Village Bank and Trust Financial - 10-Q quarterly report FY

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes £ No x

Indicate the number of shares outstanding of each of the issuer’s classes of common equity, as of the latest practicable date.

 

4,238,416 shares of common stock, $4.00 par value, outstanding as of November 9, 2010

Village Bank and Trust Financial Corp.

Form 10-Q

TABLE OF CONTENTS

PART I – FINANCIAL INFORMATION

ITEM 1 – FINANCIAL STATEMENTS

Notes to Consolidated Financial Statements (Unaudited)

Note 1 - Principles of presentation

Village Bank and Trust Financial Corp. (the “Company”) is the holding company of Village Bank (the “Bank”).  The consolidated financial statements include the accounts of the Company, the Bank and the Bank’s three wholly-owned subsidiaries, Village Bank Mortgage Company, Village Insurance Agency, Inc., and Village Financial Services Company.  All material intercompany balances and transactions have been eliminated in consolidation.

 

The Company’s financial statements are prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”) which, effective for all interim and annual periods ending after September 15, 2009, principally consist of the Financial Accounting Standards Board Accounting Standards Codification (“FASB Codification”). FASB Codification Topic 105: Generally Accepted Accounting Principles establishes the FASB codification as the source of authoritative accounting principles recognized by the FASB to be applied by nongovernmental entities in the preparation of financial statements in conformity with generally accepted accounting principles. Rules and interpretive releases of the Securities and Exchange Commission (“SEC”) under authority o f federal securities laws are also sources of authoritative guidance for SEC registrants. All guidance contained in the FASB Codification carries an equal level of authority. All non-grandfathered, non-SEC accounting literature not included in the FASB Codification is superseded and deemed non-authoritative.

 

In the opinion of management, the accompanying condensed consolidated financial statements of the Company have been prepared on the accrual basis in accordance with generally accepted accounting principles for interim financial information.  Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.  However, all adjustments that are, in the opinion of management, necessary for a fair presentation have been included.  The results of operations for the three and nine month periods ended September 30, 2010 are not necessarily indicative of the results to be expected for the full year ending December 31, 2010.  The unaudited interim financial statements should be read in conjunction with the audited financial st atements and notes to financial statements that are presented in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009 as filed with the Securities and Exchange Commission.

Note 2 – Correction of an immaterial error

During the second quarter of 2010, the Company identified an error related to the calculation of its income tax benefit for the fourth quarter of the year ended December 31, 2009.  The Company evaluated the error in accordance with Accounting Standards Codification 250-10-45-27 Materiality Determination for Correction of an Error and Staff Accounting Bulletin No. 99, Materiality.  Although the error was considered to be immaterial to the fourth quarter and year ended December 31, 2009, because of the significance of the out-of-period error to the second quarter of 2010, the Company applied the guidance of SAB No. 108, Considering the Effects of Prior Year Misstatem ents when Quantifying Misstatements in the Current Year Financial Statements, and revised its 2009 financial statements for the immaterial error.

The following is a reconciliation of the effects of the adjustments made to the Company’s previously reported December 31, 2009 consolidated balance sheet to the revised consolidated balance sheet appearing in the Form 10-Q:

The effect of the correction on retained earnings was a result of decreasing the income tax benefit for 2009 by approximately $1,094,000 which increased the net loss by the same amount, representing an increase in the loss per basic and diluted share of $0.26.

The effect of the adjustments on the Company’s capital ratios was immaterial and did not change the “well capitalized” classification of the Company or the Bank.

Note 3 - Use of estimates

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the balance sheets and statements of income for the period.  Actual results could differ significantly from those estimates.

Note 4 - Earnings per common share

The following table presents the basic and diluted earnings per share computations:

Outstanding options and warrants to purchase common stock were considered in the computation of diluted earnings per share for the periods presented.  Stock options and warrants to acquire 310,205 shares of common stock were not included in computing diluted earnings per share for the three and nine months ended September 30, 2010 because their effects were anti-dilutive.  Options and warrants to acquire 336,255 shares of common stock were anti-dilutive for the three and nine month periods ended September 30, 2009 and thus excluded from the computation of fully diluted earnings per share.

Note 5 – Investment securities available for sale

At September 30, 2010 and December 31, 2009, all of our securities were classified as available-for-sale.  The following table presents the composition of our investment portfolio at the dates indicated.

Investment securities available for sale that have an unrealized loss position at September 30, 2010 and December 31, 2009 are detailed below.

Management does not believe that any individual unrealized loss as of September 30, 2010 and December 31, 2009 is other than a temporary impairment.  These unrealized losses are primarily attributable to changes in interest rates.  The Company has the ability to hold these securities for a time necessary to recover the amortized cost or until maturity when full repayment would be received.

Note 6 – Deposits

Deposits as of September 30, 2010 and December 31, 2009 were as follows:

Note 7 – Trust preferred securities

During the first quarter of 2005, Southern Community Financial Capital Trust I, a wholly-owned subsidiary of the Company, was formed for the purpose of issuing redeemable securities.  On February 24, 2005, $5.2 million of Trust Preferred Capital Notes were issued through a pooled underwriting.  The securities have a LIBOR-indexed floating rate of interest (three-month LIBOR plus 2.15%) which adjusts, and is payable, quarterly. The interest rate at September 30, 2010 was 2.44%. The securities were redeemable par beginning on March 15, 2010 and each quarter after such date until the securities mature on March 15, 2035.  No amounts have been redeemed at September 30, 2010 and there are no plans to do so.  The principal asset of the Trust is $5.2 million of the Company’s junior subordinated debt securiti es with like maturities and like interest rates to the Trust Preferred Capital Notes.

During the third quarter of 2007, Village Financial Statutory Trust II, a wholly-owned subsidiary of the Company, was formed for the purpose of issuing redeemable securities.  On September 20, 2007, $3.6 million of Trust Preferred Capital Notes were issued through a pooled underwriting.  The securities  have a five year fixed income rate of 6.29% payable quarterly, converting after five years to a LIBOR-indexed floating rate of interest (three-month LIBOR plus 1.40%) which adjusts, and is also payable, quarterly.  The securities may be redeemed at par at any time commencing in December 2012 until the securities mature in 2037.  The principal asset of the Trust is $3.6 million of the Company’s junior subordinated debt securities with like maturities and like interest rates to the Trust Prefe rred Capital Notes.

 

The Trust Preferred Capital Notes may be included in Tier 1 capital for regulatory capital adequacy determination purposes up to 25% of Tier 1 capital after its inclusion.  The portion of the Trust Preferred Capital Notes not considered as Tier 1 capital may be included in Tier 2 capital.

 

The obligations of the Company with respect to the issuance of the Trust Preferred Capital Notes constitute a full and unconditional guarantee by the Company of the Trust’s obligations with respect to the Trust Preferred Capital Notes.  Subject to certain exceptions and limitations, the Company may elect from time to time to defer interest payments on the junior subordinated debt securities, which would result in a deferral of distribution payments on the related Trust Preferred Capital Notes and require a deferral of common dividends.

Note 8 – Stock incentive plans

The company has a stock incentive plan which authorizes the issuance of up to 455,000 shares of common stock to assist the Company in recruiting and retaining key personnel.

The following table summarizes stock options outstanding under the stock incentive plan at the indicated dates:

During the first quarter of 2009, we granted to certain officers 26,592 restricted shares of common stock with a weighted average fair market value of $4.60 per share at the date of grant.  These restricted stock awards have three-year graded vesting.  Prior to vesting, these shares are subject to forfeiture to us without consideration upon termination of employment under certain circumstances.  The total number of shares underlying non-vested restricted stock and performance share awards was 13,537 and 22,238 at September 30, 2010 and 2009, respectively.

Stock-based compensation expense was $73,072 and $123,129 for the nine months ended September 30, 2010 and 2009, respectively.  Unamortized stock-based compensation related to nonvested share based compensation arrangements granted under the Incentive Plan as of September 30, 2010 and 2009 was $147,678 and $360,247, respectively.  The time based unamortized compensation of $147,678 is expected to be recognized over a weighted average period of 1.31 years.

Note 9 — Fair value

Effective January 1, 2008, the Company adopted the provisions of FASB Codification Topic 820: Fair Value Measurements which defines fair value, establishes a framework for measuring fair value under U.S GAAP, and expands disclosures about fair value measurements.

The fair value of an asset or liability is the price that would be received to sell that asset or paid to transfer that liability in an orderly transaction between market participants.  A fair value measurement assumes that the transaction to sell the asset or transfer the liability occurs in the principal market for the asset or liability or, in the absence of a principal market, the most advantageous market for the asset or liability. The price in the principal (or most advantageous) market used to measure the fair value of the asset or liability shall not be adjusted for transaction costs. An orderly transaction is a transaction that assumes exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets and liabilities; it is not a forced transaction. Market participants are buyers and sellers in the principal market that are independent, knowledgeable, able to transact and willing to transact.

FASB Codification Topic 820: Fair Value Measurements and Disclosures establishes a hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs.  The fair values hierarchy is as follows:

The Company used the following methods to determine the fair value of each type of financial instrument:

Investment securities: The fair values for investment securities are determined by quoted prices for similar assets or liabilities (Level 2).

Impaired loans: The fair values of impaired loans are measured for impairment using the fair value of the collateral for collateral-dependent loans on a nonrecurring basis. Collateral may be in the form of real estate or business assets including equipment, inventory and accounts receivable. The use of discounted cash flow models and management’s best judgment are significant inputs in arriving at the fair value measure of the underlying collateral and are therefore classified within (Level 3).

Residential loans held for sale: The fair value of loans held for sale is determined using quoted prices for a similar asset, adjusted for specific attributes of that loan (Level 2).

Assets and liabilities measured at fair value under Topic 820 on a recurring and non-recurring basis are summarized below for the indicated dates:

 

In general, fair value of securities is based upon quoted market prices, where available. If such quoted market prices are not available, fair value is based upon market prices determined by an outside, independent entity that primarily uses as inputs, observable market-based parameters.  Fair value of loans held for sale is based upon internally developed models that primarily use as inputs, observable market-based parameters. Valuation adjustments may be made to ensure that financial instruments are recorded at fair value. These adjustments may include amounts to reflect counterparty credit quality, the Company’s creditworthiness, among other things, as well as unobservable parameters. Any such valuation adjustments are applied consistently over time. The Company valuation methodologies may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. While management believes the Company’s valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date.

Cash and cash equivalents – The carrying amount of cash and cash equivalents approximates fair value.

Investment securities – The fair value of investment securities available-for-sale is estimated based on bid quotations received from independent pricing services for similar assets.  The carrying amount of other investments approximates fair value.

Loans – For variable rate loans that reprice frequently and have no significant change in credit risk, fair values are based on carrying values.  For all other loans, fair values are calculated by discounting the contractual cash flows using estimated market discount rates which reflect the credit and interest rate risk inherent in the loans, or by using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities.

Deposits – The fair value of deposits with no stated maturity, such as demand, interest checking and money market, and savings accounts, is equal to the amount payable on demand at year-end.  The fair value of certificates of deposit is based on the discounted value of contractual cash flows using the rates currently offered for deposits of similar remaining maturities.

Borrowings – The fair value of FHLB borrowings is based on the discounted value of contractual cash flows using the rates currently offered for borrowings of similar remaining maturities.  The carrying amounts of federal funds purchased approximate their fair values.  Other borrowings are short-term in nature and the carrying amounts approximate fair value.

Accrued interest – The carrying amounts of accrued interest receivable and payable approximate fair value.

Off-balance-sheet instruments –The fair value of commitments to extend credit is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair value of commitments to extend credit, including letters of credit, is estimated to approximate their aggregate book balance and is not considered material and therefore not included in the following table.

Note 10 – Capital Purchase Program

On May 1, 2009, as part of the Capital Purchase Program established by the U.S. Department of the Treasury (the “Treasury”) under the Emergency Economic Stabilization Act of 2008 (“EESA”), the Company entered into a Letter Agreement and Securities Purchase Agreement—Standard Terms (collectively, the “Purchase Agreement”) with the Treasury, pursuant to which the Company sold (i) 14,738 shares of the Company’s Fixed Rate Cumulative Perpetual Preferred Stock, Series A, par value $4.00 per share, having a liquidation preference of $1,000 per share (the “Preferred Stock”) and (ii) a warrant (the “Warrant”) to purchase 499,029 shares of the Company’s common stock at an initial exercise price of $4.43 per share, subject to certain anti-dilution and other adjustments , for an aggregate purchase price of $14,738,000 in cash.  The fair value of the preferred stock was estimated using discounted cash flow methodology at an assumed market equivalent rate of 13%, with 20 quarterly payments over a five year period.  The fair value of the warrant was estimated using the Black-Scholes option pricing model, with assumptions of 25% volatility, a risk-free rate of 2.03%, a yield of 6.162% and an estimated life of 5 years.  The value attributed to the warrant is being accreted as a discount on the preferred stock using the effective interest rate method over five years.

The Preferred Stock qualifies as Tier 1 capital and pays cumulative dividends at a rate of 5% per annum for the first five years, and thereafter at a rate of 9% per annum.  The Preferred Stock is generally non-voting, other than on certain matters that could adversely affect the Preferred Stock.

The Warrant is immediately exercisable.  The Warrant provides for the adjustment of the exercise price and the number of shares of common stock issuable upon exercise pursuant to customary anti-dilution provisions, such as upon stock splits or distributions of securities or other assets to holders of common stock, and upon certain issuances of common stock at or below a specified price relative to the then-current market price of common stock.  The Warrant expires ten years from the issuance date.  Pursuant to the Purchase Agreement, the Treasury has agreed not to exercise voting power with respect to any shares of common stock issued upon exercise of the Warrant.

Note 11 – Recent accounting pronouncements

In January 2010, the FASB issued ASU No. 2010-06- Fair Value Measurements and Disclosures amending Topic 820.  The ASU provides for additional disclosures of transfers between assets and liabilities valued under Level 1 and 2 inputs as well as additional disclosures regarding those assets and liabilities valued under Level 3 inputs.  The new disclosures are effective for interim and annual reporting periods beginning after December 15, 2009 except for those provisions addressing Level 3 fair value measurements which provisions are effective for fiscal years, and periods therein, beginning after December 15, 2010.  The adoption of this Statement did not have a material impact on the Company’s consolidated financial statements.

In March 2010, the FASB issued ASU No. 2010-09 amending FASB ASC Topic 855 to exclude SEC reporting entities from the requirement to disclose the date on which subsequent events have been evaluated.  It further modifies the requirement to disclose the date on which subsequent events have been evaluated in reissued financial statements to apply only to such statements that have been restated to correct an error or to apply U.S. GAAP retrospectively.  The Company has complied with ASU No. 2010-09.

New authoritative accounting guidance under ASC Topic 860, “Transfers and Servicing,” amended prior accounting guidance to enhance reporting about transfers of financial assets, including securitizations, and where companies have continuing exposure to the risks related to transferred financial assets. The new authoritative accounting guidance eliminates the concept of a “qualifying special-purpose entity” and changes the requirements for derecognizing financial assets. The new authoritative accounting guidance also requires additional disclosures about all continuing involvements with transferred financial assets including information about gains and losses resulting from transfers during the period. The new authoritative accounting guidance under ASC Topic 860 became effective January 1, 2010 and did not have a sig nificant impact on the Company’s consolidated financial statements.

In July 2010, The FASB issued ASU No. 2010-20, Receivables - Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses, Topic 830.  This ASU requires entities to provide disclosures designed to facilitate financial statement users’ evaluation of(i) the nature of credit risk inherent in the entity’s portfolio of financing receivables, (ii) how that risk is analyzed and assessed in arriving at the allowance for credit losses and (iii) the changes and reasons for those changes in the allowance for credit losses. Disclosures must be disaggregated by portfolio segment, the level at which an entity develops and documents a systematic method for determining its allowance for credit losses, and class of financing receivable, which is ge nerally a disaggregation of portfolio segment. The required disclosures include, among other things, a rollforward of the allowance for credit losses as well as information about modified, impaired, non-accrual and past due loans and credit quality indicators. ASU 2010-20 will be effective for the Company’s consolidated financial statements as of December 31, 2010, as it relates to disclosures required as of the end of a reporting period. Disclosures that relate to activity during a reporting period will be required for the Company’s consolidated financial statements that include periods beginning on or after January 1, 2011. This ASU requires additional disclosures only and will not have an impact on the Company’s consolidated financial statements.

ITEM 2 - MANAGEMENT’S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION

Caution about forward-looking statements

In addition to historical information, this report may contain forward-looking statements.  For this purpose, any statement, that is not a statement of historical fact may be deemed to be a forward-looking statement. These forward-looking statements may include statements regarding profitability, liquidity, allowance for loan losses, interest rate sensitivity, market risk, growth strategy and financial and other goals.  Forward-looking statements often use words such as “believes,” “expects,” “plans,” “may,” “will,” “should,” “projects,” “contemplates,” “anticipates,” “forecasts,” “intends” or other words of similar meaning.  You can also identify them by the fact that they do not relat e strictly to historical or current facts.  Forward-looking statements are subject to numerous assumptions, risks and uncertainties, and actual results could differ materially from historical results or those anticipated by such statements.

There are many factors that could have a material adverse effect on the operations and future prospects of the Company including, but not limited to, changes in interest rates, general economic conditions, the quality or composition of the loan or investment portfolios, the level of nonperforming assets and charge-offs, the local real estate market, volatility and disruption in national and international financial markets, government intervention in the U.S. financial system, changes in regulations applicable to the Company, demand for loan products, deposit flows, competition, accounting principles, policies and guidelines, and any other risks discussed in this report or in “Item 1A Risk Factors” in the Annual Report on Form 10-K for the year ended December 31, 2009.  Monetary and fiscal policies of the U.S. Government cou ld also adversely effect the Company; such policies include the impact of any regulations or programs implemented pursuant to the Emergency Economic Stabilization Act of 2008 (EESA), the American Recovery and Reinvestment Act of 2009 (ARRA), the Dodd-Frank Wall Street Reform and Consumer Protection Act  and other policies of  the U.S. Treasury and the Federal Reserve Board.

These risks and uncertainties should be considered in evaluating the forward-looking statements contained herein, and readers are cautioned not to place undue reliance on such statements.  Any forward-looking statement speaks only as of the date on which it is made, and the Company undertakes no obligation to update any forward-looking statement to reflect events or circumstances after the date on which it is made.  In addition, past results of operations are not necessarily indicative of future results.

General

The Company was organized under the laws of the Commonwealth of Virginia as a bank holding company whose activities consist of investment in its wholly-owned subsidiary, the Bank.  The Bank is engaged in commercial and retail banking.  We opened to the public on December 13, 1999.  We place special emphasis on serving the financial needs of individuals, small and medium sized businesses, entrepreneurs, and professional concerns.

The Bank has one subsidiary, Village Bank Mortgage Corporation.  We offer a wide range of banking and related financial services, including checking, savings, certificates of deposit and other depository services, and commercial, real estate and consumer loans.  In addition we provide investment services through a separate division of the Bank, Village Investment Services.  We are a community-oriented and locally owned and managed financial institution focusing on providing a high level of responsive and personalized services to our customers, delivered in the context of a strong direct relationship with the customer.  We conduct our operations from our main office/corporate headquarters location and fourteen branch offices.

The Company’s primary source of earnings is net interest income, and its principal market risk exposure is interest rate risk.  The Company is not able to predict market interest rate fluctuations and its asset/liability management strategy may not prevent interest rate changes from having a material adverse effect on the Company’s results of operations and financial condition.  In addition, revenues are generated from fees charged on deposit accounts and gains from sale of mortgage loans to third-party investors.

Although management endeavors to minimize the credit risk inherent in the Company’s loan portfolio, it must necessarily make various assumptions and judgments about the collectability of the loan portfolio based on its experience and evaluation of economic conditions.  If such assumptions or judgments prove to be incorrect, the current allowance for loan losses may not be sufficient to cover loan losses and additions to the allowance may be necessary, which would have a negative impact on net income.

There is intense competition in all areas in which the Company conducts its business. The Company competes with banks and other financial institutions, including savings and loan associations, savings banks, finance companies, and credit unions.  Many of these competitors have substantially greater resources and lending limits and provide a wider array of banking services.  To a limited extent, the Company also competes with other providers of financial services, such as money market mutual funds, brokerage firms, consumer finance companies and insurance companies.  Competition is based on a number of factors, including prices, interest rates, services, availability of products and geographic location.

The Company experienced significant losses during the prior year primarily as a result of the economic climate.  Although we were profitable for the first, second and third quarters of 2010, a continuation of the turbulence in significant portions of the global financial markets, or worsening, could further impact the Company’s performance, both directly, by affecting both revenues and the value of the Company’s assets and liabilities, and indirectly, by affecting the Company’s counterparties.  Dramatic declines in the housing market in the past year have resulted in significant write-downs of asset values by financial institutions in the United States.  Concerns about the stability of the U.S. financial markets generally have reduced the availability of funding to certain financial institutions, l eading to a tightening of credit, reduction of business activity, and increased market volatility.  It is not clear at this time what impact liquidity and funding initiatives of the Treasury and other bank regulatory agencies that have been announced or any additional programs that may be initiated in the future will have on the financial markets and the financial services industry.  The extreme levels of volatility and limited credit availability currently being experienced could continue to affect the U.S. banking industry and the broader U.S. and global economies, which could have an effect on all financial institutions, including the Company.

For the three months ended September 30, 2010, the Company had net income totaling $334,000 and net income available to common shareholders of $112,000, or $0.03 per fully diluted share, compared to a net loss of $(2,771,000) and a net loss available to common shareholders of $(2,992,000), or $(.71) per fully diluted basis, for the same period in 2009.  The most significant factors in our improving earnings were a decline in the provision for loan losses of $4,590,000, from $6,000,000 in 2009 to $1,410,000 in 2010, and a larger decline in our cost of deposits relative to the decline in our yield on loans resulting from an increase in net interest income of $716,000.

Our total assets decreased to $583,879,000 at September 30, 2010 from $601,993,000 at December 31, 2009, a decrease of $(18,114,000), or 3%.  Liquid assets (cash and due from banks, federal funds sold and investment securities available for sale) decreased by $(28,294,000), loans held for sale increased by $19,016,000, net portfolio loans decreased by $(8,236,000), accrued interest receivable decreased by $(775,000), and other real estate owned increased by $1,662,000.

 

The following presents management’s discussion and analysis of the financial condition of the Company at September 30, 2010 and December 31, 2009, and results of operations for the Company for the three and nine month periods ended September 30, 2010 and 2009.  This discussion should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2009 as filed with the Securities and Exchange Commission as well as the third quarter 2010 financial statements and notes thereto appearing elsewhere in this report.

Results of operations

For the three months ended September 30, 2010, the Company had income totaling $334,000, and income available to common shareholders of $112,000, or $0.03 per fully diluted share, compared to net a loss of $(2,271,000) and a net loss available to common shareholders of $(2,992,000) or $(0.71) per fully diluted share, for the same period in 2009.  For the nine months ended September 30, 2010, the Company had income totaling $1,282,000, and net income available to common shareholders of $622,000, or $0.15 per share on a fully diluted basis, compared to a loss totaling $(4,628,000), and a net loss available to common shareholders of $(4,996,000) or $(1.18) per share on a fully diluted basis, for the same period in 2009.

The increase in net earnings during the three and nine months ended September 30, 2010 compared to the same periods in 2009 is primarily a result of:

The increase in net interest income is primarily attributable to the significant decline in the cost of deposits.  Our cost of deposits declined from 3.39%for the first nine months of 2009 to 2.01%for the first nine months of 2010.  The decrease in the provision for loan losses reflects management’s recognition of higher provisions in previous periods attributable to the Bank’s current level of nonperforming assets and slowing of the deterioration of asset quality and is discussed in more detail under Asset Quality and Provision for Loan Losses.  The increase in gain on sale of loans is attributable to increased loan production by the mortgage banking subsidiary of the Bank.  The mortgage subsidiary closed $77,620,000 in mortgage loans in the third quarter of 2010 compared to $61,795,000 in the third quarter of 2009, and $206,404,000 for the nine months ended September 30, 2010 compared to $189,155,000 for the same period in 2009.  The increase in rental income is a result of an increase in rented square feet in our headquarters building at the Watkins Centre as well as the expiration of rental concessions on previous rental agreements.  

 

At September 30, 2010, the headquarters building has leases and letters of intent for greater than 90% of its leasable square footage.  The increase in noninterest expenses in comparing the nine month periods is primarily attributable to increases in salaries and benefits of $1,194,000, and occupancy costs of $211,000 resulting from the addition of the mortgage company’s loan production office in Northern Virginia as well as the startup of a financial services division of the Bank.  The quarter to quarter comparison reflects similar increases in salaries and benefits and occupancy costs of $462,000 and $26,000, respectively, as well as and increase of $216,000 in expenses related to foreclosed real estate.

Net interest income

Net interest income is our primary source of earnings and represents the difference between interest and fees earned on interest-earning assets and the interest paid on interest-bearing liabilities.  The level of net interest income is affected primarily by variations in the volume and mix of those assets and liabilities, as well as changes in interest rates when compared to previous periods of operation.

Net interest income for the third quarter of $5,042,000 represents an increase of $716,000, or 17%, compared to the third quarter of 2009, and an increase of $339,000, or 7%, compared to the second quarter of 2010.  These increases are a result of a decline in our Company’s cost of funds that was greater than a decline in the yield on earning assets.  Our cost of funds declined from 3.03% for the third quarter of 2009 to 1.90% for the third quarter of 2010, a decline of 1.13%.  The yield on earning assets declined from 6.05% for the third quarter of 2009 to 5.69% for the third quarter of 2010, a decline of .36%

The Company’s net interest margin is not a measurement under accounting principles generally accepted in the United States, but it is a common measure used by the financial services industry to determine how profitably earning assets are funded.  Net interest margin is calculated by dividing net interest income by average earning assets.  Our net interest margin over the last several quarters is provided in the following table:

As interest rates were reduced by the Federal Reserve during 2007 and 2008 in reaction to the declining economy, our margin was compressed as our deposits generally do not reprice as quickly as our loans.  Because our deposits continue to reprice downward and the yield on interest earning assets appears to be stabilizing, we expect the upward trend in out net interest margin to continue.  However, given the continued depressed economy and the potential impact on interest income from new nonaccrual loans, no assurance can be provided that this will occur.

Average interest-earning assets for the first nine months of 2010 increased by $11,607,000, or 2.2%, compared to the first nine months of 2009.  The increase in interest-earning assets was due primarily to an increase in investment securities of $12,232,000 and federal funds sold of $10,178,000, offset by a decline in loans of $13,519,000.  The average yield on interest-earning assets decreased to 5.57% for the first nine months of 2010 compared to 6.31% for the first nine months of 2009.

 

Many of our loans are indexed to short-term rates affected by the Federal Reserve’s decisions about short-term interest rates, and, accordingly, as the Federal Reserve increases or decreases short-term rates, the yield on interest-earning assets is affected.  As the Federal Reserve decreased interest rates starting in 2007 and into 2008, decreasing short-term interest rates by 5% over twelve months, the average yield on our interest-earning assets decreased.  Additionally, while many of our indexed rate loans have interest rate floors included in their terms, we have decreased rates to loan customers to better reflect the current interest rate environment and in some limited cases to facilitate workouts on nonperforming loans.

Our average interest-bearing liabilities increased by $17,484,000, or 4%, for the first nine months of 2010 compared to the first nine months of 2009.  The increase in interest-bearing liabilities was primarily due to growth in average deposits of $15,953,000.  The average cost of interest-bearing liabilities decreased to 2.21% for the first nine months of 2010 from 3.42% for the first nine months of 2009.  The principal reason for the decrease in liability costs was the reduction in short-term interest rates by the Federal Reserve and our efforts to reduce rates for repricing liabilities.  See our discussion of interest rate sensitivity below for more information.

The following tables illustrate average balances of total interest-earning assets and total interest-bearing liabilities for the periods indicated, showing the average distribution of assets, liabilities, shareholders' equity and related income, expense and corresponding weighted-average yields and rates.  The average balances used in these tables and other statistical data were calculated using daily average balances.  We had no tax exempt assets for the periods presented.