Annual Reports

 
Quarterly Reports

  • 10-Q (Nov 7, 2016)
  • 10-Q (Aug 5, 2016)
  • 10-Q (May 6, 2016)
  • 10-Q (Nov 6, 2015)
  • 10-Q (Aug 7, 2015)
  • 10-Q (May 8, 2015)

 
8-K

 
Other

Cardinal Financial 10-Q 2008

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

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

 

FORM 10-Q

 

x Quarterly Report Pursuant to Section 13 or 15(d)

of the Securities Exchange Act of 1934

 

For the quarterly period ended March 31, 2008

 

or

 

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
(State or other jurisdiction of
incorporation or organization)

 

54-1874630

(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   x   No   o

 

 

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

 

Large accelerated filer o

 

Accelerated filer x

 

 

 

Non-accelerated filer o (Do not check if a smaller reporting company)

 

Smaller reporting company 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 x

 

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

 

24,161,461 shares of common stock, par value $1.00 per share,
outstanding as of May 6, 2008

 

 



 

CARDINAL FINANCIAL CORPORATION

 

INDEX TO FORM 10-Q

 

PART I – FINANCIAL INFORMATION

 

Item 1. Financial Statements:

 

 

 

 

Consolidated Statements of Condition
At March 31, 2008 (unaudited) and December 31, 2007

3

 

 

 

 

Consolidated Statements of Income
For the three months ended March 31, 2008 and 2007 (unaudited)

4

 

 

 

 

Consolidated Statements of Comprehensive Income
For the three months ended March 31, 2008 and 2007 (unaudited)

5

 

 

 

 

Consolidated Statements of Changes in Shareholders’ Equity
For the three months ended March 31, 2008 and 2007 (unaudited)

6

 

 

 

 

Consolidated Statements of Cash Flows
For the three months ended March 31, 2008 and 2007 (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

45

 

 

Item 4. Controls and Procedures

46

 

 

PART II – OTHER INFORMATION

 

 

 

Item 1. Legal Proceedings

47

Item 1A. Risk Factors

47

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

47

Item 3. Defaults Upon Senior Securities

48

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

48

Item 5. Other Information

48

Item 6. Exhibits

48

 

 

SIGNATURES

49

 

2



 

PART I - FINANCIAL INFORMATION

 

Item 1.  Financial Statements

 

CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF CONDITION

 

March 31, 2008 and December 31, 2007

 

(In thousands, except share data)

 

 

 

March 31,

 

December 31,

 

 

 

2008

 

2007

 

 

 

(Unaudited)

 

 

 

Assets

 

 

 

 

 

Cash and due from banks

 

$

19,082

 

$

20,622

 

Federal funds sold

 

20,630

 

1,799

 

 

 

 

 

 

 

Total cash and cash equivalents

 

39,712

 

22,421

 

Investment securities available-for-sale

 

302,225

 

285,998

 

Investment securities held-to-maturity (market value of $61,297 and $78,168 at March 31, 2008 and December 31, 2007, respectively)

 

61,783

 

78,948

 

 

 

 

 

 

 

Total investment securities

 

364,008

 

364,946

 

 

 

 

 

 

 

Other investments

 

16,188

 

14,188

 

Loans held for sale

 

153,339

 

170,487

 

 

 

 

 

 

 

Loans receivable, net of deferred fees and costs

 

1,042,114

 

1,039,684

 

Allowance for loan losses

 

(11,858

)

(11,641

)

 

 

 

 

 

 

Loans receivable, net

 

1,030,256

 

1,028,043

 

 

 

 

 

 

 

Premises and equipment, net

 

17,938

 

18,463

 

Deferred tax asset

 

5,667

 

6,638

 

Goodwill and intangibles, net

 

17,176

 

17,239

 

Bank-owned life insurance

 

32,638

 

32,316

 

Accrued interest receivable and other assets

 

15,139

 

15,290

 

 

 

 

 

 

 

Total assets

 

$

1,692,061

 

$

1,690,031

 

 

 

 

 

 

 

Liabilities and Shareholders’ Equity

 

 

 

 

 

 

 

 

 

 

 

Noninterest bearing deposits

 

$

124,561

 

$

123,994

 

Interest bearing deposits

 

1,015,361

 

972,931

 

 

 

 

 

 

 

Total deposits

 

1,139,922

 

1,096,925

 

 

 

 

 

 

 

Other borrowed funds

 

361,069

 

400,060

 

Mortgage funding checks

 

6,300

 

9,403

 

Escrow liabilities

 

2,950

 

1,016

 

Accrued interest payable and other liabilities

 

19,037

 

23,164

 

 

 

 

 

 

 

Total liabilities

 

1,529,278

 

1,530,568

 

 

 

 

2008

 

2007

 

 

 

 

 

Common stock, $1 par value

 

 

 

 

 

 

 

 

 

Shares authorized

 

50,000,000

 

50,000,000

 

 

 

 

 

Shares issued and outstanding

 

24,164,061

 

24,201,561

 

24,164

 

24,202

 

Additional paid-in capital

 

131,339

 

131,516

 

Retained earnings

 

5,917

 

4,213

 

Accumulated other comprehensive gain (loss), net

 

1,363

 

(468

)

 

 

 

 

 

 

Total shareholders’ equity

 

162,783

 

159,463

 

 

 

 

 

 

 

Total liabilities and shareholders’ equity

 

$

1,692,061

 

$

1,690,031

 

 

See accompanying notes to consolidated financial statements.

 

3



 

CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF INCOME

 

Three months ended March 31, 2008 and 2007
(In thousands, except per share data)
(Unaudited)

 

 

 

2008

 

2007

 

Interest income:

 

 

 

 

 

Loans receivable

 

$

16,614

 

$

14,596

 

Loans held for sale

 

2,129

 

4,379

 

Federal funds sold

 

137

 

1,020

 

Investment securities available-for-sale

 

3,308

 

2,821

 

Investment securities held-to-maturity

 

749

 

1,002

 

Other investments

 

218

 

127

 

 

 

 

 

 

 

Total interest income

 

23,155

 

23,945

 

 

 

 

 

 

 

Interest expense:

 

 

 

 

 

Deposits

 

9,347

 

12,070

 

Other borrowed funds

 

3,473

 

2,040

 

Total interest expense

 

12,820

 

14,110

 

 

 

 

 

 

 

Net interest income

 

10,335

 

9,835

 

 

 

 

 

 

 

Provision for loan losses

 

320

 

280

 

 

 

 

 

 

 

Net interest income after provision for loan losses

 

10,015

 

9,555

 

 

 

 

 

 

 

Noninterest income:

 

 

 

 

 

Service charges on deposit accounts

 

527

 

466

 

Loan service charges

 

310

 

386

 

Investment fee income

 

900

 

1,024

 

Realized and unrealized gains on mortgage banking activities

 

2,317

 

2,630

 

Net realized gain on investment securities available-for-sale

 

 

14

 

Net realized loss on investment securities trading

 

(3

)

(9

)

Management fee income

 

84

 

321

 

Litigation recovery on previously impaired investment

 

190

 

33

 

Other income

 

286

 

444

 

 

 

 

 

 

 

Total noninterest income

 

4,611

 

5,309

 

 

 

 

 

 

 

Noninterest expense:

 

 

 

 

 

Salary and benefits

 

6,003

 

6,596

 

Occupancy

 

1,399

 

1,289

 

Professional fees

 

583

 

490

 

Depreciation

 

646

 

800

 

Data processing

 

442

 

344

 

Telecommunications

 

234

 

292

 

Amortization of intangibles

 

63

 

63

 

Other operating expenses

 

2,453

 

2,488

 

 

 

 

 

 

 

Total noninterest expense

 

11,823

 

12,362

 

 

 

 

 

 

 

Net income before income taxes

 

2,803

 

2,502

 

 

 

 

 

 

 

Provision for income taxes

 

761

 

737

 

 

 

 

 

 

 

Net income

 

$

2,042

 

$

1,765

 

 

 

 

 

 

 

Earnings per common share - basic

 

$

0.08

 

$

0.07

 

 

 

 

 

 

 

Earnings per common share - diluted

 

$

0.08

 

$

0.07

 

 

 

 

 

 

 

Weighted-average common shares outstanding - basic

 

24,482

 

24,510

 

 

 

 

 

 

 

Weighted-average common shares outstanding - diluted

 

24,892

 

25,040

 

 

See accompanying notes to consolidated financial statements.

 

4



 

CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

Three months ended March 31, 2008 and 2007

(In thousands)

(Unaudited)

 

 

 

2008

 

2007

 

 

 

 

 

 

 

Net income

 

$

2,042

 

$

1,765

 

Other comprehensive income:

 

 

 

 

 

Unrealized gain on available-for-sale investment securities:

 

 

 

 

 

Unrealized holding gain arising during the period, net of tax expense of $1.1 million in 2008 and tax expense of $127 thousand in 2007

 

2,070

 

246

 

 

 

 

 

 

 

Less: reclassification adjustment for gains included in net income net of tax expense of $5 thousand in 2007

 

 

(9

)

 

 

 

 

 

 

 

 

2,070

 

237

 

 

 

 

 

 

 

Unrealized gain (loss) on derivative instruments designated as cash flow hedges, net of tax benefit of $143 thousand in 2008 and tax expense of $21 thousand in 2007

 

(239

)

36

 

 

 

 

 

 

 

Comprehensive income

 

$

3,873

 

$

2,038

 

 

See accompanying notes to consolidated financial statements.

 

5



 

CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

Three months ended March 31, 2008 and 2007

 

(In thousands)

(Unaudited)

 

 

 

 

 

 

 

 

 

 

 

Accumulated

 

 

 

 

 

 

 

 

 

Additional

 

Retained

 

Other

 

 

 

 

 

Common

 

Common

 

Paid-in

 

Earnings

 

Comprehensive

 

 

 

 

 

Shares

 

Stock

 

Capital

 

(Deficit)

 

Income (Loss)

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, December 31, 2006

 

24,459

 

$

24,459

 

$

132,985

 

$

705

 

$

(2,276

)

$

155,873

 

Stock options exercised

 

10

 

10

 

37

 

 

 

47

 

Payment of deferred compensation shares

 

 

 

3

 

 

 

3

 

Dividends on common stock of $0.01 per share

 

 

 

 

(245

)

 

(245

)

Change in accumulated other comprehensive loss

 

 

 

 

 

273

 

273

 

Net income

 

 

 

 

1,765

 

 

1,765

 

Balance, March 31, 2007

 

24,469

 

$

24,469

 

$

133,025

 

$

2,225

 

$

(2,003

)

$

157,716

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, December 31, 2007

 

24,202

 

$

24,202

 

$

131,516

 

$

4,213

 

$

(468

)

$

159,463

 

Cumulative effect adjustment at January 1, 2008 for the adoption of SFAS No. 157

 

 

 

 

 

 

 

(96

)

 

 

 

(96

)

Stock compensation expense, net of tax benefits

 

 

 

75

 

 

 

75

 

Purchase and retirement of common stock

 

(38

)

(38

)

(252

)

 

 

(290

)

Dividends on common stock of $0.01 per share

 

 

 

 

(242

)

 

(242

)

Change in accumulated other comprehensive gain (loss)

 

 

 

 

 

1,831

 

1,831

 

Net income

 

 

 

 

2,042

 

 

2,042

 

Balance, March 31, 2008

 

24,164

 

$

24,164

 

$

131,339

 

$

5,917

 

$

1,363

 

$

162,783

 

 

See accompanying notes to consolidated financial statements.

 

6



 

CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

Three Months Ended March 31, 2008 and 2007

 

(In thousands)

 

(Unaudited)

 

 

 

2008

 

2007

 

 

 

 

 

 

 

Cash flows from operating activities:

 

 

 

 

 

Net income

 

$

2,042

 

$

1,765

 

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

 

 

 

 

 

Depreciation

 

646

 

800

 

Amortization of premiums, discounts and intangibles

 

113

 

172

 

Provision for loan losses

 

320

 

280

 

Loans held for sale originated

 

(320,979

)

(618,047

)

Proceeds from the sale of loans held for sale

 

339,533

 

645,103

 

Realized and unrealized gains on mortgage banking activities

 

(2,317

)

(2,630

)

Proceeds from sale, maturity and call of investment securities trading

 

4,916

 

1,992

 

Purchase of investment securities trading

 

(4,919

)

(2,001

)

Loss on sale of investments securities trading

 

3

 

9

 

Gain on sale of investment securities available-for-sale

 

 

(14

)

Increase in cash surrender value of bank-owned life insurance

 

(322

)

(432

)

Stock compensation expense, net of tax benefits

 

75

 

 

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

 

890

 

(602

)

Increase in accrued interest payable, escrow liabilities and other liabilities

 

3,676

 

774

 

 

 

 

 

 

 

Net cash provided by operating activities

 

23,677

 

27,169

 

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Net purchases of premises and equipment

 

(121

)

(899

)

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

 

50,695

 

26,346

 

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

 

13,492

 

 

Proceeds from sale of other investments

 

 

270

 

Purchase of investment securities available-for-sale

 

(54,778

)

(47,167

)

Purchase of mortgage-backed securities available-for-sale

 

(22,437

)

(3,355

)

Purchase of other investments

 

(2,000

)

(2,002

)

Redemptions of investment securities available-for-sale

 

7,300

 

5,223

 

Redemptions of investment securities held-to-maturity

 

3,625

 

3,271

 

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

 

(2,533

)

(25,395

)

 

 

 

 

 

 

Net cash used in investing activities

 

(6,757

)

(43,708

)

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

Net increase in deposits

 

42,997

 

13,520

 

Net increase (decrease) in other borrowed funds - short term

 

(83,366

)

23,663

 

Net decrease in mortgage funding checks

 

(3,103

)

(1,516

)

Proceeds from FHLB advances - long term

 

45,000

 

45,000

 

Repayments of FHLB advances - long term

 

(625

)

(1,625

)

Stock options exercised

 

 

47

 

Purchase and retirement of common stock

 

(290

)

 

Deferred compensation payments

 

 

3

 

Dividends on common stock

 

(242

)

(245

)

 

 

 

 

 

 

Net cash provided by financing activities

 

371

 

78,847

 

 

 

 

 

 

 

Net increase in cash and cash equivalents

 

17,291

 

62,308

 

 

 

 

 

 

 

Cash and cash equivalents at beginning of the period

 

22,421

 

36,076

 

 

 

 

 

 

 

Cash and cash equivalents at end of the period

 

$

39,712

 

$

98,384

 

 

 

 

 

 

 

Supplemental disclosure of cash flow information:

 

 

 

 

 

Cash paid during the period for interest

 

$

12,724

 

$

13,959

 

Cash paid for income taxes

 

4

 

2,181

 

 

See accompanying notes to consolidated financial statements.

 

7



 

CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2008

(Unaudited)

 

Note 1

 

Organization

 

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 and its subsidiary, George Mason Mortgage, LLC (“George Mason”), a mortgage banking company based in Fairfax, Virginia. The Company also owns Wilson/Bennett Capital Management, Inc. (“Wilson/Bennett”), an asset management firm and 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, 2008 are not necessarily indicative of the results to be expected for the full year ending December 31, 2008. 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, 2007.

 

Note 2

 

Stock-Based Compensation

 

At March 31, 2008, 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 Company’s common stock to employees and members of the Company’s and its subsidiaries’ boards of directors. There were 16,471 shares of the Company’s common stock available for future grants in the Option Plan as of March 31, 2008.

 

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 Company’s common stock.  There are 219,058 shares of the Company’s common stock available for future grants and awards in the Equity Plan as of March 31, 2008.

 

8



 

Stock options are granted with an exercise price equal to the common stock’s 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 Company’s share-based compensation plans for the three months ended March 31, 2008 and 2007 was $75,000 and $100,000, respectively. The total income tax benefit recognized in the income statement for share-based compensation arrangements was $26,000 and $35,000 for the three months ended March 31, 2008 and 2007, respectively.

 

There were no options granted during the three months ended March 31, 2008. The weighted average per share fair value of stock option grants made during the three months ended March 31, 2007 was $4.89.  The fair value of the options granted during the three months ended March 31, 2007 was estimated as of the grant date using the Black-Scholes option-pricing model based on the following weighted average assumptions:

 

 

 

Three Months Ended

 

 

 

March 31, 2007

 

 

 

 

 

Estimated option life

 

6.5 years

 

Risk free interest rate

 

4.81

%

Expected volatility

 

42.10

%

Expected dividend yield

 

0.40

%

 

Expected volatility is based upon the average annual historical volatility of the Company’s common stock. The estimated option life is derived from the “simplified method” formula as described in Staff Accounting Bulletin No. 110. 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.

 

9



 

Stock option activity during the three months ended March 31, 2008 is summarized as follows:

 

 

 

 

 

 

 

Weighted

 

 

 

 

 

 

 

Weighted

 

Average

 

Aggregate

 

 

 

 

 

Average

 

Remaining

 

Intrinsic

 

 

 

Number of

 

Exercise

 

Contractual

 

Value

 

 

 

Shares

 

Price

 

Term (Years)

 

($ 000)

 

Outstanding at December 31, 2007

 

2,428,353

 

$

8.53

 

 

 

 

 

Granted

 

 

 

 

 

 

 

Exercised

 

 

 

 

 

 

 

Forfeited

 

(2,100

)

10.83

 

 

 

 

 

Outstanding at March 31, 2008

 

2,426,253

 

$

8.73

 

6.45

 

$

340

 

Options exercisable at March 31, 2008

 

2,180,153

 

$

8.43

 

6.23

 

$

957

 

 

Total intrinsic value of options exercised during the three months ended March 31, 2007 was $50,000.  No options were exercised during the three months ended March 31, 2008.

 

A summary of the status of the Company’s non-vested stock options and changes during the three months ended March 31, 2008 is as follows:

 

 

 

 

 

Weighted

 

 

 

 

 

Average

 

 

 

Number of

 

Grant Date

 

 

 

Shares

 

Fair Value

 

Balance at December 31, 2007

 

292,028

 

$

5.30

 

Granted

 

 

 

Vested

 

(45,828

)

4.75

 

Forfeited

 

(100

)

3.05

 

Balance at March 31, 2008

 

246,100

 

$

5.40

 

 

At March 31, 2008, there was $1.6 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 3.3 years. The total fair value of shares that vested during the three months ended March 31, 2008 and 2007 were $169,000 and $360,000, respectively.

 

Note 3

 

Segment Information

 

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

 

10



 

individuals, including financial planning, retirement/estate planning, trust, estates, custody, investment management, escrows, and retirement plans.

 

Information about the reportable segments and reconciliation of this information to the consolidated financial statements at and for the three months ended March 31, 2008 and 2007 is as follows:

 

At and for the Three Months Ended March 31, 2008 (in thousands):

 

 

 

 

 

 

 

Wealth Management

 

 

 

 

 

 

 

 

 

Commercial

 

Mortgage

 

and

 

 

 

Intersegment

 

 

 

 

 

Banking

 

Banking

 

Trust Services

 

Other

 

Elimination

 

Consolidated

 

Net interest income

 

$

9,954

 

$

748

 

$

 

$

(367

)

$

 

$

10,335

 

Provision for loan losses

 

320

 

 

 

 

 

320

 

Non-interest income

 

1,065

 

2,635

 

900

 

11

 

 

4,611

 

Non-interest expense

 

7,714

 

2,556

 

873

 

680

 

 

11,823

 

Provision for income taxes

 

819

 

285

 

9

 

(352

)

 

761

 

Net income (loss)

 

$

2,166

 

$

542

 

$

18

 

$

(684

)

$

 

$

2,042

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total Assets

 

$

1,667,220

 

$

169,124

 

$

3,652

 

$

179,354

 

$

(327,289

)

$

1,692,061

 

Average Assets

 

$

1,625,965

 

$

142,991

 

$

3,724

 

$

177,700

 

$

(314,622

)

$

1,635,758

 

 

At and for the Three Months Ended March 31, 2007 (in thousands):

 

 

 

 

 

 

 

Wealth Management

 

 

 

 

 

 

 

 

 

Commercial

 

Mortgage

 

and

 

 

 

Intersegment

 

 

 

 

 

Banking

 

Banking

 

Trust Services

 

Other

 

Elimination

 

Consolidated

 

Net interest income

 

$

9,366

 

$

751

 

$

 

$

(282

)

$

 

$

9,835

 

Provision for loan losses

 

280

 

 

 

 

 

280

 

Non-interest income

 

996

 

3,277

 

1,024

 

12

 

 

5,309

 

Non-interest expense

 

7,489

 

3,191

 

1,040

 

642

 

 

12,362

 

Provision for income taxes

 

799

 

299

 

(47

)

(314

)

 

737

 

Net income (loss)

 

$

1,794

 

$

538

 

$

31

 

$

(598

)

$

 

$

1,765

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total Assets

 

$

1,654,253

 

$

330,558

 

$

5,282

 

$

163,384

 

$

(433,849

)

$

1,719,628

 

Average Assets

 

$

1,599,202

 

$

253,094

 

$

5,345

 

$

163,762

 

$

(407,609

)

$

1,613,794

 

 

At March 31, 2008, 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 expense 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 months ended March 31, 2008 and 2007. 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 223,765 and 32,510 for the three months ended March 31, 2008 and 2007, respectively.

 

11



 

(In thousands,
except per share data)

 

2008

 

2007

 

Net income available to common shareholders

 

$

2,042

 

$

1,765

 

Weighted average common shares - basic

 

24,482

 

24,510

 

Weighted average common shares - diluted

 

24,892

 

25,040

 

Earnings per common share - basic

 

$

0.08

 

$

0.07

 

Earnings per common share - diluted

 

$

0.08

 

$

0.07

 

 

Basic earnings per share is impacted by the number of shares required to be issued under the Company’s 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 composition of basic outstanding shares for the three months ended March 31, 2008 and 2007:

 

(in thousands)

 

2008

 

2007

 

Weighted average common shares outstanding

 

24,189

 

24,463

 

Weighted average shares attributable to the deferred compensation plans

 

293

 

47

 

Total weighted average shares - basic

 

24,482

 

24,510

 

 

The following shows the composition of diluted outstanding shares for the three months ended March 31, 2008 and 2007:

 

(in thousands)

 

2008

 

2007

 

Weighted average shares outstanding - basic (from above)

 

24,482

 

24,510

 

Incremental weighted average shares attributable to deferred compensation plans

 

250

 

243

 

Weighted average shares attributable to vested stock options

 

160

 

287

 

Incremental shares attributable to unvested stock options

 

 

 

Total weighted average shares - diluted

 

24,892

 

25,040

 

 

Note 5

 

Derivative Instruments and Hedging Activities
 

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.

 

12



 

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, 2008, accumulated other comprehensive income included an after-tax unrealized loss of $239,000 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, 2008 that is related to the Company’s cash flow hedges will be recognized in earnings during the second quarter of 2008. For the three months ended March 31, 2008, the hedge ineffectiveness recorded through earnings was immaterial.

 

At March 31, 2008, the Company had $70.1 million in loan commitments and associated forward sales and had $110.5 million in forward sales associated with $110.5 million of loans held for sale contracts. At March 31, 2008, the derivative asset was $3.4 million and the derivative liability was $3.4 million.

 

Note 6

 

Goodwill and Other Intangibles

 

Information concerning total amortizable other intangible assets at March 31, 2008 is as follows:

 

 

 

Mortgage Banking

 

Wealth Management
and Trust Services

 

Total

 

(In thousands)

 

Gross
Carrying
Amount

 

Accumulated

Amortization

 

Gross
Carrying
Amount

 

Accumulated
Amortization

 

Gross
Carrying
Amount

 

Accumulated
Amortization

 

Balance at December 31, 2007

 

$

1,781

 

$

643

 

$

795

 

$

489

 

$

2,576

 

$

1,132

 

2008 activity:

 

 

 

 

 

 

 

 

 

 

 

 

 

Customer relationship intangibles

 

 

49

 

 

10

 

 

59

 

Trade name

 

 

 

 

4

 

 

4

 

Balance at March 31, 2008

 

$

1,781

 

$

692

 

$

795

 

$

503

 

$

2,576

 

$

1,195

 

 

The aggregate amortization expense was $63,000 for each of the three months ended March 31, 2008 and 2007.

 

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

 

 

 

(In thousands)

 

2008 (April – December)

 

$

182

 

2009

 

238

 

2010

 

238

 

2011

 

238

 

2012

 

238

 

2013 and thereafter

 

246

 

 

13



 

The carrying amount of goodwill at March 31, 2008 was as follows:

 

(In thousands)

 

Commercial
Banking

 

Mortgage
Banking

 

Wealth
Management
and Trust
Services

 

Total

 

Balance at December 31, 2007

 

$

22

 

$

12,941

 

$

2,832

 

$

15,795

 

2008 activity

 

 

 

 

 

Balance at March 31, 2008

 

$

22

 

$

12,941

 

$

2,832

 

$

15,795

 

 

Goodwill of each of the Company’s business segments is tested for impairment on an annual basis or more frequently if events or circumstances warrant. During the period ending March 31, 2008, the Company performed an evaluation of the goodwill associated with its acquisition of FBR National Trust Company, part of the wealth management and trust services segment, and no impairment was indicated.

 

Note 7

 

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 and financial guarantees. 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.  The majority of these guarantees extend until satisfactory completion of the customer’s contractual obligations.  All standby letters of credit outstanding at March 31, 2008 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.  Commitments to extend credit of $70.1 million as of March 31, 2008 are related to George Mason’s pipeline and are of a short term nature.

 

At March 31, 2008, commitments to extend credit were $418.4 million and standby letters of credit were $10.3 million. The Company has a liability of $11,000 associated with standby letters of credit at March 31, 2008.

 

Those instruments may 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 Company’s maximum exposure to credit loss under standby letters of credit and commitments to extend credit is represented by the contractual amounts of those instruments.

 

14



 

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, 2008 was $18,000.  In addition, George Mason has established a reserve of $100,000 for the estimated exposure to repurchase loans previously sold to investors for which borrowers failed to provide full and accurate information on their loan application or for which appraisals have not been acceptable.  For the quarter ended March 31, 2008, George Mason has not repurchased nor settled with investors on any such loans.

 

George Mason, as part of the service it provides to its managed companies, purchases the loans managed companies originate at the time of origination.  These loans are then sold by George Mason to investors.  George Mason has agreements with its managed companies requiring that, for any loans that were originated by a managed company and for which investors have requested George Mason to repurchase due to the borrowers failure to provide full and accurate information on or related to their loan application or for which appraisals have not been acceptable, the managed company be responsible for buying back the loan.  In the event that the managed company’s financial condition deteriorates and it is unable to fund the repurchase of such loans, George Mason may have to provide the funds to repurchase these loans from investors.  As of March 31, 2008, the Company does not believe that it will incur any losses to fund any such loans that were originated by a managed company.

 

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 customer’s 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 management’s evaluation of the counterparty.  Collateral held varies but may include deposits held by the Company, marketable securities, accounts receivable, inventory, property, plant and equipment, and income-producing commercial properties.

 

The Company has derivative counter-party risk that may arise from the possible inability of George Mason’s 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.

 

Note 8

 

Fair Value Measurements

 

Effective January 1, 2008, the Company adopted SFAS No. 157, Fair Value Measurements, which established a framework for measuring fair value in accordance with U.S. generally accepted accounting principles, and expands disclosures about fair value measurements.  In addition, the Company adopted 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.

 

SFAS No. 157 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.  SFAS No. 157 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring the fair value.  There are three levels of inputs that may be used to measure fair value:

 

Level 1 – Quoted prices in active markets for identical assets or liabilities as of the measurement date.

 

Level 2 – Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations in which all significant inputs and significant value drivers are observable in active markets.

 

Level 3 – Valuations derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable.

 

15



 

Upon adoption or at any point during the first quarter of 2008, the Company did not designate any asset or liability to be measured at fair value under SFAS No. 159.

 

Fair Value of Investment Securities Available-for-Sale and Interest Rate Swap Derivatives

 

The Company’s investment securities available-for-sale are recorded at fair value using reliable and unbiased evaluations by an industry-wide valuation service and therefore fall into the Level 2 category.  This service uses evaluated pricing models that vary based on asset class and include available trade, bid, and other market information.  Generally, the methodology includes broker quotes, proprietary models, vast descriptive terms and conditions databases, as well as extensive quality control programs.

 

The Company’s interest rate swap derivatives are recorded at fair value using observable rates from a national valuation service.  These rates are applied to a third party industry-wide valuation model, and therefore, the valuations fall into a Level 2 category.

 

Information pertaining to the Company’s investment securities available-for-sale portfolio and interest rate swap derivatives as of March 31, 2008 is shown below:

 

At March 31, 2008 (in thousands)

 

 

 

 

 

Fair Value Measurements Using

 

Description

 

Balance

 

Quoted Prices in
Active Markets for
Identical Assets
(Level 1)

 

Significant
Other
Observable
Inputs
(Level 2)

 

Significant
Unobservable
Inputs
(Level 3)

 

Investment securities available-for-sale

 

$

302,225

 

 

 

$

302,225

 

 

 

Derivative asset - interest rate swaps

 

1,054

 

 

 

1,054

 

 

 

Derivative liability - interest rate swaps

 

1,029

 

 

 

1,029

 

 

 

 

Fair Value of Interest Rate Lock Commitments, Forward Loan Sales and Mortgage Loans Held for Sale

 

In the normal course of business, George Mason enters into contractual interest rate lock commitments to extend credit to borrowers with fixed expiration dates.  The commitments become effective when the borrowers “lock-in” a specified interest rate within the time frames established by George Mason.  All borrowers are evaluated for credit worthiness prior to the extension of the commitment.  Market risk arises if interest rates move adversely between the time of the interest rate lock by the borrower and the sale date of the loan to an investor.  To mitigate the effect of the interest rate risk inherent in providing rate lock commitments to borrowers, George Mason enters into best efforts forward sales contracts to sell loans to investors.  The forward sales contracts lock in an interest rate and price for the sale of loans similar to the specific rate lock commitments.  Both the rate lock commitments to the borrowers and the forward sales contracts to investors are undesignated derivatives pursuant to the requirements of SFAS No. 133, as amended, and, accordingly, are marked to fair value through earnings.

 

Staff Accounting Bulletin No. 109, Written Loan Commitments Recorded at Fair Value Through Earnings, (“SAB No. 109”) was effective for written loan commitments initiated on or after January 1, 2008.  SAB No. 109 requires that the expected cash flows related to the servicing of a loan be included in the fair value measurement of a derivative loan commitment.  SAB No. 109 replaces Staff Accounting Bulletin No. 105, Application of Accounting Principles to Loan Commitments, which precluded the consideration of servicing cash flows in determining the fair value of a written loan commitment.

 

The effects of fair value measurements for the interest rate lock commitment derivatives and forward sales contract derivatives on earnings in the three months ended March 31, 2008 were as follows and were all based on Level 2 inputs:

 

(in thousands)

 

Notional
or
Principal
Amount

 

Expected
Premium
(Discount)
to Par

 

Movement of
Interest
Rates

 

Security
Price
Change

 

Total Fair
Value
Adjustment

 

Rate lock commitments

 

$

70,066

 

$

376

 

$

172

 

$

 

$

548

 

Forward sales contracts

 

121,422

 

 

 

(307

)

(307

)

Loans held for sale

 

51,356

 

439

 

135

 

 

574

 

 

 

 

 

$

815

 

$

307

 

$

(307

)

$

815

 

 

The expected premium (discount) to par considers two elements (a) the interest rate differential and (b) the servicing rights value.  The interest rate differential is the difference, if any, between the mortgage loan rates to be paid by the borrower in the retail market and mortgage loan pricing demanded by investors in the secondary or wholesale market.  The Company sells all of its loans on a servicing released basis, and receives a servicing release premium upon sale.  The servicing rights value is based on contractual terms with investors and ranged from 0.17% to 2.75% of the loan amount, depending on the loan type.  The Company assumes an approximate 40% fallout rate based on recent historical experience when measuring the fair value of the rate lock commitments.  Fallout is defined as interest rate lock commitments for which the Company does not close a mortgage loan.

 

16



 

The fair value of the forward sales contracts to investors considers the market price movement of the same type of security between the trade date and the balance sheet date.  The market price changes are multiplied by the notional amount of the forward sales contracts to measure the fair value.

 

To calculate the effects of the changes in interest rates from the date of the commitment through loan origination, and then period end, the Company utilizes applicable published mortgage-backed investment security prices, and multiplies the price movement between the rate lock date and the balance sheet date by the notional loan commitment amount.

 

At loan closing, the fair value of the interest rate lock commitment is included in the cost basis of loans held for sale.  Loans held for sale are carried at the lower of cost or fair value.

 

Prior to the adoption of SAB No. 109 and SFAS No. 157, the fair value calculation for interest rate lock commitments and forward sales contracts only considered the effects of interest rate changes between the date of the rate lock and either the loan closing date or the balance sheet date.  For the three months ended March 31, 2008, the change in fair value of the interest rate lock commitments, loans held for sale, and forward loan sales contracts based only on changes in market interest rates was $307,000.  Interest rate movements have an offsetting impact on the security prices that serve to measure the fair value of these instruments.

 

The impact of adopting SFAS No. 157 and SAB No. 109 on the Company’s statement of operations for the three months ended March 31, 2008 had the effect of recognizing gains associated with the Company’s mortgage loan sales activities in the first quarter rather than in a future reporting period at a time when the loan commitments would mature into closed loans and these closed loans and the Company’s existing loans held for sale would be delivered to the Company’s investors at which time the Company would receive payment.  An unrealized gain of $815,000 is reported as a component of realized and unrealized gains on mortgage banking activities reported in the statement of operations.

 

SFAS No. 157 Adoption Adjustment

 

The transition provisions of SFAS No. 157 provide for retrospective application to financial instruments that were measured at fair value at initial recognition using a transaction pricing in accordance with specific accounting literature.  The Company’s interest rate lock commitments were measured at inception at the transaction price.  SFAS No. 157 provides that at the date of adoption (January 1, 2008) a difference between the carrying amounts and the fair values of these instruments should be recognized as a cumulative effect adjustment to the opening balance of retained earnings.  The amount of this cumulative effect adjustment was $96,000.

 

Managed Company Loans

 

George Mason serves as a pass through conduit for the managed companies to sell loans to investors in the secondary market.  Concurrent with entering into a rate lock agreement with a borrower, the managed company loan is sold forward to an investor in the secondary market.  After the managed company closes the loan, it is assigned to George Mason.  George Mason then facilitates the transfer of the loan to the investor.  George Mason does not earn any spread or other fees from the loan assignment nor from the transfer to the investor.  All gains in the loan sale are earned by the managed company.  At March 31, 2008, loans held for sale includes $56.1 million of loans originated by the managed companies that will be delivered to the investors by George Mason.  Any change in the fair value of the loans held for sale originated by the managed company will result in an equal an offsetting change in liability to the managed company.

 

17



 

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 March 31, 2008 and December 31, 2007 and the unaudited results of our operations for the three months ended March 31, 2008 and 2007. 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, 2007.

 

Caution About Forward-Looking Statements

 

We make certain 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 including the local and national economy;

·                  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.

 

18



 

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, 2007.

 

Overview

 

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., asset management services through Wilson/Bennett and services through our trust division which 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.

 

Net interest income is our primary source of revenue. We define revenue as net interest income plus noninterest 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, noninterest income is an 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 mortgage loans, and management fee income.

 

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, judgments and estimates when applying these principles where precise measurements are not possible or practical.  These policies are critical because they are highly

 

19



 

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 amortizing intangible assets and other long-lived assets, 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 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 typically apply, in accordance with regulatory guidelines, a 5% loss factor to loans classified as special mention, a 15% loss factor to loans classified as substandard and a 50% loss factor to loans classified as doubtful. Loans classified as loss loans are fully reserved or charged off.   In certain instances, we evaluate the impairment of certain loans on a loan by loan basis.  For these loans, we analyze the fair value of the collateral underlying the loan and consider estimated costs to sell the collateral on a discounted basis.  If the net collateral value is less than the loan balance (including accrued interest and any unamortized premium or discount associated with the loan) we recognize an impairment and establish a specific reserve for the impaired loan.

 

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.

 

20



 

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 which is recorded in earnings.  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.

 

We discontinue hedge accounting prospectively when it is determined that the derivative is no longer highly effective. In situations in which cash flow hedge accounting is discontinued, we continue to carry the derivative at its fair value on the statement of condition and recognize any subsequent changes in fair value in earnings over the term of the forecasted transaction. When hedge accounting is discontinued because it is probable that a forecasted transaction will not occur, we recognize immediately in earnings any gains and losses that were accumulated in other comprehensive income.

 

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 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.   The forward sales contract is then designated as a hedge against the variability in cash to be received from the loan sale.  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.

 

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

 

21



 

estimate fair value of acquired assets and liabilities. 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 unit’s 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 Amortizing Intangible Assets and Other Long-Lived 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.

 

Valuation of Deferred Tax Assets

 

We record a provision for income tax expense based on the amounts of current taxes payable or refundable and the change in net deferred tax assets or liabilities during the year. Deferred tax assets and liabilities are recognized for the tax effects of differing carrying values of assets and liabilities for tax and financial statement purposes that will reverse in future periods. When substantial uncertainty exists concerning the recoverability of a deferred tax asset, the carrying value of the asset is reduced by a valuation allowance. The amount of any valuation allowance established is based upon an estimate of the deferred tax asset that is more likely than not to be recovered. Increases or decreases in the valuation allowance result in increases or decreases to the provision for income taxes.

 

New Financial Accounting Standards
 

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

 

22



 

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.  See Note 8 to the notes to the consolidated financial statements above.

 

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 item’s 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.  See Note 8 to the notes to the consolidated financial statements above.

 

In November 2007, the SEC issued Staff Accounting Bulletin No. 109 (“SAB No. 109”), Written Loan Commitments Recorded at Fair Value Through Earnings.  SAB No. 109 requires fair value measurements of derivatives or other written loan commitments recorded through earnings to include the future cash flows related to the loan’s servicing rights.  SAB No. 109 also states that internally developed intangible assets should be excluded from these measurements.  SAB No. 109, which supersedes SAB No. 105, Application of Accounting Principles to Loan Commitments, applies to all loan commitments that are accounted for at fair value through earnings.  Previously, SAB No. 105 applied to only derivative loan commitments accounted for at fair value through earnings.  SAB No. 109 should be applied prospectively to derivative loan commitments issued or modified in fiscal quarters beginning after December 15, 2007. See Note 8 to the notes to the consolidated financial statements above.

 

In December 2007, the SEC issued Staff Accounting Bulletin No. 110 (“SAB No. 110”), Certain Assumptions Used in Valuation Methods.  SAB No. 110 extends the use of the “simplified” method, under certain circumstances, in developing an estimate of expected term of “plain vanilla” share options in accordance with SFAS No. 123R, Share-Based Payment.  Prior to the issuance of SAB No. 110, SAB No. 107 stated that the simplified method was only available for grants made up to December 31, 2007.  We are continuing the use of the simplified method.

 

In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities.  SFAS No. 161 amends SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, requires companies with derivative instruments to disclose information about how and why a company uses derivative instruments, how derivative instruments and related hedged items are accounted for under SFAS No. 133, and how derivative instruments and related hedged items affect a company’s financial position, financial performance, and cash flows.  The required disclosures include the fair value of derivative instruments and their gains and losses in tabular format, information about credit-risk-related contingent features in derivative agreements, counterparty credit risk, and the company’s strategies and objectives for using derivative instruments.  SFAS No. 161 is effective prospectively for periods beginning on or after November 15, 2008.  The adoption of this standard is not expected to have a material impact on our consolidated financial condition or results of operations.

 

23



 

Statements of Income
 

General

 

Net income for the three months ended March 31, 2008 and 2007 was $2.0 million and $1.8 million, respectively, an increase of $277,000, or 16%.  The increase in net income is primarily a result of an increase in net interest income for the three months ended March 31, 2008 compared to the same three month period of 2007.

 

Net interest income after the provision for loan losses increased $460,000 to $10.0 million for the three months ended March 31, 2008 compared to $9.6 million for the three months ended March 31, 2007.  The increase in net interest income after provision for loan losses is a direct result of a decrease in our interest expense for the three months ended March 31, 2008 of $1.3 million, offset by a decrease in interest income of $790,000 and an increase in provision for loan losses of $40,000 all as compared to the same period of 2007.

 

Noninterest income for the three months ended March 31, 2008 was $4.6 million, a decrease of $698,000, or 13%, compared to $5.3 million for the three months ended March 31, 2007.  The decrease in noninterest income is primarily due to the decrease in realized and unrealized gains on mortgage banking activities of $313,000, or 12%, to $2.3 million for the three months ended March 31, 2008 as compared to $2.6 million for the three months ended March 31, 2007.  Management fee income also decreased to $84,000 for the three months ended March 31, 2008, compared to $321,000 for the same period of 2007.  These decreases are a result of the tightening credit conditions within the mortgage industry and the slowdown in the regional housing market.

 

Noninterest expense decreased $539,000, or 4%, to $11.8 million for the three months ended March 31, 2008, compared to $12.4 million for the same period of 2007.  The decrease in noninterest expense is primarily attributable to a decrease in salary and benefits expense of $593,000 for the three months ended March 31, 2008 compared to the same period of 2007 due to the decrease in the level of staffing and commissions paid at our mortgage banking subsidiary.

 

Basic and diluted earnings per common share was $0.08 for the three months ended March 31, 2008.  Basic and diluted earnings per common share for the three months ended March 31, 2007 was $0.07.  Weighted average fully diluted shares outstanding for the three months ended March 31, 2008 and 2007 was 24,891,673 and 25,039,757, respectively.

 

Return on average assets for the three months ended March 31, 2008 and 2007 was 0.50% and 0.44%, respectively. Return on average equity for the three months ended March 31, 2008 and 2007 was 5.06% and 4.50%, respectively.  The efficiency ratio for the three months ended March 31, 2008 and 2007 was 79.10% and 81.63%, respectively.  Non-interest income to average assets for the three months ended March 31, 2008 and 2007 was 1.13% and 1.32%, respectively.

 

Net income attributable to the commercial banking segment for the three months ended March 31, 2008 and 2007 was $2.2 million and $1.8 million, respectively.  The increase in net income for the three months ended March 31, 2008 compared to the same period of 2007 in the commercial banking segment is primarily attributable to an increase in net interest income.

 

The mortgage banking segment reported net income of $542,000 for the three months ended March 31, 2008 compared to net income of $538,000 for the three months ended March 31, 2007.  The increase in net income for the three months ended March 31, 2008 was primarily attributable to the adoption of SFAS No. 157 and SAB No. 109, which resulted in an increase in earnings of approximately $597,000 net of tax.

 

24



 

The wealth management and trust services segment, which includes CWS, Wilson/Bennett and the trust division of the Bank, recorded net income of $18,000 and $31,000 for the three month periods ended March 31, 2008 and 2007, respectively. 

 

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, 2008 and 2007 was $10.3 million and $9.8 million, respectively, a period-to-period increase of $500,000, or 5%. The increase in net interest income is primarily the result of a greater decrease in our cost of interest-bearing liabilities than our decrease in the yields earned for average earning assets.  We have certain loans and investment securities for which a portion of the income realized is tax-exempt.  Net interest income on a tax equivalent basis for the three months ended March 31, 2008 and 2007 was $10.4 million and $9.9 million, respectively. 

 

Our net interest margin, which equals net interest income divided by average earning assets, was 2.69% and 2.60%, respectively, for the three months ended March 31, 2008 and 2007. The increase in the net interest margin for the three months ended March 31, 2008 compared to the same period of 2007 is a result of a greater decrease in the cost of interest-bearing liabilities than the decrease 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.

 

25



 

Average Balance Sheets and Interest Rates on Interest-Earning Assets and Interest-Bearing Liabilities

Three Months Ended March 31, 2008, 2007, and 2006

(In thousands)

 

 

 

2008

 

2007

 

2006

 

 

 

 

 

Interest

 

Average

 

 

 

Interest

 

Average

 

 

 

Interest

 

Average

 

 

 

Average

 

Income/

 

Yield/

 

Average

 

Income/

 

Yield/

 

Average

 

Income/

 

Yield/

 

 

 

Balance

 

Expense

 

Rate

 

Balance

 

Expense

 

Rate

 

Balance

 

Expense

 

Rate

 

Assets

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest-earning assets:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Loans (1):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Commercial and industrial

 

$

137,047

 

$

2,355

 

6.87

%

$

103,408

 

$

1,949

 

7.54

%

$

73,098

 

$

1,305

 

7.14

%

Real estate - commercial

 

415,147

 

6,839

 

6.59

%

324,412

 

5,340

 

6.58

%

271,044

 

4,392

 

6.48

%

Real estate - construction

 

190,882

 

3,222

 

6.75

%

160,346

 

3,382

 

8.44

%

129,026

 

2,539

 

7.87

%