10-K 1 d477220d10k.htm FORM 10-K Form 10-K
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-K

 

 

Annual Report Pursuant to Section 13 or 15(d)

of the Securities Exchange Act of 1934

For the Fiscal Year Ended December 31, 2012

 

 

BANK OF THE JAMES FINANCIAL

GROUP, INC.

(Exact Name of Registrant as Specified in Its Charter)

 

 

Commission file number 001-35402

 

Virginia   20-0500300

(State or Other Jurisdiction of

Incorporation or Organization)

 

(I.R.S. Employer

Identification No.)

828 Main Street, Lynchburg, VA   24504
(Address of Principal Executive Offices)   (Zip Code)

(434) 846-2000

(Issuer’s telephone number, including area code)

Securities registered under Section 12(b) of the Exchange Act:

 

Title of Each Class

 

Name of Exchange on Which Registered

Common Stock, $2.14 par value   The NASDAQ Capital Markets

Securities registered under Section 12(g) of the Exchange Act: Common Stock, $2.14 par value

 

 

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

Indicate by check mark if the registrant is not required to file reports pursuant to Section13 or Section 15(d) of the Act.    ¨  Yes    x  No

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

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

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

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 definition of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

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

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

The aggregate value of the voting common equity held by nonaffiliates as of June 30, 2012, the last business day of the registrant’s most recently completed second fiscal quarter, was approximately $15,826,088 based on the price at which the common stock last sold on such day. This price reflects inter-dealer prices without retail mark up, mark down, or commissions, and may not represent actual transactions.

The number of shares outstanding of Common Stock, $2.14 par value as of March 19, 2013 was approximately 3,352,725.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the 2013 Proxy Statement for the Annual Meeting of Shareholders, scheduled to be held on May 21, 2013, are incorporated by reference into Part III of this Form 10-K

 

 

 


Table of Contents

Table of Contents

 

PART I

     1   

Item 1.

   Business      1   

Item 1A.

   Risk Factors      15   

Item 1B.

   Unresolved Staff Comments      15   

Item 2.

   Properties      15   

Item 3.

   Legal Proceedings      17   

Item 4.

   Mine Safety Disclosure      17   
PART II         17   

Item 5.

   Market For Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchase of Equity Securities      17   

Item 6.

   Selected Financial Data      19   

Item 7.

   Management’s Discussion and Analysis of Financial Condition and Results of Operations      19   

Item 7A.

   Quantitative and Qualitative Disclosure About Market Risk      44   

Item 8.

   Financial Statements and Supplementary Data      44   

Item 9.

   Changes in and Disagreements With Accountants on Accounting and Financial Disclosure      98   

Item 9A.

   Controls and Procedures      98   

Item 9B.

   Other Information      98   

PART III

     98   

Item 10.

   Directors, Executive Officers and Corporate Governance      98   

Item 11.

   Executive Compensation      99   

Item 12.

   Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters      99   

Item 13.

   Certain Relationships and Related Transactions, and Director Independence      99   

Item 14.

   Principal Accounting Fees and Services      99   
PART IV         99   

Item 15.

   Exhibits and Financial Statement Schedules      99   

SIGNATURES

     101   


Table of Contents

PART I

 

Item 1. Business

General

Bank of the James Financial Group, Inc. (“Financial”) is a bank holding company with its headquarters in Lynchburg, Virginia. Financial was incorporated at the direction of Bank of the James (the “Bank” or “Bank of the James”) on October 3, 2003 to serve as a bank holding company of the Bank. Financial acquired all of the shares of the Bank in a statutory share exchange on a one-for-one basis on January 1, 2004.

The Bank is a Virginia banking corporation headquartered in Lynchburg, Virginia. The Bank was incorporated under the laws of the Commonwealth of Virginia as a state chartered bank in 1998 and began banking operations in July 1999. The Bank was organized to engage in general retail and commercial banking business.

The Bank was organized in part as a response to the loss of many of the Central Virginia, Region 2000 area’s (as defined in below) local financial institutions through mergers with larger, non-local banks and bank holding companies. The organizers perceived that local customers who once relied on experienced personal attention were being forced to use 800 numbers, computerized menus, and persons in other localities who were not familiar with their needs.

The Bank opened for business on July 22, 1999 to fill this void left in the Region 2000 market. The Bank’s organizers recognized that an opportunity existed to create a banking institution designed exclusively for a market that expected personalized service. The idea was to build a financial institution staffed with experienced professionals who would place a high value on knowing their customers and serving their distinctive banking needs. This remains our philosophy today.

Management believes that the key to the Bank’s success lies in providing Bank customers with personalized service while providing products and services that meet their banking needs.

The Bank’s principal office is located at 828 Main Street, Lynchburg, Virginia 24504 and its telephone number is (434) 846-2000. The Bank also maintains a website at www.bankofthejames.com.

Financial conducts two principal activities: (1) general retail and commercial banking through Bank of the James; (2) mortgage brokerage services through Bank of the James, a division of the Bank.

In addition, Financial provides securities brokerage services through BOTJ Investment, a division of the Bank and acts as an agent for insurance and annuity products through BOTJ Insurance, Inc., a wholly-owned subsidiary of the Bank. The operating results of these business operations have not had a material impact on our financial performance and are not considered principal activities of Financial at this time.

Prior to a restructuring in February 2010, Financial provided securities brokerage services through BOTJ Investment Group, Inc., a wholly-owned subsidiary of Financial. In February 2010, the Bank began providing these services and BOTJ Investment Group, Inc. currently is a non-operating subsidiary of Financial. The Bank, BOTJ Insurance, and BOTJ Investment Group, Inc. are our only subsidiaries and primary assets.

 

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Products and Services

Retail and Commercial Banking

The Bank currently conducts business from nine full-service offices and one limited service office. Four of the full-service offices are located in Lynchburg, Virginia, one full-service location is located in Madison Heights, Virginia, one is located in the Town of Amherst, Virginia, one is located in Forest, Virginia, one is located in the City of Bedford, Virginia and one is located in the Town of Altavista, Virginia. The limited services branch is located in the Westminster-Canterbury facilities in Lynchburg. The Bank established a mortgage loan origination division that conducts business under the name “Bank of the James Mortgage, a Division of Bank of the James.” The mortgage division conducts business primarily from the division’s main office located in the Forest branch of the Bank and a seasonal office located in Moneta, Virginia. For a more detailed description of these facilities, see “Item 2. Properties” below.

Deposit Services. Deposits are a major source of our funding. The Bank offers a full range of deposit services that are typically available in most banks and other financial institutions including checking accounts, savings accounts and other time deposits of various types, ranging from daily money market accounts to longer-term certificates of deposit. The transaction accounts and time certificates are tailored to the Bank’s market area at rates competitive to those offered in the area. In addition, the Bank offers its customers Individual Retirement Accounts (IRAs) and Health Care Savings Accounts (HSAs). All deposit accounts are insured by the Federal Deposit Insurance Corporation (the “FDIC”) up to the maximum amount allowed by law (generally, $250,000 per depositor, subject to aggregation rules). The Bank solicits such accounts from individuals, businesses, associations and organizations, and governmental authorities.

Lending Services. The Bank offers a full range of short- to medium-term commercial and consumer loans. Our primary focus is on making loans to small businesses and consumers in the Region 2000 market area. In addition, we also provide a wide range of real estate finance services. Our primary lending activities are principally directed to our primary market area in the Region 2000 area. Commercial loans include both secured and unsecured loans for working capital (including inventory and receivables), business expansion (including acquisition of real estate and improvements), and purchase of equipment and machinery. Consumer loans include secured and unsecured loans for financing automobiles, home improvements, education and personal investments. Additionally, the Bank originates fixed and floating-rate mortgage loans and real estate construction and acquisition loans. Where appropriate, the Bank attempts to limit interest rate risk through the use of variable interest rates and terms of less than five years.

In general, the Bank offers the following lending services:

 

   

Commercial Business Lending. We make loans to small- and medium-sized businesses in Region 2000 for purposes such as purchases of equipment, facilities upgrades, inventory acquisition and various working capital purposes.

 

   

Real Estate Construction. We make commercial and residential construction and development loans to customers in our market area.

 

   

Commercial Real Estate Mortgage. We make loans to borrowers secured by commercial real estate. In underwriting these types of loans we consider the historic and projected future cash flows of the real estate.

 

   

Consumer. We offer various types of secured and unsecured consumer loans, including personal loans, lines of credit, overdraft lines of credit, automobile loans, installment loans, demand loans, and home equity loans. We make consumer loans primarily for personal, family or household purposes.

 

   

Loan Participations. We sell loan participations in the ordinary course of business when a loan originated by us exceeds our legal lending limit or we otherwise want to share risk with

 

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another bank. We also purchase loan participations from time to time from other banks in the ordinary course of business, usually without recourse against that bank. Purchased loan participations are underwritten in accordance with our loan policy and represent a source of loan growth.

Other Banking Services. Other services offered by the Bank include safe deposit boxes, traveler’s checks, direct deposit of payroll and social security checks, automatic drafts for various accounts, and credit card merchant services. The Bank also has become associated with a shared network of automated teller machines (ATMs) that may be used by Bank customers throughout Virginia, the United States, and internationally.

The Bank intends to introduce new products and services desired by the public and as permitted by the regulatory authorities. The Bank remains committed to meeting the challenges that require technology. The Bank provides its customers with access to the latest technological products, such as telephone banking and internet banking, including on-line bill pay. This service allows customers to handle routine transactions using a standard touch tone telephone and via the internet at the Bank’s website. The Bank recently released an application that enables customers to transact banking business on smartphones and other mobile devices.

Mortgage Banking. The Bank, through Bank of the James Mortgage, a Division of Bank of the James (the “Mortgage Division”) originates conforming and non-conforming home mortgages primarily in the Region 2000 area. As part of the Bank’s overall risk management strategy, the loans originated and closed by the Mortgage Division are pre-sold to major mortgage banking or other financial institutions. Effective April 1, 2011, the Mortgage Division began funding these pre-sold loans. The loans are transferred promptly, typically within 2 to 3 business days, to the buyer for a pre-arranged price. Management believes that there is acceptable risk associated with this arrangement.

Other Activities

We provide brokerage and investment services through the Bank’s Investment division (“Investment”). The Investment division provides securities brokerage services to Bank customers and others through an agreement with Infinex Financial Group, LLC (“Infinex”), a registered broker-dealer. Under our agreement, Infinex operates a service center at 615 Church Street, Lynchburg, Virginia. To date the operating results of the Investment division have not had a material impact on our financial performance.

We provide insurance and annuity products through BOTJ Insurance as an agent for national insurance companies. As of the date hereof, we offer the following insurance products: credit life, life insurance, fixed annuities, and disability insurance. We began providing these services in September 2008. Given the relatively short operating history of BOTJ Insurance, to date the operating results of BOTJ Insurance have not had a material impact on our financial performance.

Employees

As of March 15, 2013, we had approximately 120 full-time equivalent employees. None of our employees are represented by any collective bargaining agreements, and relations with employees are considered excellent. We maintain employee benefit programs that include health insurance, a flexible spending account, a health savings account, and a 401(k) plan.

Location and Market Area

The Bank’s market area primarily consists of Region 2000, which encompasses the seven jurisdictions of the Town of Altavista, Amherst County, Appomattox County, the City of Bedford, Bedford County, Campbell County, and the City of Lynchburg. Region 2000 supports a diverse, well-rounded economy. U.S.

 

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Routes 29, 60, 221, 460 and 501 and State Routes 24 and 40 all pass through the trade area and provide efficient access to other regions of the state. Regional airport service and rail service provide additional transportation channels.

Total population in the market area equals approximately 252,000. According to the U.S. Census, in 2010 the populations of the localities in the Region 2000 market area were approximately as follows: City of Lynchburg - 76,000; Amherst County - 32,000; Appomattox County - 15,000; Bedford County (including the City of Bedford) - 74,000; Campbell County (including the Town of Altavista) - 55,000. The area is serviced by one daily newspaper and a number of radio and television stations providing diverse media outlets. Median family income in Region 2000 has risen over the past ten years.

Region 2000 has a broad range of services, light industry, and manufacturing plants. Principal service, industrial, research and development employers include: BWX Technologies, Inc. (nuclear fuel); AREVA (nuclear services); Centra Health, Inc. (health care services); C.B. Fleet, Inc. (medical supplies); Genworth Financial (life insurance and other financial products); Frito-Lay, Inc. (snack foods); Griffin Pipe Products Co. (ductile iron pipe); R.R. Donnelley Printing Inc. (printed products); as well as six colleges including Randolph College, Sweet Briar College, Liberty University, and Lynchburg College.

Competition

Retail and Commercial Banking

The banking business is highly competitive. We compete with other commercial banks, savings institutions, credit unions, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market mutual funds and other financial institutions operating in the Region 2000 market area and elsewhere. Many of our nonbank competitors are not subject to the same extensive federal regulations that govern federally-insured banks and state regulations governing state chartered banks. As a result, such nonbank competitors may have certain advantages over the Bank in providing certain services.

Virginia law permits statewide branching by banks. Consequently, the Bank’s market area is a highly competitive, highly branched banking market. Competition in the market area for loans to individuals, small businesses, and professional concerns, the Bank’s target market, is keen, and pricing is important. Most of the Bank’s competitors have substantially greater resources and lending limits than the Bank and offer certain services, such as extensive and established branch networks and trust services, that the Bank is not currently providing. Deposit competition is strong and comes from institutions in the market, U.S. Government securities, private issuers of debt obligations and suppliers of other investment alternatives for depositors, among other sources. As a result, the Bank has paid, and may in the future pay, above-market rates to attract deposits.

The adoption of legislation permitting nationwide interstate banking and branching and the use of financial holding companies may also increase competition in the Bank’s market area. See “Supervision and Regulation of Financial” below.

Mortgage Banking

The Mortgage Division competes with large national and regional banks, credit unions, smaller regional mortgage lenders and small local mortgage brokers. Over the past five years, the industry has seen a consolidation in the number of competitors in the marketplace. However, the competition with regard to price has increased as the remaining participants struggle to achieve volume and profitability. The downturn in the housing markets related to declines in real estate values, increased payment defaults and foreclosures have had a dramatic effect on the secondary market. The guidelines surrounding agency business (i.e., loans sold to Fannie Mae and Freddie Mac) have become much more restrictive and the

 

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associated mortgage insurance for loans above 80 percent loan-to-value has continued to tighten. The jumbo markets have slowed considerably and pricing has increased dramatically for larger loans. These changes in the conventional market have caused a dramatic increase in government lending and state bond programs. The Mortgage Division competes by attracting the top sales people in the industry, providing an operational infrastructure that manages the guideline changes efficiently and effectively, offering a product menu that is both competitive in loan parameters as well as price, and providing consistently high quality customer service.

The Mortgage Division, like other residential mortgage originators and lenders, would be impacted by the inability of Fannie Mae, Freddie Mac, the FHA or the VA to purchase loans. Although the Mortgage Division sells loans to various intermediaries, the ability of these aggregators to purchase loans would be limited if these government-sponsored entities cease to exist or materially limit their purchases of mortgage loans.

SUPERVISION AND REGULATION

General

Both Financial, as a bank holding company, and the Bank are subject to extensive federal and state laws and regulations. These laws and regulations impose specific requirements or restrictions on and provide for general regulatory oversight of virtually all aspects of our operations. The following briefly summarizes the more significant provisions of applicable federal and state laws, certain regulations and the potential impact of such provisions on Financial and the Bank. These laws and regulations are generally intended to protect depositors, not shareholders. The following summary is qualified by reference to the statutory and regulatory provisions discussed.

Changes in applicable laws or regulations may have a material effect on our business and prospects. Our operations may be affected by legislative changes and the policies of various regulatory authorities. We cannot predict the effect that fiscal or monetary policies, economic control, or new federal or state legislation may have on our business and earnings in the future.

Regulation of Financial

General. Financial is subject to the periodic reporting requirements of the Securities and Exchange Act of 1934, as amended (the “Exchange Act”), including the filing with the Securities and Exchange Commission (the “SEC”) of annual, quarterly and other reports on the financial condition and performance of the organization. Financial is directly affected by the corporate responsibility and accounting reform legislation signed into law on July 30, 2002, known as the Sarbanes-Oxley Act of 2002 (the “SOX Act”), and the related rules and regulations. The SOX Act includes provisions that, among other things, require that periodic reports containing financial statements that are filed with the SEC be accompanied by chief executive officer and chief financial officer certifications as to the accuracy and compliance with law, additional disclosure requirements and corporate governance and other related rules. Although we are not required to receive an opinion of our external auditors regarding our internal control over financial reporting under section 404 of the SOX Act because of our status as a smaller reporting company, our management’s report on internal control over financial reporting is set forth in Item 8 and incorporated into Item 9A herein. Financial has expended considerable time and money in complying with the SOX Act and expects to continue to incur additional expenses in the future.

Bank Holding Company Act. As a bank holding company registered under the Bank Holding Company Act of 1956 (the “BHCA”), Financial is subject to regulation and examination by the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”). Financial is required to file with the Federal Reserve Board an annual report and such other additional information as the Federal Reserve Board may require pursuant to the BHCA.

 

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The Federal Reserve Board requires a bank holding company to act as a source of financial strength and to take measures to preserve and protect its bank subsidiaries. Financial would be compelled by the Federal Reserve Board to invest additional capital in the event the Bank experiences either significant loan losses or rapid growth of loans or deposits.

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. The BHCA, and other applicable laws and regulations, generally limit the activities of a bank holding company and its subsidiaries to that of banking, managing or controlling banks, or any other activity that is so closely related to banking or to managing or controlling banks as to be a proper incident thereto.

Since September 1995, the BHCA has permitted bank holding companies from any state to acquire banks and bank holding companies located in any other state, subject to certain conditions, including nationwide and state imposed concentration limits. Banks are also able to branch across state lines, provided certain conditions are met, including that applicable state laws expressly permit such interstate branching. Virginia has adopted legislation that permits branching across state lines, provided there is reciprocity with the state in which the out-of-state bank is based.

Gramm-Leach-Bliley Act of 1999. The Gramm-Leach-Bliley Act (the “GLB Act”) which was effective March 11, 2000, permits bank holding companies to become financial holding companies and thereby affiliate with securities firms and insurance companies and engage in other activities that are financial in nature. A bank holding company may become a financial holding company by filing a declaration that the bank holding company wishes to become a financial holding company if each of its subsidiary banks (i) is well capitalized under regulatory prompt corrective action provisions, (ii) is well managed, and (iii) has at least a satisfactory rating under the Community Reinvestment Act (“CRA”). No regulatory approval will be required for a financial holding company to acquire a company, other than a bank or savings association, engaged in activities that are financial in nature or incidental to activities that are financial in nature, as determined by the Federal Reserve Board.

The GLB Act defines “financial in nature” to include securities underwriting, dealing and market making; sponsoring mutual funds and investment companies; insurance underwriting and agency; merchant banking activities; and activities that the Board has determined to be closely related to banking. Subsidiary banks of a financial holding company must continue to be well capitalized and well managed in order to continue to engage in activities that are financial in nature without regulatory actions or restrictions, which could include divestiture of the financial in nature subsidiary or subsidiaries. In addition, a financial holding company or a bank may not acquire a company that is engaged in activities that are financial in nature unless each of the subsidiary banks of the financial holding company or the bank has a CRA rating of satisfactory or better.

The GLB Act also imposes customer privacy requirements on financial institutions. Financial institutions generally are prohibited from disclosing customer information to non-affiliated third parties, unless the customer has been given the opportunity to object and has not objected to such disclosure. Financial institutions must disclose their specific privacy policies to their customers annually. Upon making such disclosure, there is no specific restriction on financial institutions disclosing customer information to affiliated parties. Financial institutions must comply with state law, however, if it protects customer privacy more fully than federal law.

The cumulative effect of the GLB Act and other recent bank legislation has caused us to strengthen our staff to handle the procedures required by this additional regulation. The increased staff and operational costs have impacted our profitability. Although the above laws may have a significant impact on the banking industry by promoting, among other things, competition, it is not possible for the management of the Bank to determine, with any degree of certainty, the impact of such laws on the Bank.

 

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Mergers and Acquisitions. The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 authorizes the Federal Reserve Board to permit adequately capitalized and adequately managed bank holding companies to acquire all or substantially all of the assets of an out-of-state bank or bank holding company, subject to certain conditions, including nationwide and state concentration limits. Banks also are able to branch across state lines, provided certain conditions are met, including that applicable state law must expressly permit such interstate branching. Virginia law permits branching across state lines, provided there is reciprocity with the state in which the out-of-state bank is based.

Limits on the Payment of Dividends. Financial is a legal entity, separate and distinct from the Bank. Financial currently does not have any significant sources of revenue other than cash dividends paid to it by its subsidiaries. Both Financial and the Bank are subject to laws and regulations that limit the payment of cash dividends, including requirements to maintain capital at or above regulatory minimums. As a bank that is a member of the Federal Reserve System (“state member bank”), the Bank must obtain prior written approval for any cash dividend if the total of all dividends declared in any calendar year would exceed the total of its net profits for that year combined with its retained net profits for the preceding two years.

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, the FDIA prohibits insured depository institutions such as the Bank from making capital distributions, including the payment of dividends, if, after making such distribution, the institution would become undercapitalized as defined in the statute. In addition, the Federal Reserve is authorized to determine under certain circumstances relating to the financial condition of a bank that the payment of dividends would be an unsafe and unsound practice and to prohibit payment thereof. The payment of dividends that deplete a bank’s capital base could be deemed to constitute such an unsafe and unsound banking practice. The Federal Reserve has indicated that banking organizations generally pay dividends only out of current operating earnings. In addition, under Virginia law, no dividend may be declared or paid out of a Virginia bank’s paid-in capital. The Bank may be prohibited under Virginia law from the payment of dividends if the Virginia Bureau of Financial Institutions determines that a limitation of dividends is in the public interest and is necessary to ensure the Bank’s financial soundness, and may also permit the payment of dividends not otherwise allowed by Virginia law.

The Dodd-Frank Act

On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Reform Act”) was signed into law. The Dodd-Frank Reform Act represents a significant overhaul of many aspects of the regulation of the financial services industry, although many of its provisions (e.g., the interchange and trust preferred capital limitations) apply to companies that are significantly larger than Financial. The Dodd-Frank Reform Act directs applicable regulatory authorities to promulgate regulations implementing its provisions, and its effect on Financial and on the financial services industry as a whole will be clarified as those regulations are issued. Major elements of the Dodd-Frank Reform Act include:

 

   

The Dodd-Frank Reform Act changed the assessment base for federal deposit insurance from the amount of insured deposits to consolidated assets less tangible capital, eliminated the ceiling on the size of the DIF and increased the floor applicable to the size of the DIF. 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 and provided unlimited federal deposit insurance until December 31, 2012 for non-interest bearing demand transaction accounts at all insured depository institutions.

 

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The Dodd-Frank Reform 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.

 

   

The Dodd-Frank Reform Act required new disclosure relating to executive compensation and corporate governance.

 

   

The Dodd-Frank Reform Act implemented amendments to the Truth in Lending Act aimed at improving consumer protections with respect to mortgage originations, including originator compensation, minimum repayment standards, and prepayment considerations.

 

   

The Dodd-Frank Reform Act established the Financial Stability Oversight Council, which will be responsible for identifying and monitoring systemic risks posed by financial firms, activities, and practices.

 

   

The Dodd-Frank Reform Act amended the Electronic Fund Transfer Act (EFTA) to, among other things, require that debit card interchange fees must be reasonable and proportional to the actual cost incurred by the issuer with respect to the transaction. In June 2011, the Federal Reserve Board adopted regulations setting the maximum permissible interchange fee as the sum of 21 cents per transaction and 5 basis points multiplied by the value of the transaction, with an additional adjustment of up to one cent per transaction if the issuer implements additional fraud-prevention standards. Although issuers that have assets of less than $10 billion are exempt from the Federal Reserve Board’s regulations that set maximum interchange fees, these regulations are expected to significantly affect the interchange fees that financial institutions with less than $10 billion in assets are able to collect.

 

   

The Dodd-Frank Reform Act eliminated (over time) the inclusion of trust preferred securities as a permitted element of Tier 1 capital.

 

   

The Dodd-Frank Reform Act created a special regime to allow for the orderly liquidation of systemically important financial companies, including the establishment of an orderly liquidation fund.

 

   

The Dodd-Frank Reform Act requires the development of regulations to address derivatives markets, including clearing and exchange trading requirements and a framework for regulating derivatives-market participants.

 

   

The Dodd-Frank Reform Act enhanced supervision of credit rating agencies through the Office of Credit Ratings within the SEC.

 

   

The Dodd-Frank Reform Act increased the regulation of asset-backed securities, including a requirement that issuers of asset-backed securities retain at least 5% of the risk of the asset-backed securities.

 

   

The Dodd-Frank Reform Act established a Bureau of Consumer Financial Protection, within the Federal Reserve, to serve as a dedicated consumer-protection regulatory body. The Consumer Financial Protection Bureau 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, small institutions. As a smaller institution, most consumer protection aspects of the Dodd-Frank Act will continue to be overseen by the Federal Reserve.

Many aspects of the Dodd-Frank Act are subject to rulemaking and will take effect over several years. As a result, it is difficult to anticipate the overall impact of the act on Financial. Financial continues to evaluate the potential impact of the Dodd-Frank Reform Act.

Economic Emergency Stabilization Act of 2008 In response to the financial crisis affecting the banking system and financial markets and going concern threats to investment banks and other financial institutions,

 

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on October 3, 2008, the Emergency Economic Stabilization Act of 2008 (the “EESA”) was signed into law. Through its authority under the EESA, the Treasury announced in October 2008 the Troubled Asset Relief Program - Capital Purchase Program (the “CPP”) a program designed to bolster healthy institutions, like Financial, by making $250 billion of capital available to U.S. financial institutions in the form of preferred stock. Participants in the CPP are subject to executive compensation limits and are encouraged to expand their lending and mortgage loan modifications. Although Financial received preliminary approval from the United States Treasury to participate in the TARP Capital Purchase Program, Financial decided not to participate in the program.

Regardless of our lack of participation in certain programs, governmental intervention and new regulations under these programs could materially and adversely affect our business, financial condition and results of operation.

Incentive Compensation

In June 2010, the Federal Reserve, the Office of the Comptroller of the Currency (OCC) and the FDIC issued a comprehensive final guidance on incentive compensation 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 guidance, which covers all employees that have the ability to materially affect the risk profile of an organization, either individually or as part of a group, is based upon the key principles that a banking organization’s incentive compensation arrangements should (i) provide incentives that do not encourage risk-taking beyond the organization’s ability to effectively identify and manage risks, (ii) be compatible with effective internal controls and risk management, and (iii) be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors.

The Federal Reserve will review, as part of the regular, risk-focused examination process, the incentive compensation arrangements of banking organizations, such as Financial, 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. Deficiencies will be incorporated into the organization’s supervisory ratings, which can affect the organization’s ability to make acquisitions and take other actions. 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 Dodd-Frank Act requires the SEC and the federal bank regulatory agencies to establish joint regulations or guidelines that require financial institutions with assets of at least $1 billion to disclose the structure of their incentive compensation practices and prohibit such institutions from maintaining compensation arrangements that encourage inappropriate risk-taking by providing excessive compensation or that could lead to material financial loss to the financial institution.

Regulation of the Bank

The Bank is a Virginia chartered commercial bank and a state member bank. The Bank’s deposit accounts are insured by the Deposit Insurance Fund (“DIF”) of the FDIC up to the maximum legal limits of the FDIC and it is subject to regulation, supervision and regular examination by the Virginia Bureau of Financial Institutions and the Federal Reserve. The regulations of these various agencies govern most aspects of the Bank’s business, including required reserves against deposits, loans, investments, mergers and acquisitions, borrowings, dividends and location and number of branch offices. The laws and regulations governing the Bank generally have been promulgated to protect depositors and the deposit insurance funds, and not for the purpose of protecting shareholders.

 

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General. As a state-chartered commercial bank, the Bank and its subsidiaries are subject to regulation, supervision and examination by the Federal Reserve and the Virginia State Corporation Commission’s Bureau of Financial Institutions (the “Commission”). As such, the Bank is subject to various statutes and regulations administered by these agencies that govern, among other things, required reserves, investments, loans, lending limits, acquisitions of fixed assets, interest rates payable on deposits, transactions among affiliates and the Bank, the payment of dividends, mergers and consolidations, and establishment of branch offices.

The earnings of the Bank are affected by general economic conditions, management policies and the legislative and governmental actions of the various regulatory authorities, including those referred to above.

FDIC Insurance Premiums. The Bank has deposits that are insured by the Federal Deposit Insurance Corporation (FDIC). FDIC maintains a Deposit Insurance Fund (“DIF”) that is funded by risk-based insurance premium assessments on insured depository institutions. Assessments are determined based upon several factors, including the level of regulatory capital and the results of regulatory examinations. FDIC may adjust assessments if the insured institution’s risk profile changes or if the size of the DIF declines in relation to the total amount of insured deposits. In 2012, the Bank expensed $579,000 in FDIC assessments which was a material decrease from $661,000 in 2011. It is anticipated that assessments may increase in the future to offset demands on the DIF from banks that fail in the troubled economy. Such increases could adversely affect the Bank’s profitability.

On October 3, 2008, the FDIC announced that deposits at FDIC-insured institutions would be insured up to at least $250,000. It was extended to December 31, 2013, and then permanently.

After giving primary regulators an opportunity to first take action, FDIC may initiate an enforcement action against any depository institution it determines is engaging in unsafe or unsound actions or which is in an unsound condition, and the FDIC may terminate that institution’s deposit insurance.

Capital Requirements. Banks and bank holding companies are subject to various capital requirements administered by state and federal banking agencies. Capital adequacy guidelines involve quantitative measures of assets, liabilities and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators about components, risk weighting and other factors.

Under the risk-based capital requirements of these federal bank regulatory agencies, the Bank is required to maintain a minimum ratio of total capital to risk-weighted assets of at least 8.0 percent and a minimum ratio of Tier 1 capital to risk-weighted assets of at least 4.0 percent. At least half of the total capital must be Tier 1 capital, which includes common equity, retained earnings and qualifying perpetual preferred stock, less certain intangibles and other adjustments. The remainder may consist of Tier 2 capital, such as a limited amount of subordinated and other qualifying debt (including certain hybrid capital instruments), other qualifying preferred stock and a limited amount of the general loan loss allowance. The total risk-based capital ratio of the Bank as of December 31, 2012 and December 31, 2011 was 12.40% and 11.79%, respectively, exceeding the minimums required.

The regulatory agencies’ risk-based capital guidelines are based upon the 1988 capital accord (“Basel I”) of the internal Basel Committee on Bank Supervision (“Basel Committee”), a committee of central banks and bank supervisors/regulators from the major industrialized countries that develops broad policy guidelines, which each country’s supervisors can use to determine the supervisory policies they apply to their home jurisdiction. In 2004, the Basel Committee proposed a new capital accord (“Basel II”) to replace Basel I that provided approaches for setting capital standards for credit risk and capital requirements for operational risk and refining the existing capital requirements for market risk exposures. U.S. banking regulators published a final rule for Basel II implementation requiring banks with over $250 billion in consolidated total assets or on-balance sheet foreign exposure of $10 billion (“core banks”) to

 

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adopt the advanced approaches of Basel II while allowing other banks to elect to “opt in.” The regulatory agencies later issued a proposed rule for larger banks that would give banking organizations that do not use the advanced approaches the option to implement a new risk-based capital framework that would adopt the standardized approach of Basel II for credit risk, the basic indicator approach of Basel II for operational risk and related disclosure requirements. A definitive rule was not issued.

In December 2010, the Basel Committee released its final framework for strengthening international capital and liquidity regulation, now officially identified as “Basel III.” If and when implemented by the U.S. banking agencies and fully phased-in, it would require bank holding companies and their bank subsidiaries to maintain substantially more capital than currently required, with a greater emphasis on common equity.

The Basel III capital framework, among other things introduces as a new capital measure, Common Equity Tier 1 (“CET1”), more commonly known in the United States as “Tier 1 Common,” and defines CET1 narrowly by requiring that most adjustments to regulatory capital measures be made to CET1 and not to the other components of capital, and expands the scope of the adjustments as compared to existing regulations;

If fully phased in as currently proposed Basel III requires banks to maintain:

 

   

a newly adopted international standard, a minimum ratio of CET1 to risk-weighted assets of at least 4.5%, plus a 2.5% “capital conservation buffer” (which is added to the 4.5% CET1 ratio as that buffer is phased in, effectively resulting in a minimum ratio of CET1 to risk-weighted assets of at least 7%); (ii) an additional “SIFI buffer” for those large institutions deemed to be systemically important, ranging from 1.0% to 2.5%, and up to 3.5% under certain conditions; (iii) 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); (iv) 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 (v) as a newly adopted international standard, a minimum leverage ratio of 3%, calculated as the ratio of Tier 1 capital to balance sheet exposures plus certain off-balance sheet exposures (as the average for each quarter of the month-end ratios for the quarter); and

 

   

an additional “countercyclical capital buffer,” generally to be imposed when national regulators determine that excess aggregate credit growth becomes associated with a buildup of systemic risk, that would be a CET1 add-on to the capital conservation buffer in the range of 0% to 2.5% when fully implemented.

The federal bank regulatory agencies issued joint proposed rules in June 2012 that would revise the risk-based capital requirement and the method for calculating risk-weighted assets to make them consistent with Basel III and provisions of the Dodd-Frank Act. The proposed rules would apply to all depository institutions and top-tier bank holding companies with assets of $500 million or more. Among other things, the proposed rules establish a new minimum common equity Tier 1 ratio (4.5% of risk-weighted assets) and a higher minimum Tier 1 risk-based capital requirement (6.0% of risk-weighted assets) and assigns higher risk weighting to exposures that are more than 90 days past due or are on nonaccrual status and certain commercial real estate facilities that finance the acquisition, development or construction of real property. The proposed rules also require unrealized gains and losses on certain securities holdings to be included in calculating capital ratios; limit capital distributions and certain discretionary bonus payments by financial institutions defined as systemically important, though not so deemed by the Basel Committee, unless an additional capital conservation buffer of 0% to 1.0% of risk-weighted assets is maintained. The proposed rules, including alternative requirements for smaller community financial institutions like the Company, would, when finalized, be phased in through 2019. The implementation of the Basel III framework was to

 

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commence January 1, 2013; however, due to the number of comment letters received by the federal banking agencies in response to the notice of proposed rulemaking, the initial implementation has been postponed indefinitely. Requirements to maintain higher levels of capital or to maintain higher levels of liquid assets could adversely impact the Bank’s (and, if applicable, Financial’s) net income and return on equity.

Transactions with Affiliates. The Bank is subject to the provisions of Section 23A and 23B of the Federal Reserve Act and Federal Reserve Regulation W of the Federal Reserve Bank which place limits on the amount of loans or extensions of credit to affiliates (as defined in the Federal Reserve Act), investments in or certain other transactions with affiliates and on the amount of advances to third parties collateralized by the securities or obligations of affiliates. The law and regulation limit the aggregate amount of transactions with any individual affiliate to ten percent (10%) of the capital and surplus of the Bank and also limit the aggregate amount of transactions with all affiliates to twenty percent (20%) of capital and surplus. Loans and certain other extensions of credit to affiliates are required to be secured by collateral in an amount and of a type described in the regulation, and the purchase of low quality assets from affiliates is generally prohibited. The law and Regulation W also, among other things, prohibit an institution from engaging in certain transactions with certain affiliates (as defined in the Federal Reserve Act) unless the transactions are on terms substantially the same, or at least as favorable to such institution and/or its subsidiaries, as those prevailing at the time for comparable transactions with non-affiliated entities. In the absence of comparable transactions, such transactions may only occur under terms and circumstances, including credit standards that in good faith would be offered to or would apply to non-affiliated companies.

Loans to Insiders. The Bank is subject to the restrictions contained in Section 22(h) of the Federal Reserve Act and the Federal Reserve Board’s Regulation O thereunder on loans to executive officers, directors and principal stockholders. Under Section 22(h), loans to a director, an executive officer or a greater-than-10% stockholder of a bank as well as certain affiliated interests of any of the foregoing may not exceed, together with all other outstanding loans to such person and affiliated interests, the loans-to-one-borrower limit applicable to national banks (generally 15% of the institution’s unimpaired capital and surplus), and all loans to all such persons in the aggregate may not exceed the institution’s unimpaired capital and unimpaired surplus. Regulation O also prohibits the making of loans in an amount greater than $25,000 or 5% of capital and surplus but in any event not over $500,000, to directors, executive officers and greater-than-10% stockholders of a bank, and their respective affiliates, unless such loans are approved in advance by a majority of the board of directors of the bank with any “interested” director not participating in the voting. Furthermore, Regulation O requires that loans to directors, executive officers and principal stockholders of a bank be made on terms substantially the same as those that are offered in comparable transactions to unrelated third parties unless the loans are made pursuant to a benefit or compensation program that is widely available to all employees of the bank and does not give preference to insiders over other employees. Regulation O also prohibits a depository institution from paying overdrafts over $1,000 of any of its executive officers or directors unless they are paid pursuant to written pre-authorized extension of credit or transfer of funds plans.

All of the Bank’s loans to its and the Company’s executive officers, directors and greater-than-10% stockholders, and affiliated interests of such persons, comply with the requirements of Regulation W and Section 22(h) of the Federal Reserve Act and Regulation O.

Community Reinvestment Act. The Community Reinvestment Act (“CRA”) requires that, in connection with examinations of financial institutions within their respective jurisdictions, the Federal Reserve Board, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency or the Office of Thrift Supervision shall evaluate the record of the financial institutions in meeting the credit needs of their local communities, including low and moderate income neighborhoods, consistent with the safe and sound operation of those institutions. The CRA does not establish specific lending requirements or programs for financial institutions nor does it limit an institution’s discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with the CRA. An institution’s CRA activities are considered in, among other things, evaluating mergers, acquisitions and

 

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applications to open a branch or facility, as well as determining whether the institution will be permitted to exercise certain of the powers allowed by the GLB Act. The CRA also requires all institutions to make public disclosure of their CRA ratings. The Bank was last examined for CRA compliance in July 2008 and received a CRA rating of “satisfactory.”

Safety and Soundness. 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 institutions in question are “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized,” or “critically undercapitalized,” all such terms are defined under uniform regulations defining such capital levels issued by each of the federal banking agencies. 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. As of December 31, 2012, the Bank was considered “well capitalized.”

Regulatory Enforcement Authority. Applicable banking laws include substantial enforcement powers available to federal banking regulators. This enforcement authority includes, among other things, the ability to assess civil money penalties, to issue cease-and-desist or removal orders and to initiate injunctive actions against banking organizations and institution-affiliated parties. In general, these enforcement actions may be initiated for violations of laws and regulations and unsafe or unsound practices. Other actions or inactions, including the filing of misleading or untimely reports with regulatory authorities, may provide the basis for enforcement action.

Bank Secrecy Act (BSA). Under the Bank Secrecy Act, a financial institution is required to have systems in place to detect certain transactions, based on the size and nature of the transaction. Financial institutions are generally required to report cash transactions involving more than $10,000 to the Treasury. In addition, financial institutions are required to file suspicious activity reports for transactions that involve more than $5,000 and which the financial institution knows, suspects or has reason to suspect, involves illegal funds, is designed to evade the requirements of the BSA or has no lawful purpose.

USA Patriot Act. The USA Patriot Act became effective on October 26, 2001 and provides for the facilitation of information sharing among governmental entities and financial institutions for the purpose of combating terrorism and money laundering. Among other provisions, the USA Patriot Act permits financial institutions, upon providing notice to the United States Treasury, to share information with one another in order to better identify and report to the federal government concerning activities that may involve money laundering or terrorist activities. The USA Patriot Act is considered a significant banking law in terms of information disclosure regarding certain customer transactions. Although it does create a reporting obligation, the Bank does not expect the USA Patriot Act to materially affect its products, services or other business activities.

Reporting Terrorist Activities. The Federal Bureau of Investigation (“FBI”) has sent, and will send, our banking regulatory agencies lists of the names of persons suspected of involvement in the September 11, 2001, terrorist attacks on New York City and Washington, DC. The Bank has been asked, and may be asked again, to search its records for any relationships or transactions with persons on those lists. If the Bank finds any relationships or transactions, it must file a suspicious activity report and contact the FBI. The Office of Foreign Assets Control (“OFAC”), which is a division of the Department 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. OFAC has sent, and will send, our banking regulatory agencies lists of names of persons and organizations suspected of aiding, harboring or engaging in terrorist acts. If the Bank finds a name on any transaction, account or wire transfer that is on an OFAC list, it must freeze such account, file a suspicious activity report and notify the FBI. The Bank has appointed an OFAC compliance officer to oversee the inspection of its accounts and the filing of any notifications. The Bank actively checks high-risk OFAC areas such as new accounts, wire transfers

 

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and customer files. The Bank performs these checks utilizing software, which is updated each time a modification is made to the lists provided by OFAC and other agencies of Specially Designated Nationals and Blocked Persons.

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

Check Clearing for the 21st Century Act (Check 21). Check 21 gives “substitute checks,” such as a digital image of a check and copies made from that image, the same legal standing as the original paper check. The major provisions of Check 21 include: allowing check truncation without making it mandatory; demanding that every financial institution communicate to account holders in writing a description of its substitute check processing program and their rights under the law; legalizing substitutions for and replacements of paper checks without agreement from consumers; retaining in place the previously-mandated electronic collection and return of checks between financial institutions only when individual agreements are in place; requiring that when account holders request verification, financial institutions produce the original check (or a copy that accurately represents the original) and demonstrate that the account debit was accurate and valid; and requiring recrediting of funds to an individual’s account on the next business day after a consumer proves that the financial institution has erred. This legislation has not significantly increased our capital spending.

Effect of Governmental Monetary Policies

Our earnings are affected by domestic economic conditions and the monetary and fiscal policies of the United States government and its agencies. The Federal Reserve Bank’s monetary policies have had, and are likely to continue to have, an important impact on the operating results of commercial banks through its power to implement national monetary policy in order, among other things, to curb inflation or combat a recession. The monetary policies of the Federal Reserve Board have major effects upon the levels of bank loans, investments and deposits through its open market operations in United States government securities and through its regulation of the discount rate on borrowings of member banks and the reserve requirements against member bank deposits. It is not possible to predict the nature or impact of future changes in monetary and fiscal policies.

Future Regulatory Uncertainty

Legislative and regulatory proposals regarding changes in banking, and the regulation of banks, federal savings institutions, and other financial institutions and bank and bank holding company powers are being considered by the executive branch of the federal government, Congress and various state governments. Certain of these proposals, if adopted, could significantly change the regulation or operations of banks and the financial services industry. New regulations and statutes are regularly proposed that contain wide-ranging proposals for altering the structures, regulations, and competitive relationships of the nation’s financial institutions.

 

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Because federal regulation of financial institutions changes regularly and is the subject of constant legislative debate, we cannot forecast how federal regulation of financial institutions may change in the future and impact our operations. The current economic environment has required a greater degree of coordination and overlap of the duties and responsibilities of the U.S. Treasury, federal and state banking regulators and the FDIC. We fully expect that the financial institution industry will remain heavily regulated in the near future and that additional laws or regulations may be adopted further regulating specific banking practices. We cannot predict whether or in what form any proposed regulation or statute will be adopted or the extent to which our business may be affected by any new regulation or statute.

 

Item 1A. Risk Factors - Not applicable.

 

Item 1B. Unresolved Staff Comments - Not applicable.

 

Item 2. Properties

Current Locations and Property

As of December 31, 2012, the Bank conducted its banking business from ten locations, its mortgage origination services business primarily from two locations, and its investment and insurance services business primarily from one location.

Depending on such factors as cost, availability, and location, we may either lease or purchase our facilities. The existing facilities that we have purchased typically have been former branches of other financial institutions. We own 6 of our locations and lease 5 of our locations. The following table describes the location and general character of our facilities:

 

Address

  

Type of Facility

  

Year

Opened

  

Owned/Leased

5204 Fort Avenue

Lynchburg, Virginia

   Full service branch with drive thru and ATM    2000    Owned

4698 South Amherst

Highway

Madison Heights, Virginia

   Full service branch with drive thru and ATM    2002    Owned

17000 Forest Road

Forest, Virginia

  

Full service branch with drive thru and ATM

Headquarters for Mortgage Division

   2005    Owned

164 South Main Street

Amherst, Virginia

   Full service branch with drive thru and ATM    2007    Owned

1405 Ole Dominion Blvd.

Bedford, Virginia

   Full service branch with drive thru and ATM    2008    Owned

1110 Main Street

Altavista, Virginia

   Full service branch with drive thru and ATM    2009    Owned

828 Main Street

Lynchburg, Virginia

   Corporate Headquarters; Full service branch with ATM    2004    Leased (1)

615 Church Street

Lynchburg, Virginia

  

Full service branch with drive thru and ATM

Headquarters for Investment and Insurance Divisions

   1999    Leased (2)

4935 Boonsboro Road,

Suites C and D

Lynchburg, Virginia

   Full service branch with drive thru and ATM    2006    Leased (3)

1152 Hendricks Store Rd.

Moneta, Virginia

   Mortgage banking office    2005    Leased (4)

501 VES Road

Lynchburg, Virginia

   Limited service branch    2010    Leased (5)

 

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(1) Base lease expires July 31, 2014. We have one or more renewal options that we may exercise at our discretion subject to the terms and conditions outlined in the lease. The Bank leases this property from Jamesview Investment, LLC, which is wholly-owned by William C. Bryant III, a member of the Board of Directors of both Financial and the Bank.
(2) Base lease expires July 31, 2019. We have one or more renewal options that we may exercise at our discretion subject to the terms and conditions outlined in the lease.
(3) The current term expires on December 31, 2015. The Bank has one renewal option to extend the lease for an additional five year period that we may exercise at our discretion subject to the terms and conditions outlined in the lease.”
(4) Base lease expires September 30, 2013. We have one or more renewal options that we may exercise at our discretion subject to the terms and conditions outlined in the lease.
(5) Base lease expires May 31, 2015.

We believe that each of these operating facilities is maintained in good operating condition and is suitable for our operational needs.

In addition, the Bank may evaluate the feasibility of entering into sale/leaseback agreements for certain branches.

Interest in Additional Properties

As discussed in “Management’s Discussion and Analysis - Expansion Plans” in addition to the facilities set forth above, the Bank owns the following properties which are being held for possible expansion:

 

   

real property located in the Timberlake Road area of Campbell County (Lynchburg), Virginia. The Timberlake property is not suitable for its intended use as a branch bank. Management anticipates that it will be necessary to raze the current structures and replace it with appropriate new construction.

 

   

real property located at 5 Village Highway (near the intersection of Routes 501 and 24) in Rustburg, Virginia. The structure on the property has been demolished and removed. The Bank does not anticipate opening a branch at this location prior until 2014.

The Bank is considering whether to open a retail branch in the Hendricks Store Road, Moneta, Virginia location.

Management of the Bank continues to look for and evaluate additional locations for future branch growth and will consider opening an additional branch in the next 18 months if a suitable location is available on acceptable terms. The opening of all additional branches is contingent upon the receipt of regulatory approval.

 

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We will use the internet, consistent with applicable regulatory guidelines, to augment our growth plans. We currently offer online account access, bill payment, and account management functions through our website. The Bank recently released an application that enables customers to transact banking business on smartphones and other mobile devices.

 

Item 3. Legal Proceedings

There are no material pending legal proceedings to which the Company is a party or to which the property of the Company is subject.

 

Item 4. Mine Safety Disclosure - Not applicable.

PART II

 

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

Market Prices and Dividends

As of January 25, 2012, the Common Stock of Financial is traded on the NASDAQ Capital Market LLC (NASDAQ) under the symbol “BOTJ.” Prior to this time, the Common Stock of Financial was quoted on the Over the Counter Bulletin Board (OTCBB) under the symbol “BOJF (“BOJF.OB” on some systems) and transactions generally involved a small number of shares. The following table sets forth the quarterly high and low bid prices for each quarter in fiscal 2012 and 2011 for Financial and was obtained from Bloomberg. Management believes this source to be accurate.

 

     Market Prices and Dividends  
     Bid Price ($)         
     High      Low      Dividends ($)  

Fiscal 2012

        

Fourth Quarter

     6.26         5.15         0.00   

Third Quarter

     5.75         5.15         0.00   

Second Quarter

     5.60         5.31         0.00   

First Quarter

     5.87         4.40         0.00   

Fiscal 2011

        

Fourth Quarter

     5.00         3.75         0.00   

Third Quarter

     5.50         3.75         0.00   

Second Quarter

     6.25         4.80         0.00   

First Quarter

     6.65         5.20         0.00   

The quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not represent actual transactions.

As of March 18, 2013 (the most recent date available), the Common Stock traded for $             per share. As of March 18, 2013, there were approximately 3,352,725 shares of Common Stock outstanding, which shares are held by approximately 1,860 active shareholders of record. Neither Financial nor the Bank prior to the formation of Financial has declared or paid a cash dividend on its Common Stock.

 

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Dividend Policy

The Company’s future dividend policy is subject to the discretion of its Board of Directors and will depend upon a number of factors, including future earnings, financial condition, liquidity and capital requirements of both the Company and the Bank, applicable governmental regulations and policies and other factors deemed relevant by its Board of Directors.

The Company is organized under the Virginia Stock Corporation Act, which prohibits the payment of a dividend if, after giving it effect, the corporation would not be able to pay its debts as they become due in the usual course of business or if the corporation’s total assets would be less than the sum of its total liabilities plus the amount that would be needed, if the corporation were to be dissolved, to satisfy the preferential rights upon dissolution of any preferred shareholders.

The Company is a legal entity separate and distinct from its subsidiaries. Its ability to distribute cash dividends will depend primarily on the ability of the Bank to pay dividends to it, and the Bank is subject to laws and regulations that limit the amount of dividends that it can pay. As a state member bank, the Bank is subject to certain restrictions imposed by the reserve and capital requirements of federal and Virginia banking statutes and regulations. For a discussion of these restrictions, see “Supervision and Regulation of Financial - Limits on the Payment of Dividends.”

Cash dividends are not planned at this time. Financial intends to follow a policy of keeping retained earnings, if any, for the purpose of increasing net worth and reserves of the Bank during its initial years of operation in order to promote the Bank’s growth and ability to compete in its market area. As a result, Financial does not anticipate paying a cash dividend on its Common Stock in 2013.

Securities Authorized for Issuance under Equity Compensation Plans

The following table summarizes information concerning Financial’s equity compensation plans at December 31, 2012. All figures have been adjusted to reflect the 10% stock dividend declared on May 18, 2010 and paid on July 23, 2010 as well as all prior stock dividends declared by Financial. All outstanding stock options have been issued under plans approved by shareholders.

 

Plan Category

   Number of
Shares to be
Issued Upon
Exercise of
Outstanding
Options
     Weighted
Average
Exercise
Price of
Outstanding
Options
     Number of Shares Remaining
Available for Future Issuance
Under Equity Compensation Plans
(Excluding Shares Reflected in
First Column)
 

Equity compensation plans approved by shareholders - 1999 Stock Option Plan of Bank of the James Financial Group, Inc.

     175,366       $ 9.66         0   

Equity compensation plans not approved by shareholders

     N/A         N/A         N/A   

Total

     175,366       $ 9.66      

 

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Recent Sales of Unregistered Equity Securities

None.

 

Item 6. Selected Financial Data - Not applicable.

 

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

Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion is intended to assist readers in understanding and evaluating our financial condition and results of operations. You should read this discussion in conjunction with our financial statements and accompanying notes included elsewhere in this report. Because Bank of the James Financial Group, Inc. (“Financial”) has no material operations and conducts no business other than the ownership of its operating subsidiary, Bank of the James (and its divisions and subsidiary), the discussion primarily concerns the business of the Bank. However, for ease of reading and because our financial statements are presented on a consolidated basis, references to “we,” “us,” or “our” refer to Financial, Bank of the James, and their divisions and subsidiaries as appropriate. The comparison of operating results for Financial between the years ended December 31, 2012 and 2011 should be read in the context of both the size and the relatively short operating history of the Bank.

Cautionary Statement Regarding Forward-Looking Statements

This report contains statements that constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and the Private Securities Litigation Reform Act of 1995. The words “believe,” “estimate,” “expect,” “intend,” “anticipate,” “plan” and similar expressions and variations thereof identify certain of such forward-looking statements which speak only as of the dates on which they were made. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise. Readers are cautioned that any such forward-looking statements are not guarantees of future performance and involve risks and uncertainties, and that actual results may differ materially from those indicated in the forward-looking statements as a result of various factors. Factors that could cause actual results to differ from the results discussed in the forward-looking statements include, but are not limited to: economic conditions (both generally and more specifically in the markets in which we operate); competition for our customers from other providers of financial services; government legislation and regulation relating to the banking industry (which changes from time to time and over which we have no control) including but not limited to the Dodd-Frank Wall Street Reform and Consumer Protection Act; changes in the value of real estate securing loans made by the Bank; changes in interest rates; and material unforeseen changes in the liquidity, results of operations, or financial condition of our customers. Other risks, uncertainties and factors could cause our actual results to differ materially from those projected in any forward-looking statements we make.

Overview

Financial is a bank holding company headquartered in Lynchburg, Virginia. Our primary business is retail banking which we conduct through our wholly-owned subsidiary, Bank of the James (which we refer to as the “Bank”). We conduct three other business activities, mortgage banking through the Bank’s Mortgage division (which we refer to as “Mortgage”), investment services through the Bank’s Investment division (which we refer to as “Investment”), and insurance activities through BOTJ Insurance, Inc., a subsidiary of the Bank, (which we refer to as “Insurance”).

The Bank is a Virginia banking corporation headquartered in Lynchburg, Virginia. The Bank was incorporated under the laws of the Commonwealth of Virginia as a state chartered bank in 1998 and began

 

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banking operations in July 1999. In 2001 we began offering mortgage services through the Bank’s Mortgage Division. We began providing securities brokerage services to the public in April 2006 through Financial’s BOTJ Investment Group, Inc. subsidiary. Following a restructuring, we now provide the securities brokerage services through Investment. Investment conducts its business primarily from one office located in the City of Lynchburg. We began offering insurance and annuity products in September 2008. Insurance currently operates out of the same location as Investment.

Although we intend to increase other sources of revenue, our operating results depend primarily upon the Bank’s net interest income, which is determined by the difference between (i) interest and dividend income on earning assets, which consist primarily of loans, investment securities and other investments, and (ii) interest expense on interest-bearing liabilities, which consist principally of deposits and other borrowings. The Bank’s net income also is affected by its provision for loan losses, as well as the level of its noninterest income, including loan fees and service charges, and its noninterest expenses, including salaries and employee benefits, occupancy expense, data processing expenses, miscellaneous other expenses, franchise taxes, and income taxes.

As discussed in more detail below,

 

   

For the year ended December 31, 2012, Financial had net income of $2,132,000, an increase of $1,532,000 from net income of $600,000, from the year ended December 31, 2011;

 

   

For the year ended December 31, 2012, the income per basic and diluted share was $0.64, as compared income of $0.18 per basic and diluted share for the year ended December 31, 2011;

 

   

Net interest income increased to $15,737,000 for the current year from $15,327,000 for the year ended December 31, 2011;

 

   

Noninterest income (exclusive of gains and losses on sales of securities) increased to $2,944,000 for the year ended December 31, 2012 from $2,498,000 for the year ended December 31, 2011;

 

   

Total assets as of December 31, 2012 were $441,381,000 compared to $427,436,000 at the end of 2011, an increase of $13,945,000 or 3.26%;

 

   

Loans (excluding loans held for sale), net of unearned income and loan loss provision, increased to $319,922,000 as of December 31, 2012 from $318,754,000 as of the end of December 31, 2011, an increase of 0.37%; and

 

   

The net interest margin increased 14 basis points to 4.03% for 2012, compared to 3.89% for 2011.

The following table sets forth selected financial ratios:

 

     For the Year Ended
December 31,
 
     2012     2011     2010  

Return on average equity

     7.76     2.25     7.27

Return on average assets

     0.50     0.14     0.44

Dividend payout %

     0.00     0.00     0.00

Average equity to total average assets

     6.39     6.24     6.01

 

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Effect of Economic Trends

The year ended December 31, 2012 continued to reflect the turbulent economic conditions and continued weakness in the financial markets which have negatively impacted the liquidity and credit quality of financial institutions in the United States. Although the banking industry began to see some improvements regarding credit quality, concerns regarding credit losses from the weak economy continued to be a concern. Nationally, financial institutions have seen significant declines in the value of collateral for real estate loans and heightened credit losses. These declines have resulted in continued high levels of nonperforming assets, charge-offs and foreclosures.

Although management cannot be certain, it expects difficult economic conditions to persist in 2013. Financial institutions likely will continue to experience some credit losses and levels of nonperforming assets, charge-offs and foreclosures that are higher than historical averages. In light of these conditions, financial institutions also face heightened levels of scrutiny from federal and state regulators. Financial institutions experienced, and are expected to continue to experience, pressure on credit costs, loan yields, deposit and other borrowing costs, liquidity, and capital.

A variety and wide scope of economic factors affect Financial’s success and earnings. Although interest rate trends are one of the most important of these factors, Financial believes that interest rates cannot be predicted with a reasonable level of confidence and therefore does not attempt to do so with complicated economic models. Management believes that the best defense against wide swings in interest rate levels is to minimize vulnerability at all potential interest rate levels. Rather than concentrate on any one interest rate scenario, Financial prepares for the opposite as well, in order to safeguard margins against the unexpected.

The downward trend in short term interest rates beginning in the last quarter of 2007 was due to the actions of the Federal Open Market Committee (“FOMC”) resulting from a deteriorating economy. The federal funds target rate set by the Federal Reserve has remained at 0.00% to 0.25% since December 2008, following a decline from 4.25% in December 2007 through a series of rate reductions. As liquidity increased as a result of open market operations and other government actions, longer-term interest rates decreased and the yield curve remains positively sloped. Although it cannot be certain, as discussed below under “Results of Operations - Net Interest Income” management believes that short term interest rates will remain stable for the foreseeable future. An increase in long-term interest rates likely would have an adverse impact on the Mortgage Division, primarily due to reduced refinancing opportunities.

Stock Dividends

On May 19, 2010, Financial declared a 10% stock dividend, which was paid on July 23, 2010 to shareholders of record on June 21, 2010. Except as otherwise described in this report, all share amounts and dollar amounts per share in this report with regard to the common stock have been adjusted to reflect these and all prior stock dividends.

Critical Accounting Policies

Financial’s financial statements are prepared in accordance with accounting principles generally accepted in the United States (GAAP). The financial information contained within our statements is, to a significant extent, based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. The Bank uses historical loss factors as one factor in determining the inherent loss that may be present in the loan portfolio. Actual losses could differ significantly from the historical factors that the Bank uses in estimating risk. In addition, GAAP itself may change from one previously acceptable method to another method. Although the economics of Financial’s transactions would be the same, the timing of events that would impact the transactions could change.

 

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The allowance for loan losses is management’s estimate of the losses that may be sustained in our loan portfolio. The allowance is based on two basic principles of accounting: (i) ASC 450, Contingencies, which requires that losses be accrued when they are probable of occurring and are reasonably estimable and (ii) ASC 310, Impairment of a Loan, which requires that losses on impaired loans be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance. Guidelines for determining allowances for loan losses are also provided in the SEC Staff Accounting Bulletin No. 102 - “Selected Loan Loss Allowance Methodology and Documentation Issues” and the Federal Financial Institutions Examination Council’s interagency guidance, “Interagency Policy Statement on the Allowance for Loan and Lease Losses” (the “FFIEC Policy Statement”).

Because Financial has a relatively short operating history, historical trends alone do not provide sufficient information to judge the adequacy of the allowance for loan losses. Therefore, management considers industry trends, peer comparisons, as well as individual classified impaired loans, in addition to historical experience to evaluate the allowance for loan losses. Our method for determining the allowance for loan losses is discussed more fully under “Asset Quality” below.

RESULTS OF OPERATIONS

December 31, 2012 compared to year ended December 31, 2011

Net Income

The net income for Financial for the year ended December 31, 2012 was $2,132,000 or $0.64 per basic and diluted share compared with net income of $600,000 or $0.18 per basic and diluted share for the year ended December 31, 2011. Note 13 of the Audited Financial Statements provides additional information with respect to the calculation of Financial’s earnings per share.

The increase of $1,532,000 in 2012 net income compared to 2011 was due in large part the following: i) a significant decrease in provisions for loan losses in 2012 as compared to 2011; ii) a slight increase in net interest income; and iii) a significant decrease in the loss on sale of other real estate owned. The increase was partially offset by a decrease in non-interest income and an increase in non-interest expense. As discussed in more detail below, we charged off $2,599,000 in nonperforming loans during the year ended December 31, 2012 as compared with $4,716,000 in 2011. The amount of the provision to the loan loss reserve was $2,289,000 in the year ended December 31, 2012 as compared to $4,807,000 in 2011.

These operating results represent a return on average shareholders’ equity of 7.76% for the year ended December 31, 2012 compared to 2.25% for the year ended December 31, 2011. The return on average assets for the year ended December 31, 2012 was 0.50% compared to 0.14% in 2011.

Net Interest Income

The fundamental source of Financial’s earnings, net interest income, is defined as the difference between income on earning assets and the cost of funds supporting those assets. The significant categories of earning assets are loans, federal funds sold, and investment securities, while deposits, fed funds purchased, and other borrowings represent 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 operation.

 

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Interest income decreased to $18,753,000 for the year ended December 31, 2012 from $19,519,000 for the year ended December 31, 2011. This decrease was due to a decrease in the yields on average earning assets which primarily consist of loans and investment securities, as discussed below.

Interest expense decreased, as discussed more fully below.

Net interest income for 2012 increased slightly $410,000 to $15,737,000 or 2.68% from net interest income of $15,327,000 in 2011. The growth in net interest income was due in large part to a decrease in our interest expense of $1,176,000 from $4,192,000 for the year ended December 31, 2011 to $3,016,000 for the year ended December 31, 2012. This decrease in interest expense was primarily due to reductions in the interest rate paid on time deposits and savings accounts, specifically savings accounts. The average interest rate paid on time deposits decreased by 36 basis points during 2012 as compared to 2011.

The net interest margin increased to 4.03% in 2012 from 3.89% in 2011. The average rate on earning assets decreased 15 basis points from 4.95% in 2011 to 4.80% in 2012 and the average rate on interest-bearing liabilities decreased from 1.20% in 2011 to 0.88% in 2012. Although management cannot predict with certainty future interest rate decisions by the FOMC, statements from the Federal Reserve Board indicate that interest rates will remain low at least as long as the unemployment rate remains above 6-1/2 percent, inflation (between one and two years ahead) is projected to be no more than half a percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.

The following table shows the average balances of total interest earning assets and total interest bearing liabilities for the periods indicated, showing the average distribution of assets, liabilities, stockholders’ equity and related revenue, expense and corresponding weighted average yields and rates. The average balances used in this table and other statistical data were calculated using average daily balances.

 

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Net Interest Margin Analysis

Average Balance Sheets

For the Year Ended December 31, 2012 and 2011

(dollars in thousands)

 

     2012     2011  
     Average
Balance
Sheet
    Interest
Income/
Expense
     Average
Rates
Earned/
Paid
    Average
Balance
Sheet
    Interest
Income/
Expense
     Average
Rates
Earned/
Paid
 

ASSETS

              

Loans, including fees (1) (2)

   $ 322,989      $ 16,956         5.25   $ 324,456      $ 17,559         5.42

Loans AFS

     1,109        42         3.79     409        13         3.18

Federal funds sold

     9,515        25         0.26     9,310        23         0.25

Securities (3)

     57,353        1,783         3.11     58,516        1,872         3.20

Federal agency equities

     1,773        60         3.38     1,976        52         2.63

CBB equity

     116        —           0.00     116        —           0.00
  

 

 

   

 

 

      

 

 

   

 

 

    

Total earning assets

     392,855        18,866         4.80     394,374        19,519         4.95
    

 

 

        

 

 

    

Allowance for loan losses

     (5,791          (5,169     

Non-earning assets

     43,279             38,308        
  

 

 

        

 

 

      

Total assets

   $ 430,343           $ 427,513        
  

 

 

        

 

 

      

LIABILITIES AND STOCKHOLDERS’ EQUITY

              

Deposits

              

Demand interest bearing

   $ 81,448      $ 235         0.29   $ 63,666      $ 346         0.54

Savings

     150,850        473         0.31     175,866        1,329         0.76

Time deposits

     92,370        1,539         1.67     84,822        1,725         2.03
  

 

 

   

 

 

      

 

 

   

 

 

    

Total interest bearing deposits

     324,668        2,247         0.69     324,354        3,400         1.05

Other borrowed funds

              

Fed funds purchased

     —          —           0.00     10        —           0.00

Repurchase agreements

     1,638        15         0.92     8,383        75         0.89

Other borrowings

     7,036        218         3.10     10,000        297         2.97

Capital notes

     8,950        537         6.00     7,000        420         6.00
  

 

 

   

 

 

      

 

 

   

 

 

    

Total interest-bearing liabilities

     342,292        3,017         0.88     349,747        4,192         1.20
    

 

 

        

 

 

    

Noninterest bearing deposits

     60,134             50,784        

Other liabilities

     443             325        
  

 

 

        

 

 

      

Total liabilities

     402,869             400,856        

Stockholders’ equity

     27,474             26,657        
  

 

 

        

 

 

      

Total liabilities and Stockholders’ equity

   $ 430,343           $ 427,513        
  

 

 

        

 

 

      

Net interest earnings

     $ 15,849           $ 15,327      
    

 

 

        

 

 

    

Net interest margin

          4.03          3.89
       

 

 

        

 

 

 

Interest spread

          3.92          3.75
       

 

 

        

 

 

 

 

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(1) Net deferred loan fees and costs are included in interest income.
(2) Nonperforming loans are included in the average balances. However, interest income and yields calculated do not reflect any accrued interest associated with nonaccrual loans.
(3) The interest income and yields calculated on securities have been tax affected to reflect any tax exempt interest on municipal securities.

Interest income and expenses are affected by fluctuations in interest rates, by changes in the volume of earning assets and interest bearing liabilities, and by the interaction of rate and volume factors. The following table shows the direct causes of the year-to-year changes in components of net interest income on a taxable equivalent basis.

 

     Volume and Rate
(dollars in thousands)
Years Ending December 31,
 
     2012     2011  
     Volume
Effect
    Rate
Effect
    Change
in

Income/
Expense
    Volume
Effect
    Rate
Effect
    Change
in
Income/
Expense
 

Loans

   $ (20   $ (554   $ (574   $ (1,180   $ (958   $ (2,138

Federal funds sold

     1        1        2        —          (1     (1

Securities

     (37     (52     (89     91        (27     64   

Restricted stock

     (4     12        8        (13     18        5   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total earning assets

     (60     (593     (653     (1,101     (969     (2,070
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Liabilities:

            

Demand interest bearing

     169        (280     (111     (566     358        (208

Savings

     (166     (690     (856     (67     (1,355     (1,422

Time deposits

     187        (373     (186     13        (509     (496

Fed funds purchased

     —          —          —          1        (3     (2

Capital notes

     117        —          117        —          —          —     

FHLB borrowings

     (93     14        (79     (48     21        (27

Repurchase agreements

     (63     3        (60     (9     (32     (41
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total interest-bearing liabilities

   $ 151      $ (1,326   $ (1,175   $ (678   $ (1,518   $ (2,196
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Change in net interest income

   $ (211   $ 733      $ 522      $ (424   $ 550      $ 126   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Noninterest Income of Financial

Noninterest income has been and will continue to be an important factor for increasing our profitability. We recognize this and our management continues to review and consider areas where noninterest income can be increased. Noninterest income (excluding securities gains and losses) consists of mortgage loan origination fees, service fees, distributions from a title insurance agency in which we have an

 

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ownership interest, and fees generated by the investment services of Investment. Service fees consist primarily of monthly service and minimum account balance fees and charges on transactional deposit accounts, overdraft charges, and ATM service fees.

The Bank, through the Mortgage division originates both conforming and non-conforming consumer residential mortgage loans primarily in the Region 2000 area. As part of the Bank’s overall risk management strategy, all of the loans originated and closed by the Mortgage division are presold to mortgage banking or other financial institutions. The Mortgage division assumes no credit or interest rate risk on these mortgages.

The Mortgage Division originated 335 mortgage loans, totaling $59,286,000 in 2012 as compared with 290 mortgage loans, totaling $49,481,000 during the year ended December 31, 2011. In 2012, the Mortgage Division faced an improving real estate market and loans for new home purchase comprised 37% of the total volume. Refinancing increased significantly in response to continued historical low interest rates. For the year ended December 31, 2012, the Mortgage Division accounted for 5.62% of Financial’s total revenue as compared with 4.49% of Financial’s total revenue for the year ended December 31, 2011. Mortgage contributed $270,000 and $159,000 to Financial’s pre-tax net income in 2012 and 2011, respectively. Although management anticipates that residential mortgage rates will remain low by historical standards throughout 2013, management also anticipates that if rates trend higher, the loan mix will shift towards new home purchases and away from refinancing. The Mortgage Division continues to improve its market share in Region 2000. Management expects that low rates coupled with the Mortgage Division’s reputation in Region 2000 will allow us to continue to grow revenue at the Mortgage Division.

Service charges and fees and commissions increased to $1,230,000 for the year ended December 31, 2012 from $1,149,000 for the year ended December 31, 2011. This increase was due in large part to an increase in debit card fees, which increased $86,000 from $505,000 for the year ended December 31, 2011 to $591,000 for the year ended December 31, 2012. The increase was offset in part by a decrease in commissions earned on the sale of securities to $51,000 for the year ended December 31, 2012 from $69,000 for the year ended December 31, 2011.

Our Investment division provides brokerage services through an agreement with a third-party broker-dealer. Pursuant to this arrangement, the third party broker-dealer operates a service center adjacent to one of the branches of the Bank. The center is staffed by dual employees of the Bank and the broker-dealer. Investment receives commissions on transactions generated and in some cases ongoing management fees such as mutual fund 12b-1 fees. The Investment division’s financial impact on our consolidated revenue has been immaterial. Although management cannot predict the financial impact of Investment with certainty, management anticipates it will continue to be an immaterial component of revenue in 2013.

In the third quarter of 2008, we began providing insurance and annuity products to Bank customers and others, through the Bank’s Insurance subsidiary. The Bank has one full-time and one part-time employee that are dedicated to selling insurance products through Insurance. Insurance generates minimal revenue and its financial impact on our consolidated revenue has been immaterial. Management anticipates that Insurance’s impact on noninterest income will remain immaterial in 2013.

Noninterest income, exclusive of gains and losses on sale of securities, increased to $2,944,000 in 2012 from $2,498,000 in 2011. Inclusive of gains and losses on sale of securities, noninterest income decreased slightly to $3,618,000 in 2012 from $3,680,000 in 2011. The following table summarizes our noninterest income for the periods indicated.

 

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     Noninterest Income
(dollars in thousands)
December 31,
 
     2012      2011  

Mortgage fee income

   $ 1,257       $ 1,042   

Service charges, fees and commissions

     1,230         1,149   

Increase in cash value of life insurance

     323         249   

Other

     134         58   

Gain on sale of available-for-sale securities

     674         1,182   
  

 

 

    

 

 

 

Total noninterest income

   $ 3,618       $ 3,680   
  

 

 

    

 

 

 

The decrease in noninterest income for 2012 as compared to 2011 was due to a decrease in gains on sales of available-for-sale securities. These gains were largely offset by increases in the other categories of non-interest income, particularly mortgage fee income. Mortgage fee income increased due to the factors discussed previously.

Noninterest Expense of Financial

Noninterest expenses increased from $13,693,000 for the year ended December 31, 2011 to $14,391,000 for the year ended December 31, 2012. The following table summarizes our noninterest expense for the periods indicated.

 

     Noninterest Expense  
     (dollars in thousands)  
     December 31,  
     2012      2011  

Salaries and employee benefits

   $ 6,529       $ 5,668   

Occupancy

     1,150         1,091   

Equipment

     991         1,038   

Supplies

     386         365   

Professional, data processing and other outside expenses

     2,033         2,139   

Marketing

     382         333   

Credit expense

     225         257   

Loss on sale and/or writedown of other real estate owned

     930         1,021   

Amortization of tax credit investment

     247         247   

FDIC insurance expense

     579         661   

Other

     939         873   
  

 

 

    

 

 

 

Total noninterest expense

   $ 14,391       $ 13,693   
  

 

 

    

 

 

 

The increase in noninterest expense was due in large part to an increase in salaries. The increase in these costs was partially offset by a decrease in professional, data processing, and other outside expenses and the loss on the sale or writedown of OREO. Our total personnel expense, net of fees collected from borrowers to cover direct salary costs incurred in originating certain loans (in accordance with current accounting rules), increased to $6,529,000 for the year ended December 31, 2012, from $5,668,000 for the twelve months ended December 31, 2011. Compensation for some employees of the Mortgage Division and Investment is commission-based and therefore subject to fluctuation. Because of increased volume of business at Mortgage, commission compensation and the corresponding employee benefits increased significantly, in 2012. Because of an increase in the number of customers and accounts and additional services offered, our data processing expense increased from $926,000 in 2011 to $1,110,000 in 2012. The Bank’s occupancy expense also increased in large part due to increases in rent and increases in operating supplies and maintenance.

 

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The efficiency ratio, that is the cost of producing each dollar of revenue, is determined by dividing noninterest expense by the sum of net interest income plus noninterest income. Financial’s efficiency ratio increased from 70.74% in 2011 to 74.35% in 2012, in large part due to the increases in the above expenses. Management intends that additional interest earning assets will help further lower the efficiency ratio.

Income Tax Expense

For the year ended December 31, 2012, Financial had a federal income tax expense of $543,000, as compared to a federal income tax benefit of $93,000 in 2011. Although we had net income, our tax expense was decreased in both 2012 and 2011 from federal income tax benefits resulting from the tax treatment of earnings on bank owned life insurance, certain tax free municipal securities, and tax credits. Note 12 of the Audited Financial Statements provides additional information with respect to our 2012 federal income tax expense and the deferred tax accounts.

ANALYSIS OF FINANCIAL CONDITION

As of December 31, 2012 and December 31, 2011

General

Our total assets were $441,381,000 at December 31, 2012, an increase of $13,945,000 or 3.26% from $427,436,000 at December 31, 2011, primarily due to an increase in cash and cash equivalents, securities available-for-sale (which was offset in part by a decrease in securities held-to-maturity), and the cash value of bank-owned life insurance. As explained in more detail below, deposits increased from $374,234,000 on December 31, 2011 to $399,015,000 on December 31, 2012. Loans, net of unearned income and allowance, increased slightly to $319,922,000 on December 31, 2012 from $318,754,000 on December 31, 2011.

Loans

Our loan portfolio is the largest and most profitable component of our earning assets. The Bank has comprehensive policies and procedures which cover both commercial and consumer loan origination and management of credit risk. Loans are underwritten in a manner that focuses on the borrower’s ability to repay. Management’s goal is not to avoid risk, but to manage it and to include credit risk as part of the pricing decision for each product.

The Bank’s loan portfolio consists of commercial short-term lines of credit, term loans, mortgage financing and construction loans that are used by the borrower to build or develop real estate properties, and consumer loans. The consumer portfolio includes residential real estate mortgages, home equity lines and installment loans.

Loans, net of unearned income and allowance, increased slightly to $319,922,000 on December 31, 2012 from $318,754,000 on December 31, 2011. Total loans, including loans held for sale increased to $326,361,000 on December 31, 2012 from $324,800,000 on December 31, 2011. The increase in was relatively slight because of increased competition and limited applications from qualified borrowers. Management expects that the number of qualified borrowers will remain limited until the economy further improves.

As of December 31, 2012, the Bank had $6,346,000, or 1.96% of its total loans, in non-accrual status compared with $10,375,000, or 3.21% of its total loans, at December 31, 2011. This decrease is due primarily to efforts to reduce non-performing assets through enhanced collection efforts and the liquidation

 

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of underlying collateral. The Bank attempts to work with borrowers on a case-by-case basis to attempt to protect the Bank’s interests. However, despite our commitment, continued reduction of non-accrual loans can be dependent on improvements in employment, housing, and overall economic conditions at the local, regional and national levels. See “Asset Quality” below.

The following table summarizes the composition of the Bank’s loan portfolio for the periods indicated by dollar amount:

 

     Loan Portfolio
(dollars in thousands)
December 31,
 
     2012      2011      2010      2009      2008  

Commercial

   $ 55,084       $ 59,623       $ 62,786       $ 60,045       $ 51,675   

Commercial real estate

     153,416         150,622         143,428         141,530         121,800   

Consumer

     70,639         72,488         68,289         67,744         58,300   

Residential

     46,318         41,633         51,679         53,421         45,974   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total loans

     325,457         324,366         326,182         322,740         277,749   

Less allowance for loan losses

     5,535         5,612         5,467         4,288         2,859   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Net loans

   $ 319,922       $ 318,754       $ 320,715       $ 318,452       $ 274,890   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

The following table sets forth the maturities of the loan portfolio at December 31, 2012.

 

     Remaining Maturities of Selected Loans
(dollars in thousands)
At December 31, 2012
 
     Less than  One
Year
     One to  Five
Years
    Greater than  Five
Years
     Total  

Commercial

   $ 24,445       $ 12,841      $ 17,798       $ 55,084   

Commercial real estate

     19,883         15,871        117,662         153,416   

Consumer

     2,421         21,471        46,747         70,639   

Residential

     7,176         4,834        34,308         46,318   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total

   $ 53,925       $ 55,017      $ 216,515       $ 325,457   

For maturities over one year:

          

Fixed Rates

   $ 80,845         29.78     

Variable Rates

     190,687         70.22     
  

 

 

         

Total

   $ 271,532           

 

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Deposits

We experienced an increase in deposits from $374,234,000 at December 31, 2011 to $399,015,000 at December 31, 2012, for an increase of 6.62%. Noninterest-bearing deposits increased $11,348,000 or 20.42% from $55,569,000 at December 31, 2011 to $66,917,000 at December 31, 2012. The increase in non-interest bearing deposits was due almost entirely to amounts deposited in professional settlement accounts for end of the year real estate and business closings. This caused an equivalent increase in total deposits. Interest-bearing deposits increased $13,433,000 from $318,665,000 at December 31, 2011 to $332,098,000 at December 31, 2012. This 4.22% increase in interest bearing deposits was due primarily to a desire by customers to keep assets liquid in the event of an increase in rates and the Bank’s decision to offer interest on business demand accounts in lieu of non-FDIC insured sweep accounts. As a result, the funds held in the sweep accounts ($8,379,000 as of December 31, 2011) were reclassified as interest bearing deposits.

The following table sets forth the average deposit balance and the rates paid on deposits for the years indicated:

 

     Average Deposits and Rates Paid
(dollars in thousands)
Year Ended December 31,
 
     2012     2011     2010  
     Amount      Rate     Amount      Rate     Amount      Rate  

Noninterest-bearing deposits

   $ 60,134         —        $ 50,784         —        $ 45,293         —     
  

 

 

      

 

 

      

 

 

    

Interest-bearing deposits

               

Interest checking

   $ 38,447         0.28   $ 23,766         0.44   $ 21,324         0.75

Money market

     43,001         0.30     39,900         0.61     33,193         1.20

Savings

     150,850         0.31     175,866         0.76     179,998         1.52

Time deposits

               

Less than $100,000

     55,873         1.65     51,926         2.00     51,930         2.61

Greater than $100,000

     36,497         1.70     32,896         2.08     32,389         2.67
  

 

 

      

 

 

      

 

 

    

Total interest-bearing deposits

   $ 324,668         0.69   $ 324,354         1.05   $ 318,834         1.73
  

 

 

      

 

 

      

 

 

    

Total deposits

   $ 384,802         $ 375,138         $ 364,127      
  

 

 

      

 

 

      

 

 

    

The following table includes a summary of average deposits and average rates paid and maturities of CDs greater than $100,000.

 

     Maturities of CD’s Greater than $ 100,000  
     (dollars in thousands)  
     Less  than
Three
Months
     Three to
Six
Months
     Six  to
Twelve
Months
     Greater
than One
Year
     Total  

At December 31, 2012

   $ 4,801       $ 4,888       $ 7,063       $ 19,806       $ 36,558   

Cash and Cash Equivalents

Cash and cash equivalents increased from $23,340,000 on December 31, 2011 to $40,998,000 on December 31, 2012. Federal funds sold increased from $5,662,000 on December 31, 2011 to $24,171,000 on December 31, 2012. These increases were due primarily to routine fluctuations in deposits and the fluctuations in transactional accounts and professional settlement accounts as discussed above.

 

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Table of Contents

Investment Securities

The investment securities portfolio of the Bank is used as a source of income and liquidity.

The following table summarizes the fair value of the Bank’s securities portfolio for the periods indicated:

 

     Securities Portfolio
(dollars in thousands)
December 31,
 
     2012      2011      2010  

Held-to-maturity

        

U.S. agency obligations

   $ 3,417       $ 8,533       $ 14,601   
  

 

 

    

 

 

    

 

 

 

Available-for-sale

        

U.S. agency obligations

     23,069         25,485         14,341   

Mortgage - backed securities

     1,812         3,939         17,762   

Municipals

     22,804         18,914         5,465   

Corporates

     2,609         —           1,018   
  

 

 

    

 

 

    

 

 

 

Total available-for-sale

   $ 50,294       $ 48,338       $ 38,586   
  

 

 

    

 

 

    

 

 

 

Deposited funds are generally invested in overnight vehicles, including federal funds sold, until approved loans are funded. The decision to purchase investment securities is based on several factors or a combination thereof, including:

a) The fact that yields on acceptably rated investment securities (S&P “A” rated or better) are significantly better than the overnight federal funds rate;

b) Whether demand for loan funding exceeds the rate at which deposits are growing, which leads to higher or lower levels of surplus cash;

c) Management’s target of maintaining a minimum of 6% of the Bank’s total assets in a combination of federal funds sold and investment securities (aggregate of available–for-sale and held-to-maturity portfolios); and

d) Whether the maturity or call schedule meets management’s asset/liability plan.

Available-for-sale securities (as opposed to held-to-maturity securities) may be liquidated at any time as funds are needed to fund loans. Liquidation of securities may result in a net loss or net gain depending on current bond yields available in the primary and secondary markets and the shape of the U.S. Treasury yield curve. Management is cognizant of its credit standards policy and does not feel pressure to maintain loan growth at the same levels as deposit growth and thus sacrifice credit quality in order to avoid security purchases.

Management has made the decision to maintain a significant portion of its available funds in liquid assets so that funds are available to fund future growth of the loan portfolio. Management believes that this strategy will allow us to maximize interest margins while maintaining appropriate levels of liquidity.

Securities held-to-maturity decreased from $8,133,000 as of December 31, 2011 to $3,075,000 as of December 31, 2012. This decrease resulted in large part by certain issuers exercising their contractual right to redeem (call) certain of the securities. The decision to invest in securities held-to-maturity is based

 

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Table of Contents

on the same factors as the decision to invest in securities available-for-sale except that management invests surplus funds in securities held-to-maturity only after concluding that such funds will not be necessary for liquidity purposes during the term of such security. However, the held-to-maturity securities may be pledged for such purposes as short term borrowings and as collateral for public deposits.

The portfolio of securities available-for-sale increased to $50,294,000 as of December 31, 2012 from $48,338,000 as of December 31, 2011. During 2012, the Bank purchased available-for-sale securities in the amount of $44,343,000 in order to maintain the ability to fund loans if demand and quality of credits increased.

The following table shows the maturities of held-to-maturity and available-for-sale securities at amortized cost and market value at December 31, 2012 and December 31, 2011 and approximate weighted average yields of such securities. Yields on state and political subdivision securities are not shown on a tax equivalent basis. Financial attempts to maintain diversity in its portfolio and maintain credit quality and repricing terms that are consistent with its asset/liability management and investment practices and policies. For further information on Financial’s securities, see Note 4 to the consolidated financial statements included in Item 8 of this Form 10-K.

 

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Table of Contents
     Securities Portfolio Maturity Distribution /Yield Analysis  
     (dollars in thousands)  
     At December 31, 2012  
     Less
than
One
Year
     One to
Five
Years
    Five to
Ten
Years
    Greater
than Ten
Years and
Other
Securities
    Total  

Held-to-maturity

           

U.S. agency

           

Amortized cost

   $  —         $ —        $ 2,062      $ 1,013      $ 3,075   

Market value

   $ —         $ —        $ 2,369      $ 1,048      $ 3,417   

Weighted average yield

          4.00     4.05  

Available-for-sale securities

           

U.S. agency

           

Amortized cost

   $ —         $ —        $ 5,985      $ 16,995      $ 22,980   

Market value

   $ —         $ —        $ 5,997      $ 17,072      $ 23,069   

Weighted average yield

          1.95     2.85  

Mortgage Backed Securities

           

Amortized cost

   $ —         $ —        $ —        $ 1,805      $ 1,805   

Market value

   $ —         $ —        $ —        $ 1,812      $ 1,812   

Weighted average yield

            1.53  

Municipals

           

Amortized cost

   $ —         $ 479      $ 4,030      $ 17,590      $ 22,099   

Market value

   $ —         $ 480      $ 4,158      $ 18,166      $ 22,804   

Weighted average yield

        5.60     2.29     3.23  

Corporates

           

Amortized cost

   $ —         $ 500      $ 2,048      $ —        $ 2,548   

Market value

   $ —         $ 500      $ 2,109      $ —        $ 2,609   

Weighted average yield

        1.50     2.97    

Total portfolio

           

Amortized cost

   $ —         $ 979      $ 14,125      $ 37,403      $ 52,507   

Market value

   $ —         $ 980      $ 14,633      $ 38,098      $ 53,711   

Weighted average yield

        3.51     2.50     3.00  

 

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Table of Contents
     Securities Portfolio Maturity Distribution / Yield Analysis  
     (dollars in thousands)  
     At December 31, 2011  
     Less
than
One
Year
     One to
Five
Years
     Five to
Ten
Years
    Greater
than Ten
Years and
Other
Securities
    Total  

Held-to-maturity

            

U.S. agency

            

Amortized cost

   $  —         $  —         $ 2,072      $ 6,061      $ 8,133   

Market value

   $ —         $ —         $ 2,362      $ 6,171      $ 8,533   

Weighted average yield

           4.00     3.63  

Available-for-sale securities

            

U.S. agency

            

Amortized cost

   $ —         $ —         $ 6,146      $ 19,270      $ 25,416   

Market value

   $ —         $ —         $ 6,157      $ 19,328      $ 25,485   

Weighted average yield

           2.63     2.85  

Mortgage Backed Securities

            

Amortized cost

   $ —         $ —         $ —        $ 3,938      $ 3,938   

Market value

   $ —         $ —         $ —        $ 3,939      $ 3,939   

Weighted average yield

             2.18  

Municipals

            

Amortized cost

   $ —         $ —         $ 1,138      $ 17,924      $ 19,062   

Market value

   $ —         $ —         $ 1,204      $ 17,710      $ 18,914   

Weighted average yield

           4.39     3.52  

Total portfolio

            

Amortized cost

   $ —         $ —         $ 9,356      $ 47,193      $ 56,549   

Market value

   $ —         $ —         $ 9,723      $ 47,148      $ 56,871   

Weighted average yield

           3.15     3.15  

 

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Table of Contents

Cash surrender value of bank owned life insurance

On July 1, 2009, the Company funded bank owned life insurance (BOLI) for a chosen group of its officers, where the Company is the owner and sole beneficiary of the policies. As of December 31, 2012, the BOLI had a cash surrender value of $8,931,000, an increase of $322,000 from the cash surrender value of $8,609,000 as of December 31, 2011. The increase resulted from an increase in the cash surrender value relating to the aggregate earnings on all of the BOLI policies. The value of BOLI increases from the cash surrender values of the pool of insurance. The increase in cash surrender value is recorded as a component of noninterest income; however, the Company does not pay tax on increase in cash value. This profitability is used to offset a portion of current and future employee benefit costs. BOLI can be liquidated if necessary with associated tax costs. However, the Company intends to hold this pool of insurance, because it provides income that enhances the Company’s capital position. Therefore, the Company has not provided for deferred income taxes on the earnings from the increase in cash surrender value.

Liquidity

Liquidity represents the ability of a company to convert assets into cash or cash equivalents without significant loss, and the ability to raise additional funds by increasing liabilities.

The liquidity of Financial depends primarily on Financial’s current assets, available credit, and the dividends paid to it by the Bank. Payment of cash dividends by the Bank is limited by regulations of the Federal Reserve Board and is tied to the regulatory capital requirements. Although Financial’s liquidity is limited, management believes that Financial has sufficient liquidity to meet its current obligations. See “Capital Resources,” below.

The objective of liquidity management for the Bank is to ensure the continuous availability of funds to meet the demands of depositors, investors and borrowers. Liquidity management involves monitoring the Bank’s sources and uses of funds in order to meet the day-to-day cash flow requirements while maximizing profits. Stable core deposits and a strong capital position are the components of a solid foundation for the Bank’s liquidity position. Liquidity management is made more complicated because different balance sheet components are subject to varying degrees of management control. For example, the timing of maturities of securities held-to-maturity is fairly predictable and subject to a high degree of control at the time investment decisions are made. However, net deposit inflows and outflows are far less predictable and are not subject to the same degree of control.

Funding sources for the Bank primarily include paid-in capital and customer-based deposits but also include borrowed funds and cash flow from operations. The Bank has in place several agreements that will provide alternative sources of funding, including, but not limited to, lines of credit, sale of investment securities, purchase of federal funds, advances through the Federal Home Loan Bank of Atlanta (“FHLBA”) and correspondents, and brokered certificate of deposit arrangements. Management believes that the Bank has the ability to meet its liquidity needs.

At December 31, 2012, liquid assets, which include cash, interest-bearing and noninterest-bearing deposits with banks, federal funds sold, and securities available-for-sale totaled $91,292,000 on December 31, 2012 as compared to $71,678,000 at December 31, 2011. Investment securities traditionally provide a secondary source of liquidity since they can be converted into cash in a timely manner. However, approximately $7,680,000 of these securities are pledged against outstanding debt, public deposits, or lines of credit. Therefore, the related debt would need to be repaid prior to the securities being sold in order for these securities to be converted to cash.

 

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Table of Contents

The following table sets forth non-deposit sources of funding:

 

Funding Sources

(dollars in thousands)

 
     December 31, 2012  

Source

   Capacity      Outstanding      Available  

Fed funds purchased lines (unsecured)

   $ 18,000       $ —         $ 18,000   

Reverse repurchase agreements

     3,000         —           3,000   

Borrowings from FHLB Atlanta

     85,240         2,000         83,240   
  

 

 

    

 

 

    

 

 

 

Total

   $ 106,240       $ 2,000       $ 104,240   
  

 

 

    

 

 

    

 

 

 

At the end of 2012, approximately 75.17%, or $244,612 of the loan portfolio would mature or could reprice within a one-year period. At December 31, 2012, non-deposit sources of available funds totaled $104,240,000, which included $83,240,000 available from the FHLBA.

Capital Resources

Capital adequacy is an important measure of financial stability and performance. Management’s objectives are to maintain a level of capitalization that is sufficient to sustain asset growth and promote depositor and investor confidence.

Regulatory agencies measure capital adequacy utilizing a formula that takes into account the individual risk profiles of financial institutions. The guidelines define capital as Tier 1 (primarily common stockholders’ equity, defined to include certain debt obligations) and Tier 2 (remaining capital generally consisting of a limited amount of subordinated debt, certain hybrid capital instruments and other debt securities, preferred stock and a limited amount of the general valuation allowance for loan losses). The Bank’s regulatory capital levels exceed those established for well-capitalized institutions. The following table (along with Note 17 of the Audited Financial Statements) shows the minimum capital requirements and the Bank’s capital position as of December 31, 2012 and 2011.

 

Analysis of Capital for Bank of the James (Bank only)

(dollars in thousands)

 
     December 31,  
     2012      2011  

Tier 1 Capital:

     

Common stock

   $ 3,742       $ 3,742   

Additional paid in capital

     19,325         19,325   

Retained earnings

     13,006         10,394   
  

 

 

    

 

 

 

Total Tier 1 Capital

   $ 36,073       $ 33,461   
  

 

 

    

 

 

 

Tier 2 Capital:

     

Allowable portion of allowance for loan losses

     4,064         3,991   
  

 

 

    

 

 

 

Total Tier 2 Capital

   $ 4,064       $ 3,991   
  

 

 

    

 

 

 

Total risk-based capital

   $ 40,137       $ 37,452   
  

 

 

    

 

 

 

Risk weighted assets

   $ 323,655       $ 317,684   

Average total assets

   $ 428,851       $ 427,680   

 

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Table of Contents
                 Regulatory Minimums  
     December 31,     Capital
Adequacy
    Well
Capitalized
 
     2012     2011      

Capital Ratios

        

Tier 1 capital to average total assets

     8.41     7.82     4.00     5.00

Tier 1 risk-based capital ratio

     11.15     10.53     4.00     6.00

Total risk-based capital ratio

     12.40     11.79     8.00     10.00

The Bank, as predecessor to Financial, was initially capitalized through a public offering of its common stock, $4.00 (split adjusted to $2.14) par value per share (“Common Stock”), at $10.00 per share, which concluded in February, 1999 and resulted in a capitalization of the Bank of $9,356,300. On December 22, 2006, Financial completed a follow-on offering pursuant to which it raised $5,147,000 (net of costs and expenses of $106,000).

In 2009, Financial completed a private placement of unregistered debt securities pursuant to which it issued notes to accredited investors in an amount of $7,000,000 (the “2009 Notes”). The debt issued pursuant to this offering bore interest at the rate of 6% per year with interest payable quarterly in arrears. The first interest payment was due and paid on July 1, 2009. Financial used $6,000,000 of the proceeds to provide additional capital to the Bank. Financial retained $1,000,000 which it has used in part to service interest payments on the debt. The 2009 Notes were paid in full upon maturing on April 1, 2012 with proceeds from the private placement described in the following paragraph.

During the third quarter, Financial closed a private placement of unregistered debt securities (the “2012 Offering”) pursuant to which Financial issued $10,000,000 in principal of notes (the “2012 Notes”). The 2012 Notes have not been and will not be registered under the Securities Act of 1933 and may not be offered or sold in the United States absent registration or an applicable exemption from registration requirements. The 2012 Notes bear interest at the rate of 6% per year with interest payable quarterly in arrears. The 2012 Notes mature on April 1, 2017, but are subject to prepayment in whole or in part on or after April 1, 2013 at Financial’s sole discretion on 30 days written notice to the holders. Financial used $7,000,000 of the proceeds from the 2012 Offering to pay on maturity the principal due on 2009 Notes.

The proceeds from the 2012 Offering, existing capital, and funds generated from operations provide Financial with sufficient liquidity and capital with which to operate.

The capital ratios set forth in above tables state the capital position and analysis for the Bank only. Because total assets on a consolidated basis are less than $500,000,000, Financial is not subject to the consolidated capital requirements imposed by the Bank Holding Company Act. Consequently, Financial does not calculate its financial ratios on a consolidated basis. If calculated, the capital ratios for the Company on a consolidated basis would no longer be comparable to the capital ratios of the Bank because the proceeds of these private placements do not qualify as equity capital on a consolidated basis.

In December 2010, the Basel Committee on Banking Supervision (the Basel Committee) released its final framework for strengthening international capital and liquidity regulation, now officially identified by the Basel Committee as “Basel III.” Basel III, when implemented by the U.S. banking agencies and fully phased-in, will require bank holding companies and their bank subsidiaries to maintain substantially more capital, with a greater emphasis on common equity. Implementation is presently scheduled to be phased in between 2014 and 2019, although it is possible that implementation may be delayed.

In addition to Basel III, Dodd-Frank requires or permits the U.S. banking agencies to adopt regulations affecting banking institutions’ capital requirements in a number of respects, including

 

37


Table of Contents

potentially more stringent capital requirements for systemically important financial institutions. Accordingly, the regulations ultimately applicable to the Company may be substantially different from the Basel III final framework as published in December 2010. Requirements to maintain higher levels of capital or to maintain higher levels of liquid assets could adversely impact the Company’s net income and return on equity.

Stockholder’s Equity

Stockholders’ equity increased by $2,808,000 from $26,805,000 on December 31, 2011 to $29,613,000 on December 31, 2012 because of the net income of $2,132,000, plus the adjustment for other comprehensive income, in the year ended December 31, 2012.

ASSET QUALITY

We perform monthly reviews of all delinquent loans and loan officers are charged with working with customers to resolve potential payment issues. We generally classify a loan as nonaccrual when interest it is deemed uncollectible or when the borrower is 90 days or more past due. We generally restore a loan if i) a borrower is no longer 90 days past due on the loan and the borrower has demonstrated the capacity to repay the loan for six consecutive months or ii) the loan committee of the Board of Directors determines that a borrower has the capacity to repay the loan.

During 2012, our asset quality improved. Specifically, we have been successful in resolving a significant portion of our problem assets. These problem assets resulted from the economic downturn, which severely impacted commercial development loans and residential speculative housing construction loans due in part to a decline in the value of the collateral supporting those loans. Although asset quality improved in 2012, management intends to continue to be proactive in quantifying and mitigating the ongoing risk. Non-accrual loans decreased to $6,346,000 on December 31, 2012 from $10,375,000 on December 31, 2011. Management has provided for the anticipated losses on its non-accrual loans in the allowance for loan loss.

We also classify other real estate owned (OREO) as a nonperforming asset. OREO is the value of real property acquired by the Bank either at a foreclosure sale of collateral on which the Bank has a lien or by deed in lieu of foreclosure. OREO decreased 35.08% to $2,112,000 on December 31, 2012 from $3,253,000 on December 31, 2011. The following table represents the changes in OREO balance in 2012 and 2011.

OREO Changes

(Dollars in Thousands)

 

     Year Ended December 31,  
     2012     2011  

Balance at the beginning of the year (net)

   $ 3,253      $ 3,440   

Transfers from Loans

     2,070        4,619   

Transfer from premises and equipment

     —          —     

Capitalized Costs

     5        20   

Write-downs to OREO expense

     (650     (395

Sales proceeds

     (2,489     (3,944

Gain (loss) on disposition

     (77     (487
  

 

 

   

 

 

 

Balance at the end of the year (net)

   $ 2,112      $ 3,253   
  

 

 

   

 

 

 

We also classify troubled debt restructurings (TDRs) as both performing and nonperforming assets. We measure 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. We maintain a valuation allowance to the extent

 

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that the measure of the impaired loan is less than the recorded investment. TDRs occur when we agree to significantly modify the original terms of a loan by granting a concession due to the deterioration in the financial condition of the borrower. TDRs are considered impaired loans. These concessions typically are made for loss mitigation purposes and could include reductions in the interest rate, payment extensions, forgiveness of principal, forbearance or other actions. Performing TDRs decreased to $572,000 on December 31, 2012 from $783,000 on December 31, 2011.

The following table sets forth the number of outstanding TDR contracts and the total amount of the Bank’s TDRs as of December 31, 2012 and 2011.

Troubled Debt Restructurings

(Dollars in Thousands)

 

     December 31,  
     2012      2011  

Number of performing TDR contracts

     3         3   

Number of nonperforming TDR contracts

     —           2   
  

 

 

    

 

 

 

Total number of TDR contracts

     3         5   
  

 

 

    

 

 

 

Amount of performing TDR contracts

   $ 572       $ 783   

Amount of nonperforming TDR contracts

     —           1,935   
  

 

 

    

 

 

 

Total amount of TDRs contracts

   $ 572       $ 2,718   
  

 

 

    

 

 

 

The amount allocated during the year to the provision for loan losses represents management’s analysis of the existing loan portfolio and credit risks. Management’s policy is to maintain the allowance for loan losses at a level sufficient to absorb the estimated losses inherent in the loan portfolio. Both the amount of the provision and the level of the allowance for loan losses are impacted by many factors, including general economic conditions, actual and expected credit losses, loan performance measures, historical trends and specific conditions of the individual borrower.

In performing its loan loss analysis, the Bank assigns a risk rating to each commercial loan in the Bank’s portfolio.

The Bank’s allowance for loan losses decreased 1.37% from $5,612,000 on December 31, 2011 to $5,535,000 on December 31, 2012. This decrease resulted primarily from the current economic conditions and recent historic charge-off trends and reflects a slight increase in the balances in the Bank’s loan portfolio. Impairment resulting from the individual impairment analysis (ASC 310) decreased and the overall reserve decreased slightly because of the application of the Bank’s loan rating system. The decrease in reserve was partially offset by a slight increase in general reserves (ASC 450). As of December 31, 2012 the allowance for loan losses was equal to 1.70% of the total loan portfolio as compared with 1.73% at December 31, 2011.

No nonaccrual loans were excluded from impaired loan disclosure under current accounting rules at December 31, 2012 and 2011. If interest on these loans had been accrued, such income would have approximated $862,000 and $1,259,000 for 2012 and 2011, respectively. Loan payments received on nonaccrual loans are applied to principal. When a loan is placed on non-accrual status there are several negative implications. First, all interest accrued but unpaid at the time of the classification is deducted from the interest income totals for the Bank. Second, accruals of interest are discontinued until it becomes certain that both principal and interest can be repaid. Third, there may be actual losses that necessitate additional provisions for credit losses charged against earnings. These loans were included in the nonperforming loan totals listed below.

 

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The following table sets forth the detail of loans charged-off, recovered, and the changes in the allowance for loan losses as of the dates indicated:

 

     Allowance for Loan Losses  
     (dollars in thousands)  
     At December 31,  
     2012      2011      2010      2009      2008  

Balance, beginning of period

   $ 5,612       $ 5,467       $ 4,288       $ 2,859       $ 2,146   

Loans charged-off:

              

Commercial

     739         702         845         733         379   

Commercial real estate

     1,061         2,738         300         917         31   

Consumer

     697         817         369         918         82   

Residential

     102         459         385         229         197   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total loans charged off

   $ 2,599       $ 4,716       $ 1,899       $ 2,797       $ 689   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Recoveries:

              

Commercial

   $ 18       $ 16       $ 132       $ 35       $ 17   

Commercial real estate

     129         3         —           —           —     

Consumer

     77         31         119         —           —     

Residential

     9         4         44         40         30   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total recoveries

   $ 233       $ 54       $ 295       $ 75       $ 47   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Net charge-offs

   $ 2,366       $ 4,662       $ 1,604       $ 2,722       $ 642   

Provision for loan losses

     2,289         4,807         2,783         4,151         1,355   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Balance, end of period

   $ 5,535       $ 5,612       $ 5,467       $ 4,288       $ 2,859   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

The following table shows the balance and percentage of the Bank’s allowance for loan losses allocated to each major category of loans:

 

     Allocation of Allowance for Loan Losses  
     (dollars in thousands)  
     At December 31,  
     2012     2011     2010     2009     2008  
   Amount      Percent
of Loans
to Total
Loans
    Amount      Percent
of Loans
to Total
Loans
    Amount      Percent of
Loans to
Total
Loans
    Amount      Percent
of Loans
to Total
Loans
    Amount      Percent
of Loans
to Total
Loans
 

Commercial

   $ 987         16.93   $ 892         18.36   $ 473         19.25   $ 777         18.60   $ 536         19.03

Commercial - real estate

     2,849         47.14     2,677         46.37     2,897         43.97     697         52.44     1,864         49.27

Consumer

     1,057         21.70     1,486         22.31     1,207         20.94     619         19.00     305         16.04

Residential

     642         14.23     557         12.96     890         15.84     2,195         9.96     154         15.66
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 
   $ 5,535         100.00   $ 5,612         100.00   $ 5,467         100.00   $ 4,288         100.00   $ 2,859         100.00
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

 

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Table of Contents

The following table provides information on the Bank’s nonperforming assets as of the dates indicated:

 

     Nonperforming Assets  
     (dollars in thousands)  
     At December 31,  
     2012     2011     2010     2009     2008  

Nonaccrual loans

   $ 6,346      $ 10,376      $ 8,366      $ 5,687      $ 3,859   

Foreclosed property (OREO)

     2,112        3,253        3,440        666        81   

Loans past due 90 days accruing interest

     —          —          —          —          —     
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total nonperforming assets

   $ 8,458      $ 13,629      $ 11,806      $ 6,353      $ 3,940   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Restructured loans - performing portion (TDR)

   $ 572      $ 783      $ 4,987      $ 916      $ —     

Allowance for loan losses to period end loans

     1.70     1.73     1.68     1.33     1.03

Nonperforming assets to period end loans

     2.60     4.20     3.62     2.25     1.39

Net charge-offs (recoveries) to average loans

     0.74     1.44     0.49     0.90     0.26

Allowance for loan losses to non-performing loans

     87.22     54.09     65.35     75.40     74.09

Interest Rate Sensitivity

The most important element of asset/liability management is the monitoring of Financial’s sensitivity to interest rate movements. The income stream of Financial is subject to risk resulting from interest rate fluctuations to the extent there is a difference between the amount of Financial’s interest earning assets and the amount of interest bearing liabilities that prepay, mature or reprice in specified periods. Management’s goal is to maximize net interest income with acceptable levels of risk to changes in interest rates. Management seeks to meet this goal by influencing the maturity and re-pricing characteristics of the various lending and deposit taking lines of business and by managing discretionary balance sheet asset and liability portfolios.

Management also is attempting to mitigate interest rate risk by limiting the dollar amount of loans carried on its balance sheet that have fixed rates in excess of five years. To reduce our exposure to interest rate risks inherent with longer term fixed rate loans, we generally do not hold such mortgages on our books. The Bank established the Mortgage Division to serve potential customers that desired fixed rate loans in excess of five years.

Management monitors interest rate levels on a daily basis and meets in the form of the Asset/Liability Committee (“ALCO”) at least monthly or when a special situation arises (e.g., FOMC unscheduled rate change). The following reports and/or tools are used to assess the current interest rate environment and its impact on Financial’s earnings and liquidity: monthly and year-to-date net interest margin and spread calculations, monthly and year-to-date balance sheet and income statements versus budget (including quarterly interest rate shock analysis), quarterly net portfolio value analysis, a weekly survey of rates offered by other local competitive institutions, and gap analysis which matches maturities or repricing dates of interest sensitive assets to those of interest sensitive liabilities.

Financial currently subscribes to computer simulated modeling tools made available through its consultant, FinPro, Inc., to aid in asset/liability analysis. In addition to monitoring by the ALCO and Investment Committee, the board is informed of the current asset/liability position and its potential effect on earnings at least quarterly.

 

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Table of Contents

Other Borrowings

Financial uses borrowing in conjunction with deposits to fund lending and investing activities. Borrowings include funding of a short-term nature.

Short-term borrowings consist of securities sold under agreements to repurchase, which are secured transactions with customers and generally mature the day following the date sold. As discussed above, the Bank ceased offering sweep accounts to its customers and therefore no longer has short term borrowings in the form repurchase agreements. Consequently, short-term borrowings totaled $0 and $8,379,000 as of December 31, 2012 and December 31, 2011, respectively. Short-term borrowings may also include federal funds purchased, which are unsecured overnight borrowings from other financial institutions. Unsecured federal funds lines and their respective limits are maintained with the following institutions: Community Bankers’ Bank, $11,000,000, Suntrust Bank, $3,000,000, and Zions Bank, $4,000,000. In addition, the Bank maintains a $3,000,000 reverse repurchase agreement with Suntrust whereby securities may be pledged as collateral in exchange for funds for a minimum of 30 days with a maximum of 90 days. The Bank also maintains a secured federal funds line with Community Bankers’ Bank whereby it may pledge securities as collateral with no specified minimum or maximum amount or term. No amounts were outstanding on the facilities at either December 31, 2012 or December 31, 2011.

Long-term borrowing are obtained through the Federal Home Loan Bank of Atlanta (“FHLBA”). The Bank’s available credit through the FHLBA is $86,280,000 as of December 31, 2012, the most recent calculation.

The following information is provided for borrowings balances, rates and maturities:

 

(dollars in thousands)    As of December 31,  
     2012     2011  

Short Term:

    

Securities sold under agreements to repurchase

    

Maximum month-end outstanding balance

   $ 8,498      $ 9,204   

Average outstanding balance during the year

     1,638        8,383   

Average interest rate during the year

     0.92     0.89

Average interest rate at end of year

     —          0.91

Long Term:

    

Federal Home Loan Bank advances

    

Maximum month-end outstanding balance

   $ 10,000      $ 10,000   

Average outstanding balance during the year

     7,036        10,000   

Average interest rate during the year

     3.10     2.97

Average interest rate at end of year

     3.79     2.97

Maturities of FHLBA advances:

 

Amount
(dollars in
thousands)

   

Type

 

Rate

   

Ultimate Maturity
Date

 
$ 2,000      Fixed rate credit     3.785     4/15/2015   

The maximum balance on the FHLBA credit was approximately $10,000,000 for the years ended December 31, 2012 and December 31, 2011.

 

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Table of Contents

Off-Balance Sheet Arrangements

The Bank is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. Such commitments involve, to varying degrees, elements of credit risk and interest rate risk in excess of the amount recognized in the balance sheets.

The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. A summary of the Bank’s commitments is as follows:

 

    

Contract Amounts

(dollars in thousands) at

 
     December 31,  
     2012      2011  

Commitments to extend credit

   $ 60,545       $ 51,153   

Standby letters of credit

     1,653         2,574   
  

 

 

    

 

 

 

Total

   $ 62,198       $ 53,727   
  

 

 

    

 

 

 

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Because many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on its credit evaluation of the customer.

Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those letters of credit are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers. Collateral is required in instances which the Bank deems necessary.

Management does not anticipate any material losses as a result of these transactions.

The Bank rents, under non-cancelable leases, three of its banking facilities and one mortgage production office. The Bank has liability in the form of minimum annual rental commitments under these leases as follows:

 

Year Ending

   Amount
(in  thousands)
 

2013

   $ 546   

2014

     417   

2015

     240   

2016

     196   

2017

     202   

Thereafter

     332   
  

 

 

 
   $ 1,933   
  

 

 

 

 

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Table of Contents

Expansion Plans

Subject to regulatory approval, the Bank anticipates opening additional branches during the next two fiscal years. Although numerous factors could influence the Bank’s expansion plans, the following discussion provides a general overview of the additional branch location that the Bank currently is considering.

Timberlake Road Area, Campbell County (Lynchburg), Virginia. As previously disclosed, the Bank has purchased certain real property located at the intersection of Turnpike and Timberlake Roads, Campbell County, Virginia. The Bank does not anticipate opening a branch at this location prior to 2013 or beyond. The Bank has determined that the existing structure is not suitable for use as a bank branch.

Rustburg, Virginia. In March 2011, the Bank purchased certain real property near the intersection of Routes 501 and 24 in Rustburg, Virginia. The structure on the property is being demolished and removed. The Bank does not anticipate opening a branch at this location prior to the first quarter of 2014 or beyond.

The Bank estimates that the cost of improvements, furniture, fixtures, and equipment necessary to upfit the property will be between $900,000 and $1,500,000 per location.

Although the Bank cannot predict with certainty the financial impact of each new branch, management generally anticipates that each new branch will become profitable within 12 to 18 months of opening.

Recent Accounting Pronouncements

For information regarding recent accounting pronouncements and their effect on us, see “Recent Accounting Pronouncements” in Note 22 to the consolidated financial statements included in Item 8 of this Form 10-K.

 

Item 7A. Quantitative and Qualitative Disclosure About Market Risk

Not applicable

 

Item 8. Financial Statements and Supplementary Data

The following financial statements are filed as a part of this report:

Management’s Annual Report on Internal Control Over Financial Reporting

Report of Independent Registered Public Accounting Firm

Consolidated Financial Statements

Balance Sheets, December 31, 2012 and December 31, 2011

Statements of Income, Years Ended December 31, 2012 and December 31, 2011

Statements of Comprehensive Income, Years Ended December 31, 2012 and December 31, 2011

Statements of Changes in Stockholders’ Equity, Years Ended December 31, 2012 and December 31, 2011

Statements of Cash Flows, Years Ended December 31, 2012 and December 31, 2011

Notes to Consolidated Financial Statements

 

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Table of Contents

LOGO

MANAGEMENT’S ANNUAL REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

Management is responsible for the preparation and fair presentation of the consolidated financial statements included in this annual report. The consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America and reflect management’s judgments and estimates concerning effects of events and transactions that are accounted for or disclosed.

Management is also responsible for establishing and maintaining adequate internal control over financial reporting. Financial’s internal control over financial reporting includes those policies and procedures that pertain to Financial’s ability to record, process, summarize and report reliable financial data. Management recognizes that there are inherent limitations in the effectiveness of any internal control over financial reporting, including the possibility of human error and the circumvention or overriding of internal control. Accordingly, even effective internal control over financial reporting can provide only reasonable assurance with respect to financial statement preparation. Further, because of changes in conditions, the effectiveness of internal control over financial reporting may vary over time.

In order to ensure that Financial’s internal control over financial reporting is effective, management regularly assesses such controls and did so most recently for its financial reporting as of December 31, 2012. This assessment was based on criteria for effective internal control over financial reporting described in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission. Based on this assessment, management has concluded that the internal control over financial reporting was effective as of December 31, 2012.

This annual report does not include an attestation report of Financial’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by Financial’s registered public accounting firm pursuant to the rules of the Securities and Exchange Commission that permit Financial to provide only management’s report in the annual report.

The Board of Directors, acting through its Audit Committee, is responsible for the oversight of Financial’s accounting policies, financial reporting and internal control. The Audit Committee of the Board of Directors is comprised entirely of outside directors who are independent of management. The Audit Committee is responsible for the appointment and compensation of the independent registered public accounting firm and approves decisions regarding the appointment or removal of Financial’s Internal Auditor. It meets periodically with management, the independent registered public accounting firm and the internal auditors to ensure that they are carrying out their responsibilities. The Audit Committee is also responsible for performing an oversight role by reviewing and monitoring the financial, accounting and auditing procedures of Financial in addition to reviewing Financial’s financial reports. The independent registered public accounting firm and the internal auditors have full and unlimited access to the Audit Committee, with or without management, to discuss the adequacy of internal control over financial reporting, and any other matter which they believe should be brought to the attention of the Audit Committee.

 

/s/ Robert R. Chapman III

Chief Executive Officer & President

March 19, 2013

   

/s/ J. Todd Scruggs

Secretary-Treasurer (Principal Financial Officer)

March 19, 2013

See Notes to Consolidated Financial Statements

 

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Table of Contents

LOGO

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Stockholders and Board of Directors

Bank of the James Financial Group, Inc.

Lynchburg, Virginia

We have audited the accompanying consolidated balance sheets of Bank of the James Financial Group, Inc. and subsidiaries as of December 31, 2012 and 2011, and the related consolidated statements of income, comprehensive income, changes in stockholders’ equity, and cash flows for the years then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Bank of the James Financial Group, Inc. and subsidiaries as of December 31, 2012 and 2011, and the results of their operations and their cash flows for the years then ended, in conformity with U.S. generally accepted accounting principles.

 

LOGO

Winchester, Virginia

March 19, 2013

See Notes to Consolidated Financial Statements

 

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BANK OF THE JAMES FINANCIAL GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(dollars in thousands, except share data)

 

 

 

      12/31/2012     12/31/2011  

Assets

    

Cash and due from banks

   $ 16,827     $ 17,678  

Federal funds sold

     24,171       5,662  
  

 

 

   

 

 

 

Total cash and cash equivalents

     40,998       23,340  
  

 

 

   

 

 

 

Securities held-to-maturity (fair value of $3,417 in 2012 and $8,533 in 2011)

     3,075       8,133  

Securities available-for-sale, at fair value

     50,294       48,338  

Restricted stock, at cost

     1,538       1,977  

Loans, net of allowance for loan losses of $5,535 in 2012 and $5,612 in 2011

     319,922       318,754  

Loans held for sale

     904       434  

Premises and equipment, net

     8,340       8,735  

Software, net

     252       124  

Interest receivable

     1,557       1,583  

Cash value - bank owned life insurance

     8,931       8,609  

Other real estate owned, net of valuation allowance

     2,112       3,253  

Income taxes receivable

     624       675  

Deferred tax asset

     1,367       1,375  

Other assets

     1,467       2,106  
  

 

 

   

 

 

 

Total assets

   $ 441,381     $ 427,436  
  

 

 

   

 

 

 

Liabilities and Stockholders’ Equity

    

Deposits

    

Noninterest bearing demand

   $ 66,917     $ 55,569  

NOW, money market and savings

     239,812       230,386  

Time

     92,286       88,279  
  

 

 

   

 

 

 

Total deposits

     399,015       374,234  

Repurchase agreements

     —          8,379  

FHLB borrowings

     2,000       10,000  

Capital notes

     10,000       7,000  

Interest payable

     70       111  

Other liabilities

     683       907  
  

 

 

   

 

 

 

Total liabilities

   $ 411,768     $ 400,631  
  

 

 

   

 

 

 

Stockholders’ equity

    

Common stock $2.14 par value; authorized 10,000,000 shares; issued and outstanding 3,352,725 and 3,342,418 as of December 31, 2012 and December 31, 2011

   $ 7,175     $ 7,152  

Additional paid-in-capital

     22,806       22,775  

Accumulated other comprehensive income (loss)

     568       (54

Retained deficit

     (936     (3,068
  

 

 

   

 

 

 

Total stockholders’ equity

   $ 29,613     $ 26,805  
  

 

 

   

 

 

 

Total liabilities and stockholders’ equity

   $ 441,381     $ 427,436  
  

 

 

   

 

 

 

See Notes to Consolidated Financial Statements

 

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Table of Contents

BANK OF THE JAMES FINANCIAL GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(dollars in thousands, except per share amounts)

 

 

 

     Years Ended December 31,  
     2012      2011  

Interest Income

     

Loans

   $ 16,998      $ 17,572  

Securities

     

US Government and agency obligations

     913        939  

Mortgage backed securities

     23        384  

Municipals

     675        524  

Dividends

     60        52  

Other (Corporates)

     58        25  

Federal Funds sold

     26        23  
  

 

 

    

 

 

 

Total interest income

     18,753        19,519  
  

 

 

    

 

 

 

Interest Expense

     

Deposits

     

NOW, money market savings

     708        1,675  

Time Deposits

     1,539        1,725  

FHLB borrowings

     218        297  

Reverse repurchase agreements

     15        75  

Capital notes

     536        420  
  

 

 

    

 

 

 

Total interest expense

     3,016        4,192  
  

 

 

    

 

 

 

Net interest income

     15,737        15,327  

Provision for loan losses

     2,289        4,807  
  

 

 

    

 

 

 

Net interest income after provision for loan losses

     13,448        10,520  
  

 

 

    

 

 

 

Other operating income

     

Mortgage fee income

     1,257        1,042  

Service charges, fees and commissions

     1,230        1,149  

Increase in cash value of life insurance

     323        249  

Other

     134        58  

Gain on sale of available-for-sale securities

     674        1,182  
  

 

 

    

 

 

 

Total other operating income

     3,618        3,680  
  

 

 

    

 

 

 

Other operating expenses

     

Salaries and employee benefits

     6,529        5,668  

Occupancy

     1,150        1,091  

Equipment

     991        1,038  

Supplies

     386        365  

Professional, data processing, and other outside expense

     2,033        2,139  

Marketing

     382        333  

Credit expense

     225        257  

Other real estate expenses

     798        1,021  

FDIC insurance expense

     579        661  

Other

     1,071        873  

Amortization of tax credit investment

     247        247  
  

 

 

    

 

 

 

Total other operating expenses

     14,391        13,693  
  

 

 

    

 

 

 

Income before income taxes

     2,675        507  

Income tax expense (benefit)

     543        (93
  

 

 

    

 

 

 

Net Income

   $ 2,132      $ 600  
  

 

 

    

 

 

 

Weighted average shares outstanding - basic

     3,343,210        3,324,915  
  

 

 

    

 

 

 

Weighted average shares outstanding - diluted

     3,343,507        3,324,915  
  

 

 

    

 

 

 

Income per common share - basic

   $ 0.64      $ 0.18  
  

 

 

    

 

 

 

Income per common share - diluted

   $ 0.64      $ 0.18  
  

 

 

    

 

 

 

See Notes to Consolidated Financial Statements

 

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BANK OF THE JAMES FINANCIAL GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(dollars in thousands, except share and per share amounts)

 

 

 

     For the Year  Ended
December 31
 
     2012     2011  

Net Income

   $ 2,132      $ 600   
  

 

 

   

 

 

 

Other comprehensive income

    

Unrealized gains on securities available-for-sale net of deferred taxes of $549 and $731

     1,067        1,418   

Reclassification adjustment for gains included in net income, net of taxes of $229 and $402

     (445     (780
  

 

 

   

 

 

 

Other comprehensive income, net of tax

     622        638   
  

 

 

   

 

 

 

Comprehensive income

   $ 2,754      $ 1,238   
  

 

 

   

 

 

 

See Notes to Consolidated Financial Statements

 

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BANK OF THE JAMES FINANCIAL GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

(dollars in thousands)

 

 

 

     Total
Shares
Outstanding
     Common
Stock
     Additional
Paid-in
Capital
     Retained
Earnings
(Deficit)
    Accumulated
Other
Comprehensive
Income (Loss)
    Total  

Balance at December 31, 2010

     3,323,746       $ 7,113       $ 22,742       $ (3,668   $ (692   $ 25,495   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

Net Income

     —           —           —           600        —          600   

Exercise of stock options

     18,672         39         33         —          —          72   

Other Comprehensive Income

     —           —           —           —          638        638   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

Balance at December 31, 2011

     3,342,418       $ 7,152       $ 22,775       $ (3,068   $ (54   $ 26,805   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

Net Income

     —           —           —           2,132        —          2,132   

Exercise of stock options

     10,307         23         31         —          —          54   

Other Comprehensive Income

     —           —           —           —          622        622   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

Balance at December 31, 2012

     3,352,725       $ 7,175       $ 22,806       $ (936   $ 568      $ 29,613   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

See Notes to Consolidated Financial Statements

 

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BANK OF THE JAMES FINANCIAL GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(dollars in thousands)

 

 

 

     Years Ended December 31,  
     2012     2011  

Cash flows from operating activities

    

Net Income

   $ 2,132     $ 600  

Adjustments to reconcile net income to net cash provided by operating activities

    

Depreciation

     681       715  

Net amortization and accretion of premiums and discounts on securities

     547       604  

(Gain) on sale of available for sale securities

     (674     (1,182

Provision for loan losses

     2,289       4,807  

Loss on sale of other real estate owned

     77       487  

(Increase) in loans held-for-sale

     (470     (434

(Benefit) expense for deferred income taxes

     (312     195  

Amortization of tax credit investment

     247       247  

(Increase) in cash value of life insurance

     (323     (249

(Increase) decrease in interest receivable

     26       (114

Decrease in other assets

     393       1,122  

(Increase) decrease in income taxes receivable

     51       (374

(Decrease) in interest payable

     (41     (10

Increase (decrease) in other liabilities

     (224     315  

Writedown on other real estate owned

     650       395  
  

 

 

   

 

 

 

Net cash provided by operating activities

   $ 5,049     $ 7,124  
  

 

 

   

 

 

 

Cash flows from investing activities

    

Purchases of securities held to maturity

   $  —       $ (1,000

Proceeds from maturities and calls of securities held to maturity

     5,000       7,000  

Purchases of securities available for sale

     (44,343     (72,827

Proceeds from maturities, calls and paydowns of securities available for sale

     18,849       20,114  

Proceeds from sale of securities available for sale

     24,665       44,671  

Purchases of bank owned life insurance

     —          (3,000

Redemption of Federal Home Loan Bank stock

     439       203  

Proceeds from sale of other real estate owned

     1,283       2,663  

Improvements to other real estate owned

     (5     (20

Origination of loans, net of principal collected

     (4,321     (6,618

Purchases of premises and equipment

     (414     (694
  

 

 

   

 

 

 

Net cash provided by (used in) investing activities

   $ 1,153     $ (9,508
  

 

 

   

 

 

 

Cash flows from financing activities

    

Net increase in deposits

   $ 24,781     $ 5,844  

Net increase (decrease) in repurchase agreements

     (8,379     1,049  

Net (decrease) in Federal Home Loan Bank advances

     (8,000     —     

Payoff of 6% senior capital notes due 4/1/2012

     (7,000     —     

Proceeds from issuance of 6% senior capital notes due 4/1/2017

     10,000       —     

Proceeds from exercise of stock options

     54       72  
  

 

 

   

 

 

 

Net cash provided by financing activities

   $ 11,456     $ 6,965  
  

 

 

   

 

 

 

Increase in cash and cash equivalents

     17,658       4,581  

Cash and cash equivalents at beginning of period

   $ 23,340     $ 18,759  
  

 

 

   

 

 

 

Cash and cash equivalents at end of period

   $ 40,998     $ 23,340  
  

 

 

   

 

 

 

Non cash transactions

    

Transfer of loans to foreclosed assets

   $ 2,070     $ 4,619  

Portion of foreclosed assets financed

     1,206       1,281  

Fair value adjustment for securities

     942       968  
  

 

 

   

 

 

 

Cash transactions

    

Cash paid for interest

   $ 3,057     $ 4,202  

Cash paid for taxes

     800       712  
  

 

 

   

 

 

 

See Notes to Consolidated Financial Statements

 

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BANK OF THE JAMES FINANCIAL GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012 and 2011

(dollars in thousands, except per share data)

 

 

Note 1 - Organization

Bank of the James Financial Group, Inc. (“Financial” or the “Company”), a Virginia corporation, was organized in 2003 and is registered as a bank holding company under the Bank Holding Company Act of 1956, as amended. Financial is headquartered in Lynchburg, Virginia. Financial conducts its business activities through the branch offices of its wholly owned subsidiary bank, Bank of the James (the “Bank”), the Bank’s wholly-owned subsidiary, BOTJ Insurance, Inc. (“BOTJ-Ins.”), and through the Bank’s two divisions, Bank of the James Mortgage division (“Mortgage division”) and BOTJ Investment Services division (“Investment Services division”). The Mortgage division originates conforming and non-conforming home mortgages primarily in the Region 2000 area, which includes the counties of Amherst, Appomattox, Bedford and Campbell (which includes the Town of Altavista) and the cities of Bedford and Lynchburg, Virginia. Financial exists primarily for the purpose of holding the stock of its subsidiaries, the Bank and such other subsidiaries as it may acquire or establish. Financial also has one wholly-owned non-operating subsidiary.

Bank of the James was incorporated on October 23, 1998, and began banking operations on July 22, 1999. The Bank is a Virginia chartered bank and is engaged in lending and deposit gathering activities in Region 2000. It operates under the laws of Virginia and the Rules and Regulations of the Federal Reserve System and the Federal Deposit Insurance Corporation. The Bank’s ten locations consist of five branches (one of which is a limited service branch) in Lynchburg, Virginia, one in Forest, Virginia which includes the Mortgage Division, one in Madison Heights, Virginia, one in the Town of Amherst, Virginia, one in the City of Bedford, Virginia, and one in the Town of Altavista, Virginia.

Note 2 - Summary of significant accounting policies

Consolidation

The consolidated financial statements include the accounts of Bank of the James Financial Group, Inc. and its wholly owned subsidiaries. All material intercompany balances and transactions have been eliminated in consolidation.

Basis of presentation and use of estimates

The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent liabilities at the date of the financial statements, as well as the amounts of income and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, the valuation of deferred tax assets and other real estate owned, other-than-temporary impairments of securities, and the fair value of financial instruments.

Cash and cash equivalents

Cash and cash equivalents include cash and balances due from banks and federal funds sold, all of which mature within ninety days. Generally, federal funds are purchased and sold for one-day periods.

 

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BANK OF THE JAMES FINANCIAL GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012 and 2011

(dollars in thousands, except per share data)

 

 

 

Note 2 - Summary of significant accounting policies (continued)

 

Securities

Certain debt securities that management has the positive intent and ability to hold to maturity are classified as “held-to-maturity” and recorded at amortized cost. Trading securities are recorded at fair value with changes in fair value included in earnings. Securities not classified as held-to-maturity or trading, including equity securities with readily determinable fair values, are classified as “available-for-sale” and recorded at fair value, with unrealized gains and losses excluded from earnings and reported in other comprehensive income. Purchase premiums and discounts are recognized in interest income using the interest method over the terms of the securities. Gains and losses on the sale of securities are recorded on the trade date and are determined using the specific identification method.

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 (1) the Bank intends to sell the security or (2) it is more likely than not that the Bank will be required to sell the security before recovery of its amortized cost basis. If, however, the Bank does not intend to sell the security and it is not more likely than not that the Bank will be required to sell the security before recovery, the Bank must determine what portion of the impairment is attributable to a credit loss, which occurs when the amortized cost 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.

For equity securities, impairment is considered to be other-than-temporary based on our 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. We regularly review 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, our best estimate of the present value of cash flows expected to be collected from debt securities, our intention with regard to holding the security to maturity, and the likelihood that we would be required to sell the security before recovery.

Restricted investments

As members of the Federal Reserve Bank (FRB) and the Federal Home Loan Bank of Atlanta (FHLBA), the Bank is required to maintain certain minimum investments in the common stock of the FRB and FHLBA. Required levels of investment are based upon the Bank’s capital and a percentage of qualifying assets. The Bank also maintains stock ownership in Community Bankers’ Bank (CBB). The investment in CBB is minimal and is not mandated but qualifies the Bank for preferred pricing on services offered by CBB. Based on liquidation restrictions, all of these investments are carried at cost.

Loans

Financial makes real estate, commercial and consumer loans to customers. A substantial portion of the loan portfolio is represented by real estate loans collateralized by real estate within Region 2000. The ability of Financial’s debtors to honor their contracts is dependent upon the real estate and general economic conditions in the area.

Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off generally are reported at their outstanding unpaid principal balances adjusted for charge-offs, the allowance for loan losses, and any deferred fees or costs on originated loans. Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and recognized as an adjustment of the related loan yield using the interest method.

 

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BANK OF THE JAMES FINANCIAL GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012 and 2011

(dollars in thousands, except per share data)

 

 

 

Note 2 - Summary of significant accounting policies (continued)

 

Past due status

Past due status is based on the contractual terms of the loan. In all cases, loans are placed on non-accrual and potentially charged-off at an earlier date if collection of principal or interest is considered doubtful.

Non-accrual status

Financial stops accruing interest on a loan at the time the loan is 90 days past due unless the credit is well-secured and in process of collection. At the time the loan is placed on non-accrual status, all previously accrued but not collected interest is reversed against interest income. While the loan is classified as non-accrual, any payments collected are accounted for on the cash-basis or cost-recovery method which requires the entire amount of the payment to be applied directly to principal, until qualifying for return to performing status. Loans may be returned to performing status when all the principal and interest amounts contractually due are brought current (within 90 days past due), future payments are reasonably assured, and contractually required payments have been made on a timely basis for at least six consecutive months.

Charge-off

At the time a loan is placed on non-accrual status, it is generally reevaluated for expected loss and a specific reserve, if not already previously assigned, is established against the loan. Consumer term loans are typically charged-off no later than 120 days whereas consumer revolving credit loans are typically charged-off no later than 180 days. Although the goal for commercial and commercial real estate loans is for charge off not later than 180 days, a commercial or commercial real estate loan may not be fully charged off until there is reasonable certainty that no additional workout efforts, troubled debt restructurings or any other types of concession can or will be made by Financial.

Allowance for loan losses

The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.

The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectibility of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.

The allowance consists of specific, historical and general components. The specific component relates to loans that are classified as doubtful or substandard. For such loans that are also classified as impaired, an allowance is established when the collateral value of the impaired loan or discounted cash flows is lower than the carrying value of that loan. The historical component covers non-classified loans and is based on historical loss experience adjusted for qualitative factors. A general component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The general 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 portfolio. The qualitative factors used to derive the general component of the allowance may include but are not limited to:

 

  1. Known improvement or deterioration in certain classes of loans or collateral;

 

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BANK OF THE JAMES FINANCIAL GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012 and 2011

(dollars in thousands, except per share data)

 

 

 

Note 2 - Summary of significant accounting policies (continued)

 

  2. Trends in portfolio volume, maturity, or composition;

 

  3. Volume and trends in delinquencies and non-accruals;

 

  4. Local economic and industrial conditions;

 

  5. Lending, charge-off, and collection policies; and

 

  6. Experience, ability, and depth of lending staff.

A loan is considered impaired when, based on current information and events, it is probable that Financial will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis by evaluating the fair value of the underlying collateral.

Management considers the following four components when calculating its loan loss reserve requirement:

 

   

In accordance with current accounting rules (ASC 310), the Bank performs an individual impairment analysis on all loans with a risk rating of substandard, doubtful, and loss (our internal risk ratings of 7 through 9). The Bank also performs individual loan analysis and assesses potential future losses associated with those relationships risk rated as special mention (our internal risk rating of 6).

 

   

In accordance with current accounting rules (ASC 450), the Bank examines historical charge-off data by classification code in order to determine a portion of the reserve related to homogeneous pools. The Bank updates its historical charge-off data twice a year and adjusts the reserve accordingly.

 

   

The Bank applies various risk factors, including, for example, levels of trends in delinquencies, current and expected economic conditions, and levels of and trends in recoveries of prior charge-offs.

 

   

The Bank applies factors to determine the method by which to determine the general reserve for inherent losses related to the loan pool, including, for example, loan concentrations, policy and procedure changes, national and local economic trends and conditions, and overall portfolio quality.

Troubled debt restructurings

In situations where, for economic or legal reasons related to a borrower’s financial condition, management may grant a concession to the borrower that it would not otherwise consider, the related loan is classified as a troubled

 

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BANK OF THE JAMES FINANCIAL GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012 and 2011

(dollars in thousands, except per share data)

 

 

 

Note 2 - Summary of significant accounting policies (continued)

 

debt restructuring (“TDR”). Management strives to identify borrowers in financial difficulty early and work with them to modify their loan to more affordable terms before their loans reach nonaccrual status. These modified terms may include rate reductions, principal forgiveness, payment forbearance and other actions intended to minimize the economic loss and to avoid foreclosure or repossession of collateral. In cases where borrowers are granted new terms that provide for a reduction of either interest or principal, management measures any impairment on the restructuring as noted above for impaired loans. The Bank had $572 and $4,987 classified as TDRs as of December 31, 2012 and 2011, respectively.

Premises, equipment and depreciation

Premises and equipment, including leasehold improvements, are stated at cost less accumulated depreciation. Depreciation is provided over the estimated useful lives of the respective assets on the straight-line basis, which range from 3 to 7 years for equipment and 10 to 39.5 years for buildings and improvements. Leasehold improvements are amortized over a term which includes the remaining lease term and probable renewal periods. Land is carried at cost and is not depreciable. Expenditures for major renewals and betterments are capitalized and those for maintenance and repairs are charged to operating expenses as incurred.

Other real estate owned

Other real estate owned consists of properties acquired through foreclosure or deed in lieu of foreclosure. These properties are carried at fair market value less estimated costs to sell at the date of foreclosure. Losses from the acquisition of property in full or partial satisfaction of loans are charged against the allowance for loan losses. Subsequent write-downs, if any, are charged against expense. Gains and losses on the sales of foreclosed properties are included in determining net income in the year of the sale.

Transfers of financial assets

Transfers of financial assets are accounted for as sales, when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Bank - put presumptively beyond reach of the transferor and its creditors, even in bankruptcy or other receivership, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Bank does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity or the ability to unilaterally cause the holder to return specific assets.

Income taxes

Deferred income tax assets and liabilities are determined using the liability (or balance sheet) method. Under this method, the net deferred tax asset or liability is determined based on the tax effects of the temporary differences between the book and tax bases of the various balance sheet assets and liabilities and gives current recognition to changes in tax rates and laws.

When tax returns are filed, it is highly certain that some positions taken would be sustained upon examination by the taxing authorities, while others are subject to uncertainty about the merits of the position taken or the amount of the position that would be ultimately sustained. The benefit of a tax position is recognized in the financial statements in the period during which, based on all available evidence, management believes it is more likely than

 

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BANK OF THE JAMES FINANCIAL GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012 and 2011

(dollars in thousands, except per share data)

 

 

 

Note 2 - Summary of significant accounting policies (continued)

 

not that the position will be sustained upon examination, including the resolution of appeals or litigation processes, if any. Tax positions taken are not offset or aggregated with other positions. Tax positions that meet the more-likely-than-not recognition threshold are measured as the largest amount of tax benefit that is more than 50 percent likely of being realized upon settlement with the applicable taxing authority. The portion of the benefits associated with tax positions taken that exceeds the amount measured as described above is reflected as a liability for unrecognized tax benefits in the accompanying consolidated balance sheets along with any associated interest and penalties that would be payable to the taxing authorities upon examination.

Interest and penalties associated with unrecognized tax benefits are classified as additional income taxes in the consolidated statements of income. At December 31,2012 and 2011, there were no liabilities recorded for unrecognized tax benefits.

Stock options

Current accounting guidance requires the costs resulting from all share-based payments to employees be recognized in the financial statements. Stock-based compensation is estimated at the date of grant, using the Black-Scholes option valuation model for determining fair value.

There were no options granted in 2012 or 2011.

ASC 718 Compensation - Stock Compensation requires Financial to estimate forfeitures when recognizing compensation expense and that this estimate of forfeitures be adjusted over the requisite service period or vesting schedule based on the extent to which actual forfeitures differ from such estimates. Changes in estimated forfeitures are recognized through a cumulative catch-up adjustment, which is recognized in the period of change, and also will impact the amount of estimated unamortized compensation expense to be recognized in future periods.

As of December 31, 2012, all compensation expense related to the Company’s option plan had been recognized. The Company’s ability to grant additional option shares under the 1999 Plan has expired.

Earnings per share

Basic earnings per share represents income available to common stockholders divided by the weighted-average number of common shares outstanding during the period. Diluted earnings per share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed issuance. Potential common shares that may be issued by the Company relate solely to outstanding stock options, and are determined using the treasury stock method.

Reclassification

Certain 2011 amounts have been reclassified to conform to the 2012 presentation.

 

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BANK OF THE JAMES FINANCIAL GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012 and 2011

(dollars in thousands, except per share data)

 

 

 

Note 2 - Summary of significant accounting policies (continued)

 

Comprehensive income

Comprehensive income consists of net income and other comprehensive income. Other comprehensive income includes unrealized gains (losses) on securities available-for-sale.

Marketing

The Company expenses advertising costs as incurred. Advertising expenses were $328 and $261 for 2012 and 2011, respectively.

Note 3 - Restrictions on cash

To comply with Federal Reserve regulations, the Bank is required to maintain certain average cash reserve balances. The daily average cash reserve requirements were approximately $3,819 and $1,732 for the weeks including December 31, 2012 and 2011, respectively.

Note 4 - Securities

A summary of the amortized cost and fair value of securities, with gross unrealized gains and losses, follows:

 

     December 31, 2012  
     Amortized
Cost
     Gross Unrealized     Fair
Value
 
        Gains      Losses    

Held-to-maturity

          

U.S. agency obligations

   $ 3,075       $ 342       $ —        $ 3,417   
  

 

 

    

 

 

    

 

 

   

 

 

 

Available-for-sale

          

U.S. agency obligations

   $ 22,980       $ 184       $ (95   $ 23,069   

Mortgage-backed securities

     1,805         7         —          1,812   

Municipals

     22,099         780         (75     22,804   

Corporates

     2,548         61         —          2,609   
  

 

 

    

 

 

    

 

 

   

 

 

 
   $ 49,432       $ 1,032       $ (170   $ 50,294   
  

 

 

    

 

 

    

 

 

   

 

 

 

 

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BANK OF THE JAMES FINANCIAL GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012 and 2011

(dollars in thousands, except per share data)

 

 

 

Note 4 - Securities (continued)

 

     December 31, 2011  
     Amortized
Cost
     Gross Unrealized     Fair
Value
 
        Gains      Losses    

Held-to-maturity

          

U.S. agency obligations

   $ 8,133       $ 400       $ —        $ 8,533   
  

 

 

    

 

 

    

 

 

   

 

 

 

Available-for-sale

          

U.S. agency obligations

   $ 25,416       $ 117       $ (48   $ 25,485   

Mortgage-backed securities

     3,938         5         (4     3,939   

Municipals

     19,062         241         (389     18,914   
  

 

 

    

 

 

    

 

 

   

 

 

 
   $ 48,416       $ 363       $ (441   $ 48,338   
  

 

 

    

 

 

    

 

 

   

 

 

 

 

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BANK OF THE JAMES FINANCIAL GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012 and 2011

(dollars in thousands, except per share data)

 

 

 

Note 4 - Securities (continued)

 

Temporarily Impaired Securities

The following tables show the gross unrealized losses and fair value of the Bank’s investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2012 and 2011:

 

December 31, 2012    Less than 12 months      More than 12 months      Total  
     Fair
Value
     Unrealized
Losses
     Fair
Value
     Unrealized
Losses
     Fair
Value
     Unrealized
Losses
 

U.S. agency obligations

   $ 9,116       $ 95       $ —         $ —         $ 9,116       $ 95   

Municipals

     1,879         75         —           —           1,879         75   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total temporarily impaired securities

   $ 10,995       $ 170       $ —         $ —         $ 10,995       $ 170   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

December 31, 2011    Less than 12 months      More than 12 months      Total  
     Fair
Value
     Unrealized
Losses
     Fair
Value
     Unrealized
Losses
     Fair
Value
     Unrealized
Losses
 

U.S. agency obligations

   $ 13,593       $ 48       $ —         $ —         $ 13,593       $ 48   

Mortgage-backed securities

     985         4         —           —           985         4   

Municipals

     12,852         389         —           —           12,852         389   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total temporarily impaired securities

   $ 27,430       $ 441       $ —         $ —         $ 27,430       $ 441   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

U.S. agency obligations. The unrealized losses on the 5 investments in U.S. agency obligations at December 31, 2012 were caused by interest rate increases. The contractual terms of those investments do no permit the issuer to settle the securities at a price less than the amortized cost bases of the investments. Because the Bank does not intend to sell the investments and it is not more likely than not that the Bank will be required to sell the investments before recovery of their amortized cost bases, which may be maturity, the Bank does not consider those investments to be other-than-temporarily impaired at December 31, 2012. Each of these 5 investments carries an investment grade rating of AA.

 

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Table of Contents

BANK OF THE JAMES FINANCIAL GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012 and 2011

(dollars in thousands, except per share data)

 

 

 

Note 4 - Securities (continued)

 

Municipals. The unrealized losses on the 4 investments in municipal obligations at December 31, 2012 were caused by interest rate increases. The contractual terms of those investments do no permit the issuer to settle the securities at a price less than the amortized cost bases of the investments. Because the Bank does not intend to sell the investments and it is not more likely than not that the Bank will be required to sell the investments before recovery of their amortized cost bases, which may be maturity, the Bank does not consider those investments to be other-than-temporarily impaired at December 31, 2012. Each of these 4 investments carries an investment grade rating of AA or above.

The amortized costs and fair values of securities at December 31, 2012, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

 

     Held-to-Maturity      Available-for-Sale  
     Amortized
Cost
     Fair
Values
     Amortized
Cost
     Fair
Values
 

Due in one year or less

   $ —         $ —         $ —         $ —     

Due after one year through five years

     —           —           979         980   

Due after five years through ten years

     2,062         2,369         12,063         12,264   

Due after ten years

     1,013       <