UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended June 30, 2009
Commission File No. 001-33037
SOUTHERN NATIONAL BANCORP OF VIRGINIA, INC.
(Exact name of registrant as specified in its charter)
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
6830 Old Dominion Drive
McLean, Virginia 22101
(Address of principal executive offices) (zip code)
(703) 893-7400
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
YES x NO ¨
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 definition of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b–2 of the Exchange Act:
(Do not check if a smaller
reporting company)
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
As of July 31, 2009, there were 6,798,547 shares of common stock outstanding.
June 30, 2009
INDEX
Consolidated Balance Sheets as of June 30, 2009 and December 31, 2008
Consolidated Statements of Income and Comprehensive Loss for the three and six months ended June 30, 2009 and 2008
Consolidated Statements of Changes in Stockholders’ Equity for the six months ended June 30, 2009
Consolidated Statements of Cash Flows for the six months ended June 30, 2009 and 2008
Notes to Consolidated Financial Statements
ITEM I - FINANCIAL INFORMATION
PART I - FINANCIAL STATEMENTS
CONSOLIDATED BALANCE SHEETS
(dollars in thousands) (Unaudited)
ASSETS
Cash and due from financial institutions
Interest-bearing deposits in other financial institutions
Total cash and cash equivalents
Less allowance for loan losses
Net loans
Total assets
NOW accounts
Money market accounts
Savings accounts
Time deposits
Total interest-bearing deposits
Total deposits
Total liabilities
Common stock, $.01 par value. Authorized 45,000,000 shares; issued and outstanding, 6,798,547 shares at June 30, 2009 and December 31, 2008
Additional paid in capital
Retained earnings
Accumulated other comprehensive loss
Total stockholders’ equity
Total liabilities and stockholders’ equity
See accompanying notes to consolidated financial statements.
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CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE LOSS
(dollars in thousands, except per share amounts) (Unaudited)
Interest and fees on loans
Interest and dividends on taxable securities
Interest and dividends on other earning assets
Total interest and dividend income
Interest expense:
Interest on deposits
Interest on borrowings
Total interest expense
Net interest income
Provision for loan losses
Net interest income after provision for loan losses
Noninterest income:
Account maintenance and deposit service fees
Income from bank-owned life insurance
Net gain (loss) on other real estate owned
Total other-than-temporary impairment losses
Portion of loss recognized in other comprehensive income (before taxes)
Net credit impairment losses recognized in earnings
Gain on sales of securities
Other
Total noninterest income (loss)
Noninterest expenses:
Salaries and benefits
Occupancy expenses
Furniture and equipment expenses
Amortization of core deposit intangible
Virginia franchise tax expense
FDIC special assessment
FDIC assessment
Data processing expense
Telephone and communication expense
Other operating expenses
Total noninterest expenses
Income (loss) before income taxes
Income tax expense (benefit)
Net income
Other comprehensive loss:
Unrealized gain (loss) on available for sale securities
Realized amount on securities sold, net
Non-credit component of other-than-temporary impairment on held-to-maturity securities net of amounts previously recorded upon transfer to held-to-maturity from available-for-sale
Net unrealized loss
Tax effect
Other comprehensive loss
Comprehensive loss
Earnings per share, basic and diluted
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CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
FOR THE SIX MONTHS ENDED JUNE 30, 2009
Balance - January 1, 2009
Stock-based compensation expense
Change in other comprehensive income (loss) (net of tax, $927)
Total comprehensive loss
Balance - June 30, 2009
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CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE SIX MONTHS ENDED JUNE 30, 2009 AND 2008
Operating activities:
Adjustments to reconcile net income to net cash and cash equivalents provided by operating activities:
Depreciation
Amortization , net
Earnings on bank-owned life insurance
Stock based compensation expense
Impairment on held-to-maturity securities
Net (gain) loss on other real estate owned
Net increase in other assets
Net increase (decrease) in other liabilities
Net cash and cash equivalents provided by operating activities
Investing activities:
Proceeds from sales of securities available for sale
Proceeds from paydowns, maturities and calls of securities available for sale
Purchases of securities held to maturity
Proceeds from paydowns, maturities and calls of securities held to maturity
Loan originations and payments, net
Net increase in stock in Federal Reserve Bank and Federal Home Loan Bank
Proceeds from sale of other real estate owned
Purchases of bank premises and equipment
Net cash and cash equivalents used in investing activities
Financing activities:
Net increase in deposits
Proceeds from Federal Home Loan Bank advances
Net increase (decrease) in securities sold under agreement to repurchase and other short-term borrowings
Net cash and cash equivalents provided by financing activities
Increase (decrease) in cash and cash equivalents
Cash and cash equivalents at beginning of period
Cash and cash equivalents at end of period
Supplemental Disclosure of Cash Flow Information
Cash payments for:
Interest
Income taxes
Supplemental schedule of noncash investing and financing activities
Transfer from loans to other real estate owned
Acquisition of fixed assets related to Leesburg Branch
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Notes to Consolidated Financial Statements (Unaudited)
Southern National Bancorp of Virginia, Inc. (“SNBV”) is a corporation formed on July 28, 2004 under the laws of the Commonwealth of Virginia and is the holding company for Sonabank (“Sonabank”) a national bank chartered on April 14, 2005, under the laws of the United States of America. On January 1, 2009, Sonabank changed from a nationally chartered bank to a state chartered bank and moved its headquarters from Charlottesville to McLean, Virginia. Going forward, Sonabank will be regulated by the State Corporation Commission of Virginia and the Federal Reserve Bank of Richmond. Currently, all of the communities served by Sonabank are located in Virginia, and Sonabank does very little lending outside Virginia. The principal activities of Sonabank are to attract deposits and originate loans as permitted under applicable banking regulations. Sonabank conducts full-service banking operations in Fairfax County (Reston, McLean and Fairfax), Charlottesville, Warrenton, Leesburg and Clifton Forge. All of our branches are in Virginia.
The consolidated financial statements include the accounts of Southern National Bancorp of Virginia, Inc. and its subsidiary. Significant inter-company accounts and transactions have been eliminated in consolidation.
The unaudited consolidated financial statements have been prepared in accordance with U. S. generally accepted accounting principles (“U. S. GAAP”) for interim financial information and instructions for Form 10-Q and follow general practice within the banking industry. Accordingly, the unaudited consolidated financial statements do not include all of the information and footnotes required by U. S. GAAP for complete financial statements. However, in the opinion of management, all adjustments (consisting only of normal recurring accruals) necessary for a fair presentation of the results of the interim periods presented have been made. The results of operations for the interim periods are not necessarily indicative of the results that may be expected for the full year. For further information, refer to the consolidated financial statements and footnotes thereto included in SNBV’s Form 10-K for the year ended December 31, 2008.
Subsequent events have been evaluated through August 14, 2009, the date that the financial statements were issued.
Use of Estimates
The preparation of the consolidated financial statements in conformity with U. S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from these estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, the carrying value of investment securities, other than temporary impairment of investment securities, the valuation of goodwill and intangible assets, mortgage servicing rights, other real estate owned and deferred tax assets.
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Reclassifications
Some items in the prior year financial statements were reclassified to conform to the current presentation.
Recent Accounting Pronouncements
In April 2009, the FASB issued Staff Position No. 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). This FASB Staff Position (FSP) provides additional guidance for estimating fair value in accordance with FASB Statement No. 157,Fair Value Measurements, when the volume and level of activity for the asset or liability have significantly decreased. It also includes guidance on identifying circumstances that indicate a transaction is not orderly. This FSP is effective for interim and annual reporting periods ending after June 15, 2009. We have adopted this FSP for the interim reporting period ended June 30, 2009, and we followed this guidance to estimate the fair value of trust preferred securities. See Note 3 and Note 7.
In April 2009, the FASB issued FSP FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments.This FSP amends the other-than-temporary impairment guidance in U. S. GAAP 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 in the financial statements. One change to current practice relates to management’s assertion regarding recovery of fair value declines. Currently, when determining whether impairment is other-than-temporary, an entity must assess whether it has the intent and ability to hold a security until recovery of its cost basis. Under this FSP, an entity must assess whether it intends to sell the security or if it is more likely than not that it will be required to sell the security prior to recovery. If the entity does not intend to sell the security or if it is more likely than not that it will not be required to sell the security before its anticipated recovery, then all available evidence should be considered to estimate the anticipated period over which the cost basis of the security is expected to recover. If the entity does not anticipate recovery of its cost basis, an other-than-temporary impairment should be considered to have occurred and the credit loss component should be recognized in earnings and the other components should be recognized in other comprehensive income. Both the credit and noncredit components will be presented in the income statement. The total other-than-temporary impairment charge will be reduced by the amount recognized in other comprehensive income. This FSP shall be applied to existing and new investments held by an entity as of the beginning of the interim period in which it is adopted. For debt securities held at the beginning of the interim period of adoption for which an other-than-temporary impairment was previously recognized, if an entity does not intend to sell and it is not more likely than not that the entity will be required to sell the security before recovery of its amortized cost basis, the entity shall recognize the cumulative effect of initially applying this FSP as an adjustment to the opening balance of retained earnings with a corresponding adjustment to accumulated other comprehensive income. This FSP is effective for interim and annual reporting periods ending after June 15, 2009. We have adopted this FSP effective April 1, 2009. As a result of implementing the FSP, the amount of OTTI recognized in income for the period was $863 thousand. Had the FSP not been issued, the amount of OTTI that would have been recognized in income for the period would have been $5.4 million. No adjustments were recorded to prior OTTI charges upon adoption as these were for equity securities.
Also in April 2009, FASB issued FSP FAS 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments. This FSP amends FASB Statement No. 107, Disclosures about Fair Value of Financial Instruments, to require disclosures about fair value of financial
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instruments for interim reporting periods of publicly traded companies as well as in annual financial statements. This FSP also amends APB Opinion No. 28, Interim Financial Reporting, to require those disclosures in summarized financial information at interim reporting periods. This FSP is effective for interim and annual reporting periods ending after June 15, 2009. We have adopted this FSP for the interim reporting period ended June 30, 2009, and it did not have a material impact on our results of operations or financial position as it only required additional disclosures which are included in Note 7.
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. This FSP addresses concerns raised by constituents about the application of Statement No. 141(R) to assets and liabilities arising from contingencies in a business combination. The FSP provides a model more consistent with that provided in the original Statement No. 141 to account for pre-acquisition contingencies. The FSP requires an acquirer to recognize at fair value “an asset acquired or liability assumed in a business combination that arises from a contingency if the acquisition-date fair value of that asset or liability can be determined during the measurement period.” The FSP is effective for business combinations whose acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. FSP FAS 141(R)-1 is expected to have an impact on our accounting for any business combinations closing on or after January 1, 2009.
In May 2009, the FASB issued Statement No. 165, “Subsequent Events” which 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. In particular, this Statement sets forth the period after the balance sheet date during which management of a reporting entity should evaluate events or transactions that may occur for potential recognition or disclosure in the financial statements, the circumstances under which an entity should recognize events or transactions occurring after the balance sheet date in its financial statements, and the disclosures that an entity should make about events or transactions that occurred after the balance sheet date. In accordance with this Statement, an entity should apply the requirements to interim or annual financial periods ending after June 15, 2009. The impact of adoption did not have a material impact on our results of operations or financial position.
In June 2009, the FASB issued Statement No. 166, “Accounting for Transfers of Financial Assets—an amendment of FASB Statement No. 140.” This statement removes the concept of a qualifying special-purpose entity from Statement 140 and removes the exception from applying FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities, to qualifying special-purpose entities. The objective in issuing this Statement is 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. This Statement must be applied as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period and for interim and annual reporting periods thereafter. Management is currently evaluating this standard but does not expect the impact of adoption to be material to our results of operations or financial position.
On June 12, 2009, the FASB issued Statement No. 167, Amendments to FASB Interpretation No. 46(R). Statement No. 167 amends FIN 46(R) to replace the quantitative-based risks and rewards calculation for determining which enterprise, if any, has a controlling financial interest in a variable interest entity with a qualitative approach focused on identifying which enterprise has
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the power to direct the activities of a variable interest entity (VIE) that most significantly impact the entity’s economic performance and (1) the obligation to absorb losses of the entity or (2) the right to receive benefits from the entity. Unlike FIN 46 (R), this Statement requires ongoing reconsideration of whether (1) an entity is a VIE and (2) an enterprise is the primary beneficiary of a VIE. It is expected that the amendments will result in more entities consolidating VIEs that previously were not consolidated The Statement will also require additional disclosures about an enterprise’s involvement in variable interest entities. This Statement must be applied as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period and for interim and annual reporting periods thereafter. Management is currently evaluating this standard but does not expect the impact of adoption to be material to our results of operations or financial position.
In 2004, the Board of Directors adopted a stock options plan that authorized the reservation of up to 302,500 shares of common stock and provided for the granting of stock options to certain directors, officers and employees. The options granted to officers and employees are incentive stock options and the options granted to non-employee directors are non-qualified stock options. The purpose of the plan is to afford key employees an incentive to remain in the employ of SNBV and to assist in the attracting and retaining of non-employee directors by affording them an opportunity to share in SNBV’s future success. Under the plans, the options price cannot be less than the fair market value of the stock on the grant date. The maximum term of the options is ten years and options granted may be subject to a graded vesting schedule.
SNBV granted 41,500 options during the first six months of 2009. The fair value of each option granted is estimated on the date of grant using the Black-Scholes options-pricing model. The following weighted-average assumptions were used to value options granted in the six months ended June 30, 2009:
Dividend yield
Expected life
Expected volatility
Risk-free interest rate
Weighted average fair value per option granted
We have paid no dividends.
Due to SNBV’s short existence, the volatility was estimated using historical volatility of comparative publicly traded financial institutions in the Virginia market for periods approximating the expected option life.
The risk-free interest rate was developed using the U. S. Treasury yield curve for periods equal to the expected life of the options on the grant date. An increase in the risk-free interest rate will increase stock compensation expense on future option grants.
For the three and six months ended June 30, 2009, stock-based compensation expense was $13 thousand and $25 thousand, respectively, compared to $6 thousand and $13 thousand for the same periods last year. As of June 30, 2009, unrecognized compensation expense associated with the stock options was $193 thousand which is expected to be recognized over a weighted average period of 3.9 years.
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A summary of the activity in the stock option plan during the six months ended June 30, 2009 follows (dollars in thousands):
Options outstanding, beginning of period
Granted
Forfeited
Exercised
Options outstanding, end of period
Vested or expected to vest
Exercisable at end of period
The amortized cost and fair value of securities available-for-sale were as follows (in thousands):
Residential government-sponsored mortgage-backed securities
FHLMC preferred stock
Total
December 31, 2008
The carrying amount and fair value of securities held-to-maturity were as follows (in thousands):
Residential government-sponsored collateralized mortgage obligations
Other residential collateralized mortgage obligations
Trust preferred securities
The fair value and carrying amount, if different, of debt securities as of June 30, 2009 by contractual maturity were as follows (in thousands). Securities not due at a single maturity date, primarily mortgage-backed securities and collateralized mortgage securities, are shown separately.
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Due after ten years
Residential mortgage-backed securities
Residential collateralized mortgage obligations
During the six months ended June 30, 2009, we sold $9.9 million of available-for-sale mortgage-backed securities resulting in a gross gain of $223 thousand. There were no sales of securities during the first six months of 2008, or for the quarters ended June 30, 2009 and 2008. The tax provision related to the 2009 realized gain was $76 thousand. Also impacting earnings in 2009 was an other-than-temporary impairment (“OTTI”) charge related to credit loss on three trust preferred securities in the amount of $863 thousand which is described below. In the first six months of 2008, we recognized an OTTI charge in the amount of $124 thousand on an investment in FHLMC perpetual preferred stock.
Securities with a carrying amount of approximately $42.2 million and $55.8 million at June 30, 2009 and December 31, 2008, respectively, were pledged to secure public deposits, repurchase agreements and a line of credit for advances from the Federal Home Loan Bank of Atlanta (“FHLB”).
SNBV monitors the portfolio which is subject to liquidity needs, market rate changes and credit risk changes to see if adjustments are needed. As outlined in the table below, there are 9 securities with stated maturities totaling approximately $15.3 million in the portfolio that are considered temporarily impaired at June 30, 2009. Because the decline in fair value is attributable to changes in interest rates and illiquidity, and not credit quality, and because we do not have the intent to sell these securities and it is likely that we will not be required to sell the securities before their anticipated recovery, management does not consider these securities to be other-than-temporarily impaired as of June 30, 2009. All of these securities continue to perform according to the contractual terms except for MMCF XVIII, TRAP 2007-XII and TRAP 2007-XIII which have deferred interest payments (see discussion in subsequent paragraphs). The following tables present information regarding securities in a continuous unrealized loss position as of June 30, 2009 and December 31, 2008 (in thousands) by duration of time in a loss position:
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As of June 30, 2009, we owned pooled trust preferred securities as follows:
Security
Investment Grade:
ALESCO VII A1B
MMCF II B
MMCF III B
Other:
TPREF FUNDING II
TRAP 2007-XII C1
TRAP 2007-XIII D
MMC FUNDING XVIII
Other Than Temporarily Impaired:
ALESCO V C1
ALESCO XV C1
ALESCO XVI C
Five of the trust preferred securities owned by Sonabank have not continued to pay principal and interest in accordance with the contractual terms of the securities. MMC Funding XVIII continues to defer interest payments since the fourth quarter of 2008. TRAP XII, TRAP XIII, ALESCO XV and ALESCO XVI have had new deferrals which caused failures in senior class principal coverage tests during the second quarter of 2009. When this happens the cash flows to the lower classes are temporarily suspended and used to pay down the principal of the senior classes in order to restore the over-collateralization levels of the senior classes. The bonds will continue to accrue interest, but it will be capitalized rather than paid in cash, also known as payment in kind. Interest will be earned on the capitalized interest at the current coupon rate. Once the senior class coverage test is satisfied, the lower classes will begin to receive current interest as well as capitalized interest.
Management has evaluated each of these securities for potential impairment under EITF 99-20-1 and the most recently issued FSP guidance described in Note 1, and has reviewed each of the issues’ collateral participants using various techniques including the ratings provided in the Bank Financial Quarterly published by IDC Financial Publishing, Inc. Management has also reviewed the interest and principal coverage of each of the tranches it owns. In performing a detailed cash flow analysis of each security, management works with independent third parties to identify its best estimate of the cash flow estimated to be collected. If this estimate results in a present value of expected cash flows that is less than the amortized cost basis of a security (that is, credit loss exists), an OTTI is considered to have occurred. If there is no credit loss, any impairment is considered temporary. The cash flow analysis we performed included the following assumptions:
Unless the company has received funding under TARP, we assume that all of the issuers rated 1 by IDC Financial Publishing that have not already defaulted will default immediately with 100% loss.
We assume that annual defaults for the remaining life of each security will be 37.5 basis points. We assume recoveries ranging from 0% to 75% on deferrals after two years depending on the IDC rating of the deferring entity.
We assume no prepayments for 10 years and then 1% per annum for the remaining life of the security. Our securities have been modeled using the above assumptions by Sandler O’Neill or FTN Financial using the forward LIBOR curve plus original spread to discount projected cash flows to present values.
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Management’s analysis in the second quarter deemed three of the ten trust preferred securities we own other than temporarily impaired. The cash flow analysis this quarter indicated that one security, ALESCO XV C1 would probably experience significant credit losses. Two others, ALESCO V C1 and ALESCO XVI C, would probably experience minor credit losses. We have recorded OTTI charges accordingly. The credit portion of the OTTI was recognized in net income and the remainder through other comprehensive income. The following table details the three trust preferred securities with OTTI, their credit rating at June 30, 2009 and the related credit losses recognized in earnings:
Amount of other-than-temporary impairment related to credit loss at April 1, 2009
Addition
Amount of other-than-temporary impairment related to credit loss at June 30, 2009
We also own $2.2 million of SARM 2005-22 1A2. This residential collateralized mortgage obligation was downgraded from AAA to B by Standard and Poors in June 2009, but has been rated BBB by Fitch since the fourth quarter of 2008. This security was originated in 2005. The average FICO score of the underlying loans at origination was 748. As of June 30, 2009, delinquencies of more than 60 days, foreclosures and REO totaled 27.5% compared to 23.2% at March 31, 2009. Credit support is 13.9 compared to 14 when originally issued, which provides coverage of 1.54 times projected losses in the collateral. The fair market value is $1.2 million. We have evaluated this security for potential impairment and determined that an OTTI does not exist as of June 30, 2009.
We own 80,000 shares of the Freddie Mac perpetual preferred stock Series V. We have recorded total OTTI charges on this security of $1.976 million during 2008 and 2007. The fair value at June 30, 2009 was $35 thousand.
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The following table summarizes the composition of our loan portfolio as of June 30, 2009 and December 31, 2008:
Mortgage loans on real estate:
Commercial
Construction loans to residential builders
Other construction and land loans
Residential 1-4 family
Multi- family residential
Home equity lines of credit
Total real estate loans
Commercial loans
Consumer loans
Gross loans
Less unearned income on loans
Loans, net of unearned income
The following summarizes activity in the allowance for loan losses for the six months ended June 30, 2009 and 2008 (in thousands):
Balance, beginning of period
Provision charged to operations
Recoveries credited to allowance
Loans charged off
Balance, end of period
Loans identified as impaired in accordance with SFAS 114 totaled $2.4 million as of June 30, 2009. This compares to $974 thousand of impaired loans at December 31, 2008. Included in impaired loans are nonaccrual loans in the amount of $2.2 million and $1.1 million at June 30, 2009 and December 31, 2008, respectively. At June 30, 2009, there were no loans past due 90 days or more and accruing interest, and there was one loan in the amount of $135 thousand past due 90 days or more and accruing interest at December 31, 2008.
SNBV is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve elements of credit and funding risk in excess of the amount recognized in the consolidated balance sheet. Letters of credit are written conditional commitments issued by SNBV to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers. We had letters of credit outstanding totaling $1.4 million and $1.6 million as of June 30, 2009 and December 31, 2008, respectively.
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Our exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit and letters of credit is based on the contractual amount of these instruments. We use the same credit policies in making commitments and conditional obligations as we do for on-balance sheet instruments.
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments are made predominately for adjustable rate loans, and generally have fixed expiration dates of up to three months or other termination clauses and usually require payment of a fee. Since many of the commitments may expire without being completely drawn upon, the total commitment amounts do not necessarily represent future cash requirements. We evaluate each customer’s creditworthiness on a case-by-case basis.
At June 30, 2009 and December 31, 2008, we had unfunded lines of credit and undisbursed construction loan funds totaling $38.0 million and $39.0 million, respectively. Our approved loan commitments were $1.3 million and $2.1 million at June 30, 2009 and December 31, 2008, respectively.
The following is a reconciliation of the denominators of the basic and diluted earnings per share (“EPS”) computations (dollars in thousands, except per share data):
For the three months ended June 30, 2009
Basic EPS
Effect of dilutive stock options and warrants
Diluted EPS
For the three months ended June 30, 2008
For the six months ended June 30, 2009
For the six months ended June 30, 2008
There were 397,925 anti-dilutive options and warrants during the three and six months ended June 30, 2009, and there were 356,425 and 105,900 anti-dilutive options and warrants during the three and six months ended June 30, 2008, respectively.
FAS 157 establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:
Level 1: Quoted prices (unadjusted) or identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date
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Level 2: Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data
Level 3: Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability
Assets measured at fair value on a recurring basis are summarized below:
(dollars in thousands)
Financial assets:
Available for sale securities
Total available-for-sale securities
The following is a description of the valuation methodologies used for instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy:
Securities
Where quoted prices are available in an active market, securities are classified within 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. Level 2 securities would include U. S. agency securities, mortgage-backed 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. Currently, all of SNBV’s available-for-sale securities are considered to be level 2 securities.
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Assets and Liabilities Measured on a Non-recurring Basis:
Trust Preferred Securities Classified as Held-to-Maturity
Since late 2007, the markets for trust preferred securities have become increasingly inactive. According to information received from FTN Financial, there have been no issuances of pooled trust preferred securities since 2007. Beginning in the second quarter of 2008, the purchase and sale activity of trust preferred securities decreased significantly as investors elected to hold the securities instead of selling them at depressed prices. Brokers have indicated that little if any activity is occurring in this sector, and the trust preferred securities trades that are taking place are primarily distressed sales. As a result, the bid-ask spreads have widened significantly and the volume of trades decreased compared to historical volumes.
The decline in the level of observable inputs and market activity in this class of investments by the measurement date has been significant and resulted in unreliable external pricing. Broker pricing and bid/ask spreads, when available, vary widely. The once active market has become comparatively inactive. As such, management utilized guidance in FSP FAS 157-4 to value these securities. The base input in calculating fair value is a Bloomberg Fair Value Index yield curve for single issuer trust preferred securities which correspond to the ratings of the securities we own. We also use composite rating indices to fill in the gaps where the bank rating indices did not correspond to the ratings in our portfolio. When a bank index that matches the rating of our security is not available, we used the bank index that most closely matches the rating, adjusted by the spread between the composite index that most closely matches the security’s rating and the composite index with a rating that matches the bank index used. We then use the adjusted index yield, which is further adjusted by a liquidity premium, as the discount rate to be used in the calculation of the present value of the same cash flows used to evaluate the securities for OTTI. The liquidity premiums were derived in consultation with FTN Financial. The liquidity premiums we used ranged from .25% to 4%, and the adjusted discount rates ranged from 7.93% to 16.55% . Due to current market conditions as well as the limited trading activity of these securities, the market value of the securities is highly sensitive to assumption changes and market volatility. We have determined that our trust preferred securities are classified with Level 3 of the fair value hierarchy.
Based on our analysis in the second quarter of 2009, three of the ten trust preferred securities we own were considered to be other than temporarily impaired. The total par value of these three securities was $7.0 million and the fair value was $1.7 million at June 30, 2009. We recognized an OTTI charge of $863 thousand in net income and the remainder through other comprehensive income.
Impaired Loans
SFAS 157 applies to loans measured for impairment using the practical expedients permitted by SFAS 114 at the fair value of the loan’s collateral (if the loan is collateral dependent). Fair value of the loan’s collateral, when the loan is dependent on collateral, is determined by appraisals or independent valuation which is then adjusted for the cost related to liquidation of the collateral. Fair value is classified as Level 3 in the fair value hierarchy. Loans identified as impaired in accordance with SFAS 114 totaled $2.4 million as of June 30, 2009 with an allocated allowance for loan losses totaling $194 thousand compared to a carrying amount of $974 thousand with an allocated allowance for loan losses totaling $378 thousand at December 31, 2008. Charge-offs related to impaired loans totaled $140 thousand and $100 thousand during the three and six months ended June 30, 2009 and 2008, respectively.
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Other Real Estate Owned (OREO)
OREO is evaluated at the time of acquisition and recorded at fair value as determined by independent appraisal or internal market evaluation less cost to sell. OREO is further evaluated quarterly for any additional impairment. Fair value is classified as Level 3 in the fair value hierarchy. The total amount of OREO was $3.4 million at June 30, 2009 and December 31, 2008. There were no write-downs of OREO during the three and six months ended June 30, 2009 and the three months ended June 30, 2008. There were write-downs totaling $200 thousand during the six months ended June 30, 2008.
Fair Value of Financial Instruments
The carrying amount and estimated fair values of financial instruments, not previously presented, were as follows (in thousands):
Cash and cash equivalents
Securities held to maturity
Stock in Federal Reserve Bank and Federal
Home Loan Bank
Accrued interest receivable
Financial liabilities:
Deposits:
Demand deposits
Money market and savings accounts
Certificates of deposit
Securities sold under agreements to repurchase and other short-term borrowings
FHLB advances
Accrued interest payable
Carrying amount is the estimated fair value for cash and cash equivalents, accrued interest receivable and payable, demand deposits, short-term debt, and variable rate loans that reprice frequently and fully. For fixed rate loans or deposits and for variable rate loans with infrequent repricing or repricing limits, fair value is based on discounted cash flows using current market rates applied to the estimated life. It was not practicable to determine the fair value of Federal Reserve Bank and Federal Home Loan Bank stock due to restrictions placed on its transferability. Fair value of long-term debt is based on current rates for similar financing. The fair value of off-balance-sheet items is not considered material.
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As part of the purchase price of the fixed assets related to the Leesburg branch, SNBV issued 61,000 warrants for the purchase of its common stock at an exercise price of $12.73 per share during the first quarter of 2008. The warrants expire in three years. The fair value of each warrant issued was estimated using the Black-Scholes options-pricing model. The following weighted-average assumptions were used to value the warrants:
Weighted average fair value per warrant
As previously announced Sonabank has entered into a definitive agreement to acquire the Warrenton branch office, approximately $26 million in selected loans and to assume approximately $26 million of the deposits from Millennium Bank, N.A. Under the agreement, approximately half of the loans are scheduled to be transferred to Sonabank at the end of July 2009. The remaining loans and the deposits will be transferred on September 28, 2009, subject to regulatory approval.
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ITEM 2 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Management’s discussion and analysis is presented to aid the reader in understanding and evaluating the financial condition and results of operations of SNBV. This discussion and analysis should be read with the consolidated financial statements, the footnotes thereto, and the other financial data included in this report and in our annual report dated December 31, 2008 on Form 10-K. Results of operations for the three and six month periods ended June 30, 2009 are not necessarily indicative of results that may be attained for any other period.
FORWARD-LOOKING STATEMENTS
Certain statements in this report may constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are statements that include projections, predictions, expectations or beliefs about future events or results or otherwise are not statements of historical fact. Such statements are often characterized by the use of qualified words (and their derivatives) such as “expect,” “believe,” “estimate,” “plan,” “project,” or other statements concerning opinions or judgment of the Company and its management about future events. Although we believe that its expectations with respect to certain forward-looking statements are based upon reasonable assumptions within the bounds of its existing knowledge of its business and operations, there can be no assurance that actual results, performance or achievements of SNBV will not differ materially from any future results, performance or achievements expressed or implied by such forward-looking statements. Actual future results and trends may differ materially from historical results or those anticipated depending on a variety of factors, including, but not limited to, the effects of and changes in: general economic conditions, the interest rate environment, legislative and regulatory requirements, competitive pressures, new products and delivery systems, inflation, changes in the stock and bond markets, technology, and consumer spending and savings habits. We do not update any forward-looking statements that may be made from time to time by or on behalf of SNBV.
OVERVIEW
Southern National Bancorp of Virginia, Inc. (“SNBV”) is a corporation formed on July 28, 2004 under the laws of the Commonwealth of Virginia and is the holding company for Sonabank (“Sonabank”) a national bank chartered on April 14, 2005, under the laws of the United States of America. On January 1, 2009, Sonabank changed from a nationally chartered bank to a state chartered bank and moved its headquarters from Charlottesville to McLean, Virginia. Going forward, Sonabank will be regulated by the State Corporation Commission of Virginia and the Federal Reserve Bank of Richmond. Currently, all of the communities served by Sonabank are located in Virginia, and Sonabank does very little lending outside Virginia. Moreover, the change should save the company in excess of $35 thousand in regulatory fees per year with increased savings as assets grow in the future. The principal activities of Sonabank are to attract deposits and originate loans as permitted under applicable banking regulations. Sonabank conducts full-service banking operations in Fairfax County (Reston, McLean and Fairfax), Charlottesville, Warrenton, Leesburg and Clifton Forge. All of our branches are in Virginia.
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RESULTS OF OPERATIONS
Net Income
Net income for the quarter ended June 30, 2009 was $23 thousand and $549 thousand for the six months ended June 30, 2009 compared to $450 thousand and $951 thousand during the second quarter and the first six months of 2008. Earnings were adversely impacted by OTTI charges of $863 thousand before tax on three of our trust preferred securities which experienced significant incremental deferrals during the quarter. Earnings for the second quarter and the six months were also adversely impacted by the FDIC special assessment of $190 thousand before tax as well as increases in the regular assessment which amounted to $123 thousand during the second quarter of 2009 compared to $50 thousand during the second quarter of 2008.
Net Interest Income
Our operating results depend primarily on our net interest income, which is the difference between interest and dividend income on interest-earning assets such as loans and investments, and interest expense on interest-bearing liabilities such as deposits and borrowings.
Net interest income for the three months ended June 30, 2009 was $3.5 million compared to $2.9 million for the same period last year. Average interest-earning assets for the three months ended June 30, 2009 increased $30.5 million over the same period in 2008. Average loans outstanding increased by $38.1 million in the second quarter of 2009 compared to the second quarter of 2008. Average investment securities decreased by $14.4 million in the quarter ended June 30, 2009, compared to the same period last year. The average balance of other earning assets, primarily interest-earning accounts at the Federal Reserve Bank of Richmond (FRB) and the Federal Home Loan Bank of Atlanta (FHLB), increased from $7.6 million during the second quarter of 2008 to $14.5 million during the second quarter of 2009. The average yield on interest-earning assets decreased from 6.40% in 2008 to 5.60% in 2009 primarily because of the prime rate decreases of 400 basis points during 2008 which accompanied the Federal Reserve Board’s reductions in its federal funds target rate. Average interest-bearing liabilities for the three months ended June 30, 2009 increased $29.7 million compared to the same period in 2008. Average interest-bearing deposits increased by $26.0 million, while average borrowings increased by $3.8 million compared to the second quarter of 2008. The average cost of interest-bearing liabilities decreased from 3.78% in 2008 to 2.44% in 2009. The interest rate spread for the three months ended June 30, 2009 increased from 2.62% to 3.16% compared to the same period last year. The net interest margin for the three months ended June 30, 2009 increased to 3.51% from 3.20% compared to the same period last year.
The net interest margin on a linked quarter basis rose significantly from 3.12% in the first quarter of 2009 to 3.51% in the second quarter of 2009. The rise resulted from a small increase in the yield on loans from 6.04% in the first quarter to 6.08% in the second quarter. This was a result of a stabilized prime rate and Sonabank’s efforts to establish floors on prime rate based loans. This improvement was partially offset by a decline in the yield on investment securities from 4.63% in the first quarter to 4.24% in the second quarter. The yield on earning assets increased from 5.57% during the first quarter to 5.60% during the second quarter.
Net interest income for the six months ended June 30, 2009 was $6.5 million compared to $6.2 million for the same period last year. Average interest-earning assets for the six months ended June 30, 2009 increased $36.4 million over the same period in 2008. Average loans outstanding increased by $38.2 million in the first six months of 2009 compared to the same period in 2008. Average investment securities decreased by $11.5 million in the six months ended June 30, 2009, compared to the same period last year. The average balance of other earning assets, primarily
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interest-earning accounts at the Federal Reserve Bank of Richmond (FRB) and the Federal Home Loan Bank of Atlanta (FHLB), increased from $6.8 million during the first six months of 2008 to $16.5 million during the first six months of 2009. The average yield on interest-earning assets decreased from 6.84% in 2008 to 5.58% in 2009 primarily because of the prime rate decreases of 400 basis points during 2008 which accompanied the Federal Reserve Board’s reductions in its federal funds target rate. Average interest-bearing liabilities for the six months ended June 30, 2009 increased $34.7 million compared to the same period in 2008. Average interest-bearing deposits increased by $29.4 million, while average borrowings increased by $5.3 million compared to the first six months of 2008. The average cost of interest-bearing liabilities decreased from 4.03% in 2008 to 2.64% in 2009. The interest rate spread for the six months ended June 30, 2009 increased from 2.82% to 2.94% compared to the same period last year. The net interest margin for the six months ended June 30, 2009 decreased to 3.32% from 3.43% compared to the same period last year.
Our commercial loans (non-real estate), acquisition and development loans, construction loans and SBA loans are predominately priced to a spread over the prime rate, and these loans reprice virtually immediately. Commercial real estate loans are generally priced at a spread over the one, three or five year constant maturity treasury yield (CMT) or our marginal cost of funds and fixed for one, three or five years. On the liability side of the balance sheet we have a large segment of our funding which floats; but certificates of deposit (CDs) reprice only at maturity resulting in a lag which can adversely affect net interest income and the net interest margin when interest rates decline. We have seen substantial improvements during the first six months of 2009. We had CDs mature during the first six months in an amount of $133.0 million with a weighted average rate of 3.31%. During the same period we issued $144.2 million in new CDs at an average rate of 1.40%.
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The following table details average balances of interest-earning assets and interest-bearing liabilities, the amount of interest earned/paid on such assets and liabilities, and the yield/rate for the periods indicated:
Interest-earning assets:
Loans, net of unearned income (1) (2)
Investment securities
Other earning assets
Allowance for loan losses
Total non-earning assets
Interest-bearing liabilities:
Borrowings
Noninterest-bearing liabilities:
Other liabilities
Stockholders’ equity
Interest rate spread
Net interest margin
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Provision for Loan Losses
The provision for loan losses is a current charge to earnings made in order to increase the allowance for loan losses to a level deemed appropriate by management based on an evaluation of the loan portfolio, current economic conditions, changes in the nature and volume of lending, historical loan experience and other known internal and external factors affecting loan collectability. Our loan loss allowance is calculated by segmenting the loan portfolio by loan type and applying risk factors to each segment. The risk factors are determined by considering peer data, internal and external factors affecting loan collectability, as well as applying management’s judgment.
The provision for loan losses charged to operations for the three months ended June 30, 2009 and 2008 were $545 thousand and $255 thousand, respectively. We had charge-offs totaling $516 thousand and $100 thousand during the quarters ended June 30, 2009 and 2008, respectively. We had recoveries totaling $81 thousand and $1 thousand during the quarters ended June 30, 2009 and 2008, respectively.
The provision for loan losses charged to operations for the six months ended June 30, 2009 and 2008 were $1.0 million and $706 thousand, respectively. Provision expense for the year ended December 31, 2008 was $1.7 million. We had charge-offs totaling $756 thousand and $180 thousand during the six months ended June 30, 2009 and 2008, respectively. We had recoveries totaling $84 thousand and $8 thousand during the six months ended June 30, 2009 and 2008,
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respectively. We had charge-offs, net of recoveries, for the year ended December 31, 2008 in the amount of $915 thousand. The increase in provision expense for the first six months of 2009 relative to 2008 is attributable to the growth and composition of the portfolio, charge-offs, as well as management’s assessment of the current economic and market environment and its impact on loan collectability.
Noninterest Income
The following table presents the major categories on noninterest income (loss) for the three and six months ended June 30, 2009 and 2008:
Net gain on other real estate owned
Net impairment losses recognized in earnings
Gain on securities
Total noninterest income
Noninterest loss was $502 thousand during the second quarter of 2009, compared to income of $147 thousand during the same quarter of the prior year. The OTTI charges recognized offset growth in noninterest income attributable to an increase in account maintenance and deposit service fees and other noninterest income.
Noninterest income decreased from $268 thousand in the first six months of 2008 to $92 thousand in the first six months of 2009. Noninterest income for the first six months of 2009 included a gain on sale of securities of $223 thousand and gain on other real estate owned of $117 thousand, which is offset by the OTTI charge recognized totaling $863 thousand. Noninterest income for the same period last year included a net loss on other real estate owned of $175 thousand. The change in account maintenance and deposit service fees is the result of increased activity.
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Noninterest Expense
The following table presents the major categories on noninterest expense for the three and six months ended June 30, 2009 and 2008:
Total noninterest expense
The increase in noninterest expense for the quarter ended June 30, 2009 compared to the same period last year is attributable to the increase in FDIC insurance assessment rates and the FDIC special assessment. One extremely important driver of cost in the second quarter was that Sonabank has long had a semi-annual bonus plan. As a consequence of the difficulties faced in the quarter, we have suspended the bonus payments for the first half of the year, and compensation cost for the quarter is down compared to the same quarter last year.
Despite the costs associated with the new branch and drive-through facility we opened in Leesburg last year and costs to support other organic growth of the Bank, noninterest expenses were well controlled and rose 11% from $4.4 million for the first six months of 2008 to $4.9 million for the first six months of 2009. The increase in occupancy expense was due primarily to inflationary increases in rent expense and one additional month of rent expense for the Leesburg branch compared to the first six months of 2008.
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FINANCIAL CONDITION
Balance Sheet Overview
Total assets were $432.7 million at June 30, 2009, as compared to $431.9 million at December 31, 2008. Net loans grew from $298.0 million at the end of 2008 to $321.6 million at June 30, 2009. Investment securities, available for sale and held to maturity, decreased to $57.8 million at June 30, 2009 compared to $75.0 million at December 31, 2008. Cash and cash equivalents decreased from $14.8 million at December 31, 2008 to $7.4 million at June 30, 2009.
As of June 30, 2009, total deposits were $314.8 million compared to $309.5 million as of December 31, 2008. The increase was attributable mostly to an increase in CDs and noninterest-bearing demand deposits. Time deposits increased approximately $5 million during the first six months of 2009. Brokered CDs were $77.9 million at June 30, 2009, compared to $118.3 million at December 31, 2008.
Loan Portfolio
The commercial real estate loan category increased by 21%, rising from $104.9 million at year-end to $127.0 million at June 30, 2009. The commercial and industrial loan category increased by 11% to $67.8 million. Residential 1-4 family mortgage loans increased by 3% to $62.1 million.
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Asset Quality
We will generally place a loan on nonaccrual status when it becomes 90 days past due. Loans will also be placed on nonaccrual status in cases where we are uncertain whether the borrower can satisfy the contractual terms of the loan agreement. Cash payments received while a loan is categorized as nonaccrual will be recorded as a reduction of principal as long as doubt exists as to future collections.
We require appraisals on loans over $250 thousand secured by real estate. In instances where appraisals reflect reduced collateral values, we make an evaluation of the borrower’s overall financial condition to determine the need, if any, for possible write-down to their net realizable values. We record other real estate owned at fair value less our estimated costs to sell.
Our loss and delinquency experience on our loan portfolio has been limited by a number of factors, including our underwriting standards and the relatively short period of time since the loans were originated. Whether our loss and delinquency experience in the area of our portfolio will increase significantly depends upon the value of the real estate securing loans and economic factors such as the overall economy of the region.
Loans identified as impaired in accordance with SFAS 114 totaled $2.4 million as of June 30, 2009. This compares to $974 thousand of impaired loans at December 31, 2008. The increase in impaired loans since December 31, 2008, is attributable to the impairment during the second quarter of 2009 of two residential mortgage loans totaling $218 thousand and one non-residential mortgage loan in the amount of $1.5 million offset by one loan in the amount of $304 thousand which is now current and no longer considered impaired. Nonaccrual loans were $2.2 million and $1.1 million at June 30, 2009 and December 31, 2008, respectively. At June 30, 2009, there were no loans past due 90 days or more and accruing interest, and there was one loan in the amount of $135 thousand past due 90 days or more and accruing interest at December 31, 2008.
Nonperforming assets increased from $4.6 million at December 31, 2008 to $5.7 million at June 30, 2009. This increase is due to an increase in nonaccrual loans.
There was an addition of one owner occupied commercial real estate loan in the amount of $1.5 million to non-performing status. There is a $1.1 million SBA 504 loan behind us. A current appraisal values the property at $1.7 million, not including several hundred thousand in equipment. This loan was only 45 days past due at June 30, 2009, but the owners have declared Chapter 7 bankruptcy.
The sale of one residential property in other real estate owned with a carrying value of $280 thousand, as well as a short sale of another residential property to pay off a nonperforming loan with a carrying value of $391 thousand.
We have an internal loan review process and a loan committee which provide on-going monitoring to identify and address issues with problem loans. We believe the allowance for loan losses is sufficient to cover probable incurred credit losses at June 30, 2009.
The bulk of our OREO balance continues to be comprised of one property, which contains 33 finished 2 to 4 acre lots in Culpeper. We took a deed in lieu of foreclosure in June 2007. There are no new developments on that property. We continue to monitor the fair value of this property to ensure our carrying value is realizable.
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The following table sets forth selected asset quality ratios as of the dates indicated:
Allowance for loan losses to total loans
Nonperforming assets and loans past due 90 days to total assets
Nonperforming assets and loans past due 90 days to total loans
Investment securities, available for sale and held to maturity, were $57.8 million at June 30, 2009 compared to $75.0 million at December 31, 2008.
At June 30, 2009 the securities portfolio (held to maturity and available for sale) was comprised of the following:
$38.9 million of FNMA and FHLMC mortgage-backed securities. Since the conservatorship, these securities carry the full faith and credit of the U.S. Government. As of June 30, 2009, the fair market value of these securities was $39.8 million.
As of June 30, 2009 we owned pooled trust preferred securities broken down as follows:
(in thousands)
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Management has evaluated each of these securities for potential impairment under EITF 99-20-1 and the most recently issued FSP guidance described in Note 1 and has reviewed each of the issues’ collateral participants using various techniques including the ratings provided in the Bank Financial Quarterly published by IDC Financial Publishing, Inc. Management has also reviewed the interest and principal coverage of each of the tranches it owns. In performing a detailed cash flow analysis of each security, management works with independent third parties to identify its best estimate of the cash flow estimated to be collected. If this estimate results in a present value of expected cash flows that is less than the amortized cost basis of a security (that is, credit loss exists), an OTTI is considered to have occurred. If there is no credit loss, any impairment is considered temporary. The cash flow analysis we performed included the following assumptions:
We assume that annual defaults for the remaining life of each security will be 37.5 basis points. According to FTN Financial: “The FDIC lists the number of bank failures each year from 1934-2008. Comparing bank failures to the number of FDIC institutions produces an annual average default rate of 36 basis points.”
We assume recoveries ranging from 0% to 75% on deferrals after two years depending on the IDC rating of the deferring entity.
We assume no prepayments for 10 years and then 1% per annum for the remaining life of the security. According to FTN Financial: “Prepayments were common in 2006 and 2007 when issuers were able to refinance into lower cost borrowings. That was a much different environment than today and most parties expect prepayments to be very low absent a change in credit conditions.”
Our securities have been modeled using the above assumptions by Sandler O’Neill or FTN Financial using the forward LIBOR curve plus original spread to discount projected cash flows to present values.
Management’s analysis in the second quarter deemed three of the ten trust preferred securities we own other than temporarily impaired. The cash flow analysis this quarter indicated that one security, ALESCO XV C1 would probably experience significant credit losses. Two others, ALESCO V C1 and ALESCO XVI C, would probably experience minor credit losses. We have recorded OTTI charges accordingly. The credit portion of the OTTI was recognized in net income and the remainder through other comprehensive income.
Trust preferred securities which are issued by financial institutions and insurance companies are classified as held-to-maturity securities. The decline in the level of observable inputs and market activity in this class of investments by the measurement date has been significant and resulted in unreliable external pricing. Broker pricing and bid/ask spreads, when available, vary widely. The once active market has become comparatively inactive. As such, management utilized guidance in FSP FAS 157-4 to value these securities. The pricing for these securities utilized a discount rate from the Bloomberg Fair Value Index yield curve for single issuer trust preferred securities with similar ratings, interest rates and maturity dates (an observable input). In addition a liquidity premium was utilized to take into account liquidity risk (a management estimate and thus an unobservable input). Due to current market conditions as well as the limited trading activity of these securities, the market value of the securities is highly sensitive to assumption changes and market volatility.
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Liquidity and Funds Management
The objective of our liquidity management is to assure the ability to meet our financial obligations. These obligations include the payment of deposits on demand or at maturity, the repayment of borrowings at maturity and the ability to fund commitments and other new business opportunities. We obtain funding from a variety of sources, including customer deposit accounts, customer certificates of deposit and payments on our loans and investments. Historically, our level of core deposits has been insufficient to fully fund our lending activities. As a result, we have sought funding from additional sources, including institutional certificates of deposit and available-for-sale investment securities. In addition, we maintain lines credit from the Federal Home Loan Bank of Atlanta and utilize securities sold under agreements to repurchase from approved securities dealers and retail customers.
Due to the uncertain economic environment, we have maintained much more cash in interest-earning accounts at the FRB and the FHLB during the fourth quarter of 2008 and the first six months of 2009 than we usually do. The average balance held in these interest-earning accounts was $10.1 million, $14.5 million and $14.1 million during the quarters ended June 30 and March 31, 2009 and December 31, 2008, respectively. The balance as of June 30, 2009 was down to $5.7 million.
We prepare a monthly cash flow report which forecasts weekly cash needs and availability for the coming three months, based on forecasts of loan closings from our pipeline report and other factors. Management anticipates that future funding requirements will be met from the normal sources of funds.
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Capital Resources
The following table provides a comparison of our leverage and risk-weighted capital ratios and the leverage and risk-weighted capital ratios of the bank at the periods indicated to the minimum and well-capitalized regulatory standards (dollars in thousands):
Tier 1 risk-based capital ratio
Total risk-based capital ratio
Leverage ratio
The most recent regulatory notification categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the Bank’s category.
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ITEM 3 – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are engaged primarily in the business of investing funds obtained from deposits and borrowings into interest-earning loans and investments. Consequently, our earnings depend to a significant extent on our net interest income, which is the difference between the interest income on loans and other investments and the interest expense on deposits and borrowings. To the extent that our interest-bearing liabilities do not reprice or mature at the same time as our interest-earning assets, we are subject to interest rate risk and corresponding fluctuations in net interest income. We have employed asset/liability management policies that seek to manage our interest income, without having to incur unacceptable levels of credit or investment risk.
We use a duration gap of equity approach to manage our interest rate risk, and we review quarterly interest sensitivity reports prepared for us by FTN Financial using the Sendero ALM Analysis System. This approach uses a model which generates estimates of the change in our market value of portfolio equity (MVPE) over a range of interest rate scenarios. MVPE is the present value of expected cash flows from assets, liabilities and off-balance sheet contracts using standard industry assumptions about estimated loan prepayment rates, reinvestment rates and deposit decay rates.
The following tables are based on an analysis prepared by FTN Financial setting forth an analysis of our interest rate risk as measured by the estimated change in MVPE resulting from instantaneous and sustained parallel shifts in the yield curve (plus or minus 300 basis points, measured in 100 basis point increments) as of June 30, 2009 and December 31, 2008:
Change in
Interest Rates
in Basis Points
(Rate Shock)
Up 300
Up 200
Up 100
Base
Down 100
Down 200
Down 300
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Our interest rate sensitivity is also monitored by management through the use of a model run by FTN Financial that generates estimates of the change in the net interest income over a range of interest rate scenarios. Net interest income depends upon the relative amounts of interest-earning assets and interest-bearing liabilities and the interest rates earned or paid on them. In this regard, the model assumes that the composition of our interest sensitive assets and liabilities existing at June 30, 2009 and December 31, 2008 remains constant over the period being measured and also assumes that a particular change in interest rates is reflected uniformly across the yield curve regardless of the duration to maturity or repricing of specific assets and liabilities.
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Certain shortcomings are inherent in the methodology used in the above interest rate risk measurements. Modeling changes in MVPE requires the making of certain assumptions that may or may not reflect the manner in which actual yields and costs respond to changes in market interest rates. Accordingly, although the MVPE tables and Sensitivity of Net Interest Income tables provide an indication of our interest rate risk exposure at a particular point in time, such measurements are not intended to, and do not, provide a precise forecast of the effect of changes in market interest rates on our net worth and net interest income.
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ITEM 4 – CONTROLS AND PROCEDURES
Under the supervision and with the participation of management, including our chief executive officer and chief financial officer, we have evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on that evaluation, our chief executive officer and chief financial officer have concluded that these controls and procedures are effective. There were no significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation.
Disclosure controls and procedures are our controls and other procedures that are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934 is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure.
PART II – OTHER INFORMATION
ITEM 1 – LEGAL PROCEEDINGS
While SNBV and Sonabank may, from time to time, be a party to various legal proceedings arising in the ordinary course of business, there are no proceedings pending, or to management’s knowledge, threatened, against SNBV or Sonabank at this time.
ITEM 1A – RISK FACTORS
As of June 30, 2009 there were no material changes to the risk factors previously disclosed on our Annual Report on Form 10-K for the year ended December 31, 2008.
ITEM 4 – SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
SNBV held its Annual Meeting of Stockholders on April 23, 2009, at which time stockholders were asked to consider two proposals, as follows:
The vote tabulation was as follows:
Director
Georgia S. Derrico
Charles A. Kabbash
The following directors’ terms of office continued after the meeting:
Frederick L. Bollerer
Neil J. Call
John J. Forch
R. Roderick Porter
Robin R. Shield
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Votes For
Votes Against
Abstain
ITEM 6 - EXHIBITS
(a) Exhibits.
The following exhibits are filed as part of this Form 10-Q and this list includes the Exhibit Index:
Exhibit No.
Description
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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.
(Registrant)
Georgia S. Derrico,
Chairman of the Board and Chief Executive Officer
William H. Lagos,
Senior Vice President and Chief Financial Officer
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