Heritage Financial Group 10-K 2009
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2008
Commission File Number 000-51305
HERITAGE FINANCIAL GROUP
(A United States Corporation)
IRS Employer Identification Number 45-0479535
721 N. Westover Blvd., Albany, GA 31707
Securities registered pursuant to Section 12(b) of the Act:
Check whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. o Yes þ No
Check whether the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. o Yes þ No
Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the 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. þ Yes o No
Check if there is no disclosure of delinquent filers in response to Item 405 of Regulation S-K contained in this form, and no disclosure will 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. þ
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act. (Check one):
Check whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes þ No o
As of March 24, 2009, there were issued and outstanding 10,411,496 shares of the registrants common stock. The aggregate market value of the voting stock held by non-affiliates of the registrant on this date was approximately $11.7 million, computed by reference to the last sales price on NASDAQ Global Market on that date of $6.50 per share on 1,799,767 shares.
DOCUMENTS INCORPORATED BY REFERENCE
Part III of Form 10-K Portions of the Proxy Statement for the 2009 Annual Meeting of Stockholders.
TABLE OF CONTENTS
Item 1. Business
Since being formed in February 2002, Heritage Financial Group (the Company) has not engaged in any business other than through our wholly owned subsidiary, HeritageBank of the South (the Bank), and the management of its cash and investment portfolio. We neither own nor lease any business property, but we use the premises, equipment and furniture of the Bank. We employ only persons who are executive officers of the Bank as our executive officers, and we also use the support staff of the Bank. We currently do not separately compensate any employees, although, in the future, we may hire additional employees if we expand our business at the holding company level.
The Company completed an initial public offering on June 29, 2005. It sold 3,372,375 shares of common stock in that offering for $10.00 per share. The Companys employee stock ownership plan (the ESOP) purchased 440,700 shares with the proceeds of a loan from the Company. The Company received net proceeds of $32.4 million in the public offering, 50% of which was contributed to the Bank and $4.4 million of which was lent to the ESOP for its purchase of shares in the offering. The Company also issued 7,868,875 shares of common stock to Heritage, MHC (MHC). As of December 31, 2008, MHC owns approximately 75% of the Company.
The Bank was originally chartered in 1955 as a federal credit union, serving the Marine Corps Logistic Base in Albany, Georgia. Over the years, it evolved into a full-service, multi-branch community credit union in Dougherty, Lee, Mitchell and Worth counties. It was converted from a federal credit union charter to a federal mutual savings bank charter in July 2001. The objective of that charter conversion was to better serve customers and the local community though the broader lending ability of a savings bank and to expand our customer base beyond the limited field of membership permitted for credit unions. In February 2002, the Company was formed as part of a reorganization into a two-tier mutual holding company structure. On January 1, 2005, the Bank converted to a Georgia state-chartered stock savings bank.
The principal business of the Bank consists of attracting retail and commercial deposits from the general public and investing those funds primarily in permanent loans secured by first mortgages on owner-occupied, one- to four-family residences, multi-family residences and commercial property and a variety of consumer and commercial business loans. Revenues from this business are derived principally from interest on loans and securities and fee income.
The Bank offers a variety of deposit accounts having a wide range of interest rates and terms, which generally include savings accounts, money market deposit and term certificate accounts and checking accounts. It solicits deposits in our market areas and, to a lesser extent, from brokered deposits.
Forward Looking Statements
This document, including information incorporated by reference, contains forward-looking statements about the Company and its subsidiaries which we believe are within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements include, without limitation, statements with respect to anticipated future operating and financial performance, growth opportunities, interest rates, cost savings and funding advantages expected or anticipated to be realized by management. Words such as may, could, should, would, believe, anticipate, estimate, expect, intend, plan and similar expressions are intended to identify these forward-looking statements. Forward-looking statements by the Company and its management are based on beliefs, plans, objectives, goals, expectations, anticipations, estimates and the intentions of management and are not guarantees of future performance. The Company disclaims any obligation to update or revise any forward-looking statements based on the occurrence of future events, the receipt of new information, or otherwise. The important factors we discuss below, as well as other factors discussed under the caption Managements Discussion and Analysis of Financial Condition and Results of Operations and identified in our filings with the Securities and Exchange Commission (the SEC) and those presented elsewhere by our management from time to time, could cause actual results to differ materially from those indicated by the forward-looking statements made in this document:
The Company disclaims any obligation to update or revise any forward-looking statements based on the occurrence of future events, the receipt of new information, or otherwise.
We intend to continue to be a community-oriented financial institution offering a variety of financial services to meet the needs of the communities we serve. We are headquartered in Albany, Georgia, and primarily serve Southwest Georgia through offices in Albany Dougherty, Lee and Worth Counties, and North Central Florida through offices in Ocala Marion County. We occasionally make loans beyond our market area to meet customers needs and to develop new business. As of June 30, 2008, the latest date for which information is available, we had a 14.3% market share of insured deposits in the Albany metropolitan statistic area, ranking us third among all insured depository institutions. In the Ocala metropolitan statistic area, we have less than one percent of all insured deposits, and rank twenty second among all depository institutions.
Southwest Georgia Market Albany Metropolitan Statistic Area
The Southwest Georgia economy is historically based on manufacturing and agriculture, but it has become more service-oriented in the last two decades. Median household income and per capita income are below the state and national averages, reflecting the rural nature of the market and limited availability of high paying white collar and technical jobs. As of January 2009, our market area reported an unemployment rate of 8.3%, compared with the national average of 8.1%. Major employers in our market area include the Marine Corps Logistic Base, Phoebe Putney Memorial Hospital, Procter & Gamble, Teleperformance USA, Albany State University, Darton College, Palmyra Medical Centers, and Miller Brewing Company. During 2008, the area lost a major employer when Cooper Tire and Rubber Company announced they were closing their plant in Albany, eliminating 1,400 jobs. This market has a population of approximately 166,000. Population growth in this area has remained relatively flat, with a 4.8% growth from 2000 to 2008. Over the next five years, the population is expected to grow 3.7%.
North Central Florida Market Ocala Metropolitan Statistic Area
The North Central Florida market economy is a service based economy. The area is known for its world-class equestrian training facilities and its booming retirement communities. Median household income and per capita income are below the state and national averages. However, due to the large retirement populations, much more of the income is disposable in nature compared to other markets. Top employers in the area include Monroe Regional Medical Centers, Taylor, Bean & Whitaker Mortgage, Wal-Mart Stores, AT&T, Publix Supermarkets, Emergency One, Lockheed Martin, ClosetMaid and Central Florida Community College. The unemployment rate was 11.6% as of January 2009. This market has a population of approximately 339,000, and has experienced growth of 30.0% from 2000 to 2008. Over the next five years, the population is expected to grow 18.0%.
In 2008, we invested approximately $1.0 million for 4.9% of the outstanding shares in Chattahoochee Bank of Georgia (Chattahoochee), a de novo bank in Gainesville, Georgia. This investment will provide us with the opportunity to further expand outside of Southwest Georgia. In addition to our investment in Chattahoochee, we expect to participate in loans generated by Chattahoochee that exceed their legal lending limits. We believe this structure will allow us to generate loan volume and exposure to Northeast Georgia without incurring building and personnel costs. Our Chief Executive Officer, O. Leonard Dorminey, serves on Chattahoochees Board of Directors, Executive Committee and Loan Committee. As of December 31, 2008, we had $6.1 million in loans purchased from Chattahoochee. As of that date, we also had $11.0 million in fed funds purchased from Chattahoochee.
Northeast Georgia Market Gainesville Metropolitan Statistic Area
The Northeast Georgia market economy is a service based economy. The area is known as a medical hub for Northeast Georgia, and as a recreational center due to its location on Lake Lanier. Median household income is above the state and national averages, however, per capita income is below the state and national averages. Top employers in the area include Northeast Georgia Medical Center, Liberty Mutual Insurance, Elan Pharmaceuticals, Wrigley Manufacturing Company and Lake Lanier Islands. The unemployment rate was 8.3% as of January 2009. The market has a population of approximately 182,000, and has experienced growth of 29.7% from 2000 to 2008. Over the next five years, the population is expected to grow 16.4%.
We face strong competition in originating commercial, real estate and other loans and in attracting deposits. Competition in originating real estate loans comes primarily from other banks, credit unions and mortgage bankers. Other banks, credit unions and finance companies also provide vigorous competition in consumer and commercial lending.
We attract our deposits through our branch office system. Competition for those deposits is principally from other banks and credit unions located in the same community, as well as mutual funds and other alternative investments. We compete for these deposits by offering superior service and a variety of deposit accounts at competitive rates.
The Company maintains a website at www.eheritagebank.com. The information contained on that website is not included as part of, or incorporated by reference into, this Annual Report on Form 10-K. The Company currently makes available on or through its website its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to these reports, and all other Securities and Exchange Commission filings. These materials are also available free of charge on the Securities and Exchange Commissions website at www.sec.gov.
The following table presents information concerning the composition of the Banks loan portfolio in dollar amounts and in percentages (before deductions for allowances for losses) as of the dates indicated.
The following table shows the composition of the Banks loan portfolio by fixed- and adjustable-rate at the dates indicated.
The following schedule illustrates the contractual maturity of the Banks loan portfolio at December 31, 2008. Mortgages that have adjustable or renegotiable interest rates are shown as maturing in the period during which the contract is due. The schedule does not reflect the effects of possible prepayments or enforcement of due-on-sale clauses. Tax exempt loans are shown at actual rates, not at tax-equivalent rates.
Lending authority. The Bank has established lending limits for its officers. Lenders may make loans up to $250,000, based on the experience of the lender. The commercial manager may make and approve loans up to $500,000. The Chief Executive Officer of the Bank may approve loans up to $2.0 million, and the Senior Credit Officer may approve loans up to $2.0 million, in conjunction with the commercial manager. The Chief Executive Officer and the Senior Credit Officer may jointly approve loans up to $3.0 million and the Executive Loan Committee may approve loans up to $5.0 million. Loans over these amounts or outside our general underwriting guidelines must be approved by the board of directors.
We are subject to the lending limit established under Georgia law for loans to one borrower and the borrowers related entities. See How We Are Regulated the Bank Georgia Regulation. Based on our capital level at December 31, 2008, the maximum amount under Georgia law that we could loan to any one borrower and the borrowers related entities was $12.0 million for fully secured loans (including loans secured by real estate for which we have an independent appraisal) and $7.2 million for all other loans. Internally, we have set limits of $7.5 million for fully secured loans and $4.5 million for all other loans to any one borrower and the borrowers related entities. These internal limits may be exceeded by approval of the board of directors.
Major loan customers. Our five largest lending relationships are with commercial borrowers and total $29.6 million in the aggregate, or 9.8% of our $302.5 million loan portfolio at December 31, 2008. The largest relationship consists of $7.5 million for a finance company secured by accounts receivable and real estate. The next four largest relationships at December 31, 2008, were $6.8 million to a retail pharmacy business primarily secured by real estate and inventory, $5.7 million for the construction and permanent financing of a hotel, and two unrelated loans for $5.3 million and $5.1 million for the purchase and development of real estate. At December 31, 2008, our next twenty largest lending relationships totaled $61.5 million or 20.3% of our total loan portfolio. One of these loan customers with a total balance of $5.3 million was on nonaccrual status as of December 31, 2008. One of these loan customers with a total relationship of $2.7 million had loans totaling $1.4 million that were thirty to fifty nine days past due as of December 31, 2008. The remainder of these loan relationships were current as of December 31, 2008. For further information on credit quality, see also the discussion under the headings - Classified Assets and "- Loan Delinquencies and Defaults below.
One- to Four-Family Residential Real Estate Lending. We originate loans secured by first mortgages on one- to four-family residences in our lending area, and on occasion, outside our lending area for customers whose primary residences are within our lending area. The majority of these loans are originated for funding by another lender. During 2002 and 2003, this type of lending increased because of increased demand for refinancing and our decision, in 2003, to originate more fixed-rate residential loans for our portfolio. In 2004, this loan demand decreased, primarily due to a decrease in refinancing activity, and we reduced the amount of mortgage loans originated for our portfolio, though we continued to originate loans for funding by another lender. In 2005, we ceased originating 15- and 30- year one- to four-family residential loans for our own portfolio. At December 31, 2008, we had $79.7 million, or 26.4% of our loan portfolio in one- to four-family residential loans. Of these, $72.3 million were fixed-rate loans and $7.4 million were adjustable rate loans.
We generally underwrite our one- to four-family owner-occupied loans based on the applicants employment and credit history and the appraised value of the subject property. Presently, we lend up to 90% of the lesser of the appraised value or purchase price for one- to four-family residential loans. For loans with a loan-to-value ratio in excess of 80%, we generally require private mortgage insurance in order to reduce our exposure below 80%. Properties securing our one- to four-family loans are appraised by independent fee appraisers approved by the board of directors. We require our borrowers to obtain title insurance and hazard insurance, and flood insurance, if necessary.
We currently originate one- to four-family mortgage loans on either a fixed- or adjustable-rate basis, as consumer demand dictates. Our pricing strategy for mortgage loans includes setting interest rates that are competitive with other local financial institutions and consistent with our internal needs. Fixed-rate loans generally have a five-year term, with a balloon payment and a 15- to 30-year amortization calculation.
Adjustable-rate mortgage, or ARM, loans are generally offered with annual repricing with a maximum annual rate change of 1% and maximum overall rate change of 4%. We use a variety of indices to reprice our ARM loans. Our ARM loans generally provide for specified minimum and maximum interest rates, with a lifetime cap and floor, and a periodic adjustment of the interest rate over the rate in effect on the date of origination. As a consequence of using caps, the interest rates on these loans may not be as rate sensitive as is our cost of funds. Our ARM loans are written using generally accepted underwriting guidelines. ARM loans generally pose different credit risks than fixed-rate loans, primarily because as interest rates rise, the borrowers payment rises, increasing the potential for default.
We no longer originate one- to four-family loans that are assumable. However, our portfolio does contain one- to four-family loans that are assumable, subject to our approval, and may contain prepayment penalties. Due to current market conditions and rapidly changing underwriting criteria, these loans may not be readily saleable to Freddie Mac, Fannie Mae, or other private investors. Our real estate loans contain a due on sale clause allowing us to declare the unpaid principal balance due and payable upon the sale of the collateral.
We generally underwrite our non- owner-occupied, one- to four-family loans primarily based on a 1.25 times debt service coverage, though we also consider the applicants creditworthiness and the appraised value of the property. Presently, we lend up to 85% of the lesser of the appraised value or purchase price for the residence. These loans are offered with a fixed rate or an adjustable rate using the prime rate as the index. These loans have terms of up to 15 years and are not assumable. We generally obtain title opinions from our counsel regarding these properties.
Commercial and Multi-Family Real Estate Lending. We offer a variety of multi-family and commercial real estate loans. These loans are secured primarily by multi-family dwellings, and a limited amount of small retail establishments, hotels, motels, warehouses and small office buildings located in our market areas. At December 31, 2008, commercial real estate and multi-family loans totaled $52.5 million and $10.7 million or 17.4% and 3.5%, respectively, of our gross loan portfolio.
Our loans secured by multi-family and commercial real estate are originated with either a fixed or adjustable interest rate over a three-or five-year term with a balloon payment generally based on a 15 year amortization. The interest rate on adjustable-rate loans is based on a variety of indices, generally determined through negotiation with the borrower. Loan-to-value ratios on our multi-family and commercial real estate loans typically do not exceed 80% of the appraised value of the property securing the loan.
Loans secured by multi-family and commercial real estate are underwritten based on the income producing potential of the property and the financial strength of the borrower. The net operating income, which is the income derived from the operation of the property less all operating expenses, must be sufficient to cover the payments related to the outstanding debt. We generally require personal guarantees of the borrowers and an assignment of rents or leases in order to be assured that the cash flow from the project will be used to repay the debt. Appraisals on properties securing multi-family and commercial real estate loans are performed by independent state certified or licensed fee appraisers approved by the board of directors, with a second independent appraisal review performed if the loan exceeds $500,000.
We generally do not maintain a tax or insurance escrow account for loans secured by multi-family and commercial real estate. In order to monitor the adequacy of cash flows on income-producing properties, the borrower is generally required to provide periodic financial information.
Loans secured by multi-family and commercial real estate properties generally involve a greater degree of credit risk than one- to four-family residential mortgage loans. These loans typically involve large balances to single borrowers or groups of related borrowers. Because payments on loans secured by multi-family and commercial real estate properties are often dependent on the successful operation or management of the properties, repayment of these loans may be subject to adverse conditions in the real estate market or the economy. If the cash flow from the project is reduced, or if leases are not obtained or renewed, the borrowers ability to repay the loan may be impaired.
Construction and Development Lending. Our construction loan portfolio consists of loans for the construction of one- to four-family residences, multi-family residences and commercial properties. Construction lending generally affords us an opportunity to receive interest at rates higher than those obtainable from residential lending and to receive higher origination and other loan fees. In addition, construction loans are generally made with adjustable rates of interest for six- to nine-month terms, with interest-only payments due during the construction period. At December 31, 2008, we had $43.3 million in construction loans outstanding, representing 14.3% of our gross loan portfolio and consisting of $6.2 million in construction loans for one- to four-family residences, $216,000 in construction loans for multi-family properties, $13.2 million for commercial properties being constructed and $23.7 million in acquisition and development loans to builders, developers and individuals, for the development of lots for future residential and commercial construction.
Construction loans also involve additional risks because funds are advanced upon the security of the project under construction, which is of uncertain value prior to the completion of construction. Moreover, because of the uncertainties inherent in estimating construction costs, delays arising from labor problems, material shortages, and other unpredictable contingencies, it is relatively difficult to evaluate accurately the total loan funds required to complete a project, and the related loan-to-value ratios. We fund our construction loans based on percentage of completion as determined by physical property inspections. Acquisition and development loans are required to be paid down as lots are sold, though on an accelerated basis so that we are repaid before all the lots are sold. See also the discussion under the headings - Classified Assets and "- Loan Delinquencies and Defaults below.
Commercial Business Lending. At December 31, 2008, commercial business loans totaled $42.9 million or 14.2% of our gross loan portfolio. Our commercial business lending activities encompass loans with a variety of purposes and security, including loans to finance accounts receivable, inventory and equipment. Our commercial business lending policy includes credit file documentation and analysis of the borrowers background, capacity to repay the loan, the adequacy of the borrowers capital and collateral as well as an evaluation of other conditions affecting the borrower. Analysis of the borrowers past, present and future cash flows is also an important aspect of our credit analysis. We generally obtain personal guarantees on our commercial business loans. Nonetheless, these loans are believed to carry higher credit risk than traditional single family loans.
Unlike residential mortgage loans, commercial business loans are typically made on the basis of the borrowers ability to make repayment from the cash flow of the borrowers business and, therefore, are of higher risk. Commercial business loans are generally secured by business assets, such as accounts receivable, equipment and inventory. This collateral may depreciate over time, may be difficult to appraise and may fluctuate in value based on the success of the business. As a result, the availability of funds for the repayment of commercial business loans may be substantially dependent on the success of the business itself (which, in turn, is often dependent in part upon general economic conditions).
Our management recognizes the generally increased risks associated with our commercial business lending. Our commercial lending policy emphasizes complete credit file documentation and analysis of the borrowers character, capacity to repay the loan, the adequacy of the borrowers capital and collateral as well as an evaluation of the industry conditions affecting the borrower. Review of the borrowers past, present and future cash flows is also an important aspect of our credit analysis. In addition, we generally obtain personal guarantees from the borrowers on these types of loans. The majority of the Banks commercial loans have been to borrowers in Southwest Georgia and North Central Florida. We intend to continue our commercial lending in this geographic area.
Consumer Lending. We offer a variety of secured consumer loans, including home equity lines of credit, new and used auto loans, boat and recreational vehicle loans, and loans secured by deposit accounts. We also offer a limited amount of unsecured loans. We originate our consumer loans primarily in our market areas. At December 31, 2008, our consumer loan portfolio totaled $67.7 million, or 22.4% of our gross loan portfolio.
Our home equity lines of credit totaled $18.3 million, and accounted for 6.1% of our gross loan portfolio at December 31, 2008. These loans may be originated in amounts, together with the amount of the existing first mortgage, of up to 100% of the value of the property securing the loan. Home equity lines of credit generally have a 15-year draw period and require the payment of 1.5% of the outstanding loan balance per month during the draw period, which may be reborrowed at any time during the draw period. We also offer a 15-year home equity line of credit that requires interest-only payments for the first five years, then fully amortizing payments over the remaining 10 years of the loan. At December 31, 2008, unfunded commitments on home equity lines of credit totaled $11.4 million. Other consumer loan terms vary according to the type of collateral, length of contract and creditworthiness of the borrower.
We originate auto loans on a direct and indirect basis. Auto loans totaled $39.8 million at December 31, 2008, or 13.1% of our gross loan portfolio, of which $13.2 million was direct loans and $26.6 million was indirect loans. We have relationships with approximately 30 car dealerships for indirect lending under an arrangement providing a reserve fee to the referring dealer. Most of our indirect car loans are made with three of these dealerships. This indirect lending is highly competitive; however, our ability to provide same day funding makes our product more competitive. Auto loans may be written for up to six years and usually have fixed rates of interest. Loan-to-value ratios are up to 100% of the sales price for new autos and 100% of retail value on autos, based on valuation from official used car guides.
Consumer loans generally have shorter terms to maturity, which reduces our exposure to changes in interest rates, and carry higher rates of interest than do one- to four-family residential mortgage loans. In addition, management believes that offering consumer loan products helps to expand and create stronger ties to our existing customer base by increasing the number of customer relationships and providing cross-marketing opportunities.
Consumer loans may entail greater risk than do one- to four-family residential mortgage loans, particularly in the case of consumer loans that are secured by rapidly depreciable assets, such as automobiles and recreational vehicles. In these cases, any repossessed collateral for a defaulted loan may not provide an adequate source of repayment of the outstanding loan balance. As a result, 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.
Loan Originations, Purchases, Sales, Repayments and Servicing
We originate one- to four-family residential mortgage loans primarily through referrals from real estate agents, builders and from existing customers. Walk-in customers and referrals from existing customers are also important sources of loan originations. Since our conversion to a federal thrift in 2001, we have been able to expand our target market to include individuals who were not members of the credit union and have increased the number and amount of commercial real estate and commercial business loan originations. Loan origination fees earned totaled $746,000, $695,000 and $508,000 for the years ended December 31, 2008, 2007 and 2006, respectively.
While we originate both adjustable-rate and fixed-rate loans, our ability to originate loans is dependent upon customer demand for loans in our market areas. Demand is affected by competition and the interest rate environment. Loans and participations purchased must conform to our underwriting guidelines or guidelines acceptable to the management loan committee. Furthermore, during the past few years, we, like many other financial institutions, experienced significant prepayments on loans due to the low interest rate environment prevailing in the United States. In periods of economic uncertainty, the ability of financial institutions, including ours, to originate or purchase large dollar volumes of real estate loans may be substantially reduced or restricted, with a resultant decrease in interest income.
We have agreements with mortgage lenders, pursuant to which we originate residential mortgage loans for these lenders in accordance with their policies, terms and conditions and forward the loan package to those lenders for funding. We charge the borrower an origination fee for processing the borrowers application in accordance with the lenders specifications. We also may earn a premium on these loans based on the difference between the rate on the loan and the lock-in rate accepted by the lender. During 2008, we originated $35.5 million of mortgage loans for these lenders and generated approximately $400,000 of loan origination fees on these loans.
In addition to interest earned on loans and loan origination fees, we receive fees for loan commitments, late payments and other miscellaneous services. The fees vary from time to time, generally depending on the supply of funds and other competitive conditions in the market. Fees for late payments totaled $288,000, $264,000 and $172,000 for the years ended December 31, 2008, 2007 and 2006, respectively.
When a borrower fails to make a required payment on a loan, we attempt to cure the delinquency by contacting the borrower. In the case of loans secured by residential real estate, a late notice is sent 15 and 30 days after the due date, and the borrower is contacted by phone beginning 16 days after the due date. When the loan is 31 days past due, a delinquency letter is mailed to the borrower. All delinquent accounts are reviewed by a collector, who attempts to cure the delinquency by contacting the borrower once the loan is 30 days past due. If the account becomes 60 days delinquent and an acceptable repayment plan has not been agreed upon, a collection officer will generally refer the account to legal counsel, with instructions to prepare a notice of intent to foreclose. The notice of intent to foreclose allows the borrower up to 30 days to bring the account current. If foreclosed, we take title to the property and sell it directly through a real estate broker.
Delinquent consumer loans are handled in a similar manner, except that appropriate action may be taken to collect any loan payment that is delinquent for more than 15 days. Follow-up contacts are generally on an accelerated basis compared to the mortgage loan procedure. Our procedures for repossession and sale of consumer collateral are subject to various requirements under the applicable consumer protection laws as well as other applicable laws and the determination by us that it would be beneficial from a cost basis.
Delinquent commercial business loans and loans secured by multi-family, farmland and commercial real estate are initially handled by the loan officer in charge of the loan, who is responsible for contacting the borrower. The collection department also works with the commercial loan officers to see that necessary steps are taken to collect delinquent loans. In addition, we have an officer loan committee that meets at least twice a month and reviews past due and criticized loans, as well as other loans that management feels may present possible collection problems. If an acceptable workout of a delinquent commercial loan cannot be agreed upon, we generally initiate foreclosure or repossession proceedings on any collateral securing the loan.
Delinquent Loans. At December 31, 2008, we had $998,000 or 0.3% of loans that were past due sixty days or more and still accruing interest. As of that date, loans past due thirty to fifty-nine days totaled $3.5 million, or 1.1% of total loans.
Nonperforming Assets. The table below sets forth the amounts and categories of nonperforming assets in our loan portfolio. Loans are placed on non-accrual status when the collection of principal and/or interest becomes doubtful. At all dates presented, we had no accruing loans more than 90 days delinquent and no troubled debt restructurings, which involve forgiving a portion of interest or principal on any loans or making loans at a rate materially less than that of market rates. Foreclosed assets owned include assets acquired in settlement of loans.
As of December 31, 2008, the increased level of nonperforming assets is attributable primarily to our commercial and consumer lending activities. Commercial and consumer loans generally involve significantly greater credit risks than single-family residential lending. For a discussion of significant nonperforming assets, see Managements Discussion and Analysis of Financial Condition and Results of Operations in Item 7 of this 10-K.
For the year ended December 31, 2008, there was approximately $203,000 gross interest income that would have been recorded had the non-accruing loans been current in accordance with their original terms. No amount was included in interest income on these loans for this period.
Other Loans of Concern. In addition to the nonperforming assets set forth in the table above, as of December 31, 2008, there was also an aggregate of $13.4 million of loans with respect to which known information about the possible credit problems of the borrowers have caused management to have doubts as to the ability of the borrowers to comply with present loan repayment terms and which may result in the future inclusion of such items in the non-performing asset categories. These loans have been considered in managements determination of the adequacy of our allowance for loan losses.
Approximately $1.6 million of these loans of concern represent consumer bankruptcies. Bankruptcies are handled by our collection area. These loans are typically secured by adequate collateral, and repayment agreements have been established and followed. We charge off unsecured bankrupt accounts within 60 days of filing. These loans have been considered in managements determination of the adequacy of our allowance for loan losses.
Classified Assets. Federal regulations provide for the classification of loans and other assets, such as debt and equity securities considered to be of lesser quality, as substandard, doubtful or loss. An asset is considered substandard if it is inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Substandard assets include those characterized by the distinct possibility that the insured institution will sustain some loss if the deficiencies are not corrected. Assets classified as doubtful have all of the weaknesses inherent in those classified substandard, with the added characteristic that the weaknesses present make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. Assets classified as loss are those considered uncollectible and of such little value that their continuance as assets without the establishment of a specific loss reserve is not warranted.
When an institution classifies problem assets as either substandard or doubtful, it may establish specific allowances for these loans in an amount deemed prudent by management and approved by the board of directors. In addition, an institution is also required to develop general allowances. General allowances represent loss allowances that have been established to recognize the inherent risk associated with lending activities, but which, unlike specific allowances, have not been allocated to particular problem assets. When an institution classifies problem assets as loss, it is required either to establish a specific allowance for losses equal to 100% of that portion of the asset so classified or to charge off such amount. The Banks determination as to the classification of its assets and the amount of its valuation allowances is subject to review by the Federal Deposit Insurance Corporation (the FDIC) and the Georgia Department of Banking and Finance, which may order the establishment of additional general or specific loss allowances.
We regularly review the problem assets in our portfolio to determine whether any assets require classification in accordance with applicable regulations. On the basis of managements review of our assets, at December 31, 2008, we had $18.0 million of our assets internally classified, of which $15.9 million is classified as substandard, none is classified as doubtful, and $2.1 million is in other real estate and repossessions. The total amount classified represented 28.9% of our equity capital and 3.6% of our assets at December 31, 2008.
Provision for Loan Losses. We recorded a provision for loan losses for the year ended December 31, 2008 of $3.4 million, compared to $1.2 million for the year ended December 31, 2007. The provision for loan losses is charged to income to provide adequate allowance for loan losses to reflect probable incurred losses based on the factors discussed below under Allowance for Loan Losses. The provision for loan losses for the year ended December 31, 2008 was based on managements review of such factors which indicated that the allowance for loan losses reflected probable incurred losses in the loan portfolio as of the year ended December 31, 2008. For a more detailed analysis of the increased provision for loan losses in 2008, see Provision for Loan Losses included in Item 7 of this 10-K.
Allowance for Loan Losses. We maintain an allowance for loan losses to absorb probable incurred losses in the loan portfolio. The allowance is based on ongoing, monthly assessments of the estimated probable incurred losses in the loan portfolio. In evaluating the level of the allowance for loan losses, management considers the types of loans and the amount of loans in the loan portfolio, peer group information, historical loss experience, adverse situations that may affect the borrowers ability to repay, estimated value of any underlying collateral, and prevailing economic conditions. Large groups of smaller balance homogeneous loans, such as residential real estate, small commercial real estate, home equity and consumer loans, are evaluated in the aggregate using historical loss factors and peer group data adjusted for current economic conditions. Geographic peer group data is obtained by general loan type and adjusted to reflect known differences between peers and the Bank, such as loan seasoning, underwriting experience, local economic conditions and customer characteristics. More complex loans, such as multi-family and commercial real estate loans and commercial business loans, are evaluated individually for impairment, primarily through the evaluation of collateral values.
At December 31, 2008, our allowance for loan losses was $5.0 million or 1.64% of the total loan portfolio. Assessing the allowance for loan losses is inherently subjective as it requires making material estimates, including the amount and timing of future cash flows expected to be received on impaired loans, that may be susceptible to significant change. In the opinion of management, the allowance, when taken as a whole, reflects estimated probable loan losses in our loan portfolios. The allowance is discussed further in Notes 1 and 3 of the Notes to Consolidated Financial Statements and Managements Discussion and Analysis of Financial Condition and Results of Operation in Item 7 of this 10-K.
The following table sets forth an analysis of our allowance for loan losses.
The distribution of our allowance for losses on loans at the dates indicated is summarized as follows:
Georgia savings banks have the authority to invest in various types of liquid assets, including United States Treasury obligations, securities of various federal, state and local agencies and jurisdictions, including callable agency securities, certain certificates of deposit of insured banks and savings institutions, certain bankers acceptances, repurchase agreements and federal funds. Subject to various restrictions, Georgia savings banks also may invest their assets in investment grade commercial paper and corporate debt securities and mutual funds whose assets conform to the investments that a Georgia savings banks is otherwise authorized to make directly. See How We Are Regulated HeritageBank of the South Georgia Regulation for a discussion of additional restrictions on our investment activities.
The Chief Financial Officer and Treasurer have the basic responsibility for the management of our investment portfolio. They consider various factors when making decisions, including the marketability, maturity and tax consequences of the proposed investment. The maturity structure of investments will be affected by various market conditions, including the current and anticipated slope of the yield curve, the level of interest rates, the trend of new deposit inflows, and the anticipated demand for funds via deposit withdrawals and loan originations and purchases.
The general objectives of our investment portfolio are to provide liquidity when loan demand is high, to assist in maintaining earnings when loan demand is low and to maximize earnings while satisfactorily managing risk, including credit risk, reinvestment risk, liquidity risk and interest rate risk. See Managements Discussion and Analysis of Financial Condition and Results of Operations Asset and Liability Management and Market Risk in Item 7 of this 10-K.
Our investment securities currently consist of mortgage-backed securities, federal agency securities, preferred stocks, state and local government securities and corporate debt securities. See Note 2 of the Notes to Consolidated Financial Statements.
As a member of the Federal Home Loan Bank of Atlanta, we had $3.2 million in stock of the Federal Home Loan Bank of Atlanta at December 31, 2008. We maintain the minimum amount of stock the Federal Home Loan Bank of Atlanta allows based on our level of borrowings. For the year ended December 31, 2008, we received $129,000 in dividends from the Federal Home Loan Bank of Atlanta. We have been notified by the Federal Home Loan Bank of Atlanta that they do not expect to pay dividends on their stock for the current quarter and we do not anticipate any dividend payments in 2009.
The following table sets forth the composition of our securities portfolio and other investments at the dates indicated. Our securities portfolio at December 31, 2008, did not contain securities of any single issuer with an aggregate book value in excess of 10% of our equity capital, excluding those issued by the United States Government or its agencies.
For further information on the ratings of these securities, see Managements Discussion and Analysis of Financial Condition and Results of Operation in Item 7 of this 10-K.
The composition and maturities of the securities portfolio, excluding Federal Home Loan Bank stock, as of December 31, 2008 are indicated in the following table. Yields on tax exempt obligations have been computed on a tax equivalent basis.
Sources of Funds
General. Our sources of funds are deposits, borrowings, payment of principal and interest on loans, interest earned on or maturation of other investment securities and funds provided from operations.
Deposits. We offer a variety of deposit accounts to both consumers and businesses having a wide range of interest rates and terms. Our deposits consist of savings and checking accounts, money market deposit accounts, NOW and demand accounts and certificates of deposit. We solicit deposits primarily in our market areas and rely on competitive pricing policies, marketing and customer service to attract and retain these deposits. In addition, we solicit brokered deposits when terms and rates are more favorable than those in the markets we serve. At December 31, 2008, we had $53.0 million in brokered deposits, of which $25.2 million were money market deposits from a broker/ dealer, and $27.8 million were in short term certificates of deposit.
The flow of deposits is influenced significantly by general economic conditions, changes prevailing interest rates and competition. The variety of deposit accounts we offer has allowed us to be competitive in obtaining funds and to respond with flexibility to changes in consumer demand. We have become more susceptible to short-term fluctuations in deposit flows, as customers have become more interest rate conscious. We try to manage the pricing of our deposits in keeping with our asset and liability management, liquidity and profitability objectives, subject to competitive factors. Based on our experience, we believe that our deposits are relatively stable sources of funds. Despite this stability, our ability to attract and maintain these deposits and the rates paid on them has been and will continue to be significantly affected by market conditions.
Under regulations of the Board of Governors of the Federal Reserve System, we are required to maintain noninterest bearing reserves at specified levels against our transaction accounts, primarily checking and NOW accounts. At December 31, 2008, the Bank was in compliance with these Federal Reserve requirements and, as a result, would have been deemed to be in compliance with a similar reserve requirement under Georgia law.
The following tables set forth the average dollar amount of deposits in the various types of interest-bearing deposit programs we offered during the years indicated and the average rate paid on these accounts.
Borrowings. Although deposits are our primary source of funds, we may utilize borrowings when they are a less costly source of funds and can be invested at a positive interest rate spread, when we desire additional capacity to fund loan demand or when they meet our asset/liability management goals. Since converting from a credit union in 2001, our borrowings have consisted of advances from the Federal Home Loan Bank of Atlanta. See Note 10 of the Notes to Consolidated Financial Statements.
We may obtain advances from the Federal Home Loan Bank of Atlanta upon the security of certain of our mortgage loans and mortgage-backed and other securities. These advances may be made pursuant to several different credit programs, each of which has its own interest rate, range of maturities and call features, and all long-term advances are required to provide funds for residential home financing. At December 31, 2008, we had $52.5 million in Federal Home Loan Bank advances outstanding and the ability to borrow an additional $36.0 million from the Federal Home Loan Bank of Atlanta.
We also have the ability to borrow up to $37.9 million from correspondent banks, pursuant to renewable lines of credit. We do not expect to utilize this source for funds for long term financing needs prior to utilizing all borrowing capacity at the Federal Home Loan Bank of Atlanta.
The Bank is authorized to borrow from the Federal Reserve Bank of Atlantas discount window after it has exhausted other reasonable alternative sources of funds, including Federal Home Loan Bank borrowings.
The following table sets forth the maximum month-end balance and average balance of borrowings for the periods indicated.
Subsidiary and Other Activities
The Bank is engaged in the sale of securities and insurance products to customers through an agreement with a third-party broker-dealer, at a location separate from any of our deposit-taking facilities. During the year ended December 31, 2008, we earned $1.0 million in fees and commissions from this activity. This activity is conducted in accordance with applicable provisions of federal and state insurance and securities laws.
The Bank does not currently have any active subsidiaries. During 2008, the Bank had one active subsidiary, Heritage Real Estate Holdings (HRE). HRE owned a 50% interest in a partnership which owned an office building, a portion of which is used by us for the conduct of our sale of securities and insurance products. This partnership interest was sold in 2008 to a related party for a gain of approximately $100,000. After that sale, HRE had no active business activities.
How We Are Regulated
Set forth below is a brief description of certain laws and regulations that are applicable to the Company and the Bank. The description of these laws and regulations, as well as descriptions of laws and regulations contained elsewhere herein, does not purport to be complete and is qualified in its entirety by reference to the applicable laws and regulations.
Legislation is introduced from time to time in the United States Congress and Georgia General Assembly that may affect the operations of the Company and the Bank. In addition, the regulations governing the Company and the Bank may be amended from time to time by the Georgia Department of Banking and Finance, the FDIC, the Office of Thrift Supervision or the SEC, as appropriate. Any such legislative or regulatory changes in the future could adversely affect the Company and the Bank. No assurance can be given as to whether or in what form any such changes may occur.
HeritageBank of the South. The Bank, as a Georgia savings bank is subject to regulation and periodic examination by the Georgia Department of Banking and Finance and the FDIC. This regulation extends to all aspects of its operations. The Bank is required to maintain minimum levels of regulatory capital and is subject to some limitations on the payment of dividends to the Company. See - Regulatory Capital Requirements and - Limitations on Dividends and Other Capital Distributions. State and federal laws and regulations prescribe the investment and lending authority and activities of Georgia savings banks. The FDIC also insures the deposits of the Bank to the maximum extent permitted by law. This regulation of the Bank is intended for the protection of depositors and the insurance of accounts fund and not for the purpose of protecting stockholders.
Georgia Regulation. The Bank is subject to extensive regulation and supervision by the Georgia Department of Banking and Finance, including the ability to initiate enforcement actions. The Georgia Department of Banking and Finance regularly examines the Bank, often jointly with the FDIC. As a Georgia savings bank, we are required to have no more than 50% of our assets in commercial real estate and business loans. We are in compliance with this requirement. Our lending and investment authority and other activities are governed by Georgia law and regulations and polices of the Georgia Department of Banking and Finance. We are subject to a statutory lending limit for aggregate loans to one person or a group of persons combined because of certain common interests. That limit is 15% of our statutory capital base, except for loans fully secured by good collateral or ample security, which includes real estate with an independent appraisal, in which case that limit is increased to 25%. Our statutory capital base consists of our stock, paid-in-capital and surplus, capital debt and appropriated retained earnings, which is that portion of our retained earnings designated by the board of directors as not available for dividends. We have not appropriated any retained earnings. Our lending limit to a single borrower under Georgia law as of December 31, 2008 was $12.0 million secured and $7.2 million unsecured. We have no loans in excess of our lending limit. Georgia law also limits our ability to invest in real estate, including a limit on fixed assets of 60% of our statutory capital base, except for temporary grants of authority to exceed that limit granted by the Department of Banking and Finance.
Insurance of Accounts and Regulation by the FDIC. The FDIC regularly examines the Bank and prepares reports for the consideration of the Banks board of directors on any deficiencies that it may find in the Banks operations. The Bank generally must notify or obtain the approval of the FDIC if it or any of its subsidiaries intend to engage in activities not authorized for national banks. The FDIC has adopted guidelines establishing safety and soundness standards on such matters as loan underwriting and documentation, asset quality, earnings standards, internal controls and audit systems, interest rate risk exposure and compensation and other employee benefits. Any institution that fails to comply with these standards must submit a compliance plan. The FDIC also has the authority to initiate enforcement actions against the Bank.
The FDIC insures the deposits of the Bank up to the applicable limits, and such insurance is backed by the full faith and credit of the United States Government. As insurer, the FDIC imposes deposit insurance premiums and is authorized to conduct examinations of and to require reporting by insured institutions. It also may prohibit any insured institution from engaging in any activity the FDIC determines by regulation or order to pose a serious risk to the insurance fund. The FDIC may terminate deposit insurance if it determines that the insured institution has engaged in unsafe or unsound practices or is in an unsafe or unsound condition.
Heritage Financial Group and Heritage, MHC. As the holding companies of a Georgia savings bank, the Company and MHC are subject to regulation and examination by the Georgia Department of Banking and Finance. This state regulation includes the imposition of capital requirements and limits on dividend payments. See - Regulatory Capital Requirements and - Limitations on Dividends and Other Capital Distributions. As savings association holding companies, the Company and MHC also are subject to regulation and examination by the Office of Thrift Supervision. The terms of the Companys charter is prescribed by the Office of Thrift Supervision and requires us to only pursue any or all of the lawful objectives and powers of the subsidiary of a mutual holding company.
Regulation by the Office of Thrift Supervision. Pursuant to regulations of The Office of Thrift Supervision, the Company and MHC are subject to regulation, supervision and examination by the Office of Thrift Supervision. Under regulations of the Office of Thrift Supervision, MHC must own a majority of outstanding shares of the Company in order to qualify as a mutual holding company. Applicable federal law and regulations limit the activities of the Company and MHC and require the approval of the Office of Thrift Supervision for any acquisition or divestiture of a subsidiary, including another financial institution or holding company thereof.
Generally, transactions between the Bank and its affiliates are required to be on terms as favorable to the institution as transactions with non-affiliates, and certain of these transactions, such as loans to an affiliate, are restricted to a percentage of the Banks capital. In addition, the Bank may not lend to any affiliate engaged in activities not permissible for a bank holding company or acquire the securities of most affiliates. The Company and MHC are affiliates of the Bank.
Under federal law, if the Bank fails the qualified thrift lender test, the Company and MHC must obtain the approval of the Office of Thrift Supervision prior to continuing, directly or through other subsidiaries, any business activity other than those approved for multiple savings association holding companies or their subsidiaries. In addition, within one year of such failure, MHC and the Company must register as, and will become subject to, the restrictions applicable to bank holding companies. The qualified thrift lender test requires a savings institution to have at least 65% of its portfolio assets, as defined by regulation, in qualified thrift investments on a monthly average for nine out of every 12 months on a rolling basis. As an alternative, the savings institution may maintain 60% of its assets in those assets specified in Section 7701(a)(19) of the Internal Revenue Code. Under either test, such assets primarily consist of residential housing related loans and investments. At December 31, 2008, the Bank met the test.
Under regulations of the Office of Thrift Supervision, MHC, may convert to the stock form of ownership, though it has no current intention to do so. In a stock conversion, the members of MHC would have a right to subscribe for shares of stock in a new company that would own MHCs shares in the Company. In addition, each share of stock in the Company not owned by MHC, would be converted into shares in that new company in an amount that preserves the holders percentage ownership.
Georgia Regulation. The Georgia Department of Banking and Finance has supervisory and examination authority over the Company and MHC. Under this authority, there are limits on the amount of debt that can be incurred by the holding companies, and they must file periodic reports and annual registration forms.
Regulatory Capital Requirements for the Bank. The Bank is required to maintain minimum levels of regulatory capital under regulations of the FDIC. It became subject to these capital requirements on January 1, 2005, when it became a Georgia savings bank. These regulations established two capital standards, a leverage capital requirement and a risk-based capital requirement.
The capital standards require Tier 1 capital equal to at least 3.0% of total assets for the strongest institutions with the highest examination rating and 4.0% of total assets for all other institutions, unless the FDIC requires a higher level based on the particular circumstances or risk profile of the institution. Tier 1 capital generally consists of equity capital, with certain adjustments, including deducting most intangibles. At December 31, 2008, the Bank had $1.0 million in intangibles included in Tier 1 capital. At December 31, 2008, the Bank had Tier 1 capital equal to $55.2 million, or 11.0% of total average assets, which is $20.0 million above the minimum requirement of 4.0%.
The FDIC also requires the Bank to have Tier 1 capital of at least 4.0% of risk weighted-assets and total capital of at least 8.0% of risk-weighted assets. In determining the amount of risk-weighted assets, all assets, including certain off-balance sheet items, will be multiplied by a risk weight, ranging from 0% to 100%, based on the risk inherent in the type of asset. Total capital consists of Tier 1 capital, as defined above, and Tier 2 capital, which consists of certain permanent and maturing capital instruments that do not qualify as Tier 1 capital and of the allowance for possible loan and lease losses up to a maximum of 1.25% of risk-weighted assets. Tier 2 capital may be used to satisfy these risk-based requirements only to the extent of Tier 1 capital. At December 31, 2008, the Bank had $358.2 million in risk-weighted assets, $59.7 million in Tier 2 capital and $55.2 million in total capital. The FDIC is authorized to require the Bank to maintain an additional amount of total capital to account for concentration of credit risk, level of interest rate risk, equity investments in non-financial companies and the risk of non-traditional activities. On December 31, 2008, the Bank had Tier 1 capital of 15.4% of risk-weighted assets and Tier 2 capital of 16.7% of risk-weighted assets. These amounts were $14.3 million and $28.7 million, respectively, above the 4.0% and 8.0% requirement.
The FDIC is authorized and, under certain circumstances, required to take certain actions against savings banks that fail to meet their capital requirements. The FDIC is generally required to take action to restrict the activities of an undercapitalized institution, which is an institution with less than either a 4% leverage capital ratio, a 4% Tier 1 risked-based capital ratio or an 8% total risk-based capital ratio. Any such institution must submit a capital restoration plan and until such plan is approved by the FDIC may not increase its assets, acquire another institution, establish a branch or engage in any new activities, and generally may not make capital distributions. The FDIC is authorized to impose the additional restrictions.
Any institution that fails to comply with its capital plan or has Tier 1 risk-based or leverage capital ratios of less than 3% or a total risk-based capital ratio of less than 6.0% is considered significantly undercapitalized and must be made subject to one or more additional specified actions and operating restrictions that may cover all aspects of its operations and may include a forced merger or acquisition of the institution. An institution with tangible equity to total assets of less than 2% is critically undercapitalized and becomes subject to further mandatory restrictions on its. The FDIC generally is authorized to reclassify an institution into a lower capital category and impose the restrictions applicable to such category if the institution is engaged in unsafe or unsound practices or is in an unsafe or unsound condition. The imposition by the FDIC of any of these measures on the Bank may have a substantial adverse effect on its operations and profitability.
Institutions with at least a 4% leverage capital ratio, a 4% Tier 1 risked-based capital ratio and an 8.0% total risk-based capital ratio are considered adequately-capitalized. An institution is deemed well-capitalized institution if it has at least a 5% leverage capital ratio, a 6% Tier 1 risked-based capital ratio and an 10.0% total risk-based capital ratio. At December 31, 2007, the Bank was considered a well-capitalized institution.
Georgia imposes a capital requirement based on the leverage capital requirement of the FDIC. A Georgia savings bank must have at least a 4.5% leverage capital ratio, though the department of banking and Finance can impose a higher requirement for the specific circumstances and risks of the institution. Many banks are required to have a 5.5% ratio to address these specific circumstances and risks, and any bank with a less than 5.5% leverage capital ratio must submit a two-year capital plan with the Georgia Department of Banking and Finance.
Regulatory Capital Requirements for Heritage Financial Group. The Company is required to maintain a certain level of capital under a policy of the Georgia Department of Banking and Finance. That policy imposes a Tier 1 capital to total assets capital ratio of 4%, or higher for holding companies engaged in more risky, non-financial businesses. This level is based on the capital requirement imposed on bank holding companies by the Board of Governors of the Federal Reserve Systems and is similar to the Tier 1 leverage ratio imposed on the Bank. If either the Company or MHC fails to meet this requirement, it must file a capital plan and focus on reducing its more risky operations, and it may be subject to an enforcement action, including a capital directive.
Limitations on Dividends and Other Capital Distributions. Unless it meets certain financial criteria, the Bank must obtain the prior written approval of the Georgia Department of Banking and Finance before paying any dividend to the Company. Those financial criteria are having: (1) classified assets of no more than 80% of Tier 1 capital plus an allowance for loan losses at the time of its last examination; (2) paid no more than 50% of last calendar years net income in dividends in the current calendar year, and (3) a Tier 1 leverage capital ratio of at least 6%. Georgia prohibits the Company from paying a dividend if its debt to equity ratio is 30% or more or if it is not meeting its capital requirement.
In 2008 and 2009, the Bank requested and received approval from the Georgia Department of Banking and Finance to pay dividends in excess of 50% of last calendar years net income. Dividends paid by the Bank to the Company were $1.6 million in 2008 and $1.0 million through March of 2009.
In addition, MHC may elect to waive its pro rata portion of a dividend declared and paid by the Company after filing a notice with and receiving no objection from the Office of Thrift Supervision. During 2008, MHC waived its dividends. We anticipate that MHC, subject to its own need for capital and funds, will waive dividends paid by the Company. The interests of other stockholders of the Company who receive dividends are not diluted by any waiver of dividends by MHC in the event of a full stock conversion.
The Company and the Bank are subject to federal income taxation in the same general manner as other corporations, with some exceptions discussed below. The following discussion of federal taxation is intended only to summarize certain pertinent federal income tax matters and is not a comprehensive description of the tax rules applicable to the Company or the Bank. The Banks federal income tax returns have never been audited. Prior to June 2001, the Bank was a federal credit union and was not generally subject to corporate income tax.
The Company files a consolidated federal income tax return with the Bank commencing with the first taxable year after completion of the offering. Accordingly, it is anticipated that any cash distributions made by the Company to its stockholders would be considered to be taxable dividends and not as a nontaxable return of capital to stockholders for federal and state tax purposes.
Method of Accounting. For federal income tax purposes, the Bank currently reports its income and expenses on the accrual method of accounting and uses a fiscal year ending on December 31, for filing its federal income tax return.
Minimum Tax. The Internal Revenue Code imposes an alternative minimum tax at a rate of 20% on a base of regular taxable income plus certain tax preferences, called alternative minimum taxable income. The alternative minimum tax is payable to the extent such alternative minimum taxable income is in excess of an exemption amount. Net operating losses can offset no more than 90% of alternative minimum taxable income. Certain payments of alternative minimum tax may be used as credits against regular tax liabilities in future years. The Bank has not been subject to the alternative minimum tax, nor do we have any such amounts available as credits for carryover.
Net Operating Loss Carryovers. A financial institution may carryback net operating losses to the preceding two taxable years and forward to the succeeding 20 taxable years. This provision applies to losses incurred in taxable years beginning after August 6, 1997. At December 31, 2008, the Bank had no net operating loss carryforwards for federal income tax purposes.
Corporate Dividends-Received Deduction. Because it files a consolidated return with its wholly owned subsidiary, the Bank, dividends from the Bank are not included as income to the Company. The corporate dividends-received deduction is 100% or 80%, in the case of dividends received from corporations with which a corporate recipient does not file a consolidated tax return, depending on the level of stock ownership of the payor of the dividend. Corporations that own less than 20% of the stock of a corporation distributing a dividend may deduct 70% of dividends received or accrued on their behalf.
The Company and the Bank are subject to Georgia and Florida corporate income tax, which is assessed at the rate of 6%. For this purpose, taxable income generally means federal taxable income subject to certain modifications provided for in Georgia and Florida law.
The Company and the Bank also are subject to Georgia business occupation taxes computed on gross receipts after deducting exempt income and interest paid on deposits and other liabilities. These taxes are assessed by state, county and city municipalities in Georgia. The tax rates assessed vary from one municipality to another. The total occupation taxes paid in 2008 amounted to $144,000.
At December 31, 2008, we had a total of 120 full-time equivalent employees. Our employees are not represented by any collective bargaining group. Management considers its employee relations to be good.
Item 1A. Risk Factors
Our business, financial condition, and results of operations are subject to certain risks, including those described below. The risks below do not describe all risks applicable to our business and are intended only as a summary of certain material factors that affect our operations in our industry and markets. New risks may emerge at any time, and we cannot predict such risks or estimate the extent to which they may affect our financial performance in which we operate. These risk factors could cause actual results and conditions to differ materially from those projected in forward-looking statements. If the risks we face, including those listed below, actually occur, our business, financial condition or results of operations could be negatively impacted, and the trading price of our common stock could decline, which may cause you to lose all or part of your investment in our stock.
Difficult market conditions and economic trends have adversely affected our industry and our business.
Dramatic declines in the housing market, with decreasing home prices and increasing delinquencies and foreclosures, have negatively impacted the credit performance of mortgage and construction loans and resulted in significant write-downs of assets by many financial institutions. In addition, the values of real estate collateral supporting many loans have declined and may continue to decline. General downward economic trends, reduced availability of commercial credit and increasing unemployment have negatively affected the credit performance of commercial and consumer credit, resulting in additional write-downs. Concerns over the stability of the financial markets and the economy have resulted in decreased lending by some financial institutions to their customers and to each other. This market turmoil and tightening of credit has led to increased commercial and consumer delinquencies, lack of customer confidence, increased market volatility and widespread reduction in general business activity. Competition among depository institutions for deposits has increased significantly. Some financial institutions have experienced decreased access to deposits and/or borrowings.
The resulting economic pressure on consumers and businesses and the lack of confidence in the financial markets may adversely affect our business, financial condition, results of operations and stock price.
Our ability to assess the creditworthiness of customers and to estimate the losses inherent in our credit exposure is made more complex by these difficult market and economic conditions. As a result of the foregoing factors, there is a potential for new laws and regulations regarding lending and funding practices and liquidity standards, and bank regulatory agencies are expected to be very aggressive in responding to concerns and trends identified in examinations. This increased government action may increase our costs and limit our ability to pursue certain business opportunities. We also may be required to pay even higher FDIC premiums than the recently increased level, because financial institution failures resulting from the depressed market conditions have depleted and may continue to deplete the deposit insurance fund and reduce its ratio of reserves to insured deposits.
We do not believe these difficult conditions are likely to improve in the near future. A worsening of these conditions would likely exacerbate the adverse effects of these difficult market and economic conditions on us, our customers and the other financial institutions in our market area. As a result, we may experience increases in foreclosures, delinquencies and customer bankruptcies, as well as more restricted access to funds.
Recent legislative and regulatory initiatives to address difficult market and economic conditions may not stabilize the U.S. banking system.
The recently enacted Emergency Economic Stabilization Act of 2008 (the EESA) authorizes Treasury to purchase from financial institutions and their holding companies up to $700 billion in mortgage loans, mortgage-related securities and certain other financial instruments, including debt and equity securities issued by financial institutions and their holding companies, under a troubled asset relief program, or TARP. The purpose of TARP is to restore confidence and stability to the U.S. banking system and to encourage financial institutions to increase their lending to customers and to each other. The Treasury has allocated $250 billion towards the TARP Capital Purchase Program. Under the TARP Capital Purchase Program, Treasury is purchasing equity securities from participating institutions. The warrant offered by this prospectus, together with our Series A Preferred Stock, was issued by us to Treasury pursuant to the TARP Capital Purchase Program. The EESA also increased federal deposit insurance on most deposit accounts from $100,000 to $250,000. This increase is in place until the end of 2009 and is not covered by deposit insurance premiums paid by the banking industry.
The EESA followed, and has been followed by, numerous actions by the Board of Governors of the Federal Reserve System, the U.S. Congress, Treasury, the FDIC, the SEC and others to address the current liquidity and credit crisis that has followed the sub-prime meltdown that commenced in 2007. These measures include homeowner relief that encourage loan restructuring and modification; the establishment of significant liquidity and credit facilities for financial institutions and investment banks; the lowering of the federal funds rate; emergency action against short selling practices; a temporary guaranty program for money market funds; the establishment of a commercial paper funding facility to provide back-stop liquidity to commercial paper issuers; and coordinated international efforts to address illiquidity and other weaknesses in the banking sector. The purpose of these legislative and regulatory actions is to stabilize the U.S. banking system. The EESA and the other regulatory initiatives described above may not have their desired effects. If the volatility in the markets continues and economic conditions fail to improve or worsen, our business, financial condition and results of operations could be materially and adversely affected.
Our loan portfolio possesses increased risk due to our substantial number of multi-family, commercial real estate, commercial business and consumer loans.
Our multi-family, commercial real estate and commercial business loans accounted for approximately 35.1% of our total loan portfolio as of December 31, 2008. Generally, we consider these types of loans to involve a higher degree of risk compared to first mortgage loans on one-to-four family, owner-occupied residential properties. In addition, we plan to increase our emphasis on multi-family, commercial real estate and commercial business lending. Because of our planned increased emphasis on and increased investment in multi-family and commercial real estate and commercial business lending, it may become necessary to increase the level of our provision for loan losses, which could decrease our net profits.
Our loan portfolio contains residential and commercial construction loans, which increase the risk in our loan portfolio.
Our construction and land loan portfolio represented 14.3% of our total loan portfolio at December 31, 2008. Generally, we consider construction loans to involve a higher degree of risk than one-to-four family residential loans, because funds are advanced on the security of projects under construction and of uncertain value until completed. We intend to increase our residential and commercial construction lending, to the extent opportunities are available in our market area and meet our underwriting criteria. This increased emphasis on construction lending, particularly on commercial projects, may require us to increase the level of our provision for loan losses, which could decrease net profits.
If economic conditions deteriorate, our results of operations and financial condition could be adversely impacted as borrowers ability to repay loans declines and the value of the collateral securing our loans decreases.
Our financial results may be adversely affected by changes in prevailing economic conditions, including decreases in real estate values, changes in interest rates that cause a decrease in interest rate spreads, adverse employment conditions, the monetary and fiscal policies of the federal government and other significant external events. Because the majority of our borrowers are individuals and businesses located and doing business in the Georgia counties of Dougherty, Lee and Worth, and the Florida county of Marion, our success will depend significantly upon the economic conditions in those and the surrounding counties. Due to our limited market areas, these negative conditions may have a more noticeable effect on us than would be experienced by a larger institution more able to spread these risks of unfavorable local economic conditions across a large number of diversified economies. In addition, at December 31, 2008, approximately 63.5% of our total loans were secured by real estate. Accordingly, decreases in real estate values could adversely affect the value of collateral securing our loans. Adverse changes in the economy may also have a negative effect on the ability of our borrowers to make timely repayments of their loans. In this regard, a substantial majority of our loans are to individuals and businesses in Southwest Georgia and North Central Florida. These factors could expose us to an increased risk of loan defaults and losses and have an adverse impact on our earnings.
If our allowance for loan losses is not sufficient to cover actual loan losses, or if credit delinquencies increase, our earnings could decrease.
Like other financial institutions, we face the risk that our customers will not repay their loans, that the collateral securing the payment of those loans may be insufficient to assure repayment, and that we may be unsuccessful in recovering the remaining loan balances. Management makes various assumptions and judgments about the collectibility of our loan portfolio, including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral for the repayment of many of our loans. Based in part on those assumptions and judgments, we maintain an allowance for loan losses in an attempt to cover any loan losses which may occur. In determining the size of the allowance, we also rely on an analysis of our loan portfolio based on historical loss experience, volume and types of loans, trends in classification, delinquencies and non-accruals, national and local economic conditions and other pertinent information. Material additions to our allowance could materially decrease our net income. Furthermore, if those established loan loss reserves are insufficient and we are unable to raise revenue to compensate for these losses, such losses could have a material adverse effect on our operating results. Our allowance for loan losses was 1.64% of total loans and 68.0% of non-performing loans at December 31, 2008. In addition, federal and state regulators periodically review our allowance for loan losses and may require us to increase our allowance for loan losses or recognize further loan charge-offs, based on judgments different than those of our management. Higher charge-off rates and an increase in our allowance for loan losses may hurt our overall financial performance and may increase our cost of funds. As of December 31, 2008, we believe that the current allowance level is our best estimate of losses inherent in our loan portfolio.
Strong competition within our market area may limit our growth and profitability.
Competition in the banking and financial services industry is intense. In our market areas, we compete with commercial banks, savings institutions, mortgage brokerage firms, credit unions, finance companies, mutual funds, insurance companies, and brokerage and investment banking firms operating locally and elsewhere. Many of these competitors have substantially greater resources and lending limits than we do and may offer certain services that we do not or cannot provide. Our profitability depends upon our continued ability to successfully compete in our markets.
We may face risks with respect to the future expansion of our business.
As we expand our business in the future into new and emerging markets, we may also consider and enter into new lines of business or offer new products or services. Such expansion involves risks, including:
We operate in a highly regulated environment, and we may be adversely affected by changes in laws and regulations.
The Bank is subject to extensive regulation, supervision and examination by the Georgia Department of Banking and Finance, its chartering authority, and by the FDIC, its primary federal regulator. Both MHC and the Company are subject to regulation and supervision by the Office of Thrift Supervision and the Georgia Department of Banking and Finance. This regulation and supervision governs the activities in which an institution and its holding company may engage, and are intended primarily for the protection of the insurance fund and depositors. Regulatory authorities have extensive discretion in their supervisory and enforcement activities, including the imposition of restrictions on our operations, the classification of our assets and determination of the level of our allowance for loan losses. Any change in this regulation and oversight, whether in the form of regulatory policy, regulations, legislation or supervisory action, may have a material impact on our operations. In addition, the Sarbanes-Oxley Act of 2002, and the related rules and regulations promulgated by the SEC and NASDAQ, that are now applicable to us, have increased the scope, complexity and cost of corporate governance, reporting and disclosure practices, including the costs of completing our audit and maintaining our internal controls.
Liquidity risk could impair our ability to fund operations and jeopardize our financial condition.
Liquidity is essential to our business. An inability to raise funds through deposits, borrowings, the sale of loans and other sources could have a substantial negative effect on our liquidity. Our access to funding sources in amounts adequate to finance our activities or the terms of which are acceptable to us could be impaired by factors that affect us specifically or the financial services industry or economy in general. Factors that could detrimentally impact our access to liquidity sources include a decrease in the level of our business activity as a result of a downturn in the markets in which our loans are concentrated or adverse regulatory action against us. Our ability to borrow could also be impaired by factors that are not specific to us, such as a disruption in the financial markets or negative views and expectations about the prospects for the financial services industry in light of the recent turmoil faced by banking organizations and the continued deterioration in credit markets.
We may elect or be compelled to seek additional capital in the future, but that capital may not be available when it is needed.
We are required by federal regulatory authorities to maintain adequate levels of capital to support our operations. In addition, we may elect to raise additional capital to support our business or to finance acquisitions, if any, or we may otherwise elect or be required to raise additional capital. In that regard, a number of financial institutions have recently raised considerable amounts of capital in response to a deterioration in their results of operations and financial condition arising from the turmoil in the mortgage loan market, deteriorating economic conditions, declines in real estate values and other factors. Should we be required by regulatory authorities to raise additional capital, we may seek to do so through the issuance of, among other things, our common stock or preferred stock.
Our ability to raise additional capital, if needed, will depend on conditions in the capital markets, economic conditions and a number of other factors, many of which are outside our control, and on our financial performance. Accordingly, we cannot assure you of our ability to raise additional capital if needed or on terms acceptable to us. If we cannot raise additional capital when needed, it may have a material adverse effect on our financial condition, results of operations and prospects.
There is a limited market for our common stock.
Our common stock is listed for trading on the NASDAQ Global Market under the symbol HBOS. The trading volume in our common stock has been relatively low when compared with larger companies listed on the NASDAQ Global Market or other stock exchanges. We cannot say with any certainty that a more active and liquid trading market for our common stock will develop. Because of this, it may be more difficult for you to sell a substantial number of shares for the same price at which you could sell a smaller number of shares. We, therefore, can give no assurance that sales of substantial amounts of common stock in the market, or the potential for large amounts of sales in the market, would not cause the price of our common stock to decline or impair our future ability to raise capital through sales of our common stock.
Our ability to pay dividends is limited and we may be unable to pay future dividends.
Our ability to pay dividends is limited by regulatory restrictions and the need to maintain sufficient consolidated capital. The ability of our Bank subsidiary to pay dividends to us is limited by its obligations to maintain sufficient capital and by other general restrictions on its dividends that are applicable to our Bank and banks that are regulated by the Georgia Department of Banking and Finance. If we do not satisfy these regulatory requirements, we will be unable to pay dividends on our common stock.
MHC owns more than half of the common stock of the Company. As a result, MHC has enough votes to control what happens on most matters submitted to a vote of stockholders.
MHC is required by the regulations of the Office of Thrift Supervision to own more than half of our common stock of Heritage Financial Group. At December 31, 2008, MHC owned approximately 75% of our shares. The board of directors of MHC has the power to direct the voting of this stock. Depositors of the Bank, who elect the board of MHC, generally have assigned this right of election to the board by proxy. Therefore, the board of MHC will control the results of most matters submitted to a vote of stockholders of the Company. We cannot assure you that the votes cast by MHC will be in the best interests of our public stockholders.
The amount of common stock we control, our charter and bylaws, and state and federal statutory provisions could discourage hostile acquisitions of control.
In addition to the shares owned by MHC, our board of directors, executive officers and our employee stock ownership plan controlled approximately 29% of our common stock as of March 24, 2009. This inside ownership together with provisions in our charter and bylaws may have the effect of discouraging attempts to acquire the Company, pursue a proxy contest for control of the Company, assume control of the Company by a holder of a large block of common stock and remove the Companys management, all of which certain stockholders might think are in their best interests. These provisions include, among other things:
Item 2. Description of Properties
At December 31, 2008, we had five full-service offices owned by the Bank and one leased facility in the Southwest Georgia market. In February of 2009, we announced our intentions to close the leased facility in late May of 2009. We have purchased land near the leased facility, on which we plan to build a permanent branch at some point in the future. We have two full-service offices owned by the Bank in the North Central Florida market. We also have one leased facility in the North Central Florida market that served as our first office in that market. We no longer operate a full-service branch in this location, but still maintain an automated teller machine at the location.
Item 3. Legal Proceedings
In the opinion of management, the Company is not a party to any pending claims or lawsuits that are expected to have a material effect on the Companys financial condition or results of operations. Periodically, there have been various claims and lawsuits involving the Company mainly as a defendant, such as claims to enforce liens, condemnation proceedings on properties in which the Bank holds security interests, claims involving the making and servicing of real property loans and other issues incident to the Banks business. Aside from such pending claims and lawsuits, which are incident to the conduct of the Companys ordinary business, the Company is not a party to any material pending legal proceedings that would have a material effect on the financial condition or operations of the Company.
Item 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of security holders during the quarter ended December 31, 2008.
Item 5. Market for the Registrants Common Equity, Related Stockholder Matters and Small Business Issuer Purchases of Equity Securities
Market and Dividend Information
The Company completed its initial public stock offering on June 29, 2005, and its common stock is traded on the NASDAQ Global Market under the symbol HBOS. As of March 27, 2009, the Company estimates that it had approximately 1,500 stockholders, including approximately 800 beneficial owners holding shares in nominee or street name. The following table sets forth the high and low common stock prices in 2008 and 2007.
The Board of Directors of the Company commenced cash dividend payments to stockholders on October 24, 2005. The initial quarterly dividend rate was set at $0.05 per common share. In 2007, the Company raised its quarterly dividend to $0.06 per common share. The quarterly dividend was increased to $0.07 per share for 2008. In January 2009, the Company increased its dividend to $0.08 per share for the first quarter. MHC, which owns 75% of the Companys common shares, waived its right to receive cash dividends in 2005, 2006 and 2008. During 2007, MHC waived dividends on all but $42,900, which it needed for regulatory fees and operating expenses. Our cash dividend policy is continually reviewed by management and the Board of Directors. The Company intends to continue its policy of paying quarterly dividends; however, these payments will depend upon a number of factors, including capital requirements, regulatory limitations, the Companys financial condition, results of operations and the Banks ability to pay dividends to the Company. The Company relies significantly upon such dividends from the Bank to accumulate earnings for payment of cash dividends to the stockholders. For information regarding restrictions on the payment of dividends by the Bank to the Company, see Managements Discussion and Analysis of Financial Condition and Results of Operation Liquidity and Capital Resources in this Annual Report. See also Note 17 of Notes to Consolidated Financial Statements.
The Company adopted an equity incentive plan providing for the issuance of stock options, restricted stock, and stock appreciation rights. This plan was approved and became effective on May 17, 2006. The following table includes certain information with respect to the awards and this equity incentive plan as December 31, 2008:
Information on the shares purchased during the fourth quarter of 2008 is as follows:
On December 16, 2008, the Company announced that its Board of Directors had authorized the repurchase of up to 250,000 shares, or approximately 10% of its then outstanding publicly held shares of common stock. Through March 24, 2009, the Company has purchased 61,500 shares at a weighted average price of $8.68 per share for a total of $534,000 under this plan. As of March 24, 2009, the Company had 188,500 remaining shares that may be purchased under the current authorization. The repurchases may be made from time to time in open-market or negotiated transactions as deemed appropriate by the Company and will depend on market conditions. The new program will expire in December 2009 unless completed sooner or otherwise extended.
Item 6. Selected Financial Data
Selected Consolidated Financial Information
Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations
MANAGEMENTS DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Heritage Financial Group is the parent holding company of HeritageBank of the South. The Company is in a mutual holding company structure and 75% of its outstanding common stock is owned by Heritage, MHC, a federal mutual holding company.
The principal business of the Company is operating our wholly owned subsidiary, the Bank. Our results of operations depend primarily on our net interest income. Net interest income is the difference between the interest income we earn on our interest-earning assets, consisting primarily of loans and investment and mortgage-backed securities, and the interest we pay on our interest-bearing liabilities, consisting of savings and checking accounts, money market accounts, time deposits, federal funds purchased and securities sold under agreements to repurchase and borrowings. Our results of operations also are affected by our provisions for loan losses, noninterest income and noninterest expense. Noninterest income consists primarily of service charges on deposit accounts, mortgage origination fees, transaction fees, bank-owned life insurance, and commissions from investment services. Noninterest expense consists primarily of salaries and employee benefits, occupancy, equipment and data processing, advertising, professional fees and other costs. Our results of operations also may be affected significantly by general and local economic and competitive conditions, changes in market interest rates, governmental policies and actions of regulatory authorities.
Evolution of Business Strategy
We originally were chartered as a federal credit union in 1955. In 1998, we became a community chartered credit union. We accepted deposits and made loans to members who lived, worked or worshiped in the approved counties for the credit union charter. In 2001, we converted to a mutual thrift charter in order to better serve our customers and communities through a broader lending ability and an expanded customer base beyond the field of membership permitted for our credit union. The mutual holding company structure was established in 2002, and we converted from a thrift charter to a state savings bank charter in 2005. We feel this structure best suits our continued efforts to grow and expand our commercial business.
The Company completed an initial public stock offering stock offering on June 29, 2005. It sold 3,372,375 shares of common stock in that offering for $10.00 per share. The Companys employee stock ownership plan (the ESOP) purchased 440,700 shares with the proceeds of a loan from the Company. The Company received net proceeds of $32.4 million in the public offering, 50% of which was contributed to the Bank and $4.4 million of which was loaned to the ESOP for its purchase of shares in the offering. The Company also issued an additional 7,867,875 shares of common stock to MHC, so that MHC would own 70% of the outstanding common stock at the closing of the offering.
Our current business strategy is to operate a well-capitalized and profitable commercial and retail financial institution dedicated to serving the needs of our customers. We strive to be the primary financial institution in the market areas we serve. We offer a broad range of products and services while stressing personalized and efficient customer service and convenient access to these products and services. We intend to continue to operate as a commercial and consumer lender. We have structured operations around a branch system that is staffed with knowledgeable and well-trained employees. Subject to capital requirements and our ability to grow in a reasonable and prudent manner, we may open additional branches as opportunities arise. In addition to our branch system, we continue to expand electronic services for our customers. We attempt to differentiate ourselves from our competitors by providing a higher level of customer service.
Our core business is composed of the following:
1. Commercial Banking and Small Business Lending: We focus on the commercial real estate and business needs of individuals and small- to medium-sized businesses in our market area. In addition, we focus on high net worth individuals and small business owners. The commercial banking department is composed of seasoned commercial lenders and a support staff with years of combined experience in the industry. We expect this department to continue to be the fastest growing component of our business.
2. Indirect Auto Lending: We provide automobile loans to customers through long-standing relationships with a number of automobile dealerships throughout southern Georgia. While indirect lending is highly competitive, our ability to provide same-day funding makes our product attractive.
3. Retail Banking: We operate a network of six branch offices located in Dougherty, Lee and Worth counties and two branches located in Ocala, Florida. Each office is staffed with knowledgeable banking professionals who strive to deliver quality service.
4. Brokerage/Investment Services: We offer investment products, life, health, disability and long-term care insurance through our brokerage department. Our licensed personnel have over 25 years of experience in the financial services industry.
5. Mortgage Lending: Staffed with experienced mortgage originators and processors, our mortgage lending department originates residential mortgage loans that are primarily funded by third-party mortgage lenders. We collect a fee on the origination of these loans.
We continue to implement this business strategy. A critical component of this strategy includes increasing our non-consumer based lending. During 2008, our farmland, construction, commercial real estate, nonresidential, business and multifamily loans increased slightly from $155.0 million or 50.1% of the total loan portfolio to $155.1 million or 51.3% of the total loan portfolio. Our ability to continue to grow our commercial loan portfolio is an important element of our long term business strategy. These non-consumer based loans are considered to entail greater risks than one- to four-family residential loans.
Another key component of our business strategy is the expansion of our operations beyond the Southwest Georgia market. On August 8, 2006, we commenced operating a branch in Ocala, Florida. As of December 31, 2008, we had approximately $40.7 million in loans and $46.2 million in deposits generated in our North Central Florida market. Operating a branch outside of the Southwest Georgia market subjects us to additional risk factors. These risk factors include, but are not limited to the following: management of employees from a distance, lack of knowledge of the local market, additional credit risks, logistical operational issues, and time constraints of management. These risk factors, as well as others we have not specifically identified, may affect our ability to successfully operate outside of our current market area.
Asset and Liability Management and Market Risk
Our Risk When Interest Rates Change. The rates of interest we earn on assets and pay on liabilities generally are established contractually for a period of time. Market rates change over time. Like other financial institutions, our results of operations are impacted by changes in interest rates and the interest rate sensitivity of our assets and liabilities. The risk associated with changes in interest rates and our ability to adapt to these changes is known as interest rate risk and is our most significant market risk.
How We Measure Our Risk of Interest Rate Changes. As part of our attempt to manage our exposure to changes in interest rates and comply with applicable regulations, we monitor our interest rate risk. In doing so, we analyze and manage assets and liabilities based on their interest rates and payment streams, timing of maturities, repricing opportunities, and sensitivity to actual or potential changes in market interest rates.
To manage the potential for adverse effects of material and prolonged increases in interest rates on our results of operations, we adopted asset and liability management policies to understand, measure, monitor, and control the risk. These policies are designed to allow us to implement strategies to minimize the effects of interest rate changes to net income and capital position by properly matching the maturities and repricing terms of our interest earning assets and interest bearing liabilities. These policies are implemented by the risk management committee, which is composed of senior management and board members. The risk management committee establishes guidelines for and monitors the volume and mix of assets and funding sources, taking into account relative costs and spreads, interest rate sensitivity and liquidity requirements. The objectives are to manage assets and funding sources to produce results that limit negative changes in net income and capital while supporting liquidity, capital adequacy, growth, risk and profitability goals. Senior managers oversee the process on a daily basis. The risk management committee meets quarterly to review, among other things, economic conditions and interest rate outlook, current and projected needs and capital position, anticipated changes in the volume and mix of assets and liabilities, interest rate risk exposure, liquidity position and net portfolio present value. The committee also recommends strategy changes, as appropriate, based on their review. The committee is responsible for reviewing and reporting the effects of the policy implementations and strategies to the board of directors on a quarterly basis.
In order to manage our assets and liabilities and achieve the desired liquidity, credit quality, interest rate risk, profitability and capital targets, we have focused our strategies on:
The risk management committee has oversight over the asset-liability management of the Company. This committee regularly reviews interest rate risk by forecasting the impact of alternative interest rate environments on net income and the market value of portfolio equity. Market value of portfolio equity is a measurement of the value of the balance sheet at a fixed point in time. It is summarized as the fair value of assets less the fair value of liabilities. The committee reviews computations of the value of capital at current interest rates and alternative interest rates. The variance in the net portfolio value between current interest rate computations and alternative rate computations represents the potential impact on capital if rates were to change.
Comparison of Financial Condition at December 31, 2008 and December 31, 2007
Total assets increased $33.3 million, a 7.1% increase from December 31, 2007, to $502.1 million at December 31, 2008. The increase was due primarily to growth in cash and due from banks, federal funds sold and investments, funded by growth in deposits and borrowings.
Total interest earning assets increased $22.2 million or 5.2% to $449.6 million at December 31, 2008, from $427.4 million at December 31, 2007. Gross loans decreased $2.2 million or 0.7% to $302.5 million at December 31, 2008, compared with $304.7 million at December 31, 2007. Investment securities increased $8.3 million or 7.7% to $116.1 million at December 31, 2008. Federal funds purchased increased $15.8 million or 108.6% to $30.3 million at December 31, 2008. Interest-bearing deposits in banks increased $366,000 or 96.3% to $746,000 at December 31, 2008. The increase in these liquid interest earning assets was due primarily to our intent to maintain higher than historical levels of liquidity. This was done due to the amount of panic that existed in the financial markets during the third and fourth quarters of 2008. Due to this level of uncertainty, we sought to be able to meet any demands from our customers that may arise, primarily to be able to facilitate large deposit withdrawals if necessary. This strategy does cause net interest margin to decrease, however, we feel the benefits of maintaining excess liquidity during uncertain economic times outweighs the cost to net interest margin. We expect to continue to maintain excess liquidity during 2009.
The decrease in loans is due to a lack of demand we have seen from our customers and from an increase in loans transferred to other real estate owned. As the economic slowdown continues, we expect to continue to see loan demand decrease. We expect to see our loan portfolio continue to decrease due to normal amortizations and paydowns. Particularly, we expect our indirect automobile portfolio to decrease approximately $7.0 million during 2009 as we continue to see extremely weak demand for automobile sales.
Other equity securities increased to $1.0 million at December 31, 2008. This is due to our investment in Chattahoochee Bank of Georgia (Chattahoochee).
Cash surrender value of bank owned life insurance (BOLI) increased by $5.5 million, primarily due to the purchase of $5.0 million of additional BOLI in June of 2008. This purchase was made due to an advantageous interest rate environment compared to other investment alternatives. In addition, this purchase allowed us to cover many new officers of the Bank that were not covered under existing BOLI policies which were purchased in 2001.
Foreclosed assets increased $1.8 million to $2.1 million at December 31, 2008. $1.1 million of the foreclosed assets is a residential development in the Florida panhandle. This loan was a participation purchased by the Banks commercial lending division in Albany. This development consisted of 17 completed homes and 24 lots. As of December 31, 2008, we have sold 6 of the homes and one of the lots. In 2009, we sold the remainder of these homes for their approximate net book value as of December 31, 2008. Another $405,000 of the balance in foreclosed assets is a residential development in Northeast Georgia. This loan was a participation purchased by the Banks commercial lending division in Albany. The development is an unfinished subdivision, and the value is based on a current appraisal. We are currently in the process of seeking a buyer for this development. This loan was not purchased from, originated by, or related to our investment in, Chattahoochee Bank of Georgia. The remainder of the balance in foreclosed assets represents various pieces of real estate, with no single piece exceeding $200,000, and repossessed automobiles totaling $55,000.
Total liabilities increased $36.7 million or 9.1% to $439.8 million at December 31, 2008, compared with $403.1 million at December 31, 2007. This increase was due primarily to the increase in interest bearing liabilities, which increased $38.5 million or 10.3%, to $413.4 million at December 31, 2008, from $374.9 million at December 31, 2007. Deposits ended the year at $338.5 million, up 2.4% or $7.9 million from $330.6 million from December 31, 2007. This increase was attributable to our geographic expansion efforts, as well as a focus on attracting core deposits. As part of this effort, we decreased brokered deposits during 2008 by $11.9 million. Total borrowings amounted to $52.5 million at December 31, 2008, an increase of $2.5 million or 5.0% from December 31, 2007. In addition, we increased federal funds purchased and securities sold under repurchase agreements by $26.2 million or 171.4%, of which $11.0 million is in federal funds purchased from Chattahoochee Bank of Georgia. These purchases are done as an accommodation to Chattahoochee so that they can earn a competitive rate on federal funds without having to place concentrated amounts of federal funds with traditional correspondent banks. In return, these funds provide us with a stable, low cost source of funds. The remaining $15.2 million of the increase is in repurchase agreements, which were entered into to provide us with a source of low cost floating rate funds.
Total equity decreased $3.4 million or 5.2% to $62.2 million at December 31, 2008. A net loss of $262,000, dividends of $787,000, and the purchase of $4.2 million of treasury stock decreased equity. Compensation expense related to the allocation of ESOP shares of $488,000, stock-based compensation expense of $809,000, and other comprehensive income of $618,000 partially offset the decrease in equity.
During 2008, we purchased a significant amount of treasury stock. Because of the recent decrease in the overall market value of financial institutions, we believe there has been opportunity to repurchase our stock below its inherent value. We will continue to look at opportunities to repurchase stock at values we believe are below the inherent value of the Company, while also considering other capital and liquidity needs as well as other investment alternatives.
Average Balances, Net Interest Income, Yields Earned and Rates Paid
The following table presents for the periods indicated the total dollar amount of interest income from average interest-earning assets and the resultant yields, as well as the interest expense on average interest-bearing liabilities, expressed both in dollars and rates. Yields on tax-exempt obligations have been computed on a tax equivalent basis. Nonaccruing loans have been included in the table as loans carrying a zero yield. Prior year balances have been adjusted in order to compute yields on a tax equivalent basis.
The following schedule presents the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities. It distinguishes between the changes related to outstanding balances and that due to the changes in interest rates. The change in interest attributable to rate has been determined by applying the change in rate between years to average balances outstanding in the later year. The change in interest due to volume has been determined by applying the rate from the earlier year to the change in average balances outstanding between years. Changes that are not solely due to volume have been consistently attributed to rate.
Comparison of Operating Results for the Years Ended December 31, 2008 and December 31, 2007
Our net income decreased by $3.2 million or 109.0% to a loss of $262,000 compared to net income of $2.9 million for the year ended December 31, 2007. Basic and diluted net income per share decreased 110.7% or $0.31 per share to a loss of $0.03 per share for December 31, 2008, compared with net income of $0.28 per share at December 31, 2007. Impairment losses on securities of $3.1 million and a $2.2 million increase in provision for loans losses were the primary reasons for the decrease in earnings. Further explanations of these changes are discussed in more detail in the following sections.
Net Interest Income
Net interest income increased $166,000 or 1.1% to $14.7 million compared with $14.5 million for the twelve months ending 2007. Our net interest spread decreased 6 basis points to 3.16% compared with 3.22% during the year earlier period. The net interest margin decreased 25 basis points to 3.45% versus 3.70% during the same period in 2007. Average interest earning assets increased $35.5 million or 8.7% to $443.1 million compared with $407.6 million during the year-earlier period. Average interest bearing liabilities increased $46.2 million or 13.0% to $401.6 million compared with $355.4 million at December 31, 2007.
The Federal Reserve Board has made extreme moves in interest rates, dropping the federal funds rate from a high of 5.25% in mid 2007 down to its current level of a targeted range of zero to 0.25%. These decreases in the federal funds rate have caused our net interest margin to decline. In addition to the pressure these decreases have put on our margin, we have also seen pressure from historically high spreads between U.S. Treasury rates and bank certificate of deposit rates. As many banks have had to aggressively go after deposit customers, we have had to keep our rates higher than normal during such dramatic drops in interest rates. In addition, the Federal Reserve has taken measures to keep longer term interest rates down by buying U.S. Treasury bonds. This has an additional effect of keeping the yield curve relatively flat, which puts additional strain on our ability to improve the net interest margin. As long as these trends continue, we expect to see the net interest margin decrease during 2009. Additionally, as our loan demand remains weak, we will likely see a decrease in interest earning assets, which could cause our net interest income to decrease.
Provision for Loan Losses
We recorded a provision for loans losses of $3.4 million in 2008 compared with $1.2 million for the prior-year period. Net charge-offs of $2.8 million added to the increase in reserve requirement for 2008. Non-performing loans increased $4.1 million to $7.3 million at December 31, 2008, compared with $3.2 million at December 31, 2007. The ratio of non-performing loans to total loans increased to 2.41% compared with 1.05% at December 31, 2007. The allowance for loan losses as a percentage of total loans increased by 19 basis points to 1.64% compared with 1.45% at December 31, 2007.
The bulk of our non-performing loans consist of a $4.8 million loan on raw land in Atlanta, Georgia. We are currently working with the borrower to dispose of this property. It was originally purchased for commercial and residential development. However, due to the economic environment in the area, we no longer believe this is a viable alternative. The next largest non-performing loan is a real estate loan for $988,000 secured by a restaurant building in Ocala, Florida. The remainder of our non-performing loans consist of various consumer and commercial loans, none exceeding $110,000. Current appraisals on real estate loans, expected costs of potential foreclosure or other disposition, and other potential losses on these loans are considered in our analysis of the allowance for loan losses.
Loans past due 30 or more days and still accruing totaled $4.5 million, or 1.47% of total loans at December 31, 2008. This compares to $1.9 million at December 31, 2007, or 0.65% of loans. We had no loans past due 90 or more days and still accruing at December 31, 2008 or 2007.
Our internally criticized and classified assets totaled $27.0 million at December 31, 2008, compared to $13.4 million at December 31, 2007. These balances include the aforementioned nonperforming loans, other real estate, and repossessed assets. Our internal loan review processes strive to identify weaknesses in loans prior to performance issues. However, our processes do not always provide sufficient time to work out plans with borrowers that would avoid foreclosure and/or losses.
We continue to see weakness in our loan portfolio, and as economic conditions remain difficult, we expect this trend to continue until we see improvement in the overall economy. We have taken actions to prevent losses in our current portfolio, including a weekly meeting of members of management and lenders to discuss the status and action plan on each problem loan. We have also taken steps to better evaluate the capital and liquidity positions of our commercial loan guarantors, particularly those involved in commercial real estate construction and development.
We establish provisions for loan losses, which are charged to operations, at a level we believe will reflect probable credit losses based on historical loss trends and an evaluation of specific credits in the loan portfolio. In evaluating the level of the allowance for loan losses, we consider the types of loans and the amount of loans in the loan portfolio, historical loss experience, adverse situations that may affect the borrowers ability to repay, estimated value of any underlying collateral, prevailing economic conditions, and past due status and trends.
We assess the allowance for loan losses on a quarterly basis and make provisions for loan losses as necessary in order to maintain the proper level of allowance. While we use available information to recognize losses on loans, future loan loss provisions may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the allowance for loan losses and may require us to recognize additional provisions based on their judgment of information available to them at the time of their examination. The allowance for loan losses is maintained at a level that represents managements best estimate of inherent losses in the loan portfolio, and such losses were both probable and reasonably estimable. The level of the allowance is based on estimates and the ultimate losses may vary from the estimates.
Impairment Losses on Securities
During 2008, we determined that the securities of three issuers whose securities were held in our available for sale portfolio were other than temporarily impaired. The total impairment charge recorded was $3.1 million. The securities included a $1.5 million investment in the preferred stock of Freddie Mac, which we impaired completely subsequent to the government intervention into the entity. In addition, we impaired the corporate bonds of General Motors, in which we had an investment of $1.2 million that was written down to $220,000, and the corporate bonds of Ford Motor Credit, in which we held an investment of $1.0 million that was written down to $400,000. Subsequent to these impairments, we saw a significant increase in the value of our corporate bonds. Based on this change in value, we sold our investments in General Motors and Ford Motor Credit for an approximate $200,000 gain from their previously impaired values. We currently still hold our investment in the preferred stock of Freddie Mac.
As of December 31, 2008, approximately 96.3% of our investment portfolio had a rating of investment grade, with 81.1% of the portfolio having a rating of AAA. Approximately 3.6% of our investment portfolio is not rated by the major credit rating agencies.
A summary of noninterest income, excluding securities transactions, follows:
Our service charges on deposit accounts remained relatively flat. In previous years we have seen significant increases in our overdraft protection products, however, as this product has matured, our increases have become modest. We expect service charges to remain flat, or decrease slightly if economic activity continues to remain slow.
The increase in other service charges, commissions and fees was due primarily to an increase in debit and ATM transaction fees. Our customers continue to increase debit card usage instead of using cash or checks. We expect this trend to continue, despite a decrease in consumer spending.
The increase in our brokerage fees was due primarily to an increase in assets under management. However, recent declines in the stock market could cause this income to decrease in the future.
Mortgage fees increased despite a slow down in the real estate market. We have had increased refinancing activity as rates have decreased, which has more than offset the decline from a slower real estate market. Despite the increase in refinancing activity, stricter underwriting standards have caused an increase in the amount of time it takes to process each loan, which could cause a decrease in revenue.
Earnings on bank owned life insurance policies increased due to the purchase of an additional $5.0 million of cash surrender value of bank owned life insurance policies in 2008.
Other noninterest income increased due to an increase in miscellaneous service charges that took place late in 2007. The increase was offset by decreases in FHLB stock dividends of $33,000, to $129,000 for 2008. We do not expect to receive any FHLB stock dividends in 2009.
A summary of noninterest expense follows:
The decrease in salaries and employee benefits is due a decrease of $1.4 million of expenses related to executive benefit plans that were fully vested in 2007. We expect salaries and benefits to remain level in 2009.
Equipment and occupancy expenses increased primarily because of the opening of two new branches in Ocala in January and June of 2008. We expect these expenses to remain level in 2009 as increased branch expenses are offset by other cost reduction measures.
Advertising and marketing increased due to our increased business development expenses in the Ocala market.
The increase in legal and accounting fees was due to a significant increase in legal fees, while audit fees decreased slightly. The increase in legal fees were related to our investment in Chattahoochee Bank of Georgia, and legal expenses related to collection efforts on problem assets.
The decrease in directors fees is due to a decrease of $198,000 of expenses related to director retirement plans that were fully vested in 2007. In addition, incentive pay for advisory directors was not earned in 2008 as business development goals were not attained.
Consulting and other professional fees decreased primarily due to the payment of $250,000 to one vendor for an organizational restructuring, expense reduction and revenue enhancement project in 2007.
Telecommunication expenses were up slightly due to the addition of two new branches in 2008.
Supply expenses were down due to our efforts to reduce expenses and renegotiation of vendor contracts.
Data processing expenses increased due to the increased amount of debit card transactions in 2008.
The loss on sale and write-down of other real estate owned increased due to the increased amount of other real estate owned and efforts to dispose of these properties. We expect that these expenses will remain elevated until levels of other real estate owned are reduced.
Foreclosed asset expenses also increased significantly due to the increased level of foreclosed assets. We expect that these expenses will also remain elevated until levels of other real estate and repossessions are reduced.
The increase in FDIC insurance and other regulatory fees was due to an increase in FDIC premiums and the utilization of our remaining prior credits toward these premiums in 2007. For 2009, we are expecting the base premium to increase approximately 110% from the 2008 level. In addition, the recent announcement of a proposed special one time assessment from the FDIC will add an additional $350,000 to $700,000 to the already increased premium for 2009, depending on the final assessment from the FDIC. In addition, there are other provisions in the most recent FDIC board decision which will allow other special assessments to be imposed. At this time, we are not certain of the magnitude of these proposed assessments if they were to be imposed.
The increase in other operating expenses was due primarily to increases in travel and training that occurred early in 2008. We expect this to decrease as travel and training budgets have been reduced for 2009.
Income Tax Expense
Income tax benefits were $378,000 greater during the year ended December 31 2008 as compared with 2007. The majority of the income tax benefits in 2007 primarily related to the reversal of a contingent income tax liability of $1.1 million. The contingent liability had been established in 2001 upon converting to a taxable entity and reflected the potential tax impact of tax positions taken at that time. We believed the filing position was supportable based upon a reasonable interpretation of federal income tax laws and the underlying regulations, however, due to the lack of prior rulings on similar fact patterns, it was unknown whether the tax position would be sustained upon audit by either federal or state tax authorities. The applicable statue of limitations expired on September 15, 2007, making the contingency reserve unnecessary. We have no other contingent reserves for uncertain tax positions as of December 31, 2008.
Due to the unusual nature of the items in the 2008 and 2007 years, a comparison of effective tax rates is not meaningful.
Liquidity and Capital Resources
We are required to have enough cash and investments that qualify as liquid assets in order to maintain sufficient liquidity to ensure a safe and sound operation. Liquidity may increase or decrease depending upon the availability of funds and comparative yields on investments in relation to the return on loans. Historically, we have maintained liquid assets above levels believed to be adequate to meet the requirements of normal operations, including potential deposit outflows. Cash flow projections are regularly reviewed and updated to assure that adequate liquidity is maintained.
Our liquidity, represented by cash and cash equivalents, is a product of our operating, investing and financing activities. The Company has $41.2 million in cash, federal funds sold and interest bearing deposits in banks generally available for its cash needs. The Banks primary sources of funds are deposits, amortization, prepayments and maturities of outstanding loans and mortgage-backed securities, maturities of investment securities and other short-term investments and funds provided by operations. While scheduled payments from the amortization of loans and maturing short-term investments are relatively predictable sources of funds, deposit flows and loan prepayments are greatly influenced by general interest rates, economic conditions and competition. In addition, the Bank invests excess funds in short-term interest-earning assets, which provide liquidity to meet lending requirements. The Bank also generates cash through borrowings, primarily from Federal Home Loan Bank advances, to leverage its capital base, provide funds for its lending and investment activities and enhance its interest rate risk management.
Liquidity management is both a daily and long-term function of business management. Excess liquidity is generally invested in short-term investments, such as overnight deposits and federal funds. On a longer term basis, we maintain a strategy of investing in various lending products and investment securities, including mortgage-backed securities. The Bank uses its sources of funds primarily to meet its ongoing commitments, pay maturing deposits, fund withdrawals and fund loan commitments. At December 31, 2008, the total approved loan commitments and unused lines of credit outstanding amounted to $37.2 million, and outstanding letters of credit were $5.0 million. Certificates of deposit scheduled to mature in one year or less at December 31, 2008, totaled $143.9 million. It is managements policy to manage deposit rates that are competitive with other local financial institutions. Based on this management strategy, we believe that a majority of maturing deposits will remain with the Bank. In addition, the Bank had the ability, at December 31, 2008, to borrow an additional $36.0 million from the Federal Home Loan Bank of Atlanta and $37.9 million from another lender as a funding source to meet commitments and for liquidity purposes.
The consolidated statement of cash flows for the twelve months ended December 31, 2008 and 2007, details cash flows from operating, investing and financing activities. For the twelve months ended December 31, 2008, net cash provided by operating activities was $8.5 million, while investing activities used $38.8 million, primarily to fund investment growth, and financing activities provided $31.6 million primarily from an increase in deposits and other borrowings, resulting in a net increase in cash during the twelve month period of $1.2 million.
In March 2008, we purchased a lot in the Southwest Georgia market for $743,000 for potential future expansion. We are considering building a branch on this site, and may start construction later in 2009, but have not determined the cost of such an expansion.
The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. A summary of the Companys commitments as of December 31, 2008 is as follows:
Effective January 1, 2005, the Company and the Bank became subject to minimum capital requirements imposed by the Georgia Department of Banking and Finance. As of that same date, the Bank also became subject to minimum capital requirements and capital categories established by the FDIC. Based on their capital levels at December 31, 2008, the Company and the Bank exceeded these state and federal requirements. Consistent with our goals to operate a sound and profitable organization, our policy is for the Bank to maintain a well-capitalized status under the capital categories of the FDIC. Based on capital levels at December 31, 2008, the Bank was considered to be well-capitalized.
At December 31, 2008, the Company had total equity of $62.2 million or 12.4% of total assets. Under Georgia capital requirements for holding companies, the Company had Tier 1 leverage capital of $61.8 million or 12.6%, which is $42.2 million above the 4.0% requirement.
At December 31, 2008, the Bank had Tier 1 leverage capital of $55.2 million or 11.0%, which is $25.0 million above the 4.0% requirement. In addition, it had a Tier 1 risked-based capital ratio of 15.4% and total risked-based capital ratio of 16.7%.
As reflected below, the Company and the Bank exceeded the minimum capital ratios to listed at December 31, 2008:
Critical Accounting Policies
We have established certain accounting and financial reporting policies to govern the application of accounting principles generally accepted in the United States of America in the preparation of our financial statements. Our significant accounting policies are described in the Notes to Consolidated Financial Statements. Certain accounting policies involve significant judgments and assumptions by management which have a material impact on the carrying value of certain assets and liabilities. The judgments and assumptions used by management are based on historical experience and other factors that are believed to be reasonable under the circumstances. Because of the nature of the judgments and assumptions made by management, actual results could differ from the judgments and estimates adopted by management, which could have a material impact on the carrying values of assets and liabilities and the results of our operations. We believe the following accounting policies applied by us represent critical accounting policies.
Allowance for Loan Losses. We believe the allowance for loan losses is a critical accounting policy that requires the most significant judgments and estimates used in the preparation of our consolidated financial statements. The allowance for loan losses represents managements estimate of probable loan losses in the loan portfolio. Calculation of the allowance for loan losses represents a critical accounting estimate due to the significant judgment, assumptions and estimates related to the amount and timing of estimated losses, consideration of current and historical trends and the amount and timing of cash flows related to impaired loans.
Management believes that the allowance for loan losses is maintained at a level that represents our best estimate of probable losses in the loan portfolio. While management uses available information to recognize losses on loans, future additions to the allowance for loan losses may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review our allowance for loan losses. These agencies may require us to recognize additions to the allowance for loan losses based on their judgments about information available to them at the time of their examination.
Management evaluates current information and events regarding a borrowers ability to repay its obligations and considers a loan to be impaired when the ultimate collectibility of amounts due, according to the contractual terms of the loan agreement, is in doubt. If the loan is collateral-dependent, the fair value of the collateral is used to determine the amount of impairment. Impairment losses are included in the allowance for loan losses through a charge to the provision for losses on loans.
Subsequent recoveries are credited to the allowance for loan losses. Cash receipts for accruing loans are applied to principal and interest under the contractual terms of the loan agreement. Cash receipts on impaired loans for which the accrual of interest has been discontinued are applied first to principal and then to interest income.
Income Taxes. SFAS No. 109, Accounting for Income Taxes, requires the asset and liability approach for financial accounting and reporting for deferred income taxes. We use the asset and liability method of accounting for deferred income taxes and provide deferred income taxes for all significant income tax temporary differences. See Note 11 of the Notes to Consolidated Financial Statements for additional details.
As part of the process of preparing our consolidated financial statements we are required to estimate our income taxes in the jurisdiction in which we operate. This process involves estimating our actual current tax exposure together with assessing temporary differences resulting from differing treatment of items, such as depreciation and the provision for loan losses, for tax and financial reporting purposes. These differences result in deferred tax assets and liabilities that are included in our consolidated balance sheet.
After converting to a federally chartered savings association, the Bank became a taxable organization. Income tax expense is the total of the current year income tax due or refundable and the change in deferred tax assets and liabilities. Deferred tax assets and liabilities are the expected future tax amounts for the temporary difference between carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized. The Internal Revenue Code and applicable regulations are subject to interpretation with respect to the determination of the tax basis of assets and liabilities for credit unions that convert charters and become a taxable organization. Since the Banks transition to a federally chartered thrift, the Bank has recorded income tax expense based upon managements interpretation of the applicable tax regulations. Positions taken by the Company in preparing our federal and state tax returns are subject to the review of taxing authorities, and the review of the positions we have taken by taxing authorities could result in adjustments to our financial statements.
Estimates of Fair Value
The estimation of fair value is significant to a number of the Companys assets, including, but not limited to, investment securities, goodwill, other real estate owned, and other repossessed assets. These are all recorded at either fair value or at the lower of cost or fair value. Fair values are volatile and may be influenced by a number of factors. Circumstances that could cause estimates of the fair value of certain assets and liabilities to change include a change in prepayment speeds, discount rates, or market interest rates. Our estimates and assumptions are reviewed periodically and the effects of revisions are reflected in the consolidated financial statements in the period they are determined to be necessary.
Fair values for most investment securities are based on quoted market prices. If quoted market prices are not available, fair values are based on the quoted prices of similar instruments. The fair values of other real estate owned are typically determined based on appraisals by third parties, less estimated costs to sell.
Estimates of fair value are also required in performing an impairment analysis of goodwill. The Company reviews goodwill for impairment on at least an annual basis and whenever events or circumstances indicate the carrying value may not be recoverable. An impairment would be indicated if the carrying value exceeds the fair value of a reporting unit.
Item 7a. Quantitative and Qualitative Disclosures about Market Risk
The Company is exposed only to U.S. dollar interest rate changes, and, accordingly, the Company manages exposure by considering the possible changes in the net interest margin. The Company does not have any trading instruments nor does it classify any portion of the investment portfolio as held for trading. The Company monitors its sensitivity to changes in interest rates and may use derivative instruments to hedge this risk. The Company does not enter into derivatives or other financial instruments for trading or speculative purposes. Finally, the Company has no exposure to foreign currency exchange rate risk and commodity price risk.
Interest rates play a major part in the net interest income of a financial institution. The sensitivity to rate changes is known as interest rate risk. The repricing of interest-earning assets and interest-bearing liabilities can influence the changes in net interest income.
The Company uses simulation analysis to monitor changes in net interest income due to changes in market interest rates. The simulation of rising, declining and flat interest rate scenarios allows management to monitor and adjust interest rate sensitivity to minimize the impact of market interest rate swings. The analysis of the impact on net interest income over a twelve-month period is subjected to a shock in interest rates of 100, 200 and 300 basis point increase or decrease in market rates on net interest income and is monitored on a quarterly basis. We also monitor regulatory required interest rate risk analysis which simulates more dramatic changes to rates.
The Companys strategy is to mitigate interest risk to the greatest extent possible. Based on our analysis of the Companys overall risk to changes in interest rates, we structure investment and funding transactions to reduce this risk. These strategies aim to achieve neutrality to interest rate risk. Although we strive to have our net interest income neutral to changes in rates, due to the inherent nature of our business, we will never be completely neutral to changes in rates. As of December 31, 2008, a drop in interest rates would reduce our net interest income and an increase in rates would increase our net interest income. However, we feel that the level of interest rate risk is at an acceptable level.
The Company maintains a risk management committee which monitors and analyzes interest rate risk. This committee is comprised of members of senior management and outside directors. This committee meets on a monthly basis and reviews the simulations listed above, as well as other interest rate risk reports.
The following table shows the results of our projections for net interest income expressed as a percentage change over net interest income in a flat rate scenario for an immediate change or shock in market interest rates over a twelve month period.
Item 8. Financial Statements
The following documents are filed as part of this report on Pages F-1 through F-44 and are hereby incorporated by reference into this Item 8:
Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure
Item 9A. Controls and Procedures
Disclosure Controls and Procedures
The Companys Chief Executive Officer and Chief Financial Officer have evaluated the Companys disclosure controls and procedures (as such term is defined in Rules 13a-15(e) or 15d-15(e) promulgated under the Securities Exchange Act of 1934, as amended (the Exchange Act)), as of the end of the period covered by this Annual Report, as required by paragraph (b) of Rules 13a-15 or 15d-15 of the Exchange Act. Based on such evaluation, such officers have concluded that, as of the end of the period covered by this Annual Report, the Companys disclosure controls and procedures are effective.
Managements Annual Report on Internal Control Over Financial Reporting
The management of Heritage Financial Group is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. The Companys internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.
All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions or that the degree of compliance with the policies or procedures may deteriorate.
Management assessed the effectiveness of the Companys internal control over financial reporting as of December 31, 2008. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework. Based on this assessment and those criteria, management concluded that the Company maintained effective internal control over financial reporting as of December 31, 2008.
Item 9B. Other Information
Item 10. Directors and Executive Officers and Corporate Governance
Information concerning the Directors of the Company is incorporated herein by reference from the definitive proxy statement for the annual meeting of stockholders to be held May 20, 2009, a copy of which will be filed not later than 120 days after the close of the fiscal year.
Information concerning the Executive Officers of the Company is incorporated herein by reference from the definitive proxy statement for the annual meeting of stockholders to be held May 20, 2009.
Section 16(a) Compliance
Section 16(a) of the Securities Exchange Act of 1934 requires that the Companys directors and executive officers, and persons who own more than 10% of the Companys Common Stock, file with the SEC initial reports of ownership and reports of changes in ownership of the Companys Common Stock. Officers, directors and greater than 10% stockholders are required by SEC regulations to furnish the Company with copies of all Section 16(a) forms they file. MHC, which owns approximately 75% of the Companys Common Stock filed its initial ownership report on Form 3 and subsequent ownership report on Form 4 late. To the Companys knowledge, no other late reports occurred during the fiscal year ended December 31, 2008. All other Section 16(a) filing requirements applicable to our executive officers, directors and greater than 10% beneficial owners were complied with.
Code of Ethics
In March 2005, the Company adopted a written Code of Business Conduct and Ethics based upon the standards set forth under Item 406 of Regulation S-B of the Securities and Exchange Commission. The Code of Business Conduct and Ethics applies to all of the Companys directors, officers and employees. This code is available to all interested parties on the Companys website at www.eheritagebank.com, under Governance Documents in the Investor Relations section.
Item 11. Executive Compensation
Information concerning executive compensation required by this item is incorporated herein by reference from the definitive proxy statement for the annual meeting of stockholders to be held May 20, 2009, except for information contained under the heading Report of the Audit Committee, a copy of which will be filed not later than 120 days after the close of the fiscal year.
Item 12. Security Ownership of Certain Beneficial Owners and Management
Information concerning security ownership of certain beneficial owners and management required by this item is incorporated herein by reference from the definitive proxy statement for the annual meeting of stockholders to be held May 20, 2009.
Item 13. Certain Relationships and Related Transactions
Information concerning certain relationships and related transactions required by this item is incorporated herein by reference from the definitive proxy statement for the annual meeting of stockholders to be held May 20, 2009, a copy of which will be filed not later than 120 days after the close of the fiscal year. This incorporation by reference excludes the information contained under the heading Report of Audit Committee.
Information concerning the independence of our directors required by this item is incorporated herein by reference from the definitive proxy statement for the annual meeting of stockholders to be held May 20, 2009, a copy of which will be filed not later than 120 days after the close of the fiscal year. This incorporation by reference excludes the information contained under the heading Report of Audit Committee.
Item 14. Principal Accountant Fees and Services
Information concerning fees and services by our principal accountants required by this item is incorporated herein by reference from our definitive proxy statement for the annual meeting of stockholders to be held on May 20, 2009, a copy of which will be filed not later than 120 days after the close of the fiscal year.
Item 15. Exhibits
In accordance with Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints O. Leonard Dorminey his true and lawful attorney-in-fact and agent, with full power of substitution and re-substitution, for him and in his name, place and stead, in any and all capacities, to sign any and all amendments (including post-effective amendments) to this Registration Statement, and to file the same, with all exhibits thereto, and all other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorney-in-fact and agent full power and authority to do and perform each and every act and thing requisite and necessary to be done, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all said attorney-in-fact and agent or his substitute or substitutes may lawfully do or cause to be done by virtue hereof.
In accordance with the Exchange Act, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Index to Exhibits
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors
Heritage Financial Group
We have audited the accompanying consolidated balance sheets of Heritage Financial Group and Subsidiary as of December 31, 2008 and 2007, and the related consolidated statements of operations, comprehensive income, stockholders equity and cash flows for each of the two years in the period ended December 31, 2008. These financial statements are the responsibility of the Companys management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Heritage Financial Group and Subsidiary as of December 31, 2008 and 2007, and the results of their operations and their cash flows for each of the two years in the period ended December 31, 2008, in conformity with accounting principles generally accepted in the United States of America.
/s/ Mauldin & Jenkins, LLC
March 31, 2009
HERITAGE FINANCIAL GROUP AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2008 AND 2007
See Notes to Consolidated Financial Statements.
HERITAGE FINANCIAL GROUP AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS
YEARS ENDED DECEMBER 31, 2008 AND 2007
See Notes to Consolidated Financial Statements.
HERITAGE FINANCIAL GROUP AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
YEARS ENDED DECEMBER 31, 2008 AND 2007
See Notes to Consolidated Financial Statements.
HERITAGE FINANCIAL GROUP AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY
YEARS ENDED DECEMBER 31, 2008 AND 2007
See Notes to Consolidated Financial Statements.
HERITAGE FINANCIAL GROUP AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, 2008 AND 2007
HERITAGE FINANCIAL GROUP AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, 2008 AND 2007
See Notes to Consolidated Financial Statements.
HERITAGE FINANCIAL GROUP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Nature of Business
Heritage Financial Group (the Company) is a mid-tier holding company whose business is primarily conducted by its wholly-owned subsidiary, HeritageBank of the South (the Bank). The Company is a 75% owned subsidiary of Heritage, MHC, a federally chartered mutual holding company. The other 25% of the Company is owned by the public who acquired shares of the Company through a stock offering completed on June 29, 2005. Through the Bank, the Company operates a full service banking business and offers a broad range of retail and commercial banking services to its customers located in a market area which includes Southwest Georgia and Central Florida. The Company and the Bank are subject to the regulations of certain federal and state agencies and are periodically examined by those regulatory agencies.
Minority Stock Offering
The Company completed an initial public stock offering on June 29, 2005. It sold 3,372,375 shares of common stock in that offering for $10.00 per share. The Companys employee stock ownership plan (the ESOP) purchased 440,700 shares with the proceeds of a loan from the Company. The Company received net proceeds of $32.4 million in the public offering, of which 50% was contributed to the Bank and $4.4 million was lent to the ESOP for its purchase of shares in the offering. The Company also issued an additional 7,867,875 shares of common stock to Heritage, MHC, so that Heritage, MHC would own 70% of the outstanding common stock at the closing of that offering.
Basis of Presentation and Accounting Estimates
The consolidated financial statements include the accounts of the Company and its subsidiary. Significant intercompany transactions and balances have been eliminated in consolidation.
In preparing the consolidated financial statements in conformity with generally accepted accounting principles, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Material estimates that are particularly susceptible to significant change in the near-term relate to the determination of the allowance for loan losses, the valuation of foreclosed real estate, contingent assets and liabilities and deferred tax assets. The determination of the allowance for loan losses is based on estimates that are susceptible to significant changes in the economic environment and market conditions. In connection with the determination of the estimated losses on loans and the valuation of foreclosed real estate, management obtains independent appraisals for significant collateral.
Cash, Due from Banks and Cash Flows
For purposes of reporting cash flows, cash and due from banks includes cash on hand, cash items in process of collection and amounts due from banks. Cash flows from loans, federal funds sold, interest-bearing deposits, interest receivable, deposits, federal funds purchased and securities sold under repurchase agreements and interest payable in banks are reported net.
The Bank is required to maintain reserve balances in cash or on deposit with the Federal Reserve Bank. The total of those reserve balance requirements was approximately $2,141,000 and $1,749,000 at December 31, 2008 and 2007, respectively.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Debt securities that management has the positive intent and ability to hold to maturity are classified as held to maturity and recorded at amortized cost. Management has not classified any of its debt securities as held to maturity. Securities not classified as held to maturity, including equity securities with readily determinable fair values, are classified as available for sale and recorded at fair value with unrealized gains and losses excluded from earnings and reported in accumulated other comprehensive income, net of the related deferred tax effect. Equity securities, including other equity securities, without a readily determinable fair value are classified as available for sale and recorded at cost. Restricted equity securities are recorded at cost.
The amortization of premiums and accretion of discounts are recognized in interest income using methods approximating the interest method over the life of the securities. Realized gains and losses, determined on the basis of the cost of specific securities sold, are included in earnings on the settlement date. Declines in the fair value of securities available for sale below their cost that are deemed to be other than temporary are reflected in earnings as realized losses.
In estimating other than temporary impairment losses, management considers (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.
Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off are reported at their outstanding principal balances less unearned income, net deferred fees and costs on originated loans and the allowance for loan losses. Interest income is accrued on the outstanding principal balance. Loan origination fees, net of certain direct origination costs of consumer and installment loans, are recognized at the time the loan is placed on the books. Loan origination fees for all other loans are deferred and recognized as an adjustment of the yield over the life of the loan using the straight-line method.
The accrual of interest on loans is discontinued when, in managements opinion, the borrower may be unable to meet payments as they become due, unless the loan is well-secured. Past due status is based on contractual terms of the loan. Generally, loans are placed on nonaccrual or charged off at an earlier date if collection of principal or interest is considered doubtful. All interest accrued, but not collected for loans that are placed on nonaccrual or charged off, is reversed against interest income, unless management believes that the accrued interest is recoverable through the liquidation of collateral. Interest income on nonaccrual loans is subsequently recognized only to the extent cash payments are received until the loans are returned to accrual status. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
A loan is considered impaired when it is probable, based on current information and events, the Company will be unable to collect all principal and interest payments due in accordance with 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. Impaired loans are measured 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. The amount of impairment, if any, and any subsequent changes are included in the allowance for loan losses. Interest on accruing impaired loans is recognized as long as such loans do not meet the criteria for nonaccrual status. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment.
Allowance for Loan Losses
The allowance for loan losses is established as lossese are estimated to have occurred through a provision for loan losses charged to expense. Loan losses are charged against the allowance when management believes the collectibility of the principal is unlikely. Subsequent recoveries, if any, are credited to the allowance.
The allowance is an amount that management believes will absorb estimated losses relating to specifically identified loans, as well as probable credit losses inherent in the balance of the loan portfolio. The allowance for loan losses is evaluated on a regular basis by management and is based upon managements periodic review of the collectibility of loans in light of historical experience, the nature and volume of the loan portfolio, overall portfolio quality, review of specific problem loans, current economic conditions that may affect the borrowers ability to pay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.
This evaluation does not include the effects of expected losses on specific loans or groups of loans that are related to future events or expected changes in economic conditions. While management uses the best information available to make its evaluation, future adjustments to the allowance may be necessary if there are significant changes in economic conditions. In addition, regulatory agencies, as an integral part of their examination process, periodically review the Banks allowance for loan losses and may require the Bank to make additions to the allowance based on their judgment about information available to them at the time of their examinations.
The allowance consists of specific, general and unallocated components. The specific component relates to loans that are classified as impaired. For such loans that are classified as impaired, an allowance is established when the discounted cash flows, collateral value or observable market price of the impaired loan is lower than the carrying value of that loan. The general component covers non-classified loans and is based on historical loss experience adjusted for qualitative factors. An unallocated component is maintained to cover uncertainties that could affect managements estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Mortgage Origination Fees
The Company originates first mortgage loans for other investors. These loans are not funded by the Company but, upon closing, the Company receives a fee from the investor. Generally, the Company receives fees equivalent to a stated percentage of the loan amount.
Premises and Equipment
Land is carried at cost. Premises and equipment are carried at cost, less accumulated depreciation computed on the straight-line method over the estimated useful lives:
Intangible assets consist of a payment made to complete a series of transactions which allowed the Company to acquire the right to branch into Florida in 2006. This indefinite lived intangible asset is required to be tested at least annually for impairment or whenever events occur that may indicate the recoverability of the carrying amount is not probable. In the event of impairment, the amount by which the carrying amount exceeds the fair value is charged to earnings. The Company performed its annual test of impairment in the fourth quarter and determined that there was no impairment in the carrying value of this intangible asset.
Foreclosed assets acquired through or in lieu of loan foreclosure are held for sale and are initially recorded at the lower of cost or fair value less estimated costs to sell. Any write-down to fair value at the time of transfer to foreclosed assets is charged to the allowance for loan losses. (Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less cost to sell.) Costs of improvements are capitalized, whereas costs relating to holding foreclosed assets and subsequent adjustments to the value are expensed. The carrying amount of foreclosed assets at December 31, 2008 and 2007 was $2,119,818 and $364,999, respectively.
Transfers of Financial Assets
Transfers of financial assets are accounted for as sales, when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Corporation, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Corporation does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.
The compensation cost of an employees pension benefit is recognized on the projected unit credit method over the employees approximate service period. The Companys funding policy is to contribute annually an amount that satisfies the funding standard account requirements of ERISA.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Employee Stock Ownership Plan (ESOP)
The cost of shares issued to the ESOP, but not yet allocated to participants, is shown as a reduction of stockholders equity. Compensation expense is based on the market price of shares as they are committed to be released to participant accounts. Dividends on allocated ESOP shares reduce retained earnings; dividends on unearned ESOP shares reduce debt and accrued interest.
The Company accounts for its ESOP in accordance with Statement of Position 93-6. Accordingly, since the Company sponsors the ESOP with an employer loan, neither the ESOPs loan payable or the Companys loan receivable are reported in the Companys consolidated balance sheet. Likewise, the Company does not recognize interest income or interest cost on the loan. Unallocated shares held by the ESOP are recorded as unearned ESOP shares in the consolidated statement of changes in stockholders equity. As shares are released for allocation, the Company recognizes compensation expense equal to the average market price of the shares for the period.
The Companys repurchases of shares of its common stock are recorded at cost as treasury stock and result in a reduction of stockholders equity. When treasury shares are reissued, the Company uses an average cost method and any difference in repurchase cost and reissuance price is recorded as an increase or reduction in capital surplus.
Deferred income tax assets and liabilities are determined using the balance sheet method. Under this method, the net deferred tax asset or liability is determined based on the tax effects of the temporary differences between the book and tax bases of the various balance sheet assets and liabilities and gives current recognition to changes in tax rates and laws.
Managements determination of the realization of deferred tax assets is based upon managements judgment of various future events and uncertainties, including the timing, nature and amount of future income earned by certain subsidiaries and the implementation of various plans to maximize realization of deferred tax assets. Management believes that the Company will generate sufficient operating earnings to realize the deferred tax benefits.
Earnings (Loss) Per Share
Basic earnings (loss) per share represent income (loss) available to common shareholders divided by the weighted-average number of common shares outstanding during the period, excluding unearned shares of the Employee Stock Ownership Plan and unvested shares of stock. Diluted earnings (loss) per share are computed by dividing net income (loss) by the sum of the weighted-average number of shares of common stock outstanding and dilutive potential common shares. Potential common shares consist only of stock options and unvested restricted shares.
Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on securities available for sale, are reported as a separate component of the equity section of the balance sheet, such items, along with net income, are components of comprehensive income.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Recent Accounting Standards
SFAS No. 141, Business Combinations (Revised 2007). SFAS 141R replaces SFAS 141, Business Combinations, and applies to all transactions and other events in which one entity obtains control over one or more other businesses. SFAS 141R requires an acquirer, upon initially obtaining control of another entity, to recognize the assets, liabilities and any non-controlling interest in the acquiree at fair value as of the acquisition date. Contingent consideration is required to be recognized and measured at fair value on the date of acquisition rather than at a later date when the amount of that consideration may be determinable beyond a reasonable doubt. This fair value approach replaces the cost-allocation process required under SFAS 141 whereby the cost of an acquisition was allocated to the individual assets acquired and liabilities assumed based on their estimated fair value. SFAS 141R requires acquirers to expense acquisition-related costs as incurred rather than allocating such costs to the assets acquired and liabilities assumed, as was previously the case under SFAS 141. Under SFAS 141R, the requirements of SFAS 146, Accounting for Costs Associated with Exit or Disposal Activities, would have to be met in order to accrue for a restructuring plan in purchase accounting. Pre-acquisition contingencies are to be recognized at fair value, unless it is a non-contractual contingency that is not likely to materialize, in which case, nothing should be recognized in purchase accounting and, instead, that contingency would be subject to the probable and estimable recognition criteria of SFAS 5, Accounting for Contingencies. SFAS 141R is expected to have a significant impact on the Companys accounting should it enter into any business combinations closing on or after January 1, 2009.
SFAS No. 157, Fair Value Measurements. SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS 157, with the exception of certain provisions, became effective for the Company on January 1, 2008 (see Note 18 Fair Value of Financial Instruments).
SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities - Including an amendment of FASB Statement No. 115. SFAS 159 permits entities to choose to measure eligible items at fair value at specified election dates. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings at each subsequent reporting date. The fair value option (i) may be applied instrument by instrument, with certain exceptions, (ii) is irrevocable (unless a new election date occurs) and (iii) is applied only to entire instruments and not to portions of instruments. SFAS 159 became effective for the Company on January 1, 2008. The adoption of this statement did not have a significant impact on the Companys financial statements.
SFAS No. 160, Noncontrolling Interest in Consolidated Financial Statements, an amendment of ARB Statement No. 51. SFAS 160 amends Accounting Research Bulletin (ARB) No. 51, Consolidated Financial Statements, to establish accounting and reporting standards for the non-controlling interest in a subsidiary and for the deconsolidation of a subsidiary. SFAS 160 clarifies that a non-controlling interest in a subsidiary, which is sometimes referred to as a minority interest, is an ownership interest in the consolidated entity that should be reported as a component of equity in the consolidated financial statements. Among other requirements, SFAS 160 requires consolidated net income to be reported at amounts that include the amounts attributable to both the parent and the non-controlling interest. It also requires disclosure, on the face of the consolidated income statement, of the amounts of consolidated net income attributable to the parent and to the non-controlling interest. SFAS 160 is effective for the Corporation on January 1, 2009 and is not expected to have a significant impact on the Companys financial statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Recent Accounting Standards (Continued)
SFAS No. 162, The Hierarchy of Generally Accepted Accounting Principles. SFAS 162 identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles (GAAP) in the United States (the GAAP hierarchy). The hierarchical guidance provided by SFAS 162 did not have a significant impact on the Companys financial statements.
FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement 109. Interpretation 48 prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. Benefits from tax positions should be recognized in the financial statements only when it is more likely than not that the tax position will be sustained upon examination by the appropriate taxing authority that would have full knowledge of all relevant information. A tax position that meets the more-likely-than-not recognition threshold is measured at the largest amount of benefit that is greater than fifty percent likely of being realized upon ultimate settlement. Tax positions that previously failed to meet the more-likely-than-not recognition threshold should be recognized in the first subsequent financial reporting period in which that threshold is met. Previously recognized tax positions that no longer meet the more-likely-than-not recognition threshold should be derecognized in the first subsequent financial reporting period in which that threshold is no longer met. Interpretation 48 also provides guidance on the accounting for and disclosure of unrecognized tax benefits, interest and penalties. The adoption of Interpretation 48 on January 1, 2007 did not significantly impact the Companys financial statements.
FSP No. 48-1 Definition of Settlement in FASB Interpretation No. 48. FSP 48-1 provides guidance on how to determine whether a tax position is effectively settled for the purpose of recognizing previously unrecognized tax benefits. FSP 48-1 was effective retroactively to January 1, 2007 and did not significantly impact the Companys financial statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 2. SECURITIES
The amortized cost and fair value of securities available for sale with gross unrealized gains and losses are summarized as follows:
The amortized cost and fair value of debt securities available for sale as of December 31, 2008 by contractual maturity are shown below. Maturities may differ from contractual maturities in mortgage-backed securities because the mortgages underlying the securities may be called or repaid without penalty. Therefore, these securities are not included in the maturity categories in the following maturity summary.
Securities with a carrying value of $64,931,946 and $40,863,150 at December 31, 2008 and 2007, respectively, were pledged to secure public deposits, repurchase agreements and for other purposes required or permitted by law.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 2. SECURITIES (Continued)
Gains and losses on sales of securities available for sale consist of the following:
During 2008, the Company recorded an other than temporary impairment charges on securities of three issuers whose securities were held in our available for sale portfolio. An other than temporary impairment charge of $1.5 million was recorded on its investment in Freddie Mac preferred stock. The value of these securities declined significantly after the U.S. Government placed both companies into conservatorship in September 2008. The securities have a new cost basis of approximately $1. In addition, the Company impaired the corporate bonds of General Motors, in which we had an investment of $1.2 million that was written down to $220,000, and the corporate bonds of Ford Motor Credit, in which the Company held an investment of $1.0 million that was written down to $400,000. Subsequent to the write down, the Company saw a significant increase in the value of the corporate bonds. Based on the change in value, the Company sold the investments in General Motors and Ford Motor Credit for an approximate gain of $172,000. The Company still holds the investment in the preferred stock of Freddie Mac at December 31, 2008.
The following table shows the gross unrealized losses and fair value of securities aggregated by category and length of time that securities have been in a continuous unrealized loss position at December 31, 2008 and 2007.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 2. SECURITIES (Continued)
Management evaluates securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation.
In analyzing an issuers financial condition, management considers whether the securities are issued by the federal government or its agencies, whether downgrades by bond rating agencies have occurred and industry analysts reports. As management has the intent and ability to hold the securities until maturity, or for the foreseeable future and due to the fact that the unrealized losses relate primarily to changes in interest rates and do not affect the expected cash flows of the underlying collateral or issuer, no declines are deemed to be other than temporary.
The investment in the common stock of the Federal Home Loan Bank of Atlanta is accounted for by the cost method, which also represents par value, and is made for long-term business affiliation reasons. In addition, this investment is subject to restrictions relating to sale, transfer or other disposition. Dividends are recognized in income when declared. The carrying value of this investment at December 31, 2008 is $3,185,800. The estimated fair value of this investment is $3,185,800 as of December 31, 2008 and therefore is not considered impaired.
Other equity securities represent an investment in the common stock of the Chattahoochee Bank of Georgia (Chattahoochee), a de novo bank in Gainesville, Georgia. The Company accounts for this investment by the cost method. This investment represents approximately 4.9% of the outstanding shares of Chattahoochee. Since its initial capital raise, Chattahoochee has not had any stock transactions, and therefore, no fair market value is readily available. The carrying value of this investment at December 31, 2008 is $1,010,000. The Company plans to hold this investment for the foreseeable future, and does not consider it impaired as of December 31, 2008.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 3. LOANS AND ALLOWANCE FOR LOAN LOSSES
The composition of loans is summarized as follows:
The following is a summary of information pertaining to impaired loans:
Loans on nonaccrual status amounted to $7,281,226 and $3,211,635 at December 31, 2008 and 2007, respectively. There were no loans past due ninety days or more and still accruing interest at December 31, 2008 and 2007, respectively. There were no significant amounts of interest income recognized on impaired loans on the cash basis for the years ended December 31, 2008 and 2007.
Changes in the allowance for loan losses are as follows:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 3. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)
In the ordinary course of business, the Company has granted loans to certain directors, executive officers and their affiliates. Changes in related party loans at December 31, 2008 are summarized as follows:
NOTE 4. OTHER REAL ESTATE OWNED
A summary of other real estate owned is presented as follows:
NOTE 5. PREMISES AND EQUIPMENT
Premises and equipment are summarized as follows:
Construction in progress at December 31, 2008 consisted primarily of costs associated with the purchase of real estate and design for a new branch location in the Albany market area. Currently, the Company has not started construction of this facility and does not have an estimated cost for the facility.
Included in construction in progress at December 31, 2007 was $2,641,120 for the construction of two branches in Ocala, Florida. These branches were completed and placed in service in 2008 for a total cost of approximately $3.5 million.
Depreciation and amortization expense was $964,205 and $974,435 for the years ended December 31, 2008 and 2007, respectively.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 5. PREMISES AND EQUIPMENT (Continued)
The Company has three leases for office space being, two used as branch locations and one for the Companys investment division. One of the branch facilities is leased on a month-to-month basis in Lee County, Georgia. The Company intends to discontinue the lease of this location on June 30, 2009. The other branch location is under a noncancelable operating lease on its banking facility in Ocala, Florida. The lease for the investment division is under a noncancelable lease in Albany, Georgia.
The Company has also obtained assignment of a 99 year land lease associated with its main office in Ocala, Florida with a remaining life of approximately 64 years.
Rental expense under all operating leases amounted to approximately $147,225 and $129,054 for the years ended December 31, 2008 and 2007, respectively.
Future minimum lease commitments on noncancelable operating leases, excluding any renewal options, are summarized as follows:
NOTE 6. DEPOSITS
The aggregate amount of time deposits in denominations of $100,000 or more at December 31, 2008 and 2007 was $58,363,282 and $80,700,272, respectively. The scheduled maturities of time deposits at December 31, 2008 are as follows:
At December 31, 2008 and 2007, overdraft deposit accounts reclassified to loans totaled $267,806 and $513,430, respectively.
The Company had $53,039,736 and $64,894,275 in brokered deposits as of December 31, 2008 and 2007, respectively.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 7. EMPLOYEE BENEFIT PLANS
The Company provides pension benefits for eligible employees through a defined benefit pension plan. All employees that meet certain age and service requirements participate in the retirement plan on a noncontributing basis. Information pertaining to the activity in the plan is as follows:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 7. EMPLOYEE BENEFIT PLANS (Continued)
Pension Plan (Continued)
Other changes in plan assets and benefit obligations recognized in other comprehensive income for the years ended December 31, 2008 and 2007:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 7. EMPLOYEE BENEFIT PLANS (Continued)
Pension Plan (Continued)
To determine the expected rate of return on plan assets, the Company considers the current and expected asset allocations, as well as historical and expected returns on various categories of plan assets. The approximate allocation of plan assets as of December 31, 2008 and 2007 is as follows:
Plan fiduciaries set investment policies and strategies for the plan assets. Long-term strategic investment objectives include capital appreciation through balancing risk and return.
The Company expects to contribute $1,000,000 to the plan during 2009.
The amounts in accumulated other comprehensive income that are expected to be recognized as components of net periodic benefit cost during 2009 are as follows:
Estimated future benefit payments, which reflect expected future service, as appropriate, are as follows:
The Company has also established a salary deferral plan under Section 401(k) of the Internal Revenue Code. The plan allows eligible employees to defer a portion of their compensation up to 25%, subject to certain limits based on federal tax laws. Such deferrals accumulate on a tax deferred basis until the employee withdraws the funds. The Bank matches 50% of employees contributions up to 4% of their salary. Total expense recorded for the Banks match was approximately $100,000 and $87,000 for December 31, 2008 and 2007, respectively.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 7. EMPLOYEE BENEFIT PLANS (Continued)
Employee Stock Ownership Plan (ESOP)
In connection with the minority stock offering, the Company established an Employee Stock Ownership Plan (ESOP) for the benefit of its employees with an effective date of June 29, 2005. The ESOP purchased 440,700 shares of common stock from the minority stock offering with proceeds from a ten-year note in the amount of $4,407,000 from the Company. The Companys Board of Directors determines the amount of contribution to the ESOP annually, but it is required to make contributions sufficient to service the ESOPs debt. Shares are released for allocation to employees as the ESOP debt is repaid. Eligible employees receive an allocation of released shares at the end of the calendar year on a relative compensation basis. An employee becomes eligible on January 1st or July 1st immediately following the date they complete one year of service. Company dividends on allocated shares will be paid to employee accounts. Dividends on unallocated shares held by the ESOP will be applied to the ESOP note payable.
Contributions to the ESOP during 2008 and 2007 amounted to $556,691 in each year.
Compensation expense for shares committed to be released under the Companys ESOP in 2008 and 2007 were $487,882 and $650,806, respectively. Shares held by the ESOP were as follows:
NOTE 8. DEFERRED COMPENSATION PLANS
The Company has entered into separate deferred compensation arrangements with certain executive officers and directors. The plans call for certain amounts payable at retirement, death or disability. The estimated present value of the deferred compensation is being accrued over the remaining expected service period. The Company has purchased life insurance policies which they intend to use to finance this liability. Cash surrender value of life insurance of $14,136,119 and $8,640,647 at December 31, 2008 and 2007, respectively, is separately stated on the consolidated balance sheets. In September of 2007, the Company accelerated vesting under its deferred compensation agreements with each of its currently serving covered directors and executives. Under this acceleration, each covered director and executive is fully vested in their plan balance.
Accrued deferred compensation of $3,123,970 and $3,484,114 at December 31, 2008 and 2007, respectively, is included in other liabilities.
The Company has also entered into deferred salary agreements with certain officers electing to defer a portion of their salary. These amounts are expensed and the plan accumulates the deferred salary plus earnings. At December 31, 2008 and 2007, the liability for these agreements was $439,893 and $362,064, respectively, and is included in other liabilities.
Aggregate compensation expense under the plans was $61,507 and $1,443,220 for 2008 and 2007, respectively.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 9. FEDERAL FUNDS PURCHASED AND SECURITIES SOLD UNDER REPURCHASE AGREEMENTS
Federal funds purchased represent unsecured borrowings from other banks and generally mature daily. Securities sold under repurchase agreements are secured borrowings and are reflected at the amount of cash received in connection with the transactions. The Company may be required to provide additional collateral based on the fair value of the underlying securities. The Company monitors the fair value of the underlying securities on a daily basis. Federal funds purchased and securities sold under repurchase agreements at December 31, 2008 and 2007 were as follows:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 10. OTHER BORROWINGS
Other borrowings consist of the following:
The advances from Federal Home Loan Bank are collateralized by the pledging of a blanket lien on all first mortgage loans and other specific loans, as well as FHLB stock.
Other borrowings at December 31, 2008 have maturities in future years as follows:
The Company and subsidiary Bank have available unused lines of credit with various financial institutions including the FHLB totaling approximately $73,903,000 at December 31, 2008.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 11. INCOME TAXES
The income tax benefit in the consolidated statements of operations consists of the following:
The Companys income tax benefit differs from the amounts computed by applying the federal income tax statutory rates to income before income taxes. A reconciliation of the differences is as follows: