BEAR STATE FINANCIAL, INC. 10-K 2007
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the transition period from to
Commission File No.: 0-28312
First Federal Bancshares of Arkansas, Inc.
(Exact name of registrant as specified in its charter)
Registrants telephone number, including area code: (870) 741-7641
Securities registered pursuant to Section 12(b) of the Act:
Securities registered pursuant to Section 12(g) of the Act
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No x
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No x
Indicate by check mark whether the Registrant (1) has filed all reports required by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer.
Large Accelerated Filer o Accelerated Filer x Non-accelerated Filer o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12B-2 of the Act). Yes o No x
As of June 30, 2006, the aggregate value of the 4,406,332 shares of Common Stock of the Registrant issued and outstanding on such date, which excludes 613,924 shares held by directors and officers of the Registrant as a group, was approximately $98.7 million. This figure is based on the last sales price of $22.40 per share of the Registrants Common Stock on June 30, 2006.
Number of shares of Common Stock outstanding as of February 23, 2007: 4,869,871
List hereunder the following documents incorporated by reference and the Part of the Form 10-K into which the document is incorporated.
Portions of the definitive proxy statement for the 2007 Annual Meeting of Stockholders are incorporated into Part III, Items 10 through 14 of this Form 10-K.
First Federal Bancshares of Arkansas, Inc.
For the Year Ended December 31, 2006
First Federal Bancshares of Arkansas, Inc. First Federal Bancshares of Arkansas, Inc. (the Company) is a Texas corporation organized in January 1996 by First Federal Bank (First Federal or the Bank) for the purpose of becoming a unitary holding company of the Bank. The only significant assets of the Company are the capital stock of the Bank and cash. The business and management of the Company consists of the business and management of the Bank. The Company does not presently own or lease any property, but instead uses the premises, equipment and furniture of the Bank. At the present time, the Company does not employ any persons other than officers of the Bank, and the Company utilizes the support staff of the Bank from time to time. Additional employees will be hired as appropriate to the extent the Company expands or changes its business in the future. At December 31, 2006, the Company had $852.5 million in total assets, $652.3 million in total deposits and $75.6 million in stockholders equity.
The Companys executive office is located at the home office of the Bank at 1401 Highway 62-65 North, Harrison, Arkansas 72601, and its telephone number is (870) 741-7641.
First Federal Bank. The Bank is a federally chartered stock savings and loan association formed in 1934. First Federal conducts business from its main office and seventeen full service branch offices, all of which are located in a six county area in Northcentral and Northwest Arkansas comprised of Benton, Marion, Washington, Carroll, Baxter and Boone counties. First Federals deposits are insured by the Deposit Insurance Fund (DIF), which is administered by the Federal Deposit Insurance Corporation (FDIC), to the maximum extent permitted by law.
The Bank is a community-oriented financial institution offering a wide range of retail and business deposit accounts, including noninterest bearing and interest bearing checking, savings and money market accounts, certificates of deposit, and individual retirement accounts. Loan products offered by the Bank include residential real estate, consumer, construction, lines of credit, commercial real estate and commercial non-real estate. Other financial services include investment products offered through First Federal Investment Services, Inc.; automated teller machines; 24-hour telephone banking; internet banking, including account access, bill payment, e-statements and online loan applications; Bounce ProtectionTM overdraft service; debit cards; and safe deposit boxes.
The Bank is subject to examination and comprehensive regulation by the Office of Thrift Supervision (OTS), which is the Banks chartering authority and primary regulator. The Bank is also regulated by the FDIC, the administrator of the DIF. The Bank is also subject to certain reserve requirements established by the Board of Governors of the Federal Reserve System (FRB) and is a member of the Federal Home Loan Bank (FHLB) of Dallas, which is one of the 12 regional banks comprising the FHLB System.
This Form 10-K contains certain forward-looking statements and information relating to the Company that are based on the beliefs of management as well as assumptions made by and information currently available to management. In addition, in those and other portions of this document, the words anticipate, believe, estimate, expect, intend, should and similar expressions, or the negative thereof, as they relate to the Company or the Companys management, are intended to identify forward-looking statements. Such statements reflect the current views of the Company with respect to future looking events and are subject to certain risks, uncertainties and assumptions. Should one or more of these risks or uncertainties materialize or should underlying assumptions prove incorrect, actual results may vary materially from those described herein as anticipated, believed, estimated, expected or intended. The Company does not intend to update these forward-looking statements.
The Bank had 279 full-time employees and 50 part-time employees at December 31, 2006, compared to 283 full-time employees and 50 part-time employees at December 31, 2005. None of these employees is represented by a collective bargaining agent, and the Bank believes that it enjoys good relations with its personnel.
The Company makes available free of charge its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to such reports filed pursuant to Sections 13(a) or 15(d) of the Securities Exchange Act of 1934, as soon as reasonably practicable on or through its website located at www.ffbh.com after filing with the United States Securities and Exchange Commission (SEC).
The Bank faces strong competition both in attracting deposits and making loans. Its most direct competition for deposits has historically come from other savings associations, community banks, credit unions and commercial banks, including many large financial institutions that have greater financial and marketing resources available to them. In addition, the Bank has faced additional significant competition for investors funds from short-term money market securities, mutual funds and other corporate and government securities. The ability of the Bank to attract and retain savings and certificates of deposit depends on its ability to generally provide a rate of return, liquidity and risk comparable to that offered by competing investment opportunities. The Banks ability to increase checking deposits depends on offering competitive checking accounts and promoting these products through effective channels. Additionally, the Bank offers convenient hours, locations and online services to maintain and attract customers.
The Bank experiences strong competition for loans principally from savings associations, community banks, commercial banks and mortgage companies. New community banks as well as well-established financial institutions are continuing to establish branches in the Washington-Benton county area, providing for increased competition. The Bank competes for loans principally through the interest rates and loan fees it charges and the efficiency and quality of services it provides borrowers.
General. At December 31, 2006, the Banks portfolio of net loans receivable amounted to $693.1 million or 81.3% of the Companys total assets. The Bank has traditionally concentrated its lending activities on loans collateralized by real estate. Consistent with such approach, $625.2 million or 85.0% of the Banks total portfolio of loans receivable (total loan portfolio) consisted of loans collateralized by first mortgage loans at December 31, 2006.
In recent years, the Bank has placed an increased emphasis on commercial real estate lending, construction lending, and commercial lending in order to diversify its loan portfolio, take advantage of market opportunities for these types of loans, and transition to more of a full-service community bank. The table below summarizes the changes in the composition of the loan portfolio between December 31, 2002, which is the earliest year presented in the loan composition table on page 3, and December 31, 2006 (dollars in thousands):
(1) Gross of undisbursed loan funds, unearned discounts and net deferred loan fees and the allowance for loan losses.
Commercial real estate, construction and commercial lending are generally considered to involve a higher degree of risk than residential real estate lending due to the relatively larger loan amounts and the effect of general economic conditions on the successful operation of the related business and/or income-producing properties. The Bank has attempted to reduce such risk by evaluating the credit history and past performance of the borrower, the quality of the borrowers management, the debt service ratio, the quality and characteristics of the income stream generated by the business or the property and appraisals supporting the propertys valuation as applicable. However, these types of loans, and construction loans in particular, have largely been the reason for the Banks significant increase in nonaccrual loans between 2005 and 2006. See Asset Quality.
Loan Composition. The following table sets forth certain data relating to the composition of the Banks loan portfolio by type of loan at the dates indicated.
Loan Maturity and Interest Rates. The following table sets forth certain information at December 31, 2006, regarding the dollar amount of loans maturing in the Banks loan portfolio based on their contractual terms to maturity. Demand loans and loans having no stated schedule of repayments and no stated maturity are reported as due in one year or less. All other loans are included in the period in which the final contractual repayment is due.
(1) Gross of undisbursed loan funds, unearned discounts and net deferred loan fees and the allowance for loan losses.
The following table sets forth the dollar amount of the Banks loans at December 31, 2006, due after one year from such date which have fixed interest rates or which have floating or adjustable interest rates.
Scheduled contractual maturities of loans do not necessarily reflect the actual term of the Banks loan portfolio. The average life of mortgage loans is substantially less than their average contractual terms because of loan prepayments and refinancing. The average life of mortgage loans tends to increase, however, when current mortgage loan rates substantially exceed rates on existing mortgage loans and, conversely, decrease when rates on existing mortgage loans substantially exceed current mortgage loan rates.
Origination, Purchase and Sale of Loans. The lending activities of the Bank are subject to the written, non-discriminatory underwriting standards and policies established by the Banks board of directors and management. Loan originations are obtained from a variety of sources, including realtor referrals, walk-in customers to the Banks branch locations, solicitation by loan officers, radio, television and newspaper advertising, and to a lesser extent, through the Banks Internet website. The Bank continually emphasizes its community ties and its practice of quick and efficient underwriting and loan approval processes, made possible in part through the use of automated underwriting software. The Bank believes it provides exceptional personalized service to its customers. The Bank requires hazard insurance, title insurance, and to the extent applicable, flood insurance on all secured real property.
Applications are initially received by loan officers or from the Banks secure website. Applications received over the Banks website are forwarded to loan officers. All loans exceeding individual officers approval authority are subject to review by members of the appropriate loan committee. The Bank has three loan committees (Senior Loan Committee, Executive Loan Committee, and Director Loan Committee) which review and make a decision based upon type, size, and classification.
During 2006, the Bank purchased a commercial construction loan with a commitment amount of $100,000. During 2005, the Bank purchased a $397,000 participation in a commercial real estate loan. During 2004, the Bank purchased participations in five commercial construction loans with a total commitment amount of $13.8 million as well as a $1.2 million participation in a commercial real estate loan. All participations purchased were current as of December 31, 2006.
To minimize interest rate risk, fixed rate loans with terms of fifteen years or greater are typically sold to specific investors in the secondary mortgage market. The rights to service such loans are typically sold with the loans. This allows the Bank to provide its customers competitive long-term fixed rate mortgage products, which are very popular financing products for home buyers in todays market, while not exposing the Bank to undue interest rate risk. These loans are originated subject to Fannie Mae, Freddie Mac and the specific investors underwriting guidelines and are typically underwritten and validated by a third party prior to loan closing. The Secondary Market Department of the Bank typically locks and confirms the purchase price of the loan on the day of the loan application, which protects the Bank from market price movements and ensures that the Bank will receive a fair and reasonable price on the sale of the respective loan. Due to the loans being underwritten by a third party, the repurchase risk associated with these loans is substantially assumed by the underwriter. The Bank believes it has minimal risk of repurchase of these loans based upon the contracts with the specific investors. This risk typically involves potential early prepayments of the mortgage or an early default of a loan. In 2006, 2005, and 2004, the Bank was not required to repurchase any loans. In 2006, 2005, and 2004, the Banks secondary market loan sales amounted to $69.4 million, $55.4 million, and $45.8 million, respectively. The Bank is not involved in loan hedging or other speculative mortgage loan origination activities.
In addition to sales of loans on the secondary market, the Bank periodically sells larger commercial loans or participations in such loans in order to comply with the Banks loans to one borrower limit or for credit concentration purposes. In such situations the loans are typically sold with servicing retained. During the years ended December 31, 2006, 2005, and 2004, such loans sold amounted to approximately $3.4 million, $1.8 million, and $21.5 million, respectively. At December 31, 2006, 2005, and 2004, the balances of loans sold with servicing retained were approximately $22.2 million, $19.6 million, and $18.9 million, respectively. Loan servicing fee income for the years ended December 31, 2006, 2005, and 2004, was approximately $121,000, $100,000, and $159,000, respectively.
The following table shows the Banks originations, sales, purchases, and repayments of loans during the periods indicated.
(1) Gross of undisbursed loan funds, unearned discounts and net loan fees and the allowance for loan losses.
Loans to One Borrower. A savings institution generally may not make loans to one borrower and related entities in an amount which exceeds 15% of its unimpaired capital and surplus, although loans in an amount equal to an additional 10% of unimpaired capital and surplus may be made to a borrower if the loans are fully secured by readily marketable securities. At December 31, 2006, the Banks limit on loans to one borrower was approximately $11.5 million. At December 31, 2006, the Banks largest loan or group of loans to one borrower, including persons or entities related to the borrower, amounted to $10.8 million, including undisbursed loan funds. The Banks ten largest loans or groups of loans to one borrower, including persons or entities related to the borrower, including unfunded commitments, totaled $92.7 million at December 31, 2006. Two of these loans, both related to one borrower, and totaling $7.4 million, including undisbursed loan funds, were 90 days or more past due at December 31, 2006. The funded amount of these two loans totaled $5.3 million at December 31, 2006. See Asset Quality for a discussion of these loans.
One- to Four-Family Residential Real Estate Loans. The Bank has historically concentrated its lending activities on the origination of loans collateralized by first mortgage liens on existing one- to four-family residences. At December 31, 2006, $251.1 million or 34.1% of the Banks total loan portfolio consisted of one- to four-family residential real estate loans. Of the $251.1 million of such loans at December 31, 2006, $195.9 million or 78.0% had adjustable rates of interest (including $43.6 million of seven-year adjustable rate loans) and $55.2 million or 22.0% had fixed rates of interest.
The Bank currently originates both fixed rate and adjustable rate one- to four-family residential mortgage loans. The Banks fixed rate loans to be held in portfolio are typically originated with maximum terms of fifteen years and are typically fully amortizing with monthly payments sufficient to repay the total amount of the loan with interest by the end of the loan term. The Bank does offer fixed rate loans with terms exceeding fifteen years and such loans are typically sold in the secondary market. The Banks one- to four-family loans are typically originated under terms, conditions and documentation which permit them to be sold to U.S. Government-sponsored agencies such as Fannie Mae or Freddie Mac. However, as stated above, such loans with terms of less than fifteen years are generally originated for portfolio while substantially all of such loans with terms of fifteen years or longer are sold in the secondary market. The Banks fixed rate loans typically include due on sale clauses.
The Banks adjustable rate mortgage loans that are held in the portfolio typically provide for an interest rate which adjusts every one, three, five or seven years in accordance with a designated index plus a margin. Such loans are typically based on a 15-, 20-, 25- or 30-year amortization schedule. The Bank generally does not offer below market rates, and the amount of any increase or decrease in the interest rate per one- or three-year period is generally limited to 2%, with a limit of 6% over the life of the loan. The Banks five-year adjustable rate loans provide that any increase or decrease in the interest rate per period is limited to 3%, with a limit of 6% over the life of the loan. The Banks seven-year adjustable rate loans provide that any increase or decrease in the interest rate per period is limited to 5%, with a limit of 5% over the life of the loan. The Banks adjustable rate loans are assumable (generally without release of the initial borrower), do not contain prepayment penalties and do not provide for negative amortization. The Banks adjustable rate mortgage loans typically include due on sale clauses. The Bank generally underwrites its one- and three-year adjustable rate loans on the basis of the borrowers ability to pay at the rate after the first interest rate adjustment. Adjustable rate loans decrease the risks associated with changes in interest rates but involve other risks, primarily because as interest rates rise, the payment by the borrower rises to the extent permitted by the terms of the loan, thereby increasing the potential for default. At the same time, the marketability of the underlying property may be adversely affected by higher interest rates.
The Banks residential mortgage loans generally do not exceed 80% of the appraised value of the secured property. However, pursuant to the underwriting guidelines adopted by the board of directors, the Bank may lend up to 100% of the appraised value of the property securing a one- to four-family residential loan with private mortgage insurance to protect the portion of the loan that exceeds 80% of the appraised value. The Bank may, on occasion, extend a loan up to 90% of the appraised value of the secured property without private mortgage insurance coverage. However, these exceptions are minimal and are only approved on loans with exceptional credit scores, sizeable asset reserves, or other compensating factors. At December 31, 2006, the Bank had $3.0 million of nonaccrual one- to four-family residential loans. See Asset Quality.
Multi-Family Residential Real Estate Loans. The Bank offers mortgage loans for the acquisition and refinancing of multi-family residential properties. At December 31, 2006, $11.9 million or 1.6% of the Banks total loan portfolio consisted of loans collateralized by existing multi-family residential real estate properties.
The Bank currently originates both fixed rate and adjustable rate multi-family loans. Fixed rate loans are generally originated with amortization periods not to exceed 30 years, and typically have balloon periods of three, five or seven years. Adjustable rate loans are typically amortized over terms up to 30 years, with interest rate adjustments every three to seven years. Loan-to-value ratios on the Banks multi-family real estate loans are currently limited to 80%. It is also the Banks general policy to obtain corporate or personal guarantees, as applicable, on its multi-family residential real estate loans from the principals of the borrower.
Multi-family real estate lending entails significant additional risks as compared with one- to four-family residential property lending. Such loans typically involve large loan balances to single borrowers or groups of related borrowers. The payment experience on such loans is typically dependent on the successful operation of the real estate project. The success of such projects is sensitive to changes in supply and demand conditions in the market for multi-family real estate as well as regional and economic conditions generally. At December 31, 2006, the Bank did not have any nonaccrual multi-family real estate loans. See Asset Quality.
Commercial Real Estate Loans. The Bank originates mortgage loans for the acquisition and refinancing of commercial real estate properties. At December 31, 2006, $166.2 million or 22.6% of the Banks total loan portfolio consisted of loans collateralized by existing commercial real estate properties and developed as well as undeveloped land. In recent years, the Bank has placed an increased emphasis on commercial real estate lending in order to transition to a more full-service community bank as well as to take advantage of the high demand for this type of property in some of the markets we serve.
Many of the Banks commercial real estate loans are collateralized by properties such as office buildings, convenience stores, service stations, mini-storage facilities, motels, churches, small shopping malls, and strip centers. The Bank has experienced an increase in this type of lending over the last few years and underwrites commercial real estate loans specifically in relation to the type of property being collateralized. Cash flows and occupancy rates are primary considerations when underwriting loans collateralized by office buildings, mini-storage facilities and motels. Loans with borrowers that are corporations, limited liability companies, trusts, or other such legal entities are also typically personally guaranteed by the principals of the respective entity. The financial strength of the individuals who are personally guaranteeing the loan is also a primary underwriting factor.
Commercial real estate loans include loans for the acquisition of land. This segment of the portfolio totaled $41.7 million, $38.4 million, $30.9 million, $7.0 million, and $5.5 million, as of December 31, 2006, 2005, 2004, 2003, and 2002, respectively. The Bank has experienced an aggregate increase in this loan portfolio during 2006, 2005 and 2004, primarily due to opportunities resulting from the growth and development of the Benton and Washington county areas discussed below. These loans are often made to borrowers with whom the Bank has had previous favorable experience and whose personal financial position is strong. These loans include land purchased for development into single-family subdivision lots, condominium lots, and commercial lots. Generally, these loans are collateralized by properties in the Banks market areas.
The Banks policy requires real estate appraisals of all properties securing commercial real estate loans by licensed real estate appraisers pursuant to state licensing requirements. The Bank considers the quality and location of the real estate, the creditworthiness of the borrower, the cash flow of the project, and the quality of management involved with the property. The Banks commercial real estate loans are generally originated with amortization periods not to exceed 25 years and typically have three-, five-, or seven-year balloon terms. The Bank has originated some loans with variable rate terms based upon Wall Street Journal Prime. To a lesser degree, the Bank has in the past offered a limited number of fixed rate commercial real estate loans with terms not to exceed fifteen years subject to then-current interest rate scenarios. As part of the criteria for underwriting multi-family and commercial real estate loans, the Bank generally estimates a cash flow analysis that includes a vacancy rate projection, expenses for taxes, insurance, maintenance and repair reserves as well as debt coverage ratios. This information is also estimated and included in commercial real estate appraisals.
Commercial real estate lending entails additional risks as compared to the Banks one- to four-family residential property loans. Commercial real estate loans generally involve larger loan balances to single borrowers or groups of related borrowers. The payment experience on such loans is typically dependent on the successful operation of the real estate project. The success of such projects is sensitive to changes in supply and demand conditions in the market for commercial real estate, as well as regional and economic conditions generally. The Bank believes it has mitigated some of these additional risks by focusing its commercial real estate lending activities in the economically strong Washington/Benton County, Arkansas market. This region is the home of the worlds largest retailer, Wal-Mart; as well as the nations largest meat company, Tyson Foods; the trucking firm J. B. Hunt; and the University of Arkansas. Reports have ranked the region as one of the top performing economic areas in the country in the last few years. Population growth, job growth and low unemployment rates in this region add additional support to the Banks growth in the area of commercial real estate loans. At December 31, 2006, the Bank had $1.8 million of nonaccrual commercial real estate loans. See Asset Quality.
Construction Loans. The Bank originates one- to four-family residential, multi-family, and commercial real estate construction loans. However, the Banks primary emphasis has been residential construction lending. The Banks construction lending activities are typically limited to the Banks primary market areas. At December 31, 2006, construction loans amounted to $195.9 million or 26.6% of the Banks total loan portfolio, of which, $34.1 million consisted of one- to four-family residential construction loans, $78.3 million consisted of speculative one- to four-family residential construction loans, $47.5 million consisted of land development loans, $21.9 million consisted of commercial real estate construction loans, and $14.1 million consisted of multi-family residential construction loans. As discussed above in the commercial real estate section, our market areas of Benton and Washington counties have experienced tremendous prosperity and growth and provided the Bank with increased lending opportunities, which can be demonstrated by the significant growth in construction lending over the past few years. However, beginning in late 2005, the Bank limited its construction loan origination activity compared to previous years due to the oversupply of homes and lots in the Northwest Arkansas market and the increased amount of nonperforming construction loans.
The Banks construction loans generally have fixed interest rates or variable rates that float with Wall Street Journal Prime and are typically issued for terms of six to eighteen months. However, the Bank is permitted to originate construction loans with terms up to two years under its loan policy. This practice is generally limited to larger projects that cannot be completed in the typical six- to eighteen-month period. Construction loans are typically made with a maximum loan-to-value ratio of 80% on an as-completed basis.
The majority of the Banks construction loans are made to individual homeowners and local builders and developers for the purpose of constructing one- to four-family residences. To a lesser but growing extent, construction loans are also originated for multi-family and commercial properties. The Bank typically requires that permanent financing with the Bank or some other lender be in place prior to closing any non-speculative construction loan. Interest on construction/permanent loans is due upon completion of the construction phase of the loan. At such time, the loan will convert to a permanent loan at the interest rate established at the initial closing of the construction/permanent loan.
The Bank makes construction loans to local builders for the purpose of construction of speculative (or unsold) residential properties, and for the construction of pre-sold one- to four-family homes. These loans are subject to credit review, analysis of personal and, if applicable, corporate financial statements, and an appraisal of the property to be constructed. The Bank also reviews and inspects the project prior to the disbursement of funds (draws) during the construction term. Loan proceeds are disbursed after a satisfactory inspection of the project has been made based upon percentage of completion. Interest on these construction loans is due upon maturity. The Bank may extend the term of a construction loan upon payment of interest accrued if the property has not been sold by the maturity date. During 2006 the Bank began to experience an increase in the incidence of builders who were unable to pay their interest at maturity due to a softening of the housing market in Northwest Arkansas. Although the economy in the Northwest Arkansas region continues to be strong as reflected in sustained job and population growth, the supply of new residential lots and new speculative homes for sale has outpaced demand. Market data indicates an overall decrease in the number of home sales in Benton and Washington counties in 2006 compared to 2005. However, the data also indicates that average price of homes sold has risen steadily in Benton County and dipped temporarily but has begun to rise again in Washington County.
Construction lending is generally considered to involve a higher level of risk as compared to one- to four-family residential loans. This is due, in part, to the concentration of principal in a limited number of loans and borrowers, and the effects of general economic conditions on developers and builders. In addition, construction loans to a builder for construction of homes that are not pre-sold possess a greater potential risk to the Bank than construction loans to individuals on their personal residences or on houses that are pre-sold prior to the inception of the loan. The Bank analyzes each borrower involved in speculative building and limits the principal amount and number of unsold speculative homes at any one time with such borrower. At December 31, 2006, the Bank had nonaccrual construction loans totaling $11.3 million. See Asset Quality.
Commercial Loans. The Bank also offers commercial loans which primarily consist of equipment and inventory loans which are typically cross-collateralized by commercial real estate. At December 31, 2006, such loans amounted to $36.4 million or 5.0% of the total loan portfolio. At December 31, 2006, the Bank had nonaccrual commercial loans totaling $1.6 million. See Asset Quality.
The Banks commercial loans are typically originated with fixed interest rates and call provisions between one and five years. These loans are typically based on a maximum fifteen-year amortization schedule. The Bank also originates interest-only commercial loans and variable rate commercial loans. The Banks commercial loans do not provide for negative amortization
Consumer Loans. The Bank offers consumer loans in order to provide a full range of financial services to its customers while increasing the yield on its overall loan portfolio and decreasing its interest rate risk due to the relatively shorter-term nature of consumer loans. The consumer loans offered by the Bank primarily include home equity and second mortgage loans, automobile loans, deposit account secured loans, and unsecured loans. Consumer loans amounted to $74.0 million or 10.1% of the total loan portfolio at December 31, 2006, of which $48.7 million, $12.1 million and $13.2 million consisted of home equity and second mortgage loans, automobile loans, and other consumer loans, respectively. The Bank intends to continue its emphasis on consumer loans in furtherance of its role as a community-oriented financial institution.
The Banks home equity and second mortgage loans are fixed rate loans with fully amortized terms of up to fifteen years, variable rate interest-only loans with terms up to three years, or home equity lines of credit. The variable rate loans are typically tied to Wall Street Journal Prime, plus a margin commensurate with the risk as determined by the borrowers credit score. Longer-term amortizing loans typically have a balloon feature in five, seven, or ten years. The home equity lines of credit are typically either fixed rate for a term of no longer that one year or variable rate with terms typically up to three years. Although the Bank does not require that it hold the first mortgage on the secured property, the Bank does hold the first mortgage on a significant number of its home equity loans. The Bank generally limits the total loan-to-value on these mortgages to 90% of the value of the secured property.
The Banks automobile loans are typically originated for the purchase of new and used cars and trucks. Such loans are generally originated with a maximum term of five years. The Bank does offer extended terms on automobile loans to some customers based upon their creditworthiness.
Other consumer loans consist primarily of deposit account loans and unsecured loans. Loans secured by deposit accounts are originated for up to 95% of the deposit account balance, with a hold placed on the account restricting the withdrawal of the deposit account balance.
Consumer loans entail greater risk than do residential first mortgage loans, particularly in the case of consumer loans which are unsecured or secured by rapidly depreciating assets such as automobiles. In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation. In addition, consumer loan collections are dependent on the borrowers continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Furthermore, the application of various federal and state laws, including federal and state bankruptcy and insolvency laws, may limit the amount which can be recovered on such loans. At December 31, 2006, the Bank had $1.3 million of nonaccrual consumer loans. See Asset Quality.
When a borrower fails to make a required payment on a loan, the Bank attempts to cure the deficiency by contacting the borrower and seeking the payment. Depending upon the type of loan, late notices are sent and/or personal contacts are made. In most cases, deficiencies are cured promptly. While the Bank generally prefers to work with borrowers to resolve such problems, when a mortgage loan becomes 90 days delinquent, the Bank generally institutes foreclosure or other proceedings, as necessary, to minimize any potential loss.
Loans are placed on nonaccrual status when, in the judgment of management, the probability of collection of interest is deemed to be insufficient to warrant further accrual. When a loan is placed on nonaccrual status, previously accrued but unpaid interest is deducted from interest income. The Bank generally does not accrue interest on loans past due 90 days or more. Loans may be reinstated to accrual status when payments are made to bring the loan under 90 days past due and, in the opinion of management, collection of the remaining balance can be reasonably expected. The Bank may continue to accrue interest on certain loans that are 90 days past due or more if such loans are in the process of collection and collection is reasonably assured.
Real estate properties acquired through foreclosure are initially recorded at fair value less estimated selling costs. Valuations are periodically performed by management and the real estate is carried at the lower of carrying amount or fair value less cost to sell.
Delinquent Loans. The following table sets forth information concerning delinquent loans at December 31, 2006, in dollar amounts and as a percentage of the Banks total loan portfolio. The amounts presented represent the total outstanding principal balances of the related loans, rather than the actual payment amounts which are past due.
Interest income that would have been recorded under the original terms of the Banks nonaccruing loans for the year ended December 31, 2006, amounted to $1.5 million, and the interest recognized during this period amounted to $403,000.
The following table sets forth the amounts and categories of the Banks nonperforming assets at the dates indicated.
The increase in nonaccrual loans is primarily related to an increase in nonaccrual construction, commercial real estate and commercial loans to certain builders. The Northwest Arkansas market has recently experienced an oversupply of lots and speculative homes. Certain of the Banks homebuilders are experiencing extended marketing times for the sale of their homes which has resulted in inadequate cash flow to service the interest carry on their loans. The specific loan loss allowance related to these loans was approximately $325,000 at December 31, 2006.
The increase in nonaccrual construction and commercial loans is attributable primarily to four loan relationships. Three of the relationships are either in foreclosure or are likely to end up in foreclosure. The fourth is in a workout plan and based on circumstances at this time we expect the loans to eventually come off the nonaccrual list.
The first relationship totaled $6.4 million at December 31, 2006, and is comprised of two subdivision loans totaling $5.3 million, four complete speculative homes totaling approximately $600,000, and the borrowers primary residence totaling approximately $500,000. At December 31, 2006, we anticipated that the four speculative homes would sell with no loss of principal or interest to the Bank, and as a result, these loans were kept on accrual status. However, since December 31, 2006, foreclosure proceedings have begun on the subdivision and the speculative homes. These subdivision loans as well as the primary residence loans were on nonaccrual status at December 31, 2006. The subdivision loans represent two phases on the same subdivision located in Lowell, Arkansas, one of which is complete and the other is approximately 10% complete. We have estimated the costs to complete this phase of the subdivision and have compared the cost per lot of this phase as well as the completed phase to the estimated sales price of the lots, net of selling costs, and have estimated no loss on these loans as of December 31, 2006. However, due to the nature of these loans, difficulty in estimating costs to complete, and the possibility of adverse changes in market conditions, we may incur material losses on these loans in the future.
The second relationship totaled $5.3 million at December 31, 2006, and is comprised of $1.0 million in single family residential loans, most of which are rental properties, $3.0 million in speculative single family construction loans, approximately $850,000 of commercial real estate loans, and approximately $470,000 of commercial loans. The speculative homes are in various stages of completion ranging from approximately 60% to 100%. The commercial loans consist of junior liens on the speculative single family properties. This relationship includes two principals, one of which has filed for bankruptcy protection. All of the properties in this relationship are in foreclosure and bankruptcy litigation and all loans are on nonaccrual status. The properties in this relationship are cross-collateralized and we have evaluated our loss exposure on a total relationship basis. Based on estimated sales prices of the properties net of costs to sell, compared to principal balances plus estimated costs to complete, as appropriate, we have estimated losses of approximately $150,000 at December 31, 2006. However, based on factors such as the complexity of this relationship, difficulty in estimating completion costs, potential adverse changes in market conditions, and the decisions of the bankruptcy trustee, we may incur losses significantly in excess of the amount estimated.
The third relationship totaled $1.5 million at December 31, 2006, and is comprised of $1.0 million in speculative single family construction loans, approximately $300,000 of commercial real estate loans, and approximately $150,000 of commercial loans. The speculative homes are in various stages of completion ranging from approximately 75% to 100%. The commercial loans consist primarily of junior liens on the speculative single family properties. The commercial real estate loans are lot loans. This borrower has filed for bankruptcy protection. We have estimated losses of $90,000 at December 31, 2006. However, based on factors such as the difficulty in estimating completion costs, potential adverse changes in market conditions, and the decisions of the bankruptcy trustee, we may incur losses greater than the amount estimated.
The fourth relationship totaled $2.9 million at December 31, 2006, $1.8 million of which was on nonaccrual status. The $1.8 million consisted of approximately $830,000 of speculative single family construction loans on two properties, approximately $350,000 of commercial real estate loans, and approximately $650,000 of commercial loans. One of the two speculative homes is under contract and the other is listed for sale as is. The commercial real estate loans are three land and lot loans, one of which is under contract and the other two are listed for sale. The commercial loans consist of accounts receivable and unsecured loans totaling approximately $500,000, with an estimated reserve of $65,000, and junior liens on the lots and speculative homes totaling approximately $150,000, with an estimated reserve of $10,000. If the borrowers workout plan does not go as planned, if the properties do not sell in a timely manner, if adverse changes in market conditions occur, or other such factors occur, we may incur losses greater than the amount estimated.
The decrease in accruing loans 90 days or more past due and restructured loans was due to the removal of two relationships totaling $3.8 million and $4.0 million, respectively. These relationships have paid current or performed for a sufficient period to time to warrant their removal from nonperforming assets.
The increase in real estate owned was due to the addition of seven speculative homes and two lots. Three of the homes have been sold since December 31, 2006, and one is under contract. These homes were not complete at the time of foreclosure. Construction costs are added to the real estate balance to the extent that the resulting balance does not exceed the estimated fair value of the property less estimated selling costs.
Classified Assets. Federal regulations require that each insured savings association classify its assets on a regular basis. In addition, in connection with examinations of insured institutions, federal examiners have authority to identify problem assets and, if appropriate, classify them. There are three classifications for problem assets: substandard, doubtful and loss. Substandard assets have one or more defined weaknesses and are characterized by the distinct possibility that the insured institution will sustain some loss if the deficiencies are not corrected. Doubtful assets have the weaknesses of substandard assets with the additional characteristic that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions and values questionable, and there is a high possibility of loss. An asset classified loss is considered uncollectible and of such little value that continuance as an asset of the institution is not warranted. At December 31, 2006, the Bank had $25.4 million of classified assets, $24.8 million of which were classified as substandard and $583,000 of which were classified as loss. In addition, at such date, the Bank had $12.7 million of assets designated as special mention. Special mention assets have potential weaknesses that deserve managements close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or the institutions credit position at some future date.
Allowance for Loan Losses. The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes it is likely that a loan balance is uncollectible. Subsequent recoveries, if any, are credited to the allowance.
The allowance for loan losses represents managements estimate of incurred credit losses inherent in the Companys loan portfolio as of the balance sheet date. The estimation of the allowance is based on a variety of factors, including past loan loss experience, the current credit profile of the Companys borrowers, adverse situations that have occurred that may affect the borrowers ability to repay, the estimated value of underlying collateral, and general economic conditions. Losses are recognized when available information indicates that it is probable that a loss has been incurred and the amount of the loss can be reasonably estimated. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available or conditions change.
In determining the allowance for loan losses, the Company allocates a portion of the allowance to its various loan categories based on an analysis of individual loans and pools of loans. However, the entire allowance is available to absorb credit losses inherent in the total loan portfolio as of the balance sheet date.
A loan is considered impaired when, based on current information and events, it is probable that the Bank will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrowers prior payment record, and the amount of the short fall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis by either the present value of expected future cash flows discounted at the loans effective interest rate, the loans obtainable market price, or the fair value of the collateral if the loan is collateral dependent. Multi-family residential, commercial real estate, land and land development, and commercial loans that are delinquent or where the borrowers total loan relationship exceeds $1 million are evaluated on a loan by loan basis at least annually.
Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Bank does not separately identify individual consumer and residential loans for impairment disclosures. Homogeneous loans are those that are considered to have common characteristics that provide for evaluation on an aggregate or pool basis. The Bank considers the characteristics of (1) one- to four-family residential first mortgage loans; (2) unsecured consumer loans; and (3) collateralized consumer loans to permit consideration of the appropriateness of the allowance for losses of each group of loans on a pool basis. The primary methodology used to determine the appropriateness of the allowance for losses includes segregating certain specific, poorly performing loans based on their performance characteristics from the pools of loans as to type, valuing these loans, and then applying a loss factor to the remaining pool balance based on several factors including past loss experience, inherent risks, and economic conditions in the primary market areas.
In estimating the amount of credit losses inherent in our loan portfolio, various judgments and assumptions are made. For example, when assessing the condition of the overall economic environment, assumptions are made regarding future market conditions and their impact on the loan portfolio. In the event the national or local economy were to sustain a prolonged downturn, the loss factors applied to our portfolios may need to be revised, which may significantly impact the measurement of the allowance for loan losses. For impaired loans that are collateral dependent, the estimated fair value of the collateral may deviate significantly from the proceeds received when the collateral is sold in the event that the Bank has to foreclose or repossess the collateral.
Although we consider the allowance for loan losses of approximately $2.6 million adequate to cover losses inherent in our loan portfolio at December 31, 2006, no assurance can be given that we will not sustain loan losses that are significantly different from the amount recorded, or that subsequent evaluations of the loan portfolio, in light of factors then prevailing, would not result in a significant change in the allowance for loan losses.
The following table summarizes changes in the allowance for loan losses and other selected statistics for the periods indicated.
(1) Consumer loan charge-offs include overdraft charge-offs of $600,000, $522,000, $323,000, $182,000 and $214,000 for the years ended December 31, 2006, 2005, 2004, 2003, and 2002, respectively. Consumer loan recoveries include recoveries of overdraft charge-offs of $151,000, $114,000, $85,000, $50,000, and $53,000 for the years ended December 31, 2006, 2005, 2004, 2003, and 2002, respectively.
The following table presents the allocation of the Banks allowance for loan losses by the type of loan at each of the dates indicated.
(1) The allowance allocated to commercial real estate loans decreased between 2003 and 2002 primarily due to two factors. At December 31, 2002, there was a valuation allowance on an impaired loan that was not recorded in 2003 and the loss experience factor was revised downward in 2003 due to a more established history of low levels of charge-offs. The allowance increased in this category between 2003 and 2004 due primarily to loan growth.
(2) The allowance allocated to construction loans increased between 2006 and 2005 due to an increase in the loss experience factor applied to speculative 1-4 family residential construction loans and land development loans. The increase between 2005 and 2004 was due to the allowance on speculative 1-4 family residential construction loans being included with other 1-4 family residential loans in previous years.
(3) The allowance allocated to commercial loans increased between 2006 and 2005 due to an increase in specific loan loss allowances in this category.
Investment Securities. The investment policy of the Bank, as established by the board of directors, is designed primarily to provide and maintain liquidity, to provide collateral for pledging requirements, to complement the Banks interest rate risk strategy and to generate a favorable return on investments. The Banks investment policy is currently implemented by the Banks Chief Executive Officer within the parameters set by the asset/liability management committee and the board of directors. The Bank is authorized to invest in obligations issued or fully guaranteed by the U.S. Government, certain federal agency obligations, certain time deposits, negotiable certificates of deposit issued by commercial banks and other insured financial institutions, municipal securities, investment grade corporate debt securities and other specified investments.
Investment securities that management has the positive intent and ability to hold to maturity are classified as held to maturity and are reported at amortized cost. Investment securities classified as available for sale are reported at fair value, with unrealized gains and losses excluded from earnings and reported net of tax in other comprehensive income. At December 31, 2006, all of the Banks investment securities were classified as held to maturity. At December 31, 2006, approximately $50.2 million of the Banks investment securities were pledged as collateral for certain deposits in excess of $100,000. In addition, certain U.S. Government and agency securities were pledged as collateral for FHLB advances under the FHLBs blanket lien. At December 31, 2006, investments in the debt and/or equity securities of any one issuer, other than those issued by U.S. Government agencies, did not exceed more than 10% of the Companys stockholders equity.
The following table sets forth the amount of investment securities held to maturity which contractually mature during each of the periods indicated and the weighted average yields for each range of maturities at December 31, 2006. Weighted average yields for municipal obligations have not been adjusted to a tax-equivalent basis. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay the obligation without prepayment penalties.
As of December 31, 2006, there were approximately $60.2 million of investment securities at an average interest rate of 4.85% with issuer call options, of which approximately $50.0 million at an average interest rate of 4.94% are callable within one year. In a rising interest rate environment, the Company believes that the issuers would not call these investment securities.
The following table sets forth the carrying value of the Companys investment securities classified as held to maturity. The Company held no investment securities as available for sale at the dates indicated.
As a member of the FHLB of Dallas, the Bank is required to maintain an investment in FHLB stock. At December 31, 2006, the Banks investment in FHLB stock amounted to $7.1 million. No ready market exists for such stock and it has no quoted market value.
Sources of Funds
General. Deposits are the primary source of the Banks funds for lending and other investment purposes. In addition to deposits, the Bank derives funds from loan principal repayments and prepayments and interest payments, maturities and calls of investment securities and advances from the FHLB of Dallas. Loan repayments are a relatively stable source of funds, while deposit inflows and outflows are significantly influenced by general interest rates and money market conditions. Borrowings are used when funds from deposit sources are insufficient to meet funding needs. They may also be used on a longer-term basis for general business purposes. FHLB advances are the primary source of borrowings.
Deposits. The Banks deposit products include a broad selection of deposit instruments, including negotiable order of withdrawal (NOW) accounts, demand deposit accounts (DDA), money market accounts, regular savings accounts and term certificate accounts. Deposit account terms vary, with the principal differences being the minimum balance required, the time period the funds must remain on deposit, early withdrawal penalties and the interest rate.
The Bank considers its primary market area to be Northcentral and Northwest Arkansas. The Bank utilizes traditional marketing methods to attract new customers and savings deposits. In the second quarter of 2004, the Bank began a direct mail campaign to solicit checking accounts. The Bank will continue to focus much of its marketing resources on cross-selling checking accounts and developing new checking account relationships with the Bank. The Bank does not advertise for deposits outside of its primary market area and management believes that an insignificant number of deposit accounts were held by non-residents of Arkansas at December 31, 2006. Services of deposit brokers have been used on a limited basis with less than 1% of certificates of deposit at December 31, 2006, obtained through a broker.
The Bank has been competitive in the types of accounts and in interest rates it has offered on its deposit products but does not necessarily seek to match the highest rates paid by competing institutions. Although market demand generally dictates which deposit maturities and rates will be accepted by the public, the Bank intends to continue to offer longer-term deposits to the extent possible and consistent with its asset and liability management goals.
The following table shows the distribution of, and certain other information relating to, the Banks deposits by type of deposit, as of the dates indicated.
During 2006 and 2005, due in large part to increases in short-term market interest rates, the Bank experienced a shift in deposits from money market accounts and savings accounts to higher rate certificates of deposit. The increase in rates is also reflected in the shift between lower rate certificates of deposit to higher rate certificates of deposit.
The following table presents the average balance of each type of deposit and the average rate paid on each type of deposit and/or total deposits for the periods indicated.
The following table presents, by various interest rate categories, certificates of deposit at December 31, 2006 and 2005, and the amounts at December 31, 2006, which mature during the periods indicated.