Cowlitz Bancorporation 10-Q 2006
SECURITIES AND EXCHANGE COMMISSION
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.
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 [ ] Accelerated filer [X] Non-accelerated filer
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).
Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.
Common Stock, no par value on October 31, 2006: 4,884,748 shares
Managements discussion and the information in this document and the accompanying financial statements contain forward-looking statements, within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements, which are based on certain assumptions and describe future plans, strategies and expectations of the Company, are generally identifiable by words such as "expect", "believe", "intend", "anticipate", "estimate" or similar expressions, and are subject to risks and uncertainties that could cause actual results to differ materially from those stated. Examples of such risks and uncertainties that could have a material adverse effect on the operations and future prospects of the Company, and could render actual results different from those expressed in the forward-looking statements, include, without limitation: those set forth in our most recent Form 10-K and other filings with the SEC, changes in general economic conditions, competition for financial services in the market area of the Company, the level of demand for loans, quality of the loan and investment portfolio, deposit flows, legislative and regulatory initiatives, and monetary and fiscal policies of the U.S. Government affecting interest rates. The reader is advised that this list of risks is not exhaustive and should not be construed as any prediction by the Company as to which risks would cause actual results to differ materially from those indicated by the forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
1. Organization and Summary of Significant Accounting Policies
Organization- Cowlitz Bancorporation (the Company) was organized in 1991 under Washington law to become the holding company for Cowlitz Bank (the Bank), a Washington state-chartered bank that commenced operations in 1978. The principal executive offices of the Company are located in Longview, Washington. The Bank operates four branches in Cowlitz County in southwest Washington. Outside of Cowlitz County, the Bank does business under the name Bay Bank with branches in Seattle, Bellevue and Vancouver, Washington, a full service branch in Portland, Oregon and a limited service branch in a retirement center in Wilsonville, Oregon. The Bank also provides mortgage-banking services through its Bay Mortgage division with offices in Longview and Vancouver.
The Company offers or makes available a broad range of financial services to its customers, primarily small and medium-sized businesses, professionals, and retail customers. The Bank's commercial and personal banking services include commercial and real estate lending, international banking services, internet banking, trust services, mortgage banking and consumer lending.
Principles of consolidation- The accompanying consolidated financial statements include the accounts of the Company and its subsidiary. All significant intercompany transactions and balances have been eliminated. Certain reclassifications have been made in prior years data to conform to the current years presentation.
The interim financial statements have been prepared without an audit and in accordance with the instructions to Form 10-Q, generally accepted accounting principles, and banking industry practices. Accordingly, they do not include all the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments, including normal recurring accruals necessary for a fair presentation of the financial condition and results of operations for the interim periods included herein, have been made. The results of operations for the three and nine months ended September 30, 2006 are not necessarily indicative of results to be anticipated for the year ending December 31, 2006. The interim consolidated financial statements should be read in conjunction with the December 31, 2005 consolidated financial statements, including the notes thereto, included in the Companys 2005 Form 10-K.
Operating segments- Internal financial information is primarily recorded and aggregated in three lines of business: commercial banking, mortgage banking, and trust services. While management monitors the revenue streams of the various products and services, the mortgage banking, international trade services and trust segments are not individually material and operations are managed and financial performance is evaluated on a company-wide basis. Accordingly, all financial service operations are considered by management to be aggregated within one reportable operating segment.
Use of estimates in preparation of the consolidated financial statements- Preparation of the consolidated financial statements, in conformity with accounting principles generally accepted in the United States of America, requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Significant estimates include the allowance for credit losses and carrying values of the Company's goodwill and other intangibles.
Hedging activities- In the ordinary course of business, the Company may enter into derivative transactions to manage its exposure to interest rate fluctuations. Derivatives that may be used for interest rate risk management include interest rate swaps, futures, forward and option structures with indices that relate to the pricing of specific on-balance sheet assets. Under the guidance of Statement of Financial Accounting Standards (SFAS) No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended, all derivative instruments that qualify for hedge accounting are recorded on the balance sheet at fair value and classified either as a hedge of the fair value of a recognized asset, liability or firm commitment (fair value hedge) or as a hedge of the variability of cash flows to be received or paid related to a recognized asset or liability or a forecasted transaction (cash flow hedge). The Company formally documents all relationships between hedging instruments and hedged items, as well as its risk-management objective and strategy, at the inception of each hedge transaction. The Company performs an assessment, both at inception of the hedge and on a quarterly basis thereafter, when required, to determine whether these derivatives are highly effective in offsetting changes in the value of the hedged items.
In March 2006, the Company entered into a 5-year interest rate floor agreement to hedge the variability of expected interest income related to loans priced with a floating rate index. The notional amount of this agreement is $50 million. For the purpose of this hedge, the Company elected to exclude the time value portion of the interest rate
floor agreement. The effective portion of the change in the fair value of the derivative instrument is recorded as a component of other comprehensive income and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. The remaining gain or loss on the derivative instrument in excess of the cumulative change in the present value of future cash flows of the hedged item, if any, is recognized in other non-interest expenses during the period of change.
Recently Issued Accounting Standards- In February 2006, the Financial Accounting Standards Board ("FASB") issued FASB Statement No. 155, Accounting for Certain Hybrid Instruments. The Statement provides entities with relief from having to separately determine the fair value of an embedded derivative that would otherwise be required to be bifurcated from its host contract in accordance with Statement 133. Statement 155 allows an entity to make an irrevocable election to measure such a hybrid financial instrument at fair value in its entirety, with changes in fair value recognized in earnings. The Statement also (1) clarifies which interest-only strips and principal-only strips are not subject to Statement 133; (2) establishes a requirement for holders of securitized financial assets to evaluate whether the interest is a freestanding derivative or a hybrid financial instrument that contains an embedded derivative requiring bifurcation; (3) clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives; and (4) eliminates the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. The Statement is effective for all financial instruments acquired, issued or subject to a re-measurement event occurring after the beginning of an entity's first fiscal year that begins after September 15, 2006, and is not expected to have any significant impact on the Company's financial condition or results of operations.
In March 2006, the FASB issued Statement No. 156, Accounting for Servicing of Financial Assets. The Statement provides relief for loan servicers that use derivatives to economically hedge fluctuations in the fair value of loan servicing rights. The Statement allows servicers the option to measure their servicing rights at fair value, which is the same accounting basis used to measure derivatives. A servicer can also choose to continue applying the existing amortization method in Statement 140. The Statement also requires additional disclosures regardless of which method is applied. The Statement is effective as of the beginning of the first fiscal year that begins after September 15, 2006, and is not expected to have a significant impact on the Company's financial condition or results of operations.
In July 2006, the FASB issued FASB Interpretation No. 48 ("FIN 48"), Accounting for Uncertainty in Income Taxes: an interpretation of FASB Statement No. 109. FIN 48 clarifies Statement 109, Accounting for Income Taxes, to indicate a criterion that an individual tax position would have to meet for some or all of the benefit of that position to be recognized in an entity's financial statements. FIN 48 is effective for fiscal years beginning after December 15, 2006 and is not expected to have a significant impact on the Company's consolidated financial condition or results of operations.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements. The Statement provides enhanced guidance for measuring assets and liabilities using fair value and applies whenever other standards require or permit assets or liabilities to be measured at fair value. Statement 157 also requires expanded disclosure of items that are measured at fair value, the information used to measure fair value, and the effect of fair value measurements on earnings. The Statement is effective for financial statements issued for fiscal years beginning after November 15, 2007 and is not expected to have a significant impact on the Company's consolidated financial condition or results of operations.
In October 2006, the FASB issued SFAS No. 158, Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans. The Statement is an amendment of Statements No. 87, 88, 106, and 132(R). Statement 158 requires most public companies, as defined in the Statement, to fully recognize an asset or liability for the overfunded or underfunded status of their post retirement benefit plans in financial statements. The Statement is effective for entities with publicly traded equity securities for fiscal years ending after December 15, 2006 and is not expected to have a significant impact on the Company's consolidated financial condition or results of operations.
For the purpose of presentation in the statements of cash flows, cash and cash equivalents include cash on hand, amounts due from banks including short-term certificates of deposit, and federal funds sold. Federal funds sold generally mature the day following purchase.
The following table reconciles the denominator of the basic and diluted earnings per share computations:
At September 30, 2006, the Company had one stock-based compensation plan (the Plan) available for issuing option grants and an Employee Stock Purchase Plan (ESPP). Under the Plan, options may be granted to the Companys employees, non-employee directors and others whom management believes contribute to the long-term financial success of the Company. The Plan permits the grant of stock options and restricted stock grants for up to 500,000 shares, of which 4,000 share grants remained available for issue at September 30, 2006. The exercise price of nonqualified stock options under the Plan must be at least equal to the fair value of the common stock on the date of grant, and the vesting schedule is set at the discretion of the Board of Directors Compensation Committee.
The Company adopted SFAS No. 123(R) on January 1, 2006 using the modified prospective method, and, accordingly, did not restate consolidated net income for prior interim periods or fiscal years. Compensation cost recognized in the first quarter of 2006 included: (1) compensation cost for all share-based payments granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with SFAS 123; and (2) compensation cost for all share-based awards granted on or after January 1, 2006. Prior to the adoption of SFAS No. 123(R), the Company presented all tax benefits of deductions resulting from the exercise of stock options as operating cash flows in the Statement of Cash Flows. SFAS No. 123(R) requires the cash flows from the tax benefits resulting from tax deductions in excess of the compensation costs recognized for those options (excess tax benefits) to be classified as financing cash flows.
As a result of adopting SFAS No. 123(R) on January 1, 2006, the Companys income before income taxes was lower by $15,000 and $48,000 in the third quarter and first nine months of 2006, respectively. Net income was lower by $10,000 for the third quarter and $31,000 for the first nine months of 2006 than if the Company had continued to account for share-based compensation under APB No. 25. There was no significant impact on basic and diluted earnings per share, cash flows from operations or financing activities for the third quarter or first nine months of 2006 related to the expensing of stock-based compensation. In addition, during the first six months of 2006, the Company recognized expense of $43,000 related to the accelerated vesting of stock options for one former employee and one former director whose services ceased during the period. As of September 30, 2006, there was approximately $30,000 of unrecognized compensation costs related to stock options, expected to be recognized over a weighted-average period of 0.7 years.
The following table summarizes information about stock option activity for the nine months ended September 30, 2006:
The fair value of each option grant was estimated as of the grant date using the Black-Scholes option-pricing model based on the following assumptions. Expected volatility is based on the historical volatility of the price of the Companys stock for a period consistent with the expected life of the options. The Company uses historical data to estimate option exercise and employee termination rates within the valuation model. The expected term of options represents the period of time that stock options are expected to be outstanding and is estimated based on historical exercise and forfeiture activity. Expected dividends are estimated to be zero due to the Companys recent historical practice of not paying dividends. The risk-free rate of return for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of the grant.
Under SFAS No. 123, the Black-Scholes option pricing model was used to estimate the fair value of options granted in the first nine months of 2005 using weighted average assumptions as follows: expected volatility of 35.1%; expected term of 4.26 years; dividend yield of zero; and risk-free interest rate of 4.00% . Pro forma net income and earnings per share information are provided in the following table as if the Company accounted for employee stock option plans under the fair value method of SFAS No. 123 in the first nine months of 2005.
Stock options granted in the first nine months of 2005 were fully vested upon grant, resulting in full recognition of stock-based compensation expense under the fair value method in the pro forma amounts in the table above.
The Companys ESPP allows eligible employees to defer from 1% to 10% of their salaries over a period of six months in order to purchase shares of company stock. The purchase price is set at 85% of the lowest market price on either the first or last day of the six-month deferral period. The Company is authorized to issue up to 175,000 shares of common stock under the ESPP. The Company issued 2,997 shares on June 30, 2006 under the ESPP, and there were 108,257 shares remaining for issuance. Shares issued under the ESPP in 2005 totaled 5,925. Under SFAS No.123(R), the plan is considered compensatory, however, compensation expense related to the ESPP for the first nine months of 2006 and 2005 was not significant.
For the Company, comprehensive income primarily includes net income reported on the statements of income and changes in the fair value of available-for-sale investment securities. These amounts are included in Accumulated Other Comprehensive Income (Loss) on the consolidated statement of changes in shareholders equity.
The following table presents the composition and carrying value of the Companys available for sale investment portfolio:
The following table presents the gross unrealized losses and fair value of the Companys investment securities aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at September 30, 2006:
At September 30, 2006, there were 46 investment securities in an unrealized loss position, of which 32 were in a continuous loss position for 12 months or more. The Company believes these unrealized losses were due to changes in market interest rates and not credit quality. The Company has the ability and intent to hold these securities until a market price recovery or to maturity, and, therefore, the unrealized losses on these securities are not considered other-than-temporarily impaired. The Company periodically reviews its investment securities portfolio as part of its asset/liability management. As a result of this review certain securities may be sold and other securities acquired to improve the overall yield of the portfolio or modify future cash flows.
As of March 31, 2006, the Company reclassified the portion of its allowance for credit losses related to unfunded lending commitments to a separate liability account included in other liabilities in the consolidated balance sheet. The amount at December 31, 2005 ($251,000) was also reclassified. The reclassifications had no effect on the provision for credit losses as reported.
The Companys consolidated financial statements do not reflect various commitments and contingent liabilities of the Bank that arise in the normal course of business and that involve elements of credit risk, interest rate risk, and liquidity risk. These commitments and contingent liabilities are commitments to extend credit, credit card arrangements, and standby letters of credit.
A summary of the Banks undisbursed commitments and contingent liabilities at September 30, 2006, was as follows:
Commitments to extend credit, credit card arrangements, and standby letters of credit all include exposure to some credit loss in the event of non-performance of the customer. The Banks credit policies and procedures for credit commitments and financial guarantees are the same as those for extension of credit that are recorded in the consolidated statements of condition. Because most of these instruments have fixed maturity dates and many of them expire without being drawn upon, they do not generally present a significant liquidity risk to the Bank.
As of September 30, 2006, the Company had one wholly owned Delaware statutory business trust subsidiary, Cowlitz Statutory Trust I (the Trust), which issued $12,000,000 of guaranteed undivided beneficial interests in the Companys Junior Subordinated Deferrable Interest Debentures (Trust Preferred Securities) in 2005. The Company owns all of the common securities of the Trust. The proceeds from the issuance of the common securities and the Trust Preferred Securities were used by the Trust to purchase $12,372,000 of junior subordinated debentures of the Company. In accordance with Financial Accounting Standards Boards Interpretation No. 46 (revised December 2003) Consolidation of Variable Interest Entities, the Company does not consolidate the Trust because it is not the primary beneficiary.
The debentures, which represent the sole asset of the Trust, accrue and pay distributions quarterly at a variable rate of 90-day LIBOR plus 1.75% per annum of the stated liquidation value of $1,000 per capital security. These debentures qualify as Tier 1 capital under Federal Reserve Board guidelines. Federal Reserve guidelines limit inclusion of trust-preferred securities and certain other preferred capital elements to 25% of Tier 1 capital. As of September 30, 2006, trust preferred securities accounted for 20% of Tier 1 capital. There can be no assurance that
the Federal Reserve Board will not further limit the amount of trust preferred securities permitted to be included in Tier 1 capital for regulatory capital purposes.
Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
The Companys most critical accounting policy is related to the allowance for credit losses. The Company utilizes both quantitative and qualitative considerations in establishing an allowance for credit losses believed to be appropriate as of each reporting date.
Changes in the above factors could significantly affect the determination of the adequacy of the allowance for credit losses. Management performs a full analysis, no less often than quarterly, to ensure that changes in estimated loan loss levels are adjusted on a timely basis. For further discussion of this significant management estimate, see Allowance for Credit Losses. Another critical accounting policy of the Company is related to the carrying value of goodwill and other intangibles. Under Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets" (SFAS No. 142), the Company ceased amortization of goodwill on January 1, 2002 and at least annually tests intangibles with indefinite lives for impairment. Impairment analysis of the fair value of goodwill involves a substantial amount of judgment, as does establishing and monitoring estimated amounts and lives of other intangible assets.
Results of Operations for the Three and Nine Months Ended September 30, 2006
The Companys net income for the third quarter of 2006 was $1.3 million, or $0.26 per diluted share, compared with net income of $756,000, or $0.17 per diluted share for the third quarter of 2005. Net income was $585,000, or 77%, higher in the third quarter of 2006 compared with the same period of 2005. Net income for the first nine months of 2006 was $3.5 million, or $0.69 per diluted share, compared with $2.1 million, or $0.48 per diluted share, in the same period of 2005. The Companys increase in net income in 2006 was primarily due to higher average loans outstanding and a higher net interest spread. A significant portion of the loan increase was related to the acquisition of Asia-Europe-Americas Bancshares, Inc. in the fourth quarter of 2005.
Net interest income was $2.2 million higher in the third quarter of 2006, compared with the same period in 2005. Through September 30, 2006, net interest income was $5.8 million higher than the first nine months of 2005. Average earning assets were $401.5 million in the third quarter of 2006, compared with $296.7 million in the third quarter of 2005. Average interest-bearing liabilities in the third quarter of 2006 were $280.5 million, compared with $209.5 million in the third quarter of 2005.
The Company recorded a provision for credit losses of $800,000 in the third quarter of 2006 and $1.5 million for the first nine months of 2006. This compares with a provision for credit losses of $310,000 in the third quarter and $370,000 for the first nine months of 2005. The 2006 provision increased the allowance for credit losses to primarily support loan growth.
At September 30, 2006, total assets were $456.6 million, an increase of $86.3 million, or 23%, from December 31, 2005. Interest-bearing liabilities increased to $281.1 million as of September 30, 2006 from $225.1 million as of year-end 2005. Non-interest-bearing demand deposits increased $21.4 million during the same period. Total loans were up $74.0 million, or 27%, from year-end 2005. Loan growth was funded by an increase in deposits, primarily certificates of deposits, and a decrease in cash and cash equivalents from year-end 2005.
The primary component of the Companys earnings is net interest income. Net interest income is the difference between interest income, principally from loans and the investment securities portfolio, and interest expense, principally on customer deposits and borrowings. Changes in net interest income, net interest spread, and net interest margin result from changes in asset and liability volume and mix, and to rates earned or paid. Net interest spread refers to the difference between the yield on interest-earning assets and the cost of interest-bearing liabilities. Net interest margin is the ratio of net interest income to total interest-earning assets and is influenced by the volume and relative mix of interest-earning assets and interest-bearing liabilities. Volume refers to the dollar level of interest-earning assets and interest-bearing liabilities.
Interest income from certain of the Companys earning assets is non-taxable. The following tables present interest income and expense, including adjustments for non-taxable interest income, and the resulting tax-adjusted yields earned, rates paid, interest rate spread, and net interest margin for the periods indicated on an annualized basis.
Comparing the third quarter of 2006 to the third quarter of 2005, tax-equivalent net interest income was $2.2 million higher, primarily due to an increase of $104.9 million in average interest-earning assets and an increase in the net interest spread. Interest expense increased $1.3 million, as the volume of average interest-bearing liabilities increased $71.0 million, and average rates paid increased 116 b.p. The third quarter of 2006 net interest margin increased 89 b.p. over the third quarter of 2005, due to a higher net interest spread and an increase in the value of non-interest-bearing deposits in a higher rate environment. The higher spread was primarily due to steadily increasing market interest rates since the third quarter of 2005. On a year-to-date basis, the net interest margin in 2006 increased 90 b.p. over the same period of 2005. The Companys margin in the second quarter of 2006 included $157,000 of interest income previously unrecognized on non-accrual loans paid off in the quarter. The Company estimates the year-to-date 2006 impact on its net interest margin of this recovery of previously unrecognized nonaccrued interest to be an increase of 6 b.p.
The amount of the allowance for credit losses is analyzed by management on a regular basis to ensure that it is adequate to absorb losses inherent in the loan portfolio as of the reporting date. When a provision for credit losses is recorded, the amount is based on the current volume of loans and commitments to extend credit, anticipated changes in loan volumes, past charge-off experience, managements assessment of the risk of loss on current loans, the level of non-performing and impaired loans, evaluation of future economic trends in the Company's market area, and other factors relevant to the loan portfolio. An internal loan risk grading system is used to evaluate potential losses of individual loans. The Company does not, as part of its analysis, group loans together by loan type to assign risk. See "Allowance for Credit Losses" below for a more detailed discussion.
The Company recorded a provision for credit losses of $800,000 in the third quarter and $1.5 million year-to-date in 2006, compared with a $310,000 provision in the third quarter and $370,000 for the first nine months of 2005. The 2006 provision reflected loan growth during the period and the higher level of net loan charge-offs when compared with the same period of 2005.
Non-interest income consists of the following components:
Total non-interest income, excluding securities and sale of other real estate owned transactions, increased $227,000, or 37%, when comparing the quarters ending September 30, 2006 and 2005, and $594,000, or 34%, when comparing the first nine months of 2006 with the same period of 2005. Wire fee revenues increased in 2006 as compared with 2005, primarily due to customer services available in the Companys Seattle branch, which was acquired in the fourth quarter of 2005. In addition, the Company expanded its international trade finance capabilities in the second quarter of 2006 resulting in higher fees associated with foreign exchange and letter of credit services. Service charges on deposit accounts and earnings related to bank owned life insurance were also higher in 2006. In the third quarter of 2006, the Company sold 10 securities with a book value of $7.1 million at a loss of $184,000 and replaced them primarily with higher yielding securities.
Almost every type of non-interest expense was higher in the 2006 periods compared with the 2005 periods. These increases primarily reflected an overall higher level of staffing, occupancy, data processing and branch activities due to loan growth and two additional branches. In addition to the Seattle branch acquisition, the Company opened a full-service branch in Vancouver, Washington in the first quarter and added an international trade finance department in the second quarter of 2006. At September 30, 2006, the Company had 129 full-time equivalent employees compared with 107 at September 30, 2005.
During the third quarter of 2006, the Company underwent a conversion of core processing, lending and internet banking systems. These system conversions are expected to improve long-term operating and financial reporting efficiencies, as well as provide the infrastructure to support the Companys plans for growth. Beginning in August 2006, the Company outsourced its core processing systems to a third party service provider. Costs associated with the outsourced core processing in the third quarter of 2006 were approximately $160,000. In addition, prepaid maintenance contracts and computer equipment associated with the Companys former in-house core processing system of approximately $52,000 were written off during the quarter. The higher level of travel and education in the 2006 periods was partially attributable to travel to attend training for the new systems.
In March 2006, the Company entered into a five-year interest rate floor agreement to hedge the variability of expected interest income related to loans priced with a floating rate index. The notional amount of this agreement was $50 million and the deferred transaction fee was $880,000. The floor contains a strike price of 7.50% . If the prime rate decreases below the strike price at any time during the term of the agreement, the Company will receive a monthly payment for the difference between the strike price and the prime rate. Under a rate scenario in which the prime rate remains above the strike price of the floor during the contracts 5-year life, the Companys pre-tax earnings will decrease $880,000, which is the cost of the transaction fee associated with the floor. The interest rate floor assists the Company in managing the impact of declining interest rates on earnings. In the third quarter of 2006, the Company recorded an increase of $67,000 in the carrying value of the interest rate floor contract. In the second quarter of 2006, the Company recorded a decrease in the carrying value of the contract of $206,000 ($182,000 recorded in non-interest expense and $24,000 as a reduction of non-interest income related to the valuation adjustment recorded at March 31, 2006). The valuation adjustment in the third quarter of 2006 related primarily to decreases in forward market interest rates subsequent to June 30, 2006.
The effective tax rate for the first nine months of 2006 was 27% compared with 26% during the same period of 2005. The higher effective rate was primarily due to the higher level of earnings and a decrease in the relative proportion of nontaxable interest income.
The following table presents the composition and carrying value of the Companys available for sale investment portfolio:
Total investment securities as of September 30, 2006 were $54.2 million, compared with $52.5 million at December 31, 2005. The increase was primarily due to the purchase of $16.9 million of securities, which exceeded maturities and sales of securities sold of $14.9 million. Proceeds from maturities and sales of securities in 2006 were used to invest in higher yielding loans or reinvested in other securities to improve the overall yield of the portfolio. Securities sold resulted in a realized loss of $348,000 in the first nine months of 2006. The Companys securities, classified as available for sale, are used by management as part of its asset/liability management strategy and may be sold in response to changes in interest rates or significant prepayment risk.
Total loans outstanding were $344.3 million and $270.2 million at September 30, 2006 and December 31, 2005, respectively. Unfunded loan commitments were $111.0 million at September 30, 2006 and $87.6 million at December 31, 2005.
The following table presents the composition of the Company's loan portfolio at the dates indicated:
The allowance for credit losses represents management's estimate of potential losses as of the date of the financial statements. The loan portfolio is regularly reviewed to evaluate the adequacy of the allowance for credit losses. In determining the level of the allowance, the Company estimates losses inherent in all loans and commitments to make loans, and evaluates non-performing loans to determine the amount, if any, necessary for a specific reserve. An important element in determining the adequacy of the allowance for credit losses is an analysis of loans by loan risk-rating categories. At a loans inception and periodically throughout the life of the loan, management evaluates the credit risk by using a risk-rating system. This grading system currently includes eleven levels of risk. Risk ratings range from 1 for the strongest credits to 10 for the weakest. A 10 rated loan would normally represent a loss. All loans rated 7-10 collectively comprise the Company's Watch List. The specific grades from 7-10 are watch list (risk-rating 7), special mention (risk-rating 7.5), substandard (risk-rating 8), doubtful (risk-rating 9), and loss (risk-rating 10). When indicators such as operating losses, collateral impairment or delinquency problems show that a credit may have weakened, the credit will be downgraded as appropriate. Similarly, as borrowers bring loans current, show improved cash flows or improve the collateral position of a loan, the credits may be upgraded. The result of managements ongoing evaluations and the risk ratings of the portfolio is an allowance with four components: specific reserves; general reserves; special reserves; and an amount available for other factors.
Specific Allowance. Loans on the Bank's Watch List, as described above, are specifically reviewed and analyzed. Management considers in its analysis expected future cash flows, the value of collateral and other factors that may impact the borrower's ability to pay. When significant conditions or circumstances exist on an individual loan indicating greater risk, a specific allowance may be allocated in addition to the general allowance percentage for that particular risk rating, as outlined in Statement of Financial Accounting Standards No. 114, Accounting by Creditors for Impairment of a Loan.
General Allowance. All loans that do not require a specific allocation are subject to a general allocation based upon historic loss factors. Management determines these factors by analyzing the volume and mix of the existing loan portfolio, in addition to other factors. Management also analyzes the following:
Special Allowance. From time to time, special allowances will be established to facilitate a change in the Banks strategy and other factors. Special allocations are to take into consideration various factors that include, but are not limited to:
Amounts Available for Other Factors. Management also attempts to ensure that the overall allowance appropriately reflects a margin for the imprecision necessarily inherent in estimates of expected credit losses.
The quarterly analysis of specific, general, and special allocations of the allowance is the principal method relied upon by management to ensure that changes in estimated credit loss levels are adjusted on a timely basis. The inclusion of historical loss factors in the process of determining the general component of the allowance also acts as a self-correcting mechanism of management's estimation process, as past and more remote loss experience is replaced by more recent experience. In its analysis of the specific, general, and special allocations of the allowance, management also considers regulatory guidance in addition to the Company's own experience.
Loans and other extensions of credit deemed uncollectable are charged to the allowance. Subsequent recoveries, if any, are credited to the allowance. Actual losses may vary from current estimates and the amount of the provision for credit losses may be either greater than or less than actual net charge-offs when and if they occur. The related provision for credit losses that is charged to income is the amount necessary to adjust the allowance for loan losses and the liability for unfunded credit commitments to the level determined through the above process.
Management's evaluation of the loan portfolio resulted in a total allowance for credit losses of $5.5 million at September 30, 2006 and $4.7 million December 31, 2005. The increase in the allowance for credit losses primarily related to growth of the loan portfolio. The allowance for credit losses, as a percentage of total loans, decreased from 1.73% on December 31, 2005 to 1.59% at September 30, 2006. Management believes the allowance for credit losses at September 30, 2006 is adequate to absorb current potential or anticipated losses.
The following table shows the components of the allowance for credit loss for the periods indicated:
In the third quarter of 2006, the company charged off $500,000 of a commercial loan that was specifically reserved for in the first quarter of 2006. Additional specific reserves totaling $343,000 were added in the third quarter of 2006, primarily related to two commercial loans. In the first quarter of 2006, the Company reclassified the portion of the allowance for loan losses related to unfunded credit commitments to other liabilities on the balance sheet in accordance with GAAP and bank regulatory requirements. Amounts at December 31, 2005 were reclassified.
The allowance for credit losses is based upon estimates of probable losses inherent in the loan portfolio and the Companys commitments to extend credit to borrowers. The amount of loss ultimately incurred for these loans can vary significantly from the estimated amounts. The following table shows the Companys loan loss performance for the periods indicated.
The Bank, during its normal loan review procedures, considers a loan to be impaired when it is probable that the Bank will be unable to collect all amounts due according to the contractual terms of the loan agreement. A loan is not considered to be impaired during a period of minimal delay (less than 90 days) unless available information strongly suggests impairment. The Bank measures impaired loans based on the present value of expected future cash flows discounted at the loan's effective interest rate or, as a practical expedient, at the loan's observable market price or the fair market value of the collateral if the loan is collateral dependent. Impaired loans are charged to the allowance when management believes that, after considering economic and business conditions, collection efforts, and collateral position, the borrower's financial condition indicates that collection of principal is not probable.
Generally, no interest is accrued on loans when factors indicate collection of interest is doubtful or when principal or interest payments become 90 days past due, unless collection of principal and interest are anticipated within a reasonable period of time and the loans are well secured. For such loans, previously accrued but uncollected interest is charged against current earnings, and income is only recognized to the extent payments are subsequently received and collection of the remaining recorded principal balance is considered probable.
Non-performing assets includes repossessed real estate or other assets and loans for which the accrual of interest has been suspended. The following table presents information on the Companys non-performing assets at the dates indicated:
Total non-performing assets at September 30, 2006 decreased to $2.0 million from $4.2 million at December 31, 2005. Of the total non-performing loans at September 30, 2006, $1.1 million is fully guaranteed by an agency of the U.S. government, and the workout period for this loan is currently expected to extend to 2007. The Company has not identified any other potential problem loans that were not classified as non-performing but for which known information about the borrowers financial condition caused management to have concern about the ability of the borrowers to comply with the repayment terms of their loans.
Liquidity represents the ability to meet deposit withdrawals and fund loan demand, while retaining the flexibility to take advantage of business opportunities. The Bank's primary sources of funds have been customer and brokered deposits, loan payments, sales or maturities of investments, sales of loans or other assets, borrowings, and the use of the federal funds market. Investment in securities available-for-sale was $54.2 million at September 30, 2006 compared with $52.5 million at December 31, 2005.
The following table presents the composition of the Companys deposit liabilities on the dates indicated:
The Companys loan growth in the first nine months of 2006 exceeded its core deposit generation, and the Company has supplemented its core deposits with brokered certificates of deposits. At September 30, 2006, the Banks brokered certificate of deposit totaled $68.0 million, compared with $33.0 million at December 31, 2005. The Bank has overnight federal funds borrowing lines with correspondent banks that provide access to an additional $45.0 million for short-term liquidity needs. In addition, the parent company has a $2 million line of credit with a correspondent bank. The Bank also has an established borrowing line with the Federal Home Loan Bank (the FHLB) that permits it to borrow up to 20% of the Bank's assets subject to collateral limitations. With the collateral available on September 30, 2006, the Bank could borrow up to $64.6 million. FHLB borrowings in excess of $47.2 million would require the Company to purchase additional FHLB stock. The line is available for overnight federal funds, or notes with other terms and maturities. At September 30, 2006, the Company had no overnight federal funds borrowings with FHLB.
As disclosed in the accompanying Consolidated Statements of Cash Flows, net cash from operating activities was $9.9 million for the first nine months of 2006, principally from earnings and an increase in accrued interest payable and other liabilities. The increase in accrued interest and other liabilities primarily related to income tax refunds received in the second quarter of 2006 and applied to net taxes payable. Net cash from operating activities in the first nine months of 2005 was principally from earnings. Net cash used by investing activities in the 2006 and 2005 periods was due primarily to loan growth, and, to a lesser extent, an increase in investment securities. Cash provided by financing activities in the first nine months of 2006 was primarily related to the $61.3 million increase in certificates of deposits and a $16.3 million increase in other deposits. In the first nine months of 2005, net deposit growth provided $21.3 million of cash. In addition, in April 2005, the Company received $12.4 million from the issuance of junior subordinated debentures.
The Company and the Bank are subject to various regulatory capital requirements administered by federal and state banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory or discretionary actions by regulators that, if undertaken, could have a direct material effect on the Companys consolidated financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. Capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
The following table presents selected capital information for the Company and the Bank as of September 30, 2006 and December 31, 2005:
Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the tables above) of Tier 1 capital to average assets, and Tier 1 and total risk-based capital to risk-weighted assets (all as defined in the regulations). As of September 30, 2006 and December 31, 2005, the Company and the Bank substantially exceeded all relevant capital adequacy requirements.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
The Bank, like other lenders, is subject to credit risk, which is the risk of losing principal and interest due to customers' failure to repay loans in accordance with their terms. The Bank relies on loan reviews, prudent loan underwriting standards and an adequate allowance for credit losses to help mitigate credit risk. However, a downturn in economic conditions or in the real estate market, or a rapid increase in interest rates could have a negative effect on collateral values, cash flows, and borrowers' ability to repay. The Bank's targeted customers are small to medium-size businesses, professionals and retail customers that may have limited capital resources to repay loans during a prolonged economic downturn.
The Banks earnings are largely derived from net interest income, which is interest income and fees earned on loans and investment income, less interest expense paid on deposits and other borrowings. Interest rates are highly sensitive to many factors that are beyond the control of the Banks management, including general economic conditions, and the policies of various governmental and regulatory authorities. As interest rates change, net interest income is affected. With fixed rate assets (such as fixed rate loans) and liabilities (such as certificates of deposit), the effect on net interest income is dependent upon on the maturities of the assets and liabilities. The Banks primary objective in managing interest rate risk is to minimize the adverse impact of changes in interest rates on the Banks net interest income and capital, while structuring the Banks asset/liability position to obtain the maximum yield-cost spread on that structure. Such structuring includes the use of interest rate derivative contracts. Interest rate risk is managed through the monitoring of the Banks gap position and sensitivity to interest rate risk by subjecting the Banks balance sheet to hypothetical interest rate shocks using a computer based model. In a falling rate environment, the spread between interest yields earned and interest rates paid may narrow, depending on the relative level of fixed and variable rate assets and liabilities. In a stable or increasing rate environment the Banks variable rate loans will remain steady or increase immediately with changes in interest rates, while fixed rate liabilities, particularly certificates of deposit, will only re-price as the liability matures. As of September 30, 2006, the Bank was asset sensitive.
For a complete description of the Companys disclosures about market risk, see Quantitative and Qualitative Disclosures About Market Risk in Part II, Item 7A of the Annual Report on Form 10-K for the year end December 31, 2005.
As of September 30, 2006, the Company evaluated, under the supervision and the participation of management, including the Chief Executive Officer and Chief Financial Officer, the effectiveness of the design and operation of disclosure controls and procedures. Based on that evaluation, management, including the Chief Executive Officer and Chief Financial Officer, concluded that disclosure controls and procedures were effective in timely alerting them to material information relating to the Company that is required to be included in its periodic SEC filings.
There have been no significant changes in the Company's internal controls or in other factors that could significantly affect these controls subsequent to the date of the evaluation.
During the quarter ended September 30, 2006, the Company changed its core data processing system, including its core financial reporting system. In connection with this system conversion, internal controls and procedures have been modified as necessary to reflect the new system environments, however, our overall financial reporting controls have not changed significantly. No other material changes to internal controls and procedures occurred during the three months ended September 30, 2006.
The Company from time to time enters into routine litigation resulting from the collection of secured and unsecured indebtedness as part of its business of providing financial services. In some cases, such litigation will involve counterclaims or other claims against the Company. Such proceedings against financial institutions sometimes also involve claims for punitive damages in addition to other specific relief. The Company is not a party to any litigation other than in the ordinary course of business. In the opinion of management, the ultimate outcome of all pending legal proceedings will not individually or in the aggregate have a material adverse effect on the financial condition or the results of operations of the Company.
There were no material changes to the risk factors set forth in the Companys Form 10-K for the year ended December 31, 2005.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Item 4. Submission of Matters to a Vote of Security Holders
Pursuant to the requirements of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.