UNITED STATESSECURITIES AND EXCHANGE COMMISSIONWASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
FOR THE QUARTERLY PERIOD ENDED: SEPTEMBER 30, 2005
OR
For the transition period from:_______________ to _________________
Commission file number: 51018
THE BANCORP, INC.(Exact name of registrant as specified in its charter)
405 Silverside Road Wilmington, DE 19809(Address of principalexecutive offices)(Zip code)
Registrant's telephone number, including area code: (302) 385-5000
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.
Indicate by check mark whether the Registrant is an accelerated filer (as defined 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.)
Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.
As of November 11, 2005 there were 13,588,935 outstanding shares of Common Stock, $1.00 par value.
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PART I – FINANCIAL INFORMATION
Item 1. Financial statements
The Bancorp, Inc.
Consolidated Balance Sheets
The Bancorp Inc.
Consolidated Statements of Income
(See notes to consolidated financial statements)
THE BANCORP INC.Statements of Changes in Shareholder's EquityFor the nine months ended September 30, 2005 (unaudited) and for the year ended December 31, 2004
The Bancorp, Inc.Statements of Cash Flows (in thousands)(unaudited)
Basis of Presentation
The financial statements of The Bancorp, Inc. (Company) as of September 30, 2005 and for the nine month periods ended September 30, 2005 and 2004 are unaudited. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted in this Form 10-Q pursuant to the rules and regulations of the Securities and Exchange Commission. However, in the opinion of management, these interim financial statements include all necessary adjustments to fairly present the results of the interim periods presented. The unaudited interim consolidated financial statements should be read in conjunction with the audited financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004. The results of operations for the three and nine month period ended September 30, 2005 may not necessarily be indicative of the results of operations for the full year ending December 31, 2005.
The Company accounts for its stock options under Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation, which contains a fair value-based method for valuing stock-based compensation that entities may use that measures compensation cost at the grant date based on the fair value of the award. Alternatively, SFAS No. 123 permits entities to continue accounting for employee stock options and similar equity instruments under Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees. Entities that continue to account for stock options using APB Opinion No. 25 are required to make pro forma disclosures of net income and earnings per share, as if the fair value-based method of accounting defined in SFAS No. 123 had been applied.
At September 30, 2005, the Company had two stock-based compensation plans, which are more fully described in its Form 10-K report and proxy statement. The Company accounts for these plans under the recognition and measurement principles of APB Opinion No. 25 and related interpretations. With the exception of the grant made in the third quarter stock-based employee compensation costs are not reflected in net income, as all options granted under the plan had an exercise price equal to the market value of the underlying common stock on the date of grant. The grant in the third quarter of 2005 resulted in $18,000 of salary expense for the period. The following table illustrates the effect on net income (loss) and earnings (loss) per share if the Company had applied the fair value recognition provisions of SFAS No. 123 for the Company plan to stock-based employee compensation (in thousands).
Stock options were outstanding with respect to 1,402,603 shares and 1,101,101 shares at September 30, 2005 and 2004, respectively. The fair value of each option grant is estimated on the date of grant using the Black-Scholes options-pricing model with the following weighted average assumptions used for grants in 2005: third quarter: grants expected volatility of 32%, risk-free interest rate of 3.99% and expected lives of 7 years; first quarter: expected volatility of 38%, risk-free interest rate of 4.26% and expected lives of 10 years. The assumptions used for grants in 2004 were grants expected volativity of 38%, risk-free interest rate of 4.01% and expected lives of 10 years. The weighted average fair value of each option granted under the Company’s stock option plans was $7.95 in 2005 and $6.99 in 2004.
In December 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123(R), Share-Based Payment, that addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments. Under SFAS No. 123(R), all forms of share-based payments to employees, including employee stock options, would be treated the same as other forms of compensation by recognizing the related cost in the income statement. The expense of the award would generally be measured at fair value at the grant date. Current accounting guidance requires that the expense relating to so-called fixed plan employee stock options only be disclosed in the footnotes to the financial statements. SFAS No. 123(R) eliminates the ability to account for share-based compensation transactions using APB Opinion No. 25. SFAS No. 123(R) is effective for public companies as of the beginning of the first fiscal year that begins after June 15, 2005. All public companies that used the fair-value-based method for either recognition or disclosure under SFAS No. 123 will apply SFAS No. 123(R) using a modified method of prospective application. Under this transition method, compensation cost is recognized on or after the required effective date for the portion of outstanding awards for which the requisite service has not yet been rendered based on the grant-date fair value of those awards calculated under SFAS No. 123 for either recognition or pro forma disclosures. The impact of this new standard, if it had been in effect, on the net earnings and related per share amounts for the quarters ended September 30, 2005 and 2004 is disclosed in the table above.
On March 29, 2005, the SEC released Staff Accounting Bulletin 107, Valuation of Share Based Payment, Arrangements for Public Companies (SAB 107). The interpretations in SAB 107 express views of the SEC staff regarding the application of SFAS No. 123(R). Among other things, SAB 107 provides interpretive guidance related to the interaction between SFAS No. 123(R) and certain SEC rules and regulations, as well as provides the staff’s views regarding the valuation of share-based payment arrangements for public companies. On April 14, 2005, the SEC adopted a new rule amending the effective dates of SFAS 123(R) for public companies by issuing Release 33-8568. The new rule allows registrants to implement SFAS 123(R) at the beginning of their next fiscal year, instead of the next interim period, that beings after June 15, 2005. SFAS 123(R) will therefore be effective for the Company beginning the first quarter of 2006. The Company is evaluating the impact that the implementation of SAB 107 and SFAS No. 123 (R) will have on future option grants.
Note 3. Earnings Per Share
Basic earnings per share for a particular period of time is calculated by dividing net income by the weighted average number of common shares outstanding during that period.
Diluted earnings per share is calculated by dividing net income by the weighted average number of common shares and common share equivalents. The Company’s only outstanding “common share equivalents” are options to purchase its common stock.
The following schedule shows the calculation of the Company’s diluted earnings per share for the periods presented:
Stock options of 40,000 for $16.67 per share were outstanding at September 30, 2005 but were not included in the weighted average shares because the exercise price was greater than the market price.
Stock options of 70,000 for $11.00 per share were outstanding at September 30, 2004 but were not included in the weighted average shares because the exercise price was equal to the market price.
Note 4. Investment securities
The amortized cost, gross unrealized gains and losses, and fair values of the Company’s investment securities available-for-sale are summarized as follows (in thousands):
In June 2005, the FASB approved the issuance of FASB Staff Position (FSP) 115-1. FSP 115-1 will replace the guidance in paragraphs 10-18 of EITF Issue 03-1 (which had been deferred by FSP EITF 03-1, “Effective Date of Paragraphs 10–20 of EITF Issue No. 03-1, The Meaning of Other-Than-Temporary Imapairment and Its Application to Certain Investments”) with references to existing other-than-temporary impairment guidance, such as Statement 115, Accounting for Investments in Debt and Equity Securities, SAB 59, Accounting for Noncurrent Marketable Equity Securities, and Opinion 18, The Equity Method of Accounting for Investments in in Common Stock. FSP 115-1 will codify the guidance set forth in EITF Topic D-44 and clarify that an investor should recognize an impairment loss no later than when the impairment is considered other than temporary, even if a decision to sell has not been made. FSP 115-1 will also include language from EITF Issue 03-1 regarding the accounting for debt securities subsequent to an other-than-temporary impairment.
FSP FAS 115-1 will be effective for other-than-temporary impairment analysis conducted in periods beginning after December 15, 2005. The FASB approved the proposed FSP subject to a vote on the final draft. The Company will evaluate the impact that FSP 115-1 will have on its financial statements when the final FSP is issued.
The amortized cost and fair value of the Company’s investment securities available-for-sale at September 30, 2005, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Note 5. Loans
Major classifications of loans are as follows (in thousands):
Note 6. Transactions with affiliates
The Company purchased a total of $2,654,000 in loans from Resource America, Inc. in 2001. The outstanding balance of the loans purchased from Resource America was $1,969,000 at December 31, 2004. The loan was paid in full on February 25, 2005. The Chairman and the Chief Executive Officer of the Company are the brother and parent, respectively, of the Chief Executive Officer of Resource America and the son and spouse, respectively, of Resource America's Chairman.
The Company paid $16,900 and $9,300 to Cohen Bros. & Company (Cohen Bros.) for investment securities brokerage services performed for the periods ended September 30, 2005 and September 30, 2004. The Chairman of the Company is the principal of Cohen Bros. Financial LLC which owns 100% of Cohen Bros. & Company. A member of the Company’s Board of Directors is the Chief Operating Officer of Cohen Bros. & Company.
The Company entered into a sublease for office space in Philadelphia, Pennsylvania and a technical support agreement with RAIT Investment Trust (RAIT) commencing in October 2000. The Chief Executive Officer of RAIT is the Chief Executive Officer of the Company. Under the technical support agreements, which commenced in January 2001, the Company also provides technical support to RAIT for a fee of $5,000 a month. RAIT paid the Company $45,000 for such services for the nine months ended September 30, 2005 and 2004. RAIT paid the Company approximately $230,000 for rent for the first nine months of 2005 and $193,000 for the first nine months of 2004.
The Company also has a sublease for office space in Philadelphia, Pennsylvania with Cohen Bros. commencing in July 2002. Cohen Bros. paid approximately $88,000 in rent for the nine months ended September 30, 2005 and $60,000 for the first nine months of 2004.
In July 2002, Cohen Bros. entered into an agreement with the Company under which Cohen Bros. pays fees for technical support and for telephone system support services. Technical and telephone support fees for Cohen Bros. were $54,600 and $41,000 for the periods ended September 30, 2005 and 2004, respectively.
The Company maintains deposits for various affiliated companies totaling approximately $91,484,000 and $41,793,000 as of September 30, 2005 and December 31, 2004, respectively. The majority of these deposits are short-term in nature and rates are consistent with market rates.
The Company has entered into lending transactions in the ordinary course of business with directors, executive officers, principal stockholders and their affiliates on the same terms as those prevailing for comparable transactions with other borrowers. At September 30, 2005, these loans were current as to principal and interest payments and, in the opinion of management, do not involve more than normal risk of collectibility. At September 30, 2005 loans to these related parties amounted to $1,797,000 in outstanding principal amount.
Note 7. Reclassifications
Certain reclassifications to the merchant credit card fees have been made to the 2004 financial statements to conform to the 2005 presentation. The Company has reclassified the merchant expense to show the net merchant credit card fees in non-interest income.
Note 8. Acquisitions
On January 3, 2005, the Company completed the acquisition of Mears Motor Livery Corp. (Mears) pursuant to which Mears was merged into the Company. Mears shareholders received $1.0 million in cash and 253,126 shares of the Company’s stock. The total purchase price was $4.9 million. As a result of the acquisition, the Company recorded $3.5 million in goodwill and recorded the assets and liabilities at fair value. The transaction was accounted for under the purchase method of accounting. The Company’s results of operations include the Mears’ results of operations from January 3, 2005 forward.
The Company is in the process of finalizing final purchase accounting adjustments and anticipates that it will complete them in the fourth quarter 2005.
Note 9. Repayment of Subordinated Debentures
In March 2005, the Bancorp Capital Trust redeemed its trust preferred securities at their face value including accrued interest through March 31, 2005 and a prepayment premium representing the discounted present value of dividends payable on the trust preferred securities through June 12, 2007, the date the Company could call these securities. The proceeds for the redemption came from the Company’s redemption of its subordinated debenture to the Bancorp Capital Trust. The aggregate redemption price was $6.1 million. The Company recorded an expense of approximately $1.3 million for the three months ended March 31, 2005, reflecting a prepayment premium of $819,000 and the charge-off of $466,000 of unamortized offering.
Note 10. Conversion of Series A Preferred Stock
In July 2005, the Company commenced a solicitation of its Series A preferred stockholders, requesting that they convert their Series A preferred stock to common stock. The Company offered a conversion premium of $.60 per share for each share of Series A preferred stock converted. Because of uncertainty as to whether receipt of a premium would cause the common stock received upon conversion to be restricted as to transfer under the Securities Act of 1933, the Company afforded the holders the option of converting their Series A preferred stock to common stock without receipt of the premium. The solicitation terminated September 30, 2005. As a result of the solicitation, 894,912 shares of Series A preferred stock were converted into 894,912 shares of common stock. The Company paid an aggregate conversion premium of $459,000.
Note 11. Exercise of Warrants
During 2005, shareholders exercised warrants issued in connection with the Company’s offering of Series A Preferred Stock in 2002. The warrant exercise resulted in the issuance of 420,456 shares of common stock. The Company received proceeds of $4.0 million from the warrant exercises.
Part I - Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION
Forward-Looking Statements
When used in this Form 10-Q, the words “believes” “anticipates” “expects” and similar expressions are intended to identify forward-looking statements. Such statements are subject to certain risks and uncertainties more particularly described in Item 1, under the caption “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2004. These risks and uncertainties could cause actual results to differ materially. Readers are cautioned not place undue reliance on these forward-looking statements, which speak only as of the date hereof. We undertake no obligation to publicly release the results of any revisions to forward-looking statements which we may make to reflect events or circumstances after the date of this Quarterly Report on Form 10-Q or to reflect the occurrence of unanticipated events.
In the following discussion we provide information about our results of operations, financial condition, liquidity and asset quality. We intend that this information facilitate your understanding and assessment of significant changes and trends related to our financial condition and results of operations. You should read this section in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operation” included in our Annual Report on Form 10-K for the year ended December 31, 2004.
Critical Accounting Policies and Estimates
Our accounting and reporting policies conform with accounting principles generally accepted in the United States and general practices within the financial services industry. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the financial statements and the accompanying notes. Actual results could differ from those estimates.
We believe that the determination of our allowance for loan and lease losses involves a higher degree of judgment and complexity than our other significant accounting policies. We determine our allowance for loan and lease losses with the objective of maintaining a reserve level we believe to be sufficient to absorb our estimated probable credit losses. We base our determination of the adequacy of the allowance on periodic evaluations of our loan portfolio and other relevant factors. However, this evaluation is inherently subjective as it requires material estimates, including, among others, expected default probabilities, the amount of loss we may incur on a defaulted loan, expected commitment usage, the amounts and timing of expected future cash flows on impaired loans, value of collateral, estimated losses on consumer loans and residential mortgages, and historical loss experience. We also evaluate economic conditions, uncertainties in estimating losses and inherent risks in the loan portfolio. All of these factors may be susceptible to significant change. To the extent actual outcomes differ from our estimates, we may need additional provisions for loan losses that would adversely impact our earnings.
We capitalize costs associated with internally developed and purchased software systems for new products and enhancements to existing products that have reached the application stage and meet recoverability tests. Capitalized costs include external direct costs of materials and services used in developing or obtaining internal-use software, payroll and payroll related expenses for employees who are directly associated with and devote time to internal-use software projects and interest costs incurred, if material, while developing internal-use software. Capitalization of these costs begins when we complete the preliminary project stage, and ceases no later than the point at which the project is substantially complete and ready for its intended purpose.
We account for income taxes under the liability method whereby we determine deferred tax assets and liabilities based on the difference between the carrying values on our financial statements and the tax basis of assets and liabilities as measured by the enacted tax rates which will be in effect when these differences reverse. Deferred tax expense (benefit) is the result of changes in deferred tax assets and liabilities.
Results of Operations
(Third quarter 2005 to third quarter 2004)
Net Income: Net income for the third quarter of 2005 was $2.3 million, compared to net income of $829,000 for the third quarter of 2004. Diluted earnings per share were $0.12 in the third quarter of 2005 as compared to $0.05 for the third quarter of 2004. Return on average assets was 1.22% and return on average equity was 6.96% for the third quarter of 2005, as compared to 0.66% and 2.93%, respectively for the third quarter of 2004.
Net Interest Income: Our interest income for the third quarter of 2005 increased to $12.8 million from $6.6 million in the third quarter of 2004, while our net interest income increased to $8.8 million from $4.8 million. Our average loans increased to $583.1 million for the third quarter of 2005 from $332.7 million for the third quarter of 2004. The primary reason for the increases in our interest income and net interest income was our ability to increase our earning assets through continued organic growth of our loan portfolio, as well as the acquisition of Mears Motor Livery Corp. in January 2005 which increased our portfolio of direct financing leases.
Our net interest margin for the third quarter 2005 increased to 4.77% from 3.95% for the third quarter of 2004, an increase of 82 basis points (.82%). The increased net interest margin resulted from the following:
In general, changes in rates immediately affect our variable rate loans, while deposit rates tend to take a longer period to adjust. For the third quarter of 2005 the average yield on our interest-earning assets increased to 6.98% from 5.48% for third quarter of 2004, an increase of 150 basis points (1.50%) . Cost of interest-bearing deposits increased to 3.07% for the third quarter of 2005 from 2.16% for the third quarter of 2004, an increase of 91 basis points (.91%). The increase in the cost of interest-bearing deposits was the result of interest rate increases by the Federal Reserve Board in the third quarter of 2005 over those prevailing in the third quarter of 2004. Average interest bearing deposits increased to $472.6 million from $286.0 million, an increase of $186.6 million or 65.2%.
Average Daily Balances. The following table presents the average daily balances of assets, liabilities and stockholders’ equity and the respective interest earned or paid on interest-earning assets and interest-bearing liabilities, as well as average rates, for the periods indicated:
In the third quarter of 2005, average interest-earning assets increased to $734.7 million, an increase of $251.9 million, or 52.2 %, from the third quarter of 2004.
Provision for Loan and Lease Losses. Our provision for loan and lease losses was $550,000 for the third quarter of 2005 compared to $250,000 for the third quarter of 2004. For more information about our provisions and allowance for loan and lease losses and our loss experience see “ – Allowance for Loan and Lease Losses” and “ – Summary of Loan and Lease Loss Experience,” below.
Non-Interest Income. Non-interest income, exclusive of gains on sales of investment securities, was $970,000 for the third quarter of 2005 as compared to $556,000 for the third quarter of 2004, an increase of $414,000 or 74.5% . Gains on sales of investment securities totaled $-0- in the third quarter of 2005 compared to $188,000 of gain on sale investment securities for the same period last year. The principal reasons for the increase in non-interest income were an increase in income from merchant credit card fees, an increase in leasing income, and other income. Our merchant credit card income was $246,000 for the third quarter of 2005, an increase of $79,000 or 47.3% as compared to the third quarter of 2004. This increase was substantially the result of one of the independent service organizations with which we have an existing relationship transferring a merchant portfolio to us from another institution. Leasing income increased $175,000 to $273,000 for the third quarter of 2005 over the same period in 2004. The increase was the result of the acquisition of Mears and its $25.7 million portfolio of leases in January 2005. Other income increased to $266,000, an increase of $141,000 or 112.8% . The majority of the increase was from automated clearing house (ACH) fees which increased $90,000 over the same period in 2004. The increase was the result of new agreements in which the Company processor ACHS as the Originating Depository Financial Institution (ODFI) for third party processors.
Non-Interest Expense. Total non-interest expense was $5.7 million for the third quarter of 2005, as compared to $4.4 million for third quarter of 2004, an increase of $1.2 million or 28.0% . Salaries and employee benefits amounted to $2.8 million for the third quarter of 2005 as compared to $2.3 million for the third quarter of 2004. The increase reflects the addition of twenty-three Mears employees as a result of our acquisition of Mears in January 2005 as well as increases in our commercial lending and affinity group staffs. Computer expense increased to $394,000 for the third quarter of 2005 an increase of $121,000 or 44.3% . The increase reflects the upgrade of our internet banking platform in 2005. Professional fees increased to $414,000 for the third quarter of 2005 an increase of $186,000 or 81.6% . The increase reflects the increasing compliant costs that are associated with being a public company.
(First nine months of 2005 to first nine months of 2004)
Net Income: Net income for the first nine months of 2005 was $4.8 million, compared to net income of $1.8 for the first nine months of 2004. Diluted earnings per share were $0.28 in the first nine months of 2005 as compared to $.10 for the first nine months of 2004. Return on average assets was 0.90% and return on average equity was 4.96% for first nine months of 2005, as compared to .54% and 2.47%, respectively for the first nine months of 2004.
Net Interest Income: Our interest income for the first nine months of 2005 increased to $32.8 million from $17.0 million in the first nine months of 2004, while our net interest income increased to $22.6 million from $12.1 million. Our average loans increased to $522.9 million for first nine months of 2005 from $292.0 million for the first nine months of 2004. As stated above, the primary reason for the increases in our interest income and net interest income was our ability to increase our earning assets through continued organic growth of our loan portfolio, as well as the acquisition of Mears in January 2005 which increased our portfolio of direct financing leases.
Our net interest margin for the first nine months 2005 increased to 4.47% from 3.79% for the first nine months of 2004, an increase of 68 basis points (.68%). The increased net interest margin resulted from the following:
For the first nine months of 2005 the average yield on our interest-earning assets increased to 6.50% from 5.31% for first nine months of 2004, an increase of 119 basis points (1.19%) . The Cost of our interest-bearing deposits increased to 2.73% for the first nine months of 2005 from 2.12% for the first nine months of 2004, an increase of 61 basis points (.61%). The increase in the cost of interest-bearing deposits was the result of interest rate increases by the Federal Reserve Board in first three quarters of 2005 over those prevailing in the first three quarters of 2004. Average interest bearing deposits increased to $438.2 million from $262.9 million, an increase of $175.3 million or 66.7% .
Provision for Loan and Lease Losses. Our provision for loan and lease losses was $1.6 million for the first nine months of 2005 compared to $982,000 for the first nine months of 2004. For more information about our provisions and allowance for loan and lease losses and our loss experience see “ – Allowance for Loan and Lease Losses” and “ – Summary of Loan and Lease Loss Experience,” below.
Non-Interest Income. Non-interest income, exclusive of gains on sales of investment securities, was $3.2 million for the first nine months of 2005 as compared to $1.7 for the first nine months of 2004, an increase of $1.5 million or 90.7% . Gains on sales of investment securities totaled $67,000 in the first nine months of 2005 compared to $481,000 of gains on sale investment securities for the same period in 2004. The principal reasons for the increase in non-interest income were an increase in income from merchant credit card fees, an increase in leasing income, and an increase in other income. Our merchant credit card income was $827,000 for the first nine months of 2005, an increase of $340,000 or 69.8% as compared to the first nine months of 2004. This increase was substantially the result of one of the independent service organizations with which we have an existing relationship transferring a merchant portfolio to us from another institution. Leasing income increased $942,000 to $1.1 million for first nine months of 2005 over the same period in 2004. The increase was the result of the acquisition of Mears and its $25.7 million portfolio of leases in January 2005. Other income was $737,000 for the first nine months of 2005, an increase of $269,000 or 57.5% . The majority of the increase was due to an increase in ACH processing fees of $166,000 over the prior year period. As stated above the increase was the result of new agreements in which the Company processes achs as the ODFI for this party processor.
Non-Interest Expense. Total non-interest expense was $17.1 million for the first nine months of 2005, as compared to $11.6 million for first nine months of 2004, an increase of $5.5 million or 47.8% . Salaries and employee benefits amounted to $7.7 million for the first nine months of 2005 as compared to $5.9 million for the first nine months of 2004. The increase reflects the addition of twenty-three Mears employees as a result of our acquisition of Mears in January 2005 as well as increases in our commercial lending and affinity group staffs. Computer expense increased to $1.0 million for the first nine months of 2005 an increase of $745,000 or 36.7% . The increase reflects the upgrade of our internet banking platform in 2005. Professional fees increased to $955,000 for the first nine months of 2005 an increase of $520,000 or 119.5% . The increase reflects the increasing compliance costs that are associated with being a public company. In the first quarter of 2005, we redeemed our outstanding subordinated debentures at a premium of $869,000. The redemption of the subordinated debentures, which supported our trust preferred securities, also resulted in the write-off $466,000 of unamortized offering costs from our trust preferred securities offering in 2002. The total expense associated with our redemption of the subordinated debentures in the first quarter of 2005 was $1.3 million.
Liquidity and Capital Resources
Liquidity defines our ability to generate funds to support asset growth, meet deposit withdrawals, satisfy borrowing needs and otherwise operate on an ongoing basis. We invest the funds we do not need for operation primarily in overnight federal funds.
Since commencement of operations, the primary source of funds for our financing activities have been cash inflows from net increases in deposits, which were $269.6 million in the first nine months of 2005, and from an offering of common stock by our subsidiary bank in February 2004 which resulted in net proceeds of $82.9 million. We have also used sources outside of our core deposit products to fund our loan growth including the Federal Home Loan Bank and repurchase agreements. As of September 30, 2005, we had $40.0 million of outstanding Federal Home Loan Bank advances and $5.5 million in repurchase agreements.
Funding was directed primarily at cash outflows required for loans, which were $180.2 million in the first nine months of 2005. At September 30, 2005, we had outstanding commitments to fund loans, including unused lines of credit, of $237.5 million.
We must comply with capital adequacy guidelines issued by the Federal Deposit Insurance Corporation, or FDIC. A bank must, in general, have a leverage ratio of 5.0%, a ratio of Tier I capital to risk-weighted assets of 6.0% and a ratio of total capital to risk-weighted assets of 10.0% in order to be considered “well capitalized.” A Tier I leverage ratio is the ratio of Tier 1 capital to average assets for the period. “Tier I capital” includes common shareholders’ equity, certain qualifying perpetual preferred stock and minority interests in equity accounts of consolidated subsidiaries, less goodwill. At September 30, 2005 we were “well capitalized” under banking regulations.
The following table sets forth the regulatory capital amounts and ratios for the periods indicated:
Asset and Liability Management
The management of rate sensitive assets and liabilities is essential to controlling interest rate risk and optimizing interest margins. An interest rate sensitive asset or liability is one that, within a defined time period, either matures or experiences an interest rate change in line with general market rates. Interest rate sensitivity measures the relative volatility of a bank’s interest margin resulting from changes in market interest rates.
We monitor and control interest rate risk through a variety of techniques, including use of traditional interest rate sensitivity analysis (also known as “gap analysis”). Traditional gap analysis involves arranging our interest-earning assets and interest-bearing liabilities by repricing periods and then computing the difference (or “interest rate sensitivity gap”) between the assets and liabilities that are estimated to reprice during each time period and cumulatively through the end of each time period.
Gap analysis requires estimates as to when individual categories of interest-sensitive assets and liabilities will reprice, and assumes that assets and liabilities assigned to the same repricing period will reprice at the same time and in the same amount. Gap analysis does not account for the fact that repricing of assets and liabilities is discretionary and subject to competitive and other pressures. A gap is considered positive when the amount of interest rate sensitive assets exceeds the amount of interest rate sensitive liabilities. A gap is considered negative when the amount of interest rate sensitive liabilities exceeds interest rate sensitive assets. During a period of falling interest rates, a positive gap would tend to adversely affect net interest income, while a negative gap would tend to result in an increase in net interest income. During a period of rising interest rates, a positive gap would tend to result in an increase in net interest income while a negative gap would tend to affect net interest income adversely.
The following table sets forth the estimated maturity/repricing structure of our interest-earning assets and interest-bearing liabilities at September 30, 2005. Except as stated below, the amounts of assets or liabilities shown which reprice or mature during a particular period were determined in accordance with the contractual terms of each asset or liability. The majority of interest-bearing demand deposits and savings deposits are assumed to be “core” deposits, or deposits that will generally remain with us regardless of market interest rates. Therefore, 50% of core interest checking deposits and 25% of our core savings and money market deposits are shown as maturing or repricing within the “1 – 90 days” column with the remainder shown in the “1 – 3 years” column. We estimate the repricing characteristics of these deposits based on historical performance, past experience at other institutions and other deposit behavior assumptions. However, we may choose not to reprice liabilities proportionally to changes in market interest rates for competitive or other reasons. Payments of fixed-rate loans and mortgage-backed securities are scheduled based on their anticipated cash flow, including prepayments based on historical data and current market trends. The table does not necessarily indicate the impact of general interest rate movements on our net interest income because the repricing of certain categories of assets and liabilities is beyond our control as, for example, prepayments of loans and withdrawal of deposits. As a result, certain assets and liabilities indicated as repricing within a stated period may in fact reprice at different times and at different rate levels.
The method used to analyze interest rate sensitivity in this table has a number of limitations. Certain assets and liabilities may react differently to changes in interest rates even though they reprice or mature in the same or similar time periods. The interest rates on certain assets and liabilities may change at different times than changes in market interest rates, with some changing in advance of changes in market rates and some lagging behind changes in market rates. Additionally, the actual prepayments and withdrawals we experience when interest rates change may deviate significantly from those assumed in calculating the data shown in the table.
Financial Condition
General. Our total assets at September 30, 2005 were $838.8 million, of which our total loans were $612.7 million. At December 31, 2004 our total assets were $576.3 million, of which our total loans were $427.9 million. Our portfolio of commercial, commercial mortgage and construction loans grew $114.2 million, or 34.9%, from year-end 2004 to $441.5 million at September 30, 2005.
Investment portfolio. For detailed information on the composition and maturity distribution of our investment portfolio, see Note 3 to the Notes to Financial Statements contained in this Quarterly Report on Form 10-Q. Total investment securities decreased to $105.8 million on September 30, 2005, a decrease of $14.3 million or 11.9% from year-end 2004. Investments decreased due to a $40 million investment security being called in the first quarter of 2005. We purchased approximately $30 million in investment securities to replace the called security and the remaining funds were used to fund loan growth.
Loan Portfolio. Total loans increased to $612.7 million at September 30, 2005 from $427.9 million at December 31, 2004, an increase of $184.8 million or 43.2% .
The following table summarizes our loan portfolio by loan category for the periods indicated (in thousands):
Allowance for Loan and Lease Losses. Management reviews the adequacy of our allowance for loan and lease losses on at least a quarterly basis to ensure that the provision for loan losses which has been charged against earnings is in the amount necessary to maintain our allowance at a level that is appropriate, based on management’s estimate of probable losses. Our estimates of loan and lease losses are intended to, and, in management’s opinion, do, meet the criteria for accrual of loss contingencies in accordance with Statement of Financial Accounting Standards, or SFAS, No. 5, “Accounting for Contingencies,” and SFAS No. 114, “Accounting by Creditors for Impairment of a Loan.” The process of evaluating this adequacy has two basic elements: first, the identification of problem loans or leases based on current financial information and the fair value of the underlying collateral; and second, a methodology for estimating general loss reserves. See “_Critical Accounting Policies and Estimates.” For loans or leases classified as “special mention,” “substandard” or “doubtful,” we record all estimated losses at the time we classify the loan or lease. This “specific” portion of the allowance is the total of potential, although unconfirmed, losses for individually classified loans. Because we immediately charge off all identified losses, no portion of the allowance for loan losses is restricted to any individual loan or groups of loans, and the entire allowance is available to absorb any and all loan losses.
The second phase of our analysis represents an allocation of the allowance. This methodology analyzes pools of loans that have similar characteristics and applies historical loss experience and other factors for each pool to determine its allocable portion of the allowance. This estimate is intended to represent the potential unconfirmed and inherent losses within the portfolio. Individual loan pools are created for major loan categories: commercial loans, commercial mortgages, construction loans and direct lease financing, and for the various types of loans to individuals. The historical experience for each loan pool is augmented by accounting for such items as: current economic conditions, current loan portfolio performance, loan policy or management changes, loan concentrations, increases in our lending limit, the average loan size, and other factors as appropriate. For example, as a result of significant growth in construction lending, which was the result of a construction lending group being hired at the end of the third quarter of 2003, our allocation to the construction loan pool increased in the last half of 2003 and the first nine months of 2004. We enhance our allowance methodology through the efforts of our chief risk officer, who directly oversees the loan review processes and measures the adequacy of the allowance independently from management. The chief risk officer reports directly to the Bank’s audit committee. The chief risk officer’s individual loan oversight parameters include: borrower relationships over $2.0 million and loans 90 days or more past due or that have been previously classified as substandard. Pursuant to these parameters, approximately 67% of our loans, by dollar amount, are subject to the chief risk officer’s oversight.
Although the performance of our loan portfolio has been above that of our peers, and we do not currently foresee a change in that performance, our analysis for purposes of deriving the historical loss component of the allowance includes factors in addition to our historical loss experience, such as management’s experience with similar loan and lease portfolios at other institutions, the historic loss experience of our peers and statistical information from various industry reports such as the FDIC’s Quarterly Banking Profile.
While we consider our allowance for loan and lease losses to be adequate based on information currently available, future additions to the allowance may be necessary due to changes in economic conditions or management’s assumptions as to future delinquencies, recoveries and losses and management’s intent with regard to the disposition of loans and leases. We review the adequacy of the allowance on at least on a quarterly basis to ensure that the provision for loan and lease losses that has been charged against earnings is an amount necessary to maintain the allowance at a level that is appropriate based on management's assessment of probable estimated losses. The following table summarizes our credit loss experience for each of the periods indicated:
Non-Performing Loans. Loans are considered to be non-performing if they are on a non-accrual basis or terms have been renegotiated to provide a reduction or deferral of interest or principal because of a weakening in the financial positions of the borrowers. A loan which is past due 90 days or more and still accruing interest remains on accrual status only when it is both adequately secured as to principal and is in the process of collection. We did not have non-accrual or renegotiated loans at September 30, 2005 or 2004. Loans past due 90 days or more still accruing interest amounted to $247,000 and $-0-at September 30, 2005 and 2004, respectively.
Deposits. A primary source for funding our growth is through deposit accumulation. We offer a variety of deposit accounts with a range of interest rates and terms, including savings accounts, checking accounts, money market savings accounts and certificates of deposit. At September 30, 2005, we had total deposits of $657.7 million as compared to $388.1 million at December 31, 2004, an increase of $296.6 million or 69.5% . The following table presents the average balance and rates paid on deposits for the periods indicated:
Borrowings
At September 30, 2005 we had $40.0 million in advances from the Federal Home Loan Bank. The advances mature on a daily basis and are collateralized with investment securities.
Shareholders’ Equity
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
There has been no material change in our assessment of our sensitivity to market risk since our presentation in our Annual Report on Form 10-K for the year ended December 31, 2004 except as set forth in Part I, Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Quarterly Report on Form 10-Q.
Item 4. Controls and Procedures
We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in Securities and Exchange Act of 1934 reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our chief executive officer and our chief financial officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, our management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and our management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
During the third quarter 2005, management began to implement changes to our information technology system designed to provide more extensive controls around segregation of duties on our core processing system. Management is in the process of developing new system access rights for all employees and management believes that the changes made are appropriately designed. This project is expected to be completed during the fourth quarter of 2005 and will be tested for effectiveness prior to year end. The Company will perform an evaluation of the effectiveness of its internal control over financial reporting in connection with its Annual Report on Form 10-K for the year ended December 31, 2005, to be filed with the Securities and Exchange Commission in early 2006.
Under the supervision of our chief executive officer and chief financial officer, we have carried out an evaluation of the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report. Based upon that evaluation, our chief executive officer and chief financial officer concluded that our disclosure controls and procedures are effective at the reasonable assurance level.
There have been no significant changes in our internal controls over financial reporting that have materially affected, or are reasonably likely to materially effect, our internal control over financial reporting during our most recent quarter.
PART II OTHER INFORMATION
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.