10-K 1 v429408_10k.htm FORM 10-K

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-K

 

xAnnual Report Pursuant to Section 13 OR 15(d) of the Securities Exchange Act of 1934

For the fiscal year ended December 31, 2015

or

 

¨Transition Report Pursuant to Section 13 OR 15(d) of the Securities Exchange Act of 1934

For the transition period from __________ to _________

 

Commission file number 000-23565

 

EASTERN VIRGINIA BANKSHARES, INC.

(Exact name of registrant as specified in its charter)

 

Virginia   54-1866052
(State or other jurisdiction of   (I.R.S. Employer Identification No.)
incorporation or organization)    

 

330 Hospital Road

Tappahannock, Virginia 22560

(Address of principal executive offices) (Zip Code)

 

Registrant’s telephone number, including area code: (804) 443-8400

 

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

 

Common Stock, $2 par value per share   The NASDAQ Stock Market LLC
Title of each class   Name of each exchange on which registered

 

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

NONE

 

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

 

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

 

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

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes x No ¨

 

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

 

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

 

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

 

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

 

The aggregate market value of common stock held by non-affiliates of the registrant as of June 30, 2015 was $78.7 million.

 

There were 13,029,550 shares of common stock, par value $2.00 per share, outstanding as of March 10, 2016.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the definitive Proxy Statement to be delivered to shareholders in connection with the 2015 Annual Meeting of Shareholders are incorporated by reference into Part III of this Annual Report on Form 10-K.

 

   

 

 

TABLE OF CONTENTS

 

Part I    
     
Item 1. Business 3
     
Item 1A. Risk Factors 14
     
Item 1B. Unresolved Staff Comments 23
     
Item 2. Properties 23
     
Item 3. Legal Proceedings 24
     
Item 4. Mine Safety Disclosures 24
     
Part II    
     
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 25
     
Item 6. Selected Financial Data 27
     
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 28
     
Item 7A. Quantitative and Qualitative Disclosures About Market Risk 67
     
Item 8. Financial Statements and Supplementary Data 69
     
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 69
     
Item 9A. Controls and Procedures 69
     
Item 9B. Other Information 70
     
Part III    
     
Item 10. Directors, Executive Officers and Corporate Governance 70
     
Item 11. Executive Compensation 70
     
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 70
     
Item 13. Certain Relationships and Related Transactions, and Director Independence 70
     
Item 14. Principal Accountant Fees and Services 70
     
Part IV    
     
Item 15. Exhibits, Financial Statement Schedules 71
     
Signatures   73

 

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Part I

 

Item 1. Business

 

General

 

Eastern Virginia Bankshares, Inc. (the “Company”) is a bank holding company headquartered in Tappahannock, Virginia that was organized and chartered under the laws of the Commonwealth of Virginia on September 5, 1997 and commenced operations on December 29, 1997. Through our wholly-owned bank subsidiary, EVB (the “Bank”), we operate twenty-four full service branches and two drive-in facilities in eastern Virginia, and one loan production office in Chesterfield County, Virginia. Two of EVB’s three predecessor banks, Bank of Northumberland, Inc. and Southside Bank, were established in 1910. The third bank, Hanover Bank, was established as a de novo bank in 2000. In April 2006, these three banks were merged and the surviving bank was re-branded as EVB. Additionally, the Company acquired Virginia Company Bank (“VCB”) on November 14, 2014 and merged VCB with and into the Bank with the Bank surviving, thereby adding to the Bank three additional branches located in Newport News, Williamsburg and Hampton.

 

EVB is a community bank targeting small to medium-sized businesses and consumers in our traditional coastal plain markets and the emerging suburbs outside of the Richmond, Tidewater, and southern Virginia areas. Our mission is dedicated to providing the highest quality financial services to our customers, enriching the health and vitality of the communities we serve, and enhancing shareholder value.

 

The accompanying consolidated financial statements include the accounts of the Company, the Bank and its subsidiaries, at times collectively referred to as the “Company”, “we”, “our”, or “us.”

 

We provide a broad range of personal and commercial banking services including commercial, consumer and real estate loans. We complement our lending operations with an array of retail and commercial deposit products and fee-based services. Our services are delivered locally by well-trained and experienced bankers, whom we empower to make decisions at the local level, so they can provide timely lending decisions and respond promptly to customer inquiries. Having been in many of our markets for over 100 years, we have established relationships with and an understanding of our customers. We believe that, by offering our customers personalized service and a breadth of products, we can compete effectively as we expand within our existing markets and into new markets.

 

Historically, the Company’s goal has been to expand our footprint in eastern and central Virginia. To accomplish that goal, we have expanded and improved our branch network, including most recently through our acquisition of VCB. Also in 2014, we opened a loan production office in Chesterfield County, Virginia to expand our footprint in the Richmond, Virginia metropolitan area. While we continuously evaluate strategies of building new branches in growing markets and purchasing other locations as the opportunities arise, the economic environment over the past few years has made expansion challenging. We have closed three branches during the last five years, with our Glenns branch closing in December 2011, our Bowling Green branch closing in September 2012 and our Old Church branch closing in October 2013. These branch closures were also part of our strategic focus from 2011 to 2013 of aggressively managing our noninterest expenses. Other changes to the branch system could occur in the future. Our goal continues to be to expand whenever possible when it is financially feasible.

 

The Bank owns EVB Financial Services, Inc., which in turn has a 100% ownership interest in EVB Investments, Inc. EVB Investments, Inc. is a full-service brokerage firm offering a comprehensive range of investment services. On May 15, 2014, the Bank acquired a 4.9% ownership interest in Southern Trust Mortgage, LLC. Pursuant to an independent contractor agreement with Southern Trust Mortgage, LLC, the Company advises and consults with Southern Trust Mortgage, LLC and facilitates the marketing and brand recognition of their mortgage business. In addition, the Company provides Southern Trust Mortgage, LLC with offices at three retail branches in the Company’s market area and access to office equipment at these locations during normal business hours. For its services, the Company receives fixed monthly compensation from Southern Trust Mortgage, LLC in the amount of $2 thousand, which is adjustable on a quarterly basis. The Bank had a 75% ownership interest in EVB Title, LLC, which primarily sold title insurance to the mortgage loan customers of the Bank and EVB Mortgage, LLC. Effective January 2014, the Bank ceased operations of EVB Title, LLC due to low volume and profitability. On October 1, 2014, the Bank acquired a 6.0% ownership interest in Bankers Title, LLC. Bankers Title, LLC is a multi-bank owned title agency providing a full range of title insurance settlement and related financial services. The Bank has a 2.87% ownership in Bankers Insurance, LLC, which primarily sells insurance products to customers of the Bank, and other financial institutions that have an equity interest in the agency. The Bank also has 100% ownership interests in Dunston Hall LLC, POS LLC, Tartan Holdings LLC and ECU-RE LLC, which were formed to hold the title to real estate acquired by the Bank upon foreclosure on property of real estate secured loans. The financial position and operating results of all the subsidiaries of the Bank are not significant to the Company as a whole and are not considered principal activities of the Company at this time.

 

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The Company also owns one non-operating subsidiary, EVB Statutory Trust I (the “Trust”), that was formed in September 2003. The Trust was formed for the purpose of issuing $10.0 million of trust preferred capital securities. The Trust is an unconsolidated subsidiary of the Company and its principal asset is $10.3 million of the Company’s junior subordinated deferrable interest debentures (the “Junior Subordinated Debt”) that is reported as a liability of the Company.

 

Market Areas

 

The Company currently conducts business through twenty-four full service branches and two drive-in facilities, primarily in the eastern portion of the state. Our markets are located east of U.S. Route 250 and extend from northeast of Richmond to the Chesapeake Bay and Hampton in central Virginia and across the James River from Colonial Heights to southeastern Virginia. Geographically, we have five primary market areas: Northern Neck, Middle Peninsula, Capital (suburbs of Richmond), Tidewater (Williamsburg, Newport News and Hampton), and Southern.

 

Our Northern Neck and Middle Peninsula regions are in the eastern coastal plain of Virginia, often referred to as River Country. A number of the branches in this locale have been in business for over one hundred years and have strong customer ties going back over multiple generations. According to the Virginia Economic Development Partnership, the region’s industries have traditionally been associated with abundant natural resources that include five rivers and the Chesapeake Bay. The diversified economy includes seafood harvesting, light manufacturing, agriculture, leisure, marine services and service sectors dedicated to many upscale retirement communities.

 

Our Capital region is currently comprised of Chesterfield, Hanover, Henrico and King William counties and Colonial Heights, which are largely emerging suburbs of Richmond. Hanover County is approximately 10 miles from downtown Richmond and eighty-six miles south of Washington, DC. Hanover County is the largest county by area in the Richmond metropolitan area. The county provides residents and businesses the geographic advantages of a growing metropolitan area coupled with substantial acreage for expansion in a suburban setting. With a branch in the adjacent county of Henrico, which is closer to Richmond, we have the advantage of an established economic setting with many small business prospects. Our location in Colonial Heights puts us in the south Richmond suburbs and allows us to capitalize on economic activity related to the U.S. Army facility at Fort Lee. The other county, King William, offers us growth opportunities as the Richmond suburbs expand farther east of their current boundaries.

 

Our Tidewater region is currently comprised of Williamsburg, Newport News and Hampton. This area, located approximately 60 miles east of Richmond along the U.S. Interstate 64 corridor, is part of the Hampton Roads MSA and is a densely populated and well-established area. This major metropolitan area is the second largest metropolitan area in Virginia behind the Northern Virginia area and is home to the third largest harbor in the U.S., which supports extensive military and commercial shipping operations. In addition to being home to several Fortune 500 companies, the region has a high value customer base, such as entrepreneurs, small businesses, and professionals, which often are not well served by our larger competitors. The banking facilities in this region offer a wide range of banking products and services, including mortgage, investment and insurance products.

 

Our Southern region is comprised of New Kent, Surry, Sussex, and Southampton counties. New Kent has shown continued population growth over the past several years. Our Southern Region is located southeast of Richmond and north of Williamsburg placing us in the growth zone of U.S. Interstate 64 that runs from Richmond to the Virginia Beach area of the Virginia Tidewater region. The other three counties are approximately fifty miles southeast of Richmond along or just off the state U.S. Route 460 corridor and are adjacent to the Greater Tidewater area. The ports of Hampton Roads are approximately fifty miles to the east of our Southern region. The region’s close proximity to major military, naval and research centers and transportation infrastructure make this an attractive location for contractors and service and manufacturing companies.

 

Business Strategy

 

As a result of over 100 years of experience serving the Northern Neck and Middle Peninsula regions, we have a stable, loyal customer base and a high deposit market share in these regions. Due to the lower projected population growth of these markets, we expanded in Chesterfield, Hanover, Henrico, Gloucester, New Kent and King William Counties and the city of Colonial Heights to target the higher potential growth in these existing and emerging suburban markets. The deposit market share we have accumulated in our Northern Neck, Middle Peninsula and Southern regions has helped fund our loan growth in the emerging suburban areas in the Capital region. Additionally, in 2014 we expanded into our Tidewater region through the acquisition of VCB. This acquisition added three branches and expanded our footprint along the U.S. Interstate 64 corridor into the attractive and growing markets of the Virginia Peninsula.

 

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We believe that economic growth and bank consolidation have created a growing number of businesses and consumers in need of a broad range of products and services, as well as the high level of personal service that we provide. While we have largely worked through the economic challenges of the past few years and look at 2016 as a year to strengthen our existing markets, our long-term business plan is to capitalize on the growth opportunity in our markets by further developing our branch network in our existing markets and augmenting our market area by expanding further in areas near the urban markets of Richmond and the Greater Tidewater area.

 

Competition

 

The Bank encounters strong competition for its banking services within its primary market areas. The sources of competition vary based on the particular market of operation, which can range from a small rural town to part of a large urban market. The Bank competes with large national and regional financial institutions, savings associations and other independent community banks, as well as credit unions, mutual funds and life insurance companies. The banking business in the Bank’s primary market areas is highly competitive for both loans and deposits, and is dominated by a relatively small number of large banks with many offices operating over a wide geographic area. Among the advantages such large banks have over the Bank are their ability to offer banking products and services at large branch networks, to launch and finance wide-ranging advertising campaigns and, by virtue of their greater total capitalization, to have substantially higher lending limits than the Bank. In addition, large banks may more easily comply with certain regulations applicable to banking activities and consumer financial products and services.

 

Factors such as interest rates offered, the number and location of branches and the types of products offered, as well as the reputation of the institution, affect competition for deposits and loans. The Bank competes by emphasizing customer service and technology, establishing long-term customer relationships, building customer loyalty, and providing products and services to address the specific needs of its customers. The Bank targets individuals and small to medium sized business customers. No material part of the Bank’s business is dependent upon a single or a few customers, and the loss of any single customer would not have a material adverse effect upon the Bank’s business.

 

Because federal regulation of financial institutions changes regularly and is the subject of constant legislative debate, we cannot foresee how federal regulation of financial institutions may change in the future. However, it is possible that current and future governmental regulatory and economic initiatives could impact the competitive landscape in the Bank’s markets.

 

Employees

 

As of December 31, 2015, the Company had 311 full-time equivalent employees. Management of the Company considers its relations with employees to be excellent. No employees are represented by a union or any similar group, and the Company has never experienced any strike or labor dispute.

 

Regulation and Supervision

 

General

 

Bank holding companies, banks and their affiliates are extensively regulated under both federal and state law. The regulatory framework is intended primarily for the protection of depositors, federal deposit insurance funds and the banking system as a whole and not for the protection of shareholders and creditors. The following summary briefly describes significant provisions of currently applicable federal and state laws and certain regulations and the potential impact of such provisions on the Company and the Bank. This summary is not complete, and we refer you to the particular statutory or regulatory provisions or proposals for more information. Because regulation of financial institutions changes regularly and is the subject of constant legislative and regulatory debate, we cannot forecast how federal and state regulation and supervision of financial institutions may change in the future and affect the Company’s and the Bank’s operations.

 

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Regulatory Reform

 

The financial crisis of 2008, including the downturn of global economic, financial and money markets and the threat of collapse of numerous financial institutions, and other related events led to the adoption of numerous laws and regulations that apply to financial institutions. The most significant of these laws is the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), adopted on July 21, 2010 to implement significant structural reforms to the financial services industry. The Dodd-Frank Act is discussed in more detail below.

 

The Company continues to experience a period of rapidly changing regulatory requirements and an environment of constant regulatory reform. These regulatory changes could have a significant effect on how the Company conducts its business. The full extent of the Dodd-Frank Act and other potential regulatory reforms cannot yet be fully predicted and will depend to a large extent on the specific regulations that are adopted.

 

Regulation of the Company

 

As a public company, the Company is subject to the reporting requirements of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). As a result, the Company must file annual, quarterly, current and other reports with the Securities and Exchange Commission (the “SEC”), and also comply with other laws and regulations of the SEC applicable to public companies.

 

As a bank holding company, the Company is also subject to the Bank Holding Company Act of 1956 (the “BHCA”) and supervision and regulation by the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”). Generally, a bank holding company is required to obtain the approval of the Federal Reserve Board before acquiring direct or indirect ownership or control of more than five percent of the voting shares of a bank or bank holding company, including through a bank or bank holding company merger or acquisition, completing a non-bank acquisition, or engaging in an activity considered to be a banking activity, either directly or through a subsidiary. Bank holding companies and their subsidiaries are also subject to restrictions on transactions with insiders and affiliates.

 

Pursuant to the BHCA, the Federal Reserve Board has the power to order any bank holding company or its subsidiaries to terminate any activity or to terminate its ownership or control of any subsidiary when the Federal Reserve Board has reasonable grounds to believe that continuation of such activity or ownership constitutes a serious risk to the financial soundness, safety or stability of any bank subsidiary of the bank holding company.

 

The BHCA generally limits the activities of a bank holding company and its subsidiaries to that of banking, managing or controlling banks, or any other activity that is closely related to banking or to managing or controlling banks, and permits interstate banking acquisitions subject to certain conditions, including national and state concentration limits. The Federal Reserve Board has jurisdiction under the BHCA to approve any bank or non-bank acquisition, merger or consolidation proposed by a bank holding company. A bank holding company must be well capitalized and well managed to engage in an interstate acquisition or merger, and banks may branch across state lines provided that the law of the state in which the branch is to be located would permit establishment of the branch if the bank were a state bank chartered by such state.

 

A bank holding company is prohibited from engaging in or acquiring, either directly or indirectly through a subsidiary, ownership or control of more than five percent of the voting shares of any company engaged in non-banking activities. A bank holding company may, however, engage in or acquire an interest in a company that engages in activities that the Federal Reserve Board has determined by regulation or order are so closely related to banking as to be a proper incident to banking. A bank holding company also may become eligible to engage in activities that are financial in nature or complimentary to financial activities by qualifying as a financial holding company under the Gramm-Leach-Bliley Act of 1999 (the “GLBA”). To qualify as a financial holding company, each insured depository institution controlled by the bank holding company must be well-capitalized, well-managed and have at least a satisfactory rating under the Community Reinvestment Act. To date, the Company has not qualified as a financial holding company, and the qualification as such by other bank holding companies has not had a material impact on the business of the Company.

 

Each of the Bank’s depository accounts is insured by the Federal Deposit Insurance Corporation (the “FDIC”) against loss to the depositor to the maximum extent permitted by applicable law, and federal law and regulatory policy impose a number of obligations and restrictions on the Company and the Bank to reduce potential loss exposure to the depositors and to the FDIC insurance funds. For example, pursuant to the Dodd-Frank Act and Federal Reserve Board policy, a bank holding company must commit resources to support its subsidiary depository institutions, which is referred to as serving as a “source of strength.” In addition, insured depository institutions under common control must reimburse the FDIC for any loss suffered or reasonably anticipated by the Deposit Insurance Fund (the “DIF”) as a result of the default of a commonly controlled insured depository institution. The FDIC may decline to enforce the provisions if it determines that a waiver is in the best interest of the DIF. An FDIC claim for damage is superior to claims of stockholders of an insured depository institution or its holding company but is subordinate to claims of depositors, secured creditors and holders of subordinated debt, other than affiliates, of the commonly controlled insured depository institution.

 

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The Federal Deposit Insurance Act (the “FDIA”) provides that amounts received from the liquidation or other resolution of any insured depository institution must be distributed, after payment of secured claims, to pay the deposit liabilities of the institution before payment of any other general creditor or stockholder of that institution - including that institution’s parent holding company. This provision would give depositors a preference over general and subordinated creditors and stockholders if a receiver is appointed to distribute the assets of the Bank.

 

The Company also is subject to regulation and supervision by the Virginia State Corporation Commission Bureau of Financial Institutions (the “Bureau”).

 

Capital Requirements

 

The Federal Reserve Board and the FDIC have adopted rules to implement the Basel III capital framework as outlined by the Basel Committee on Banking Supervision and standards for calculating risk-weighted assets and risk-based capital measurements (collectively, the “Basel III Capital Rules”) that apply to banking organizations they supervise. For the purposes of these capital rules, (i) common equity tier 1 capital (“CET1”) consists principally of common stock (including surplus) and retained earnings; (ii) Tier 1 capital consists principally of CET1 plus non-cumulative preferred stock and related surplus, and certain grandfathered cumulative preferred stocks and trust preferred securities; and (iii) Tier 2 capital consists principally of Tier 1 capital plus qualifying subordinated debt and preferred stock, and limited amounts of the allowance for loan losses. Each regulatory capital classification is subject to certain adjustments and limitations, as implemented by the Basel III Capital Rules. The Basel III Capital Rules also establish risk weightings that are applied to many classes of assets held by community banks, importantly including applying higher risk weightings to certain commercial real estate loans.

 

The Basel III Capital Rules were effective January 1, 2015, and the Basel III Capital Rules capital conservation buffer will be phased in from 2015 to 2019.

 

When fully phased in, the Basel III Capital Rules require banks to maintain (i) a minimum ratio of CET1 to risk-weighted assets of at least 4.5%, plus a 2.5% “capital conservation buffer” (which is added to the 4.5% CET1 ratio as that buffer is phased in, effectively resulting in a minimum ratio of CET1 to risk-weighted assets of at least 7%), (ii) a minimum ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus the capital conservation buffer (which is added to the 6.0% Tier 1 capital ratio as that buffer is phased in, effectively resulting in a minimum Tier 1 capital ratio of 8.5% upon full implementation), (iii) a minimum ratio of total (that is, Tier 1 plus Tier 2) capital to risk-weighted assets of at least 8.0%, plus the capital conservation buffer (which is added to the 8.0% total capital ratio as that buffer is phased in, effectively resulting in a minimum total capital ratio of 10.5% upon full implementation) and (iv) a minimum leverage ratio of 4%, calculated as the ratio of Tier 1 capital to balance sheet exposures plus certain off-balance sheet exposures (computed as the average for each quarter of the month-end ratios for the quarter).

 

The Basel III Capital Rules provide deductions from and adjustments to regulatory capital measures, primarily to CET1, including deductions and adjustments that were not applied to reduce CET1 under historical regulatory capital rules. For example, mortgage servicing rights, deferred tax assets, dependent upon future taxable income, and significant investments in non-consolidated financial entities must be deducted from CET1 to the extent that any one such category exceeds 10% of CET1 or all such categories in the aggregate exceed 15% of CET1. These deductions from and adjustments to regulatory capital will generally be phased in beginning in 2015 through 2018.

 

The Basel III Capital Rules permanently includes in Tier 1 capital trust preferred securities issued prior to May 19, 2010 by bank holding companies with less than $15 billion in total assets, subject to a limit of 25% of Tier 1 capital. The Company expects that its trust preferred securities will be included in the Company’s Tier 1 capital until their maturity.

 

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

 

Under the Basel III Capital Rules, the initial minimum capital ratios as of December 31, 2015 were as follows:

 

·4.5% CET1 to risk-weighted assets.
·6.0% Tier 1 capital to risk-weighted assets.
·8.0% Total capital to risk-weighted assets.

 

The Basel III Capital Rules prescribe a standardized approach for risk weightings that expand the risk-weighting categories to a much larger and more risk-sensitive number of categories than has been historically applied, depending on the nature of the assets, generally ranging from 0% for U.S. government and agency securities, to 600% for certain equity exposures, and resulting in higher risk weights for a variety of asset categories. Specific changes that impacted the Company’s determination of risk-weighted assets included, among other things:

 

·Applying a 150% risk weight instead of a 100% risk weight for certain high volatility commercial real estate acquisition, development and construction loans.

 

·Assigning a 150% risk weight to exposures (other than residential mortgage exposures) that are 90 days past due.

 

·Providing for a 20% credit conversion factor for the unused portion of a commitment with an original maturity of one year or less that is not unconditionally cancellable (currently set at 0%).

 

Management believes that, as of December 31, 2015, the Company would have met all capital adequacy requirements under the Basel III Capital Rules on a fully phased-in basis as if such requirements were then in effect.

 

Limits on Dividends

 

The Company is a legal entity that is separate and distinct from the Bank, and the ability of the Company to pay dividends depends upon the amount of dividends declared by the Bank, if any. In addition, the ability of the Company to pay dividends is subject to various laws and regulations, including limits on the sources of dividends and requirements to maintain capital at or above regulatory minimums. Regulatory restrictions also exist with respect to the Bank’s ability to pay dividends. Banking regulators have indicated that Virginia banking organizations should generally pay dividends only (1) from net undivided profits of the bank, after providing for all expenses, losses, interest and taxes accrued or due by the bank, and (2) if the prospective rate of earnings retention appears consistent with the organization’s capital needs, asset quality and overall financial condition. In addition, Federal Reserve Board supervisory guidance indicates that the Federal Reserve Board may have safety and soundness concerns if a bank holding company pays dividends that exceed earnings for the period in which the dividend is being paid. Further, the FDIA prohibits insured depository institutions such as the Bank from making capital distributions, including paying dividends, if after making such distribution the institution would become undercapitalized as defined in the statute.

 

Reporting Obligations

 

As a bank holding company, the Company must file with the Federal Reserve Board an annual report and such additional information as the Federal Reserve Board may require pursuant to the BHCA. The Bank must submit to federal and state regulators annual audit reports prepared by independent auditors. The Company’s annual report, which includes the report of the Company’s independent auditors, can be used to satisfy this requirement. The Bank must submit quarterly, to the FDIC, Reports of Condition and Income (referred to in the banking industry as a Call Report). The Company must submit quarterly, to the Federal Reserve Board, Consolidated Financial Statements for Bank Holding Companies (FR Y-9C) and Parent Company Only Financial Statements for Large Bank Holding Companies (FR Y-9LP).

 

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The Dodd-Frank Act

 

The Dodd-Frank Act implements far-reaching changes across the financial regulatory landscape, including changes that have affected all bank holding companies and banks, including the Company and the Bank. Provisions that significantly affect the business of the Company and the Bank include the following:

 

·Insurance of Deposit Accounts. The Dodd-Frank Act changed the assessment base for federal deposit insurance from the amount of insured deposits to consolidated assets less tangible capital. The Dodd-Frank Act also made permanent the $250,000 limit for federal deposit insurance and increased the cash limit of Securities Investor Protection Corporation protection from $100,000 to $250,000.

 

·Payment of Interest on Demand Deposits. The Dodd-Frank Act repealed the federal prohibitions on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts.

 

·Creation of the Consumer Financial Protection Bureau (“CFPB”). The Dodd-Frank Act centralized significant aspects of consumer financial protection by creating a new agency, the CFPB, which is discussed in more detail below.

 

·Debit Card Interchange Fees. The Dodd-Frank Act imposed limits for debit card interchange fees for issuers that have over $10 billion in assets, which could affect the amount of interchange fees collected by financial institutions with less than $10 billion in assets.

 

In addition, the Dodd-Frank Act implements other changes to financial regulations, including provisions that:

 

·Restrict the preemption of state law by federal law and disallow subsidiaries and affiliates of national banks from availing themselves of such preemption.

 

·Impose comprehensive regulation of the over-the-counter derivatives market, subject to significant rulemaking processes, which would include certain provisions that would effectively prohibit insured depository institutions from conducting certain derivatives businesses in the institution itself.

 

·Require loan originators to retain 5 percent of any loan sold or securitized, unless it is a "qualified residential mortgage," subject to certain exceptions.

 

·Implement corporate governance revisions that apply to all public companies not just publicly-traded financial institutions.

 

The Dodd-Frank Act contains many other provisions, and federal regulators continue to draft implementing regulations which may affect the Company or the Bank. Accordingly, the topics discussed above are only a representative sample of the types of new or increasing regulatory issues in the Dodd-Frank Act that may have an impact on the Company and the Bank.

 

Source of Strength Doctrine

 

The Dodd-Frank Act codifies and expands the existing Federal Reserve Board policy that a bank holding company is required to serve as a source of financial and managerial strength to its subsidiary banks. Under the Dodd-Frank Act, the term “source of financial strength” is defined to mean the “ability of a company that directly or indirectly controls an insured depository institution to provide financial assistance to such insured depository institution in the event of the financial distress of the insured depository institution.” As of March 2016, implementing regulations of the Dodd-Frank Act source of strength provisions, however, have not yet been promulgated. It is the Federal Reserve Board’s existing policy that a bank holding company should stand ready to use available resources to provide adequate capital to its subsidiary banks during periods of financial stress or adversity and should maintain the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks. Consistent with this, the Federal Reserve Board has stated that, as a matter of prudent banking, a bank holding company should generally not maintain a given rate of cash dividends unless its net income available to common shareholders has been sufficient to fully fund the dividends and the prospective rate of earnings retention appears to be consistent with the organization’s capital needs, asset quality, and overall financial condition.

 

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Incentive Compensation

 

The Federal Reserve, the Office of the Comptroller of the Currency and the FDIC have issued regulatory guidance (the “Incentive Compensation Guidance”) intended to ensure that the incentive compensation policies of banking organizations do not undermine the safety and soundness of such organizations by encouraging excessive risk-taking. The Federal Reserve Board will review, as part of the regular, risk-focused examination process, the incentive compensation arrangements of banking organizations, such as the Company, that are not “large, complex banking organizations.” These reviews will be tailored to each organization based on the scope and complexity of the organization’s activities and the prevalence of incentive compensation arrangements. The findings of the supervisory initiatives will be included in reports of examination and incorporated into the organization’s supervisory ratings. Enforcement actions may be taken against a banking organization if its incentive compensation arrangements, or related risk-management control or governance processes, pose a risk to the organization’s safety and soundness and the organization is not taking prompt and effective measures to correct the deficiencies. The federal banking agencies emphasize that all banking organizations must carefully design and oversee incentive compensation policies to ensure such policies do not undermine the safety and soundness of such organizations.

 

As required by the Dodd-Frank Act, in March 2011 the SEC and the federal bank regulatory agencies proposed regulations that would prohibit financial institutions with assets of at least $1 billion from maintaining executive compensation arrangements that encourage inappropriate risk taking by providing excessive compensation or that could lead to material financial loss to the financial institution, but these regulations have not yet been finalized. If the regulations are adopted in the form initially proposed, they will impose limitations on the manner in which the Company may structure compensation for its executives. These proposed regulations incorporate the principles discussed in the Incentive Compensation Guidance. A final rule has not yet been published.

 

Regulation of the Bank

 

The Bank, as a state-chartered member bank of the Federal Reserve System, is subject to regulation and examination by the Bureau and the Federal Reserve Board. The various laws and regulations issued and administered by the regulatory agencies (including the CFPB) affect corporate practices, such as the payment of dividends, the incurrence of debt and the acquisition of financial institutions and other companies, and affect business practices and operations, such as the payment of interest on deposits, the charging of interest on loans, and the types of business conduct, the products and terms offered to customers. In addition, the Bank is subject to the rules and regulations of the FDIC, which currently insures substantially all of the Bank’s deposits up to applicable limits of the DIF, and is subject to deposit insurance assessments to maintain the DIF.

 

Prior approval of the applicable primary federal regulatory and the Bureau is required for a Virginia chartered bank or a bank holding company to merge with another bank or bank holding company, or purchase the assets or assume the deposits of another bank or bank holding company, or acquire control of another bank or bank holding company. In reviewing applications seeking approval of merger and acquisition transactions, the bank regulatory authorities will consider, among other things, the competitive effect and public benefits of the transactions, the capital position of the combined organization, the risks to the stability of the U.S. banking or financial system, the applicant’s performance record under the Community Reinvestment Act and fair housing initiatives, the data security and cybersecurity infrastructure of the constituent organizations and the combined organization, and the applicant’s compliance with and the effectiveness of the subject organizations in combating money laundering activities and complying with Bank Secrecy Act requirements.

 

FDIC Insurance, Assessments and Regulation

 

The Bank’s deposits are insured by the DIF of the FDIC up to the standard maximum insurance amount for each deposit ownership category. As of March 2016, the basic limit on FDIC deposit insurance coverage was $250,000 per depositor. Under the FDIA, the FDIC may terminate deposit insurance upon a finding that the institution has engaged in unsafe and 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 the FDIC, subject to administrative and potential judicial hearing and review processes.

 

The DIF is funded by assessments on banks and other depository institutions calculated based on average consolidated total assets minus average tangible equity (defined as Tier 1 capital). As required by the Dodd-Frank Act, the FDIC has adopted a large-bank pricing assessment scheme, set a target “designated reserve ratio” (described in more detail below) of 2% for the DIF and established a lower assessment rate schedule when the reserve ratio reaches 1.15% and, in lieu of dividends, provides for a lower assessment rate schedule, when the reserve ratio reaches 2% and 2.5%. An institution's assessment rate depends upon the institution's assigned risk category, which is based on supervisory evaluations, regulatory capital levels and certain other factors. Initial base assessment rates ranges from 2.5 to 45 basis points. The FDIC may make the following further adjustments to an institution's initial base assessment rates: decreases for long-term unsecured debt including most senior unsecured debt and subordinated debt; increases for holding long-term unsecured debt or subordinated debt issued by other insured depository institutions; and increases for broker deposits in excess of 10% of domestic deposits for institutions not well rated and well capitalized.

 

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The Dodd-Frank Act transferred to the FDIC increased discretion with regard to managing the required amount of reserves for the DIF, or the “designated reserve ratio.” Among other changes, the Dodd-Frank Act (i) raised the minimum designated reserve ratio to 1.35% and removed the upper limit on the designated reserve ratio, (ii) requires that the designated reserve ratio reach 1.35% by September 2020, and (iii) requires the FDIC to offset the effect on institutions with total consolidated assets of less than $10 billion of raising the designated reserve ratio from 1.15% to 1.35% – which requirement will be met through rules proposed by the FDIC during 2015. The FDIA requires that the FDIC consider the appropriate level for the designated reserve ratio on at least an annual basis. On October 2010, the FDIC adopted a new DIF restoration plan to ensure that the fund reserve ratio reaches 1.35% by September 30, 2020, as required by the Dodd-Frank Act.

 

FDIC insurance expense totaled $821 thousand, $921 thousand and $1.8 million in 2015, 2014 and 2013, respectively. FDIC insurance expense includes deposit insurance assessments and Financing Corporation (“FICO”) assessments related to outstanding FICO bonds. The FICO is a mixed-ownership government corporation established by the Competitive Equality Banking Act of 1987 whose sole purpose was to function as a financing vehicle for the now defunct Federal Savings & Loan Insurance Corporation. The FICO assessment rate for the DIF ranged between a high of 0.60 basis points for 2015, with a low of 0.58 basis points for the third quarter of 2015. For the first quarter of 2015, the FICO assessment rate for the DIF is 0.58 basis points resulting in a premium of $0.0058 per $100 of DIF-eligible deposits.

 

Prompt Corrective Action

 

The federal banking agencies have broad powers under current federal law to take prompt corrective action to resolve problems of insured depository institutions. The extent of these powers depends upon whether the institution in question is “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” or “critically undercapitalized.” These terms are defined under uniform regulations issued by each of the federal banking agencies regulating these institutions. An insured depository institution which is less than adequately capitalized must adopt an acceptable capital restoration plan, is subject to increased regulatory oversight and is increasingly restricted in the scope of its permissible activities. The Company believes that, as of December 31, 2015, its bank subsidiary, EVB, was “well capitalized” based on the applicable ratios.

 

Mortgage Banking Regulation

 

In connection with making mortgage loans, the Bank is subject to rules and regulations that, among other things, establish standards for loan origination, prohibit discrimination, require certain disclosures, provide for inspections and appraisals of property, require credit reports on prospective borrowers and, in some cases, restrict certain loan features and fix maximum interest rates and fees. In addition to other federal laws, mortgage origination activities are subject to the Equal Credit Opportunity Act, Truth-in-Lending Act (“TILA”), Home Mortgage Disclosure Act, Real Estate Settlement Procedures Act (“RESPA”), and Home Ownership Equity Protection Act, and the regulations promulgated under these acts. These laws prohibit discrimination, require the disclosure of certain information to mortgagors concerning credit and settlement costs, limit payment for settlement services to the reasonable value of the services rendered and require the maintenance and disclosure of information regarding the disposition of mortgage applications based on race, gender, geographical distribution and income level. The Dodd-Frank Act has transferred rulemaking authority under many of these laws to the CFPB.

 

Compliance with the requirements of TILA, RESPA, and other federal and state laws and regulations (including regulations adopted by the CFPB) may require substantial investments in mortgage lending systems and processes and implementation efforts to respond to regulatory developments, all of which may impose significant costs on the Bank.  For example, compliance with the CFPB’s Integrated Mortgage Disclosure Rules under TILA and RESPA (or “TRID”), which became effective in October 2015, requires the Bank to implement at significant cost new systems and processes that will apply to most closed-end mortgage loans originated by the Bank.

 

The Bank’s mortgage origination activities are also subject to Regulation Z, which implements TILA. As amended and effective in January 2014, certain provisions of Regulation Z require mortgage lenders to make a reasonable and good faith determination, based on verified and documented information, that a consumer applying for a mortgage loan has a reasonable ability to repay the loan according to its terms. Alternatively, a mortgage lender can originate “qualified mortgages”, which are generally defined as mortgage loans without negative amortization, interest-only payments, balloon payments, terms exceeding 30 years, and points and fees paid by a consumer equal to or less than 3% of the total loan amount. Higher-priced qualified mortgages (e.g., subprime loans) receive a rebuttable presumption of compliance with ability-to-repay rules, and other qualified mortgages (e.g., prime loans) are deemed to comply with the ability-to-repay rules. The Bank predominately originates mortgage loans that comply with Regulation Z’s “qualified mortgage” rules.

 

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Consumer Protection

 

The Dodd-Frank Act created the CFPB, a federal regulatory agency that is responsible for implementing, examining and enforcing compliance with federal consumer financial laws for institutions with more than $10 billion of assets and, to a lesser extent, smaller institutions. The Dodd-Frank Act gives the CFPB authority to supervise and regulate providers of consumer financial products and services, establishes the CFPB’s power to act against unfair, deceptive or abusive practices and gives the CFPB rulemaking authority in connection with numerous federal consumer financial protection laws (for example, but not limited to, TILA and RESPA).

 

As a smaller institution (i.e., with assets of $10 billion or less), most consumer protection aspects of the Dodd-Frank Act will continue to be applied to the Company and the Bank by the Federal Reserve Board. However, the CFPB may include its own examiners in regulatory examinations by a small institution’s prudential regulators and may require smaller institutions to comply with certain CFPB reporting requirements. In addition, regulatory positions taken by the CFPB and administrative and legal precedents established by CFPB enforcement activities, including in connection with supervision of larger bank holding companies, could influence how the Federal Reserve Board applies consumer protection laws and regulations to financial institutions that are not directly supervised by the CFPB. The precise impact of the CFPB’s consumer protection activities on the Company and the Bank cannot be determined with certainty.

 

Confidentiality and Required Disclosures of Customer Information

 

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

 

The Company and the Bank are also subject to various laws and regulations that attempt to combat money laundering and terrorist financing. The Bank Secrecy Act requires all financial institutions to, among other things, create a system of controls designed to prevent money laundering and the financing of terrorism, and imposes recordkeeping and reporting requirements. The USA Patriot Act facilitates information sharing among governmental entities and financial institutions for the purpose of combating terrorism and money laundering, and requires financial institutions to establish anti-money laundering programs. The Federal Bureau of Investigation (“FBI”) sends banking regulatory agencies lists of the names of persons suspected of involvement in terrorist activities, and requests banks to search their records for any relationships or transactions with persons on those lists. If the Bank finds any relationships or transactions, it must file a suspicious activity report with the U.S. Department of the Treasury (the “Treasury”) and contact the FBI. The Office of Foreign Assets Control (“OFAC”), which is a division of the Treasury, is responsible for helping to ensure that United States entities do not engage in transactions with “enemies” of the United States, as defined by various Executive Orders and Acts of Congress. If the Bank finds a name of an “enemy” of the United States on any transaction, account or wire transfer that is on an OFAC list, it must freeze such account or place transferred funds into a blocked account, file a suspicious activity report with the Treasury and notify the FBI.

 

Although these laws and programs impose compliance costs and create privacy obligations and, in some cases, reporting obligations, and compliance with all of the laws, programs and privacy and reporting obligations may require significant resources of the Company and the Bank, these laws and programs do not materially affect the Bank’s products, services or other business activities.

 

Community Reinvestment Act

 

The Community Reinvestment Act (“CRA”) imposes on financial institutions an affirmative and ongoing obligation to meet the credit needs of their local communities, including low and moderate-income neighborhoods, consistent with the safe and sound operation of those institutions. A financial institution’s efforts in meeting community credit needs are assessed based on specified factors. These factors also are considered in evaluating mergers, acquisitions and applications to open a branch or facility. Following the Bank’s most recent scheduled compliance examination in September 2014, it received a CRA performance evaluation of “satisfactory.”

 

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Federal Home Loan Bank of Atlanta

 

The Bank is a member of the Federal Home Loan Bank (“FHLB”) of Atlanta, which is one of 12 regional FHLBs that provide funding to their members for making housing loans as well as for affordable housing and community development loans. Each FHLB serves as a reserve, or central bank, for the members within its assigned region. Each is funded primarily from proceeds derived from the sale of consolidated obligations of the FHLB System. Each FHLB makes loans to members in accordance with policies and procedures established by the Board of Directors of the FHLB. As a member, the Bank must purchase and maintain stock in the FHLB of Atlanta. In 2004, the FHLB converted to its new capital structure, which established the minimum capital stock requirement for member banks as an amount equal to the sum of a membership requirement and an activity-based requirement. At December 31, 2015, the Bank held $5.9 million of FHLB of Atlanta stock.

 

Volcker Rule

 

The Dodd-Frank Act prohibits bank holding companies and their subsidiary banks from engaging in proprietary trading except in limited circumstances, and places limits on ownership of equity investments in private equity and hedge funds (the “Volcker Rule”). On December 10, 2013, the U.S. financial regulatory agencies (including the Federal Reserve, the FDIC and the SEC) adopted final rules to implement the Volcker Rule. In relevant part, these final rules would have prohibited banking entities from owning collateralized debt obligations (“CDOs”) backed by trust preferred securities, effective July 21, 2015. However, subsequent to these final rules the U.S. financial regulatory agencies issued an interim rule effective April 1, 2014 to exempt CDOs backed by trust preferred securities from the Volcker Rule and the final rule, provided that (a) the CDO was established prior to May 19, 2010, (b) the banking entity reasonably believes that the CDO’s offering proceeds were used to invest primarily in trust preferred securities issued by banks with less than $15 billion in assets, and (iii) the banking entity acquired the CDO investment on or before December 10, 2013.

 

Smaller banks, with total consolidated assets of $10 billion or less, engaged in modest proprietary trading activities for their own accounts are subject to a simplified compliance program under the final rules. Several portions of the Volcker Rule remain subject to regulatory rulemaking and legislative activity, including to further delay effectiveness of some provisions of the Volcker Rule. The Company believes that its financial condition will not be significantly impacted by the Volcker Rule, and does not expect that any delays in the effectiveness of the Volcker Rule will significantly impact its financial condition.

 

Future Regulation

 

Including and in addition to the specific proposals described above, from time to time, various legislative and regulatory initiatives are introduced in Congress and state legislatures, as well as by regulatory agencies. Such initiatives may include proposals to expand or contract the powers of bank holding companies and depository institutions or proposals to substantially change the financial institution regulatory system. Such legislation could change banking statutes and the operating environment of the Company in substantial and unpredictable ways. If enacted, such legislation could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance among banks, savings associations, credit unions, and other financial institutions. The Company cannot predict whether any such legislation will be enacted, and, if enacted, the effect that it, or any implementing regulations, would have on the financial condition or results of operations of the Company. A change in statutes, regulations, regulatory policies or regulatory guidance or interpretative positions applicable to the Company or any of its subsidiaries could have a material effect on the business of the Company.

 

Available Information

 

The Company’s SEC filings are filed electronically and are available to the public over the Internet at the SEC’s web site at http://www.sec.gov. In addition, any document filed by the Company with the SEC can be read and copied at the SEC’s public reference facilities at 100 F Street, N.E., Room 1580, Washington, D.C. 20549. Copies of documents can be obtained at prescribed rates by writing to the Public Reference Section of the SEC at 100 F Street, N.E., Washington, D.C. 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The Company’s SEC filings also are available through our web site at http://www.evb.org under “SEC Filings” as soon as reasonably practicable after they are filed with the SEC. Copies of documents also can be obtained free of charge by writing to the Company’s Corporate Secretary at P.O. Box 1455, Tappahannock, VA 22560 or by calling 804-443-8400. The information on the Company’s website is not, and shall not be deemed to be, a part of this Annual Report on Form 10-K or incorporated into any other filings the Company makes with the SEC.

 

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Item 1A. Risk Factors

 

An investment in our common stock involves significant risks inherent to the Company’s business. Like other bank holding companies, we are subject to a number of risks, many of which are outside of our control. If any of the events or circumstances described in the following risk factors actually occur, our business, financial condition, results of operations and prospects could be harmed. These risks are not the only ones that we may face. Other risks of which we are not aware, including those which relate to the banking and financial services industry in general and us in particular, or those which we do not currently believe are material, may harm our future business, financial condition, results of operations and prospects. Readers should consider carefully the following important risks, in conjunction with the other information in this Annual Report on Form 10-K including our consolidated financial statements and related notes, in evaluating us, our business and an investment in our securities.

 

Deterioration in economic conditions could adversely affect us.

 

Deterioration in economic and market conditions, such as the economic downturn and recession that resulted from the financial crisis of 2008, could hurt our business and our financial condition and results of operations. Our business is directly affected by general economic and market conditions, broad trends in industry and finance, and inflation, all of which are beyond our control. A deterioration in economic conditions, and in particular an economic slowdown within our markets, could result in increases in loan delinquencies, problem assets and foreclosures, and could result in decreases in demand for our products and services, and values of collateral supporting our loans. Declines in the housing market, including as experienced through falling home prices and rising foreclosures, can negatively impact the credit performance of real estate related loans. Declines in the employment markets, including as experienced through high unemployment and underemployment, can negatively impact the credit performance of consumer loans. Any of the foregoing effects could negatively impact our business, financial condition and results of operations.

 

We operate in a mixed market environment with influences from both rural and urban areas, and we will be affected by economic conditions in our Northern Neck, Middle Peninsula, Capital, Tidewater and Southern market areas. Changes in the local economy may influence the growth rate of our loans and deposits, the quality of the loan portfolio, and loan and deposit pricing. Although we might not have significant credit exposure to all the businesses in our market areas, a downturn in any business sector of a market area or a downturn with respect to any significant business in a market area could have a negative impact on local economic conditions and real estate collateral values in that market area, which could negatively affect our profitability.

 

Offerings of our securities and other potential capital strategies or the conversion of shares of our non-voting mandatorily convertible non-cumulative preferred stock, Series B (the “Series B Preferred Stock”) into common stock could dilute your investment or otherwise affect your rights as a shareholder.

 

In the future we may seek to raise additional capital through offerings of our common stock, preferred stock, securities convertible into common stock, or rights to acquire such securities or our common stock. Under our Articles of Incorporation, we have additional authorized shares of common stock that we can issue from time to time at the discretion of our Board of Directors, without further action by shareholders, except where shareholder approval is required by applicable law or listing requirements of the NASDAQ Stock Market. The issuance of any additional shares of common stock or securities convertible into common stock in a subsequent offering could be substantially dilutive to holders of our common stock. Holders of our common stock have no preemptive rights as a matter of law that entitle them to purchase their pro-rata share of any offering or shares of any class or series. In addition, under our Articles of Incorporation, we can authorize and issue additional shares of our preferred stock, in one or more series the terms of which would be determined by our Board of Directors without shareholder approval, unless such approval is required by applicable law or listing requirements of the NASDAQ Stock Market. The market price of our common stock could decline as a result of future sales of our securities or the perception that such sales could occur.

 

New investors, particularly with respect to newly authorized series of preferred stock, also may have rights, preferences, and privileges that are senior to, and that could adversely affect, our then current shareholders, and particularly holders of our common stock. For example, a new series of preferred stock could rank senior to shares of our common stock. As a result, we could be required to make any dividend payments on such preferred stock before any dividends can be paid on our common stock, and in the event of our bankruptcy, dissolution, or liquidation, we may have to pay the holders of this new series of preferred stock in full prior to any distributions being made to the holders of our common stock.

 

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In addition, the conversion of shares of our Series B Preferred Stock into common stock would dilute the voting power of our then-outstanding shares of common stock.

 

We cannot predict or estimate the amount, timing, or nature of our future securities offerings or other capital initiatives or whether, when or how many shares of our Series B Preferred Stock will be converted into shares of common stock. Thus, our shareholders bear the risk of our future offerings or future conversions of shares of our Series B Preferred Stock diluting their stock holdings, adversely affecting their rights as shareholders, and/or reducing the market price of our common stock.

 

Affiliates of Castle Creek Capital Partners (“Castle Creek”) and GCP Capital Partners (“GCP Capital”) are substantial holders of our common stock.

 

Castle Creek holds approximately 8.1% of our common stock and approximately 28.0% of our combined common stock and Series B Preferred Stock. GCP Capital holds approximately 8.6% of our common stock and approximately 12.7% of our combined common stock and Series B Preferred Stock. Pursuant to the terms of the securities purchase agreements entered into with Castle Creek and GCP Capital, Castle Creek and GCP Capital each have a right to appoint a representative on our Board of Directors and on the Bank’s board of directors. Boris M. Gutin serves on the Boards of Directors of the Company and the Bank at the request of an affiliate of GCP Capital. Castle Creek and GCP Capital may have individual economic interests that are different from the other’s interests and different from the interests of our other shareholders.

 

Compliance with laws, regulations and supervisory guidance, both new and existing, may adversely impact our business, financial condition and results of operations.

 

We are subject to numerous laws, regulations and supervision from both federal and state agencies. During the past few years, there has been an increase in legislation related to and regulation of the financial services industry. We expect this increased level of oversight to continue. Failure to comply with these laws and regulations could result in financial, structural and operational penalties, including receivership. In addition, establishing systems and processes to achieve compliance with these laws and regulations may increase our costs and/or limit our ability to pursue certain business opportunities.

 

Laws and regulations, and any interpretations and applications with respect thereto, generally are intended to benefit consumers, borrowers and depositors, not shareholders. The legislative and regulatory environment is beyond our control, may change rapidly and unpredictably and may negatively influence our revenue, costs, earnings, and capital levels. Our success depends on our ability to maintain compliance with both existing and new laws and regulations.

 

Failure to comply with regulatory requirements could subject us to regulatory action.

 

The Company and the Bank are supervised by the Federal Reserve Board and the Bureau. As such, each is subject to extensive supervision and prudential regulation. Both the Company and the Bank must maintain certain risk-based and leverage capital ratios and operate in a safe and sound manner as required by the Federal Reserve and the Bureau. If the Company or the Bank fails to meet regulatory capital requirements or is deemed to be operating in an unsafe and unsound manner or in violation of law, it may be subject to a variety of informal or formal regulatory actions. Informal regulatory actions may include a memorandum of understanding which is initiated by the regulator and outlines an institution’s agreement to take specified actions within specified time periods to correct violations of law or unsafe and unsound practices. In addition, as part of the regular examination process, regulators may advise the Company or the Bank to operate under various restrictions as a prudential matter. Any of these restrictions, in whatever manner imposed, could have a material adverse effect on our business, financial condition and results of operations.

 

In addition to informal regulatory actions, we may also be subject to formal regulatory actions. Failure to comply with an informal regulatory action could lead to formal regulatory actions. Formal regulatory actions include written agreements, cease and desist orders, the imposition of substantial fines and other penalties. Furthermore, if the Bank became severely undercapitalized, it could become subject to the prompt corrective action framework which imposes progressively more restrictive constraints on operations, management and capital. A failure to meet regulatory capital requirements could also subject the Company to capital raising requirements. Additional capital raisings would be dilutive to holders of our common stock.

 

Any remedial measure or regulatory action, whether formal or informal, could impose restrictions on our ability to operate our businesses and adversely affect our prospects, financial condition or results of operations. In addition, any formal enforcement action could harm our reputation and our ability to retain and attract customers, and impact the trading price of our common stock.

 

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Our regulatory compliance burden and associated costs could continue to increase, which could place restrictions on certain products and services, and limit our future capital strategies.

 

A wide range of regulatory initiatives directed at the financial services industry have been proposed in recent years. One of those initiatives, the Dodd-Frank Act, represents a sweeping overhaul of the financial services industry within the United States and mandates significant changes in the financial regulatory landscape that has impacted and will continue to impact all financial institutions, including the Company and the Bank. The federal regulatory agencies, and particularly bank regulatory agencies, are given significant discretion in drafting the Dodd-Frank Act’s implementing rules and regulations, and certain of the implementing rules and regulations have not yet been proposed or approved; consequently the full details and impact of the Dodd-Frank Act will depend on the final implementing rules and regulations. Accordingly, it remains too early to fully assess the full impact of the Dodd-Frank Act and subsequent regulatory rulemaking processes on our business, financial condition or results of operations.

 

The Dodd-Frank Act creates a new financial consumer protection agency, the CFPB, that can impose new regulations on us and include its examiners in our routine regulatory examinations conducted by the Federal Reserve Bank of Richmond (the “Reserve Bank”), which could increase our regulatory compliance burden and costs and restrict the financial products and services we can offer to our customers. The CFPB, through the agency’s rulemaking and enforcement authority with respect to the Dodd-Frank Act’s prohibitions against unfair, deceptive and abusive business practices, may reshape the consumer financial protection laws and directly impact the business operations of financial institutions offering consumer financial products or services, including the Company and the Bank. This agency’s broad rulemaking authority includes identifying practices or acts that are unfair, deceptive or abusive in connection with any consumer financial transaction or consumer financial product or service. The costs and limitations related to this additional regulatory agency and the limitations and restrictions that will be placed upon the Company with respect to its consumer product and service offerings have yet to be determined. However, these costs, limitations and restrictions may produce significant, material effects on our business, financial condition and results of operations.

 

The Basel III Capital Rules require higher levels of capital and liquid assets, which could adversely affect our net income and return on equity.

 

The Basel III Capital Rules, which began to apply to the Company and the Bank on January 1, 2015, represent the most comprehensive overhaul of the U.S. banking capital framework in over two decades. These rules require bank holding companies and their subsidiaries, such as the Company and the Bank, to dedicate more resources to capital planning and regulatory compliance, and maintain substantially more capital as a result of higher required capital levels and more demanding regulatory capital risk-weightings and calculations. The rules also require all banks to substantially change the manner in which they collect and report information to calculate risk-weighted assets, and likely increase risk-weighted assets at many banking organizations as a result of applying higher risk-weightings to certain types of loans and securities. As a result, we may be forced to limit originations of certain types of commercial and mortgage loans, thereby reducing the amount of credit available to borrowers and limiting opportunities to earn interest income from the loan portfolio, or change the way we manage past-due exposures.

 

Due to the changes to bank capital levels and the calculation of risk-weighted assets, many banks could be required to access the capital markets on short notice and in relatively weak economic conditions, which could result in banks raising capital that significantly dilutes existing shareholders. Additionally, many community banks could be forced to limit banking operations and activities, and growth of loan portfolios and interest income, in order to focus on retention of earnings to improve capital levels. If the Basel III Capital Rules require the Company to access the capital markets in this manner, or similarly limit the Bank’s operations and activities, the Basel III Capital Rules would have a detrimental effect on our net income and return on equity and limit the products and services we provide to our customers.

 

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We have a high concentration of loans secured by both residential and commercial real estate and a further downturn in either or both real estate markets, for any reason, may increase our credit losses, which would negatively affect our financial results.

 

We offer a variety of secured loans, including commercial lines of credit, commercial term loans, real estate, construction, home equity, consumer and other loans. Most of our loans are secured by real estate (both residential and commercial) in our market areas. At December 31, 2015, approximately 85.0% of our $880.8 million loan portfolio was secured by residential and commercial real estate. Changes in the real estate market, such as a deterioration in market value of collateral, or a decline in local employment rates or economic conditions, could adversely affect our customers’ ability to pay these loans, which in turn could impact our profitability. Repayment of our commercial loans is often dependent on the cash flow of the borrower, which may be unpredictable. If the value of real estate serving as collateral for the loan portfolio materially declines, a significant portion of the loan portfolio could become under-collateralized. If the loans that are secured by real estate become troubled when real estate market conditions are declining or have declined, in the event of foreclosure we may not be able to realize the amount of collateral that was anticipated at the time of originating the loan.  In that event, we may have to increase the provision for loan losses, which could have a material adverse effect on our operating results and financial condition.

 

Our small to medium-sized business target market may have fewer financial resources to weather a downturn in the economy.

 

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

 

We have a concentration of credit exposure in acquisition and development (or “ADC”) real estate loans.

 

At December 31, 2015, we had approximately $66.4 million in loans for the acquisition and development of real estate and for construction of improvements to real estate, representing approximately 7.5% of our total loans outstanding as of that date. These loans are to developers, builders and individuals. Project types financed include acquisition and development of residential subdivisions and commercial developments, builder lines for one to four family home construction and loans to individuals for primary and secondary residence construction. These types of loans are generally viewed as having more risk of default than residential real estate loans. Completion of development projects and sale of developed properties may be affected significantly by general economic conditions, and further downturn in the local economy or in occupancy rates in the local economy where the property is located could increase the likelihood of default. Because our loan portfolio contains acquisition and development loans with relatively large balances, the deterioration of one or a few of these loans could cause a significant increase in our percentage of non-performing loans. An increase in non-performing loans could result in a loss of earnings from these loans, an increase in the provision for loan losses and an increase in charge-offs, all of which could have a material adverse effect on our financial condition and results of operations.

 

We may need to raise additional capital that may not be available to us.

 

We may need to or may otherwise be required to raise additional capital in the future, including if we incur losses or due to regulatory mandates. The ability to raise additional capital, if needed, will depend in part on conditions in the capital markets at that time, which are outside our control, and on our financial performance. Accordingly, additional capital may not be raised, if and when needed, on terms acceptable to us, or at all. If we cannot raise additional capital when needed, our ability to maintain our capital ratios could be materially impaired, and we could face additional regulatory challenges.

 

If our allowance for loan losses becomes inadequate, our results of operations may be adversely affected.

 

Making loans is an essential element of our business. The risk of nonpayment is affected by a number of factors, including but not limited to: the duration of the credit; credit risks of a particular customer; changes in economic and industry conditions; and, in the case of a collateralized loan, risks resulting from uncertainties about the future value of the collateral. We cannot be sure that we will be able to identify deteriorating loans before they become nonperforming assets, or that we will be able to limit losses on those loans that are identified. Our allowance for loan losses is determined by analyzing historical loan losses, current trends in delinquencies and charge-offs, current economic conditions that may affect a borrower’s ability to repay and the value of collateral, changes in the size and composition of the loan portfolio and industry information. Also included in our estimates for loan losses are considerations with respect to the impact of economic events, the outcome of which are uncertain. Because any estimate of loan losses is necessarily subjective and the accuracy of any estimate depends on the outcome of future events, we face the risk that charge-offs in future periods will exceed our allowance for loan losses and that additional increases in the allowance for loan losses will be required. Additions to the allowance for loan losses would result in a decrease of our net income. We cannot be certain that our allowance for loan losses is adequate to absorb probable losses in our loan portfolio.

 

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We may incur losses if we are unable to successfully manage interest rate risk.

 

Our profitability depends in substantial part upon the spread between the interest rates earned on investments and loans and interest rates paid on deposits and other interest-bearing liabilities. These rates are normally in line with general market rates and rise and fall based on the asset liability committee’s view of our financing and liquidity needs. We may selectively pay above-market rates to attract deposits, as we have done in some of our marketing promotions in the past. Changes in interest rates will affect our operating performance and financial condition in diverse ways including the pricing of securities, loans and deposits, which, in turn, may affect the growth in loan and retail deposit volume. Our net interest income will be adversely affected if market interest rates change so that the interest we pay on deposits and borrowings increases faster than the interest we earn on loans and investments.  Our net interest spread will depend on many factors that are partly or entirely outside our control, including competition, federal economic, monetary and fiscal policies, and economic conditions generally. Fluctuations in market rates are neither predictable nor controllable and may have a material and negative effect on our business, financial condition and results of operations.

 

Changes in interest rates also affect the value of our loans.  An increase in interest rates could adversely affect our borrowers’ ability to pay the principal or interest on existing loans or reduce their desire to borrow more money.  This may lead to an increase in nonperforming assets or a decrease in loan originations, either of which could have a material and negative effect on our results of operations.

 

Our future success is dependent on our ability to compete effectively in the highly competitive banking industry.

 

We face vigorous competition from other banks and other financial institutions, including savings and loan associations, savings banks, finance companies and credit unions for deposits, loans and other financial services in our market area. A number of these banks and other financial institutions are significantly larger than we are and have substantially greater access to capital and other resources, as well as larger lending limits and branch systems, and offer a wider array of banking services. To a limited extent, we also compete with other providers of financial services, such as money market mutual funds, brokerage firms, consumer finance companies, insurance companies and governmental organizations which may offer more favorable financing than we can. Many of our non-bank competitors are not subject to the same extensive regulations that govern us. As a result, these non-bank competitors have advantages over us in providing certain services. We may face a competitive disadvantage as a result of our smaller size, smaller asset base, lack of geographic diversification and inability to spread our marketing costs across a broader market. If we have to raise interest rates paid on deposits or lower interest rates charged on loans to compete effectively, our net interest margin and income could be negatively affected. Failure to compete effectively to attract new or to retain existing, clients may reduce or limit our margins and our market share and may adversely affect our results of operations, financial condition and growth.

 

We face risks in connection with our strategic and other business initiatives and we may not be able to fully execute on these initiatives, which could have a material adverse effect on our financial condition or results of operations.

 

From time to time we may pursue, develop, and implement strategic business initiatives, which may include acquisitions, investments, asset purchases or other business growth initiatives or undertakings. There can be no assurance that we will successfully identify appropriate opportunities, that we will be able to negotiate or finance such opportunities or that such opportunities, if pursued, will be successful.

 

We remain focused on building a robust banking franchise and continue to evaluate and undertake various strategic activities and business initiatives. These initiatives may include strategic acquisitions, investments, joint ventures, or partnerships, and may involve banking activities, products or services that are new to us. There can be no assurance that we will successfully identify appropriate initiatives, that we will be able to negotiate or finance such initiatives or that such initiatives, if undertaken, will be successful.

 

Our ability to execute strategic and other business initiatives successfully will depend on a variety of factors. These factors likely will vary based on the nature of the initiative but may include: overall market conditions, meeting applicable regulatory requirements and receiving approval of any regulatory applications or filings, hiring or retaining key employees, achieving anticipated business results, our success in operating effectively with any co-investor or partner with whom we elect to do business, our success in integrating any company that we choose to acquire, and achieving anticipated synergies of any acquisition, investment, joint venture or partnership. Our ability to address these factors successfully cannot be assured. In addition, our strategic efforts may divert resources or management's attention from ongoing business operations and may subject us to additional regulatory scrutiny and potential liability. If we do not successfully execute a strategic initiative, it could adversely affect our business, financial condition, results of operations, reputation or growth prospects. In connection with executing any such initiative, we would expect to incur additional non-interest expense, and perhaps the initiative’s entire cost, in advance of realizing improved financial condition and results of operations as a result of the initiative.

 

 18 

 

 

We may not be able to successfully manage our long-term growth, which may adversely affect our results of operations and financial condition.

 

A key aspect of our long-term business strategy is our continued growth and expansion. Our ability to continue to grow depends, in part, upon our ability to:

 

·open new branch offices or acquire existing branches or other financial institutions;
·attract deposits to those locations; and
·identify attractive loan and investment opportunities.

 

We may not be able to successfully implement our growth strategy if we are unable to identify attractive markets, locations or opportunities to expand in the future, or if we are subject to regulatory restrictions on growth or expansion of our operations. Our ability to manage our growth successfully also will depend on whether we can maintain capital levels adequate to support our growth, maintain cost controls and asset quality and successfully integrate any businesses we acquire into our organization. As we identify opportunities to implement our growth strategy by opening new branches or acquiring branches or other banks, we may incur increased personnel, occupancy and other operating expenses. In the case of new branches, we must absorb those higher expenses while we begin to generate new deposits, and there is a further time lag involved in redeploying new deposits into attractively priced loans and other higher yielding earning assets. Thus, any plans for branch expansion could decrease our earnings in the short run, even if we efficiently execute our branching strategy.

 

Deterioration in the soundness of our counterparties could adversely affect us.

 

Our ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial services institutions are interrelated as a result of trading, clearing, counterparty or other relationships, and we routinely execute transactions with counterparties in the financial industry, including brokers and dealers, commercial banks, and other institutional clients. As a result, defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry generally, could create another market-wide liquidity crisis similar to that experienced in late 2008 and early 2009 and could lead to losses or defaults by us or by other institutions. There is no assurance that the failure of our counterparties would not materially adversely affect the Company’s results of operations.

 

Cyber-attacks or other security breaches could have a material adverse effect on our business.

 

As a financial institution, our operations rely heavily on the secure data processing, storage and transmission of confidential and other information on our computer systems and networks. Any failure, interruption or breach in security or operational integrity of these systems could result in failures or disruptions in our online banking system, customer relationship management, general ledger, deposit and loan servicing and other systems. The security and integrity of our systems and the technology we use could be threatened by a variety of interruptions or information security breaches, including those caused by computer hacking, cyber-attacks, electronic fraudulent activity or attempted theft of financial assets. We may fail to promptly identify or adequately address any such failures, interruptions or security breaches if they do occur. While we have certain protective policies and procedures in place, the nature and sophistication of the threats continue to evolve. We may be required to expend significant additional resources in the future to modify and enhance our protective measures.

 

The nature of our business may make it an attractive target and potentially vulnerable to cyber-attacks, computer viruses, physical or electronic break-ins or similar disruptions. The technology-based platform we use processes sensitive data from our borrowers and investors. While we have taken steps to protect confidential information that we have access to, our security measures and the security measures employed by the owners of the technology in the platform that we use could be breached. Any accidental or willful security breaches or other unauthorized access to our systems could cause confidential customer, borrower and investor information to be stolen and used for criminal purposes. Security breaches or unauthorized access to confidential information could also expose us to liability related to the loss of the information, time-consuming and expensive litigation and negative publicity. If security measures are breached because of third-party action, employee error, malfeasance or otherwise, or if design flaws in the technology-based platform that we use are exposed and exploited, our relationships with borrowers and investors could be severely damaged, and we could incur significant liability.

 

 19 

 

  

Because techniques used to sabotage or obtain unauthorized access to systems change frequently and generally are not recognized until they are launched against a target, we and our collaborators may be unable to anticipate these techniques or to implement adequate preventative measures. In addition, federal regulators and many federal and state laws and regulations require companies to notify individuals of data security breaches involving their personal data. These mandatory disclosures regarding a security breach are costly to implement and often lead to widespread negative publicity, which may cause customers, borrowers and investors to lose confidence in the effectiveness of our data security measures. Any security breach, whether actual or perceived, would harm our reputation and could cause us to lose customers, borrowers, investors and partners and adversely affect our business and operations.

 

We rely heavily on our management team and the unexpected loss of any of those personnel could adversely affect our operations; we depend on our ability to attract and retain key personnel.

 

We are a customer-focused and relationship-driven organization. We expect our future growth to be driven in a large part by the relationships maintained with our customers by our president and chief executive officer and other senior officers. We have entered into employment agreements with certain of our executive officers, including our Chief Executive Officer. The existence of such agreements, however, does not necessarily assure that we will be able to continue to retain their services. The unexpected loss of any of our key employees could have an adverse effect on our business and possibly result in reduced revenues and earnings. The implementation of our business strategy will also require us to continue to attract, hire, motivate and retain skilled personnel to develop new customer relationships as well as new financial products and services. Many experienced banking professionals employed by our competitors are covered by agreements not to compete or solicit their existing customers if they were to leave their current employment. These agreements make the recruitment of these professionals more difficult. The market for these people is competitive, and we cannot assure you that we will be successful in attracting, hiring, motivating or retaining them.

 

Our deposit insurance premiums could increase in the future, which may adversely affect our future financial performance.

 

The FDIC insures deposits at FDIC insured financial institutions, including the Bank. The FDIC charges insured financial institutions premiums to maintain the DIF at a certain level. The financial crisis of 2008 and the resulting recession increased the rate of bank failures and expectations for further bank failures, requiring the FDIC to make payments for insured deposits from the DIF – which depleted the DIF – and prepare for future payments from the DIF.

 

On April 1, 2011, final rules to implement changes required by the Dodd-Frank Act with respect to the FDIC assessment rules became effective. The rules provide that a depository institution’s deposit insurance assessment will be calculated based on the institution’s total assets less tangible equity, rather than the previous base of total deposits. These changes have not materially increased the Company’s FDIC insurance assessments for comparable asset and deposit levels. However, if the Bank’s asset size increases or the FDIC takes other actions to replenish the DIF, the Bank’s FDIC insurance premiums could increase.

 

It may be difficult to fully integrate the business of VCB and we may fail to realize all of the anticipated benefits of the acquisition of VCB.

 

If our costs to fully integrate the business of VCB into our existing operations are greater than anticipated, or we are not able to achieve the anticipated benefits of the acquisition, including cost savings and other synergies, our business could be negatively affected. In addition, it is possible that we could lose key employees from VCB’s legacy operations, and that fully integrating VCB’s legacy operations could result in loss of customers, the disruption of our ongoing businesses or inconsistencies in standards, controls, procedures and policies that adversely affect our ability to maintain relationships with customers and employees or to achieve the anticipated benefits of the acquisition. Integration efforts also may divert management attention and resources, which could adversely affect our ability to service our existing business and generate new business, which in turn could adversely affect our business and financial results.

 

Certain losses or other tax assets could be limited if we experience an ownership change, as defined in the Internal Revenue Code.

 

Our ability to use net operating loss carryforwards, built-in losses and certain other tax assets may be limited in the event of an “ownership change” as defined by Section 382 of the Internal Revenue Code of 1986, as amended (the “Code”). In general, an “ownership change” will occur if there is a cumulative change in our ownership by “5% shareholders” (as defined in the Code) that exceeds 50 percentage points over a rolling three-year period. If an “ownership change” occurs, Section 382 would impose an annual limit on the amount of losses or other tax assets we can use to reduce our taxable income equal to the product of the total value of our outstanding equity immediately prior to the “ownership change” and the applicable federal long-term tax-exempt interest rate. A number of special rules apply to calculating this limit. While stock issuances that we have completed since 2013 and other changes in ownership of certain of our shareholders may have increased the likelihood of an “ownership change,” we currently believe that an “ownership change” has not occurred. If such an ownership change has occurred or occurs in the future, we may not be able to use all of our net operating losses and other tax assets to offset taxable income, thus paying higher income taxes which would negatively impact our financial condition and results of operations.

 

 20 

 

  

Our disclosure controls and procedures and internal controls may not prevent or detect all errors or acts of fraud.

 

Our disclosure controls and procedures are designed to reasonably assure that information required to be disclosed by the our in reports it files or submits under the Exchange Act is accumulated and communicated to management, and recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. We believe that any disclosure controls and procedures or internal controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or omission. Additionally, controls can be circumvented by individual acts, by collusion by two or more people and/or by override of the established controls. Accordingly, because of the inherent limitations in our control systems and in human nature, misstatements due to error or fraud may occur and not be detected.

 

Our operations rely on certain external vendors.

 

We are reliant upon certain external vendors to provide products and services necessary to maintain our day-to-day operations. Accordingly, our operations are exposed to risk that these vendors will not perform in accordance with the contracted arrangements under service level agreements. We maintain a system of comprehensive policies and a control framework designed to monitor vendor risks including, among other things, (i) changes in the vendor’s organizational structure, (ii) changes in the vendor’s financial condition, (iii) changes in the vendor’s support for existing products and services and (iv) changes in the vendor’s strategic focus. While we believe these policies and procedures help to mitigate risk, the failure of an external vendor to perform in accordance with the contracted arrangements under service level agreements could be disruptive to our operations, which could have a material adverse impact on our business and, in turn, our financial condition and results of operations.

 

Our communication and information systems may experience an interruption in service.

 

We rely heavily on communications and information systems to conduct our business. Any failure or interruption of these systems could result in failures or disruptions in our customer relationship management, transaction processing systems and various accounting and data management systems. While we have policies and procedures designed to prevent and/or limit the effect of any failure or interruption of our communication and information systems, there can be no assurance that any such failures or interruptions will not occur, or, if they do occur, they will be adequately addressed on a timely basis. The occurrence of failures or interruptions of our communication and information systems could damage our reputation, result in a loss of customer business and subject us to additional regulatory scrutiny, which could have a material adverse effect on our financial condition and results of operations.

 

We continually encounter technological change.

 

The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better serve customers and to reduce costs. Our future success depends, in part, upon our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands, as well as to create additional efficiencies in our operations. Many of our competitors have substantially greater resources to invest in technological improvements. Although recently we have significantly increased our focus on technological innovation and have introduced new, more technologically-advanced products and services, we may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to our customers. Failure to successfully keep pace with technological change affecting the financial services industry could have a material adverse impact on our business and, in turn, our financial condition and results of operations.

 

 21 

 

  

We are subject to environmental liability risk associated with lending activities.

 

A significant portion of our loan portfolio is secured by real property. During the ordinary course of business, we may foreclose on and take title to properties securing certain loans. In doing so, there is a risk that hazardous or toxic substances could be found on these properties. If hazardous or toxic substances are found, we may be liable for remediation costs, as well as for personal injury and property damage. Environmental laws may require us to incur substantial expenses and may materially reduce the affected property’s value or limit our ability to use or sell the affected property. In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase our exposure to environmental liability. Although we have policies and procedures to perform an environmental review before initiating any foreclosure action on real property, these reviews may not be sufficient to detect all potential environmental hazards. The remediation costs and any other financial liabilities associated with an environmental hazard could have a material adverse effect on our financial condition and results of operations.

 

Severe weather, natural disasters, acts of war or terrorism and other external events could significantly impact our business.

 

Severe weather, natural disasters, acts of war or terrorism and other adverse external events could have a significant impact on our ability to conduct business. In addition, such events could affect the stability of our deposit base, impair the ability of borrowers to repay outstanding loans, impair the value of collateral securing loans, cause significant property damage, result in loss of revenue and/or cause us to incur additional expenses. The occurrence of any such event in the future could have a material adverse effect on our business, which, in turn, could have a material adverse effect on our financial condition and results of operations.

 

Changes in accounting standards and management’s selection of accounting methods, including assumptions and estimates, could materially impact our financial statements.

 

From time to time the SEC and the Financial Accounting Standards Board (“FASB”) change the financial accounting and reporting standards that govern the preparation of the Company’s financial statements. These changes can be hard to predict and can materially impact how the Company records and reports its financial condition and results of operations. In some cases, the Company could be required to apply a new or revised standard retroactively, resulting in changes to previously reported financial results, or a cumulative charge to retained earnings. In addition, management is required to use certain assumptions and estimates in preparing our financial statements, including determining the fair value of certain assets and liabilities, among other items. If the assumptions or estimates are incorrect, the Company may experience unexpected material consequences.

 

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

 

The Company relies on dividends from the Bank as its primary source of additional liquidity, and the payment of dividends by the Bank to the Company is restricted by applicable state and federal law. The primary sources of funds of the Bank are client deposits and loan repayments. While scheduled loan repayments are a relatively stable source of funds, they are subject to the ability of borrowers to repay the loans. The ability of borrowers to repay loans can be adversely affected by a number of factors, including changes in economic conditions, adverse trends or events affecting business industry groups, reductions in real estate values or markets, business closings or lay-offs, inclement weather, natural disasters and international instability. Additionally, deposit levels may be affected by a number of factors, including rates paid by competitors, general interest rate levels, regulatory capital requirements, returns available to clients on alternative investments and general economic conditions. Accordingly, we may be required from time to time to rely on secondary sources of liquidity to meet withdrawal demands or otherwise fund operations. Such sources include FHLB advances, sales of securities and loans, and federal funds lines of credit from correspondent banks, as well as out-of-market time deposits. While we believe that these sources are currently adequate, there can be no assurance they will be sufficient to meet future liquidity demands.

 

We may be parties to certain legal proceedings that may impact our earnings.

 

We face significant legal risks in our businesses, and the volume of claims and amount of damages and penalties claimed in litigation and regulatory proceedings against financial institutions remain high. Substantial legal liability or significant regulatory action against us could have material adverse financial impact or cause significant reputational risk to us, which in turn could seriously harm our business prospects.

 

 22 

 

  

We have goodwill that may become impaired, and thus result in a charge against earnings.

 

The Company is no longer required to perform a test for impairment unless, based on an assessment of qualitative factors related to goodwill, it determines that it is more likely than not that the fair value of goodwill is less than its carrying amount. If the likelihood of impairment is more than 50 percent, the Company must perform a test for impairment and we may be required to record impairment charges. In assessing the recoverability of the Company’s goodwill, the Company must make assumptions in order to determine the fair value of the respective assets. Major assumptions used in the impairment analysis are discounted cash flows, merger and acquisition transaction values (including as compared to tangible book value), and stock market capitalization. The Company has elected to bypass the preliminary assessment and conduct a full goodwill impairment analysis on an annual basis through the use of an independent third party specialist. As of December 31, 2015, we had $17.1 million of goodwill related to branch acquisitions in 2003 and 2008 and the acquisition of VCB in 2014. To date, we have not recorded any impairment charges on our goodwill, however there is no guarantee that we may not be forced to recognize impairment charges in the future as operating and economic conditions change. Any material impairment charge would have a negative effect on the Company’s financial results and shareholders’ equity.

 

Other-than-temporary impairment could reduce our earnings.

 

We may be required to record other-than-temporary impairment (or “OTTI”) charges on our investment securities if they suffer a decline in value that is considered other-than-temporary. Numerous factors, including lack of liquidity for re-sales of certain investment securities, absence of reliable pricing information for certain investment securities, adverse changes in business climate, adverse actions by regulators, or unanticipated changes in the competitive environment could have a negative effect on our securities portfolio in future periods. An OTTI charge could have a material adverse effect on our results of operations and financial condition.

 

Our common stock trading volume may not provide adequate liquidity for investors.

 

Although shares of the Company’s common stock are listed on the NASDAQ Global Select Market, the average daily trading volume in the common stock is less than that of many other financial services companies. A public trading market having the desired characteristics of depth, liquidity and orderliness depends on the presence in the marketplace of a sufficient number of willing buyers and sellers of the common stock at any given time. This presence depends on the individual decisions of investors and general economic and market conditions over which we have no control. Given the daily average trading volume of the Company’s common stock, significant sales of the common stock in a brief period of time, or the expectation of these sales, could cause a decline in the price of the Company’s common stock.

 

Our common stock and Series B Preferred Stock are not insured deposits.

 

Our common stock and non-voting mandatorily convertible non-cumulative preferred stock, Series B (the “Series B Preferred Stock”) are not bank deposits and, therefore, losses in their value are not insured by the FDIC, any other deposit insurance fund or by any other public or private entity. Investment in the Company’s common stock or Series B Preferred stock is inherently risky for the reasons described in this “Risk Factors” section and elsewhere in this Form 10-K, and is subject to the same market forces and investment risks that affect the price of capital stock in any other company, including the possible loss of some or all principal invested.

 

Item 1B. Unresolved Staff Comments

 

None.

 

Item 2. Properties

 

Our principal executive offices are located at 330 Hospital Road, Tappahannock, Virginia 22560 where we opened a 15,632 square foot corporate headquarters and operations center in July 2003. In November 2014 the Company acquired VCB which added three full service branches and one business condo unit housing a commercial and administrative center in the Tidewater region. Of the former VCB properties, one branch and the business condo unit are owned and two branches are under long-term land leases on which the owned branch is located. At the end of 2015, the Company owned twenty-one full service branch buildings including the land on which eighteen of those buildings are located and two remote drive-in facilities. The Company currently has long-term leases for six of its branches and one loan production office. Three of the leases are for branch buildings, three of the leases are for the land on which Company owned branches are located and one lease is for a loan production office building in Chesterfield, Virginia. All leases are under long-term non-cancelable operating lease agreements with renewal options, at total annual rentals of approximately $478 thousand as of December 31, 2016. The counties of Northumberland and Middlesex are each the home to three of our branches. The counties of Essex and Gloucester are home to two branch offices. In addition, Essex County houses the Company’s corporate/operations center. Hanover County houses three branch offices, the Bank’s loan administration center, and an administrative center, while Henrico, King William County, Lancaster, New Kent, Southampton, Surry, Sussex Counties and the cities of Colonial Heights, Hampton, Newport News and Williamsburg each have one full service branch office. In addition, the city of Newport News houses a commercial/administrative center. Southampton County and Sussex County also each have a stand-alone drive-in/automated teller machine location.

 

 23 

 

  

The Company believes its facilities are in good operating condition, are suitable and adequate for its operational needs and are adequately insured.

 

See Item 13. “Certain Relationships and Related Transactions, and Director Independence” and Item 8. “Financial Statements and Supplementary Data,” under the heading “Note 23. Related Party Leases” of this Form 10-K for more information on the Company’s related party leases.

 

Item 3. Legal Proceedings

 

The Company is not a party to, nor is any of its property the subject of, any material pending legal proceedings incidental to its businesses other than those arising in the ordinary course of business. Although the amount of any ultimate liability with respect to such matters cannot be determined, in the opinion of management, any such liability from legal proceedings incidental to the Company’s business will not have a material adverse effect on the consolidated financial position or results of operations of the Company.

 

Item 4. Mine Safety Disclosures

 

None.

 

Executive Officers of the Registrant

 

Following are the persons who are currently executive officers of the Company, their ages as of December 31, 2015, their current titles and positions held during the last five years:

 

Joe A. Shearin, 59, joined the Company in 2001 as the President and Chief Executive Officer of Southside Bank. Mr. Shearin served in that capacity until 2006 when he became President and Chief Executive Officer of the Bank. Mr. Shearin became the President and Chief Executive Officer of the Company in 2002.

 

J. Adam Sothen, 39, joined the Company in June 2010 as Vice President and Corporate Controller of the Bank. In September 2011, Mr. Sothen was appointed as the Company’s Chief Financial Officer and the Bank’s Executive Vice President and Chief Financial Officer. Mr. Sothen served as the Corporate Controller until October 2012.

 

James S. Thomas, 61, joined the Company in 2003 as Senior Vice President and Retail Banking Manager of Southside Bank. In 2005, he became Executive Vice President and Chief Operating Officer of Southside Bank. In April 2006, Mr. Thomas became Executive Vice President of Retail Banking for the Bank. In June 2007, Mr. Thomas was promoted to Executive Vice President and Chief Credit Officer of the Bank.

 

Douglas R. Taylor, 59, joined the Company in April 2010 as Executive Vice President and Chief Risk Officer of the Bank.

 

Ann-Cabell Williams, 54, joined the Company in July 2011 as Executive Vice President and Retail Executive of the Bank.  From January 2007 until joining the Company, Ms. Williams served as Chief Operation Officer and Retail Executive for Bank of Virginia. 

 

Bruce T. Brockwell, 50, joined the Company in April 2011 as Senior Vice President and Senior Commercial Lending Officer of the Bank. In May 2012, he became Senior Vice President and Director of Commercial Banking of the Bank. In August 2013, Mr. Brockwell was promoted to Executive Vice President and Director of Commercial Banking of the Bank.

 

Mark C. Hanna, 47, joined the Company in November 2014 as Executive Vice President and Regional Executive of the Bank. From November 2006 until joining the Company, Mr. Hanna served as President and Chief Executive Officer for Virginia Company Bank. From September 2005 to November 2006, Mr. Hanna served as President of Virginia Company Bank.

 

Dianna B. Emery, 57, joined the Company in December 2007 as Cash Management Sales Officer of the Bank and later transitioned to Senior Business Analyst of the Bank.  In March 2011, she became Vice President and Operations Manager of the Bank.  In July 2015, she became Senior Vice President and Chief Operations Officer of the Bank.  In November 2015, Ms. Emery was promoted to Executive Vice President and Chief Operations Officer of the Bank.

 

 24 

 

  

Part II

 

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

Common Stock Performance and Dividends

 

The Company’s common stock is traded on the NASDAQ Global Market under the symbol “EVBS.” As of March 10, 2016, there were approximately 2,730 shareholders of record. As of that date, the closing price of our common stock on the NASDAQ Global Market was $6.88. Set forth in the table below is the high and low sales prices of our common stock as reported by the NASDAQ Stock Market during each quarter for 2015 and 2014, along with the dividends that were declared quarterly in 2015. The Company did not declare any dividends during 2014.

 

   2015   2014 
Quarter  High   Low   Dividends   High   Low   Dividends 
First  $6.50   $6.12   $0.01   $7.25   $6.00   $- 
Second   6.57    5.80    0.01    6.95    6.20    - 
Third   7.24    6.12    0.02    6.44    6.08    - 
Fourth   7.24    6.25    0.02    6.57    5.33    - 

 

Payment of dividends is at the discretion of the Company’s board of directors and is subject to various federal and state regulatory limitations. For further information regarding payment of dividends refer to Item 1, “Business,” under the heading “Limits on Dividends” of this Annual Report on Form 10-K.

 

Stock Performance Graph

 

The graph below presents five-year cumulative total return comparisons through December 31, 2015, in stock price appreciation and dividends for the Company’s common stock, the NASDAQ Composite and the SNL $1 billion - $5 billion Bank Index. Returns assume an initial investment of $100 at the market close on December 31, 2010 and reinvestment of dividends. Values as of each year end of the $100 initial investment are shown in the table and graph below.

 

 

 

 

 

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Dividend Reinvestment and Stock Purchase Plan

 

The Company has a Dividend Reinvestment and Stock Purchase Plan (the “DRIP”), which provides for the automatic conversion of dividends into common stock for enrolled shareholders. The DRIP also permits participants to make voluntary cash payments of up to $20 thousand per shareholder per calendar quarter for the purchase of additional shares of the Company’s common stock. When the administrator of the DRIP purchases shares of common stock from the Company, the purchase price will generally be the market value of the common stock on the purchase date as defined by the Nasdaq Stock Market. When the administrator purchases shares of common stock in the open market, the purchase price will be the weighted average of the prices actually paid for the shares for the relevant purchase date, excluding all fees, brokerage commissions, and expenses. When the administrator purchases shares of common stock in privately negotiated transactions, the purchase price will be the weighted average of the prices actually paid for the shares for the relevant purchase date, excluding all fees, brokerage commissions, and expenses.

 

Beginning on August 15, 2012, the issuance of common stock under the DRIP was temporarily suspended. The Company plans to restore the plan during the second quarter of 2016. 

 

Purchases of Equity Securities by the Issuer

 

In January 2001, the Company announced a stock repurchase program by which management was authorized to repurchase up to 300,000 shares of the Company’s common stock. This plan was amended in 2003 and the number of shares by which management is authorized to repurchase is up to 5% of the outstanding shares of the Company’s common stock on January 1 of each year. There is no stated expiration date for the program. During 2015, 2014 and 2013, the Company did not repurchase any of its common stock under the program.

 

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Item 6. Selected Financial Data

  

SELECTED FINANCIAL DATA

(dollars in thousands, except per share data)

 

   Year Ended December 31, 
Operating Statement Data:  2015   2014   2013   2012   2011 
Interest and dividend income  $47,964   $41,918   $42,024   $45,071   $49,538 
Interest expense   5,589    4,428    8,045    11,568    14,651 
Net interest income   42,375    37,490    33,979    33,503    34,887 
Provision for loan losses   -    250    1,850    5,658    8,800 
Net interest income after provision for loan losses   42,375    37,240    32,129    27,845    26,087 
Noninterest income   6,453    6,675    7,748    9,898    9,518 
Noninterest expense   39,040    35,804    44,901    33,346    34,039 
Income (loss) before income taxes   9,788    8,111    (5,024)   4,397    1,566 
Income tax expense (benefit)   2,494    2,447    (2,392)   945    (211)
Net income (loss)   7,294    5,664    (2,632)   3,452    1,777 
Effective dividend on preferred stock   386    1,948    1,504    1,500    1,496 
Net income (loss) available to common shareholders  $6,908   $3,716   $(4,136)  $1,952   $281 
                          
Per Share Data:                         
Basic and Diluted income (loss) per common share  $0.38   $0.22   $(0.45)  $0.32   $0.05 
Cash dividends paid per share, common stock  $0.06   $-   $-   $-   $- 
Dividend payout ratio   15.86%   n/a    n/a    n/a    n/a 
Book value per common share  $8.11   $7.67   $7.41   $12.56   $11.83 
                          
Balance Sheet Data:                         
Assets  $1,270,384   $1,181,972   $1,027,074   $1,075,553   $1,063,034 
Loans, net of unearned income   880,778    820,569    657,197    684,668    734,530 
Investment securities   269,600    253,707    275,979    286,164    246,582 
Deposits   988,719    939,254    834,462    838,373    829,951 
Total shareholders' equity   126,275    134,274    132,949    99,711    95,123 
Average common shares outstanding - basic   13,017    12,015    9,205    6,051    6,008 
Average common shares outstanding - diluted   18,257    17,255    9,205    6,051    6,008 
                          
Performance Ratios:                         
Return on average assets   0.57%   0.35%   -0.39%   0.18%   0.03%
Return on average common shareholders' equity   6.76%   3.96%   -4.98%   2.66%   0.40%
Efficiency ratio (1)   78.93%   80.99%   79.46%   79.09%   76.63%
Average equity to average assets   10.53%   12.85%   11.13%   9.13%   8.79%
Asset Quality Ratios:                         
Allowance for loan losses to period end loans   1.29%   1.59%   2.25%   2.97%   3.28%
Allowance for loan losses to nonaccrual loans   183.43%   196.63%   134.03%   171.29%   79.56%
Nonperforming assets to period end loans and other real estate owned   0.89%   1.04%   1.80%   2.41%   5.09%
Net charge-offs to average loans   0.20%   0.28%   1.11%   1.32%   1.32%
                          
Capital Ratios:                         
Leverage capital ratio   9.20%   10.76%   12.06%   8.13%   7.67%
CET1 risk-based capital   9.80%   n/a    n/a    n/a    n/a 
Tier 1 risk-based capital   12.66%   14.06%   18.22%   12.64%   11.23%
Total risk-based capital   16.17%   15.31%   19.48%   13.88%   12.47%

 

Note: (1) Efficiency ratio is computed by dividing noninterest expense by the sum of net interest income on a tax equivalent basis and noninterest income, net of gains or losses.

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

This commentary provides an overview of the Company’s financial condition as of December 31, 2015 and 2014, and changes in financial condition and results of operations for the years 2013 through 2015. This section of the Form 10-K should be read in conjunction with the Consolidated Financial Statements and related Notes thereto included under Item 8. “Financial Statements and Supplementary Data” of this Form 10-K.

 

Forward Looking Statements

 

Certain statements contained in this Annual Report on Form 10-K that are not historical facts may constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. In addition, certain statements may be contained in the Company’s future filings with the SEC, in press releases, and in oral and written statements made by or with the approval of the Company that are not statements of historical fact and constitute forward-looking statements within the meaning of the Act. Examples of forward-looking statements include, but are not limited to: (i) projections of revenues, expenses, income or loss, earnings or loss per share, the payment or nonpayment of dividends, capital structure and other financial items; (ii) statements of plans, objectives and expectations of the Company or its management or Board of Directors, including those relating to products or services, the performance or disposition of portions of the Company’s asset portfolio, future changes to the Bank’s branch network, and the payment of dividends; (iii) statements of future financial performance and economic conditions; (iv) statements regarding the adequacy of the allowance for loan losses; (v) statements regarding the effect of future sales of foreclosed properties; (vi) statements regarding the Company’s liquidity; (vii) statements of management’s expectations regarding future trends in interest rates, real estate values, and economic conditions generally and in the Company’s markets; (viii) statements regarding future asset quality, including expected levels of charge-offs; (ix) statements regarding potential changes to laws, regulations or administrative guidance; (x) statements regarding strategic initiatives of the Company or the Bank and the results of these initiatives; and (xi) statements of assumptions underlying such statements. Words such as “believes,” “anticipates,” “expects,” “intends,” “targeted,” “continue,” “remain,” “will,” “should,” “may” and other similar expressions are intended to identify forward-looking statements but are not the exclusive means of identifying such statements.

 

Forward-looking statements involve risks and uncertainties that may cause actual results to differ materially from those in such statements. Factors that could cause actual results to differ from those discussed in the forward-looking statements include, but are not limited to:

 

qfactors that adversely affect our strategic and business initiatives, including, without limitation, changes in the economic or business conditions in the Company’s markets;
qour ability and efforts to assess, manage and improve asset quality;
qthe strength of the economy in the Company’s target market area, as well as general economic, market, political, or business factors;
qchanges in the quality or composition of our loan or investment portfolios, including adverse developments in borrower industries or in the repayment ability of individual borrowers or issuers;
qconcentrations in segments of the loan portfolio or declines in real estate values in the Company’s markets;
qthe effects of our adjustments to the composition of our investment portfolio;
qthe strength of the Company’s counterparties;
qan insufficient allowance for loan losses;
qour ability to meet the capital requirements of our regulatory agencies;
qchanges in laws, regulations and the policies of federal or state regulators and agencies, including the Basel III Capital Rules;
qchanges in the interest rates affecting our deposits and loans;
qthe loss of any of our key employees;
qfailure, interruption or breach of any of the Company’s communication or information systems, including those provided by external vendors;
qour potential growth, including our entrance or expansion into new markets, the opportunities that may be presented to and pursued by us and the need for sufficient capital to support that growth;
qfuture mergers or acquisitions, if any;
qchanges in government monetary policy, interest rates, deposit flow, the cost of funds, and demand for loan products and financial services;
qour ability to maintain internal control over financial reporting;

 

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qour ability to realize our deferred tax assets, including in the event the Company experiences an ownership change as defined by section 382 of the Code;
qour ability to raise capital as needed by our business;
qour reliance on secondary sources, such as FHLB advances, sales of securities and loans and federal funds lines of credit from correspondent banks to meet our liquidity needs; and
qother circumstances, many of which are beyond our control.

 

Although the Company believes that its expectations with respect to the forward-looking statements are based upon reliable assumptions and projections within the bounds of its knowledge of its business and operations, there can be no assurance that actual results, performance, actions or achievements of the Company will not differ materially from any future results, performance, actions or achievements expressed or implied by such forward-looking statements. Readers should not place undue reliance on such statements. Forward-looking statements speak only as of the date on which such statements are made. The Company undertakes no obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made, or to reflect the occurrence of unanticipated events. The reader should refer to risks detailed under Item 1A. “Risk Factors” included above in this Form 10-K and in our periodic and current reports filed with the SEC for specific factors that could cause our actual results to be significantly different from those expressed or implied by our forward-looking statements.

 

Critical Accounting Policies

 

The preparation of financial statements requires us to make estimates and assumptions. Those accounting policies with the greatest uncertainty and that require our most difficult, subjective or complex judgments affecting the application of these policies, and the likelihood that materially different amounts would be reported under different conditions, or using different assumptions, are described below.

 

Allowance for Loan Losses

 

The Company establishes the allowance for loan losses through charges to earnings in the form of a provision for loan losses. Loan losses are charged against the allowance when we believe that the collection of the principal is unlikely. Subsequent recoveries of losses previously charged against the allowance are credited to the allowance. The allowance represents an amount that, in our judgment, will be adequate to absorb any losses on existing loans that may become uncollectible. Our judgment in determining the level of the allowance is based on evaluations of the collectability of loans while taking into consideration such factors as trends in delinquencies and charge-offs, changes in the nature and volume of the loan portfolio, current economic conditions that may affect a borrower’s ability to repay and the value of collateral, overall portfolio quality and review of specific potential losses. This evaluation is inherently subjective because it requires estimates that are susceptible to significant revision as more information becomes available. For more information see the section titled “Asset Quality” within Item 7.

 

Impairment of Loans

 

The Company considers a loan impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal and interest when due, according to the contractual terms of the loan agreement. The Company does not consider a loan impaired during a period of insignificant payment shortfalls if we expect the ultimate collection of all amounts due. Impairment is measured on a loan by loan basis for real estate (including multifamily residential, construction, farmland and non-farm, non-residential) and commercial loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent. Large groups of smaller balance homogeneous loans, representing consumer, one to four family residential first and seconds and home equity lines, are collectively evaluated for impairment. The Company maintains a valuation allowance to the extent that the measure of the impaired loan is less than the recorded investment. Troubled debt restructurings (“TDRs”) are also considered impaired loans. A TDR occurs when the Company, for economic or legal reasons related to the borrower’s financial condition, grants a concession (including, without limitation, rate reductions to below-market rates, payment deferrals, forbearance and, in some cases, forgiveness of principal or interest) to the borrower that it would not otherwise consider. For more information see the section titled “Asset Quality” within this Item 7.

 

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Loans Acquired in a Business Combination

 

The Company accounts for loans acquired in a business combination, such as the Company’s acquisition of VCB, in accordance with the FASB Accounting Standards Codification (“ASC”) Topic 805, “Business Combinations.” Accordingly, acquired loans are segregated between purchased credit-impaired (“PCI”) loans and purchased performing loans and are recorded at estimated fair value on the date of acquisition without the carryover of the related allowance for loan losses.

 

PCI loans are those for which there is evidence of credit deterioration since origination and for which it is probable at the date of acquisition that the Company will not collect all contractually required principal and interest payments. When determining fair market value, PCI loans were aggregated into pools of loans based on common characteristics as of the date of acquisition such as loan type, date of origination, and evidence of credit quality deterioration such as internal risk grades and past due and nonaccrual status. The Company estimates the amount and timing of expected cash flows for each loan or pool, and the expected cash flows in excess of amount paid is recorded as interest income over the remaining life of the loan or pool (accretable yield). The excess of the loan’s or pool’s contractual principal and interest over expected cash flows is not recorded (nonaccretable difference). Over the life of the loan or pool, expected cash flows continue to be estimated. If the present value of expected cash flows is less than the carrying amount, a loss is recorded as a provision for loan losses. If the present value of expected cash flows is greater than the carrying amount, it is recognized as part of future interest income. Loans not designated PCI loans as of the acquisition date are designated purchased performing loans. The Company accounts for purchased performing loans using the contractual cash flows method of recognizing discount accretion based on the acquired loans’ contractual cash flows. Purchased performing loans are recorded at fair value, including a credit discount. The fair value discount is accreted as an adjustment to yield over the estimated lives of the loans. There is no allowance for loan losses established at the acquisition date for purchased performing or PCI loans. A provision for loan losses is recorded for any deterioration in these loans subsequent to the acquisition.

 

Impairment of Securities

 

Impairment of securities occurs when the fair value of a security is less than its amortized cost. For debt securities, impairment is considered other-than-temporary and recognized in its entirety in net income if either (i) the Company intends to sell the security or (ii) it is more likely than not that the Company will be required to sell the security before recovery of its amortized cost basis. If, however, the Company does not intend to sell the security and it is not more likely than not that the Company will be required to sell the security before recovery, the Company must determine what portion of the impairment is attributable to a credit loss, which occurs when the amortized cost basis of the security exceeds the present value of the cash flows expected to be collected from the security. If there is no credit loss, there is no other-than-temporary impairment. If there is a credit loss, other-than-temporary impairment exists, and the credit loss must be recognized in net income and the remaining portion of impairment must be recognized in other comprehensive income (loss). For equity securities, impairment is considered to be other-than-temporary based on the Company’s ability and intent to hold the investment until a recovery of fair value. Other-than-temporary impairment of an equity security results in a write-down that must be included in net income. The Company regularly reviews each investment security for other-than-temporary impairment based on criteria that include the extent to which cost exceeds market price, the duration of that market decline, the financial health of and specific prospects for the issuer, the Company’s best estimate of the present value of cash flows expected to be collected from debt securities, the Company’s intention with regard to holding the security to maturity and the likelihood that the Company would be required to sell the security before recovery.

 

Other Real Estate Owned (“OREO”)

 

Real estate acquired through, or in lieu of, foreclosure is held for sale and is stated at fair value of the property, less estimated disposal costs, if any. Any excess of cost over the fair value less costs to sell at the time of acquisition is charged to the allowance for loan losses. The fair value is reviewed periodically by management and any write-downs are charged against current earnings.

 

Goodwill

 

With the adoption of FASB Accounting Standards Update (“ASU”) 2011-08, “Intangible-Goodwill and Other-Testing Goodwill for Impairment,” the Company is no longer required to perform a test for impairment unless, based on an assessment of qualitative factors related to goodwill, it determines that it is more likely than not that the fair value of goodwill is less than its carrying amount. If the likelihood of impairment is more than 50 percent, the Company must perform a test for impairment and we may be required to record impairment charges. In assessing the recoverability of the Company’s goodwill, the Company must make assumptions in order to determine the fair value of the respective assets. Major assumptions used in the impairment analysis were discounted cash flows, merger and acquisition transaction values (including as compared to tangible book value), and stock market capitalization. The Company chose to bypass the preliminary assessment of qualitative impairment factors and completed its annual goodwill impairment test during the fourth quarter of 2015 through the use of an independent third party specialist and determined there was no impairment to be recognized in 2015. If the underlying estimates and related assumptions change in the future, the Company may be required to record impairment charges.

 

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Retirement Plan

 

The Company has historically maintained a defined benefit pension plan. Effective January 28, 2008, the Company took action to freeze the plan with no additional contributions for a majority of participants. Employees age 55 or greater or with 10 years of credited service were grandfathered in the plan. No additional participants have been added to the plan. The plan was again amended on February 28, 2011 to freeze the plan with no additional contributions for grandfathered participants. Benefits for all participants have remained frozen in the plan since such action was taken. Effective January 1, 2012, the plan was amended and restated as a cash balance plan. Under a cash balance plan, participant benefits are stated as an account balance. An opening account balance was established for each participant based on the lump sum value of his or her accrued benefit as of December 31, 2011 in the original defined benefit pension plan. Each participant’s account will be credited with an “interest” credit each year. The interest rate for each year is determined as the average annual interest rate on the 2 year U.S. Treasury securities for the month of December preceding the plan year. Plan assets, which consist primarily of mutual funds invested in marketable equity securities and corporate and government fixed income securities, are valued using market quotations. The Company’s actuary determines plan obligations and annual pension expense using a number of key assumptions. Key assumptions may include the discount rate, the estimated return on plan assets and the anticipated rate of compensation increases. Changes in these assumptions in the future, if any, or in the method under which benefits are calculated may impact pension assets, liabilities or expense.

 

Accounting for Income Taxes

 

Determining the Company’s effective tax rate requires judgment. In the ordinary course of business, there are transactions and calculations for which the ultimate tax outcomes are uncertain. In addition, the Company’s tax returns are subject to audit by various tax authorities. Although we believe that the estimates are reasonable, no assurance can be given that the final tax outcome will not be materially different than that which is reflected in the income tax provision and accrual.

 

The realization of deferred income tax assets is assessed and a valuation allowance is recorded if it is “more likely than not” that all or a portion of the deferred tax asset will not be realized.  “More likely than not” is defined as greater than a 50% chance.  Management considers all available evidence, both positive and negative, to determine whether, based on the weight of that evidence, a valuation allowance is needed. For more information, see Item 8. “Financial Statements and Supplementary Data,” under the heading “Note 11. Income Taxes.”

 

For further information concerning accounting policies, refer to Item 8. “Financial Statements and Supplementary Data,” under the heading “Note 1. Summary of Significant Accounting Policies.”

 

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Business Overview

 

The Company provides a broad range of personal and commercial banking services including commercial, consumer and real estate loans. We complement our lending operations with an array of retail and commercial deposit products and fee-based services. Our services are delivered locally by well-trained and experienced bankers, whom we empower to make decisions at the local level, so they can provide timely lending decisions and respond promptly to customer inquiries. Having been in many of our markets for over 100 years, we have established relationships with and an understanding of our customers. We believe that, by offering our customers personalized service and a breadth of products, we can compete effectively as we expand within our existing markets and into new markets.

 

The Company is committed to delivering strong long-term earnings using a prudent allocation of capital, in business lines where we have demonstrated the ability to compete successfully. During 2015, the national and local economies continued to show slow, but measured signs of recovery with the main challenges continuing to be underemployment above historical levels and uneven economic growth. Macro-economic and political issues continue to temper the global economic outlook and, as such, the Company remains cautiously optimistic regarding the improvements seen in our local markets. Despite this, the Company believes that our local markets are poised for stronger growth in the coming months and years than the economic recovery has provided in our markets in recent periods.

 

Since 2013 the Company has completed strategic initiatives that have significantly improved the Company’s financial condition. These initiatives represent significant progress toward the Company’s long-term goal of growing a more robust community banking business, and will provide the platform for continued growth and success in future periods. These initiatives include:

 

·Raising in 2013 an aggregate of $50.0 million of gross proceeds from sales of the Company’s common stock and Series B Preferred Stock in private placements to certain institutional investors ($45.0 million in gross proceeds) and a rights offering to existing shareholders ($5.0 million in gross proceeds) (collectively, the “2013 Capital Initiative”);
·Using a portion of the proceeds from the 2013 Capital Initiative to prepay long-term, higher-rate FHLB advances and to accelerate the disposition of adversely classified assets;
·Paying all current and previously deferred interest and all current and previously deferred, but accumulated, dividends on the Company’s Junior Subordinated Debt and Series A Preferred Stock (defined in Item 8. “Financial Statements and Supplementary Data,” under the heading “Note 22. Preferred Stock and Warrant” of this Annual Report on Form 10-K), respectively;
·Redeeming all of the Company’s Series A Preferred Stock, which eliminated one of the Company’s most expensive sources of capital;
·Acquiring VCB effective November 14, 2014, thus adding three branches to the Bank’s branch network and an aggregate of $128.9 million of assets to the Company’s balance sheet. All former VCB branches have been fully integrated into the Bank’s branch network and operate as branches of the Bank, expanding the Bank’s branch network into the Virginia cities of Hampton, Newport News and Williamsburg;
·Opening a loan production office in Chesterfield County, Virginia to increase the Bank’s presence in the Richmond metropolitan area;
·Declaring dividends to holders of both the Company’s common stock and Series B Preferred Stock. Dividends of $0.01 were declared as of March 6, 2015 and May 8, 2015, which were paid on March 20, 2015 and May 22, 2015, respectively. Dividends of $0.02 were declared as of August 7, 2015 and November 7, 2015, which were paid on August 21, 2015 and November 20, 2015, respectively; and
·Raising in the second quarter of 2015 an aggregate of $20.0 million in gross proceeds from sales of Senior Subordinated Debt (defined in Item 8. “Financial Statements and Supplementary Data” under the heading “Note 9. Junior and Senior Subordinated Debt”) in private placements to certain institutional investors. A portion of these proceeds were used to redeem the remainder of the Company’s Series A Preferred Stock and to repurchase the Warrant (defined in Item 8. “Financial Statements and Supplementary Data,” under the heading “Note 22. Preferred Stock and Warrant” of this Annual Report on Form 10-K) that was issued to the Treasury through the Capital Purchase Program.

 

The Company expects to recognize the continued benefits of these initiatives during 2016, including through lower interest expense related to the extinguished FHLB advances in 2013, elimination of the Series A Preferred Stock dividend as of June 15, 2015, additional interest income and cost savings related to the acquisition of VCB, and positive contributions to the Company’s loan portfolio generated by the three branches acquired from VCB and the Chesterfield County, Virginia loan production office. During 2016, the Company also plans to continue its focus on developing online and mobile banking options and offering these products and services to the Bank’s customers.

 

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While the Company has largely worked through the economic challenges of the past few years and believes that it is positioned for future success, in significant part due to the successful execution of the strategic initiatives summarized above, the Company will continue to evaluate business development and other strategic initiatives and opportunities it identifies during 2016. These opportunities and initiatives could include opportunities to grow the Company’s business or strengthen the Bank’s branch network in existing or new markets. Also, during the first half of 2015, the Company engaged an independent consultant to conduct a comprehensive assessment of its operations. This assessment identified operating efficiencies and revenue enhancement opportunities. The Company has leveraged the assessment’s findings and the Company’s focus on growth and profitability and has begun to realize targeted increases in revenues and declines in certain noninterest expenses. Throughout 2016 and forward, we plan to evaluate and implement additional strategies that we believe will improve the performance and will increase the value of our company.

 

Summary of 2015 Operating Results and Financial Condition

 

Table 1: Performance Summary

 

   Years Ended December 31, 
(dollars in thousands, except per share data)  2015   2014 
Net income (1)  $7,294   $5,664 
Net income available to common shareholders (1)  $6,908   $3,716 
Basic and diluted net income per common share  $0.38   $0.22 
Return on average assets   0.57%   0.35%
Return on average common shareholders' equity   6.76%   3.96%
Net interest margin (tax equivalent basis) (2)   3.84%   3.85%

 

(1)The difference between net income and net income available to common shareholders is the effective dividend to holders of the Company’s Series A Preferred Stock. The Company redeemed the remaining shares of Series A Preferred Stock during the second quarter of 2015.
(2)For more information on the calculation of net interest margin on a tax equivalent basis, see the average balance sheet and net interest margin analysis for the years ended December 31, 2015 and 2014 contained in "Results of Operations" in this Item 7.

 

For the year ended December 31, 2015, the following key points were significant factors in our reported results:

 

·Increase in net interest income of $4.9 million from the same period in 2014, principally due to a $6.1 million increase in interest and fees on loans driven primarily by loans acquired through the acquisition of VCB, partially offset by an increase in interest expense associated with the issuance of $20.0 million in Senior Subordinated Debt during the second quarter of 2015;
·Increase in salaries and employee benefits of $2.7 million from the same period in 2014, primarily due to increased staff levels and support positions associated with the addition of three branches through the acquisition of VCB;
·Operating results were impacted by acquisition accounting adjustments in relation to the VCB acquisition. As a result, yields on acquired loans increased and were partially offset by amortization of the core deposit intangible and the fair value adjustment for time deposits. The net accretion attributable to accounting adjustments related to the VCB acquisition was $479 thousand;
·No provision for loan losses was recorded during the twelve months ended December 31, 2015 compared to $250 thousand for the same period in 2014. Net charge-offs decreased to $1.7 million for the twelve months ended December 31, 2015 from $2.0 million in the same period of 2014;
·Decrease in merger and merger related expenses of $1.6 million due to certain costs associated with the VCB acquisition during 2014 that were not repeated in 2015;
·Nonperforming assets at December 31, 2015 decreased $701 thousand from December 31, 2014, primarily due to a $1.3 million decline in OREO and a $447 thousand decline in nonaccrual loans, partially offset by an increase of $1.1 million in loans past due 90 days and accruing interest;
·Marketing and advertising expenses increased $354 thousand as compared to the same period in 2014 due to the timing of campaigns and costs associated with the acquisition of VCB and other marketing initiatives;

 

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·Other operating expenses increased $1.5 million for the twelve months ended December 31, 2015 as compared to the same period in 2014, primarily driven by increased costs associated with outsourcing of the Bank’s core information technology processing. Additionally, amortization expense for the core deposit intangible related to the VCB acquisition increased $227 thousand for the twelve months ended December 31, 2015, as compared to the same period in 2014; and
·Decrease in the effective dividend on preferred stock of $1.6 million from the same period in 2014. This was due to the redemption of the Company’s Series A Preferred Stock (10,000, 5,000 and 9,000 shares on October 15, 2014, January 15, 2015 and June 15, 2015, respectively).

 

Results of Operations

 

The table below lists our quarterly performance for the years ended December 31, 2015 and 2014.

  

Table 2: Summary Of Financial Results By Quarter

 

   Three Months Ended   Three Months Ended 
   2015   2014 
(dollars in thousands)  Dec. 31   Sep. 30   June 30   Mar. 31   Dec. 31   Sep. 30   June 30   Mar. 31 
Interest and dividend income  $12,280   $11,984   $11,935   $11,765   $11,261   $10,084   $10,197   $10,376 
Interest expense   1,585    1,484    1,329    1,191    1,085    1,121    1,107    1,115 
Net interest income   10,695    10,500    10,606    10,574    10,176    8,963    9,090    9,261 
Provision for loan losses   -    -    -    -    -    -    -    250 
Net interest income after provision for loan losses   10,695    10,500    10,606    10,574    10,176    8,963    9,090    9,011 
Noninterest income   1,678    1,724    1,532    1,519    1,539    1,605    1,639    1,892 
Noninterest expenses   9,357    9,517    10,199    9,967    10,479    8,628    8,519    8,178 
Income before income taxes   3,016    2,707    1,939    2,126    1,236    1,940    2,210    2,725 
Income tax expense   848    697    432    517    505    658    555    729 
Net income  $2,168   $2,010   $1,507   $1,609   $731   $1,282   $1,655   $1,996 
Less:  Effective dividend on preferred stock   -    -    166    220    349    540    541    518 
Net income available to common shareholders  $2,168   $2,010   $1,341   $1,389   $382   $742   $1,114   $1,478 
                                         
Income per common share: basic and diluted  $0.12   $0.11   $0.07   $0.08   $0.03   $0.04   $0.06   $0.09 

 

Net Interest Income and Net Interest Margin

 

Net interest income, the fundamental source of the Company’s earnings, is defined as the difference between income on earning assets and the cost of funds supporting those assets. Significant categories of earning assets are loans and investment securities, while deposits, short-term borrowings, long-term borrowings, Junior Subordinated Debt and Senior Subordinated Debt represent the major portion of interest bearing liabilities. The level of net interest income is impacted primarily by variations in the volume and mix of these assets and liabilities, as well as changes in interest rates when compared to previous periods of operations and the yield of our interest earning assets compared to our cost of funding these assets.

 

Table 3 presents the average interest earning assets and average interest bearing liabilities, the average yields earned on such assets (on a tax equivalent basis) and rates paid on such liabilities, and the net interest margin for the indicated periods. The variance in interest income and expense caused by differences in average balances and rate is shown in Table 4.

 

For comparative purposes, income from tax-exempt securities is adjusted to a tax-equivalent basis using the federal statutory tax rate of 34% and adjusted by the Tax Equity and Fiscal Responsibility Act adjustment. This latter adjustment is for the disallowance as a deduction of a portion of total interest expense related to the ratio of average tax-exempt securities to average total assets. By making these adjustments, tax-exempt income and their yields are presented on a comparable basis with income and yields from fully taxable earning assets. The net interest margin is calculated by expressing tax-equivalent net interest income as a percentage of average interest earning assets, and represents the Company’s net yield on its earning assets. Net interest margin is an indicator of the Company’s effectiveness in generating income from its earning assets. The net interest margin is affected by the structure of the balance sheet as well as by competitive pressures, Federal Reserve Board policies and the economy. The spread that can be earned between interest earning assets and interest bearing liabilities is also dependent to a large extent on the slope of the yield curve.

 

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Table 3: Average Balance Sheet and Net Interest Margin Analysis

 

   Year Ended December 31, 
(dollars in thousands)  2015   2014   2013 
   Average   Income/   Yield/   Average   Income/   Yield/   Average   Income/   Yield/ 
   Balance   Expense   Rate (1)   Balance   Expense   Rate (1)   Balance   Expense   Rate (1) 
Assets:                                             
Securities                                             
Taxable  $224,159   $4,934    2.20%  $232,639   $5,171    2.22%  $250,474   $5,443    2.17%
Restricted securities   7,965    427    5.36%   7,075    387    5.47%   7,796    323    4.14%
Tax exempt (2)   33,079    1,315    3.98%   28,466    1,133    3.98%   23,857    959    4.02%
Total securities   265,203    6,676    2.52%   268,180    6,691    2.49%   282,127    6,725    2.38%
Interest bearing deposits in other banks   7,574    18    0.24%   7,354    18    0.24%   39,537    105    0.27%
Federal funds sold   180    -    0.00%   191    -    0.00%   162    -    0.00%
Loans, net of unearned income (3)   840,814    41,672    4.96%   706,812    35,555    5.03%   669,520    35,487    5.30%
Total earning assets   1,113,771    48,366    4.34%   982,537    42,264    4.30%   991,346    42,317    4.27%
Less allowance for loan losses   (12,327)             (14,547)             (18,527)          
Total non-earning assets   113,691              100,162              97,047           
Total assets  $1,215,135             $1,068,152             $1,069,866           
                                              
Liabilities & Shareholders' Equity:                                             
Interest-bearing deposits                                             
Checking  $291,955   $1,067    0.37%   262,765   $949    0.36%  $248,675   $929    0.37%
Savings   93,645    131    0.14%   90,015    120    0.13%   90,065    142    0.16%
Money market savings   162,360    748    0.46%   120,541    498    0.41%   123,559    515    0.42%
Large dollar certificates of deposit (4)   117,991    1,040    0.88%   99,521    1,187    1.19%   120,852    1,574    1.30%
Other certificates of deposit   118,509    1,071    0.90%   126,274    1,156    0.92%   129,654    1,516    1.17%
Total interest-bearing deposits   784,460    4,057    0.52%   699,116    3,910    0.56%   712,805    4,676    0.66%
Federal funds purchased and repurchase agreements   8,065    46    0.57%   4,698    28    0.60%   3,489    21    0.60%
Short-term borrowings   89,580    194    0.22%   72,565    151    0.21%   16,963    38    0.22%
Long-term borrowings   -    -    0.00%   -    -    0.00%   73,278    2,958    4.04%
Junior subordinated debt   10,310    329    3.19%   10,310    339    3.29%   10,310    352    3.41%
Senior subordinated debt   13,361    963    7.21%   -    -    0.00%   -    -    0.00%
Total interest-bearing liabilities   905,776    5,589    0.62%   786,689    4,428    0.56%   816,845    8,045    0.98%
Noninterest-bearing liabilities                                             
Demand deposits   174,150              139,991              127,211           
Other liabilities   7,265              4,171              6,732           
Total liabilities   1,087,191              930,851              950,788           
Shareholders' equity   127,944              137,301              119,078           
Total liabilities and shareholders' equity  $1,215,135             $1,068,152             $1,069,866           
                                              
Net interest income (2)       $42,777             $37,836             $34,272      
                                              
Interest rate spread (2)(5)             3.72%             3.74%             3.29%
Interest expense as a percent of average earning assets             0.50%             0.45%             0.81%
Net interest margin (2)(6)             3.84%             3.85%             3.46%

 

Notes:

(1)Yields are based on average daily balances.
(2)Income and yields are reported on a tax equivalent basis assuming a federal tax rate of 34%, with an adjustment of $402, $346 and $293 in 2015, 2014 and 2013, respectively.
(3)Nonaccrual loans have been included in the computations of average loan balances.
(4)Large dollar certificates of deposit are certificates issued in amounts of $100 or greater.
(5)Interest rate spread is the average yield on earning assets, calculated on a fully taxable basis, less the average rate incurred on interest-bearing liabilities.
(6)Net interest margin is the net interest income, calculated on a fully taxable basis, expressed as a percentage of average earning assets.

 

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2015 compared with 2014

 

Net interest income and net interest margin

 

Net interest income for the year ended December 31, 2015 increased $4.9 million, or 13.0%, as compared to the same period in 2014.  The Company's net interest margin (tax equivalent basis) decreased to 3.84% for the year ended December 31, 2015, representing a 1 basis point decrease over the Company's net interest margin (tax equivalent basis) for the year ended December 31, 2014.  The most significant factors impacting net interest income during the year ended December 31, 2015 were as follows:

 

Positive Impacts:

 

·Average loan balances increased primarily due to the acquisition of VCB, organic loan growth and the purchase of $21.6 million in loans between June 2015 and December 2015; and
·Average rates paid on total interest-bearing deposits decreased for the year ended December 31, 2015 over the comparable period in 2014.  However, the Company experienced higher average interest-bearing deposit balances during the year ended December 31, 2015 over the comparable 2014 period, primarily due to interest-bearing deposits assumed from the VCB acquisition.  This drove a slight increase in interest expense attributable to the Company’s deposit portfolio.

 

Negative Impact:

 

·Private placement of $20.0 million of Senior Subordinated Debt in April 2015 resulted in increases to total average interest-bearing liabilities and related interest expense. 

 

Total interest and dividend income

 

Total interest and dividend income increased 14.4% for the year ended December 31, 2015 as compared to the same period in 2014.  The increase in total interest and dividend income was primarily driven by an increase in average loan balances and was partially offset by a decrease in average loan yields. 

 

Loans

 

Average loan balances increased for the year ended December 31, 2015, as compared to the same period in 2014, due primarily to the acquisition of VCB loans totaling $101.5 million as of November 14, 2014, net of fair value adjustments, the purchase of $21.6 million in performing one-to-four family residential mortgage loans, consumer loans and government guaranteed loans between June 2015 and December 2015, organic loan growth and the opening of a new loan production office in Chesterfield County, Virginia in the second quarter of 2014.  Despite a 2.3% increase in loans during the fourth quarter of 2015 which was in line with internal targets, loan growth came in slightly below our expectations for the year.  Loan growth in our rural markets, especially with respect to consumer loans, remains weak while competition for commercial loans, especially in the Richmond and Tidewater markets, has been and we expect will continue to be intense given the historically low rate environment.  The Company’s average loan balances increased $134.0 million for the year ended December 31, 2015, as compared to average loan balances for the same period in 2014.  Total average loans were 75.5% of total average interest-earning assets for the year ended December 31, 2015, compared to 71.9% for the year ended December 31, 2014.

 

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Investment securities

 

Average total investment securities balances declined 1.1% for the year ended December 31, 2015, as compared to the same period in 2014.  The overall decline during 2015 was the result of the Company moving toward its long term target of the investment securities portfolio comprising 20% of the Company’s total assets, the lack of investment opportunities with acceptable risk-adjusted rates of return and liquidity needs to support our operations and strategic initiatives.  The yields on average investment securities increased 3 basis points for the year ended December 31, 2015, as compared to the same period in 2014.

 

Interest-bearing deposits

 

Average total interest-bearing deposit balances increased for the year ended December 31, 2015, as compared to the same period in 2014, primarily due to the assumption of VCB’s interest-bearing deposit liabilities, which totaled $85.6 million as of November 14, 2014, and organic deposit growth that was in part driven by the Company’s marketing and advertising initiatives.

 

Borrowings

 

Average total borrowings increased for the year ended December 31, 2015, as compared to the same period in 2014, primarily due to the issuance of $20.0 million in senior subordinated debt in April 2015 and increased short-term borrowings.  Average short-term borrowings increased for the year ended December 31, 2015, as compared to the same period in 2014, due to the assumption of $8.7 million in short-term FHLB advances as a result of the VCB acquisition, as well as additional short-term FHLB advances totaling $28.9 million during 2015 to fund loan growth and other strategic initiatives.  The issuance of the Senior Subordinated Debt was a significant driver of higher interest expense and a lower net interest margin during the second half of 2015.   

 

2014 compared with 2013

 

Net interest income and net interest margin

 

Net interest income for the year ended December 31, 2014 increased $3.5 million, or 10.3%, when compared to the same period in 2013. The Company’s net interest margin increased to 3.85% for the year ended December 31, 2014, representing a 39 basis point increase over the Company’s net interest margin for the year ended December 31, 2013. The most significant factors impacting net interest income during 2014 were as follows:

 

Positive Impacts:

 

·Acquisition of VCB and the related loans and deposits;
·Increasing average loan balances primarily due to the acquisition of VCB, the acquisition of $27.2 million of performing mortgage loans, the opening of a new loan production office in Chesterfield County, Virginia and the origination of a line of credit to fund originations through Southern Trust Mortgage, LLC;
·Extinguishment of higher-rate long-term FHLB advances during the third quarter of 2013, which drove declines in the Company’s interest expense and rate paid on average interest-bearing liabilities; and
·Decreases in the average balances of and average rates paid on total interest-bearing deposits for the year ended December 31, 2014.

 

Negative Impacts:

 

·Decreasing yields on the Company’s loan portfolio;
·Decreases in the average balances of total investment securities, but partially offset by higher average rates earned during 2014 as compared to 2013; and
·Decreases in average short-term investment balances for the year ended December 31, 2014.

 

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Total interest and dividend income

 

Total interest and dividend income decreased 0.3% for the year ended December 31, 2014, as compared to the same period in 2013. The slight decrease in total interest was primarily driven by declines in the yield on the loan portfolio and a decrease in average investment securities. These declines were mostly offset by higher yields on investment securities and higher average loan balances.

 

Loans

 

Average loan balances increased for the year ended December 31, 2014, as compared to the same period in 2013, due primarily to the acquisition of VCB loans totaling $101.5 million, net of credit and liquidity marks, the purchase of $27.2 million in performing one-to-four family residential loans in the first quarter of 2014, the opening of a new loan production office in Chesterfield County, Virginia in the second quarter of 2014, and the origination of a line of credit to fund loan originations through Southern Trust Mortgage, LLC (balance of $10.9 million as of December 31, 2014) in the second quarter of 2014. These additions to the Company’s loan portfolio were partially offset by weak loan demand in the Company’s markets as a result of challenging economic conditions, such that the Company’s average loan balances increased $37.3 million for the year ended December 31, 2014, as compared to the same period in 2013. In addition, due to the low interest rate environment and competitive pressures, loans were originated during the full year 2014 at much lower yields than seasoned loans in the Company’s loan portfolio, which contributed significantly to average yields on the loan portfolio declining 27 basis points for the year ended December 31, 2014, as compared to the same period in 2013. Total average loans were 71.9% of total average interest-earning assets for the year ended December 31, 2014, as compared to 67.5% for the same period in 2013.

 

Investment securities

 

Average investment securities balances declined 4.9% for the year ended December 31, 2014, as compared to the same period in 2013, due to the Company’s efforts to rebalance the investment securities portfolio and provide additional liquidity, while yields on investment securities increased 11 basis points for the year ended December 31, 2014, as compared to the same period in 2013. Increasing yields on the investment securities portfolio were driven by increases in interest rates from 2013 to 2014 and portfolio rebalancing efforts during late 2013 and the first half of 2014, which largely consisted of accelerated prepayments on lower yield Agency mortgage-backed and Agency CMO securities and allocating a greater proportion of the portfolio to SBA Pool securities and higher yielding, longer duration municipal securities. The decline in average investment securities was also driven by the Company’s decision, in light of the low rate environment, to permit the investment securities portfolio to run off during 2014 and deploy proceeds received from investment securities in other segments of the Company’s balance sheet.

 

Interest-bearing deposits in other banks

 

Average interest bearing deposits in other banks decreased significantly for the year ended December 31, 2014, as compared to the same period in 2013, due to the overall decrease in our average total deposits, the purchase of $27.2 million in performing one-to-four family mortgage loans in the first quarter of 2014 and declines in average total borrowings that were largely due to extinguishing the Company’s long-term FHLB advances during the third quarter of 2013.

 

Interest-bearing deposits

 

Average total interest bearing deposit balances and related rates paid decreased for the year ended December 31, 2014, as compared to the same period in 2013, contributing to the reduction in interest expense during 2014 compared to 2013. Retail deposits continued to shift from higher priced certificates of deposit and money market savings accounts to lower priced checking accounts.

 

Borrowings

 

Average total borrowings and related rates paid decreased for the year ended December 31, 2014, as compared to the same period in 2013, significantly driving the reduction in interest expense in the full year 2014. Average total borrowings and related rates paid decreased primarily due to the extinguishment of higher rate long-term FHLB advances during the third quarter of 2013. The long-term FHLB advances were replaced with short-term FHLB advances at a significantly lower rate.

 

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Table 4: Volume and Rate Analysis (1)

 

   2015 from 2014   2014 from 2013 
   Increase (Decrease)   Increase (Decrease) 
   Due to Changes in:   Due to Changes in: 
(dollars in thousands)  Volume   Rate   Total   Volume   Rate   Total 
Interest income:                              
Securities:                              
Taxable  $(191)  $(46)  $(237)  $(402)  $130   $(272)
Restricted securities   48    (8)   40    (53)   117    64 
Tax exempt (2)   182    -    182    183    (9)   174 
Total securities   39    (54)   (15)   (272)   238    (34)
Interest bearing deposits in other banks   -    -    -    (76)   (11)   (87)
Federal funds sold   -    -    -    -    -    - 
Loans, net of unearned income   6,604    (487)   6,117    797    (729)   68 
Total interest income   6,643    (541)   6,102    449    (502)   (53)
                               
Interest expense:                              
Interest-bearing deposits:                              
Checking   91    27    118    44    (24)   20 
Savings   2    9    11    5    (27)   (22)
Money market savings   184    66    250    (5)   (12)   (17)
Large dollar certificates of deposit (3)   361    (508)   (147)   (262)   (125)   (387)
Other certificates of deposit   (60)   (25)   (85)   (43)   (317)   (360)
Total interest-bearing deposits   578    (431)   147    (261)   (505)   (766)
Federal funds purchased and repurchase agreements   19    (1)   18    7    -    7 
Short-term borrowings   35    8    43    115    (2)   113 
Long-term borrowings   -    -    -    (2,958)   -    (2,958)
Junior subordinated debt   -    (10)   (10)   -    (13)   (13)
Senior subordinated debt   963    -    963    -    -    - 
Total interest expense   1,595    (434)   1,161    (3,097)   (520)   (3,617)
Change in net interest income  $5,048   $(107)  $4,941   $3,546   $18   $3,564 

 

Notes:

(1) Changes caused by the combination of rate and volume are allocated based on the percentage caused by each.

(2) Income and yields are reported on a tax-equivalent basis, assuming a federal tax rate of 34%.

(3) Large dollar certificates of deposit are certificates issued in amounts of $100 or greater.

 

Interest Sensitivity

 

Our primary goals in interest rate risk management are to minimize negative fluctuations in net interest margin as a percentage of earning assets and to increase the dollar amount of net interest income at a growth rate consistent with the growth rate of total assets. These goals are accomplished by managing the interest sensitivity gap, which is the difference between interest sensitive assets and interest sensitive liabilities in a specific time interval. Interest sensitivity gap is managed by balancing the volume of floating rate liabilities with a similar volume of floating rate assets, by keeping the fixed rate average maturity of asset and liability contracts reasonably consistent and short, and by routinely adjusting pricing to market conditions on a regular basis.

 

The Company strives to maintain a position flexible enough to move to a balanced position between rate-sensitive assets and rate-sensitive liabilities, which may be desirable when there are wide and frequent fluctuations in interest rates. Matching the amount of assets and liabilities maturing in the same time interval helps to hedge interest rate risk and to minimize the impact on net interest income in periods of rising or falling interest rates. Interest rate gaps are managed through investments, loan pricing and deposit pricing strategies. When an unacceptable positive gap within a one-year time frame occurs, maturities can be extended by selling shorter-term investments and purchasing longer maturities. When an unacceptable negative gap occurs, variable rate loans can be increased (subject to customer demand for these loans) and greater investment in shorter-term investments can be made.

 

 39 

 

  

The Company believes that it will be a challenge for the Company to maintain its net interest margin at its current level if funds obtained from loan and investment security repayments, as well as any deposit growth, cannot be fully used to originate new loans and are instead reinvested in lower-yield earning assets, and if reductions in earning asset yields exceeds interest rate declines in interest-bearing liabilities. As the economy remains in an uncertain recovery and with continued lack of quality loan demand in our rural markets, especially with respect to consumer loans, coupled with competitive pressures for commercial loans, the Company has focused on restructuring the investment portfolio and recognized some gains on the disposition of securities held due to an increase in prices as rates have continued to fall. With the expectation that interest rates will not change significantly during 2016 and that they will likely remain low for an extended period of time, the Company continues to redeploy its excess funds in the investment portfolio with a focus on securities that provide steady cash flow at a low risk weighting to maximize earnings until consistent loan demand returns. Given this limited earnings environment and the low yields on investment securities, the Company has continued to maintain its low deposit costs to offset the overall compression of our margins.

 

Noninterest Income

 

Noninterest income is comprised of all sources of income other than interest income on our earning assets. Significant revenue items include fees collected on certain deposit account transactions, debit and credit card fees, fees from other general services, earnings from other investments we own in part or in full and gains or losses on sales of investment securities, loans and fixed assets.

 

The following table depicts the components of noninterest income for the years ended December 31, 2015 and 2014:

  

Table 5: Noninterest Income

 

   Years Ended December 31,         
(dollars in thousands)  2015   2014   Change $   Change % 
Service charges and fees on deposit accounts  $2,845   $3,257   $(412)   -12.6%
Debit/credit card fees   1,728    1,416    312    22.0%
Gain on sale of available for sale securities, net   224    538    (314)   -58.4%
Gain on sale of held to maturity securities, net   10    -    10    100.0%
(Loss) gain on sale of bank premises and equipment   (58)   6    (64)   -1066.7%
Other operating income   1,704    1,458    246    16.9%
Total noninterest income  $6,453   $6,675   $(222)   -3.3%

 

2015 Compared to 2014

 

Key changes in the components of noninterest income for the year ended December 31, 2015, as compared to the same period in 2014, are discussed below:

 

·Service charges and fees on deposit accounts declined due to decreases in service charge and overdraft fees on checking accounts;
·Debit/credit card fees increased primarily due to an increase in debit card fees driven by the acquisition of VCB and a higher utilization rate of debit cards by our customer base;
·Gain on sale of available for sale securities, net decreased primarily due to the sale of a portion of its previously impaired agency preferred securities (FNMA & FHLMC) that generated gains during the first quarter of 2014, and because the Company did not generate comparable gains during 2015;
·(Loss) gain on sale of bank premises and equipment during 2015 was primarily due to the sale of our former Heathsville branch building as operations were relocated to a new facility and the disposal of certain office equipment, with no similar losses occurring during 2014; and
·Other operating income increased primarily due to higher earnings from the Bank’s subsidiaries, its investment in Bankers Insurance, LLC and bank owned life insurance policies, partially offset by higher losses from the Bank’s investments in housing equity funds. Additionally, other operating income includes earnings from the Bank’s investments in Southern Trust Mortgage, LLC and Bankers Title, LLC.

 

 40 

 

 

The following table depicts the components of noninterest income for the years ended December 31, 2014 and 2013:

  

Table 5A: Noninterest Income

 

   Years Ended December 31,         
(dollars in thousands)  2014   2013   Change $   Change % 
Service charges and fees on deposit accounts  $3,257   $3,286   $(29)   -0.9%
Debit/credit card fees   1,416    1,469    (53)   -3.6%
Gain on sale of available for sale securities, net   538    1,507    (969)   -64.3%
Gain on sale of bank premises and equipment   6    249    (243)   -97.6%
Other operating income   1,458    1,237    221    17.9%
Total noninterest income  $6,675   $7,748   $(1,073)   -13.8%

 

2014 Compared to 2013

 

Key changes in the components of noninterest income for the year ended December 31, 2014, as compared to the same period in 2013, are discussed below:

 

·Service charges and fees on deposit accounts decreased due to decreases in service charge and overdraft fees on checking accounts;
·Gain on sale of available for sale securities, net decreased as the Company recognized gains during the fourth quarter of 2013 primarily due to the sale of a portion of its previously impaired agency preferred securities (FNMA & FHLMC), and the Company did not generate comparable gains during 2014;
·Gain on sale of bank premises and equipment decreased as the Company sold its former Bowling Green branch office during the third quarter of 2013 (which generated a gain of $224 thousand), with no such gain being recognized during 2014; and
·Other operating income increased for the year ended December 31, 2014, as compared to the same period in 2013, primarily due to higher earnings from sales of insurance products through Bankers Insurance, LLC and higher earnings from bank owned life insurance policies during 2014. Additionally, other operating income for 2014 includes earnings from the Bank’s investments in Southern Trust Mortgage, LLC (acquired 4.9% ownership on May 15, 2014) and Bankers Title, LLC (acquired 6.0% ownership on October 1, 2014).

 

Noninterest Expense

 

Noninterest expense includes all expenses with the exception of those paid for interest on borrowings and deposits. Significant expense items included in this component are salaries and employee benefits, occupancy and other operating expenses.

 

The following table depicts components of noninterest expense for the years ended December 31, 2015 and 2014:

 

Table 6: Noninterest Expense

 

   Years Ended December 31,         
(dollars in thousands)  2015   2014   Change $   Change % 
Salaries and employee benefits  $21,649   $18,982   $2,667    14.1%
Occupancy and equipment expenses   5,762    5,109    653    12.8%
Telephone   933    992    (59)   -5.9%
FDIC expense   821    921    (100)   -10.9%
Consultant fees   1,143    1,395    (252)   -18.1%
Collection, repossession and other real estate owned   519    323    196    60.7%
Marketing and advertising   1,359    1,005    354    35.2%
Loss on sale of other real estate owned   25    78    (53)   -67.9%
Impairment losses on other real estate owned   5    24    (19)   -79.2%
Merger and merger related expenses   224    1,831    (1,607)   -87.8%
Other operating expenses   6,600    5,144    1,456    28.3%
Total noninterest expenses  $39,040   $35,804   $3,236    9.0%

 

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2015 Compared to 2014

 

Key changes in the components of noninterest expense for the year ended December 31, 2015, as compared to the same period in 2014, are discussed below:

 

·Salaries and employee benefits increased primarily due to the increased staff levels and support positions associated with the addition of three branches through the acquisition of VCB. Additionally, salaries and employee benefits were higher in 2015 due to annual merit salary increases, increased restricted stock compensation expense, increased bonuses, commissions and other incentive compensation and valuation adjustments related to pension plan liabilities, partially offset by an increase in deferred compensation on loan originations, lower group insurance expenses and reductions in staff levels during the second half of 2015 that were driven by operating efficiencies gained through a previously completed comprehensive assessment of our operations;
·Occupancy and equipment expenses increased primarily due to depreciation expense associated with certain acquired VCB assets and increased rent, building repairs and maintenance and real estate tax expenses related to the acquired VCB branch locations;
·FDIC expense decreased due to lower base insurance assessment rates resulting from the improvement in the Bank’s overall composite rating in connection with the termination of the Company’s regulatory memorandum of understanding in March 2014;
·Consultant fees decreased as higher costs related to compliance, loan operations and outsourcing of the bank’s core information technology processing were incurred during 2014, as compared to 2015. This decrease was partially offset by costs incurred related to the Company’s engagement of an independent consultant during the first half of 2015 to conduct a comprehensive assessment of its operations;
·Collection, repossession and other real estate owned expenses increased due to increases in average carrying balances of and costs associated with OREO and classified assets during certain periods of the second and third quarters of 2015;
·Marketing and advertising increased due to expenses related to marketing and advertising initiatives;
·Merger and merger related expenses decreased due to certain costs associated with the acquisition of VCB in 2014 that were not repeated in 2015; and
·Other operating expenses increased due to elevated costs associated with outsourcing of the Bank’s core information technology processing, higher franchise taxes, loan closing costs, internet banking expenses and core deposit intangible amortization expense.

 

The following table depicts components of noninterest expense for the years ended December 31, 2014 and 2013:

  

Table 6A: Noninterest Expense

 

   Years Ended December 31,         
(dollars in thousands)  2014   2013   Change $   Change % 
Salaries and employee benefits  $18,982   $17,156   $1,826    10.6%
Occupancy and equipment expenses   5,109    5,226    (117)   -2.2%
Telephone   992    1,142    (150)   -13.1%
FDIC expense   921    1,765    (844)   -47.8%
Consultant fees   1,395    1,051    344    32.7%
Collection, repossession and other real estate owned   323    540    (217)   -40.2%
Marketing and advertising   1,005    787    218    27.7%
Loss on sale of other real estate owned   78    775    (697)   -89.9%
Impairment losses on other real estate owned   24    585    (561)   -95.9%
Loss on extinguishment of debt   -    11,453    (11,453)   -100.0%
Merger and merger related expenses   1,831    -    1,831    100.0%
Other operating expenses   5,144    4,421    723    16.4%
Total noninterest expenses  $35,804   $44,901   $(9,097)   -20.3%

 

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2014 Compared to 2013

 

Key changes in the components of noninterest expense for the year ended December 31, 2014, as compared to the same period in 2013, are discussed below:

 

·Salaries and employee benefits increased due to annual merit increases, increased restricted stock expense, lower deferred compensation on loan originations and higher group term insurance costs, partially offset by an increase in the actuarial pension benefit recognized. Additionally, the Bank incurred higher personnel costs in 2014 associated with increased staff levels and support positions associated with the addition of three branches through the acquisition of VCB;
·Telephone decreased primarily due to changing vendors in 2014;
·FDIC expense decreased due to lower base assessment rates resulting from the improvement in the Bank’s overall composite rating in connection with the termination of the Company’s regulatory written agreement in July 2013, and corresponding decreases in FDIC insurance assessment rates during 2014;
·Consultant fees increased due to additional services related to compliance and loan operations and outsourcing of the Bank’s core information technology processing;
·Collection, repossession and other real estate owned expenses decreased due to declines in carrying balances of and costs associated with OREO and classified assets;
·Marketing and advertising increased due to expenditures related to the VCB acquisition, digital marketing initiatives and other local market events;
·Loss on the sale of other real estate owned declined primarily due to the Company’s strategic initiative to remove risk from its balance sheet by expediting the resolution and disposition of OREO during the fourth quarter of 2013, lower OREO balances during 2014 and stabilization of real estate prices in our markets;
·Impairment losses on other real estate owned decreased as OREO balances continued to decline and real estate prices in our markets have continued to stabilize;
·Loss on extinguishment of debt of $11.5 million was recognized in August 2013 due to the prepayment of $107.5 million in long-term FHLB advances with no such loss or prepayment present in 2014;
·Merger and merger related expenses increased due to certain costs associated with the acquisition of VCB in 2014; and
·Other operating expenses increased primarily due to higher franchise taxes, director expenses, and increased customer check and coupon incentives, partially offset by a decrease in ATM charge-off expense.

 

Income Taxes

 

The Company recorded an income tax expense of $2.5 million in 2015 and $2.4 million in 2014, compared to income tax benefit of $2.4 million in 2013. The increase in income tax expense from 2013 to 2014 was the result of the Company’s pretax income increasing by approximately $13.1 million, due substantially to the $11.5 million prepayment penalty on the long-term FHLB advances prepaid during the third quarter of 2013 that was not repeated during 2014, and partially offset by increases in the amount of tax-exempt income on investment securities (as the Company rebalanced its securities portfolio during 2013), increases in tax-exempt income from bank owned life insurance policies and partially offset by merger related expenses that are not tax deductible.

 

The Company’s effective tax rate for the years ended December 31, 2015, 2014 and 2013 was 25.5%, 30.1% and 39.1%, respectively. The decrease in the effective tax rate from 2014 to 2015 was primarily related to increased tax-exempt interest income on the investment portfolio, increased tax-exempt bank owned life insurance income as a percentage of pre-tax income and the recognition of $1.4 million in nondeductible expenses related to the acquisition of VCB in 2014. The effective tax rate differs from the statutory income tax rate of 34% due to the Company’s investment in tax-exempt loans and securities, income from bank owned life insurance, and community/housing development tax credits. For further information concerning Income Taxes, refer to Item 8. “Financial Statements and Supplementary Data,” under the heading “Note 11. Income Taxes.”

 

 43 

 

  

Asset Quality

 

Provision and Allowance for Loan Losses

 

The allowance for loan losses is a reserve for estimated credit losses on individually evaluated loans determined to be impaired as well as estimated credit losses inherent in the loan portfolio, and is based on periodic evaluations of the collectability and historical loss experience of loans. A provision for loan losses, which is a charge against earnings, is recorded to bring the allowance for loan losses to a level that, in management’s judgment, is appropriate to absorb probable losses inherent in the loan portfolio. Actual credit losses are deducted from the allowance for loan losses for the difference between the carrying value of the loan and the estimated net realizable value or fair value of the collateral, if collateral dependent. Subsequent recoveries, if any, are credited to the allowance for loan losses.

 

The allowance for loan losses is comprised of a specific allowance for identified problem loans and a general allowance representing estimations performed pursuant to either FASB ASC Topic 450 “Accounting for Contingencies”, or FASB ASC Topic 310 “Accounting by Creditors for Impairment of a Loan.” The specific component relates to loans that are classified as impaired, and is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. For collateral dependent loans, an updated appraisal will be ordered if a current one is not on file. Appraisals are performed by independent third-party appraisers with relevant industry experience. Adjustments to the appraised value may be made based on recent sales of like properties or general market conditions when deemed appropriate. The general component covers non-classified or performing loans and those loans classified as substandard, doubtful or loss that are not impaired. The general component is based on migration analysis adjusted for qualitative factors, such as economic conditions, interest rates and unemployment rates. The Company uses a risk grading system for real estate (including multifamily residential, construction, farmland and non-farm, non-residential) and commercial loans. Loans are graded on a scale from 1 to 9. Non-impaired real estate and commercial loans are assigned an allowance factor which increases with the severity of risk grading. A general description of the characteristics of the risk grades is as follows:

 

Pass Grades

·Risk Grade 1 loans have little or no risk and are generally secured by cash or cash equivalents;
·Risk Grade 2 loans have minimal risk to well qualified borrowers and no significant questions as to safety;
·Risk Grade 3 loans are satisfactory loans with strong borrowers and secondary sources of repayment;
·Risk Grade 4 loans are satisfactory loans with borrowers not as strong as risk grade 3 loans but may exhibit a higher degree of financial risk based on the type of business supporting the loan; and
·Risk Grade 5 loans are loans that warrant more than the normal level of supervision and have the possibility of an event occurring that may weaken the borrower’s ability to repay.

 

Special Mention

·Risk Grade 6 loans have increasing potential weaknesses beyond those at which the loan originally was granted and if not addressed could lead to inadequately protecting the Company’s credit position.

 

Classified Grades

·Risk Grade 7 loans are substandard loans and are inadequately protected by the current sound worth or paying capacity of the obligor or the collateral pledged. These have well defined weaknesses that jeopardize the liquidation of the debt with the distinct possibility the Company will sustain some loss if the deficiencies are not corrected;
·Risk Grade 8 loans are doubtful of collection and the possibility of loss is high but pending specific borrower plans for recovery, its classification as a loss is deferred until its more exact status is determined; and
·Risk Grade 9 loans are loss loans which are considered uncollectable and of such little value that their continuance as a bank asset is not warranted.

 

The Company uses a past due grading system for consumer loans, including one to four family residential first and seconds and home equity lines. The past due status of a loan is based on the contractual due date of the most delinquent payment due. The past due grading of consumer loans is based on the following categories: current, 1-29 days past due, 30-59 days past due, 60-89 days past due and over 90 days past due. The consumer loans are segregated between performing and nonperforming loans. Performing loans are those that have made timely payments in accordance with the terms of the loan agreement and are not past due 90 days or more. Nonperforming loans are those that do not accrue interest, are greater than 90 days past due and accruing interest or considered impaired. Non-impaired consumer loans are assigned an allowance factor which increases with the severity of past due status. This component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the loan portfolio.

 

 44 

 

  

The Company's ALL Committee is responsible for assessing the overall appropriateness of the allowance for loan losses and monitoring the Company's allowance for loan losses methodology, particularly in the context of current economic conditions and a rapidly changing regulatory environment.  The ALL Committee reviews at least annually the Company's allowance for loan losses methodology.

 

During 2013, the ALL Committee reviewed, with input from and consultation with independent external parties, the allowance for loan losses methodology with a specific focus on whether the Company should use migration analysis instead of historical loan loss experience on balances collectively evaluated for impairment. Migration analysis tracks the movement of loans through various loan classifications in order to estimate the percentage of losses likely to be incurred in a loan portfolio. In addition to evaluating multiple scenarios using migration analysis over a period of time, the ALL Committee engaged an independent third party to audit the Company’s existing allowance for loan losses methodology and validate its migration analysis. After this review, the ALL Committee determined that the Company should modify its methodology to use migration analysis in the calculation of the allowance for loan losses, effective December 31, 2013.

 

For prior financial periods ending with the third quarter of 2013, historical loan loss experience was calculated using a rolling three year average of historical loan loss experience. Beginning with the quarter ended December 31, 2013, the Company calculated the allowance for loan losses based on a migration analysis of loans, segmented by an identical risk grading system or past due grading system, depending on type of loan as previously used with the historical loan loss experience methodology. Other adjustments may be made to the allowance for loan losses for pools of loans after an assessment of internal and external factors on credit quality that are not fully reflected in the past due or risk grading data. The Company believes this change in methodology provides a more accurate evaluation of the potential risk in our loan portfolio and establishes a stronger focus on areas of weakness and strength within the portfolio. A tabular presentation comparing the provision for loan losses for the year ended December 31, 2013 calculated using the current methodology, to the provision as would have been calculated for the same period using the former methodology, can be found in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013 under Item 8. “Financial Statements and Supplementary Data,” under the heading “Note 4. Loan Portfolio.”

 

The allocation methodology applied by the Company includes management’s ongoing review and grading of the loan portfolio into criticized loan categories (defined as specific loans warranting either specific allocation, or a classified status of substandard, doubtful or loss). The allocation methodology focuses on evaluation of several factors, including but not limited to: evaluation of facts and issues related to specific loans, management’s ongoing review and grading of the loan portfolio, consideration of migration analysis and delinquency experience on each portfolio category, trends in past due and nonaccrual loans, the level of classified loans, the risk characteristics of the various classifications of loans, changes in the size and character of the loan portfolio, concentrations of loans to specific borrowers or industries, existing economic conditions, the fair value of underlying collateral, and other qualitative and quantitative factors which could affect potential credit losses. Because each of the criteria used is subject to change, the allocation of the allowance for loan losses is made for analytical purposes and is not necessarily indicative of the trend of future loan losses in any particular loan category. The total allowance is available to absorb losses from any segment of the portfolio. In determining the allowance for loan losses, the Company considers its portfolio segments and loan classes to be the same.

 

Management believes that the level of the allowance for loan losses is appropriate in light of the credit quality and anticipated risk of loss in the loan portfolio. While management uses available information to recognize losses on loans, future additions to the allowance for loan losses 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 Company’s allowance for loan losses. Such agencies may require the Company to recognize additions to the allowance for loan losses through increased provisions for loan losses or may require that certain loan balances be charged-off or downgraded into classified loan categories when their credit evaluations differ from those of management based on their judgments about information available to them at the time of their examinations.

 

 45 

 

  

The following table presents the Company’s loan loss experience for the past five years:

 

Table 7: Allowance for Loan Losses

 

   Years Ended December 31, 
(dollars in thousands)  2015   2014   2013   2012   2011 
Average loans outstanding*  $840,814   $706,812   $669,520   $714,254   $757,123 
Allowance for loan losses, January 1  $13,021   $14,767   $20,338   $24,102   $25,288 
Charge-offs:                         
Commercial, industrial and agricultural   336    340    635    1,219    1,257 
Real estate - one to four family residential:                         
Closed end first and seconds   1,113    483    1,529    2,664    1,868 
Home equity lines   160    444    184    1,112    348 
Real estate - construction:                         
One to four family residential   129    118    57    98    309 
Other construction, land development and other land   -    -    1,196    1,622    2,987 
Real estate - non-farm, non-residential:                         
Owner occupied   139    292    2,370    2,337    2,107 
Non-owner occupied   -    389    1,944    1,506    1,119 
Consumer   33    190    153    391    683 
Other   68    293    138    99    113 
Total loans charged-off   1,978    2,549    8,206    11,048    10,791 
Recoveries:                         
Commercial, industrial and agricultural   51    75    319    774    303 
Real estate - one to four family residential:                         
Closed end first and seconds   116    265    85    61    162 
Home equity lines   31    15    34    11    - 
Real estate - construction:                         
One to four family residential   4    7    61    55    6 
Other construction, land development and other land   1    9    69    2    1 
Real estate - non-farm, non-residential:                         
Owner occupied   1    27    1    100    45 
Non-owner occupied   -    13    57    409    - 
Consumer   49    96    108    179    238 
Other   31    46    51    35    50 
Total recoveries   284    553    785    1,626    805 
Net charge-offs   1,694    1,996    7,421    9,422    9,986 
Provision for loan losses   -    250    1,850    5,658    8,800 
Allowance for loan losses, December 31  $11,327   $13,021   $14,767   $20,338   $24,102 
Ratios:                         
Ratio of allowance for loan losses to total loans outstanding, end of year   1.29%   1.59%   2.25%   2.97%   3.28%
Ratio of net charge-offs to average loans outstanding during the year   0.20%   0.28%   1.11%   1.32%   1.32%

 

* Net of unearned income and includes nonaccrual loans.

 

No provision for loan losses was recorded in 2015, as compared to provision for loan losses of $250 thousand in 2014, $1.9 million in 2013, $5.7 million in 2012 and $8.8 million in 2011. The allowance for loan losses totaled $11.3 million at December 31, 2015, representing a decline of $1.7 million from December 31, 2014. The decline in the allowance for loan losses from December 31, 2014 was primarily due to measured improvements in the economic and financial conditions in the Company’s markets, improvements in the Company’s asset quality and charge-offs of loans for which the Company had specifically reserved.  Impaired loans decreased approximately $1.0 million from December 31, 2014, primarily due to the upgraded credit quality of two large commercial borrowers.   Additionally, due to purchase accounting related to the Company’s acquisition of VCB, the Company recorded loans acquired from VCB at fair value at the effective time of the acquisition, and any allowance for loan losses previously established by VCB was not recorded on the Company’s financial statements. 

 

 46 

 

  

Net charge-offs in 2015 were $1.7 million compared to $2.0 million in 2014, $7.4 million in 2013, $9.4 million in 2012 and $10.0 million in 2011. This represents 0.20% of average loans outstanding in 2015, 0.28% in 2014, 1.11% in 2013 and 1.32% in 2012 and 2011. Management believes that measured improvements in the economic and financial markets and the Company’s asset quality improvements indicate that credit quality issues are less likely to significantly impact our loan portfolio and our operating results in future periods than in periods that more immediately followed the height of the financial crisis of 2008. Net charge-offs decreased $302 thousand, or 15.1%, from the year ended December 31, 2014 to the same period of 2015 due to improvements in some of the Company’s credit quality metrics, including nonperforming assets, and other factors, such as a decline in adversely rated credits which are reflective of improving economic conditions. This decline in net charge-offs contributed to the Company’s decision to reduce its provision for loan losses from 2014 to 2015. The Company continues to focus on credit quality initiatives to improve its asset quality and resolve its remaining nonperforming assets, and such initiatives should further reduce net charge-offs in future periods.

 

The following table shows the allocation of the allowance for loan losses at the dates indicated. Notwithstanding these allocations, the entire allowance for loan losses is available to absorb charge-offs in any category of loan.

  

Table 8: Allocation of Allowance for Loan Losses

 

   At December 31, 
   2015   2014   2013   2012   2011 
(dollars in thousands)  Allowance   Percent   Allowance   Percent   Allowance   Percent   Allowance   Percent   Allowance   Percent 
Commercial, industrial and agricultural  $1,894    11.22%  $1,168    10.37%  $1,787    8.17%  $2,340    7.58%  $4,389    7.76%
Real estate - one to four family residential:                                                  
Closed end first and seconds   1,609    26.43%   1,884    28.86%   2,859    33.25%   2,876    34.91%   2,856    34.51%
Home equity lines   795    13.20%   1,678    13.42%   1,642    15.19%   720    14.56%   278    13.93%
Real estate - multifamily residential   78    3.37%   89    3.07%   79    2.75%   62    2.31%   29    1.77%
Real estate - construction:                                                  
One to four family residential   295    2.21%   235    2.40%   364    2.46%   419    2.96%   382    2.89%
Other construction, land development and other land   2,423    5.32%   2,670    4.34%   1,989    3.30%   3,897    5.04%   6,861    5.75%
Real estate - farmland   272    1.30%   144    1.15%   116    1.24%   41    1.25%   15    0.80%
Real estate - non-farm, non-residential:                                                  
Owner occupied   1,964    21.27%   2,416    19.22%   3,236    19.26%   5,092    17.50%   4,831    18.42%
Non-owner occupied   1,241    11.86%   1,908    12.77%   1,770    11.39%   4,093    10.48%   3,172    10.11%
Consumer   287    2.27%   305    1.94%   387    2.55%   215    2.94%   776    3.86%
Other   469    1.55%   524    2.46%   538    0.44%   583    0.47%   513    0.20%
Total allowance for loan losses  $11,327    100.00%  $13,021    100.00%  $14,767    100.00%  $20,338    100.00%  $24,102    100.00%

 

(Percent is portfolio loans in category divided by total loans)

 

 47 

 

  

The following table presents commercial loans by credit quality indicator at December 31, 2015:

  

Table 9: Commercial Credit Quality Indicators

 

(dollars in thousands)  Pass   Special
Mention
   Substandard   Doubtful   Impaired   Acquired
loans -
purchased
impaired
   Total 
Commercial, industrial and agricultural  $95,440   $1,709   $291   $-   $839   $549   $98,828 
Real estate - multifamily residential   29,672    -    -    -    -    -    29,672 
Real estate - construction:                                   
One to four family residential   19,000    220    89    -    186    -    19,495 
Other construction, land development and                                   
    other land   38,013    1,785    1,242    -    5,562    275    46,877 
Total real estate - construction   57,013    2,005    1,331    -    5,748    275    66,372 
Real estate - farmland   10,396    318    165    -    539    -    11,418 
Real estate - non-farm, non-residential:                                   
Owner occupied   162,103    12,206    2,283    -    6,336    4,296    187,224 
Non-owner occupied   86,894    2,130    1,040    -    12,792    1,600    104,456 
Total real estate - non-farm, non-                                   
residential   248,997    14,336    3,323    -    19,128    5,896    291,680 
Total commercial loans  $441,518   $18,368   $5,110   $-   $26,254   $6,720   $497,970 

   

The following table presents commercial loans by credit quality indicator at December 31, 2014:

  

Table 9A: Commercial Credit Quality Indicators

 

(dollars in thousands)  Pass   Special
Mention
   Substandard   Doubtful   Impaired   Acquired
loans -
purchased
impaired
   Total 
Commercial, industrial and agricultural  $79,191   $2,779   $675   $-   $1,451   $1,023   $85,119 
Real estate - multifamily residential   25,157    -    -    -    -    -    25,157 
Real estate - construction:                                   
One to four family residential   18,978    300    244    -    176    -    19,698 
Other construction, land development and                                   
   other land   26,916    1,791    1,144    -    5,661    79    35,591 
Total real estate - construction   45,894    2,091    1,388    -    5,837    79    55,289 
Real estate - farmland   9,471    -    -    -    -    -    9,471 
Real estate - non-farm, non-residential:                                   
Owner occupied   132,266    11,339    2,253    -    10,046    1,841    157,745 
Non-owner occupied   84,951    4,771    1,817    -    9,816    3,472    104,827 
Total real estate - non-farm, non-                                   
residential   217,217    16,110    4,070    -    19,862    5,313    262,572 
Total commercial loans  $376,930   $20,980   $6,133   $-   $27,150   $6,415   $437,608 

 

 48 

 

 

The following table presents consumer loans, including one to four family residential first and seconds and home equity lines, by payment activity at December 31, 2015:

 

Table 10: Consumer Payment Activity

 

(dollars in thousands)  Performing   Nonperforming   Total 
Real estate - one to four family residential:               
Closed end first and seconds  $220,016   $12,810   $232,826 
Home equity lines   115,434    875    116,309 
Total real estate - one to four family residential   335,450    13,685    349,135 
Consumer   19,655    338    19,993 
Other   13,678    2    13,680 
Total consumer loans  $368,783   $14,025   $382,808 

 

The following table presents consumer loans, including one to four family residential first and seconds and home equity lines, by payment activity at December 31, 2014:

  

Table 10A: Consumer Payment Activity

 

(dollars in thousands)  Performing   Nonperforming   Total 
Real estate - one to four family residential:               
Closed end first and seconds  $226,801   $9,960   $236,761 
Home equity lines   109,565    535    110,100 
Total real estate - one to four family residential   336,366    10,495    346,861 
Consumer   15,548    371    15,919 
Other   20,175    6    20,181 
Total consumer loans  $372,089   $10,872   $382,961 

 

 49 

 

   

Nonperforming Assets

 

The past due status of a loan is based on the contractual due date of the most delinquent payment due. Loans, including impaired loans, are generally classified as nonaccrual if they are past due as to maturity or payment of principal or interest for a period of more than 90 days, unless such loans are well-secured and in the process of collection. Loans greater than 90 days past due may remain on an accrual status if management determines it has adequate collateral to cover the principal and interest. If a loan or a portion of a loan is adversely classified, or is partially charged off, the loan is generally classified as nonaccrual. Additionally, whenever management becomes aware of facts or circumstances that may adversely impact the collectability of principal or interest on loans, it is management’s practice to place such loans on a nonaccrual status immediately, rather than delaying such action until the loans become 90 days past due. As of December 31, 2015, management is not aware of any potential problem loans to place immediately on nonaccrual status.

 

When a loan is placed on nonaccrual status, previously accrued and uncollected interest is reversed, and the amortization of related deferred loan fees or costs is suspended. While a loan is classified as nonaccrual and the future collectability of the recorded loan balance is doubtful, collections of interest and principal are generally applied as a reduction to principal outstanding. When the future collectability of the recorded loan balance is expected, interest income may be recognized on a cash basis. In the case where a nonaccrual loan has been partially charged off, recognition of interest on a cash basis is limited to that which would have been recognized on the recorded loan balance at the contractual interest rate. Cash interest receipts in excess of that amount are recorded as recoveries to the allowance for loan losses until prior charge-offs have been fully recovered. These policies are applied consistently across the Company’s loan portfolio.

 

A loan (including a TDR) may be returned to accrual status if the borrower has demonstrated a sustained period of repayment performance (typically six months) in accordance with the contractual terms of the loan and there is reasonable assurance the borrower will continue to make payments as agreed.

 

Real estate acquired through, or in lieu of, foreclosure (or “OREO”) is held for sale and is stated at fair value of the property, less estimated disposal costs, if any. Cost includes loan principal and accrued interest. Any excess of cost over the fair value less costs to sell at the time of acquisition is charged to the allowance for loan losses. The fair value is reviewed periodically by management and any write-downs are charged against current earnings. Development and improvement costs relating to property are capitalized. Net operating income or expenses of such properties are included in collection, repossession and OREO expenses.

 

 50 

 

 

The following table presents information concerning nonperforming assets for the periods indicated:

 

Table 11: Nonperforming Assets

 

   December 31, 
(dollars in thousands)  2015   2014   2013   2012   2011 
Nonaccrual loans*  $6,175   $6,622   $11,018   $11,874   $30,293 
Loans past due 90 days and accruing interest   1,117    53    -    -    168 
Total nonperforming loans   7,292    6,675    11,018    11,874    30,461 
Other real estate owned   520    1,838    800    4,747    7,326 
Total nonperforming assets  $7,812   $8,513   $11,818   $16,621   $37,787 
                          
Nonperforming assets to total loans and other real estate owned   0.89%   1.04%   1.80%   2.41%   5.09%
Allowance for loan losses to nonperforming loans   155.34%   195.07%   134.03%   171.29%   79.12%
Allowance for loan losses to nonaccrual loans   183.43%   196.63%   134.03%   171.29%   79.56%
Net charge-offs to average loans for the year   0.20%   0.28%   1.11%   1.32%   1.32%
Allowance for loan losses to year end loans   1.29%   1.59%   2.25%   2.97%   3.28%
Foregone interest income on nonaccrual loans  $290   $124   $413   $335   $1,347 

 

*Includes $1.3 million, $3.4 million, $4.2 million, $5.1 million and $13.4 million in nonaccrual TDRs at December 31, 2015, 2014, 2013, 2012 and 2011 respectively.

 

The following table presents the change in the OREO balance for 2015 and 2014:

 

Table 12: OREO Changes

 

(dollars in thousands)  2015   2014   Change $   Change % 
Balance at the beginning of year, gross  $1,914   $1,054   $860    81.6%
Transfers from loans   1,966    1,657    309    18.6%
Acquired from Virginia Company Bank   -    103    (103)   100.0%
Capitalized costs   1    -    1    -100.0%
Sales proceeds   (3,255)   (620)   (2,635)   -425.0%
Previously recognized impairment losses on disposition   (79)   (202)   123    60.9%
Loss on disposition   (25)   (78)   53    67.9%
Balance at the end of year, gross   522    1,914    (1,392)   -72.7%
Less valuation allowance   (2)   (76)   74    97.4%
Balance at the end of year, net  $520   $1,838   $(1,318)   -71.7%

 

The following table presents the change in the valuation allowance for OREO for 2015, 2014 and 2013:

  

Table 13: OREO Valuation Allowance Changes

 

(dollars in thousands)  2015   2014   2013 
Balance at the beginning of year  $76   $254   $811 
Valuation allowance   5    24    585 
Charge-offs   (79)   (202)   (1,142)
Balance at the end of year  $2   $76   $254 

 

 51 

 

  

Nonperforming assets were $7.8 million, or 0.89%, of total loans and OREO at December 31, 2015 compared to $8.5 million or 1.04% at December 31, 2014. The slow and measured economic recovery has prompted the Company to maintain the heightened level of the allowance for loan losses as compared to pre-2009 levels, which is 183.43% of nonaccrual loans at December 31, 2015, compared to 196.63% at December 31, 2014. Nonperforming loans have increased $617 thousand, or 9.2%, during the year ended December 31, 2015 to $7.3 million, primarily due to increases in loans past due 90 days and accruing interest and partially offset by a decrease in nonaccrual loans.

 

Nonaccrual loans were $6.2 million at December 31, 2015, a decrease of approximately $447 thousand, or 6.8%, from $6.6 million at December 31, 2014. Of the current $6.2 million in nonaccrual loans, $6.0 million, or 96.6%, is secured by real estate in our market area. Of these real estate secured loans, $4.6 million are one to four family residential real estate, $1.3 million are commercial properties and $89 thousand are real estate construction.

 

Loans past due 90 days and accruing interest were $1.1 million at December 31, 2015 and increased from $53 thousand at December 31, 2014. This increase was due to the nonpayment of a large one to four family residential real estate loan as a result of the deteriorating financial condition of the borrower. This loan remained on accrual status as it was well secured and full recovery was anticipated.

 

OREO, net of valuation allowance at December 31, 2015 was $520 thousand, a decrease of approximately $1.3 million, or 71.7%, from December 31, 2014. The balance of OREO at December 31, 2015 was comprised of ten properties of which $423 thousand were one to four family residential properties, $68 thousand were real estate construction properties and $29 thousand were nonfarm, nonresidential properties. During the year ended December 31, 2015, new foreclosures included eighteen properties totaling $2.0 million transferred from loans, including one commercial property during the second quarter of 2015 totaling $700 thousand. Sales of nineteen OREO properties for the year ended December 31, 2015 resulted in a net loss of $25 thousand. Subsequent to December 31, 2015, five properties totaling $416 thousand were foreclosed on and transferred from loans, and nine properties totaling $300 thousand were under contracts for sale and are not expected to generate any material losses on sale. The remaining properties are being actively marketed and the Company does not anticipate any material losses associated with these properties. The Company recorded losses of $5 thousand in its consolidated statements of income for the year ended December 31, 2015, due to valuation adjustments on OREO properties as compared to $24 thousand for the same period of 2014. Asset quality continues to be a top priority for the Company. The Company continues to allocate significant resources to the expedient disposition and collection of nonperforming and other lower quality assets.

 

As discussed earlier in Item 7, the Company measures impaired loans based on the present value of expected future cash flows discounted at the effective interest rate of the loan or, as a practical expedient, at the loan’s observable market price or the fair value of the collateral if the loan is collateral dependent. The Company maintains a valuation allowance to the extent that the measure of the impaired loan is less than the recorded investment. TDRs are considered impaired loans. TDRs occur when we agree to modify the original terms of a loan by granting a concession due to the deterioration in the financial condition of the borrower. These concessions can be temporary and are made in an attempt to avoid foreclosure and with the intent to restore the loan to a performing status once sufficient payment history can be demonstrated. These concessions could include, without limitation, rate reductions to below market rates, payment deferrals, forbearance, and, in some cases, forgiveness of principal or interest.

 

 52 

 

  

The following table presents loans individually evaluated for impairment, excluding purchased credit impaired loans, by class of loans as of December 31, 2015:

 

Table 14: Impaired Loans

 

(dollars in thousands)  Recorded
Investment
   Unpaid
Principal
Balance
   Recorded
Investment
With No
Allowance
   Recorded
Investment
With
Allowance
   Related
Allowance
   Average
Recorded
Investment
   Interest
Income
Recognized
 
Commercial, industrial and agricultural  $839   $839   $-   $839   $562   $753   $49 
Real estate - one to four family residential:                                   
Closed end first and seconds   8,163    8,530    3,981    4,182    517    8,386    416 
Home equity lines   625    625    175    450    265    521    16 
Total real estate - one to four family residential   8,788    9,155    4,156    4,632    782    8,907    432 
Real estate - construction:                                   
One to four family residential   186    186    20    166    67    235    8 
Other construction, land development and other land   5,562    5,562    -    5,562    1,263    5,611    260 
Total real estate - construction   5,748    5,748    20    5,728    1,330    5,846    268 
Real estate - farmland   539    541    -    539    210    167    36 
Real estate - non-farm, non-residential:                                   
Owner occupied   6,336    6,336    3,506    2,830    824    8,995    292 
Non-owner occupied   12,792    12,792    7,686    5,106    810    11,312    595 
Total real estate - non-farm, non- residential   19,128    19,128    11,192    7,936    1,634    20,307    887 
Consumer   338    350    12    326    88    352    19 
Other   2    2    2    -    -    4    - 
Total loans  $35,382   $35,763   $15,382   $20,000   $4,606   $36,336   $1,691 

 

 53 

 

 

The following table presents loans individually evaluated for impairment, excluding purchase credit impaired loans, by class of loans as of December 31, 2014:

 

Table 14A: Impaired Loans

 

(dollars in thousands)  Recorded
Investment
   Unpaid
Principal
Balance
   Recorded
Investment
With No
Allowance
   Recorded
Investment
With
Allowance
   Related
Allowance
   Average
Recorded
Investment
   Interest
Income
Recognized
 
Commercial, industrial and agricultural  $1,451   $1,451   $1,451   $-   $-   $2,010   $128 
Real estate - one to four family residential:                                   
Closed end first and seconds   8,713    8,813    3,611    5,102    1,006    9,800    474 
Home equity lines   175    175    175    -    -    289    - 
Total real estate - one to four family residential   8,888    8,988    3,786    5,102    1,006    10,089    474 
Real estate - construction:                                   
One to four family residential   176    176    -    176    78    312    7 
Other construction, land development and other land   5,661    5,661    -    5,661    1,632    5,399    256 
  Total real estate - construction   5,837    5,837    -    5,837    1,710    5,711    263 
Real estate - farmland   -    -    -    -    -    -    - 
Real estate - non-farm, non-residential:                                   
Owner occupied   10,046    10,146    3,734    6,312    1,240    12,056    534 
Non-owner occupied   9,816    9,816    4,262    5,554    1,262    9,356    456 
Total real estate - non-farm, non-residential   19,862    19,962    7,996    11,866    2,502    21,412    990 
Consumer   371    371    -    371    106    420    21 
Other   6    6    6    -    -    328    - 
Total loans  $36,415   $36,615   $13,239   $23,176   $5,324   $39,970   $1,876 

 

The Company’s impaired loans have declined when comparing 2015 to 2014, but impaired loans remain elevated over historical levels due to the uneven economic recovery and challenging economic conditions in portions of our markets, which have contributed to increased unemployment and underemployment, lower profitability of some local businesses, and reduced the ability of some customers to keep their loans current.

 

The following table presents the balances of TDRs at December 31, 2015, 2014, 2013, 2012 and 2011:

 

Table 15:  Troubled Debt Restructurings (TDRs)

 

   December 31, 
(dollars in thousands)  2015   2014   2013   2012   2011 
Performing TDRs  $15,535   $15,223   $16,026   $4,433   $5,517 
Nonperforming TDRs*   1,300    3,438    4,188    5,089    13,378 
Total TDRs  $16,835   $18,661   $20,214   $9,522   $18,895 

 

* Included in nonaccrual loans in Table 11: Nonperforming Assets.

 

At the time of a TDR, the loan is placed on nonaccrual status. A loan may be returned to accrual status if the borrower has demonstrated a sustained period of repayment performance (typically six months) in accordance with the contractual terms of the loan and there is reasonable assurance the borrower will continue to make payments as agreed.

 

 54 

 

 

Financial Condition

 

Summary

 

At December 31, 2015, the Company had total assets of $1.27 billion, an increase of approximately $88.4 million or 7.5% from $1.18 billion at December 31, 2014. The increase in total assets was principally the result of increases in loans, interest bearing deposits with banks and investment securities principally funded by short term borrowings, the Company’s issuance of Senior Subordinated Debt during the second quarter of 2015, and continued deposit growth. Major categories and changes in our balance sheet are as detailed in the following schedule:

  

Table 16: Balance Sheet Changes

 

   December 31,   December 31,         
(dollars in thousands)  2015   2014   Change $   Change % 
Total assets  $1,270,384   $1,181,972   $88,412    7.5%
Interest bearing deposits with banks   18,304    5,272    13,032    247.2%
Securities available for sale, at fair value   230,943    214,011    16,932    7.9%
Securities held to maturity, at carrying value   29,698    32,163    (2,465)   -7.7%
Total loans   880,778    820,569    60,209    7.3%
Total deposits   988,719    939,254    49,465    5.3%
Total borrowings   148,760    102,013    46,747    45.8%
Total shareholders' equity   126,275    134,274    (7,999)   -6.0%

 

Loan Portfolio

 

The Company offers an array of lending and credit services to customers including mortgage, commercial and consumer loans. A substantial portion of the loan portfolio is represented by commercial and residential mortgage loans in our market area. The ability of our debtors to honor their contracts is dependent upon the real estate and general economic conditions in our market area. The loan portfolio is the largest component of earning assets and accounts for the greatest portion of total interest income. Total loans were $880.8 million at December 31, 2015, an increase of $60.2 million, or 7.3%, from $820.6 million at December 31, 2014. As discussed previously, loans increased in 2015 primarily due to organic loan growth, the purchase of loans and the opening of a new loan production office in Chesterfield County, Virginia in the second quarter of 2014. These additions were partially offset by weak loan demand in our rural markets, especially with respect to consumer loans, and intense competition for commercial loans, especially in the Richmond and Tidewater markets.

 

 55 

 

 

The following table presents the composition of the loan portfolio at the dates indicated:

 

Table 17:  Summary of Loans

 

   December 31, 
   2015   2014   2013   2012   2011 
(dollars in thousands)  Amount   Percent   Amount   Percent   Amount   Percent   Amount   Percent   Amount   Percent 
Commercial, industrial and agricultural  $98,828    11.22%  $85,119    10.37%  $53,673    8.17%  $51,881    7.58%  $57,021    7.76%
Real estate - one to four family residential:                                                  
Closed end first and seconds   232,826    26.43%   236,761    28.86%   218,472    33.25%   239,002    34.91%   253,465    34.51%
Home equity lines   116,309    13.20%   110,100    13.42%   99,839    15.19%   99,698    14.56%   102,297    13.93%
Total real estate - one to four family residential   349,135    39.63%   346,861    42.28%   318,311    48.44%   338,700    49.47%   355,762    48.44%
Real estate - multifamily residential   29,672    3.37%   25,157    3.07%   18,077    2.75%   15,801    2.31%   13,035    1.77%
Real estate - construction:                                                  
One to four family residential   19,495    2.21%   19,698    2.40%   16,169    2.46%   20,232    2.96%   21,212    2.89%
Other construction, land development and other land   46,877    5.32%   35,591    4.34%   21,690    3.30%   34,555    5.04%   42,208    5.75%
Total real estate - construction   66,372    7.53%   55,289    6.74%   37,859    5.76%   54,787    8.00%   63,420    8.64%
Real estate - farmland   11,418    1.30%   9,471    1.15%   8,172    1.24%   8,558    1.25%   5,860    0.80%
Real estate - non-farm, non-residential:                                                  
Owner occupied   187,224    21.27%   157,745    19.22%   126,569    19.26%   119,824    17.50%   135,294    18.42%
Non-owner occupied   104,456    11.86%   104,827    12.77%   74,831    11.39%   71,741    10.48%   74,231    10.11%
Total real estate - non-farm, non-residential   291,680    33.13%   262,572    31.99%   201,400    30.65%   191,565    27.98%   209,525    28.53%
Consumer   19,993    2.27%   15,919    1.94%   16,782    2.55%   20,173    2.94%   28,355    3.86%
Other   13,680    1.55%   20,181    2.46%   2,923    0.44%   3,203    0.47%   1,553    0.20%
Total loans   880,778    100.00%   820,569    100.00%   657,197    100.00%   684,668    100.00%   734,531    100.00%
Less unearned income   -         -         -         -         (1)     
Less allowance for loan losses   (11,327)        (13,021)        (14,767)        (20,338)        (24,102)     
Loans, net  $869,451        $807,548        $642,430        $664,330        $710,428      

  

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The following table presents the changes in the loans held in the portfolio from December 31, 2014 to December 31, 2015, and from December 31, 2013 to December 31, 2014:

 

Table 17A:  Changes in Loans Held
   2015 vs. 2014   2014 vs. 2013 
(dollars in thousands)  $ Change   % Change   $ Change   % Change 
Commercial, industrial and agricultural  $13,709    16.1%  $31,446    58.6%
Real estate - one to four family residential:                    
Closed end first and seconds   (3,935)   -1.7%   18,289    8.4%
Home equity lines   6,209    5.6%   10,261    10.3%
Total real estate - one to four family residential   2,274    0.7%   28,550    9.0%
Real estate - multifamily residential   4,515    17.9%   7,080    39.2%
Real estate - construction:                    
One to four family residential   (203)   -1.0%   3,529    21.8%
Other construction, land development and other land   11,286    31.7%   13,901    64.1%
Total real estate - construction   11,083    20.0%   17,430    46.0%
Real estate - farmland   1,947    20.6%   1,299    15.9%
Real estate - non-farm, non-residential:                    
Owner occupied   29,479    18.7%   31,176    24.6%
Non-owner occupied   (371)   -0.4%   29,996    40.1%
Total real estate - non-farm, non-residential   29,108    11.1%   61,172    30.4%
Consumer   4,074    25.6%   (863)   -5.1%
Other   (6,501)   -32.2%   17,258    590.4%
 Total loans  $60,209    7.3%  $163,372    24.9%

 

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The following table presents the estimated remaining maturities of loans held in the portfolio at December 31, 2015:

 

Table 18: Remaining Maturities of Loans

 

   December 31, 2015 
   Variable Rate   Fixed Rate     
(dollars in thousands)  Within 1 year   1 to 5 years   After 5 years   Total   Within 1 year   1 to 5 years   After 5 years   Total   Total Maturities 
Commercial, industrial and agricultural  $40,542   $3,253   $441   $44,236   $7,963   $30,384   $16,245   $54,592   $98,828 
Real estate - one to four family residential:                                             
Closed end first and seconds   31,585    128,878    11,860    172,323    4,851    19,069    36,583    60,503    232,826 
Home equity lines   80,996    1,069    34,065    116,130    -    154    25    179    116,309 
Real estate - multifamily residential   1,820    11,852    2,040    15,712    1,303    3,817    8,840    13,960    29,672 
Real estate - construction:                                             
One to four family residential   8,260    7,200    929    16,389    1,302    1,670    134    3,106    19,495 
Other construction, land development and other land    28,290    1,322    -    29,612    13,297    3,878    90    17,265    46,877 
Real estate - farmland   3,180    3,676    848    7,704    1    2,776    937    3,714    11,418 
Real estate - non-farm, non-residential:                                             
Owner occupied   18,196    58,013    18,754    94,963    11,210    47,340    33,711    92,261    187,224 
Non-owner occupied   11,616    26,470    13,453    51,539    4,603    28,035    20,279    52,917    104,456 
Consumer   1,701    36    2    1,739    1,128    3,949    13,177    18,254    19,993 
Other   1,019    854    -    1,873    -    11,807    -    11,807    13,680 
Total loans  $227,205   $242,623   $82,392   $552,220   $45,658   $152,879   $130,021   $328,558   $880,778 

 

The principal risk associated with each of the categories of loans in our portfolio is the creditworthiness of our borrowers. Within each category, such risk may increase or decrease depending on various factors. The risks associated with real estate mortgage loans, commercial loans and consumer loans vary based on employment levels, consumer confidence, fluctuations in the value of real estate and other conditions that affect the ability of borrowers to repay indebtedness. The risk associated with real estate construction loans varies based on the supply and demand for the type of real estate under construction. In an effort to manage these risks, we have loan approval limits for individual loan officers based on their position and level of experience.

 

We have written policies and procedures to help manage credit risk. We use a loan review process that includes a portfolio management strategy, guidelines for underwriting standards and risk assessment, procedures for ongoing identification and management of credit deterioration, and regular independent third party portfolio reviews to establish loss exposure and to monitor compliance with policies. Third party reviews are done on an annual basis by a consulting firm that is comprised of experienced commercial lenders who understand the laws, regulations and critical areas of portfolio management. They provide management with an unbiased opinion of our credits and actions needed to strengthen them or protect the company.

 

Our loan approval process includes our Management Loan Committee, Directors Loan Committee and, for larger loans, the Board of Directors. Our Chief Credit Officer is responsible for reporting to the Directors Loan Committee monthly on the activities of the Management Loan Committee and on the status of various delinquent and nonperforming loans. The Directors Loan Committee also reviews lending policies proposed by management. Our Board of Directors establishes our total lending limit policy which is less than the legal lending limit.

 

At December 31, 2015, loans secured by real estate were $748.3 million, or 85.0%, of the portfolio, compared to $699.4 million, or 85.2%, of the portfolio at December 31, 2014.

 

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Consistent with our focus on providing community-based financial services, we generally do not make loans outside of our principal market region. We may, from time to time, invest in high quality loans that were originated by banks outside our core geographic markets, including by purchasing pools of performing loans. We do not engage in foreign lending activities and consequently the loan portfolio is not exposed to the sometimes volatile risk from foreign credits. We further maintain a policy not to originate or purchase loans classified by regulators as highly leveraged transactions or loans to foreign entities or individuals. Historically, our loan collateral has been primarily real estate because of the nature of our market region; however, in our newer markets, we are encountering other collateral options in lieu of real estate, which are booked based on strong credit guidelines and controls to monitor the status and value of the collateral.

 

Investment Securities

 

The investment securities portfolio plays a primary role in the management of the Company’s interest rate sensitivity. In addition, the investment securities portfolio serves as a source of liquidity and is used as needed to meet collateral requirements, such as those related to secure public deposits, balances with the Federal Reserve Bank and repurchase agreements. The investment securities portfolio consists of held to maturity and available for sale investment securities. We classify investment securities as available for sale or held to maturity based on our investment strategy and management’s assessment of our intent and ability to hold the investment securities until maturity. Management determines the appropriate classification of investment securities at the time of purchase, subject to any subsequent change to intent and ability to hold the investment securities until maturity. If management has the intent and the Company has the ability at the time of purchase to hold the investment securities to maturity, they are classified as investment securities held to maturity and are stated at amortized cost, adjusted for amortization of premiums and accretion of discounts using the interest method. Investment securities which the Company may not hold to maturity are classified as investment securities available for sale, as management has the intent and ability to hold such investment securities for an indefinite period of time, but not necessarily to maturity. Investment securities available for sale may be sold in response to changes in market interest rates, changes in prepayment risk, increases in loan demand, general liquidity needs and other similar factors and are carried at estimated fair value. Total investment securities were $260.6 million at December 31, 2015, reflecting an increase of approximately $14.5 million, or 5.9%, from $246.2 million at December 31, 2014. The valuation allowance for the available for sale investment securities portfolio had an unrealized (loss), net of tax benefit, of ($1.7) million at December 31, 2015 compared with an unrealized (loss), net of tax benefit, of ($1.5) million at December 31, 2014. These unrealized (losses) as of December 31, 2015 are principally due to financial market conditions for these types of investments, particularly related to changes in interest rates, which rose during late 2015 causing bond prices to decline, and are not attributable to credit deterioration. Interest rates had declined somewhat as of the third quarter of 2015, thereby reducing the amount of unrealized losses at that time. However, interest rates increased during the fourth quarter of 2015, primarily as a result of the Federal Reserve’s actions to raise the federal funds target rate to a range of 25-50 basis points in December 2015.

 

During 2015, the Company primarily invested in Agency commercial mortgage-backed securities, Agency CMO securities and securities issued by State and political subdivisions. The Company decreased its investments in Agency residential mortgage-backed securities while increasing its investments in Agency commercial mortgage-backed securities and Agency CMO securities in an effort to enhance the portfolio’s overall structure and provide more consistent cash flows through lower projected prepayment rates and reinvestment opportunities. The increased investment in securities issued by State and political subdivisions was due to the higher yield offered by these securities. In addition, the Company decreased its investments in SBA Pool securities in order to diversify its investment securities portfolio and target investments with a higher risk-adjusted rate of return. As part of our overall asset/liability management strategy, we are targeting our investment securities portfolio to be approximately 20% of our total assets. As of December 31, 2015 and 2014, our investment securities portfolio was 20.5% and 20.8%, respectively, of total assets.

 

There are no investment securities classified as “Trading” at December 31, 2015 or 2014. During the fourth quarter of 2013, the Company transferred investment securities with an amortized cost of $35.5 million, previously designated as “Available for Sale,” to “Held to Maturity” classification. The fair value of those investment securities as of the date of the transfer was $34.5 million, reflecting a gross unrealized loss of $994 thousand. The gross unrealized loss net of tax at the time of transfer remained in Accumulated Other Comprehensive Income (Loss) and is being amortized over the remaining life of the investment securities as an adjustment to interest income, beginning with the fourth quarter of 2013. During the third quarter of 2015, the Company sold a State and political subdivisions security that was classified as “Held to Maturity” due to the significant deterioration in the issuer’s financial condition. The carrying value of this security was $521 thousand and a gain of $10 thousand was recognized as a result of the sale.

 

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The Company’s mortgage-backed securities consist of commercial and residential mortgage-backed securities. The Company’s mortgage-backed securities are all guaranteed by an agency (including a government-sponsored entity) of the U.S. Government and rated Aaa and AA+ by Moody and S&P, respectively, with no subprime issues. The Company follows a policy of not investing in instruments considered to be derivative in nature such as options, futures, swaps or forward commitments. The Company considers derivatives to be speculative in nature and contrary to our historical investment philosophy.

 

The Company’s pooled trust preferred securities previously included one senior issue of Preferred Term Securities XXVII which remained current on all payments and on which the Company took an impairment charge in the third quarter of 2009 to reduce the Company’s book value to the market value at September 30, 2009. On December 9, 2014 the Company sold this security resulting in a gain on sale of $82 thousand, and the Company reversed the related impairment reserve. During the second quarter of 2010, the Company recognized an impairment charge in the amount of $77 thousand on the Company’s investment in Preferred Term Securities XXIII mezzanine tranche, thus reducing the book value of this investment to $0. On September 22, 2014 the Company sold this security resulting in a gain on sale of $2 thousand and the Company subsequently reversed the related impairment reserve.

 

The following tables present the amortized cost or carrying value and estimated fair value of investment securities at the dates indicated:

 

Table 19:  Investment Securities Available for Sale           
(dollars in thousands)  December 31, 2015   December 31, 2014   December 31, 2013 
   Amortized   Fair   Amortized   Fair   Amortized   Fair 
   Cost   Value   Cost   Value   Cost   Value 
Available for Sale:                              
Obligations of U.S. Government agencies  $9,404   $9,262   $14,991   $14,569   $14,989   $13,390 
SBA Pool securities   64,866    63,826    76,469    74,799    89,531    86,035 
Agency residential mortgage-backed securities   24,250    23,903    28,740    28,629    36,261    35,254 
Agency commercial mortgage-backed securities   18,503    18,315    -    -    -    - 
Agency CMO securities   52,870    52,171    39,343    39,215    43,277    41,378 
Non agency CMO securities   61    61    820    828    1,304    1,306 
State and political subdivisions   61,604    61,405    55,877    55,926    60,834    56,342 
Pooled trust preferred securities   -    -    -    -    467    749 
FNMA and FHLMC preferred stock   -    -    7    45    22    481 
Corporate securities   2,000    2,000    -    -    -    - 
Total  $233,558   $230,943   $216,247   $214,011   $246,685   $234,935 

 

Table 19A:  Investment Securities Held to Maturity           
(dollars in thousands)  December 31, 2015   December 31, 2014   December 31, 2013 
   Carrying   Fair   Carrying   Fair   Carrying   Fair 
   Value   Value   Value   Value   Value   Value 
Held to Maturity:                              
Agency CMO securities  $11,371   $11,676   $11,993   $12,287   $12,500   $11,953 
State and political subdivisions   18,327    18,899    20,170    21,080    22,995    22,568 
Total  $29,698   $30,575   $32,163   $33,367   $35,495   $34,521 

 

The Company reviews the investment securities portfolio on a quarterly basis to monitor its exposure to other-than-temporary impairment that may result due to adverse economic conditions and associated credit deterioration. Based on the Company’s evaluation, and because management believes that unrealized losses are principally due to changes in interest rates, management does not believe any unrealized loss at December 31, 2015 represents an other-than-temporary impairment. At December 31, 2015, there were 139 debt securities with fair values totaling $181.2 million considered temporarily impaired. Of these debt securities, 92 with fair values totaling $117.6 million were in an unrealized loss position of less than 12 months and 47 with fair values totaling $63.6 million were in an unrealized loss position of 12 months or more. Because the Company intends to hold these investments in debt securities until recovery of the amortized cost basis and it is more likely than not that the Company will not be required to sell these investments before a recovery of unrealized losses, the Company does not consider these investments to be other-than-temporarily impaired at December 31, 2015 and no impairment has been recognized. At December 31, 2015, there were no equity securities in an unrealized loss position.

 

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However, in the event that the Company is required or decides to use its investment securities portfolio in 2016 to manage its liquidity position, the Company may sell a portion of the investment securities in a temporary unrealized loss position before these investment securities recover their fair value, which would result in the Company recognizing losses on the sale of investment securities.

 

The following tables present the maturity and yields of investment securities at their amortized cost or carrying value at the date indicated:

 

Table 20: Maturity and Yields of Available for Sale Securities

 

   December 31, 2015 
(dollars in thousands)  Maturing within 1
year
   Maturing after 1
year, but within 5
years
   Maturing after 5
years, but within 10
years
   Maturing after 10
years
   Total 
Available for Sale:  Amortized
Cost
   Weighted
Average
Yield
   Amortized
Cost
   Weighted
Average
Yield
   Amortized
Cost
   Weighted
Average
Yield
   Amortized
Cost
   Weighted
Average
Yield
   Amortized
Cost
   Weighted
Average
Yield
 
Obligations of U.S. Government agencies  $-    0.00%  $-    0.00%  $9,404    2.31%  $-    0.00%  $9,404    2.31%
SBA Pool securities - Fixed   -    0.00%   904    3.51%   39,597    2.26%   -    0.00%   40,501    2.29%
SBA Pool securities - Variable   -    0.00%   11,289    4.81%   6,495    1.61%   6,581    2.27%   24,365    3.27%
Agency residential mortgage-backed securities   -    0.00%   9,306    1.51%   13,591    2.01%