Cardinal Financial 10-K 2006
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2005
o TRANSITION REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission file number: 0-24557
CARDINAL FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)
Registrants telephone number, including area code: (703) 584-3400
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Stock, par value $1.00 per share
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No x
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No x
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer o Accelerated filer x Non-accelerated filer o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No x
State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold as of June 30, 2005: $209,948,494.
The number of shares outstanding of Common Stock, as of February 28, 2006, was 24,364,425.
Portions of the registrants definitive Proxy Statement for the 2006 Annual Meeting of Shareholders are incorporated by reference into Part III of this Form 10-K. With the exception of the portions of the Proxy Statement specifically incorporated herein by reference, the Proxy Statement is not deemed to be filed as part of this Form 10-K.
This Annual Report of Form 10-K has not been reviewed, or confirmed for accuracy or relevance, by the Federal Deposit Insurance Corporation.
Cardinal Financial Corporation, a financial holding company, was formed in late 1997 as a Virginia corporation, principally in response to opportunities resulting from the consolidation of several Virginia-based banks with regional bank holding companies. In our market area, these bank consolidations had been accompanied by the dissolution of local boards of directors and relocation or termination of management and customer service professionals.
We own Cardinal Bank, a Virginia state-chartered community bank headquartered in Tysons Corner, Virginia. Cardinal Bank has offices in Alexandria, Annandale, Arlington, Clifton, Fairfax, Fredericksburg, Herndon, Leesburg, Manassas, McLean, Purcellville, Reston, Stafford, Sterling, Sterling Park, Tysons Corner, and Woodbridge, Virginia and Washington, D.C. We conduct all of our business through Cardinal Bank (the Bank), our principal operating unit, its subsidiary George Mason Mortgage, LLC (George Mason), Cardinal Wealth Services, Inc. (CWS), and Wilson/Bennett Capital Management, Inc. (Wilson/Bennett).
Cardinal Bank offers a wide range of traditional bank loan and deposit products and services to both our commercial and retail customers. Our commercial relationship managers focus on attracting small and medium sized businesses as well as government contractors, commercial real estate developers and builders and professionals, such as physicians, accountants and attorneys. We have 22 branch office locations and provide competitive products and services.
George Mason engages primarily in the origination and acquisition of residential mortgages for sale into the secondary market on a best efforts basis through nine branches located throughout the metropolitan Washington, D.C. region. George Mason is one of the largest residential mortgage originators in the greater Washington metropolitan area, generating originations of approximately $4.3 billion in 2005, excluding advances on construction loans and including loans purchased from other mortgage banking companies which are owned by local home builders but managed by George Mason, and $3.5 billion in 2004, which includes managed company originations and loans of $1.9 billion originated prior to our acquisition of George Mason.
CWS provides brokerage and investment services through a contract with Raymond James Financial Services, Inc. Under this contract, financial advisors can offer our customers an extensive range of financial products and services, including estate planning, qualified retirement plans, mutual funds, annuities, life insurance, fixed income and equity securities and equity research and recommendations. CWSs principal source of revenue is the net commissions it earns on the purchases and sales of investment products by its customers.
Wilson/Bennett provides professional investment management of financial assets with asset preservation as the primary goal. Clients include individuals, pension plans and medium size corporations. Wilson/Bennett utilizes a value oriented investment approach and focuses on large capitalization stocks. Wilson/Bennett earns fees based upon the market value of its clients portfolios.
On June 9, 2005, we acquired Wilson/Bennett for a total consideration of $6.5 million, which consisted of a payment of $1.5 million in cash and the issuance of 611,111 shares of our common stock, which we valued at $4.9 million. We believe that the Wilson/Bennett acquisition furthers our strategies of enhancing fee income, and diversifying our revenue stream and the services we deliver to our customers.
In December 2004, Cardinal Bank converted from a nationally-chartered bank to a state-chartered bank.
Cardinal Bank acquired George Mason for $17.0 million in cash on July 7, 2004. George Mason engages primarily in the origination and acquisition of residential mortgages for sale into the secondary market on a best efforts basis. George Mason conducts its business through nine branches located throughout the metropolitan Washington, D.C. region. George Mason has approximately 200 employees and does business in eight states and the District of Columbia. George Masons primary sources of revenue include net interest income earned on loans held for sale, gains on sales of loans and management fees related to services provided to other mortgage companies owned by local home builders.
George Mason also provides back-office and operational support for five independent mortgage companies that are generally owned by local home builders. At the time a rate lock commitment is given to a managed companys customer, George Mason enters into a best efforts forward sale of the loan. The loan is closed in the name of the managed company and immediately purchased by George Mason at the loans forward sale price. George Mason holds the loans which are pending sale for periods of up to sixty days before they are sold to an investor. George Masons fees are based upon the managed companies pretax operating income.
In July 2004, we formed a wholly-owned subsidiary, Cardinal Statutory Trust I for the purpose of issuing $20.0 million of floating rate junior subordinated deferrable interest debentures (trust preferred securities). These trust preferred securities are due in 2034 and have an interest rate of LIBOR (London Interbank Offered Rate) plus 2.40%, which adjusts quarterly.
We believe that the strong demographic characteristics of our market, the ongoing bank consolidation, and the vibrant economy in the metropolitan Washington, D.C. area, particularly in Northern Virginia, provide a significant opportunity to continue building a successful community-focused banking franchise. We intend to continue to expand our business through internal growth, as well as selective geographic expansion, while maintaining strong asset quality and achieving increasing profitability. The strategy for achieving these objectives includes the following:
Expand our footprint through branch expansion. We intend to continue to expand our footprint by establishing new branches and potentially acquiring existing branches or other financial institutions in communities that present attractive growth opportunities within Northern Virginia and other markets in the greater Washington, D.C. metropolitan area. During 2005, we opened three branch banking offices, one in Sterling, Virginia in the first quarter of the year, a second in Woodbridge, Virginia in the second quarter and the third in the headquarters of our mortgage banking subsidiary, George Mason, in Fairfax, Virginia in the fourth quarter. We opened a branch banking office in Washington, D.C. in February 2006.
As a result of the recent consolidation of banks in our market, we expect to continue to have opportunities to acquire or lease former branch sites from other financial institutions. As we have done in the past, we may acquire additional sites prior to planned branch openings when we believe the sites are attractive and are available on favorable terms. At the present time, we have a first right of refusal that gives us the option to purchase one branch facility if the financial institution now operating this location chooses to close or move its operations anytime before January 2010. We are also currently in negotiations to purchase or lease additional branch sites located in the greater Washington, D.C. metropolitan area, although there can be no assurance that we will be successful in acquiring any of them. Our current plans, which are subject to change, contemplate that we will add as many as six new branches by the end of 2006. Because the opening of each new branch increases our operating expenses, we intend to stage new branch openings in an effort to minimize the impact of these expenses on our results of operations.
Capitalize on the continued bank consolidation in our market. We anticipate that recently announced or completed bank mergers will result in further consolidation in our target market and intend to capitalize on the dislocation of customers resulting from this consolidation. We believe this consolidation creates opportunities for us to further expand our branch network, as discussed above, as well as to increase our market share of bank deposits within our target market. As a local banking organization, we believe we can compete effectively by providing a high level of personalized service in a service-oriented and customer-centric branch system.
Although we are not at this time engaged in negotiations with any specific bank acquisition targets, we will continue to explore the possibility of further growth through acquisition in Virginia, the metropolitan Washington, D.C. market, or other areas if we believe that such expansion will strengthen the Company by diversifying its customer base and sources of revenue and be accretive to earnings within a reasonable time frame.
Expand our lending activities. We have substantially increased our legal lending limit to $19.4 million as of December 31, 2005 as a result of the completion of our secondary common stock offering in May 2005, and earnings retained in the business. The increase in our legal lending limit allows us to further expand our commercial and real estate lending activities. It also improves our ability to serve larger residential homebuilders and allows us to seek business from larger government contractors. Federal government spending in the greater Washington region was approximately $107 billion in 2004, and we believe there are unique growth opportunities in this sector of our regional economy. Our goal is to aggressively grow our loan portfolio while maintaining superior asset quality through conservative underwriting practices. During periods of growth in our loan portfolio, our earnings could be adversely impacted by provisions to our allowance for loan losses as a result of increases in loan balances.
Continue to recruit experienced bankers. We have been successful in recruiting senior bankers with experience in and knowledge of our market who have been displaced or have grown dissatisfied as a result of the previously mentioned bank consolidation. We intend to continue our efforts to recruit experienced bankers, particularly experienced lenders, who can immediately generate additional loan volume through their existing credit relationships.
Focus on specialized lending services. We have expanded certain existing product lines, including government contract receivables lending, SBA guaranteed lending, and retail lending. Our commercial relationship managers focus on attracting small and medium sized businesses, including commercial real estate developers, builders and professionals such as physicians, accountants and attorneys. Our goal is to create a diversified, community-focused banking franchise, balanced between retail, commercial and real estate transactions and services.
Offer additional financial products and services. George Mason has increased our fee income and has allowed us to offer our existing customer base a far greater array of mortgage loan products. In addition, we aggressively market our traditional banking and wealth management products to the George Mason customer base. Our focus at George Mason is to build and maintain relationships with local and national homebuilders in an attempt to reduce reliance on the cyclical refinancing market. Building relationships with larger homebuilders assists us in our efforts to increase our commercial real estate lending activities.
We plan to further develop and expand the investment services we offer through our wealth management subsidiary and the addition of Wilson/Bennett, which has recently begun to offer an attractive cash management product. We believe we have opportunities to cross-sell additional services to both our traditional banking customers and George Masons customers. We further believe we will be able to attract new customers by offering a broader array of financial products and services.
In 2003 and for the first six months of 2004, we operated and reported in two business segments, commercial banking and investment services. As of July 7, 2004, we began operating in a third business segment, mortgage banking, with the completion of our acquisition of George Mason. The commercial banking segment includes both commercial and consumer lending and provides customers such products as commercial loans, real estate loans, and other business financing and consumer loans. In addition, this segment provides customers with several choices of deposit products, including demand deposit accounts, savings accounts and certificates of deposit. The mortgage banking segment engages primarily in the origination and acquisition of residential mortgages for sale into the secondary market on a best efforts basis. The investment services segment provides advisory services to businesses and individuals, including financial planning and retirement/estate planning.
For financial information about the reportable segments, see Business Segment Operations in Item 7 below and note 18 of the notes to the consolidated financial statements in Item 8 below.
We consider our primary target market to be the greater Washington metropolitan area, which includes the District of Columbia, the Northern Virginia counties of Arlington, Fairfax, Fauquier, Loudoun, Prince William, Spotsylvania and Stafford, the Northern Virginia cities of Alexandria, Fairfax, Falls Church, Fredericksburg, and Manassas, and the Maryland counties of Frederick, Montgomery and Prince Georges. We will, however, consider expansion into other areas if we believe such expansion will strengthen the Company by diversifying its customer base and sources of revenue and be accretive to earnings within a reasonable time frame.
In 2005, the population of the greater Washington metropolitan area was approximately 5.8 million people, the fourth largest market in the country. The median annual household income for this area in 2005 was approximately $76,000, the second wealthiest market in the country. Based on estimates released by the Bureau of Labor Statistics of the U.S. Department of Labor for December 2005, the unemployment rate for the greater Washington metropolitan area was approximately 2.9%, compared to a national unemployment rate of 5.1%. As of June 30, 2005, total deposits in this area were approximately $131 billion as reported by the Federal Deposit Insurance Corporation (FDIC).
Our headquarters is located approximately seven miles west of Washington, D.C. in Fairfax County, Virginia. The 2000 U.S. census data indicates that Fairfax County is the most populous county in Virginia with a population of approximately one million people. In 2005, Fairfax County had a median household income of approximately $100,800. Based on estimates released by the Bureau of Statistics of the U.S. Department of Labor for December 2005, the unemployment rate in Fairfax County was 2.1%.
The greater Washington region is dominated by branches of large regional or national banks headquartered outside of the region. Our market area is a highly competitive, highly branched, banking market. We compete as a financial intermediary with other commercial banks, savings and loan associations, savings banks, credit unions, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, mutual fund groups and other types of financial institutions. George Mason faces significant competition from both traditional financial institutions and other national and local mortgage banking operations.
The competition to acquire deposits and to generate loans, including mortgage banking loans, is intense, and pricing is important. Many of our competitors are larger and have substantially greater resources and lending limits than we do. In addition, many competitors offer more extensive branch and
ATM networks than we currently have. Larger institutions operating in the greater Washington market have access to funding sources at lower costs than are available to us since they have larger and more diverse fund generating capabilities. However, we believe that we have and will continue to be successful in competing in this environment due to an emphasis on a high level of personalized customer service, localized and more responsive decision making, and community involvement.
Of the $131 billion in bank deposits in the greater Washington region at June 30, 2005, approximately 77% were held by banks that are either based outside of the greater Washington region or are operating wholesale banks that generate deposits nationally. In just over seven years, we have grown to the seventh largest financial institution headquartered in the greater Washington region as measured by total deposits. By providing competitive products and more personalized service and being actively involved in our local communities, we believe we can continue to increase our share of this deposit market.
We believe that the recent and ongoing bank consolidation within Northern Virginia and the greater Washington region provides a significant opportunity to build a successful, locally-oriented banking franchise. We also believe that many of the larger financial institutions in our area do not emphasize the high level of personalized service to small and medium-sized commercial businesses, professionals or individual retail customers that we emphasize.
We expect to continue serving these business and professional markets with experienced commercial relationship managers, and we have increased our retail marketing efforts through the expansion of our branch network and development of additional retail products and services. We expanded our deposit market share through aggressive marketing of our Presidents Club and Monster Money Market relationship products and our Totally Free Checking product.
Our principal business is to accept deposits from the public and to make loans and other investments. The principal sources of funds for the banks loans and investments are demand, time, savings and other deposits, repayments of existing loans, and borrowings. Our principal source of income is interest collected on loans, investment securities and other investments. Non-interest income, which includes among other things deposit and loan fees and service charges, gains on sales of loans and management fee income, is the next largest component of our revenues. Our principal expenses are interest expense on deposits and borrowings, employee compensation and benefits, occupancy-related expenses, and other overhead expenses.
The principal business of George Mason, the Banks mortgage banking subsidiary, is to originate residential loans for sale into the secondary market on a best efforts basis. These loans are closed and serviced by George Mason on an interim basis pending their ultimate sale to a permanent investor. The mortgage subsidiary funds these loans through a line of credit from Cardinal Bank, lines of credit through third party lenders and cash available through its own operations. George Masons income on these loans is generated from the fees it charges its customers, the gains it recognizes upon the sales of the loans and the interest income it earns while the loans are being serviced. Costs associated with these loans are primarily comprised of salaries and commissions paid to loan originators and support personnel, interest expense incurred while the loans are held pending sale and other expenses associated with the origination of the loans. In addition, George Mason generates management fee income by providing specific services to other mortgage banking companies owned by local home builders.
George Mason also offers a construction-to-permanent loan program. This program provides variable rate financing for customers to construct their residences. Once the home has been completed, the loan converts to fixed rate financing and is sold into the secondary market. These construction-to-permanent
loans generate fee income as well as net interest income for George Mason and are classified as loans held for sale.
George Masons business is both cyclical and seasonal. The cyclical nature of its business is influenced by, among other things, the levels of and trends in mortgage interest rates, national and local economic conditions and consumer confidence in the economy. Historically, George Mason has its lowest levels of quarterly loan closings during the first quarter of the year.
Both Cardinal Bank and George Mason are committed to providing high quality products and services to their customers, and have made a significant investment in their core information technology systems. These systems provide the technology that fully automates the branches, processes bank transactions, mortgage originations, other loans and electronic banking, conducts database and direct response marketing, provides cash management solutions, streamlined reporting and reconciliation support.
With this investment in technology, the bank offers internet-based delivery of products for both individuals and commercial customers. Customers can open accounts, apply for loans, check balances, check account history, transfer funds, pay bills, download account transactions into Quicken and Microsoft Money, and correspond via e-mail with the bank over the internet. The internet provides an inexpensive way for the bank to expand its geographic borders and branch activities while providing services offered by larger banks.
We offer a broad array of products and services to our customers. A description of products and services is set forth below.
We offer a full range of short to long-term commercial, real estate and consumer lending products and services, which are described in further detail below. We have established target percentage goals for each type of loan to insure adequate diversification of our loan portfolio. These goals, however, may change from time to time as a result of competition, market conditions, employee expertise, and other factors. Commercial and industrial loans, real estate-commercial loans, real estate-construction loans, real estate-residential loans, home equity loans, and consumer loans account for approximately 10%, 39%, 18%, 21%, 11% and 1%, respectively of our loan portfolio at December 31, 2005. At December 31, 2005, approximately 1% of our total loan portfolio is unsecured.
Commercial and Industrial Loans. We make commercial loans to qualified businesses in our market area. Our commercial lending portfolio consists primarily of commercial and industrial loans for the financing of accounts receivable, inventory, property, plant and equipment. Our government contract lending group provides secured lending to government contracting firms and businesses based primarily on receivables from the federal government. We also offer Small Business Administration (SBA) guaranteed loans and asset-based lending arrangements to our customers. We are certified as a preferred lender by the SBA, which provides us with much more flexibility in approving loans guaranteed under the SBAs various loan guaranty programs.
Commercial and industrial loans generally have a higher degree of risk than residential mortgage loans, but have commensurately higher yields. Residential mortgage loans generally are made on the basis of the borrowers ability to repay the loan from his or her salary and other income and are secured by residential real estate, the value of which generally is readily ascertainable. In contrast, commercial loans typically are made on the basis of the borrowers ability to repay the loan from the cash flow from its business and are secured by business assets, such as commercial real estate, accounts receivable, equipment and inventory, the values of which may decline over time and generally cannot be appraised with as much precision as residential real estate. As a result, the availability of funds for the repayment of commercial loans may be substantially dependent upon the commercial success of the business itself.
To manage these risks, our policy is to secure the commercial loans we make with both the assets of the business, which are subject to the risks described above, and other additional collateral and guarantees that may be available. In addition, we actively monitor certain attributes of the borrower and the credit facility, including advance rate, cash flow, collateral value and other credit factors that we consider appropriate.
Commercial Mortgage Loans. We originate commercial mortgage loans. These loans are primarily secured by various types of commercial real estate, including office, retail, warehouse, industrial and other non-residential types of properties and are made to the owners and/or occupiers of such property. These loans generally have maturities ranging from one to ten years.
Commercial mortgage lending entails significant additional risk compared with traditional residential mortgage lending. Commercial mortgage loans typically involve larger loan balances concentrated with single borrowers or groups of related borrowers. Additionally, the repayment of loans secured by income-producing properties is typically dependent upon the successful operation of a business or real estate project and thus may be subject, to a greater extent than is the case with residential mortgage loans, to adverse conditions in the commercial real estate market or in the general economy. Our commercial real estate loan underwriting criteria require an examination of debt service coverage ratios, the borrowers creditworthiness and prior credit history and reputation, and we generally require personal guarantees or endorsements with respect to these loans. In the loan underwriting process, we also carefully consider the location of the property that will be collateral for the loan.
Loan-to-value ratios for commercial mortgage loans generally do not exceed 80%. We permit loan-to-value ratios of up to 80% if the borrower has appropriate liquidity, net worth and cash flow.
Residential Mortgage Loans. Residential mortgage loans are originated by both Cardinal Bank and George Mason. Our residential mortgage loans consist of residential first and second mortgage loans, residential construction loans and home equity lines of credit and term loans secured by the residences of borrowers. Second mortgage and home equity lines of credit are used for home improvements, education and other personal expenditures. We make mortgage loans with a variety of terms, including fixed, floating and variable interest rates, with maturities ranging from three months to thirty years.
Residential mortgage loans generally are made on the basis of the borrowers ability to repay the loan from his or her salary and other income and are secured by residential real estate, the value of which is generally readily ascertainable. These loans are made consistent with our appraisal and real estate lending policies, which detail maximum loan-to-value ratios and maturities. Residential mortgage loans and home equity lines of credit secured by owner-occupied property generally are made with a loan-to-value ratio of up to 80%. Loan-to-value ratios of up to 95% may be allowed on residential owner-occupied property if the borrower exhibits unusually strong creditworthiness. We do not make residential loans which, at the time of inception, have loan-to-value ratios in excess of 95%.
Construction Loans. Our construction loan portfolio consists of single-family residential properties, multi-family properties and commercial projects. Construction lending entails significant additional risks compared with residential mortgage lending. Construction loans often involve larger loan balances concentrated with single borrowers or groups of related borrowers. Construction loans also involve additional risks since funds are advanced while the property is under construction, which property has uncertain value prior to the completion of construction. Thus, it is more difficult to evaluate accurately the total loan funds required to complete a project and related loan-to-value ratios. To reduce the risks associated with construction lending, we limit loan-to-value ratios for owner occupied residential or commercial properties to 80%, and for investor-owned residential or commercial properties to 75% of when-completed appraised values. We expect that these loan-to-value ratios will provide sufficient protection against fluctuations in the real estate market to limit the risk of loss. Maturities for construction loans generally range from 12 to 24 months for residential, non-residential and multi-family properties.
Consumer Loans. Our consumer loans consist primarily of installment loans made to individuals for personal, family and household purposes. The specific types of consumer loans we make include home improvement loans, automobile loans, debt consolidation loans and general consumer lending.
Consumer loans may entail greater risk than residential mortgage loans, particularly in the case of consumer loans that are unsecured, such as lines of credit, or secured by rapidly depreciable assets, such as automobiles. In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation. The remaining deficiency often does not warrant further substantial collection efforts against the borrower. In addition, consumer loan collections are dependent on the borrowers continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Furthermore, the application of various federal and state laws, including federal and state bankruptcy and insolvency laws, may limit the amount that can be recovered on such loans. A loan may also give rise to claims and defenses by a consumer loan borrower against an assignee of such loan, such as the bank, and a borrower may be able to assert against such assignee claims and defenses that it has against the seller of the underlying collateral.
Our policy for consumer loans is to accept moderate risk while minimizing losses, primarily through a careful credit and financial analysis of the borrower. In evaluating consumer loans, we require our lending officers to review the borrowers level and stability of income, past credit history, amount of debt currently outstanding and the impact of these factors on the ability of the borrower to repay the loan in a timely manner. In addition, we require our banking officers to maintain an appropriate differential between the loan amount and collateral value.
We also issue credit cards to certain of our customers. In determining to whom we will issue credit cards, we evaluate the borrowers level and stability of income, past credit history and other factors. Finally, we make additional loans that are not classified in one of the above categories. In making such loans, we attempt to ensure that the borrower meets our loan underwriting standards.
From time to time we purchase and sell commercial loan participations to or from other banks within our market area. All loan participations purchased have been underwritten using the banks standard and customary underwriting criteria and are in good standing.
We offer a broad range of interest-bearing and non-interest-bearing deposit accounts, including commercial and retail checking accounts, money market accounts, individual retirement accounts, regular interest-bearing savings accounts and certificates of deposit with a range of maturity date options. The primary sources of deposits are small and medium-sized businesses and individuals within our target market. Senior management has the authority to set rates within specified parameters in order to remain competitive with other financial institutions in our market area. All deposits are insured by the Federal Deposit Insurance Corporation up to the maximum amount permitted by law. We have a service charge fee schedule, which is generally competitive with other financial institutions in our market, covering such matters as maintenance fees and per item processing fees on checking accounts, returned check charges and other similar fees.
We offer courier services to our business customers. Courier services permit us to provide the convenience and personalized service that our customers require by scheduling pick-ups of deposits and other banking transactions.
Telephone and Internet Banking
We believe that there is a strong demand within our market for telephone banking and internet banking. These services allow both commercial and retail customers to access detailed account information and execute a wide variety of the banking transactions, including balance transfers and bill payment. We believe that these services are particularly attractive to our customers, as it enables them at any time to conduct their banking business and monitor their accounts. Telephone and internet banking assist us in attracting and retaining customers and encourages our existing customers to consider Cardinal for all of their banking and financial needs.
Automatic Teller Machines
We have an ATM at each of our branch offices and we make other financial institutions ATMs available to our customers.
Other Products and Services
We offer other banking-related specialized products and services to our customers, such as travelers checks, coin counters, wire services, and safe deposit box services. We issue letters of credit and standby letters of credit for some of our commercial customers, most of which are related to real estate construction loans. We have not engaged in any securitizations of loans.
Our chief credit officer and senior lending officers are primarily responsible for maintaining both a quality loan portfolio and a strong credit culture throughout the organization. The chief credit officer is responsible for developing and updating our credit policies and procedures, which are approved by the board of directors. Senior lending officers may make exceptions to these credit policies and procedures as appropriate, but any such exception must be documented and made for sound business reasons, and, if the loan is in excess of the officers lending limit, be approved by the chief credit officer.
Credit quality is controlled by the chief credit officer through compliance with our credit policies and procedures. Our risk-decision process is actively managed in a disciplined fashion to maintain an acceptable risk profile characterized by soundness, diversity, quality, prudence, balance and accountability. Our credit approval process consists of specific authorities granted to the lending officers and combinations of lending officers. Loans exceeding a particular lending officers level of authority, or the combined limit of several officers, are reviewed and considered for approval by an officers loan committee and, when above a specified amount, by a committee of the banks board of directors. Generally, loans of $500,000 or more require committee approval. Our policy allows exceptions for very specific conditions, such as loans secured by deposits at our bank. The chief credit officer works closely with each lending officer at the bank level to ensure that the business being solicited is of the quality and structure that fits our desired risk profile.
Under our credit policies, we monitor our concentration of credit risk. We have established credit concentration guideline limits for any individual or entity, any group of borrowers related as to the source of repayment, or any specific industry. Furthermore, the bank has established limits on the total amount of the banks outstanding loans to one borrower, all of which are set below legal lending limits.
Loans closed by George Mason are underwritten in accordance with guidelines established by the various secondary market investors to which George Mason sells its loans. George Mason may originate non-traditional loans, such as negative amortization loans, for these investors.
CWS provides brokerage and investment services through an arrangement with Raymond James Financial Services, Inc. Under this arrangement, financial advisors can offer our customers an extensive range of investment products and services, including estate planning, qualified retirement plans, mutual funds, annuities, life insurance, fixed income and equity securities and equity research and recommendations. With the addition of Wilson/Bennett in June 2005, we also offer asset management services to customers using a value-oriented approach that focuses on large capitalization stocks.
At December 31, 2005, we had 406 full-time equivalent employees. None of our employees are represented by any collective bargaining unit. We believe our relations with our employees are good.
As a financial holding company, we are subject to regulation under the Bank Holding Company Act of 1956, as amended, and the examination and reporting requirements of the Board of Governors of the Federal Reserve System. Other federal and state laws govern the activities of our bank subsidiary, including the activities in which it may engage, the investments that it makes, the aggregate amount of loans that it may grant to one borrower, and the dividends it may declare and pay to us. Our bank subsidiary is also subject to various consumer and compliance laws. As a state-chartered bank, the Bank is primarily subject to regulation, supervision and examination by the Bureau of Financial Institutions of the Virginia State Corporation Commission. Our bank subsidiary also is subject to regulation, supervision and examination by the Federal Deposit Insurance Corporation. As part of our bank subsidiary, George Mason is subject to the same regulations as the Bank.
The following description summarizes the more significant federal and state laws applicable to us. To the extent that statutory or regulatory provisions are described, the description is qualified in its entirety by reference to that particular statutory or regulatory provision.
The Bank Holding Company Act
Under the Bank Holding Company Act, we are subject to periodic examination by the Federal Reserve and required to file periodic reports regarding our operations and any additional information that the Federal Reserve may require. Our activities at the bank holding company level are limited to:
· banking, managing or controlling banks;
· furnishing services to or performing services for our subsidiaries; and
· engaging in other activities that the Federal Reserve has determined by regulation or order to be so closely related to banking as to be a proper incident to these activities.
Some of the activities that the Federal Reserve Board has determined by regulation to be closely related to the business of a bank holding company include making or servicing loans and specific types of leases, performing specific data processing services and acting in some circumstances as a fiduciary or investment or financial adviser.
With some limited exceptions, the Bank Holding Company Act requires every bank holding company to obtain the prior approval of the Federal Reserve before:
· acquiring substantially all the assets of any bank; and
· acquiring direct or indirect ownership or control of any voting shares of any bank if after such acquisition it would own or control more than 5% of the voting shares of such bank (unless it already owns or controls the majority of such shares), or merging or consolidating with another bank holding company.
In addition, and subject to some exceptions, the Bank Holding Company Act and the Change in Bank Control Act, together with their regulations, require Federal Reserve approval prior to any person or company acquiring control of a bank holding company. Control is conclusively presumed to exist if an individual or company acquires 25% or more of any class of voting securities of the bank holding company. Control is rebuttably presumed to exist if a person acquires 10% or more, but less than 25%, of any class of voting securities and if the institution has registered securities under Section 12 of the Securities Exchange Act of 1934 or no other person owns a greater percentage of that class of voting securities immediately after the transaction. The regulations provide a procedure for challenging this rebuttable control presumption.
In November 1999, Congress enacted the Gramm-Leach-Bliley Act (GLBA), which made substantial revisions to the statutory restrictions separating banking activities from other financial activities. Under the GLBA, bank holding companies that are well-capitalized and well-managed and meet other conditions can elect to become financial holding companies. As financial holding companies, they and their subsidiaries are permitted to acquire or engage in previously impermissible activities, such as insurance underwriting and securities underwriting and distribution. In addition, financial holding companies may also acquire or engage in certain activities in which bank holding companies are not permitted to engage in, such as travel agency activities, insurance agency activities, merchant banking and other activities that the Federal Reserve determines to be financial in nature or complementary to these activities. Financial holding companies continue to be subject to the overall oversight and supervision of the Federal Reserve, but the GLBA applies the concept of functional regulation to the activities conducted by subsidiaries. For example, insurance activities would be subject to supervision and regulation by state insurance authorities. We became a financial holding company in 2004.
Payment of Dividends
We are a legal entity separate and distinct from Cardinal Bank, CWS, Wilson/Bennett, and Cardinal Statutory Trust I. Virtually all of our cash revenues will result from dividends paid to us by our bank subsidiary and interest earned on short term investments. Our bank subsidiary is subject to laws and regulations that limit the amount of dividends that it can pay. Under Virginia law, a bank may not declare a dividend in excess of its accumulated retained earnings. Additionally, our bank subsidiary may not declare a dividend if the total amount of all dividends, including the proposed dividend, declared by the bank in any calendar year exceeds the total of the banks retained net income of that year to date, combined with its retained net income of the two preceding years, unless the dividend is approved by the FDIC. Our bank subsidiary may not declare or pay any dividend if, after making the dividend, the bank would be undercapitalized, as defined in the banking regulations.
The FDIC and the state have the general authority to limit the dividends paid by insured banks if the payment is deemed an unsafe and unsound practice. Both the state and the FDIC have indicated that paying dividends that deplete a banks capital base to an inadequate level would be an unsound and unsafe banking practice.
In addition, we are subject to certain regulatory requirements to maintain capital at or above regulatory minimums. These regulatory requirements regarding capital affect our dividend policies. Regulators have indicated that financial holding companies should generally pay dividends only if the organizations net income available to common shareholders over the past year has been sufficient to fully
fund the dividends, and the prospective rate of earnings retention appears consistent with the organizations capital needs, asset quality and overall financial condition.
Insurance of Accounts, Assessments and Regulation by the FDIC
The deposits of our bank subsidiary are insured by the FDIC up to the limits set forth under applicable law. The deposits of our bank subsidiary are subject to the deposit insurance assessments of the Bank Insurance Fund, or BIF, of the FDIC.
The FDIC has implemented a risk-based deposit insurance assessment system under which the assessment rate for an insured institution may vary according to regulatory capital levels of the institution and other factors, including supervisory evaluations. For example, depository institutions insured by the BIF that are well capitalized and that present few or no supervisory concerns are required to pay only the statutory minimum annual assessment of $2,000 for deposit insurance, while all other banks are required to pay premiums ranging from 0.03% to 0.27% of domestic deposits. These rate schedules are subject to future adjustments by the FDIC. In addition to being influenced by the risk profile of the particular depository institution, FDIC premiums are also influenced by the size of the FDIC insurance fund in relation to total deposits in FDIC insured banks. The FDIC has authority to impose special assessments.
The FDIC is authorized to prohibit any insured institution from engaging in any activity that the FDIC determines by regulation or order to pose a serious threat to the BIF. Also, the FDIC may initiate enforcement actions against banks, after first giving the institutions primary regulatory authority an opportunity to take such action. The FDIC may terminate the deposit insurance of any depository institution if it determines, after a hearing, that the institution has engaged or is engaging in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, order or any condition imposed in writing by the FDIC. It also may suspend deposit insurance temporarily during the hearing process for the permanent termination of insurance, if the institution has no tangible capital. If deposit insurance is terminated, the deposits at the institution at the time of termination, less subsequent withdrawals, shall continue to be insured for a period from six months to two years, as determined by the FDIC. We are unaware of any existing circumstances that could result in termination of any of our bank subsidiarys deposit insurance.
Each of the FDIC and the Federal Reserve Board has issued risk-based and leverage capital guidelines applicable to banking organizations that it supervises. Under the risk-based capital requirements, we and our bank subsidiary are each generally required to maintain a minimum ratio of total capital to risk-weighted assets (including specific off-balance sheet activities, such as standby letters of credit) of 8%. At least half of the total capital must be composed of Tier 1 Capital, which is defined as common equity, retained earnings, qualifying perpetual preferred stock and minority interests in common equity accounts of consolidated subsidiaries, less certain intangibles. The remainder may consist of Tier 2 Capital, which is defined as specific subordinated debt, some hybrid capital instruments and other qualifying preferred stock and a limited amount of the loan loss allowance and pretax net unrealized holding gains on certain equity securities. In addition, each of the federal banking regulatory agencies has established minimum leverage capital requirements for banking organizations. Under these requirements, banking organizations must maintain a minimum ratio of Tier 1 capital to adjusted average quarterly assets equal to 3% to 5%, subject to federal bank regulatory evaluation of an organizations overall safety and soundness. In summary, the capital measures used by the federal banking regulators are:
· Total Risk-Based Capital ratio, which is the total of Tier 1 Risk-Based Capital (which includes common shareholders equity, trust preferred securities, minority interests and qualifying preferred
stock, less goodwill and other adjustments) and Tier 2 Capital (which includes preferred stock not qualifying as Tier 1 capital, mandatory convertible debt, limited amounts of subordinated debt, other qualifying term debt and the allowance for loan losses up to 1.25 percent of risk-weighted assets and other adjustments) as a percentage of total risk-weighted assets
· Tier 1 Risk-Based Capital ratio (Tier 1 capital divided by total risk-weighted assets), and
· the Leverage ratio (Tier 1 capital divided by adjusted average total assets)
Under these regulations, a bank will be:
· well capitalized if it has a Total Risk-Based Capital ratio of 10% or greater, a Tier 1 Risk-Based Capital ratio of 6% or greater, a Leverage ratio of 5% or greater, and is not subject to any written agreement, order, capital directive, or prompt corrective action directive by a federal bank regulatory agency to meet and maintain a specific capital level for any capital measure
· adequately capitalized if it has a Total Risk-Based Capital ratio of 8% or greater, a Tier 1 Risk-Based Capital ratio of 4% or greater, and a Leverage ratio of 4% or greater (or 3% in certain circumstances) and is not well capitalized
· undercapitalized if it has a Total Risk-Based Capital ratio of less than 8%, a Tier 1 Risk-Based Capital ratio of less than 4% (or 3% in certain circumstances), or a Leverage ratio of less than 4% (or 3% in certain circumstances)
· significantly undercapitalized if it has a Total Risk-Based Capital ratio of less than 6%, a Tier 1 Risk-Based Capital ratio of less than 3%, or a Leverage ratio of less than 3%, or
· critically undercapitalized if its tangible equity is equal to or less than 2% of tangible assets.
The risk-based capital standards of each of the FDIC and the Federal Reserve Board explicitly identify concentrations of credit risk and the risk arising from non-traditional activities, as well as an institutions ability to manage these risks, as important factors to be taken into account by the agency in assessing an institutions overall capital adequacy. The capital guidelines also provide that an institutions exposure to a decline in the economic value of its capital due to changes in interest rates be considered by the agency as a factor in evaluating a banking organizations capital adequacy.
The FDIC may take various corrective actions against any undercapitalized bank and any bank that fails to submit an acceptable capital restoration plan or fails to implement a plan acceptable to the FDIC. These powers include, but are not limited to, requiring the institution to be recapitalized, prohibiting asset growth, restricting interest rates paid, requiring prior approval of capital distributions by any financial holding company that controls the institution, requiring divestiture by the institution of its subsidiaries or by the holding company of the institution itself, requiring new election of directors, and requiring the dismissal of directors and officers. We are considered well-capitalized at December 31, 2005 and, in addition, our bank subsidiary maintains sufficient capital to remain in compliance with capital requirements and is considered well-capitalized at December 31, 2005.
Other Safety and Soundness Regulations
There are significant obligations and restrictions imposed on financial holding companies and their depository institution subsidiaries by federal law and regulatory policy that are designed to reduce potential loss exposure to the depositors of such depository institutions and to the FDIC insurance fund in the event that the depository institution is insolvent or is in danger of becoming insolvent. These obligations and restrictions are not for the benefit of investors. Regulators may pursue an administrative action against any financial holding company or bank which violates the law, engages in an unsafe or unsound banking practice, or which is about to engage in an unsafe or unsound banking practice. The
administrative action could take the form of a cease and desist proceeding, a removal action against the responsible individuals or, in the case of a violation of law or unsafe and unsound banking practice, a civil monetary penalty action. A cease and desist order, in addition to prohibiting certain action, could also require that certain actions be undertaken. Under the policies of the Federal Reserve Board, we are required to serve as a source of financial strength to our subsidiary depository institution and to commit resources to support the bank in circumstances where we might not do so otherwise.
The Bank Secrecy Act
Under the Bank Secrecy Act (BSA), a financial institution is required to have systems in place to detect certain transactions, based on the size and nature of the transaction. Financial institutions are generally required to report cash transactions involving more than $10,000 to the United States Treasury. In addition, financial institutions are required to file suspicious activity reports for transactions that involve more than $5,000 and which the financial institution knows, suspects or has reason to suspect, involves illegal funds, is designed to evade the requirements of the BSA or has no lawful purpose. The USA PATRIOT Act of 2001, enacted in response to the September 11, 2001 terrorist attacks, requires bank regulators to consider a financial institutions compliance with the BSA when reviewing applications from a financial institution. As part of its BSA program, the USA PATRIOT Act of 2001 also requires a financial institution to follow recently implemented customer identification procedures when opening accounts for new customers and to review U.S. government-maintained lists of individuals and entities that are prohibited from opening accounts at financial institutions.
The commercial banking business is affected not only by general economic conditions but also by the monetary policies of the Federal Reserve Board. The instruments of monetary policy employed by the Federal Reserve Board include open market operations in United States government securities, changes in the discount rate on member bank borrowings and changes in reserve requirements against deposits held by federally insured banks. The Federal Reserve Boards monetary policies have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future. In view of changing conditions in the national and international economy and in the money markets, as well as the effect of actions by monetary and fiscal authorities, including the Federal Reserve System, no prediction can be made as to possible future changes in interest rates, deposit levels, loan demand or the business and earnings of our bank subsidiary, its subsidiary, or any of our other subsidiaries.
Federal Reserve System
In 1980, Congress enacted legislation that imposed reserve requirements on all depository institutions that maintain transaction accounts or non-personal time deposits. NOW accounts and demand deposit accounts that permit payments or transfers to third parties fall within the definition of transaction accounts and are subject to these reserve requirements. For net transaction accounts in 2006, the first $7.8 million of balances will be exempt from reserve requirements. A 3% reserve ratio will be assessed on net transaction account balances over $7.8 million to and including $48.3 million. A 10% reserve ratio will be applied to amounts in net transaction account balances in excess of $48.3 million. These percentages are subject to adjustment by the Federal Reserve Board. Because required reserves must be maintained in the form of vault cash or in a non-interest-bearing account at, or on behalf of, a Federal Reserve Bank, the effect of the reserve requirement is to reduce the amount of our interest-earning assets.
Transactions with Affiliates
Transactions between banks and their affiliates are governed by Sections 23A and 23B of the Federal Reserve Act. An affiliate of a bank is any bank or entity that controls, is controlled by or is under common
control with such bank. Generally, Sections 23A and 23B (i) limit the extent to which the bank or its subsidiaries may engage in covered transactions with any one affiliate to an amount equal to 10% of such institutions capital stock and surplus, and maintain an aggregate limit on all such transactions with affiliates to an amount equal to 20% of such capital stock and surplus, and (ii) require that all such transactions be on terms substantially the same as, or at least as favorable to those that, the bank has provided to a non-affiliate. The term covered transaction includes the making of loans, purchase of assets, issuance of a guarantee and similar other types of transactions. Section 23B applies to covered transactions as well as sales of assets and payments of money to an affiliate. These transactions must also be conducted on terms substantially the same as, or at least favorable to those that, the bank has provided to non-affiliates.
Loans to Insiders
The Federal Reserve Act and related regulations impose specific restrictions on loans to directors, executive officers and principal shareholders of banks. Under Section 22(h) of the Federal Reserve Act, loans to a director, an executive officer and to a principal shareholder of a bank, and to entities controlled by any of the foregoing, may not exceed, together with all other outstanding loans to such person and entities controlled by such person, the banks loan-to-one borrower limit. Loans in the aggregate to insiders and their related interests as a class may not exceed two times the banks unimpaired capital and unimpaired surplus until the banks total assets equal or exceed $100,000,000, at which time the aggregate is limited to the banks unimpaired capital and unimpaired surplus. Section 22(h) also prohibits loans above amounts prescribed by the appropriate federal banking agency to directors, executive officers and principal shareholders of a bank or bank holding company, and to entities controlled by such persons, unless such loan is approved in advance by a majority of the board of directors of the bank with any interested director not participating in the voting. The FDIC has prescribed the loan amount, which includes all other outstanding loans to such person, as to which such prior board of director approval is required, as being the greater of $25,000 or 5% of capital and surplus (up to $500,000). Section 22(h) requires that loans to directors, executive officers and principal shareholders be made on terms and underwriting standards substantially the same as offered in comparable transactions to other persons.
Community Reinvestment Act
Under the Community Reinvestment Act and related regulations, depository institutions have an affirmative obligation to assist in meeting the credit needs of their market areas, including low and moderate-income areas, consistent with safe and sound banking practice. The Community Reinvestment Act requires the adoption by each institution of a Community Reinvestment Act statement for each of its market areas describing the depository institutions efforts to assist in its communitys credit needs. Depository institutions are periodically examined for compliance with the Community Reinvestment Act and are periodically assigned ratings in this regard. Banking regulators consider a depository institutions Community Reinvestment Act rating when reviewing applications to establish new branches, undertake new lines of business, and/or acquire part or all of another depository institution. An unsatisfactory rating can significantly delay or even prohibit regulatory approval of a proposed transaction by a financial holding company or its depository institution subsidiaries.
The Gramm-Leach-Bliley Act and federal bank regulators have made various changes to the Community Reinvestment Act. Among other changes, Community Reinvestment Act agreements with private parties must be disclosed and annual reports must be made to a banks primary federal regulator. A financial holding company or any of its subsidiaries will not be permitted to engage in new activities authorized under the GLBA if any bank subsidiary received less than a satisfactory rating in its latest Community Reinvestment Act examination.
Consumer Laws Regarding Fair Lending
In addition to the Community Reinvestment Act described above, other federal and state laws regulate various lending and consumer aspects of our business. Governmental agencies, including the Department of Housing and Urban Development, the Federal Trade Commission and the Department of Justice, have become concerned that prospective borrowers may experience discrimination in their efforts to obtain loans from depository and other lending institutions. These agencies have brought litigation against depository institutions alleging discrimination against borrowers. Many of these suits have been settled, in some cases for material sums of money, short of a full trial.
These governmental agencies have clarified what they consider to be lending discrimination and have specified various factors that they will use to determine the existence of lending discrimination under the Equal Credit Opportunity Act and the Fair Housing Act, including evidence that a lender discriminated on a prohibited basis, evidence that a lender treated applicants differently based on prohibited factors in the absence of evidence that the treatment was the result of prejudice or a conscious intention to discriminate, and evidence that a lender applied an otherwise neutral non-discriminatory policy uniformly to all applicants, but the practice had a discriminatory effect, unless the practice could be justified as a business necessity.
Banks and other depository institutions also are subject to numerous consumer-oriented laws and regulations. These laws, which include the Truth in Lending Act, the Truth in Savings Act, the Real Estate Settlement Procedures Act, the Electronic Funds Transfer Act, the Equal Credit Opportunity Act, and the Fair Housing Act, require compliance by depository institutions with various disclosure requirements and requirements regulating the availability of funds after deposit or the making of some loans to customers.
Gramm-Leach-Bliley Act of 1999
The Gramm-Leach-Bliley Act of 1999 covers a broad range of issues, including a repeal of most of the restrictions on affiliations among depository institutions, securities firms and insurance companies. The following description summarizes some of its significant provisions.
The GLBA repeals sections 20 and 32 of the Glass-Steagall Act, thus permitting unrestricted affiliations between banks and securities firms. It also permits bank holding companies to elect to become financial holding companies. A financial holding company may engage in or acquire companies that engage in a broad range of financial services, including securities activities such as underwriting, dealing, investment, merchant banking, insurance underwriting, sales and brokerage activities. In order to become a financial holding company, the bank holding company and all of its affiliated depository institutions must be well-capitalized, well-managed and have at least a satisfactory Community Reinvestment Act rating. We became a financial holding company in 2004.
The GLBA provides that the states continue to have the authority to regulate insurance activities, but prohibits the states in most instances from preventing or significantly interfering with the ability of a bank, directly or through an affiliate, to engage in insurance sales, solicitations or cross-marketing activities. Although the states generally must regulate bank insurance activities in a nondiscriminatory manner, the states may continue to adopt and enforce rules that specifically regulate bank insurance activities in areas identified under the law. Under the law, the federal bank regulatory agencies adopted insurance consumer protection regulations that apply to sales practices, solicitations, advertising and disclosures.
The GLBA adopts a system of functional regulation under which the Federal Reserve Board is designated as the umbrella regulator for financial holding companies, but financial holding company affiliates are principally regulated by functional regulators such as the FDIC for bank affiliates, the Securities and Exchange Commission for securities affiliates, and state insurance regulators for insurance affiliates. It repeals the broad exemption of banks from the definitions of broker and dealer for purposes of the Securities Exchange Act of 1934, as amended. It also identifies a set of specific activities,
including traditional bank trust and fiduciary activities, in which a bank may engage without being deemed a broker, and a set of activities in which a bank may engage without being deemed a dealer. Additionally, GLBA makes conforming changes in the definitions of broker and dealer for purposes of the Investment Company Act of 1940, as amended, and the Investment Advisers Act of 1940, as amended.
The GLBA contains extensive customer privacy protection provisions. Under these provisions, a financial institution must provide to its customers, both at the inception of the customer relationship and on an annual basis, the institutions policies and procedures regarding the handling of customers nonpublic personal financial information. The law provides that, except for specific limited exceptions, an institution may not provide such personal information to unaffiliated third parties unless the institution discloses to the customer that such information may be so provided and the customer is given the opportunity to opt out of such disclosure. An institution may not disclose to a non-affiliated third party, other than to a consumer credit reporting agency, customer account numbers or other similar account identifiers for marketing purposes. The GLBA also provides that the states may adopt customer privacy protections that are stricter than those contained in the act.
Future Regulatory Uncertainty
Because federal and state regulation of financial institutions changes regularly and is the subject of constant legislative debate, we cannot forecast how federal and state regulation of financial institutions may change in the future and, as a result, impact our operations. Although Congress and the state legislature in recent years have sought to reduce the regulatory burden on financial institutions with respect to the approval of specific transactions, we fully expect that the financial institution industry will remain heavily regulated in the near future and that additional laws or regulations may be adopted further regulating specific banking practices.
We file with or furnish to the Securities and Exchange Commission (SEC) annual, quarterly and current reports, proxy statements, and various other documents under the Securities Exchange Act of 1934, as amended (the Exchange Act). The public may read and copy any materials that we file with or furnish to the SEC at the SECs Public Reference Room, which is located at 100 F Street, NE, Washington, D.C. 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. Also, the SEC maintains an internet website at www.sec.gov that contains reports, proxy and information statements and other information regarding registrants, including us, that file or furnish documents electronically with the SEC.
We also make available free of charge on or through our internet website (www.cardinalbank.com) our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and, if applicable, amendments to those reports as filed or furnished pursuant to Section 13(a) of the Exchange Act as soon as reasonably practicable after we electronically file such materials with, or furnish them to, the SEC.
Our operations are subject to many risks that could adversely affect our future financial condition and performance and, therefore, the market value of our securities. The risk factors applicable to us are the following:
Our mortgage banking revenue is sensitive to changes in economic conditions, decreased economic activity, a slowdown in the housing market or higher interest rates and may adversely impact our profits.
Our mortgage banking segment is a significant portion of our consolidated business and maintaining our revenue stream in this segment is dependent upon our ability to originate loans and sell them to investors. Loan production levels are sensitive to changes in economic conditions and can suffer from decreased economic activity, a slowdown in the housing market or higher interest rates. Generally, any sustained period of decreased economic activity or higher interest rates could adversely affect our mortgage originations and, consequently, reduce our income from mortgage banking activities. As a result, these conditions may adversely affect our net income.
We have goodwill and other intangibles that may become impaired, and thus result in a charge against earnings.
At December 31, 2005, we had $12.9 million and $3.6 million of goodwill related to the George Mason and Wilson/Bennett acquisitions, respectively. In addition, we have identified and recorded other intangible assets, such as customer relationships and employment agreements, as of the acquisition dates of both George Mason and Wilson/Bennett. The carrying amounts of these intangibles at December 31, 2005 was $1.5 million at George Mason and $2.4 million at Wilson/Bennett. Goodwill and other intangibles are tested for impairment on an annual basis or when facts and circumstances indicate that impairment may have occurred.
As noted above, our mortgage banking segment is sensitive to changes in economic conditions, decreased economic activity, a slowdown in the housing market and higher interest rates. In addition to directly impacting our revenues and net income, these conditions, if sustained, may result in an impairment charge related to the goodwill and other intangibles at George Mason if we determine the carrying value of the goodwill and other intangible assets is greater than their fair value.
When we acquired Wilson/Bennett, it had approximately $225.0 million of assets under management. As of December 31, 2005, assets under management were approximately $169.0 million. While we anticipated an initial decline in assets under management at the time of the acquisition, significant further declines of the assets managed by Wilson/Bennett may result in an impairment condition, which would require an impairment charge if we determine the carrying value of the goodwill and other intangible assets is greater than their fair value.
We may be adversely affected by economic conditions in our market area.
We are headquartered in Northern Virginia, and our market is the greater Washington, D.C. metropolitan area. Because our lending and deposit-gathering activities are concentrated in this market, we will be affected by the general economic conditions in the greater Washington area, which may, among other factors, be impacted by the level of federal government spending. Changes in the economy, and government spending in particular, may influence the growth rate of our loans and deposits, the quality of the loan portfolio and loan and deposit pricing. A significant decline in general economic conditions caused by inflation, recession, unemployment or other factors which are beyond our control would impact these local economic conditions and the demand for banking products and services generally, and could negatively affect our financial condition and performance.
We have operated at a cumulative loss since our inception.
We have operated at a cumulative loss since our organization in 1997. While we reported net income in each of the three years ended December 31, 2005, we cannot assure you that we will be able to continue to operate profitably as we continue to grow.
We may not be able to successfully manage our growth or implement our growth strategies, which may adversely affect our results of operations and financial condition.
During the last five years, we have experienced significant growth, and a key aspect of our business strategy is our continued growth and expansion. Our ability to continue to grow depends, in part, upon our ability to:
· open new branch offices or acquire existing branches or other financial institutions;
· attract deposits to those locations and cross-sell new and existing depositors additional products and services; and
· identify attractive loan and investment opportunities.
We may not be able to successfully implement our growth strategy if we are unable to identify attractive markets, locations or opportunities to expand. Our ability to successfully manage our growth will also depend upon our ability to maintain capital levels sufficient to support this growth, maintain effective cost controls and adequate asset quality such that earnings are not adversely impacted to a material degree.
As we continue to implement our growth strategy by opening new branches or acquiring branches or other banks, we expect to incur increased personnel, occupancy and other operating expenses. In the case of new branches, we must absorb those higher expenses while we begin to generate new deposits, and there is a further time lag involved in redeploying new deposits into attractively priced loans and other higher yielding earning assets. Thus, our plans to branch aggressively could depress our earnings in the short run, even if we efficiently execute our branching strategy.
We rely heavily on our management team and the unexpected loss of any of those personnel could adversely affect our operations; we depend on our ability to attract and retain key personnel.
We are a customer-focused and relationship-driven organization. We expect our future growth to be driven in a large part by the relationships maintained with our customers by our Chairman and Chief Executive Officer, Bernard H. Clineburg, and our other executive and senior lending officers. We have entered into employment agreements with Mr. Clineburg and three other executive officers. The existence of such agreements, however, does not necessarily assure us that we will be able to continue to retain their services. The unexpected loss of Mr. Clineburg or other key employees could have a significant adverse effect on our business and possibly result in reduced revenues and earnings. We do not maintain key man life insurance policies on any of our corporate executives.
The implementation of our business strategy will also require us to continue to attract, hire, motivate and retain skilled personnel to develop new customer relationships, as well as develop new financial products and services. Many experienced banking professionals employed by our competitors are covered by agreements not to compete or solicit their existing customers if they were to leave their current employment. These agreements make the recruitment of these professionals more difficult. While we have been recently successful in acquiring what we consider to be talented banking professionals, the market for talented people is competitive and we may not continue to be successful in attracting, hiring, motivating or retaining experienced banking professionals.
We may incur losses if we are unable to successfully manage interest rate risk.
Our future profitability will substantially depend upon our ability to maintain or increase the spread between the interest rates earned on investments and loans and interest rates paid on deposits and other interest-bearing liabilities. Changes in interest rates will affect our operating performance and financial condition. Being asset sensitive as of December 31, 2005, the Banks net interest income should improve in a rising rate environment while net interest income should fall if rates decline. The shape of the yield curve can also impact net interest income. Changing rates will impact how fast our mortgage loans and mortgage-backed securities will have the principal repaid. Rate changes can also impact the behavior of our depositors, especially depositors in non-maturity deposits such as demand, interest checking, savings and money market accounts. While we attempt to minimize our exposure to interest rate risk, we are unable to eliminate it as it is an inherent part of our business. Our net interest spread will depend on many factors that are partly or entirely outside our control, including competition, federal economic, monetary and fiscal policies, and industry-specific conditions and economic conditions generally.
Our concentration in loans secured by real estate may increase our future credit losses, which would negatively affect our financial results.
We offer a variety of secured loans, including commercial lines of credit, commercial term loans, real estate, construction, home equity, consumer and other loans. Approximately 93% of our loans are secured by real estate, both residential and commercial, substantially all of which are located in our market area. A major change in the regions real estate market, resulting in a deterioration in real estate values, or in the local or national economy, including changes caused by raising interest rates, could adversely affect our customers ability to pay these loans, which in turn could adversely impact us. Risk of loan defaults and foreclosures is inherent in the banking industry, and we try to limit our exposure to this risk by carefully underwriting and monitoring our extensions of credit. We cannot fully eliminate credit risk, and as a result credit losses may occur in the future.
If our allowance for loan losses becomes inadequate, our results of operations may be adversely affected.
We maintain an allowance for loan losses that we believe is a reasonable estimate of known and inherent losses in our loan portfolio. Through a periodic review and analysis of the loan portfolio, management determines the adequacy of the allowance for loan losses by considering such factors as general and industry-specific market conditions, credit quality of the loan portfolio, the collateral supporting the loans and financial performance of our loan customers relative to their financial obligations to us. The amount of future losses is susceptible to changes in economic, operating and other conditions, including changes in interest rates, which may be beyond our control, and actual losses may exceed our current estimates. Rapidly growing loan portfolios are, by their nature, unseasoned. Our net loan losses since the inception of the Company are approximately $250,000. As a result, estimating loan loss allowances is more difficult than with seasoned portfolios, and may be more susceptible to changes in estimates and to losses exceeding estimates. Although we believe the allowance for loan losses is a reasonable estimate of known and inherent losses in our loan portfolio, we cannot fully predict such losses or assert that our loan loss allowance will be adequate in the future. Future loan losses that are greater than current estimates could have a material impact on our future financial performance.
Banking regulators periodically review our allowance for loan losses and may require us to increase our allowance for loan losses or recognize additional loan charge-offs, based on credit judgments different than those of our management. Any increase in the amount of our allowance or loans charged-off as required by these regulatory agencies could have a negative effect on our operating results.
Our future success is dependent on our ability to compete effectively in the highly competitive banking and financial services industry.
We face vigorous competition from other commercial banks, savings and loan associations, savings banks, credit unions, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market funds and other types of financial institutions for deposits, loans and other financial services in our market area. A number of these banks and other financial institutions are significantly larger than we are and have substantially greater access to capital and other resources, as well as larger lending limits and branch systems, and offer a wider array of banking services. Many of our nonbank competitors are not subject to the same extensive regulations that govern us. As a result, these nonbank competitors have advantages over us in providing certain services. This competition may reduce or limit our margins and our market share and may adversely affect our results of operations and financial condition.
Our profitability and the value of any equity investment in us may suffer because of rapid and unpredictable changes in the highly regulated environment in which we operate.
We are subject to extensive supervision by several governmental regulatory agencies at the federal and state levels. Recently enacted, proposed and future banking and other legislation and regulations have had, and will continue to have, or may have a significant impact on the financial services industry. These regulations, which are generally intended to protect depositors and not our shareholders, and the interpretation and application of them by federal and state regulators, are beyond our control, may change rapidly and unpredictably, and can be expected to influence our earnings and growth. Our success depends on our continued ability to maintain compliance with these regulations. Many of these regulations increase our costs and thus place other financial institutions that may not be subject to similar regulation in stronger, more favorable competitive positions.
If we need additional capital in the future to continue our growth, we may not be able to obtain it on terms that are favorable. This could negatively affect our performance and the value of our common stock.
Our business strategy calls for continued growth. We anticipate that we will be able to support this growth through the generation of additional deposits at existing and new branch locations, as well as expanded loan and other investment opportunities. However, we may need to raise additional capital in the future to support our continued growth and to maintain desired capital levels. Our ability to raise capital through the sale of additional equity securities or the placement of financial instruments that qualify as regulatory capital will depend primarily upon our financial condition and the condition of financial markets at that time. We may not be able to obtain additional capital in the amounts or on terms satisfactory to us. Our growth may be constrained if we are unable to raise additional capital as needed.
We have extended off-balance sheet commitments to borrowers, which could expose us to credit and interest rate risk.
We enter into certain off-balance sheet arrangements in the normal course of business to meet the financing needs of our customers. These off-balance sheet arrangements include commitments to extend credit, standby letters of credit and guarantees that would impact our liquidity and capital resources to the extent customers accept or use these commitments. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheet. Our exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit and guarantees written is represented by the contractual or notional amount of those instruments. We use the same credit policies in making commitments and conditional obligations as we do for on-balance-sheet instruments.
Cardinal Bank, excluding its George Mason subsidiary, conducts its business from 22 branch offices. Eight of these facilities are owned and 14 are leased. Leased branch banking facilities range in size from 1,000 square feet to 11,182 square feet. Our leases on these facilities expire at various dates through 2014, but all our leases have renewal options. Fourteen of our branch banking locations have drive-up banking capabilities and all have ATMs.
Cardinal Wealth Services, Inc. conducts its business from three of Cardinal Banks branch facilities.
George Mason conducts its business from nine leased facilities which range in size from 1,428 square feet to 22,056 square feet. The leases have various expiration dates through 2010 and generally do not have renewal options.
Wilson/Bennett conducts its business from office space leased in Alexandria, Virginia. Its lease expires July 15, 2006 and has a rolling six month renewal option.
Our headquarters facility in Tysons Corner, Virginia comprises 40,000 square feet of leased office space. This lease expires in January 2010 but has renewal options. In addition to housing various administrative functionsincluding accounting, data processing, compliance, treasury, marketing, deposit and loan operationsour commercial and industrial and commercial real estate lending functions and various other departments are located there.
We believe that all of our properties are maintained in good operating condition and are suitable and adequate for our operational needs.
We are not a party to any material legal proceeding.
In the ordinary course of our operations, we, from time to time, become party to various legal proceedings. See Note 24 of the Notes to the consolidated financial statements in Item 8 below for a discussion of certain immaterial legal proceedings that are outside the ordinary course of business.
No matters were submitted to a vote of security holders, through the solicitation of proxies or otherwise, during the fourth quarter of 2005.
Our common stock is currently listed for quotation on the Nasdaq National Market under the symbol CFNL. As of December 31, 2005, our common stock was held by 680 shareholders of record. In addition, we estimate that there were 4,800 beneficial owners of our common stock who own their shares through brokers or banks.
The high and low sale prices per share for our common stock for each quarter of 2005 and 2004 as reported on the Nasdaq National Market were as follows:
We declared our first cash dividend of $0.01 per share on October 19, 2005 to the shareholders of record of our common stock on October 31, 2005. These dividends were paid on November 15, 2005. We declared a second cash dividend of $0.01 per share on January 18, 2006 to the shareholders of record of our common stock on January 31, 2006. These dividends were paid on February 15, 2006.
The board of directors intends to follow a policy of retaining any earnings necessary to operate our business in accordance with all regulatory policies while maximizing the long-term return for the Companys investors. Our future dividend policy is subject to the discretion of the board of directors and future dividend payments will depend upon a number of factors, including future earnings, alternative investment opportunities, financial condition, cash requirements, and general business conditions.
Our ability to distribute cash dividends will depend primarily on the ability of our subsidiaries to pay dividends to us. Cardinal Bank is subject to legal limitations on the amount of dividends it is permitted to pay. Furthermore, neither Cardinal Bank nor we may declare or pay a cash dividend on any of our capital stock if we are insolvent or if the payment of the dividend would render us insolvent or unable to pay our obligations as they become due in the ordinary course of business. For additional information on these limitations, see Government Regulation and SupervisionPayment of Dividends in Item 1 above.
We did not repurchase any of our securities during 2005.
(1) Net interest margin is calculated as net interest income divided by total average earning assets.
(2) Efficiency ratio is calculated as total non-interest expense divided by the total of net interest income and non-interest income.
The following presents managements discussion and analysis of our consolidated financial condition at December 31, 2005 and 2004 and the results of our operations for the years ended December 31, 2005, 2004 and 2003. The discussion should be read in conjunction with the consolidated financial statements and related notes included in this report.
We make certain forward-looking statements in this Form 10-K that are subject to risks and uncertainties. These forward looking statements include statements regarding our profitability, liquidity, allowance for loan losses, interest rate sensitivity, market risk, growth strategy, and financial and other goals. The words believes, expects, may, will, should, projects, contemplates, anticipates, forecasts, intends, or other similar words or terms are intended to identify forward-looking statements.
These forward-looking statements are subject to significant uncertainties because they are based upon or are affected by factors including:
· the ability to successfully manage our growth or implement our growth strategies if we are unable to identify attractive markets, locations or opportunities to expand in the future;
· changes in interest rates and the successful management of interest rate risk;
· risks inherent in making loans such as repayment risks and fluctuating collateral values;
· maintaining cost controls and asset quality as we open or acquire new branches;
· maintaining capital levels adequate to support our growth;
· reliance on our management team, including our ability to attract and retain key personnel;
· competition with other banks and financial institutions, and companies outside of the banking industry, including those companies that have substantially greater access to capital and other resources;
· changes in general economic and business conditions in our market area;
· demand, development and acceptance of new products and services;
· problems with technology utilized by us;
· changing trends in customer profiles and behavior;
· changes in banking, other laws and regulations applicable to us; and
· other factors discussed in Risk Factors in Item 1A above.
Because of these uncertainties, our actual future results may be materially different from the results indicated by these forward-looking statements. In addition, our past results of operations do not necessarily indicate our future results.
We are a locally managed financial holding company headquartered in Tysons Corner, Virginia, committed to providing superior customer service, a diversified mix of financial products and services, and convenient banking to our retail and business consumers. We own Cardinal Bank (the Bank), a Virginia state-chartered community bank, Cardinal Wealth Services, Inc. (CWS), an investment services subsidiary, and Wilson/Bennett Capital Management, Inc. (Wilson/Bennett), an Alexandria, Virginia-based asset management firm acquired in June 2005. Through these three subsidiaries and George Mason Mortgage, LLC (George Mason), a mortgage banking subsidiary of the Bank, we offer a wide range of traditional banking products and services to both our commercial and retail customers. Our commercial relationship managers focus on attracting small and medium sized businesses as well as government
contractors, commercial real estate developers and builders and professionals, such as physicians, accountants and attorneys. We have twenty-two branch office locations, nine mortgage banking office locations and provide competitive products and services. We complement our core banking operations by offering a full range of investment products and services to our customers through our third-party brokerage relationship with Raymond James Financial Services, Inc. and asset management services through Wilson/Bennett.
On June 9, 2005, we acquired Wilson/Bennett for a total consideration of $6.5 million, which consisted of a payment of $1.5 million in cash and the issuance of 611,111 shares of our common stock, which we valued at $4.9 million. This transaction was accounted for as a purchase and Wilson/Bennetts assets and liabilities were recorded at fair value as of the purchase date. This transaction resulted in the recognition of $3.6 million of goodwill and $2.6 million of other intangible assets. We believe that the Wilson/Bennett acquisition furthers our strategies of enhancing fee income and diversifying our revenue stream and the services we deliver to our customers. Wilson/Bennett uses a value-oriented approach that focuses on large capitalization stocks. Wilson/Bennetts primary source of revenue is management fees earned on the assets it manages for its customers. These management fees are generally based upon the market value of assets under management and, accordingly, revenues from Wilson/Bennett will, assuming a consistent base, be more when appropriate indices, such as the S&P 500, are higher and lower when such indices are depressed.
When we acquired Wilson/Bennett, it had approximately $225.0 million of assets under management. At December 31, 2005, assets under management by Wilson/Bennett were approximately $169.0 million. While we anticipated an initial decline in the assets under management at the time of the acquisition, significant further declines in the assets managed by Wilson/Bennett may result in an impairment condition, which would require an impairment charge if we determine the carrying value of the goodwill and other intangible assets is greater than their fair value.
On July 7, 2004, we acquired George Mason in a cash transaction for $17.0 million. This transaction resulted in the recognition of $12.9 million of goodwill and $1.7 million of amortizable intangible assets. This transaction was accounted for as a purchase, and George Masons assets and liabilities were recorded at fair value as of the purchase date, and its operating results are included in our consolidated results since the date of the acquisition. George Mason, based in Fairfax, Virginia, engages primarily in the origination and acquisition of residential mortgages for sale into the secondary market on a best efforts basis through nine branches located throughout the metropolitan Washington, D.C. region. George Mason has approximately 200 employees and does business in eight states, primarily Virginia, Maryland, and the District of Columbia. George Mason is one of the largest residential mortgage originators in the greater Washington metropolitan area, generating originations of approximately $4.3 billion of loans in 2005, excluding advances on construction loans and including loans purchased from other mortgage banking companies which are owned by local home builders but managed by George Mason and $3.5 billion of loans in 2004, which includes managed company originations and loans originated of $1.9 billion prior to our acquisition of George Mason. George Masons primary sources of revenue include net interest income earned on loans held for sale, gains on sales of loans and contractual management fees earned relating to services provided to other mortgage companies owned by local home builders. Loans are made pursuant to purchase commitments and are sold servicing released.
George Mason also offers a construction-to-permanent loan program. This program provides variable rate financing for customers to construct their residences. Once the home has been completed, the loan converts to fixed rate financing and is sold into the secondary market. These construction-to-permanent loans generate fee income as well as net interest income for George Mason and are classified as loans held for sale.
George Masons business is both cyclical and seasonal. The cyclical nature of its business is influenced by, among other factors, the levels of and trends in mortgage interest rates, national and local economic
conditions and consumer confidence in the economy. Historically, George Mason has its lowest levels of quarterly loan closings during the first quarter of the year.
In July 2004, we formed a wholly-owned subsidiary, Cardinal Statutory Trust I, for the purpose of issuing $20.0 million of floating rate junior subordinated deferrable interest debentures (trust preferred securities). These trust preferred securities are due in 2034 and pay interest at a rate equal to LIBOR (London Interbank Offered Rate) plus 2.40%, which adjusts quarterly. These securities are redeemable at a premium through March 2008 and at par thereafter. The interest rate on this debt was 6.89% at December 31, 2005. We have guaranteed payment of these securities. The $20.6 million payable by us to Cardinal Statutory Trust I is included in other borrowed funds in the consolidated statements of condition since Cardinal Statutory Trust I is an unconsolidated subsidiary as we are not the primary beneficiary of this entity. We utilized the proceeds from the issuance of the trust preferred securities to make a capital contribution into the Bank.
Net interest income is our primary source of revenue. We define revenue as net interest income plus non-interest income. As discussed further in the interest rate sensitivity section, we manage our balance sheet and interest rate risk exposure to maximize, and concurrently stabilize, net interest income. We do this by monitoring our liquidity position and the spread between the interest rates earned on interest-earning assets and the interest rates paid on interest-bearing liabilities. We attempt to minimize our exposure to interest rate risk, but are unable to eliminate it entirely. In addition to management of interest rate risk, we also analyze our loan portfolio for exposure to credit risk. Loan defaults and foreclosures are inherent risks in the banking industry and we attempt to limit our exposure to these risks by carefully underwriting and then monitoring our extensions of credit. In addition to net interest income, non-interest income is an increasingly important source of revenue for us and includes, among other things, service charges on deposits and loans, investment fee income and gains and losses on sales of investment securities available-for-sale, gains on sales of loans and management fee income. Our acquisition of George Mason in July 2004 has resulted in non-interest income becoming a larger component of our total revenues, and the acquisition of Wilson/Bennett in June 2005 has further contributed to this trend.
Net interest income and non-interest income represented the following percentages of total revenue for the three years ended December 31, 2005:
Non-interest income is a larger percentage of our total revenue in 2005 than 2004 primarily because we owned George Mason for a full year in 2005 compared to approximately a half year in 2004.
Our business strategy is to grow through geographic expansion, while maintaining strong asset quality and achieving increased profitability. We completed a secondary common stock offering that raised $39.8 million in capital during the second quarter of 2005. This capital is being used to support our continuing expansion and balance sheet growth. As a result of this increased capital and retained earnings, we increased our legal lending limit to $19.4 million as of December 31, 2005, which allows us to expand our commercial and real estate loan portfolios.
The year ended December 31, 2003 was our first full year of profitability. We had net income available to common shareholders of $5.7 million, or $0.54 per diluted common share in 2003, primarily as a result of an income tax benefit of $3.5 million attributable to the recognition of deferred tax assets relating to
cumulative losses since our inception, as we determined that it was more likely than not that these assets would be realized. The pretax profit to common shareholders in 2003 was $2.6 million.
The year ended December 31, 2004 was our second year of profitability. For that year, net income was $3.5 million. George Mason was included in our operating results since July 7, 2004 and contributed approximately $1.4 million to consolidated net income during 2004. The decrease in net income from the prior year was the result of the previously described tax benefit being recognized in 2003. Total assets increased by $575.3 million in 2004, from $636.2 million at December 31, 2003, to $1.21 billion at December 31, 2004. Total loans receivable, net of deferred fees and costs, increased to $489.9 million at December 31, 2004, compared to $336.0 million at December 31, 2003, an increase of $153.9 million. Total deposits increased by $350.1 million in 2004, from $474.1 million at December 31, 2003, to $824.2 million at December 31, 2004.
The year ended December 31, 2005 was our third consecutive year of profitability. For the year, we reported net income of $9.9 million. George Mason was included in our operating results for the full year and contributed $6.7 million to consolidated net income during 2005. Wilson/Bennett is included in our operating results since June 9, 2005, the date of its acquisition, and contributed $107,000 of pretax income. Total assets increased by $240.7 million in 2005, from $1.21 billion at December 31, 2004, to $1.45 billion at December 31, 2005. Total loans receivable, net of deferred fees and costs, increased to $705.6 million at December 31, 2005, compared to $489.9 million at December 31, 2004, an increase of $215.7 million. Total deposits increased by $245.7 million in 2005, from $824.2 million at December 31, 2004, to $1.07 billion at December 31, 2005.
U.S. generally accepted accounting principles are complex and require management to apply significant judgment to various accounting, reporting, and disclosure matters. Management must use assumptions, judgments, and estimates when applying these principles where precise measurements are not possible or practical. These policies are critical because they are highly dependent upon subjective or complex judgments, assumptions and estimates. Changes in such judgments, assumptions and estimates may have a significant impact on the consolidated financial statements. Actual results, in fact, could differ from those estimates.
The accounting policies we view as critical are those relating to judgments, assumptions and estimates regarding the determination of the allowance for loan losses, accounting for economic hedging activities, and the valuation allowance for deferred tax assets.
Accounting for Business Combinations
We account for acquisitions of other businesses in accordance with Statement of Financial Accounting Standards (SFAS) No. 141, Business Combinations. This statement mandates the use of purchase accounting and, accordingly, assets and liabilities, including previously unrecorded assets and liabilities, are recorded at fair values as of the acquisition date. We utilize a variety of valuation methods to estimate fair value of acquired assets and liabilities. These methodologies are often based upon assumptions and estimates which may change at a future date and require that the carrying amount of assets and liabilities acquired be adjusted. To reduce the possibility of future adjustments, we have utilized independent consultants to identify and value identifiable purchased intangibles. The difference between the fair value of assets acquired and the liabilities assumed is recorded as goodwill. Goodwill and any other intangible assets are accounted for in accordance with SFAS No. 142, Goodwill and Other Intangible Assets. In accordance with this statement, goodwill will not be amortized but will be tested on at least an annual basis for impairment.
To test goodwill for impairment, we perform an analysis to compare the fair value of the reporting unit to which the goodwill is assigned to the carrying value of the reporting unit. We make estimates of the discounted cash flows from the expected future operations of the reporting unit. If the analysis indicates that the fair value of the reporting unit is less than its carrying value, we do an analysis to compare the implied fair value of the reporting units goodwill with the carrying amount of that goodwill. The implied fair value of the goodwill is determined by allocating the fair value of the reporting unit to all its assets and liabilities. If the implied fair value of the goodwill is less than the carrying value, an impairment loss is recognized.
Allowance for Loan Losses
We maintain the allowance for loan losses at a level that represents managements best estimate of known and inherent losses in our loan portfolio. Both the amount of the provision expense and the level of the allowance for loan losses are impacted by many factors, including general and industry-specific economic conditions, actual and expected credit losses, historical trends and specific conditions of the individual borrowers. Unusual and infrequently occurring events, such as hurricanes and other weather-related disasters, may impact our assessment of possible credit losses. As a part of our analysis, we use comparative peer group data and qualitative factors, such as levels of and trends in delinquencies and non-accrual loans, national and local economic trends and conditions and concentrations of loans exhibiting similar risk profiles to support our estimates.
For purposes of our analysis, we categorize our loans into one of five categories: commercial and industrial, commercial real estate (including construction), home equity lines of credit, residential mortgages, and consumer loans. In the absence of meaningful historical loss factors, peer group loss factors are applied and are adjusted by the qualitative factors mentioned above. The indicated loss factors resulting from this analysis are applied to each of the five categories of loans. In addition, we individually assign loss factors to all loans that have been identified as having loss attributes, as indicated by deterioration in the financial condition of the borrower or a decline in underlying collateral value if the loan is collateral dependent. Since we have limited historical data on which to base loss factors for classified loans, we apply, in accordance with regulatory guidelines, a 5% loss factor to all loans classified as special mention, a 15% loss factor to all loans classified as substandard and a 50% loss factor to all loans classified as doubtful. Loans classified as loss loans are fully reserved or charged off.
Credit losses are an inherent part of our business and, although we believe the methodologies for determining the allowance for loan losses and the current level of the allowance are adequate, it is possible that there may be unidentified losses in the portfolio at any particular time that may become evident at a future date pursuant to additional internal analysis or regulatory comment. Additional provisions for such losses, if necessary, would be recorded in the commercial banking or mortgage banking segment, as appropriate, and would negatively impact earnings.
Derivative Instruments and Hedging Activities
We account for derivatives and hedging activities in accordance with SFAS No. 133, Accounting for Derivative Instruments and Certain Hedging Activities, as amended, which requires that all derivative instruments be recorded on the statement of condition at their fair values.
In the normal course of business, we enter into contractual commitments, including rate lock commitments, to finance residential mortgage loans. These commitments, which contain fixed expiration dates, offer the borrower an interest rate guarantee provided the loan meets underwriting guidelines and closes within the timeframe established by us. Interest rate risk arises on these commitments and subsequently closed loans if interest rates change between the time of the interest rate lock and the delivery of the loan to the investor. Loan commitments related to residential mortgage loans intended to be sold are considered derivatives.
To mitigate the effect of interest rate risk inherent in providing rate lock commitments, we economically hedge our commitments by entering into best efforts delivery forward loan sales contracts. During the rate lock commitment period, these forward loan sales contracts are marked to market through earnings and are not designated as accounting hedges under SFAS No. 133, as amended. Changes in the fair values of loan commitments and changes in the fair values of forward sales contracts generally move in opposite directions and the net impact of the changes of these valuations on net income during the loan commitment period is generally inconsequential. At the closing of the loan, the loan commitment derivative expires and we record a loan held for sale and continue to be obligated under the same forward loan sales contract. Loans held for sale are accounted for at the lower of cost or market in accordance with SFAS No. 65, Accounting for Certain Mortgage Banking Activities. Prior to October 1, 2005, the changes in value of the forward loan sales contracts from the date the loan closed to the date it was sold to an investor were marked to market through earnings.
On October 1, 2005, we began designating our forward sales contracts as hedges to mitigate the variability in cash flow to be received from the sale of mortgage loans. We contemporaneously document the hedging relationship including the risk management objective and strategy for undertaking the hedge, how effectiveness will be assessed at inception and at each reporting period and the method for measuring ineffectiveness. We designate each forward loan sale agreement as a cash flow hedge of a specific loan held for sale. For derivatives designated as cash flow hedges, the fair value adjustments are recorded as a component of other comprehensive income except for the ineffective portion which is recorded through the income statement.
We discontinue hedge accounting prospectively when it is determined that the derivative is no longer highly effective in offsetting changes in anticipated cash flows of the loans held for sale.
In situations in which hedge accounting is discontinued, we continue to carry the derivative at its fair value on the balance sheet and recognize any subsequent changes in its fair value in earnings. When hedge accounting is discontinued because it is probable an anticipated loan sale will not occur, we recognize immediately in earnings any gains and losses that were accumulated in other comprehensive income.
Valuation of Deferred Tax Assets
We record a provision for income tax expense based on the amounts of current taxes payable or refundable and the change in net deferred tax assets or liabilities during the year. Deferred tax assets and liabilities are recognized for the tax effects of differing carrying values of assets and liabilities for tax and financial statement purposes that will reverse in future periods. When substantial uncertainty exists concerning the recoverability of a deferred tax asset, the carrying value of the asset is reduced by a valuation allowance. The amount of any valuation allowance established is based upon an estimate of the deferred tax asset that is more likely than not to be recovered. Increases or decreases in the valuation allowance result in increases or decreases to the provision for income taxes.
In December 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123R, Share-Based Payments: an Amendment of FASB Statements 123 and 95 (FAS 123R). This statement requires that companies recognize in the income statement the grant-date fair value of stock options and other equity-based compensation. It is required to be applied by us beginning January 1, 2006. This statement requires that stock awards be classified as either an equity award or a liability award. Equity classified awards are valued as of the grant date using either an observable market price or a valuation methodology. Liability classified awards are valued at fair value at each reporting date. We will adopt FAS 123R using the modified prospective application method which requires, among other things, that we recognize compensation cost for all awards outstanding at January 1, 2006 for which the requisite service has not been rendered. We estimate that this new standard will result in an increase in pretax expense of
approximately $200,000 in 2006 based on current stock options outstanding. Additional expense would be recorded for any future stock option grants.
On October 19, 2005, our board of directors authorized that any existing outstanding options that were or became underwater (i.e., their per share exercise price is greater than the market price) before December 31, 2005 be amended to become fully vested. This modification resulted in the immediate vesting of 54,000 stock options which were held by our employees. The options that vested had exercise prices ranging from $9.58 to $11.15. On October 19, 2005, the market value of our common stock was $9.81. This modification did not result in the recognition of expense in 2005 because the options had no intrinsic value at the grant date or on the date of modification. Vesting of these options was accelerated to eliminate the need to recognize the remaining fair value compensation expense associated with these options following the adoption of SFAS No. 123R. The amount of compensation expense related to these options that would have been recognized in the financial statements after our implementation of SFAS No. 123R, assuming no forfeitures, was $127,000.
2005 Compared to 2004
At December 31, 2005, total assets were $1.45 billion, an increase of 19.9%, or $240.7 million, from $1.21 billion at December 31, 2004. Total loans receivable, net of deferred fees and costs, increased 44.0%, or $215.7 million, to $705.6 million at December 31, 2005, from $489.9 million at December 31, 2004. Total investment securities increased by $4.7 million, or 1.6%, to $294.2 million at December 31, 2005, from $289.5 million at December 31, 2004. Total deposits increased 29.8%, or $245.8 million, to $1.07 billion at December 31, 2005, from $824.2 million at December 31, 2004. Other borrowed funds, which primarily include repurchase agreements, FHLB advances and our payable to Cardinal Statutory Trust I, decreased $45.7 million to $155.4 million at December 31, 2005, from $201.1 million at December 31, 2004.
Shareholders equity at December 31, 2005 was $147.9 million, an increase of $52.8 million from $95.1 million at December 31, 2004. The increase in shareholders equity was primarily attributable to $39.8 million of additional equity raised during our 2005 common stock offering and net income of $9.9 million. Total shareholders equity to total assets at December 31, 2005 and 2004 was 10.2% and 7.9%, respectively. Book value per share at December 31, 2005 and 2004 was $6.07 and $5.15, respectively. Total risk-based capital to risk-weighted assets was 15.65% at December 31, 2005 compared to 13.40% at December 31, 2004. Accordingly, the Company was considered well capitalized for regulatory purposes at December 31, 2005. Risk-based capital to risk-weighted assets increased from 2004 to 2005 primarily as a result of the additional capital raised during our 2005 common stock offering.
We recorded net income of $9.9 million, or $0.44 per diluted common share, for the year ended December 31, 2005, compared to net income available to common shareholders of $3.5 million, or $0.19 per diluted common share, in 2004. As previously mentioned, George Mason is included in our operating results for the full year ended December 31, 2005 compared to approximately the last six months of 2004.
The return on average assets for the years ended December 31, 2005 and 2004 was 0.74% and 0.37%, respectively. The return on average equity for the years ended December 31, 2005 and 2004 was 7.67% and 3.69%, respectively.
2004 Compared to 2003
At December 31, 2004, total assets were $1.21 billion, an increase of 90.4%, or $575.3 million, compared to $636.2 million at December 31, 2003. Total loans receivable, net of deferred fees and costs, increased 45.8%, or $153.9 million, to $489.9 million at December 31, 2004, from $336.0 million at December 31, 2003. Total investment securities increased by $15.9 million, or 5.8%, to $289.5 million at December 31, 2004, from $273.6 million at December 31, 2003. Total deposits increased 73.8%, or $350.1 million, to $824.2 million at December 31, 2004, from $474.1 million at December 31, 2003. Other
borrowed funds increased $126.6 million to $201.1 million at December 31, 2004, from $74.5 million at December 31, 2003. During 2003, we introduced repurchase agreements to our customers, which totaled $25.5 million at December 31, 2003 and $30.4 million at December 31, 2004. Advances from the Federal Home Loan Bank of Atlanta were $49.0 million at December 31, 2003, and $137.0 million at December 31, 2004.
Shareholders equity at December 31, 2004 was $95.1 million, an increase of $9.7 million from $85.4 million at December 31, 2003. The increase in shareholders equity was primarily attributable to $6.3 million of additional equity raised as a result of the underwriters exercising in January 2004 their over allotment option in connection with our 2003 stock offering and net income of $3.5 million. Total shareholders equity to total assets at December 31, 2004 and 2003 were 7.9% and 13.4%, respectively. Book value per share at December 31, 2004 and 2003 was $5.15 and $4.80, respectively. Total risk-based capital to risk-weighted assets was 13.40% at December 31, 2004 compared to 20.66% at December 31, 2003. Accordingly, the Company was considered well capitalized for regulatory purposes at December 31, 2004. Risk-based capital to risk-weighted assets declined from 2003 to 2004 despite our issuance of $20.0 million of trust preferred securities, which is included as a component of regulatory capital, because of our growth during 2004 and the fact that goodwill and intangibles, which increased by $14.7 million as a result of the George Mason acquisition, are excluded from regulatory capital.
We recorded net income of $3.5 million, or $0.19 per diluted common share, for the year ended December 31, 2004, compared to net income available to common shareholders of $5.7 million or $0.54 per diluted common share, in 2003. Net income for 2003 included an income tax benefit of $3.5 million attributable to the recognition of prior periods net operating loss carryforwards. The 2003 earnings per common share included the effect of preferred stock dividends of $495,000. All outstanding shares of the preferred stock were converted into shares of our common stock in March 2004.
The return on average assets for the years ended December 31, 2004 and 2003 was 0.37% and 1.18%, respectively. The return on average equity for the years ended December 31, 2004 and 2003 was 3.69% and 13.84%, respectively.
Net Interest Income/Margin
Net interest income is our primary source of revenue, representing the difference between interest and fees earned on interest-bearing assets and the interest paid on deposits and other interest-bearing liabilities. The level of net interest income is affected primarily by variations in the volume and mix of these assets and liabilities, as well as changes in interest rates. At the end of 2003, the prime lending rate was at 4.00%, its lowest level in over forty years. During 2004, as economic activity increased, the Federal Reserve raised the key federal funds rate six times to 2.50% by year end. The Federal Reserve continued this policy in 2005, increasing the federal funds rate seven times to 4.25% by year end. The prime lending rate increased from 4.00% at the end of 2003 to 5.50% at the end of 2004 to 7.25% at the end of 2005. See Interest Rate Sensitivity for further information.
Net interest income for the year ended December 31, 2005 was $37.5 million, compared to $24.6 million for the year ended December 31, 2004, an increase of $12.9 million, or 52.7%. The increase in net interest income was primarily a result of increases in the average volume of loans held for sale and loans receivable, net of the impact of increased funding costs during 2005, compared with 2004. The increase in funding costs was primarily attributable to an increase in rates paid on average interest-bearing liabilities. Net increases in loans held for sale and loans receivable were funded through the increases in total deposits and other borrowed funds.
Our net interest margin for the years ended December 31, 2005 and 2004 was 2.92% and 2.72%, respectively, primarily as a result of a 75 basis point increase in the rate earned on average interest-earning assets partially offset by an increased cost of average interest-bearing liabilities of 63 basis points. The average yield on interest-earning assets increased to 5.24% in 2005 from 4.49% in 2004, and our cost of interest-bearing liabilities increased to 2.90% in 2005 from 2.17% in 2004. The cost of other borrowed funds, which generally are shorter term fundings and which we utilized in 2005 to help fund our balance sheet growth, increased 83 basis points to 3.01% in 2005 from 2.18% in 2004. The cost of deposit liabilities increased 65 basis points to 2.90% in 2005 from 2.25% for 2004.
Total earning assets increased by 19.6% to $1.39 billion at December 31, 2005, compared to $1.16 billion at December 31, 2004. This resulted primarily from a $215.7 million increase in loans receivable, net of deferred fees and costs. This increase was funded by deposit growth of $245.7 million, or 29.8%. Other borrowed funds decreased by $45.7 million during 2005 to $155.4 million at December 31, 2005, from $201.1 million at December 31, 2004.
Average loans receivable increased $196.1 million to $587.5 million during 2005 from $391.4 million in 2004. Average balances of nonperforming assets, which consist of non-accrual loans, are included in the net interest margin calculation and did not have a material impact on our net interest margin in 2005 and 2004. Additional interest income of approximately $18,000 for 2005 and $25,000 for 2004 would have been realized had all nonperforming assets performed as originally expected. Nonperforming assets exclude loans that are both past due 90 days or more and still accruing interest due to an assessment of collectibility.
Average total deposits increased $321.0 million to $973.7 million in 2005 from $652.7 million in 2004. The largest increase in average deposit balances was experienced in certificates of deposit, which increased $192.9 million compared to 2004, a result of our branch expansion and increased advertising of our rates. During 2004, to assist in the funding of George Masons loans held for sale, we began using the brokered certificates of deposit market. At December 31, 2004, we had $86.7 million of brokered certificates of deposit. At December 31, 2005, our brokered certificates of deposit decreased $76.9 million to $9.8 million. As maturities in our brokered certificates of deposit portfolio occurred, we were able to replace that funding with increases in our core deposit products. Our utilization of the brokered certificates of deposit market averaged $38.9 million in 2005, a decrease of $13.4 million from an average of $52.3 million in 2004.
Net interest income was $24.6 million for the year ended December 31, 2004, up $9.4 million or 61.8% from 2003. The increase was due primarily to an increase in average volumes of investment securities, loans held for sale and loans receivable, net of the impact of decreased yields during 2004 compared to 2003. These increases were funded through the increases in total deposits and other borrowed funds.
Our net interest margin for the years ended December 31, 2004 and 2003 was 2.72% and 3.00%, respectively. The decrease in the net interest margin was a result of earning asset yields declining more quickly than the cost of interest-bearing liabilities in 2004. The average yield on interest-earning assets decreased to 4.49% in 2004 from 4.89% in 2003, and our cost of interest-bearing liabilities decreased to 2.17% in 2004 from 2.31% in 2003. The yield on other borrowed funds, which are generally shorter term fundings and which we utilized to a greater extent in 2004 than 2003 as a result of the George Mason acquisition, increased 50 basis points to 2.18% in December 31, 2004 compared to 1.68% for 2003.
Total earning assets increased by 88.3% to $1.16 billion at December 31, 2004, compared to $616.7 million at December 31, 2003. This resulted primarily from a $365.5 million increase in loans held for sale as a result of our George Mason acquisition and a $153.9 million increase in loans receivable. These increases were funded by deposit growth of $350.1 million, or 73.8%, and other borrowed funds and warehouse financing growth of $156.9 million over December 31, 2003 balances. In addition, other
borrowed funds increased by $126.6 million during 2004 to $201.1 million at December 31, 2004, compared to $74.5 million at December 31, 2003.
Average loans receivable increased $118.7 million to $391.4 million in 2004 from $272.8 million in 2003. Average balances of nonperforming assets are included in the net interest margin calculation and did not have a material impact on our net interest margin in 2004 and 2003. Additional interest income of approximately $25,000 in 2004 and $39,000 in 2003 would have been realized had all nonperforming assets performed as originally expected. Nonperforming assets exclude loans that are both past due 90 days or more and still accruing interest due to an assessment of collectibility.
Average total deposits increased $219.9 million to $652.7 million in 2004 from $432.8 million in 2003. The largest increase in average deposit balances was experienced in certificates of deposit, which increased $194.8 million compared to 2003, as a result of our branch expansion and increased advertising of our rates on certificates of deposit. In addition, to assist in the funding of George Masons loans held for sale, we began using the brokered certificates of deposit market during 2004. At December 31, 2004, we had $86.7 million of brokered certificates of deposit. Our utilization of the brokered certificates of deposit market averaged $52.3 million in 2004. We had no brokered certificates of deposit at December 31, 2003.
The following is a summary of our average earning and non-earning assets and interest-bearing and non-interest-bearing liabilities for the three years ended December 31, 2005 and the resulting yields and cost of funding for those years.
(1) Non-accrual loans are included in average balances and do not have a material effect on the average yield. Interest income on non-accruing loans was not material for years presented.
(2) We do not have investments that have tax benefit attributes; therefore, there are no tax equivalent adjustments to our net interest income.