10-K 1 d10k.htm FORM 10-K Form 10-K
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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, 2010                                 Commission File Number 0-13823

FNB UNITED CORP.

(Exact name of Registrant as specified in its Charter)

 

   North Carolina    56-1456589   
  

(State of Incorporation)

   (I.R.S. Employer Identification No.)   
  

150 South Fayetteville Street

     
  

Asheboro, North Carolina

   27203   
  

(Address of principal executive offices)

   (Zip Code)   

(336) 626-8300

(Registrant’s telephone number, including area code)

 

 

Securities Registered Pursuant to Section 12(g) of the Securities Exchange Act of 1934:

Title of each class

 

 

Common Stock, $2.50 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¨ Nox

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes¨ Nox

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

Indicate by check mark whether the registrant (1) has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files.) Yes¨ No¨

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

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

 

  Large accelerated filer  ¨

  Accelerated filer  ¨  

Non-accelerated filer  ¨

  Smaller reporting company  x
   

(Do not check if a smaller

reporting company)

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes¨ Nox

The aggregate market value of the Registrant’s common stock held by nonaffiliates of the Registrant, assuming, without admission, that all directors and officers of the Registrant may be deemed affiliates, was approximately $8.3 million as of June 30, 2010, the last business day of the Registrant’s most recently completed second fiscal quarter. As of March 10, 2011 (the most recent practicable date), the Registrant had outstanding 11,424,390 shares of Common Stock.

Portions of the Proxy Statement of the Registrant for the Annual Meeting of Shareholders to be held on July 19, 2011, are incorporated by reference in Part III of this report.


Table of Contents

FNB United Corp.

Form 10-K

Table of Contents

 

Index

          Page   

PART I

  

Item 1.

     BUSINESS      1   

Item 1A.

     RISK FACTORS      12   

Item 1B.

     UNRESOLVED STAFF COMMENTS      22   

Item 2.

     PROPERTIES      22   

Item 3.

     LEGAL PROCEEDINGS      22   

Item 4.

     RESERVED      22   

PART II

  

Item 5.

     MARKET FOR REGISTRANTS COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES      23   

Item 6.

     SELECTED FINANCIAL DATA      25   

Item 7.

     MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS      26   

Item 7A.

     QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK      51   

Item 8.

     FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA      52   

Item 9.

     CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE      110   

Item 9A.

     CONTROLS AND PROCEDURES      110   

Item 9B.

     OTHER INFORMATION      110   

PART III

  

Item 10.

     DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE      111   

Item 11.

     EXECUTIVE COMPENSATION      111   

Item 12.

     SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED SHAREHOLDER MATTERS      111   

Item 13.

     CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE      111   

Item 14.

     PRINCIPAL ACCOUNTANT FEES AND SERVICES      111   

PART IV

  

Item 15.

     EXHIBITS AND FINANCIAL STATEMENT SCHEDULES      111   
     SIGNATURES      116   


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Cautionary Statement Regarding Forward-Looking Statements

The statements contained in this Annual Report on Form 10-K of FNB United Corp. (“FNB United”) that are not historical facts are forward-looking statements, as such term is defined in the Private Securities Litigation Reform Act of 1995. These statements can be identified by the use of forward-looking terminology, such as “believes,” “expects,” “plans,” “projects,” “goals,” “estimates,” “may,” “should,” “could,” “would,” “intends,” “outlook” or “anticipates,” or the negative of such terms, variations of these and similar words, or by discussions of strategy that involve risks and uncertainties. In addition, from time to time FNB United or its representatives have made or may make forward-looking statements, orally or in writing. Such forward-looking statements may be included in, but are not limited to, various filings made by FNB United with the Securities and Exchange Commission, or press releases or oral statements made by or with the approval of an authorized officer of FNB United. Forward-looking statements are based on management’s current views and assumptions and involve risks and uncertainties that could significantly affect expected results.

FNB United wishes to caution the reader that factors, such as those listed below, in some cases have affected and could affect FNB United’s actual results, causing actual results to differ materially from those in any forward-looking statement. These factors include, without limitation: (i) competitive pressures in the banking industry or in FNB United’s markets may increase significantly; (ii) inflation, interest rate, market and monetary fluctuations; (iii) general economic conditions, either nationally or regionally, may be less favorable than expected, resulting in, among other things, credit quality deterioration or a reduced demand for credit or other services; (iv) the effects of and changes in trade, monetary and fiscal policies and laws, including interest rate policies of the Board of Governors of the Federal Reserve System; (v) adverse changes in the securities markets; (vi) changes may occur in banking and other applicable legislation and regulation; (vii) changes in accounting principles and standards; (viii) adverse changes in financial performance or condition of FNB United’s borrowers, which could affect repayment of such borrowers’ outstanding loans; (ix) changes in general business conditions; (x) competitors of FNB United may have greater financial resources and develop products that enable them to compete more successfully than FNB United; (xi) unpredictable natural and other disasters could have an adverse effect on FNB United in that such events could materially disrupt its operations or the ability or willingness of its customers to access the financial services offered by FNB United; (xii) local, state or federal taxing authorities may take tax positions that are adverse to FNB United; (xiii) FNB United’s success at managing the risks involved in the foregoing, and (xiv) regulatory actions and developments, including the potential impact of the Dodd-Frank Wall Street Reform and Consumer Protection Act; (xv) fluctuations in our stock price; (xvi) the effect of any mergers, acquisitions or other transactions to which we or our subsidiary may from time to time be a party; and (xvii) FNB United’s failure of assumptions underlying the establishment of our allowance for loan losses. FNB United cautions that this list of factors is not exclusive. Our forward-looking statements may also be subject to other risks and uncertainties, including those discussed elsewhere in this report, such as in Item 1A, “Risk Factors,” and in the Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” or in our other filings with the Securities and Exchange Commission.

All forward-looking statements speak only as of the date on which such statements are made, and FNB United undertakes no obligation to update any statement, whether written or oral, to reflect events or circumstances after the date on which such statement is made or to reflect the occurrence of unanticipated events.

 

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PART I

 

Item 1. BUSINESS

General

FNB United Corp. (“FNB United”) is a bank holding company incorporated under the laws of the State of North Carolina in 1984. On July 2, 1985, through an exchange of stock, FNB United acquired a wholly owned bank subsidiary, CommunityONE Bank, National Association (the “Bank”), a national banking association founded in 1907 and formerly known as First National Bank and Trust Company. The Bank has two operating subsidiaries, Dover Mortgage Company (“Dover”) and First National Investor Services, Inc.; and an inactive subsidiary, Premier Investment Services, Inc. FNB United is also parent to FNB United Statutory Trust I, FNB United Statutory Trust II, and Catawba Valley Capital Trust II, which were formed to facilitate the issuance of trust preferred securities. FNB United and its subsidiaries are collectively referred to as the “Company.”

The Bank, which is a full-service bank, currently conducts all of its operations in Alamance, Alexander, Ashe, Catawba, Chatham, Gaston, Guilford, Iredell, Mecklenburg, Montgomery, Moore, Orange, Randolph, Richmond, Rowan, Scotland, Watauga and Wilkes counties in North Carolina. The Bank has forty-five offices, including the headquarters office in the City of Asheboro. Some of the major banking services offered include regular checking accounts, interest checking accounts (including package account versions that offer a variety of products and services), money market accounts, savings accounts, certificates of deposit, individual retirement accounts, debit cards, credit cards (offered through an agent relationship), and loans — both secured and unsecured — for business, agricultural and personal use. Other services offered include home mortgages, online and mobile banking, cash management, investment management and trust services. The Bank also has automated teller machines and is a member of Plus, a national automated teller machine network, and Star, a regional network.

Dover, acquired by FNB United in 2003, originates, underwrites and closes mortgage loans for sale into the secondary market. Dover has a retail origination network based in Charlotte, North Carolina, originating loans for properties located in North Carolina. Dover previously engaged in the wholesale mortgage origination business and conducted retail mortgage origination business outside of North Carolina. These operations were closed in February 2011.

First National Investor Services, Inc., which does business as Marketplace Finance, is engaged in servicing loans purchased by the Bank from automobile dealers.

Competition

The banking industry within the Bank’s marketing area is extremely competitive. The Bank faces direct competition in the counties in which it maintains offices from approximately 112 different financial institutions, including commercial banks, savings institutions and credit unions. Although no one of these entities is dominant, the Bank considers itself to be one of the significant financial institutions in the area in terms of total assets and deposits. Further competition is provided by banks located in adjoining counties, as well as other types of financial institutions, such as insurance companies, finance companies, pension funds and brokerage houses and other money funds. The principal methods of competing in the commercial banking industry are improving customer service through the quality and range of services provided, improving cost efficiencies and pricing services competitively.

Dover faces competition within its market area from other mortgage banking companies and from all types of financial institutions engaged in the mortgage loan business. The principal methods of competing in the mortgage banking business are offering competitively priced mortgage loan products and providing prompt and efficient customer service.

Regulation and Supervision

The following discussion sets forth material elements of the regulatory framework applicable to bank holding companies and their subsidiaries. It also provides certain specific information relevant to FNB United. This regulatory framework is intended primarily for the protection of customers and depositors and the deposit insurance funds that insure deposits of banks and savings institutions, and not for the protection of security holders. To the extent that the following information describes statutory and regulatory provisions, it is qualified in its entirety by reference to those provisions. A change in the statutes, regulations or regulatory policies applicable to FNB United or its subsidiaries may have a material effect on the business of the Company. Additional information related to regulatory matters is contained in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

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General

As a bank holding company, FNB United is subject to regulation under the Bank Holding Company Act of 1956, as amended, and to inspection, examination and supervision by the Federal Reserve Board. Under the Bank Holding Company Act, bank holding companies, such as FNB United, that have not elected to become financial holding companies under the Gramm-Leach-Bliley Act generally may not acquire ownership or control of more than 5% of the voting shares or substantially all the assets of any company, including a bank, without the Federal Reserve Board’s prior approval. With limited exceptions, bank holding companies may engage only in the business of banking or managing or controlling banks or furnishing services to or performing services for their subsidiary banks. A significant exception is that a bank holding company may own shares in a company whose activities the Federal Reserve Board has determined to be closely related to banking or managing or controlling banks.

As a national banking association, the Bank is subject to regulation and examination primarily by the Office of the Comptroller of the Currency (“OCC”). It is also regulated by the Federal Deposit Insurance Corporation (“FDIC”) and the Federal Reserve Board. The Bank’s deposits are insured by the FDIC through the Deposit Insurance Fund. The OCC and the FDIC impose various requirements and restrictions on the Bank, including requirements to maintain reserves against deposits, restrictions on the types and amounts of loans that may be granted and the interest that may be charged on loans, limitations on the types of investments that may be made and the types of services that may be offered, and requirements governing capital adequacy, liquidity, earnings, dividends, management practices and branching. As a member of the Federal Reserve System, the Bank is subject to the applicable provisions of the Federal Reserve Act, which imposes restrictions on loans by subsidiary banks to a holding company and its other subsidiaries and on the use of stock or securities as collateral security for loans.

Dover, as an operating subsidiary of the Bank, is regulated by the OCC. Because Dover underwrites mortgages guaranteed by the government, it is subject to other audits and examinations as required by the government agencies or the investors who purchase the mortgages.

Various consumer laws and regulations also affect the operations of the Company. In addition to the impact of regulation, financial institutions may be significantly affected by legislation, which can change the statutes affecting them in substantial and unpredictable ways and by the actions of the Federal Reserve Board as it attempts to control the money supply and credit availability to influence the economy. The instruments of monetary policy used by the Federal Reserve Board include its open market operations in U.S. Government securities, changes in the discount rate on member bank borrowings, and changes in reserve requirements on member bank deposits. The actions of the Federal Reserve Board influence the growth of bank loans, investments and deposits and also affect interest rates charged on loans or paid on deposits.

In view of changing conditions in the national economy and money markets, as well as the effect of actions by monetary and fiscal authorities, no prediction can be made as to possible future changes in interest rates, deposit levels, loan demand or the business and earnings of the Company.

Liability for Bank Subsidiaries

Under current Federal Reserve Board policy, a bank holding company is expected to act as a source of financial and managerial strength to its subsidiary banks and to maintain resources adequate to support each subsidiary bank. This support may be required at times when the bank holding company may not have the resources to provide it. Similarly, the cross-guaranty provisions of the Federal Deposit Insurance Act provide that if the FDIC suffers or anticipates a loss as a result of a default by a banking subsidiary or by providing assistance to a subsidiary in danger of default, then any other bank subsidiaries may be assessed for the FDIC’s loss. Federal law authorizes the OCC to order an assessment of FNB United if the capital of the Bank were to become impaired. If the assessment were not paid within three months, the OCC could order the sale of FNB United’s stock in the Bank to cover the deficiency.

Any capital loans by a bank holding company to any of its bank subsidiaries are subordinate in right of payment to deposits and to certain other indebtedness of such bank subsidiaries. In the event of a bank holding company’s bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank will be assumed by the bankruptcy trustee and entitled to a priority of payment.

Transactions with Affiliates

There are certain restrictions on the ability of FNB United and certain of its nonbank affiliates to borrow from, and engage in other transactions with, its bank subsidiary and on the ability of its bank subsidiary to pay dividends to FNB United. In general, these restrictions require that any extensions of credit must be secured by designated amounts of specified collateral and are limited, as to any one of FNB United or a nonbank affiliate, to 10% of the lending bank’s capital stock and surplus, and, as to FNB United and all such nonbank affiliates in the aggregate, to

 

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20% of such lending bank’s capital stock and surplus. These restrictions, other than the 10% of capital limit on covered transactions with any one affiliate, are also applied to transactions between national banks and their financial subsidiaries. In addition, certain transactions with affiliates must be on terms and conditions, including credit standards, that are substantially the same, or at least as favorable to the institution, as those prevailing at the time for comparable transactions involving other nonaffiliated companies or, in the absence of comparable transactions, on terms and conditions, including credit standards, that in good faith would be offered to, or would apply to, nonaffiliated companies.

Unsafe and Unsound Practices

The OCC has authority under the Financial Institutions Advisory Act to prohibit national banks from engaging in any activity that, in the OCC’s opinion, constitutes an unsafe or unsound practice in conducting their businesses. The Federal Reserve Board has similar authority with respect to FNB United.

Regulatory Actions

Consent Order

Due to the Bank’s condition, on July 22, 2010, pursuant to a Stipulation and Consent to the Issuance of a Consent Order, the Bank consented and agreed to the issuance of a Consent Order (“Order”) by the OCC. In the Order, the Bank and the OCC agreed as to areas of the bank’s operations that warrant improvement and a plan for making those improvements. The Order includes a capital directive, which requires the Bank to achieve and maintain minimum regulatory capital levels in excess of the statutory minimums to be well-capitalized, and a directive to develop a liquidity risk management and contingency funding plan, in connection with which the Bank could be subject to limitations on the maximum interest rates it can pay on deposit accounts. The Order also contains restrictions on future extensions of credit and requires the development of various programs and procedures to improve the Bank’s asset quality as well as routine reporting on the Bank’s progress toward compliance with the Order to the Board of Directors and the OCC. Specifically, the Order imposed the following requirements on the Bank:

 

   

to appoint a Compliance Committee to monitor and coordinate the Bank’s adherence to the Order.

   

to develop and submit to the OCC for review a written strategic plan covering at least a three-year period.

   

to achieve within 90 days and thereafter maintain total capital at least equal to 12% of risk-weighted assets and Tier 1 capital at least equal to 9% of adjusted total assets.

   

to submit to the OCC within 60 days a written capital plan for the Bank covering at least a three-year period.

   

to develop, implement and ensure the Bank’s compliance with written programs to improve the Bank’s loan portfolio management and to reduce the high level of credit risk in the Bank.

   

to adopt and ensure implementation and adherence to an enhanced written commercial real estate concentration management program consistent with OCC guidelines.

   

to obtain current and complete credit information on all loans and ensure proper collateral documentation is maintained on all loans.

   

to develop and implement an independent review and analysis process to ensure that appraisals conform to appraisal standards and regulations.

   

to implement and adhere to a written program for the maintenance of an adequate allowance for loan losses, providing for review of the allowance by the Board of Directors at least quarterly.

   

to increase the Bank’s liquidity to a level sufficient to sustain the Bank’s current operations and to withstand any anticipated or extraordinary demand against its funding base.

   

to implement and maintain a comprehensive liquidity risk management program, assessing on an ongoing basis the Bank’s current and projected funding needs and ensuring that sufficient funds or access to funds exists to meet those needs.

   

to develop and implement a written program to strengthen internal controls over accounting and financial reporting.

The Order permits the OCC to extend the time periods under the Order upon written request. Any material failure to comply with the Order could result in further enforcement actions by the OCC. In addition, if the OCC does not accept the capital plan or the Bank fails to achieve and maintain the minimum capital levels, the OCC may require the Bank to sell, merge or liquidate the Bank.

The Bank has submitted all required materials and plans requested to the OCC within the given time periods. The Board of Directors submitted written strategic plans and capital plans to the OCC covering the requisite three-year

 

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period. Upon receipt of the OCC’s written determination of no supervisory objection, the Bank will adopt and implement the plans. The Bank can give no assurance as to whether or when the OCC will provide such written determination. In the meantime, the Bank is working diligently to comply with the terms of the Order and within the parameters of its proposed plans.

Written Agreement

On October 21, 2010, FNB United entered into a written agreement with the Federal Reserve Bank of Richmond (“FRBR”). Pursuant to the agreement, FNB United’s Board of Directors is to take appropriate steps to utilize fully FNB United’s financial and managerial resources to serve as a source of strength to the Bank, including causing the Bank to comply with the Order it entered into with the OCC on July 22, 2010.

In the agreement, FNB United agreed that it would not declare or pay any dividends without prior written approval of the FRBR and the Director of the Division of Banking Supervision and Regulation of the Board of Governors of the Federal Reserve System (the “Director”). It further agreed that it would not take dividends or any other form of payment representing a reduction in capital from the Bank without the FRBR’s prior written approval. The agreement also provides that neither FNB United nor any of its nonbank subsidiaries will make any distributions of interest, principal or other amounts on subordinated debentures or trust preferred securities without the prior written approval of the FRBR and the Director.

The agreement further provides that neither FNB United nor any of its subsidiaries shall incur, increase or guarantee any debt without FRBR approval. In addition, FNB United must obtain the prior approval of the FRBR for the repurchase or redemption of its shares of stock.

Within 60 days from the date of the agreement, FNB United submitted to the FRBR a written plan to maintain sufficient capital at FNB United on a consolidated basis. Within 30 days of the agreement, FNB United submitted to the FRBR a statement of its planned sources and uses of cash for operating expenses and other purposes for 2011. FNB United is to submit such a cash flow projection for each subsequent calendar year by December of the preceding year.

The agreement permits the FRBR to grant written extensions of time for FNB United to comply with its provisions.

FNB United is to report to the FRBR monthly regarding its progress in complying with the agreement. The provisions of the agreement will remain effective and enforceable until they are stayed, modified, terminated, or suspended in writing by the FRBR.

Capital Requirements

FNB United and the Bank are required to comply with federal regulations on capital adequacy. There are two measures of capital adequacy: a risk-based measure and a leverage measure. All capital standards must be satisfied for an institution to be considered in compliance. The risk-based capital standards are designed to make regulatory capital requirements more sensitive to differences in risk profile among banks and bank holding companies, to account for off-balance sheet exposure, and to minimize disincentives for holding liquid assets. Assets and off-balance sheet items are assigned to broad risk categories, each with appropriate weights. The resulting capital ratios represent capital as a percentage of total risk-weighted assets and off-balance sheet items. For additional information, see “Capital Adequacy” in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

Prompt Corrective Action

The Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”) established a system of prompt corrective action to resolve the problems of undercapitalized institutions. Under this system, the federal banking regulators have established five capital categories (well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized), and are required to take certain mandatory supervisory actions, and are authorized to take other discretionary actions, with respect to institutions in the three undercapitalized categories. The severity of the action will depend upon the capital category in which the institution is placed. Generally, subject to a narrow exception, the banking regulator must appoint a receiver or conservator for an institution that is critically undercapitalized.

The federal banking agencies have specified by regulation the relevant capital level for each category as follows: (1) “Well capitalized,” consisting of institutions with a total risk-based capital ratio of 10.0% or greater, a Tier 1 risk-based capital ratio of 6.0% or greater and a leverage ratio of 5.0% or greater and which are not operating under an order, written agreement, capital directive or prompt corrective action directive; (2) “Adequately capitalized,” consisting of institutions with a total risk-based capital ratio of 8.0% or greater, a Tier 1 risk-based capital of 4.0%

 

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or greater and a leverage ratio of 4.0% or greater and which do not meet the definition of a “well capitalized” institution; (3) “Undercapitalized,” consisting of institutions with a total risk-based capital ratio of less than 8.0%, a Tier 1 risk-based capital ratio of less than 4.0%, or a leverage ratio of less than 4.0%; (4) “Significantly undercapitalized,” consisting of institutions with a total risk-based capital ratio of less than 6.0%, a Tier 1 risk-based capital ratio of less than 3.0%, or a leverage ratio of less than 3.0%; and (5) “Critically undercapitalized,” consisting of institutions with a ratio of tangible equity to total assets that is equal to or less than 2.0%.

An institution that is categorized as undercapitalized, significantly undercapitalized, or critically undercapitalized is required to submit an acceptable capital restoration plan to its appropriate federal banking agency. A bank holding company must guarantee that a subsidiary depository institution meets its capital restoration plan, subject to certain limitations. The controlling holding company’s obligation to fund a capital restoration plan is limited to the lesser of 5.0% of an undercapitalized subsidiary’s assets or the amount required to meet regulatory capital requirements. An undercapitalized institution is also generally prohibited from increasing its average total assets, making acquisitions, establishing any branches or engaging in any new line of business, except under an accepted capital restoration plan or with FDIC approval. In addition, the appropriate federal banking agency may treat an undercapitalized institution in the same manner as it treats a significantly undercapitalized institution if it determines that those actions are necessary.

Not later than 90 days after an institution becomes critically undercapitalized, the institution’s primary federal bank regulatory agency must appoint a receiver or a conservator, unless the agency, with the concurrence of the FDIC, determines that the purposes of the prompt corrective action provisions would be better served by another course of action. Any alternative determination must be documented by the agency and reassessed on a periodic basis. Notwithstanding the foregoing, a receiver must be appointed after 270 days unless the FDIC determines that the institution has positive net worth, is in compliance with a capital plan, is profitable or has a sustainable upward trend in earnings, and is reducing its ratio of non-performing loans to total loans, and unless the head of the appropriate federal banking agency and the chairperson of the FDIC certify that the institution is viable and not expected to fail.

Dividend Restrictions

FNB United is a legal entity separate and distinct from its bank and other subsidiaries. Because the principal source of FNB United’s revenues is dividends from the subsidiary bank, the ability of FNB United to pay dividends to its shareholders and to pay service on its own debt depends largely upon the amount of dividends its subsidiaries may pay to FNB United. There are statutory and regulatory limitations on the payment of dividends by the Bank to FNB United, as well as by FNB United to its shareholders.

Generally, the Bank must obtain the prior approval of the OCC to pay dividends if the total of all dividends declared by the Bank in any calendar year will exceed the sum of its net income for that year and its retained net income for the preceding two calendar years, less any transfers required by the OCC or to be made to retire any preferred stock. Currently, any dividend declaration by the Bank would require OCC approval under this requirement. Federal law also prohibits the Bank from paying dividends that in the aggregate would be greater than its undivided profits after deducting statutory bad debts in excess of its loan loss allowance.

FNB United and the Bank are also subject to various general regulatory policies and requirements relating to the payment of dividends, including requirements to maintain adequate capital above regulatory minimums. If, in the opinion of the appropriate federal regulatory authority, a bank under its jurisdiction is engaged in or is about to be engaged in an unsafe or unsound practice, the authority may require that the bank cease and desist from such practice. The Federal Reserve Board, the OCC and the FDIC have indicated that paying dividends that deplete a bank’s capital base to an inadequate level would be an unsafe and unsound banking practice. Under the Federal Deposit Insurance Corporation Improvement Act (“FDICIA”), an insured bank may not pay any dividend if payment would cause it to become undercapitalized or if it already is undercapitalized. Further, the Federal Reserve Board, OCC and FDIC have each indicated that banking institutions should generally pay dividends only out of current operating earnings.

The Consent Order with the OCC and the written agreement with the FRBR described above prohibit the payment of dividends by either the Bank or FNB United without written regulatory approval. The FDICIA prohibits dividend payments by the Bank because it is significantly undercapitalized.

FDIC Insurance

The deposits of the Bank are insured by the Deposit Insurance Fund (“DIF”) of the FDIC up to the limits set forth under applicable law and are subject to the deposit insurance premium assessments of the DIF. The FDIC imposes a risk-based deposit premium assessment system, which was amended pursuant to the Federal Deposit Insurance

 

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Reform Act of 2005 (the “Reform Act”) and further amended by the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). Under this system, as amended, the assessment rates for an insured depository institution vary according to the level of risk incurred in its activities. To arrive at an assessment rate for a banking institution, the FDIC places it in one of four risk categories determined by reference to its capital levels and supervisory ratings. In addition, in the case of those institutions in the lowest risk category, the FDIC further determines its assessment rate based on certain specified financial ratios or, if applicable, its long-term debt ratings. The assessment rate schedule can change from time to time, at the discretion of the FDIC, subject to certain limits. Under the current system, premiums are assessed quarterly. The FDIC has published guidelines under the Reform Act on the adjustment of assessment rates for certain institutions. In addition, insured depository institutions have been required to pay a pro rata portion of the interest due on the obligations issued by the Financing Corporation (FICO) to fund the closing and disposal of failed thrift institutions by the Resolution Trust Corporation.

On October 16, 2008, in response to the problems facing the financial markets and the economy, the Federal Deposit Insurance Corporation published a restoration plan (Restoration Plan) designed to replenish the Deposit Insurance Fund (DIF) such that the reserve ratio would return to 1.15% within five years. On December 16, 2008, the FDIC adopted a final rule increasing risk-based assessment rates uniformly by seven basis points, on an annual basis, for the first quarter 2009.

On February 27, 2009, the FDIC concluded that the problems facing the financial services sector and the economy at large constituted extraordinary circumstances and amended the Restoration Plan and extended the time within which the reserve ratio would return to 1.15% from five to seven years (Amended Restoration Plan). In May 2009, Congress amended the statutory provision governing establishment and implementation of a Restoration Plan to allow the FDIC eight years to bring the reserve ratio back to 1.15%, absent extraordinary circumstances.

On May 22, 2009, the FDIC adopted a final rule imposing a five basis point special assessment on each insured depository institution’s assets minus Tier 1 capital as of June 30, 2009. The special assessment was collected on September 30, 2009.

In a final rule issued on September 29, 2009, the FDIC amended the Amended Restoration Plan as follows:

 

   

The period of the Amended Restoration Plan was extended from seven to eight years.

   

The FDIC announced that it will not impose any further special assessments under the final rule it adopted in May 2009.

   

The FDIC announced plans to maintain assessment rates at their current levels through the end of 2010. The FDIC also immediately adopted a uniform three basis point increase in assessment rates effective January 1, 2011 to ensure that the DIF returns to 1.15 percent within the Amended Restoration Plan period of eight years.

   

The FDIC announced that, at least semi-annually following the adoption of the Amended Restoration Plan, it will update its loss and income projections for the DIF. The FDIC also announced that it may, if necessary, adopt a new rule prior to the end of the eight-year period to increase assessment rates in order to return the reserve ratio to 1.15 percent.

On November 12, 2009, the FDIC adopted a final rule requiring insured institutions to prepay their quarterly risk-based deposit insurance assessments for the fourth quarter of 2009, and for all of 2010, 2011 and 2012, on December 30, 2009, to replenish the depleted insurance fund.

The Dodd-Frank Act makes permanent the $250,000 deposit insurance limit for insured deposits and provides for full insurance of noninterest bearing transaction accounts beginning December 31, 2010, for two years. It also revises the assessment base against which an insured depository institution’s deposit insurance premiums paid to the DIF will be calculated. Under the amendments, the FDIC assessment base will no longer be the institution’s deposit base, but rather its average consolidated total assets less its average equity. The Dodd-Frank Act also changes the minimum designated reserve ratio of the DIF, increasing the minimum from 1.15% to 1.35% of the estimated amount of total insured deposits by September 30, 2020, and eliminating the requirement that the FDIC pay dividends to depository institutions when the reserve ratio exceeds certain thresholds. The FDIC is required to offset the effect of the increased minimum reserve ratio for banks with assets of less than $10 billion.

On November 21, 2008, the FDIC Board of Directors adopted a final rule implementing the Temporary Liquidity Guarantee Program (“TLGP”). The TLGP consists of two basic components: a guarantee of newly issued senior unsecured debt of banks, thrifts, and certain holding companies (the debt guarantee program) and full guarantee of non-interest bearing deposit transaction accounts, such as business payroll accounts, regardless of dollar amount (the transaction account guarantee program). The purpose of the guarantee of transaction accounts and the debt

 

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guarantee was to reduce funding costs and allow banks and thrifts to increase lending to consumers and businesses. All insured depository institutions were automatically enrolled in both programs unless they elected to opt out by a specified date.

As originally adopted, the transaction account guarantee program was to terminate on December 31, 2009, although the FDIC subsequently extended the program through December 31, 2010. The Dodd-Frank Act, which was adopted on July 21, 2010, included a provision that effectively replaced the transaction account guarantee program and extended the unlimited FDIC guarantee of noninterest bearing transaction accounts through December 31, 2012 for all insured depository institutions, not just those that elect to participate. Also, the Dodd-Frank Act provision, unlike the transaction account guarantee program, does not include low-interest NOW accounts within the definition of noninterest-bearing transaction accounts, and such accounts are therefore not covered by unlimited deposit insurance coverage. A subsequent amendment to the Dodd-Frank Act that became effective on December 31, 2010 extended unlimited deposit insurance coverage for “Interest on Lawyers Trust Accounts” through December 31, 2012.

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

Community Reinvestment Act

The Bank is subject to the provisions of the Community Reinvestment Act of 1977, as amended (“CRA”). Under the CRA, all financial institutions have a continuing and affirmative obligation consistent with their safe and sound operation to help meet the credit needs for their entire communities, including low- and moderate-income neighborhoods. 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.

The CRA requires the appropriate federal bank regulatory agency, in connection with its examination of the bank, to assess the bank’s record in meeting the credit needs of the community served by the bank, including low- and moderate-income neighborhoods. The regulatory agency’s assessment of the bank’s record is made available to the public. Should the Company fail to serve the community adequately, potential penalties are regulatory denials to expand branches, relocate, add subsidiaries and affiliates, expand into new financial activities and merge with or purchase other financial institutions.

Interstate Banking and Branching

The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (“Interstate Banking Act”) permits interstate acquisitions of banks by bank holding companies. FNB United and any other bank holding company located in North Carolina may acquire a bank located in any other state, and any bank holding company located outside North Carolina may lawfully acquire any North Carolina-based bank, regardless of state law to the contrary, in either case subject to certain deposit-percentage limitations, aging requirements and other restrictions. The Interstate Banking Act, as amended by the Dodd-Frank Act, also generally provides that a national or state-chartered bank may establish de novo branches in another state if the law of the state where the branch is to be located would permit a state bank chartered by that state to open the branch. The Interstate Banking Act and the Dodd-Frank Act may have the effect of increasing competition within the markets in which FNB United operates.

Depositor Preference Statute

Under federal law, depositors and certain claims for administrative expenses and employee compensation against an insured depository institution would be afforded a priority over other general unsecured claims against such an institution, including federal funds and letters of credit, in the “liquidation or other resolution” of such an institution by any receiver.

Gramm-Leach-Bliley Act

The Gramm-Leach-Bliley Act allows bank holding companies to engage in a wider range of nonbanking activities, including greater authority to engage in the securities and insurance businesses. Under the Gramm-Leach-Bliley Act, a bank holding company that elects to become a financial holding company may engage in any activity that is financial in nature, is incidental to financial activity or complements financial activity and does not pose a substantial risk to the safety or soundness of depository institutions or the financial system generally. Activities

 

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cited by the law as being “financial in nature” include securities underwriting, dealing in securities and market making, insurance underwriting and agency, providing financial, investment or economic advisory services, and activities that the Federal Reserve Board has determined to be closely related to banking. FNB United has not elected to become a financial holding company.

Subject to certain limitations on investment, a national bank or its financial subsidiary may also engage in activities that are financial in nature, other than insurance underwriting, insurance company portfolio investment, real estate development and real estate investment, so long as the bank is well-capitalized, well-managed and has at least a satisfactory CRA rating. Subsidiary banks of a financial holding company or national banks with financial subsidiaries must continue to be well-capitalized and well-managed to continue to engage in activities that are financial in nature. 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 at least a satisfactory CRA rating.

Privacy and Consumer Protection Laws

The Gramm-Leach-Bliley Act also modified other financial laws, including laws related to financial privacy. Under the act, federal banking regulators adopted rules limiting the ability of banks and other financial institutions to disclose nonpublic information about consumers to nonaffiliated third parties. The rules require disclosure of privacy policies to consumers and, in some circumstances, allow consumers to prevent disclosure of certain personal information to nonaffiliated third parties. The Fair Credit Reporting Act restricts information sharing among affiliates and was amended in December 2003 to restrict further affiliate sharing of information for marketing purposes.

In connection with their lending activities, the Bank and Dover are subject to a number of federal laws designed to protect borrowers. These laws include the Equal Credit Opportunity Act, the Trust in Lending Act, the Home Mortgage Disclosure Act, and the Real Estate Settlement Procedures Act.

International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001

The USA Patriot Act of 2001 contains the International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001 (the “IMLAFA”). The IMLAFA substantially broadens existing anti-money laundering legislation and the extraterritorial jurisdiction of the United States, imposes compliance and due diligence obligations, creates crimes and penalties, compels the production of documents located both inside and outside the United States, including those of foreign institutions that have a correspondent relationship in the United States, and clarifies the safe harbor from civil liability to customers. The U.S. Treasury Department has issued a number of regulations implementing the USA Patriot Act that apply certain of its requirements to financial institutions such as the Bank. The regulations impose obligations on financial institutions to maintain appropriate policies, procedures and controls to detect, prevent and report money laundering and terrorist financing and to verify the identity of their customers. The obligations of financial institutions under the USA Patriot Act have increased and may continue to increase. This increase has resulted in greater costs for the Bank, which may continue to rise and also may subject the Bank to greater liability.

Pursuant to the IMLAFA, the Company established anti-money laundering compliance and due diligence programs.

Sarbanes-Oxley Act of 2002

The Sarbanes-Oxley Act of 2002 addresses, among other issues, corporate governance, auditing and accounting, executive compensation and enhanced and timely disclosure of corporate information. The act is intended to allow shareholders to monitor more easily and efficiently the performance of public companies and their directors.

Emergency Economic Stabilization Act of 2008

In response to recent unprecedented market turmoil, the Emergency Economic Stabilization Act of 2008 (“EESA”) was enacted on October 3, 2008. EESA established the Troubled Asset Relief Program (“TARP”), which authorizes the Secretary of the Treasury to purchase or guarantee up to $700 billion in troubled assets from financial institutions. Pursuant to authority granted under EESA and as part of the TARP, the Secretary created the Capital Purchase Program (“CPP”) under which the Treasury Department would invest up to $250 billion in senior preferred stock of U.S. banks and savings associations or their holding companies. Qualifying financial institutions may issue senior preferred stock with a value equal to not less than 1% of risk-weighted assets and not more than the lesser of $25 billion or 3% of risk-weighted assets.

 

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Institutions participating in the TARP or CPP are required to issue warrants for common or preferred stock or senior debt to the Secretary. If an institution participates in the CPP or if the Secretary acquires a meaningful equity or debt position in the institution as a result of TARP participation, the institution is required to meet certain standards for executive compensation and corporate governance, including a prohibition against incentives to take unnecessary and excessive risks, recovery of bonuses paid to senior executives based on materially inaccurate earnings or other statements and prohibition against the payment of golden parachutes. Additional and modified standards with respect to executive compensation and corporate governance for institutions that have participated or will participate in the TARP (including the CPP) were enacted as part of the American Recovery and Reinvestment Act of 2009 (“ARRA”), described below.

CPP Participation

On February 13, 2009, FNB United entered into a Letter Agreement (the “Purchase Agreement”) with the Treasury Department under the CPP, pursuant to which FNB United agreed to issue 51,500 shares of its Fixed Rate Cumulative Perpetual Preferred Stock, Series A (the “Preferred Stock”), having a liquidation amount per share equal to $1,000, for a total price of $51.5 million. The Preferred Stock is to pay cumulative dividends at a rate of 5% per year for the first five years and thereafter at a rate of 9% per year. FNB United may not redeem the Preferred Stock during the first three years except with the proceeds from a “qualified equity offering” (as defined in FNB United’s articles of incorporation). However, under the ARRA, FNB United may redeem the Preferred Stock without a “qualified equity offering,” subject to the approval of its primary federal regulator. After three years, FNB United may, at its option, redeem the Preferred Stock at par value plus accrued and unpaid dividends. The Preferred Stock is generally non-voting, but does have the right to vote as a class on the issuance of any preferred stock ranking senior, any change in its terms or any merger, exchange or similar transaction that would adversely affect its rights. The holder(s) of Preferred Stock also have the right to elect two directors if dividends have not been paid for six periods.

As part of its purchase of the Preferred Stock, the Treasury Department received a warrant (the “Warrant”) to purchase 2,207,143 shares of FNB United’s common stock at an initial per share exercise price of $3.50. The Warrant provides for the adjustment of the exercise price and the number of shares of FNB United’s common stock issuable upon exercise pursuant to customary anti-dilution provisions, such as upon stock splits or distributions of securities or other assets to holders of FNB United’s common stock, and upon certain issuances of FNB United’s common stock at or below a specified price relative to the initial exercise price. The Warrant expires ten years from the issuance date. Pursuant to the Purchase Agreement, the Treasury Department has agreed not to exercise voting power with respect to any shares of common stock issued upon exercise of the Warrant. Under the ARRA, the Warrant would be liquidated upon the redemption by FNB United of the Preferred Stock.

Both the Preferred Stock and the Warrant are accounted for as components of Tier 1 capital.

Prior to February 13, 2012, unless FNB United has redeemed the Preferred Stock or the Treasury Department has transferred the Preferred Stock to a third party, the consent of the Treasury Department will be required for FNB United to (1) declare or pay any dividend or make any distribution on its common stock (other than regular quarterly cash dividends of not more than $0.10 per share of common stock) or (2) redeem, purchase or acquire any shares of its common stock or other equity or capital securities, other than in connection with benefit plans consistent with past practice and certain other circumstances specified in the Purchase Agreement.

American Recovery and Reinvestment Act of 2009

The ARRA was enacted on February 17, 2009. The ARRA includes a wide variety of programs intended to stimulate the economy and provide for extensive infrastructure, energy, health, and education needs. In addition, the ARRA amends the EESA and imposes certain new executive compensation and corporate governance obligations on all current and future TARP recipients, including FNB United, until the institution has redeemed the preferred stock, which TARP recipients are now permitted to do under the ARRA without regard to the three-year holding period and without the need to raise new capital, subject to approval of its primary federal regulator. The executive compensation restrictions under the ARRA (described below) are more stringent than those currently in effect under the CPP.

The ARRA amended Section 111 of the EESA to require the Secretary to adopt additional standards with respect to executive compensation and corporate governance for TARP recipients (including FNB United). The standards required to be established by the Secretary include, in part, (1) prohibitions on making golden parachute payments to senior executive officers and the next five most highly compensated employees during such time as any obligation arising from financial assistance provided under the TARP remains outstanding (the “Restricted Period”),

 

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(2) prohibitions on paying or accruing bonuses or other incentive awards for certain senior executive officers and employees, except for awards of long-term restricted stock with a value equal to no greater than one-third of the subject employee’s annual compensation that do not fully vest during the Restricted Period or unless such compensation is pursuant to a valid written employment contract prior to February 11, 2009, (3) requirements that TARP CPP participants provide for the recovery of any bonus or incentive compensation paid to senior executive officers and the next 20 most highly-compensated employees based on statements of earnings, revenues, gains or other criteria later found to be materially inaccurate, with the Secretary having authority to negotiate for reimbursement, and (4) a review by the Secretary of all bonuses and other compensation paid by TARP participants to senior executive employees and the next 20 most highly-compensated employees before the date of enactment of the ARRA to determine whether such payments were inconsistent with the purposes of the Act.

The ARRA also sets forth additional corporate governance obligations for TARP recipients, including requirements for the Secretary to establish standards that provide for semi-annual meetings of compensation committees of the board of directors to discuss and evaluate employee compensation plans in light of an assessment of any risk posed from such compensation plans. TARP recipients are further required by the ARRA to have in place company-wide policies regarding excessive or luxury expenditures and to include non-binding shareholder “say-on-pay” proposals in proxy materials. The chief executive officer and chief financial officer are required to provide written certifications with respect to compliance. The Secretary promulgated regulations to implement the executive compensation and certain corporate governance provisions detailed in the ARRA, which became effective June 15, 2009.

Dodd-Frank Wall Street Reform and Consumer Protection Act

On July 21, 2010, the Dodd-Frank Act was signed into law. The Dodd-Frank Act is extensive, complicated and comprehensive legislation that affects practically all aspects of a banking organization and represents a significant overhaul of many aspects of the regulation of the financial services industry. It is intended to affect a fundamental restructuring of federal banking regulation. Among other things, the Dodd-Frank Act creates a new Financial Stability Oversight Council to identify systemic risks in the financial system and gives federal regulators new authority to take control of and liquidate financial firms. The Dodd-Frank Act also provides for the creation of a new independent federal regulator to administer federal consumer protection laws.

Many aspects of the Dodd-Frank Act are subject to rulemaking and will take effect over several years, making it difficult to anticipate its overall financial impact on the Company, its customers or the financial industry more generally. Provisions in the legislation that affect deposit insurance assessments, payment of interest on demand deposits and interchange fees could increase the costs associated with deposits as well as place limitations on certain revenues those deposits may generate. Among the provisions that are likely to affect the Company are the following:

Holding Company Capital Requirements - The Dodd-Frank Act requires the Federal Reserve to apply consolidated capital requirements to depository institution holding companies that are no less stringent than those currently applied to depository institutions. Under these standards, trust preferred securities will be excluded from Tier 1 capital unless such securities were issued prior to May 19, 2010 by a bank holding company with less than $15 billion in assets. The Dodd-Frank Act additionally requires capital requirements to be countercyclical so that the required amount of capital increases in times of economic expansion and decreases in times of economic contraction, consistent with safety and soundness.

Corporate Governance - The Dodd-Frank Act will require publicly traded companies to give shareholders a non-binding vote on executive compensation at their first annual meeting taking place six months after the date of enactment and at least every three years thereafter and on so-called “golden parachute” payments in connection with approvals of mergers and acquisitions unless previously voted on by shareholders. The new legislation also authorizes the Securities and Exchange Commission (“SEC”) to promulgate rules that would allow shareholders to nominate their own candidates using a company’s proxy materials. Additionally, the Dodd-Frank Act directs the federal banking regulators to promulgate rules prohibiting excessive compensation paid to executives of depository institutions and their holding companies with assets in excess of $1.0 billion, regardless of whether the company is publicly traded or not. The Dodd-Frank Act gives the SEC authority to prohibit broker discretionary voting on elections of directors and executive compensation matters.

Prohibition Against Charter Conversions of Troubled Institutions - Effective one year after enactment, the Dodd-Frank Act prohibits a depository institution from converting from a state to federal charter or vice versa while it is the subject of a cease and desist order or other formal enforcement action or a memorandum of understanding with

 

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respect to a significant supervisory matter unless the appropriate federal banking agency gives notice of the conversion to the federal or state authority that issued the enforcement action and that agency does not object within 30 days. The notice must include a plan to address the significant supervisory matter. The converting institution must also file a copy of the conversion application with its current federal regulator which must notify the resulting federal regulator of any ongoing supervisory or investigative proceedings that are likely to result in an enforcement action and provide access to all supervisory and investigative information relating hereto.

Interstate Branching - The Dodd-Frank Act authorizes national and state banks to establish branches in other states to the same extent as a bank chartered by that state would be permitted to branch. Previously, banks could establish branches in other states only if the host state expressly permitted out-of-state banks to establish branches in that state. Accordingly, banks will be able to enter new markets more freely.

Transactions with Affiliates and Insiders - Effective one year from the date of enactment, the Dodd-Frank Act expands the definition of affiliate for purposes of quantitative and qualitative limitations of Section 23A of the Federal Reserve Act to include mutual funds advised by a depository institution or its affiliates. The Dodd-Frank Act will apply Section 23A and Section 22(h) of the Federal Reserve Act (governing transactions with insiders) to derivative transactions, repurchase agreements and securities lending and borrowing transaction that create credit exposure to an affiliate or an insider. Any such transactions with affiliates must be fully secured. The current exemption from Section 23A for transactions with financial subsidiaries will be eliminated. The Dodd-Frank Act will additionally prohibit an insured depository institution from purchasing an asset from or selling an asset to an insider unless the transaction is on market terms and, if representing more than 10% of capital, is approved in advance by the disinterested directors.

Consumer Financial Protection Bureau - The Dodd-Frank Act creates a new, independent federal agency called the Consumer Financial Protection Bureau (“CFPB”), which is granted broad rulemaking, supervisory and enforcement powers under various federal consumer financial protection laws, including the Equal Credit Opportunity Act, Truth in Lending Act, Real Estate Settlement Procedures Act, Fair Credit Reporting Act, Fair Debt Collection Act, the Consumer Financial Privacy provisions of the Gramm-Leach-Bliley Act and certain other statutes. The CFPB will have examination and primary enforcement authority with respect to depository institutions with $10 billion or more in assets. Smaller institutions will be subject to rules promulgated by the CFPB but will continue to be examined and supervised by federal banking regulators for consumer compliance purposes. The CFPB will have authority to prevent unfair, deceptive or abusive practices in connection with the offering of consumer financial products. The Dodd-Frank Act authorizes the CFPB to establish certain minimum standards for the origination of residential mortgages, including a determination of the borrower’s ability to repay. In addition, the Dodd-Frank Act will allow borrowers to raise certain defenses to foreclosure if they receive any loan other than a “qualified mortgage,” as defined by the CFPB. The Dodd-Frank Act permits states to adopt consumer protection laws and standards that are more stringent than those adopted at the federal level and, in certain circumstances, permits state attorneys general to enforce compliance with both the state and federal laws and regulations.

Future Legislation

Changes to the laws and regulations in the United States and North Carolina can affect the Company’s operating environment in substantial and unpredictable ways. FNB United cannot predict whether those changes in laws and regulations will occur, and, if those changes occur, the ultimate effect they would have upon the financial condition or results of operations of the Company. The nature and extent of future legislative, regulatory or other changes affecting financial institutions is highly unpredictable at this time. Due to the current economic environment and issues facing the financial services industry in particular, new legislative and regulatory initiatives may be anticipated over the next several years, including those focused specifically on banking and mortgage lending.

Employees

As of December 31, 2010, FNB United had four officers, all of whom were also officers of the Bank. On that same date, the Bank had 426 full-time employees and 40 part-time employees and Dover had 56 full-time employees and no part-time employees. The Bank and Dover each considers its relationship with its employees to be excellent. The Company provides employee benefit programs, including a matching retirement/savings (“401(k)”) plan, group life, health and dental insurance, paid vacations and sick leave.

The Company’s employee benefit programs formerly included a noncontributory defined benefit pension plan and healthcare and life insurance benefits for retired employees. In September 2006, the Board of Directors of FNB United approved a modified freeze to the pension plan. Effective December 31, 2006, no new employees were eligible to enter the plan. Participants who were at least age 40, had earned 10 years of vesting service as an

 

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employee of FNB United and remain an active employee as of December 31, 2006 qualified for continued benefits under a grandfathering provision. Under that provision, the grandfathered participant will continue to accrue benefits under the plan through December 31, 2011. All other eligible participants in the plan had their retirement benefit frozen as of December 31, 2006. Effective January 1, 2007, the 401(k) plan became the primary retirement benefit plan. However, in November 2010, the Board of Directors of the Company approved an additional amendment to the plan which ceases participant benefit accruals as of December 31, 2010.

The Company has a noncontributory, nonqualified supplemental executive retirement plan (the “SERP”) covering certain executive employees. Annual benefits payable under the SERP are based on factors similar to those for the pension plan, with offsets related to amounts payable under the pension plan and social security benefits. SERP costs, which are actuarially determined using the projected unit credit method and recorded on an unfunded basis, are charged to current operations and credited to a liability account on the consolidated balance sheet. In 2010, the Board of Directors approved an amendment to the plan which stops additional benefit accrual under the SERP after December 31, 2010. This action does not impact a participant’s vested or accrued benefit in the plan.

In conjunction with the modified freeze of the pension plan, the postretirement medical and life insurance plan was also amended. Effective December 31, 2006, no new employees were eligible to enter the plan. Participants who were at least age 40, had earned 10 years of vesting service as an employee of the Company and remained an active employee as of December 31, 2006 qualified under a grandfathering provision. Under the grandfathering provision, the participant was eligible to continue to accrue benefits under the plan through December 31, 2011. However, in November 2010, the Board of Directors of the Company approved an additional amendment to the plan which ceases participant benefit accruals as of December 31, 2010.

Available Information

The Company makes its annual report on Form 10-K, quarterly reports on Form 10-Q, and current reports on Form 8-K, and amendments to those reports, available free of charge on its internet website at www.MyYesBank.com, as soon as reasonably practicable after the reports are electronically filed or furnished with the Securities and Exchange Commission. Any materials that the Company files with the SEC may be read or copied or both at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. Information on the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. These filings are also accessible on the SEC’s website at www.sec.gov. FNB United will provide without charge a copy of its annual report on Form 10-K to any shareholder by mail. Requests should be sent to FNB United Corp., Attention: Secretary, 150 South Fayetteville Street (27203), P.O. Box 1328, Asheboro, North Carolina 27204.

Additionally, the Company’s corporate governance policies, including the charters of the Audit, Compensation, and Corporate Governance and Nominating Committees; and the Company’s Code of Business Ethics may also be found through the “Investor Relations” link on the Company’s website.

 

Item 1A. RISK FACTORS

The Company is subject to certain risks and an investment in the Company’s securities may involve risks due to the nature of the Company’s business and activities related to that business. In addition to the factors discussed below, please see the discussion under “Item 7A. Quantitative and Qualitative Disclosure about Market Risk.” These factors, along with the other information in this Annual Report on Form 10-K, should be considered in evaluating forward-looking statements, and undue reliance should not be placed on such statements.

Failure to Comply with Regulatory Orders Could Result in Adverse Actions and Restrictions.

The Company is operating under a Consent Order issued by the OCC, the Bank’s primary regulator, on July 22, 2010, and a written agreement with the Federal Reserve Bank of Richmond, entered into on October 21, 2010. In the Consent Order, the Bank and the OCC agreed as to the areas of the Bank’s operations that warrant improvement and a plan for making those improvements. The Consent Order required the Bank to develop and submit written strategic and capital plans covering at least a three-year period. The Bank is required to review and revise various policies and procedures, including those associated with concentration management, the allowance for loan losses, liquidity management, criticized asset, loan review and credit. The written agreement with the Federal Reserve Bank obligates FNB United to cause the Bank to comply with the OCC Consent Order and requires, among other things, that FNB United submit to it an acceptable written capital plan for the Company, cash flow projections for 2011 and thereafter on an annual basis, and quarterly progress reports as to its compliance with the agreement.

Any material failure to comply with the provisions of the Consent Order could result in further enforcement actions by the OCC or the Federal Reserve Bank. In addition, if the OCC does not accept the capital plan or the Bank fails to achieve the minimum capital levels, the OCC may require that the Bank develop a plan to sell, merge or liquidate

 

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the Bank. While the Company intends to take such actions as may be necessary to enable it to comply with the requirements of the Consent Order and the written agreement, there can be no assurance that the Bank will be able to comply fully with the provisions of the Consent Order, or that efforts to comply with the Consent Order and written agreement, particularly the limitations on interest rates offered by the Bank, will not have adverse effects on the operations and financial condition of the Company and the Bank.

There Is Substantial Doubt about FNB United’s Ability to Continue as a Going Concern.

As discussed above, the Bank is subject to a Consent Order issued by the OCC and FNB United is under a written agreement with the Federal Reserve Bank of Richmond that require the Company to increase its leverage and total risk-based capital ratios and, at December 31, 2010, the Company was significantly below the required levels. Failure to increase the Company’s capital ratios or further declines in the capital ratios exposes the Company to additional restrictions and regulatory actions, including potential regulatory receivership. This uncertainty as to the Company’s ability to meet existing or future regulatory requirements raises substantial doubt about its ability to continue as a going concern. Unless the Company is able to raise sufficient levels of capital in the very near future, it will be unable to meet the capital ratio requirement. The Company’s audited financial statements were prepared under the assumption that it will continue its operations on a going concern basis, which contemplates the realization of assets and the discharge of liabilities in the normal course of business. The Company’s financial statements do not include any adjustments that might be necessary if the Company is unable to continue as a going concern. If the Company cannot continue as a going concern, the FNB United shareholders will lose some or all of their investment in the Company. In addition, the Bank’s customers, employees, vendors, correspondent institutions, and others with whom the Bank does business may react negatively to the substantial doubt about our ability to continue as a going concern. This negative reaction may lead to heightened concerns regarding the Company’s financial condition that could result in a significant loss in deposits and customer relationships, key employees, vendor relationships and our ability to do business with correspondent institutions upon which we rely.

The Bank Is Significantly Undercapitalized; A Further Decline in FNB United’s Capital Position, and the Unavailability of Additional Regulatory Capital, Could Adversely Its Financial Condition and Operations.

At December 31, 2010, the Bank was classified as “significantly undercapitalized” for regulatory capital purposes. Being significantly undercapitalized subjects the Bank to prompt corrective action restrictions on its activities, including, without limitation, limitations on its asset growth and possible required reductions in assets, restrictions on interest rates payable on deposits, prohibitions on accepting, renewing or rolling over brokered deposits, additional restrictions on transactions with affiliates, a prohibition on the Bank’s accepting employee benefit plan deposits, and the required alteration or termination of any activity that the OCC determines poses excessive risks to the Bank. If the Bank’s capital levels were to decline further to “critically undercapitalized,” the Bank may be subject to being placed in regulatory receivership.

FNB United’s ability to increase and maintain capital levels, sources of funding and liquidity could be adversely affected by changes in the capital markets in which the Company operates. Loan loss provisions of $115.2 million during 2010 contributed to the decrease in total capital to risk-adjusted assets at both FNB United and the Bank. FNB United’s ability to raise additional capital will depend on conditions in the capital markets, which are outside the Company’s control, and on FNB United’s financial performance and its ability to obtain resolution of nonperforming assets. Additional significant increases in the Bank’s allowance for loan losses, significant write-downs of foreclosed real estate and other assets, or other operating losses would decrease the Company’s capital levels further.

FNB United Is Vulnerable to the Economic Conditions within the Relatively Small Region in Which It Operates

FNB United’s overall success is dependent on the general economic conditions within its market area, which extends from the central and southern Piedmont and Sandhills of North Carolina to the foothills and mountains of western North Carolina. The economic downturn in this fairly small geographic region has negatively affected FNB United’s customers and has adversely affected FNB United. For example, high levels of unemployment and depressed real estate values have weakened the economy of the region and depressed the Company’s earnings and financial condition.

Overall, during 2009 and 2010, the North Carolina business environment has been adverse for many households and businesses and continues to deteriorate. There can be no assurance that these conditions will improve in the near term. The continuation of these conditions could further adversely affect the credit quality of the Company’s loans, the value of collateral securing loans to borrowers, the value of the Company’s investment securities and its overall results of operation and financial condition. Until the economic conditions within FNB United’s footprint improve, the Company expects that its business, financial condition and results of operations to be adversely affected.

 

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Weaknesses in the Markets for Residential or Commercial Real Estate Could Reduce FNB United’s Net Income and Profitability

Real estate lending (including commercial, construction, land development, and residential) is a large portion of the Bank’s loan portfolio. These categories constitute $1.2 billion, or approximately89.4%, of the Bank’s total loan portfolio. These categories are generally affected by changes in economic conditions, fluctuations in interest rates and the availability of loans to potential purchasers, changes in tax and other laws and acts of nature. Further downturns in the real estate markets in which the Company originates, purchases, and services mortgage and other loans could hurt its business because these loans are secured by real estate. The softening of the real estate market through 2009 and 2010 has adversely affected the Company’s net income. If there are further declines in the market, they will adversely affect the Company’s future earnings.

FNB United Faces Significant Operational Risk

FNB United is exposed to many types of operational risk, including reputational risk, legal and compliance risk. Operational risk includes the risk of fraud or theft by employees or persons outside FNB United, unauthorized transactions by employees or operational errors, including clerical or recordkeeping errors or those resulting from faulty or disabled computer or telecommunications systems, and breaches of the internal control system and compliance requirements. Negative public opinion can result from FNB United’s actual or alleged conduct in a variety of areas, including lending practices, corporate governance and acquisitions and from actions taken by government regulators and community organizations in response to those activities. Negative public opinion can adversely affect FNB United’s ability to attract and retain customers and can expose it to litigation and regulatory action. Operational risk also includes potential legal actions that could arise from an operational deficiency or as a result of noncompliance with applicable regulatory standards.

Because the nature of the banking business involves a high volume of transactions, certain errors may be repeated or compounded before they are found and corrected. FNB United’s necessary reliance upon automated systems to record and process its transactions may further increase the risk that technical flaws or employee tampering or manipulation of those systems will result in losses that are difficult to detect. FNB United may also be subject to disruptions of its operating systems arising from events that are wholly or partially beyond its control (e.g., computer viruses or electrical or telecommunications outages), which may give rise to disruption of service to customers and to financial loss or liability. The Company is further exposed to the risk that its external vendors may be unable to fulfill their contractual obligations (or will be subject to the same risk of fraud or operational errors by their employees as is FNB United) and to the risk that the Company’s (or its vendors’) business continuity and data security systems prove to be inadequate.

FNB United’s Decisions Regarding Credit Risk Could Be Inaccurate and Its Allowance for Loan Losses May Be Inadequate, Which May Adversely Affect FNB United’s Financial Condition and Results of Operations

The Company’s largest source of revenue is payments on loans made to the Bank’s customers. Borrowers may not repay their loans according to the terms of those loans, and the collateral securing the payment of the loans may not be sufficient to assure repayment. The Company may experience significant loan losses, which could have a material adverse effect on FNB United’s operating results. Management makes various assumptions and judgments about the collectability of the loan portfolio, including the creditworthiness of the borrowers and the value of the real estate, which is obtained from independent appraisers, and other assets serving as collateral for the repayment of the loans.

FNB United maintains an allowance for loan losses that it considers adequate to absorb losses inherent in the loan portfolio based on its assessment of all available information. In determining the size of the allowance, FNB United relies on an analysis of the loan portfolio based on, among other things, historical loss experience, volume and types of loans, trends in classification, volume and trends in delinquencies and nonaccruals, and general economic conditions, both local and national. If management’s assumptions are wrong, the loan loss allowance may not be sufficient to cover loan losses, and adjustments may be necessary to allow for different economic conditions or adverse developments in the loan portfolio. Material additions to the allowance would materially decrease FNB United’s net income. Banking regulators periodically review the Company’s allowance for loan losses and may require FNB United to increase the allowance or recognize further loan charge-offs based on judgments different from those of management. Any increase in the allowance for loan losses or loan charge-offs required by regulatory authorities could have a negative effect on FNB United’s operating results.

 

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Increases in FDIC Insurance Premiums May Adversely Affect FNB United’s Net Income and Profitability.

FNB United is generally unable to control the amount of premiums that the Company is required to pay for FDIC insurance. During 2008 and continuing in 2010, higher levels of bank failures have dramatically increased resolution costs of the FDIC and depleted the deposit insurance fund. In addition, the FDIC instituted two temporary programs to further insure customer deposits at FDIC insured banks: deposit accounts are now insured up to $250,000 per customer (up from $100,000) and noninterest-bearing transactional accounts are currently fully insured (unlimited coverage). These programs have placed additional stress on the deposit insurance fund. To maintain a strong funding position and restore reserve ratios of the deposit insurance fund, the FDIC has increased assessment rates of insured institutions. On November 12, 2009, the FDIC adopted a rule requiring banks to prepay three years worth of estimated deposit insurance premiums by December 31, 2009. The Dodd-Frank Act also imposes additional assessments and costs with respect to deposits, requiring the FDIC to impose deposit insurance assessments based on total assets rather than total deposits, as well as making permanent the increase of deposit insurance to $250,000 and providing for full insurance of non-interest bearing transaction accounts beginning December 31, 2010, for two years. These announced increases, legislative and regulatory changes and any future increases or required prepayments of FDIC insurance premiums may adversely affect FNB United’s earnings and financial condition. If there are additional bank or financial institution failures, or the cost of resolving prior failures exceeds expectations, the Company may be required to pay even higher FDIC premiums than the recently increased levels.

FNB United’s Liquidity Could Be Impaired by an Inability to Access the Capital Markets or an Unforeseen Outflow of Cash.

Liquidity is essential to FNB United’s businesses and FNB United has a significant base of core deposits, which historically has been stable. Due to circumstances that FNB United may be unable to control, however, such as a general market disruption or an operational problem that affects third parties or FNB United, the Company’s liquidity could be impaired by an inability to access the capital markets or an unforeseen outflow of cash.

The Capital and Credit Markets Have Experienced Unprecedented Levels of Volatility.

During the economic downturn, the capital and credit markets experienced extended volatility and disruption. In some cases, the markets produced downward pressure on stock prices and credit capacity for certain issuers without regard to those issuers’ underlying financial strength. If these levels of market disruption and volatility continue, worsen or abate and then arise at a later date, the Company’s ability to access capital could be materially impaired. FNB United’s inability to access the capital markets could constrain the Company’s ability to comply with the terms of the Consent Order with the OCC and the written agreement with the Federal Reserve Bank of Richmond, to make new loans, and to meet the Company’s existing lending commitments and, ultimately jeopardize the Company’s overall liquidity and capitalization.

FNB United May Experience Significant Competition in its Market Area, Which May Adversely Affect its Business

The commercial banking industry within FNB United’s market area is extremely competitive. In addition, FNB United competes with other providers of financial services, such as savings and loan associations, credit unions, insurance companies, consumer finance companies, brokerage firms, the mutual funds industry, and commercial finance and leasing companies, some of which are subject to less extensive regulations than is the Company with respect to the products and services they provide. Some of FNB United’s larger competitors include several large interstate financial holding companies that are among the largest in the nation and are headquartered in North Carolina. These companies have a significant presence in FNB United’s market area, have greater resources than FNB United, may have higher lending limits and may offer products and services not offered by FNB United. These institutions may be able to offer the same products and services at more competitive rates and prices.

FNB United also experiences competition from a variety of institutions outside of the Company’s market area. Some of these institutions conduct business primarily over the Internet and may thus be able to realize certain cost savings and offer products and services at more favorable rates and with greater convenience to the customer who can pay bills and transfer funds directly without going through a bank. This “disintermediation” could result in the loss of fee income, as well as the loss of customer deposits and income generated from those deposits. In addition, changes in consumer spending and saving habits could adversely affect FNB United’s operations, and the Company may be unable to timely develop competitive new products and services in response to these changes.

Changes in Interest Rates May Have an Adverse Effect on FNB United’s Profitability

FNB United’s earnings and financial condition are dependent to a large degree upon net interest income, which is the difference between interest earned from loans and investments and interest paid on deposits and borrowings. The narrowing of the margin between interest rates earned on loans and investments and the interest rates paid on

 

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deposits and borrowings could adversely affect FNB United’s earnings and financial condition. FNB United can neither predict with certainty nor control changes in interest rates. These changes can occur at any time and are affected by many factors, including national, regional and local economic conditions, competitive pressures, and monetary policies of the Federal Reserve Board. FNB United has ongoing policies and procedures designed to manage the risks associated with changes in market interest rates. Notwithstanding these policies and procedures, changes in interest rates may have an adverse effect on FNB United’s financial results. For example, high interest rates could adversely affect FNB United’s mortgage banking business because higher interest rates could cause customers to apply for fewer mortgages or mortgage refinancings.

FNB United’s Ability to Pay Dividends Is Limited and the Payment of Any Dividend Has Been Restricted by Law and Regulatory Order, Leaving Appreciation in the Value of the Company’s Common Stock as the Sole Opportunity for Returns on Investments Made in FNB United Common Stock.

The holders of FNB common stock are entitled to receive dividends when and if declared by the board of directors out of funds legally available for the payment of dividends. Because the principal source of FNB United’s revenues is dividends from the Bank, the ability of FNB United to pay dividends to its shareholders is dependent upon the amount of dividends the Bank may pay to FNB United. There are statutory and regulatory limitations on the payment of dividends by the Bank to FNB United, as well as by FNB United to its shareholders.

The Federal Deposit Insurance Corporation Improvement Act prohibits the Bank’s paying any dividend because of its being “significantly undercapitalized.” In addition, under the terms of the Consent Order with the OCC, the Bank is prohibited from paying any dividends or making any capital distributions until such time as it is compliance with the capital plan required by the Consent Order and it receives the prior written approval of the OCC. In addition, the Bank must obtain the prior approval of the OCC to pay dividends if the total of all dividends declared by the Bank in any calendar year will exceed the sum of its net income for that year and its retained net income for the preceding calendar years, less certain transfers. The written agreement between FNB United and the Federal Reserve Bank of Richmond prohibits FNB United from declaring or paying any dividends without the prior written approval of the Federal Reserve Bank and the Director of the Division of Banking Supervision and Regulation of the Board of Governors of the Federal Reserve System. The written agreement further prohibits FNB United from taking any dividends or any other form of payment representing a reduction in capital from the Bank without the prior written approval of the Federal Reserve Bank.

The Treasury Department’s Investment in FNB United Imposes Restrictions and Obligations Limiting FNB United’s Ability to Increase Dividends, Repurchase Common Stock or Preferred Stock and Access the Equity Capital Markets

In February 2009, FNB United issued preferred stock and a warrant to purchase common stock to the Treasury Department under the CPP. Prior to February 13, 2012, unless FNB United has redeemed all of the preferred stock, or the Treasury Department has transferred all of the preferred stock to a third party, the consent of the Treasury Department will be required for FNB United to, among other things, increase quarterly common stock dividends beyond $0.10 per share or effect repurchases of common stock or other equity or capital securities (with certain exceptions, including the repurchase of FNB United Corp. common stock to offset share dilution from equity-based employee compensation awards). FNB United’s ability to declare or pay dividends or repurchase its common stock or other equity or capital securities is also subject to restrictions in the event that FNB United fails to declare and pay full dividends (or declare and set aside a sum sufficient for payment thereof) on the preferred stock held by the Treasury Department.

The Company’s Decision to Defer Interest on Its Trust Preferred Securities Will Likely Restrict Its Access to the Trust Preferred Securities Market until Such Time as It Is Current on Interest Payments, Which Will Limit Its Sources of Liquidity.

On April 22, 2010, the Board of Directors elected to defer further interest payments on each of the series of junior subordinated debt securities relating to the trust preferred securities of FNB United Statutory Trust I, FNB United Statutory Trust II, and Catawba Valley Capital Trust II. The Company has the right under each indenture for the junior subordinated debt securities to defer interest payments for up to 20 consecutive calendar quarters. The deferral provisions for these securities were intended to provide the Company with a measure of financial flexibility during times of financial stress due to market conditions, such as the current state of the financial and real estate markets.

As a result of the Company’s election to exercise its contractual right to defer interest payments on its junior subordinated debt securities, it is likely that the Company will not have access to the trust preferred securities market until the Company becomes current on those obligations. This may also adversely affect the Company’s ability in the market to obtain debt financing. Therefore, the Company is likely to have greater difficulty in obtaining

 

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financing and, thus, will have fewer sources to enhance its capital and liquidity position. In addition, the Company will be unable to pay dividends on its common stock until such time as the Company is current on interest payments on its junior subordinated debt securities. Currently there is no market for trust preferred securities.

FNB United’s Stock Price Can Be Volatile.

FNB United’s stock price can fluctuate widely in response to a variety of factors including actual or anticipated variations in quarterly operating results, recommendations by securities analysts, operating and stock price performance of other companies that investors deem comparable to FNB United, news reports relating to trends, concerns and other issues in the financial services industry, changes in government regulations, and geopolitical conditions such as acts or threats of terrorism or military conflicts.

FNB United’s Business Could Suffer If It Fails to Attract and Retain Skilled People

FNB United’s success depends, in large part, on its ability to attract and retain competent, experienced people. As a result of FNB United’s participation in the CPP, the Company is required to meet certain standards for executive compensation as set forth under the EESA, and related regulations. The Company’s financial condition and results of operations have caused the board of directors of FNB United to freeze salaries and members of management generally have not seen increases in their salaries since 20    . The imposition of compensation limits resulting from the Treasury Department’s investment in FNB United and the salary freeze, in addition to other competitive pressures, may have an adverse effect on the ability of FNB United to attract and retain skilled personnel, resulting in FNB United’s not being able to hire or retain the best people. The loss of key personnel could have an adverse effect on the Bank and the Company’s future results of operations.

Changes in Laws and Regulations and the Regulatory Environment Could Have a Material Adverse Effect on FNB United

FNB United is extensively regulated under federal and state banking laws and regulations that are intended primarily for the protection of depositors, federal deposit insurance funds and the banking system as a whole. In addition, the Company is subject to changes in federal and state laws as well as changes in banking and credit regulations, and governmental economic and monetary policies. FNB United cannot predict whether any of these changes may adversely and materially affect the Company. The current regulatory environment for financial institutions entails significant potential increases in compliance requirements and associated costs, including those related to consumer credit, with a focus on mortgage lending. For example, the enactment of the Dodd-Frank Act represents a significant overhaul of many aspects of the regulation of the financial services industry, which could result in higher compliance costs and otherwise materially adversely affect FNB United’s business, financial condition or results of operations.

Federal and state banking regulators possess broad powers to take supervisory actions as they deem appropriate. These actions may result in higher capital requirements, higher insurance premiums and limitations on FNB United’s activities that could have a material adverse effect on the Company’s business and profitability.

The Passage of the Dodd-Frank Act May Result in Lower Revenues and Higher Costs.

On July 21, 2010, the President signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law. The law includes, among other things: the creation of a Financial Services Oversight Council to identify emerging systemic risks and improve interagency cooperation; the creation of a Bureau of Consumer Financial Protection (“CFPB”) authorized to promulgate and enforce consumer protection regulations relating to financial products, which would affect both banks and non-bank finance companies; the establishment of strengthened capital and prudential standards for banks and bank holding companies; enhanced regulation of financial markets, including derivatives and securitization markets; the elimination of certain trading activities from banks; and a permanent increase of the previously implemented temporary increase of FDIC deposit insurance to $250,000.

While the bill has been signed into law, a number of provisions of the law remain to be implemented through the rulemaking process at various regulatory agencies. FNB United is unable to predict what the final form of these rules will be when implemented by the respective agencies, but management believes that certain aspects of the new legislation, including, without limitation, the additional cost of higher deposit insurance and the costs of compliance with disclosure and reporting requirements and examinations by the CFPB, could have a significant impact on the Company’s business, financial condition and results of operations. Additionally, FNB United cannot predict whether there will be additional proposed laws or reforms that would affect the U.S. financial system or financial institutions, whether or when such changes may be adopted, how such changes may be interpreted and enforced or how such changes may affect the Company.

 

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The Provisions of the Dodd-Frank Act Restricting Bank Interchange Fees May Negatively Affect FNB United’s Revenues and Earnings.

Under the Dodd-Frank Act, the Federal Reserve must adopt rules regarding the interchange fees that may be charged with respect to electronic debit transactions, to take effect one year after enactment. The limits to be placed on debit interchange fees may significantly reduce the Bank’s debit card interchange revenues. Interchange fees, or “swipe” fees, are charges that merchants pay to the Bank and other credit card companies and card-issuing banks for processing electronic payment transactions. The Dodd-Frank Act provides the Federal Reserve with authority over interchange fees received or charged by a card issuer and requires that fees must be “reasonable and proportional” to the costs of processing such transactions. Although final rules have not yet been adopted, this provision of the Dodd-Frank Act and the applicable rules ultimately issued under the Act are expected to cause significant reductions in future card-fee revenues generated by the Bank, while also creating meaningful compliance costs.

Recently Enacted Consumer Protection Regulations Related to Automated Overdraft Payment Programs Could Adversely Affect FNB United’s Business Operations, Net Income and Profitability.

The Federal Reserve and the FDIC recently enacted consumer protection regulations related to automated overdraft payment programs offered by financial institutions. The Bank has implemented, and is in the process further implementing, changes to its business practices relating to overdraft payment programs to comply with these regulations.

For the years ended December 31, 2010 and December 31, 2009, the Bank’s overdraft and insufficient funds fees have represented a significant amount of non-interest fees collected by it. Implementing the changes required by these regulations will decrease the amount of fees the Bank receives for automated overdraft payment services and adversely affect the Bank’s non-interest income. Complying with these regulations results in increased operational costs for the Bank, which may continue to rise. The actual impact of these regulations in future periods could vary due to a variety of factors, including changes in customer behavior, economic conditions and other factors, which could adversely affect FNB United’s business operation, net income and profitability.”

Differences in Interpretation of Tax Laws and Regulations May Adversely Affect FNB United’s Financial Statements.

Local, state or federal tax authorities may interpret tax laws and regulations differently than FNB United and challenge tax positions that FNB United has taken on its tax returns. This may result in the disallowance of deductions or credits, differences in the timing of deductions and the payment of additional taxes, interest or penalties that could have a material adverse effect on FNB United’s performance.

Significant Litigation Could Have a Material Adverse Effect on FNB United.

FNB United faces legal risks in its business, and the volume of claims and amount of damages and penalties claimed in litigation and regulatory proceedings against financial institutions remain high. Substantial legal liability or significant regulatory action against FNB United may have material adverse financial effects or cause significant reputational harm to FNB United, which in turn could seriously harm FNB United’s business prospects.

Maintaining or Increasing FNB United’s Market Share May Depend on Lowering Prices and Market Acceptance of New Products and Services.

FNB United’s success depends, in part, on its ability to adapt its products and services to evolving industry standards. There is increasing pressure to provide products and services at lower prices. Lower prices can reduce FNB United’s net interest margin and revenues from its fee-based products and services. In addition, the widespread adoption of new technologies, including internet services, could require the Company to make substantial expenditures to modify or adapt its existing products and services. Also, these and other capital investments in FNB United’s business may not produce expected growth in earnings anticipated at the time of the expenditure. The Company may not be successful in introducing new products and services, achieving market acceptance of its products and services, or developing and maintaining loyal customers.

Market Developments May Adversely Affect FNB United’s Industry, Business and Results of Operations.

Significant declines in the housing market, with falling home prices and increasing foreclosures and unemployment, have resulted in significant write-downs of asset values by many financial institutions, including government-sponsored entities and major commercial and investment banks. These write-downs, initially of mortgage-backed securities but spreading to credit default swaps and other derivative securities, caused many financial institutions to seek additional capital, to merge with larger and stronger institutions and, in some cases, to fail. During this time FNB United has experienced significant challenges, its credit quality has deteriorated and its net income and results

 

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of operations have been adversely affected. Reflecting concern about the stability of the financial markets generally and the strength of counterparties, many lenders and institutional investors have reduced, and in some cases, ceased to provide funding to borrowers including other financial institutions. FNB United is part of the financial system and a systemic lack of available credit, a lack of confidence in the financial sector, increased volatility in the financial markets and/or reduced business activity could materially adversely affect the Company’s business, financial condition and results of operations.

The Soundness of Other Financial Institutions Could Adversely Affect FNB United.

Financial services institutions are interrelated as a result of trading, clearing, counterparty, or other relationships. FNB United has exposure to many different industries and counterparties, and FNB United routinely executes transactions with counterparties in the financial services industry, including brokers and dealers, commercial banks, investment banks, mutual and hedge funds, and other institutional clients. Many of these transactions expose the Company to credit risk in the event of default of its counterparty or client. In addition, the Company’s credit risk may be exacerbated when collateral is liquidated at prices not sufficient to recover the full amount of the loan or derivative exposure due FNB United. These types of losses could materially and adversely affect the Company’s results of operations or financial condition.

FNB United Faces Systems Failure Risks as Well as Security Risks, Including “Hacking” and “Identity Theft”

The computer systems and network infrastructure used by FNB United and others could be vulnerable to unforeseen problems. These problems may arise in the Company’s internally developed systems or the systems of its third-party vendors or both. The Company’s operations are dependent upon its ability to protect computer equipment against damage from fire, power loss, or telecommunications failure. Any damage or failure that causes an interruption in the Company’s operations could adversely affect FNB United’s business and financial results. In addition, the Company’s computer systems and network infrastructure present security risks, and could be susceptible to hacking or identity theft.

FNB United’s Reported Financial Results Depend on Management’s Selection of Accounting Methods and Certain Assumptions and Estimates.

FNB United’s accounting policies and methods are fundamental to the methods by which the Company records and reports its financial condition and results of operations. The Company’s management must exercise judgment in selecting and applying many of these accounting policies and methods so they comply with generally accepted accounting principles and reflect management’s judgment of the most appropriate manner to report FNB United’s financial condition and results. In some cases, management must select the accounting policy or method to apply from two or more alternatives, any of which may be reasonable under the circumstances, yet may result in the Company reporting materially different results than would have been reported under a different alternative.

Certain accounting policies are critical to presenting FNB United’s financial condition and results. They require management to make difficult, subjective or complex judgments about matters that are uncertain. Materially different amounts could be reported under different conditions or using different assumptions or estimates. These critical accounting policies include: the allowance for credit losses; the determination of fair value for financial instruments; the valuation of goodwill and other intangible assets; the accounting for pension and postretirement benefits and the accounting for income taxes. Because of the uncertainty of estimates involved in these matters, the Company may be required to do one or more of the following: significantly increase the allowance for credit losses or sustain credit losses that are significantly higher than the reserve provided or both; recognize significant impairment on its financial instruments and other intangible asset balances; or significantly increase its liabilities for taxes or pension and post retirement benefits.

Management Has Identified a Material Weakness in FNB United’s Internal Control over Financial Reporting, Which If Not Remediated Could Result in Material Misstatements in FNB United’s Future Interim and Annual Financial Statements and Have a Material Adverse Effect on FNB United’s Business, Financial Condition and Results of Operations and the Price of FNB United Common Stock.

Management is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with U.S. generally accepted accounting principles.

As further described in Item 9A “Controls and Procedures,” management has identified a material weakness in the Company’s internal control over financial reporting. A material weakness, as defined in the standards established by the Public Company Accounting Oversight Board (PCAOB), is a deficiency, or a combination of deficiencies, in

 

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internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of a corporation’s annual or interim financial statements will not be prevented or detected on a timely basis. The Company identified the material weakness in its internal control over financial reporting as of December 31, 2010, based upon there being ineffective controls with respect to the timely recognition and measurement of impairment of other real estate owned.

Although the Company is in the process of implementing initiatives aimed at addressing the material weakness and preventing additional material weaknesses from occurring, these initiatives may not remediate the material weakness or prevent additional material weaknesses from occurring. Failure to achieve and maintain effective internal control over financial reporting could result in FNB United’s not being able to report accurately its financial results, prevent or detect fraud or provide timely and reliable financial information pursuant to FNB United’s reporting obligations as a public company, which could have a material adverse effect on the Company’s business, financial condition and results of operations. It also could cause FNB United’s investors to lose confidence in the financial information reported by the Company, adversely affecting the price of FNB United common stock.

Changes in Accounting Standards Could Materially Affect FNB United’s Financial Statements.

From time to time accounting standards setters change the financial accounting and reporting standards that govern the preparation of FNB United’s financial statements. These changes can be hard to predict and can materially affect how the Company records and reports its financial condition and results of operations. In some cases, the Company could be required to apply a new or revised standard retroactively, resulting in changes to previously reported financial results, or a cumulative charge to retained earnings.

FNB United Relies on Other Companies to Provide Key Components of Its Business Infrastructure.

Third party vendors provide key components of FNB United’s business infrastructure such as internet connections and network access. While FNB United has selected these third party vendors carefully, it does not control their actions. Any problems caused by these third parties, including those which result from their failure to provide services for any reason or their poor performance of services, could adversely affect FNB United’s ability to deliver products and services to its customers and otherwise to conduct its business. Replacing these third party vendors could also entail significant delay and expense.

There Is a Limited Market for FNB United Common Stock

Although FNB United common stock is traded on The Nasdaq Capital Market, the volume of trading has historically been limited, averaging 27,291shares per day. Therefore, there can be no assurance that a holder of FNB United common stock who wishes to sell his or her shares would be able to do so immediately or at an acceptable price.

The Price of the Company’s Common Stock and FNB United’s Shareholders’ Equity May Not Reach Levels Necessary to Maintain Listing on Nasdaq, Resulting in Further Limitations in the Market for FNB United Common Stock.

FNB United’s common stock is currently listed on The Nasdaq Capital Market. On August 2, 2010, FNB United received a written notice from The Nasdaq Stock Market indicating that FNB United was not in compliance with Rule 5450(a)(1), the bid price rule, because the closing bid price per share of its common stock had been below $1.00 per share for 30 consecutive business days. In accordance with the rules of The Nasdaq Stock Market, FNB United was afforded a 180-day grace period to achieve compliance with the bid price rule. As of January 31, 2011, FNB United had not achieved compliance and submitted an application to The Nasdaq Stock Market to transfer the listing of its common stock to The Nasdaq Capital Market from The Nasdaq Global Select Market, where it had been listed. The application was granted effective February 3, 2011, and FNB United became eligible for an additional 180 calendar day period, or until August 1, 2011, to achieve compliance with the bid price rule. Approval to transfer to The Nasdaq Capital Market was conditioned upon FNB United’s agreeing to effect a reverse stock split during the additional 180-day period should it become necessary to do so to meet the minimum $1.00 bid price per share requirement. There can be no assurance that the bid price rule will be satisfied during the additional grace period.

The continued listing standards of The Nasdaq Capital Market provide that FNB United must meet certain other minimum levels, among them minimum shareholders’ equity. At December 31, 2010, FNB United did not meet any of the standards for continued listing and anticipates receiving a notice of deficiency from The Nasdaq Stock Market. Upon receiving that notice, FNB United expects to submit a written plan of compliance, which will include plans to increase its shareholders’ equity to satisfy the minimum requirement. The Nasdaq Stock Market may in its

 

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discretion grant up to 180 days for FNB United to increase its shareholders’ equity. There can be no assurance that The Nasdaq Stock Market will accept such a plan and grant a sufficient period of time for the plan to be accomplished or that FNB United will successfully the implement the plan.

The perception or possibility that FNB United’s common stock could be delisted in the future could negatively affect its liquidity and price. Delisting would have an adverse effect on the liquidity of the common shares and, as a result, the market price for the common stock might become more volatile. Delisting could also make it more difficult for the Company to raise additional capital. Although the Company expects that quotes for its common stock would continue to be available on the OTC Bulletin Board or on the “Pink Sheets,” such alternatives are generally considered to be less efficient markets, and the stock price, as well as the liquidity of the common stock, may be adversely affected as a result.

Also, in the future FNB United could fall out of compliance with other minimum criteria for continued listing. A failure to meet any of these other continued listing requirements could result in delisting of FNB United common stock.

Certain Provisions of FNB United’s Articles of Incorporation and Bylaws May Discourage Takeovers

FNB United’s articles of incorporation and bylaws contain certain anti-takeover provisions that may discourage or may make more difficult or expensive a tender offer, change in control or takeover attempt that is opposed by FNB United’s board of directors. In particular, FNB United’s articles of incorporation and bylaws:

 

   

classify its board of directors into three classes, so that shareholders elect only one-third of its board of directors each year.

 

   

permit FNB United’s board of directors to issue, without shareholder approval unless otherwise required by law, voting preferred stock with such terms as the board may determine, and

 

   

require the affirmative vote of the holders of at least 75% of FNB United’s voting shares to approve major corporate transactions unless the transaction is approved by three-fourths of FNB United’s “disinterested” directors.

These provisions of FNB United’s articles of incorporation and bylaws could discourage potential acquisition proposals and could delay or prevent a change in control, even though a majority of FNB United’s shareholders may consider such proposal desirable. Such provisions could also make it more difficult for third parties to remove and replace the members of FNB United’s board of directors. They may also inhibit increases in the trading price of FNB United’s common stock that could result from takeover attempts.

Acts or Threats of Terrorism and Political or Military Actions Taken by the United States or Other Governments Could Adversely Affect General Economic or Industry Conditions.

Geopolitical conditions may affect FNB United’s earnings. Acts or threats of terrorism and political or military actions taken by the United States or other governments in response to terrorism, or similar activity, could adversely affect general economic or industry conditions.

Unpredictable Catastrophic Events Could Have a Material Adverse Effect on FNB United.

The occurrence of catastrophic events such as hurricanes, tropical storms, earthquakes, pandemic disease, windstorms, floods, severe winter weather (including snow, freezing water, ice storms and blizzards), fires and other catastrophes could adversely affect FNB United’s consolidated financial condition or results of operations. Unpredictable natural and other disasters could have an adverse effect on the Company in that such events could materially disrupt its operations or the ability or willingness of its customers to access the financial services offered by FNB United. The Company’s property and casualty insurance operations also expose it to claims arising out of catastrophes. The incidence and severity of catastrophes are inherently unpredictable. Although the Company carries insurance to mitigate its exposure to certain catastrophic events, these events could nevertheless reduce FNB United’s earnings and cause volatility in its financial results for any fiscal quarter or year and have a material adverse effect on FNB United’s financial condition or results of operations or both.

Other Risks

There are risks and uncertainties relating to an investment in FNB United common stock or to economic conditions and regulatory matters generally that should affect other financial institutions in similar ways. These aspects are discussed under “Cautionary Statement Regarding Forward-Looking Statements” and “Regulation and Supervision” elsewhere in this Annual Report on Form 10-K.

 

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Item 1B. UNRESOLVED STAFF COMMENTS

None

 

Item 2. PROPERTIES

The principal executive and administrative offices of FNB United and the Bank are located in an office building at 150 South Fayetteville Street, Asheboro, North Carolina. The Bank also has six other facilities in Asheboro containing three community banking operations and various administrative and operational functions. The Bank has other community banking offices in Archdale, Belmont, Biscoe, Boone, Burlington, China Grove, Cornelius, Dallas, Ellerbe, Gastonia, Graham, Greensboro (two offices), Hickory (three offices), Hillsborough, Jamestown, Kannapolis, Laurinburg, Millers Creek, Mooresville, Mt. Holly, Newton, Pinehurst, Ramseur, Randleman, Rockingham (two offices), Salisbury (two offices), Seagrove, Siler City, Seven Lakes, Southern Pines, Stanley, Statesville, Taylorsville, Trinity, West Jefferson, and Wilkesboro (two offices), North Carolina. Ten of the community banking offices are leased facilities, and four such offices are situated on land that is leased. Two of the facilities housing operational functions in Asheboro are leased.

Dover operates out of a leased office located in Charlotte, North Carolina.

 

Item 3. LEGAL PROCEEDINGS

In the ordinary course of operations, the Company is party to various legal proceedings. The Company is not involved in, nor has it terminated during the fourth quarter of 2010, any pending legal proceedings other than routine, nonmaterial proceedings occurring in the ordinary course of business.

 

Item 4. RESERVED

 

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PART II

 

Item 5. MARKET FOR REGISTRANTS COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Market Prices and Dividend Policies

FNB United’s common stock is traded on The Nasdaq Capital Market under the symbol “FNBN.”

On August 2, 2010, FNB United received written notice from Nasdaq indicating that FNB United was not in compliance with Rule 5450(a)(1), the bid price rule, because the closing price per share of its common stock had been below $1.00 per share for 30 consecutive business days. In accordance with the rules of The Nasdaq Stock Market, FNB United was afforded a 180-day grace period to achieve compliance with the bid price rule. As of January 31, 2011, FNB United had not achieved compliance and submitted an application to The Nasdaq Stock Market to transfer the listing of its common stock to The Nasdaq Capital Market from The Nasdaq Global Select Market, where it had been listed. The application was granted effective February 3, 2011, and FNB United became eligible for an additional 180 calendar day period, or until August 1, 2011, to achieve compliance with the bid price rule. Approval to transfer to The Nasdaq Capital Market was conditioned upon FNB United’s agreeing to effect a reverse stock split during the additional 180-day period should it become necessary to do so to meet the minimum $1.00 bid price per share requirement.

On December 20, 2010, FNB United received a second written notice from The Nasdaq Stock Market indicating that FNB United was not in compliance with Rule 5450(b)(1)(C), the market value rule, because the market value of its publicly held shares was below $5.0 million for the 30 consecutive business days ended December 17, 2010. By transferring the listing of its common stock to the Nasdaq Capital Market, FNB United became subject to the continued listing requirements of the market, which provide that the market value of FNB United’s publically held shares must exceed $1.0 million. FNB United satisfies this requirement.

The following table shows the high and low sale prices of FNB United common stock on The Nasdaq Global Select Market, based on published financial sources, for each of the last two fiscal years. The table also reflects the per share amount of cash dividends paid for each share during the fiscal quarter for each of the last two fiscal years.

 

Calendar Period

   High      Low      Dividends
Declared
 

Quarter ended March 31, 2009

   $     4.50       $     1.61       $ 0.025   

Quarter ended June 30, 2009

     3.39         1.85         0.025   

Quarter ended September 30, 2009

     2.88         1.77         -   

Quarter ended December 31, 2009

     2.65         1.10         -   

Quarter ended March 31, 2010

   $     1.70       $     1.03       $ -   

Quarter ended June 30, 2010

     2.42         0.67         -   

Quarter ended September 30, 2010

     0.93         0.45         -   

Quarter ended December 31, 2010

     0.74         0.27         -   

As March 10, 2011, there were approximately 6,275 beneficial holders of FNB United’s common stock. For a discussion as to any restrictions on or the ability of FNB United or the Bank to pay dividends, see Item 1 - Regulation and Supervision. See also Note 17 - Regulatory Matters in the notes to the financial statements set forth in Item 8.

Recent Sales of Unregistered Securities

Except for the issuance and sale to the Treasury Department of 51,500 shares of its Fixed Rate Cumulative Perpetual Stock, Series A and a warrant to purchase 2,207,143 shares of its common stock on February 13, 2009 pursuant to the Capital Purchase Program, FNB United did not sell any of its securities in the three fiscal years ended December 31, 2010, which were not registered under the Securities Act of 1933, as amended.

 

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FIVE-YEAR STOCK PERFORMANCE TABLE

Performance Graph

The following graph and table are furnished with this Annual Report on Form 10-K and compare the cumulative total shareholder return of FNB United common stock for the five-year period ended December 31, 2010 with the SNL Southeast Bank Index and the Russell 3000 Stock Index, assuming an investment of $100 at the beginning of the period and the reinvestment of dividends.

FNB United Corp.

LOGO

 

     Period Ending   

Index

     12/31/05         12/31/06         12/31/07         12/31/08         12/31/09         12/31/10   

FNB United Corp.

     100.00         99.76         68.85         19.01         8.02         2.01   

SNL Southeast Bank

     100.00         117.26         88.33         35.76         35.90         34.86   

Russell 3000

     100.00         115.71         121.66         76.27         97.89         114.46   

 

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Item 6. SELECTED FINANCIAL DATA

The annual selected historical financial data presented in the accompanying table is derived from the audited consolidated financial statements for FNB United Corp. and Subsidiary. As this information is only a summary, you should read it in conjunction with the historical financial statements (and related notes) of the Company and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere herein.

 

(dollars in thousands, except per share data)    As of and for the Year Ended December 31,  
      2010     2009     2008     2007     2006  

Income Statement Data

          

Net interest income

   $ 52,202      $ 62,196      $ 60,017      $ 63,612      $ 56,214   

Provision for loan losses

     115,248        61,741        27,759        5,514        2,526   

Noninterest income

     30,987        21,753        22,918        21,593        19,215   

Noninterest expense

     79,601        119,912        118,103        61,044        53,441   

Net (loss)/income before goodwill impairment charges

     (112,919     (49,301     (2,009     12,719        13,812   

Net (loss)/income

     (112,919     (101,696     (59,809     12,361        12,187   

Preferred stock dividends

     (3,294     (2,871     -        -        -   

Net (loss)/income to common shareholders’

     (116,213     (104,567     (59,809     12,361        12,187   

Period End Balances

          

Assets

   $ 1,921,277      $ 2,101,296      $ 2,044,434      $ 1,906,506      $ 1,814,905   

Loans held for sale

     37,079        58,219        36,138        17,586        20,862   

Loans held for investment (1)

     1,303,975        1,563,021        1,585,195        1,446,116        1,301,840   

Allowance for loan losses

     76,180        49,461        34,720        17,381        15,943   

Goodwill

     -        -        52,395        110,195        110,956   

Deposits

     1,696,390        1,722,128        1,514,747        1,441,042        1,421,013   

Borrowings

     218,315        261,459        365,757        231,125        167,018   

Shareholders’ equity

     (9,929     98,359        147,917        216,256        207,668   

Average Balances

          

Assets

   $ 2,036,603      $ 2,158,123      $ 2,040,204      $ 1,862,602      $ 1,575,307   

Loans held for sale

     36,345        57,007        21,925        19,627        18,229   

Loans held for investment (1)

     1,494,959        1,583,213        1,555,113        1,357,256        1,124,121   

Allowance for loan losses

     63,057        38,283        20,493        15,882        14,213   

Goodwill

     -        39,045        109,193        110,724        85,956   

Deposits

     1,725,019        1,639,830        1,483,749        1,440,604        1,218,071   

Borrowings

     226,660        334,332        322,643        188,790        166,507   

Shareholders’ equity

     68,190        172,217        215,571        212,841        174,135   

Per Common Share Data

          

Net (loss)/income before goodwill impairment charges

   $ (10.17   $ (4.57   $ (0.18   $ 1.12      $ 1.44   

Net (loss)/income per common share:

          

Basic

     (10.17     (9.16     (5.24     1.09        1.27   

Diluted

     (10.17     (9.16     (5.24     1.09        1.25   

Cash dividends declared

     -        0.05        0.45        0.60        0.62   

Book value

     (6.15     4.05        12.94        18.93        18.39   

Tangible book value

     (6.51     3.61        7.85        8.71        8.56   

Performance Ratios

          

Return on average assets before goodwill impairment charges

     (5.54 ) %      (2.28 ) %      (0.10 ) %      0.68     0.88

Return on average assets

     (5.54     (4.71     (2.93     0.66        0.77   

Return on average tangible assets (2)

     (5.56     (4.81     (3.11     0.71        0.82   

Return on average equity before goodwill impairment charges (3)

     (165.59     (28.63     (0.93     5.98        7.93   

Return on average equity (3)

     (165.59     (59.05     (27.74     5.81        7.00   

Return on average tangible equity (2)

     (177.57     (79.59     (59.78     12.99        14.75   

Net interest margin (tax equivalent)

     2.81        3.11        3.40        4.01        4.18   

Dividend payout on common shares (4)

     N/M        N/M        N/M        55.21        51.17   

Asset Quality Ratios

          

Allowance for loan losses to period end loans held for investment

     5.84     3.16     2.19     1.20     1.22

Nonperforming loans to period end allowance for loan losses

     433.03        352.63        276.57        107.63        69.84   

Net chargeoffs (annualized) to average loans held for investment

     5.92        2.97        0.67        0.27        0.17   

Nonperforming assets to period end loans held for investment and foreclosed property (5)

     28.78        13.12        6.45        1.50        1.13   

Capital and Liquidity Ratios

          

Average equity to average assets

     3.35     7.98     10.57     11.43     11.05

Total risk-based capital

     (1.23     10.29        10.39        10.43        11.53   

Tier 1 risk-based capital

     (1.23     6.86        6.94        8.03        8.36   

Leverage capital

     (0.91     5.68        6.11        7.54        7.16   

Average loans to average deposits

     86.66        96.55        106.29        95.58        93.79   

Average loans to average deposits and borrowings

     76.60        80.20        87.30        84.82        82.51   

 

(1) Loans held for investment, net of unearned income, before allowance for loan losses.
(2) Refer to the “Non-GAAP Measures” section in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
(3) Net loss to common shareholders, which excludes preferred stock dividends, divided by average realized common equity which excludes accumulated other comprehensive loss.
(4) Not meaningful due to net loss.
(5) Nonperforming loans and nonperforming assets include loans past due 90 days or more that are still accruing interest.

 

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Item 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following presents management’s discussion and analysis of the financial condition and results of operations of FNB United and should be read in conjunction with the financial statements and related notes included elsewhere in this Annual Report on Form 10-K. This discussion may contain forward-looking statements that involve risks and uncertainties. Actual results could differ significantly from those anticipated in forward-looking statements as a result of various factors. The following discussion is intended to assist in understanding the financial condition and results of operations of FNB United.

Executive Overview

Description of Operations

FNB United is a bank holding company with a full-service subsidiary bank, CommunityONE Bank, National Association, which offers a complete line of consumer, mortgage and business banking services, including loan, deposit, cash management, investment management and trust services, to individual and business customers. The Bank has offices in Alamance, Alexander, Ashe, Catawba, Chatham, Gaston, Guilford, Iredell, Mecklenburg, Montgomery, Moore, Orange, Randolph, Richmond, Rowan, Scotland, Watauga and Wilkes counties in North Carolina.

The Bank has a mortgage banking subsidiary, Dover Mortgage Company, that originates, underwrites and closes loans for sale into the secondary market. Dover has a retail origination network based in Charlotte, North Carolina, originating loans for properties located in North Carolina. Dover previously engaged in the wholesale mortgage origination business and conducted retail mortgage origination business outside of North Carolina. These operations were closed in February 2011.

Management’s Plans and Intentions

The Company incurred significant net losses in 2009, which have continued in 2010, primarily from the higher provisions for loan losses due to the significant level of nonperforming assets and the write-off of goodwill. The Bank consented and agreed to the issuance of the Consent Order (“Order”) by the OCC in July 2010 and FNB United entered into a written agreement with the FRB in October 2010. The Company’s independent registered public accounting firm issued a report with respect to the Company’s audited financial statements for the fiscal years ended December 31, 2010 and 2009, which contained an explanatory paragraph indicating that there is substantial doubt about the Company’s ability to continue as a going concern. The following strategies have been or are being implemented:

Held-to-Maturity Investment Securities ReclassificationAs part of the Bank’s contingency funding plan, the Bank’s Board of Directors approved in April 2010 the reclassification of the entire held-to-maturity investment securities portfolio to available-for-sale investment securities. The conversion of the portfolio occurred on May 3, 2010 and provides additional liquidity to the Bank. The transfer resulted in the unrealized holding gains of $2.1 million, net of tax, at the date of transfer being recognized in other comprehensive income. The corresponding deferred tax on the unrealized holding gain allowed the Bank to realize a one-time reduction in deferred tax valuation allowance of $1.4 million in the second quarter of 2010.

Deferring Preferred Stock and Trust Preferred Securities PaymentsThe Company began deferring the payment of cash dividends on its outstanding Fixed Rate Cumulative Perpetual Preferred Stock, Series A, beginning in the second quarter 2010, as well as the payment of interest on the outstanding junior subordinated notes related to its trust preferred securities to enhance the Company’s liquidity. The expense associated with trust preferred securities continues to accrue and is reflected in the Company’s Consolidated Statements of Loss. The dividends on preferred stock are shown as an increase to net loss to derive net loss to common shareholders in the Consolidated Statements of Loss.

Balance Sheet ReductionsManagement is implementing strategies to improve capital ratios through the reduction of assets and off-balance sheet commitments. At December 31, 2010, risk-weighted assets have been reduced by $313.2 million since December 31, 2009. Reductions occurred primarily in reductions in the commercial loan portfolio. On December 30, 2010, the Bank sold $32.9 million of mortgage loans held for investment and recognized a net gain of $383,000, including transaction costs. Management expects future reductions in risk-weighted assets to be moderate and occur primarily in the loan portfolio. To offset the majority of asset reductions, liabilities declined primarily through reductions in deposits by $25.7 million. Because asset reductions exceeded liability reductions in the twelve months ending December 31, 2010, cash balances increased by $132.9 million.

 

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Future liability reductions are expected to occur primarily in deposits, primarily public unit deposits and high-rate NOW accounts and certificates of deposits.

EarningsOn June 22, 2010, the Bank retired $33.0 million in Federal Home Loan Bank (“FHLB”) advances and paid an early redemption penalty of $1.0 million to the FHLB for the retirement of these advances. The penalty is included in other noninterest expenses. On July 2, 2010, the Bank purchased $30.0 million in brokered certificates of deposit to replace these funds. The advances had a remaining average life of 1.0 years and an average interest rate of 3.93%. The brokered certificates of deposit have maturities ranging from 30 months to 42 months with interest rates ranging from 1.75% to 2.20%. As a result of this transaction, the interest expense savings during the first year is estimated at an annualized rate of 1.94% on the $30.0 million restructured.

Stimulus Loan ProgramThe Bank has implemented a stimulus loan program to facilitate the sale of residential real estate held as collateral for some of the Bank’s nonperforming and performing loans, and certain Bank-owned properties. The purpose of the program is to reduce the Bank’s credit concentrations and nonperforming assets by providing attractive terms that both fill the mortgage lending void created by the ongoing recession and incent potential buyers to purchase real estate. The Bank has offered a reduced interest rate to qualified new borrowers to encourage them to purchase properties in this program. New borrowers are qualified according to the Bank’s normal consumer and mortgage underwriting standards. The Bank is required to record these loans at fair value at inception. The Bank currently has $41.1 million in loans under the stimulus program and has recognized an initial fair value adjustment of $172,200. As of December 31, 2010 the fair value adjustment was reduced to $114,100 due to the accretion of the adjustment into interest income. The fair value adjustment is recorded as a reduction of the outstanding loan balance on the balance sheet and accreted into interest income over the contractual life of the loan.

Additional CapitalThe Company has engaged two investment banking firms to assist the Company in identifying strategic alternatives and in raising capital. Currently, the Company is working diligently to raise additional capital in the next few months and is actively seeking to secure potential investors; however, there are no assurances that an offering will be completed or that the Company will succeed in this endeavor. In addition, a transaction would likely involve equity financing, resulting in substantial dilution to current shareholders and an adverse effect on the price of the Company’s common stock. The Bank’s ability to raise capital is contingent on the current capital markets and on its financial performance. Available capital markets are not currently favorable, and the Bank cannot be certain of its ability to raise capital on any terms.

Liquidity

The Company has a 45-office system of community offices, commonly referred to as branches, that has provided a significant and stable source of local funding. In addition, the Company has a contingency funding plan pursuant to which FNB United and the Bank review each quarter or more frequently liquidity needs based on a number of potential stress conditions. These conditions include, but are not limited to, deposit outflow and reductions in wholesale borrowing lines, including brokered deposits. Liquidity sources are stressed to determine if sufficient liquidity is available to meet potential funding needs. In all scenarios determined plausible by management, the Bank is able to meet liquidity needs through remaining borrowing lines, reducing loan originations, sales of assets, and scheduled cash flow that is not redeployed. The Bank is active in maximizing borrowing lines that can be drawn against under all financial conditions, as well as managing asset and liability cash flows to maintain adequate liquidity levels.

Both FNB United and the Bank actively manage liquidity. FNB United suspended its dividend to shareholders until such time as the Bank returns to profitability and either receives or is not required to receive regulatory approval for the payment of dividends. FNB United began deferring the payment of cash dividends on its outstanding Fixed Rate Cumulative Perpetual Preferred Stock, Series A, beginning in the second quarter 2010, as well as the payment of interest on the outstanding junior subordinated notes related to its trust preferred securities to enhance the Company’s liquidity. The expense associated with trust preferred securities continues to accrue and is reflected in the Company’s Consolidated Statements of Loss. The dividends on preferred stock are shown as an increase to net loss to derive net loss to common shareholders in the Consolidated Statements of Loss.

At December 31, 2010, FNB United had approximately $180,000 of cash held in deposits with the Bank. Based on current and expected liquidity needs and sources, management expects the Bank to be able to meet its obligations at least through December 31, 2011. Cash and cash equivalents at the Bank at December 31, 2010 were approximately $160.6 million. Liquidity at the Bank is dependent upon deposits, which fund 88% of the Company’s assets. Despite reported negative earnings performance during 2010, the Bank’s deposits decreased from December 31, 2009 to December 31, 2010 by only $25.7 million. The Company is reducing its assets to improve capital ratios.

 

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The Bank’s loan portfolio does not have features that could rapidly draw additional funds, which would cause an elevated need for additional liquidity at the Bank.

Access to brokered deposits as a contingency funding source for the Bank has been eliminated since the Bank is deemed not well-capitalized.

As a result of its efforts to control the level of assets, management expects reductions in deposits through the end of 2011 as part of a planned deleveraging of the balance sheet. Stress testing of potential severe deposit outflow demonstrates that the Bank is well positioned to respond to withdrawals. Additional sales and maturities of investment securities could provide further liquidity if needed. The Bank reclassified the entire held-to-maturity investment securities portfolio to available-for-sale investment securities to further enhance the Bank’s liquidity. The reclassification of these securities was completed in the second quarter of 2010.

On December 30, 2010 and February 28, 2011, the Bank entered into and consummated conversion agreements with SunTrust Bank, pursuant to which $12.5 million of the outstanding principal amount of the $15.0 million subordinated term loan from SunTrust to the Bank issued on June 30, 2008 was converted into 12.5 million shares of nonvoting, nonconvertible, nonredeemable cumulative preferred stock, par value $1.00 per share, of the Bank. The Bank amended its articles of association to authorize the preferred stock issued to SunTrust in the conversions. The preferred stock carries an 8.0% dividend rate.

Capital

The Bank has increased minimum capital requirements from the OCC. The Company has begun to take steps to increase capital. The Company plans to control asset growth, which should help reduce its risk profile and improve capital ratios through reductions in the amount of outstanding loans, particularly loans with higher risk weights, and a corresponding reduction of liabilities. Outstanding loans will be reduced by slowing loan originations and through normal principal amortization. The Company may also seek commercial note sales arrangements with other lenders or private equity sources. Based on its forecasts and projections, management expects the Bank to remain below well-capitalized, according to current regulatory guidelines, through December 31, 2011, unless current capital improvement efforts are successful.

As a result of the Order, the Board of Directors of the Bank has formed a compliance committee of some of its members to oversee management’s response to all sections of the Order. The committee will monitor compliance with the Order, including adherence to deadlines for submission to the OCC of any information required under the Order.

The Company has engaged legal counsel, regulatory experts and various consultants to assist it with compliance with the Order. They are advising the Company on additional action plans and strategies to reduce the level of nonperforming assets and to increase capital. These advisors work directly with the Board of Directors and Bank management to assure that all opportunities for improvement are considered. The Company’s ability to raise capital is contingent on the current capital markets and on its financial performance. Available capital markets are not currently favorable, and the Company cannot be certain of its ability to raise capital on any terms.

Credit Quality

The Company has taken proactive steps to resolve its nonperforming loans, including negotiating repayment restructuring plans, forbearances, loan modifications and loan extensions with borrowers when appropriate. The Bank also has a separate special assets department to monitor and attempt to reduce exposure to further deterioration in asset quality, to manage OREO properties, and to liquidate property in the most cost-effective manner. The Bank is applying more conservative underwriting practices to new loans, including, among other things, increasing the amount of required collateral or equity requirements, reducing loan-to-value ratios, and increasing interest rates.

To improve its results of operations, the Company’s primary focus is to reduce significantly the amount of its nonperforming assets. Nonperforming assets decrease profitability because they reduce the balance of earning assets, may require additional loan loss provisions or write-downs, and require significant devotion of staff time and financial resources to resolve. The level of nonperforming assets (loans not accruing interest, restructured loans, loans past due 90 days or more and still accruing interest, and other real estate owned) increased to $393.7 million as of December 31, 2010, as compared to $209.7 million as of December 31, 2009. The Company believes that the increase in the level of nonperforming assets occurred largely as a result of the severe housing downturn and deterioration in the residential real estate market, as many of the Bank’s commercial loans are for residential real estate projects.

 

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The Company has moved aggressively to address the credit quality issues by increasing its reserves for losses and directing the efforts of a team of experienced workout specialists solely to manage the resolution of nonperforming assets. This group allows the remainder of the Bank’s credit administration and banking personnel to focus on managing the performing loan portfolio, while enhancing objectivity in problem loan resolution by removing from that process the originating or managing lender.

With the assistance of a third-party loan review firm, the Bank conducted a thorough review of the loan portfolio during 2010, including both nonperforming loans and performing loans. The Company believes that the reserves recorded in its allowance for loan losses as of December 31, 2010 are adequate to cover losses inherent in the portfolio as of that date.

It is the Company’s goal to remove the majority of the nonperforming assets from its balance sheet while still obtaining reasonable value for these assets. Given the current conditions in the real estate market, accomplishing this goal is a tremendous undertaking, requiring both time and the considerable effort of staff. The Company is committed to continuing to devote significant resources to these efforts. Sales of real estate in the current market could result in losses.

Continued Expense Control

The Company has made it a priority to identify cost savings opportunities throughout all phases of operations. In 2008, the Bank engaged a third party to review and recommend a cost savings strategy for the Bank. The Bank continues to follow those recommendations and continues to see improvements in expense control. The Company is committed to maintaining these cost control measures and believes that this effort will play a major role in improving its performance. The Company also believes that its technology allows it to be efficient in its back-office operations. In addition, as the level of nonperforming assets is reduced, the operating costs associated with carrying those assets, such as maintenance, insurance and taxes will decrease.

The Company is focused on its collection of core deposits. Core deposit balances, generated from customers throughout the Bank’s branch network, are generally a stable source of funds similar to long-term funding, but core deposits such as checking and savings accounts are typically less costly than alternative fixed-rate funding. The Company believes that this cost advantage makes core deposits a superior funding source, in addition to providing cross-selling opportunities and fee income possibilities. To the extent the Bank grows its core deposits, the cost of funds should decrease, thereby increasing the Bank’s net interest margin.

Conclusion

Management projections for 2011 reflect continued stress on the bank’s loan portfolio followed by significant earnings improvement in 2012 primarily as a result of lower levels of loan loss provisions and some recoveries of previously recognized loan losses. In the current interest rate environment, earnings will at most be only minimally affected by further declines in interest rates. Any increase in interest rates is expected to have a positive impact on the earnings of the Bank, with the extent of that impact dependent on the amount of increase. Management’s current projections and forecasts for 2011 include an insignificant increase in interest rates, notwithstanding increasing evidence of economic recovery.

The Company is evaluating and pursuing the feasibility of various strategic options, including capital raising alternatives and the sale of selective assets. While the Company plans to focus on the above actions and to pursue strategic alternatives, the Company can give no assurance that efforts to raise additional capital in the current economic environment will be successful and result in the Company’s desired capital position. The Bank’s ability to decrease its levels of nonperforming assets is also subject to market conditions as some of its borrowers rely on an active real estate market as a source of repayment, and the sale of real estate in this market is difficult. If the real estate market does not improve, the Bank’s level of nonperforming assets may continue to increase.

While the Company believes that it is taking appropriate steps to respond to these economic risks and regulatory actions, continuation as a going concern is subject to raising additional capital. Accordingly, the Company is taking steps that would raise capital above required regulatory levels and levels at which the Bank could profitably operate; however, no assurances that additional capital will be raised can be made.

Primary Financial Data for 2010

FNB United experienced a loss of $116.2 million in 2010, an 11% increase from the net loss of $104.6 million in 2009. Basic and diluted (loss) per share increased 11% from $(9.16) in 2009 to $(10.17) in 2010. Total assets were $1.9 billion at December 31, 2010, down 9% from year-end 2009. Loans amounted to $1.3 billion at December 31, 2010, decreasing 17% from the prior year. Total deposits decreased $25.7 million, to $1.7 billion in 2010.

 

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Significant Factors Affecting Earnings

2010 presented challenges for FNB United as well as for the entire banking industry. The strains in the local and national financial and housing markets presented a challenging environment during 2010. This difficult environment required a significant increase in FNB United’s loan loss provision, which depressed operating results but was a necessary response to increased non-performing loans. FNB United has not originated any subprime real estate loans.

The provision for loan losses was $115.2 million in 2010, compared to $61.7 million in 2009, an increase of 87%. This increase resulted primarily from continued deterioration in credit performance of the residential real estate development and construction sectors of the Bank’s commercial loan portfolio, resulting in loan charge-offs and increased impairment identified in loans determined to be impaired during the year. Nonperforming assets increased 89%, to $393.7 million during 2010 from $209.7 million at the close of 2009. Net loan charge-offs increased to $88.5 million in 2010, compared to $47.0 million in 2009. Loans held for investment decreased by $259.0 million during 2010. The allowance for loan losses was increased to 5.84% of loans held for investment at December 31, 2010. The allowance was 3.16% at December 31, 2009.

The provision for loan losses was $61.7 million in 2009, compared to $27.8 million in 2008, an increase of 122%. Nonperforming assets increased 104%, to $209.7 million during 2009 from $102.6 million at the end of 2008.

The Bank has fully reserved for its deferred tax assets that are dependent upon future taxable income for realization with a valuation allowance. In assessing whether deferred tax assets will be realized, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. In evaluating the positive and negative evidence to support the realization of the asset under current guidance, there is insufficient positive evidence to support a conclusion that it is more likely than not this asset will be realized in the foreseeable future. The Bank has fully reserved for its deferred tax assets that are dependent upon future taxable income for realization with a valuation allowance.

Noninterest income increased 42.4% to $31.0 million, compared to $21.8 million in 2009. Of this increase, $5.0 million was attributable to an other-than-temporary impairment (“OTTI”) charge in 2009 on an investment security owned by the Bank for which the Bank deemed it would be unlikely to recover its investment. Mortgage loan income decreased $4.4 million resulting from a reduction in production of 35% and the reduction in value of derivative loan commitments as the pipeline contracted. Other service charges, commissions and fees ended 2010 at $1.0 million compared to $1.1 million for 2009. Net securities gains of $10.6 million were recognized in 2010 compared to $1.0 million in 2009. Noninterest income, excluding the 2009 OTTI charge, was $31.0 million for 2010 compared to $26.7 million in 2009 thus representing a 15.9% increase.

In 2009, noninterest income was $21.8 million, representing a 5.1% decrease when compared to $22.9 million in 2008. Of this decrease, $5.0 million was attributable to an other-than-temporary impairment (“OTTI”) charge in 2009 on an investment security owned by the Bank that the Bank deemed would be unlikely to recover its investment. Mortgage loan income increased $3.5 million resulting from mortgage loan sale activity exceeding $692.6 million in 2009 versus $317.1 million in 2008. Noninterest income, excluding the OTTI charge, improved to $26.7 million for the year compared to $22.9 million in 2008 thus representing a 16.7% increase.

Noninterest expense decreased from $119.9 million in 2009 to $79.6 million in 2010, representing a 33.6% decrease. Contributing to this decrease was a goodwill impairment charge taken in 2009 for $52.4 million, when the Company’s remaining goodwill was written off. Excluding the goodwill impairment charges, noninterest expense was $67.5 million in 2009, compared to $79.6 million in 2010, an increase of $12.1 million or 17.9%. FDIC insurance for 2010 was $5.9 million compared to $4.2 million for 2009, a 40.4% increase year over year. OREO-related expenses increased 278.2% to $13.1 million for 2010 compared to $3.5 million in 2009 due to valuation adjustments required on OREO properties because of continued weakness in the economy and the effect that the current economic environment is having on the valuation of real estate within the Company’s loan portfolio.

Noninterest expense was significantly affected in 2009 and 2008 by goodwill impairment charges of $52.4 million and $57.8 million, respectively, as discussed in Note 2 to the Consolidated Financial Statements. Excluding the goodwill impairment charges, noninterest expense was $67.5 million, compared to $60.3 million in 2008, an increase of $7.2 million or 12.0%. FDIC insurance for 2009 was $4.2 million compared to $0.9 million for 2008, a 366.4% increase year over year. OREO-related expenses increased 469.2% to $3.5 million for 2009 compared to $0.6 million in 2008 due to valuation adjustments required on OREO properties because of continued weakness in

 

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the economy and the effect that the current economic recovery is having on the valuation of real estate within the Company’s banking footprint.

FDIC Insurance Assessment

On May 22, 2009, the FDIC adopted a final rule imposing a five basis point special assessment on each insured depository institution’s assets minus Tier 1 capital as of June 30, 2009. The special assessment was collected on September 30, 2009.

In a final rule issued on September 29, 2009, the FDIC amended the Amended Restoration Plan as follows:

 

   

The period of the Amended Restoration Plan was extended from seven to eight years.

   

The FDIC announced that it will not impose any further special assessments under the final rule it adopted in May 2009.

   

The FDIC announced plans to maintain assessment rates at their current levels through the end of 2010. The FDIC also immediately adopted a uniform three basis point increase in assessment rates effective January 1, 2011 to ensure that the DIF returns to 1.15 percent within the Amended Restoration Plan period of eight years.

   

The FDIC announced that, at least semi-annually following the adoption of the Amended Restoration Plan, it will update its loss and income projections for the DIF. The FDIC also announced that it may, if necessary, adopt a new rule prior to the end of the eight-year period to increase assessment rates in order to return the reserve ratio to 1.15 percent.

On November 12, 2009, the FDIC adopted a final rule to require insured institutions to prepay their quarterly risk-based deposit insurance assessments for the fourth quarter of 2009, and for all of 2010, 2011 and 2012, on December 30, 2009.

The Dodd-Frank Act makes permanent the $250,000 deposit insurance limit for insured deposits and provides full insurance of noninterest bearing transaction accounts beginning December 31, 2010, for two years. It also revises the assessment base against which the insured depository institution’s deposit insurance premiums paid to the DIF will be calculated. Under the amendments, the FDIC assessment base will no longer be the institution’s deposit base, but rather its average consolidated total assets less its average equity. The Dodd-Frank Act also changes the minimum designated reserve ratio of the DIF, increasing the minimum from 1.15% to 1.35% of the estimated amount of total insured deposits by September 30, 2020, and eliminating the requirement that the FDIC pay dividends to depository institutions when the reserve ratio exceeds certain thresholds. The FDIC is required to offset the effect of the increased minimum reserve ratio for banks with assets of less than $10 billion.

Recent Legislation Affecting the Financial Services Industry

On July 21, 2010, sweeping financial regulatory reform legislation entitled the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) was signed into law. The Dodd-Frank Act implements far-reaching changes across the financial regulatory landscape, including provisions that, among other things, will:

 

   

Centralize responsibility for consumer financial protection by creating a new agency, the Consumer Financial Protection Bureau, responsible for implementing, examining and enforcing compliance with federal consumer financial laws.

   

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

   

Apply the same leverage and risk-based capital requirements that apply to insured depository institutions to most bank holding companies, which, among other things, will require the Company to deduct, over three years beginning January 1, 2013, all trust preferred securities from the Company’s Tier 1capital. This restriction does not apply to the CPP preferred stock, which will continue to be included in Tier 1 capital.

   

Require the Office of the Comptroller of the Currency to seek to make its capital requirements for national banks countercyclical so that capital requirements increase in times of economic expansion and decrease in times of economic contraction.

   

Require financial holding companies to be well-capitalized and well-managed as of July 21, 2011. Bank holding companies, including FNB United, and banks must also be both well-capitalized and well-managed in order to acquire banks located outside their home state.

   

Change the assessment base for federal deposit insurance from the amount of insured deposits to consolidated assets less tangible capital, eliminate the ceiling on the size of the Deposit Insurance

 

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Fund (“DIF”) and increase the floor of the size of the DIF, which generally will require an increase in the level of assessments for institutions with assets in excess of $10 billion.

   

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

   

Implement corporate governance revisions, including with regard to executive compensation and proxy access by shareholders, that apply to all public companies, not just financial institutions.

   

Make permanent the $250,000 limit for federal deposit insurance and increase the cash limit of Securities Investor Protection Corporation protection from $100,000 to $250,000 and provide unlimited federal deposit insurance until January 1, 2013 for noninterest-bearing demand transaction accounts at all insured depository institutions.

   

Repeal the federal prohibitions on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts.

   

Amend the Electronic Fund Transfer Act (“EFTA”) to, among other things, give the Federal Reserve the authority to establish rules regarding interchange fees charged for electronic debit transactions by payment card issuers having assets over $10 billion and to enforce a new statutory requirement that such fees be reasonable and proportional to the actual cost of a transaction to the issuer.

Many aspects of the Dodd-Frank Act are subject to rulemaking and will take effect over several years, making it difficult to anticipate its overall financial impact on the Company, its customers or the financial industry more generally. Provisions in the legislation that affect deposit insurance assessments, payment of interest on demand deposits and interchange fees could increase the costs associated with deposits as well as place limitations on certain revenues those deposits may generate.

Transaction Account Guarantee Program

On November 21, 2008, the FDIC Board of Directors adopted a final rule implementing the Temporary Liquidity Guarantee Program (“TLGP”). The TLGP consists of two basic components: a guarantee of newly issued senior unsecured debt of banks, thrifts, and certain holding companies (the debt guarantee program) and full guarantee of non-interest bearing deposit transaction accounts, such as business payroll accounts, regardless of dollar amount (the transaction account guarantee program). The purpose of the guarantee of transaction accounts and the debt guarantee was to reduce funding costs and allow banks and thrifts to increase lending to consumers and businesses. All insured depository institutions were automatically enrolled in both programs unless they elected to opt out by a specified date.

As originally adopted, the transaction account guarantee program was to terminate on December 31, 2009, although the FDIC subsequently extended the program through December 31, 2010. The Dodd-Frank Act included a provision that effectively replaced the transaction account guarantee program and extended the unlimited FDIC guarantee of noninterest bearing transaction accounts through December 31, 2012 for all insured depository institutions, not just those that elected to participate. Also, the Dodd-Frank Act provision, unlike the transaction account guarantee program, does not include low-interest NOW accounts within the definition of noninterest-bearing transaction accounts, and such accounts are therefore not covered by unlimited deposit insurance coverage. A subsequent amendment to the Dodd-Frank Act that became effective on December 31, 2010 extended unlimited deposit insurance coverage for “Interest on Lawyers Trust Accounts” through December 31, 2012.

Earnings Review

FNB United’s net loss of $116.2 million in 2010, primarily the result of an increased provision for loan losses of $53.5 million, compared to the net loss of $104.6 million in 2009, primarily a result of goodwill impairment charges of $52.4 million. Certain factors specifically affecting the elements of income and expense and the comparability of operating results on a year-to-date basis between 2010 and 2009 are discussed in “Significant Factors Affecting Earnings.”

FNB United’s net loss in 2009 was $104.6 million compared to net loss of $59.8 million in 2008. Earnings were negatively impacted in 2009 and 2008 by a goodwill charge of $52.4 million and $57.8 million, respectively. An increase of 122.4%, or $34.0 million in provision for loan losses was recognized in 2009 when compared to 2008. Also affecting 2009 was a $5.0 million OTTI charge compared to no OTTI charge in 2008.

Return on average assets was (5.54)% in 2010, compared to (4.71)% in 2009 and (2.93)% in 2008. Return on average shareholders’ equity decreased from (27.74)% in 2008 to (59.05)% in 2009 and (165.59)% in 2010. In

 

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2010, return on average tangible assets and average tangible equity (calculated by deducting average goodwill and core deposit premiums from average assets and from average equity) amounted to (5.56)% and (177.50)%, respectively, compared to (4.81)% and (79.59)% in 2009 and (3.11)% and (59.78)% in 2008.

Net Interest Income

Net interest income is the difference between interest income, principally from loans and investments, and interest expense, principally on customer deposits. Changes in net interest income result from changes in interest rates and in the volume, or average dollar level, and mix of earning assets and interest-bearing liabilities.

Table 1

Average Balance Sheet and Net Interest/Dividend Income Analysis

Fully Taxable Equivalent Basis

 

    Year Ended December 31,  
(dollars in thousands)   2010     2009           2008  
   

Average

Balance (3)

   

Income /

Expense

   

Average

Yield /

Rate

         

Average

Balance (3)

   

Income /

Expense

   

Average

Yield /

Rate

         

Average

Balance (3)

   

Income /

Expense

   

Average

Yield /

Rate

 

Interest earning assets:

                     

Loans (1)(2)

    $   1,531,304          $   69,121          4.51         $   1,640,220          $   84,322          5.14         $   1,577,038          $   103,567          6.57  

Taxable investment securities

    255,629          11,976          4.68            281,047          16,256          5.78            152,436          7,820          5.13     

Tax-exempt investment securities (1)

    33,169          1,551          4.68            49,884          2,256          4.52            52,454          3,138          5.98     

Overnight Federal funds sold

    1,585          3          0.19            10,851          21          0.19            1,316          25          1.90     

Other earning assets

    48,702          500          1.03            19,326          377          1.95            19,728          785          3.98     
                                                         

Total earning assets

    1,870,389          83,151          4.45            2,001,328          103,232          5.16            1,802,972          115,335          6.40     

Non-earning assets:

                     

Cash and due from banks

    66,854                27,502                29,121         

Goodwill and core deposit premium

    4,598                44,438                115,520         

Other assets, net

    94,762                84,855                92,591         
                                       

Total assets

    $   2,036,603                $   2,158,123                $   2,040,204         
                                       

Interest-bearing liabilities:

                     

Interest-bearing demand deposits

    $   228,054          $   2,277          1.00       $ 198,343        $ 2,250          1.13       $ 168,395        $ 2,007          1.19  

Savings deposits

    43,224          112          0.26            40,301          106          0.26            40,803          113          0.28     

Money market deposits

    321,180          3,129          0.97            308,690          4,381          1.42            274,818          6,389          2.32     

Time deposits

    974,192          19,393          1.99            940,138          25,753          2.74            841,741          33,702          4.00     

Retail repurchase agreements

    13,355          98          0.73            18,737          127          0.68            29,954          651          2.17     

Federal Home Loan Bank advances

    140,078          3,517          2.51            185,284          5,795          3.13            204,877          7,223          3.53     

Federal funds purchased

    1,537          4          0.26            58,609          156          0.27            21,310          501          2.35     

Other borrowed funds

    71,690          2,105          2.94            71,702          2,407          3.36            66,502          3,432          5.16     
                                                         

Total interest-bearing liabilities

    1,793,310          30,635          1.71            1,821,804          40,975          2.25            1,648,400          54,018          3.28     

Noninterest-bearing liabilities and shareholders’ equity:

  

   

Noninterest-bearing demand deposits

    158,369                152,358                157,992         

Other liabilities

    16,734                11,744                18,241         

Shareholders’ equity

    68,190                172,217                215,571         
                                       

Total liabilities and equity

    $   2,036,603                $   2,158,123                $   2,040,204         
                                       

Net interest income and net yield on earning assets (4)

      $   52,516          2.81           $   62,257          3.11           $   61,317          3.40  
                                                         

Interest rate spread (5)

        2.74             2.91             3.12  
                                       

 

(1) The fully tax equivalent basis is computed using a federal tax rate of 35%.
(2) The average loan balances include nonaccruing loans and loans held for sale.
(3) The average balances for all years include market adjustments to fair value for securities and loans held for sale.
(4) Net yield on earning assets is computed by dividing net interest income by average earning assets.
(5) Earning asset yield minus interest bearing liabilities rate.

Table 1 sets forth for the periods indicated information with respect to FNB United’s average balances of assets and liabilities, as well as the total dollar amounts of interest income (taxable equivalent basis) from earning assets and interest expense on interest-bearing liabilities, resultant rates earned or paid, net interest income, net interest spread and net yield on earning assets. Net interest spread refers to the difference between the average yield on earning assets and the average rate paid on interest-bearing liabilities. Net yield on earning assets, or net interest margin, refers to net interest income divided by average earning assets and is influenced by the level and relative mix of earning assets and interest-bearing liabilities.

Net interest income according to the Consolidated Statements of Loss was $52.2 million in 2010, compared to $62.2 million in 2009. This decrease of $10.0 million, or 16.1%, resulted primarily from a 6.5% decrease in the level of average earning assets accompanied by a decline in the net yield on earning assets, or net interest margin, from 3.11% in 2009 to 2.81% in 2010. In 2009, the increase of $2.2 million, or 3.6%, resulted primarily from an 11% increase in the level of average earning assets partially offset by a decline in the net yield on earning assets, or net

 

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interest margin, from 3.40% in 2008 to 3.11% in 2009. On a taxable equivalent basis, the changes in net interest income were a $9.7 million decrease in 2010and an increase of $0.9 million for 2009, reflecting changes in the relative mix of taxable and non-taxable earning assets in each year.

In 2010, the net interest spread decreased by 17 basis points from 2.91% in 2009, to 2.74% in 2010, reflecting the net effect of decreases in both the average total yield on earning assets and the average rate paid on interest-bearing liabilities, or cost of funds. The yield on earning assets decreased by 71 basis points, from 5.16% in 2009 to 4.45% in 2010, while the cost of funds also decreased by 54 basis points, from 2.25% to 1.71%. In 2009, the 21 basis points decrease in net interest spread resulted from a 124 basis points decrease in the yield on earning assets, which was partially offset by a 103 basis points decrease in the cost of funds.

Changes in the net interest margin and net interest spread tend to correlate with movements in the prime rate of interest. There are variations, however, in the degree and timing of rate changes, compared to prime, for the different types of earning assets and interest-bearing liabilities.

Table 2 analyzes net interest income on a taxable equivalent basis, as measured by volume and rate variances. The table reflects the extent to which changes in the interest income and interest expense are attributable to changes in volume (changes in volume multiplied by prior year rate) and changes in rate (changes in rate multiplied by prior year volume).

Table 2

Volume and Rate Variance Analysis

 

(dollars in thousands)    2010 vs 2009          2009 vs 2008  
    

Volume

Variance

   

Rate

Variance

   

Total

Variance

        

Volume

Variance

   

Rate

Variance

   

Total

Variance

 

Interest income:

               

Loans, net

       $  (5,599)      $ (9,602   $ (15,201        $   4,149      $ (3,394   $   (19,245)   

Taxable investment securities

     (1,470     (2,810     (4,280        6,598        1,838        8,436   

Tax exempt investment securities

     (756     51        (705        (154     (728     (882

Overnight Federal funds sold

     (18     0        (18        181        (185     (4

Other earning assets

     573        (450     123           (16     (392     (408
                   

Total interest income

     (7,270     (12,811     (20,081        10,758        (22,861     (12,103
                   

Interest expense:

               

Interest-bearing demand deposits

     337        (310     27           357        (114     243   

Savings deposits

     8        (2     6           (1     (6     (7

Money market deposits

     177        (1,429     (1,252        787        (2,795     (2,008

Time deposits

     933        (7,293     (6,360        3,940        (11,889     (7,949

Retail repurchase agreements

     (36     7        (29        (244     (280     (524

Federal Home Loan Bank advances

     (1,414     (864     (2,278        (691     (737     (1,428

Federal funds purchased

     (152     0        (152        877        (1,222     (345

Other borrowed funds

     0        (302     (302        268        (1,293     (1,025
                   

Total interest expense

     (147     (10,193     (10,340        5,293        (18,336     (13,043
                   

Increase (decrease) in net interest income

       $  (7,123)      $ (2,618   $ (9,741        $   5,465      $ (4,525   $ 940   
                   

Regular cuts to the target federal funds rate continued through 2008 with year-end rates at 0.25% and remained at this level for all of 2009 and 2010.

Provision for Loan Losses

This provision is the charge against earnings to provide an allowance for probable losses inherent in the loan portfolio. The amount of each year’s charge is affected by several considerations, including management’s evaluation of various risk factors in determining the adequacy of the allowance (see “Asset Quality” below), actual loan loss experience and loan portfolio growth. The provision for loan losses was $115.2 million in 2010, $61.7 million in 2009 and $27.8 million in 2008. This increase in the level of the provision for loan losses is discussed and analyzed in detail as part of the discussions in the “Significant Factors Affecting Earnings” and “Asset Quality” sections.

Noninterest Income

Noninterest income increased $9.2 million, or 42.4%, in 2010, due primarily to a $10.6 million gain on sale of securities in order to take advantage of market opportunities. Additional information concerning factors that specifically affected noninterest income in 2010 is discussed in “Significant Factors Affecting Earnings” section.

 

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Noninterest income decreased $1.2 million, or 5.1%, in 2009, due primarily to a $5.0 million OTTI charge on an investment security owned by the Bank for which the Bank deemed it would be unlikely to recover its investment.

 

(dollars in thousands)    December 31,  
     2010      2009      2008  

Service charges on deposit accounts

     $   7,358           $         8,956            $ 9,167     

Mortgage loan income

     5,510           9,888            6,340     

Cardholder and merchant services income

     3,000           2,514            2,395     

Trust and investment services

     1,946           1,741            1,827     

Bank owned life insurance

     988           1,068            983     

Other service charges, commissions and fees

     1,030           1,158            796     

Securities gains, net

     10,647           989            646     

Gain on fair value swap

     273           66            -     

Total other-than-temporary impairment loss

     -           (4,985)           -     

Portion of loss recognized in other comprehensive income

     -           -            -     

Net impairment loss recognized in earnings

     -           (4,985)           -     

Other income

     235           358            764     
                          

Total noninterest income

     $     30,987           $ 21,753            $     22,918     
                          

In 2009, the Federal Reserve adopted amendments to its Regulation E that restricted the Bank’s ability to charge customers overdraft fees beginning in July 2010. Pursuant to the adopted regulation, customers were given the option to opt-in to an overdraft service for the Bank to collect overdraft fees. Additional legislation is being considered in Congress that would further restrict the Bank from collecting overdraft fees or limit the amount of overdraft fees that may be collected. These changes had a minimal impact on the Bank’s noninterest income.

Noninterest Expense

Noninterest expense was $40.3 million, or 33.6%, lower in 2010 mainly due to a goodwill impairment charge of $52.4 million for 2009, which significantly impacted noninterest expense in that year. OREO related expenses increased 278.2% to $13.1 million for 2010 compared to $3.5 million in 2009. Excluding the goodwill impairment charges of $52.4 million in 2009, noninterest expense was $12.1 million higher in 2010 than in 2009. FDIC insurance for 2010 was $5.9 million compared to $4.2 million for 2009, a 40.4% increase year over year. Noninterest expense was $1.8 million, or 1.5%, higher in 2009 compared to 2008. In 2008, noninterest expense was $118.1 million. The major component of the increase from 2008 to 2009 was a $2.9 million increase in OREO related expenses.

On November 12, 2009, the FDIC adopted a final rule imposing a 13-quarter prepayment of FDIC premiums to replenish the depleted insurance fund. This regulation required insured depository institutions to prepay their estimated quarterly regular risk-based assessments for the fourth quarter of 2009, through the fourth quarter of 2012 on December 30, 2009, at the same time that institutions paid their regular quarterly deposit insurance assessments for the third quarter of 2009. The estimated prepayment amount will be used to offset future FDIC premiums beginning on March 30, 2010, which represents payment of the regular insurance assessment for the 2009 fourth quarter. As of December 31, 2010, the Bank has $4.0 million remaining in the FDIC prepaid assessment.

 

(dollars in thousands)    December 31,  
     2010      2009      2008  

Personnel expense

     $     30,360           $     32,932           $     33,081     

Net occupancy expense

     5,031           5,522           5,343     

Furniture, equipment and data processing expense

     7,056           7,121           6,705     

Professional fees

     3,908           2,070           2,552     

Stationery, printing and supplies

     526           703           1,174     

Advertising and marketing

     1,634           2,056           1,371     

Other real estate owned expense

     13,131           3,472           610     

Credit/debit card expense

     1,715           1,672           1,716     

FDIC insurance

     5,856           4,170           894     

Goodwill impairment

     -           52,395           57,800     

Mortgage servicing rights impairment

     2,995           -           -     

Other expense

     7,389           7,799           6,857     
                          

Total noninterest expense

     $ 79,601           $ 119,912           $ 118,103     
                          

 

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Provision for Income Taxes

The effective income tax rate increased from (4.1)% in 2009 to (1.1)% in 2010 due principally to the impact of deferred tax assets and valuation allowance on losses in 2010. Nondeductible expenses included a goodwill impairment charge of $52.4 million in 2009. The effective income tax rate decreased from 5.0% in 2008 to (4.1)% in 2009 due principally to lower net interest income and the higher level of nondeductible expenses in 2009.

During 2009, the deferred tax asset had to be evaluated and to the extent that it was determined that recovery was not likely, a valuation allowance was established. Although a valuation allowance was required for deferred tax assets at year end, there is no guarantee that an additional valuation allowance will not be required in the future. Adjustments to increase or decrease the valuation allowance are charged or credited, respectively, to income tax expense. The Bank maintained a full valuation allowance for deferred tax asset less unrealized losses on investment securities at December 31, 2010.

Liquidity

Liquidity for the Bank refers to its continuing ability to meet deposit withdrawals, fund loan and capital expenditure commitments, maintain reserve requirements, pay operating expenses and provide funds to FNB United for payment of dividends, debt service and other operational requirements. Liquidity is immediately available from three major sources: (a) cash on hand and on deposit at other banks, (b) the outstanding balance of federal funds sold, and (c) the investment securities portfolio.

A stable deposit base, supplemented by Federal Home Loan Bank (“FHLB”) advances and a modest amount of brokered time deposits, has been sufficient to meet the Bank’s loan demand. Additionally, the Bank’s investment securities portfolio provides a source of readily available liquidity.

Liquidity for Dover refers to its continuing ability to fund mortgage loan commitments and pay operating expenses. Liquidity is principally available from a line of credit with the Bank, established in 2007. Prior to that date, the line of credit was with a large national bank.

Contractual Obligations

Under existing contractual obligations, FNB United will be required to make payments in future periods. Table 3 presents aggregated information about the payments due under such contractual obligations at December 31, 2010. Transaction deposit accounts with indeterminate maturities have been classified as having payments according to an expected decay rate. Benefit plan payments cover estimated amounts due through 2020.

Table 3

Contractual Obligations

 

(dollars in thousands)    Payments Due by Period at December 31, 2010  
     One Year or
Less
     One to Three
Years
     Three to Five
Years
     Over Five
Years
     Total  
        

Deposits

     $     607,963           $     499,550           $     185,139           $     403,738           $     1,696,390     

Retail repurchase agreements

     9,628           -           -           -           9,628     

Federal Home Loan Bank advances

     25,000           50,624           18,452           50,409           144,485     

Subordinated debt

     -           -           -           7,500           7,500     

Trust preferred securities

     -           -           -           56,702           56,702     

Lease obligations

     1,419           2,134           1,903           10,100           15,556     

Estimated benefit plan payments:

              

Pension

     612           1,235           1,384           4,014           7,245     

Other

     140           366           380           1,014           1,900     
        

Total contractual cash obligations

       $    644,762             $553,909             $207,258             $533,477             $1,939,406     
        

Commitments, Contingencies and Off-Balance Sheet Risk

Information about FNB United’s off-balance sheet risk exposure is presented in Note 19 to the accompanying consolidated financial statements.

 

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Asset/Liability Management and Interest Rate Sensitivity

One of the primary objectives of asset/liability management is to maximize the net interest margin while minimizing the earnings risk associated with changes in interest rates. One method used to manage interest rate sensitivity is to measure, over various time periods, the interest rate sensitivity positions, or gaps; however, this method addresses only the magnitude of timing differences and does not address earnings or market value. Therefore, management uses an earnings simulation model to prepare, on a monthly basis, earnings projections based on a range of interest rate scenarios in order to more accurately measure interest rate risk. For additional information, see Item 7A, “Quantitative and Qualitative Disclosure about Market Risk.”

Table 4 presents information about the periods in which the interest-sensitive assets and liabilities at December 31, 2010 will mature, prepay, or be subject to repricing in accordance with market rates, and the resulting interest-sensitivity gaps. This table shows the sensitivity of the balance sheet at one point in time and is not necessarily indicative of what the sensitivity will be on other dates. As a simplifying assumption concerning repricing behavior, 50% of the interest-bearing demand, savings and money market deposits are assumed to reprice immediately and 50% are assumed to reprice beyond one year.

Table 4

Interest Rate Sensitivity Analysis

 

    December 31, 2010  
(dollars in thousands)   Rate Maturity in Days              
    1-90     91-180     181-365     Beyond One
Year
    Total  
       

Earning Assets

         

Investment securities (1)

    $     48,757      $     1,035       $     5,023       $     251,378       $     306,193      

Loans

    633,365        92,121         264,488         314,001         1,303,975      

Loans held for sale

    37,079                             37,079      

Interest-bearing bank balances

    139,543                             139,543      

Other earning assets

    11,501        3,761                       15,262      
       

Total interest-earning assets

    870,245        96,917         269,511         565,379         1,802,052      
       

Interest-Bearing Liabilities

         

Interest-bearing deposits:

         

Demand deposits

    115,042                      115,042         230,084      

Savings deposits

    21,862                      21,862         43,724      

Money market deposits

    156,004                      156,003         312,007      

Time deposits of $100,000 or more

    70,393        85,559         140,941         247,839         544,732      

Other time deposits

    67,325        63,865         115,937         169,783         416,910      

Retail repurchase agreements

    9,628                             9,628      

Federal Home Loan Bank advances

    -               25,000         119,485         144,485      

Subordinated debt

    -                      7,500         7,500      

Trust preferred securities

    56,702                             56,702      
       

Total interest-bearing liabilities

    496,956        149,424         281,878         837,514             1,765,772      
       

Interest Sensitivity Gap

    $ 373,289      $ (52,507)      $ (12,367)      $ (272,135)      $ 36,280      
       

Cumulative gap

    $     373,289          $ 320,782       $     308,415       $     36,280       $ 36,280      

Ratio of interest-sensitive assets to interest-sensitive liabilities

    175%        65%        96%        68%        102%    

 

(1) Securities are based on amortized cost.

FNB United’s balance sheet was asset-sensitive at December 31, 2010. An asset sensitive position means that in a declining rate environment, FNB United’s assets will reprice down faster than liabilities, resulting in a reduction in net interest income. Conversely, when interest rates rise, FNB United’s earnings position should improve. Included in interest-bearing liabilities subject to rate changes within 90 days is a portion of the interest-bearing demand, savings and money market deposits. These types of deposits historically have not repriced coincidentally with or in the same proportion as general market indicators.

Market Risk

Market risk is the possible chance of loss from unfavorable changes in market prices and rates. These changes may result in a reduction of current and future period net interest income, which is the favorable spread earned from the excess of interest income on interest-earning assets, over interest expense on interest-bearing liabilities.

 

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FNB United’s market risk arises primarily from interest rate risk inherent in its lending and deposit-taking activities. The structure of FNB United’s loan and deposit portfolios is such that a significant decline in interest rates may adversely impact net market values and net interest income. FNB United does not maintain a trading account nor is FNB United subject to currency exchange risk or commodity price risk. Interest rate risk is monitored as part of FNB United’s asset/liability management function, which is discussed in “Asset/Liability Management and Interest Rate Sensitivity” above. The use of interest rate swaps in conjunction with asset/liability management objectives is discussed in Note 1 to the accompanying consolidated financial statements.

Table 5 presents information about the contractual maturities, average interest rates and estimated values at current rates of financial instruments considered market risk sensitive at December 31, 2010.

Table 5

Market Risk Analysis of Financial Instruments

 

(dollars in thousands)   Contractual Maturities at December 31, 2010              
    2011     2012     2013     2014     2015    

Beyond

Five Years

    Total     Average
Interest
Rate (1)
   

Estimated

Value at

Current Rates

 
       

Financial Assets

                 

Debt securities (2):

                 

Fixed rate

    $ 6,323        $ 1,021        $ 2,688        $ 317        $ 101        $ 247,251        $ 257,701        2.90     $ 257,252   

Variable rate

    -        -        -        -        -        48,492        48,492        0.76     48,079   

Loans (3):

                 

Fixed rate

    105,537        56,303        51,311        66,499        26,910        173,086        479,646        6.02     480,500   

Variable rate

    360,891        59,542        43,406        31,484        13,113        315,893        824,329        3.17     773,350   

Held for sale

    37,079        -        -        -        -        -        37,079        3.61     37,079   

Interest-bearing bank balances

    139,543        -        -        -        -        -        139,543        0.60     139,543   

Other earning assets

    15,262        -        -        -        -        -        15,262        1.82     15,262   
       

Total

    $ 664,635        $ 116,866        $ 97,405        $ 98,300        $ 40,124        $ 784,722        $     1,802,052        3.62     $ 1,751,065   
       

Financial Liabilities

                 

Interest-bearing demand deposits

    $ -        $ -        $ -        $ -        $ -        $ 230,084        $ 230,084        1.00     $ 209,439   

Savings deposits

    -        -        -        -        -        43,724        43,724        0.26     44,723   

Money market deposits

    -        -        -        -        -        312,007        312,007        0.97     307,299   

Time deposits:

                 

Fixed rate

    533,760        243,865        118,890        24,033        27,440        66        948,054        1.68     958,570   

Variable rate

    10,259        3,119        110        100        -        -        13,588        5.14     13,740   

Retail repurchase agreements

    -        -        -        -        -        -        9,628        0.78     9,628   

Federal Home Loan Bank advances Fixed rate

    25,000        15,000        20,320        15,304        18,452        50,409        144,485        2.55     150,466   

Subordinated debt

    -        -        -        -        -        -        7,500        3.90     7,500   

Trust preferred securities

    -        -        -        -        -        -        56,702        2.65     41,681   
       

Total

    $     569,019        $     261,984        $     139,320        $     39,437        $     45,892        $     636,290        $     1,765,772        1.56     $     1,743,046   
       

 

(1) The average interest rate related to debt securities is stated on a fully taxable equivalent basis, assuming a 35% federal income tax rate.
(2) Contractual maturities of debt and equity securities are based on amortized cost.
(3) Nonaccrual loans are included in the balance of loans. The allowance for loan losses is excluded.

For a further discussion on market risk and how FNB United addresses this risk, see Item 7A of this Annual Report on Form 10-K.

Capital Adequacy

Under guidelines established by the Board of Governors of the Federal Reserve System, capital adequacy is currently measured for regulatory purposes by certain risk-based capital ratios, supplemented by a leverage capital ratio. The risk-based capital ratios are determined by expressing allowable capital amounts, defined in terms of Tier 1 and Tier 2, as a percentage of risk-weighted assets, which are computed by measuring the relative credit risk of both the asset categories on the balance sheet and various off-balance sheet exposures. Tier 1 capital consists primarily of common shareholders’ equity and qualifying perpetual preferred stock and qualifying trust preferred securities, net of goodwill and other disallowed intangible assets. Tier 2 capital, which is limited to the total of Tier 1 capital, includes allowable amounts of subordinated debt, mandatory convertible debt, preferred stock, trust preferred securities and the allowance for loan losses. Total capital, for risk-based purposes, consists of the sum of Tier 1 and Tier 2 capital. Under current requirements, the minimum total risk based capital ratio is 8.0% and the minimum Tier 1 capital ratio is 4.0%. The Company is subject to increased minimum capital requirements as part of

 

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the Consent Order with the Comptroller of the Currency. Under the requirements of the Consent Order the Bank must maintain total capital at least equal to 12% of risk-weighted assets and Tier 1 capital at least equal to 9% of adjusted total assets. At December 31, 2010, FNB United and the Bank had total risk based capital ratios of (1.23)% and 4.70%, respectively, and Tier 1 risk based capital ratios of (1.23)% and 2.47%, respectively. The leverage capital ratio, which serves as a minimum capital standard, considers Tier 1 capital only and is expressed as a percentage of average total assets for the most recent quarter, after reduction of those assets for goodwill and other disallowed intangible assets at the measurement date. As currently required, the minimum leverage capital ratio is 4.0%. At December 31, 2010, FNB United and the Bank had leverage capital ratios of (.91)% and 1.81%, respectively. For further discussion on capital strategies, refer to “Management’s Plans and Intentions” above.

Table 6

Regulatory Capital

 

(dollars in thousands)    For year ended December 31,  
     2010     2009     2008  

Total risk-based capital

              

Consolidated

       $     (17,911     (1.2) %            $     181,990         10.3  %            $     185,312         10.4  %     

Subsidiary Bank

     68,178        4.7           178,023         10.1              182,084         10.2         

Tier 1 risk-based capital

              

Consolidated

     (17,911     (1.2)              121,207         6.9              123,796         6.9         

Subsidiary Bank

     35,813        2.5             140,604         8.0              144,654         8.1         

Leverage capital

              

Consolidated

     (17,911     (0.9)              121,207         5.7              123,796         6.1         

Subsidiary Bank

     35,813        1.8               140,604         6.6              144,654         7.2         

The Bank is also required to comply with prompt corrective action provisions established by the Federal Deposit Insurance Corporation Improvement Act. The Order, as set forth above, requires the Bank to achieve and maintain Tier 1 capital of not less than 9% and total risk-based capital of not less than 12% for the life of the Order. The Bank has not achieved the required capital levels by the deadline imposed under the Order but is continuing to work to comply with the capital directive. As noted in Table 6 above, at December 31, 2010, the Bank was “significantly undercapitalized” under the regulatory framework for prompt corrective action. If the Company is unsuccessful in its efforts to raise additional capital, the Bank could become “critically undercapitalized” for capital reporting purposes, as defined by regulatory guidelines, as early as the end of the first quarter of 2011. As of February 28, 2011, the Bank was not “critically undercapitalized.”

Balance Sheet Review

Total assets decreased $180.0 million, or 9%, in 2010 and $56.9 million, or 3%, in 2009. By similar comparison, deposits decreased $25.7 million to $1.7 million, or 2% in 2010 and increased $207.4 million, or 14% in 2009. The level of total assets was also affected in 2010 by a net decrease of $259.0 million of loan outstandings as a direct result of management’s decision to deleverage the balance sheet. Average assets decreased by 6% in 2010 compared to a growth of 6% in 2009. The corresponding average deposit growth rate was 5% in 2010 compared to a growth of 11% in 2009. In addition, the Company recorded $45.0 million in deferred tax valuation allowance for 2010.

Investment Securities

Investments are carried on the consolidated balance sheet at estimated fair value for available-for-sale securities and at amortized cost for held-to-maturity securities. Table 7 presents information, on the basis of selected maturities, about the composition of the investment securities portfolio for each of the last two years.

Table 7

Investment Securities Portfolio Analysis

The following table presents the amortized costs, fair value and weighted-average yield of securities by contractual maturity at December 31, 2010. The average yields are based on the amortized cost. In some cases, the issuers may have the right to call or prepay obligations without call or prepayment penalties prior to the contractual maturity date. Rates are calculated on a fully tax-equivalent basis using a 35% federal income tax rate.

 

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On May 3, 2010, the Company reclassified the entire held-to-maturity investment securities portfolio to available-for-sale investment securities to provide additional liquidity to the Bank. At the time of reclassification, the held-to-maturity investment securities were carried at amortized cost of $83.2 million with an unrealized net gain of $3.5 million.

Available-for-Sale

 

(dollars in thousands)   Within 1
Year
    1 to 5
Years
    5 to 10
Years
    Over 10
Years
    Total  
Amortized Cost          

Obligations of:

         

U.S. Treasury and government agencies

      $ 20              $ -              $ -              $ -              $ 20       

U.S. government sponsored agencies

    5,003            -            18,487            -            23,490       

States and political subdivisions

    1,300            4,127            4,261            14,179            23,867       

Residential mortgage-backed securities

    -            -            8,566            250,250            258,816       
                                       

Total available-for-sale securities

      $ 6,323              $ 4,127              $ 31,314              $ 264,429              $ 306,193       
                                       
Fair Value          

Obligations of:

         

U.S. Treasury and government agencies

      $ 21            -          $ -          $ -              $ 21       

U.S. government sponsored agencies

    5,161            -            18,355            -            23,516       

States and political subdivisions

    1,309            4,104            4,172            14,873            24,458       

Residential mortgage-backed securities

    -            -            8,568            248,768            257,336       
                                       

Total available-for-sale securities

      $     6,491              $     4,104              $     31,095              $     263,641              $     305,331       
                                       

Total average yield

    4.64%          3.32%          2.46%          2.52%          2.56%     

 

The following table presents the amortized costs, fair value and weighted-average yield of securities by contractual maturity at December 31, 2009. The average yields are based on the amortized cost. In some cases, the issuers may have the right to call or prepay obligations without call or prepayment penalties prior to the contractual maturity date. Rates are calculated on a fully tax-equivalent basis using a 35% federal income tax rate.

 

Available-for-Sale

 

     

  

(dollars in thousands)   Within 1
Year
    1 to 5
Years
    5 to 10
Years
    Over 10
Years
    Total  
Amortized Cost          

Obligations of:

         

U.S. Treasury and government agencies

      $ -              $ 61          $ -          $ -          $ 61       

U.S. government sponsored agencies

    -            32,395            33,031            6,270            71,696       

States and political subdivisions

    4,043            6,833            15,806            18,582            45,264       

Residential mortgage-backed securities

    -            -            -            99,307            99,307       

Equity securities

    -            -            -            2,667            2,667       

Corporate notes

    7,971            5,939            -            -            13,910       
                                       

Total available-for-sale securities

      $     12,014              $     45,228              $ 48,837              $ 126,826              $ 232,905       
                                       

Fair Value

         

Obligations of:

         

U.S. Treasury and government agencies

      $ -              $ 63              $ -              $ -              $ 63       

U.S. government sponsored agencies

    -            33,278            33,406            6,283            72,967       

States and political subdivisions

    4,057            6,989            15,763            19,619            46,428       

Residential mortgage-backed securities

    -            -            -            101,613            101,613       

Collateralized debt obligations

    -            -            -            45            45       

Equity securities

    -            -            -            2,168            2,168       

Corporate notes

    8,081            6,265            -            -            14,346       
                                       

Total available-for-sale securities

      $ 12,138              $ 46,595              $ 49,169              $ 129,728              $ 237,630       
                                       

Total average yield

    4.91%          4.42%          4.55%          4.46%          4.49%     

 

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Held-to-Maturity

 

(dollars in thousands)    Within 1
Year
     1 to 5
Years
     5 to 10
Years
     Over 10
Years
     Total  

Amortized Cost

              

Obligations of:

              

States and political subdivisions

   $ 1,555         $ 4,678         $ 5,906         $ 1,779         $ 13,918     

Residential mortgage-backed securities

     -           -           -           52,127           52,127     

Commercial mortgage-backed securities

     -           -           -           21,513           21,513     

Corporate notes

     -           1,001           -           -           1,001     
                                            

Total held-to-maturity securities

   $ 1,555         $ 5,679         $ 5,906         $ 75,419         $ 88,559     
                                            

Fair Value

              

Obligations of:

              

States and political subdivisions

   $ 1,566         $ 4,884         $ 6,136         $ 1,818         $ 14,404     

Residential mortgage-backed securities

     -           -           -           53,022           53,022     

Commercial mortgage-backed securities

     -           -           -           23,232           23,232     

Corporate notes

     -           863           -           -           863     
                                            

Total held-to-maturity securities

   $ 1,566         $ 5,747         $ 6,136         $ 78,072         $ 91,521     
                                            

Total average yield

     2.67%           3.39%           3.75%           8.80%           8.01%     

Additions to the investment securities portfolio depend to a large extent on the availability of funds that are not otherwise needed to satisfy loan demand.

Loans

FNB United’s primary source of revenue and largest component of earning assets is the loan portfolio. In 2010, loans decreased $259.0 million, or 17%, due to the Bank’s decision to reduce outstanding loans because of its current financial condition. In 2009, loans decreased $22.2 million, or 1%, due to reduction in loan demand stemming from ongoing uncertainty in the general economy and the market. In 2008, loans increased $139.1 million, or 10%, due entirely to internal loan generation.

Table 8 sets forth the major categories of loans for each of the last five years.

Table 8

Loan Portfolio Composition

 

(dollars in thousands)   December 31,  
    2010     2009     2008     2007     2006  

Loans held for sale

  $ 37,079        $ 58,219        $ 17,586        $ 20,862        $ 17,615     
                                                 

Loans held for investment:

                   

Commercial and agricultural

  $ 93,747        7.2    %    $ 194,134        12.4    %    $ 184,909        11.7    %    $ 182,713        12.6    %    $ 315,184        24.2    % 

Real estate-construction

    276,976        21.2        394,427        25.2        453,668        28.6        373,401        25.8        278,124        21.4   

Real estate-mortgage:

                   

1-4 family residential

    388,859        29.8        398,134        25.5        369,948        23.3        331,194        22.9        319,182        24.5   

Commercial

    494,861        38.0        529,822        33.9        540,192        34.1        522,737        36.2        350,261        26.9   

Consumer

    49,532        3.8        46,504        3.0        36,478        2.3        36,071        2.5        39,089        3.0   
                                       

Total

  $ 1,303,975        100.0    %    $ 1,563,021        100.0    %    $ 1,585,195        100.0    %    $ 1,446,116        100.0    %    $ 1,301,840        100.0    % 
                                       

In 2010, loans held for sale decreased over 36%. This decrease is a result of the discontinuation of a wholesale purchasing agreement with Fannie Mae as well as lower production in 2010. Held-for-sale loans do not include any reclassifications from the held-for-investment portfolio. The held-for-investment portfolio experienced composition changes with a 5.2% decrease in commercial and agricultural loans and a 3.9% decrease in real estate construction loans, both offset by a 1.6% increase in 1-4 family residential mortgages, a 4.0% increase in commercial real estate mortgages and a 3.5% increase in consumer loans. In 2009 the held-for-investment portfolio experienced small composition changes primarily with a 3.4% decrease in real estate construction loans partially offset by a 2.2% increase in 1-4 family residential mortgages and a 0.7% increase in consumer loans.

 

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The maturity distribution and interest rate sensitivity of selected loan categories at December 31, 2010 are presented in Table 9.

Table 9

Selected Loan Maturities

 

(dollars in thousands)

     December 31, 2010  
     One Year or
Less
       One to Five
Years
       Over Five
Years
       Total  
          

Commercial and agricultural

       $ 53,964           $ 27,684           $ 12,099           $ 93,747   

Real estate-construction

       217,770           45,229           13,977           276,976   
          

Total

       $     271,734           $     72,913           $     26,076           $     370,723   
          

Sensitivity to rate changes:

                   

Fixed interest rates

       $ 27,695           $ 31,875           $ 18,006           $ 77,576   

Variable interest rates

       244,039           41,038           8,070           293,147   
          

Total

       $ 271,734           $ 72,913           $ 26,076           $ 370,723   
          

Asset Quality

Management considers the asset quality of the Bank to be of primary importance. A formal loan review function, independent of loan origination, is used to identify and monitor problem loans. As part of the loan review function, a third-party assessment group has been employed to review the underwriting documentation and risk grading analysis.

In June 2010, an external loan review of the Bank’s loan portfolio (as of April 30, 2010) was conducted, covering 49% of the total outstanding portfolio balance. The external loan review resulted in 9.3% of loans reviewed being downgraded from pass to non-pass. All risk downgrades identified during this review were included as factors in the computation of the allowance for loan losses as of June 30, 2010. Since December 31, 2009 the Company increased its allowance for loan losses to $76.2 million or 5.84% of gross loans.

Nonperforming assets

Nonperforming assets are comprised of nonaccrual loans, accruing loans past due 90 days or more, repossessed assets and other real estate owned (“OREO”). Nonperforming loans are loans placed in nonaccrual status when, in management’s opinion, the collection of all or a portion of interest becomes doubtful. Loans are returned to accrual status when the factors indicating doubtful collectability cease to exist and the loan has performed in accordance with its terms for a demonstrated period of time. OREO represents real estate acquired through foreclosure or deed in lieu of foreclosure and is generally carried at fair value, less estimated costs to sell.

The level of nonperforming loans increased significantly from $174.4 million, or 11.2% of loans held for investment at December 31, 2009, to $329.9 million, or 25.3% of loans held for investment at December 31, 2010. OREO was $63.6 million at December 31, 2010, compared to $35.2 million at December 31, 2009. General downward economic trends, increased unemployment and the depressed housing market in particular have negatively affected the credit performance of the residential real estate development and construction sectors of the Bank’s commercial portfolio in particular, and consumer credit more generally, resulting in additional delinquencies and loans placed on nonaccrual.

The continued softening of the real estate market through 2010 has adversely affected the Company’s net income. Real estate lending (including commercial, construction, land development, and residential) is a large portion of the Bank’s loan portfolio. These categories constitute $1.2 billion, or approximately 89.4%, of the Bank’s total loan portfolio. These categories are generally affected by changes in economic conditions, fluctuations in interest rates and the availability of loans to potential purchasers, changes in tax and other laws and acts of nature. The downturn in the real estate markets in which the Company originates, purchases, and services mortgage and other loans hurts its business because these loans are secured by real estate. Further declines will adversely affect the Company’s future earnings.

 

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Allowance for Loan Losses

In determining the allowance for loan losses and any resulting provision to be charged against earnings, particular emphasis is placed on the results of the loan review process. Consideration is also given to a review of individual loans, historical loan loss experience, the value and adequacy of collateral, and economic conditions in the Bank’s market area. For loans determined to be impaired, the allowance is based on discounted cash flows using the loan’s initial effective interest rate or the fair value of the collateral for certain collateral dependent loans. This evaluation is inherently subjective as it requires material estimates, including the amounts and timing of future cash flows expected to be received on impaired loans, that may be susceptible to significant change. In addition, the Office of the Comptroller of the Currency (OCC), a federal regulatory agency, as an integral part of its examination process, periodically reviews the Bank’s allowance for loan losses. The OCC may require the Bank to recognize changes to the allowance based on its judgments about information available to it at the time of its examinations. Loans are charged off when, in the opinion of management, they are deemed to be uncollectible. Recognized losses are charged against the allowance, and subsequent recoveries are added to the allowance.

The allowance for loan losses, as a percentage of loans held for investment, amounted to 5.84% at December 31, 2010 compared to 3.16% at December 31, 2009. Net charge-offs also significantly increased in 2010. A substantial portion of 2010 charge-offs were related to impaired loans, and consisted of loans considered wholly impaired and loans with partial impairment. During 2010, net charge-offs totaled $88.5 million, which exceeded the combined net charge-offs for the prior seven years. The provision for loan losses recorded in 2010 also exceeded the combined provision recorded in the prior seven years. As discussed above, the increased levels of nonperforming assets and charge-offs resulted largely from loan quality issues driven by worsening economic conditions, including strains in housing and real estate markets. Management continually performs thorough analyses of the loan portfolio. As a result of these analyses, certain loans have migrated to higher, more adverse risk grades and an aggressive posture towards the timely charge-off of identified impairment has also continued. Actual past due loans and loan charge-offs have remained at manageable levels and management continues to diligently work to improve asset quality. Management believes the allowance for loan losses of $76.2 million at December 31, 2010 is adequate to cover probable losses inherent in the loan portfolio; however, assessing the adequacy of the allowance is a process that requires considerable judgment.

Troubled debt restructurings generally occur when a borrower is experiencing, or is expected to experience, financial difficulties in the near-term. As a result, the Bank will work with the borrower to prevent further difficulties, and ultimately to improve the likelihood of recovery on the loan. To facilitate this process, a concessionary modification that would not otherwise be considered may be granted resulting in classification as a troubled debt restructuring. The Bank considers all troubled debt restructurings to be impaired loans. Troubled debt restructurings can involve loans remaining on nonaccrual, moving to nonaccrual, or continuing on accruing status, depending on the individual facts and circumstances of the borrower. Generally, a nonaccrual loan that is restructured remains on nonaccrual for a period of six months to demonstrate the borrower can meet the restructured terms. However, performance prior to the restructuring, or significant events that coincide with the restructuring, are considered in assessing whether the borrower can meet the new terms and may result in the loan being returned to accrual status after a shorter performance period. If the borrower’s ability to meet the revised payment schedule is not reasonably assured, the loan remains in a nonaccrual status.

The majority of the Bank’s loan modifications relates to commercial lending and involves extending the term of the loan. In these cases, the Bank does not typically lower the interest rate or forgive principal or interest as part of the loan modification. In addition, it is common for the Bank to seek additional collateral or guarantor support when modifying a loan. The amount of loan restructurings increased during 2010, as the Bank continues to work with borrowers who are experiencing financial difficulties. As a result of continued economic stress, the Bank anticipates that it will have further increases in loan restructurings during 2011.

The Bank’s criteria for nonperforming status, impaired status and troubled debt restructures have been described earlier. The following table presents the Bank’s level and composition of nonperforming loans as of December 31:

 

(dollars in thousands)

 

   2010      2009  

Nonperforming Loans:

     

Current, nonaccrual

     $ 76,216         $ 62,469     

Delinquent 30-89 days, nonaccrual

     53,440           17,626     

Delinquent 90+ days, nonaccrual

     195,412           87,411     

Delinquent 90+ days, accruing

     4,818           6,908     
                 

Total Nonperforming Loans

     $     329,886           $     174,414     
                 

 

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Nonperforming loans and impaired loans are overlapping sets of loans. Impaired loans are problem loans that may, or may not, have been placed into nonaccrual status. The complete repayment of principal and interest is considered probable for those impaired loans that have not been placed into a nonaccrual status, but not within contracted terms.

The differential between the amount of nonperforming impaired loans and total impaired loans noted above arises from two loans totaling $5.0 million, which were in the process of being refinanced at other institutions. Neither had been previously impaired. The refinancing process exceeded 90 days in both cases, however, which resulted in the loans being placed in nonaccrual.

The following table presents the level, composition and the reserves associated with those loan balances:

 

(dollars in thousands)    December 31, 2010      December 31, 2009  
     Balance     

Associated

Reserves

     Balance     

Associated

Reserves

 
                 

Impaired loans, not individually reviewed for impairment

     $ 717         $ -           $ 5,660         $ 38     

Impaired loans, individually reviewed, with no impairment

     144,832         -           84,928         -     

Impaired loans, individually reviewed, with impairment

     185,504         52,827           98,010         28,868     
                 

Total impaired loans *

     $   331,053         $     52,827           $   188,598         $   28,906     
                 

* Included at December 31, 2010 and December 31, 2009 were $6.5 million and $24.7 million, respectively, in restructured and performing loans.

At December 31, 2010, the bank had 83 impaired loans exceeding $1.0 million each, with total impairment of $42.7 million, comprised of 58 borrowing relationships. The average carrying value of impaired loans was $291.6 million in 2010 and $147.2 million in 2009.

Troubled debt restructures are a subset of impaired loans. The following table presents the level, accrual status and the reserves associated with these loan balances:

 

(dollars in thousands)    December 31, 2010      December 31, 2009  
Troubled Debt Restructures:    Balance      Nonaccrual     

Associated

Reserves

     Balance      Nonaccrual     

Associated

Reserves

 
                 

TDRs with no impairment

     $ 66,919       $ 60,345       $ -           $ 58,897       $ 34,334       $ -     

TDRs with impairment

     79,573         79,573         18,908           36,784         36,604         5,859     
                 

Total Troubled Debt Restructures

     $    146,492       $ 139,918       $   18,908           $   95,681       $ 70,938       $ 5,859     
                 
The following table presents the composition of impaired loans across loan types, along with the accrual status and the associated reserves, by type:    
(dollars in thousands)    December 31, 2010      December 31, 2009  
     Impaired      Nonaccrual     

Associated

Reserves

     Impaired      Nonaccrual     

Associated

Reserves

 
                 

Impaired Loans (composition across loan types):

                 

Commercial and agricultural

     $ 21,153       $ 20,550       $ 4,788           $ 5,061       $ 4,930       $ 849     

Real estate - construction

     145,540         144,403         24,802           100,459         99,583         17,840     

Real estate - mortgage:

                 

1 - 4 family residential

     39,693         36,272         2,443           22,495         22,283         3,339     

Commercial

     124,459         123,681         20,794           60,300         36,750         6,877     

Consumer

     208         162         -           283         24         1     
                 

Total Impaired Loans

     $     331,053       $ 325,068       $   52,827           $     188,598       $ 163,570       $ 28,906     
                 

The Bank designates loans as “Special Mention” when the borrower’s financial condition or performance indicates that the loan may potentially become a problem loan. These loans are not classified as problem loans, nor are they impaired, and they have not been modified under conditions that require designation as troubled debt restructurings. At December 31, 2010, the Bank had designated $130.8 million as Special Mention loans, of which 15.3% were delinquent more than 30 days. 33 Special Mention loans had balances over $1.0 million and comprised approximately 66.1% of the total. Approximately 33.3% of the total Special Mention loans were categorized as land acquisition, development, and construction loans, with non-owner occupied commercial rental properties approximating another 15.0% of that total. These categories are generally affected by changes in economic conditions, fluctuations in interest rates and the availability of loans to potential purchasers, changes in tax and other laws and acts of nature. In particular, a continuing trend of adverse economic conditions in the residential real estate market may result in Special Mention loans being individually reclassified as problem loans in the future.

 

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Table 10

Summary of Allowance for Loan Losses

Table 10 presents an analysis of the changes in the allowance for loan losses and of the level of nonperforming assets for each of the last five years as of December 31.

 

(dollars in thousands)   2010     2009     2008     2007     2006  

Balance, beginning of year

      $ 49,461            $ 34,720            $ 17,381            $ 15,943            $ 9,945     

Chargeoffs:

         

Commercial and agricultural

    9,824          3,417          6,479          1,262          1,817     

Real estate - construction

    53,374          32,737          2,000          459          499     

Real estate - mortgage

    24,478          9,789          414          941          210     

Consumer

    3,574          3,442          3,532          2,831          2,104     
                                       

Total chargeoffs

    91,250          49,385          12,425          5,493          4,630     
                                       

Recoveries:

         

Commercial and agricultural

    581          70          292          415          1,123     

Real estate - construction

    52          544          -          42          120     

Real estate - mortgage

    449          264          197          171          268     

Consumer

    1,639          1,507          1,516          1,091          1,231     

Leases

    -          -          -          -          3     
                                       

Total recoveries

    2,721          2,385          2,005          1,719          2,745     
                                       

Net chargeoffs

    88,529          47,000          10,420          3,774          1,885     

Provision charged to operations

    115,248          61,741          27,759          5,514          2,526     

Purchase accounting acquisition

    -          -          -          -          6,038     

Adjustment for reserve for unfunded commitments

    -          -          -          -          (677)    

Allowance adjustment for loans sold

    -          -          -          (302)         (4)    
                                       

Balance, end of year