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Cardinal Financial 10-Q 2005

Documents found in this filing:

  1. 10-Q
  2. Ex-31.1
  3. Ex-31.2
  4. Ex-32.1
  5. Ex-32.2
  6. Ex-32.2

 

U.S. SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C.  20549

 

FORM 10-Q

 

ý  Quarterly Report Pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934

 

or

 

For the quarterly period ended September 30, 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)

 

Virginia

 

54-1874630

(State or other jurisdiction of
incorporation or organization)

 

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

 

 

 

8270 Greensboro Drive, Suite 500

 

 

McLean, Virginia

 

22102

(Address of principal executive offices)

 

(Zip Code)

 

(703) 584-3400

(Registrant’s telephone number, including area code)

 

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   ý   No   o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act)

 

Yes  ý   No   o

 

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

 

Yes  o   No   ý

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

 

24,357,955 shares of common stock, par value $1.00 per share,

outstanding as of October 31, 2005

 

 



 

CARDINAL FINANCIAL CORPORATION

 

INDEX TO FORM 10-Q

 

PART I – FINANCIAL INFORMATION

 

 

 

Item 1. Financial Statements:

3

 

 

Consolidated Statements of Condition

 

At September 30, 2005 (unaudited) and December 31, 2004

3

 

 

Consolidated Statements of Income

 

For the three and nine months ended September 30, 2005 and 2004 (unaudited)

4

 

 

Consolidated Statements of Comprehensive Income

 

For the three and nine months ended September 30, 2005 and 2004 (unaudited)

5

 

 

Consolidated Statements of Changes In Shareholders’ Equity

 

For the nine months ended September 30, 2005 and 2004 (unaudited)

6

 

 

Consolidated Statements of Cash Flows

 

For the nine months ended September 30, 2005 and 2004 (unaudited)

7

 

 

Notes to Consolidated Financial Statements (unaudited)

8

 

 

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

17

 

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

41

 

 

Item 4. Controls and Procedures

42

 

 

PART II – OTHER INFORMATION

 

 

 

Item 1. Legal Proceedings

43

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

43

Item 3. Defaults Upon Senior Securities

43

Item 4. Submission of Matters to a Vote of Security Holders

43

Item 5. Other Information

43

Item 6. Exhibits

43

 

 

SIGNATURES

44

 

2



 

PART I – FINANCIAL INFORMATION

 

Item 1.  Financial Statements

 

CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CONDITION

September 30, 2005 and December 31, 2004

(In thousands, except share data)

 

 

 

 

 

 

 

(Unaudited)

 

 

 

 

 

 

 

 

 

September 30,
2005

 

December 31,
2004

 

Assets

 

 

 

 

 

 

 

 

 

Cash and due from banks

 

 

 

 

 

$

16,658

 

$

15,205

 

Federal funds sold

 

 

 

 

 

86,415

 

8,203

 

Total cash and cash equivalents

 

 

 

 

 

103,073

 

23,408

 

Investment securities available-for-sale

 

 

 

 

 

171,833

 

151,554

 

Investment securities held-to-maturity (market value of $118,875 and $136,609 at September 30, 2005 and December 31, 2004, respectively)

 

 

 

 

 

120,794

 

137,953

 

Total investment securities

 

 

 

 

 

292,627

 

289,507

 

Other investments

 

 

 

 

 

7,363

 

8,110

 

Loans held for sale, net

 

 

 

 

 

454,660

 

365,454

 

Loans receivable, net of deferred fees and costs

 

 

 

 

 

632,148

 

489,896

 

Allowance for loan losses

 

 

 

 

 

(7,706

)

(5,878

)

Loans receivable, net

 

 

 

 

 

624,442

 

484,018

 

Premises and equipment, net

 

 

 

 

 

17,591

 

15,531

 

Deferred tax asset

 

 

 

 

 

4,762

 

3,238

 

Goodwill and intangibles, net

 

 

 

 

 

20,644

 

14,694

 

Accrued interest receivable and other assets

 

 

 

 

 

14,464

 

7,616

 

Total assets

 

 

 

 

 

$

1,539,626

 

$

1,211,576

 

 

 

 

 

 

 

 

 

 

 

Liabilities and Shareholders’ Equity

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Non-interest bearing deposits

 

 

 

 

 

$

128,467

 

$

105,424

 

Interest bearing deposits

 

 

 

 

 

965,924

 

718,786

 

Other borrowed funds

 

 

 

 

 

163,892

 

201,085

 

Warehouse financing

 

 

 

 

 

 

30,245

 

Mortgage funding checks

 

 

 

 

 

104,283

 

46,392

 

Escrow liabilities

 

 

 

 

 

9,626

 

3,020

 

Accrued interest payable and other liabilities

 

 

 

 

 

20,696

 

11,519

 

Total liabilities

 

 

 

 

 

1,392,888

 

1,116,471

 

 

 

 

 

 

 

 

 

 

 

Common stock, $1 par value

 

2005

 

2004

 

 

 

 

 

Authorized

 

50,000,000

 

50,000,000

 

 

 

 

 

Issued and outstanding

 

24,354,505

 

18,462,597

 

24,355

 

18,463

 

Additional paid-in capital

 

 

 

 

 

132,255

 

92,868

 

Accumulated deficit

 

 

 

 

 

(8,256

)

(15,145

)

Accumulated other comprehensive loss

 

 

 

 

 

(1,616

)

(1,081

)

Total shareholders’ equity

 

 

 

 

 

146,738

 

95,105

 

Total liabilities and shareholders’ equity

 

 

 

 

 

$

1,539,626

 

$

1,211,576

 

 

See accompanying notes to consolidated financial statements.

 

3



 

CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

Three and nine months ended September 30, 2005 and 2004

(In thousands, except share and per share data)

(Unaudited)

 

 

 

Three Months Ended September 30,

 

Nine Months Ended September 30,

 

 

 

2005

 

2004

 

2005

 

2004

 

Interest income:

 

 

 

 

 

 

 

 

 

Loans receivable

 

$

9,365

 

$

5,826

 

$

24,979

 

$

15,425

 

Loans held for sale

 

6,101

 

3,268

 

14,117

 

3,268

 

Federal funds sold

 

208

 

49

 

346

 

96

 

Investment securities available-for-sale

 

1,414

 

1,536

 

4,376

 

4,360

 

Investment securities held-to-maturity

 

1,197

 

1,432

 

3,757

 

4,260

 

Other investments

 

56

 

78

 

183

 

162

 

Total interest income

 

18,341

 

12,189

 

47,758

 

27,571

 

Interest expense:

 

 

 

 

 

 

 

 

 

Deposits

 

6,782

 

3,668

 

16,989

 

8,448

 

Other borrowed funds

 

1,339

 

1,116

 

3,602

 

1,887

 

Warehouse financing

 

109

 

211

 

109

 

211

 

Total interest expense

 

8,230

 

4,995

 

20,700

 

10,546

 

Net interest income

 

10,111

 

7,194

 

27,058

 

17,025

 

Provision for loan losses

 

500

 

529

 

1,869

 

918

 

Net interest income after provision for loan losses

 

9,611

 

6,665

 

25,189

 

16,107

 

Non-interest income:

 

 

 

 

 

 

 

 

 

Service charges on deposit accounts

 

348

 

296

 

958

 

798

 

Loan service charges

 

771

 

129

 

2,015

 

414

 

Investment fee income

 

497

 

150

 

947

 

498

 

Net gain on sales of loans

 

4,752

 

1,398

 

12,368

 

1,460

 

Net realized gain on investment securities available-for-sale

 

 

3

 

33

 

245

 

Management fee income

 

969

 

802

 

2,467

 

802

 

Other income

 

12

 

6

 

19

 

9

 

Total non-interest income

 

7,349

 

2,784

 

18,807

 

4,226

 

Non-interest expense:

 

 

 

 

 

 

 

 

 

Salary and benefits

 

6,430

 

4,802

 

16,866

 

8,904

 

Occupancy

 

1,063

 

932

 

3,134

 

1,893

 

Professional fees

 

875

 

578

 

1,824

 

922

 

Depreciation

 

711

 

583

 

2,100

 

1,215

 

Data processing

 

233

 

255

 

1,227

 

647

 

Telecommunications

 

303

 

197

 

913

 

405

 

Amortization of intangibles

 

143

 

 

265

 

 

Other operating expenses

 

2,647

 

1,546

 

7,293

 

3,760

 

Total non-interest expense

 

12,405

 

8,893

 

33,622

 

17,746

 

Net income before income taxes

 

4,555

 

556

 

10,374

 

2,587

 

Provision for income taxes

 

1,570

 

172

 

3,485

 

850

 

Net income

 

$

2,985

 

$

384

 

$

6,889

 

$

1,737

 

Earnings per share - basic

 

$

0.12

 

$

0.02

 

$

0.32

 

$

0.10

 

Earnings per share - diluted

 

$

0.12

 

$

0.02

 

$

0.32

 

$

0.09

 

Weighted-average shares outstanding - basic

 

24,346,701

 

18,439,021

 

21,344,071

 

18,101,639

 

Weighted-average shares outstanding - diluted

 

24,631,402

 

18,697,179

 

21,606,448

 

18,361,013

 

 

See accompanying notes to consolidated financial statements.

 

4



 

CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

Three and nine months ended September 30, 2005 and 2004

(In thousands)

(Unaudited)

 

 

 

Three Months Ended September 30,

 

Nine Months Ended September 30,

 

 

 

2005

 

2004

 

2005

 

2004

 

 

 

 

 

 

 

 

 

 

 

Net income

 

$

2,985

 

$

384

 

$

6,889

 

$

1,737

 

Other comprehensive income:

 

 

 

 

 

 

 

 

 

Unrealized gain (loss) on available-for-sale investment securities:

 

 

 

 

 

 

 

 

 

Unrealized holding gain (loss) arising during the period, net of tax

 

(242

)

2,537

 

(513

)

(93

)

Less: reclassification adjustment for gains included in net income, net of tax

 

 

(2

)

(22

)

(161

)

 

 

 

 

 

 

 

 

 

 

Comprehensive income

 

$

2,743

 

$

2,919

 

$

6,354

 

$

1,483

 

 

See accompanying notes to consolidated financial statements.

 

5



 

CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

Nine months ended September 30, 2005 and 2004

(In thousands)

(Unaudited)

 

 

 

Preferred
Shares

 

Preferred
Stock

 

Common
Shares

 

Common
Stock

 

Additional
Paid-in
Capital

 

Accumulated
Deficit

 

Accumulated
Other
Comprehensive
Loss

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, December 31, 2003

 

1,364

 

$

1,364

 

16,377

 

$

16,377

 

$

86,790

 

$

(18,614

)

$

(505

)

$

85,412

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Stock options exercised

 

 

 

93

 

93

 

306

 

 

 

399

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Public offering shares issued

 

 

 

945

 

945

 

5,358

 

 

 

6,303

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Preferred stock converted to common stock

 

(1,364

)

(1,364

)

1,026

 

1,026

 

338

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Change in accumulated other comprehensive loss

 

 

 

 

 

 

 

(254

)

(254

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

 

 

 

 

 

1,737

 

 

1,737

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, September 30, 2004

 

 

$

 

18,441

 

$

18,441

 

$

92,792

 

$

(16,877

)

$

(759

)

$

93,597

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, December 31, 2004

 

 

$

 

18,463

 

$

18,463

 

$

92,868

 

$

(15,145

)

$

(1,081

)

$

95,105

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Stock options exercised

 

 

 

106

 

106

 

544

 

 

 

650

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Public offering shares issued

 

 

 

5,175

 

5,175

 

34,592

 

 

 

39,767

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Shares issued in Wilson/Bennett Acquisition

 

 

 

611

 

611

 

4,251

 

 

 

4,862

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Change in accumulated other comprehensive loss

 

 

 

 

 

 

 

(535

)

(535

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

 

 

 

 

 

6,889

 

 

6,889

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, September 30, 2005

 

 

$

 

24,355

 

$

24,355

 

$

132,255

 

$

(8,256

)

$

(1,616

)

$

146,738

 

 

See accompanying notes to consolidated financial statements.

 

6



 

CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

Nine months ended September 30, 2005 and 2004

(In thousands)

(Unaudited)

 

 

 

2005

 

2004

 

Cash flows from operating activities:

 

 

 

 

 

Net income

 

$

6,889

 

$

1,737

 

Adjustments to reconcile net income to net cash provided by (used in) operating activities:

 

 

 

 

 

Depreciation

 

2,100

 

1,215

 

Amortization of premiums, discounts and intangibles

 

1,357

 

1,557

 

Provision for loan losses

 

1,869

 

918

 

Loans held for sale originated and acquired

 

(3,902,910

)

(1,247,010

)

Proceeds from the sale of loans held for sale

 

3,826,072

 

900,999

 

Gain on sale of loans held for sale

 

(12,368

)

(1,460

)

Gain on sale of investment securities available-for-sale

 

(33

)

(245

)

Loss on sale of other assets

 

13

 

 

Increase in accrued interest receivable, other assets, and deferred tax asset

 

(8,372

)

(19,351

)

Increase (decrease) in accrued interest payable, escrow liabilities and other liabilities

 

15,778

 

(13,335

)

 

 

 

 

 

 

Net cash used in operating activities

 

(69,605

)

(374,975

)

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Purchase of premises and equipment

 

(4,169

)

(9,425

)

Proceeds from sale, maturity and call of investment securities available-for-sale

 

6,000

 

14,000

 

Proceeds from sale, maturity and call of mortgage-backed securities available-for-sale

 

4,896

 

9,719

 

Proceeds from maturity and call of investment securities held-to-maturity

 

 

5,490

 

Proceeds from sale of other investments

 

8,353

 

7,442

 

Purchase of investment securities available-for-sale

 

(42,776

)

(6,000

)

Purchase of mortgage-backed securities available-for-sale

 

(12,715

)

(72,959

)

Purchase of investment securities held-to-maturity

 

 

(16,472

)

Purchase of mortgage-backed securities held-to-maturity

 

 

(14,042

)

Purchase of other investments

 

(7,594

)

(10,098

)

Redemptions of investment securities available-for-sale

 

22,990

 

22,817

 

Redemptions of investment securities held-to-maturity

 

16,594

 

21,089

 

Net cash (paid) acquired in acquisition

 

(1,379

)

27,599

 

Net increase in loans receivable, net of deferred fees and costs

 

(141,986

)

(103,592

)

 

 

 

 

 

 

Net cash used in investing activities

 

(151,786

)

(124,432

)

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

Net increase in deposits

 

270,181

 

345,805

 

Net increase (decrease) in other borrowed funds

 

(54,318

)

27,152

 

Net increase (decrease) in warehouse financing

 

(30,240

)

88,846

 

Net increase in mortgage funding checks

 

57,891

 

 

Proceeds from FHLB advances - long term

 

25,000

 

45,000

 

Repayments of FHLB advances - long term

 

(7,875

)

(7,875

)

Proceeds from public offering

 

39,767

 

6,303

 

Proceeds from trust preferred issuance

 

 

20,000

 

Stock options exercised

 

650

 

399

 

 

 

 

 

 

 

Net cash provided by financing activities

 

301,056

 

525,630

 

 

 

 

 

 

 

Net increase in cash and cash equivalents

 

79,665

 

26,223

 

 

 

 

 

 

 

Cash and cash equivalents at beginning of the period

 

23,408

 

13,083

 

 

 

 

 

 

 

Cash and cash equivalents at end of the period

 

$

103,073

 

$

39,306

 

 

 

 

 

 

 

Supplemental disclosure of cash flow information:

 

 

 

 

 

Cash paid during the period for interest

 

$

20,867

 

$

9,622

 

Cash paid for income taxes

 

1,436

 

80

 

 

 

 

 

 

 

Supplemental schedule of noncash investing and financing activities:

 

 

 

 

 

On June 9, 2005, the Company acquired all of the issued and outstanding common stock of Wilson/Bennett Capital Management, Inc. In conjunction with the acquisition, the following noncash changes to our financial condition occurred:

 

 

 

 

 

Fair value of non-cash assets acquired

 

$

6,296

 

 

 

Fair value of liabilities assumed

 

33

 

 

 

Common shares issued in acquisition

 

4,862

 

 

 

 

 

 

 

 

 

On July 7, 2004, the Company acquired all of the issued and outstanding membership interests of George Mason Mortgage, LLC. In conjunction with the acquisition, the following noncash changes to our financial condition occurred:

 

 

 

 

 

Fair value of non-cash assets acquired

 

 

 

$

14,703

 

Fair value of liabilities assumed

 

 

 

 

338,232

 

 

See accompanying notes to consolidated financial statements.

 

7



 

CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2005
(Unaudited)

 

Note 1

 

Organization

 

Cardinal Financial Corporation (the “Company”) was incorporated on November 24, 1997 under the laws of the Commonwealth of Virginia as a holding company whose activities consist of investment in its wholly owned subsidiaries.  The Company opened Cardinal Bank, N.A. (the “Bank”) in 1998 and Cardinal Wealth Services, Inc., an investment services subsidiary, in 1999.  In 1999, the Company opened two additional banking subsidiaries and, in late 2000, completed an acquisition of Heritage Bancorp, Inc. and its banking subsidiary, The Heritage Bank.  These banking subsidiaries were consolidated into the Bank as of March 1, 2002.  On April 15, 2004, the Company received approval from the Federal Reserve Bank of Richmond to be a financial holding company.  Effective July 7, 2004, the Bank acquired George Mason Mortgage, LLC (“George Mason”), a mortgage banking company based in Fairfax, Virginia.  In December 2004, the Bank converted to a state chartered institution and changed its name to Cardinal Bank.  Effective June 9, 2005, the Company acquired Wilson/Bennett Capital Management, Inc. (“Wilson/Bennett”), an asset management firm based in Alexandria, Virginia.

 

Basis of Presentation

 

In the opinion of management, the accompanying consolidated financial statements have been prepared in accordance with the requirements of Regulation S-X, Article 10.  Accordingly, they do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements.  However, all adjustments that are, in the opinion of management, necessary for a fair presentation have been included.  The results of operations for the three and nine months ended September 30, 2005 are not necessarily indicative of the results to be expected for the full year ending December 31, 2005.  The unaudited interim financial statements should be read in conjunction with the audited financial statements and notes to financial statements that are included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004 (the “2004 Form 10-K”).

 

Stock-Based Compensation

 

At September 30, 2005, the Company had two stock-based employee compensation plans, the 1999 Stock Option Plan and the 2002 Equity Compensation Plan.  These plans are described more fully in Footnote 18 of the 2004 Form 10-K.

 

As permitted under Statement of Financial Accounting Standards (“SFAS”) No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure, which amended SFAS No. 123, Accounting for Stock-Based Compensation, the Company has elected to continue to utilize the intrinsic value method in accounting for its stock-based employee compensation arrangements as defined by Accounting Principles Board Opinion (“APB”) No. 25, Accounting for Stock Issued to Employees, and related interpretations including Financial Accounting Standards Board Interpretation No. 44, Accounting for Certain Transactions Involving Stock Compensation, an

 

8



 

interpretation of APB No. 25.  The following table illustrates the effect on net income and earnings per share of common stock if the Company had applied the fair value recognition provisions of SFAS No. 123, as amended, to stock-based employee compensation.

 

(In thousands, except per share data)

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2005

 

2004

 

2005

 

2004

 

Net income

 

$

2,985

 

$

384

 

$

6,889

 

$

1,737

 

Deduct: Total stock-based employee compensation expense determined under fair value- based method for all awards, net of tax

 

(215

)

(753

)

(3,987

)

(1,428

)

Pro forma net income

 

$

2,770

 

$

(369

)

$

2,902

 

$

309

 

 

 

 

 

 

 

 

 

 

 

Earnings per share:

 

 

 

 

 

 

 

 

 

Basic - as reported

 

$

0.12

 

$

0.02

 

$

0.32

 

$

0.10

 

Basic - pro forma

 

0.11

 

(0.02

)

0.14

 

0.02

 

Diluted - as reported

 

0.12

 

0.02

 

0.32

 

0.09

 

Diluted - pro forma

 

0.11

 

(0.02

)

0.13

 

0.02

 

 

The weighted average per share fair values of grants of stock options made during the three months ended September 30, 2005 and 2004 were $5.92 and $3.30, respectively.  The weighted average per share fair values of grants made during the nine months ended September 30, 2005 and 2004 were $5.97 and $3.08, respectively.  The fair values of the options granted for these periods were estimated as of the grant date using the Black-Scholes option-pricing model based on the following weighted average assumptions:

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2005

 

2004

 

2005

 

2004

 

Estimated option life

 

10 years

 

10 years

 

10 years

 

10 years

 

Risk free interest rate

 

4.21

%

4.29

%

4.25

%

4.12

%

Expected volatility

 

43.11

%

11.80

%

43.11

%

11.80

%

Expected dividend yield

 

0.00

%

0.00

%

0.00

%

0.00

%

 

There were options to purchase 44,000 and 963,911 shares of common stock granted during the three and nine months ended September 30, 2005, respectively.  Of those grants, 44,000 and 955,911 immediately vested on the grant date for the three and nine months ended September 30, 2005, respectively.

 

In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123R, Share-Based Payment:  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

 

9



 

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 as of each reporting date.  The Company intends to adopt FAS 123R using the modified prospective application method which requires, among other things, recognition of compensation costs for all awards outstanding at January 1, 2006 for which the requisite service has not been rendered.  The Company estimates that this new standard will result in an increase in pretax expense of approximately $64,000 quarterly and $256,000 annually in 2006 based on the current stock options outstanding.  Additional expense would be recorded for any future stock option grants.  On October 19, 2005, the Company’s board of directors authorized that any existing outstanding options that are or become “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 will not result in the recognition of additional expense because the intrinsic value of the awards at the grant date was zero and the intrinsic value of these awards on the date of modification will also be zero.

 

Note 2

 

Acquisitions

 

On June 9, 2005, the Company acquired Wilson/Bennett for a total consideration of $6.5 million, which consisted of a payment of $1.6 million in cash and the issuance of 611,111 shares of its common stock valued at $4.9 million.  This transaction was accounted for as a purchase and Wilson/Bennett’s 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.  Wilson/Bennett’s 2004 unaudited revenues were approximately $1.4 million.  The Company anticipates that the acquisition of Wilson/Bennett will not have a material impact on 2005 earnings.

 

The primary shareholder of Wilson/Bennett at the time of its acquisition by the Company was, and continues to be, a member of the Company’s Board of Directors.  The Company has entered into an employment agreement with this person which ends on April 30, 2008, with automatic one-year renewals beginning on that date and each April 30 thereafter unless notice of non-renewal is provided by either party.

 

The common stock utilized to complete this transaction is newly issued by the Company, is not registered with the Securities and Exchange Commission (the “SEC”), and therefore cannot be sold until so registered or sold pursuant to an exemption from such registration. Because of this trading restriction, the Company has valued for purchase accounting purposes the 611,111 restricted shares at 89% of the fair market value of its unrestricted shares.

 

The operating results of Wilson/Bennett are included in the Company’s consolidated operating results and its investment services segment information since the date of acquisition and are not separately material to consolidated operating results. The acquisition resulted in the recognition of the following intangible assets which are being amortized on a straight-line basis over the periods indicated:

 

Employment/non-compete agreement - $698,000 (4 years)

Trade name intangible-$46,000 (3 years)

Purchased customer relationships-$1,858,000 (10 years)

 

10



 

The transaction also resulted in the recognition of goodwill of $3.5 million. The Company used the assistance of an independent valuation consultant to determine the value assigned to identifiable amortizable intangibles. Goodwill will not be amortized but will be reviewed, along with the other identified intangibles, for impairment when evidence of impairment exists or, at a minimum, on an annual basis.

 

The Company has agreed to provide certain demand registration rights with respect to the 611,111 common shares issued. The owners of these shares have the right to make one written request to the Company for the registration of one-third of the shares under the Securities Act of 1933, as amended, to permit the resale of the shares.  In the event that a change of control of the Company occurs, or the Company’s employment of its current chief executive officer terminates, both as described in a registration rights agreement, then the registration rights would cover all the shares.  The purchase price has been increased by the estimated cost to register these shares with the SEC.  At the end of two years, the shares will no longer be restricted.

 

On July 7, 2004, the Bank completed its acquisition of George Mason. George Mason was acquired in a cash transaction for $17.0 million and is operating as a subsidiary of the Bank.  This transaction was accounted for as a purchase and George Mason’s assets and liabilities were recorded at fair value as of the purchase date.  George Mason’s operating results are included in the consolidated results of operations since the date of acquisition.  This transaction resulted in the recognition of $12.9 million of goodwill and $1.7 million of other intangible assets.  George Mason’s primary sources of revenue include net interest income earned on loans held for sale, gain on sale of loans and management fees earned.  Loans are made pursuant to purchase commitments and are sold servicing released.  The Bank purchased George Mason primarily to diversify its sources of income, increase non-interest income and be a source of residential loans for its loans receivable portfolio.

 

The following unaudited pro forma condensed financial information presents the results of operations of the Company for the periods indicated as if George Mason had been acquired on January 1, 2004.

 

11



 

 

 

Three Months Ended

 

Nine Months Ended

 

(In thousands, except share and per share data)

 

September 30, 2004

 

September 30, 2004

 

Net interest income

 

$

7,308

 

$

21,146

 

Non-interest income

 

4,605

 

23,157

 

Provision for loan losses

 

529

 

918

 

Non-interest expense

 

9,415

 

35,698

 

Net income before income taxes

 

1,969

 

7,687

 

Provision for income taxes

 

652

 

2,365

 

Net income

 

$

1,317

 

$

5,322

 

 

 

 

 

 

 

Earnings per common share - basic

 

$

0.07

 

$

0.29

 

Earnings per common share - diluted

 

$

0.07

 

$

0.29

 

Weighted-average common shares outstanding - basic

 

18,439,021

 

18,101,639

 

Weighted-average common shares outstanding - diluted

 

18,697,179

 

18,361,013

 

 

The unaudited pro forma results of operations summarized above are not necessarily indicative of the results that would have occurred if the acquisition had been consummated on January 1, 2004.

 

Note 3

 

Segment Information

 

Prior to July 7, 2004, the Company operated and reported in two business segments, commercial banking and investment services.  As of July 7, 2004, the Company began operating in a third business segment, mortgage banking, with the completion of its acquisition of George Mason.

 

The commercial banking segment includes both commercial and consumer lending and provides customers with such products as commercial loans, real estate loans, and other business financing and consumer loans.  In addition, this segment also 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.  Wilson/Bennett is included in the investment services segment since the date of its acquisition, June 9, 2005.

 

Information about the reportable segments and reconciliation of this information to the consolidated financial statements at and for the three and nine months ended September 30, 2005 and 2004, is as follows:

 

12



 

(In thousands)

At and for the Three Months Ended September 30, 2005:

 

 

 

Commercial
Banking

 

Mortgage
Banking

 

Investment
Services

 

Intersegment
Elimination

 

Other

 

Consolidated

 

Net interest income

 

$

8,544

 

$

1,780

 

$

 

$

 

$

(213

)

$

10,111

 

Provision for loan losses

 

500

 

 

 

 

 

500

 

Non-interest income

 

479

 

6,362

 

497

 

 

11

 

7,349

 

Non-interest expense

 

6,542

 

4,845

 

454

 

 

564

 

12,405

 

Provision for income taxes

 

659

 

1,153

 

3

 

 

(245

)

1,570

 

Net income (loss)

 

$

1,322

 

$

2,144

 

$

40

 

$

 

$

(521

)

$

2,985

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total Assets

 

$

1,409,575

 

$

467,261

 

$

7,330

 

$

(511,520

)

$

166,980

 

$

1,539,626

 

 

At and for the Three Months Ended September 30, 2004:

 

 

 

Commercial
Banking

 

Mortgage
Banking

 

Investment
Services

 

Intersegment
Elimination

 

Other

 

Consolidated

 

Net interest income

 

$

5,716

 

$

1,583

 

$

 

$

 

$

(105

)

$

7,194

 

Provision for loan losses

 

529

 

 

 

 

 

529

 

Non-interest income

 

325

 

2,304

 

150

 

 

5

 

2,784

 

Non-interest expense

 

4,239

 

4,156

 

189

 

 

309

 

8,893

 

Provision for income taxes

 

402

 

(76

)

(15

)

 

(139

)

172

 

Net income (loss)

 

$

871

 

$

(193

)

$

(24

)

$

 

$

(270

)

$

384

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total Assets

 

$

1,075,460

 

$

356,438

 

$

677

 

$

(370,480

)

$

115,220

 

$

1,177,315

 

 

At and for the Nine Months Ended September 30, 2005:

 

 

 

Commercial
Banking

 

Mortgage
Banking

 

Investment
Services

 

Intersegment
Elimination

 

Other

 

Consolidated

 

Net interest income

 

$

22,980

 

$

4,723

 

$

 

$

 

$

(645

)

$

27,058

 

Provision for loan losses

 

1,869

 

 

 

 

 

1,869

 

Non-interest income

 

1,325

 

16,512

 

946

 

 

24

 

18,807

 

Non-interest expense

 

18,008

 

13,223

 

999

 

 

1,392

 

33,622

 

Provision for income taxes

 

1,490

 

2,691

 

(35

)

 

(661

)

3,485

 

Net income (loss)

 

$

2,938

 

$

5,321

 

$

(18

)

$

 

$

(1,352

)

$

6,889

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total Assets

 

$

1,409,575

 

$

467,261

 

$

7,330

 

$

(511,520

)

$

166,980

 

$

1,539,626

 

 

At and for the Nine Months Ended September 30, 2004:

 

 

 

Commercial
Banking

 

Mortgage
Banking

 

Investment
Services

 

Intersegment
Elimination

 

Other

 

Consolidated

 

Net interest income

 

$

15,493

 

$

1,583

 

$

 

$

 

$

(51

)

$

17,025

 

Provision for loan losses

 

918

 

 

 

 

 

918

 

Non-interest income

 

1,430

 

2,304

 

487

 

 

5

 

4,226

 

Non-interest expense

 

12,017

 

4,156

 

613

 

 

960

 

17,746

 

Provision for income taxes

 

1,313

 

(76

)

(45

)

 

(342

)

850

 

Net income (loss)

 

$

2,675

 

$

(193

)

$

(81

)

$

 

$

(664

)

$

1,737

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total Assets

 

$

1,075,460

 

$

356,438

 

$

677

 

$

(370,480

)

$

115,220

 

$

1,177,315

 

 

13



 

At September 30, 2005, the Company did not have any operating segments other than those reported.  Parent company financial information is included in the “Other” category and represents an overhead function rather than an operating segment.  The parent company’s most significant assets are its net investments in its subsidiaries.  The parent company’s net interest income is comprised of interest income from short-term investments and interest expense on trust preferred securities.  The parent company’s non-interest expense is primarily non-allocable executive salaries and professional services related to the Company’s regulatory requirements.

 

Note 4

 

Earnings Per Share
 

The following is the calculation of basic and diluted earnings per share for the three and nine months ended September 30, 2005 and 2004. Stock options outstanding at September 30, 2005 and 2004 were 2,049,817 and 1,245,625 respectively.  Stock options issued that were not included in the calculation of diluted earnings per share because the exercise prices were greater than the average market price were 27,363 and 29,000 for the three months ended September 30, 2005 and 2004, respectively.  Stock options issued that were not included in the calculation of diluted earnings per share because the exercise prices were greater than the average market price were 28,357 and 22,000 for the nine months ended September 30, 2005 and 2004, respectively.

 

(In thousands,

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

except share and per share data)

 

2005

 

2004

 

2005

 

2004

 

 

 

 

 

 

 

 

 

 

 

Net income available to common shareholders

 

$

2,985

 

$

384

 

$

6,889

 

$

1,737

 

 

 

 

 

 

 

 

 

 

 

Weighted average common shares - basic

 

24,346,701

 

18,439,021

 

21,344,071

 

18,101,639

 

 

 

 

 

 

 

 

 

 

 

Weighted average common shares - diluted

 

24,631,402

 

18,697,179

 

21,606,448

 

18,361,013

 

 

 

 

 

 

 

 

 

 

 

Earnings per common share - basic

 

$

0.12

 

$

0.02

 

$

0.32

 

$

0.10

 

 

 

 

 

 

 

 

 

 

 

Earnings per common share - diluted

 

$

0.12

 

$

0.02

 

$

0.32

 

$

0.09

 

 

Note 5

 

Derivatives and Hedging Activities
 

The Company accounts for derivatives and hedging activities in accordance with SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended by SFAS No. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities, and SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities.  All derivatives are recognized on the consolidated statements of condition at their fair value.

 

14



 

In the normal course of business, the Company enters into contractual commitments to extend credit to finance one-to-four family homes.  The commitments, which contain fixed expiration dates, become effective when the borrowers lock-in a specified interest rate within time frames established by the Company (“interest rate locks”).  Interest rate risk arises if interest rates move adversely between the time of the lock-in of rates by the borrower and the sale of the loan.  The interest rate locks related to loans that are intended to be sold are considered derivatives.

 

To mitigate the effect of the interest rate risk inherent in providing rate lock commitments, the Company economically hedges each commitment by entering into a best efforts forward loan sale contract.  These forward contracts are marked to market through earnings and are not designated as accounting hedges under SFAS No. 133.  The fair values of all loan commitments and all forward sales contracts generally move in opposite directions and, accordingly, the impact of changes in these valuations on net income during the loan commitment period is generally inconsequential.

 

Although the forward loan sale contracts serve as an economic hedge of interest rate risk from holding fixed-rate loans held for sale, these forward contracts have not been designated as accounting hedges under SFAS No. 133 and, accordingly, 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.

 

At September 30, 2005, the fair value of interest rate lock commitments with a notional value of $156.2 million was $(1.1 million), and the fair value of forward sale commitments with a notional value of $519.0 million was $3.0 million.  These derivatives are recorded in other assets and other liabilities on the consolidated statements of condition at their fair values.  In addition to these market value adjustments for interest rate lock loan commitments and forward sale commitments at September 30, 2005, a basis adjustment of $(1.9 million) has been recorded related to the loans held for sale as of that date and is included in loans held for sale, net in the consolidated statements of condition.

 

Note 6

 

Goodwill and Other Intangibles

 

Information concerning total amortizable other intangible assets at September 30, 2005 is as follows:

 

 

 

Mortgage Banking

 

Investment Services

 

Total

 

(In thousands)

 

Gross
Carrying
Amount

 

Accumulated
Amortization

 

Gross
Carrying
Amount

 

Accumulated
Amortization

 

Gross
Carrying
Amount

 

Accumulated
Amortization

 

Balance at December 31, 2004

 

$

1,781

 

$

49

 

$

 

$

 

$

1,781

 

$

49

 

Customer relationship intangibles

 

 

148

 

1,858

 

58

 

1,858

 

206

 

Employment/non-compete agreement

 

 

 

698

 

54

 

698

 

54

 

Trade name

 

 

 

46

 

5

 

46

 

5

 

 

 

$

1,781

 

$

197

 

$

2,602

 

$

117

 

$

4,383

 

$

314

 

 

15



 

The aggregate amortization expense for the three and nine months ended September 30, 2005 was $143,000 and $265,000, respectively.  There was no amortization expense for the comparable periods of 2004.

 

The estimated amortization expense for the next five years is as follows:

 

 

 

(In thousands)

 

2005 (October - December)

 

$

143

 

2006

 

574

 

2007

 

574

 

2008

 

565

 

2009

 

460

 

2010

 

384

 

 

The changes in the carrying amount of goodwill for year to date September 30, 2005 are as follows:

 

(In thousands)

 

Commercial
Banking

 

Mortgage
Banking

 

Investment
Services

 

Total

 

Balance at December 31, 2004

 

$

22

 

$

12,941

 

$

 

$

12,963

 

Goodwill attributable to Wilson/Bennett acquisition

 

 

 

3,612

 

3,612

 

Balance at September 30, 2005

 

$

22

 

$

12,941

 

$

3,612

 

$

16,575

 

 

Note 7

 

Subsequent Event

 

On October 19, 2005, the Company’s Board of Directors declared a cash dividend of $0.01 per share of its outstanding common stock.  This dividend will be paid on November 15, 2005 to shareholders of record as of the close of business on October 31, 2005.  This represents the first dividend declared by the Company in its history.

 

16



 

Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

The following presents management’s discussion and analysis of our consolidated financial condition at September 30, 2005 and December 31, 2004 and the unaudited results of our operations for the three and nine months periods ended September 30, 2005 and 2004.  This discussion should be read in conjunction with our unaudited consolidated financial statements and the notes thereto appearing elsewhere in this report, the audited consolidated financial statements and the notes to consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2004.

 

Caution About Forward-Looking Statements

 

We make forward-looking statements in this Form 10-Q 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 the 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; and

                  changes in banking and other laws and regulations applicable to us.

 

17



 

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.

 

In addition, this section should be read in conjunction with the description of our “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2004.

 

Overview

 

Cardinal Financial Corporation, a locally managed financial holding company headquartered in Tysons Corner, Virginia, is 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., 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 Cardinal 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-one retail bank office locations and provide competitive retail 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 $1.6 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/Bennett’s 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, 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/Bennett’s 2004 unaudited revenues were approximately $1.4 million.  We anticipate that the acquisition of Wilson/Bennett will not have a material impact on our 2005 earnings.

 

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 intangibles.  This transaction was accounted for as a purchase, and George Mason’s assets and liabilities were recorded at their fair values as of the purchase date.  George Mason’s operating results are included in our consolidated results since the acquisition date.  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 eight branches located throughout the metropolitan Washington region.  George Mason has approximately 200 employees and does business in eight states, including Virginia, Maryland and the District of Columbia.  George Mason is one of the largest residential mortgage originators in the greater Washington metropolitan area, with originations of over $3.5 billion in 2004 and $4.5 billion in 2003.  George Mason’s originations for the first nine months of 2005 were $3.3 billion.

 

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George Mason’s primary sources of revenue include net interest income earned on loans held for sale, gain on the sale of loans held for sale 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.

 

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.  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 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 analyze our loan portfolio for exposure to credit risk.  Loan defaults and foreclosures are unavoidable in the banking industry and we try to limit our exposure to this risk by carefully underwriting and 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 (losses) on sales of investment securities available-for-sale, gains on sales of loans held for sale, 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.

 

Our business strategy is to grow through geographic expansion while maintaining strong asset quality and achieving sustained 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 the continuing expansion of our branch office network and balance sheet growth.  As a result of this increased capital and retained earnings, our legal lending limit increased to $18.7 million as of September 30, 2005, which allowed us to expand our commercial and real estate lending loan portfolios.  In addition, we expect to increase our loan-to-deposit ratio and shift the mix of our earning assets to higher yielding loans.

 

Critical Accounting Policies

 

General

 

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 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,

 

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assumptions and estimates may have a significant impact on the consolidated financial statements.  Actual results could differ from initial 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 of deferred tax assets.

 

Allowance for Loan Losses

 

We maintain the allowance for loan losses at a level that represents management’s 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 economic conditions, actual and expected credit losses, historical trends and specific conditions of 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 nonaccrual loans, national and local economic trends and conditions and concentrations of loans exhibiting similar risk profiles to support our estimates.

 

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 September 30, 2005 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.

 

For purposes of our analysis, we categorize loans into one of five categories:  commercial and industrial, commercial real estate (including construction), home equity lines of credit, residential mortgages, and consumer.  In the absence of 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 for 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.

 

Hedging

 

We account for our derivatives and hedging activities in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended by SFAS No. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities, and SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities.

 

In the normal course of our mortgage banking operations at George Mason, we enter rate lock commitments to extend credit to finance residential properties.  These commitments, which contain fixed expiration dates, offer the borrower an interest rate guarantee provided the loan

 

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meets underwriting guidelines and closes within the time frame 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 mortgage loans that are intended to be sold are considered derivatives in accordance with the guidance of SEC Staff Accounting Bulletin No. 105, Application of Accounting Principles to Loan Commitments.  Accordingly, the fair value of these derivatives as of the end of the reporting period has been determined through an analysis of