other general unsecured claims against such an institution, including federal funds and letters of credit, in the “liquidation or other resolution” of such an institution by any receiver.

 

Effect of Governmental Policies

 

The Company and the Bank are affected by the policies of regulatory authorities, including the Federal Reserve System.  An important function of the Federal Reserve System is to regulate the national money supply.  Among the instruments of monetary policy used by the Federal Reserve are: (i) purchases and sales of U.S. Government securities in the marketplace; (ii) changes in the discount rate, which is the rate any depository institution must pay to borrow from the Federal Reserve; (iii) and changes in the reserve requirements of depository institutions.  These instruments are effective in influencing economic and monetary growth, interest rate levels and inflation.

 

The monetary policies of the Federal Reserve System and other governmental policies have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future.  Because of changing conditions in the national economy and in the money market, as well as the result of actions by monetary and fiscal authorities, it is not possible to predict with certainty future changes in interest rates, deposit levels, loan demand or the business and earnings of the Bank or whether the changing economic conditions will have a positive or negative effect on operations and earnings.

 

9



 

Bills are pending before the United States Congress and the Tennessee General Assembly and proposed regulations are pending before the various state and federal regulatory agencies that could affect the business of the Company and the Bank, and there are indications that other similar bills and proposed regulations may be introduced in the future.  It cannot be predicted whether or in what form any of these or future proposals will be adopted or the extent to which the business of the Company and the Bank may be affected thereby.

 

Sarbanes-Oxley Act of 2002

 

The Sarbanes-Oxley Act of 2002 represents a comprehensive revision of laws affecting corporate governance, accounting obligations and corporate reporting. The Sarbanes-Oxley Act is applicable to all companies with equity securities registered, or that file reports, under the Securities Exchange Act of 1934, as amended.  In particular, the act established (i) requirements for audit committees, including independence, expertise and responsibilities; (ii) responsibilities regarding financial statements for the chief executive officer and chief financial officer of the reporting company and new requirements for them to certify the accuracy of periodic reports; (iii) standards for auditors and regulation of audits; (iv) disclosure and reporting obligations for the reporting company and its directors and executive officers; and (v) civil and criminal penalties for violations of the federal securities laws. The legislation also established a new accounting oversight board to enforce auditing standards and restrict the scope of services that accounting firms may provide to their public company audit clients.

 

Availability of Information

 

We file periodic reports with the SEC. The SEC maintains an internet website, www.sec.gov, that contains reports, proxy and information statements, and other information regarding us that we file electronically with the SEC.  The Corporation makes its annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports available free of charge on the Bank’s website at www.tncommercebank.com under the “Investor Relations” heading.

 

ITEM 1A.          RISK FACTORS

 

Changes in interest rates could adversely affect our results of operations and financial condition.

 

Changes in interest rates may affect our level of interest income, the primary component of our gross revenue, as well as the level of our interest expense. Interest rates are highly sensitive to many factors that are beyond our control, including general economic conditions and the policies of various governmental and regulatory authorities.  Accordingly, changes in interest rates could decrease our net interest income.  Changes in the level of interest rates also may negatively affect our ability to originate loans, the value of our assets and our ability to realize gains from the sale of our assets, all of which ultimately affects our earnings.

 

Our business is subject to the success of the local economies where we operate.

 

Our success significantly depends upon the growth in population, income levels, deposits and new businesses in the Nashville MSA and our other market areas. If the communities in which we operate do not grow or if prevailing economic conditions locally or nationally are unfavorable, our business may not succeed. Adverse economic conditions in our specific market areas could reduce our growth rate, affect the ability of our customers to repay their loans to us and generally affect our financial condition and results of operations. Moreover, we cannot give any assurance that we will benefit from any market growth or favorable economic conditions in our primary market areas if they do occur.

 

Our business strategy includes the continuation of growth plans, and our financial condition and results of operations could be negatively affected if our business strategies are not effectively executed.

 

We intend to continue pursuing a growth strategy for our business through organic growth of the loan portfolio. Our prospects must be considered in light of the risks, expenses and difficulties that can be encountered by financial service companies in rapid growth stages, which include the risks associated with the following:

 

10



 

·                  maintaining loan quality;

 

·                  maintaining adequate management personnel and information systems to oversee such growth;

 

·                  maintaining adequate control and compliance functions; and

 

·                  securing capital and liquidity needed to support our anticipated growth.

 

There can be no assurance that we will maintain or achieve deposit levels, loan balances or other operating results necessary to avoid losses or produce profits. Our growth will cause growth in overhead expenses as we routinely add staff. As a result, historical results may not be indicative of future results. Failure to successfully address these issues identified above could have a material adverse effect on our business, future prospects, financial condition or results of operations.

 

We rely heavily on the services of key personnel.

 

We depend substantially on the strategies and management services of our executive officers – Arthur F. Helf, Chairman and Chief Executive Officer, Michael R. Sapp, President, George W. Fort, Chief Financial Officer, and H. Lamar Cox, Chief Administrative Officer and acting Chief Financial Officer. The loss of the services of any of these executive officers could have a material adverse effect on our business, results of operations and financial condition. We are also dependent on certain other key officers who have important customer relationships or are instrumental to our operations. Changes in key personnel and their responsibilities may be disruptive to our business and could have a material adverse effect on our business, financial condition and results of operations.  We believe that our future results will also depend in part upon our attracting and retaining highly skilled and qualified management, as well as sales and marketing personnel. Competition for such personnel is intense, and we cannot assure you that we will be successful in attracting or retaining such personnel.

 

National market funding outside of the Nashville MSA has different risks.

 

Approximately 35.72% of our loan portfolio is composed of national market funding loans to non-Middle Tennessee businesses referred to us by a small network of equipment vendors and financial service companies. These loans account for approximately 32.72% and 32.04%, respectively, of the increase in total loans at December 31, 2007 and 2006, over the prior year. This lending causes us to have somewhat different risks than those typical for community banks generally. Our loan portfolio is more geographically diverse, and as a result the loan collateral is also more widely dispersed geographically. This may result in longer time periods to locate collateral and higher costs to dispose of collateral in the event that the collateral is used to satisfy the loan obligation. This part of our portfolio also provides geographic risk diversification by reducing the adverse impact of a regional downturn in the economy.

 

Our ability to attract deposits may restrict growth.

 

We derive a substantial portion of our deposits through internet-based wholesale funding alternatives. In the event that we were no longer able to sell our deposits easily to institutional and retail investors, our ability to fund our loan portfolio could be adversely affected. We post rates to an internet-based program that retail and institutional investors nationwide subscribe to in order to invest funds. Our wholesale funding portfolio is therefore geographically dispersed and generally made up of deposits in FDIC insured amounts of $100,000 or less.

 

An inadequate allowance for loan losses would reduce our earnings.

 

The risk of credit losses on loans varies with, among other things, general economic conditions, the type of loan being made, the creditworthiness of the borrower over the term of the loan and, in the case of a collateralized loan, the value and marketability of the collateral for the loan. Management maintains an allowance for loan losses based upon, among other things, historical experience, an evaluation of economic conditions and regular reviews of delinquencies and loan portfolio quality. Based upon such factors, management makes various assumptions and judgments about the ultimate collectability of the loan portfolio and provides an allowance for loan losses based upon a percentage of the outstanding balances and takes a charge against earnings with respect to specific loans when their ultimate collectability is considered questionable. If management’s assumptions and judgments prove to be incorrect and the allowance for loan losses is inadequate to absorb losses, or if the bank regulatory authorities require us to increase the allowance for loan losses as a part of their examination process, our earnings and capital could be significantly and adversely affected.

 

11



 

Our ability to maintain adequate capital may restrict our activities.

 

Our continued pace of growth may require us to raise additional capital in the future, but that capital may not be available when it is needed.  We are required by federal and state regulatory authorities to maintain adequate levels of capital to support our operations, so we may at some point need to raise additional capital to support any continued growth.

 

Our ability to raise additional capital, if needed, will depend on conditions in the capital markets at that time, which are outside our control, and on our financial performance. Accordingly, we cannot assure our shareholders that we will be able to raise additional capital if needed on terms acceptable to us. If we cannot raise additional capital when needed, our ability to continue our growth could be materially impaired.

 

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

 

The banking business is highly competitive and we experience competition in our markets from many other financial institutions.  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 community banks and super-regional and national financial institutions that operate in the Nashville MSA and elsewhere.  We not only compete with these companies in the Nashville MSA, but also in the regional and national markets in which we engage in our indirect funding programs.

 

Additionally, in the Nashville MSA, we face competition from de novo community banks, including those with senior management who were previously affiliated with other local or regional banks or those controlled by investor groups with strong local business and community ties. These de novo community banks may offer higher deposit rates or lower cost loans in an effort to attract our customers, and may attempt to hire our management and employees.

 

We compete with these other financial institutions both in attracting deposits and in making loans. In addition, we have to attract our customer base in the Nashville MSA from consumers with an existing relationship with other financial institutions and from new residents.  We expect competition to increase in the future as a result of legislative, regulatory and technological changes and the continuing trend of consolidation in the financial services industry. Our profitability depends upon our continued ability to successfully compete with an array of financial institutions in the Nashville MSA and regionally and nationally with respect to our indirect funding programs.

 

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

 

The primary source of our funds is customer 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 general economic conditions, adverse trends or events affecting business industry groups, reductions in real estate values or markets, business closings or lay-offs, inclement weather, natural disasters and international instability. Additionally, deposit levels may be affected by a number of factors, including rates paid by competitors, general interest rate levels, returns available to customers on alternative investments and general economic conditions. Accordingly, we may be required from time to time to rely on secondary sources of liquidity to meet withdrawal demands or otherwise fund operations. These sources include Federal Home Loan Bank advances and federal funds lines of credit from correspondent banks. While our management believes that these sources are currently adequate, there can be no assurance they will be sufficient to meet future liquidity demands. We may be required to slow or discontinue loan growth, capital expenditures or other investments or liquidate assets should these sources not be adequate.

 

12



 

We are subject to extensive regulation that could limit or restrict our activities.

 

We operate in a highly regulated industry and are subject to examination, supervision and comprehensive regulation by various federal and state agencies including the Federal Reserve Board, the FDIC and the TDFI. Our regulatory compliance is costly and restricts certain of our activities, including payment of dividends, mergers and acquisitions, investments, loans and interest rates charged, and interest rates paid on deposits. We are also subject to capitalization guidelines established by our regulators, which require us to maintain adequate capital to support our growth.

 

The laws and regulations applicable to the banking industry could change at any time, and we cannot predict the effects of these changes on our business and profitability. Because government regulation greatly affects the business and financial results of all commercial banks and bank holding companies, our cost of compliance could adversely affect our ability to operate profitably.

 

The Sarbanes-Oxley Act of 2002, and the related rules and regulations promulgated by the Securities and Exchange Commission and The NASDAQ Stock Market that are applicable to us, have increased the scope, complexity and cost of our corporate governance, reporting and disclosure practices. As a result, we have experienced, and may continue to experience, greater compliance costs.

 

Our ability to continue to engage in and grow our national market funding programs depends on stable business relationships.

 

Our ability to continue to grow the national market funding portion of our portfolio is dependent upon our retaining those members of our senior management and those loan officers who have experience and relationships with those equipment vendors and financial services companies who originate the underlying lease transactions. In the event that any of these members of senior management, particularly President Mike Sapp, were to terminate his or her employment with us, or in the event that our relationships with any of these vendor/brokers were to be discontinued, our ability to continue to increase our national market funding portfolio could be adversely affected.

 

Material fluctuations in non-interest income may occur.

 

A substantial portion of our non-interest income is derived from the sale of loans, particularly loans generated for our national market funding portfolio. The timing and extent of these loan sales may not be predictable, and could cause material variation in our non-interest income on a quarter to quarter basis.

 

The success and growth of our business will depend on our ability to adapt to technological changes.

 

The banking industry and the ability to deliver financial services is becoming more dependent on technological advancement, such as the ability to process loan applications over the Internet, accept electronic signatures, provide process status updates instantly and offer on-line banking capabilities and other customer expected conveniences that are cost efficient to our business processes. As these technologies are improved in the future, we may, in order to remain competitive, be required to make significant capital expenditures.

 

We could sustain losses if our asset quality declines.

 

Our earnings are affected by our ability to properly originate, underwrite and service loans.  We could sustain losses if we incorrectly assess the creditworthiness of our borrowers or fail to detect or respond to deterioration in asset quality in a timely manner.  Problems with asset quality could cause our interest income and net interest margin to decrease and our provision for loan losses to increase, which could adversely affect our results of operations and financial condition.

 

We may issue additional common stock or other equity securities in the future which could dilute the ownership interest of existing shareholders.

 

In order to maintain our capital at desired levels or required regulatory levels, or to fund future growth, our board of directors may decide from time to time to issue additional shares of common stock, or securities convertible into, exchangeable for or representing rights to acquire shares of our common stock. The sale of these securities may significantly dilute our shareholders’ ownership interest as a shareholder and the market price of our common stock. New investors of other equity securities issued by us in the future may also have rights, preferences and privileges senior to our current shareholders which may adversely impact our current shareholders.

 

13



 

Holders of our subordinated debentures have rights that are senior to those of our common shareholders.

 

In 2005, we supported our continued growth through the issuance of trust preferred securities from an affiliated special purpose trust and accompanying subordinated debentures. At December 31, 2007, we had outstanding trust preferred securities and accompanying subordinated debentures totaling $8.2 million. Our board of directors may also decide to issue additional tranches of trust preferred securities in the future. We conditionally guarantee payments of the principal and interest on the trust preferred securities. Further, the accompanying subordinated debentures we issued to the trust are senior to our shares of common stock. As a result, we must make payments on the subordinated debentures before any dividends can be paid on our common stock and, in the event of our bankruptcy, dissolution or liquidation, the holders of the subordinated debentures must be satisfied before any distributions can be made on our common stock. We have the right to defer distributions on our subordinated debentures (and the related trust preferred securities) for up to five years (from the date of issuance) during which time we may not pay dividends on our common stock.

 

Changes in monetary policy could adversely affect operating results.

 

Like all regulated financial institutions, we are affected by monetary policies implemented by the Federal Reserve Board and other federal instrumentalities.  A primary instrument of monetary policy employed by the Federal Reserve Board is the restriction or expansion of the money supply through open market operations.  This instrument of monetary policy frequently causes volatile fluctuations in interest rates, and it can have a direct, adverse effect on the operating results of financial institutions.  Borrowings by the United States government to finance the government debt may also cause fluctuations in interest rates and have similar effects on the operating results of such institutions.

 

Our ability to declare and pay dividends on our common stock is limited by law and we may be unable to pay future dividends.

 

We derive our income solely from dividends on the shares of common stock of the bank. The bank’s ability to declare and pay dividends to us is limited by its obligations to maintain sufficient capital and by other general restrictions on its dividends that are applicable to banks that are regulated by the FDIC and the TDFI. The Federal Reserve Board may also impose restrictions on our ability to pay dividends on our common stock. In addition, we must make payments on the subordinated debentures before any dividends can be paid on our common stock, and we may not pay dividends while we are deferring interest payments on our trust preferred securities and the related subordinated debentures. As a result, we cannot assure our shareholders that we will declare or pay dividends on shares of our common stock in the future.

 

Even though our common stock is currently traded on The NASDAQ Global Market, the trading volume of our common stock has been low and the sale of substantial amounts of our common stock in the public market could depress the price of our common stock.

 

While we believe that because we are listed on The NASDAQ Global Market, the trading volume of our common stock should increase, we cannot be certain when a more active and liquid trading market for our common stock will develop or be sustained. Because of this, our shareholders may not be able to sell their shares at the volumes, prices or times that they desire.

 

We cannot predict the effect, if any, that future sales of our common stock in the market, or availability of shares of our common stock for sale in the market, will have on the market price of our common stock. We, therefore, can give no assurance that sales of substantial amounts of our common stock in the market, or the potential for large amounts of sales in the market, would not cause the price of our common stock to decline or impair our ability to raise capital through sales of our common stock.

 

14



 

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

 

Our recent results may not be indicative of our future results.

 

We may not be able to sustain our historical rate of growth or may not even be able to grow our business at all. In addition, our recent growth may distort some of our historical financial ratios and statistics. In the future, we may not have the benefit of several recently favorable factors, a strong local business environment, and relationships with an extensive group of equipment vendors and financial services companies. Various factors, such as economic conditions, regulatory and legislative considerations and competition, may also impede or prohibit our ability to grow.

 

ITEM 1B.               UNRESOLVED STAFF COMMENTS

 

None

 

ITEM 2.                PROPERTIES

 

Our main office is located in Williamson County at 381 Mallory Station Road, Suite 207, Franklin, Tennessee 37067, which is also the main office of the Bank.  This location is centrally located and in a high traffic/exposure area. The Bank leases 32,711 square feet at a competitive rate and the term of the lease expires in December 2017.  The Bank provides services throughout the community by use of a network of couriers, third party ATMs and state-of-the-art electronic banking. The Bank also operates a loan production office located in Jefferson County at One Chase Corporate Center, Suite 400, Birmingham, Alabama 35244, where the Bank leases 560 square feet at a competitive rate under the terms of a lease.

 

ITEM 3.                LEGAL PROCEEDINGS

 

To the best of our knowledge, there are no pending legal proceedings, other than routine litigation incidental to the business, to which we or the Bank is a party or of which any of our or the Bank’s property is the subject.

 

ITEM 4.                SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

No matter was submitted to a vote of security holders during the fourth quarter of 2007 through the solicitation of proxies or otherwise.

 

15



 

PART II

 

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

 

Our common stock has been listed on The NASDAQ Global Market since June 9, 2006. Before that date, it was traded on the Over-The-Counter Bulletin Board from December 16, 2005, and prior to that time, it was not traded through an organized exchange. The number of shareholders of record at March 14, 2008, was 411. The table below shows the quarterly range of high and low sale prices for our common stock during the fiscal years 2007 and 2006. These sale prices represent known transactions and do not necessarily represent all trading transactions for the periods.

 

Year

 

High

 

Low

 

 

 

 

 

 

 

 

 

2006:

 

First Quarter

 

$

25.00

 

$

19.00

 

 

 

Second Quarter

 

$

20.50

 

$

17.90

 

 

 

Third Quarter

 

$

22.23

 

$

15.91

 

 

 

Fourth Quarter

 

$

32.20

 

$

22.15

 

2007:

 

First Quarter

 

$

31.00

 

$

26.89

 

 

 

Second Quarter

 

$

30.00

 

$

23.52

 

 

 

Third Quarter

 

$

28.19

 

$

21.04

 

 

 

Fourth Quarter

 

$

27.10

 

$

19.75

 

 

Dividends

 

We have never declared or paid dividends on our common stock. Our payment of cash dividends is subject to the discretion of our Board of Directors and the Bank’s ability to pay dividends.  The Bank’s ability to pay dividends is restricted by applicable regulatory requirements. For more information on these restrictions, please see PART I, ITEM 1 “BUSINESS – Supervision and Regulation – Payment of Dividends.”  No assurances can be given that any dividend will be declared or, if declared, what the amount of such dividend would be or whether such dividends would continue in the future.

 

Recent Sales of Unregistered Securities

 

At various times during 2007, options to purchase 272,522 shares of our common stock were exercised by employees of the Bank, in 38 different transactions, at exercise prices ranging from $5.00 to $16.00 per share for an aggregate price of $2.1 million. We issued these shares of our common stock in reliance upon the exemption from the registration requirements of the Securities Act of 1933, as amended, as set forth in Section 4(2) under the Securities Act and Rule 701 of Regulation D promulgated thereunder relating to sales by an issuer not involving any public offering, to the extent an exemption from such registration was required.

 

Purchases of Equity Securities by the Registrant and Affiliated Purchasers

 

The Corporation made no repurchases of its equity securities, and no Affiliated Purchasers (as defined in Rule 10b-18(a)(3) under the Securities Exchange Act of 1934) purchased any shares of the Corporation’s equity securities during the fourth quarter of the fiscal year ended December 31, 2007.

 

16



 

ITEM 6.                                           SELECTED FINANCIAL DATA

 

The following selected financial data for the years ended December 31, 2007, 2006, 2005, 2004 and 2003 should be read in conjunction with the financial statements included in Item 8:

 

 

 

2007

 

2006

 

2005

 

2004

 

2003

 

 

 

(Dollars in Thousands except share data)

 

Operating Data:

 

 

 

 

 

 

 

 

 

 

 

Total interest income

 

$

62,206

 

$

41,245

 

$

23,633

 

$

13,185

 

$

8,205

 

Total interest expense

 

34,934

 

21,868

 

10,006

 

4,265

 

2,976

 

Net interest income

 

27,272

 

19,377

 

13,627

 

8,920

 

5,229

 

Provision for loan losses

 

(6,350

)

(4,350

)

(3,700

)

(2,420

)

(1,115

)

Net interest income after provision for loan losses

 

20,922

 

15,027

 

9,927

 

6,500

 

4,114

 

Non-interest income:

 

 

 

 

 

 

 

 

 

 

 

Investment securities gains

 

26

 

 

4

 

33

 

132

 

Gain on sale of loans

 

2,687

 

2,025

 

1,106

 

504

 

 

Other income

 

167

 

(262

)

201

 

263

 

300

 

Non-interest expense

 

(13,263

)

(9,056

)

(6,246

)

(4,552

)

(3,459

)

Income before income taxes

 

10,539

 

7,734

 

4,992

 

2,748

 

1,087

 

Income tax (expense) benefit

 

(3,643

)

(2,985

)

(1,925

)

(1,082

)

(188

)

Net income

 

$

6,896

 

$

4,749

 

$

3,067

 

$

1,666

 

$

899

 

 

 

 

 

 

 

 

 

 

 

 

 

Per Share Data :

 

 

 

 

 

 

 

 

 

 

 

Net income, basic

 

$

1.49

 

$

1.24

 

$

0.95

 

$

0.57

 

$

0.40

 

Net income, diluted

 

$

1.41

 

$

1.14

 

$

0.87

 

$

0.53

 

$

0.38

 

Book value

 

$

13.36

 

$

11.51

 

$

8.16

 

$

7.29

 

$

5.44

 

 

 

 

 

 

 

 

 

 

 

 

 

Financial Condition Data:

 

 

 

 

 

 

 

 

 

 

 

Assets

 

$

900,153

 

$

623,518

 

$

404,040

 

$

245,917

 

$

156,075

 

Loans, net

 

784,001

 

538,550

 

344,187

 

213,326

 

133,187

 

Investments

 

73,753

 

56,943

 

31,992

 

18,690

 

12,978

 

Cash and due from financial institutions

 

5,236

 

177

 

6,877

 

3,838

 

5,224

 

Federal funds sold

 

9,573

 

13,820

 

12,535

 

6,582

 

2,498

 

Premises and equipment, net

 

1,413

 

1,633

 

769

 

609

 

673

 

Deposits

 

815,053

 

560,567

 

367,705

 

221,394

 

142,293

 

Federal funds purchased

 

2,000

 

 

 

 

 

Long term debt

 

8,248

 

8,248

 

8,248

 

 

 

Other liabilities

 

11,592

 

3,479

 

1,657

 

923

 

384

 

Shareholders’ equity

 

63,121

 

51,224

 

26,430

 

23,600

 

13,398

 

 

 

 

 

 

 

 

 

 

 

 

 

Selected Ratios:

 

 

 

 

 

 

 

 

 

 

 

Overhead ratio (1)

 

1.76

%

1.80

%

1.98

%

2.26

%

2.70

%

Efficiency ratio (2)

 

43.99

%

42.84

%

41.81

%

46.83

%

61.11

%

Net yield on earning assets

 

8.50

%

8.46

%

7.70

%

6.74

%

6.62

%

Cost of funds

 

5.18

%

4.94

%

3.66

%

2.54

%

2.75

%

Net Interest margin

 

3.72

%

3.98

%

4.44

%

4.56

%

4.22

%

Operating expenses to average earning assets

 

1.81

%

1.86

%

2.03

%

2.33

%

2.79

%

Return on average assets

 

0.91

%

0.95

%

0.97

%

0.83

%

0.70

%

Return on average equity

 

12.13

%

12.68

%

12.29

%

8.92

%

8.00

%

Average equity to average assets

 

7.53

%

7.46

%

7.90

%

9.28

%

8.78

%

Ratio of nonperforming assets to average assets

 

1.14

%

0.94

%

1.40

%

1.90

%

1.99

%

Ratio of allowance for loan losses to average assets

 

1.37

%

1.39

%

1.39

%

1.41

%

1.56

%

Ratio of allowance for loan losses to nonperforming assets

 

119.94

%

146.91

%

99.43

%

74.45

%

78.59

%

 


(1) Operating expenses divided by average assets.

(2) Operating expenses divided by net interest income and noninterest income.

 

17



 

ITEM 7.

 

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION

 

Forward-Looking Statements

 

Certain statements contained in this report may not be based on historical facts and are “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements may be identified by reference to a future period or by the use of forward-looking terminology, such as “expect,” “anticipate,” “believe,” “estimate,” “foresee,” “may,” “might,” “will,” “intend,” “could,” “would,” “plan,” “forecast” or future or conditional verb tenses and variations or negatives of such terms. These forward-looking statements include, without limitation, those relating to the efficiency and efficacy of the business bank model, the conduct of business apart from the activities of the Bank, competition, employee relations of the Bank, legislative changes affecting banks or bank holding companies, the payment of dividends, the Bank’s capitalization under FDICIA, the impact of the Interstate Act on the Bank, brokered deposits regulation, FDIC insurance premiums, monetary policies of the Federal Reserve System, liquidity, capital adequacy and the Bank’s ability to raise additional capital, growth of our market area, an acquisitive banking environment, our practice of competing for loans based on superior service rather than lowest price, loan loss reserve, loans classified as doubtful or substandard, allowance for loan losses, non-interest income, revenue results from our mortgage unit, loan sales, opportunities offered by Bank growth, the hiring of additional employees, salaries and benefits expense, tax rates, earning asset to total asset ratio, the cost of funds for local deposits, utilization of an electronic bulletin board for funding in the wholesale deposit market, engagement of a deposit broker, borrowers’ ability to repay loans, the impact of recent accounting pronouncements, rate sensitivity gap analysis, economic value of equity, maturities of debt securities, fair value of debt securities, unrecognized tax benefits and the issuance of preferred stock. We caution you not to place undue reliance on the forward-looking statements contained in this report because actual results could differ materially from those indicated in such forward-looking statements as a result of a variety of factors. These factors include, but are not limited to, changes in economic conditions, competition for loans, mortgages and other financial services and products, changes in interest rates, concentrations within our loan portfolio, our ability to maintain credit quality, the effectiveness of our risk monitoring systems, changes in consumer preferences, the ability of our borrowers to repay loans, the availability of and costs associated with maintaining and/or obtaining adequate and timely sources of liquidity, changes in our operating strategy, our ability to meet regulatory capital adequacy requirements, our ability to collect amounts due under loan agreements and to attract deposits, our ability to attract, train and retain qualified personnel, the geographic concentration of our assets, our ability to operate and integrate new technology, our ability to provide market competitive products and services, our ability to diversify revenue, our ability to fund growth with lower cost liabilities, laws and regulations affecting financial institutions in general and other factors detailed from time to time in our press releases and filings with the Securities and Exchange Commission. We undertake no obligation to update these forward-looking statements to reflect the occurrence of changes or unanticipated events, circumstances or results that occur after the date of this report.

 

Overview

 

(Dollars in thousands except share data in the remainder of this Item 7.)

 

The results of operations for the year 2007 compared to 2006 reflected a 45.21% increase in net income and a 23.68% increase in diluted earnings per share.  The increase in earnings resulted primarily from a 40.74% increase in net interest income because of higher average loan balances.  The net interest margin for 2007 was 3.72%. The increased revenue was partially offset by increases in non-interest expense and the provision for loan losses.  The year 2007 reflected a continuation of the Bank’s trend of rapid asset growth.  The asset growth was a result of the strength of the Middle Tennessee economy and the success of our Business Bank operating strategy.

 

Our growth in assets was a result of growth in the market area and effective marketing. The improvement in results including net income and earnings per share was a result of the business focus of the Bank. From 2000 to 2007, the Bank’s market area experienced explosive growth. In Williamson County, demographic information shows a 31.84% growth in the number of households from 2000 to 2007.  Estimates from SNL show that by 2012 the number of households will have grown by another 20.63%. Although estimates of growth are not guaranteed and actual growth may be affected by factors beyond our control, management believes that the projected growth of our market area will positively impact the Bank’s future growth.

 

18



 

The Bank has also grown by marketing to business owners that have been left without a long standing banking relationship. The Middle Tennessee area has experienced several bank mergers or acquisitions in the last ten years resulting in the termination of many long standing relationships. These acquisitions also resulted in loan funding decisions being made out-of-state, creating unpredictability for local lending personnel and uncertainty for local businesses. The Bank has taken advantage of this uncertainty by offering loans at a fair rate and funded locally in a timely manner. Management believes the competitive advantage created by this environment will continue to positively impact results from operations.

 

The Business Bank operating strategy has enabled management to focus on managing results. Rather than focusing on building a multi-branch infrastructure including hiring and construction of buildings, management focuses on managing net interest margin aggressively and controlling non-interest expense. This has resulted in a 11.85% decrease in the net interest margin from 2003 to 2007. Non-interest expense is controlled by efficiently staffing the Bank’s operations. In 2007, that resulted in $14,060 in assets per employee at year end. Management believes that the Business Bank operating strategy will continue to be an effective model in the future.

 

Changes in Results of Operations

 

Net Income - Net income for 2007 was $6,896, an increase of $2,147, or 45.21%, compared to the $4,749 earned in 2006. The increase was attributable to a 40.74% increase in net interest income from $19,377 in 2006 to $27,272 in 2007. The increase of $7,895 in net interest income was the result of higher average loan balances. Non-interest income increased by $1,117, from $1,763 to $2,880, or 63.36%, primarily a result of gains on loan sales. These positive effects were partially offset by a 45.98% increase in the provision for loan losses, from $4,350 in 2006 to $6,350 in 2007, and an increase of $4,207 in non-interest expense, up 46.46% to $13,263 in 2007 compared to $9,056 in 2006. The increase in the provision for loan losses was the result of funding the loan loss reserve to match the growth in the loan portfolio and loan charge-offs. The increase in non-interest expense was a result of the increase in personnel and general operating expenses attributable to the Corporation’s growth.

 

Net income for 2006 was $4,749, an increase of $1,682, or 54.84%, compared to the $3,067 earned in 2005.  The increase was attributable to a 42.20% increase in net interest income from $13,627 in 2005 to $19,377 in 2006.  The increase of $5,750 in net interest income was the result of higher average loan balances.  Non-interest income increased by $452, from $1,311 to $1,763, or 34.48%, primarily as a result of to gains on loan sales. These positive effects were partially offset by a 17.57% increase in the provision for loan losses, from $3,700 in 2005 to $4,350 in 2006 and an increase of $2,810 in non-interest expense, up 44.99% to $9,056 in 2006 compared to $6,246 in 2005.  The increase in the provision for loan losses was the result of funding the loan loss reserve to match the growth in the loan portfolio and loan charge-offs.  The increase in non-interest expense was a result of the increase in personnel and general operating expenses attributable to the Corporation’s growth.

 

Net Interest Income - The primary source of earnings for the Bank is net interest income, which is the difference between the interest earned on interest earning assets and the interest paid on interest bearing liabilities.  The major factors which affect net interest income are changes in volumes, the yield on earning assets and the cost of interest bearing liabilities.  Management’s ability to respond to changes in interest rates by effective asset-liability management techniques is critical to maintaining the stability of the net interest margin and the momentum of the Bank’s primary source of earnings.

 

In mid-2004, the Federal Reserve Open Market Committee (“FOMC”) began a series of increases in short-term interest rates.  By year-end 2007, the FOMC had increased rates by 300 basis points. During 2007, $20,656 of our net loan growth occurred in floating rate construction loans and approximately 14.63% of the $141,156 increase in commercial loans was related to floating rate transactions. Management expects to continue its practice of competing for loans based on providing superior service rather than the lowest price.

 

Net interest income for 2007 was $27,272 compared to $19,377, a gain of $7,895 or 40.74%. The increase in net interest income was largely attributable to strong loan growth. Net loans increased from $538,550 at December 31, 2006 to $784,001 at December 31, 2007, an increase of $245,451 or 45.58%.  Net interest income was favorably impacted by the increase in the Bank’s indirect funding program for small transactions. These loans, which are purchased at a minimum rate of 8%, increased from $113,400 at year-end 2006 to $153,100 at the end of 2007. The loan growth was matched by an increase in deposits from $560,567 at December 31, 2006 to $815,053 in 2007, an increase of $254,486 or 45.40%.

 

19



 

Net interest income for 2006 was $19,377 compared to $13,627 in 2005, a gain of $5,750 or 42.20%.  The increase in net interest income was largely attributable to strong loan growth.  Net loans increased from $344,187 at December 31, 2005 to $538,550 at December 31, 2006 — an increase of $194,363 or 56.47%. Net interest income was favorably impacted by the expansion of the Bank’s indirect funding program for small transactions. These loans, which are purchased at a minimum rate of 8%, increased from $87,000 at year-end 2005 to $113,400 at the end of 2006.  This high yielding portfolio was a key component in the stability and strength of net interest income.  The loan growth was matched by an increase in deposits from $367,705 at December 31, 2005 to $560,567 in 2006 – an increase of $192,862 or 52.45%.

 

Investments - The Bank views the investment portfolio as a source of income and liquidity. Management’s investment strategy is to accept a lower immediate yield in the investment portfolio by targeting shorter term investments.   The Bank’s investment policy requires a minimum portfolio level equal to 7.00% of total assets and a maximum portfolio level of 20.00% of total assets.  Management has maintained the portfolio at the lower end of the policy guidelines with the portfolio at 8.19%, 9.13% and 7.91% of total assets at year-end in 2007, 2006 and 2005, respectively.

 

The investment portfolio at December 31, 2007 was $73,753 compared to $56,943 at year-end 2006. The interest earned on investments rose from $2,216 in 2006 to $3,492 in 2007, as a result of higher average portfolio balances as well as increased yields. The average yield on the investment portfolio investments rose from 4.91% in 2006 to 5.43% in 2007, or 52 basis points.

 

The investment portfolio at December 31, 2006 was $56,943, compared to $31,992 at year-end 2005. The average yield on the investment portfolio was 4.91% in 2006 compared to 4.19% in 2005.

 

Net Interest Margin Analysis - The net interest margin is impacted by the average volumes of interest sensitive assets and interest sensitive liabilities and by the difference between the yield on interest sensitive assets and the cost of interest sensitive liabilities (spread).  Loan fees collected at origination represent an additional adjustment to the yield on loans. The Bank’s spread can be affected by economic conditions, the competitive environment, loan demand and deposit flows.  The net yield on earning assets is an indicator of the effectiveness of a bank’s ability to manage the net interest margin by managing the overall yield on assets and the cost of funding those assets.

 

The two factors that make up the spread are the interest rates received on loans and the interest rates paid on deposits. The Bank has been disciplined in raising interest rates on deposits only as the market demands and thereby managing the cost of funds. Also, the Bank has not competed for new loans on interest rate alone but has relied on effective marketing to business customers. Business customers are not influenced by interest rates alone but are influenced by other factors such as timely funding.

 

The net interest margin declined from 3.98% in 2006 to 3.72% in 2007 because the cost of funds rose faster than the yield on earning assets during 2007. Interest income increased by $20,961, or 50.82%, from $41,245 in 2006 to $62,206 in 2007. The increase was primarily a result of increased loan volume. Average earning assets increased from $486,668 in 2006 to $731,749 in 2007, an increase of $245,081 or 50.36%. The increase in earning assets was a result of loan growth. Average loans increased $228,024 or 53.25% from 2006 to 2007. The average yield on earning assets increased from 8.46% in 2006 to 8.50% in 2007, or 4 basis points. The increase in the Bank’s indirect funded small loan portfolio favorably impacted the average yield on earning assets. The average yield on this type of loan in 2007 was 8.75%. These loans increased 35.01% from $113,400 at year-end 2006 to $153,100 at the end of 2007.   Interest expense increased from $21,868 in 2006 to $34,934 in 2007. The $13,066, or 59.75%, increase in expense was a result of increases in the volume of deposits as well as an increase in the cost of funds. Average deposits increased from $451,235 in 2006 to $685,063 in 2007, an increase of $233,828 or 51.82%. The cost of funds increased from 4.94% in 2006 to 5.18% in 2007, or 24 basis points.

 

20



 

The net interest margin declined from 4.44% in 2005 to 3.98% in 2006 because of the cost of funds rose faster than the yield on earning assets during 2006.  Interest income increased by $17,612, or 74.52%, from $23,633 in 2005 to $41,245 in 2006.  The increase was primarily a result of increased loan volume.  Average earning assets increased from $306,765 in 2005 to $486,668 in 2006, an increase of $179,903 or 58.65%.  The increase in earning assets was a result of loan growth. Average loans increased $150,365 or 54.12%.  The average yield on earning assets increased from 7.70% in 2005 to 8.46% in 2006, or 76 basis points. The net interest margin was favorably impacted by the expansion of the Bank’s indirect funded small loan portfolio.  These loans increased from $87,100 at year-end 2005 to $113,400 at the end of 2006.  This high yielding portfolio is a key component in the strength of the net interest margin.

 

Interest expense increased from $21,868 in 2006 to $34,934 in 2007.  The $13,066, or 59.75%, increase in expense was a result of increases in the volume of deposits as well as interest rates. Average interest bearing deposits increased from $432,910 in 2006 to $663,816 in 2007, an increase of $230,906 or 53.34%. Additionally, the cost of funds increased from 4.94% in 2006 to 5.18% in 2007.

 

Interest expense increased from $10,006 in 2005 to $21,868 in 2006.  The $11,862, or 118.55%, increase in expense was a result of increases in the volume of deposits.   Average interest bearing deposits increased from $266,214 in 2005 to $432,910 in 2006, an increase of $166,696 or 62.62%.  Despite the fact that rates started increasing in the last half of 2006, management was aggressive in lowering interest rates on savings accounts and other products during the year.  As a result, the cost of funds increased from 3.66% in 2005 to 4.94% in 2006, an increase of 128 basis points. The local deposit market is highly competitive and rates tend to lead national averages.  The Bank partially offsets the higher cost of local deposits by acquisition of wholesale funding in the national market.

 

Provision for Loan Losses - Management assesses the adequacy of the allowance for loan losses with a combination of qualitative and quantitative factors.  At inception, each loan is assigned a risk rating that ranges from “RR1 to RR4.”  An RR1 assignment indicates a “Superior” credit, RR2 represents an “Excellent” credit, RR3 represents an “Above-Average” loan, and RR4 designates an “Average” credit.  The assignment of a risk rating is based on an evaluation of the credit risk in the transaction.  The evaluation includes consideration of the borrower’s financial capacity, collateral, cash flows, liquidity, and alternative sources of repayment.  If a loan deteriorates and the level of risk increases, management downgrades the loan to RR5–“Watch,” RR6–“Criticized,” or RR7–“Substandard,” depending on the circumstances.  A review by an independent accounting firm of the assigned risk ratings is an integral part of the Bank’s external loan review program.

 

Management reviews the loan portfolio regularly to determine if loans should be placed on non-accrual for revenue recognition. If a loan is placed on non-accrual, all interest earned since the last current payment is immediately reversed.  Loans may remain on non-accrual status until the underlying collateral is repossessed and valued or until the amount of loss in the credit can be reasonably determined.  Once collateral is repossessed and appraised, the collateral is recorded as a repossession at the lower of fair value or the investment in the related loan.  Any difference between the estimated fair value of the collateral and the loan balance is charged off.  Variances in fair value estimates are recorded as a gain or loss on sale when the collateral is sold.   Non-accrual loans totaled $6,465, $2,689 and $2,928 at year-end 2007, 2006 and 2005, respectively.  These amounts represented 0.82%, 0.50% and 0.85%, respectively, of net loans at the end of each year.

 

Management uses the weighted average risk rating to monitor the overall credit quality and trends in the loan portfolio. At December 31, 2007, the weighted average risk rating of the $784,001 net loan portfolio was 3.56. At December 31, 2006, the weighted average risk rating of the $538,550 net loan portfolio was 3.56.  The Board of Directors reviews the weighted average risk rating of loans booked during the previous month.  In addition, the Board reviews all credits classified RR5 or higher monthly.  Management closely monitors other key loan quality indicators including delinquencies, changes in the portfolio mix and general economic conditions.  These actions provide a degree of objectivity in assessing the risk in the portfolio and establishing an adequate loan loss reserve.  To the extent that actual and anticipated losses differ, adjustments are made to the loan loss provision or to the level of the allowance for loan losses. At December 31, 2007, the loan loss reserve of $10,321 was 1.30% of gross loans of $794,322.

 

The provision for loan losses in 2007 was $6,350, an increase of $2,000, or 45.98%, above the provision of $4,350 expensed in 2006. Of this provision, $3,353, or 52.80%, was attributable to loan growth recorded during 2007. The remainder of the loan loss provision in 2007 funded net charge offs of $2,997.

 

21



 

The provision for loan losses in 2006 was $4,350, an increase of $650, or 17.57%, above the provision expensed in 2005. Of this provision, $2,569, or 59.06%, was attributable to maintaining a general reserve for the loan growth recorded during 2006.  The remainder of the loan loss provision in 2006 funded net charge offs of $1,781.

 

The Bank targets small and medium sized businesses as loan customers. Because of their size, these borrowers may be less able to withstand competitive or economic pressures than larger borrowers in periods of economic weakness. If loan losses occur to a level where the loan loss reserve is not sufficient to cover actual loan losses, the Bank’s earnings will decrease. The Bank uses an independent accounting firm to review our loans quarterly for quality in addition to the reviews that may be conducted by bank regulatory agencies as part of their usual examination process.

 

The following table presents information regarding non-accrual, past due and restructured loans at December 31, 2007, 2006, 2005, 2004 and 2003:

 

 

 

December 31,

 

 

 

2007

 

2006

 

2005

 

2004

 

2003

 

 

 

(Dollars in thousands)

 

Non-accrual loans

 

 

 

 

 

 

 

 

 

 

 

Number

 

130

 

60

 

46

 

17

 

12

 

Amount

 

$

6,465

 

$

2,689

 

$

2,928

 

$

2,161

 

$

1,136

 

 

 

 

 

 

 

 

 

 

 

 

 

Accruing loans which are contractually past due 90 days or more as to principal and interest payments

 

 

 

 

 

 

 

 

 

 

 

Number

 

44

 

18

 

9

 

4

 

6

 

Amount

 

$

1,992

 

$

940

 

$

352

 

$

111

 

$

308

 

 

 

 

 

 

 

 

 

 

 

 

 

Loans defined as “troubled debt restructurings”

 

 

 

 

 

 

 

 

 

 

 

Number

 

1

 

3

 

3

 

2

 

1

 

Amount

 

$

148

 

$

1,114

 

$

1,144

 

$

1,544

 

$

1,101

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross interest income lost on the non-accrual loans

 

$

436

 

$

174

 

$

133

 

$

82

 

$

193

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest income included in net income on the accruing loans

 

$

605

 

$

73

 

$

31

 

$

48

 

$

29

 

 

As of December 31, 2007, there were no loans classified for regulatory purposes as doubtful or substandard that have not been disclosed in the above table, which (i) represent or result from trends or uncertainties that management reasonably expects will materially impact future operating results, liquidity, or capital resources, or (ii) represent material credits about which management is aware of any information which causes management to have serious doubts as to the ability of such borrowers to comply with the loan repayment terms.

 

The Bank had no tax-exempt loans during the years ended December 31, 2007 and December 31, 2006. The Bank had no loans outstanding to foreign borrowers at December 31, 2007 and December 31, 2006.

 

22



 

An analysis of the Bank’s loss experience is furnished in the following table for December 31, 2007, 2006, 2005, 2004 and 2003, and the years then ended:

 

 

 

December 31,

 

(Dollars in thousands)

 

2007

 

2006

 

2005

 

2004

 

2003

 

Allowance for loan losses at beginning of period

 

$

6,968

 

$

4,399

 

$

2,841

 

$

2,000

 

$

1,103

 

Charge-offs:

 

 

 

 

 

 

 

 

 

 

 

Real estate:

 

 

 

 

 

 

 

 

 

 

 

Construction

 

32

 

 

 

 

 

1 to 4 family residential

 

 

 

 

101

 

 

Other

 

 

 

 

131

 

 

Commercial, financial and agricultural

 

3,262

 

2,026

 

2,379

 

1,366

 

235

 

Consumer

 

16

 

11

 

32

 

57

 

48

 

Other

 

 

 

 

 

 

Total Charge-offs

 

3,310

 

2,037

 

2,411

 

1,655

 

283

 

 

 

 

 

 

 

 

 

 

 

 

 

Recoveries:

 

 

 

 

 

 

 

 

 

 

 

Real estate:

 

 

 

 

 

 

 

 

 

 

 

Construction

 

 

 

 

 

 

1 to 4 family residential

 

 

 

1

 

 

 

Other

 

 

 

 

3

 

 

Commercial, financial and agricultural

 

313

 

234

 

245

 

68

 

64

 

Consumer

 

 

22

 

23

 

5

 

1

 

Other

 

 

 

 

 

 

Total Recoveries

 

313

 

256

 

269

 

76

 

65

 

 

 

 

 

 

 

 

 

 

 

 

 

Net Charge-offs

 

2,997

 

1,781

 

2,142

 

1,579

 

218

 

 

 

 

 

 

 

 

 

 

 

 

 

Provision for loan losses charged to expense

 

6,350

 

4,350

 

3,700

 

2,420

 

1,115

 

 

 

 

 

 

 

 

 

 

 

 

 

Allowance for loan losses at end of period

 

$

10,321

 

$

6,968

 

$

4,399

 

$

2,841

 

$

2,000

 

 

 

 

December 31,

 

 

 

2007

 

2006

 

2005

 

2004

 

2003

 

Net charge-offs as a percentage of average total loans outstanding during the year

 

0.45

%

0.41

%

0.76

%

0.89

%

0.20

%

Ending allowance for loan losses as a percentage of total loans outstanding at end of year

 

1.30

%

1.28

%

1.26

%

1.31

%

1.48

%

 

The allowance for loan losses is established by charges to operations based on management’s evaluation of the loan portfolio, past due loan experience, collateral values, current economic conditions and other factors considered necessary to maintain the allowance at an adequate level. Management believes that the allowance was adequate at December 31, 2007.

 

23



 

At December 31, 2007, 2006, 2005, 2004 and 2003, the allowance for loan losses was allocated as follows:

 

 

 

2007

 

2006

 

2005

 

2004

 

2003

 

(Dollars in thousands)

 

Amount

 

Percentage
of loans in
each
category to
total loans

 

Amount

 

Percentage
of loans in
each
category to
total loans

 

Amount

 

Percentage
of loans in
each
category to
total loans

 

Amount

 

Percentage
of loans in
each
category to
total loans

 

Amount

 

Percentage
of loans in
each
category to
total loans

 

Real estate:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Construction

 

$

1,132

 

14.15

%

$

745

 

13.65

%

$

383

 

10.98

%

$

175

 

10.55

%

$

71

 

7.68

%

1 to 4 family residential

 

335

 

4.22

%

229

 

4.19

%

225

 

5.27

%

75

 

7.38

%

57

 

10.00

%

Other

 

1,440

 

18.13

%

840

 

15.40

%

504

 

14.45

%

265

 

15.59

%

331

 

14.85

%

Commercial, financial and agricultural

 

7,130

 

60.14

%

5,048

 

64.89

%

3,197

 

67.11

%

2,272

 

64.68

%

1,510

 

65.03

%

Consumer

 

56

 

0.50

%

37

 

0.60

%

45

 

0.90

%

54

 

1.80

%

31

 

2.44

%

Other

 

228

 

2.86

%

69

 

1.27

%

45

 

1.29

%

 

0.00

%

 

0.00

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

10,321

 

100.00

%

$

6,968

 

100.00

%

$

4,399

 

100.00

%

$

2,841

 

100.00

%

$

2,000

 

100.00

%

 

Non-interest Income - Non-interest income is income that is not related to interest-earning assets.  In a typical retail bank, non-interest income consists primarily of service charges and fees on deposit accounts and mortgage origination fees.  Because of the business focus of the Bank and its lack of a large retail customer base, revenues from these traditional sources will remain modest.

 

The Bank earned $76 in mortgage origination fees in 2007 compared to $89 earned in 2006, a decline of $13 or 14.61%. The decline in mortgage loan demand and mortgage origination income was attributed to the disruption in the mortgage market in 2007. Management believes that in 2008 the mortgage unit will provide a value-added service with modest revenue results.

 

The Bank earned $2,687 in 2007 on a series of loan sale transactions compared to $2,025 in 2006. The Bank is located in a vibrant market area and can generate quality assets at a faster rate than it can adequately fund them. In addition to lending in the local marketplace, the Bank provides collateral-based loans to business borrowers in other states through two types of indirect funding programs. Management has identified a network of community banks eager to purchase quality assets. Management has installed appropriate systems and processes to sell assets to other banks located in slower growing markets and believes that loan sales will be a recurring source of revenue.

 

In 2006, the Bank earned $2,025 on a series of loan sale transactions.  The Bank earned $89 in mortgage origination fees in 2006 compared to $105 earned in 2005, a decline of $16 or 15.24%.  The decline in mortgage origination income was attributed to rising interest rates in 2006.  Income earned in the form of service charges on deposits totaled $112, a loss of $2, or 1.75% below the $114 earned in 2005.  Gain on sales of securities declined by $4 or 100% from $4 in 2005 to $0 in 2006.

 

Non-interest Expense - Non-interest expense includes salaries and benefits expense, occupancy costs and other operating expenses including data processing, professional fees, supplies, postage, telephone and other items. Management views the control of operating expense as a critical element in the success of the Business Bank strategy.  The Bank operates more efficiently than most peer banks because it conducts business from a single location and does not provide banking services for many retail customers with high transaction volume.

 

Management targets $7,500 in assets per full-time employee as a measure of staffing efficiency. Management believes that the growth of the Bank will offer additional opportunities to leverage personnel resources.  The Bank does expect to hire employees in 2008, so salaries and benefits expense will increase, but the target for Average Assets per Employee will remain at $7,500 per employee.

 

Non-interest expense for 2007 was $13,263, an increase of $4,207 or 46.46%, over the $9,056 expensed in 2006. Approximately 70% of the increase was attributable to the addition of new employees during the year. The Bank ended 2007 with 64 full-time employees. Assets per employee were $14,060 at year-end 2007 compared to $12,500 at year-end 2006.

 

Non-interest expense for 2006 was $9,056, an increase of $2,810 or 44.99%, over the $6,246 expensed in 2005.  Approximately 48% of the increase was attributable to the addition of new employees during the year.  The Bank ended 2006 with 50 full-time employees.  Assets per employee were $12,500 at year-end 2006 and $9,800 at year-end 2005.

 

24



 

Income Taxes — Our effective tax rate in 2007 was 34.57% compared to 38.60% in 2006 and 38.56% in 2005. Management anticipates that tax rates in future years will approximate the rates paid in 2007.

 

Changes in Financial Condition

 

Assets - Total assets at December 31, 2007 were $900,153, an increase of $276,635 or 44.37%, over total assets of $623,518 at December 31, 2006. Average assets for 2007 were $755,254, an increase of $253,276, or 50.46% over average assets in 2006. Loan growth was the primary reason for the increases. Year-end 2007 net loans were $784,001, up $245,451, or 45.58% over the year-end 2006 total net loans of $538,550.

 

Total assets at December 31, 2006, were $623,518, an increase of $219,478 or 54.32%, over total assets of $404,040 at December 31, 2005.  Average assets for 2006 were $501,978, an increase of $186,004, or 58.87% over average assets in 2005.  Loan growth was the primary reason for the increases.  Year-end 2006 net loans were $538,550, up $194,363, or 56.47% over the year-end 2005 total net loans of $344,187.

 

The Bank’s Business Bank model of operation results in a higher level of earning assets than most peer banks.  Earning assets are defined as assets that earn interest income.  Earning assets include short-term investments, the investment portfolio and net loans.  The Bank maintains a relatively high level of earning assets because few assets are allocated to facilities, cash and due-from bank accounts used for transaction processing. Earning assets at December 31, 2007 were $867,327, or 96.35% of total assets of $900,153. Earning assets at December 31, 2006 were $610,322, or 97.88% of total assets of $623,518.  Management targets an earning asset to total asset ratio of 97% or higher. This ratio is expected to generally continue at these levels, although it may be affected by economic factors beyond the Bank’s control.

 

Liabilities - The Bank relies on increasing its deposit base to fund loan and other asset growth.  The Williamson County marketplace is highly competitive with 24 financial institutions and 83 banking facilities (as of June 30, 2007). The Bank competes for local deposits by offering attractive products with premium rates.  The Bank expects to have a higher average cost of funds for local deposits than most competitor banks because of its single location and lack of a branch network.  Management’s strategy is to offset the higher cost of funding with a lower level of operating expense and firm pricing discipline for loan products.  The Bank has promoted electronic banking services by providing them without charge and by offering in-bank customer training.

 

The Bank also obtains funding in the wholesale deposit market which is accessed by means of an electronic bulletin board.  This electronic market links banks and sellers of deposits to deposit purchasers such as credit unions, school districts, labor unions, and other organizations with excess liquidity.  Deposits may be raised in $99 or $100 increments in maturities from two weeks to five years.  Management believes the utilization of the electronic bulletin board is highly efficient and the average rate has been generally less than rates paid in the local market. Participants in the electronic market pay a modest annual licensing fee and there are no transaction charges.  Management has established policies and procedures to govern the acquisition of funding through the wholesale market.  Wholesale deposits are categorized as “Purchased Time Deposits” on the detail of deposits shown in this Item 7. Management may also, from time to time, engage the services of a deposit broker to raise a block of funding at a specified maturity date.

 

Total average deposits in 2007 were $685,063, an increase of $233,828, or 51.82% over the total average deposits of $451,235 in 2006. Average non-interest bearing deposits increased by $2,922, or 15.95%, from $18,325 in 2006 to $21,247 in 2007. Average savings deposits decreased by $5,423 from $12,678 in 2006 to $7,255 in 2007. Average purchased deposits increased by $62,547, or 32.57%, from $192,064 in 2006 to $254,611 in 2007. The average rate paid on purchased deposits in 2007 was 5.28% compared to 4.82% in 2006. Purchased time deposit funding represented 37.27% of total funding in 2007 compared to 33.96% in 2006.

 

Total average deposits in 2006 were $451,235, an increase of $168,532, or 59.61% over the total average deposits of $282,703 in 2005.  Average non-interest bearing deposits increased by $1,836 or 11.13%, from $16,489 in 2005 to $18,325 in 2006. Average savings deposits decreased by $10,107 from $22,785 in 2005 to $12,678 in 2006.  Average purchased deposits increased by $45,738, or 31.26%, from $146,326 in 2005 to $192,064 in 2006.  The average rate paid on purchased time deposits in 2006 was 4.82% compared to 3.55% in 2005.  Purchased time deposit funding represented 42.56% of total funding in 2006 compared to 51.34% in 2005.

 

25



 

Loan Policy - Lending activity is conducted under guidelines defined in the Bank’s Loan Policy.  The Loan Policy establishes guidelines for analyzing financial transactions including an evaluation of a borrower’s credit history, repayment capacity, collateral value, and cash flow.  Loans may be at a fixed or variable rate, with the maximum maturity of fixed rate loans set at five years.

 

All lending activities of the Bank are under the direct supervision and control of the Officers Loan Committee, the Executive Committee of the Board and, in some cases, the full Board of Directors. The Officers Loan Committee consists of Arthur F. Helf, Michael R. Sapp and H. Lamar Cox, and approves loans up to $1,000. The Executive Committee consists of Arthur F. Helf, Michael R. Sapp and H. Lamar Cox and two outside directors, and approves loans up to 15% of Tier I Capital. The full Board of Directors approves all loans above those limits. The full Board of Directors also approves loan authorizations, if any, for any executive officer. The Bank’s established maximum loan volume to deposits is 100%. The Executive Committee of the Board makes a monthly review of loans which are 90 days or more past due and the full Board of Directors makes a quarterly review of loans which are 90 days or more past due.

 

Management of the Bank periodically reviews the loan portfolio, particularly non-accrual and renegotiated loans.  The review may result in a determination that a loan should be placed on a non-accrual status for income recognition.  In addition, to the extent that management identifies potential losses in the loan portfolio, it reduces the book value of such loans, through charge-offs, to their estimated collectible value.  The Bank’s policy is that accrual of interest is discontinued on a loan when management of the Bank determines that collection of interest is doubtful based on consideration of economic and business factors affecting collection efforts.

 

When a loan is classified as non-accrual, any unpaid interest is reversed against current income.  Interest is included in income thereafter only to the extent received in cash.  The loan remains in a non-accrual classification until such time as the loan is brought current, when it may be returned to accrual classification.  When principal or interest on a non-accrual loan is brought current, if in management’s opinion future payments are questionable, the loan would remain classified as non-accrual.  After a non-accrual or renegotiated loan is charged off, any subsequent payments of either interest or principal are applied first to any remaining balance outstanding, then to recoveries and lastly to income.

 

The Bank’s underwriting guidelines are applied to four major categories of loans, commercial and industrial, consumer, agricultural and real estate which includes residential, construction and development and certain other real estate loans.  The Bank requires its loan officers and loan committee to consider the borrower’s character, the borrower’s financial condition, the economic environment in which the loan will be repaid, as well as, for commercial loans, the borrower’s management capability and the borrower’s industry. Before approving a loan, the loan officer or committee must determine that the borrower is creditworthy, is a capable manager, understands the specific purpose of the loan, understands the source and plan of repayment, and determine that the purpose, plan and source of repayment as well as collateral are acceptable, reasonable and practical given the normal framework within which the borrower operates.

 

The maintenance of an adequate loan loss reserve is one of the fundamental concepts of risk management for every financial institution.  Management is responsible for ensuring that controls are in place to monitor the adequacy of the loan loss reserve in accordance with generally accepted accounting principles (“GAAP”), the Bank’s stated policies and procedures, and regulatory guidance.  Quantification of the level of reserve which is prudently conservative, but not excessive, involves a high degree of judgment.

 

Management’s assessment of the adequacy of the loan loss reserve considers a wide range of factors including portfolio growth, mix, collateral and geographic diversity, and terms and structure.  Portfolio performance trends, including past dues and charge-offs, are monitored closely.  Management’s assessment includes a continuing evaluation of current and expected market conditions and the potential impact of economic events on borrowers.  Management’s assessment program is monitored by an ongoing loan review program conducted by an independent accounting firm and periodic examinations by bank regulators.

 

Management uses a variety of financial methods to quantify the level of the loan loss reserve.  At inception, each loan transaction is assigned a risk rating that ranges from “RR1—Excellent” to “RR4—Average.”  The risk rating is determined by an analysis of the borrower’s credit history and capacity, collateral, and cash flow.  The weighted average risk rating of the portfolio provides an indication of overall risk and identifies trends.  The portfolio is additionally segmented by loan type, collateral, and purpose.  Loan transactions that have exhibited signs of increased risk are downgraded to a “Watch,” “Critical,” or “Substandard” classification, i.e., RR5, RR6 and RR7, respectively.  These loans are closely monitored for rehabilitation or potential loss and the loan loss reserve is adjusted accordingly.

 

26



 

It is management’s intent to maintain a loan loss reserve that is adequate to absorb current and estimated losses which are inherent in a loan portfolio.  The historical loss ratio (net charge-offs as a percentage of average loans) was 0.76%, 0.41% and 0.45% for the years ended December 31, 2005, 2006 and 2007, respectively.  The year end loan loss reserve as a percentage of end of period loans was 1.26%, 1.28% and 1.30%, respectively, for the same years.  Because of the commercial emphasis of the bank’s operation, management has kept a reserve level in excess of historical results.

 

The provision for loan losses for 2007 was $6,350,000, an increase of $2,000,000 over the $4,350,000 provision for 2006.  In 2007, expense reflected the impact of $3,310,000 in charge-offs during the year and the incremental provision required as a result of the $249,000 increase in loan volume.

 

Credit Risk Management and Reserve for Loan Losses

 

Credit risk and exposure to loss are inherent parts of the banking business.  Management seeks to manage and minimize these risks through its loan and investment policies and loan review procedures.  Management establishes and continually reviews lending and investment criteria and approval procedures that it believes reflect the risk sensitive nature of the Bank.  The loan review procedures are set to monitor adherence to the established criteria and to ensure that on a continuing basis such standards are enforced and maintained.  Management’s objective in establishing lending and investment standards is to manage the risk of loss and provide for income generation through pricing policies.

 

The Bank targets small- and medium-sized businesses as loan customers. Because of their size, these borrowers may be less able to withstand competitive or economic pressures than larger borrowers in periods of economic weakness. If loan losses occur to a level where the loan loss reserve is not sufficient to cover actual loan losses, the Bank’s earnings will decrease. The Bank uses an independent accounting firm to review its loans for quality in addition to the reviews that may be conducted by bank regulatory agencies as part of their usual examination process.

 

Management regularly reviews the loan portfolio and determines the amount of loans to be charged-off.  In addition, management considers such factors as the Bank’s previous loan loss experience, prevailing and anticipated economic conditions, industry concentrations and the overall quality of the loan portfolio. While management uses available information to recognize losses on loans and real estate owned, future additions to the allowance may be necessary based on changes in economic conditions.  In addition, various regulatory agencies, as an integral part of their examination process, periodically review the allowances for losses on loans and real estate owned.  Such agencies may require the Bank to recognize additions to the allowances based on their judgments about information available at the time of their examinations.  In addition, any loan or portion thereof which is classified as a “loss” by regulatory examiners is charged-off.

 

Financial Tables

 

The following financial information regarding the Corporation and the Bank should be read in conjunction with our financial statements included in Item 8 of this Report.

 

Average Balance Sheets, Net Interest Income and Changes in Interest Income and Interest Expense

 

The following tables present the average yearly balances of each principal category of assets, liabilities and stockholders’ equity of the Corporation and the Bank. The tables are presented on taxable equivalent basis, as applicable.

 

27



 

 

 

12 months Ended December 31, 2007

 

 

 

Average

 

 

 

Average

 

(Dollars in thousands)

 

Balance

 

Interest

 

Rate

 

ASSETS

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest earning assets

 

 

 

 

 

 

 

Securities

 

 

 

 

 

 

 

Taxable (1)

 

$

63,838

 

$

3,492

 

5.43

%

Tax-exempt

 

 

 

 

Total securities

 

63,838

 

3,492

 

5.43

%

 

 

 

 

 

 

 

 

Loans (2) (3)

 

656,210

 

58,114

 

8.86

%

Federal funds sold

 

11,701

 

600

 

5.13

%

Total interest earning assets

 

731,749

 

62,206

 

8.50

%

 

 

 

 

 

 

 

 

Non-interest earning assets

 

 

 

 

 

 

 

Cash and due from banks

 

5,057

 

 

 

 

 

Net fixed assets and equipment

 

1,539

 

 

 

 

 

Accrued interest and other assets

 

16,909

 

 

 

 

 

 

 

 

 

 

 

 

 

Total assets

 

$

755,254

 

 

 

 

 

 

 

 

 

 

 

 

 

LIABILITIES AND SHAREHOLDERS’ EQUITY

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest bearing liabilities

 

 

 

 

 

 

 

Deposits (other than demand)

 

$

663,816

 

34,245

 

5.16

%

Federal funds purchased

 

889

 

57

 

6.41

%

Subordinated debt

 

9,355

 

632

 

6.76

%

Total interest bearing liabilities

 

674,060

 

34,934

 

5.18

%

 

 

 

 

 

 

 

 

Non-interest bearing liabilities

 

 

 

 

 

 

 

Non-interest bearing demand deposits

 

21,247

 

 

 

 

 

Other liabilities

 

3,090

 

 

 

 

 

Shareholders’ equity

 

56,857

 

 

 

 

 

 

 

 

 

 

 

 

 

Total liabilities and shareholders’ equity

 

$

755,254

 

 

 

 

 

 

Net interest spread

 

3.32

%

 

 

 

 

Net interest margin

 

3.72

%

 


(1)   Unrealized loss of $463 is excluded from yield calculation.

(2)   Non-accrual loans are included in average loan balances and loan fees of $3,890 are included in interest income.

(3)   Loans are presented net of allowance for loan loss.

 

28



 

 

 

12 months Ended December 31, 2006

 

 

 

Average

 

Average

 

 

 

(Dollars in thousands)

 

Balance

 

Interest

 

Rate

 

ASSETS

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest earning assets

 

 

 

 

 

 

 

Securities

 

 

 

 

 

 

 

Taxable (1)

 

$

44,317

 

$

2,216

 

4.91

%

Tax-exempt

 

 

 

 

Total securities

 

44,317

 

2,216

 

4.91

%

 

 

 

 

 

 

 

 

Loans (2) (3)

 

428,186

 

38,382

 

8.96

%

Federal funds sold

 

14,165

 

647

 

4.57

%

Total interest earning assets

 

486,668

 

41,245

 

8.46

%

 

 

 

 

 

 

 

 

Non-interest earning assets

 

 

 

 

 

 

 

Cash and due from banks

 

4,268

 

 

 

 

 

Net fixed assets and equipment

 

1,146

 

 

 

 

 

Accrued interest and other assets

 

9,896

 

 

 

 

 

 

 

 

 

 

 

 

 

Total assets

 

$

501,978

 

 

 

 

 

 

 

 

 

 

 

 

 

LIABILITIES AND SHAREHOLDERS’ EQUITY

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest bearing liabilities

 

 

 

 

 

 

 

Deposits (other than demand)

 

$

432,910

 

21,216

 

4.90

%

Federal funds purchased

 

990

 

55

 

5.56

%

Subordinated debt

 

8,804

 

597

 

6.78

%

Total interest bearing liabilities

 

442,704

 

21,868

 

4.94

%

 

 

 

 

 

 

 

 

Non-interest bearing liabilities

 

 

 

 

 

 

 

Non-interest bearing demand deposits

 

18,325

 

 

 

 

 

Other liabilities

 

3,508

 

 

 

 

 

Shareholders’ equity

 

37,441

 

 

 

 

 

 

 

 

 

 

 

 

 

Total liabilities and shareholders’ equity

 

$

501,978

 

 

 

 

 

 

Net interest spread

 

3.52

%

 

 

 

 

Net interest margin

 

3.98

%

 


(1)   Unrealized loss of $803 is excluded from yield calculation.

(2)   Non-accrual loans are included in average loan balances and loan fees of $2,774 are included in interest income.

(3)   Loans are presented net of allowance for loan loss.

 

29



 

 

 

12 months Ended December 31, 2005

 

 

 

Average

 

 

 

Average

 

(Dollars in thousands)

 

Balance

 

Interest

 

Rate

 

ASSETS

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest earning assets

 

 

 

 

 

 

 

Securities

 

 

 

 

 

 

 

Taxable (1)

 

$

23,034

 

$

980

 

4.19

%

Tax-exempt

 

 

 

 

Total securities

 

23,034

 

980

 

4.19

%

 

 

 

 

 

 

 

 

Loans (2) (3)

 

277,821

 

22,488

 

8.09

%

Federal funds sold

 

5,910

 

165

 

2.79

%

Total interest earning assets

 

306,765

 

23,633

 

7.70

%

 

 

 

 

 

 

 

 

Non-interest earning assets

 

 

 

 

 

 

 

Cash and due from banks

 

4,097

 

 

 

 

 

Net fixed assets and equipment

 

731

 

 

 

 

 

Accrued interest and other assets

 

4,381

 

 

 

 

 

 

 

 

 

 

 

 

 

Total assets

 

$

315,974

 

 

 

 

 

 

 

 

 

 

 

 

 

LIABILITIES AND SHAREHOLDERS’ EQUITY

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest bearing liabilities

 

 

 

 

 

 

 

Deposits (other than demand)

 

$

266,214

 

9,568

 

3.59

%

Federal funds purchased

 

589

 

22

 

3.74

%

Subordinated debt

 

6,237

 

416

 

6.68

%

Total interest bearing liabilities

 

273,040

 

10,006

 

3.66

%

 

 

 

 

 

 

 

 

Non-interest bearing liabilities

 

 

 

 

 

 

 

Non-interest bearing demand deposits

 

16,489

 

 

 

 

 

Other liabilities

 

1,481

 

 

 

 

 

Shareholders’ equity

 

24,964

 

 

 

 

 

 

 

 

 

 

 

 

 

Total liabilities and shareholders’ equity

 

$

315,974

 

 

 

 

 

 

Net interest spread

 

4.03

%

 

 

 

 

Net interest margin

 

4.44

%

 


(1)   Unrealized loss of $357 is excluded from yield calculation.

(2)   Non-accrual loans are included in average loan balances and loan fees of $1,438 are included in interest income.

(3)   Loans are presented net of allowance for loan loss.

 

The following tables outline the components of the net interest margin for the years 2007, 2006 and 2005 and identify the impact of changes in volume and rate.

 

30



 

 

 

December 31, 2007 change from

 

 

 

December 31, 2006 a result of:

 

(Dollars in thousands)

 

Volume

 

Rate

 

Total

 

Interest income

 

 

 

 

 

 

 

Loans

 

$

20,199

 

$

(467

)

$

19,732

 

Securities – taxable

 

1,041

 

235

 

1,276

 

Federal funds sold

 

(121

)

74

 

(47

)

Total interest income

 

21,119

 

(158

)

20,961

 

 

 

 

 

 

 

 

 

Interest expense

 

 

 

 

 

 

 

Deposits (other than demand)

 

11,858

 

1,171

 

13,029

 

Federal funds purchased

 

(6

)

8

 

2

 

Subordinated debt

 

37

 

(2

)

35

 

Total interest expense

 

11,889

 

1,177

 

13,066

 

 

 

 

 

 

 

 

 

Net interest income

 

$

9,230

 

$

(1,335

)

$

7,895

 

 

 

 

December 31, 2006 change from

 

 

 

December 31, 2005 a result of:

 

(Dollars in thousands)

 

Volume

 

Rate

 

Total

 

Interest income

 

 

 

 

 

 

 

Loans

 

$

13,262

 

$

2,632

 

$

15,894

 

Securities – taxable

 

1,021

 

215

 

1,236

 

Federal funds sold

 

331

 

151

 

482

 

Total interest income

 

14,614

 

2,998

 

17,612

 

 

 

 

 

 

 

 

 

Interest expense

 

 

 

 

 

 

 

Deposits (other than demand)

 

7,369

 

4,279

 

11,648

 

Federal funds purchased

 

19

 

14

 

33

 

Subordinated debt

 

174

 

7

 

181

 

Total interest expense

 

7,562

 

4,300

 

11,862

 

 

 

 

 

 

 

 

 

Net interest income

 

$

7,052

 

$

(1,302

)

$

5,750

 

 

Liability and Asset Management

 

The matching of assets and liabilities may be analyzed by examining the extent to which such assets and liabilities are “interest rate sensitive” and by monitoring an institution’s interest rate sensitivity “gap.”  An asset or liability is said to be interest rate sensitive within a specific time period if it will mature or reprice within that time period.  The interest rate sensitivity gap is defined as the difference between the dollar amount of rate sensitive assets re-pricing during a period and the volume of rate sensitive liabilities re-pricing during the same period. A gap is considered positive when the amount of interest rate sensitive assets exceeds the amount of interest rate sensitive liabilities.  A gap is considered negative when the amount of interest rate sensitive liabilities exceeds the amount of interest rate sensitive assets.  During a period of rising interest rates, a negative gap would tend to adversely affect net interest income while a positive gap would tend to result in an increase in net interest income.  During a period of falling interest rates, a negative gap would tend to result in an increase in net interest income while a positive gap would tend to adversely affect net interest income.

 

The Bank’s Asset Liability and Investment Committee, which consists of our executive officers, Arthur F. Helf, Michael R. Sapp, H. Lamar Cox and George W. Fort, is charged with monitoring the liquidity and funds position of the Bank.  The committee regularly reviews (a) the rate sensitivity position on a three-month, six-month and one-year time horizon; (b) loans to deposit ratios; and (c) average maturity for certain categories of liabilities.  The Bank operates an asset/liability management model.  At December 31, 2007, the Bank had a negative cumulative re-pricing gap within one year of approximately $(59,608) or approximately 6.79% of total year-end earning assets. See Part II, Item 7A “QUANTITATIVE AND QUALITATIVE ANALYSIS OF MARKET RISK” for additional information.

 

31



 

Deposits

 

The Bank’s primary source of funds is interest-bearing deposits. The following tables present the average amount of and average rate paid on each of the following deposit categories for 2007, 2006 and 2005:

 

 

 

Year Ended December 31,

 

 

 

2007

 

2006

 

2005

 

 

 

 

 

Average

 

 

 

Average

 

 

 

Average

 

 

 

Average

 

Rate

 

Average

 

Rate

 

Average

 

Rate

 

(Dollars in thousands)

 

Balance

 

Paid

 

Balance

 

Paid

 

Balance

 

Paid

 

Types of Deposits

 

 

 

 

 

 

 

 

 

 

 

 

 

Non-interest-bearing demand deposits

 

$

21,247

 

 

$

18,325

 

 

$

16,489

 

 

Interest-bearing demand deposits

 

6,659

 

3.36

%

5,119

 

3.64

%

3,097

 

1.90

%

Money market accounts

 

111,747

 

4.84

%

72,866

 

5.23

%

39,485

 

3.88

%

Savings accounts

 

7,255

 

2.66

%

12,678

 

2.67

%

22,785

 

2.61

%

IRA accounts

 

17,522

 

5.88

%

5,450

 

4.91

%

2,183

 

4.31

%

Purchased time deposits

 

254,611

 

5.28

%

192,064

 

4.82

%

146,326

 

3.55

%

Time deposits

 

266,022

 

5.29

%

144,733

 

5.09

%

52,338

 

4.00

%

Total deposits

 

$

685,063

 

 

 

$

451,235

 

 

 

$

282,703

 

 

 

 

The following table indicates amount outstanding of time certificates of deposit of $100,000 or more and respective maturities as of December 31, 2007 (in thousands):

 

 

 

2007

 

 

 

 

 

Three months or less

 

$

69,310

 

 

 

 

 

Over three through 12 months

 

201,332

 

 

 

 

 

More than 12 months

 

94,155

 

Total

 

$

364,797

 

 

Investment Portfolio

 

The Bank’s investment portfolio at December 31, 2007, 2006 and 2005 consisted of the following (dollars in thousands):

 

32



 

 

 

 

 

Gross

 

Gross

 

Estimated

 

 

 

Amortized

 

Unrealized

 

Unrealized

 

Market

 

 

 

Cost

 

Gain

 

Loss

 

Value

 

As of December 31, 2007

 

 

 

 

 

 

 

 

 

Securities available for sale  

 

 

 

 

 

 

 

 

 

U.S. Government agencies

 

$

63,622

 

$

504

 

$

(36

)

$

64,090

 

Mortgage-backed securities

 

5,410

 

 

(104

)

5,306

 

Corporate debt securities

 

3,841

 

1

 

(66

)

3,776

 

Other

 

380

 

201

 

 

581

 

Total

 

$

73,253

 

$

706

 

$

(206

)

$

73,753