Monarch Financial Holdings 10-K 2009
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
for the fiscal year ended December 31, 2008
for the transition period from to
MONARCH FINANCIAL HOLDINGS, INC.
[EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER]
Registrants telephone number, including area code (757) 389-5111
Securities registered pursuant to Section 12(b) of the Act:
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $5.00 par value
(Title of class)
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ No x
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No x
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ¨ No x
The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant as of June 30, 2008 was approximately $57,545,000.
The number of shares of common stock outstanding as of March 1, 2009 was 5,744,507.
We are a Virginia-chartered Bank Holding Company engaged in business and consumer banking, investment and insurance sales, and mortgage origination and brokerage. We were created on June 1, 2006 through a reorganization plan, under the laws of the Commonwealth of Virginia, in which Monarch Bank (the Bank) became a wholly-owned subsidiary of Monarch Financial Holdings, Inc. (the Company). Monarch Bank was incorporated on May 1, 1998, and opened for business on April 14, 1999.
We are a member of the Federal Reserve and the Bank is Federal Deposit Insurance Corporation (FDIC) insured. We serve the needs of local businesses, professionals, executives and individuals in the South Hampton Roads area of Southeastern Virginia and in Northeastern North Carolina. The Bank currently has locations in Chesapeake, Virginia, where it is headquartered; Virginia Beach, Virginias largest city; and Norfolk, with an additional location in Kitty Hawk, North Carolina operating as OBX Bank, a division of Monarch Bank. The Company is a community oriented, locally owned and operated institution. Mortgage operations are located in Virginia Beach, Chesapeake, Suffolk, Norfolk and Fredericksburg in Virginia, with six additional offices in Maryland and one in North Carolina.
Our current capitalization enables us to provide loans in amounts that are responsive to the credit needs of a large portion of our targeted market segments. If clients have credit requirements that exceed our credit limits, we generally accommodate those clients by arranging loans on a participation basis with other financial institutions. Our Board of Directors believes that our capitalization supports current growth levels in loans and deposits, however, any additional capital will increase our loan-to-one borrower limit and permit us to retain more of a borrowers loan if we deem it to be in the shareholders best long-term interest.
Other services offered by us include investment advisory services, insurance sales, safe deposit boxes, cash management services, check and bankcard services, direct deposit of payroll and social security checks and automatic drafts for various accounts. We offer our clients access to their accounts and our banking services utilizing traditional in-office transactions as well as remote deposit capture, internet banking and internet cash management, and through 50 automated teller machines (ATMs) located throughout Southeastern Hampton Roads and Northeastern North Carolina.
We operate in several integrated lines of business:
Our Business Banking Group has been a core line of business since our opening. This group supports our business/commercial clients and offers both secured and unsecured commercial loans for working capital (including inventory and receivables), business expansion (including acquisition of real estate and improvements) and the purchase of equipment and machinery, as well as loans secured by commercial real estate. This group also originates business deposits and related services. We have Business Banking groups in each of our four cities, each led by a market President.
Our Real Estate Banking Group has been a core line of business since our opening. This group supports the delivery of residential and commercial real estate construction, acquisition and development loans, with the majority of their focus in the 1-4 family residential development markets of Hampton Roads and Northeastern North Carolina. This group supports this type of banking in all of our current markets.
Our Private Banking Group delivers the banking and financial needs of our consumer clients and has also been a core line of business since we opened. The Private Banking Group targets the financial needs of professionals and business executives, and provides custom tailored product and service solutions to their clients. The Private Banking Group services the deposit needs for all of our clients and offers consumer lending and general banking services. We offer a full range of deposit services including checking accounts, savings accounts and other time deposits of various types, ranging from daily money market accounts to longer-term certificates of deposit. Consumer loans include home equity lines of credit and loans, professional lines of credit, secured and unsecured loans for financing automobiles, home improvements, education and personal investments.
Monarch Mortgage (MM) originates and sells permanent residential mortgage loans. MM, a division of Monarch Bank was formed in May 2007 as a result of reorganizing our mortgage operations to focus on expansion. As a mortgage lender, MM underwrites mortgage loans for our clients to be sold in the secondary market or booked on our balance sheet. MM currently has twelve offices with locations in Chesapeake, Norfolk,
Virginia Beach, Suffolk and Fredericksburg, Virginia, as well as two offices in Rockville, Maryland and offices in Bowie, Crofton, Waldorf, and College Park, Maryland, and one office in Kitty Hawk, North Carolina. MM originates and sells loans under two different financial models. Our Fredericksburg, Virginia office and all the offices in Maryland operate as fee-based offices, with each office paying a per loan processing fee with the net income or loss of each office the responsibility of each offices manager or management team. The fee-based offices allow Monarch Mortgage to attract quality entrepreneurial leaders focused on their bottom line. The loan fees from these operations lower the cost basis and breakeven volume for the Virginia operations while reducing the downside risk of startup and operating losses. The remaining Virginia and North Carolina offices are traditional operations with the profits and losses accruing to Monarch Mortgage.
Monarch Capital, LLC, a wholly-owned subsidiary of Monarch Bank formed in 2004, provides structured financing and commercial mortgage brokerage services in the placement of primarily long-term fixed-rate, non-recourse debt for the commercial, hospitality, and multi-family housing markets.
Monarch Investment, LLC, a wholly-owned subsidiary of Monarch Bank, has ownership interests in several subsidiaries. We deliver services through these subsidiaries or investments as follows:
Virginia Asset Group, LLC, formed in October 2006, offers investment advisory services through licensed investment advisors and also sells specific lines of insurance. Investment services are offered through Infinex Financial, LLC, a broker-dealer located in Meriden, Connecticut. Monarch Investment, LLC owns a minority shareholder interest in Infinex Financial, LLC, following the April 20, 2008 merger of BI Investments, LLC, into Infinex Financial, LLC. Monarch Investment, LLC, also owns a minority interest in Bankers Insurance, LLC, a joint venture with the Virginia Bankers Association and many other community banks in Virginia. This insurance agency offers a full line of commercial and personal lines of insurance to the general public and to the Companys clients. Insurance services are also offered through other carriers. Virginia Asset Group, LLC, is 51% owned by Monarch Investment, LLC, and 49% by Mr. Darin Ely, the President of Virginia Asset Group.
Coastal Home Mortgage, LLC, became a subsidiary of Monarch Investment, LLC, in July 2007 when a 51% ownership interest in the company was purchased from another bank. This is a joint venture with four individuals involved with commercial and residential construction in Hampton Roads, with their primary mission to provide residential mortgage loan services for their end product. All loans are processed and underwritten by Monarch Mortgage.
In October of 2007 Real Estate Security Agency, LLC, was formed to offer title insurance services to clients of Monarch Mortgage and Monarch Bank. This agency offers residential and commercial title and settlement services to the Companys clients. Monarch Investment, LLC, owns 75% of this new company with 25% owned by TitleVentures, LLC. In 2007 we sold our minority interest in Bankers Title of Central Virginia, LLC, a joint venture with the Virginia Bankers Association and many other community banks in Virginia.
Home Mortgage Solutions, LLC, was formed in March 2008 and is 51% owned by Monarch Investment, LLC. This is a joint venture with a local builder and developer involved with residential construction in the Richmond, Virginia and Hampton Roads, Virginia markets. Their primary mission is to provide residential mortgage loan services for their end products. All loans are processed and underwritten by Monarch Mortgage.
Our primary market area includes South Hampton Roads, Virginia, which includes the cities of Virginia Beach, Chesapeake, Norfolk, Suffolk and Portsmouth and the Outer Banks region of northeastern, North Carolina. South Hampton Roads, with a population of over 1 million, has experienced steady growth in recent years and is one of the largest metropolitan areas in Virginia. South Hampton Roads is also home to the Port of Hampton Roads, the second largest volume port on the east coast in terms of general cargo and the largest U.S. port on total tonnage. The area has a significant military base presence, with all of the U.S. armed forces represented in the area. The most notable military base is Naval Station Norfolk, the largest naval installation in the world. Within South Hampton Roads, we currently concentrate our operations in Chesapeake, Virginia Beach and Norfolk, the three largest cities.
Chesapeake, which has a population of just over 221,000, has the regions highest median family income of $73,190 according to Money Magazines August 2008 Best Places to Live (MMag) issue. Chesapeakes greatest employment concentration is in the area of sales and service, led primarily by health care and support centers. Chesapeake is also home to industries including, trade, manufacturing, maritime, military related industries, and oil and petroleum businesses. All of these demographics make Chesapeake an attractive market for banking services. Our headquarters is located in Chesapeake, and we also have two full service banking offices as well as a mortgage office in the Greenbrier and Great Bridge sections of Chesapeake.
Virginia Beach, which has a population of over 435,000, is the most populous city in Virginia and the 38th largest city in the United States. Virginia Beach has a median family income of approximately $68,969 according to MMag. Virginia Beachs major industries include tourism, retail and wholesale trade, light manufacturing and military related industries. All of these demographics also make Virginia Beach an attractive market for banking services. We operate banking offices in the Lynnhaven, Oceanfront, Town Center and Kempsville areas of Virginia Beach. We believe these are excellent market areas within the city of Virginia Beach. The Kempsville office opened in January 2007. The headquarters for Monarch Mortgage, which includes a sales office, and the headquarters for Virginia Asset Group, LLC, are located in Virginia Beach.
Norfolk, which has a population of 229,000, is the cultural, industrial, business and medical center of Hampton Roads and hosts the areas international airport. Median family income is $46,759, according to MMag. The city is undergoing a successful renewal, including new office, retail, hotel construction and new residential development. We operate two banking offices and one mortgage office in the city of Norfolk. Our banking offices are in the Ghent area with our second office in downtown Norfolk. The mortgage banking office is located in Ghent.
Outer Banks, a primarily two county (Currituck and Dare) area on North Carolinas northeast coast, is one of the healthiest economic growth markets in North Carolina particularly considering that both counties are relatively small by statewide population standards. OBX Bank operates as a division of Monarch Bank, and OBX Bank is a registered trademark. The Outer Banks area is focused on tourism and residential construction and development, and has a growing year round retiree population. We operate one banking location in the town of Kitty Hawk, North Carolina. The latest population estimates show that Currituck County had approximately 23,900 residents in 2006. This made Currituck only the 78th largest county in the state (out of 100). However, from 2000 to 2006, Currituck County experienced total population growth of 31.4%, indicating faster growth when compared to all of the counties in the state, except two. Dare County, with an approximate population of 36,500 in 2006, is the states 66th most populated county and experienced total population growth of 21.7% from 2000 to 2006. While Dares population growth is lower than Curritucks, it is the 8th fastest growing county in the state and exceeds the statewide average annual growth rate during the same period (1.4%). Population projections show Currituck County growing by 30.1% and Dare County growing by 17.6% during the five year period from 2006 to 2011. Based on 2006 information, median household income for Currituck County was the 16th highest in North Carolina at $48,055, and Dare County had the 9th highest in North Carolina at $51,332. As of the 2000 census, there were 13,631 housing units in Currituck County and 30,972 housing units in Dare County, with 65% of Currituck and 48% of Dare households being owner occupied. As of June 30, 2007, the most recent date available, there were over $1 billion in deposits in Dare and Currituck Counties.
Our mortgage offices outside of the Hampton Roads and Outer Banks markets are located for the convenient delivery and sales of residential mortgage loans. We have additional mortgage offices in Fredericksburg, Virginia, Richmond, Virginia through our Home Mortgage Solutions joint venture; College Park, Rockville (2), Waldorf, Crofton and Bowie, Maryland.
Over the past year the general economy has been deteriorating. In direct relationship to this deterioration the banking industry, as a whole, has been under stress. Banks, in general, have come under sharp criticism for the aggressive lending practices of some of the larger players in the mortgage and banking field. Although we have not participated in the practices that have led to industry criticism, as a member of that group we have experienced downward pressure on earnings. Our goals remain the same; to continue to be a strong bank, with a conservative management style that has been the mainstay of healthy bank performance throughout history. As such, we are committed to serving our community with competitive loan and deposit pricing and a wide array of services.
As of February 15, 2009, the Company and its subsidiaries had two hundred, sixty-four (264) full-time and thirty-one (31) part-time employees. None of its employees are represented by any collective bargaining agreements, and relations with employees are considered excellent.
The principal risk associated with each of the categories of loans in our portfolio is the creditworthiness of its borrowers. Within each category, such risk is increased or decreased, depending on prevailing economic conditions. In an effort to manage the risk, our loan policy gives loan amount approval limits to individual bankers based on their position and level of experience, and to our loan committees based on the size of the lending relationship. The risk associated with real estate and construction loans, commercial loans and consumer loans varies, based on market employment levels, consumer confidence, fluctuations in the value of real estate and other conditions that affect the ability of borrowers to repay indebtedness. The risk associated with real estate construction loans varies, based on the supply and demand for the type of real estate under construction.
We have written policies and procedures to help manage credit risk. We utilize an outside third party loan review process that includes regular portfolio reviews to establish loss exposure and to ascertain compliance with our loan policy.
A Management Loan Committee and a Directors Loan Committee are utilized to approve loans. The Management Loan Committee is comprised of members of management, and the Directors Loan Committee is composed of seven Directors, of which four are independent Directors. Both Committees approve new, renewed and modified loans that exceed officer loan authorities. The Directors Loan Committee also reviews any changes to the Banks lending policies, which are then approved by the Board of Directors.
Construction and Development Lending
We make construction loans, primarily residential, and land acquisition and development loans. We also offer a construction-permanent loan that is administered through Monarch Mortgage. All construction loans are secured by the building under construction and the underlying land for which the loan was obtained. The average life of a construction loan is approximately 12 months, and it is typically repriced monthly. Because the majority of the interest rates charged on these loans float with the market, the construction loans help us to manage interest rate risk. Construction lending entails significant additional risks, compared with residential mortgage lending. Construction loans often involve larger loan balances concentrated with single borrowers or groups of related borrowers. Another risk involved in construction lending is attributable to the fact that loan funds are advanced upon the security of the land or home under construction, which value is estimated prior to the completion of construction. Thus, it is more difficult to evaluate accurately the total loan funds required to complete a project and related loan-to-value ratios. To mitigate the risks associated with construction lending, we generally limit loan amounts to 70% to 90% of appraised value or cost, in addition to analyzing the creditworthiness of its borrowers. We also obtain a first lien on the property as security for construction loans and typically require personal guarantees from the borrowers principal owners.
Commercial Real Estate Lending
Commercial real estate loans are secured by various types of commercial real estate primarily in our market area, including multi-family residential buildings, commercial buildings and offices, shopping centers and churches. Commercial real estate lending entails significant additional risk, compared with residential mortgage lending. Commercial real estate loans typically involve larger loan balances concentrated with single borrowers or groups of related borrowers. Additionally, the payment experience on loans secured by income producing properties is typically dependent on the successful operation of a business or a real estate project and thus may be subject, to a greater extent, to adverse conditions in the real estate market or in the economy in general. Our commercial real estate loan underwriting criteria require an examination of debt service coverage ratios and the borrowers creditworthiness, prior credit history and reputation. We also evaluate the location of the security property and typically require personal guarantees or endorsements of the borrowers principal owners.
Business loans generally have a higher degree of risk than residential mortgage loans, but have higher yields. To manage these risks, we generally obtain appropriate collateral and personal guarantees from the borrowers principal owners and monitor the financial condition of its business borrowers. Residential mortgage loans generally are made on the basis of the borrowers ability to make repayment from their employment and other income and are secured by real estate whose value tends to be readily ascertainable. In contrast, business loans typically are made on the basis of the borrowers ability to make repayment from cash flow from its business and are secured by business assets, such as real estate, accounts receivable, equipment and inventory. As a
result, the availability of funds for the repayment of business loans is substantially dependent on the success of the business itself. Furthermore, the collateral for business loans may depreciate over time and generally cannot be appraised with as much precision as residential real estate.
We offer various consumer loans, including personal loans and lines of credit, professional lines of credit, automobile loans, deposit account loans, installment and demand loans, and home equity lines of credit and loans. Such loans are generally made to clients with whom we have a pre-existing relationship. We currently originate all of our consumer loans in our geographic market area.
The underwriting standards we employed for consumer loans include a determination of the applicants payment history on other debts and an assessment of ability to meet existing obligations and payments on the proposed loan. The stability of the applicants monthly income may be determined by verification of gross monthly income from primary employment, and additionally from any verifiable secondary income. Although creditworthiness of the applicant is of primary consideration, the underwriting process also includes an analysis of the value of the security in relation to the proposed loan amount. For home equity lines of credit and loans, our primary consumer loan category, the Bank requires title insurance, hazard insurance and if required, flood insurance.
Portfolio Mortgage Lending
Through our mortgage division Monarch Mortgage, for our own portfolio, we offer adjustable rate mortgages and construction loans to individual borrowers. All adjustable rate mortgages have initial resets in seven years or less and are structured for a potential later sale on the secondary market. Our construction permanent loan program offers individual clients, typically working with a custom builder, a residential construction loan with the ability to sell the loan on the secondary market once complete through a Monarch Mortgage loan. The majority of the residential mortgage loans originated by Monarch Mortgage are sold to investors on the secondary market.
The banking business is highly competitive. We encounter strong competition from a variety of bank and non-bank financial services providers. These competitors include commercial banks, savings banks, credit unions, consumer finance companies, brokerage firms, money market mutual funds, mortgage banks, mortgage brokers, leasing, and finance companies. In addition, the delivery of financial services has changed significantly with the telephone, ATM, personal computer and the Internet being used to access information and perform banking transactions.
Competition in our target market area for loans to businesses, professionals and consumers is very strong. Many of our competitors have substantially greater resources and lending limits than we do and offer certain services, such as extensive and established branch networks and other services that we cannot provide. Moreover, larger institutions operating in the South Hampton Roads have access to borrowed funds at a lower cost than we do. Several community banks are headquartered in our trade areas. Several regional and super-regional banks, as well as a number of large credit unions, also have offices in our market area. Competition among institutions for deposits in the area is intense.
Supervision and Regulation
Bank Holding Company Act. In order to acquire the shares of Monarch Bank and thereby become a bank holding company within the meaning of the Bank Holding Company Act, we were required to obtain approval from, and register as a bank holding company, with the Federal Reserve Board (the Board), and are subject to ongoing regulation, supervision and examination by the Board. As a condition to its approval, the Board required that we agree that we would obtain approval of the Federal Reserve Bank of Richmond prior to incurring any indebtedness. We are required to file with the Board periodic and annual reports and other information concerning its own business operations and those of its subsidiaries. In addition, the Bank Holding Company Act requires a bank holding company to obtain Board approval before it acquires, directly or indirectly, ownership or control of any voting shares of a second or subsequent bank if, after such acquisition, it would own or control more than 5% of such shares, unless it already owns or controls a majority of such voting shares. Board approval must also be obtained before a bank holding company acquires all or substantially all of the assets of another bank or merges or consolidates with another bank holding company. Any acquisition by a bank holding company of more than 5% of the voting shares, or of all or substantially all of the assets, of a bank located in another state may not be approved by the Board unless such acquisition is specifically authorized by the laws of that second state.
A bank holding company is prohibited under the Bank Holding Company Act, with limited exceptions, from acquiring or obtaining direct or indirect ownership or control of more than 5% of the voting shares of any company that is not a bank, or from engaging in any activities other than those of banking or of managing or controlling banks or furnishing services to or performing services for its subsidiaries. An exception to these prohibitions permits a bank holding company to engage in, or acquire an interest in a company which engages in, activities which the Board, after due notice and opportunity for hearing by regulation or order, has determined is so closely related to banking or to managing or controlling banks as to be proper incident thereto. A number of such activities have been determined by the Board to be permissible, including servicing loans, performing certain data processing services, and acting as a fiduciary, investment or financial advisor.
A bank holding company may not, without providing notice to the Board, purchase or redeem its own stock if the gross consideration to be paid, when added to the net consideration paid by the Company for all purchases or redemptions by the Company of its equity securities within the preceding 12 months, will equal 10% or more of the Companys consolidated net worth, unless it meets the requirements of a well capitalized and well managed organization.
Set forth below is a summary of statutes and regulations affecting companies like Monarch. Federal and state laws and regulations provide regulatory oversight for virtually all aspects of the Companys operations. This summary is qualified in its entirety by reference to these statutes and regulations.
General. Our subsidiary, Monarch Bank is a state bank and member of the Federal Reserve System. The Federal Reserve and the Virginia Bureau of Financial Institutions regulate and monitor all significant aspects of the our operations. The Federal Reserve requires quarterly reports on our financial condition, and we receive periodic examinations from both federal and state regulators. The cost of complying with these regulations and reporting requirements can be significant. In addition, some of these regulations, such as the ability to pay dividends, impact investors directly.
For member banks like Monarch, the Federal Reserve has the authority to prevent the continuance or development of unsound and unsafe banking practices and to approve conversions, mergers and consolidations. Obtaining regulatory approval of these transactions can be expensive, time consuming, and ultimately may not be successful. We are required to have prior regulatory approval to open any additional banking offices. This approval takes into account a number of factors, including, among others, adequate Bank capital to support additional expansion and a finding that public interest will be served by such expansion. While we plan to seek regulatory approval to establish additional banking offices, there can be no assurance when, or if, we will be permitted to so expand.
As a member of the Federal Reserve, the Company and its subsidiary, Monarch Bank, are also required to comply with rules that restrict preferential loans by the Company to insiders. We are required to keep information on loans to principal shareholders and executive officers, and prohibit certain director and officer interlocks between financial institutions. Our loan operations, particularly for consumer and residential real estate loans, are also subject to numerous legal requirements as are our deposit activities. In addition to regulatory compliance costs, these laws may create the risk of liability to us for noncompliance.
Dividends. The amount of cash dividends we are permitted to pay is limited by federal and state law, regulations and policy and will depend upon our earnings and capital position. Virginia law imposes restrictions on the ability of all banks chartered under Virginia law to pay dividends. Under Virginia law, no dividend may be declared or paid that would impair a banks paid-in capital, and payments must be paid from retained earnings. Virginia Banking regulators and the Federal Reserve have the general authority to limit dividends we pay if such payments are deemed to constitute an unsafe and unsound practice.
Under current supervisory practice, prior approval of the Federal Reserve is required if cash dividends declared in any given year exceed the total of its net profits for such year, plus its retained net profits for the preceding two years. In addition, we may not pay a dividend in an amount greater than our undivided profits on hand after deducting current losses and bad debts. For this purpose, bad debts are generally defined to include the principal amount of all loans which are in arrears with respect to interest by six months or more, unless such loans are fully secured and in the process of collection. Federal law further provides that no insured depository institution may make any capital distribution (which would include a cash dividend) if, after making the distribution, the institution would not satisfy one or more of its minimum capital requirements.
FDIC Insurance. Effective October 2008 through December 31, 2009, interest-bearing deposits are insured by the FDIC for a maximum of $250,000 per depositor. Additionally, we are a participant in the FDICs Transaction Account Guarantee Program which provides that through December 31, 2009, all non-interest bearing transaction accounts are fully guaranteed by the FDIC for the entire amount in the account. For this protection, we pay a semi-annual statutory assessment and must comply with the rules and regulations of the FDIC. FDIC assessments can change, affecting our costs, depending on the solvency of the Banking industry as a whole. In addition, the cost of complying with FDIC rules and regulations may negatively impact our profitability.
Bank Capital Guidelines. Federal bank regulatory authorities have adopted risk-based capital adequacy guidelines that redefine traditional capital ratios to take into account assessments of risks related to each balance sheet category, as well as off-balance sheet financing activities. This represents an effort to measure capital adequacy in a way that is more sensitive to the individual risk profiles of specific financial institutions. The risk-weighted asset base is equal to the sum of the aggregate dollar value of assets and certain off-balance sheet items (such as currency or interest rate swaps) in each of the four separate risk categories, multiplied by the risk weight assigned to each specific asset category. After the items in each category have been totaled and multiplied by the categorys risk factor, category totals are aggregated to derive the total risk-weighted assets, and the total adjusted capital base is divided by the total risk-weighted assets to derive a ratio.
Under the Federal Reserves current risk-based capital guidelines for member banks, we are required to maintain a minimum ratio of total capital to risk-weighted assets of 8%, with at least 4% consisting of Tier 1 capital. Tier 1 capital consists of common and qualifying preferred stock, certain other qualifying instruments, and minority interests in equity accounts of consolidated subsidiaries, less goodwill and other intangible assets. In addition, the Federal Reserve requires its member banks to maintain a minimum ratio of Tier 1 capital to average total assets. This capital measure generally is referred to as the leverage capital ratio. The minimum required leverage capital ratio is 4% if the Federal Reserve determines that the institution is not anticipating or experiencing significant growth and has well-diversified risksincluding no undue interest rate exposure, excellent asset quality, high liquidity and good earningsand, in general, is considered a strong banking organization and rated Composite 1 under the Uniform Financial Institutions Rating Systems. If we do not satisfy any of these criteria, we may be required to maintain a ratio of total capital to risk-based assets of 10% and a ratio of Tier 1 capital to risk-based assets of at least 6%. We would then be required to maintain a 5% leverage capital ratio. These regulations can impact Monarch by requiring it to hold more capital and may inhibit our ability to grow.
Affiliate Transactions and Branching. The Federal Reserve Act restricts loans, investments, asset purchases and other transactions between banks and their affiliates, including placing collateral requirements and requiring that those transactions are on terms and under conditions substantially the same as those prevailing at the time for comparable transactions with non-affiliates. Subject to receipt of required regulatory approvals we may branch without geographic restriction in Virginia, and we may acquire branches or banks or merge across state lines in most cases.
Community Reinvestment Act. The Community Reinvestment Act of 1977, or CRA, requires that federal banking regulators evaluate the record of financial institutions in meeting the credit needs of their local communities, including low and moderate income neighborhoods, consistent with the safe and sound operation of those institutions. These factors are also considered in evaluating mergers, acquisitions, and applications to open a branch or facility. We received a Satisfactory CRA rating in the Companys latest CRA examination.
Other Regulations. We are subject to a variety of other regulations. State and federal laws restrict interest rates on loans, potentially affecting our income. The Truth in Lending Act and the Home Mortgage Disclosure Act impose information requirements on the Company in making loans. The Equal Credit Opportunity Act prohibits discrimination in lending on the basis of race, creed, or other prohibited factors. The Fair Credit Reporting Act and the Fair and Accurate Credit Transactions Act govern the use and release of information to credit reporting agencies. The Truth in Savings Act requires disclosure of yields and costs of deposits and deposit accounts. Other acts govern confidentiality of consumer financial records, automatic deposits and withdrawals, check settlement, endorsement and presentment, and disclosure of cash transactions exceeding $10,000 to the Internal Revenue Service.
USA PATRIOT Act of 2001. In October 2001, the USA PATRIOT Act was enacted in response to the terrorist attacks in New York, Pennsylvania and Washington, D.C., which occurred on September 11, 2001. The USA PATRIOT Act is intended to strengthen the ability of U.S. law enforcement agencies and the intelligence communities to work cohesively to combat terrorism on a variety of fronts. The potential impact of the USA
PATRIOT Act on financial institutions of all kinds is significant and wide ranging. The USA PATRIOT Act contains sweeping anti-money laundering and financial transparency laws and imposes various regulations, including standards for verifying client identification at account opening, and rules to promote cooperation among financial institutions, regulators and law enforcement entities in identifying parties that may be involved in terrorism or money laundering.
Sarbanes-Oxley Act of 2002. On July 30, 2002, President Bush signed into law the Sarbanes-Oxley Act of 2002, or SOX. The stated goals of SOX are to increase corporate responsibility, to provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies and to protect investors by improving the accuracy and reliability of corporate disclosures pursuant to the securities laws. SOX is the most far-reaching U.S. securities legislation enacted since the 1930s. SOX generally applies to all companies that, like Monarch, file or are required to file periodic reports under the Securities Exchange Act of 1934. The required implementation of SOX for companies with less than $75 Million in market capitalization was in 2007, with a delay until 2009 for our external auditors to test our SOX workpapers and samples. We anticipate the cost of SOX compliance to be only slightly negative to profitability based on the 2008 work performed.
SOX includes very specific additional disclosure requirements and new corporate governance rules, requires the Securities and Exchange Commission, or SEC, and securities exchanges to adopt extensive additional disclosure, corporate governance and other related rules and mandates further studies of specified issues by the SEC. SOX represents significant federal involvement in matters traditionally left to state regulatory systems, such as the regulation of the accounting profession, and to state corporate law, such as the relationship between a board of directors and management and between a board of directors and its committees.
SOX addresses, among other matters: audit committees; certification of financial statements by the chief executive officer and the chief financial officer; the forfeiture of bonuses or other incentive-based compensation and profits from the sale of an issuers securities by directors and senior officers in the twelve month period following initial publication of any financial statements that later require restatement; a prohibition on insider trading during pension plan black out periods; disclosure of off-balance sheet transactions; a prohibition on personal loans to directors and officers (subject to certain exceptions for public companies that are financial institutions, like us); disclosure of a code of ethics and filing a Form 8-K for a change or waiver of such code; real time filing of periodic reports; the formation of a public accounting oversight board; auditor independence; and various increased criminal penalties for violations of securities laws.
United States Treasury Department Oversight. In October 2008 the United States Treasury Department, the Federal Reserve Board and the Federal Deposit Insurance Corporation jointly announced additional programs pursuant to the Emergency Economic Stabilization Act of 2008 to address instability in the financial markets. We applied, under the Capital Purchase Program, for additional capital in the form of preferred stock with associated common stock warrants, and were approved for $14.7 million in additional capital. We received this capital on December 19, 2008. We also elected to participate in the Temporary Liquidity Guarantee Program to provide unlimited FDIC insurance coverage for non-interest bearing transaction accounts until the expiration of this program on December 31, 2009. On February 17, 2009 President Obama signed into law the American Recovery and Reinvestment Act of 2009 that modified many previously established provisions of the Emergency Economic Stabilization Act of 2008. These regulations and their implementation may change in the future. Until we repay the investment by the United States Treasury Department under the Capital Purchase Program we will be under certain restrictions on capital repurchases, cash dividends, and executive compensation.
Governmental Monetary Policies
Our earnings and growth is affected not only by general economic conditions, but also by the monetary policies of various governmental regulatory authorities, particularly the Board of Governors of the Federal Reserve System (the Federal Reserve Board or Federal Reserve). The Federal Reserve Boards Open Market Committee implements national monetary policy in United States government securities, control of the discount rate and establishment of reserve requirements against both member and nonmember financial institutions deposits. These actions have a significant effect on the overall growth and distribution of loans, investments and deposits, as well as the rates earned on loans, or paid on deposits.
Our management is unable to predict the effect of possible changes in monetary policies upon our future operating results.
Access to Filings
We make available all periodic and current reports, free of charge, on our website as soon as reasonably practicable after such material is electronically filed with, or furnished to the Securities and Exchange Commission (SEC). Monarchs website address is www.monarchbank.com. After accessing the Website, the filings are available upon selecting the About Monarch & Investor Documents menu items. The contents of the website are not incorporated into this report or into Monarchs other filings with the SEC.
The public may read and copy any materials Monarch Financial Holdings, Inc., files with the SEC at the SECs Public Reference Room at 100 F Street, NE, Washington, DC 20549. In addition the public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC at its website (http://www.sec.gov).
An investment in our common stock involves risk, and you should not invest in our common stock unless you can afford to lose some or all of your investment. You should carefully read the risks described below before you decide to buy any of our common stock. Our business, prospects, financial condition and results of operations could be harmed by any of the following risks.
Risks Relating to Our Business
Changes in interest rates may impact our net interest margin and profitability.
Our profitability depends in substantial part on our net interest margin, which is the difference between the rates we receive on loans and investments and the rates we pay for deposits and other sources of funds. Our net interest margin depends on many factors that are partly or completely outside of our control, including competition, monetary and fiscal policies, and economic conditions generally. Prior to June of 2004, the Federal Reserve cut short-term interest rates 12 times beginning January 2001. Since June 2004, the Federal Reserve has increased short-term interest rates 17 times. Between September 2007 and December 2008 the Federal Reserve lowered rates 10 times. Our net interest margin is negatively impacted when the Federal Reserve lowers rates and positively impacted when they increase rates due to our large portfolio of floating rate loans tied to the Wall Street Journal Prime Rate. It is possible that our profitability will decline in the current falling rate environment unless we can lower our cost of deposits and other borrowings which are used to fund our loans at a similar pace. We try to minimize our exposure to interest rate risk, but we are unable to completely eliminate this risk.
Our profitability depends significantly on economic conditions in our market area.
Our success depends to a large degree on the general economic conditions in South Hampton Roads, Virginia. An economic downturn in our market area could cause any of the following consequences, each of which could adversely affect our business:
Additionally, the adverse consequences to us in the event of an economic downturn in our market could be compounded by the fact that the majority of our commercial and real estate loans are secured by real estate located in our market area. A significant decline in real estate values in our market would mean that the collateral for many of our loans would provide less security. As a result, we would be more likely to suffer losses on defaulted loans because our ability to fully recover on defaulted loans by selling the real estate collateral securing the loans would be diminished. In addition, many of our loans are dependent on the successful completion of real estate projects and the demand for the sale of homes, both of which could be adversely affected by a decline in the real estate markets.
Future economic conditions in our market will depend on factors outside of our control such as political and market conditions, broad trends in industry and finance, legislative and regulatory changes, changes in government, military and fiscal policies and inflation. Adverse changes in economic conditions in our market would likely impair our ability to collect loans and could otherwise have a negative effect on our financial condition.
If we experience greater loan losses than anticipated, it will have an adverse effect on our net income and our ability to fund our growth strategy.
While the risk of nonpayment of loans is inherent in banking, if we experience greater nonpayment levels than we anticipate, our earnings and overall financial condition, as well as the value of our common stock, could be adversely affected. We cannot assure you that our monitoring, procedures and policies will reduce certain lending risks or that our allowance for loan losses will be adequate to cover actual losses. In addition, as a result of the growth in our loan portfolio, loan losses may be greater than managements estimates of the appropriate level for the allowance. Loan losses can cause insolvency and failure of a financial institution and, in such an event, our shareholders could lose their entire investment. In addition, future provisions for loan losses could materially and adversely affect our profitability. Any loan losses will reduce the loan loss allowance. A reduction in the loan loss allowance may be restored by an increase in our provision for loan losses. This would reduce our earnings, which could have an adverse effect on our stock price.
We rely heavily on our management team and the unexpected loss of any of those personnel could adversely affect our operations; we depend on our ability to attract and retain key personnel.
We are a client-focused and relationship-driven organization. We expect our future growth to be driven in a large part by the relationships maintained with our clients by our executive and senior lending officers. We have entered into employment agreements with Mr. Rountree, President and Chief Executive Officer; Mr. Schwartz, Executive Vice President and Chief Operating and Financial Officer; and Mr. Crawford, Norfolk President. The existence of such agreements, however, does not necessarily assure that we will be able to continue to retain their services. The unexpected loss of these or other key employees could have a material adverse effect on our business and possibly result in reduced revenues and earnings. We maintain key man life insurance policies on many of our executives and officers.
Also, our anticipated growth and success, in large part, will be due to the services provided by our mortgage banking officers and the employees of our residential mortgage division. The loss of services of one or more of these persons could have a material adverse effect on our operations and our business could suffer. Our mortgage loan originators are not a party to any employment agreement with us, and they could terminate their employment with us at any time and for any reason.
The implementation of our business strategy will also require us to continue to attract, hire, motivate and retain skilled personnel to develop new customer relationships as well as new financial products and services. Many experienced banking professionals employed by our competitors are covered by agreements not to compete or solicit their existing clients if they were to leave their current employment. These agreements make the recruitment of these professionals more difficult. The market for these people is competitive, and we cannot assure you that we will be successful in attracting, hiring, motivating or retaining them.
We may incur losses if we are unable to successfully manage interest rate risk.
Our profitability will depend in substantial part upon the spread between the interest rates earned on investments and loans and interest rates paid on deposits and other interest-bearing liabilities. We may pay above-market rates to attract deposits as we have done in some of our marketing promotions in the past to fund loan growth. Changes in interest rates will affect our operating performance and financial condition in diverse ways including the pricing of securities, loans and deposits, the volume of loan originations in our mortgage banking business and the value we can recognize on the sale of mortgage and home equity loans in the secondary market. We attempt to minimize our exposure to interest rate risk, but we will be unable to eliminate it. Based on our asset/liability position at December 31, 2008, a rise in interest rates would benefit our net interest income in the short term. Our net interest spread will depend on many factors that are partly or entirely outside our control, including competition, federal economic, monetary and fiscal policies, and economic conditions generally.
Our profitability depends on our ability to manage our balance sheet to minimize the effects of interest rate fluctuation on our net interest margin.
Our results of operations depend on the stability of our net interest margin, which is the difference in the yield we earn on our earning assets and our cost of funds, both of which are influenced by interest rate fluctuations. Interest rates, because they are influenced by, among other things, expectations about future events, including the level of economic activity, federal monetary and fiscal policy and geo-political stability, are not predictable or controllable. In addition, the interest rates we can earn on our loan and investment portfolios and the interest rates we pay on our deposits are heavily influenced by competitive factors. Community banks are often at
a competitive disadvantage in managing their cost of funds compared to the large regional, super-regional or national banks that have access to the national and international capital markets. These factors influence our ability to maintain a stable net interest margin.
Our long-term goal is to maintain a balanced position in terms of the volume of assets and liabilities that mature or re-price during any period so that we may reasonably predict our net interest margin; however, interest rate fluctuations, loan prepayments, loan production and deposit flows are constantly changing and influence our ability to maintain this neutral position. Generally speaking, our earnings will be more sensitive to fluctuations in interest rates the greater the variance in the volume of assets and liabilities that mature or re-price in any period. The extent and duration of the sensitivity will depend on the cumulative variance over time, the velocity and direction of interest rates, and whether the Company is more asset sensitive or liability sensitive. Accordingly, we may not be successful in maintaining this position and, as a result, our net interest margin may suffer, which will negatively impact our earnings.
Our directors and executive officers own our common stock, and their interests may conflict with those of our other shareholders.
As of March 1, 2009, our directors and executive officers beneficially owned approximately 974,350 shares or 17.33% of our common stock. Accordingly, such persons will be in a position to exercise substantial influence over our affairs and may impede the acquisition of control by a third party. We cannot assure investors that the interests of our directors and executive officers will always align precisely with the interests of the holders of our common stock.
We do not plan to pay cash dividends on common stock in the immediate, foreseeable future.
We do not expect to pay cash dividends on our common stock in the near future. Our ability to declare and pay cash dividends will be dependent upon, among other things, restrictions imposed by the reserve and capital requirements of Virginia and federal banking regulations, our income and financial condition, tax considerations and general business conditions.
We are required, through our participation in the Troubled Asset Relief Program Capital Purchase Program to pay a quarterly 5% dividend on our cumulative perpetual preferred stock, series A, to the United States Department of the Treasury. In accordance with our acceptance of funds from the US Treasury, cash dividends on common stock are not permitted without prior approval from the US Department of Treasury.
Our future success will depend on our ability to compete effectively in the highly competitive financial services industry.
The Banking business is highly competitive, and we face substantial competition in all phases of our operations from a variety of different competitors. Our future growth and success will depend on our ability to compete effectively in this highly competitive financial services environment. Some of the financial services organizations with which we compete are not subject to the same degree of regulation as is imposed on bank holding companies and federally insured state-chartered banks, national banks and federal savings institutions. As a result, these non-bank competitors have certain advantages over us in accessing funding and in providing various services. Some of these competitors are subject to similar regulation but have the advantages of larger established customer bases, higher lending limits, extensive branch networks, numerous ATMs, greater advertising-marketing budgets and other factors.
Monarch Bank encounters strong competition from a variety of bank and non-bank financial services providers. These competitors include commercial banks, savings banks, credit unions, consumer finance companies, brokerage firms, money market mutual funds, mortgage banks, leasing, and finance companies. In addition, the delivery of financial services has changed significantly with the telephone, ATM, personal computer and the Internet being used to access information and perform banking transactions.
Competition in our target market area for loans to businesses, professionals and consumers is very strong. Most of our competitors have substantially greater resources and lending limits than we do and offer certain services, such as extensive and established branch networks and trust services that we cannot provide. Moreover, larger institutions operating in the South Hampton Roads have access to borrowed funds at lower cost than we will have available. Several community banks are headquartered in our trade areas. Several regional and super-regional banks, as well as a number of large credit unions, also have banking offices in our market area. Competition among institutions for checking and saving deposits in the area is intense.
Our concentration in loans secured by real estate may increase our credit losses, which would negatively affect our financial results.
We offer a variety of secured loans, including commercial lines of credit, commercial term loans, real estate, construction, home equity, consumer and other loans. Many of our loans are secured by real estate (both residential and commercial) in our market area. A major change in the real estate market, such as deterioration in the value of this collateral, or in the local or national economy, could adversely affect our clients ability to pay these loans, which in turn could impact us. Risk of loan defaults and foreclosures are unavoidable in the Banking industry, and we try to limit our exposure to this risk by monitoring our extensions of credit carefully. We cannot fully eliminate credit risk, and as a result credit losses may occur in the future.
Our legal lending limit may limit our growth.
We are limited in the amount we can lend to a single borrower by the amount of our capital. Generally, under current law, we may lend up to 15% of our unimpaired capital and surplus to any one borrower. As of December 31, 2008, we were permitted, by law, to lend approximately $9,400,000 to any one borrower. However, we have set a house lending limit of $8,200,000. This amount is significantly less than that of many of our competitors and may discourage potential borrowers who have credit needs in excess of our legal lending limit from doing business with us. Our legal lending limit also impacts the efficiency of our lending operation because it tends to lower our average loan size, which means we have to generate a higher number of transactions to achieve the same portfolio volume. We can accommodate larger loans by selling participations in those loans to other financial institutions, but this strategy is not efficient or always available. We may not be able to attract or maintain clients seeking larger loans or may not be able to sell participations in such loans on terms we consider favorable.
If our allowance for loan losses becomes inadequate, our results of operations may be adversely affected.
We maintain an allowance for loan losses that we believe is a reasonable estimate of known and inherent losses in our loan portfolio. Through a periodic review and consideration of the loan portfolio, management determines the amount of the allowance for loan losses by considering general market conditions, credit quality of the loan portfolio, the collateral supporting the loans and performance of our clients relative to their financial obligations with us. The amount of future losses is susceptible to changes in economic, operating and other conditions, including changes in interest rates; that may be beyond our control, and these losses may exceed our current estimates. Rapidly growing loan portfolios are, by their nature, unseasoned. As a result, estimating loan loss allowances is more difficult, and may be more susceptible to changes in estimates, and to losses exceeding estimates, than more seasoned portfolios. Although we believe the allowance for loan losses is a reasonable estimate of known and inherent losses in our loan portfolio, we cannot fully predict such losses or that our loan loss allowance will be adequate in the future. Excessive loan losses could have a material impact on our financial performance. Because of our growth strategy, we expect that our earnings will be negatively impacted by loan growth, which requires additions to our allowance for loan losses. Consistent with our loan loss reserve methodology, we expect to make additions to our loan loss reserve levels as a result of our growth strategy, which may affect our short-term earnings.
Federal and state regulators periodically review our allowance for loan losses and may require us to increase our provision for loan losses or recognize further loan charge-offs, based on judgments different than those of our management. Any increase in the amount of our provision or loans charged-off as required by these regulatory agencies could have a negative effect on our operating results.
Our operations depend upon third party vendors that perform services for us.
We outsource many of our operating and banking functions, including our data processing function, our item processing and the interchange and transmission services for our ATM network. As such, our success and our ability to expand our operations depend on the services provided by these third parties. Disputes with these third parties can adversely affect our operations. We may not be able to engage appropriate vendors to adequately service our needs, and the vendors that we engage may not be able to perform successfully.
Our ability to operate profitably may be dependent on our ability to implement various technologies into our operations.
The market for financial services, including banking services and consumer finance services is increasingly affected by advances in technology, including developments in telecommunications, data processing, computers, automation, internet-based banking and telebanking. Our ability to compete successfully in our markets may depend on the extent to which we are able to exploit such technological changes. If we are not able to afford such technologies, properly or timely anticipate or implement such technologies, or properly train our staff to use such technologies, our business, financial condition or operating results could be adversely affected.
If we need additional capital in the future to continue our growth, we may not be able to obtain it on terms that are favorable. This could negatively affect our performance and the value of our common stock.
Our business strategy calls for continued growth. We may need to raise additional capital in the future to support our continued growth and to maintain our capital levels. Our ability to raise capital through the sale of additional securities will depend primarily upon our financial condition and the condition of financial markets at that time. We may not be able to obtain additional capital in the amounts or on terms satisfactory to us. Our growth may be constrained if we are unable to raise additional capital as needed.
We may in the future issue additional stock, any or all of which will dilute your percentage ownership and, possibly, the value of your shares.
Our board of directors has the authority to issue all or part of any authorized but unissued common shares without prior shareholder approval and without allowing the shareholders the right to purchase their pro rata portion of such shares. This includes shares authorized to be issued under our stock option plans. The issuance of any new common shares will dilute your percentage ownership, and could dilute the value of your shares.
There is a limited trading market for our common stock; it may be difficult to sell our shares after you have purchased them.
Our common stock is currently listed on the NASDAQ Capital Market under the symbol MNRK. The volume of trading activity in our stock is relatively limited. Even if a more active market develops, there can be no assurance that such market will continue, or that you will be able to sell your shares at or above your purchase price.
Our need to comply with extensive and complex government regulation could have an adverse effect on our business.
The Banking industry is subject to extensive regulation by state and federal banking authorities. Many of the Banking regulations we are governed by are intended to protect depositors, the public or the insurance funds maintained by the Federal Deposit Insurance Corporation, not shareholders. Banking regulations affect our lending practices, capital structure, investment practices, dividend policy and many other aspects of our business. These requirements may constrain our rate of growth and changes in regulations could adversely affect us. The burden imposed by these federal and state regulations may place banks in general, and the Company specifically, at a competitive disadvantage compared to less regulated competitors. In addition, the cost of compliance with regulatory requirements could adversely affect our ability to reduce losses or operate profitably.
In addition, because federal regulation of financial institutions changes regularly and is the subject of constant legislative debate, we cannot forecast how federal regulation of financial institutions may change in the future nor the impact those changes may have on our operations. Although Congress in recent years has sought to reduce the regulatory burden on financial institutions with respect to the approval of specific transactions, we fully expect that the financial institution industry will remain heavily regulated in the near future and that additional laws or regulations may be adopted further regulating specific banking practices.
The costs of being a public company are proportionately higher for small companies like us due to the requirement of the Sarbanes-Oxley Act.
The Sarbanes-Oxley Act of 2002 and the related rules and regulations promulgated by the Securities and Exchange Commission have increased the scope, complexity, and cost of corporate governance, reporting, and disclosure practices. These regulations are applicable to our company. We expect to experience increasing compliance costs, including costs related to internal controls and the requirement that our auditors attest to and report on managements assessment of our internal controls, as a result of the Sarbanes-Oxley Act. These necessary costs are proportionately higher for a company of our size and will affect our profitability more than that of some of our larger competitors.
The listing below provides certain information with respect to our properties. We believe our facilities are in good operating condition, are suitable and adequate for our operational needs and are adequately insured.
1101 Executive Boulevard, Chesapeake, VA (leased)
Monarch Bank Offices
750 Volvo Parkway, Chesapeake, VA (land leased, building owned)
1034 S. Battlefield Boulevard, Chesapeake, VA (owned)
100 Lynnhaven Parkway, Virginia Beach, VA (leased)
3701 Pacific Avenue, Suite 100, Virginia Beach, VA (leased)
4216 Virginia Beach Boulevard, Virginia Beach, VA (leased)
5225 Providence Road, Virginia Beach, VA (leased)
318 W. 21st Street, Norfolk, VA (leased)
150 Boush Street, Norfolk, Suite 100, VA (leased)
OBX Bank Offices
3708 Croatan Highway, Kitty Hawk, NC (leased)
Monarch Mortgage Offices
2809 S. Lynnhaven Road, Suite 200, Virginia Beach, VA (leased) (headquarters)
750 Volvo Parkway, Chesapeake, VA (land leased, building owned)
320 W. 21st Street, Norfolk, VA (leased)
1320 Central Park Blvd, Suite 214 and 215, Fredericksburg, VA (leased)
114 North Main Street, Suffolk, VA (leased)
3708 Croatan Highway, Kitty Hawk, NC (leased)
2138 Priest Bridge Court, Suite 7, Crofton, MD (leased)
600 Jefferson Plaza, Suites 205 and 360, Rockville, MD (leased)
6321 Greenbelt Road, College Park, MD (leased)
3261 Old Washington Road, Suite 2020, Waldorf, MD (leased)
4201 Northview Drive, Bowie, MD (leased)
Monarch Capital Offices
150 Boush Street, Suite 201, Norfolk, VA (leased)
Coastal Home Mortgage Offices
2101 Parks Avenue, Suite 101, Virginia Beach, VA (leased)
Home Mortgage Solutions, LLC
5943 Harbour Park Drive, Suite B, Midlothian, VA (leased)
Virginia Asset Group Offices
621 Lynnhaven Parkway, Suites 250 and 251, Virginia Beach, VA (leased)
There are no legal proceedings pending against the Company.
There were no matters submitted to a vote of security holders during the three month period ending December 31, 2008.
Our common stock is listed on the NASDAQ Capital Market under the symbol MNRK. As of March 1, 2009, there were 2,038 known holders of Common Stock.
The table below presents the high and low closing sales prices for our common stock for the past two years. Market values are shown per share and are based on the shares outstanding, on a split adjusted basis, for 2008 and 2007.
We have never declared a cash dividend on our common stock. We are subject to certain restrictions imposed by the reserve and capital requirements of Federal and Virginia banking statutes and regulations, as well as, the US Department of Treasury. It is anticipated that all of our earnings in the foreseeable future will be required for use in the development of our business. The declaration and payment of cash dividends will depend on our earnings, financial condition, and other factors. Thus, there can be no assurance of when, and if, we will pay cash dividends on our shares. On July 15, 2003, Monarch Bank completed a combined shareholder rights offering and public offering for a total of 947,232 shares in both offerings at an adjusted price of $7.89 per share. We raised approximately $7.0 million in the offerings after payment of expenses. On May 31, 2005, we sold 594,000 shares at $10.98 per share in a private offering, which raised approximately $6.5 million after the payment of expenses. In June 2008, we raised $6.8 million in capital through the sale of 774,110 shares of our common stock in two private placements at an average price of $9.31 per share.
We did not repurchase any shares of its common stock during the three months ended December 31, 2008.
The following consolidated summary sets forth our selected financial data for the periods and at the dates indicated. The selected financial data have been derived from our audited financial statements for each of the five years that ended December 31, 2008, 2007, 2006, 2005 and 2004.
Risks and Cautionary Statement Concerning Forward Looking Statement
The Private Securities Litigation Reform Act of 1995 (the 1995 Act) provides a safe harbor for forward-looking statements made by or on our behalf. These forward-looking statements involve risks and uncertainties and are based on the beliefs and assumptions of our management and on information available at the time these statements and disclosures were prepared.
This report includes and incorporates by reference forward-looking statements within the meaning of the 1995 Act. These statements are included throughout this report, and in the documents incorporated by reference in this report, and relate to, among other things, projections of revenues, earnings, earnings per share, cash flows, capital expenditures, or other financial items, expectations regarding acquisitions, discussions of estimated future revenue enhancements, potential dispositions, and changes in interest rates. These statements also relate to our business strategy, goals and expectations concerning our market position, future operations, margins, profitability, liquidity, and capital resources. The words believe, anticipate, could, estimate, expect, intend, may, plan, predict, project, will, and similar terms and phrases identify forward-looking statements in this report and in the documents incorporated by reference in this report.
Although we believe the assumptions upon which these forward-looking statements are based are reasonable, any of these assumptions could prove to be inaccurate and the forward-looking statements based on these assumptions could be incorrect. Our operations involve risks and uncertainties, many of which are outside of our control, and any one of which, or a combination of which, could materially affect our results of operations and whether the forward-looking statements ultimately prove to be correct.
Actual results and trends in the future may differ materially from those suggested or implied by the forward-looking statements depending on a number of factors. Factors that may cause actual results to differ materially from those expected include the following:
The purpose of this discussion is to focus on important factors affecting our financial condition and results of operations. The discussion and analysis should be read in conjunction with the audited consolidated financial statements and related notes to assist in the evaluation of our 2008 performance.
ANALYSIS OF OPERATING RESULTS
We reported net income of $1,132,883 for the year ended December 31, 2008 compared to $3,158,174 and $3,626,458 for the years ended December 31, 2007 and 2006, respectively. For the year ended December 31, 2008, the basic and diluted earnings per share were both $0.21. The basic and diluted earnings per share were $0.66 and $0.63 for December 31, 2007, and $0.76 and $0.72, respectively, for the year ended December 31, 2006.
Two important and commonly used measures of profitability are return on assets (net income as a percentage of average total assets) and return on shareholders equity (net income as a percentage of average common shareholders equity). Our returns on average assets were 0.20%, 0.76% and 1.05% for the years ended December 31, 2008, 2007 and 2006, respectively. The returns on average shareholders equity were 2.66%, 8.86% and 11.38% for the same time periods.
Net income was down in 2008 compared to 2007 $2,025,291 or 64.1% and net income declined $468,284 or 12.9% in 2007 compared to 2006. Net interest income declined 10.6% in 2008 or $1,723,668 compared to 2007, which had increased $2,016,128 or 14.1% over 2006. Provision for loan losses increased 413% or $4,037,598 in 2008 compared to 2007, which had increased 74.6% or $417,134 over 2006.
Non-interest income increased $13,034,254 or 155.6% in 2008 compared to 2007 and $4,793,301 or 133.7% in 2007 compared to 2006. These trends represent a combination of factors which include a severe downturn in the economy, low interest rates, and prudent management decisions with regard to asset management and deployment.
Non-interest expenses increased 54.3% or $10,210,440 for a total of $29,022,845 in 2008 and $6,942,813 or 58.5% for a total of $18,812,405, compared to $11,869,592 in 2006. The majority of the increases were in salaries and benefits, occupancy expenses and loan origination expenses. The net effect on 2008 pre-tax income was a decrease of 65.1% or $3,054,100 to $1,637,383 compared to 2007 which had a pre-tax income decrease of 13.3%, or 720,681 to $4,691,483, when compared to $5,412,164 in 2006.
Net non-interest income, which represents non-interest income minus non-interest expense, improved dramatically in 2008 with the growth of our non-interest income lines of business. A lower net non-interest income number will typically lead to greater profitability, and we focus more closely on this number than on the industry standard efficiency ratio. In 2008, our net non-interest loss was $7,609,532 compared to $10,433,346 in 2007, a 27.1% improvement. In 2007 this number grew $2,149,512 or 25.9% when compared to $8,283,834 in 2006 due to the expansion of our mortgage and banking operations.
NET INTEREST INCOME
Net interest income, our primary source of revenue, is the excess of interest income over interest expense. Net interest income is influenced by a number of factors, including the volume of interest-earning assets and interest-bearing liabilities, the mix of interest-earning assets and interest-bearing liabilities, the interest rates earned on earning assets, and the interest rates paid to obtain funding to support the assets. For analytical purposes, net interest income is adjusted to a taxable equivalent basis to recognize the income tax savings on tax-exempt assets, such as bank owned life insurance (BOLI) and municipal securities and loans. A tax rate of 34% was used in adjusting interest on BOLI, tax-exempt securities and loans to a fully taxable equivalent basis. The difference between rates earned on interest-earning assets (with an adjustment made to tax-exempt income to provide comparability with taxable income, i.e. the FTE adjustment) and the cost of the supporting funds is measured by the net interest margin.
Net interest income declined $1,723,668 to $14,542,221 in 2008 compared to $16,265,889 in 2007. Net interest income growth in 2007 was $2,016,128 or 14.2% over 2006. We have an asset sensitive balance sheet with the majority of our earning assets set to reprice within a one year time frame and many of our loans repricing on a daily basis based on market indexes. When comparing the components of net interest income in 2007 to 2006 the numbers indicate that our total interest costs increased $3,625,939 or 33.4% to $14,486,625 on average volume growth of $60.1 million while total interest income increased $5,642,067 or 22.5% to $30,752,514 on average volume growth of $61.1 million. The same comparison in 2008 to 2007 shows that our total interest costs only increased $229,358 or 1.6% to $14,715,983 on average volume growth of $123.8 million while total interest income declined $1,494,310 or 4.9% to $29,258,204 on average volume growth of $106.6 million.
As stated previously we are asset-sensitive and the current economic environment has created challenges in 2008 that began in late 2007. A majority of the loan portfolio is tied to the Wall Street Journal Prime rate which has moved in tandem with the changes in the federal funds rate. The Federal Reserve Open Market Committee, which sets the federal funds rate, decreased the target funds rate five times in 2008 for a total of 400 basis points which has resulted the historically low federal funds rate of 0.25%. In 2007 they decreased rates three times for a total of 100 basis points between September and December. Interest earning assets repriced more rapidly than interest bearing deposits which represent 92.9% of total interest bearing liabilities, creating a timing difference between declines in interest earnings and cost.
Table 1 depicts interest income on average earning assets and related yields, as well as interest expense on average interest-bearing liabilities and related rates paid for the periods indicated.
Our net yield on earning assets or net interest margin, which is calculated by dividing net interest income by average earning assets, was 3.00% in 2008 compared to 4.25% and 4.43% in 2007 and 2006, respectively. Our earning asset yield decreased 201 basis points in 2008 to 5.95% compared to a 24 basis point increase to 7.96% in 2007 over the 2006 rate of 7.72%. During the same periods liability costs declined 121 basis points to 3.32% compared to a 35 basis point increase to 4.53% in 2007 over 4.18% in 2006. The result of these changes is a 79 basis point margin compression in 2008 to a spread of 2.64% compared to 3.43% in 2007 and 3.54% in 2006. Comparing the basis point decrease in our earning asset yield to the decrease in the index reveals that we have been able to soften the effect of the economic change through management strategies. With 75% of all loans repricing due to maturity or contractual repricing (to the prime rate or another market index) in 2008 and 79% in 2007, we have negotiated floors on the majority of our commercial and mortgage loan portfolio which prevented further declines in asset earnings. On the cost side, we have promoted funding growth that is short term, with 93% of interest bearing liabilities set to reprice within the next twelve months. These strategies should enable us to react more quickly to index changes going forward.
Table 2 presents the dollar amount of changes in interest income and interest expense, and distinguishes between the changes related to increases or decreases in average outstanding balances of interest-earning assets and interest-bearing liabilities (volume), and the changes related to increases or decreases in average interest rates on such assets and liabilities (rate).
Comparing the rate and volume of the periods presented further points to the impact that rate had on our performance. As indicated by Table 2, in 2008 net rate changes took $4.2 million from income and net growth could only replace $2.5 million for a decline of $1.7 million in net interest income. The majority of the rate impact was on loan yields where rate decreases reduced interest income $8.5 million and growth could only replace $7.1 million for a net loss of $1.4 million. On the other hand, the decrease in rates helped lessen the impact that deposit growth had on cost. The overall decline in other borrowings was due more to rate than volume. Comparing 2007 to 2006, when net interest income increased $2.0 million, loan growth improved earnings $6.0 million while rate contributed $182 thousand. Deposit growth increased cost $2.0 million and rate added another $404 thousand. Other borrowings also were impacted by both rate and growth for additional cost.
Table 1NET INTEREST INCOME ANALYSIS
The following is an analysis of net interest income, on a taxable equivalent basis.
Table 2Changes in Net Interest Income (Rate/Volume Analysis)
Net interest income is the product of the volume of average earning assets and the average rates earned, less the volume of average interest-bearing liabilities and the average rates paid. The portion of change in relating to both rate and volume is allocated to each of the rate and volume changes based on the relative change in each caterogy. The following table analyzes the changes in both rate and volume components of net interest income on a taxable equivalent basis.
MARKET RISK MANAGEMENT
In 2008 as with 2007, we spent a great deal of time focusing on the management of the balance sheet to maximize net interest income. Our primary component of market risk is interest rate volatility. Our primary objectives for managing interest rate volatility is to identify opportunities to maximize net interest income while ensuring adequate liquidity and carefully managing interest rate risk. The Asset/Liability Management Committee (ALCO), which is composed of executive officers, is responsible for:
Interest rate risk refers to the exposure of our earnings and market value of portfolio equity (MVE) to changes in interest rates. The magnitude of the change in earnings and MVE resulting from interest rate changes is impacted by the time remaining to maturity on fixed-rate obligations, the contractual ability to adjust rates prior to maturity, competition, and the general level of interest rates and customer actions.
There are several common sources of interest rate risk that must be effectively managed if there is to be minimal impact on our earnings and capital. Repricing risk arises largely from timing differences in the pricing of assets and liabilities. Reinvestment risk refers to the reinvestment of cash flows from interest payments and maturing assets at lower or higher rates. Basis risk exists when different yield curves or pricing indices do not change at precisely the same time or in the same magnitude such that assets and liabilities with the same maturity are not all affected equally. Yield curve risk refers to unequal movements in interest rates across a full range of maturities.
In determining the appropriate level of interest rate risk, ALCO reviews the changes in net interest income and MVE given various changes in interest rates. We also consider the most likely interest rate scenarios, local economics, liquidity needs, business strategies, and other factors in determining the appropriate levels of interest rate risk. To effectively measure and manage interest rate risk, simulation analysis is used to determine the impact on net interest income and MVE from changes in interest rates.
Interest rate sensitivity analysis presents the amount of assets and liabilities that are estimated to reprice through specified periods if there are no changes in balance sheet mix. The interest rate sensitivity analysis in Table 3 reflects our assets and liabilities on December 31, 2008 that will either be repriced in accordance with market rates, mature or are estimated to mature early or prepay within the periods indicated (in thousands). This is a one-day position that is continually changing and is not necessarily indicative of our position at any other time. Interest-bearing demand deposits and Money Market balances are considered interest sensitive for 50% of the outstanding balances. Management believes this structure makes for a more accurate and meaningful view of our interest sensitivity position.
As illustrated in the table, Monarch is asset-sensitive, primarily due to its adjustable rate loan portfolio. The majority of these loans is indexed to the Wall Street Journal Prime rate and can adjust either daily or monthly. To match this, we have also kept the maturities of most of our borrowings short, either maturing or repricing within one month.
Table 3Interest Rate Sensitivity Analysis
Because of inherent limitations in interest rate sensitivity analysis, ALCO uses more sophisticated interest rate risk measurement techniques. Simulation analysis is used to subject the current repricing conditions to rising
and falling interest rates in increments and decrements of 1%, 2% and 3% to determine how net interest income changes for the next twelve months. ALCO also measures the effects of changes in interest rates on MVE by discounting future cash flows of deposits and loans using new rates at which deposits and loans would be made to similar depositors and borrowers. Market value changes in the investment portfolio are estimated by discounting future cash flows and using duration analysis. Loan and investment security prepayments are estimated using current market information. Table 4 shows the estimated impact of changes in interest rates up and down 1%, 2% and 3% on net interest income and on MVE as of December 31, 2008 (in thousands).
The projected changes in net interest income to changes in interest rates at December 31, 2008 were in compliance with established guidelines for increases and decreases in rate of 3% but were not in compliance for changes of 1% and 2%. The projected changes in MVE to changes in interest rates at December 31, 2008, were in compliance with established policy guidelines for increases and decreases in rate of 2% and 3%, as well as, decreases in rate of 1%. However, the project changes in income were not in compliance for a decrease in rate of 1%. These projected changes in the MVE model are based on numerous assumptions of growth and changes in the mix of assets or liabilities.
The positive gap in the interest rate sensitivity analysis indicates that our net interest income would rise if rates increase and fall if rates decline. The simulation analysis presents a more accurate picture since certain rate indices that affect liabilities do not change with the same magnitude over the same period of time as changes in the prime rate or other indices that reprice loans and investment securities. The projected changes in net interest income at December 31, 2008 were in compliance with established policy guidelines. We continue to focus on compliance through the tightening of lending guidelines and the establishment of floors for certain products.
Table 4Change in Net Interest Income and
Market Value of Portfolio Equity
Non-interest income totaled $21,413,313 in 2008, an increase of $13,034,254 or 155.6% over 2007, which was $4,793,301 or 133.7% higher than 2006. The following table lists the major components of non-interest income for December 31, 2008, 2007 and 2006.
Mortgage banking income represents fees from originating and selling residential mortgage loans as well as commercial mortgages through Monarch Mortgage and our subsidiary, Monarch Capital, LLC. Monarch Mortgage, our division, was reorganized and expanded in June 2007, making 2008 its first full year of operations. They closed 2,208 loans in 2008 compared to 826 in 2007 and 301 in 2006. The dollar volume closed in 2008 was $577,009,434 compared to $196,916,302 in 2007 and $67,299,157 in 2006. Net interim interest income on loans closed but unfunded is shown as a component of mortgage banking income in all years presented.
Investment and insurance commissions showed some increase in a difficult year for investment activity. Income in 2007 was significantly higher than 2006 because of the formation in late 2006 of Virginia Asset Group, LLC (VAG) a 51% owned subsidiary of our wholly owned subsidiary, Monarch Investments, LLC. VAG has been a top producer for the past two years for the broker-dealer in which Monarch Investments, LLC, has ownership. A gain on acquisition of Infinex Financial, LLC equity has been recorded in 2008 due to the merger of the broker-dealer, BI Investments, LLC, into Infinex Financial, LLC. Following this merger, Monarch Investment, LLC, owns a 1.72% interest in Infinex Financial, LLC.
Service charges continued to grow with deposits. The fees charged in connection with our overdraft/NSF program, which allows retail clients to overdraw their accounts without the negative stigma associated with a returned check, also increased. This program was initiated in 2004 with broad customer acceptance. As noted above, the primary reason for the increase was deposit growth coupled with our overdraft/NSF program, which began in 2004. Service charge pricing on deposit accounts is typically reevaluated annually to reflect current costs and competition.
Net security losses in 2008 were related primarily to the sale of a poorly performing security in the fourth quarter which carried a loss of $71,158. Gains related to rate calls on discounted securities totaled $14,730 in 2008. Securities losses of $29,139 in 2006 were due to the sale of lower yielding investment securities. In 2006 management sold lower yielding mortgage-backed securities.
In 2008 we sold three foreclosed properties for a net loss of $31,244. There were no gains or losses to report in either 2007 or 2006. 2008 is the first year we have had foreclosed properties.
Title income increased notably in 2008 due to our newly formed title company, Real Estate Security Agency, LLC. Our wholly owned subsidiary, Monarch Investment, LLC, owns 75% of this new company with 25% owned by TitleVentures, LLC. Prior years income was from our minority interest in Bankers Title of Central Virginia, LLC, a joint venture with the Virginia Bankers Association and many other community banks in Virginia which we sold in 2007.
In October 2005 we purchased $6,000,000 in bank owned life insurance that has resulted in income and commissions in each of the three years presented. In 2007 the Company entered into a sale-leaseback agreement on its Lynnhaven banking office that resulted in a total gain of $1,406,038. In compliance with GAAP, $817,257 of that gain was deferred and is being amortized over the life of the lease. The reportable gain has been included in non-interest income for 2007. In 2006 other income included a one time gain from early repayment on a Federal Home Loan Bank borrowing in the amount of $138,000.
Other income represents a variety of nominal recurring and non-recurring activities and transactions that have occurred throughout the year.
Non-interest expense for 2008 was $29,022,845 compared to $18,812,405, and $11,869,592 for 2007 and 2006, respectively. The following table lists the major components of non-interest expense for December 31, 2008, 2007 and 2006.
Expenses that had the highest dollar increase year-over year are broken out by dollar increase and percentage change below.
In all periods presented, the majority of the increase in expense growth was due to increased staffing and higher benefits costs. 2008 represents a full year of salary expense related to our 2007 expansion in mortgage operations as well as increases related to two additional banking offices, additional lenders and support staffing which has more than doubled the number of our employees. At December 31, 2008, we employed a total of 295 full and part-time employees compared to 254 and 126 at year-end 2007 and 2006, respectively. In addition, higher production related incentives, and higher health insurance costs and other benefits such as social security taxes, Medicare taxes, and 401k contribution expenses have contributed to the increase.
The expansion of our mortgage operations has been the major contributor to the growth in loan expense. Costs associated with underwriting and processing mortgage loans at our current volume are significant. Bank related loan expense has also increased due to higher loan volume. Additionally, expense related to the shipping of mortgage loan packages to secondary market investors has had an impact on postage.
Occupancy plus furniture and fixture expense have increased as a result of expansion. We currently have twenty-seven offices, the majority of which we lease. This compares with twenty office locations in 2007 and thirteen in 2006.
Our industry requires that our loan officers be mobile, but accessible to their clients. The telephone is a necessary tool in their daily communication. The growth noted earlier is attributable to both the increase in the number of employees and our volume growth.
The current state of the economy has had a direct impact on our regulatory assessment. The number of bank failures in the past eighteen months has decreased deposit insurance reserves. As such the remaining banks must bear the burden of restoring these reserves through the payment of assessments. The Federal Deposit Insurance Commission has had to increase their assessments rates in both 2008 and 2007, resulting in a significantly higher expense in both years.
We continue to focus on controlling overhead expenses in relation to income growth. The efficiency ratio, a productivity measure used to determine how well non-interest expense is managed, was 80.2% in 2008, compared to 76.33% in 2007, and 66.55%, in 2006. The Bank only efficiency ratio was 78.6% in 2008, compared to 68.00% in 2007, and 64.50% in 2006. A lower efficiency ratio indicates more favorable expense efficiency. The efficiency ratio is calculated by dividing non-interest expense by the sum of taxable equivalent net interest income and non-interest income. The expansion of our non-interest income lines of business has negatively impacted this ratio.
The Company recognized federal income tax expense of $504,500 resulting in an effective tax rate of 30.8%. During 2007 we recognized federal income tax expense of $1,533,309 resulting in an effective tax rate of 32.7% and in 2006 we recognized federal income tax expense of $1,785,706 resulting in an effective tax rate of 33.0%. The major difference between the statutory rate and the effective rate results from income that is not taxable for Federal income tax purposes. The primary non-taxable income is that of state and municipal securities or loans and Bank Owned Life Insurance.
FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES
Our total assets at year-end 2008 were $597.2 million, an increase of $94.0 million from $503.2 million at year-end 2007. Net loans outstanding at year-end 2008 were $496.7 million, an increase of $81.5 million from $415.1 million at year-end 2007. The primary source of asset growth in 2008 has been in the loan portfolio and loans held for sale, which are loans originated for the secondary market by Monarch Mortgage, which have closed but not yet been funded by the investor.
Total liabilities were $537.3 million at December 31, 2008, compared to $466.6 million at December 31, 2007, an increase of $70.7 million or 15.2%. Total deposits increased $106.4 million to $496.1 million during 2008 compared to $389.7 million at December 31, 2007. Our deposit growth allowed us to reduce FHLB borrowings $35.8 million from $63.5 at December 31, 2007 to $27.7 million at December 31, 2008. Total stockholders equity was $59.8 million at December 31, 2008, compared to $36.5 million at December 31, 2007, an increase of $23.3 million and 63.8%.
Our securities portfolio consists primarily of securities for which an active market exists. Our policy is to invest primarily in securities of the U. S. Government and its agencies and in other high grade fixed income securities to minimize credit risk. Our securities portfolio plays a role in the management of interest rate sensitivity and generates additional interest income. In addition, our portfolio serves as a source of liquidity and is used to meet collateral requirements.
Our securities portfolio consists of two components, securities held-to-maturity and securities available-for-sale. Securities are classified as held-to-maturity based on our intent and ability, at the time of purchase, to hold such securities to maturity. These securities are carried at amortized cost. Securities which may be sold in response to changes in market interest rates, changes in securities prepayment risk, increases in loan demand, general liquidity needs, and other similar factors are classified as available-for-sale and are carried at estimated fair value.
Table 5Securities Portfolio
The following table sets forth the estimated maturities of securities, based on current performance. Contractual maturities may be different.
Table 6Estimated Maturities of Securities Held as of Period Indicated
At year-end 2008, total investment securities were $6.3 million, compared to $31.0 million at year-end 2007. Excluding securities of U.S. agencies, neither the aggregate book value nor the aggregate market value of the securities of any issuer exceeded ten percent of our stockholders equity. Additional information on our investment securities portfolio is in Note 2 to Monarchs Financial Statements (included as an exhibit in this Form 10-K).
As of December 31, 2008, there was a net unrealized gain of $41,367 related to the available-for-sale investment portfolio compared to a net unrealized loss of $27,104 at year-end 2007. The market value of securities held-to-maturity at December 31, 2008 was $18,260 over the book value and $4,321 over the book value in 2007. Note 2 of the consolidated financial statements provides details of the amortized cost, unrealized gains and losses, and estimated fair value of each category of the investment portfolio as of December 31, 2008 and 2007.
Our lending activities are our principal source of income. Loans, net of unearned income, increased $85,558,800 or 20.4% during 2008. Loans held for sale are loans originated for the secondary market by Monarch Mortgage that have closed but not funded increased 189.3% or $35,576,647 to $54,369,215 on December 31, 2008 compared to $18,792,568 on December 31, 2007. This notable increase was due to a recent boom in the mortgage industry coupled with a full year under our restructured mortgage division model, Monarch Mortgage, which has resulted in a significant increase in both the number and dollar amount of loans originated monthly. The discussion below excludes loans held for sale.
Commercial loans and commercial loans secured by real estate should be considered together under the title of commercial when comparing loans outstanding in 2008 compared to prior years. In May 2008, we evaluated the classification of our loan portfolio as reported on March 31, with regard to underlying collateral. Based on that evaluation, loans previously classified as commercial were moved to commercial secured by real estate. Prior years presented have not been restated.
Construction and land development loans, commercial and home equity loans were our primary areas of growth in 2008. Loans secured by real estate comprise 86.3% of our total loan portfolio as of December 31, 2008, and include a diverse portfolio. Commercial loans comprised 39.0% of our total loans portfolio as of December 31, 2008 compared to 44.8% in 2007. Real Estate Construction and Development loans comprise 25.2% of the loan portfolio as of December 31, 2008 and 17.4% one year prior. Our consumer portfolio, excluding home equity lines of credit and loans included above, comprised 0.7% of total loans as of December 31, 2008, and 0.9% as of December 31, 2007.
We consider our overall loan portfolio diversified as it consists of 34.2% in residential real estate loans including home equity and residential construction loans, 52.1% in other real estate secured loans including commercial real estate, multi-family, farmland and construction and land development loans, 13.0% in commercial, industrial and agricultural loans, and 0.7% in consumer loans as of December 31, 2008, as detailed in Table 7 (in thousands) classified by type.
Interest income on consumer, commercial, and real estate mortgage loans was computed on the principal balance outstanding. Most variable rate loans carry an interest rate tied to the Wall Street Journal Prime Rate, as published in the Wall Street Journal. Note 3 to Monarchs Financial Statements (included as an exhibit in this Form 10-K) provides a schedule of loans by type and other information. We do not participate in highly leveraged lending transactions, as defined by the regulators, and there are no loans of this nature recorded in the loan portfolio. We do not have foreign loans in our portfolio. At December 31, 2008, we had loan concentrations (loans to borrowers engaged in similar activities) which exceeded 10% of total loans in two areas. These areas of concentration are to borrowers who are principally engaged in the acquisition, development and construction of 1-4 single family homes and developments and to residential home owners with equity lines.
Table 8Loan Maturities
ALLOWANCE AND PROVISION FOR LOAN LOSSES
Our allowance for loan losses is to provide for losses inherent in the loan portfolio. Our Management is responsible for determining the level of the allowance for loan losses, subject to review by the Board of Directors. Among other factors, this Committee considers on a quarterly basis our historical loss experience, the size and composition of our loan portfolio, the value and adequacy of collateral and guarantors, non-performing credits including impaired loans and our risk-rating-based loan "Watch" list, and national and local economic conditions.
The economy of our trade area is well diversified. There are additional risks of future loan losses that cannot be precisely quantified or attributed to particular loans or classes of loans. Since those factors include general economic trends as well as conditions affecting individual borrowers, the allowance for loan losses is an estimate. The sum of these elements is our managements recommended level for the allowance. The unallocated portion of the allowance is based on loss factors that cannot be associated with specific loans or loan categories. These factors include management's subjective evaluation of such conditions as credit quality trends, collateral values, portfolio concentrations, specific industry conditions in the regional economy, regulatory examination results, external audit and loan review findings, recent loss experiences in particular portfolio segments, etc. The unallocated portion of the allowance for loan losses reflects management's attempt to ensure that the overall reserve appropriately reflects a margin for the imprecision necessarily inherent in estimates of credit losses.
We developed a methodology to determine an allowance to absorb probable loan losses inherent in the portfolio based on evaluations of the collectability of loans, historical loss experience, peer bank loss experience, delinquency trends, economic conditions, portfolio composition, and specific loss estimates for loans considered substandard or doubtful. All commercial and commercial real estate loans that exhibit probable or observed credit weaknesses are subject to individual review. Based on managements evaluation, estimated loan loss allowances are assigned to the individual loans which present a greater risk of loan loss. If necessary, reserves would be allocated to individual loans based on management's estimate of the borrower's ability to repay the loan given the availability of collateral and other sources of cash flow. Any reserves for impaired loans are measured based on the present rate or fair value of the underlying collateral. We evaluate the collectability of both principal and interest when assessing the need for a loss accrual. A composite allowance factor that considers our and other peer bank loss experience ratios, delinquency trends, economic conditions, and portfolio composition are applied to the total of commercial and commercial real estate loans not specifically evaluated.
The remaining loan loss allowance is allocated to the remaining loans on an overall portfolio basis based on industry and or historical loss experience. The allowance is subject to regulatory examinations and determination as to adequacy, which may take into account such factors as the methodology used to calculate the allowance and the size of the allowance in comparison to peer banks identified by regulatory agencies. Homogenous loans, such as consumer installment, residential mortgage loans, and home equity loans are not individually reviewed and are generally risk graded at the same levels. The risk grade and reserves are established for each homogenous pool of loans based on the expected net charge offs from a current trend in delinquencies, losses or historical experience and general economic conditions.
In 2008, we accrued $5,014,076 in provision for loan losses compared to $976,478 in 2007. Based on the current economic environment and the composition of our loan portfolio, the level of our charged-off loans combined with our peer bank loss experience, we considered it prudent to allocate additional funds to our loan loss allowance in 2008. The unfortunate side effect of this decision is a decrease in our earnings for the year ended December 31, 2008, because the additional allocation had to run through our income statement.
Loans charged off during 2008 totaled $1,032,929 compared to $237,689 in 2007 and recoveries totaled $88,853 and $2,211 in 2008 and 2007, respectively. The ratio of net charge-offs to average outstanding loans was 0.20% in 2008 compared to 0.06% in 2007. Table 9 presents our loan loss and recovery experience (in thousands) for the past five years.
The allowance for loan losses totaled $8,046,000 at December 31, 2008, an increase of 102.4% over December 31, 2008. The ratio of the allowance to loans, less unearned income, was 1.59% at December 31, 2008 and 0.95% at December 31, 2007. The allowance to loans ratio is supported by the level of non-performing loans, the seasoning of the loan portfolio, and the growing experience of the lending staff in the market. We believe that the allowance for loan losses is adequate to absorb any inherent losses on existing loans in our loan portfolio at December 31, 2008. See Note 4 to Monarchs Financial Statements (included as an exhibit in this Form 10-K) for more information concerning our loan loss and recovery experience.
Table 9Loan Loss Allowance and Loss Experience (in thousands)
ASSET QUALITY AND NON-PERFORMING LOANS
We identify specific credit exposures through periodic analysis of our loan portfolio and monitor general exposures from economic trends, market values and other external factors. We maintain an allowance for loan losses, which is available to absorb losses inherent in the loan portfolio. The allowance is increased by the provision for losses and by recoveries from losses. Charged-off loan balances are subtracted from the allowance. The adequacy of the allowance for loan losses is determined on a quarterly basis. Various factors as defined in the previous section "Allowance and Provision for Loan Losses" are considered in determining the adequacy of the allowance. Loans are generally placed on non-accrual status after they are past due for 90 days.
Non-performing loans include loans on which interest is no longer accrued, accruing loans that are contractually past due 90 days or more as to principal and interest payments, and loans classified as troubled debt restructurings are detailed in Table 10. Total non-performing loans as a percentage of total loans were 1.49% and 0.10% at December 31, 2008 and December 31, 2007, respectively.
The majority of our non-performing loans at December 31, 2008 are related to one secured relationship. There were twenty-three loans totaling $7,506,336 in non-accrual status at December 31, 2008 and three loans at December 31, 2007 totaling $81,751. All of these loans have been identified as impaired according to Financial Accounting Statement No. 114 Accounting by Creditors for Impairment of a Loan and later amended by Financial Accounting Statement No. 118 Accounting by Creditors for Impairment of a Loan Income Recognition and Disclosures. A loan is considered impaired if it is probable that the lender will be unable to collect all amounts due under the contractual terms of the loan agreement. We have provided specific reserves for these loans in our allowance for loan loss of $4,217,970 at December 31, 2008, and $48,000 in 2007. We recognized interest income on these loans of $359,518 and $11,332 in 2008 and 2007, respectively. Our average recorded investment in impaired loans was $1,509,479 in 2008 and $21,578 in 2007.
There were no loans on accrual status and past due 90 days or more at December 31, 2008 and one loan for $332,520 at December 31, 2007. There were three loans totaling $532,932 in other real estate held due to loan foreclosure on December 31, 2008 and none on December 31, 2007. There were no other classified assets.
Table 10Nonperforming Assets
Amounts are in thousands, except ratios.
Our major source of funds and liquidity is our deposit base. Deposits provide funding for our investment in loans and securities. Our primary objective is to increase core deposits as a means to fund asset growth at a lower cost. Interest paid for deposits must be managed carefully to control the level of interest expense. We offer individuals and small-to-medium sized businesses a variety of deposit accounts, including checking, savings, money market, and certificate of deposits.
Table 11 presents the average balances of deposits and the average rates paid on those deposits for the past two years (in thousands).
We are continually evaluating the mix of our deposit base (time deposits versus demand, money market and savings) in relation to our funding needs and current market conditions. In 2008 we developed two higher yielding products in areas that have traditionally offered lower rates; an interest bearing demand account and savings account. In response, interest bearing demand deposits increased $5.8 million on average with an average rate increase of 0.69% over 2007 and average savings deposits have increased $3.5 million with average rate increase of 0.62%. Non-interest bearing demand deposits increased an average of $7.5 million. We are a participant in the Federal Deposit Insurance Transaction Account Guarantee Program which provides that through December 31, 2009, our clients receive unlimited coverage for balances in their non-interest bearing deposits. Stiff competition in the industry for money market accounts coupled with a level of migration to other products we offer have resulted in a $21.4 million decline in average money market accounts.
In the third quarter of 2008 we ran a certificate of deposit campaign which brought in $40.5 million in new money at a cost of 3.72% to increase liquidity. This campaign offered market competitive rates on shorter term certificates of deposits. We continue to balance our yield on deposits by maintaining a level of out-of-market brokered products which allow for more flexibility in pricing and timing of maturities. At December 31, 2008 our total brokered certificates of deposits to total deposits was 18.1% compared to 16.9% at December 31, 2007. Certificates of deposit of $100,000 or more are detailed in Table 12. More information on deposits is contained in Note 8 to Monarchs Financial Statements (included as an exhibit in this Form 10-K).
Table 12Certificates of Deposits
Certificates of deposit as of December 31, 2008 and 2007 in amounts of $100,000 or more were classified by maturity as follows ( in thousands)
Although brokered deposits are purchased in large denomination transactions, the source of these deposits is in denominations of less than $100,000, providing us with a balance of stability and flexibility. In 2008 the FDIC increased the level of insurance on interest bearing accounts to $250,000 until December 31, 2009. As of December 31, 2008, our non-brokered deposits in excess of $250,000 totaled $20.5 million.
Liquidity represents an institutions ability to meet present and future financial obligations through either the sale of existing assets or the acquisition of additional funds through short-term borrowings. Our liquidity is provided from cash and amounts due from banks, federal funds sold, interest-bearing deposits in other banks, repayments from loans, increases in deposits, lines of credit from the Federal Home Loan Bank and five
correspondent banks, and maturing investments. As a result of our management of liquid assets, and our ability to generate liquidity through liability funding, we believe that we maintain overall liquidity sufficient to satisfy our depositors requirements and to meet clients credit needs. We also take into account any liquidity needs generated by off-balance sheet transactions such as commitments to extend credit, commitments to purchase securities and standby letters of credit.
We monitor and plan our liquidity position for future periods. Liquidity strategies are implemented and monitored by our Asset/Liability Committee (ALCO). The Committee uses a simulation and budget model to assess current and future liquidity needs.
Cash, cash equivalents and federal funds sold totaled $8.6 million as of December 31, 2008, down $868,208 from the year ended December 31, 2007. At December 31, 2008, cash, securities classified as available for sale and federal funds sold were $14.4 million or 2.7% of total earning assets, compared to $18.3 million or 4.0% of total earning assets at December 31, 2007.
We have additional sources of liquidity available to us including the capacity to borrow additional funds through several established arrangements. Further information on Borrowings is contained in Note 9 to Monarchs Financial Statements (included as an exhibit in this Form 10-K).
In the course of operations, due to fluctuations in loan and deposit levels, we occasionally find it necessary to purchase federal funds on a short-term basis. We maintain unsecured federal funds line arrangements with five other banks, which allow us to purchase funds totaling $31,000,000. These lines mature and reprice daily. At both December 31, 2008 and 2007, we had $385,000 and $0, respectively, in fed funds purchased.
We also have access to the Federal Reserve Bank of Richmonds discount window should a liquidity crisis occur. We have not used this facility in the past and consider it a backup source of funds.
We are a member of the Federal Home Loan Bank of Atlanta (FHLB) and as such, may borrow funds under a line of credit based on criteria established by the FHLB. This line of credit would allow us to borrow up to 40% of assets, or approximately $238,879,400, if collateralized, as of December 31, 2008. We currently pledge loans and investment securities to secure this line. Blanket liens pledged on certain designated loan portfolios amounted to $91.0 million at December 31, 2008 and $77.8 million at December 31, 2007. Additionally, investment securities with carrying values of $733 thousand at December 31, 2008 and $1.0 million at December 31, 2007 were pledged to secure any borrowings. Based on pledged collateral we had a line of $91.7 million at December 31, 2008. This line was reduced by $5.0 million, which has been pledged as collateral for public deposits. Should we ever desire to increase the line of credit beyond the 40% limit, the FHLB would allow borrowings of up to 50% of total assets once we met specific eligibility criteria.
We had $27,675,272 of FHLB borrowings outstanding on December 31, 2008 and $63,531,200 outstanding as of December 31, 2007. We had $6,000,000 in daily rate borrowings which reprice daily and $21,675,272 in three fixed-term advance contracts outstanding on December 31, 2008:
We review the adequacy of our capital on an ongoing basis with reference to the size, composition, and quality of our resources and consistent with regulatory requirements and industry standards. We seek to maintain a capital structure that will assure an adequate level of capital to support anticipated asset growth and absorb potential losses.
In December 2008, we were approved for and received $14.7 million from the U.S. Treasury Department under the TARP Capital Purchase Program. Under this program we issued 14,700 shares of Series A, $1,000 par value, cumulative perpetual preferred stock. This stock will carry a 5% dividend for each of the first 5 years of the investment, and 9% thereafter, unless we elect to redeem the shares. These shares also carry certain warrants to on our common stock.
In June 2008, we raised $6.8 million net in capital through the sale of 774,110 shares of our common stock in two private placements. Selling shareholders were accredited investors and included certain qualifying insiders. These insiders were members of our board of directors and senior management whose purchases were made in accordance with Nasdaq Capital Market guidelines. More information this issue is contained in Note 11 to Monarchs Financial Statements (included as an exhibit in this Form 10-K).
On July 5, 2006, we issued Trust Preferred Subordinated Notes in the amount of $10,000,000 through a private transaction. These notes, which are non-dilutive to common stock, may be included in Tier I capital for regulatory capital determination purposes. The notes have a LIBOR-indexed rate which adjusts, and is payable, quarterly. The rate on the notes at December 31, 2008 was 3.07%. The notes may be redeemed at par beginning on September 30, 2011. This capital was used for general corporate purposes to support the continued growth.
On April 11, 2005, we announced an offering of a minimum of 414,900 shares and a maximum of 742,500 shares of common stock at a pre-established price of $8.78 per share. The offering ran until May 31, 2005 with the full 742,500 shares sold. The number of shares issued and outstanding increased to 4,714,098 from 3,971,598 with the completion of this offering. This capital was used for general corporate purposes to support the continued growth.
The Federal Reserve, the Comptroller of the Currency and the Federal Deposit Insurance Bank have adopted capital guidelines to supplement the existing definitions of capital for regulatory purposes and to establish minimum capital standards. Specifically, the guidelines categorize assets and off-balance sheet items into four risk-weighted categories. At December 31, 2008, the required minimum ratio of qualifying total capital to risk-weighted assets was 8%, of which 4% must be tier-one capital. Tier-1 capital includes stockholders equity, retained earnings and a limited amount of perpetual preferred stock, less certain goodwill items. At December 31, 2008, our total risk-based capital ratio was 14.79%, which is well above the regulatory minimum of 8% and the well capitalized minimum of 10%. Further information on capital adequacy for the Company may be found in Note 17 of Monarchs Financial Statements (included as an exhibit in this Form 10-K).
All share and per share amounts are retroactively adjusted to reflect the stock dividend and splits.
OFF-BALANCE SHEET TRANSACTIONS
We enter into certain financial transactions in the ordinary course of performing traditional banking services that result in off-balance sheet transactions. Our off-balance sheet transactions recognized as of December 31, 2008 were a line of credit to secure public funds, commitments to extent credit and standby letters of credit.
Our line of credit to secure public funds was from the Federal Home Loan Bank. This line was for $5.0 million at December 31, 2008 and 2007.
Commitments to extend credit and unfunded commitments under existing lines of credit amounted to $166.3 million at December 31, 2008 and $242.2 million at December 31, 2007, which represent legally binding agreements to lend to clients with fixed expiration dates or other termination clauses. Since many of the commitments are expected to expire without being funded, the total commitment amounts do not necessarily represent future liquidity requirements.
Standby letters of credit are conditional commitments we issue guaranteeing the performance of a client to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements. At December 31, 2008 and December 31, 2007, we had $6.1 million and $6.2 million respectively, in outstanding standby letters of credit. We do not have any off-balance sheet subsidiaries or special purpose entities. There were no commitments to purchase securities at December 31, 2008 or December 31, 2007.
We and our subsidiaries have twenty-one non-cancellable leases for premises. Further information on lease commitments is contained in Note 4 to Monarchs Financial Statements (included as an exhibit in this Form 10-K).
RECENT ACCOUNTING PRONOUNCEMENTS
In December 2007, the Financial Accounting Standards Board (FASB) issued SFAS 141(R), Business Combinations, which replaces SFAS 141, Business Combinations. This Statement establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed and any non-controlling interest in the acquiree as well as the goodwill acquired in the business combination or a gain from a bargain purchase. SFAS 141(R) also establishes disclosure requirements which will enable users to evaluate the nature and financial effects of the business combination. SFAS 141(R) is effective for fiscal years beginning after December 15, 2008. The Company is currently evaluating the potential impact of the adoption of SFAS 141(R) on the Company's consolidated financial position and results of operations.
In December 2007, the FASB issued SFAS 160, Noncontrolling Interests in Consolidated Financial Statementsan Amendment to ARB No. 51, which establishes accounting and reporting standards for ownership interests in subsidiaries held by parties other than the parent, the amount of consolidated net income attributable to the parent and to the noncontrolling interest, changes in a parent's ownership interest, and the valuation of retained noncontrolling equity investments when a subsidiary is deconsolidated. SFAS 160 also establishes expanded disclosure requirements that clearly identify and distinguish between the interest of the parent's owners and the interests of the noncontrolling owners of a subsidiary. SFAS 160 is effective for fiscal years beginning December 15, 2008. The Company is currently evaluating the potential impact, if any, of the adoption of SFAS 160 on the Companys consolidated financial position and results of operations.
In February, 2008, the FASB issued FASB Staff Position (FSP) FAS 140-3, Accounting for Transfers of Financial Assets and Repurchase Financing Transactions (FSP 140-3). FSP 140-3 requires that an initial transfer of a financial asset and a repurchase financing that was entered into contemporaneously with, or in contemplation of, the initial transfer be evaluated together as a linked transaction under SFAS 140, unless certain criteria are met. FSP 140-3 is effective for the Companys financial statements for the year beginning on January 1, 2009 and earlier adoption is not permitted. The adoption of FAS 140-3 will not have a material impact on the Companys financial condition and results of operations.
The Company adopted the Securities and Exchange Commissions (SEC) Staff Accounting Bulletin (SAB) No. 109, Written Loan Commitments Recorded at Fair Value Through Earnings (SAB 109) for loan commitments measured at fair value through earnings which were issued or modified since adoption. SAB 109 requires that the expected net future cash flows related to servicing of a loan be included in the measurement of all written loan commitments that are accounted for at fair value through earnings. The adoption of SAB 109 generally has resulted in higher fair values being recorded upon initial recognition of derivative interest rate lock commitments.
In March 2008, the FASB issued SFAS 161, Disclosures about Derivative Instruments and Hedging Activities, an amendment of SFAS 133. The standard requires enhanced disclosures about derivative instruments and hedged items that are accounted for under SFAS 133 and related interpretations. The standard will be effective for periods beginning after November 15, 2008, with early adoption permitted. The standard expands the disclosure requirements for derivatives and hedged items and is not expected to have a material impact on the Companys consolidated financial position and results of operations.
On October 10, 2008, the FASB issued FSP FAS 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active. The FSP clarifies the application of SFAS 157, Fair Value Measurements, in a market that is not active and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for that financial asset is not active. The FSP is effective upon issuance, including prior periods for which financial statements have not been issued. The provisions of FSP FAS 157-3 did not have an impact on the Companys consolidated financial position or results of operations.
CRITICAL ACCOUNTING POLICIES
Critical accounting policies are those applications of accounting principles or practices that require considerable judgment, estimation, or sensitivity analysis by management. In the financial service industry, examples, though not an all inclusive list, of disclosures that may fall within this definition are the determination of the adequacy of the allowance for loan losses, valuation of mortgage servicing rights, valuation of derivatives or securities without a readily determinable market value, and the valuation of the fair value of intangibles and
goodwill. Except for the determination of the adequacy of the allowance for loan losses and fair value estimations, we do not believe there are other practices or policies that require significant sensitivity analysis, judgments, or estimations.
Our financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). The financial information contained within our statements is, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained when earning income, recognizing an expense, recovering an asset or relieving a liability. In addition, GAAP itself may change from one previously acceptable method to another method. Although the economics of our transactions would be the same, the timing of events that would impact our transactions could change.
Our critical accounting policies are listed below. A summary of our significant accounting policies is set forth in Note 1 to the Consolidated Financial Statements in our 2008 Annual Report on Form 10-K.
Allowance for Loan Losses
Our allowance for loan losses is an estimate of the losses that may be sustained in our loan portfolio. The allowance is based on two basic principles of accounting: (i) SFAS 5, Accounting for Contingencies, which requires that losses be accrued when they have a probability of occurring and are estimable and (ii) SFAS 114, Accounting by Creditors for Impairment of a Loan, which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance.
Our allowance for loan losses has three basic components: the formula allowance, the specific allowance and the unallocated allowance. Each of these components is determined based upon estimates that can and do change when the actual events occur. The formula allowance uses a historical loss view as an indicator of future losses along with various economic factors and, as a result, could differ from the loss incurred in the future. However, since this history is updated with the most recent loss information, the errors that might otherwise occur are mitigated. The specific allowance uses various techniques to arrive at an estimate of loss for specifically identified loans. Historical loss information, expected cash flows and fair market value of collateral are used to estimate these losses. The unallocated allowance captures losses whose impact on the portfolio have occurred but have yet to be recognized in either the formula or specific allowance. The use of these values is inherently subjective, and our actual losses could be greater or less than the estimates.
Fair Value Measurements
On January 1, 2008 we adopted SFAS 157, Fair Value Measurements, which establishes a framework for measuring fair value in generally accepted accounting principles (GAAP) and SFAS 159, The Fair Value Option for Financial Assets and Financial Liabilities, which permits entities to choose to measure many financial instruments and certain other items at fair value. The estimation of fair value is significant to certain assets, including loans held-for-sale, available-for-sale securities, rate lock commitments, and real estate owned. These assets are recorded at fair value or lower of cost or fair value, as applicable. The fair values of loans held-for-sale are based on commitments from investors. The fair values of available-for-sale securities are based on published market rates or dealer quotes. The fair values of rate lock commitments are based on fees currently charged to enter into similar agreements, and may consider the difference between current interest rates and committed rates. The fair value of real estate owned is estimated based on our evaluation of fair value of similar properties.
Fair values can be volatile and may be influenced by a number of factors, including market interest rates, prepayment speeds, discount rates, and market conditions, among others. Since these factors can change significantly and rapidly, fair values are difficult to predict and subject to material changes that could impact our financial condition and results of operation.
Our managements discussion and analysis refers to the efficiency ratio, which is computed by dividing non-interest expense by the sum of net interest income on a tax equivalent basis and non-interest income. This is a non-GAAP financial measure which we believe provides investors with important information regarding our operational efficiency. Comparison of our efficiency ratio with those of other companies may not be possible because other companies may calculate the efficiency ratio differently. In referring to our net income, we are referring to income under generally accepted accounting principals, or GAAP.
The analysis of net interest income in this document is performed on a tax equivalent basis. We feel the tax equivalent presentation better reflects total return, as many financial assets have specific tax advantages that modify their effective yields. A reconcilement of tax-equivalent net interest income to net interest income under generally accepted accounting principals, or GAAP, is provided in those statements.
IMPACT OF INFLATION AND CHANGING PRICES
The majority of assets and liabilities of a financial institution are monetary in nature and therefore differ greatly from most industrial companies that have significant investments in fixed assets. Due to this fact, the effects of inflation on our balance sheet are minimal, meaning that there are no substantial increases or decreases in net purchasing power over time. The most significant effect of inflation is on other expenses that tend to rise during periods of general inflation. We feel that the most significant impact on financial results is changes in interest rates and our ability to react to those changes. As discussed previously, management is attempting to measure, monitor and control interest rate risk.
Market risk is the risk of loss in a financial instrument arising from adverse changes in market rates or prices such as interest rates, foreign currency exchange rates, commodity prices and equity prices. Our primary market risk exposure is interest rate risk. The ongoing monitoring and management of this risk is an important component of our asset/liability management process, which is governed by policies established by our Board of Directors that are reviewed and approved annually. Our Board of Directors delegates responsibility for carrying out asset/liability management policies to our Asset Liability Committee (ALCO). In this capacity, our ALCO Committee develops guidelines and strategies that govern our asset/liability management related activities, based upon estimated market risk sensitivity, policy limits and overall market interest rate levels and trends.
Interest rate risk represents the sensitivity of earnings to changes in market interest rates. As interest rates change, the interest income and expense streams associated with our financial instruments also change, affecting net interest income, the primary component of our earnings. Our ALCO Committee uses the results of a detailed and dynamic simulation model to quantify the estimated exposure of net interest income to sustained interest rate changes. While our ALCO Committee routinely monitors simulated net interest income sensitivity over a rolling twelve month horizon, it also employs additional tools to monitor potential longer-term interest rate risk.
The simulation model captures the impact of changing interest rates on the interest income received and interest expense paid on all assets and liabilities reflected on our balance sheet. The simulation model is prepared and updated four times during each year. This sensitivity analysis is compared to our ALCO Committee policy limits, which specify a maximum tolerance level for net interest income exposure over a one-year horizon, assuming no balance sheet growth, given a 300, 200 and 100 basis point (bp) upward or downward shift in interest rates. A parallel and pro rata shift in rates over a 12-month period is assumed. The following reflects the range of our net interest income sensitivity analysis and Market Value of Portfolio Equity Sensitivity as of December 31, 2008. All except the 100 basis point increase of the Market Value of Portfolio Equity Sensitivity results met the approved policy limits of our Asset Liability Management Policy. The 300 basis point shifts in the net interest income sensitivity results were within the approved limits. We continue to focus its efforts on complying with approved limits.
Table 13Change in Net Interest Income and Market Value of Portfolio Equity
At the end of 2008, our interest rate risk model indicated that in a rising rate environment of 200 basis points over a 12 month period net interest income could increase by 11.79% on average. For the same time period the interest rate risk model indicated that in a declining rate environment of 200 basis points over a 12 month period net interest income could decrease by 10.89% on average. While these numbers are subjective based upon the parameters used within the model, management believes the balance sheet is very balanced with little risk to rising rates in the future.
In 2008 our balance sheet grew by $94 million. Deposit inflows, primarily in the form of short-term certificates of deposits have provided the funding for the growth in the loan portfolio. Overall, we continue to have moderate interest rate risks to both falling and rising interest rates. Based upon final 2008 simulation, we could expect an average positive impact to net interest income of $2,582,000 over the next 12 months if rates rise 200 basis points. If rates were to decline 200 basis points, the Company could expect an average negative impact to net interest income of $2,386,000 over the next 12 months.
The preceding sensitivity analysis does not represent a Bank forecast and should not be relied upon as being indicative of expected operating results. These hypothetical estimates are based upon numerous assumptions, including the nature and timing of interest rate levels including yield curve shape, prepayments on loans and securities, deposit decay rates, pricing decisions on loans and deposits, reinvestment or replacement of asset and liability cash flow. While assumptions are developed based upon current economic and local market conditions, we cannot make any assurances about the predictive nature of these assumptions, including how customer preferences or competitor influences might change.
Also, as market conditions vary from those assumed in the sensitivity analysis, actual results will also differ due to factors such as prepayment and refinancing levels likely deviating from those assumed, the varying impact of interest rate change, caps or floors on adjustable rate assets, the potential effect of changing debt service levels on clients with adjustable rate loans, depositor early withdrawals and product preference changes, and other internal and external variables. Furthermore, the sensitivity analysis does not reflect actions that our ALCO Committee might take in response to or anticipation of changes in interest rates.
Additional information called for by this item is contained in Monarchs Annual Report to Shareholders for the year ended December 31, 2008, and is incorporated herein by reference.
Our management, including our Chief Executive Officer and Chief Financial Officer, evaluated our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934), as amended (the Exchange Act) as of December 31, 2008. Based on this evaluation, our Chief Executive Officer
and Chief Financial Officer concluded that our disclosure controls and procedures are effective to ensure that the information we are required to disclose in the reports that we file or submit under the Exchange Act are recorded, processed, summarized, and reported within the time periods specified in SEC rules and forms. There are no significant changes in our internal controls over financial reporting that occurred during the year ended December 31, 2008 that have materially affected or are reasonably likely to materially affect our internal control over financial reporting.
MANAGEMENTS REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
Our management is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America. Management regularly monitors its internal control over financial reporting and takes appropriate action to correct any deficiencies that may be identified.
Management assessed our internal controls over financial reporting as of December 31, 2008. This assessment was based on criteria established in Internal Controls Integrated Framework issued by the Commission of Sponsoring Organizations of the Treadway Commission. Based on this assessment, management concluded that we maintained effective internal control over financial reporting as of December 31, 2008.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Further, because of changes in conditions, internal control effectiveness may vary over time.
This annual report does not include an attestation report of our registered public accounting firm regarding internal control over financial reporting. Managements report was not subject to attestation by our registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit us to provide only managements report in this annual report.
March 18, 2009
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Stockholders
Monarch Financial Holdings, Inc. and Subsidiaries
We have audited the accompanying consolidated balance sheets of Monarch Financial Holdings, Inc. and Subsidiaries (the Company) as of December 31, 2008 and 2007, and the related consolidated statements of income, shareholders equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2008. Monarch Financial Holdings, Inc. and Subsidiaries management is responsible for these financial statements. Our responsibility is to express an opinion on these consolidated 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. The company is not required to have, nor are we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the companys internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, 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 Monarch Financial Holdings, Inc. and Subsidiaries as of December 31, 2008 and 2007, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2008 in conformity with accounting principles generally accepted in the United States of America.
March 18, 2009
MONARCH FINANCIAL HOLDINGS, INC.
CONSOLIDATED BALANCE SHEETS
The accompanying notes are an integral part of these consolidated financial statements.
MONARCH FINANCIAL HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF INCOME
The accompanying notes are an integral part of these consolidated financial statements.
MONARCH FINANCIAL HOLDINGS, INC
CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY
The accompanying notes are an integral part of these consolidated financial statements.
MONARCH FINANCIAL HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS