Virginia Commerce Bancorp 10-K 2009
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Annual report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the fiscal year ended December 31, 2008
Commission file number: 000-28635
Virginia Commerce Bancorp, Inc.
(Exact name of registrant as specified in its charter)
Registrants telephone number: 703.534.0700
Securities registered under Section 12(b) of the Act
Securities registered under Section 12(g) of the Act: None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Section 405 of the Securities Act. Yes o No x
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No x
Indicate by check mark whether the registrant; (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports); and (2) has been subject to such filing requirements for the past 90 days.
Yes x No o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) 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. o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of large accelerated filer accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x
The registrants Common Stock is traded on the Nasdaq Global Select Market under the symbol VCBI. The aggregate market value of the approximately 19,188,995 shares of Common Stock of the registrant issued and outstanding held by non-affiliates on June 30, 2008 was approximately $99.6 million, based on the closing sales price of $5.19 per share on that date. For purposes of this calculation, the term affiliate refers to all directors, executive officers and 10% shareholders of the registrant.
As of the close of business on March 1, 2009, 26,688,143 shares of the registrants Common Stock were outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrants definitive Proxy Statement for the Annual Meeting of Shareholders, to be held on April 29, 2009, are incorporated by reference in part III hereof.
Form 10-K Cross Reference Sheet
The following shows the location in this Annual Report on Form 10-K or the Companys Proxy Statement for the Annual Meeting of Stockholders to be held on April 29, 2009, of the information required to be disclosed by the United States Securities and Exchange Commission Form 10-K. References to pages only are to pages in this report.
FIVE YEAR FINANCIAL SUMMARY
(1) Adjusted for all years presented giving retroactive effect to five-for-four stock splits in the form of 25% stock dividends in 2004 and 2005, a three-for-two stock split in the form of a 50% stock dividend in 2006, and a 10% stock dividend in 2007 and 2008.
(2) Computed by dividing non-interest expense by the sum of net interest income on a tax equivalent basis and non-interest income, net of securities gains or losses. This is a non-GAAP financial measure, which we believe provides investors with important information regarding our operational efficiency. Comparison of our efficiency ratio with those of other companies may not be possible, because other companies may calculate the efficiency ratio differently.
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This managements discussion and analysis and other portions of this report, contain forward-looking statements within the meaning of the Securities and Exchange Act of 1934, as amended, including statements of goals, intentions, and expectations as to future trends, plans, events or results of Company operations and policies and regarding general economic conditions. In some cases, forward-looking statements can be identified by use of words such as may, will, anticipates, believes, expects, plans, estimates, potential, continue, should, and similar words or phrases. These statements are based upon current and anticipated economic conditions, nationally and in the Companys market, interest rates and interest rate policy, competitive factors, and other conditions which by their nature, are not susceptible to accurate forecast, and are subject to significant uncertainty. Because of these uncertainties and the assumptions on which this discussion and the forward-looking statements are based, actual future operations and results may differ materially from those indicated herein. Readers are cautioned against placing undue reliance on any such forward-looking statements. The Companys past results are not necessarily indicative of future performance.
This managements discussion and analysis refers to the efficiency ratio, which is computed by dividing non-interest expense by the sum of net interest income on a tax equivalent basis and non-interest income. This is a non-GAAP financial measure that we believe provides investors with important information regarding our operational efficiency. Comparison of our efficiency ratio with those of other companies may not be possible because other companies may calculate the efficiency ratio differently. The Company, in referring to its net income, is referring to income under accounting principles generally accepted in the United States, or GAAP.
The following presents managements discussion and analysis of the consolidated financial condition and results of operations of Virginia Commerce Bancorp, Inc. and subsidiaries (the Company) as of the dates and for the periods indicated. This discussion should be read in conjunction with the Companys Consolidated Financial Statements and the Notes thereto, and other financial data appearing elsewhere in this report. The Company is the parent bank holding company for Virginia Commerce Bank (the Bank), a Virginia state-chartered bank that commenced operations in May 1988. The Bank pursues a traditional community banking strategy, offering a full range of business and consumer banking services through twenty-seven branch offices, one residential mortgage office and one investment services office.
Headquartered in Arlington, Virginia, Virginia Commerce serves the Northern Virginia suburbs of Washington, D.C., including Arlington, Fairfax, Fauquier, Loudoun, Prince William, Spotsylvania and Stafford Counties and the cities of Alexandria, Fairfax, Falls Church, Fredericksburg, Manassas and Manassas Park. Its service area also covers, to a lesser extent, Washington, D.C. and the nearby Maryland counties of Montgomery and Prince Georges. The Banks customer base includes small-to-medium sized businesses including firms that have contracts with the U.S. government, associations, retailers and industrial businesses, professionals and their firms, business executives, investors and consumers.
Critical Accounting Policies
During the year ended December 31, 2008, there were no changes in the Companys critical accounting policies as reflected in the Companys most recent annual or quarterly report.
The Companys financial statements are prepared in accordance with accounting principles generally accepted in the United States (GAAP). The financial information contained within our statements is, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. We use historical loss factors as one factor in determining the inherent loss that may be present in our loan portfolio. Actual losses could differ significantly from the historical factors that we use. In addition, GAAP itself may change from one previously acceptable method to another method. Although the economics of our transactions would be the same, the timing of events that would impact our transactions could change.
Estimates, assumptions, and judgments are necessary when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset not carried on the financial statements at fair value warrants an impairment write-down or valuation reserve to be established, or when an asset or liability needs to be recorded contingent upon a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by other third-party sources, when available. The estimates used in managements assessment of the adequacy of the allowance for loan losses require that management make assumptions about matters that are uncertain at the time of estimation. Differences in these assumptions and differences between the estimated and actual losses could have a material effect.
The allowance for loan losses is an estimate of the losses that are inherent in our loan portfolio. The allowance is based on two basic principles of accounting: (i) SFAS 5, Accounting for Contingencies, which requires that losses be accrued when they are probable of occurring and estimable and (ii) SFAS 114, Accounting by Creditors for Impairment of a Loan, which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance.
Our allowance for loan losses has two basic components: the specific allowance and the unallocated allowance. Each of these components is determined based upon estimates that can and do change when the actual events occur. The specific allowance is used to individually allocate an allowance for impaired loans. Impairment testing includes consideration of the borrowers overall financial condition, resources and payment record, support available from financial guarantors and the fair market value of collateral. These factors are combined to estimate the probability and severity of inherent losses based on the Companys calculation of the loss embedded in the individual loan. Large groups of smaller balance, homogeneous loans are collectively evaluated for impairment. Impaired loans which meet the criteria for substandard, doubtful and loss are segregated from performing loans within the portfolio. Internally classified loans are then grouped by loan type (commercial, commercial real estate, commercial construction, residential real estate, residential construction or installment). The unallocated formula is used to estimate the loss of non-classified loans. These un-criticized loans are also segregated by loan type and allowance factors are assigned by management based on delinquencies, loss history, trends in volume and terms of loans, effects of changes in lending policy, the experience and depth of management, national and local economic trends, concentrations of credit, quality of the loan review system and the effect of external factors (i.e. competition and regulatory requirements). The factors assigned differ by loan type. The unallocated allowance recognizes potential losses whose impact on the portfolio has yet to be recognized by a specific allowance. Allowance factors and the overall size of the allowance may change from period to period based on managements assessment of the above described factors and the relative weights given to each factor. For further information regarding the allowance for loan losses see Notes 1 and 4 to the Consolidated Financial Statements and the discussion under the caption Asset Quality Provision and Allowance for Loan Losses at page 12.
The Companys 1998 Stock Option Plan (the Plan), which is shareholder-approved, permits the grant of share options to its directors and officers for up to 2.4 million shares of common stock, as adjusted for the ten percent stock dividend paid on May 1, 2008. Option awards are generally granted with an exercise price equal to the market price of the Companys stock at the date of grant, generally vest based on 5 years of continuous service and have 10-year contractual terms. The fair value of each option award is estimated on the date of grant using a Black-Scholes option pricing model that currently uses historical volatility of the Companys stock based on a 7.2 year expected term, before exercise, for the options granted, and a risk-free interest rate based on the U.S. Treasury curve in effect at the time of the grant to estimate total stock-based compensation expense. This amount is then amortized on a straight-line basis over the requisite service period, currently 5 years, to salaries and benefits expense. See Notes 1 and 12 to the Consolidated Financial Statements for additional information regarding the Stock Option Plan and related expense.
Financial Performance Overview
During 2008, the financial industry encountered significant volatility and stress as economic conditions worsened, unemployment increased and the effects of the mortgage crisis became more widespread. The Company did not have direct exposure to the subprime mortgage issues in that it did not make subprime residential mortgage loans to retail customers, and did not invest in private label mortgage backed securities or securities backed by subprime or Alt A mortgages or the preferred stock of Freddie Mac and Fannie Mae. However, the effects of the rapidly slowing economy, and the precipitous and steep declines in housing starts and residential real estate development and sales activity, adversely affected the Companys portfolio of loans to builders and developers of residential real estate in
the Companys markets, particularly in the outer suburbs, The Companys loans to commercial customers in the building trades and allied industries have also been adversely impacted, as the effect of the housing slowdown spread. As a result, the Companys income was dramatically reduced in 2008, primarily due to increased provisions for loan losses.
For the year ended December 31, 2008, total assets increased $376.2 million, or 16.1%, from $2.34 billion at December 31, 2007, to $2.72 billion, with loans, net of the allowance for loan losses, increasing $348.3 million, or 18.1%, from $1.92 billion at December 31, 2007, to $2.27 billion at December 31, 2008. This growth in loans and total assets was funded by an increase in total deposits of $303.0 million, or 16.2%, from $1.87 billion at December 31, 2007, to $2.17 billion. Additional funding was provided by the sale of $25 million in trust preferred securities to the Companys directors and certain of its executive officers and the issuance of $71 million in preferred stock to the United States Department of the Treasury (the Treasury) under the Capital Purchase Program. Please refer to Capital Issuancesat page 20 for a discussion of the issuance of securities under the Capital Purchase Program. Net income for the year ended December 31, 2008, was down $12.7 million, or 49.3%, from $25.8 million in 2007, to $13.1 million, due to a $21.0 million increase in loan loss provisions from $4.3 million in 2007 to $25.4 million.
In 2007, total assets increased $390.6 million, or 20.0%, from $1.95 billion at December 31, 2006, to $2.34 billion, with loans increasing $294.9 million, or 18.1%, from $1.63 billion at December 31, 2006, to $1.92 billion. As in 2008, the majority of the growth in loans and total assets was funded by increases in deposits, with total deposits rising $263.2 million, or 16.4%, from $1.61 billion at December 31, 2006, to $1.87 billion at the end of 2007. Additional funding was provided by a $73.6 million increase in repurchase agreements and federal funds purchased and $25 million in other borrowed funds. Net income in 2007 was up $1.3 million, or 5.2%, from $24.5 million in 2006, to $25.8 million with growth in net-interest income being the primary factor.
As noted, the Company achieved significant growth in loans in 2008. Loans are the Companys principal asset class and primary contributor to interest income. The majority of loan growth occurred in non-farm, non-residential real estate loans, which rose $175.8 million, or 21.0%, from $835.5 million at December 31, 2007, to $1.01 billion at December 31, 2008. One-to-four family residential real estate loans represented the second largest increase rising $90.9 million, or 34.1%, from $266.4 million at December 31, 2007, to $357.3 million, while construction loans increased $40.8 million, or 7.5%, from $544.3 million at the end of 2007, to $585.1 million and commercial loans rose $40.8 million, or 17.1%, from $238.7 million at December 31, 2007 to $279.5 million. Increases in one-to-four family residential loans are due to the Company holding more of its originations in portfolio rather than selling them, because of reduced demand and product availability in the secondary market, while the growth in construction loans was concentrated in commercial real estate projects. Year-over-year, residential construction loans are down $9.0 million and are expected to decline further as that lending focus has been significantly curtailed in light of conditions in the housing market. In 2007, non-farm non-residential real estate loans rose $146.4 million, one-to-four family residential loans were up $73.2 million, commercial loans increased by $48.1 million and construction loans grew $29.3 million.
While loans are the Companys major asset, deposits are the Companys major source of funding and as a result the major contributor to interest expense. In 2008, deposits increased by $303.3 million, or 16.2%, with non-interest-bearing demand deposits decreasing by $19.0 million, or 8.9%, to $194.8 million, savings and interest-bearing demand deposits mostly unchanged and time deposits growing $321.1 million, or 28.2%, from $1.14 billion at December 31, 2007, to $1.46 billion. For the year ended December 31, 2007, deposit growth included an increase in non-interest-bearing demand deposits by $26.9 million, a $57.7 million increase in savings and interest-bearing demand deposits, and a $178.7 million increase in time deposits. Repurchase agreements, the majority of which represent sweep funds of significant commercial demand deposit customers, and Federal funds purchased decreased $34.5 million, or 15.5%, from $222.5 million at December 31, 2007, to $188.0 million at December 31, 2008, and increased $73.6 million, or 49.5%, in 2007.
The Companys investment securities portfolio represents its second largest asset class and contributor to interest income, and is generally maintained as a primary source of liquidity. In 2008, the portfolio increased by $10.6 million, or 3.2%, from $326.2 million at December 31, 2007, to $336.8 million at December 31, 2008, with growth concentrated in obligations of states and political subdivisions. In 2007, the portfolio increased $92.0 million, or 39.3%, from $234.2 million at December 31, 2006, to $326.2 million, with growth concentrated in both U.S. Government Agency obligations and obligations of states and political subdivisions.
For the year ended December 31, 2008, earnings were down $12.7 million, or 49.3% compared to earnings of $25.8 million for the prior fiscal year as net interest income increased $7.8 million, or 10.5%, from $75.2 million in 2007,
to $83.0 million in 2008, non-interest income decreased $1.5 million, or 18.4%, from $7.9 million in 2007, to $6.4 million, while provisions for loan losses were up $21.0 million, and non-interest expense rose 12.8%, from $39.7 million in 2007, to $44.8 million. As a result, the Companys efficiency ratio, as defined, rose from 47.8% for the year ended December 31, 2007, to 50.1% in 2008. In 2007, earnings of $25.8 million increased $1.3 million, or 5.2%, compared to earnings of $24.5 million in 2006, with net interest income increasing $6.4 million, or 9.2%, non-interest income rising $560 thousand, or 7.6%, provisions for loan losses decreasing $66 thousand, while non-interest expense rose $5.4 million, or 15.8%. For the year ended December 31, 2006, earnings of $24.5 million represented an increase of 24.6% compared to earnings of $19.7 million in 2005. On a diluted per common share basis earnings were $0.47, $0.95, and $0.89 in 2008, 2007, and 2006, respectively, while the Companys return on average assets was 0.51% for 2008, as compared to 1.21% in 2007 and 1.40% in 2006. Return on average equity was 7.18% in 2008, 16.75% in 2007, and 19.51% in 2006.
Stockholders equity increased by $84.1 million in 2008, or 49.8%, from $169.1 million at December 31, 2007, to $253.3 million, with earnings of $13.1 million, a $1.9 million decrease in other comprehensive income related to the investment securities portfolio, and $911 thousand in proceeds and tax benefits related to the exercise of options by Company directors, officers and employees and stock option expense credits. On September 24, 2008, the Company raised $25 million in qualifying capital through the sale of trust preferred securities to the Companys directors and certain of its executive officers. In connection with the issuance of the trust preferred securities, the Company also issued warrants to purchase an aggregate of 1.5 million shares of common stock to the purchasers. On December 12, 2008, the Company issued $71 million in preferred stock to the Treasury under the Capital Purchase Program. In connection with the issuance of the preferred stock, the Company also issued to the Treasury warrants to purchase approximately 2.7 million shares of common stock. In 2007, stockholders equity increased $29.2 million, or 20.9%, from $139.9 million at December 31, 2006, to $169.1 million, with earnings of $25.8 million, a $1.9 million increase in other comprehensive income related to the investment securities portfolio, and $1.6 million in proceeds and tax benefits related to the exercise of options by Company directors, officers and employees and stock option expense credits. The total number of common shares outstanding increased in 2008 by 2,552,719, with 2,411,508 shares issued due to a ten percent stock dividend in May 2008, and 141,211 shares issued as a result of the exercise of options by Company directors, officers and employees.
Net Interest Income
Net interest income is the excess of interest earned on loans and investments over the interest paid on deposits and borrowings and is the Companys primary revenue source. Net interest income is thereby affected by overall balance sheet growth, changes in interest rates and changes in the mix of investments, loans, deposits and borrowings. In 2008, net interest income increased $7.8 million, or 10.5%, from $75.2 million in 2007, to $83.0 million due to the significant growth in loans as the net interest margin fell from 3.65% in 2007, to 3.30%. In 2007, net interest income increased $6.4 million, or 9.2%, from $68.8 million in 2006, to $75.2 million due again to significant loan growth as the net interest margin fell from 4.07% in 2006, to 3.65%. In 2006, net interest income increased $12.1 million, or 21.2%, from $56.7 million in 2005, to $68.8 million.
In 2006, the Federal Open Market Committee (the FOMC) continued a campaign of increasing its Fed funds target rate that began in 2004 by another 100 basis points to 5.25%. As that increase also increased the prime lending rate to 8.25%, of which many of the Companys loan rates are tied to, the Companys yield on interest-earning assets rose from 6.57% in 2005 to 7.41% in 2006. However, as the treasury yield curve eventually inverted with higher short-term than long-term rates, funds began shifting from lower rate to higher rate accounts, and as competition for deposits in the local market intensified, the cost of interest-bearing liabilities increased to a greater extent, from 2.79% in 2005 to 4.00% in 2006. As a result, the net interest margin fell from 4.30% in 2005 to 4.07% in 2006.
In 2007, as short term interest rates remained high for most of the year, and strong competition for deposits in the local market continued, the cost of interest-bearing liabilities rose from 4.00% in 2006 to 4.46%, while the yield on interest-earning assets rose by only five basis points from 7.41% in 2006 to 7.46%. The FOMC began easing rates in September 2007 and the prime lending rate fell to 7.25% by year end. In 2008, as the prime lending rate fell to 3.25% as the FOMC reduced the Federal funds target rate to 2.25% in September 2008 and to a range of 0-0.25% in December 2008, and the Company experienced a significant increase in non-performing loans, the yield on interest-earning assets fell 111 basis points from 7.46% to 6.35%, while the cost of interest-bearing liabilities fell 94 basis points to 3.52%. Tables 1, 2 and 3 provide further information with regard to yields, costs, the changes in net interest income and associated risk.
TABLE 1: AVERAGE BALANCES, INCOME AND EXPENSE, YIELDS AND RATES
The following table shows the average balance sheets for each of the years ended December 31, 2008, 2007, and 2006. In addition, the amounts of interest earned on interest-earning assets, with related yields, and interest expense on interest-bearing liabilities, with related rates, are shown. Loans placed on a non-accrual status are included in the average balances. Net loan fees and late charges included in interest income on loans totaled $5.0 million, $5.5 million and $5.4 million for 2008, 2007, and 2006, respectively.
(1) Yields on securities available-for-sale have been calculated on the basis of historical cost and do not give effect to changes in the fair value of those securities, which are reflected as a component of stockholders equity. Average yields on tax-exempt securities are stated on a tax equivalent basis, using a 35% rate.
TABLE 2: RATE-VOLUME VARIANCE ANALYSIS
Interest income and expense are affected by changes in interest rates, by changes in the volumes of earning assets and interest-bearing liabilities, and by changes in the mix of these assets and liabilities. The following analysis shows the year-to-year changes in the components of net interest income.
Asset/Liability Management and Quantitative and Qualitative Disclosures about Market Risk
In the normal course of business, the Company is exposed to market risk, or interest rate risk, as its net income is largely dependent on its net interest income. Market risk is managed by the Companys Asset/Liability Management Committee that formulates and monitors the performance of the Company based on established levels of market risk as dictated by policy. In setting tolerance levels, or limits on market risk, the Committee considers the impact on earnings and capital, the level and general direction of interest rates, liquidity, local economic conditions and other factors. Interest rate risk, or interest sensitivity, can be defined as the amount of forecasted net interest income that may be gained or lost due to favorable or unfavorable movements in interest rates. Interest rate risk, or sensitivity, arises when the maturity or repricing of interest-earning assets differs from the maturing or repricing of interest-bearing liabilities and as a result of the difference between total interest-earning assets and interest-bearing liabilities. The Company seeks to manage interest rate sensitivity while enhancing net interest income by periodically adjusting this asset/liability position.
One of the tools used by the Company to assess interest sensitivity on a monthly basis is the static gap analysis that measures the cumulative differences between the amounts of assets and liabilities maturing or repricing within various time periods. It is the Companys goal to limit the one-year cumulative difference, or gap, in an attempt to limit changes in future net interest income from changes in market interest rates. A static gap analysis is shown in Table 3 below, and reflects the earlier of the maturity or repricing dates for various assets, including prepayment and amortization estimates, and liabilities as of December 31, 2008. At that point in time, the Company had a cumulative net liability sensitive one-year gap position of $404.5 million, or a negative 15.2% of total interest-earning assets.
This position would generally indicate that over a period of one-year net interest earnings should decrease in a rising interest rate environment as more liabilities would reprice than assets and should increase in a falling interest rate environment. However, this measurement of interest rate risk sensitivity represents a static position as of a single day and is not necessarily indicative of the Companys position at any other point in time, does not take into account the differences in sensitivity of yields and costs on specific assets and liabilities to changes in market rates, and it does not take into account the specific timing of when changes to a specific asset or liability will occur. More accurate measures of interest sensitivity are provided to the Company using earnings simulation models.
TABLE 3: STATIC GAP ANALYSIS
In order to more closely measure interest sensitivity, the Company uses earnings simulation models on a quarterly basis. These models utilize the Companys financial data and various management assumptions as to balance sheet growth, interest rates, operating expenses and other non-interest income sources to forecast a base level of earnings over a one-year period. This base level of earnings is then shocked assuming a 200 basis points higher and lower level of interest rates (but not below zero) over the forecasted period. The most recent earnings simulation model was run based on data as December 31, 2008, and consistent with the Companys belief from its static gap analysis that its balance sheet structure was liability sensitive at that time, the model projected that forecasted net-interest income over a one-year period would decrease by 2.50% if interest rates were to be 200 basis points higher than expected, and forecasted net-interest income would decrease by 0.10% if interest rates were to be 100 basis points lower than expected. As noted above, normally these earnings models are shocked downward 200 basis points; however, as the Federal funds target rate dropped to a range of 0% to 0.25%, the prime lending rate to 3.25%, and treasury yields to historically low levels, a downward shock in rates of that magnitude was not deemed practical, or likely to occur.
Management believes the modeled results are consistent with the short duration of its balance sheet and given the many variables that affect the actual timing of when assets and liabilities will reprice. Since the earnings model uses numerous assumptions regarding the effect of changes in interest rates on the timing and extent of repricing characteristics, future cash flows and customer behavior, the model cannot precisely estimate net income and the effect on net income from sudden changes in interest rates. Actual results will differ from the simulated results due to the timing, magnitude and frequency of interest rate changes and changes in market conditions and management strategies, among other factors.
The Companys non-interest income sources include service charges and other fees on deposit accounts, fees and net gains from loans originated and sold through its mortgage lending division, commissions from non-deposit investment sales and increases in the cash surrender value of Bank owned life insurance policies. Non-interest income decreased $1.5 million in 2008, or 18.4%, from $7.9 million in 2007 to $6.4 million, and increased $560 thousand, or 7.6%, from $7.3 million in 2006, to $7.9 million in 2007. In 2006, non-interest income increased $647 thousand, or 9.7%, from $6.7 million in 2005, to $7.3 million. Of the total decline in non-interest income in 2008, $1.2 million was due to lower fees and net gains on mortgage loans originated for sale. Since 2005, the level of
mortgages originated for sale has declined from $202.3 million to $174.9 million in 2006, to $158.0 million in 2007, and to $80.6 million in 2008 as the Bank began to hold more of its originations in portfolio rather than selling them, due to a reduction in demand and available loan products in the secondary market. As a result, fees and net gains on these sold loans fell from $3.3 million in 2005, to $3.1 million, $2.7 million, and $1.5 million in 2006, 2007 and 2008, respectively.
Service charges and other fees, which include monthly deposit account maintenance charges, overdraft fees, ATM fees and charges, debit card interchange income, safe deposit box rents, merchant discount fee income, and lock-box service fees, increased $514 thousand, or 15.2%, from $3.4 million in 2007, to $3.9 million in 2008. In 2007, service charges and other fees were up $162 thousand, or 5.0%, from $3.2 million to $3.4 million, while in 2006 they were up $673 thousand, or 26.4%. The increase in 2008 was due to a new debit card rewards program that increased debit card interchange income, while the increase in 2006 was due to higher overdraft fees associated with a new overdraft protection program implemented in September 2005.
Non-deposit investment services commissions, which the Bank offers through a third party arrangement, were down $68 thousand in 2008 from $770 thousand in 2007, and were up $149 thousand in 2007 from $621 thousand in 2006. Other income decreased $439 thousand in 2008 to $329 thousand, increased $350 thousand in 2007, and was up $57 thousand in 2006. The majority of this income source is related to $14.2 million in Bank owned life insurance policies, which accounted for most of the $439 thousand decrease in other income in 2008. These polices, which are recorded on the Companys balance sheets under other assets, also accounted for $608 thousand of the $768 thousand in other income in 2007, and $309 thousand of the $418 thousand in other income in 2006. The Company does not anticipate additional purchases of this insurance. Income from Bank owned life insurance is non-taxable.
In 2007, non-interest income results also include a gain on the sale of OREO of $638 thousand and a loss of $387 thousand on the sale of securities related to a partial restructuring of the securities portfolio.
Non-interest expense increased $5.1 million, or 12.8%, from $39.7 million in 2007, to $44.8 million in 2008, increased $5.4 million, or 15.8%, from $34.3 million in 2006 to $39.7 million in 2007, and increased $4.8 million, or 16.4%, from $29.5 million in 2005 to $34.3 million in 2006. Salaries and benefits accounted for $826 thousand, or 16.2%, of the total increase in non-interest expense in 2008, $2.6 million, or 48.6%, in 2007, and $2.6 million, or 53.7% in 2006. Commissions and incentive compensation associated with the significant increases in total loans and the hiring of additional loan officers, together with increased compensation and benefits expense associated with additional employees added due to overall growth and branch expansion were the reasons for the increases in 2006 and 2007, while the much lower increase in 2008 was due to lower commissions and incentive compensation due to lower Company earnings.
Occupancy expenses, which include rents, depreciation, maintenance on buildings, leaseholds and equipment, increased $1.8 million, or 26.0%, from $7.0 million in 2007, to $8.8 million in 2008, and increased $1.6 million, or 29.1%, in 2007. In 2006, occupancy expense was up $969 thousand, or 21.6%. These increases over the three year period were due to the opening of eight new branch locations and expanded office facilities for lending units and other back office support departments.
Other operating expenses, which include advertising and public relations expenses, bank franchise taxes, legal and professional fees, insurance, FDIC insurance, telecommunications, supplies and postage, increased by $2.2 million, or 26.9%, from $8.2 million in 2007, to $10.4 million in 2008, and increased $1.2 million, or 17.4%, from $7.0 million in 2006, to $8.2 million in 2007. In 2006, other operating expenses increased $863 thousand, or 14.1%. The increases over the years are generally due to branch expansion and overall growth, with year-over-year increases in advertising, public relations and bank franchise tax expenses, while in the second quarter of 2007 the Bank, along with all other depository institutions insured by the FDIC, began to pay deposit insurance premiums for the first time since the mid 1990s. Those premiums are expected to rise significantly in 2009. See Regulation, Supervision and Governmental Policy Deposit Insurance Premiums at page 70.
The Companys income tax provisions are adjusted for non-deductible expenses and non-taxable interest after applying the U.S. federal income tax rate of 35%. The provision for income taxes totaled $6.2 million, $13.2 million
and $12.9 million, for the years ended December 31, 2008, 2007 and 2006, respectively. The effects of non-deductible expenses and non-taxable interest on the Companys income tax provisions are minimal. For further information regarding the provisions for income taxes see Note 8 to the Consolidated Financial Statements.
Asset Quality - Provision and Allowance For Loan Losses
The provision for loan losses is based upon managements estimate of the amount required to maintain an adequate allowance for loan losses reflective of the risks in the loan portfolio. In 2008, net charge-offs totaled $11.2 million compared to $181 thousand and $126 thousand in 2007 and 2006, respectively. The provision for loan loss expense in 2008 was $25.4 million compared to $4.3 million in 2007, and $4.4 million in 2006. As a result, the total allowance for loan losses increased $14.2 million, or 63.9%, from $22.3 million at December 31, 2007, to $36.5 million at December 31, 2008, increased $4.2 million, or 23.0%, in 2007, and increased 31.0% in 2006. These increases in the total allowance for loan losses for 2006 and 2007 were consistent with an 18.1% increase in loans in 2007, and a 28.3% increase in 2006, as net-charge offs were minimal and the level of non-performing assets and loans 90 + days past due were very low. In 2008, while some of the increase in the allowance was associated with overall loan growth, the most significant factor was a $120.5 million increase in non-performing assets and loans 90 + days past due from $4.4 million at December 31, 2007, to $124.9 million at December 31, 2008. In addition, other identified potential problem loans, which are classified as impaired loans, although well-secured and currently performing, but in some instances requiring higher reserve levels, rose from $11.6 million at December 31, 2006, to $15.4 million at December 31, 2007, and to $49.3 million at December 31, 2008. The allowance has also increased as a percent of total loans from 1.10% at December 31, 2006, to 1.14% as of December 31, 2007, and to 1.58% as of December 31, 2008. See Risk Elements and Non-Performing Assets later in this discussion for more information on non-performing assets and loans 90 + days past due and other impaired loans.
Management feels that the allowance for loan losses is adequate at December 31, 2008. However, there can be no assurance that additional provisions for loan losses will not be required in the future, including as a result of possible changes in the economic assumptions underlying managements estimates and judgments, adverse developments in the economy, and the residential real estate market in particular, on a national basis or in the Companys market area, or changes in the circumstances of particular borrowers. In 2009, Management intends to pursue more aggressive strategies for problem loan resolution and is committed to utilize earnings to the maximum extent necessary to bolster loan loss reserves to levels sufficient to absorb losses recognized in the pursuit of this strategy. The Companys increased capital level gives it the added safety cushion to do so.
The Company generates a quarterly analysis of the allowance for loan losses, with the objective of quantifying portfolio risk into a dollar figure of inherent losses, thereby translating the subjective risk value into an objective number. Emphasis is placed on semi-annual independent external loan reviews and monthly internal reviews. The determination of the allowance for loan losses is based on applying and summing the results of eight qualitative factors and one quantitative factor to each category of loans along with any specific allowance for impaired loans within the particular category. Each factor is assigned a percentage weight and that total weight is applied to each loan category. The resulting sum from each loan category is then combined to arrive at a total allowance for all categories. Factors are different for each loan category. Qualitative factors include: levels and trends in delinquencies and non-accruals, trends in volumes and terms of loans, effects of any changes in lending policies, the experience, ability and depth of management, national and local economic trends and conditions, concentrations of credit, quality of the Companys loan review system, and regulatory requirements. The total allowance required thus changes as the percentage weight assigned to each factor is increased or decreased due to its particular circumstance, as the various types and categories of loans change as a percentage of total loans and as specific allowances are required due to an increase in impaired loans. For further information regarding the allowance for loan losses see Notes 1 and 4 to the Consolidated Financial Statements.
TABLE 4: PROVISION AND ALLOWANCE FOR LOAN LOSSES
TABLE 5: ALLOCATION OF ALLOWANCE FOR LOAN LOSSES
The allowance for loan losses includes specific allowances for impaired loans and a general allowance applicable to all loan categories; however, management has allocated the allowance to provide an indication of the relative risk characteristics of the loan portfolio. The allocation is an estimate and should not be interpreted as an indication that charge-offs will occur in these amounts, or that the allocation indicates future trends. The allocation of the allowance at December 31 for the years indicated and the ratio of related outstanding loan balances to total loans are as follows:
See Notes 1 and 4 to the Consolidated Financial Statements for additional information regarding the provision and allowance for loan losses.
Risk Elements and Non-Performing Assets
Non-performing assets consist of non-accrual loans, restructured loans, and other real estate owned (foreclosed properties). The total non-performing assets and loans that are 90 + days past due and still accruing interest increased by $120.5 million, or 2,738.6%, from $4.4 million at year-end 2007 to $124.9 million at year-end 2008,
and increased by $485 thousand, or 12.4%, from $3.9 million at year-end 2006. As a result, the level of non-performing assets and loans 90 + days past due to total assets was down slightly from .20% at December 31, 2006, to .19% at December 31, 2007, and rose significantly to 4.60% at December 31, 2008.
Non-performing loans continue to be concentrated in residential and commercial construction and land development loans in the Companys outer sub-markets hardest hit by the residential downturn and commercial and consumer credits experiencing the after shocks in sub-contracting businesses and workforce employment. Overall, as of December 31, 2008, $105.7 million or 66% of non-performing loans and other impaired loans represented construction and land development and another $18.2 million, or 11.4%, represented commercial or other loans which are also housing related. Other sectors, including non-farm, non-residential real estate and inner sub-markets of the broader loan portfolio, continue to perform well, with low levels of delinquencies at the present time. Management is focused on risk identification and mitigation activities within the impacted portfolio segments and sub-markets and is prudently establishing specific reserves where warranted, based upon a current market value analysis of the underlying collateral. The market decline remains dynamic. As non-performing loans are addressed, charge-offs for 2009 are anticipated to be at least 0.50% of average loans outstanding. With problem loan trends in the residential and commercial construction portfolio, non-performing assets could prospectively rise above 5.0% of total assets by year-end. See Notes 1 and 4 to the Consolidated Financial Statements for additional information regarding the Companys non-performing assets. Tables 6 and 7 provide a breakdown of the construction loan portfolio by location including loans on non-accrual status and percentage of net-charge offs in 2008.
TABLE 6: RESIDENTIAL, ACQUISITION, DEVELOPMENT AND CONSTRUCTION LOANS
TABLE 7: COMMERCIAL, ACQUISITION, DEVELOPMENT AND CONSTRUCTION LOANS
Loans are placed in non-accrual status when in the opinion of management the collection of additional interest is unlikely or a specific loan meets the criteria for non-accrual status established by regulatory authorities. No interest
is taken into income on non-accrual loans. A loan remains on non-accrual status until the loan is current as to both principal and interest or the borrower demonstrates the ability to pay and remain current, or both.
Foreclosed real properties include properties that have been substantively repossessed or acquired in complete or partial satisfaction of debt. Such properties, which are held for resale, are carried at the lower of cost or fair value, including a reduction for the estimated selling expenses, or principal balance of the related loan. In July 2007, the Company foreclosed on a $1.8 million non-performing loan and subsequently sold the collateral property in September 2007 for a pre-tax gain of $638 thousand. As of December 31, 2008, the Company held $7.6 million in foreclosed real properties.
TABLE 8: NON-PERFORMING ASSETS
The Banks lending activities are its principal source of income. Real estate loans, including residential permanents and construction, and commercial permanents, represent the major portion of the Banks loan portfolio. Loans, net of unearned income and the allowance for loan losses, increased $348.3 million, or 18.1%, from $1.92 billion at December 31, 2007, to $2.27 billion at December 31, 2008, and increased $294.9 million, or 18.1%, from $1.63 billion at December 31, 2006, to $1.92 billion at year-end 2007. The increase in loans in 2008 included an increase in real estate mortgage loans of $276.4 million, or 23.9%, an increase in commercial loans of $40.8 million, or 17.1%, and an increase in real estate construction loans of $40.8 million, or 7.5%. In 2007, real estate mortgage loans increased $218.6 million, or 23.2%, while commercial loans represented the second largest increase rising $48.2 million, or 25.3%, and real estate construction loans increased $29.3 million, or 5.7%. The majority of the increase in real estate mortgage loans is concentrated in non-farm non-residential properties, which has been a primary focus of the Bank since its organization, while the increase in real estate construction loans in 2007 and 2008 was attributable to commercial properties. At December 31, 2008, $296.3 million of total real estate construction loans were to commercial builders of single-family housing, $20.7 million were to individuals on single-family properties and $268.1 million were related to commercial properties. At December 31, 2007, $302.4 million of real estate construction loans were to commercial builders of single-family housing, $23.6 million were to individuals on single-family properties and $218.3 million were related to commercial properties. The Bank expects that its real estate construction loan portfolio will begin to decline as that lending focus is significantly curtailed.
As noted above, the majority of the Banks loan portfolio consists of construction and commercial real estate loans. At December 31, 2008, the Bank had $296.3 million of construction loans to commercial builders of single family housing in the Northern Virginia market, representing 9.2% of total loans. These loans are made to a number of unrelated entities and generally have a term of twelve to eighteen months. Adverse developments in the Northern Virginia real estate market and economy have adversely impacted this portfolio of loans and the Companys income and financial position. In addition, the Bank had $1.01 billion, or 43.7% of the loan portfolio at December 31, 2008, secured by non-farm non-residential properties with $418.4 million of these loans representing owner-occupied properties. All these non-farm non-residential loans represent obligations of a diversified pool of borrowers across numerous businesses and industries in the Northern Virginia market and include some loans that, although secured by commercial real estate, are commercial purpose loans made based on the financial condition of the underlying
business. At December 31, 2008, the Company had no other concentrations of loans in any one industry exceeding 10% of its total loan portfolio. An industry for this purpose is defined as a group of counterparties that are engaged in similar activities and have similar economic characteristics that would cause their ability to meet contractual obligations to be similarly affected by changes in economic or other conditions. The Bank seeks to manage its concentrations of loans through the establishment of limits on the level of its various loan types to total loans and to total capital. For further information regarding concentrations of loans see Note 17 to the Consolidated Financial Statements.
Under guidance from the federal banking regulators, banks which have concentrations in construction, land development or commercial real estate loans would be expected to maintain higher levels of risk management and, potentially, higher levels of capital. It is possible that we may be required to maintain higher levels of capital than we would otherwise be expected to maintain as a result of our levels of construction, development and commercial real estate loans, which may require us to obtain additional capital. Excluded from the scope of this guidance are loans secured by non-farm nonresidential properties where the primary source of repayment is the cash flow from the ongoing operations and activities conducted by the party, or affiliate of the party, who owns the property
Tables 9 and 10 present information pertaining to the composition of the loan portfolio including unearned income, the allowance for loan losses, and the maturity and repricing characteristics of selected loans.
TABLE 9: SUMMARY OF TOTAL LOANS
TABLE 10: MATURITY/REPRICING SCHEDULE OF TOTAL LOANS