UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
For the quarterly period ended June 30, 2009
For the transition period from to
Commission File Number 000-23423
C&F Financial Corporation
(Exact name of registrant as specified in its charter)
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
802 Main Street West Point, VA 23181
(Address of principal executive offices) (Zip Code)
(804) 843-2360
(Registrant’s telephone number, including area code)
N/A
(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 file such reports), and (2) has been subject to such filing requirements for the past 90 days. x Yes ¨ 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, 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 x No
At August 5, 2009, the latest practicable date for determination, 3,043,741 shares of common stock, $1.00 par value, of the registrant were outstanding.
TABLE OF CONTENTS
Part I - Financial Information
Item 1.
Item 2.
Item 3.
Item 4.
Part II - Other Information
Item 1A.
Item 6.
Signatures
PART I - FINANCIAL INFORMATION
CONSOLIDATED BALANCE SHEETS
(In thousands, except for share and per share amounts)
ASSETS
Cash and due from banks
Interest-earning deposits in other banks
Total cash and cash equivalents
Securities-available for sale at fair value, amortized cost of $110,755 and $100,778, respectively
Loans held for sale, net
Loans, net of allowance for loan losses of $21,532 and $19,806, respectively
Federal Home Loan Bank stock
Corporate premises and equipment, net
Other real estate owned
Accrued interest receivable
Goodwill
Other assets
Total assets
LIABILITIES AND SHAREHOLDERS’ EQUITY
Deposits
Noninterest-bearing demand deposits
Savings and interest-bearing demand deposits
Time deposits
Total deposits
Short-term borrowings
Long-term borrowings
Trust preferred capital notes
Accrued interest payable
Other liabilities
Total liabilities
Commitments and contingent liabilities
Shareholders’ equity
Preferred stock ($1.00 par value, 3,000,000 shares authorized, 20,000 and 0 issued and outstanding, respectively)
Common stock ($1.00 par value, 8,000,000 shares authorized, 3,043,741 and 3,037,441 shares issued and outstanding, respectively)
Additional paid-in capital
Retained earnings
Warrant to purchase common stock
Discount on preferred stock
Accumulated other comprehensive loss, net
Total shareholders’ equity
Total liabilities and shareholders’ equity
The accompanying notes are an integral part of the consolidated financial statements.
1
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
Interest income
Interest and fees on loans
Interest on money market investments
Interest and dividends on securities
U.S. government agencies and corporations
Tax-exempt obligations of states and political subdivisions
Corporate bonds and other
Total interest income
Interest expense
Savings and interest-bearing deposits
Certificates of deposit, $100 or more
Other time deposits
Borrowings
Total interest expense
Net interest income
Provision for loan losses
Net interest income after provision for loan losses
Noninterest income
Gains on sales of loans
Service charges on deposit accounts
Other service charges and fees
Gains on calls of available for sale securities
Other income
Total noninterest income
Noninterest expenses
Salaries and employee benefits
Occupancy expenses
Other expenses
Total noninterest expenses
Income before income taxes
Income tax expense
Net income
Effective dividends on preferred stock
Net income available to common shareholders
Per common share data
Net income – basic
Net income – assuming dilution
Cash dividends declared
Weighted average number of shares – basic
Weighted average number of shares – assuming dilution
2
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
(In thousands)
December 31, 2008
Comprehensive income:
Other comprehensive income, net of tax
Changes in defined benefit plan assets and benefit obligations, net of tax
Unrealized gains on securities, net of reclassification adjustment
Comprehensive income
Issuance of preferred stock
Amortization of preferred stock discount
Share-based compensation
Cash dividends:
Preferred stock
Common stock
June 30, 2009
Disclosure of Reclassification Amount:
Unrealized net holding gains arising during period, net of tax
Less: reclassification adjustment for gains included in net income, net of tax
3
December 31, 2007
Other comprehensive income, net of tax:
Unrealized loss on securities, net of reclassification adjustment
Purchase of common stock
Stock options exercised
Cash dividends
June 30, 2008
Unrealized net holding losses arising during period, net of tax
Unrealized losses on securities, net of reclassification adjustment
4
CONSOLIDATED STATEMENTS OF CASH FLOWS
Operating activities:
Adjustments to reconcile net income to net cash (used in) provided by operating activities:
Depreciation
Amortization of prepaid pension transition costs
Accretion of discounts and amortization of premiums on investment securities, net
Net realized gain on securities
Proceeds from sales of loans
Origination of loans held for sale
Gain on sales of corporate premises and equipment
Change in other assets and liabilities:
Net cash (used in) provided by operating activities
Investing activities:
Proceeds from maturities and calls of securities available for sale
Purchases of securities available for sale
Net redemptions (purchases) of Federal Home
Loan Bank stock
Net increase in customer loans
Purchases of corporate premises and equipment
Disposals of corporate premises and equipment
Net cash used in investing activities
Financing activities:
Net increase in demand, interest-bearing demand and savings deposits
Net increase in time deposits
Net (decrease) increase in borrowings
Proceeds from exercise of stock options
Net proceeds from issuance of preferred stock
Net cash provided by financing activities
Net increase in cash and cash equivalents
Cash and cash equivalents at beginning of period
Cash and cash equivalents at end of period
Supplemental disclosure
Interest paid
Income taxes paid
Supplemental disclosure of noncash investing activities and financing activities
Unrealized gains (losses) on securities available for sale
Loans transferred to other real estate owned
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1
The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial reporting and with applicable quarterly reporting regulations of the Securities and Exchange Commission (the “SEC”). They do not include all of the information and notes required by accounting principles generally accepted in the United States of America for complete financial statements. Therefore, these consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the C&F Financial Corporation Annual Report on Form 10-K for the year ended December 31, 2008.
In the opinion of C&F Financial Corporation’s management, all adjustments, consisting only of normal recurring accruals, necessary to present fairly the financial position as of June 30, 2009, the results of operations for the three and six months ended June 30, 2009 and 2008, and cash flows for the six months ended June 30, 2009 and 2008 have been made. The results of operations for the interim periods are not necessarily indicative of the results to be expected for the full year.
The consolidated financial statements include the accounts of C&F Financial Corporation (the “Corporation”) and its subsidiary, Citizens and Farmers Bank (the “Bank”), with all significant intercompany transactions and accounts being eliminated in consolidation. In addition, the Corporation owns C&F Financial Statutory Trust I and C&F Financial Statutory Trust II, which are unconsolidated subsidiaries. The subordinated debt owed to these trusts is reported as a liability of the Corporation.
Share-Based Compensation: Compensation expense for the second quarter and first six months of 2009 included $80,000 ($49,000 after tax) and $160,000 ($99,000 after tax), respectively, for restricted stock granted during 2006 through 2009. Compensation expense for the second quarter and first six months of 2008 included $79,000 ($49,000 after tax) and $156,000 ($97,000 after tax), respectively, for options and restricted stock granted during 2006 through 2008. As of June 30, 2009, there was $958,000 of total unrecognized compensation expense related to unvested restricted stock that will be recognized over the remaining requisite service periods.
Stock option activity for the six months ended June 30, 2009 is summarized below:
Options outstanding, January 1, 2009
Expired
Options exercisable at June 30, 2009
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Note 2
On January 9, 2009, as part of the Capital Purchase Program (“Capital Purchase Program”) established by the U.S. Department of the Treasury (“Treasury”) under the Emergency Economic Stabilization Act of 2008 (“EESA”), the Corporation issued and sold to Treasury for an aggregate purchase price of $20.0 million in cash (1) 20,000 shares of the Corporation’s fixed rate cumulative perpetual preferred stock, Series A, par value $1.00 per share, having a liquidation preference of $1,000 per share (“Series A Preferred Stock”) and (2) a ten-year warrant to purchase up to 167,504 shares of the Corporation’s common stock, par value $1.00 per share (“Common Stock”), at an initial exercise price of $17.91 per share (“Warrant”). The Series A Preferred Stock may be treated as Tier 1 capital for regulatory capital adequacy determination purposes.
Cumulative dividends on the Series A Preferred Stock will accrue on the liquidation preference at a rate of 5% per annum for the first five years, and at a rate of 9% per annum thereafter. The Series A Preferred Stock has no maturity date and ranks senior to the Common Stock with respect to the payment of dividends. Under the terms of the certificate of designations of the Series A Preferred Stock in the Corporation’s articles of incorporation, the Corporation may redeem the Series A Preferred Stock at 100% of its liquidation preference (plus any accrued and unpaid dividends) beginning on February 15, 2012. Prior to this date, the Corporation may redeem the Series A Preferred Stock at 100% of its liquidation preference (plus any accrued and unpaid dividends) if (i) the Corporation has raised aggregate gross proceeds in one or more “qualified equity offerings” of at least $5.0 million, and (ii) the aggregate redemption price does not exceed the aggregate net proceeds from such qualified equity offerings. The phrase “qualified equity offering” means the sale and issuance for cash by the Corporation, to persons other than the Corporation or any Corporation subsidiary after January 9, 2009, of shares of perpetual preferred stock, Common Stock or any combination of such stock, that, in each case, qualify as and may be included in Tier 1 capital of the Corporation at the time of issuance under the applicable risk-based capital guidelines of the Federal Deposit Insurance Corporation (“FDIC”) (other than any such sales and issuances made pursuant to agreements or arrangements entered into, or pursuant to financing plans which were publicly announced, on or prior to October 13, 2008). However, the American Recovery and Reinvestment Act of 2009 (“ARRA”) appears to change these provisions to provide that the Corporation may redeem the Series A Preferred Stock at any time, at its option, from any source of funds. Any such redemption would be at 100% of the Series A Preferred Stock liquidation preference, plus any accrued and unpaid dividends. In either event, any redemption is subject to the consent of the FDIC.
The purchase agreement pursuant to which the Series A Preferred Stock and the Warrant were sold contains limitations on the payment of dividends or distributions on the Common Stock (including the payment of cash dividends in excess of the amount per share of the Corporation’s last quarterly cash dividend declared before October 14, 2008, which was 31 cents per share and on the Corporation’s ability to repurchase, redeem or acquire its Common Stock or other securities, and subjects the Corporation to certain of the executive compensation limitations included in the EESA, as amended by the ARRA, until such time as Treasury no longer owns any Series A Preferred Stock acquired through the Capital Purchase Program. Accordingly, the Corporation purchased no shares of Common Stock during the first six months of 2009. During the first six months of 2008, the Corporation purchased 600 shares of Common Stock in open-market transactions at prices from $28.80 to $31.06 per share.
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Note 3
The Corporation calculates its basic and diluted earnings per common share (“EPS”) in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 128, Earnings Per Share. The components of the Corporation’s EPS calculations for the three and six months ended June 30, 2009 and 2008 are as follows:
Accumulated dividends on Series A Preferred Stock
Amortization of Series A Preferred Stock discount
Weighted average number of common shares used in earnings per common share—basic
Effect of dilutive securities:
Stock option awards
Weighted average number of common shares used in earnings per common share—assuming dilution
In June 2008, the Financial Accounting Standards Board (“FASB”) finalized FASB Staff Position (“FSP”) No. EITF 03-6-1, Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities. FSP EITF 03-6-1 affects entities that accrue cash dividends on share-based payment awards during the awards’ service period when the dividends do not need to be returned if the employees forfeit the awards. The FASB concluded that all outstanding unvested share-based payment awards that contain rights to nonforfeitable dividends participate in undistributed earnings with common shareholders. Because the awards are considered participating securities, the issuing entity is required to apply the two-class method of computing basic and diluted EPS. The transition guidance in FSP EITF 03-6-1 requires an entity to retroactively adjust all prior-period EPS computations to reflect the FSP’s provisions. The retroactive adjustments encompass EPS computations included in interim financial statements. The Corporation adopted FSP EITF 03-6-1 effective January 1, 2009, and has applied its provisions to its EPS calculations for the three and six months ended June 30, 2009 and 2008 because the Corporation’s unvested restricted shares outstanding contain rights to nonforfeitable dividends. Accordingly, the weighted average number of common shares used in the calculation of basic and diluted EPS includes both vested and unvested common shares outstanding. The retroactive adjustments made to the EPS computations resulted in reductions of $0.01 in diluted EPS for the three months ended June 30, 2008 and $0.01 in both basic and diluted EPS for the six months ended June 30, 2008.
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EPS, assuming dilution, has been calculated on the basis of the weighted average number of shares of common stock and common stock equivalents outstanding for the applicable periods. Potentially-dilutive common stock had no effect on net income available to common shareholders.
Note 4
Debt and equity securities are summarized as follows:
Available for Sale
Mortgage-backed securities
Obligations of states and political subdivisions
The amortized cost and estimated fair value of securities at June 30, 2009, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to prepay obligations with or without call or prepayment penalties.
Due in one year or less
Due after one year through five years
Due after five years through ten years
Due after ten years
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Proceeds from the maturities and calls of securities available for sale for the first six months of 2009 were $15.0 million, resulting in gross realized gains of $30,000. Securities with an aggregate amortized cost of $41.4 million and an aggregate fair value of $41.6 million were pledged at June 30, 2009 to secure public deposits, repurchase agreements, Federal Reserve Bank treasury, tax and loan deposits and borrowings from the Federal Reserve Bank.
Securities in an unrealized loss position at June 30, 2009, by duration of the period of the unrealized loss, are shown below.
Subtotal-debt securities
Total temporarily impaired securities
There are 146 debt securities and seven equity securities totaling $45.4 million and $829,000, respectively, in a loss position at June 30, 2009. The primary cause of the temporary impairments in the Corporation’s investments in debt securities was fluctuations in interest rates. Because the Corporation intends to hold these investments to maturity and it is more likely than not that the Corporation will not be required to sell these investments before a recovery of unrealized losses, the Corporation does not consider these investments to be other-than-temporarily impaired at June 30, 2009 and no impairment has been recognized. In April 2009, the FASB issued FSP Financial Accounting Standards (“FAS”) 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments. FSP FAS 115-2 and FAS 124-2 amends other-than-temporary impairment guidance for debt securities to make the guidance more operational and to improve the presentation and disclosure of other-than-temporary impairments on debt and equity securities. The FSP does not amend existing recognition and measurement guidance related to other-than-temporary impairments of equity securities. FSP FAS 115-2 and FAS 124-2 became effective for interim and annual periods ending after June 15, 2009. The adoption of FSP FAS 115-2 and FAS 124-2 did not have a material effect on the Corporation’s consolidated financial statements.
Securities in an unrealized loss position at December 31, 2008, by duration of the period of the unrealized loss, are shown below.
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The Corporation’s investment in Federal Home Loan Bank (“FHLB”) stock totaled $3.9 million at June 30, 2009. FHLB stock is generally viewed as a long-term investment and as a restricted investment security, which is carried at cost, because there is no market for the stock, other than the FHLBs or member institutions. Therefore, when evaluating FHLB stock for impairment, its value is based on the ultimate recoverability of the par value rather than by recognizing temporary declines in value. Despite the FHLB’s temporary suspension of cash dividend payments and repurchases of excess capital stock in 2009, the Corporation does not consider this investment to be other-than-temporarily impaired at June 30, 2009 and no impairment has been recognized.
Note 5
The Bank has a non-contributory defined benefit plan for which the components of net periodic benefit cost are as follows:
Service cost
Interest cost
Expected return on plan assets
Amortization of net obligation at transition
Amortization of prior service cost
Amortization of net loss
Net periodic benefit cost
The Bank made a $1.0 million contribution to this plan in the first quarter of 2009.
Note 6
The Corporation operates in a decentralized fashion in three principal business segments: Retail Banking, Mortgage Banking and Consumer Finance. Revenues from Retail Banking operations consist primarily of interest earned on loans and investment securities and service charges on deposit accounts. Mortgage Banking operating revenues consist principally of gains on sales of loans in the secondary market, loan origination fee income and interest earned on mortgage loans held for sale. Revenues from Consumer Finance consist primarily of interest earned on automobile retail installment sales contracts.
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The Corporation’s other segments include an investment company that derives revenues from brokerage services, an insurance company that derives revenues from insurance services, and a title company that derives revenues from title insurance services. The results of these other segments are not significant to the Corporation as a whole and have been included in “Other.” Revenue and expenses of the Corporation are also included in “Other,” and consist primarily of dividends received on the Corporation’s investment in equity securities and interest expense associated with the Corporation’s trust preferred capital notes.
Revenues:
Other
Total operating income
Expenses:
Personnel expenses
Total operating expenses
Income (loss) before income taxes
Provision for (benefit from) income taxes
Net income (loss)
Capital expenditures
12
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The Retail Banking segment extends a warehouse line of credit to the Mortgage Banking segment, providing a portion of the funds needed to originate mortgage loans. The Retail Banking segment charges the Mortgage Banking segment interest at the daily FHLB advance rate plus 50 basis points. The Retail Banking segment also provides the Consumer Finance segment with a portion of the funds needed to originate loans by means of a variable rate line of credit that carries interest at one-month LIBOR plus 175 basis points and fixed rate loans that carry interest rates ranging from 5.4 percent to 8.0 percent. The Retail Banking segment acquires certain residential real estate loans from the Mortgage Banking segment at prices similar to those paid by third-party investors. These transactions are eliminated to reach consolidated totals. Certain corporate overhead costs incurred by the Retail Banking segment are not allocated to the Mortgage Banking, Consumer Finance and Other segments.
Note 7
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements. SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (“GAAP”), and expands disclosures about fair value measurements. SFAS 157 does not require any new fair value measurements, but rather, provides enhanced guidance to other pronouncements that require or permit assets or liabilities to be measured at fair value. The Corporation adopted SFAS 157 on January 1, 2008. The FASB approved a one-year deferral for the implementation of SFAS 157 for nonfinancial assets and liabilities that are recognized or disclosed at fair value in the financial statements on a nonrecurring basis. The Corporation adopted the provisions of SFAS 157 for nonfinancial assets and liabilities as of January 1, 2009 without a material effect on its consolidated financial statements.
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In April 2009, the FASB issued FSP FAS 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly. FSP FAS 157-4 provides additional guidance for estimating fair value in accordance with SFAS 157 when the volume and level of activity for the asset or liability have significantly decreased. The FSP also includes guidance on identifying circumstances that indicate a transaction is not orderly. FSP FAS 157-4 became effective for interim and annual periods ending after June 15, 2009, and shall be applied prospectively. The adoption of FSP FAS 157-4 did not have a material effect on the Corporation’s consolidated financial statements.
The fair value hierarchy under SFAS 157 is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date, and prioritizes the inputs to valuation techniques used to measure fair value in three broad levels (Level 1, Level 2 and Level 3). Level 1 inputs are unadjusted quoted prices in active markets (as defined) for identical assets or liabilities that the reporting entity has the ability to access at the measurement date. Level 2 inputs are inputs that include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument. Level 3 inputs are unobservable inputs for the asset or liability and reflect the reporting entity’s own assumptions regarding the inputs that market participants would use in pricing the asset or liability.
The following describes the valuation techniques used by the Corporation to measure certain financial assets recorded at fair value on a recurring basis in the financial statements.
Securities Available for Sale: Securities available for sale are recorded at fair value on a recurring basis. Where quoted prices are available in an active market, securities are classified as Level 1 of the valuation hierarchy. Level 1 securities would include highly liquid government bonds, mortgage products and exchange-traded equities. If quoted market prices are not available, then fair values are estimated by using pricing models, quoted prices of securities with similar characteristics, or discounted cash flow and are classified within Level 2 of the valuation hierarchy. Level 2 securities would include U.S. agency securities, mortgage-backed agency securities, obligations of states and political subdivisions and certain corporate, asset-backed and other securities. In certain cases where there is limited activity or less transparency around inputs to the valuation, securities are classified within Level 3 of the valuation hierarchy.
The following table presents the balances of financial assets measured at fair value on a recurring basis at June 30, 2009. There were no liabilities measured at fair value on a recurring basis at June 30, 2009.
Securities available for sale
Certain financial assets are measured at fair value on a nonrecurring basis in accordance with GAAP. Adjustments to the fair value of these assets usually result from the application of lower-of-cost-or-market accounting or write-downs of individual assets. The following describes the valuation techniques used by the Corporation to measure certain financial assets recorded at fair value on a nonrecurring basis in the financial statements.
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Loans Held for Sale: Loans held for sale are required to be measured at the lower of cost or fair value. These loans currently consist of residential loans originated for sale in the secondary market. Fair value is based on the price secondary markets are currently offering for similar loans using observable market data, which is not materially different than cost due to the short duration between origination and sale (Level 2). As such, the Corporation records any fair value adjustments on a nonrecurring basis. No nonrecurring fair value adjustments were recorded on loans held for sale during the three or six months ended June 30, 2009.
Impaired Loans: SFAS 157 applies to loans measured for impairment using the practical expedients permitted by SFAS No. 114, Accounting by Creditors for Impairment of a Loan, including impaired loans measured at an observable market price (if available), or at the fair value of the loan’s collateral (if the loan is collateral dependent). Collateral may be in the form of real estate or business assets including equipment, inventory and accounts receivable. A significant portion of the collateral securing the Corporation’s impaired loans is real estate. The fair value of real estate collateral is determined utilizing an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the Corporation using observable market date (Level 2). However, if an appraisal of the real estate property is over two years old, then the fair value is considered Level 3. The value of business equipment is based upon an outside appraisal if deemed significant, or the net book value on the applicable business’s financial statements if not considered significant using observable market data. Likewise, values for inventory and accounts receivable collateral are based on financial statement balances or aging reports (Level 3).
Other Real Estate Owned: Other real estate owned (“OREO”) is measured at fair value based on an appraisal conducted by an independent, licensed appraiser outside of the Corporation using observable market date (Level 2). However, if an appraisal of the real estate property is over two years old, then the fair value is considered Level 3.
The following table summarizes the Company’s financial assets that were measured at fair value on a nonrecurring basis during the three months ended June 30, 2009:
Impaired loans
OREO
Total
In April 2009, the FASB issued FSP FAS 107-1 and Accounting Principles Board (“APB”) Opinion 28-1, Interim Disclosures about Fair Value of Financial Instruments. FSP FAS 107-1 and APB 28-1 amend SFAS No. 107, Disclosures about Fair Value of Financial Instruments, to require disclosures about fair value of financial instruments for interim reporting periods of publicly traded companies as well as in annual financial statements. In addition, the FSP amends APB Opinion No. 28, Interim Financial Reporting, to require those disclosures in summarized financial information at interim reporting periods. The FSP became effective for interim periods ending after June 15, 2009, and the Corporation’s disclosures are presented below. The following describes the valuation
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techniques used by the Corporation to measure certain financial assets and financial liabilities not previously described elsewhere in this note that are not recorded at fair value on a recurring basis in the financial statements:
Cash and short-term investments. The nature of these instruments and their relatively short maturities provide for the reporting of fair value equal to the historical cost.
Loans. The estimated fair value of the loan portfolio is based on present values using discount rates equal to the market rates currently charged on similar products.
Deposits and borrowings. The fair value of all demand deposit accounts is the amount payable at the report date. For all other deposits and borrowings, the fair value is determined using the discounted cash flow method. The discount rate was equal to the rate currently offered on similar products.
Accrued interest. The carrying amount of accrued interest approximates fair value.
Letters of credit. The estimated fair value of letters of credit is based on estimated fees the Corporation would pay to have another entity assume its obligation under the outstanding arrangements. These fees are not considered material.
Unused portions of lines of credit. The estimated fair value of unused portions of lines of credit is based on estimated fees the Corporation would pay to have another entity assume its obligation under the outstanding arrangements. These fees are not considered material.
(in 000’s)
Financial assets:
Cash and short-term investments
Securities
Net loans
Financial liabilities:
Demand deposits
The Corporation assumes interest rate risk (the risk that general interest rate levels will change) as part of its normal operations. As a result, the fair values of the Corporation’s financial instruments will change when interest rate levels change and that change may be either favorable or unfavorable to the Corporation. Management attempts to match maturities of assets and liabilities to the extent believed necessary to balance minimizing interest rate risk and increasing net interest income in current market conditions. However, borrowers with fixed rate obligations are less likely to prepay in a rising rate environment and more likely to prepay in a falling rate environment. Conversely, depositors who are receiving fixed rates are more likely to withdraw funds before maturity in a rising rate environment and less likely to do so in a falling rate environment. Management monitors rates, maturities and repricing dates of assets and liabilities and attempts to manage interest rate risk by adjusting terms of new loans, deposits and borrowings and by investing in securities with terms that mitigate the Corporation’s overall interest rate risk.
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Note 8
In April 2009, the FASB issued FSP FAS 141(R)-1, Accounting for Assets Acquired and Liabilities Assumed in a Business Combination That Arise from Contingencies. FSP FAS 141(R)-1 amends and clarifies SFAS 141(R) to address application issues on initial recognition and measurement, subsequent measurement and accounting, and disclosure of assets and liabilities arising from contingencies in a business combination. The FSP is effective for assets and liabilities arising from contingencies in business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. The adoption of FSP FAS 141(R)-1 did not have a material effect on the Corporation’s consolidated financial statements.
In April 2009, the SEC issued Staff Accounting Bulletin (“SAB”) No. 111, which amends and replaces SAB Topic 5.M. in the SAB Series entitled “Other Than Temporary Impairment of Certain Investments in Debt and Equity Securities.” SAB 111 maintains the SEC Staff’s previous views related to equity securities and amends SAB Topic 5.M. to exclude debt securities from its scope. The implementation of SAB 111 did not have a material effect on the Corporation’s consolidated financial statements.
In May 2009, the FASB issued SFAS No. 165, Subsequent Events. SFAS 165 establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. SFAS 165 became effective for interim and annual periods ending after June 15, 2009. The adoption of SFAS 165 did not have a material effect on the Corporation’s consolidated financial statements.
In June 2009, the FASB issued SFAS No. 166,Accounting for Transfers of Financial Assets – an Amendment of FASB Statement No. 140. SFAS 166 provides guidance to improve the relevance, representational 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 transferor’s continuing involvement, if any, in transferred financial assets. SFAS 166 must be applied as of the beginning of the first annual reporting period that begins after November 15, 2009 and for interim periods within that first annual reporting period. Earlier application is prohibited. The Corporation does not expect the adoption of SFAS 166 to have a material effect on its consolidated financial statements.
In June 2009, the FASB issued SFAS No. 167, Amendments to FASB Interpretation No. 46(R). SFAS 167 improves financial reporting by enterprises involved with variable interest entities. SFAS 167 will be effective as of the first annual reporting period that begins after November 15, 2009 and for interim periods within that first annual reporting period. Earlier application is prohibited. The Corporation does not expect the adoption of SFAS 166 to have a material effect on its consolidated financial statements.
In June 2009, the FASB issued SFAS No. 168, The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles – a Replacement of FASB Statement No. 162. SFAS 168 establishes the FASB Accounting Standards Codification (“Codification”), which will become the source of authoritative U.S. GAAP recognized by the FASB to be applied by nongovernmental entities. Rules and interpretive releases of the SEC under authority of federal securities laws are also sources of authoritative GAAP for SEC registrants. On the effective date, the
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Codification will supersede all then-existing non-SEC accounting and reporting standards. All other nongrandfathered non-SEC accounting literature not included in the Codification will become nonauthoritative. SFAS 168 is effective for financial statements issued for interim and annual periods ending after September 15, 2009. The Corporation does not expect the adoption of SFAS 168 to have a material effect on its consolidated financial statements.
In June 2009, the SEC issued SAB No. 112, which revises or rescinds portions of the interpretative guidance included in the codification of SABs in order to make the interpretive guidance consistent with current U.S. GAAP. The implementation of SAB 112 did not have a material effect on the Corporation’s consolidated financial statements.
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CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
This report contains statements concerning the Corporation’s expectations, plans, objectives, future financial performance and other statements that are not historical facts. Statements which express “belief,” “intention,” “expectation,” and similar expressions identify forward-looking statements. These forward-looking statements are based on the beliefs of the Corporation’s management, as well as assumptions made by, and information currently available to, the Corporation’s management. These statements are inherently uncertain, and there can be no assurance that the underlying assumptions will prove to be accurate. Actual results could differ materially from those anticipated by such statements. Factors that could have a material adverse effect on the operations and future prospects of the Corporation include, but are not limited to, changes in:
general business conditions, as well as conditions within the financial markets
general economic conditions, including unemployment levels
the commercial and residential real estate markets
the legislative/regulatory climate, including policies of the FDIC
continued increases in FDIC premiums and/or additional FDIC special assessments
monetary and fiscal policies of the U.S. Government, including policies of the Treasury and the Federal Reserve Board
interest rates
demand for loan products
the quality or composition of the loan portfolios and the value of the collateral securing those loans
the level of net charge-offs on loans
the value of securities held in the Corporation’s investment portfolios
deposit flows
the strength of the Corporation’s counterparties
competition from both banks and non-banks
demand for financial services in the Corporation’s market area
technology
reliance on third parties for key services
the Corporation’s expansion and technology initiatives
accounting principles, policies and guidelines
In addition, a continuation of the turbulence in significant portions of the global financial markets, particularly if it worsens, could impact the Corporation’s performance, both directly by affecting the Corporation’s revenues and the value of its assets and liabilities, and indirectly by affecting the Corporation’s counterparties and the economy generally. Concerns about the stability of the financial markets generally have reduced the availability of funding to certain financial institutions, leading to a tightening of credit, reduction of business activity and increased market volatility. The EESA provides the Treasury with broad authority to implement certain actions aimed at restoring stability and liquidity to U.S. markets. The EESA includes, among other things, the Capital Purchase Program, the Troubled Assets Relief Program and the FDIC Temporary Liquidity Guarantee Program (“TLGP”).
Although the Corporation currently has diverse sources of liquidity and its capital ratios exceed the minimum levels required for well-capitalized status, the Corporation issued and sold its Series A Preferred Stock and Warrant for a $20.0 million investment from Treasury under the Capital
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Purchase Program on January 9, 2009. The Corporation also elected to participate in the FDIC TLGP; however, the Corporation currently has no unsecured borrowings to which this program applies. The Bank is participating in the FDIC Transaction Account Guarantee Program, under which all noninterest-bearing transaction accounts (as defined within the program) are fully guaranteed by the FDIC for the entire amount in the account through December 31, 2009.
Our ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial services institutions are interrelated as a result of trading, clearing, counterparty or other relationships, and we routinely execute transactions with counterparties in the financial industry, including brokers and dealers, commercial banks, and other institutional clients. As a result, defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry generally, could exacerbate the market-wide liquidity crisis and could lead to losses or defaults by us or by other institutions. There is no assurance that any such losses would not materially adversely affect the Corporation’s results of operations.
Further, there can be no assurance that the actions taken by the Treasury and the Federal Reserve Bank will stabilize the U.S. financial system or alleviate the industry or economic factors that may adversely affect the Corporation’s business and financial performance.
These risks and uncertainties should be considered in evaluating the forward-looking statements contained herein. We caution readers not to place undue reliance on those statements, which speak only as of the date of this report.
The following discussion supplements and provides information about the major components of the results of operations, financial condition, liquidity and capital resources of the Corporation. This discussion and analysis should be read in conjunction with the accompanying consolidated financial statements.
CRITICAL ACCOUNTING POLICIES
The preparation of financial statements requires us to make estimates and assumptions. Those accounting policies with the greatest uncertainty and that require our most difficult, subjective or complex judgments affecting the application of these policies, and the likelihood that materially different amounts would be reported under different conditions, or using different assumptions, are described below.
Allowance for Loan Losses: We establish the allowance for loan losses through charges to earnings in the form of a provision for loan losses. Loan losses are charged against the allowance when we believe that the collection of the principal is unlikely. Subsequent recoveries of losses previously charged against the allowance are credited to the allowance. The allowance represents an amount that, in our judgment, will be appropriate to absorb any losses on existing loans that may become uncollectible. Our judgment in determining the level of the allowance is based on evaluations of the collectibility of loans while taking into consideration such factors as trends in delinquencies and charge-offs, changes in the nature and volume of the loan portfolio, current economic conditions that may affect a borrower’s ability to repay and the value of collateral, overall portfolio quality and specific potential losses. This evaluation is inherently subjective because it requires estimates that are susceptible to significant revision as more information becomes available.
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Allowance for Indemnifications: The allowance for indemnifications is established through charges to earnings in the form of a provision for indemnifications, which is included in other noninterest expenses. A loss is charged against the allowance for indemnifications under certain conditions when a purchaser of a loan (investor) sold by C&F Mortgage Corporation incurs a loss due to borrower misrepresentation or early default. The allowance represents an amount that, in management’s judgment, will be adequate to absorb any losses arising from indemnification requests. Management’s judgment in determining the level of the allowance is based on the volume of loans sold, current economic conditions and information provided by investors. This evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as more information becomes available.
Impairment of Loans: We measure impaired loans based on the present value of expected future cash flows discounted at the effective interest rate of the loan (or, as a practical expedient, at the loan’s observable market price) or the fair value of the collateral if the loan is collateral dependent. We consider a loan impaired when it is probable that the Corporation will be unable to collect all interest and principal payments as scheduled in the loan agreement. We do not consider a loan impaired during a period of delay in payment if we expect the ultimate collection of all amounts due. We maintain a valuation allowance to the extent that the measure of the impaired loan is less than the recorded investment.
Impairment of Securities: Impairment of securities occurs when the fair value of a security is less than its amortized cost. For debt securities, impairment is considered other-than-temporary and recognized in its entirety in net income if either (i) we intend to sell the security or (ii) it is more-likely-than-not that we will be required to sell the security before recovery of its amortized cost basis. If, however, we do not intend to sell the security and it is not more-likely-than-not that we will be required to sell the security before recovery, we must determine what portion of the impairment is attributable to a credit loss, which occurs when the amortized cost basis of the security exceeds the present value of the cash flows expected to be collected from the security. If there is no credit loss, there is no other-than-temporary impairment. If there is a credit loss, other-than-temporary impairment exists, and the credit loss must be recognized in net income and the remaining portion of impairment must be recognized in other comprehensive income. For equity securities, impairment is considered to be other-than-temporary based on our ability and intent to hold the investment until a recovery of fair value. Other-than-temporary impairment of an equity security results in a write-down that must be included in net income. We regularly review each investment security for other-than-temporary impairment based on criteria that include the extent to which cost exceeds market price, the duration of that market decline, the financial health of and specific prospects for the issuer, our best estimate of the present value of cash flows expected to be collected from debt securities, our intention with regard to holding the security to maturity and the likelihood that we would be required to sell the security before recovery.
Other Real Estate Owned: Assets acquired through, or in lieu of, loan foreclosure are held for sale and are initially recorded at the lower of the loan balance or the fair value less costs to sell at the date of foreclosure. Subsequent to foreclosure, management periodically performs valuations of the foreclosed assets based on updated appraisals, general market conditions, length of time the properties have been held, and our ability and intention with regard to continued ownership of the properties. The Corporation may incur additional write-downs of foreclosed assets to fair value less costs to sell if valuations indicate a further other-than-temporary deterioration in market conditions.
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Goodwill: Goodwill is no longer subject to amortization over its estimated useful life, but is subject to at least an annual assessment for impairment using a two-step process that begins with an estimation of the fair value of the reporting unit. In assessing the recoverability of the Corporation’s goodwill, all of which was recognized in connection with the Bank’s acquisition of C&F Finance Company in September 2002, we must make assumptions in order to determine the fair value of the respective assets. Major assumptions used in determining impairment were increases in future income, sales multiples in determining terminal value and the discount rate applied to future cash flows. As part of the impairment test, we performed a sensitivity analysis by increasing the discount rate, lowering sales multiples and reducing increases in future income. We completed the annual test for impairment during the fourth quarter of 2008 and determined there was no impairment to be recognized in 2008. If the underlying estimates and related assumptions change in the future, we may be required to record impairment charges.
Retirement Plan: The Bank maintains a non-contributory, defined benefit pension plan for eligible full-time employees as specified by the plan. Plan assets, which consist primarily of marketable equity securities and corporate and government fixed income securities, are valued using market quotations. The Bank’s actuary determines plan obligations and annual pension expense using a number of key assumptions. Key assumptions may include the discount rate, the estimated future return on plan assets and the anticipated rate of future salary increases. Changes in these assumptions in the future, if any, or in the method under which benefits are calculated may impact pension assets, liabilities or expense.
Accounting for Income Taxes: Determining the Corporation’s effective tax rate requires judgment. In the ordinary course of business, there are transactions and calculations for which the ultimate tax outcomes are uncertain. In addition, the Corporation’s tax returns are subject to audit by various tax authorities. Although we believe that the estimates are reasonable, no assurance can be given that the final tax outcome will not be materially different than that which is reflected in the income tax provision and accrual.
For further information concerning accounting policies, refer to Note 1 of the Corporation’s Consolidated Financial Statements in the Corporation’s Annual Report on Form 10-K for the year ended December 31, 2008.
OVERVIEW
Our primary financial goals are to maximize the Corporation’s earnings and to deploy capital in profitable growth initiatives that will enhance shareholder value. We track three primary performance measures in order to assess the level of success in achieving these goals: (i) return on average assets (“ROA”), (ii) return on average common equity (“ROE”) and (iii) growth in earnings. In addition to these financial performance measures, we track the performance of the Corporation’s three principal business activities: Retail Banking, Mortgage Banking and Consumer Finance. We also manage our capital through growth, dividends, and historically, stock purchases.
Financial Performance Measures.Net income for the Corporation increased to $1.8 million for the second quarter ended June 30, 2009, compared with $1.4 million for the second quarter of 2008. Net income available to common shareholders for the second quarter of 2009 was $1.5 million, or 48 cents per common share assuming dilution, compared with $1.4 million, or 46 cents per common share assuming dilution, for the second quarter of 2008. Net income for the Corporation increased to $3.3 million for the first six months of 2009, compared to $2.8 million for the first six months of 2008. Net income available to common shareholders for the first half of 2009 was $2.7 million, or 89 cents per common share assuming dilution, compared with $2.8 million, or 93 cents per common share assuming dilution, for the first half of 2008. The difference between reported net income and net income available to common shareholders in the three months and six months ended June 30, 2009 is a result of the Series A Preferred Stock dividends and amortization of the Warrant related to the Corporation’s participation in the Capital Purchase Program. The Series A Preferred Stock and Warrant were issued in the first quarter of 2009 and, therefore, did not impact net income available to common shareholders for 2008. Financial results for the second quarter and first six months of 2009 were primarily affected by the positive effects of the lower interest rate environment on loan production at our Mortgage Banking segment and on the net interest margin at our Consumer Finance segment.
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The favorable performance of these segments in the first six months of 2009 offset the losses at our Retail Banking segment, which principally resulted from the effect of margin compression on net interest income, lower service charges on deposit accounts, higher expenses associated with nonaccrual loans and foreclosed properties for which loan loss provisions or write downs to fair market value were necessary, and higher assessments for FDIC deposit insurance, including the special assessment recognized in the second quarter of 2009 to help replenish the Deposit Insurance Fund.
The Corporation’s ROE and ROA, on an annualized basis, were 8.82 percent and 0.66 percent, respectively, for the second quarter of 2009, compared with 8.61 percent and 0.69 percent for the second quarter of 2008. For the first six months of 2009, on an annualized basis, the Corporation’s ROE was 8.25 percent and its ROA was 0.61 percent, compared with an 8.67 percent ROE and a 0.71 percent ROA for the first six months of 2008. In 2009, these ratios reflect the effects of Series A Preferred Stock dividends and amortization of the Warrant on net income available to common shareholders, as well as asset growth since the end of the second quarter of 2008.
Principal Business Activities. An overview of the financial results for each of the Corporation’s principal segments is presented below. A more detailed discussion is included in “Results of Operations.”
Retail Banking:The Retail Banking segment, which consists of the Bank, reported a net loss of $447,000 for the second quarter of 2009, compared to net income of $179,000 for the second quarter of 2008. The Bank’s net loss was $308,000 for the first six months of 2009, compared to net income of $788,000 for the first six months of 2008. The decline in 2009 earnings included the effects of (1) margin compression and competition for loans and deposits on net interest income, (2) a higher provision for loan losses attributable to the continued slow down in the economy and an increase in nonperforming assets, most of which are commercial relationships secured by real estate, (3) lower service charges on deposits, (4) higher assessments for deposit insurance resulting from the FDIC’s special assessment in the second quarter of 2009 to help restore the Deposit Insurance Fund, coupled with the effects of its amended risk-based assessment system and (5) higher nonaccrual loan and foreclosed properties expenses primarily resulting from the work-out of several commercial relationships. The decline in the Bank’s net interest margin was attributable to interest rate cuts by the Federal Reserve Bank throughout 2008, which reduced yields on the Bank’s adjustable-rate loans faster than interest rates declined on the Bank’s deposits, which are its largest source of funds.
General economic trends, particularly the economic recession that we are experiencing in the Bank’s markets, can affect the quality of the loan portfolio and, therefore, our provision for loan losses, as well as the level of our nonperforming assets. Managing the risks inherent in our loan portfolio and expenses associated with nonperforming assets will influence the Bank’s performance during the remainder of 2009. In addition, the significant increase in FDIC insurance premiums and assessments will affect the Bank’s noninterest expenses in future periods.
Mortgage Banking: Second quarter net income for the Mortgage Banking segment, which consists of C&F Mortgage Corporation (the “Mortgage Company”), was $1.2 million in 2009, compared to $454,000 in 2008. Net income for the first six months of 2009 was $2.0 million, compared to $738,000 for the first six months of 2008. Earnings in 2009 included the effects of lower interest rates on loan origination volume, which increased 57.5 percent and 66.3 percent for the second quarter and first half of 2009, respectively. For the second quarter of 2009, the amount of loan originations at the
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Mortgage Company for refinancings was $171.4 million compared to $54.5 million for the second quarter of 2008. Loan originations for home purchases for these two periods were $162.0 million and $157.2 million, respectively. For the first six months of 2009, the amount of loan originations at the Mortgage Company for refinancings was $391.4 million compared to $117.7 million for the second quarter of 2008. Loan originations for home purchases for these two time periods were $260.9 million and $274.5 million, respectively. Higher loan production in 2009 resulted in gains on sales of loans of $7.4 million and $13.9 million for the three months and six months ended June 30, 2009, respectively, compared to $4.7 million and $8.4 million for the three months and six months ended June 30, 2008, respectively. This increase in revenue was offset in part by (1) increases of $196,000 and $846,000 in the provisions for indemnification and foreclosed properties losses in the second quarter and first half of 2009, respectively, and (2) increases of $1.9 million and $3.6 million in personnel costs in the second quarter and first half of 2009, respectively, resulting principally from higher commission-based compensation associated with the increase in loan production. The increases in the provisions for indemnification and foreclosed properties losses resulted from increased nonperforming loans as a result of continued deterioration of the economy, especially the housing market, together with higher unemployment. While we mitigate the risk of loan repurchase and indemnification liability by underwriting to the purchasers’ guidelines, we cannot eliminate the possibility that a prolonged period of payment defaults and foreclosures will result in an increase in requests for repurchases or indemnifications and the need for additional indemnification and foreclosed properties loss provisions in the future.
Consumer Finance: Second quarter net income for the Consumer Finance segment, which consists of C&F Finance Company (the “Finance Company”), was $1.1 million in 2009, compared to $904,000 in 2008. Net income was $1.8 million for the first six months of 2009, compared to $1.6 million for the first six months of 2008. The Finance Company has benefited from growth in average consumer finance loans outstanding since the end of the second quarter of 2008, as well as the decline in its costs of borrowings throughout 2009 compared to 2008. Its fixed-rate loan portfolio is partially funded by a variable-rate line of credit indexed to LIBOR, which has resulted in an increase in its net interest margin during 2009 as short term interest rates fell throughout 2008. However, the Finance Company has experienced higher loan charge-offs in 2009 compared to 2008, which, in combination with loan growth, has resulted in increases in the provision for loan losses of $450,000 in the second quarter of 2009 and $1.5 million in the first half of 2009, compared to the same periods in 2008. We expect the ongoing effects of the economic recession will result in more delinquencies and repossessions at the Finance Company. Depending on the severity of any further downturn in the economy, decreased consumer demand for automobiles and declining values of automobiles securing outstanding loans could result. This could weaken collateral coverage and increase the amount of loss in the event of default.
Capital Management. Total shareholders’ equity increased $21.4 million to $86.3 million at June 30, 2009, compared to $64.9 million at December 31, 2008. This increase primarily occurred in connection with the Corporation’s participation in the Treasury’s Capital Purchase Program, as previously described. One means by which we manage our capital is through dividends. The Corporation’s board of directors reduced the Corporation’s quarterly dividend for the second quarter of 2009 to 25 cents per common share, which resulted in a common dividend payout ratio of 52 percent based on net income available to common shareholders for the second quarter of 2009. This compares to a 76 percent common dividend payout ratio for the first quarter of 2009. In deciding to reduce the Corporation’s dividend, the board of directors considered the dividend payout in relation to earnings levels and the need to maintain a strong capital position. The board of directors will continue to evaluate the Corporation’s dividends in light of changes in economic conditions, the Corporation’s capital levels and its future levels of earnings. Another means by which we historically have managed our capital is through purchases of the Corporation’s Common Stock. However, as a participant in the Capital Purchase Program there are limitations on the Corporation’s ability to repurchase Common Stock prior to the earlier of January 9, 2012 or the date on which Treasury no longer holds any of the Corporation’s Series A Preferred Stock.
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RESULTS OF OPERATIONS
Net Interest Income
Selected Average Balance Sheet Data and Net Interest Margin
Loans, net
Federal funds sold
Total earning assets
Time and savings deposits
Total interest-bearing liabilities
Net interest margin
Interest-earnings deposits in other banks
Interest income and expense are affected by fluctuations in interest rates, by changes in the volume of earning assets and interest-bearing liabilities, and by the interaction of rate and volume factors. The following table shows the direct causes of the changes in the components of net interest income on a taxable-equivalent basis from the second quarter of 2008 to the second quarter of 2009 and from the first half of 2008 to the first half 2009. Rate/volume variances, the third element in the
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calculation, are not shown separately in the table, but are allocated to the rate and volume variances in proportion to the relationship of the absolute dollar amounts of the change in each. Loans include both nonaccrual loans and loans held for sale.
Increase
Interest income:
Loans
Interest-bearing deposits in other banks and federal funds sold
Interest expense:
Change in net interest income
Net interest income, on a taxable-equivalent basis, for the second quarter of 2009 was $12.7 million, compared to $10.9 million for the second quarter of 2008. Net interest income, on a taxable-equivalent basis, for the first half of 2009 was $24.5 million, compared to $21.6 million for the first half of 2008. The higher net interest income resulted from increases of 9.2 percent and 11.3 percent in the average balance of interest-earning assets for the second quarter and first half of 2009, respectively, compared with the same periods in 2008, coupled with increases of 34 basis points and 10 basis points in the net interest margin for the second quarter and first half of 2009, respectively, compared with the same periods in 2008. The increase in the net interest margin occurred primarily at the Finance Company because its fixed-rate loan portfolio is partially funded by a variable-rate line of credit indexed to LIBOR, which has declined since the end of the second quarter of 2008. The Bank’s net interest margin has been compressing since the end of the second quarter of 2008 as a result of the combination of rapidly declining short-term interest rates and increased competition for deposits. With interest rates stabilizing throughout the second quarter of 2009, deposit repricing in the lower interest rate environment has begun to mitigate the effects of lower interest rates on the Bank’s loan portfolio, and margins have begun to stabilize. In addition, interest rate floors have been put in place on adjustable rate loans at the Bank upon origination or renewal, which have had the effect of increasing rates on these loans.
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Average loans held for investment increased $20.9 million and $33.4 million in the second quarter and the first six months of 2009, respectively, compared to the same periods in 2008. The Retail Banking segment’s average loan portfolio increased $16.2 million in the second quarter of 2009 and $26.2 million in the first half of 2009, compared to the same periods in 2008, primarily as a result of residential mortgage loan and commercial loan growth. The Consumer Finance segment’s average loan portfolio increased $6.4 million in the second quarter of 2009 and $8.4 million in the first half of 2009, compared to the same periods in 2008, primarily as result of the purchase of a portfolio of seasoned loans in the Virginia market from an unrelated finance company. Average loans held for sale at the Mortgage Banking segment increased $30.2 million in the second quarter of 2009 and $31.6 million in the first half of 2009, compared to the same periods in 2008, as a result of higher loan demand in the lower interest rate environment in 2009. The overall yield on loans held for investment at all of our business segments and loans held for sale at the Mortgage Banking segment decreased in the second quarter and first half of 2009 in relation to the same periods in 2008 as a result of a general decrease in interest rates.
Average securities available for sale increased $19.4 million in the second quarter of 2009 and $19.8 million in the first half of 2009, compared to the same periods in 2008. The increase in securities available for sale occurred predominantly in the Retail Banking segment’s municipal bond portfolio. This resulted from a strategy to increase the Bank’s securities portfolio as a percentage of total assets. The lower investment portfolio yield in the second quarter and first half of 2009 in relation to the same periods in 2008 resulted from the current interest rate environment in which securities purchases have been made at yields less than those being called, coupled with a decline in dividends on FHLB stock in 2009.
Average interest-earning deposits at other banks, primarily the FHLB, and federal funds sold decreased $945,000 in the second quarter of 2009 and $1.3 million in the first half of 2009, compared to the same periods in 2008. Fluctuations in the average balance of these low-yielding assets occurred in response to loan demand and an increase in the securities portfolio. The lower average yield on interest-earning deposits at other banks in the second quarter and first half of 2009 relative to the same periods in 2008 resulted from the decline in short-term interest rates during 2008.
Average interest-bearing time and savings deposits increased $32.5 million in the second quarter of 2009 and $30.7 million in the first half of 2009, compared to the same periods in 2008. Growth in lower-rate transaction accounts resulted from our deposit strategies that emphasize retention of multi-service customer relationships. Growth in time deposits occurred in deposits of municipalities in our market areas and retail depositors who are maintaining flexibility in their investing options due to the unpredictability in the stock market. The average cost of deposits declined 76 basis points in the second quarter of 2009 and 79 basis points in the first half of 2009 in relation to the same periods in 2008. The lower average cost of deposits resulted from the repricing of transaction accounts as interest rates declined throughout 2008 and the more gradual repricing of time deposits to interest rates that are lower than their maturing rates.
Average borrowings increased $4.9 million in the second quarter of 2009 and $23.2 million in the first half of 2009, compared to the same periods in 2008. This increase was attributable to increased use of borrowings from the FHLB and the Federal Reserve Bank to fund loan growth at the Retail Banking and Consumer Finance segments and increased production at the Mortgage Banking segment of loans to be sold in the secondary market. The average cost of borrowings decreased 149
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basis points in the second quarter of 2009 and 194 basis points in the first half of 2009 in relation to the same periods in 2008 because a portion of the Corporation’s borrowings is indexed to short-term interest rates and reprices as short-term interest rates change.
Interest rates and economic conditions will be significant factors influencing the performance of all of the Corporation’s business segments during 2009. The net interest margin may be negatively affected if nonperforming loans continue to increase and if declining economic conditions result in lower-yielding loan growth. However, the continued repricing of time deposits to lower interest rates should reduce funding costs and relieve some pressure on the net interest margin, unless competition for deposits hinders a decline in rates paid for deposits.
Noninterest Income
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Total noninterest income increased $2.8 million in the second quarter of 2009 and $5.9 million in the first half of 2009, compared to the same periods in 2008. These increases primarily resulted (1) at the Mortgage Banking segment from the effect of increased loan production on gains on sale of loans and ancillary fees associated with loan originations and (2) at the Bank from higher bank card interchange fees and a fee received in connection with a change in its debit card processor. These latter increases were offset by a lower volume of overdraft charges at the Bank. The decrease in overdraft charges at the Bank resulted from economic conditions over the past year, which have caused a decrease in the use of this product.
Noninterest Expense
Occupancy expense
Total noninterest expense
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Total noninterest expense increased $2.6 million in the second quarter of 2009 and $5.0 million in the first half of 2009, compared to the same periods in 2008. The Mortgage Banking segment reported higher variable personnel and operating expenses as a result of the increase in loan production in 2009. A decrease during 2009 in personnel costs at the Retail Banking segment attributable to a reduction in the number of employees, primarily resulting from attrition, was offset by an increase in other expenses arising from higher FDIC deposit insurance premiums and the special assessment to help replenish the Deposit Insurance Fund, bank card processing expenses, expenses associated with loan work-outs, and foreclosed properties expenses. Increases in personnel costs and operating expenses at the Consumer Finance segment during 2009 resulted from staff additions to support loan growth and operating expenses associated with loan production.
Income Taxes
Income tax expense for the second quarter of 2009 totaled $640,000, resulting in an effective tax rate of 26.8 percent, compared to $413,000, or 22.6 percent, for the second quarter of 2008. Income tax expense for the first half of 2009 was $1.0 million, resulting in an effective tax rate of 24.2 percent, compared to $808,000, resulting in an effective tax rate of 22.1 percent, for the first half of 2008. The increase in the effective tax rates during 2009 resulted from a higher proportion of pre-tax earnings occurring at the non-bank business segments, which are not exempt from state income taxes, the effects of which were offset in part by higher tax-exempt securities income resulting from growth in the Bank’s municipal bond portfolio.
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ASSET QUALITY
Allowance for Loan Losses
The allowance for loan losses represents an amount that, in our judgment, will be adequate to absorb any losses on existing loans that may become uncollectible. The provision for loan losses increases the allowance, and loans charged off, net of recoveries, reduce the allowance. The following tables summarize the allowance activity for the periods indicated:
Allowance, beginning of period
Loans charged off
Recoveries of loans previously charged off
Net loans charged off
Allowance, end of period
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There has been a $715,000 increase in the allowance for loan losses at the combined Retail Banking and Mortgage Banking segments since December 31, 2008, and the provision for loan losses at these combined segments increased $775,000 and $1.4 million in the second quarter and first half of 2009, respectively, compared to the same periods in 2008. These increases were attributable to the increase in nonperforming assets of the combined Retail Banking and Mortgage Banking segments as discussed below. In addition, net charge-offs for these combined segments for the first half of 2009 included write downs at the Bank of three collateral-dependent commercial relationships based on an impairment analysis, which indicated that their respective carrying values exceeded the fair market value of the underlying real estate collateral. We believe that the current level of the allowance for loan losses is adequate to absorb any losses on existing loans that may become uncollectible. If current economic conditions continue or worsen, a higher level of nonperforming loans may be experienced in future periods, which may then require a higher provision for loan losses.
The Consumer Finance segment’s allowance for loan losses increased to $13.6 million since December 31, 2008, and its provision for loan losses increased $450,000 and $1.5 million in the second quarter and first half of 2009, respectively, compared to the same periods in 2008. The increase in the provision for loan losses was primarily attributable to higher net charge-offs in 2009 and loan growth. We believe that the current level of the allowance for loan losses at C&F Finance is adequate to absorb any losses on existing loans that may become uncollectible. However, if unemployment continues to rise throughout 2009 and if weakening consumer demand for automobiles results in declining values of automobiles securing outstanding loans, a higher provision for loan losses may become necessary.
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Nonperforming Assets
Retail and Mortgage Banking
Nonaccrual loans*-Retail Banking
Nonaccrual loans*-Mortgage Banking
OREO**-Retail Banking
OREO**-Mortgage Banking
Total nonperforming assets
Accruing loans* past due for 90 days or more
Total loans*
Allowance for loan losses
Nonperforming assets to total loans* and OREO**
Allowance for loan losses to total loans*
Allowance for loan losses to nonaccrual loans*
Consumer Finance
Nonaccrual loans
Accruing loans past due for 90 days or more
Total loans
Nonaccrual consumer finance loans to total consumer finance loans
Allowance for loan losses to total consumer finance loans
Nonperforming assets at the combined Retail Banking and Mortgage Banking segments increased to $21.3 million at June 30, 2009 and consist of $10.8 million of nonaccrual loans and $10.5 million of foreclosed properties. The largest components of the Bank’s nonaccrual loans are two commercial relationships aggregating $9.2 million, which are secured by residential real estate. The largest components of the Bank’s foreclosed properties are $9.7 million of residential properties associated with two commercial relationships, $10.7 million of which was in nonaccrual loan status as of December 31, 2008. These properties have been written down to their estimated fair market values based upon current appraisals less selling costs. Nonaccrual loans and foreclosed properties of the Mortgage Banking segment totaled $944,000 and $690,000, respectively, at June 30, 2009, and resulted primarily from loans that were repurchased from investors because of documentation issues. In addition, loans past due for 90 days or more and still accruing interest totaled $453,000 at the combined Retail and Mortgage Banking segment at June 30, 2009, and consist primarily of a small number of loans secured by real estate. We have increased our allowance as a percentage of total loans at the combined Retail and Mortgage Banking segment largely as a result of the increase in nonperforming loans, and the continued deterioration in the economy, in particular the housing market. We may continue to make adjustments to the allowance level in the future based upon changes in our loan portfolios and general economic conditions.
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Nonaccrual loans at the Consumer Finance segment have declined from $798,000 at December 31, 2008 to $318,000 at June 30, 2009. Nonetheless, the allowance for loan losses increased from $12.6 million at December 31, 2008 to $13.6 million at June 30, 2009, and the ratio of the allowance for loan losses to total consumer finance loans increased 27 basis points, as a result of our concern about general employment levels and economic conditions. The Finance Company’s loan portfolio could be immediately adversely affected by the ongoing effects of the economic recession. Increasing unemployment levels, decreased consumer demand for automobiles and declining values of automobiles securing outstanding loans could increase the level of charge-offs. We may make adjustments to our allowance level in the future based upon changes in our loan portfolio and general economic conditions.
FINANCIAL CONDITION
At June 30, 2009, the Corporation had total assets of $879.4 million compared to $855.7 million at December 31, 2008. The increase was principally a result of increases in investment securities at the Bank and loans held for sale at the Mortgage Company, which were offset in part by a decline in loans held for investment at the Bank. Asset growth was primarily funded with increased deposits.
Loan Portfolio
The following table sets forth the composition of the Corporation’s loans held for investment in dollar amounts and as a percentage of the Corporation’s total gross loans held for investment at the dates indicated:
Real estate – residential mortgage
Real estate – construction
Commercial, financial and agricultural1
Equity lines
Consumer
Consumer – Consumer Finance
Less allowance for loan losses
Total loans, net
Includes loans secured by real estate for builder lines, acquisition and development and commercial development, as well as commercial loans secured by personal property.
The decline in total loans occurred in the consumer real estate-construction and commercial categories as a result of the slowdown in new residential construction, coupled with the foreclosure of two commercial relationships that were secured by residential real estate.
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Investment Securities
The following table sets forth the composition of the Corporation’s securities available for sale at fair value and as a percentage of the Corporation’s total securities available for sale at the dates indicated:
Total debt securities
Total available for sale securities
Deposits totaled $581.2 million at June 30, 2009, compared to $550.7 million at December 31, 2008, which is an increase of $30.5 million. Growth in time deposits, which increased $27.9 million, occurred in the shorter-term time deposits of municipalities in our market areas and of retail depositors who are maintaining flexibility in their investing options due to the unpredictability in the stock market.
Borrowings totaled $172.8 million at June 30, 2009, compared to $198.8 million at December 31, 2008. This decrease was attributable to growth in deposits, which replaced borrowings as a funding source for lending activities at the Mortgage Banking segment, and the liquidity created by the sale of the Series A Preferred Stock and Warrant.
Off-Balance Sheet Arrangements
As of June 30, 2009, there have been no material changes to the off-balance sheet arrangements disclosed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in the Corporation’s Annual Report on Form 10-K for the year ended December 31, 2008.
Contractual Obligations
As of June 30, 2009, there have been no material changes outside the ordinary course of business to the contractual obligations disclosed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in the Corporation’s Annual Report on Form 10-K for the year ended December 31, 2008.
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Liquidity
Liquid assets, which include cash and due from banks, interest-earning deposits at other banks, federal funds sold and nonpledged securities available for sale, at June 30, 2009, totaled $79.8 million. The Corporation’s funding sources consist of: (1) established federal funds lines with third-party financial institutions totaling $24.0 million that had $18.3 million outstanding as of June 30, 2009, (2) a $5.0 million repurchase agreement outstanding with a third-party broker as of June 30, 2009, (3) an established line with the FHLB that had $52.5 million outstanding under a total line of $88.3 million as of June 30, 2009, (4) an established line with the Federal Reserve Bank that had $15.0 million outstanding under a total line of $50.4 million as of June 30, 2009 and (5) a revolving line of credit with a third-party bank that had $75.8 million outstanding under a total line of $120.0 million as of June 30, 2009. We have no reason to believe these arrangements will not be renewed at maturity. The decrease in availability from the FHLB since December 31, 2008 resulted from the release of a portion of the blanket lien securing FHLB advances in order to pledge additional loans for future borrowings from the Federal Reserve Bank above the current lendable collateral value.
As a result of the Corporation’s management of liquid assets and the ability to generate liquidity through liability funding, management believes that the Corporation maintains overall liquidity sufficient to satisfy its operational requirements and contractual obligations.
Capital Resources
The Corporation’s and the Bank’s actual capital amounts and ratios are presented in the following table.
As of June 30, 2009:
Total Capital (to Risk-Weighted Assets)
Corporation
Bank
Tier 1 Capital (to Risk-Weighted Assets)
Tier 1 Capital (to Average Tangible Assets)
As of December 31, 2008:
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On January 9, 2009, as part of the Capital Purchase Program, the Corporation issued and sold to Treasury 20,000 shares of the Corporation’s Series A Preferred Stock having a liquidation preference of $1,000 per share and a Warrant for the purchase of up to 167,504 shares of the Corporation’s Common Stock, for a total price of $20.0 million. The Series A Preferred Stock has been treated as Tier 1 capital for regulatory capital adequacy determination purposes as of June 30, 2009.
Effects of Inflation
The effect of changing prices on financial institutions is typically different from other industries as the Corporation’s assets and liabilities are monetary in nature. Interest rates are significantly impacted by inflation, but neither the timing nor the magnitude of the changes is directly related to price level indices. Impacts of inflation on interest rates, loan demand and deposits are reflected in the consolidated financial statements.
There have been no significant changes from the quantitative and qualitative disclosures made in the Corporation’s Annual Report on Form 10-K for the year ended December 31, 2008.
The Corporation’s management, with the participation of the Corporation’s Chief Executive Officer and the Chief Financial Officer, has evaluated the effectiveness of the Corporation’s disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and the Chief Financial Officer have concluded that the Corporation’s disclosure controls and procedures were effective as of June 30, 2009 to ensure that information required to be disclosed by the Corporation in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms and that such information is accumulated and communicated to the Corporation’s management, including the Corporation’s Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that the Corporation’s disclosure controls and procedures will detect or uncover every situation involving the failure of persons within the Corporation or its subsidiary to disclose material information required to be set forth in the Corporation’s periodic reports.
Management of the Corporation is also responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act). There were no changes in the Corporation’s internal control over financial reporting during the Corporation’s second quarter ended June 30, 2009 that have materially affected, or are reasonably likely to materially affect, the Corporation’s internal control over financial reporting.
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PART II - OTHER INFORMATION
There have been no material changes in the risk factors faced by the Corporation from those disclosed in the Corporation’s Annual Report on Form 10-K for the year ended December 31, 2008.
There have been no purchases of the Corporation’s Common Stock during 2009 as part of the board-approved authorization on July 24, 2008. As of June 30, 2009, there were 99,000 shares that could still be purchased under the program, which expired in July 2009. However, in connection with the Corporation’s sale to Treasury of its Series A Preferred Stock and Warrant under the Capital Purchase Program, as previously described, there are limitations on the Corporation’s ability to purchase Common Stock prior to the earlier of January 9, 2012 or the date on which Treasury no longer holds any of the Series A Preferred Stock. Prior to such time, the Corporation generally may not purchase any Common Stock without the consent of the Treasury.
As noted earlier, the purchase agreement pursuant to which the Series A Preferred Stock and the Warrant were sold contains limitations on the Corporation’s payment of dividends or distributions on the Common Stock (including the payment of cash dividends in excess of the amount per share of the Corporation’s last quarterly cash dividend declared before October 14, 2008, which was 31 cents per share) until the earlier of January 9, 2012 or such time as Treasury no longer owns any Series A Preferred Stock acquired through the Capital Purchase Program. In addition, as is typical with cumulative preferred stocks, dividend payments on the Series A Preferred Stock must be paid before dividends can be paid on junior shares, such as the Corporation’s Common Stock.
The Corporation held its Annual Meeting of Shareholders on April 21, 2009. A quorum of shareholders was present, consisting of a total of 2,568,821 shares. At the Annual Meeting, the shareholders elected Larry G. Dillon, James H. Hudson III and C. Elis Olsson as Class I directors to serve on the board of directors until the 2012 Annual Meeting of Shareholders. The following Class II and Class III directors whose terms expire in 2010 and 2011, respectively, continued in office: Class II - Audrey D. Holmes, Joshua H. Lawson, Paul C. Robinson; Class III - J.P. Causey Jr., Barry R. Chernack and William E. O’Connell Jr. The vote on Class I director elections was as follows:
Larry G. Dillon
James H. Hudson III
C. Elis Olsson
At the Annual Meeting, the shareholders also approved, in an advisory vote, the compensation of the Corporation’s named executive officers. The advisory vote results were as follows:
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
C&F FINANCIAL CORPORATION
(Registrant)
August 5, 2009
/s/ Larry G. Dillon
/s/ Thomas F. Cherry
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