Monarch Financial Holdings 10-Q 2010
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
For Quarterly Period Ended: September 30, 2010
Commission File Number: 001-34565
MONARCH FINANCIAL HOLDINGS, INC.
(Exact name of registrant as specified in its charter)
1101 Executive Blvd.
Chesapeake, Virginia 23320
(Name, address, including zip code, and telephone number, including area code, of agent for service)
(Former name, former address and former fiscal year, if changed since last report)
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 filed such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ¨ No ¨
Indicate by check mark whether the registrant is a large accelerated filer, and accelerated filer, or a non-accelerated filer, or a smaller reporting company. See definition of large accelerated filer, and accelerated filer, and smaller reporting company in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
The number of shares of common stock outstanding as of November 15, 2010 was 5,904,139.
SEPTEMBER 30, 2010
ITEM 1. FINANCIAL STATEMENTS
MONARCH FINANCIAL HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF CONDITION
The accompanying notes are an integral part of the consolidated financial statements.
ITEM 1. FINANCIAL STATEMENTS (Continued)
CONSOLIDATED STATEMENTS OF INCOME
The accompanying notes are an integral part of the consolidated financial statements.
ITEM 1. FINANCIAL STATEMENTS (Continued)
CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY AND COMPREHENSIVE INCOME
The accompanying notes are an integral part of the consolidated financial statement.
ITEM 1. FINANCIAL STATEMENTS (Continued)
CONSOLIDATED STATEMENTS OF CASH FLOWS
The accompanying notes are an integral part of the consolidated financial statements.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. BASIS OF PRESENTATION
In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments consisting of normal recurring accruals necessary to present fairly Monarch Financial Holdings, Inc.s financial position as of September 30, 2010; the consolidated statements of income for the three and nine months ended September 30, 2010 and 2009; the consolidated statements of changes in stockholders equity and comprehensive income for the nine months ended September 30, 2010 and 2009; and the consolidated statements of cash flows for the nine months ended September 30, 2010 and 2009. These financial statements have been prepared in accordance with the instructions to Form 10-Q and, therefore, do not include all of the disclosures and notes required by generally accepted accounting principles. The financial statements include the accounts of Monarch Financial Holdings, Inc. and its subsidiaries, and all significant intercompany accounts and transactions have been eliminated. Operating results for the three and nine month periods ended September 30, 2010 are not necessarily indicative of the results that may be expected for the year ended December 31, 2010. Certain prior year amounts have been reclassified to conform to current year presentations.
Recent Issued Accounting Standards
On September 17, 2010, the Securities and Exchange Commission (SEC) issued Release No. 33-9144, Commission Guidance on Presentation of Liquidity and Capital Resources Disclosures in Managements Discussion and Analysis. This interpretive release is intended to improve discussion of liquidity and capital resources in Managements Discussion and Analysis of Financial Condition and Results of Operations in order to facilitate understanding by investors of the liquidity and funding risks facing the registrant. This release was issued in conjunction with a proposed rule, Short-Term Borrowings Disclosures, that would require public companies to disclose additional information to investors about their short-term borrowing arrangements. Release No. 33-9144 was effective on September 28, 2010. The additional disclosures required by this release have not had a material impact on our consolidated financial statements.
On September 15, 2010, the SEC issued Release No. 33-9142, Internal Control Over Financial Reporting In Exchange Act Periodic Reports of Non-Accelerated Filers. This release issued a final rule adopting amendments to its rules and forms to conform them to Section 404(c) of the Sarbanes-Oxley Act of 2002 (SOX), as added by Section 989G of the Dodd-Frank Wall Street Reform and Consumer Protection Act. SOX Section 404(c) provides that Section 404(b) shall not apply with respect to any audit report prepared for an issuer that is neither an accelerated filer nor a large accelerated filer as defined in Rule 12b-2 under the Securities Exchange Act of 1934. Release No. 33-9142 was effective September 21, 2010. We are a smaller reporting company and as such, SOX Section 404(b) does not apply to any audit report prepared on our consolidated financial statements.
In July 2010, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses. This update is intended to provide for disclosures that facilitate financial statement users evaluation of 1) the nature of credit risk inherent in the entitys portfolio of financing receivables, 2) how that risk is analyzed and assessed in arriving at the allowance for credit losses, and 3) the changes and reasons for those changes in the allowance for credit losses. Required disclosures include disaggregation of receivables into two levels portfolio segment and class of financing receivable. A portfolio segment is defined as the level at which an entity develops and documents a systematic method for determining its allowance for credit losses. Classes of financing receivables generally are a disaggregation of portfolio segment. Required disclosures on a disaggregated basis include a roll-forward of the allowance for credit losses as well as impaired, nonaccrual, restructured and past due loans, and credit quality indicators. The disclosures as of the end of the reporting period are effective for interim and annual reporting periods ending on or after December 15, 2010. The disclosures about the activity that occurs during a reporting period are effective for interim and annual reporting periods beginning on or after December 15, 2010. We are currently evaluating the impact of this guidance on disclosures in our consolidated financial statements.
In February 2010, the FASB issued ASC 2010-09, Subsequent Events (Topic 855) - Amendments to Certain Recognition and Disclosure Requirements. This guidance, among other things, requires an entity that is either (a) an SEC filer or (b) a bond obligor for conduit debt securities that are traded in a public market to evaluate subsequent events through the date that the financial statements are issued. The amendments remove the requirement for an SEC filer to disclose a date in both issued and revised financial statements. This guidance is effective for interim or annual periods ending after June 15, 2010 and did not have a material impact on our consolidated financial statements.
In March 2010, FASB issued ASU 2010-11, Derivatives and Hedging (Topic 815) Scope Exception Related to Embedded Credit Derivatives. This update provides clarification to the scope exceptions (ASU 815-15-15-8 through 15-9) for embedded credit derivative features related to the transfer of credit risk in the form of one financial instrument to another. The amendments address how to determine which embedded credit derivative features, including those in collateralized debt obligations and synthetic collateralized debt obligations, are considered to be embedded derivatives that should not be analyzed under Section 815-15-25 for potential bifurcation and separate accounting. The guidance in this update was effective for the quarter beginning after June 15, 2010, and did not have a significant impact on our consolidated financial statements.
In January 2010, the FASB issued ASU 2010-04, Accounting for Various Topics Technical Corrections to SEC Paragraphs. ASU 2010-04 makes technical corrections to existing SEC guidance including the following topics: accounting for subsequent investments, termination of an interest rate swap, issuance of financial statements - subsequent events, use of residual method to value acquired assets other than goodwill, adjustments in assets and liabilities for holding gains and losses, and selections of discount rate used for measuring a defined benefit obligation. The adoption of the new guidance did not have a material impact on our consolidated financial statements.
In January 2010, the FASB issued ASU 2010-06, Fair Value Measurements and Disclosures (Topic 820) Improving Disclosures about Fair Value Measurements (Subtopic 820-10). This update will require new disclosures for transfers in and out of Levels 1 and 2 and expand the activity disclosure for Level 3. It will also clarify existing disclosures by requiring disaggregation of subsets of assets and liabilities when providing fair value and disclosure of inputs and valuations techniques for fair value measures of Level 2 and 3. This guidance, effective for interim and annual reporting periods beginning after December 15, 2009, (except for the disclosures about purchases, sales, issuances and settlements in the roll forward of activity in Level 3 fair value measures), did not have a significant impact on our consolidated financial statements. The remaining disclosure with regard to Level 3, are effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years, and is not expected to have a significant impact on our consolidated financial statements.
In August 2009, the FASB issued ASU 2009-05, Fair Value Measurements and Disclosures (Topic 820) Measuring Liabilities at Fair Value. This update provides clarification for circumstances in which a quoted price in an active market for the identical liability is not available. In such circumstances a reporting entity is required to measure fair value using one or more of the following techniques: (1) A valuation technique that uses: (a) the quoted price of the identical liability when traded as an asset; or (b) quoted prices for similar liabilities or similar liabilities when traded as assets; or (2) another valuation technique that is consistent with the principles of Topic 820 such as an income approach or a market approach. The guidance in this update was effective for the quarter beginning October 1, 2009, and did not have a significant impact on our consolidated financial statements.
In June 2009, the FASB issued guidance that establishes the FASB Accounting Standards Codification (the Codification or ASC) as the source of authoritative generally accepted accounting principles (GAAP) recognized by the FASB for nongovernmental entities. Rules and interpretive releases of the Securities and Exchange Commission (SEC) under authority of federal securities laws are also included in the Codification as sources of authoritative GAAP for SEC registrants. The Codification is
effective for financial statements issued for interim and annual periods ending after September 15, 2009. The Codification supersedes all existing non-SEC accounting and reporting standards. Following this effective date, instead of issuing new standards in the form of Statements, FASB Staff Positions, or Emerging Issues Task Force Abstracts, the FASB issues Accounting Standards Updates, which serves only to: (a) update the Codification; (b) provide background information about the guidance; and (c) provide the bases for conclusions on the change(s) in the Codification. We started following the guidelines in the Codification effective July 1, 2009.
In June 2009, the FASB issued ASU 2009-16 (formerly FASB 166, Accounting for Transfers of Financial Assets an amendment of FASB Statement No. 140), to improve the relevance, faithfulness, and comparability of the information that a reporting entity provides in its financial statements about a transfer of financial assets; the effects of a transfer on its financial position, financial performance, and cash flows; and a transferors continuing involvement, if any, in transferred assets. This statement, effective for periods beginning after November 15, 2009, did not have a significant effect on our consolidated financial statements.
In June 2009, the FASB issued ASU 2009-17 (formerly FASB 167, Amendments to FASB Interpretation No. 46(R)). This statement amends Interpretation 46(R) to require an enterprise to replace the quantitative-based analysis in determining whether the enterprises variable interest or interests give it controlling financial interest in a variable interest entity with a more qualitative approach by providing additional guidance regarding considerations for consolidating an entity. This guidance also requires enhanced disclosures to provide users of financial information with more transparent information about the enterprises involvement in a variable interest entity. This statement, effective for periods beginning after November 15, 2009, did not have a significant effect on our consolidated financial statements.
NOTE 2. GENERAL
We are a Virginia-chartered bank holding company engaged in business and consumer banking, investment and insurance sales, and mortgage origination and brokerage. We were created on June 1, 2006 through a reorganization plan, under the laws of the Commonwealth of Virginia, in which Monarch Bank became our wholly-owned subsidiary. Monarch Bank was incorporated on May 1, 1998, and opened for business on April 14, 1999. Our corporate office and main office are located in the Greenbrier area of Chesapeake. In addition we have eight other Virginia banking offices in the Great Bridge area in Chesapeake, the Lynnhaven area, the Town Center area, the Oceanfront, the Kempsville area, and the Hilltop area in Virginia Beach, and the Ghent area and in the downtown area in Norfolk. Our North Carolina banking division operates as OBX Bank through two offices in Kitty Hawk and Nags Head.
In August 2001, we formed Monarch Investment, LLC, to enable us to offer additional services to our clients. We own 100% of Monarch Investment, LLC. As Monarch Investment, LLC, we invested in the formation of Bankers Investment Group, LLC, the parent company of BI Investments, LLC, a registered brokerage firm and investment advisor. On April 30, 2008, Bankers Investment Group, LLC, and BI Investments, LLC, were merged into Infinex Financial Group (Infinex), a broker-dealer headquartered in Meriden, Connecticut, with Monarch Investment, LLC, now holding a 5.62% ownership interest in Infinex. In June of 2008, investment clients began using Infinex as their broker-dealer. Infinex sells non-deposit investment products in over 200 community banks throughout the country.
In January 2003, Monarch Investment, LLC, purchased a noncontrolling interest in Bankers Insurance, LLC, in a joint venture with the Virginia Bankers Association and many other community banks. Bankers Insurance, LLC, is a full service property/casualty and life/health agency that ranks as one of the largest agencies in Virginia. Bankers Insurance, LLC, provides insurance to our customers and to the general public.
In February 2004, we formed Monarch Capital, LLC, for the purpose of engaging in the commercial real estate brokerage business. We own a 100% interest in Monarch Capital, LLC.
In March 2006, Monarch Investment, LLC, formed a subsidiary titled Virginia Asset Group, LLC (VAG). VAG was owned 51% by Monarch Investment, LLC, and 49% by a minority shareholder. In August 2009, Monarch Investment, LLC, sold its 51% ownership in VAG to the minority shareholder and began providing non-deposit investment services under the name of Monarch Investments.
In May 2007, we expanded banking operations into northeastern North Carolina with the opening of a banking office in the town of Kitty Hawk, under the name of OBX Bank (OBX). We opened a second office in the town of Nags Head in December 2009. OBX Bank, which operates as our division, is led by a local management team and a local advisory board of directors.
In June 2007, we announced the expansion of our mortgage operations through the acquisition of a team of experienced mortgage bankers, and our mortgage division began operating as Monarch Mortgage (MM). MM originates and sells conventional, FHA, VA and VHDA residential loans and offers additional mortgage products such as construction-permanent loans for Monarch Banks loan portfolio. Their primary office is in Virginia Beach with additional offices in Chesapeake, Norfolk, Richmond, Midlothian, Manassas, Fairfax, Woodbridge and Reston, Virginia, Rockville, Waldorf, Crofton, Bowie, Towson and Greenbelt, Maryland and Kitty Hawk, Wilmington and Charlotte, North Carolina, and Greenwood, South Carolina.
In July 2007, Monarch Investment, LLC, purchased a 51% ownership in Coastal Home Mortgage, LLC, from another bank. This joint venture provides residential loan services through Monarch Mortgage. The 49% ownership is shared by four individuals involved in commercial and residential construction in the Hampton Roads area.
In October 2007, Monarch Investment, LLC, formed a title insurance company, Real Estate Security Agency, LLC (RESA) along with TitleVentures, LLC. Monarch Investment, LLC, owns 75% of RESA and TitleVentures, LLC, owns 25%. RESA offers residential and commercial title insurance to the clients of Monarch Mortgage and Monarch Bank.
In March 2008, Monarch Investment, LLC, formed Home Mortgage Solutions, Inc., in the Richmond area of Virginia. Monarch Investment, LLC, owns 51% with BPRP Funding, LLC, a builder/developer, owning 49%. The primary goal of Home Mortgage Solutions, Inc. is to provide mortgages to the clients of BPRP Funding, LLC. In January 2010, we closed our Home Mortgage Solutions, Inc. operations.
In March 2010, Monarch Investment, LLC, formed Regional Home Mortgage, LLC, in Chesapeake, Virginia. Monarch Investment, LLC, owns 51% with TREG Funding, LLC, owning 49%, to provide residential mortgages to clients of TREG Funding, LLC.
In September 2010, Monarch Investment, LLC, formed Monarch Home funding, LLC, in Norfolk, Virginia. Monarch Investment, LLC, owns 51% with Danaus, LLC, owning 49% to provide residential mortgages to clients of Danaus, LLC.
NOTE 3. EARNINGS PER SHARE (EPS)
Basic earnings per share (EPS) exclude dilution and are computed by dividing income available to common shareholders by the weighted-average number of shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised, converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity. The following is a reconciliation of the numerators and denominators of the basic and diluted earnings per share computations.
For the three months ended September 30, 2010 and 2009, average options to purchase 155,056 and 143,968 shares, respectively, were not included in the computation of earnings per common share, because they were anti-dilutive. Year-to-date 2010 and 2009, average options to purchase 155,056 and 160,006 shares, respectively, were not included in the computations of earnings per common share, because they were anti-dilutive.
NOTE 4. FAIR VALUE ACCOUNTING
Fair Value Hierarchy and Fair Value Measurement
We group our assets and liabilities that are recorded at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:
The following table presents our assets and liabilities related to continuing operations, which are measured at fair value on a recurring basis for each of the fair value hierarchy levels, as of September 30, 2010 and December 31, 2009:
The changes in restricted equity securities (Level 3 assets) measured at fair value on a recurring basis are summarized below as:
The changes in rate lock commitments (Level 3 assets) measured at fair value on a recurring basis are summarized below as:
The following table provides quantitative disclosures about the fair value measurements of our assets related to continuing operations which are measured at fair value on a nonrecurring basis as of September 30, 2010 and 2009:
For the three and nine months ended September 30, 2010, we recorded a loss on sale of the real estate owned of $97,381 and $199,377, respectively. For the three and nine months ended September 30, 2009, we recorded a gain on the sale of real estate owned of $94,911 and $111,366, respectively. These amounts are itemized in other noninterest income for the periods indicated.
At the time a loan secured by real estate becomes real estate owned we record the property at the lower of its carrying amount or fair value. Upon foreclosure and through liquidation, we evaluate the propertys fair value as compared to its carrying amount and record a valuation adjustment when the carrying amount exceeds fair value. Any valuation adjustments at the time a loan becomes real estate owned is charged to the allowance for loan losses. Any subsequent valuation adjustments are applied to earnings in our consolidated statements of income. We recorded a loss of $0 and $51,955 in the three and nine months ended September 30, 2010, respectively, due to valuation adjustments on real estate owned in our consolidated statements of income. These adjustments were recorded within the financial statement caption other noninterest income for the respective period. We recorded a $24,750 a loss due to valuation adjustments on real estate owned in our consolidated statements of income in the third quarter and first nine months of 2009.
Fair Value Option for Financial Assets and Financial Liabilities
Under GAAP, we may elect to report most financial instruments and certain other items at fair value on an instrument-by-instrument basis with changes in fair value reported in earnings. After the initial adoption, the election is made at the acquisition of an eligible financial asset, financial liability, or firm commitment or when certain specified reconsideration events occur. The fair value election may not be revoked once an election is made.
Fair Value of Financial Instruments
The following table presents the carrying amounts and fair value of our financial instruments at September 30, 2010 and December 31, 2009. GAAP defines the fair value of a financial instrument as the amount at which the instrument could be exchanged in a current transaction between willing parties, other than through a forced or liquidation sale for purposes of this disclosure. The carrying amounts in the table are included in the balance sheet under the indicated captions.
The following notes summarize the significant assumptions used in estimating the fair value of financial instruments:
Short-term financial instruments are valued at their carrying amounts included in the Banks balance sheet, which are reasonable estimates of fair value due to the relatively short period to maturity of the instruments. This approach applies to cash and cash equivalents and overnight borrowings.
Loans are valued on the basis of estimated future receipts of principal and interest, which are discounted at various rates. Loan prepayments are assumed to occur at the same rate as in previous periods when interest rates were at levels similar to current levels. Future cash flows for homogeneous categories of consumer loans, such as motor vehicle loans, are estimated on a portfolio basis and discounted at current rates offered for similar loan terms to new borrowers with similar credit profiles.
Investment securities are valued at quoted market prices if available. For unquoted securities, the fair value is estimated by the Bank on the basis of financial and other information.
Restricted equity securities are estimated based on the basis of financial and other information.
The fair value of demand deposits and deposits with no defined maturity is taken to be the amount payable on demand at the reporting date. The fair value of fixed-maturity deposits is estimated using rates currently offered for deposits of similar remaining maturities. The intangible value of long-term relationships with depositors is not taken into account in estimating the fair values disclosed.
The fair value of short- term borrowings is based on discounting expected cash flows at the interest rate of debt with the same or similar remaining maturities and collateral requirements.
The carrying amounts of accrued interest approximate fair value.
The fair value of the derivative financial liability is based on the discounted cashflows using observable market inputs, reflecting market inputs of future interest rates as of the measurement date. Consideration is given to our credit risk as well as the counterpartys credit quality in determining the fair value of the derivative.
It is not practicable to separately estimate the fair values for off-balance-sheet credit commitments, including standby letters of credit and guarantees written, due to the lack of cost-effective reliable measurement methods for these instruments.
NOTE 5. COMPREHENSIVE INCOME
Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on available-for-sale securities, are reported as a separate component of the equity section of the balance sheet, such items, along with net income, are components of comprehensive income. Components of other comprehensive income are unrealized gains and losses on available-for-sale securities and a derivative financial liability related to an interest rate swap. The following is a detail of comprehensive income for the three and nine months ended September 30, 2010 and 2009:
NOTE 6. STOCK-BASED COMPENSATION
In May 2006, our stockholders ratified the adoption of a new stock-based compensation plan to succeed the Monarch Bank 1999 Incentive Stock Option Plan. The new Monarch Bank 2006 Equity Incentive Plan (2006EIP) authorizes the compensation committee to grant options, stock appreciation rights, stock awards, performance stock awards, and stock units to designated directors, officers, key employees, consultants and advisors to the Company and its subsidiaries. The Plan authorizes us to issue up to 630,000 split-adjusted shares of our Common Stock plus the number of shares of our Common Stock outstanding under the 1999 Plan. The Plan also provides that no award may be granted more than 10 years after the May 2006 ratification date.
Since May 2006, we have issued stock awards under the new Plan at a price equal to the stock price on the issue date with vesting periods of up to five years from issue. Total compensation costs are recognized over the service period to vesting.
NOTE 7. SEGMENT REPORTING
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. Retail mortgage banking originates residential loans and
subsequently sells them to investors. Our mortgage banking segment is a strategic business unit that offers different products and services. It is managed separately because the segment appeals to different markets and, accordingly, requires different technology and marketing strategies. The segments most significant revenue and expense is non-interest income and non-interest expense, respectively. We do not have other reportable operating segments. (The accounting policies of the segment are the same as those described in the summary of significant accounting policies in Note 1 of our annual 10-K.) All intersegment sales prices are market based. The assets and liabilities and operating results 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 three and nine months ended September 30, 2010 and 2009 is shown in the following table.
Selected Financial Information
NOTE 8. GOODWILL AND INTANGIBLE ASSETS
Goodwill and intangible assets with indefinite lives are recorded at cost and are reviewed at least annually for impairment based on evidence of certain impairment indicators. Intangible assets with identifiable lives are amortized over their estimated useful lives. The intangible assets have a weighted-average useful life of seven years.
Information concerning goodwill and intangible assets is presented in the following table:
Amortization expense for intangible assets totaled $44,643 and $133,929 for each of the three and nine month periods, ending September 30, 2010 and 2009.
NOTE 9. DERIVATIVE FINANCIAL INSTRUMENTS AND HEDGING ACTIVITIES
We entered into an interest rate swap agreement with PNC Bank (PNC) of Pittsburgh, PA on July 29, 2009, for our $10 million Trust preferred borrowing, which carries a floating interest rate of 90 day London Interbank Offered Rate (LIBOR) plus 160 basis points. The terms of this hedge allows us to mitigate our exposure to interest-rate fluctuations by swapping our floating rate obligation for a fixed rate obligation. The notional amount of the swap agreement is $10 million, and has an expiration date of September 30, 2014. Under the terms of our agreement, at the end of each quarter we will swap our floating rate for a fixed rate of 3.26%. Including the additional 160 basis points, the effective fixed rate of interest cost will be 4.86% on our $10 million Trust Preferred borrowing for five years.
The fixed-rate payment feature of this swap is structured to mirror the provisions of the hedged borrowing agreement. This swap qualifies as a cash flow hedge and the underlying liability is carried at fair value in other liabilities, with the changes in fair value of the instrument included in Stockholders Equity in accumulated other comprehensive income.
Our credit exposure, if any, on the interest rate swap is limited to the net favorable value (net of any collateral pledged) and interest payments of the swap by the counterparty. Conversely, when an interest rate swap is in a liability position we are required to post collateral to PNC which is evaluated monthly and adjusted based on the fair value of the hedge on the last day of the month. The fair value of this swap instrument was a liability of $841 thousand at September 30, 2010 for which our collateral requirement on September 30, 2010, was $900 thousand.
On June 15, 2010, we began participating in a mandatory delivery program for mortgage loans. Prior to that date we managed our interest rate risk by locking in the interest rate for each mortgage loan with our correspondent investors and borrowers at the same time, which is a best efforts delivery system. Under the mandatory delivery system, loans with interest rate locks are paired with the purchase of a notional security bearing similar attributes. Interim income or loss on the pairing of the loans and securities is recorded on our income statement. In addition the loans and the securities are matched at the time the loan is delivered to an investor and an additional gain or loss on the pairing is recorded on our income statement. At September 30, 2010 management has elected to limit our exposure to this form of delivery to $25 million. At September 30, 2010 we had gross loans of $18,698,858 paired with notional securities of $14,000,000 for net position of $4,698,858. We reported income related to our mandatory delivery program of $251 thousand during the third quarter and first nine months of 2010.
MONARCH FINANCIAL HOLDINGS, INC.
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
The purpose of this discussion is to focus on important factors affecting our financial condition and results of operations. This discussion and analysis should be read in conjunction with the Consolidated Financial Statements and supplemental financial data.
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 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 and commercial 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.
This report contains forward-looking statements with respect to our financial condition, results of operations and business. 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. Factors that may cause actual results to differ materially from those expected include the following:
A summary of our significant risk factors is set forth in Part 1, Item 1A Risk Factors our 2009 Form 10-K.
Net income for the quarter ended September 30, 2010 was $1.5 million compared to $1.2 million at September 30, 2009, an increase of $300 thousand or 31.1%. Net income for the first nine months of 2010 was $4.2 million, an increase of $600 thousand or 15.2% over $3.6 million for the same period in 2009. Basic earnings per share were $0.20 for the third quarter of 2010 and $0.53 for the first nine months of 2010, while diluted earnings per share were $0.19 and $0.52 for the same periods, respectively. Basic earnings and diluted earnings per share were $0.17 for the third quarter of 2009. For the first nine months of 2009, basic earnings per share were $0.54 and diluted earnings per share were $0.53.
Two important and commonly used measures of profitability are return on assets (net income as a percentage of average total assets) and return on equity (net income as a percentage of average stockholders equity). Our annualized return on assets (ROA) was 0.74% for the three months periods ended September 30, 2010 and 2009, and our year-to-date ROA for 2010 and 2009 was 0.75%. Our
annualized return on equity (ROE) for the third quarter of 2010 was 8.65% compared to 7.25% in 2009. Our ROE for the first nine months of 2010 was 8.14% compared to 7.84% for the same period in 2009. Growth in net interest income for the quarter and year-to-date were the primary contributor to our improvement in ROE.
Net interest income increased $2.7 million and $6.1 million in the third quarter and first nine months of 2010, respectively, when compared to the same periods in 2009. Non-interest income increased $8.3 million in the third quarter of 2010 and $10.5 million year to date 2010, compared to 2009. Higher loan yield coupled with lower interest costs on deposits contributed to improvement in our net interest income, and higher levels of production and improved margins. Our mortgage division was the source of the increase in non-interest income.
Our provision for loan losses increased $1.5 million in the third quarter of 2010 compared to 2009 and $1.7 million in the first nine months of 2010 compared to 2009. Non-interest expense increased $8.4 million for the quarter and $13.5 million for the first nine months of 2010 compared to 2009, with the areas of greatest non-interest expense growth in mortgage commissions and incentives, salaries and benefits and loan origination expense.
Net Interest Income
Net interest income, the excess of interest income over interest expense, is a significant source of our revenue. A number of factors influence net interest income, including the interest rates earned on earning assets, and the interest rates paid to obtain funding to support the assets, the volume of interest-earning assets and interest bearing liabilities, and the mix of interest-earning assets and interest bearing liabilities,.
Interest rates have remained at a record low for an extended period, which has allowed us to realign our longer term liability costs with that of our assets. The federal funds rate that is set by the Federal Reserve Banks Federal Open Market Committee has been 0.25% since December 2008. For comparable periods, the Wall Street Journal Prime Rate (WSJ), which generally moves with the federal funds rate, was 3.25%. Historically, we were an asset sensitive company, with the majority of our loan portfolio indexed to the Wall Street Journal Prime Rate and set to re-price quickly. This asset sensitivity meant our net interest income was negatively impacted when rates declined because repricing of our liabilities lagged behind that of our assets. This extended stable, though low, rate environment has allowed us to position our balance sheet into one that is more favorable to us in the future when rates begin to rise.
We have modified the pricing and terms of both our interest earning assets and our interest bearing liabilities to better buffer our sensitivity to rising rates. The steps we have taken to neutralize this sensitivity include renegotiating the majority of our commercial and real estate loans to either short term fixed rates or to variable rates. In addition, we have re-priced deposits as they matured, moving them to lower market rate products.
Net interest income increased $2.7 million and $6.1 million in the third quarter and first nine months of 2010, respectively, compared to 2009. Interest and fees on loans are the largest component of our interest income and the area in which income growth has occurred. The yield on our loan portfolio was 5.60% in the third quarter and 5.69%, year-to-date; a 19 and 27, basis point increase, respectively, through September 30, 2010 compared to 5.41% and 5.42% for the same periods in 2009. The decrease in third quarter yield compared to our year to date yield is a result of our loan portfolio composition and trends in the market.
Our loan portfolio is comprised of two major classifications of loans: loans held for sale and loans held for investment. Loans held for sale, which are residential mortgages originated by our mortgage division and sold to investors, earn interest while on our books, but are at historic low rates. The normal holding period for these loans is approximately 35 to 45 days, and outstanding balances have increased while the yield on these balances has declined. Loans held for investment, which are primarily commercial and real estate loans, have grown $39.0 million when compared to September 2009. The average yield on loans held for investment was 5.97% for the third quarter and 5.91% for the first nine months of 2010 compared to 5.50% for the third quarter and 5.51% for the first nine months of 2009.
At September 2010, the blended cost of deposits has declined 65 basis points for the quarter and 74 basis points in the first nine months when compared to 2009. The cost of our time deposits decreased 63 basis points for the quarter and 93 basis points, year-to-date, despite a $26.4 million increase in our time deposits outstanding. Total interest expense declined $384 thousand in the third quarter and $1.6 million in the first nine months of 2010 when compared to 2009.
For analytical purposes, net interest income is adjusted to a taxable equivalent basis to recognize the income tax savings on tax-exempt assets, such as bank owned life insurance (BOLI) and state and municipal securities. 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 net interest margin.
Our net interest rate spread on a tax-equivalent basis increased 89 and 83 basis points, respectively, to 4.12% and 3.95% for third quarter and first nine months of 2010, respectively, when compared to 3.23% and 3.12% for the same periods in 2009. Yield on earning assets increased 22 basis point to 5.47% from 5.25%, quarter over quarter, and 15 basis points to 5.46% from 5.31% for the first nine months of 2010 compared to 2009. The cost of interest bearing liabilities decreased 67 and 68 basis points, respectively, in the third quarter and year-to-date 2010 compared to 2009.
Bank Owned Life Insurance (BOLI) has been included in interest earning assets. We purchased $6,000,000 in BOLI during the fourth quarter of 2005. The income on BOLI is not subject to Federal Income tax, giving it a tax-effective yield of 6.11% for the third quarter and 6.10% for the first nine months of 2010 compared to 5.68% for the same periods in 2009.
In July, 2006, we added additional capital through the issuance of $10,000,000 in trust preferred securities. These securities are treated as subordinated debt and have been included in other borrowings. The cost on trust preferred securities increased to an average of 4.86% from 2.74% in the first nine months of 2010 compared to 2009.
The following tables set forth average balances of total interest earning assets and total interest bearing liabilities for the periods indicated, showing the average distribution of assets, liabilities, stockholders equity and the related income, expense and corresponding weighted average yields and costs.
NET INTEREST INCOME ANALYSIS
The following is an analysis of net interest income, on a taxable equivalent basis.
NET INTEREST INCOME ANALYSIS
The following is an analysis of net interest income, on a taxable equivalent basis.
The goal of a rate/volume analysis is to compare two or more periods to determine whether the difference between those periods is the result of 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 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 change between periods is the impact of differing rates and how much is volume driven.
For discussion purposes, our Rate/Volume Analysis and Average Balances, Income and Expenses, Yields and Rates tables include tax equivalent income on bank owned life insurance (BOLI) that is not in compliance with Generally Accepted Accounting Principals (GAAP). The following table is a reconciliation of our income statement presentation to these tables.
RECONCILIATION OF NET INTEREST INCOME
TO TAX EQUIVALENT INTEREST INCOME
Net interest income increased $2.8 million, quarter over quarter and $6.1 million in a nine month comparative. The impact of growth in the third quarter was greater than the impact of rate changes, although both increased net interest income, contributing approximately $1.5 million and $1.2 million, respectively. Growth in net interest income for the first nine months of 2010 compared to 2009 was driven more by rate changes which provided $3.5 million in additional income, than growth, which added $2.6 million to income.
Interest income from loans was the source of growth in both the third quarter and first nine months of 2010. In the third quarter increased interest income from loans added $2.4 million total, $1.9 million due to volume and $526 thousand due to rate. Year to date, loan growth has provided $4.5 million in additional income, $3.3 million due to volume and $1.2 million due to rate increase.
Reduction in the cost of interest bearing deposits provided a savings in deposit costs of $596 thousand in the third quarter and $2.2 million year to date 2010. Deposit growth has reduced this savings $238 thousand and $630 thousand for the same periods, for an overall reduction in savings costs of $358 thousand and $1.6 million, respectively.
The following table sets forth an analysis of the impact of changes in rate and volume on our interest bearing assets and liabilities for the third quarter and first nine months of 2010 compared to 2009.
Changes in Net Interest Income (Rate/Volume Analysis)
Net interest income is the product of the volume of average earning assets and the average rates earned, less the volume of average interest-bearing liabilities and the average rates paid. The portion of change relating to both rate and volume is allocated to each of the rate and volume changes based on the relative change in each category. The following table analyzes the changes in both rate and volume components of net interest income on a tax equivalent basis.
RATE / VOLUME ANALYSIS
Non-interest income was $17.1 million for the third quarter of 2010, an increase of $8.3 million or 94.3% over the same period in 2009. Year-to-date 2010 non-interest income was $37.0 million, compared to $26.5 million, one year prior. Mortgage banking income continues to be the driver in non-interest income growth. Non-interest income is broken out into more detail in the following table:
Mortgage banking income represents fees from originating and selling residential mortgage loans as well as commercial mortgages through Monarch Mortgage and our wholly owned commercial mortgage banking subsidiary, Monarch Capital, LLC. The overwhelming majority of this growth has been in the area of residential mortgages. Gross mortgage banking income increased in the third quarter and first nine months of 2010 compared to 2009 due to higher production in both periods. In the third quarter of 2010 Monarch Mortgage originated 2,401 loans totaling $503.3 million, compared to 1,066 loan originations totaling $265.5 million for the same period in 2009. Through September 30, 2010, our residential mortgage operations originated 4,938 loans totaling $1.1 billion, compared to 3,470 loans totaling $904.0 million. Purchase money loans comprised roughly 59% of these loans. We anticipate that while residential mortgage rates remain low quarterly production will be high, however; based upon historic seasonal trends our gross mortgage banking income may decline slightly in the fourth quarter.
Investment and insurance commissions declined $89 thousand, quarter over quarter, and $461 thousand in the first nine months of 2010 compared to 2009, as a result of changes we have made in delivery of these products. In August 2009, we ended the joint venture we had through Monarch Investment, LLC.
Service charges and fees on deposit accounts increased $2 thousand in the quarter and $169 thousand year to date 2010 compared to the same periods in 2009. The primary components of service charges and fees are nonsufficient fund and overdraft fees and ATM transaction fees. Recent regulatory changes on the charging of fees on certain transactions have impacted fee income in the third quarter. We have an agreement with a third-party vendor to brand ATMs in Food Lion grocery stores in southeast Virginia and northeast North Carolina. In return for supplying the cash for the machines and paying the machines cash servicing fees, we receive a portion of the transaction surcharge, and our customers can withdraw cash from the machines without a fee or transaction surcharge. We have 11 ATMs located at our banking center sites. Combined with our third-party vendor relationship, our network includes over 50 active branded ATMs.
There were no security gains or losses in the first nine months of 2010 or 2009. In the second quarter of 2009 we sold two parcels of land on Hanbury Road, attached to our Great Bridge office for a gain of $302,269.
We sold three properties in other real estate during the third quarter of 2010 and recorded losses, net of valuation adjustments of $97 thousand, compared to four properties for the same period in 2009 with a recorded gain, net of valuation adjustments of $14 thousand. Year to date 2010, we have sold eleven properties and recorded losses, net of valuation adjustments of $199 thousand, compared to six properties with gains, net of valuation adjustments of $111 thousand in 2009.
BOLI is included in the net interest income calculation for yield analysis. We purchased $6.0 million in BOLI during the fourth quarter of 2005. The income from BOLI, which is not subject to tax, increased $8 thousand quarter-over-quarter, $23 thousand, year-to-date in 2010 compared to 2009. The tax-effective income earnings are $111 for the third quarter of 2010 compared to $99 for the same period in 2009 and $326 thousand in the first nine months of 2010 compared to $292 thousand for the same period in 2009.
Through Monarch Investment, LLC, we own a 75% interest in a title company, Real Estate Security Agency, LLC (RESA), which is being treated as a consolidated entity for accounting purposes. RESA showed an increase of income for the third quarter and first nine months of 2010 when compared to 2009 of $75 thousand and $99 thousand, respectively.
The following table summarizes our non-interest expense for the periods indicated:
Total non-interest expenses increased $8.4 million in the third quarter of 2010, an increase of 76.9% over the same period in 2009, and $13.5 million in the first nine months of 2010, an increase of 41.3% over prior year. Excluding salaries and employee benefits and commissions and incentives, non-interest expense increased $1.5 million or 41.6% in the third quarter and $3.3 million or 31.6% in the first nine months of 2010 compared to 2009.
Employee compensation; in the form of salaries, benefits, commissions and incentives, represent an approximate 74% and 71% of non-interest expense in third quarter and first nine months of 2010 compared to 68% and 69% for the same periods in 2009. Our full time equivalent employees, at September 30, 2010 totaled 495, compared to 351 in 2009. Employee compensation growth was primarily in commissions and incentives, through our mortgage operations, but we also expanded the Banks sales team and added staffing for two new banking offices; in the Hilltop area of Virginia Beach and in Nags Head, NC. In addition, during the third quarter we relocated our corporate headquarters after a substantial renovation of a building purchased in the second quarter. Over fifty-five percent of our mortgage employees are paid commissions based on their production levels. Secondary increases are attributable to the following factors: 1) an increase in loan origination expense related to higher production by the bank and higher vendor expenses for Monarch Mortgage; 2) growth related increases in occupancy, equipment, and data service expenses; 3) increased marketing expense related to company newsletters and the addition of mortgage specific advertising in 2010; and 4) increased professional fees related to loan collections and our properties in other real estate.
FDIC insurance increased $7 thousand in the third quarter but is $317 thousand lower in the first nine months when compared to the same periods in 2009 due to a one-time special assessment in the second quarter of that year.
The following summary identifies, in descending order, non-interest expenses with the most significant quarter-over-quarter increase.
Our income tax provision was $1.3 million for the quarter and $2.6 million for the first nine months of 2010 compared to $620 thousand and $1.8 million for the same periods, respectively, in 2009. Included in our third quarter 2010 taxes is a one-time adjustment totaling $211 thousand for previous period Maryland state taxes related to our mortgage operations in addition to estimated 2010 quarterly state taxes for Maryland, North Carolina and South Carolina of $232 thousand. The effective tax rate for the quarter was 45.5% and 38.1% for the first nine months of 2010, compare to 34.6% and 32.5% for the same periods in 2009.
FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES
Total assets were $876.2 million at September 30, 2010, a $186.6 million or 27.1% increase compared to assets of $689.6 million at December 31, 2009. On an annual basis total assets increased $224.4 million, a 34.4% increase when compared to assets of $651.8 million at September 30, 2009. The primary driver of this growth was in loans held for sale which increased $158.8 million or 201.0% to $237.8 million at September 30, 2010 compared to $79.0 million at December 31, 2009. On an annual basis loans held for sale increased $166.6 million or 233.8% compared to $71.2 million at September 30, 2009. The secondary source of asset growth was total loans held for investment which increased $23.7 million to $561.4 million as of September 30, 2010, a 4.4% increase over year-end 2009 totals of $537.7 million. On an annual basis, total loans held for investment increased $39.0 million, or 7.5%, from $522.3 million in September 2009. Property and equipment increased $9.9 million or 110.2% to $18.9 million at September 30, 2010 compared to $9.0 million at year-end 2009 and $10.6 million or a 128.6% increase over $8.3 million at September 30, 2009. Investment securities were $7.9 million at September 30, 2010 compared to $7.2 million at December 31, 2009, and $6.3 million at September 30, 2009. Cash and cash equivalents were $24.6 million, decreasing $9.7 million from $34.4 million at December 31, 2009, and $1.6 million from $26.2 million one year prior.
Loans held for sale represent mortgage loans that have been closed and are awaiting investor purchase. A majority of our mortgage loans are pre-sold and remain on our books for thirty to forty-five days. Outstanding balances are dependent on the current mortgage market and may fluctuate significantly between periods. The significant growth noted at September 30, 2010 compared to year-end 2009 and September 30, 2009 is a product of a low rate environment and higher refinanced loan volumes coupled with record production by our mortgage division.
In April 2010, we purchased a building in Chesapeake, Virginia, which was renovated and in September became our new corporate headquarters. Also in April 2010, we purchased a piece of land in the Ghent section of Norfolk, Virginia. We are currently in the construction phase of that project which, when complete, will be the new home of our existing Ghent banking office and Norfolk Monarch Mortgage headquarters. In May 2010 we opened a new office in the Hilltop area of Virginia Beach, Virginia, which is a leased location. These purchases and the renovation and furnishing of our leased location were the primary source of the increase in property and equipment.
Total liabilities were $805.6 million at September 30, 2010, an increase of $184.0 million or 29.6% over year-end 2009 liabilities of $621.6 million. Year over year total liabilities increased $217.0 million or 36.9% increase over $588.6 million at September 30, 2009. The primary source of our liability growth is our deposits. Total deposits increased $135.0 million or 25.0% to $675.0 million at September 30, 2010, when compared to $540.0 million at year-end 2009 and increased $134.9 million or 25.0% compared to $540.1 million, one year prior. Total borrowings increased $45.2 million to $121.3 million at September 30, 2010, a 59.4% increase from $76.1 million at December 31, 2009 and a $78.2 million or 181.4% increase over $43.1 million at September 30, 2009.
Non-interest bearing demand deposits increased $19.7 million over December 2009 to $95.8 million and on an annual basis $11.4 million over September 30, 2009. Interest bearing demand deposits were $29.9 million, an increase of $10.2 million and $10.7 million when compared to December 31, 2009 and September 30, 2009 totals of $19.7 million and $19.2 million, respectively. We are primarily a business bank and, as such, have focused our efforts on obtaining company operating and escrow accounts, which are demand deposit accounts. Escrow accounts ordinarily house real estate funds, which makes them sensitive to the growth of the current mortgage environment. Our focus on the business sector, coupled with the growth in business operating and escrow accounts, has resulted in significant growth in demand deposits.
Our interest bearing deposits are comprised of savings accounts, money market accounts and certificates of deposits (CDs). Savings accounts have declined compared to year end 2009 and on an annual basis. CDs increased $32.0 million to $296.1 million at September 30, 2010, compared to $264.1 at year-end 2009, and increased $26.4 million over prior year. Money market accounts have shown marked growth in 2010 compared to both, 2009 year-end and prior year.
Savings deposits have declined $1.1 million to $21.8 million at September 30, 2010 compared to $22.8 million at December 31, 2009 and $27.7 at September 30, 2009. This decline is the result of a change in pricing. In 2008, we introduced a multi-tiered savings product that rewarded higher balances with a higher rate which resulted in notable increases in savings balances. However, over the past year we have lowered the rates on the higher tiers and the decline, year over year, is attributable to the rate sensitivity of those clients who initially migrated to the product. Some of the decline may be attributable to migration by more rate sensitive clients to our higher yield money market product.
Total money market balances were $231.4 million at September 30, 2010, an increase of $74.1 million compared to $157.3 million at December 31, 2009. On an annual basis, money market accounts have increased $92.3 million compared to $139.1 million at September 30, 2009. Early in the recession, money market accounts had lost favor with many of our clients preferring fixed rate products such as CDs. During that time the fact that our prime money market product remained very competitive compared to our peers had little impact on the balances in that product. However, progressive improvement in consumer confidence has resulted in renewed interest in this attractive and competitive product.
CDs remain popular with clients because of the rate stability inherent in a fixed product. Core CDs which are comprised of CDs with balances of less than $100 thousand, increased $6.0 million to $185.5 million, when compared to $179.5 million at December 31, 2009. On an annual basis, core CDs have decline $323 thousand. At September 30, 2010, for classification purposes, we have included our Certificate of Deposit Account Registry Service® (CDARS) product in Jumbo CDs. In exchange for fully insured balances, clients in our CDARS product receive lower rates on their CDs. CDARs are non-core brokered deposits because we utilize the services of an outside network to disburse funds in insurable amounts across a large number of financial institutions in exchange for a fee. Jumbo CDs, which are CDs with balances of $100 thousand or greater, increased $26.1 million to $110.7 million at September 30, 2010 compared to $84.6 million at December 31, 2009, and $26.7 million compared to $83.9 million at September 30, 2009. All of this growth was in CDARs. We utilize our non-core brokered deposits to help fund growth in our loans held for investments.
Stockholders equity was $70.4 million at September 30, 2010, compared to $67.9 million at December 31, 2009. Components of the change in stockholders equity include net income of $4.2 million, increase in unrealized losses in other comprehensive income of $293 thousand, stock based
compensation totaling $267 thousand, stock option exercises of $184 thousand, repurchase of stock warrants of $260 thousand, preferred stock dividend payment of $1.1 million, and common stock dividend payment of $411 thousand.
Allowance and Provision for Loan Losses
Our allowance for loan losses is to provide for losses inherent in the loan portfolio. Our management is responsible for determining the level of the allowance for loan losses, subject to review by the board of directors. Among other factors, management considers our historical loss experience, the size and composition of our loan portfolio, the value and adequacy of collateral and guarantors, non-performing credits including impaired loans and our risk-rating-based loan watch-list, and national and local economic conditions on a quarterly basis.
The economy of our trade area is well diversified. There are additional risks of future loan losses that cannot be precisely quantified or attributed to particular loans or classes of loans. Since those factors include general economic trends as well as conditions affecting individual borrowers, the allowance for loan losses is an estimate. The sum of these elements is our managements recommended level for the allowance. The unallocated portion of the allowance is based on loss factors that cannot be associated with specific loans or loan categories. These factors include 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 segments, etc. The 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.
We developed a methodology to determine an allowance to absorb probable loan losses inherent in the portfolio based on evaluations of the collectability of loans, historical loss experience, peer bank loss experience, delinquency trends, environmental factors, economic conditions, portfolio composition, and specific loss estimates for loans considered substandard or doubtful. All commercial and commercial real estate loans that exhibit probable or observed credit weaknesses are subject to individual review. Based on managements evaluation, estimated loan loss allowances are assigned to the individual loans which present a greater risk of loan loss. If necessary, reserves would be allocated to individual loans based on managements estimate of the borrowers ability to repay the loan given the availability of collateral and other sources of cash flow. Any reserves for impaired loans are measured based on the fair value of the underlying collateral. We evaluate the collectability of both principal and interest when assessing the need for a loss accrual. A composite allowance factor that considers our and other peer bank loss experience ratios, delinquency trends, economic conditions, and portfolio composition are applied to the total of commercial and commercial real estate loans not specifically evaluated.
The residual loan loss allowance is allocated to the remaining loans on an overall portfolio basis based on industry and or historical loss experience. The allowance is subject to regulatory examinations and determination as to adequacy, which may take into account such factors as the methodology used to calculate the allowance and the size of the allowance in comparison to peer banks identified by regulatory agencies. Homogenous loans, such as consumer installment, residential mortgage loans, and home equity loans are not individually reviewed and are generally risk graded at the same levels. The risk grade and reserves are established for each homogenous pool of loans based on the expected net charge offs from a current trend in delinquencies, losses or historical experience and general economic conditions.
While we believe we have sufficient allowance for our existing portfolio, there can be no assurances that an additional allowance for losses on existing loans may not be necessary in the future. The allowance for loan losses totaled $10.2 million at September 30, 2010 and $9.3 million September 30, 2009. The ratio of the allowance for loan losses to total loans held for investment was 1.83% at September 30, 2010 and 2009.
We recorded provision expense of $3.0 million during the third quarter of 2010 and $5.8 million in the first nine months of 2010 compared to $1.5 million and $4.1 million, for the same periods in 2009, respectively. Gross charge-offs for the quarter were $1.4 million and $5.1 million, year-to-date 2010,
offset by recoveries of $61 thousand and $251 thousand. In 2009, gross charge-offs were $1.1 million for the quarter and $2.7 million, year-to-date, offset by recoveries of $23 thousand and $81 thousand. The table below summarizes the activity in the allowance for loans losses for the three and nine month periods ending September 30, 2010 and 2009.
LOAN LOSS ALLOWANCE AND LOSS EXPERIENCE
Asset Quality and Non-Performing Loans
We identify specific credit exposures through periodic analysis of our loan portfolio and monitor general exposures from economic trends, market values and other external factors. We maintain an allowance for loan losses, which is available to absorb losses inherent in the loan portfolio. The allowance is increased by the provision for losses and by recoveries from losses. Charged-off loan balances are subtracted from the allowance. The adequacy of the allowance for loan losses is determined on a quarterly basis. Various factors as defined in the previous section Allowance and Provision for Loan Losses are considered in determining the adequacy of the allowance. Loans are generally placed on non-accrual status after they are past due for 90 days.
Non-performing loans include loans on which interest is no longer accrued, accruing loans that are contractually past due 90 days or more as to principal and interest payments, and loans classified as troubled debt restructurings. Total non-performing loans as a percentage of total loans were 1.52% and 1.40% at September 30, 2010 and December 31, 2009, respectively.
We had non-performing assets totaling $10.8 million at September 30, 2010 compared to $9.7 million at December 31, 2009. Net charge-offs for the third quarter and first nine months of 2010 were $1.3 million and $4.9 million, respectively. Non-performing assets traditionally consist of nonaccrual loans, loans past due 90 days or more and still accruing interest, restructured loans and other real estate owned. All of these loans have been identified as impaired according to applicable GAAP for impaired loans. We have provided specific reserves for our non-performing assets in our allowance for loan loss of $970 thousand at September 30, 2010 and $1.7 million at December 31, 2009. We continue to demand a high level of credit quality on new loans.
Liquidity represents an institutions ability to meet present and future financial obligations through either the sale of existing assets or the acquisition of additional funds through short-term borrowings. Our liquidity is provided from cash and amounts due from banks, federal funds sold, interest-bearing deposits in other banks, repayments from loans, increases in deposits, lines of credit from the Federal Home Loan Bank and five correspondent banks, and maturing investments. As a result of our management of liquid assets, and our ability to generate liquidity through liability funding, we believe that we maintain overall liquidity sufficient to satisfy our depositors requirements and to meet clients credit needs. We also take into account any liquidity needs generated by off-balance sheet transactions such as commitments to extend credit, commitments to purchase securities and standby letters of credit.
We monitor and plan our liquidity position for future periods. Liquidity strategies are implemented and monitored by our Asset/Liability Committee (ALCO). The Committee uses a simulation and budget model to assess current and future liquidity needs.
Cash, cash equivalents and federal funds sold totaled $24.6 million as of September 30, 2010 compared to $34.4 million as of December 31, 2009. At September 30, 2010, cash, securities classified as available for sale and federal funds sold were $32.5 million or 3.9% of total earning assets, compared to $41.5 million or 6.4% of total earning assets at December 31, 2009.
In the course of operations, due to fluctuations in loan and deposit levels, we occasionally find it necessary to purchase federal funds on a short-term basis. We maintain unsecured federal funds line arrangements with five other banks, which allow us to purchase funds totaling $34.5 million. These lines mature and re-price daily. At September 30, 2010 and December 31, 2009, we had $0 in federal funds purchased.
We have access to the Federal Reserve Bank of Richmonds discount window should a liquidity crisis occur. We have not used this facility in the past and consider it a backup source of funds.
We are also members of the Promontory Network and have access to a program through their Certificate of Deposit Account Registry Service® (CDARS) to use their CDARS One Way BuySM to purchase cost-effective funding without collateralization (and in lieu of generating funds through traditional brokered CDs or the Federal Home Loan Bank). These funds are accessed through a weekly auction. The auction typically takes place on Wednesdays, with next day settlement. There are seven maturities available ranging from 4 weeks to 5 years. If we are allotted funds in the auction, we incur no transaction fees or commissions. Although the process to compete for these deposits is different from the process for traditional brokered CDs, they are still considered brokered for Call Report purposes. These funds which are included in our Jumbo CDs are subject to discretionary limitations on volume that we normally would impose on traditional brokered deposits. Based on our well capitalized status, we are able to draw up to $79.1 million from this program. We had $25.0 million on our balance sheet from this program at September 30, 2010 and $0 at December 31, 2009.
We have lines of credit with the Federal Home Loan Bank of Atlanta (FHLB) that can equal up to 30% of our assets. Our primary line of credit (Primary) totaled approximately $65.5 million with $58.0 million available at September 30, 2010. This line is currently reduced by $6.0 million, which has been pledged as collateral for public deposits.
In February 2009, we negotiated an additional line of credit with FHLB which is secured by a portion of our loans held for sale (LHFS). We pledge these loans, which have been sold to FHLB approved investors, as collateral. In return, we are allowed to borrow up to 70% of these loans for 120 days. The investor remits the proceeds for the purchased loans directly to FHLB, which then releases the collateral pledged. At September 30, 2010, we had assets pledged totaling $156.9 million and advances outstanding totaled $109.8 million, with $0 excess available on the line.
Borrowings outstanding under the combined FHLB lines of credit were $111.3 million at September 30, 2010 and $66.2 million at December 31, 2009. We had the following borrowing advances under our Primary line outstanding as of September 30, 2010, with the following final maturities:
The advance maturing in 2015 is a principal reducing credit that matures on September 28, 2015. Terms include 39 quarterly principal payments of $25 thousand beginning December 2005, with a final payment of $1.0 million in September 2015. We are utilizing this advance to match-fund several long term fixed rate loans. The interest rate for this advance is fixed at 4.96%.
In June 2010 we repaid a $10.0 million advance from FHLB and incurred a prepayment penalty of $145 thousand. This advance, which was scheduled to mature in November 2010, bore a fixed rate of 3.97%.
Under our LHFS line we had four advances outstanding at September 30, 2010. All advances mature in December 2010 and are broken down as follows:
We have no material commitments or long-term debt for capital expenditures at the report date. The only long-term debt is for funding loans.
Off-Balance Sheet Arrangements
We enter into certain financial transactions in the ordinary course of performing traditional banking services that result in off-balance sheet transactions. The off-balance sheet transactions recognized as of September 30, 2010 and December 31, 2009 were a line of credit to secure public funds and commitments to extend credit and standby letters of credit issued to customers. The line of credit to secure public funds was from the Federal Home Loan Bank for $6 million at September 30, 2010 and $5 million at December 31, 2009.
We entered into an interest rate swap agreement with PNC Bank of Pittsburgh, PA on July 29, 2009, for our $10 million Trust Preferred borrowings which carries a floating interest rate of 90 day LIBOR plus 160 basis points. Under the terms of this agreement, at the end of each quarter we will swap our floating rate for a fixed rate of 3.26%. The effective date of this swap is September 30, 2009, with an expiration date of September 30, 2014. This swap will fix our interest cost on our $10 million Trust Preferred borrowings of 4.86% for five years.
Commitments to extend credit, which include rate lock commitments, amounted to $461.5 million at September 30, 2010 and $262.5 million at December 31, 2009, represent legally binding agreements to lend to customers with fixed expiration dates or other termination clauses. Since many of the commitments are expected to expire without being funded, the total commitment amounts do not necessarily represent future liquidity requirements.
We did not have any outstanding commitments to purchase securities on September 30, 2010 or December 31, 2009.
Standby letters of credit are conditional commitments we issue guaranteeing the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements. We had $5.6 million in outstanding standby letters of credit at September 30, 2010 and $5.3 million at December 31, 2009.
We have twenty-eight non-cancelable leases for premises. The original lease terms are from one to eighteen years and have various renewal and option dates.
We review the adequacy of our capital on an ongoing basis with reference to the size, composition, and quality of our resources and consistent with regulatory requirements and industry standards. We seek to maintain a capital structure that will assure an adequate level of capital to support anticipated asset growth and absorb potential losses.
The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on our financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, banks must meet specific capital guidelines that involve quantitative measures of the banks assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. Capital amounts and classification are also subject to qualitative judgments by the regulators about components (such as interest rate risk), risk weighting, and other factors.
The Bank, as a Virginia banking corporation, may pay dividends only out of retained earnings. In addition, regulatory authorities may limit payment of dividends by any bank, when it is determined that such limitation is in the public interest and necessary to ensure financial soundness of the Bank. Regulatory agencies place certain restrictions on dividends paid and loans or advances made by the Bank to the Company. The amount of dividends the Bank may pay to the Company, without prior approval, is limited to current year earnings plus retained net profits for the two preceding years. At September 30, 2010, the amount available was approximately $10.1 million. We currently pay a quarterly dividend on our series B noncumulative, perpetual preferred stock of 7.8%, or $390,000 per quarter. In addition, we paid our first common stock dividend in June 2010 of $411,287. On October 25, 2010, our board announced a $0.07 per share cash dividend on our common stock, payable on November 30, 2010 to our shareholders of record as of November 10, 2010.
Quantitative measures established by regulation to ensure capital adequacy require that the Bank maintain minimum amounts and ratios (set forth in the table below) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital (as defined) to average assets (as defined). Management believes, as of September 30, 2010, the Bank meets all capital adequacy requirements to which it is subject.
As of September 30, 2010, the Bank was categorized as well capitalized, the highest level of capital adequacy. To be categorized as well capitalized, the Bank must maintain minimum total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios as set forth in the table. The Banks actual capital amounts and ratios are also presented in the table as of September 30, 2010 and December 31, 2009.