Cardinal Financial 10-Q 2007
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
x Quarterly Report Pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934
For the quarterly period ended March 31, 2007
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)
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 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 Exchange Act)
Indicate the number of shares outstanding of each of the issuers classes of common stock, as of the latest practicable date:
24,470,001 shares of common stock, par value $1.00 per share,
CARDINAL FINANCIAL CORPORATION
INDEX TO FORM 10-Q
See accompanying notes to consolidated financial statements.
See accompanying notes to consolidated financial statements.
See accompanying notes to consolidated financial statements.
See accompanying notes to consolidated financial statements.
See accompanying notes to consolidated financial statements.
Cardinal Financial Corporation (the Company) is incorporated under the laws of the Commonwealth of Virginia as a financial holding company whose activities consist of investment in its wholly-owned subsidiaries. The principal operating subsidiary of the Company is Cardinal Bank (the Bank), a state-chartered institution. On July 7, 2004, the Bank acquired George Mason Mortgage, LLC (George Mason), a mortgage banking company based in Fairfax, Virginia. On June 9, 2005, the Company acquired Wilson/Bennett Capital Management, Inc. (Wilson/Bennett), an asset management firm. The Company also owns Cardinal Wealth Services, Inc. (CWS), an investment services subsidiary. On February 9, 2006, the Bank acquired certain fiduciary and other assets and assumed certain liabilities of FBR National Trust Company, formerly a subsidiary of Friedman, Billings, Ramsey Group, Inc.
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 months ended March 31, 2007 are not necessarily indicative of the results to be expected for the full year ending December 31, 2007. 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 Companys Annual Report on Form 10-K for the year ended December 31, 2006.
Summary of Significant Accounting Policies
Investment Securities Held for Trading
The Company established a new investment securities category, investment securities held for trading, during the period ending March 31, 2007. Investment securities held for trading are those securities for which the Company has purchased and holds for the purpose of selling in the near future.
Investment securities held for trading are carried at estimated fair value. Unrealized market value adjustments, fees, and realized gains or losses, net of applicable tax, on trading securities are reported in noninterest income. Interest income on trading securities is included in interest income from investment securities within the consolidated statements of income.
At March 31, 2007, the Company had two stock-based employee compensation plans, the 1999 Stock Option Plan (the Option Plan) and the 2002 Equity Compensation Plan (the Equity Plan).
In 1998, the Company adopted the Option Plan pursuant to which the Company may grant stock options for up to 625,000 shares of the Companys common stock to employees and members of the Companys and its subsidiaries boards of directors. There are 17,644 shares of the Companys common stock available for future grants in the Option Plan as of March 31, 2007.
In 2002, the Company adopted the Equity Plan. The Equity Plan authorizes the granting and award of incentive stock options, non-qualified stock options, stock appreciation rights, restricted stock awards, phantom stock awards and performance share awards to directors, eligible officers and key employees of the Company. The Equity Plan currently authorizes grants and awards with respect to 2,420,000 shares of the Companys common stock. There are 250,283 shares of the Companys common stock available for future grants and awards in the Equity Plan as of March 31, 2007.
Stock options are granted with an exercise price equal to the common stocks fair market value at the date of grant. Director stock options have ten year terms and vest and become fully exercisable at the grant date. Certain employee stock options have ten year terms and vest and become fully exercisable after three years. Other employee stock options have ten year terms and vest and become fully exercisable in 20% increments beginning as of the grant date. In addition, the Company has granted stock options to employees of the Company that have ten year terms and vest and become fully exercisable in 20% increments beginning after their first year of service. During 2005, certain stock options granted to employees had ten year terms and vested and became fully exercisable immediately.
The Company has only made awards of stock options under the Option Plan and the Equity Plan.
Total expense related to the Companys share-based compensation plans for the three months ended March 31, 2007 and 2006 was $100,000 and $62,000, respectively. The total income tax benefit recognized in the income statement for share-based compensation arrangements was $35,000 and $22,000 for the three months ended March 31, 2007 and 2006, respectively.
The weighted average per share fair values of stock option grants made during the three months ended March 31, 2007 and 2006 were $4.89 and $5.80, 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:
Expected volatility is based upon the average annual historical volatility of the Companys common stock. The estimated option life is derived from the simplified method formula as described in Staff Accounting Bulletin No. 107. The risk free interest rate is based upon the five-year U.S. Treasury note rate in effect at the time of grant. The expected dividend yield is based upon implied and historical dividend declarations.
Stock option activity during the three months ended March 31, 2007 is summarized as follows:
Total intrinsic values of options exercised during the three months ended March 31, 2007 and 2006 were $50,000 and $53,000, respectively.
A summary of the status of the Companys non-vested stock options and changes during the three months ended March 31, 2007 is as follows:
At March 31, 2007, there were $1.5 million of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under the plans. The cost is expected to be recognized over a weighted average period of 3.7 years. The total fair value of shares that vested during the three months ended March 31, 2007 and 2006 were $360,000 and $211,000, respectively.
The Company operates in three business segments: Commercial Banking, Mortgage Banking, and Wealth Management and Trust Services.
The Commercial Banking segment includes both commercial and consumer lending and provides customers with such products as commercial loans, real estate loans, 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 Wealth Management and Trust Services segment provides investment and financial advisory services to businesses and individuals, including financial planning, retirement/estate planning, trust, estates, custody, investment management, escrows, and retirement plans.
Results related to the assets acquired, and liabilities assumed, from FBR National Trust Company are reflected in the Wealth Management and Trust Services segment since the date of their acquisition and assumption, February 9, 2006.
Information about the reportable segments and reconciliation of this information to the consolidated financial statements at and for the three months ended March 31, 2007 and 2006 is as follows:
At and for the Three Months Ended March 31, 2007 (in thousands):
At and for the Three Months Ended March 31, 2006 (in thousands):
At March 31, 2007, 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 companys most significant assets are its net investments in its subsidiaries. The parent companys net interest expense is comprised of interest income from short-term investments and interest expense on trust preferred securities. The parent companys non-interest expense is primarily non-allocable executive salaries and professional services related to the Companys regulatory requirements.
The following is the calculation of basic and diluted earnings per share for the three months ended March 31, 2007 and 2006. Stock options outstanding at March 31, 2007 and 2006 were 2,407,128 and 2,409,671, 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 32,510 and 487 for the three months ended March 31, 2007 and 2006, respectively.
Basic earnings per share is impacted by the number of shares required to be issued under the Companys various deferred compensation plans, and diluted earnings per share is impacted by those common shares which may be, but are not required to be, issued (depending on the elections of the participants) under these plans.
The following shows the calculation of basic outstanding shares for the three months ended March 31, 2007 and 2006:
The following shows the calculation of diluted outstanding shares for the three months ended March 31, 2007 and 2006:
The Company is a party to forward loan sales contracts, which are utilized to mitigate exposure to fluctuations in interest rates related to closed loans that are held for sale.
The Company designates these derivatives as cash flow hedges in accordance with Statement of Financial Accounting Standards (SFAS) No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended. These hedges are recorded at fair value in the statement of condition as an other asset or other liability with a corresponding offset to accumulated other comprehensive income in shareholders equity. Amounts are reclassified from accumulated other comprehensive income to the income statement in the period or periods that the loan sale is reflected in income.
At March 31, 2007, accumulated other comprehensive income included an after-tax unrealized gain of $36,000 related to forward loan sales contracts. Loans held for sale are generally sold within sixty days of closing and, therefore, substantially all of the amount recorded in accumulated other comprehensive income at March 31, 2007 that is related to the Companys cash flow hedges will be recognized in earnings during the second quarter of 2007. For the three months ended March 31, 2007, the hedge ineffectiveness recorded through earnings was immaterial.
At March 31, 2007, the derivative asset was $2.4 million and the derivative liability was $1.4 million. The Company had $125.0 million in loan commitments and $274.2 million in associated forward loan sales. The Company also had $274.2 million in forward loan sales contracts hedging the majority of its loans held for sale portfolio.
Goodwill and Other Intangibles
Information concerning total amortizable other intangible assets at March 31, 2007 is as follows:
The aggregate amortization expense for the three months ended March 31, 2007 and 2006 was $63,000 and $145,000, respectively.
The estimated amortization expense for the next five years is as follows:
The carrying amount of goodwill at March 31, 2007 was as follows:
The Company evaluates impairment of goodwill annually. During the period ending March 31, 2007, the Company performed an impairment evaluation on the assets acquired and liabilities assumed from FBR National Trust Company, and no impairment was indicated.
Commitments and Contingencies
The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. Commitments to extend credit are agreements to lend to a customer so long as there is no violation of any condition established in
the contract. Commitments generally have fixed expiration dates up to one year or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future funding requirements.
Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of the contractual obligations by a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing, and similar transactions. The credit risk involved in issuing standby letters of credit is essentially the same as that involved in extending loan facilities to customers. The Company holds certificates of deposit, deposit accounts, and real estate as collateral supporting those commitments when collateral is deemed necessary. The majority of these guarantees extend until satisfactory completion of the customers contractual obligations. All standby letters of credit outstanding at March 31, 2007 are collateralized.
These instruments represent obligations of the Company to extend credit or guarantee borrowings and are not recorded on the consolidated statements of financial condition. The rates and terms of these instruments are competitive with others in the market in which the Company operates. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated statements of financial condition. Credit risk is defined as the possibility of sustaining a loss because the other parties to a financial instrument fail to perform in accordance with the terms of the contract. The Companys maximum exposure to credit loss under standby letters of credit and commitments to extend credit is represented by the contractual amounts of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. The Company evaluates each customers creditworthiness on a case-by-case basis and requires collateral to support financial instruments when deemed necessary. The amount of collateral obtained upon extension of credit is based on managements credit evaluation of the counterparty. Collateral held varies but may include accounts receivable, inventory, property and equipment, and income-producing commercial properties.
At March 31, 2007, commitments to extend credit were $422.5 million and standby letters of credit were $9.0 million. The Company has not recorded a liability associated with standby letters of credit at March 31, 2007 as such amounts were immaterial.
George Mason maintains a reserve for loans sold that pay off earlier than the contractual agreed upon period, thereby requiring that George Mason refund part of the service release premium and/or premium pricing received from the investor. The reserve as of March 31, 2007 was $63,000.
The Company has derivative counter-party risk that may arise from the possible inability of George Masons third party investors to meet the terms of their forward sales contracts. George Mason works with third-party investors that are generally well-capitalized, are investment grade and exhibit strong financial performance to mitigate this risk. The Company does not expect any third-party investor to fail to meet its obligation.
New Accounting Pronouncement
The Company adopted the provisions of Financial Accounting Standards Board Interpretation No. 48 (FIN No. 48), Accounting for Uncertainty in Income Taxes, on January 1, 2007. This interpretation clarifies the accounting for uncertainty in income taxes recognized in an entitys financial statements in accordance with SFAS No. 109, Accounting for Income Taxes. FIN No. 48 prescribes a recognition threshold and measurement principles for financial statement disclosure of tax positions taken or expected to be taken on a tax return. FIN No. 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition.
As of March 31, 2007 and December 31, 2006, the Company had no unrecognized tax benefits. The Company also had no interest expense and/or tax penalties during the three months ended March 31, 2007. If the Company had such expenses, they would be classified in the consolidated statements of income as part of the provision for income tax expense.
The following presents managements discussion and analysis of our consolidated financial condition at March 31, 2007 and December 31, 2006 and the unaudited results of our operations for the three months ended March 31, 2007 and 2006. This discussion should be read in conjunction with our unaudited consolidated financial statements and the notes thereto appearing elsewhere in this report and 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, 2006.
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 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;
· risks and uncertainties related to future trust operations;
· changes in the operations of Wilson/Bennett Capital Management, Inc., its customer base and assets under management and any associated impact on the fair value of goodwill in the future;
· 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.
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 Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2006.
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 customers. 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 asset management firm. 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 25 branch office locations and seven 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 February 9, 2006, we acquired certain fiduciary and other assets and assumed certain liabilities of FBR National Trust Company, formerly a subsidiary of Friedman, Billings, Ramsey Group, Inc. Our trust division acts as trustee or custodian for assets in excess of $6.1 billion as of March 31, 2007. Services provided by this division include trust, estates, custody, investment management, escrows, and retirement plans. The trust division is included, along with CWS and Wilson/Bennett, in the Wealth Management and Trust Services segment. In prior periods, this segment was called Investment Services or Trust and Investment Services.
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 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, which includes trust revenues, gains and losses on sales of investment securities available-for-sale, gains on sales of loans, and management fee income.
Critical Accounting Policies
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 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, accounting for business combinations and impairment testing of goodwill, accounting for the impairment of intangible assets, and the valuation of deferred tax assets.
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 individual borrowers. Unusual and infrequently occurring events, such as 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.
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 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.
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 segments, as appropriate, and would negatively impact earnings.
Accounting for Economic Hedging Activities
We account for our derivatives and hedging activities in accordance with Statement of Financial Accounting Standards (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. We do not enter into derivative transactions for speculative purposes. For derivatives designated as hedges, 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 evaluate the effectiveness of these transactions at inception and on an ongoing basis. Ineffectiveness is recorded through earnings. For derivatives designated as cash flow hedges, the fair value adjustment is recorded as a component of other comprehensive income, except for the ineffective portion. For derivatives designated as fair value hedges, the fair value adjustments for both the hedged item and the hedging instrument are recorded through the income statement with any difference considered the ineffective portion of the hedge.
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 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 residential mortgage loans intended to be sold are considered derivatives and are marked to market through earnings.
To mitigate the effect of the interest rate risk inherent in providing rate lock commitments, we economically hedge our commitments by entering into a 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. The fair values of loan commitments and the fair values of forward loan sales contracts generally move in opposite directions, and the net impact of 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.
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 statements of condition and recognize any subsequent changes in 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.
Accounting for Business Combinations and Impairment Testing of Goodwill
We account for acquisitions of other businesses in accordance with 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 support our purchase allocations, 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 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.
Accounting for the Impairment of Intangible Assets
In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, we continually review our long-lived assets for impairment whenever events or changes in circumstances indicate that the remaining estimated useful life of such assets might warrant revision or that the balances may not be recoverable. We evaluate possible impairment by comparing estimated future cash flows, before interest expense and on an undiscounted basis, with the net book value of long-term assets, including amortizable intangible assets. If undiscounted cash flows are insufficient to recover assets, further analysis is performed in order to determine the amount of the impairment.
An impairment loss is then recorded for the excess of the carrying amount of the assets over their fair values. Fair value is usually determined based on the present value of estimated expected future cash flows using a discount rate commensurate with the risks involved.
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.
On July 13, 2006, the Financial Accounting Standards Board (FASB) issued Interpretation No. 48 (FIN No. 48), Accounting for Uncertainty in Income Taxes: an interpretation of FASB Statement No. 109. This interpretation clarifies the accounting for uncertainty in income taxes recognized in an entitys financial statements in accordance with SFAS No. 109, Accounting for Income Taxes. FIN No. 48 prescribes a recognition threshold and
measurement principles for financial statement disclosure of tax positions taken or expected to be taken on a tax return. This interpretation is effective for fiscal years beginning after December 15, 2006. The adoption of FIN No. 48 did not have any impact on our consolidated financial position or results of operations.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements. SFAS No. 157 defines fair value, establishes a framework for measuring fair value in accordance with U.S. generally accepted accounting principles, and expands disclosures about fair value measurements. The statement clarifies that the exchange price is the price in an orderly transaction between market participants to sell an asset or transfer a liability at the measurement date. The statement emphasizes that fair value is a market-based measurement and not an entity-specific measurement. It also establishes a fair value hierarchy used in fair value measurements and expands the required disclosures of assets and liabilities measured at fair value. This standard is effective for fiscal years beginning after December 15, 2007. The adoption of this standard is not expected to have a material impact on our consolidated financial position or results of operations.
In September 2006, the FASB issued SFAS No. 158, Employers Accounting for Defined Benefit Pension and Other Postretirement Plans. SFAS No. 158 amends SFAS Nos. 87, 88, 106 and 132R. SFAS No. 158 requires employers to recognize in its statement of financial position an asset for a plans overfunded status or a liability for a plans underfunded status. Secondly, it requires employers to measure the plan assets and obligations that determine its funded status as of the end of the fiscal year. Lastly, employers are required to recognize changes in the funded status of a defined benefit postretirement plan in the year that the changes occur with the changes reported in comprehensive income. The standard was effective for fiscal years ending December 15, 2006. Adoption of this standard did not have any impact on our consolidated financial position or results of operations.
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities including an amendment of FAS 115. SFAS No. 159 allows entities to choose, at specified election dates, to measure eligible financial assets and liabilities at fair value that are not otherwise required to be measured at fair value. If a company elects the fair value option for an eligible item, changes in that items fair value in subsequent reporting periods must be recognized in current earnings. SFAS No. 159 also establishes presentation and disclosure requirements designed to draw comparison between entities that elect different measurement attributes for similar assets and liabilities. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. We are currently evaluating the requirements of this standard.
Net income for the three months ended March 31, 2007 and 2006 was $1.8 million and $2.6 million, respectively, a decrease of $802,000, or 31%. The decrease in net income for the three months ended March 31, 2007 compared to the same period of 2006 is primarily a result of decreases in net interest income and increases in non-interest expense.
Net interest income after provision for loan losses decreased $590,000, or 6%, to $9.6 million for the three months ended March 31, 2007 compared to $10.1 million for the same period of 2006. This decrease is primarily a result of increases in interest expense which were greater than the increases in interest income. Non-interest income increased $146,000 to $5.3 million for the three months ended March 31, 2007 compared to $5.2 million for the same period of 2006. Non-interest expense increased $930,000, or 8%, to $12.4 million for the three months ended March 31, 2007, compared to $11.4 million for the same period of 2006.
Basic earnings per share were $0.07 and $0.11 for the three months ended March 31, 2007 and 2006, respectively. For the three months ended March 31, 2007 and 2006, diluted earnings per share were $0.07 and $0.10, respectively. Weighted average fully diluted shares outstanding for the three months ended March 31, 2007 and 2006 were 25,039,757 and 25,041,694, respectively.
Return on average assets for the three months ended March 31, 2007 and 2006 was 0.44% and 0.75%, respectively. Return on average equity for the three months ended March 31, 2007 and 2006 was 4.50% and 6.87%, respectively.
Net income attributable to the Commercial Banking segment for the three months ended March 31, 2007 and 2006 was $1.8 million and $2.6 million, respectively. The decrease in net income for the three months ended March 31, 2007 compared to the same period of 2006 in the Commercial Banking segment is primarily attributable to an increase in non-interest expense related to the additional branch offices opened over the past twelve months and a decline in net interest income.
Net income attributable to the Mortgage Banking segment for the three months ended March 31, 2007 and 2006 was $538,000 and $419,000, respectively. The increase in the Mortgage Banking segments net income for the three months ended March 31, 2007 compared to the same period of 2006 was due to decreases in non-interest expense related to expense controls put in place during the second half of 2006.
The Wealth Management and Trust Services segment, which includes CWS, Wilson/Bennett and the trust division of the Bank, recorded net income of $31,000 for the three months ended March 31, 2007, compared to net income of $26,000 for the same period 2006. The trust division of the Bank is included in the results of operations since the date of acquisition, February 9, 2006.
Net Interest Income
Net interest income represents the difference between interest and fees earned on interest-earning assets and the interest paid on deposits and other interest-bearing liabilities. The level of net interest income is impacted primarily by variations in the volume and mix of these assets and liabilities, as well as changes in interest rates. Net interest income for the three months ended March 31, 2007 and 2006 was $9.8 million and $10.4 million, respectively, a period-to-period decrease of $560,000, or 5%. The decrease in net interest income is primarily the result of the current interest margin pressure resulting from the inverted yield curve which is causing a higher increase in our cost of interest-bearing liabilities than our increase in the yields earned for average earning assets. Net interest income on a tax equivalent basis for the three months ended March 31, 2007 and 2006 was $9.9 million and $10.4 million, respectively.
Our net interest margin, which equals net interest income divided by average earning assets, was 2.60% and 3.16%, respectively, for the three months ended March 31, 2007 and 2006. The decrease in the net interest margin for the three months ended March 31, 2007 compared to the same period of 2006 is a result of a higher increase in the cost of interest-bearing liabilities
than the increase in yields earned for average earning assets. Tables 1 and 2 present an analysis of average earning assets and interest-bearing liabilities with related components of interest income and interest expense on a tax equivalent basis.