Monarch Financial Holdings 10-K 2012
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
For the fiscal year ended December 31, 2011
Commission File No. 001-34565
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:
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ No þ
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 þ
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 þ No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Date File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes þ 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. ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of accelerated filer, large accelerated filer and smaller reporting company 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 þ
The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant as of June 30, 2011 was approximately $47,020,000.
The number of shares of common stock outstanding as of March 28, 2012 was 5,981,489.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrants definitive Proxy Statement relating to its 2011 Annual Meeting of Shareholders are incorporated by reference into Part III of this Annual Report on Form 10-K where indicated.
MONARCH FINANCIAL HOLDINGS, INC.
Monarch Financial Holdings, Inc. (sometimes referred to herein as the Company or Monarch) is a Virginia-chartered bank holding company headquartered in Chesapeake, Virginia engaged in commercial and retail banking, investment and insurance sales, and mortgage origination and brokerage. We conduct our operations through our wholly-owned subsidiary, Monarch Bank (sometimes referred to herein as the Bank), and its two wholly-owned subsidiaries, Monarch Investment, LLC and Monarch Capital, LLC. We also do business in some markets as OBX Bank, Monarch Mortgage and under various names via joint ventures with other partners.
Monarch was created on June 1, 2006 through a reorganization plan, under the laws of the Commonwealth of Virginia, in which Monarch Bank became its wholly-owned subsidiary. Monarch Bank was incorporated on May 1, 1998 and opened for business on April 14, 1999 as a Virginia-chartered bank and a member of the Federal Reserve banking system. The Company has grown through de novo expansion, acquisition and the hiring of seasoned banking professionals in our target markets. While Monarch has grown rapidly in recent years, the Company strategy has been to do so profitably and without compromising asset quality.
Monarch Bank serves the needs of local businesses, professionals, corporate executives and individuals in the South Hampton Roads area of Southeastern Virginia and the Outer Banks region of Northeastern North Carolina. We operate nine banking offices, twelve residential mortgage offices and one investment services office in the cities of Chesapeake, Norfolk and Virginia Beach, Virginia. We have two full-service banking offices operating under the name OBX Bank and two residential mortgage offices operating under the name of OBX Bank Mortgage in the Outer Banks region of Northeastern North Carolina in the towns of Kitty Hawk and Nags Head. We also operate twenty-two additional residential mortgage offices outside of our primary market areas.
We utilize a Market President approach to deliver products and services in each of our primary banking markets. We hire experienced bankers to serve in these leadership roles, and each Market President is responsible for building a strong team of bankers in their respective markets, developing and managing an advisory board of directors, managing sales and service delivery, and integrating our other lines of business in their communities. We believe this approach allows us to expand into new markets with fewer banking office locations and achieve profitability earlier than by utilizing the traditional banking model of opening a banking office and then looking for bankers to staff the location.
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. Our board of directors believes our capitalization supports current growth levels in loans and deposits.
Commercial and Other Banking
Monarch operates in several integrated lines of business. Our Business Banking Group has been a core line of business since we opened. 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 Chesapeake, Norfolk, Virginia Beach and the Outer Banks, each led by a Market President. With the hiring of a Market President for Suffolk, we have begun efforts toward expansion to that market.
Our Real Estate Finance Group has been a core line of business since we opened. This group provides the delivery of residential real estate construction, acquisition and development loans, with the majority of its focus in the 1-4 family residential markets of Hampton Roads and Northeastern North Carolina. This group supports this type of banking in all of our current markets.
Monarch has a Commercial Real Estate Finance Group specializing in underwriting commercial real estate loans, which are either financed for our balance sheet or brokered to other investors. Non-owner occupied and income producing real estate loans require a specialized approach to underwriting, structuring, and pricing. We formed this group to ensure proper risk management and customer relationships are retained with those clients that expect an experienced and well equipped banking platform. Our Commercial Real Estate Finance Group supports this type of banking in all our markets.
Our Private Banking / Cash Management Group support our deposit gathering and service operations, along with the delivery of consumer lending. Our dedicated cash management specialists focus on the acquisition, support and delivery of deposit products and services to our business banking clients. They deliver cash management services for small and moderate size businesses in all our markets. We offer a full range of deposit services including checking accounts, savings accounts and 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, professional lines of credit, secured and unsecured loans for financing automobiles, home improvements, education and personal investments.
Monarch offers other services which include investment advisory services, insurance sales, safe deposit boxes, cash management services, check and bankcard services, online banking 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 internet banking, remote deposit capture, and online cash management, and through more than 50 automated teller machines (ATMs) located throughout South Hampton Roads and Northeastern North Carolina.
Monarch Investment, LLC, a wholly-owned subsidiary of Monarch Bank, offers investment advisory services through licensed investment advisors and also has ownership interests in several subsidiaries. Monarch Investment, LLC owns a minority stockholder interest in Infinex Financial, LLC, a broker-dealer located in Meriden, Connecticut. Investment services are offered through Infinex. Monarch Investment 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 our clients.
Monarch Mortgage, a division of Monarch Bank, was formed in May 2007 when we hired a group of approximately 70 experienced mortgage professionals to staff the division. At that time our employment of these individuals increased the size of our mortgage group from approximately 10 to approximately 80 mortgage professionals. Monarch Mortgage is a residential mortgage lender with offices in Virginia, Maryland, North Carolina and South Carolina. We sell 99% of the mortgages we originate on a loan by loan basis to a large number of national banks, mortgage companies, and directly to certain governmental agencies. By maintaining correspondent and broker relationships with a number of companies, and by monitoring the financial condition of those companies, we feel we can limit the risk of our correspondents not purchasing loans we originate. We originate and sell primarily long-term fixed rate mortgage loans, both conventional and for government programs such as FHA, VA, and the Virginia Housing and Development Authority. A small portion of our loan clients select shorter term, variable rate loans. All loans originated are considered prime loans. We do not securitize pools of loans.
Mortgage originations and sales have become a major source of revenue and net income for the Company since the formation of Monarch Mortgage in 2007, with significant growth in 2008 through 2011 due to a low interest rate environment coupled with government stimulus to the mortgage marketplace. We manage the majority of our interest rate risk by locking in the interest rate for each mortgage loan with our correspondents and borrowers at the same time. When markets are favorable, a small portion of our mortgage loans are included in a mandatory delivery program which utilizes pairing of agency securities with pool of loans to manage interest rate risk. We do not currently have any loans in a mandatory delivery program.
As a mortgage lender, Monarch Mortgage underwrites mortgage loans for our clients to be sold in the secondary market or booked on our balance sheet. Monarch Mortgage currently has offices with locations in Alexandria, Chesapeake, Fairfax, Fredericksburg, Manassas, Midlothian, Norfolk, Oakton, Reston, Richmond, Virginia Beach and Woodbridge, Virginia; Bowie, Crofton, Dunkirk, Greenbelt, Rockville, Towson and Waldorf, Maryland; Charlotte, Kitty Hawk, Mooresville, Nags Head and Wilmington, North Carolina; and Greenwood, South Carolina. Monarch Mortgage originates and sells loans under two different financial models. All the offices in Maryland, and the majority of the offices in Northern Virginia, North Carolina and South Carolina, operate as fee-based offices, with each office paying a per loan processing fee along with a percentage of net income to Monarch Mortgage, with the remaining net income or loss of each office the responsibility of each offices manager or management team. The fee-based office model allows 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 OBX Bank mortgage 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 commercial mortgage brokerage services in the placement of primarily long-term fixed-rate debt for the commercial, hospitality, and multi-family housing markets.
Monarch Investment, LLC also delivers mortgages and mortgage related services through other subsidiaries or investments as follows:
Our Market Areas
Commercial and Other Banking
Monarch operates in the Virginia Beach-Norfolk-Newport News, VA-NC MSA, more commonly known as Greater Hampton Roads. The Greater Hampton Roads area includes the cities of Virginia Beach, Norfolk, Newport News, Chesapeake, Hampton, Portsmouth and Suffolk, and is the 2nd largest MSA in Virginia and the 5th largest MSA in the Southeast with a population of approximately 1.7 million people as of July 2011. Greater Hampton Roads has a diversified economy that includes military, tourism, government, education, shipping, healthcare and professional services which has resulted in lower unemployment rates when compared to the overall United States. As of November 2011, the unemployment rate for the Greater Hampton Roads area was 7.0% compared to 8.6% for the U.S. and on December 2010 the unemployment rate for the Greater Hampton Roads area was 6.7% compared to 9.4% for the U.S.
Our primary market areas are South Hampton Roads, which includes the cities of Virginia Beach, Norfolk, Chesapeake, Portsmouth and Suffolk, Virginia, and the Outer Banks region of Northeastern North Carolina, which is comprised of Currituck and Dare counties. We believe the economic conditions encountered in South Hampton Roads, including the level of home purchases and sales, are consistent with those encountered in Greater Hampton Roads as a whole.
South Hampton Roads, with a population of over one million people as of July 2010, has experienced steady growth in recent years and is one of the largest metropolitan areas in Virginia. 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. Norfolk is also the home of the Port of Hampton Roads, the third largest volume port on the East Coast in terms of general cargo. The presence of the military and port provide stability to the market and help the area weather market downturns in other sectors of the local economy. We currently concentrate our operations and have banking offices in Chesapeake, Virginia Beach and Norfolk, Virginia.
The Outer Banks region primarily consists of Currituck and Dare counties on North Carolinas northeast coast and is a natural extension of our South Hampton Roads market. Currituck County is a part of the Virginia Beach-Norfolk-Newport News, VA-NC MSA. We operate two banking offices under the name OBX Bank in the town of Kitty Hawk and Nags Head, North Carolina.
Our mortgage offices outside of the Hampton Roads and Outer Banks markets are all located for the convenient delivery and sales of residential mortgage loans. We have additional mortgage offices in Towson, Rockville (2), Greenbelt, Dunkirk, Crofton, Bowie, and Waldorf, Maryland; Charlotte (2), Kitty Hawk, Nags Head and Wilmington, North Carolina; Greenwood, South Carolina; Richmond, Midlothian, Reston, Oakton, Fairfax, Fredericksburg, Woodbridge, and Manassas, Virginia.
As of February 15, 2011, the Company and its subsidiaries had five hundred, sixty-one (561) full-time and eighteen (18) part-time employees. None of our employees are represented by any collective bargaining agreements, and relations with employees are considered excellent.
Commercial and Other Banking Lending Activities
The principal risk associated with each of the categories of loans in our portfolio is the creditworthiness of our 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 loan officers 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.
We use a management loan committee and a directors loan committee to approve loans. The management loan committee is comprised of members of management, and the directors loan committee is composed of six directors, of which four are independent directors. Both committees approve new, renewed and or modified loans that exceed officer loan authorities. The directors loan committee also reviews any changes to our lending policies, which are then approved by our board of directors.
Construction and Development Lending
We make construction loans, primarily residential, and land acquisition and development loans. The construction loans are secured by residential houses under construction and the underlying land for which the loan was obtained. The average life of a construction loan is typically less than 12 months. 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. Therefore, 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 75% to 85% of appraised value, in addition to analyzing the creditworthiness of our borrowers. We also obtain a first lien on the property as security for our 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 in our market area, including multi-family residential buildings, commercial buildings and offices, shopping centers and churches. Commercial real estate lending entails significant additional risks, 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 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 our business borrowers. Residential mortgage loans generally are made on the basis of the borrowers ability to make repayment from his 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, 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 employed by us 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, we require title insurance, hazard insurance and, if required, flood insurance.
Mortgage Banking Lending Activities
Through our mortgage division Monarch Mortgage, for our own portfolio, we offer mortgages and construction loans to individual borrowers. Mortgages typically have initial resets in five 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 Monarch Mortgage. All other residential mortgage loans originated by Monarch Mortgage are sold to investors on the secondary market.
Commercial and Other Banking
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, 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 us and offer certain services, such as extensive and established banking office 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 us. Several community banks are headquartered in our trade market 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 remains strong.
Factors affecting the competition for bank loans and deposits are interest rates and terms offered, number and location of banking offices and types of products offered, as well as the reputation of the institution. The advantages we have over our competition include experienced and dedicated employees, our Market President structure, long-term customer relationships, strong historical financial performance, a commitment to excellent customer service, experienced management and directors, and the support and involvement in the communities that we serve. We focus on providing products and services to individuals, professionals, and small to medium-sized businesses within our communities. According to FDIC deposit data as of June 30, 2011, Monarch Bank was ranked 9th in deposit market share with 3.02% of the $22 billion in deposits in the Greater Hampton Roads market. OBX Bank was ranked 4th in deposit market share with 8.15% of the $1.8 billion in deposits in the Outer Banks market. The top five banks in our markets together control 75% of the total deposits in the Greater Hampton Roads market and the top three banks together control 62% of the total deposits in the Outer Banks, providing us with ample opportunity to continue to grow our market share.
Factors affecting competition for our mortgage banking operations are our status as a mortgage lender as opposed to being a mortgage broker, the number and location of mortgage offices and types of loan programs offered, as well as the reputation of Monarch and our mortgage loan officers. Our advantages over the competition include experienced and dedicated employees, long-term customer and referral relationships, local and experienced underwriting, a commitment to excellent customer service, experienced management, and the support and involvement in the communities that we serve. We focus on residential mortgage loan origination and placement in the secondary market.
Supervision and Regulation
As a financial holding company, we are subject to regulation under the Bank Holding Company Act of 1956, as amended, and the examination and reporting requirements of the Federal Reserve. Other federal and state laws govern the activities of our bank subsidiary, Monarch Bank, including the activities in which it may engage, the investments that it makes, the aggregate amount of loans that it may grant to one borrower, the amount of capital it must retain, and the dividends it may declare and pay to us. Monarch Bank is also subject to various consumer and compliance laws. As a state-chartered bank, Monarch Bank is primarily subject to regulation, supervision and examination by the Bureau of Financial Institutions of the Virginia State Corporation Commission and the Federal Reserve Board of Richmond. Monarch Bank also is subject to regulation, supervision and examination by the FDIC.
The following description summarizes the more significant federal and state laws applicable to us. To the extent that statutory or regulatory provisions are described, the description is qualified in its entirety by reference to that particular statutory or regulatory provision.
Bank Holding Company Act
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, and are subject to ongoing regulation, supervision and examination by the Federal Reserve. As a condition to its approval, the Federal Reserve required that we obtain approval of the Federal Reserve Bank of Richmond prior to incurring any indebtedness. We are required to file with the Federal Reserve periodic and annual reports and other information concerning our business operations and those of our subsidiaries. In addition, the Bank Holding Company Act requires a bank holding company to obtain Federal Reserve 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. Federal Reserve 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 Federal Reserve 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 Federal Reserve, after due notice and opportunity for hearing, by regulation or order, has determined is so closely related to banking or of managing or controlling banks as to be a proper incident thereto. A number of such activities have been determined by the Federal Reserve 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 Federal Reserve, 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.
The Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) was signed into law in July 2010, incorporating numerous financial institution regulatory reforms. Many of these reforms will be implemented over the course of 2011 and beyond through regulations to be adopted by various federal banking and securities regulatory agencies. The Dodd-Frank Act implements far-reaching reforms of major elements of the financial landscape, particularly for larger financial institutions. Many of its provisions do not directly impact community-based institutions like the Bank. For instance, provisions that regulate derivative transactions and limit derivatives trading activity of federally-insured institutions, enhance supervision of systemically significant institutions, impose new regulatory authority over hedge funds, limit proprietary trading by banks, and phase-out the eligibility of trust preferred securities for Tier 1 capital are among the provisions that do not directly impact the Bank either because of exemptions for institutions below a certain asset size or because of the nature of the Banks operations. Provisions that could impact the Bank include the following:
Many aspects of the Dodd-Frank Act are subject to rulemaking and will take effect over several years, and their impact on the Company or the financial industry is difficult to predict before such regulations are adopted.
Regarding capital requirements
The Dodd-Frank Act contains a number of provisions dealing with capital adequacy of insured depository institutions and their holding companies, which may result in more stringent capital requirements. Under the Collins Amendment to the Dodd-Frank Act, federal regulators have been directed to establish minimum leverage and risk-based capital requirements for, among other entities, banks and bank holding companies on a consolidated basis. These minimum requirements cant be less than the generally applicable leverage and risk-based capital requirements established for insured depository institutions nor quantitatively lower than the leverage and risk-based capital requirements established for insured depository institutions that were in effect as of July 21, 2010. These requirements in effect create capital level floors for bank holding companies similar to those in place currently for insured depository institutions. The Collins Amendment also excludes trust preferred securities issued after May 19, 2010 from being included in Tier 1 capital unless the issuing company is a bank holding company with less than $500 million in total assets. Trust preferred securities issued prior to that date will continue to count as Tier 1 capital for bank holding companies with less than $15 billion in total assets, and such securities will be phased out of Tier 1 capital treatment for bank holding companies with over $15 billion in total assets over a three-year period beginning in 2013. Accordingly, our trust preferred securities will continue to qualify as Tier 1 capital.
Regarding FDIC insurance and assessments
The FDIC is required to maintain a designated minimum ratio of the DIF to insured deposits in the United States. The Dodd Frank Act requires the FDIC to assess insured depository institutions to achieve a DIF ratio of at least 1.35 percent by September 30, 2020. The FDIC has adopted new regulations that establish a long-term target DIF ratio of greater than two percent. Deposit insurance assessment rates are subject to change by the FDIC and will be impacted by the overall economy and the stability of the banking industry as a whole.
Pursuant to the Dodd Frank Act, FDIC insurance coverage limits were permanently increased to $250,000 per customer. The Dodd Frank Act also provides for unlimited FDIC insurance coverage for noninterest-bearing demand deposit accounts for a two year period beginning on December 31, 2010 and ending on December 31, 2012.
The Dodd Frank Act also changed the methodology for calculating deposit insurance assessments by changing the assessment base from the amount of an insured depository institutions domestic deposits to its total assets minus tangible equity. On February 7, 2011, the FDIC issued a new regulation implementing revisions to the assessment system mandated by the Dodd Frank Act. The new regulation was effective April 1, 2011 and was reflected in the June 30, 2011 FDIC fund balance and the invoices for assessments due September 30, 2011. As a result of the new regulations, our annual deposit insurance assessments are lower than before the regulation. While the burden on replenishing the DIF will be placed primarily on institutions with assets of greater than $10 billion, any future increases in required deposit insurance premiums or other bank industry fees could have a significant adverse impact on our financial condition and results of operations.
Regarding transactions with insiders
The Dodd-Frank Act also provides that banks may not purchase an asset from, or sell an asset to a bank insider (or their related interests) unless (i) the transaction is conducted on market terms between the parties, and (ii) if the proposed transaction represents more than 10 percent of the capital stock and surplus of the bank, it has been approved in advance by a majority of the banks non-interested directors.
Regarding debit card interchange fees
One provision of the Financial Reform Act requires the Federal Reserve to set a cap on debit card interchange fees charged to retailers. In June 2011, the Federal Reserve issued a final rule capping the fee at a level below the average that banks were currently charging. While banks with less than $10 billion in assets (such as the Bank) are exempted from this measure, as a practical matter we expect that all banks could be forced by market pressures to lower their interchange fees or face potential rejection of their cards by retailers. As a result, our debit card revenue could be adversely impacted.
The Federal Reserve and the Virginia Bureau of Financial Institutions regulate and monitor all significant aspects of Monarch Banks operations. The Federal Reserve requires quarterly reports on our financial condition, and both federal and state regulators conduct periodic examinations of us. 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 Bank, 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. The opening of any additional banking offices by us requires prior regulatory approval, which takes into account a number of factors, including, among others, adequate 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, we are also required to comply with rules that restrict preferential loans by us to insiders, require us to keep information on loans to principal stockholders 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.
The amount of cash dividends permitted to be paid by us will depend upon our earnings and capital position and is limited by federal and state law, regulations and policy. 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 paid by us 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 our net profits for such year, plus our retained net profits for the preceding two years. In addition, we may not pay a dividend in an amount greater than our undivided profits then 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.
Federal Deposit Insurance Corporation
Our deposits are insured by the Deposit Insurance Fund, as administered by the FDIC, to the maximum amount permitted by law. The Emergency Economic Stabilization Act of 2008 (EESA), as amended by the Helping Families Save Their Homes Act of 2009, temporarily increased the limit on FDIC coverage to $250 thousand for all accounts through December 31, 2013. Additionally, on October 14, 2008, after receiving a recommendation from the boards of the FDIC and the Federal Reserve, and consulting with the President, the Secretary of the Treasury signed the systemic risk exception to the FDI Act, enabling the FDIC to establish its Temporary Liquidity Guarantee Program (TLGP). Under the transaction account guarantee program of the TLGP, the FDIC fully guaranteed, until June 30, 2010 but later extended until December 31, 2011, all non-interest bearing transaction accounts, including NOW accounts with interest rates of 0.5 percent or less and IOLTAs (lawyer trust accounts). The TLGP also guaranteed all senior unsecured debt of insured depository institutions or their qualified holding companies issued between October 14, 2008 and June 30, 2009 with a stated maturity greater than 30 days.
Section 335 of the Dodd-Frank Act made permanent the standard maximum deposit insurance (SMDI) coverage of $250,000. On November 15, 2010 the FDIC published a final rule to implement Section 343 of the Dodd-Frank Act (Section 343). Section 343 amended the deposit insurance provisions of the Federal Deposit Insurance Act (FDI Act) to provide temporary unlimited and separate insurance coverage for noninterest-bearing transaction accounts, defined as a deposit or account maintained at an insured institution with respect to which interest is neither accrued nor paid. On December 29, 2010, the FDIC adopted a final rule amending the FDI Act to extend the temporary unlimited deposit insurance to Interest on Lawyers Trust Accounts (IOLTAs) for two years starting December 31, 2011. Section 627 of the Dodd-Frank Act allowed insured depository institutions to begin paying interest on demand deposit accounts, effective July 21, 2011 but requires institutions that modify the terms of demand deposit accounts to pay interest must notify affected customers that the account no longer will be eligible for unlimited deposit insurance coverage as a noninterest-bearing transaction account.
On February 7, 2010 the FDIC issued a final rule to implement revisions to the FDI Act made by the Dodd-Frank Act by modifying the definition of an institutions deposit insurance assessment base; to change the assessment rate adjustments; to revise the deposit insurance assessment rate schedules in light of the new assessment base and altered adjustments and to revise the large insured depository institution assessment system to better differentiate for risk and better take into account losses from large institution failures. The final rule took effect for the quarter beginning April 1, 2011, and was reflected in the June 30, 2011 fund balance and the invoices for assessments due September 30, 2011. This rule reduced the assessments of smaller banks like Monarch Bank. On November 17, 2009 the FDIC had amended it regulations requiring all insured institutions, including Monarch Bank, to prepay their FDIC premiums for the fourth quarter of 2009 and all of 2010 through 2012. The prepaid assessments for these periods were collected on December 31, 2010. This represented a charge of approximately $3.5 million with $3.2 million to be spread over the next three years. At December 31, 2011, approximately $1.6 million of this prepayment remained. It is not clear at this time, how the final rule will impact the accuracy of our prepaid assessment.
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 acquire banking offices without geographic restriction in Virginia, and we may acquire banking offices or banks or merge across state lines in most cases.
Community Reinvestment Act
The Community Reinvestment Act of 1977 requires that federal banking regulators evaluate the record of the 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 banking office or facility. We received a Satisfactory CRA rating in our latest CRA examination.
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 us 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. The Secure and Fair Enforcement for Mortgage Licensing Act requires that mortgage loan originators employed by Agency-regulated institutions be registered with the National Mortgage Licensing System and Registry. Other acts govern confidentiality of consumer financial records, automatic deposits and withdrawals, check settlement, endorsement and presentment, and disclosure of cash transactions exceeding $10 thousand 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. The stated goals of the Sarbanes-Oxley Act are to increase corporate responsibility, to provide for enhanced penalties for accounting and auditing improprieties in publicly traded companies and to protect investors by improving the accuracy and reliability of corporate disclosures pursuant to the securities laws. The Sarbanes-Oxley Act is the most far-reaching U.S. securities legislation enacted since the 1930s. The Sarbanes-Oxley Act generally applies to all companies that, like us, file or are required to file periodic reports under the Securities Exchange Act of 1934, as amended.
The Sarbanes-Oxley Act 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 12-month period following initial publication of any financial statements that later require restatement, a prohibition on insider trading during pension plan blackout 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 public accounting oversight board, auditor independence, and various increased criminal penalties for violations of securities laws.
So long as we remain a small reporting company, we were not required to comply with the Sarbanes-Oxley Act Section 404(b) reporting requirements for auditor attestation.
Governmental Monetary Policies
Our earnings and growth are affected not only by general economic conditions, but also by the monetary policies of various governmental regulatory authorities, particularly the Federal Reserve. The Federal Reserves Open Market Committee implements national monetary policy in U.S. 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. Our net interest margin is impacted when the Federal Reserve increases or decreases interest rates, due to our loan and deposit maturities and structure. We anticipate that our profitability will continue to hold in the current rate environment by our ability to control the costs of deposits and other borrowings which are used to fund loans. We try to minimize our exposure to interest rate risk, but we are unable to completely eliminate this risk.
Changes in our delivery method for loans held for sale may impact profitability.
We manage the majority of our interest rate risk by locking in the interest rate for each mortgage loan with our correspondents (investors) and borrowers at the same time, which is a best efforts delivery system. From time to time we may modify the delivery system on a small portion of our mortgage loans to incorporate a mandatory delivery process. Under the mandatory delivery system the interest rate risk associated with a rate lock on a mortgage loan shifts from the investor back to our Company. Therefore, to the extent we adopt the mandatory delivery system our interest income could be adversely impacted if mortgage rates were to become volatile. There were no mandatory delivery commitments at year end.
Our profitability depends significantly on economic conditions in our market area.
Our success depends to a large degree on the general economic conditions in Greater Hampton Roads, Virginia. Our market has experienced a downturn in which we have seen falling home prices, rising foreclosures, reduced economic activity, increased unemployment and an increased level of commercial and consumer delinquencies. The economic climate has created diminished cash flows for many of our borrowers, and at times left some borrowers unable to properly service their loan obligations. The rise in unemployment has also affected the ability of consumers to properly service their debt obligations. Management has been aggressive during this period in
the recognition, provisioning and charging off of non-performing loans, and this has had an impact on the net income of our commercial and other banking segment. If economic conditions in our market do not improve or deteriorate further, we could experience any of the following consequences, each of which could further adversely affect our business:
We could experience further adverse consequences in the event of a prolonged economic downturn in our market due to our exposure to commercial loans across various lines of business. A prolonged economic downturn could impact collateral values or cash flows of the borrowing businesses, and as a result our primary source of repayment could be insufficient to service the debt. In addition, adverse consequences to us in the event of a prolonged economic downturn in our market could be compounded by the fact that many of our commercial and real estate loans are secured by real estate located in our market area. A further 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 would be diminished. In addition, a number of our loans are dependent on successful completion of real estate projects and demand for homes, both of which could be affected adversely 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 absolutely 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 stockholders 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 will 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.
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 between the rates we receive on loans and investments and the rates we pay for deposits and other sources of funds. 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 neutral 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 we are more asset sensitive or liability sensitive. Accordingly, we may not be successful in
maintaining this neutral position and, as a result, our net interest margin may suffer, which will negatively impact our earnings. Based on our asset and liability position at December 31, 2011, a rise or decline in interest rates would have limited impact on our net interest income in the short term
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 an employment agreement with Mr. Schwartz, Chief Executive Officer of the Company, E. Neal Crawford, Jr., Executive Vice President of the Company and President of Monarch Bank, and William T. Morrison, Executive Vice President and Chief Executive Officer of Monarch Mortgage. The existence of such agreements, however, does not necessarily ensure that we will be able to continue to retain their services. Several other members of management currently have employment agreements to retain their services. The unexpected loss of key employees could have a material adverse effect on our business and possibly result in reduced revenues and earnings.
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. With the exception of Mr. Morrison, 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 client 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.
Revenue from our mortgage banking operations are sensitive to changes in economic conditions, decreased economic activity, a slowdown in the housing market, higher interest rates or new legislation and may adversely impact our profits.
Our mortgage banking division, Monarch Mortgage, has provided a significant portion of our consolidated revenue and maintaining our revenue stream in this segment is dependent upon our ability to originate loans and sell them to investors. Mortgage loan production levels are sensitive to changes in economic conditions and can suffer from decreased economic activity, a slowdown in the housing market or higher interest rates. Generally, any sustained period of decreased economic activity or higher interest rates could adversely affect Monarch Mortgages mortgage originations and, consequently, reduce its income from mortgage lending activities. In addition, new legislation could adversely affect its operations.
Deteriorating economic conditions may also cause home buyers to default on their mortgages. In addition, if it is proven that the borrower failed to provide full and accurate information on or related to their loan application or that appraisals have not been acceptable or the loan was not underwritten in accordance with the loan program specified by the loan investor, Monarch may be required to repurchase the loan or provide financial settlement to the investor. Such repurchases or settlements would also adversely affect our net income.
Periods of rising interest rates will adversely affect our income from our mortgage division.
In periods of rising interest rates, consumer demand for new mortgages and re-financings decreases which in turn, adversely impacts our mortgage banking division. Because interest rates depend on factors outside of our control, we cannot eliminate the interest rate risk associated with our mortgage operations.
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. As of December 31, 2011, $522.8 million, or 86.0% of our loans held for investment were secured by real estate (both residential and commercial). 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 negatively 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.
If we fail to maintain an effective system of internal controls, we may not be able to accurately report our financial results.
Effective internal controls are necessary for us to provide reliable financial reports. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. Any failure to maintain an effective system of internal controls could harm our operating results or cause us to fail to meet our reporting obligations.
We may not be able to successfully manage our growth or implement our growth strategies, which may adversely affect our results of operations and financial condition.
A key aspect of our business strategy is our continued growth and expansion. Our ability to continue to grow depends, in part, upon our ability to:
We may not be able to successfully implement our growth strategy if we are unable to identify attractive markets, locations or opportunities to expand in the future. Our ability to manage our growth successfully also will depend on whether we can maintain capital levels adequate to support our growth; maintain cost controls and asset quality and successfully integrate any new banking offices into our organization.
As we continue to implement our growth strategy by opening new banking and mortgage offices, we expect to incur construction costs and increased personnel, occupancy and other operating expenses. We generally must absorb those higher expenses while we continue to generate new deposits, and there is a further time lag involved in redeploying new deposits into attractively priced loans and other higher yielding earning assets. Thus, our plans to grow could depress our earnings in the short run, even if we efficiently execute this growth.
Difficult market conditions have adversely affected our industry.
Dramatic declines in the housing market over the past years, with falling home prices and increasing foreclosures, unemployment and under-employment, have negatively impacted the credit performance of all types of loans and resulted in significant write-downs of asset values by financial institutions. These write-downs, initially of asset-backed securities but spreading to other securities and loans, have caused many financial institutions to seek additional capital, to reduce or eliminate dividends, to merge with larger and stronger institutions and, in some cases, to fail. Many lenders and institutional investors have reduced or ceased providing funding to borrowers. This tightening of credit led to an increased level of commercial and consumer delinquencies, lack of consumer confidence, increased market volatility and widespread reduction of business activity generally. The resulting economic pressure on consumers and lack of confidence in the financial markets adversely affected our business and results of operations. Market developments may affect consumer confidence levels and may cause adverse changes in payment patterns, causing increases in delinquencies and default rates, which may impact our charge-offs and provision for credit losses. While some of these conditions improved in 2011, a worsening of these conditions would likely exacerbate the adverse effects of these difficult market conditions on us and others in the financial institutions industry.
Recent levels of market volatility were unprecedented.
During 2008 and 2009 the capital and credit markets experienced unprecedented volatility and disruption. In some cases, the markets produced downward pressure on stock prices and credit availability for certain issuers without regard to those issuers underlying financial strength. If recent levels of market disruption and volatility return, there can be no assurance that we will not experience an adverse effect, which may be material, on our ability to access capital and on our business, financial condition and results of operations.
The soundness of other financial institutions could adversely affect us.
Our ability to engage in routine funding transactions could be affected adversely by the actions and commercial soundness of other financial institutions. Financial services institutions are interrelated as a result of trading, clearing, counterparty and other relationships. We have exposure to many different industries and counterparties, and we routinely execute transactions with counterparties in the financial industry. As a result, defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry generally, have led to market-wide liquidity problems and could lead to losses or defaults by us or by other institutions. Many of these transactions expose us to credit risk in the event of default of our counterparty or client. In addition, our credit risk may be exacerbated when the collateral held by us cannot be realized upon or is liquidated at prices insufficient to recover the full amount of the financial instrument exposure due to us. There is no assurance that any such losses would not materially and adversely affect our results of operations.
Recent legislative regulatory initiatives to address difficult market and economic conditions could adversely affect us.
Banking regulations are primarily intended to protect depositors funds, federal deposit insurance funds and the banking system as a whole, not security holders. These regulations affect our lending practices, capital structure, investment practices, dividend policy and growth, among other things. Congress and federal regulatory agencies continually review banking laws, regulations and policies for possible changes. The Dodd-Frank Act, enacted in July 2010, instituted major changes to the banking and financial institutions regulatory regimes in light of the recent performance of and government intervention in the financial services sector. Other changes to statutes, regulations or regulatory policies, including changes in interpretation or implementation of statutes, regulations or policies, could affect the Company in substantial and unpredictable ways. Such changes could subject us to additional costs, limit the types of financial services and products we may offer and/or increase the ability of non-banks to offer competing financial services and products, among other things. Failure to comply with laws, regulations or policies could result in sanctions by regulatory agencies, civil money penalties and/or reputation damage, which could have a material adverse effect on our business, financial condition and results of operations.
The recent repeal of federal prohibitions on payment of interest on demand deposits could increase our interest expense.
All federal prohibitions on the ability of financial institutions to pay interest on demand deposit accounts to businesses were repealed as part of the Dodd-Frank Act. As a result, beginning on July 21, 2011, financial institutions could commence offering interest on demand deposits to compete for clients. We do not yet know what interest rates other institutions may offer. Our interest expense may increase and our net interest margin may decrease if we begin paying interest on demand deposits to attract additional clients or to maintain current clients, which could have a material adverse effect on our business, financial condition and results of operations.
Our directors and executive officers own our common stock, and their interests may conflict with those of our other shareholders.
As of March 1, 2012, our directors and executive officers beneficially owned approximately 627,095 shares or 10.21% 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.
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 client bases, higher lending limits, extensive banking office networks, numerous ATMs, greater advertising-marketing budgets and other factors.
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 us and offer certain services, such as extensive and established banking office networks and trust services that we cannot provide. Moreover, larger institutions operating in South Hampton Roads have access to borrowed funds at a lower cost than is available to us. 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 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 the unimpaired capital and surplus, of Monarch Bank, to any one borrower. As of December 31, 2011, we were allowed to lend approximately $13.8 million to any one borrower and maintained an in-house limit of $11.0 million to any one borrower. 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 affected by changes in estimates, and by 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 and adverse 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 ability to operate profitably may depend 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 anticipate that we will be able to support this growth through the generation of additional deposits at new banking locations as well as investment opportunities. However, 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.
Continued growth may require raising additional capital which may dilute current stockholders ownership percentage.
In order to meet applicable regulatory capital requirements, we may, from time to time, need to raise additional capital to support continued growth. If selling our equity securities raises additional funds, the relative ownership interests of our existing stockholders would likely be diluted.
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 FDIC, not stockholders. 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 us 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. 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.
Compliance with the Recently Enacted Dodd-Frank Act Will Increase Our Regulatory Compliance Burdens, and May Increase Our Operating Costs and/or Adversely Impact Our Earnings and/or Capital Ratios.
On July 21, 2010, President Obama signed the Dodd-Frank Act, which represented a significant overhaul of many aspects of the regulation of the financial services industry. Among other things, the Dodd-Frank Act created a new federal Consumer Financial Protection Bureau (CFPB), tightened capital standards, imposed clearing and margining requirements on many derivatives activities, and generally increased oversight and regulation of financial institutions and financial activities.
In addition to the self-implementing provisions of the statute, the Dodd-Frank Act calls for over 200 administrative rulemakings by numerous federal agencies to implement various parts of the legislation. While some rules have been finalized and/or issued in proposed form, many have yet to be proposed. It not possible at this time to predict when all such additional rules will be issued or finalized, and what the content of such rules will be. We will have to apply resources to ensure that we are in compliance with all applicable provisions of the Dodd-Frank Act and any implementing rules, which may increase our costs of operations and adversely impact our earnings and/or capital.
The Dodd-Frank Act and any implementing rules that are ultimately issued could have adverse implications on the financial industry, the competitive environment, and/or our ability to conduct business.
Virginia law and the provisions of our articles of incorporation and bylaws could deter or prevent takeover attempts by a potential purchaser of our Common Stock that would be willing to pay you a premium for your shares of our Common Stock.
Our articles of incorporation and bylaws contain provisions that may be deemed to have the effect of discouraging or delaying uninvited attempts by third parties to gain control of us. These provisions include the division of our board of directors into classes with staggered terms, the ability of our board of directors to set the price, term and rights of, and to issue, one or more series of our preferred stock and the ability of our board of directors, in evaluating a proposed business combination or other fundamental change transaction, to consider the effect of the business combination on us and our stockholders, employees, customers and the communities which we serve. Similarly, the Virginia Stock Corporation Act contains provisions designed to protect Virginia corporations
and employees from the adverse effects of hostile corporate takeovers. These provisions reduce the possibility that a third party could affect a change in control without the support of our incumbent directors. These provisions may also strengthen the position of current management by restricting the ability of stockholders to change the composition of the board of directors, to affect its policies generally and to benefit from actions which are opposed by the current board of directors.
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.
1435 Crossways Blvd., Chesapeake, VA (owned)
Monarch Bank Offices
1034 S. Battlefield Boulevard, Chesapeake, VA (owned)
750 Volvo Parkway, Chesapeake, VA (land leased, building owned)
1635 Laskin Road, Virginia Beach, VA (leased)
100 Lynnhaven Parkway, Virginia Beach, VA (leased)
3701 Pacific Avenue, Suite 100, Virginia Beach, VA (leased)
5225 Providence Road, Virginia Beach, VA (leased)
4216 Virginia Beach Boulevard, Virginia Beach, VA (leased)
500 W. 21st Street, Norfolk, VA (owned)
101 W. Main Street, Suite 1000, Norfolk, VA (leased)
OBX Bank Offices
4629 North Croatan Highway, Kitty Hawk, NC (land leased, building owned)
2525 South Croatan Highway, Nags Head, NC (land leased, building owned)
Monarch Mortgage Offices
2809 S. Lynnhaven Road, Suite 200, 310 and 350, Virginia Beach, VA (leased) (headquarters)
1034 S. Battlefield Boulevard, Chesapeake, VA (owned)
636 Cedar Rd, Chesapeake, VA (leased)
750 Volvo Parkway, Chesapeake, VA (land leased, building owned)
101 W. Main Street, Suite 1000, Norfolk, VA (leased)
809 E. Ocean View Avenue, Norfolk, VA (leased)
701 W. 21st Street, Norfolk, VA (leased)
500 W. 21st Street, Norfolk, VA (owned)
222 Central Park Avenue, Suite 1560, Virginia Beach, VA (leased)
1635 Laskin Road, Virginia Beach, VA (leased)
100 Lynnhaven Parkway, Virginia Beach, VA (leased)
3701 Pacific Avenue, Suite 100, Virginia Beach, VA (leased)
510 King Street, Suite 410, Alexandria, VA (leased)
4035 Ridge Top Road, Suite 250, Fairfax, VA (leased)
1320 Central Park Blvd, Suite 214 and 215, Fredericksburg, VA (leased)
10611 Balls Ford Road, Suite 130, Manassas, VA (leased)
14700 Village Square Place, Midlothian, VA (leased)
3050 Chain Bridge Road, Suite 300, Oakton, VA (leased)
1801 Robert Fulton Drive, Suite 570, Reston, VA (leased)
1801 Bayberry Court, Suite 201, Richmond, VA (leased)
12700 Black Forest Lane, Suite 205, Woodbridge, VA (leased)
4201 Northview Drive, Bowie, MD (leased)
2138 Priest Bridge Court, Suite 7, Crofton, MD (leased)
3150 West Ward Road, Suites 401 and 402, Dunkirk, MD (leased)
6301 Ivy Lane, Suite 206, Greenbelt, MD (leased)
600 Jefferson Plaza, Suites 360 and 400, Rockville, MD (leased)
100 West Road, Suite 203, Towson, MD (leased)
2670 Crain Highway, Suite 407, Waldorf, MD (leased)
4520 Mint Hill Village Lane, Suites 205, 206, 207, and 208, Charlotte, NC (leased)
6555 Old Monroe Road, Suite A, Charlotte, NC (leased)
4629 North Croatan Highway, Kitty Hawk, NC (land leased, building owned)
111-C Raceway Drive, Mooresville, NC (leased)
2525 South Croatan Highway, Nags Head, NC (land leased, building owned)
1427 Military Cutoff Road, Suite 207, Wilmington, NC (leased)
4022 Old Bridge Road, Unit B, Southport, NC (leased)
224-A West Cambridge Avenue, Greenwood, SC (leased)
Monarch Capital Offices
101 W. Main Street, Suite 1000, Norfolk, VA (leased)
Coastal Home Mortgage Offices
4104 Holly Road, Suite 101, Virginia Beach, VA (leased)
Monarch Home Funding, LLC
500 W. 21st Street, Norfolk, VA (leased)
Regional Home Mortgage, LLC
1112-G Eden Way North, Chesapeake, VA (leased)
401 N. Great Neck Road, Suite 126, Virginia Beach, VA (leased)
Real Estate Security Agency, LLC
501 Baylor Court, Suite 150, Chesapeake, VA (leased)
There are no legal proceedings pending against the Company. In the ordinary course of our operations, we become party to various legal proceedings. Currently, we are not party to any material legal proceedings, and no such proceedings are, to managements knowledge, threatened against us.
Our Common Stock is listed on the NASDAQ Capital Market under the symbol MNRK. As of March 16, 2012, there were 1,965 known holders of Common Stock.
The table below presents the high and low 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 2011 and 2010.
We paid semi-annual cash dividends of $0.08 per share on our Common Stock in June and November of 2011. We are subject to certain restrictions imposed by the reserve and capital requirements of Federal and Virginia banking statutes and regulations. See Item 1. Business Supervision and Regulation Dividends on page 11. In addition, holders of our 7.80% Series B Noncumulative Convertible Perpetual Preferred Stock have a priority on the receipt of dividends relative to the holders of our Common Stock. If we have not declared and paid or set aside for full payment of the quarterly dividends on the Series B Preferred Stock for a particular dividend period, we may not declare or pay dividends on our Common Stock during the next succeeding dividend period. The final determination of the timing, amount and payment of dividends is at the discretion of our board of directors and is dependent upon our and our subsidiaries earnings, principally Monarch Bank, our financial condition and other factors, including general economic conditions and applicable governmental regulations and policies. Thus, there can be no assurance of when, and if, we will continue to pay cash dividends on our Common shares.
On September 12, 2011 we announced a program to repurchase up to three percent of our outstanding common stock, or approximately 180,000 shares. Repurchases were to be conducted through open market purchases or privately negotiated transactions. There is no expiration date for the repurchase program. We repurchased 29,700 shares of our Common Stock during the three months ended December 31, 2011, at an average price of $7.77 per share. Total cost less commissions for these repurchases was $230,639. We did not redeem any shares of our preferred stock during the three months ended December 31, 2011.
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, 2011, 2010, 2009, 2008 and 2007.
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:
Because of these uncertainties, our actual future results may be materially different from the results indicated by these forward-looking statements. In addition, our past results of operations do not necessarily indicate our future results. Therefore, we caution you not to place undue reliance on our forward-looking information and statements. We will not update the forward-looking statements to reflect actual results or changes in the factors affecting the forward-looking statements.
The purpose of this discussion is to provide information about the major components of our results of operations and financial condition, liquidity and capital resources. 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 2011 performance.
We generate a significant amount of our income from the net interest income earned by Monarch Bank. Net interest income is the difference between interest income and interest expense. Interest income depends on the amount of interest-earning assets outstanding during the period and the interest rates earned thereon. Monarch Banks cost of money is a function of the average amount of deposits and borrowed money outstanding during the period and the interest rates paid thereon. The quality of the assets further influences the amount of interest income lost on non-accrual loans and the amount of additions to the allowance for loan losses.
We also generate income from non-interest sources. Non-interest income sources include bank related service charges, fee income from residential mortgage sales, fee income from the sale of investment and insurance services, income from bank owned life insurance (BOLI) policies, as well as gains or losses from the sale of investment securities.
ANALYSIS OF OPERATING RESULTS
Our consolidated financial statements include the accounts of the Company, the Bank and its subsidiaries, after all significant intercompany transactions have been eliminated. Net income attributable to our noncontrolling interests of $459,753 and $262,596, respectively, are deducted for the years ended December 31, 2011 and 2010, after the income tax provision, to arrive at net income attributable to Monarch Financial Holdings, Inc. The ensuing references and ratios are related to net income attributable to Monarch Financial Holdings, Inc., (hereon referred to as net income) after net income attributable to noncontrolling interest has been deducted.
We reported net income for December 31, 2011 of $7,125,612, compared to $5,949,391 for December 31, 2010. Our basic earnings per share were $0.93 and $0.77 for the years ended December 31, 2011 and 2010, respectively. Diluted earnings per share were $0.84 for December 31, 2011, and $0.75 for December 31, 2010.
Two important and commonly used measures of profitability are return on assets (net income as a percentage of average total assets) and return on stockholders equity (net income as a percentage of average stockholders equity). Our returns on average assets were 0.88% and 0.76% for the years ended December 31, 2011, and 2010, respectively. The returns on average stockholders equity were 9.66%, and 8.59% for the same time periods.
Net income for the year ended December 31, 2011 was $7,125,612, an increase of 22.1% compared to 2010. This growth was attributable to an increase in both net interest income and non-interest income as well as a reduction in loan loss provision, when compared to 2010. Net income available to common stockholders, which is net of preferred stock dividends of $1,560,000 in both periods presented, was $5,565,612 at December 31, 2011, compared to $4,389,391 in 2010.
Net interest income increased $3.1 million or 10.3% to $33.6 million in 2011 compared to 2010. Earning asset growth coupled with lower cost liabilities were the source of this increase. Loans held for sale increased $36.1 million and loans held for investment grew $48.7 million, year over year. Average outstanding loans held for investment increased $28.9 million while average loans held for sale decreased $17.6 million. The combined yield on these assets improved 6 basis points. Deposits increased $34.4 million year over year and average outstanding deposits outstanding increased $82.0 million. The overall costs associated with deposits declined 39 basis points. Although total borrowings increased $40.6 million, year over year, average outstanding borrowings declined $56.0 million, thereby reducing interest expense to further benefit net interest income.
Non-interest income increased $1.3 million to $54.7 million in 2011. Our primary source of non-interest income is mortgage banking income, which increased $857 thousand, or 1.7% for a total of $51.4 million. Our mortgage division, operating under the name of Monarch Mortgage delivered strong production. Other non-interest income increased $516 thousand in 2011 compared to 2010. Included in other non-interest income are net proceeds from bank owned life insurance (BOLI) totaling $421,010.
Non-interest expenses increased $5.6 million to $71.0 million in 2011, compared to $65.5 million in 2010. The majority of these increases were in salaries and benefits, occupancy, loan origination expenses, marketing, data processing, and professional fees. These increases were due to several factors which include loan growth, regulatory changes and operational upgrades and expansion.
Our provision for loan losses was $6.3 million in 2011, $2.3 million, or 26.9% less than our 2010 provision of $8.6 million. At the same time net charge offs were $5.4 million, a decrease in net losses of $3.4 million or 39.0% compared to $8.9 million one year prior. Our allowance for future losses increased $892 thousand in 2011. The provision is a function of loan portfolio management in that management seeks to provide for future losses inherent in the existing portfolio and in new loan growth by utilizing various metrics including but not limited to, loss history, economic conditions and industry trends. It requires a great deal of judgment and is a primary focus of our management team.
The net effect on 2011 pre-tax and pre-noncontrolling interest income was an increase of 12.8%, or $1,247,538, to $11,004,057 compared to $9,756,519 in 2010.
NET INTEREST INCOME
Net interest income, which is the excess of interest income over interest expense, is a significant source of revenue. 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.
Net interest income was $33,622,872 for the year ended December 31, 2011. This represents an increase of 10.3% or $3,147,593 over 2010 when net interest income was $30,475,279.
Rates, though stable, have remained at historically low levels over the past three years while we have been at, or near, the bottom of an economic downturn that began in the later months of 2007. At that time, the Federal Reserve Open Market Committee (FOMC), which sets the federal funds rate, in an effort to stabilize the economy and head-off a recession, began to decrease the target funds rate. Between September 2007 and December 2008 they decreased the target funds rate a total of 500 basis points which resulted in the current, historically low, federal funds rate of 0.25%. During this same period, Wall Street Journal Prime (WSJP), which moves in tandem with the federal funds target rate, has held at 3.25%. Comments by the FOMC indicate that this low rate environment is expected to extend into 2014.
During 2011 we continued the work we began in 2010 of reshaping our balance sheet in preparation for future increases in rates. Our focus has been on building our core deposit base while reducing our reliance on noncore funding sources and supporting growth in both our loans held for sale and our loans held for investment portfolios. We define our core deposits as non-brokered, in- market deposits.
Our loans held for sale remain in our portfolio for an average of 33 days before being delivered to our investors. Therefore any growth in this portfolio is a function of production and timing. In 2011 our loans held for sale increased $36.2 million, or 20.6% to $211.6 million. The mortgage industry which is interest rate sensitive, continued to offer historically low rates in 2011, leading to high production in both purchase money and refinance markets. We utilize noncore deposits to support this short term growth. Despite the growth in this portfolio in 2011, we have reduced our reliance on noncore deposits $38.1 million, through core growth in demand deposits. In addition, 54.5% of our noncore deposits, compared to 6.8% one year prior, now have a maturity of less than 30 days, to allow us to react quickly to changes in loan demand.
We have also worked to stabilize our loans held for investment by strengthening and supporting our existing client base, promoting disciplined growth with regard to new clients, and promoting short term fixed rate loan pricing. Our outstanding loans held for investment have increased $48.7 million or 8.7% to $607.6 million in 2011, despite $96.2 million in loan payouts.
Total interest income was $40,419,327 in 2011 compared to $39,272,833 in 2010. Earning asset yield declined 1 basis point to 5.41% in 2011 compared to 5.42% in the prior year. Loan yield is the result of both the interest rate and any fees collected on a loan. Interest and fees on loans are the largest component of our interest income. Interest and fees on loans held for investment increased 9 basis points in 2011 to a blended yield of 6.02% compared to 5.93% in 2010. The yield on our loans held for sale, is driven by the performance of the 10 year Treasury note, which has been at record lows for much of 2011. Therefore, the yield on our loans held for sale portfolio declined 30 basis points in 2011 to 4.19% compared to 4.49% in 2010. Volume fluctuations coupled with the changes in yield discussed previously have resulted in an increase in the combined loan portfolios of 6 basis points to 5.68% in 2011 from 5.62% in 2010.
The yield on our securities portfolio declined 77 basis points from 2.29% in 2010 to 1.52% in 2011. During 2011, $13.5 million of the $17.6 million in outstanding securities at December 31, 2010 either matured or were subject to rate call. Securities purchased in 2011 had a blended yield which was lower resulting in an overall decline in portfolio yield. The yield on our BOLI also declined in 2011 from 6.03% to 5.67% due to market rates.
Total interest expense declined $2,001,099, or 22.75% to $6,796,455, for the year ended December 31, 2011, compared to 2010. Interest cost declined 33 basis points from 1.45% in 2010 to 1.12% in 2011. Interest bearing deposits are the largest component of interest expense, representing on average, 97% of interest bearing liabilities in 2011 and 88% in 2010. The blended cost of our deposit portfolio declined 35 basis points to 1.05% in 2011 from 1.40% in 2010. Despite a year over year decline in money market accounts of $13.5 million, core money market accounts grew $37.5 million while noncore brokered money market balances declined $51.0 million. Average outstanding money market accounts increased $87.1 million. A market adjustment in the interest paid on our core money market accounts resulted in a 25 basis point reduction in money market interest from 1.04% in 2010 to 0.79% in 2011. During 2011 through management of both core and noncore time deposit pricing, time deposit yields also declined from 1.83% in 2010 to 1.50%, a 33 basis point reduction in rate.
Despite a $40.6 million year end 2011 increase in Federal Home Loan Bank advances, average outstanding borrowings were only $17.3 million in 2011 compared to $73.3 million in 2010. The increase in the interest cost on other borrowings, which is primarily Federal Home Loan Bank, to 3.45% from 1.78% is a function of lower borrowing volume as opposed to an overall increase in rates. Included in our Federal Home Loan borrowings in both periods is a note for approximately $1.4 million which bears a fixed rate of 4.96%. The impact of this note on interest cost is greater because the lower cost borrowings which typically buffer this high cost note were significantly reduced in 2011.
Additional analysis with regard to interest income will reference the following tables. For discussion purposes, our net interest income analysis and our changes in net interest income (rate/volume analysis) tables are adjusted to include tax equivalent income on bank owned life insurance (BOLI) and tax exempt municipal securities that is not in compliance with Generally Accepted Accounting Principles (GAAP). The following table is a reconciliation of our income statement presentation to these tables.
RECONCILIATION OF NET INTEREST INCOME TO TAX EQUIVALENT NET INTEREST INCOME
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.
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 4.51% in 2011 compared to 4.22% in 2010. Our earning asset yield was 5.41% in 2011 a decrease of 1 basis point from 5.42% in 2010. During the same periods liability costs declined 33 basis points to 1.12% in 2011 from 1.45% in 2010. Our interest rate spread, which is the difference between the average yield on earning assets and the average cost on interest bearing liabilities, was 4.29% in 2011 compared to 3.97% in 2010. The result of these changes is a 29 basis point improvement in margin for 2011 compared to 2010.
Table 1 - NET INTEREST INCOME ANALYSIS
The following is an analysis of net interest income, on a taxable equivalent basis.
Table 2 presents changes in net interest income in a rate/volume analysis format. The goal of a rate/volume analysis is to compare two or more earning periods to determine whether the difference between the results of those periods is due to changes in rate, or volume, or some combination of the two. This is achieved through a what if analysis. We calculate what the potential income would have been in the new period if the prior period rate had remained unchanged, and compare that result to what the potential income would have been in the prior period if the current rates were in effect. Through the analysis of these income potentials, we are able to determine how much of the dollar change between periods is due to the impact of differing rates and how much is volume driven. Net interest income has been adjusted to include income from BOLI and the tax effect of tax exempt municipal securities.
Our net interest income in 2011 increased $3.1 million when compared to 2010, $2.6 million of this increase was due to changes in volume and $523 thousand was due to changes in rates. Earning asset growth provided $1.4 million to volume driven earnings while reductions in high cost liabilities provided an additional $1.2 million to interest income growth. Lower blended deposit rates saved an additional $1.5 million in liability costs which were reduced to $523 thousand by changes in rates in both loans and other borrowings.
Growth and changes in interest rates of our loans held for investment portfolio contributed an additional $2.2 million to income while the impact of both rates and volume on our loans held for sale portfolio was an interest reduction of $1.2 million. The combined contribution to net interest income of our remaining earning assets was $49 thousand driven by growth in our average outstanding securities which was offset by lower earning rates.
A decrease in interest expense contributed an additional $2.0 million to net interest income in 2011. Reductions in liability cost of $781 thousand were further enhanced by changes in volume which resulted in a cost savings of $1.2 million. Interest bearing deposits, which are the primary source of interest expense, grew an average of $57.2 million in 2011 at a potential cost of $198 thousand which was more than offset by a $1.5 million savings potential due to rate reductions. Other borrowings provided $710 thousand in interest cost reductions, $1.4 million due to lower average borrowings which was partially offset by higher rates on those borrowings.
Table 2 - CHANGES IN NET INTEREST INCOME (RATE/VOLUME ANALYSIS)
MARKET RISK MANAGEMENT
We spend 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, and our primary objectives for managing interest rate volatility are 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, 2011 that will either be repriced in accordance with market rates, mature or are estimated to mature early or prepay within the periods indicated. 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, we appear to be liability-sensitive at three months or less, primarily due to our large money market base and short term brokered time deposit maturities. With the majority of our borrowings and deposits short, our current structure allows us pricing flexibility to react to changes in rates when they occur.
Table 3 - INTEREST 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 interest rates in increments of 1%, 2%, 3% and 4% and falling interest rates in decrements of 1% and 2% to determine how net interest income changes for the next twelve and twenty-four months, with flat growth, under two rate assumptions. The assumptions are shocked, in which the entire rate change is assumed to have occurred in a
single month, and ramped, in which the rate change is assumed to have occurred spread throughout the analysis period. ALCO also applies a shocked and ramped assumption when measuring the effects of changes in interest rates over a twelve month period 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. Tables 4 and 4A show the estimated impact of changes in interest rates up 1%, 2%, 3% and 4% and down 1% and 2%, on net interest income and on MVE as of December 31, 2011 (in thousands).
Change in Net Interest Income
Shocked Assumption Results: The projected change in net interest income due to changes in interest rates in the twelve month projection at December 31, 2011, were in compliance with our established guidelines for increases of 1%, 2%, 3%, and 4% and decreases of 1%. In the twenty-four month projection, the degree of change in net interest income due to changes in interest rates were in compliance with our established guidelines for increases of 1%, 2%, and 3% and down 1%. Decreases in interest rates of 2% were non-compliant under both time projected time periods and increases of 4% were non-compliant for twenty-four months.
Ramped Assumption Results: The projected change in net interest income due to changes in interest rates in the twelve month projection at December 31, 2011, were in compliance with our established guidelines at all rate increments. In the twenty-four month projection, the degree of change in net interest income due to changes in interest rates were in compliance with our established guidelines for increases of 1%, 2%, 3% and 4% and down 1%, but a change in interest income due to a decrease of 2% was non-compliant.
Market Value of Equity
Under both the shocked and ramped assumptions changes in the market value of equity for increases of 1%, 2%, 3%, and 4%, and decreases in rate of 1% were in compliance with our established guidelines. However for decreases of 2% the results were not within our guidelines. These projected changes in the MVE model are based on flat growth assumptions and no 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 supports the actions that management has made with regard to shortening of maturities and the introduction of short term fixed pricing on loans coupled with deposit rate and term adjustments to position the Company for future changes in rates. We continue to focus on compliance through the tightening of lending guidelines and the establishment of floors for certain products.
Table 4 - CHANGE IN NET INTEREST INCOME
Table 4A - CHANGE IN MARKET VALUE OF PORTFOLIO EQUITY
Non-interest income increased $1,345,145 or 2.5% in 2011 when compared to 2010. The following table lists the major components of non-interest income for December 31, 2011 and 2010.
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 residential mortgage division, was reorganized and expanded in June 2007, making 2008 its first full year of operations. 2011 was another record year for Monarch Mortgage with total dollar volume of $1,648,847,556 compared to $1,624,462,921 in 2010. The total number of loans closed was 6,801 in 2011 compared to 6,682 in 2010.
Service charges declined $7 thousand in 2011 despite growth in deposits. In June 2010 changes by the Federal Reserve to Regulation E limited the ability of banks to charge fees for paying overdrafts caused by ATM and debit card transactions. These changes adversely impacted our overdraft/NSF program, by limiting the forms of transactions to be covered for a retail client who overdraws their accounts without the negative stigma associated with a returned check. Service charge pricing on deposit accounts is typically reevaluated annually to reflect current costs and competition.
Title income increased $20 thousand in 2011 with the increased levels of loan closings during the year. Title income was generated through Real Estate Security Agency, LLC, a subsidiary of Monarch Investment, LLC, which owns 75% of the company.
During the third quarter of 2011, we received proceeds from BOLI of $1,077,632 which resulted in a $654,674 reduction in the value of our BOLI asset. The remaining $422,957 in proceeds is tax-exempt non-interest income. The majority of this income was paid out in death benefits. The tax-effective income from these proceeds was $637,892. In October 2005 we purchased $6,000,000 in bank owned life insurance (BOLI) that has resulted in income and commissions in each of the two years presented. Income from BOLI is not subject to tax. The tax-effective income earnings from BOLI are $407,974 in 2011 and $433,214 in 2010.
We offer investment services, through our investment division, Monarch Investments. Investment and insurance commissions decreased $39 thousand in 2011 compared to 2010. A change in investment advisors in the later part of 2011 had a short term impact on production levels.
We sold two autos and a piece of equipment for a net gain of $37,223. In 2010 we sold an auto for a gain of $22,073. There was one security gain of $3,107 recorded in 2011 on the sale of a mortgage-backed security and no security losses. There were no security gains or losses recorded in 2010.
Other income represents a variety of nominal recurring and non-recurring activities and transactions that have occurred throughout the years presented.
Non-interest expense was $71,044,366 for 2011 compared to $65,479,761 in 2010, an increase of $5,564,605 or 8.5%. The following table lists the major components of non-interest expense for December 31, 2011 and 2010.
The dollar and percentage change of listed expenses is provided below.
A portion of the increase in salaries and employee benefits is related to the decrease in commissions. The majority of commissions paid are tied to mortgage origination production. New regulations imposed by the Dodd-Frank Act that limit when and how commissions are paid to our mortgage sales team have resulted in shifts between commissions and salaries for some employees, which brought us into compliance with the Act. Further, new compliance requirements and growth related expansion throughout the Company have added to compensation expense. At December 31, 2011, we employed a total of 557 full and part-time employees compared to 535 at year-end 2010. In addition, higher compensation related benefits such as social security tax and Medicare tax expenses have contributed to the increase.
Foreclosed property expense is related to maintenance and sale of our other real estate. At January 1, 2011 there were five properties in other real estate. During the year, fifteen additional properties were moved into other real estate and fourteen properties were sold. The fourteen properties were sold at a net gain of $49,720. Based on additional market information and property evaluations, five properties were written down $574,192 after being moved into other real estate. Maintenance and selling costs associated with other real estate were $324,051 in 2011. At January 1, 2010 there were eight properties in other real estate. During the year, thirteen additional properties were moved into other real estate and sixteen properties were sold. The sixteen properties were sold at a net gain of $155,050. One property was written down $51,955 subsequent to being moved into other real estate. Maintenance and selling costs associated with other real estate were $231,202 in 2010.
We relocated three of our banking offices in 2011 in an effort to improve our presence in the community and position for future growth. These offices were the Downtown Norfolk office which was relocated to the World Trade Center in Downtown Norfolk, our Ghent office, which was moved from a small store front location to a freestanding, Company owned, building located on a prominent corner in the Ghent section of Norfolk, and our Kitty Hawk office, which was also relocated from a store front to a freestanding, Company owned, building on a prominent corner in Kitty Hawk. We continue to upgrade our corporate headquarters which we moved into in September 2010. Our mortgage operations continue to expand to new markets as well. These additions and improvements have contributed to the increases in both occupancy and furniture and equipment expense in 2011.
Loan expense continues to grow as a function of costs associated with underwriting and processing mortgage loans at our current volume. Additionally, expense related to the shipping of mortgage loan packages to secondary market investors has had an impact on postage. The telephone is a critical tool for our mortgage lenders as most spend time out of the office meeting with clients and prospects. This expense has grown with our mortgage operations.
In 2011, Monarch stepped up its marketing focus to include activities aimed at gaining greater recognition in the community. These activities included, media advertisement, higher visibility sponsorships, greater community involvement, and the launch of the first annual Top Flight award aimed at recognizing small businesses in the community that have demonstrated a strong performance in a number of key areas.
Technology is critical to our success as a company. Changes and innovations in technology are rapidly finding their way to the banking industry and in 2011 Monarch made a commitment to focus our efforts on providing our clients with secure, leading edge technology and service. Although we are still in the early stages, expenses related to upgrades and technology conversion of our existing systems have resulted in increased data processing costs.
Professional fees include legal, accounting, and consulting expenses. Loan portfolio management, company growth and increased and changing regulatory issues have led to increased professional fees as we seek advice in areas outside our expertise.
FDIC insurance declined for the first time since 2007. In 2011, the FDIC changed its methodology for assessing banks from a deposit-based to an asset- and equity-based calculation. This change resulted in a shift in the insurance burden to larger institutions and a savings for smaller institutions.
We continue to focus on controlling overhead expenses in relation to income growth. Our efficiency ratio, a productivity measure used to determine how well non-interest expense is managed, was 80.2% in 2011 and 77.9% in 2010. Our Bank only efficiency ratio was 54.5% in 2011, compared to 50.9% in 2010. 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. Increased regulatory burden and expenses associated with our non-interest income lines of business have negatively impacted this ratio.
In 2011 we recognized federal income tax expense of $3,074,552, resulting in an effective tax rate of 27.9%. Included in 2011 income are life insurance proceeds, BOLI income and municipal security income that is not subject to federal tax totaling $716,091. Additionally, deferred tax adjustments related to a change in our statutory tax rate from 34% to 35% on earnings in excess of $10.0 million resulted in a reduction in current year tax recognition. We recognized state tax expense related to our multi-state mortgage operations of $344,140.
In 2010 we recognized federal income tax expense of $3,197,823, resulting in an effective tax rate of 32.8%. We also recognized state tax expense related to our multi-state mortgage operations of $346,709, which included $211,274 in taxes from previous years. The major difference between the statutory rate and the effective rate results from income that is not taxable and expenses that are not deductible for Federal income tax purposes. The primary non-taxable income is from Bank Owned Life Insurance and non-deductible expenses are for meals entertainment.
Our reportable segments include community banking and retail mortgage banking services. Community banking involves making loans to and generating deposits from individuals and businesses in the markets where we have offices. Our mortgage banking services consist of originating residential loans and subsequently selling them to investors. Our mortgage banking segment is a strategic business unit that is managed separately from the community banking segment because the mortgage banking services segment appeals to different markets and, accordingly, requires different technology and marketing strategies. We do not have other reportable operating segments. For discussion of our segment accounting policies, see Note 1 to our Consolidated Financial Statements (included in Item 8. of this Form-K). The assets and liabilities and operating results of one of our other wholly owned subsidiary, Monarch Capital, LLC, is included in the mortgage banking segment. Monarch Capital, LLC, provides commercial mortgage brokerage services.
Segment information for the years 2011, and 2010 is shown in the following table. The Other column includes corporate related items, results of insignificant operations and, as it relates to segment profit (loss), income and expense not allocated to reportable segments and intercompany eliminations.
Selected Financial Information
FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES
Total assets were $908.5 million at December 31, 2011, an increase of $82.9 million, or 10.0% over $825.6 million at year-end 2010. This increase is primarily attributable to growth in both the loans held for sale and the loans held for investment portfolios. Loans held for sale increased $36.2 million, or 20.6% to $211.6 million in 2011 compared to 2010. Loans held for investment increased $48.7 million, or 8.7% to $607.6 million. Total cash and cash equivalents increased $4.3 million to $31.7 million at year-end 2011 compared to $27.4 million in 2010. Investment securities were $9.2 million at year-end 2010 compared to $17.6 million one year prior. Property and equipment increased $2.3 million to $23.1 million and other real estate, net of valuation allowance increased $1.6 million to $3.4 million in 2011. Restricted equity securities declined $2.3 million to $6.4 million and BOLI declined $389 thousand when compared to year end 2010.
Total liabilities increased $77.8 million, or 10.3% to $831.6 million at December 31, 2011, compared to $753.8 million at December 31, 2010. Total deposits were $740.1 million at year end 2011, an increase of 4.9% or $34.4 million over $705.7 million at December 31, 2010. FHLB borrowings increased $40.6 million to $70.9 million at December 31, 2011. Total stockholders equity was $76.8 million at December 31, 2011, compared to $71.7 million at December 31, 2010, an increase of $5.1 million or 7.1%.
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 limited 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 for municipal deposits.
All of the securities in our portfolio are classified, available-for-sale. These securities are carried at estimated fair value and 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.
Table 5 - SECURITIES PORTFOLIO
The amortized cost and estimated fair value of securities, all of which are classified as available for sale, at December 31, 2011, by the earlier of contractual maturity or expected maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to prepay obligations with or without call or prepayment penalties.
Table 6 - ESTIMATED MATURITIES OF SECURITIES AS OF PERIOD INDICATED
Total investment securities were $9.2 million at December 31, 2011, compared to $17.6 million in 2010. At year end, 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 our Consolidated Financial Statements (included in Item 8. of this Form 10-K).
As of December 31, 2011, there was a net unrealized gain of $134,386 related to the available-for-sale investment portfolio compared to a net unrealized gain of $116,881 at year end 2010. Note 2 to our Consolidated Financial Statements (included in Item 8. of this Form 10-K) 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, 2011 and 2010.
Our lending activities are our principal source of income. Loans held for investment, net of unearned income, increased $48,744,219 or 8.7% during 2011. Loans held for sale, loans originated for the secondary market by Monarch Mortgage that have closed but not funded, increased 20.6% or $36,166,738 to $211,555,094 on December 31, 2011 compared to $175,388,356 on December 31, 2010. This increase was due to company expansion coupled with a boom in the mortgage industry, created by an extended period of record low mortgage rates. Discussions below exclude loans held for sale.
Our loan portfolio is divided into three loan types; commercial, real estate, and consumer. The commercial segment represents 13.0%, the real estate segment represents 86.0%, and the consumer segment represents 1.0% of our loan portfolio.
Real estate secured loans, increased $53.6 million or 11.4% to $522.9 million in 2011 compared to 2010. The blended yield on this segment is 5.78% in 2011 compared to 5.75% in 2010. The real estate secured segment is further divided based on loan purpose and includes construction, 1-4 family residential properties, home equity lines, multifamily and real estate secured commercial loans. Monarch has continued to make real estate secured
loans throughout the recent economic downturn, which is counter to many of our competitors. Despite the compression in the real estate market, there still exist a large number of financially sound companies and individuals with borrowing needs that have allowed us to grow our portfolio while maintaining strong credit quality. Real estate commercial loans represent 37.6% of total real estate secured loans and increased $33.6 million or 20.7%, to $196.4 million in 2011. Owner occupied real estate commercial loans comprise 53.2% of that total. Real estate construction loans represent 26.6% of total real estate secured loans and increased $19.4 million in 2011 to $139.3 million. 1-4 family residential represents 16.4% of this segment and increased 1.1% in 2011 to $85.7 million. Home equity lines, which represent 14.3% of total real estate secured loans, have been trending downward since 2008 and declined 7.6% or $6.1 million in 2011 to $74.7 million. Multifamily loans increased $5.8 million or 27.7% to $26.8 million at December 31, 2011.
Commercial loans, which represent our second largest portfolio segment, declined 6.3% or $5.4 million in 2011 to $81.1 million . Commercial loan yield is 5.85% in 2011 compared to 6.09% in 2010. Competition for commercial loans, from the standpoint of pricing and the number of opportunities available in the market, is strong given the fact that many competitors have stopped real estate lending.
Consumer loans, which comprise less than 1.0% of our loans held for investment, increased marginally in 2011. The yield on consumer and installment loans has declined from 13.23% in 2010 to 10.64% in 2011.
We consider our overall loan portfolio diversified as it consists of 13.4% in commercial loans, 22.9% in construction loans, 14.1% in loans secured by 1-4 family residential properties, 12.3% in home equity lines, 32.3% in commercial loans secured by real estate, 3.8% in multifamily loans and less than 1% in consumer loans as of December 31, 2011, as detailed in Table 7 (in thousands) classified by type.
Interest income on consumer, commercial, and real estate mortgage loans is 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 our Consolidated Financial Statements (included in Item 8. of 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, 2011, we had two 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 7 - LOANS
Table 8 - LOAN MATURITIES
ALLOWANCE AND PROVISION FOR LOAN LOSSES
We have certain lending policies and procedures in place that are designed to balance loan growth and income with an acceptable level of risk, which management reviews and approves on a regular basis. Our review process is supported by a series of reports related to loan production, loan quality, credit concentrations, policy exceptions, loan delinquencies and non-performing and potential problem loans. We also utilize diversification in our loan portfolio as a means of managing risk.
Our allowance for loan losses is to provide for losses inherent in the loan portfolio. Management is responsible for determining the level of the allowance for loan losses, subject to review by our Board of Directors. Among other factors, we consider on a monthly 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 local and national 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.
To determine the total allowance for loan losses, we estimate the reserves needed for each segment of the portfolio, including loans analyzed on both, a pooled basis and individually. Our allowance for loan losses consists of amounts applicable to the following loan types: (i) the commercial loan portfolio; (ii) the real estate loan portfolio; (iii) the consumer loan portfolio. In addition, loans within these portfolios are evaluated as a group or on an individual or relationship basis and assigned a risk grade based on the underlying characteristics. Loans are pooled by risk grade within the portfolio types, and losses are modeled utilizing metrics such as the risk rating, historical experience, other known and inherent risks, and quantitative techniques which management has determined fit the characteristics of that type.
The commercial loan portfolio includes commercial and industrial loans which are usually secured by the assets being financed or other business assets such as accounts receivable or inventory and normally incorporate a personal guarantee; however, some short-term loans may be made on an unsecured basis. Commercial loans are underwritten after evaluating and understanding the borrowers ability to operate profitably and prudently expand its business.
The real estate loan portfolio includes all loans secured by real estate. This type is further broken down into the following segments: construction loans, residential 1-4 family loans, home equity lines, multifamily loans, and commercial real estate loans. Construction and multifamily loans are underwritten utilizing feasibility studies, independent appraisal reviews, sensitivity analysis of absorption and lease rates and financial analysis of the developers and property owners. Construction loans are generally based upon estimates of costs and value associated with the complete project. Residential 1-4 family and home equity loan originations utilize analytics to supplement the underwriting process. Commercial real estate loans are subject to underwriting standards and processes similar to commercial loans, in addition to those of real estate loans. These loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate.
Commercial and real estate portfolio loans are evaluated on an individual or relationship basis and assigned a risk grade at the time the loan is made. Additionally, we perform periodic reviews of the loan or relationship to determine if there have been any changes in the original underwriting which would change the risk grade and/or impact the borrowers ability to repay the loan.
The consumer loan portfolio includes consumer and installment loans and overdraft protection loans. These loans, which are in relatively small loan amounts, are spread across many individual borrowers. We utilize analytics to supplement general underwriting. Loans within the consumer class are assigned risk grades and evaluated as a pool, unless specifically identified through delinquency or other signs of credit deterioration, at which time the identified loan is individually evaluated. Additionally, loans that have been specifically identified as a credit risk due to circumstances that may affect the ability of the borrower to repay interest and/or principal are analyzed on an individual basis. Adverse circumstances may include loss of repayment source, deterioration in the estimated value of collateral, elevated trends of delinquencies, and charge-offs.
We evaluate the adequacy of the allowance for loan losses monthly in order to maintain the allowance at a level that is sufficient to absorb probable credit losses. Such factors as the level and trend of interest rates and the condition of the national and local economies are also considered. From time to time, events or economic factors may affect the loan portfolio, causing management to provide additional amounts to or release balances from the allowance for loan losses. Our allowance for loan losses is sensitive to risk ratings assigned to individually evaluated loans, economic assumptions, and delinquency trends driving statistically modeled reserves.
There are nine numerical risk grades that can be assigned to loans:
The following table delineates, in thousands, our loan portfolio by class and pass and watch list risk grade for the years ended December 31, 2011 and 2010.
Table 9 - LOANS BY RISK GRADE
A loan risk graded a loss is charged-off when identified and a loan risk graded as doubtful is classified as a nonaccrual loan. At December 31, 2011 we did not have any loans risk graded as a loss or as doubtful. We do not have any potential problem loans which have not been evaluated and disclosed at December 31, 2011. Loans identified as special mention and substandard may or may not be classified as nonaccrual, based on current performance. Watch list loans are evaluated on an individual or relationship basis to determine if any, or all, of our loans to the borrower is at risk. We evaluate the collectability of both principal and interest when assessing the need for a loss accrual. For additional discussion on this evaluation refer to Note 1 and Note 3 to our Consolidated Financial Statements (included in Item 8. of this Form 10-K).
This evaluation includes, but is not limited to, the application of a loss factor using a three-year moving average look back at our historical losses. This loss factor is multiplied by the outstanding principal within each segment to arrive at an overall loss estimate. Environmental factors may also be applied to a class or classes of loans based on managements 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 classes, etc. Any unallocated portion of the allowance for loan losses reflects managements attempt to ensure that the overall reserve appropriately reflects a margin for the imprecision necessarily inherent in estimates of credit losses.
The allowance is subject to regulatory examinations and determination as to adequacy. This examination 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.
In 2011, we accrued $6,319,887 in provision for loan losses compared to $8,639,292 in 2010. 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 this provision to be a prudent allocation of funds for our loan loss allowance.
Loans charged off during 2011 totaled $6,126,600 compared to $9,171,033 in 2010 and recoveries totaled $698,913 and $269,541 in 2011 and 2010, respectively. The ratio of net charge-offs to average outstanding loans was 0.93% in 2011 compared to 1.61% in 2010.
In 2011, approximately $2.4 million of the loan balances charged-off were tied to four relationships which had been identified by management as impaired or uncollectible; $1.3 million of that was related to a single borrower whose business activities failed. In 2011, $2.2 million in loans charged off were related to failed real estate projects, $2.3 million in loans charged off were related to failed business activities and the remaining $1.6 million were related to residential properties.
In 2010, approximately $6.2 million of the loan balances charged-off were tied to seven relationships which had been identified by management as impaired or uncollectible; $4.2 million of that total was related to three real estate development projects which have been adversely impacted by the downturn in the real estate market and $2.0 million was due to four failed business activities. Several smaller charge-offs were also related to failed business activities totaling approximately $486 thousand. Approximately $1.1 million was related to equity line default and an additional $680 thousand in charged-off balances were related to residential properties.
During 2011, we developed a new allowance model. As disclosed during the second and third quarter 10-Q filings, we ran the original model and the new model concurrently, which resulted in no difference in the calculated provision for loan losses. As of December 31, 2011, we reverted back to the original model.
Table 10 presents our loan loss and recovery experience (in thousands) for the past five years.
The allowance for loan losses totaled $9,930,000 at December 31, 2011, an increase of $892,200 or 9.9% over December 31, 2010. The ratio of the allowance to loans, less unearned income, was 1.63% at December 31, 2011 and 1.62% at December 31, 2010. 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, 2011. The allowance to loans ratio is supported by the level of non-performing loans, the seasoning of the loan portfolio, and the experience of the lending staff in the market. See Note 3 to our Consolidated Financial Statements (included in Item 8. of this Form 10-K) for more information concerning our loan loss and recovery experience.
Table 10 - LOAN LOSS ALLOWANCE AND LOSS EXPERIENCE
TABLE 11 - ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES
For the Years Ended December 31, 2011 and 2010