ITEM 1. BUSINESS
Unless this Form 10-K indicates otherwise or the context otherwise requires, the terms “we,” “our,” “us,” “the Company” or “Community First” as used herein refer to Community First, Inc. and its subsidiaries, including Community First Bank & Trust, which we sometimes refer to as “the Bank,” “our Bank” or our Bank subsidiary.
(Dollar amounts in thousands, except per share data)
General
Community First is a registered bank holding company under the Bank Holding Company Act of 1956, as amended, and became so upon the acquisition of all the voting shares of the Bank on August 30, 2002. An application for the bank holding company was approved by the Federal Reserve Bank of Atlanta (the “FRB”) on August 6, 2002. The Company was incorporated under the laws of the State of Tennessee as a Tennessee corporation on April 9, 2002.
The Bank commenced business on May 18, 1999 as a Tennessee-chartered commercial bank whose deposits are insured by the Federal Deposit Insurance Corporation’s (the “FDIC”) Deposit Insurance Fund (the “DIF”). The Bank is primarily regulated by the Tennessee Department of Financial Institutions (the “Department”) and the FDIC. The Bank’s sole subsidiary is Community First Title, Inc., a Tennessee corporation (“Title”). CFBT Investments, Inc., a Nevada corporation (“Investments”), is a wholly-owned subsidiary of Community First Title, Inc., and is the parent of Community First Properties, Inc., a Maryland corporation, which was established as a real estate investment trust (the “REIT”) pursuant to Internal Revenue Service regulations. The Bank’s principal business is to accept demand and saving deposits from the general public and to make residential mortgage, commercial, and consumer loans. In an effort to reduce overhead expenses and due to the fact that the Company has maximized the tax benefit to be obtained from operating the REIT, management is in the process of preparing a revocation of the REIT’s status under the IRS rules and regulations which the Company expects will be filed prior to March 31, 2012. In addition, management anticipates that in connection with this process, it will dissolve and liquidate two of its subsidiaries, Title and Investments, and distribute those entities’ assets up to the Bank, making the REIT a direct subsidiary of the Bank. This restructuring of the Company’s subsidiaries is expected to be completed during the first quarter of 2012.
The Company completed its acquisition of 100% of the outstanding shares of common stock of The First National Bank of Centerville, a national banking association headquartered in Centerville, Tennessee (“First National”), on October 26, 2007 pursuant to the terms of an Agreement and Plan of Reorganization and Share Exchange, dated as of August 1, 2007, by and between the Company and First National. First National operated under a national bank charter and provides full banking services. As a national bank, First National was subject regulation by the Office of the Comptroller of the Currency and the FDIC. On January 31, 2008, First National was merged with and into the Bank, with the Bank continuing as the surviving entity.
The Company conducts banking activities from the main office and three branch offices in Columbia, Tennessee, one branch office in Mount Pleasant, Tennessee, one branch office in Franklin, Tennessee, one branch office in Murfreesboro, Tennessee, one branch office in Centerville, Tennessee, one branch office in Lyles, Tennessee and one branch office in Thompson Station, Tennessee. The Company also operates six automated teller machines in Maury County, two automated teller machines in Williamson County, Tennessee, one automated teller machine in Rutherford County, Tennessee and two automated teller machines in Hickman County, Tennessee. On December 28, 2011, the Bank entered into a Purchase and Assumption Agreement with Southern Community Bank (“Southern Community”), pursuant to which the Bank has agreed to sell certain of its loans and deposits of its Murfreesboro branch location to Southern Community. We expect this transaction to close in the first quarter of 2012. On February 9, 2012, the Bank entered into a Purchase and Assumption Agreement with CapStar Bank, pursuant to which the Bank has agreed to sell certain of its loans and deposits of its Franklin, Tennessee
branch location to CapStar Bank. We expect this transaction to close in the second quarter of 2012. Information regarding the sale of the Murfreesboro branch and the Franklin branch is discussed in detail in the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” section of this Form 10-K.
The Company’s assets consist primarily of its investment in the Bank. Its primary activities are conducted through the Bank. At December 31, 2011, the Company’s consolidated total assets were $616,773, its consolidated net loans, including loans held for sale, were $420,049, its total deposits were $555,037, and its total shareholders’ equity was $9,575. At December 31, 2010, consolidated total assets were $667,380, the Company’s consolidated net loans, including loans held for sale, were $493,089, its total deposits were $595,069, and its total shareholders’ equity was $22,761. At December 31, 2009, the Company’s consolidated total assets were $701,191, its consolidated net loans, including loans held for sale, were $532,578, its total deposits were $606,196, and its total shareholders’ equity was $43,645.
Loans
We make secured and unsecured loans to individuals, partnerships, corporations, and other business entities within the Middle Tennessee area. Our loan portfolio consists of commercial, financial and agricultural loans, residential and commercial mortgage loans, and consumer loans. Our legal lending limits under applicable regulations (based upon the legal lending limits of 25% of capital and surplus) were $7,683 as of December 31, 2011.
Commercial loans are made primarily to small and medium-sized businesses. Some of these loans are guaranteed by U.S. Government entities such as the U.S. Small Business Administration and the U.S. Department of Agriculture as well as on a conventional basis. These loans are secured and unsecured and are made available for general operating inventory and accounts receivables as well as for real estate construction and development as well as any other purposes considered appropriate. We will generally look to a borrower’s business operations as the principal source of repayment, but will also receive, when appropriate, a security interest in personal property and/or personal guarantees. In addition, the majority of commercial loans that are not mortgage loans are secured by a lien on equipment, inventory, and/or other assets of the commercial borrower, or, in the case of real estate construction and development loans, the underlying real estate property.
Commercial lending (including commercial real estate lending) involves more risk than residential real estate lending because loan balances are greater and repayment is dependent upon the borrower’s operations. We attempt to minimize the risks associated with these transactions by generally limiting our exposure to owner-operated properties of customers with an established profitable history. In many cases, risk can be further reduced by limiting the amount of credit to any one borrower to an amount less than our legal lending limit and avoiding types of commercial real estate financing considered risky.
We originate residential mortgage loans with either fixed or variable interest rates. Our general policy is to sell most fixed rate loans in the secondary market. This policy is subject to review by management and may be revised as a result of changing market and economic conditions and other factors. We do not retain servicing rights with respect to secondary market residential mortgage loans that we originate. Typically, all of our residential real estate loans are secured by a first lien on the real estate. Also, we offer home equity loans, which are secured by junior liens on the subject residence.
We make personal loans and lines of credit available to consumers for various purposes, such as the purchase of automobiles, boats and other recreational vehicles, and the making of home improvements and personal investments. All such loans are retained by us.
Consumer loans generally have shorter terms and higher interest rates than residential mortgage loans and usually involve more credit risk than mortgage loans because of the type and nature of the collateral. Consumer lending collections are dependent on a borrower’s continuing financial stability and are thus likely to be adversely affected by job loss, illness, or personal bankruptcy. In many cases, repossessed collateral for a defaulted consumer loan will not provide an adequate source of repayment of the outstanding loan balance because of depreciation of the underlying collateral. We underwrite our loans carefully, with a strong emphasis on the amount of the down payment, credit quality and history, employment stability, and monthly income. These loans are generally expected to be repaid on a monthly repayment schedule with the payment amount tied to the borrower’s periodic income. We believe that the generally higher yields earned on consumer loans help compensate for the increased credit risk associated with such loans and that consumer loans are important to our efforts to serve the credit needs of our customer base.
Although we take a progressive and competitive approach to lending, we seek to maintain high quality in our loans. We are subject to written loan policies that contain general lending guidelines and are subject to periodic review and revision by our Board of Directors and by the Loan Committee established by the Board of Directors. These policies concern loan administration, documentation, approval, and reporting requirements for various types of loans.
Lending Policies of the Company
While the ultimate authority to approve loans rests with the Board of Directors, lending authority is delegated by the Board of Directors to the loan officers and Loan Committee. Loan officers, each of whom are limited as to the amount of secured and unsecured loans that he or she can make to a single borrower or related group of borrowers, report to the Chief Credit Officer, Jim Bratton. Louis Holloway, the President of our Bank, chairs the Loan Committee. The Chief Credit Officer, Jim Bratton, also serves as Vice Chairman of the Loan Committee. Lending limits of individual loan officers are documented in the Bank’s Loan Policy and Procedures and are approved by the Board of Directors. Loan officers discuss with the Chief Credit Officer or President any loan request that exceeds their individual lending limit. The loan must have approval from the President, Chief Credit Officer or the Loan Committee as required by Loan Policy and Procedures. The President, Louis Holloway, and the Chief Credit Officer, Jim Bratton, have lending authority on secured and unsecured loans up to $1,000,000.
Our policies provide written guidelines for lending activities and are reviewed periodically by the Board of Directors. The Board of Directors recognize that, from time to time, it is in the best interests of the Company to deviate from the established, written credit policy and have established guidelines for granting exceptions to the policy. Situations in which such exceptions might be granted include the waiving of requirements for independent audited financial statements when a comfort level with respect to the financial statements of the borrower can be otherwise obtained and when it is deemed desirable to meet the terms offered by a competitor.
We seek to maintain a diversified loan portfolio, including secured and unsecured consumer loans, secured loans to individuals for business purposes, secured commercial loans, secured agricultural production loans, and secured real estate loans. Our primary trade area lies in the counties of Middle Tennessee, with the primary focus in Maury, Williamson, Hickman and Rutherford Counties, though our efforts in Rutherford County and Williamson County will decrease with the sale of our Murfreesboro, Tennessee branch and Franklin, Tennessee branch in the first half of 2012. The Loan Committee must approve all out-of-trade area loans.
As a general rule, we seek to maintain loan-to-collateral value ratios in conformity with industry and regulatory guidelines. The following standards, established by inter-agency guidelines by the federal bank regulators, including the FDIC, went into effect on March 19, 1993:
(1) Multifamily construction includes condominiums and cooperatives.
(2) A loan-to-value limit has not been established for permanent mortgage or home equity loans or owner-occupied, 1-4 family residential property. However, for any such loan with a loan-to-value ratio that equals or exceeds 90% at origination, appropriate credit enhancement in the form of either mortgage insurance or readily marketable collateral is required. Home equity lines of credit (HELOC) loan-to-value may be up to 100% of the collateral appraisal value.
Loan Review and Nonperforming Assets
We have an internal loan review system to determine deficiencies and corrective action to be taken. Loans are graded as follows:
GRADE 1 - EXCELLENT - Loans in this category are to persons or entities with strong balance sheets and highly liquid financial positions, with stable earnings. Guarantors have substantial new worth, are highly liquid, with strong earnings. Collateral is liquid and well margined. These borrowers have exceptional/top quality management, have performed without question on past obligations, and the Bank expects their performance to continue. Internally generated cash flow covers current maturities of long-term debt by a substantial margin.
GRADE 2 - GOOD - These are loans to persons or entities with solid balance sheets and reasonable liquidity with good earnings. Guarantors have strong new worth, good liquidity and earnings. Collateral securing the Bank’s debt is at 60 percent or less of the advance rate. These borrowers have strong, high quality management and have previously handled their obligations with the Bank satisfactorily. Internally generated cash flow covers current maturities of long-term debt more than adequately.
GRADE 3 - ACCEPTABLE - Loans in this category are to persons or entities with good balance sheets, acceptable liquidity and earnings. Guarantors have reasonable net worth, liquidity and earnings. Collateral is acceptable and is at or below policy advance rates. These borrowers have acceptable, good quality management and have handled previous obligations with the Bank substantially within terms. Cash flow is adequate to service long-term debt. These entities are minimally profitable now, with projections indicating continued profitability into the foreseeable future. Closely held corporations or businesses where a majority of the profits are withdrawn by the owners or paid in dividends are included in the rating category. Overall, these loans are basically sound.
GRADE 4 - PASS/WATCH - Loans rated “Pass/Watch” warrant more than the normal level of supervision and may warrant formal quarterly reporting to management due to strain on the borrower.
General Characteristics
•
Loans with aspects of the underwriting that do not conform to policy.
•
Borrowers that have had adverse events that have affected or could affect the borrower’s cash flow, financial posture, or ability to continue operating profitably; provided, however, that the events or circumstances prompting this rating do not constitute an undue or unwarranted credit risk.
•
Loans to borrowers engaged in an industry that is experiencing an economic downturn or is particularly susceptible to uncontrollable external factors.
•
Loans to newly formed companies or operations, or established companies with new or unproven management. Generally, such borrowers are adequately capitalized, but a stabilized cash flow has not yet been achieved.
•
Loans that constitute an approved loan policy exception, and/or loans which lack complete credit/collateral documentation. Not necessarily all policy or documentation exceptions would warrant a “Low Pass” rating.
•
Loans which lack proper structuring or adequate performance since inception, although the borrower’s repayment capacity appears adequate. Loans without a definite repayment plan may be an example.
•
Loans made essentially on the strength of a guarantor(s), although the guarantor is not the primary source of repayment. A more severe rating may be appropriate if the guarantor’s ability or willingness to service the debt as agreed is questionable or unknown.
•
Loans which need closer supervision as determined by the account officer, or require above-average servicing.
GRADE 5 - SPECIAL MENTION - Assets which are currently protected but have potential weaknesses which, if not corrected, may inadequately protect the Bank’s credit position at some future date. Credit factors are apparent which warrant a Special Mention rating as an indication to management that special attention is needed. Assets with actual, well-defined weaknesses receive a more severe rating. Special Mention loans are not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification.
General Characteristics
•
Loans with potential weaknesses including documentation exceptions, inadequate control over collateral or the lack of a loan agreement which would require special attention. Structure of the loans and other credit factors should also be given consideration.
•
Loans to borrowers exhibiting adverse financial trends, but not to the point that repayment is jeopardized. Profitability may be temporarily impaired, but capitalization and liquidity continue to be adequate.
•
Significant concentrations of accounts receivable or revenues from a source which is demonstrating cash flow problems. Such instances would pose a direct threat to the borrower’s operations because of significance.
•
Loans which are not performing in accordance with the terms of the loan or loan agreement, representing a decline in quality since the loans were originally granted.
•
Loans susceptible to economic conditions or market conditions which may adversely affect the obligor’s repayment capacity in the future.
Assets rated Special Mention remain collectable without extensive problems, although the financial condition of the borrower has weakened. These loans deserve more than normal management attention in order to correct deficiencies and prevent further deterioration. Such attention would include placement on the Watch List with progress reports prepared as required.
GRADE 6 - SUBSTANDARD - Loans which are inadequately protected by the current sound worth and paying capacity of the obligor or pledged collateral, if any. Loans so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.
General Characteristics
•
Loss potential, while existing in the aggregate amount of substandard assets, does not have to exist in individual assets classified substandard.
•
Collection of all principal from collateral would be questionable in liquidation.
•
Loans where borrower, endorsers or guarantors exhibit a questionable capacity and/or willingness to liquidate the credit at maturity or to reduce it in accordance with repayment agreement.
•
Loans requiring a substantial amount of servicing and monitoring.
•
Loans to borrowers with cash flow deficiencies which jeopardize future loan payments.
GRADE 7 - DOUBTFUL - Loans classified Doubtful have all the weaknesses inherent in ones classified substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.
General Characteristics
•
Loans with little or no liquidity.
•
Loans of unsatisfactory quality.
•
Loans with a high probability of total or substantial loss, but extraneous factors might make the strengthening or liquidation of the asset possible.
•
Loans supported by collateral with an inadequate value in relation to the debt and/or a financial condition and profit record of the borrower, endorser or guarantor, which indicate a strong possibility of loss.
•
Loans where borrower, endorser or guarantors exhibit an incapacity and/or unwillingness to liquidate the credit in accordance with repayment agreement.
•
Loans which will require the utmost attention to salvage.
GRADE 8 - LOSS - Loans that are considered uncollectible and of such little value, that their continuance as bankable assets is not warranted. This classification does not mean that the loan has absolutely no recovery or salvage value, but rather, it is not practical or desirable to defer writing off this basically worthless asset even though partial recovery may be affected in the future.
General Characteristics
•
Loans with no clearly defined source of repayment.
•
Loans where collateral support is non-existent or negligible, and/or a financial condition and profit record of the borrower, endorsers or guarantors which indicate the lack of ability to liquidate the debt.
•
Loans where borrower, endorsers or guarantors exhibit an unwillingness to liquidate the debt.
Loans graded “4”, “5”, “6”, “7”, or “8” are referred to management for inclusion on our “watch list”. Loans graded “4” are not considered adversely classified.
Nonperforming loans are placed on the non-accrual basis of accounting if: (i) there is deterioration in the financial condition of the borrower; (ii) payment in full of principal or interest is not expected; or (iii) principal or interest has been in default for 90 days or more, unless the obligation is well secured and in the process of collection. The three categories of nonperforming loans are non-accrual status loans, renegotiated debt, and loans in Chapter 13 bankruptcy unless a repayment schedule is adopted that pays out the loan.
Asset/Liability Management
A committee composed of certain officers and directors of the Bank is responsible for managing the assets and liabilities. The chairperson of the committee is the Chief Financial Officer, Dianne Scroggins. This committee attempts to manage asset growth, liquidity and capital in order to maximize income and reduce interest rate risk. The committee directs our overall acquisition and allocation of funds. The committee reviews and discusses our assets and liability funds budget in relation to the actual flow of funds. This committee also reviews and discusses peer group comparisons; the ratio of the amount of rate-sensitive assets to the amount of rate-sensitive liabilities; the ratio of allowance for loan losses to outstanding and nonperforming loans; and other variables, such as expected loan demand, investment opportunities, core deposit growth within specific categories, regulatory changes, monetary policy adjustments, and the overall state of the local and national economies.
Investment Policy
Our investment portfolio policy is designed to provide guidelines by which the funds not otherwise needed to meet loan demand of our market area can best be invested to meet fluctuations in the loan demand and deposit structure. The Chief Financial Officer, Dianne Scroggins, also serves as Investment Officer. We seek to balance the market and credit risk against the potential investment return, make investments compatible with the pledging requirements of our deposits of public funds, maintain compliance with regulatory investment requirements, and assist the various local public entities with their financing needs. Our investment policy is reviewed annually by the Investment Committee, chaired by Director Randy Maxwell, and by the Board of Directors.
Customers
In the opinion of management, there is no single customer or affiliated group of customers whose deposits, if withdrawn, would have a material adverse effect on our business. As of December 31, 2011, we had a total of 162 ending relationships that represent exposure to us of at least $500. We believe that the loss of one of these relationships or an affiliated group of relationships, while significant, would not materially impact our performance.
Competition and Seasonality
The banking business is highly competitive. Our primary market area consists of Maury, Williamson, Hickman, and Rutherford Counties in Tennessee, although we are exiting the Rutherford County market
and reducing our presence in the Williamson County market with our pending branch divestitures. We compete with numerous commercial banks and savings institutions with offices in these market areas. In addition to these competitors, we compete for loans with insurance companies, regulated small loan companies, credit unions, and certain government agencies. We also compete with numerous companies and financial institutions engaged in similar lines of business, such as mortgage banking companies, brokerage companies, investment banking firms and lending companies. These competitors have up to $978 million in deposits in the Maury County market area, up to $5.94 billion in deposits in the Williamson County market area, up to $2.89 billion in the Rutherford County market area and up to $96 million in the Hickman County market area, as reported by the FDIC as of June 30, 2011. At December 31, 2011, the Bank had deposits of approximately $555 million. The Company does not experience significant seasonal trends in its operations.
Employees
As of December 31, 2011, we had 137 full-time equivalent employees and 140 total employees. The Company plans to continue to hire additional employees as necessary to meet the demands of its customers. Neither the Company nor any of its subsidiaries is a party to any collective bargaining agreement, and the Company believes that its employee relations are in good standing.
Participation in the United States Department of the Treasury’s Capital Purchase Program
On February 27, 2009, as part of the Capital Purchase Program (the “CPP”) established by the U.S. Department of the Treasury (the “U.S. Treasury”) under the Emergency Economic Stabilization Act of 2008, as amended by the American Recovery and Reinvestment Act of 2009 (the “ARRA”) (the “EESA”), the Company issued and sold to the U.S. Treasury (i) 17,806 shares of the Company’s Fixed Rate Cumulative Perpetual Preferred Stock, Series A, having a liquidation preference of $1,000 per share (the “Series A Preferred Stock”), and (ii) a ten-year warrant to purchase 890 shares of the Company’s Fixed Rate Cumulative Perpetual Preferred Stock, Series B, having a liquidation preference of $1,000 per share (the “Series B Preferred Stock” and, together with the Series A Preferred Stock, the “Preferred Stock”), at an initial exercise price of $0.01 per share (the “Warrant”), for an aggregate purchase price of $17,806,000 in cash. On February 27, 2009, the U. S. Treasury exercised the Warrant to purchase 890 shares (after net settlement without cash payment) of Series B Preferred Stock.
The Preferred Stock qualifies as Tier 1 capital under current regulatory guidelines and pays cumulative dividends (i) with respect to the Series A Preferred Stock, at a rate of 5% per annum for the first five years following issuance and 9% per annum thereafter, and (ii) with respect to the Series B Preferred Stock, at a rate of 9% per annum. Dividends are payable on the Preferred Stock quarterly and are payable on February 15, May 15, August 15 and November 15 of each year. If the Company fails to pay a total of six dividend payments on either the Series A Preferred Stock or the Series B Preferred Stock, whether or not consecutive, holders of the series of Preferred Stock on which such dividends have not been paid shall be entitled, voting together with the other series of Preferred Stock and any other series of voting parity stock, to elect two directors to the Company’s Board of Directors until the Company has paid all such dividends that it had failed to pay. As a result of our deteriorating financial condition we informally committed to the Federal Reserve Bank of Atlanta (the “FRB”) on January 18, 2011 that we would not, among other things, pay dividends on the Preferred Stock we have sold to the U.S. Treasury without the prior approval of the FRB. Beginning with the dividend payment due on May 15, 2011, we have been unable to secure the approval of the FRB to pay dividends on the Series A Preferred Stock or Series B Preferred Stock.
The Series A Preferred Stock has no maturity date and ranks senior to the Company’s common stock, no par value per share (the “Common Stock”), with respect to the payment of dividends and distributions and
amounts payable upon liquidation, dissolution and winding up of the Company. The Series B Preferred Stock has no maturity date and ranks senior to the Common Stock, and pari passu with the Series A Preferred Stock, with respect to the payment of dividends and distributions and amounts payable upon liquidation, dissolution and winding up of the Company. The Preferred Stock is generally non-voting.
Under the ARRA, the Preferred Stock may be redeemed by the Company at any time subject to prior approval by the FRB. No shares of Series B Preferred Stock may be redeemed prior to the Company’s redemption, repurchase or other acquisition of all outstanding shares of Series A Preferred Stock.
Supervision and Regulation
General
As a registered bank holding company and Tennessee-chartered, federally insured commercial bank, the Company and the Bank are subject to extensive regulation. Lending activities and other investments must comply with various statutory and regulatory requirements, including prescribed minimum capital standards. The Bank is regularly examined by the FDIC and the Department and files periodic reports concerning its activities and financial condition with its regulators. The Bank’s relationships with depositors and borrowers are also regulated to a great extent by both federal law and the laws of the State of Tennessee, especially in such matters as the ownership of accounts and the form and content of mortgage documents.
Federal and state banking laws and regulations govern all areas of the operation of the Company and the Bank, including reserves, loans, mortgages, capital, issuance of securities, payment of dividends, and establishment of branches. Federal and state bank regulatory agencies also have the general authority to limit the dividends paid by insured banks if such payments should be deemed to constitute an unsafe and unsound practice. Both the Department and the FDIC have the authority to impose penalties, initiate civil and administrative actions and take other steps intended to prevent banks from engaging in unsafe or unsound practices.
The following summaries of statutes and regulations affecting banks do not purport to be complete. Such summaries are qualified in their entirety by reference to the statutes and regulations described.
The Dodd-Frank Wall Street Reform and Consumer Protection Act - On July 21, 2010, the “Dodd-Frank Wall Street Reform and Consumer Protection Act” (the “Dodd-Frank Act”) was signed into law. The Dodd-Frank Act implements far-reaching reforms of major elements of the financial landscape, particularly for larger financial institutions. Many of its most far-reaching provisions do not directly impact community-based institutions like the Company. For instance, provisions that regulate derivative transactions and limit derivatives trading activity of federally-insured institutions, enhance supervision of “systemically significant” institutions, impose new regulatory authority over hedge funds, limit proprietary trading by banks, and phase-out the eligibility of trust preferred securities for Tier 1 capital are among the provisions that do not directly impact the Company either because of exemptions for institutions below a certain asset size or because of the nature of the Company’s operations. Those provisions that have been adopted or are expected to be adopted have impacted and will continue to impact the Company include the following:
•
Changing the assessment base for federal deposit insurance from the amount of insured deposits to consolidated assets less tangible capital, eliminating the ceiling and increasing the size of the floor of the DIF, and offsetting the impact of the increase in the minimum floor on institutions with less than $10 billion in assets;
•
Making permanent the $250 limit for federal deposit insurance, increasing the cash limit of Securities Investor Protection Corporation protection to $250 and providing unlimited federal deposit insurance until December 31, 2012 for non interest bearing demand transaction accounts at all insured depository institutions;
•
Repealing the federal prohibition on payment of interest on demand deposits, thereby permitting depositing institutions to pay interest on business transaction and other accounts;
•
Centralizing responsibility for consumer financial protection by creating a new agency, the Consumer Financial Protection Bureau, responsible for implementing federal consumer protection laws, although banks below $10 billion in assets will continue to be examined and supervised for compliance with these laws by their federal banking regulator;
•
Restricting the preemption of state law by federal law and disallowing national bank subsidiaries from availing themselves of such preemption;
•
Limiting the debit interchange fees that certain financial institutions are permitted to charge;
•
Imposing new requirements for mortgage lending, including new minimum underwriting standards, prohibitions on certain yield-spread compensation to mortgage originators, special consumer protections for mortgage loans that do not meet certain provision qualifications, prohibitions and limitations on certain mortgage terms and various new mandated disclosures to mortgage borrowers;
•
Applying the same leverage and risk based capital requirements that apply to insured depository institutions to holding companies, although the Company’s currently outstanding subordinated debentures (but not new issuances) will continue to qualify as Tier 1 capital, subject to existing limitations on the amount that may so qualify;
•
Permitting national and state banks to establish de novo interstate branches at any location where a bank based in that state could establish a branch, and requiring that bank holding companies and banks be well capitalized and well managed in order to acquire banks located outside their home state;
•
Imposing new limits on affiliated transactions and causing derivative transactions to be subject to lending limits; and
•
Implementing certain corporate governance revisions that apply to all public companies.
As described above, many aspects of the Dodd-Frank Act are not yet effective and remain subject to rulemaking and will take effect over several years, and their impact on the Company or the financial industry is difficult to predict before such regulations are adopted.
Bank Holding Company Act of 1956 - The Company is a bank holding company registered under the provisions of the federal Bank Holding Company Act of 1956, as amended (the “BHC Act”), and consequently is subject to examination by the Board of Governors of the Federal Reserve System (the “FRS”).
As a bank holding company, the Company is required to file, with the FRB, annual reports and other information regarding its business operations and those of its subsidiaries. It is also subject to
examination by the FRB and is required to obtain FRB approval prior to acquiring, directly or indirectly, ownership or control of any voting shares of any bank, if, after such acquisition, it would own or control, directly or indirectly, more than 5% of the voting stock of such bank unless it already owns a majority of the voting stock of such bank. Furthermore, a bank holding company is, with limited exceptions, prohibited from acquiring direct or indirect ownership or control of any voting stock of any company which is not a bank or a bank holding company, and must engage only in the business of banking or managing or controlling banks or furnishing services to or performing services for its subsidiary banks. One of the exceptions to this prohibition is the ownership of shares of a company, the activities of which the FRS has determined to be so closely related to banking or management or controlling banks as to be properly incident thereto.
A bank holding company and its subsidiaries are also prohibited from engaging in certain tying arrangements in connection with the extension of credit or provision of any property or service. Thus, an affiliate of a bank holding company may not extend credit, lease, sell property, or furnish any services or fix or vary the consideration for these on the condition that (i) the customer must obtain or provide some additional credit, property, or services from or to the bank holding company or subsidiaries thereof or (ii) the customer may not obtain some other credit, property, or services from a competitor, except to the extent reasonable conditions are imposed to assure the soundness of the credit extended. The FRS has adopted significant amendments to its anti-tying rules that: (1) removed FRS-imposed anti-tying restrictions on bank holding companies and their non-bank subsidiaries; (2) allow banks greater flexibility to package products with their affiliates; and (3) establish a safe harbor from the tying restrictions for certain foreign transactions. These amendments were designed to enhance competition in banking and non-banking products and to allow banks and their affiliates to provide more efficient, lower cost service to their customers.
In approving acquisitions by bank holding companies of banks and companies engaged in banking-related activities, the FRB considers a number of factors, including expected benefits to the public such as greater convenience, increased competition, or gains in efficiency, as weighed against the risks of possible adverse effects, such as undue concentration of resources, decreased or unfair competition, conflicts of interest, or unsound banking practices. The FRB is also empowered to differentiate between new activities and activities commenced through the acquisition of a going concern.
The Change in Bank Control Act of 1978, as amended, requires a person (or group of persons acting in concert) acquiring “control” of a bank holding company to provided the FRB with 60 days’ prior written notice of the proposed acquisition. Following receipt of this notice, the FRB has 60 days within which to issue a notice disapproving the proposed acquisition, but the FRB may extend this time period for up to another 30 days. An acquisition may be completed before expiration of the disapproval period if the FRB issues written notice of its intent not to disapprove the transaction. In addition, any “company” must obtain the FRB’s approval before acquiring 25% (5% if the “company” is a bank holding company) or more of the outstanding shares or otherwise obtaining control over the company.
The Attorney General of the United States may, within 15 days after approval by the FRB of an acquisition, bring an action challenging such acquisition under the federal antitrust laws, in which case the effectiveness of such approval is stayed pending a final ruling by the courts. Failure of the Attorney General to challenge an acquisition does not, however, exempt the holding company from complying with both state and federal antitrust laws after the acquisition is consummated or immunize the acquisition from future challenge under the anti-monopolization provisions of the Sherman Act.
Bank holding companies are not permitted to engage in “unsafe and unsound” banking practices. The FRS’s Regulation Y, for example, generally requires a bank holding company to give the FRS prior notice of any redemption or repurchase of its own equity securities, if the consideration to be paid,
together with consideration paid for any repurchases or redemptions in the preceding year, is equal to 10% or more of the bank holding company’s consolidated net worth. The FRS may oppose the transaction if it believes that the transaction would constitute an unsafe and unsound practice or would violate any law or regulation. Depending upon the circumstances, the FRS could take the position that paying a dividend would constitute an unsafe and unsound banking practice. Supervisory guidance from the FRS indicates that bank holding companies that are participants in the CPP that are experiencing financial difficulty generally should eliminate, reduce or defer dividends on Tier 1 capital instruments (as we have done) including trust preferred securities, preferred stock or common stock, if the holding company needs to conserve capital for safe and sound operation and to serve as a source of strength to its subsidiaries.
The FRS has broad authority to prohibit activities of bank holding companies and their non-bank subsidiaries which represent unsafe and unsound banking practices or which constitute knowing or reckless violations of laws or regulations, if those activities caused a substantial loss to a depository institution. These penalties can be as high as one million dollars for each day the activity continues.
Securities Registration and Reporting - The Common Stock of the Company is registered as a class with the SEC under the Exchange Act and thus the Company is subject to the periodic reporting and proxy solicitation requirements and the insider-trading restrictions of the Act. In addition, the securities issued by the Company are subject to the registration requirements of the Securities Act and applicable state securities laws unless exemptions are available. The periodic reports, proxy statements, and other information filed by the Company with the SEC are available at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The Company is an electronic filer with the SEC and the Company’s filings may be obtained free of charge at the SEC website (http://www.sec.gov). The Company also makes available on its website (http://www.cfbk.com), free of charge, its annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports as soon as reasonably practicable after the Company files such material with, or furnishes such material to, the SEC.
Participation in the Capital Purchase Program of the Troubled Asset Relief Program - As a result of the Company’s participation in the CPP, the Company is required to comply with certain limits and restrictions concerning executive compensation throughout the time that the U.S. Treasury holds any equity or debt securities acquired from the Company pursuant to the CPP, including a requirement that any bonus or incentive compensation paid to the Company’s senior executive officers and next twenty most highly compensated employees during the period that the U.S. Treasury holds the preferred stock be subject to “clawback” or recovery if the payment was based on materially inaccurate financial statements or other materially inaccurate performance metrics criteria and a prohibition on making any “golden parachute” payment (as defined in Section 111 of the EESA, as amended by the ARRA as well as all rules, regulations, guidance or other requirements issued thereunder including the interim final rule issued by the U.S. Treasury on June 15, 2009 (the “June 2009 IFR”)) during that same period to any senior executive officer or the next five most highly compensated employees. The prohibition on “golden parachute” payments has been expanded under the ARRA and the June 2009 IFR to prohibit any payment to these employees for departure from the Company for any reason, except for payments for services performed or benefits accrued.
In addition to the above-described restrictions and limitations on executive compensation, the Company’s participation in the CPP also means that the Company must (i) ensure that the incentive compensation programs for its senior executive officers do not encourage unnecessary and excessive risks that threaten the value of the Company; (ii) not make any bonus, incentive or retention payment to the Company’s chief executive officer, except as permitted under the June 2009 IFR; (iii) not deduct for tax purposes
executive compensation in excess of $500 in any one fiscal year for each of the Company’s senior executive officers; (iv) establish a Company-wide policy regarding “excessive or luxury expenditures;” and (v) include in the Company’s proxy statement for its annual shareholder meeting a non-binding, advisory shareholder vote on the compensation the Company paid to its senior executive officers.
Tennessee Supervision and Regulation - As a Tennessee-chartered commercial bank, the Bank is subject to various state laws and regulations which limit the amount that can be loaned to a single borrower, the type of permissible investments, and geographic expansion, among other things. The Bank must submit an application and receive the approval of the Department before opening a new branch office or merging with another financial institution. The Department regularly examines state chartered banks like the Bank and in connection with its examinations may identify matters necessary to improve a bank’s operation in accordance with principles of safety and soundness. Any matters identified in such examinations are required to be appropriately addressed by the bank being examined and may include maintaining capital at levels above those required by federal statutory provisions to be considered well capitalized and not paying dividends without the prior approval of the Commissioner of the Department. During the first quarter of 2011, the Bank was subject to a joint examination by the FDIC and the Tennessee Department of Financial Institutions (the “Department”). On September 20, 2011, the Bank consented to the issuance of a consent order (the “Consent Order”) by the Federal Deposit Insurance Corporation (the “FDIC”). The Consent Order replaces the memorandum of understanding (“MOU”) that the Bank had entered into with the FDIC on October 19, 2010. Under the terms of the Consent Order, the Bank has agreed to, among other things, take the following actions:
• Establish, within 30 days after September 20, 2011, a board committee to oversee the Bank’s compliance with the Consent Order;
• Make, within 30 days after September 20, 2011, provisions to its allowance for loan and lease losses (the “ALLL”) in an amount equal to those loans required to be charged off by the Consent Order, and thereafter maintain a reasonable ALLL and quarterly have its board of directors review the adequacy of the ALLL;
• Review, within 30 days after September 20, 2011, the Bank’s Consolidated Reports on Condition and Income filed with the FDIC after December 31, 2010, and amend such reports if necessary to accurately reflect the Bank’s financial condition as of such dates;
• Use, within 30 days after September 20, 2011, Financial Accounting Standards Board Accounting Standards Codification Numbers 450 and 310 for determining the Bank’s ALLL reserve adequacy;
• Retain, within 60 days after September 20, 2011, a bank consultant to develop, within 90 days after September 20, 2011, a written analysis and assessment of the Bank’s management and staffing needs for the purpose of providing qualified management;
• Formulate and submit to the FDIC and the Department, within 60 days after September 20, 2011, a written policy covering expense reimbursement to the Bank’s directors, officers and employees, and while the Consent Order is in effect have the Bank’s Board of Directors conduct monthly reviews of all expenses submitted for customer entertainment, business development and/or any other expense submitted by the Bank’s officers and directors;
• Prepare and submit, within 120 days after September 20, 2011, to its supervisory authorities a budget and profit plan for calendar year 2012;
• On or before December 31, 2011 achieve, and thereafter, maintain the Bank’s Tier 1 leverage capital ratio, Tier 1 risk-based capital ratio and Total risk-based capital ratios equal to or greater than 8.5%, 10.0% and 12.0%, respectively;
• If the Bank’s capital ratios fall below the minimum levels set out in the previous bullet as of the date of any of the Bank’s Reports on Condition and Income, submit within 30 days of receiving a request to do so, to the FDIC and the Department a capital plan to increase the Bank’s capital to levels above these minimum levels; then initiate action within 30 days after the FDIC and the Department respond to the plan;
• Refrain from paying cash dividends to the Company without the prior written consent of the FDIC and the Department;
• Increase, within 30 days after September 20, 2011, the participation of the Bank’s board of directors in the affairs of the Bank by assuming full responsibility for the approval of the Bank’s policies and objectives and for the supervision of management, including all Bank activities;
• Develop, within 120 days after September 20, 2011, a strategic plan that addresses issues including plans for sustaining adequate liquidity, strategies for pricing policies and asset/liability management, goals for reducing problem loans, plans for attracting and retaining qualified individuals to fill vacancies in the lending and accounting functions, financial goals and formulation of a mission statement;
• Not extend, directly or indirectly, any additional credit to or for the benefit of any borrower whose extension of credit is classified “Doubtful” and/or “Substandard” by the FDIC or the Department unless the Bank’s Board of Directors has signed a detailed written statement giving reasons why the failure to extend such credit would be detrimental to the Bank;
• Take, within 30 days after September 20, 2011, specific actions to eliminate all assets classified as “Loss” as of March 14, 2011, and, within 60 days of September 20, 2011 submit a written plan to reduce the level of assets classified “Doubtful” or “Substandard” with a balance in excess of $1,000,000, in each case as of March 14, 2011;
• Refrain from extending any additional credit to, or for the benefit of, any borrower who has a loan or other extension of credit from the Bank that has been charged off or classified in a certain specified manner and is uncollected;
• Take, within 120 days after September 20, 2011, specified actions to reduce concentrations of construction and development loans in the Bank’s portfolio to not more than 100% of the Bank’s Tier 1 capital and commercial real estate loans (other than owner-occupied commercial real estate loans) to not more than 300% of the Bank’s Tier 1 capital;
• Take, within 60 days after September 20, 2011, specified action for the reduction and collection of delinquent loans;
• Eliminate, within 30 days after September 20, 2011, and/or correct all applicable violations of law and regulation as discussed in the Bank’s most recent exam report and implement procedures to ensure future compliance with all applicable laws and regulations;
• Refrain from entering into any new line of business without the prior written consent of the FDIC while the Consent Order is in effect;
• Establish, within 30 days after September 20, 2011, a loan review committee (at least two-thirds of the members of which shall be independent directors) to periodically review the Bank’s loan portfolio and identify and categorize problem credits;
• Review, within 90 days after September 20, 2011, and annually thereafter, the Bank’s loan policy and procedures for effectiveness; and
• Furnish, within 30 days following the end of each calendar quarter, quarterly progress reports to the banking regulators.
The Bank’s capital levels as of December 31, 2011 were below those that the Bank agreed to achieve by that date under the terms of the Consent Order. Based on December 31, 2011 levels of average assets and risk-weighted assets, the required amount of additional Tier 1 capital necessary to meet the requirements of the Consent Order was approximately $22,413, which would also satisfy the total capital requirement. As a result of entering into the Consent Order, the Bank is subject to additional limitations on its operations including a prohibition on paying interest on deposits above national rate caps and accepting rolling over or renewing brokered deposits, which could adversely affect the Bank’s liquidity and/or operating results. The Bank is also limited, as a result of its condition, in its ability to pay severance payments to its employees and must receive the consent of the FDIC and the Department to appoint new officers or directors.
The Commissioner of the Department has the authority to enforce state laws and regulations by ordering a director, officer or employee of the Bank to cease and desist from violating a law or regulation and from engaging in unsafe or unsound banking practices. The Bank will be required to file annual reports and such other additional information as Tennessee law requires. Tennessee law contains limitations on the interest rates that may be charged on various types of loans and restrictions on the nature and amount of loans that may be granted and on the type of investments which may be made. The operations of banks are also affected by various consumer laws and regulations, including those relating to equal credit opportunity and regulation of consumer lending practices. All Tennessee banks, including the Bank, must become and remain insured under the Federal Deposit Insurance Act.
Dividends - The Company is a legal entity separate and distinct from the Bank. The principal source of the Company’s revenues however, is from dividends declared by the Bank. Under Tennessee law, the Bank can only pay dividends in an amount equal to or less than the total amount of its net income for that year combined with retained net income of the preceding two (2) years. Payment of dividends in excess of this amount requires prior approval by the Commissioner of the Department. The Bank’s ability to pay dividends also may depend on its ability to meet minimum capital levels established from time to time by the FDIC. Under such regulations, FDIC-insured state banks are prohibited from paying dividends, making other distributions or paying any management fee to a parent if, after such payment, the bank would fail to have a risk-based Tier 1 capital ratio of 4%, a risk-based total capital ratio of 8% and a Tier 1 leverage capital ratio of 4%. The Bank’s ability to pay dividends to the Company may also be limited by limitations imposed on the Bank by the FDIC or the Department, including both formal and informal actions like the Consent Order, which prohibits the Bank from paying dividends to the Company without the prior consent of the FDIC and the Department.
Under Tennessee law, the Company may pay common stock dividends if, after giving effect to the dividends, the Company can pay its debts as they become due in the ordinary course of business and the Company’s total assets exceed its total liabilities. The payment of dividends by the Company also may be affected or limited by certain factors, such as the requirements to maintain adequate capital above regulatory guidelines. In addition, if, in the opinion of the applicable regulatory authority, a bank holding
company or a bank under its jurisdiction is engaged in or is about to engage in an unsafe or unsound practice (which, depending on the financial condition of the bank, could include the payment of dividends), such authority may take various supervisory actions to prevent such action, including a cease and desist order prohibiting such practice. At the request of the Federal Reserve Bank (“FRB”), the Board of Directors of the Company, on January 18, 2011, adopted a board resolution agreeing that the Company would not, among other things, incur additional debt, pay dividends on any of its common stock or preferred stock, or redeem treasury stock without approval from the FRB. The Company requested permission to make dividend payments on its Preferred Stock and interest payments on its subordinated debt that were scheduled for the first quarter of 2011. In the first quarter of 2011, the FRB granted the Company permission to pay the dividends on its Preferred Stock that were due on February 15, 2011, but denied the Company permission to make interest payments on its subordinated debt. As a result of the FRB’s decision, the Company was required to begin the deferral of interest payments on each of its three subordinated debentures during the first quarter of 2011. The Company has the right to defer the payment of interest on the subordinated debentures at any time, for a period not to exceed 20 consecutive quarters. During the period in which it is deferring the payment of interest on its subordinated debentures, the indentures governing the subordinated debentures provide that the Company cannot pay any dividends on its Common Stock or Preferred Stock. Accordingly, the Company was required to suspend its dividend payments on its Preferred Stock beginning in the second quarter of 2011. At December 31, 2011, the Company has $849 of dividends accrued but unpaid on its Preferred Stock. Additionally, because the Company has deferred the payment of interest on its subordinated debt, its REIT subsidiary, Community First Properties, Inc., is also prohibited from paying dividends on its issued and outstanding preferred stock and common stock until such time as the Company is current on the payment of interest on its subordinated debt. As a result of the prohibition, Community First Properties, Inc. did not make its $8 semi-annual dividend payment on its preferred stock due December 30, 2011. At December 31, 2011, the Company has $1,497 of interest accrued on its subordinated debentures for which payment is being deferred.
As a result of its losses in 2011, 2010 and 2009, the Bank is prohibited under applicable Tennessee law from declaring dividends, without prior approval from the Department. The terms of the Consent Order also prohibit the Bank from paying dividends to the Company without prior the Department and FDIC approval. The Company is currently considering the options available to it to increase capital levels at the Bank, including the sale of common or preferred stock of the Company or the sale of certain branch locations or other assets, or alternatively the sale of the Company. In the fourth quarter of 2011 and first quarter of 2012, respectively, the Bank entered into agreements to sell certain loans and other assets and transfer certain deposits associated with the Bank’s Murfreesboro, Tennessee and Franklin, Tennessee branch locations. The Company expects that these sales if consummated will improve the Bank’s capital levels. Any sale of the Company’s common stock would likely be at a price that would result in substantial dilution in ownership for the Company’s existing common shareholders and could result in a change in control of the Company. The Company is also unlikely to pay any dividends as a result of its informal commitment to the FRB and the suspension of dividends on the preferred stock the Company sold the U. S. Treasury and of interest on its trust preferred securities.
In addition to the limitations on the Company’s ability to pay dividends under Tennessee law and in its commitment to the FRB, the Company’s ability to pay dividends on its Common Stock is also limited by the Company’s participation in the CPP, by the terms of the indentures governing its subordinated debentures and by certain statutory or regulatory limitations.
Subject to certain restrictions, from February 28, 2012 until February 27, 2019, unless the U.S. Treasury has transferred the Preferred Stock to third parties or the Preferred Stock has been completely redeemed, the Company may increase the dividends paid to holders of its Common Stock by up to 3% in the aggregate per year over the amount paid in the prior year without the U.S. Treasury’s consent; provided
that no increase in the dividends paid to holders of Common Stock may be made as a result of any dividend paid in shares of Common Stock, any stock split or any similar transactions. From February 28, 2019, until the the Preferred Stock held by the U.S. Treasury has been completely redeemed or transferred to third parties, the Company may not declare or pay any dividend or make any distribution on any capital stock or other equity securities of the Company other than regular dividends on shares of the Preferred Stock in accordance with the terms thereof and which are permitted by the terms of the Preferred Stock, or dividends or distributions by any wholly-owned subsidiary of the Company. Further, during such period the Company may not redeem, purchase or acquire any shares of Common Stock or other capital stock or other equity securities of any kind of the Company, including any trust preferred securities, other than the Preferred Stock.
State banks are subject to regulation by the Department with regard to capital requirements. Tennessee has adopted the provisions of FRS Regulation O with respect to restrictions on loans and other extensions of credit to bank “insiders.” Further, under Tennessee law, state banks are prohibited from lending to any one person, firm or corporation amounts more than fifteen percent (15%) of its equity capital accounts, except (i) in the case of certain loans secured by negotiable title documents covering readily marketable nonperishable staples, or (ii) with the prior approval of the state bank’s board of directors or finance committee (however titled), the state bank may make a loan to any person, firm or corporation of up to twenty-five percent (25%) of its equity capital accounts.
Deposit Insurance - Our deposit accounts are insured by the FDIC up to applicable limits by the DIF. The DIF was designated as an insurance fund pursuant to the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (“FIRREA”). FIRREA provides that a depository institution insured by the FDIC can be held liable for any loss incurred by, or reasonably expected to be incurred by, the FDIC after August 9, 1989 in connection with (i) the default of a commonly controlled FDIC insured depository institution or (ii) any assistance provided by the FDIC to a commonly controlled FDIC insured depository institution in danger of default. FIRREA provides that certain types of persons affiliated with financial institutions can be fined by the federal regulatory agency having jurisdiction over a depository institution with federal deposit insurance (such as the Bank) could be fined up to $1 million per day for each violation of certain regulations related (primarily) to lending to and transactions with executive officers, directors, and principal shareholders, including the interests of these individuals. Other violations may result in civil money penalties of $5 to $25 per day or in criminal fines and penalties. In addition, the FDIC has been granted enhanced authority to withdraw or to suspend deposit insurance in certain cases.
As an insurer, the FDIC issues regulations, conducts examinations, requires the filing of reports and generally supervises and regulates the operations of state-chartered banks that are not members of the Federal Reserve System. FDIC approval is required prior to any merger or consolidation involving state, nonmember banks, or the establishment or relocation of an office facility thereof. FDIC supervision and regulation is intended primarily for the protection of depositors and the FDIC insurance fund. The FDIC regularly examines state chartered banks like the Bank and in connection with its examinations may identify matters necessary to improve a bank’s operation in accordance with principles of safety and soundness. Any matters identified in such examinations are required to be appropriately addressed by the bank being examined and may include maintaining capital at levels above those required by federal statutory provisions to be considered well capitalized or not paying dividends without the prior approval of the FDIC.
The FDIC has adopted a risk-based assessment system for insured depository institutions that takes into account the risks attributable to different categories and concentrations of assets and liabilities. In early 2006, Congress passed the Federal Deposit Insurance Reform Act of 2005, which made certain changes to the Federal deposit insurance program. These changes included merging the Bank Insurance Fund and the Savings Association Insurance Fund to form the DIF, increasing retirement account coverage to $250 and
providing for inflationary adjustments to general coverage beginning in 2010, providing the FDIC with authority to set the fund’s reserve ratio within a specified range, and requiring dividends to banks if the reserve ratio exceeds certain levels. In November 2009, the FDIC issued a rule that required all insured depository institutions, with limited exceptions, to prepay their estimated quarterly risk-based assessments for the fourth quarter of 2009 and for all of 2010, 2011 and 2012.
Under the Dodd-Frank Act, the FDIC adopted regulations that base deposit insurance assessments on total assets less capital rather than deposit liabilities and include off-balance sheet liabilities of institutions and their affiliates in risk-based assessments.
The Dodd-Frank Act increased the basic limit on federal deposit insurance coverage from $100 to $250 per depositor. In addition, FDIC coverage of non-interest bearing deposit transaction accounts have unlimited FDIC insurance coverage until December 31, 2012. The Dodd-Frank Act also repealed the prohibition on paying interest on demand transaction accounts, but did not extend unlimited insurance protection for these accounts.
Any insured bank which does not operate in accordance with or conform to FDIC regulations, policies and directives may be sanctioned for non-compliance. For example, proceedings may be instituted against any insured bank or any director, officer or employee of such bank who engages in unsafe and unsound practices, including the violation of applicable laws and regulations. The FDIC has the authority to terminate deposit insurance pursuant to procedures established for that purpose.
FDICIA & Prompt Corrective Action - The Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”), which was enacted on December 19, 1991, substantially revised the depository institution regulatory and funding provisions of the Federal Deposit Insurance Act (“FDIA”) and several other banking statutes. The additional supervisory powers and regulations mandated by FDICIA include a “prompt corrective action” program based upon five regulatory zones for banks, in which all banks are placed, largely based on their capital positions. Regulators are permitted to take increasingly harsh action as a bank’s financial condition declines. Regulators are also empowered to place in receivership or require the sale of a bank to another depository institution when a bank’s capital leverage ratio reaches two percent. Better capitalized institutions are generally subject to less onerous regulation and supervision than banks with lesser amounts of capital. Each federal banking agency is required to implement a system of prompt corrective action for institutions which it regulates. The FDIC has adopted regulations implementing the prompt corrective action provisions of the FDICIA, which place financial institutions in the following five categories based upon capital ratios: (i) a “well capitalized” institution if it has a total risk-based capital ratio of 10.0%, a Tier 1 risk-based ratio of at least 6% and a leverage ratio of at least 5% and is not subject to a written agreement, order or directive to maintain capital above a specified level; (ii) an “adequately capitalized” institution has a total risk-based capital ratio of at least 8%, a Tier 1 risk-based capital ratio of at least 4%, and a leverage ratio of 4%; (iii) an “undercapitalized” institution has a total risk-based capital ratio of under 8%, a Tier 1 risk-based capital ratio of under 4% or a leverage ratio of under 4%; (iv) a “significantly undercapitalized” institution has a total risk-based capital ratio of under 6%, a Tier 1 risk-based ratio of under 3% or a leverage ratio of under 3%; and (v) a “critically undercapitalized” institution has a leverage ratio of 2% or less.
The regulations also establish procedures for “downgrading” an institution to a lower capital category based on supervisory factors other than capital. Specifically, Section 38 of the FDIA and the implementing regulations provide that a federal banking agency may, after notice and an opportunity for a hearing, reclassify a well-capitalized institution as adequately capitalized and may require an adequately capitalized institution or an undercapitalized institution to comply with supervisory actions as if it were in the next lower category if the institution is in an unsafe or unsound condition or engaging in an unsafe or unsound practice. (The FDIC may not, however, reclassify a significantly undercapitalized institution as
critically undercapitalized). The FDIC may also, as part of its examination of a bank, require that a bank maintain capital at levels above those required to be well capitalized under the prompt corrective action provisions of FDICIA. If the FDIC were to impose higher capital ratio requirements on a financial institution in connection with any written agreement, consent order, order to cease and desist, capital directive or prompt corrective action directive that institution even if well capitalized under statutorily required minimums would be reclassified as adequately capitalized for certain purposes including the acceptance or renewal of brokered deposits and limits on the rates that the institution may pay on deposits.
FDICIA generally prohibits an FDIC-insured depository institution from making any capital distribution (including payment of dividends) or paying any management fee to its holding company if the depository institution would thereafter be undercapitalized. Undercapitalized depository institutions are subject to restrictions on borrowing from the FRS. In addition, undercapitalized depository institutions are subject to growth limitations and are required to submit capital restoration plans. A depository institution’s holding company must guarantee the capital plan, up to an amount equal to the lesser of 5% of the depository institution’s assets at the time it becomes undercapitalized or the amount of the capital deficiency when the institution fails to comply with the plan. The federal banking agencies may not accept a capital plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institution’s capital. If a depository institution fails to submit an acceptable plan, it is treated as if it is significantly undercapitalized.
Significantly undercapitalized depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become adequately capitalized, requirements to reduce total assets and cessation of receipt of deposits from correspondent banks. Critically undercapitalized depository institutions are subject to appointment of a receiver or conservator.
FDICIA contains numerous other provisions, including accounting, audit and reporting requirements, beginning in 1995 termination of the “too big to fail” doctrine except in special cases, limitations on the FDIC’s payment of deposits at foreign branches, new regulatory standards in such areas as asset quality, earnings and compensation and revised regulatory standards for, among other things, powers of state banks, real estate lending and capital adequacy. FDICIA also requires that a depository institution provide 90 days prior notice of the closing of any branches.
Various other legislation, including proposals to revise the bank regulatory system and to limit or expand the investments that a depository institution may make with insured funds, is from time to time introduced in Congress. The Department and the FRB examines us periodically for compliance with various regulatory requirements. Such examinations, however, are for the protection of the DIF and depositors and not for the protection of investors and shareholders.
Standards for Safety and Soundness - The FDIA requires the federal banking regulatory agencies to prescribe, by regulation, standards for all insured depository institutions relating to: (i) internal controls, information systems and internal audit systems; (ii) loan documentation; (iii) credit underwriting; (iv) interest rate risk exposure; (v) asset growth; and (vi) compensation, fees and benefits. The federal banking agencies have adopted regulations and Interagency Guidelines Prescribing Standards for Safety and Soundness (the “Guidelines”) to implement safety and soundness standards required by the FDIA. The Guidelines set forth the safety and soundness standards that the federal banking agencies use to identify and address problems at insured depository institutions before capital becomes impaired. The agencies also adopted asset quality and earnings standards which are part of the Guidelines. Under the regulations, if the FDIC determines that the Bank fails to meet any standards prescribed by the Guidelines, the agency may require the Bank to submit to the agency an acceptable plan to achieve compliance with the standard, as required by the FDIA. The final regulations establish deadlines for the submission and review of such safety and soundness compliance plans.
Support of Subsidiary Institutions - Under the Dodd-Frank Act, and previously under FRS policy, the Company is required to act as a source of financial strength for the Bank, and to commit resources to support the Bank. This support can be required at times when it would not be in the best interest of the Company’s shareholders or creditors to provide it. In the unlikely event of our bankruptcy, any commitment by the Bank to a federal bank regulatory agency to maintain the capital of the Bank would be assumed by the bankruptcy trustee and entitled to a priority of payment.
Capital Requirements - The FDIC’s minimum capital standards applicable to FDIC-regulated banks and savings banks require the most highly-rated institutions to meet a “Tier 1” leverage capital ratio of at least 3.0% of total assets. Tier 1 (or “core capital”) consists of common stockholders’ equity, noncumulative perpetual preferred stock, and minority interests in consolidated subsidiaries minus all intangible assets other than limited amounts of purchased mortgage servicing rights and certain other accounting adjustments. All other banks must have a Tier 1 leverage ratio of at least 100-200 basis points above the 3% minimum. The FDIC capital regulations establish a minimum leverage ratio of not less than 4% for banks that are not highly rated or are anticipating or experiencing significant growth. The preferred stock that the Company sold to the U.S. Treasury in connection with the CPP qualifies as Tier 1 Capital as do the subordinated debentures the Company has previously issued, and, as described below, each will continue to qualify as Tier 1 capital following passage of the Dodd-Frank Act. Tier 2 capital is an amount equal to the sum of (i) the allowance for possible loan losses in an amount up to 1.25% of risk-weighted assets; (ii) cumulative perpetual preferred stock with an original maturity of 20 years or more and related surplus; (iii) hybrid capital instruments (instruments with characteristics of both debt and equity), perpetual debt and mandatory convertible debt securities; and (iv) in an amount up to 50% of Tier 1 capital, eligible term subordinated debt and intermediate-term preferred stock with an original maturity of five years or more, including related surplus. The inclusion of the foregoing elements of Tier 2 capital is subject to certain requirements and limitations of the FDIC.
FDIC capital regulations require higher capital levels for banks which exhibit more than a moderate degree of risk or exhibit other characteristics which necessitate that higher than minimum levels of capital be maintained. Any insured bank with a Tier 1 capital to total assets ratio of less than 2% is deemed to be operating in an unsafe and unsound condition pursuant to Section 8(a) of the FDIA unless the insured bank enters into a written agreement, to which the FDIC is a party, to correct its capital deficiency. Insured banks operating with Tier 1 capital levels below 2% (and which have not entered into a written agreement) are subject to an insurance removal action. Insured banks operating with lower than the prescribed minimum capital levels generally will not receive approval of applications submitted to the FDIC. Also, inadequately capitalized state nonmember banks will be subject to such administrative action as the FDIC deems necessary.
FDIC regulations also require that banks meet a risk-based capital standard. The risk-based capital standard requires the maintenance of total capital (which is defined as Tier 1 capital and Tier 2 or supplementary capital) to risk weighted assets of 8% and Tier 1 capital to risk-weighted assets of 4%. In determining the amount of risk-weighted assets, all assets, plus certain off balance sheet items, are multiplied by a risk-weight of 0% to 100%, based on the risks the FDIC believes are inherent in the type of asset or item. The components of Tier 1 capital are equivalent to those discussed above under the 3% leverage requirement. The components of mandatory convertible securities, long-term subordinated debt, intermediate-term preferred stock and allowance for possible loan losses. Allowance for possible loan losses includable in supplementary capital is limited to a maximum of 1.25% of risk-weighted assets. Overall, the amount of capital counted toward supplementary capital cannot exceed 100% of Tier 1 capital. The FDIC includes in its evaluation of a bank’s capital adequacy an assessment of risk-based
capital focusing principally on broad categories of credit risk. No measurement framework for assessing the level of a bank’s interest rate risk exposure has been codified but, effective board and senior management oversight of the banks tolerance for interest rate risk is required.
The FDIC has adopted the Federal Financial Institutions Examination Council’s recommendation regarding the adoption of ASC 320, “Accounting for Certain Investments in Debt and Equity Securities.” Specifically, the FDIC determined that net unrealized holding gains or losses on available for sale debt and equity securities should not be included when calculating core and risk-based capital ratios.
FDIC capital requirements are designated as the minimum acceptable standards for banks whose overall financial condition is fundamentally sound, which are well-managed and have no material or significant financial weakness. The FDIC capital regulations state that, where the FDIC determines that the financial history or condition, including off-balance sheet risk, managerial resources and/or the future earnings prospects of a bank are not adequate and/or a bank has a significant volume of assets classified substandard, doubtful or loss or otherwise criticized, the FDIC may determine that the minimum adequate amount of capital for that bank is greater than the minimum standards established in the regulation.
In addition, the FRS has established minimum leverage ratio guidelines for bank holding companies. These guidelines provide that a minimum ratio of Tier 1 capital to average assets, less goodwill and other specified intangible assets, of at least 4% should be maintained for most bank holding companies. For a bank holding company to be considered “well capitalized,” it must maintain a total risk-based capital ratio of at least 10%, a Tier 1 risk-based capital ratio of at least 6% and not be subject to a written agreement, order or directive to maintain capital above a specified level. The guidelines also provide that bank holding companies experiencing high internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels. Furthermore, the FRS has indicated that it will consider a bank holding company’s Tier 1 capital leverage ratio, after deducting all intangibles, and other indicators of capital strength in evaluating proposals for expansion or new activities.
In late 2010, the Basel Committee on Banking Supervision issued Basel III, a new capital framework for banks and bank holding companies. Basel III imposes a stricter definition of capital, with more focus on common equity for those banks to which it is applicable. At this time, we do not know whether Basel III, as implemented in the United States, will be applicable to the Company and the Bank. The FRS has recently adopted regulations applicable to bank holding companies with assets over $50 billion that require such holding companies to develop and submit to the FRS annually capital plans demonstrating the company’s ability to meet, under various stressed economic conditions and over a nine-quarter planning horizon, the above-described minimum leverage capital, Tier 1 risk-based capital and total risk-based capital requirements, as well as a minimum Tier 1 common capital ratio (Tier 1 risk-based capital less preferred stock and trust preferred securities) of at least 5%. Although these regulations are not applicable to us, it is possible that similar requirements may be imposed on smaller bank holding companies like us through the regulatory examination process. Failure to meet statutorily mandated capital guidelines or more restrictive ratios separately established for a financial institution could subject a bank or bank holding company to a variety of enforcement remedies, including issuance of a capital directive by the FDIC, the termination of deposit insurance by the FDIC, a prohibition on accepting or renewing brokered deposits, limitations on the rates of interest that the institution may pay on its deposits and other restrictions on its business. As described above, significant additional restrictions can be imposed on FDIC-insured depository institutions that fail to meet applicable capital requirements.
The Dodd-Frank Act contains a number of provisions dealing with capital adequacy of insured depository institutions and their holding companies, and for the most part will result in insured depository institutions and their holding companies being subject to more stringent capital requirements. Under the
so-called “Collins Amendment” to the Dodd-Frank Act, federal regulators have established minimum leverage and risk-based capital requirements for, among other entities, banks and bank holding companies on a consolidated basis. These minimum requirements require that a bank holding company maintain a Tier 1 risk-based capital ratio of not less than 6% and a total risk-based capital ratio of not less than 10%. The Collins Amendment also excludes trust preferred securities issued after May 19, 2010 from being included in Tier 1 capital unless the issuing company is a bank holding company with less than $500 million in total assets. Trust preferred securities issued prior to that date will continue to count as Tier 1 capital for bank holding companies with less than $15 billion in total assets, and such securities will be phased out of Tier 1 capital treatment for bank holding companies with over $15 billion in total assets over a three-year period beginning in 2013. The Collins Amendment did not exclude preferred stock issued to the U.S. Treasury through the CPP from Tier 1 capital treatment. Accordingly, the Company’s subordinated debentures and preferred stock issued to the U.S. Treasury through the CPP should continue to qualify as Tier 1 capital.
The Consent Order required the Bank to achieve by December 31, 2011, and thereafter maintain, a Tier 1 leverage capital ratio of at least 8.5%, a Tier 1 risk-based capital ratio of at least 10.0% and a total risk-based capital ratio of at least 12.0%. Because the Bank’s capital levels at December 31, 2011 were below these levels, the Bank must increase its capital levels. The Bank believes that the pending sale of certain assets of the Bank’s Murfreesboro and Franklin, Tennessee branch locations will, if these transactions are consummated, improve the Bank’s capital levels. However, even after giving effect to these sales, the Bank’s capital levels are not expected to exceed those required to be maintained by the Consent Order. As a result, and because the Company does not have cash available to contribute to the Bank in an amount sufficient to enable the Bank to achieve the capital levels it committed to maintain in the Consent Order, the Company will have to seek additional alternatives beyond the branch sales (including the issuance of common stock) to raise capital in order to assist the Bank in meeting its obligations.
Restrictions on Transactions with Affiliates - Both the Company and the Bank are subject to the provisions of Section 23A of the Federal Reserve Act. Section 23A places limits on the amount of:
•
A bank’s loans or extensions of credit, including purchases of assets subject to an agreement to repurchase, to affiliates;
•
A bank’s investment in affiliates;
•
Assets a bank may purchase from affiliates, except for real and personal property exempted by the FRS;
•
The amount of loans or extensions of credit to third parties collateralized by the securities or obligations of affiliates;
•
Transactions involving the borrowing or lending of securities and any derivative transaction that results in credit exposure to an affiliate; and
•
A bank’s guarantee, acceptance or letter of credit issued on behalf of an affiliate.
The total amount of the above transactions is limited in amount, as to any one affiliate, to 10% of a bank’s capital and surplus and, as to all affiliates combined, to 20% of a bank’s capital and surplus. In addition to the limitation on the amount of these transactions, each of the above transactions must also meet specified collateral requirements. The Bank must also comply with other provisions designed to avoid the taking of low-quality assets.
The Company and the Bank are also subject to the provisions of Section 23B of the Federal Reserve Act which, among other things, prohibits an institution from engaging in the above transactions with affiliates unless the transactions are on terms substantially the same, or at least as favorable to the institution or its subsidiaries, as those prevailing at the time for comparable transactions with nonaffiliated companies.
The Bank is also subject to restrictions on extensions of credit to its executive officers, directors, principal shareholders and their related interests. These extensions of credit (1) must be made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with third parties, and (2) must not involve more than the normal risk of repayment or present other unfavorable features.
Activities and Investments of Insured State-Chartered Banks - Section 24 of the FDIA, as amended by the FDICIA, generally limits the activities and equity investments of FDIC-insured, state-chartered banks to those that are permissible for national banks. Under regulations dealing with equity investments, an insured state bank generally may not directly or indirectly acquire or retain any equity investment of a type, or in an amount, that is not permissible for a national bank. An insured state bank is not prohibited from, among other things, (i) acquiring or retaining a majority interest in a subsidiary, (ii) investing as a limited partner in a partnership, the sole purpose of which is direct or indirect investment in the acquisition, rehabilitation or new construction of a qualified housing project, provided that such limited partnership investment may not exceed 2% of the bank’s total assets, (iii) acquiring up to 10% of the voting stock of a company that solely provides or reinsures directors’, trustees’ and officers’ liability insurance coverage or bankers’ blanket bond group insurance coverage for insured depository institutions, and (iv) acquiring or retaining the voting shares of a depository institution if certain requirements are met.
In addition, an insured state bank (i) that is located in a state which authorized as of September 30, 1991 investment in common or preferred stock listed on a national securities exchange (“listed stock”) or shares of a registered investment company (“registered shares”), and (ii) which during the period beginning September 30, 1990 through November 26, 1991 (the “measurement period”) made or maintained investments in listed stocks and registered shares, may retain whatever shares that were lawfully acquired or held prior to December 19, 1991 and continue to acquire listed stock and registered shares, provided that the bank does not convert its charter to another form or undergo a change in control. In order to acquire or retain any listed stock or registered shares, however, the bank must file a one-time notice with the FDIC which meets specified requirements and which sets forth its intention to acquire and retain stocks or shares, and the FDIC must determine that acquiring or retaining the listed stocks or registered shares will not pose a significant risk to the deposit insurance fund of which the bank is a member.
FDIC regulations implementing Section 24 of the FDIA provide that an insured state-chartered bank may not, directly, or indirectly through a subsidiary, engage as “principal” in any activity that is not permissible for a national bank unless the FDIC has determined that such activities would pose no risk to the insurance fund of which it is a member, and the bank is in compliance with applicable regulatory capital requirements. Any insured state-chartered bank or savings bank directly or indirectly engaged in any activity that is not permitted for a national bank must cease the impermissible activity.
Loans-to-One-Borrower - The aggregate amount of loans that we are permitted to make under applicable regulations to any one borrower, including related entities, is the greater of 25% of unimpaired capital and surplus or $500. Based on the Bank’s capitalization of $31,988 at December 31, 2011, our loans-to-one borrower limit is approximately $7,997. Our house limit on loans-to-one borrower is equal to the loan to one borrower limit.
Federal Reserve System - In 1980 Congress enacted legislation which imposed Federal Reserve requirements (under “Regulation D”) on all depository institutions that maintain transaction accounts or non-personal time deposits. These reserves may be in the form of cash or non-interest-bearing deposits with the regional Federal Reserve Bank. NOW accounts and other types of accounts that permit payments or transfers to third parties fall within the definition of transaction accounts and are subject to Regulation D reserve requirements, as are any non-personal time deposits at a bank.
Community Reinvestment Act - The Company is also subject to the provisions of the Community Reinvestment Act of 1977, which requires the appropriate federal bank regulatory agency, in connection with its regular examination of a bank, to assess the bank’s record in meeting the credit needs of the community serviced by the bank, including low and moderate income neighborhoods. The regulatory agency’s assessment of the Company’s record is made available to the public. Further, such assessment is required of any bank which has applied, among other things, to establish a new branch office that will accept deposits, relocate an existing office or merge or consolidate with, or acquire the assets or assume the liabilities of, a federally regulated financial institution. As a component of its Community Reinvestment Act outreach, the Company has instituted an affordable home loan program for first-time home buyers and low to moderate income borrowers.
Interstate Banking - The Reigle-Neal Interstate Banking and Branching Efficiency Act of 1994 (“Interstate Act”), which was enacted on September 29, 1994, among other things and subject to certain conditions and exceptions, (i) permits bank holding company acquisitions of banks of a minimum age of up to five years as established by state law in any state, (ii) mergers of national and state banks after May 31, 1997 across state lines unless the home state of either bank has opted out of the interstate bank merger provision, (iii) branching de novo by national and state banks into others states if the state has elected this provision of the Interstate Act, and (iv) certain interstate bank agency activities after one year after enactment. Following the passage of the Dodd-Frank Act, national or state chartered banks are permitted to branch across state lines to the same extent as banks chartered in the state of the branch.
Gramm-Leach Bliley Act - The Gramm-Leach-Bliley Act of 1999 (the “Act”) represented a pivotal point in the history of financial services regulation in the United States. The Act removes large parts of a regulatory structure that had its roots in the 1930’s and creates new opportunities for banks, other depository institutions, insurance companies and securities firms to enter into combinations. The Act also provides new flexibility to design financial products and services that better serve the banking consumer. The Act, among other provisions, (i) substantially eliminates the prohibition under the BHC Act which existed previously on affiliations between banks and insurance companies; (ii) repeals Section 20 of the Glass-Steagall Act which prohibited banks from affiliating with securities firms; (iii) sets forth procedures for such affiliations; (iv) provides for the formation of financial holding companies; and (v) eliminates the blanket exclusion of banks from the definitions of the terms “broker” and “dealer” under the Exchange Act, while permitting banks to continue to conduct certain limited brokerage and dealer activities without registration under the Exchange Act as a broker-dealer.
In addition to expanding the activities in which banks and bank holding companies may engage, the Act also imposed new requirements on financial institutions with respect to customer privacy. The Act generally prohibits disclosure of customer information to non-affiliated third parties unless the customer has been given the opportunity to object and has not objected to such disclosure. Financial institutions are further required to disclose their privacy policies to customers annually. Financial institutions, however, will be required to comply with state law if it is more protective of customer privacy than the Act.
The USA Patriot Act of 2001 - The Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the “USA Patriot Act”) was enacted in October 2001. The USA Patriot Act is intended to strengthen U.S. law enforcement’s and the intelligence
communities’ ability to work cohesively to combat terrorism on a variety of fronts. The potential impact of the USA Patriot Act on financial institutions of all kinds is significant and wide ranging. The USA Patriot Act contains sweeping anti-money laundering and financial transparency laws and requires various regulations, including: (i) due diligence requirements for financial institutions that administer, maintain, or manage private bank accounts or correspondent accounts for non-U.S. persons; (ii) standards for verifying customer identification at account opening; (iii) rules to promote cooperation among financial institutions, regulators and law enforcement entities in identifying parties that may be involved in terrorism or money laundering; (iv) reports by non-financial trades and businesses filed with the U.S. Treasury’s Financial Crimes Enforcement Network for transactions exceeding $10; and (v) filing of suspicious activities reports involving securities by brokers and dealers if they believe a customer may be violating U.S. laws and regulations.
Proposed Legislation and Regulatory Action - New regulations and statutes are regularly proposed that contain wide-ranging proposals for altering the structures, regulations and competitive relationships of the nation’s financial institutions. The Company cannot predict whether or in what form any proposed regulation or statute will be adopted or the extent to which the Company may be affected by any new regulation or statute. With the enactments of EESA, ARRA and the Dodd-Frank Act, and the significant amount of rulemaking mandated by the Dodd-Frank Act, the nature and extent of future legislative and regulatory changes affecting financial institutions is very unpredictable at this time.
Effect of Governmental Monetary Policies - The Company’s earnings are affected by domestic economic conditions and the monetary and fiscal policies of the United States government and its agencies. The Federal Reserve’s monetary policies have had, and are likely to continue to have, an important impact on the operating results of commercial banks through the Federal Reserve’s statutory power to implement national monetary policy in order, among other things, to curb inflation or combat a recession. The Federal Reserve, through its monetary and fiscal policies, affects the levels of bank loans, investments and deposits through its control over the issuance of United States government securities, its regulation of the discount rate applicable to member banks and its influence over reserve requirements to which member banks are subject. The Company cannot predict the nature or impact of future changes in monetary and fiscal policies.
Change in Control Restrictions
Statutory Provisions
The Change in Bank Control Act requires the written consent of the FDIC be obtained prior to any person or company acquiring “control” of a state-chartered bank. Tennessee law also requires the prior written consent of the Department to acquire control of a Tennessee-chartered bank. Upon acquiring control, a company will be deemed to be a bank holding company and must register with the FRB. Conclusive control is presumed to exist if, among other things, an individual or company acquires more than 25% of any class of voting stock of a bank. Rebuttable control is presumed to exist if, among other things, a person acquires more than 10% of any class of voting stock and the issuer’s securities are registered under Section 12 of the Exchange Act (the common stock is not expected to be so registered) or the person would be the single largest stockholder. Restrictions applicable to the operations of a bank holding company and conditions that may be imposed by the FRB in connection with its approval of a company to become a bank holding company may deter companies from seeking to obtain control of the Bank.
Other
While not directly restricting efforts to acquire control of the Company, certain other characteristics of our organization may discourage attempts to acquire control of the Company. The Company’s Charter
provides that approximately one-third of its Directors are elected each year (see “Management - Classification of Directors”), thereby making it more difficult for a potential acquirer of control of the Company to replace the members of the Board of Directors than it would be if directors were elected at more frequent intervals or if a greater percentage of directors were elected at any one time.
As a result of all of the foregoing restrictions on acquisitions, the Company is a less attractive target for a “takeover” attempt than other less-highly regulated companies generally. Accordingly, these restrictions might deter offers to purchase the Company which shareholders may consider to be in their best interests, and may make it more difficult to remove incumbent management.
Monetary Policy
The Bank, like other depository institutions, is affected by the monetary policies implemented by the Board of Governors of the FRS. The FRS has the power to restrict or expand the money supply through open market operations, including the purchase and sale of government securities and the adjustment of reserve requirements. These actions may result in significant fluctuations in market interest rates, which could adversely affect the operations of the Bank, such as its ability to make loans and attract deposits, as well as market demand for loans. See “Supervision and Regulation.”
Capital Adequacy
See Supervision and Regulation - Capital Requirements for a discussion of bank regulatory agencies’ capital adequacy requirements.
ITEM 1A.
ITEM 1A. RISK FACTORS
Negative developments in the U.S. and local economy and in local real estate markets have adversely impacted our operations and results and may continue to adversely impact our results in the future.
Economic conditions in the markets in which we operate deteriorated significantly between early 2008 and the middle of 2010 and remained sluggish into 2011. As a result, we incurred significant losses in 2009, 2010 and 2011. These losses resulted primarily from provisions for loan losses and other real estate expenses related to declining collateral values in our construction and development loan portfolio and increased costs associated with our portfolio of other real estate owned. We believe that we will continue to experience a challenging economic environment in 2012, and we expect that our results of operations will continue to be negatively impacted in 2012 by higher than normal provisioning expense and increased other real estate costs, in which case we could continue to experience significant losses and write-downs of assets, as well as capital and liquidity constraints.
We are geographically concentrated in the Middle Tennessee area and changes in local economic conditions could impact our profitability.
Our primary market area consists of Maury County, Tennessee. We also have operations in Rutherford and Williamson Counties in Tennessee, although upon consummation of the pending sales of two of our branches in these counties, our presence in those markets will be significantly reduced, if not completely eliminated. In late 2007, we acquired First National with two branches in Hickman County, Tennessee. Substantially all of our loan customers and most of our deposit and other customers live or have operations in this same geographic area. Accordingly, our success has significantly depended upon the growth in population, income levels, and deposits in these areas, along with the continued attraction of business ventures to the area and the stability of the housing market, and our profitability is impacted by the changes in general economic conditions in this market.
With the sale of our branch locations in Murfreesboro and Franklin, Tennessee, our results of operations will be more dependent on the economic climate in our primary market, Maury County, in 2012 and thereafter. Economic conditions in the Maury County market weakened in 2009 and continued to be challenging in 2010 and 2011, negatively affecting our operations, particularly the real estate construction and development segment of our portfolio. Unemployment rose significantly in the Maury County market in 2009 from 2008 levels and remained at elevated levels throughout 2010 and 2011.
We cannot assure you that economic conditions in the Maury and Hickman County markets will improve in 2012 or thereafter, and continued weak economic conditions in those markets could cause us to suffer additional losses, affect the ability of our customers to repay their loans and generally affect our financial condition and results of operations. We are less able than a larger institution to spread the risks of unfavorable local economic conditions across a large number of diversified economies.
Our loan portfolio includes a significant amount of real estate loans, including construction and development loans, which loans have a greater credit risk than residential mortgage loans.
As of December 31, 2012, approximately 87.9% of our loans held for investment were secured by real estate. Of this amount, approximately 45.5% were commercial real estate loans, 36.3% were residential real estate loans, 16.0% were construction and development loans and 2.2% were other real estate loans. Any sustained period of increased payment delinquencies, foreclosures or losses caused by adverse market or economic conditions in the markets we serve or in the State of Tennessee, like those we experienced in 2008, 2009, 2010 and 2011, have adversely affected, and could continue to adversely affect, the value of our assets, our revenues, results of operations and financial condition. In addition, construction and development lending is generally considered to have relatively high credit risks because the principal is concentrated in a limited number of loans with repayment dependent on the successful completion and operation of the related real estate project. Consequently, the credit quality of many of these loans has deteriorated as a result of the current adverse conditions in the real estate market. Over the last three years, the number of newly constructed homes or lots sold in our market areas continued to decline, negatively affecting collateral values and contributing to increased provision and other real estate expense and higher levels of non-performing assets. A continued reduction in residential real estate market prices and demand could result in further price reductions in home and land values adversely affecting the value of collateral securing the construction and development loans that we hold. These adverse economic and real estate market conditions may lead to further increases in non-performing loans and other real estate owned, increased losses and expenses from the management and disposition of non-performing assets, increases in provision for loan losses, and increases in operating expenses as a result of the allocation of management time and resources to the collection and workout of loans, all of which would negatively impact our financial condition and results of operations.
The Consent Order that the Bank has entered into, and the Bank’s current condition, may negatively impact the Bank’s and the Company’s operations, liquidity and capital resources.
During the third quarter of 2011, the Bank entered into the Consent Order. As described above, the terms of the Consent Order require that the Bank, among other things, (i) increase its regulatory capital; (ii) improve the management and oversight of the Bank; (iii) institute a plan for the reduction of charge-offs and classified assets; (iv) restrict its advances to certain classified borrowers; and (v) implement a plan for the reduction of certain loan concentrations. Because the Consent Order constitutes a formal enforcement action requiring the Bank to maintain specified capital levels above those required to be “well-capitalized” under the prompt corrective action provisions of the FDICIA, the Bank is subject to additional limitations on its operations including its ability to pay interest on deposits above certain
national rate caps and its ability to accept, rollover or renew brokered deposits, which could adversely affect the Bank’s liquidity and/or operating results. Limits on the Bank’s ability to accept, renew or rollover brokered deposits could also cause funding constraints that could limit the Bank’s ability to grow its asset base. If the Bank fails to comply with the requirements of the Consent Order, it may be subject to further regulatory action. The FDIC and the Department each has broad authority to take additional actions against the Bank, including assessing civil fines and penalties, issuing additional consent or cease and desist orders and removing officers and directors.
The Bank is also limited in its ability to pay severance payments to its employees and must receive the consent of the FDIC and Department to appoint new executive officers or directors. These restrictions may make it more difficult to retain or hire additional qualified employees.
The Bank’s capital levels are below those levels that the Bank committed to maintain in the Consent Order.
The terms of the Consent Order require that the Bank achieve by December 31, 2011, and thereafter maintain, a ratio of Tier 1 capital to average assets of at least 8.5%; a ratio of Tier 1 capital to risk-weighted assets of at least 10%; and a ratio of total capital to risk-weighted assets of at least 12%. At December 31, 2011, none of the Bank’s capital levels exceeded the minimum amounts that it had committed to achieve in the Consent Order. The amount of the capital shortfall at December 31, 2011 was approximately $22,413. While the sale of the Bank’s Murfreesboro and Franklin, Tennessee branch locations is expected to increase the Bank’s capital levels, it is unlikely that those transactions will result in the Bank’s capital levels meeting or exceeding those that the Bank is required to maintain under the Consent Order. The Company does not have sufficient capital available to contribute to the Bank to aid the Bank in meeting its commitments (even after giving effect to the impact of the sale of the branch locations), and, accordingly, is currently considering the options available to it to increase capital levels at the Bank, including through the sale of common or preferred stock of the Company or the sale of other assets, or alternatively the sale of the Company. Any sale of the Company’s common stock would likely be at a price that would result in substantial dilution in ownership for the Company’s existing common shareholders and could result in a change in control of the Company.
If we are unable to consummate the pending sales of our Murfreesboro, Tennessee and Franklin, Tennessee branch locations, the expected increase in our capital levels will not be realized and our results of operations could be negatively impacted.
The sale of our Murfreesboro, Tennessee and Franklin, Tennessee branch locations are both conditioned on the satisfaction of customary conditions to closing, including receipt of required regulatory approvals. While the Bank and Southern Community have received the requisite regulatory approvals necessary to consummate the sale of the Murfreesboro, Tennessee branch location, the approvals required for the Franklin, Tennessee branch sale have not yet been received. If the FDIC and the Department do not approve this transaction, including as a result of the regulators’ concerns regarding the Bank or CapStar Bank, then the transaction will not be consummated. If one or both of these transactions are not consummated, it is possible that customers of these branches, or other customers of the Bank, may cease to do business with the Bank, which could negatively affect the Bank’s operations. Furthermore, if one or both of these transactions are not consummated, employees of those branch locations may terminate their employment relationships with the Bank which could negatively impact our ability to retain existing customers of those branch locations. We believe that the sale of these branch locations will improve the Bank’s capital levels; accordingly, if these transactions are not consummated the expected improvement in the Bank’s capital levels will not be achieved and the amount of capital that the Bank must raise in order to meet the capital maintenance requirements of the Consent Order will increase.
As the Bank’s capital levels decline, the amounts that it can lend any one borrower are reduced.
At December 31, 2011, the Bank’s legal lending limit under applicable regulations (based upon the maximum legal lending limits of 25% of capital and surplus) was $7,683. As the Bank’s capital levels have declined, its legal lending limit has been reduced. If the legal lending limit is reduced below the level of credit, including lines of credit, that the Bank has extended to a borrower, it can no longer renew or continue undrawn credit lines or make additional loans or advances to its largest borrower relationships, and its ability to renew outstanding loans to such customers is extremely limited. Additionally, if the Bank seeks to reduce the amount of credit that it has extended to a particular borrower because of a reduction in its legal lending limit, the borrower may decide to move its loan relationships to another financial institution with legal lending limits high enough to accommodate the borrower’s relationships. A loss of loan customers as a result of being subject to lower lending limits, could negatively impact the Bank’s liquidity and results of operations.
We could sustain additional losses if our asset quality continues to deteriorate.
Our earnings are significantly affected by our ability to properly originate, underwrite and service loans. A significant portion of our loans are real estate based or made to real estate based borrowers, and the credit quality of such loans has deteriorated and could deteriorate further if real estate market conditions continue to decline or fail to stabilize nationally or, more importantly, in our market areas. We have sustained losses, and could continue to sustain losses if we incorrectly assess the creditworthiness of our borrowers or fail to detect or respond to further deterioration in asset quality in a timely manner. Problems with asset quality could cause our interest income and net interest margin to decrease and our provisions for loan losses to increase, which could adversely affect our results of operations and financial condition.
An inadequate allowance for loan losses would reduce our earnings.
The risk of credit losses on loans varies with, among other things, general economic conditions, real estate market conditions, the type of loan being made, the creditworthiness of the borrower over the term of the loan and, in the case of a collateralized loan, the value and marketability of the collateral for the loan.
Management maintains an allowance for loan losses based upon, among other things, historical experience, an evaluation of economic conditions and regular reviews of delinquencies and loan portfolio quality. Based upon such factors, management makes various assumptions and judgments about the ultimate collectability of the loan portfolio and provides an allowance for loan losses based upon its estimate of probable incurred credit losses, using past loan experience, volume and types of loans in the portfolio, nature and value of the portfolio, specific borrower and collateral value information, internal loan classifications, trends in classifications, volumes and trends in delinquencies, nonaccruals and charge-offs, loss experience of various loan categories, economic conditions and other factors. A charge against earnings with respect to the provision is made quarterly to maintain the allowance at appropriate levels after loan charge offs less recoveries. If management’s assumptions and judgments prove to be incorrect and the allowance for loan losses is inadequate to absorb losses, our earnings and capital could be significantly and adversely affected.
In addition, federal and state regulators periodically review our loan portfolio and may require us to increase our allowance for loan losses or recognize loan charge-offs. Their conclusions about the quality of a particular borrower of ours or of our entire loan portfolio may be different than ours. Any increase in our allowance for loan losses or loan charge offs as required by these regulatory agencies could have a negative effect on our operating results. Moreover, additions to the allowance may be necessary based on
changes in economic and real estate market conditions, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of our management’s control. These additions may require increased provision expense which would negatively impact our results of operations.
Our ability to maintain required capital levels and adequate sources of funding and liquidity could be impacted by changes in the capital markets and deteriorating economic and market conditions.
We, and the Bank, are required to maintain certain capital levels established by banking regulations or specified by bank regulators, including those capital maintenance standards imposed on us as a result of the Dodd-Frank Act, and we are required to serve as a source of financial strength to the Bank. In addition to the minimum capital levels that we and the Bank are required to maintain under federal banking regulations, the Bank has entered into the Consent Order which requires the Bank to achieve by December 31, 2011, and thereafter maintain, a ratio of Tier 1 capital to average asset of at least 8.50%; a ratio of Tier 1 capital to risk-weighted assets of at least 10%; and a ratio of total capital to risk-weighted assets of at least 12%, which the Bank failed to achieve at December 31, 2011. The Company, separate from the Bank is regulated by the Federal Reserve Bank (“FRB”). The Company has an informal agreement with the FRB prohibiting the Company from, among other things, paying interest on its subordinated debentures and dividends on its common and Preferred Stock without the prior approval of the FRB. The informal agreement does not establish any specific capital ratios that must be attained by the Company. During the fourth quarter of 2011, the Company was informed that the FRB would be proposing a formal agreement following an offsite examination of the Company that was completed during the third quarter of 2011. Management has not yet been informed as to the provisions of that expected agreement but we expect that it will require the Company to achieve, and thereafter maintain, capital levels in excess of those required to be considered well capitalized. We must also maintain adequate funding sources in the normal course of business to support our operations and fund outstanding liabilities. Our, and the Bank’s, ability to maintain capital levels at or above those required by federal banking regulations, or the Consent Order, as well as adequate sources of funding and liquidity could be impacted by changes in the capital markets in which we operate and deteriorating economic and market conditions. In addition, we have from time to time supported our capital position with the issuance of trust preferred securities. The trust preferred market has deteriorated significantly since the second half of 2007 and following the passage of the Dodd-Frank Act we will no longer be able to count trust preferred securities issued after its passage as Tier 1 capital, if our total assets exceed $500 million.
Failure by the Bank to meet applicable capital guidelines or commitments, like those the Bank has made in the Consent Order, or to satisfy certain other regulatory requirements could subject the Bank to a variety of enforcement remedies available to the federal and state regulatory authorities. These include limitations on the ability to pay dividends, the issuance by the regulatory authority of a capital directive to increase capital, and the termination of deposit insurance by the FDIC.
We have increased levels of other real estate, primarily as a result of foreclosures, and we anticipate higher levels of foreclosed real estate expense.
As we have begun to resolve non-performing real estate loans, we have increased the level of foreclosed properties, primarily those acquired from builders and from residential land developers.
Foreclosed real estate expense consists of three types of charges: maintenance costs, valuation adjustments owed on new appraisal values and gains or losses on disposition. These charges will increase as levels of other real estate increase, and also as local real estate values decline, negatively affecting our results of operations.
If we are unable to redeem the remaining outstanding shares of the Preferred Stock held by the U.S. Treasury prior to February 27, 2014, the dividend rate payable by us on those shares increases to 9% per annum.
The dividend rate on our Series A Preferred Stock is currently 5% per annum and will remain 5% per annum until the five year anniversary of the issuance date of those shares. Thereafter, the dividend rate increases to 9% per annum. The dividend rate on our Series B Preferred Stock is 9% per annum. While we are seeking to redeem our outstanding Preferred Stock prior to the dividend rate increasing on the Series A Preferred Stock, we must receive the approval of the FRB in order to do so. If we are unable to redeem the Series A Preferred Stock prior to the dividend rate increasing, including as a result of the FRB not granting us the necessary approval, our results of operations will be negatively impacted by the increased dividend rate. If we are required to sell additional shares of Common Stock to raise additional equity capital in connection with the redemption of the outstanding shares of our Series A Preferred Stock or Series B Preferred Stock, we will likely have to sell these shares of Common Stock at prices below the then current market price of those shares, diluting the ownership interest of our then common shareholders.
We have informally committed to the FRB that, among other things, we will obtain its prior approval prior to paying dividends on our capital stock or on our subordinated debentures.
We supported much of our historic growth, including as a result of our acquisition of First National, through the issuance of trust preferred securities from special purpose trusts and accompanying junior subordinated debentures. At December 31, 2011, we had issued trust preferred securities and accompanying junior subordinated debentures totaling $23 million. Payments of the principal and interest on the trust preferred securities of these trusts are conditionally guaranteed by us. Further, the accompanying junior subordinated debentures the Company issued to the trusts are senior to shares of our Common Stock and Preferred Stock. As a result, we must make payments on the junior subordinated debentures before any dividends can be paid on our Preferred Stock, Common Stock and, in the event of our bankruptcy, dissolution or liquidation, the holders of the junior subordinated debentures must be satisfied before any distributions can be made on our Common Stock and Preferred Stock. We have the right to defer distributions on these junior subordinated debentures (and the related trust preferred securities) for up to five years, during which time no dividends may be paid on our Common Stock or Preferred Stock. As described above, we have informally committed to the FRB that we will not pay interest on the subordinated debentures without the prior approval of the FRB. In the first quarter of 2011, we sought approval to pay the quarterly interest payment due on March 15, 2011. The FRB denied our request and we have been unable to secure the approval of the FRB to pay the quarterly interest payments since. Accordingly, we were not permitted to make these payments and notified the trustee under the associated trust of our intent to defer the interest payments. Under the terms of the indentures pursuant to which these subordinated debentures were issued, we, and our subsidiaries, are prohibited from paying dividends on our Common Stock and Preferred Stock and from paying interest on any other series of subordinated debentures that rank equal, or junior to, these subordinated debentures until such time as we are current in the payment of interest on these subordinated debentures. Accordingly, until we are able to secure the approval of the FRB to again make quarterly interest payments on our subordinated debentures and bring those payments current, we will not be permitted to make such payments of interest or payments of dividends. Additionally, for so long as the Company is not current in the payment of interest on its subordinated debentures, its REIT subsidiary, Community First Properties, Inc., is also prohibited from paying dividends on its issued and outstanding preferred stock or common stock.
Environmental liability associated with commercial lending could result in losses.
In the course of business, the Bank may acquire, through foreclosure, properties securing loans it has originated or purchased which are in default. Particularly in commercial real estate lending, there is a risk that hazardous substances could be discovered on these properties. In this event, we, or the Bank, might be required to remove these substances from the affected properties at our sole cost and expense. The cost of this removal could substantially exceed the value of affected properties.
Liquidity needs could adversely affect our results of operations and financial condition.
We rely on dividends from the Bank as our primary source of funds, and the Bank relies on customer deposits and loan repayments as its primary source of funds. While scheduled loan repayments are a relatively stable source of funds, they are subject to the ability of borrowers to repay the loans. The ability of borrowers to repay loans can be adversely affected by a number of factors, including changes in economic conditions, adverse trends or events affecting business industry groups, reductions in real estate values or markets, business closings or lay-offs, inclement weather, natural disasters, and international instability. Additionally, deposit levels may be affected by a number of factors, including rates paid by competitors, general interest rate levels, returns available to customers on alternative investments, and general economic conditions. Historically, we have relied to a significant degree on national time deposits and brokered deposits, which may be more volatile and expensive than local time deposits. Throughout 2010 and 2011 we have reduced our reliance on these types of deposits, but these deposits remain a material portion of our total deposits. At December 31, 2011, brokered deposits represented 4.5% of our total deposits. As a result of entering into the Consent Order, the Bank is no longer considered well capitalized and accordingly, the Bank must receive the consent of the FDIC in order to accept, renew or rollover brokered deposits. While we believe that our stable core deposit base and secondary sources of liquidity, including Federal Home Loan Bank advances and federal funds lines of credit from correspondent banks, are currently adequate for our liquidity needs, there can be no assurance they will be sufficient to meet future liquidity demands, particularly as our brokered deposits continue to mature.
We rely on dividends from our bank subsidiary as our primary source of liquidity and payment of these dividends is limited under Tennessee law.
Under Tennessee law, the amount of dividends that may be declared by the Bank in a year without approval of the Commissioner of the Department is limited to net income for that year combined with retained net income for the two preceding years. In addition, the FDIC and the Department have broad discretion to impose limitations on the Bank’s ability to pay dividends to us and as described above, the terms of the Consent Order prohibit the Bank from paying dividends without the prior approval of the FDIC and the Department. In addition, because of the losses incurred by the Bank in 2009, 2010 and 2011, the Bank may not pay dividends to us without prior approval by the Commissioner of the Department. As a result of the restriction on the Bank’s ability to pay dividends to us and the terms of the informal commitment the Company has made to the FRB not to pay interest or dividends without the FRB’s prior approval, we have deferred the interest and dividend payments on our trust preferred securities and Preferred Stock beginning in the first quarter and second quarter of 2011, respectively.
Although we have initiated efforts to reduce our reliance on noncore funding, this type of funding still represents a large component of our funding base, and as a result of the Bank’s entry into the Consent Order, the Bank may not accept, renew or rollover brokered deposits without the prior approval of the FDIC.
In addition to the traditional core deposits, such as demand deposit accounts, interest checking, money market savings and certificates of deposits, we have historically utilized several noncore funding sources, such as brokered certificates of deposit, Federal Home Loan Bank of Cincinnati advances, Federal funds purchased and other sources. We utilized these noncore funding sources to fund the ongoing operations and growth of the Bank. Our ability to utilize brokered deposits is specifically limited by the Bank’s entering into the Consent Order and as our existing brokered deposits mature we will not be able to replace those deposits or fund the payment of those deposits with new brokered deposits. Although we believe that our available cash and other liquid assets, including our available for sale investment securities and loan repayments, and our secondary sources of liquidity will provide sufficient liquidity to meet these demands, we can provide no assurance that these sources of liquidity will be adequate. The availability of these noncore funding sources are subject to broad economic conditions and to investor assessment of our financial strength and, as such, the cost of funds may fluctuate significantly and/or be restricted, thus impacting our net interest income, our immediate liquidity and/or our access to additional liquidity. We have somewhat similar risks to the extent that core deposits exceed the amount of deposit insurance coverage available.
Implementation of the various provisions of the Dodd-Frank Act may increase our operating costs or otherwise have a material effect on our business, financial condition or results of operations.
On July 21, 2010, President Obama signed the Dodd-Frank Act. This landmark legislation includes, among other things, (i) the creation of a Financial Services Oversight Counsel to identify emerging systemic risks and improve interagency cooperation; (ii) the elimination of the Office of Thrift Supervision and the transfer of oversight of federally chartered thrift institutions and their holding companies to the Office of the Comptroller of the Currency and the Federal Reserve; (iii) the creation of a Consumer Financial Protection Agency authorized to promulgate and enforce consumer protection regulations relating to financial products that would affect banks and non-bank finance companies; (iv) the establishment of new capital and prudential standards for banks and bank holding companies; (v) the termination of investments by the U.S. Treasury under TARP; (vi) enhanced regulation of financial markets, including the derivatives, securitization and mortgage origination markets; (vii) the elimination of certain proprietary trading and private equity investment activities by banks; (viii) the elimination of barriers to de novo interstate branching by banks; (ix) a permanent increase of the previously implemented temporary increase of FDIC deposit insurance to $250; (x) the authorization of interest-bearing transaction accounts; and (xi) changes in how the FDIC deposit insurance assessments will be calculated and an increase in the minimum designated reserve ratio for the DIF.
Certain provisions of the legislation are not immediately effective or are subject to required studies and implementing regulations. Further, community banks with less than $10 billion in assets (like the Bank) are exempt from certain provisions of the legislation. Although certain regulations implementing portions of the Dodd-Frank Act have been promulgated, we are still unable to predict how this significant new legislation may be interpreted and enforced or how implementing regulations and supervisory policies may affect us. There can be no assurance that these or future reforms will not significantly increase our compliance or operating costs or otherwise have a significant impact on our business, financial condition and results of operations.
National or state legislation or regulation may increase our expenses and reduce earnings.
Federal bank regulators are increasing regulatory scrutiny and additional restrictions (including those originating from the Dodd-Frank Act) on financial institutions have been proposed or adopted by regulators and by Congress. Changes in tax law, federal legislation, regulation or policies, such as bankruptcy laws, deposit insurance, consumer protection laws, and capital requirements, among others, can result in significant increases in our expenses and/or charge-offs, which may adversely affect our earnings. Changes in state or federal tax laws or regulations can have a similar impact. Furthermore, financial institution regulatory agencies are expected to continue to be very aggressive in responding to concerns and trends identified in examinations, including the continued issuance of additional formal or enforcement or supervisory actions. These actions, whether formal or informal, could result in our agreeing to limitations or to take actions that limit our operational flexibility, limit the Bank’s ability to pay dividends to us, restrict our growth or increase our capital or liquidity levels. Failure to comply with any formal or informal regulatory restrictions would lead to further regulatory enforcement actions. Negative developments in the financial services industry and the impact of recently enacted or new legislation in response to those developments could negatively impact our operations by restricting our business operations, including our ability to originate or sell loans, and adversely impact our financial performance. In addition, industry, legislative or regulatory developments may cause us to materially change our existing strategic direction, capital strategies, compensation or operating plans.
Competition from financial institutions and other financial service providers may adversely affect our profitability.
The banking business is highly competitive and we experience competition in each of our markets, particularly our Williamson and Rutherford County, Tennessee markets, where we have a small market share. We compete with commercial banks, credit unions, savings and loan associations, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market funds and other mutual funds, as well as other community banks, super-regional and national financial institutions that operate offices in our primary market areas and elsewhere. Many of our competitors are well-established, larger financial institutions that have greater resources and lending limits and a lower cost of funds than we have.
If the federal funds rate remains at current extremely low levels, our net interest margin, and consequently our net earnings, may continue to be negatively impacted.
Because of significant competitive deposit pricing pressures in our market and the negative impact of these pressures on our cost of funds, coupled with the fact that a significant portion of our loan portfolio has variable rate pricing that moves in concert with changes to the FRS’s federal funds rate (which is at an extremely low rate as a result of current economic conditions), our net interest margin continues to be negatively impacted. Because of these competitive pressures, we have been unable to lower the rate that we pay on interest-bearing liabilities to the same extent and as quickly as the yields we charge on interest-earning assets. Additionally, the amount of nonaccrual loans and other real estate owned has been and may continue to be elevated. As a result, our net interest margin, and consequently our profitability, have been, and may continue to be, negatively impacted.
Changes in interest rates could adversely affect our results of operations and financial condition.
Changes in interest rates may affect our level of interest income, the primary component of our gross revenue, as well as the level of our interest expense, our largest recurring expenditure. Interest rates are highly sensitive to many factors that are beyond our control, including general economic conditions and the policies of various governmental and regulatory authorities. In a period of rising interest rates, our interest expense, particularly deposit costs, could increase in different amounts and at different rates, while the interest that we earn on our assets may not change in the same amounts or at the same rates.
Accordingly, increases in interest rates could decrease our net interest income. Changes in the level of interest rates also may negatively affect our ability to originate real estate loans, the value of our assets and our ability to realize gains from the sale of our assets, all of which ultimately affect our earnings.
Loss of our senior executive officers or other key employees could impair our relationship with our customers and adversely affect our business.
We have assembled a senior management team which has substantial background and experience in banking and financial services in the Nashville MSA, and particularly the Maury County and Williamson County, Tennessee markets. Loss of these key personnel could negatively impact our earnings because of their skills, customer relationships and/or the potential difficulty of promptly replacing them.
The limitations on bonuses, retention awards, severance payments and incentive compensation contained in ARRA may adversely affect our ability to retain our highest performing employees.
For so long as any equity securities that we issued to the U.S. Treasury under the CPP remain outstanding, ARRA severely restricts bonuses, retention awards, severance payments and other incentive compensation payable to our most highly compensated employee, and in some cases up to the next 20 highest paid employees. It is possible that we may be unable to create a compensation structure that permits us to retain such employees or recruit additional employees, especially if we are competing against institutions that are not subject to the same restrictions. If this were to occur, our business and results of operations could be materially adversely affected.
Events beyond our control may disrupt operations and harm operating results.
We may be adversely affected by a war, terrorist attack, third party acts, natural disaster or other catastrophe. A catastrophic event could have a direct negative impact on us, our customers, the financial markets or the overall economy. It is impossible to fully anticipate and protect against all potential catastrophes. A security breach, criminal act, military action, power or communication failure, flood, hurricane, severe storm or the like could lead to service interruptions, data losses for customers, disruptions to our operations, or damage to our facilities. Any of these could have a material adverse effect on our business and financial results. In addition, we may incur costs in repairing any damage beyond our applicable insurance coverage.
We operate in a highly regulated environment that is becoming more heavily regulated and are supervised and examined by various federal and state regulatory agencies who may adversely affect our ability to conduct business.
The Company is a bank holding company regulated by the FRS. The Bank is a state chartered bank and comes under the supervision of the Commissioner of the Department and the FDIC. The Bank is also governed by the laws of the state of Tennessee and federal banking laws under the FDICA, the FDICIA and the Federal Reserve Act. The Bank is also regulated by other agencies including, but not limited to, the Internal Revenue Service, OSHA, and the Department of Labor. These and other regulatory agencies impose certain regulations and restrictions on the Bank, including:
•
explicit standards as to capital and financial condition;
•
limitations on the permissible types, amounts and extensions of credit and investments;
•
requirements for brokered deposits;
•
restrictions on permissible non-banking activities; and
•
restrictions on dividend payments.
Federal and state regulatory agencies have extensive discretion and power to prevent or remedy unsafe or unsound practices or violations of law by banks and bank holding companies. As a result, we must expend significant time and expense to assure that we are in compliance with regulatory requirements and agency practices.
We also undergo periodic examinations by one or more regulatory agencies. Following such examinations, we may be required, among other things, to make additional provisions to our allowance for loan loss, to restrict our operations, to maintain capital at levels above these required by federal statutes to be well capitalized or to not pay dividends. These actions would result from the regulators’ judgments based on information available to them at the time of their examination.
Our operations are also governed by a wide variety of state and federal consumer protection laws and regulations. These federal and state regulatory restrictions limit the manner in which we may conduct business and obtain financing. These laws and regulations can and do change significantly from time to time and any such change could adversely affect our results of operations.
The Preferred Stock that we have issued to the U.S. Treasury impacts net income available to our common shareholders and our earnings per share.
As long as the Preferred Stock is outstanding, no dividends may be paid on our Common Stock unless all dividends on the Preferred Stock have been paid in full. The dividends declared on the Preferred Stock along with the accretion of the discount upon issuance, will reduce the net income available to common shareholders and our earnings per share of Common Stock. Holders of the Preferred Stock that we have issued to the U.S. Treasury have rights that are senior to those of the holders of our Common Stock.
The Preferred Stock that we have issued to the U.S. Treasury is senior to our Common Stock and holders of the Preferred Stock have certain rights and preferences that are senior to those of the holders of our Common Stock.
The Preferred Stock ranks senior to our Common Stock and all other equity securities of ours designated as ranking junior to these shares. So long as any of these shares remain outstanding, unless all accrued and unpaid dividends for all prior dividend periods have been paid or are contemporaneously declared and paid in full on the Preferred Stock, no dividend whatsoever shall be paid or declared on our Common Stock or other junior stock, other than, during the first ten years after issuance of the Preferred Stock, a dividend payable solely in shares of our Common Stock. Furthermore, the Preferred Stock is entitled to a liquidation preference over our Common Stock in the event of our liquidation, dissolution or winding up.
Holders of the Preferred Stock that we have issued to the U.S. Treasury may, under certain circumstances, have the right to elect two directors to our Board of Directors.
As described above, we have informally committed to the FRB that we will not pay dividends on our Common Stock or Preferred Stock without the FRB’s prior approval. We also are prohibited from paying dividends on our Common Stock and Preferred Stock at times when we are not current on the payment of interest on our subordinated debentures. Beginning in May 2011, we have deferred the dividend payments due on our Preferred Stock for the last three quarterly dividend periods. In the event that we fail to pay dividends on the Preferred Stock for an aggregate of six quarterly dividend periods or more (whether or not consecutive), the authorized number of directors then constituting our Board of Directors will be increased by two. Holders of the series of the Preferred Stock for which we have failed to pay dividends, together with the holders of any outstanding parity stock with like voting rights, including in the case of the Series A Preferred Stock and the Series B Preferred Stock, voting as a single class, will be entitled to elect the two additional directors to our board, referred to as the preferred stock directors, at the next annual meeting (or at a special meeting called for the purpose of electing the preferred stock directors prior to the next annual meeting) and at each subsequent annual meeting until all accrued and unpaid dividends on the Preferred Stock for all past dividend periods have been paid in full.
We are dependent on our information technology and telecommunications systems and third-party servicers, and systems failures, interruptions or breaches of security could have an adverse effect on our financial condition and results of operations.
Our operations rely on the secure processing, storage and transmission of confidential and other information in our computer systems and networks. Although we take protective measures and endeavor to modify these systems as circumstances warrant, the security of our computer systems, software and networks may be vulnerable to breaches, unauthorized access, misuse, computer viruses or other malicious code and other events that could have a security impact.
We outsource many of our major systems, such as data processing, loan servicing and deposit processing systems. The failure of these systems, or the termination of a third-party software license or service agreement on which any of these systems is based, could interrupt our operations. Because our information technology and telecommunications systems interface with and depend on third-party systems, we could experience service denials if demand for such services exceeds capacity or such third-party systems fail or experience interruptions. If sustained or repeated, a system failure or service denial could result in a deterioration of our ability to process new and renewal loans, gather deposits and provide customer service, compromise our ability to operate effectively, damage our reputation, result in a loss of customer business and/or subject us to additional regulatory scrutiny and possible financial liability, any of which could have a material adverse effect on our financial condition and results of operations.
In addition, we provide our customers the ability to bank remotely, including online over the Internet. The secure transmission of confidential information is a critical element of remote banking. Our network could be vulnerable to unauthorized access, computer viruses, phishing schemes, spam attacks, human error, natural disasters, power loss and other security breaches. We may be required to spend significant capital and other resources to protect against the threat of security breaches and computer viruses, or to alleviate problems caused by security breaches or viruses. To the extent that our activities or the activities of our customers involve the storage and transmission of confidential information, security breaches and viruses could expose us to claims, litigation and other possible liabilities. Any inability to prevent security breaches or computer viruses could also cause existing customers to lose confidence in our systems and could adversely affect our reputation, results of operations and ability to attract and maintain customers and businesses. In addition, a security breach could also subject us to additional regulatory scrutiny, expose us to civil litigation and possible financial liability and cause reputational damage.
We are subject to certain litigation, and our expenses related to this litigation may adversely affect our results.
We are from time to time subject to certain litigation in the ordinary course of our business. These claims and legal actions, including supervisory actions by our regulators, could involve large monetary claims and significant defense costs. The outcome of these cases is uncertain. However, during the current credit crisis, we have seen both the number of cases and our expenses related to those cases increase. Substantial legal liability or significant regulatory action against us could have material adverse financial effects or cause significant reputational harm to us, which in turn could seriously harm our business prospects.
An established public market for our common stock does not currently exist.
While our Common Stock is freely transferable by most shareholders, there is not an established public market for trading in our Common Stock and we cannot be sure when an active or established trading market will develop for our Common Stock, or, if one develops, that it will continue. Our Common Stock is traded locally among individuals and is not currently listed on The NASDAQ Global Market, the NASDAQ Capital Market or any other securities market.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None
ITEM 2.
ITEM 2. PROPERTIES
The Company’s principal office building is located at 501 South James M. Campbell Boulevard, Columbia, Tennessee 38401. The Bank constructed the building and owns the building and the property. Prior to the completion of construction in November, 2000, the Bank’s main office was located in a modular building at this location.
The Bank operates a branch office at 601 North Garden Street, Columbia, Tennessee. The Bank owns the building and leases the property at this location pursuant to the terms of a lease that expires on December 1, 2026.
In October 2007, the Company acquired First National with branches in Centerville and Lyles, Tennessee. As a result of the acquisition, the Company now owns the building and the property at both locations. In addition, the Company owns a storage facility located at Hackberry Street East in Centerville.
The Bank operates a branch office at 105 Public Square, Mount Pleasant, Tennessee. The Bank owns the building and the property at this location.
The Bank operates a branch office in the Wal-Mart store at 2200 Brookmeade Drive in Columbia. The Bank leases the space occupied by the branch at this location.
The Bank has an operations building located at 501 South James Campbell Boulevard, Columbia, Tennessee, 38401. The Bank owns the building and property.
The Bank operates a branch office at 9045 Carothers Parkway, Franklin, Tennessee in Williamson county. The Bank owns the building and the property. However, the building and property will be acquired by Capstar upon completion of the branch sale.
The Bank operates a branch office at 1950 Old Fort Parkway, Murfreesboro, Tennessee in Rutherford county. The Bank currently leases the building and property at this location pursuant to the terms of a lease that expires on September 30, 2012. However, the lease will be assumed by Southern Community upon completion of the branch sale.
The Bank operates a branch office at Neely’s Mill, 1412 Trotwood Avenue, Columbia, Tennessee. The Bank owns the building and leases the property.
The Bank operates a branch office at 4809 Columbia Pike, Thompson Station, Tennessee. The Bank owns the building and leases the property.
At December 31, 2011, the cost of office properties and equipment (less allowances for depreciation and amortization) owned by us was $9,277.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company and the Bank are party to certain routine claims and litigation that is incidental to the business and occurs in the normal course of operations. In the opinion of management, none of these matters, when resolved, will have a material effect on the financial position of the Company, the Bank or their respective future operations.
ITEM 4.
ITEM 4. MINE SAFETY DISCLOSURES
None.
PART II
ITEM 5:
ITEM 5: MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
No public market exists for the Company’s Common Stock, and there can be no assurance that a public trading market for the Company’s Common Stock will develop. As of March 30, 2012 there were 2,178 holders of record of the Company’s Common Stock and 3,273,915 shares outstanding, excluding vested options. As of March 30, 2012, there were 119,550 vested options outstanding to purchase shares of Common Stock.
While there is no public market for the Company’s Common Stock, the most recent trade of the Company’s Common Stock known to the Company occurred on February 15, 2012 at a price of $7.00 per share. These sales are isolated transactions and, given the small volume of trading in the Company’s Common Stock, may not be indicative of its present value. Below is a table which sets forth Company’s high and low prices of which the Company is aware for the relevant quarters during the three fiscal years ended December 31:
Historically, the principal sources of cash revenue for the Company were dividends paid to it by the Bank. There are certain restrictions on the payment of these dividends imposed by federal banking laws, regulations and authorities. Further, the dividend policy of the Bank is subject to the discretion of the Board of Directors of the Bank and will depend upon such factors as future earnings, financial conditions, cash needs, capital adequacy and general business conditions. The Company paid no dividends to common shareholders in 2011 or 2010, $121 in cash dividends and $314 in stock dividends to shareholders in the second quarter of 2009. Tennessee law provides that without the approval of the Commissioner of the Department dividends may be paid by the Bank in an amount equal to net income in the calendar year the dividend is declared plus retained earnings for the prior two years. This means that because of the losses we incurred in 2010 and 2009, the Bank cannot pay to us dividends in 2012 without the prior approval of the Commissioner of the Department. Tennessee laws regulating banks require
certain charges against and transfers from an institution’s undivided profits account before undivided profits can be made available for the payment of dividends. In addition to these general restrictions applicable to Tennessee state-chartered banks, the terms of the Consent Order prohibit the Bank from paying dividends to us without the prior approval of the Department and the FDIC.
In addition to the limitations on the Company’s ability to pay dividends under Tennessee law, the Company’s ability to pay dividends on its Common Stock is also limited by the Company’s participation in the CPP and by the terms of the indentures pursuant to which its subordinated debentures have been issued.
From February 28, 2012 until February 27, 2019, unless the U.S. Treasury has transferred the Senior Preferred and Warrant Preferred shares to third parties or the Senior Preferred and Warrant Preferred shares have been redeemed in total, the Company may increase the dividends paid to holders of the Common Stock by up to 3% in the aggregate per year over the amount paid in the prior year without the U.S. Treasury’s consent; provided that no increase in common dividends may be made as a result of any dividend paid in common shares, any stock split or any similar transactions. From February 28, 2019 until the Senior Preferred and Warrant Preferred shares held by the U.S. Treasury have been redeemed in whole or the U.S. Treasury has transferred all of the Senior Preferred and Warrant Preferred shares to third parties, the Company may not declare or pay any dividend or make any distribution on any capital stock or other equity securities of the Company other than regular dividends on shares of preferred stock in accordance with the terms thereof and which are permitted by the terms of the Senior Preferred and Warrant Preferred shares, or dividends or distributions by any wholly-owned subsidiary of the Company. Further, during such period the Company may not redeem, purchase or acquire any shares of Common Stock or other capital stock or other equity securities of any kind of the Company, including any trust preferred securities, other than the Senior Preferred and Warrant Preferred shares.
In the future, the declaration and payment of dividends on the Company’s common stock will depend upon the Company’s earnings and financial condition, liquidity and capital requirements, the general economic and regulatory climate, the Company’s ability to service any equity or debt obligations senior to the Common Stock, including the Senior Preferred and Warrant Preferred shares, and other factors deemed relevant by the Board of Directors.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA (Dollars in thousands, except per share data)
The following selected financial data for the five years ended December 31, 2011, was derived from our consolidated financial statements and the related notes thereto. This data should be read in conjunction with our audited consolidated financial statements, including the related notes, and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
(1) Includes the operations of First National from October 27, 2007, the date the Company acquired all of the outstanding common stock of that bank.
(2) Net interest margin is the result of net interest income for the period divided by average interest earning assets.
(3) Leverage ratio is defined as Tier 1 capital (pursuant to risk-based capital guidelines) as a percentage of adjusted average assets.
ITEM 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(Dollars in thousands, except per share data)
The following is a discussion of our financial condition at December 31, 2011 and December 31, 2010, and our results of operations for the three year period ended December 31, 2011. The purpose of this discussion is to focus on information about our financial condition and results of operations which is not otherwise apparent from the annual audited consolidated financial statements. You should read the following discussion and analysis along with our consolidated financial statements and the related notes included elsewhere herein.
FORWARD-LOOKING STATEMENTS
Certain of the statements made herein, including information incorporated herein by reference to other documents, are “forward-looking statements” within the meaning and subject to the protections of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Forward-looking statements include statements with respect to our beliefs, plans, objectives, goals, expectations, anticipations, assumptions, estimates, intentions, and future performance, and involve known and unknown risks, uncertainties and other factors, which may be beyond our control, and which may cause our actual results, performance or achievements to be materially different from future results, performance or achievements expressed or implied by such forward-looking statements. All statements other than statements of historical fact are statements that could be forward-looking statements. You can identify these forward-looking statements through our use of words such as “may,” “will,” “anticipate,” “assume,” “should,” “indicate,” “would,” “believe,” “contemplate,” “expect,” “estimate,” “continue,” “plan,” “point to,” “project,” “could,” “intend,” “target,” and other similar words and expressions of the future. These forward-looking statements may not be realized due to a variety of factors, including, without limitation, those described under “Item 1A. Risk Factors” in our Annual Report on Form 10-K and the following:
•
deterioration in the financial condition of borrowers resulting in significant increases in loan losses and provisions for those losses;
•
greater than anticipated deterioration or lack of sustained growth in the national or local economies including the Nashville-Davidson-Murfreesboro-Franklin MSA;
•
our potential growth, including our entrance or expansion into new markets, and the need for sufficient capital to support that growth;
•
governmental monetary and fiscal policies, as well as legislative and regulatory changes, including changes in banking, securities and tax laws and regulations, including those resulting from the Dodd-Frank Wall Street Reform and Consumer Protection Act (“the Dodd-Frank Act”);
•
the risks of changes in interest rates on the levels, composition and costs of deposits, loan demand, and the values of loan collateral, securities, and interest sensitive assets and liabilities;
•
continuation of the historically low short-term interest rate environment;
•
rapid fluctuations or unanticipated changes in interest rates;
•
failure to maintain capital levels above levels required by federal banking regulations or commitments or agreements the Company or the Bank makes with its regulators;
•
any activity that would cause the Company to conclude that there was impairment of any asset, including other intangible assets;
•
the effects of competition from a wide variety of local, regional, national and other providers of financial, investment, and insurance services;
•
the failure of assumptions underlying the establishment of valuation allowances for probable loan losses and other estimates;
•
further deterioration in the valuation of other real estate owned;
•
changes in accounting policies, rules and practices;
•
the impact of governmental restrictions on entities participating in the CPP;
•
changes in technology or products that may be more difficult, or costly, or less effective, than anticipated;
•
the effects of war or other conflict, acts of terrorism or other catastrophic events that may affect general economic conditions; and
•
other circumstances, many of which may be beyond our control.
All written or oral forward-looking statements that are made by or are attributable to us are expressly qualified in their entirety by this cautionary notice. We have no obligation and do not undertake to update, revise or correct any of the forward-looking statements after the date of this report, or after the respective dates on which such statements otherwise are made.
General
Community First, Inc., (the “Company”) is a registered bank holding company under the Bank Holding Company Act of 1956, as amended, and became so upon the acquisition of all the voting shares of Community First Bank & Trust on August 30, 2002. We were incorporated under the laws of the State of Tennessee as a Tennessee corporation on April 9, 2002, and conduct substantially all of our activities through and derive substantially all of our income from our wholly-owned bank subsidiary, Community First Bank & Trust, a Tennessee chartered bank (the “Bank”).
The Bank commenced business on May 18, 1999, as a Tennessee-chartered commercial bank whose deposits are insured by the Federal Deposit Insurance Corporation’s Deposit Insurance Fund. The Bank is regulated by the Tennessee Department of Financial Institutions (the “Department”) and the Federal Deposit Insurance Corporation (“FDIC”). This report has not been reviewed, or confirmed for accuracy or relevance, by the FDIC.
The Company conducts banking activities from a main office and three branch offices in Columbia, Tennessee, one branch office in Mount Pleasant, Tennessee, one branch office in Thompson’s Station, Tennessee, one branch office in Centerville, Tennessee, one branch office in Lyles, Tennessee, one
branch office in Franklin, Tennessee, and one branch office in Murfreesboro, Tennessee. The Company also operates six automated teller machines (“ATMs”) in Maury County, two ATMs in Williamson County, one ATM in Rutherford County, and two ATMs in Hickman County, Tennessee.
On December 28, 2011, the Bank entered into a Purchase and Assumption Agreement with Southern Community Bank (“Southern Community”), pursuant to which the Bank agreed to sell certain of its loans and deposits of its Murfreesboro, Tennessee branch location to Southern Community. This transaction is expected to close on March 30, 2012. On February 9, 2012, the Bank entered into a Purchase and Assumption Agreement with CapStar Bank, pursuant to which the Bank agreed to sell certain of its loans and deposits of its Franklin, Tennessee branch location to CapStar Bank. This transaction is expected to close in the second quarter of 2012. Information regarding the pending sale of these branches is discussed in detail in Note 2 to the Financial Statements.
The Company’s and its subsidiaries’ principal business is to accept demand, savings and time deposits from the general public and to make residential mortgage, commercial, construction, and consumer loans. The Company’s results of operations depend primarily on net interest income, which is the difference between the interest income from earning assets, such as loans and investments, and the interest expense incurred on interest bearing liabilities, such as deposits, subordinated debentures, and other borrowings. The Company also generates noninterest income, including service charges on deposit accounts, mortgage lending income, investment service income, earnings on bank owned life insurance (“BOLI”), and other charges, and fees. The Company’s noninterest expense consists primarily of employee compensation and benefits, net occupancy and equipment expense, expenses associated with the Bank’s portfolio of other real estate owned and other operating expenses. The Company’s results of operations are significantly affected by its provision for loan losses and its provision for income taxes. The following discussion provides a summary of the Company’s operations for the past three years and should be read in conjunction with the consolidated financial statements and related notes presented elsewhere in this report.
Critical Accounting Estimates
The accounting principles we follow and our methods of applying these principles conform with the accounting principles generally accepted in the United States of America and with general practices within the banking industry. In connection with the application of those principles, we have made judgments and estimates which, in the case of the determination of our allowance for loan losses, fair value of financial instruments, including securities and other real estate owned, other-than-temporary impairment of securities, goodwill and other intangibles, retirement plans and income taxes have been critical to the determination of our financial position, results of operations and cash flows.
Securities: Debt securities are classified as available for sale when they might be sold before maturity. Securities available for sale are carried at fair value, with unrealized holding gains and losses reported in other comprehensive income, net of tax. Interest income includes amortization of purchase premium or discount. Premiums and discounts on securities are amortized on the level-yield method without anticipating prepayments, except for mortgage-backed securities where prepayments are anticipated. Gains and losses on sales are recorded on the trade date and determined using the specific identification method.
Management evaluates securities for other-than-temporary impairment (“OTTI”) on at least a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. For securities in an unrealized loss position, management considers the extent and duration of the unrealized loss, and the financial condition and near-term prospects of the issuer. Management also assesses whether it intends to sell, or it is more likely than not that it will be required to sell, a security in an
unrealized loss position before recovery of its amortized cost basis. If either of the criteria regarding intent or requirement to sell is met, the entire difference between amortized cost and fair value is recognized as impairment through earnings. For debt securities that do not meet the aforementioned criteria, the amount of impairment is split into two components as follows: 1) OTTI related to credit loss, which must be recognized in the income statement and 2) OTTI related to other factors, which is recognized in other comprehensive income. The credit loss is defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis.
Allowance for Loan Losses: The allowance for loan losses is a valuation allowance for probable incurred credit losses. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged off.
The allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired.
A loan is impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Loans for which the terms have been modified resulting in a concession, and for which the borrower is experiencing financial difficulties, are considered troubled debt restructurings and classified as impaired.
Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed.
Commercial and commercial real estate loans over $25 are individually evaluated for impairment. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Large groups of smaller balance homogeneous loans, such as consumer and residential real estate loans, are collectively evaluated for impairment, and accordingly, they are not separately identified for impairment disclosures. Troubled debt restructurings are separately identified for impairment disclosures and are measured at the present value of estimated future cash flows using the loan’s effective rate at inception. If a troubled debt restructuring is considered to be a collateral dependent loan, the loan is reported, net, at the fair value of the collateral. For troubled debt restructurings that subsequently default, the Company determines the amount of reserve in accordance with the accounting policy for the allowance for loan losses.
The general component covers non-impaired loans and is based on historical loss experience adjusted for current factors. The historical loss experience is determined by portfolio segment and is based on the actual loss history experienced by the Company over the most recent three years. This actual loss experience is supplemented with other economic factors based on the risks present for each portfolio segment. These economic factors include consideration of the following: levels of and trends in
delinquencies and impaired loans; levels of and trends in charge-offs and recoveries; trends in volume and terms of loans; effects of any changes in risk selection and underwriting standards; other changes in lending policies, procedures, and practices; experience, ability, and depth of lending management and other relevant staff; national and local economic trends and conditions; industry conditions; and effects of changes in credit concentrations. The following loan portfolio segments have been identified with a discussion of the risk characteristics of these portfolio segments: real estate construction; 1-4 family residential; commercial real estate; other real estate secured; commercial, financial, and agricultural; consumer; tax exempt; and other loans.
Other Real Estate Owned: Real estate assets acquired through or instead of loan foreclosure are reported as other real estate owned and initially recorded at the lower of cost or fair value less costs to sell when acquired, establishing a new cost basis. If fair value declines subsequent to foreclosure, a valuation allowance is recorded through expense. Operating costs after acquisition are expensed.
Goodwill and Other Intangible Assets: Goodwill resulting from business combinations prior to January 1, 2009 represents the excess of the purchase price over the fair value of the net assets of businesses acquired. Goodwill and intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but tested for impairment at least annually. Intangible assets with definite useful lives are amortized over their estimated useful lives to their estimated residual values. Other intangible assets consist of core deposit and acquired customer relationship intangible assets arising from the Company’s acquisition of the First National Bank of Centerville, in Centerville, Tennessee (“First National”). These assets are initially measured at fair value and then are amortized on an accelerated method over their estimated useful lives, which was determined to be 15 years.
Retirement Plans: Supplemental employee retirement plan (“SERP”) expense is the net of service and interest cost. Employee 401(k) and profit sharing plan expense is the amount of matching contributions. The Company has matched 100% of the first 3% and 50% of the next 2% the employee contributes to their 401(k) annually.
Income Taxes: Income tax expense is the total of the current year income tax due or refundable and the change in deferred tax assets and liabilities. Deferred tax assets and liabilities are the expected future tax amounts for the temporary differences between carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized.
A tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded. The Company recognizes interest and/or penalties related to income tax matters in income tax expense.
ANALYSIS OF RESULTS OF OPERATION
The Company had a net loss of $15,052 for the year ended December 31, 2011, compared to the net loss of $18,206 for 2010. Net loss in 2009 was $9,572. Pretax loss increased from $16,575 in 2010 to $16,607 in 2011. Pretax loss in 2009 was $10,950. Non-interest expense decreased in 2011 compared to 2010 primarily due to a reduction in salaries and employee benefits. Total income tax benefit in 2011 was $1,555 compared to tax expense of $1,631 in 2010.
Net Interest Income
Net interest income represents the amount by which interest earned on various earning assets exceeds interest paid on deposits and other interest-bearing liabilities and is the most significant component of the Company’s earnings.
2011 compared to 2010
Net interest income before the provision for loan losses was $19,598 in 2011, a decrease of $1,406 or 6.7% from $21,004 in 2010. The decrease in net interest income is primarily due to a decrease in loan interest income. The decrease in interest income was somewhat offset by a decrease in interest expense. Loan interest income decreased by 12.5% while deposit interest expense decreased 28.0% during 2011.
Total interest income on loans was $26,308 in 2011, a decrease of $3,755 or 12.5% from $30,063 in 2010. The decrease was primarily due to the decrease in the average balance of loans during 2011 compared to 2010. The decrease was also impacted by continued high levels of nonaccrual loans in the portfolio. The decrease in average balance of loans reflects the reduction in loan demand that began during the second half of 2010 and continued throughout 2011. Management anticipates that the Bank’s market will continue to experience very weak loan demand during 2012, which together with the sale of certain loans originated at the Bank’s Murfreesboro and Franklin, Tennessee branch locations that the Bank is in the process of selling, will lead to further reductions in the average balance of loans during 2012.
Interest income on taxable securities was $1,598 in 2011, a decrease of $563 or 26.1% from $2,161 in 2010 despite higher average balances of investment securities in 2011. The decrease is primarily due to a decrease in the average rate earned on taxable securities during 2011 compared to 2010. The average rate earned on taxable securities during 2011 was 3.17% compared to 3.96% in 2010.
Interest income on tax exempt securities was $459, an increase of $45 or 10.9% from $414 in 2010. The increase in income is due to an increase in the average balance of tax exempt securities during 2011 compared to 2010, offset by a decrease in the average rate earned. The average rate earned on tax exempt securities was 3.44% in 2011 compared to 3.59% in 2010.
Overall yield on the Bank’s securities portfolio decreased during 2011, primarily due to the very low rates that are available for securities that meet the Bank’s investment quality requirements. During 2011, several of the Bank’s highest-yield securities were called, forcing the Bank to reinvest in new securities at lower rates. Management anticipates that this trend will continue, with rates available for new securities purchases continuing to be low in 2012, which will likely result in further reductions in the average rate earned on securities during 2012. This coupled with the declining loan balances in 2012 and the fact that investment securities we expected to constitute a larger percentage of interest earning assets in 2012 will cause downward pressure on the Company’s interest income in 2012.
Total interest income on federal funds sold and other was $321 in 2011, an increase of $34 or 11.8% from $287 in 2010. The increase is due to a significant increase in the average balance of federal funds sold and other during 2011 compared to 2010. The increase in average balance is primarily due to loan payoffs outpacing decreases in deposits, resulting in the Bank carrying cash balances larger than it typically would if market conditions provided stronger investment options. Management works to position the Bank’s cash into interest bearing facilities that will maximize the return while considering the Bank’s liquidity needs. The majority of the Bank’s cash is left on deposit with the Federal Reserve Bank, which earns interest at the Federal Funds rate, which was 0.25% during 2011. The Bank has also been able to utilize interest bearing money market accounts in other financial institutions to achieve a higher return, though deposits in other banks are limited by the Bank’s correspondent concentration policy.
Total interest expense was $9,088 in 2011, a decrease of $2,833 or 23.8% from $11,921 in 2010. The decrease was primarily due to the decrease in the average rate paid on deposits during 2011 compared to 2010.
Total interest expense on deposits was $7,082 in 2011, a decrease of $2,752 or 28.0% from $9,834 in 2010. The average rate paid on deposits was 1.34% in 2011 compared to 1.81% in 2010. The decrease in rate is due to continued decreases in market rates in the Bank’s market area. During 2010 and to a lesser extent in 2011, management was successful at reducing rates for various deposit products while growing the Bank’s core deposit base and reducing reliance on wholesale funding sources. This success was possible due to historically low rates combined with excess liquidity in the Bank’s market area. Management anticipates that rates will remain low throughout 2012, which should provide for additional opportunities to reprice longer-term deposits at lower market rates. We expect that this will allow for some modest reductions in deposit cost of funds during 2012, however changes in market conditions and other factors could prevent that from occurring. Management also anticipates further reduction in deposit cost of funds as a result of the branch divestitures. The two branches being held for sale are located in the portion of the Bank’s market area with the highest deposit rates.
Total interest expense on FHLB advances and federal funds purchased was $375 in 2011, a decrease of $81 or 17.8% from $456 in 2010. The decrease is due to the maturity of one FHLB advance during 2010 that was not renewed or replaced.
Other interest expense is comprised of interest paid on the Company’s subordinated debentures and repurchase agreement. The majority of the facilities in this category are at a fixed rate, which resulted in no change in other interest expense in 2011 from 2010.
Net interest margin was 3.20% in 2011, a decrease of 14 basis points (“bps”) from 3.34% in 2010. The
decrease in net interest margin is primarily due to the decrease in the average balance of loans during 2011 and a decrease in the average rate earned on loans in the portfolio. The average rate earned on loans during 2011 was 5.41% compared to 5.69% in 2010. The decrease in loan interest income was somewhat offset by decreases in deposit interest expense. The average rate paid on deposit accounts was 1.34% in 2011 compared to 1.81% in 2010. Management anticipates that there will not be a significant fluctuation in net interest margin in 2012, unless market rates begin to increase, which would decrease net interest margin until market rates increase to the point that loans in the portfolio that are currently at their floor rate begin to increase. If the Bank encounters additional increases in nonaccrual loans or experiences larger than expected decreases in gross loans, net interest margin could be negatively impacted.
2010 compared to 2009
Net interest income before the provision for loan losses for 2010 increased $3,270, or 18.4%, to $21,004 compared to $17,734 in 2009. The increase was primarily due to decreases in the Bank’s cost of funds for deposit liabilities, partially offset by decreases in securities and loan interest income.
Net interest margin was 3.34% in 2010 compared to 2.68% in 2009 and 2.81% in 2008. The increase in net interest margin in 2010 was primarily due to the decrease in deposit interest expense.
Total interest income in 2010 was $32,925, a decrease of $2,333 or 6.6% from $35,258 in 2009. The factors causing the decrease are discussed below.
Interest and fee income on loans in 2010 was $30,063, a decrease of $1,313, or 4.1%, from 2009. The decrease in interest income is primarily due to the decrease in gross loans. The decrease was also impacted by the increase in nonaccrual loans in 2010 compared to 2009. The average rate earned on loans was 5.69% in 2010 compared to 5.60% in 2009. The average balance of loans outstanding decreased during 2010 primarily due to payments in excess of loan originations, charge offs and transfers to other real estate. The Bank further tightened its lending standards during 2010, which when combined with weaker loan demand, resulted in fewer new loan originations during 2010.
Interest income on taxable securities was $2,161 in 2010, a decrease of $1,111 or 34.0% compared to $3,272 in 2009. The decrease is primarily due to the decrease in the average balance of taxable securities, which was $54,564 in 2010 compared to $70,975 in 2009. The decrease in interest income on taxable securities was further impacted by a decrease in the average rate earned for taxable securities, which was 3.96% in 2010 compared to 4.52% in 2009. The decrease in both average balance and average rate earned is due to the sale of particular securities from the portfolio in an effort to reduce the risk of extended repayment periods as a result of current market rates associated with mortgage backed securities. A portion of the proceeds from the sale were reinvested in tax exempt municipal securities and securities issued by U.S. Government sponsored entities (“GSE”). The replacement municipal and GSE securities bear a lower rate of interest than those that were sold due to the current market rates. The Bank recorded a gain on sale of securities of $522 in 2010 as a result of the transactions.
Interest income on tax-exempt securities was $414, an increase of $100 or 31.8% from $314 in 2009. The average rate earned on tax-exempt securities was 3.59% in 2010 compared to 3.75% in 2009. The increase in income is due to an increase in the average balance of tax-exempt securities, which was $11,541 in 2010 compared to $8,383 in 2009, partially offset by a decrease in the average rate earned. The increase in average balance of tax-exempt securities was due to the Bank purchasing additional tax-exempt securities as replacement for some of the taxable securities that were sold during the year.
Interest income on federal funds sold and other was $287 in 2010, a decrease of $9 or 3.0% from $296 in 2009.
Total interest expense in 2010 was $11,921, a decrease of $5,603 or 32.0% from $17,524 in 2009. The factors driving the decrease in interest expense are discussed below.
Interest expense on deposits was $9,834 in 2010, a decrease of $5,249 or 34.8% from $15,083 in 2009. The decrease in expense is primarily due to repricing of time deposits during 2010 at market rates that are lower than the rates paid for time deposits in 2009. The average cost of funds for interest bearing deposits in 2010 was 1.81% compared to 2.66% in 2009. The average cost of funds decreased for all categories of deposits, with the most significant decline being in other time deposits. The average cost of funds for other time deposits was 2.11% in 2010 compared to 3.15% in 2009.
Interest expense on FHLB advances and federal funds purchased was $456 in 2010, a decrease of $243 or 34.8% from $699 in 2009. The decrease in expense is primarily due to the decrease in the average balance of FHLB advances outstanding during 2010, which was $17,592 compared to $22,471 in 2009. The decrease in expense was further impacted by a decrease in the average rate paid for FHLB advances in 2010 compared to 2009. The average rate in 2010 was 2.59% compared to 3.07% in 2009.
Other interest expense is comprised of the Company’s subordinated debentures and repurchase agreement. Other interest expense was $1,631 in 2010, a decrease of $111 or 6.4% from $1,742 in 2009. The majority of the expense is related to the Company’s subordinated debentures. The largest issuance of subordinated debentures is a fixed rate debenture, which prevented the average rate paid for subordinated debentures from declining during 2010 as dramatically as the average rates for other funding sources. The average rate paid for subordinated debentures in 2010 was 6.09% compared to 6.42% in 2009. The Company’s repurchase agreement is a fixed rate agreement, which resulted in no change in expense or average rate for 2010 compared to 2009.
Average Balance Sheets, Net Interest Income
Changes in Interest Income and Interest Expense
The following table shows the average daily balances of each principal category of our assets, liabilities and stockholders’ equity and an analysis of net interest income for each of the three years ended December 31, 2011.
Interest income includes fees on loans of $468, $578, and $638 in 2011, 2010 and 2009.
Nonaccrual loans are included in average loan balances and the associated income (recognized on a cash basis) is included in interest.
Amortization cost is included in the calculation of yields on securities available for sale.
Net interest income to average interest earning assets.
The following table reflects how changes in the volume of interest earning assets and interest-bearing liabilities and changes in interest rates have affected our interest income, interest expense, and net interest income for the periods indicated. Information is provided in each category with respect to changes attributable to (1) changes in volume (changes in volume multiplied by prior rate); (2) changes in rate (changes in rate multiplied by prior volume); and (3) changes in rate/volume (changes in rate multiplied by change in volume). The changes attributable to the combined impact of volume and rate have all been allocated to the changes due to rate.
Analysis of Changes in Net Interest Income
(a) Interest income includes fees on loans of $468, $578, and $638 in 2011, 2010 and 2009
(b) Nonaccrual loans are included in average loan balances and the associated income (recognized on a cash basis) is included in interest.
(1) Changes in volume multiplied by prior rate
(2) Changes in rate multiplied by prior volume
(3) Changes in rate multiplied by change in volume
Noninterest Income
The Company’s noninterest income consists of service charges on deposit accounts, mortgage banking activities, investment service income, earnings on bank owned life insurance policies (BOLI), and other noninterest income.
2011 compared to 2010
Total noninterest income was $3,353 in 2011, a decrease of $1,310 or 28.1% from $4,663 in 2010. The decrease in noninterest income is primarily due to reductions in gain on sale of securities available for sale, gain on sale of loans, and investment services income.
The Bank sold no securities during 2011 which resulted in no gains on sale. In 2010, the Bank sold a group of securities that resulted in a gain on sale of $522.
Gain on sale of loans was $548 in 2011, a reduction of $426 or 43.7% from $974 in 2010. Gain on sale of loans is comprised of two main components, secondary market sales of traditional single family mortgages, and sales of Small Business Administration (“SBA”) guaranteed commercial loans.
Income recognized from sale of traditional single family mortgages totaled $205 in 2011 compared to $967 in 2010. The reduction in income is due to a reduction in demand for refinance activity and continued low sales activity in the housing market. The decrease in mortgage activity was also impacted by a restructuring of the Bank’s mortgage banking operations that occurred in the first quarter of 2011. In prior years, mortgage banking activities have produced significant revenue for the Bank however; operations, additional regulatory requirements, and potential for recourse losses have prevented the Bank from operating the service line profitably. During the first quarter of 2011 the Bank partnered with a third-party mortgage originator to continue offering residential mortgage products to our customers while moving much of the overhead and a portion of the revenue to the third party. Due to this new partnership, the Bank believes it is relieved of significant regulatory reporting requirements and potential recourse losses. The restructuring of the product line also eliminated 5 full time employee positions at the Bank, resulting in significant cost savings. Management expects the reduction in revenue in future periods will be more than offset by the overhead cost savings allowing the product line to contribute to net income.
Income recognized from sale of SBA guaranteed loans totaled $343 in 2011, compared to $7 in 2010.
Investment services income was $226 in 2011 compared to $588 in 2010. The decrease is primarily due to a reduction in the size of the Bank’s investment services department from three agents to one.
Other service charges, commissions, and fees were $284 in 2011, an increase of $30 or 11.8% from $247 in 2010. The increase is primarily due to the Bank leasing previously unoccupied square footage in its branch location in Franklin, Tennessee. With the pending sale of our Franklin, Tennessee branch location, this leasing income is not expected to continue beginning in the second half of 2012.
2010 compared to 2009
Total noninterest income was $4,663 in 2010, a decrease of $653 or 12.3% from $5,316 in 2009. The decrease is primarily due to decreases in gain on securities available-for-sale, service charges on deposit accounts, and mortgage banking activities, offset by increases in investment services income.
Deposit service charges were $1,844 in 2010, a decrease of $183 from $2,027 in 2009. The decrease is primarily due to reduced overdraft fee income as well as lower average deposit balances. Overdraft fee income was negatively impacted by new financial regulations that became effective in the second quarter of 2010 which require a customer to affirmatively opt in to overdraft protection for ATM and debit card transactions.
Total gain on sale of loans was $974 in 2010 compared to $1,110 in 2009. The decrease is primarily due to lower demand for mortgage refinances in 2010 compared to 2009 and continued lower levels of activity in new home sales when compared to historic levels.
Gain on sale of securities available-for-sale was $522 in 2010, a decrease of $613 or 54.0% from $1,135 in 2009. The decrease is due to the Bank selling fewer securities in 2010 compared to 2009.
Investment services income was $588 in 2010, an increase of $314 or 114.6% from $274 in 2009. The increase in income is due to customers taking advantage of improving market conditions during 2010, resulting in more investment transactions and commissions for the Bank. Investment services also added one additional investment officer during 2010, helping to increase investment activity.
Other service charges, commissions, and fees were $247 in 2010, an increase of $27 or 12.3% from $220 in 2009. The increase in income was primarily due to a gain on sale of a Bank owned automobile during 2010. The recorded gain on sale was $25.
The table below shows noninterest income for each of the three years ended December 31:
Noninterest Expense
Noninterest expense consists of salaries and employee benefits, net occupancy, furniture and equipment, data processing, advertising and public relations, other real estate owned expenses, regulatory and compliance expense, and other operating expenses.
2011 compared to 2010
Total noninterest expense was $26,529 in 2011, a decrease of $1,279 or 4.6% from $27,808 in 2010. The decrease is primarily due to decrease in goodwill impairment charges, salaries and employee benefits, advertising and public relations, loan expense, and other real estate expense offset by an increase in securities impairment losses, and losses on other repossessed assets.
In the third quarter of 2011, the Company experienced losses of $5,000 related to impairment of a trust preferred security held by the Bank and issued by Tennessee Commerce Statutory Trust, an affiliate of Tennessee Commerce Bancorp, Inc. On January 27, 2012, Tennessee Commerce Bancorp, Inc.’s bank subsidiary, Tennessee Commerce Bank, was placed into receivership by the Tennessee Department of Financial Institutions after Tennessee Commerce Bank’s capital deteriorated significantly in the third quarter of 2011. The Company does not anticipate that it will recover any of the Bank’s investment in the trust preferred security. As a result, the Company recorded an impairment charge of $5,000 during the third quarter of 2011, which represents the Company’s full investment in the trust preferred securities.
During 2010, the Company concluded that the carrying value of its goodwill was impaired and recognized a loss of $5,204, resulting in no goodwill being reported as of December 31, 2010. As a result, there were no additional goodwill impairment charges during 2011.
Losses on other repossessed assets totaled $1,025 in 2011, compared to $0 in 2010. The entire loss relates to assets acquired through one lending relationship. The repossessed assets consisted of shares of common stock in two separate bank holding companies. The balance reported at September 30, 2011 was based on an appraisal of each company as of that date. 2011 financial results for the subsidiary bank under each holding company were such that management concluded the value of the shares had declined to the point that the shares had no value as of December 31, 2011.
Management has been focused on reducing noninterest expenses wherever possible. Those efforts have resulted in reductions in several categories. The most significant decrease is in salaries and employee benefits, which totaled $8,353 in 2011, a decrease of $1,161 or 12.2% from $9,514 in 2010. The reduction in expense is primarily due to a reduction in workforce that occurred in the first quarter of 2011. The reduction in workforce affected approximately 10% of the Bank’s full time employees, with reductions affecting most departments, but most significantly impacting the mortgage banking department as discussed above. Management anticipates a gross annual savings of approximately $900 as a result of the reductions, with a portion of that savings being offset by regular salary increases for remaining employees. In addition to the reduction in workforce, reduced levels of mortgage loan production and investment services revenue resulted in lower commissions in 2011.
Advertising and public relations totaled $357 in 2011, a reduction of $287 or 44.6% from $644 in 2010. The reduction is due to management’s efforts to reduce noninterest expenses and reflect changes in the Bank’s marketing plan that have resulted in less expense during 2011.
Loan expense totaled $208 in 2011, a decrease of $261 or 55.7% from $469 in 2010. The decrease in loan expense is due to lower loan demand resulting in fewer loan origination expenses for the Bank.
Other real estate expense is composed of three types of charges: maintenance, marketing and selling costs; valuation adjustments based on new appraisals; and gains or losses on disposition. Other real estate expenses totaled $3,016 in 2011, a decrease of $242 or 7.4% from $3,258 in 2010. Maintenance, marketing, and selling costs totaled $996, valuation adjustments based on new appraisals totaled $1,578, and losses on sale of other real estate totaled $442 in 2011. The valuation adjustments relate to two specific high-value residential properties. Market values for homes in that segment of the real estate market have continued to experience significant declines in the Bank’s market area. Market values for homes at or below the median home price have begun to level off. The majority of the Bank’s residential other real estate is in this more stable category. Management currently does not expect significant amounts of additional adjustments based on new appraisals during 2012; however if market conditions and real estate values deteriorate further, additional losses could be incurred and those losses could be significant. The balance of other real estate owned, net of valuation allowance increased 87.1% to $22,055 at December 31, 2011 compared to $11,791 at December 31, 2010.
Management anticipates continued high levels of other real estate in 2012, which could result in additional expense.
Audit, accounting and legal expense totaled $733 in 2011, an increase of $103 or 16.4% from $630 in 2010. The majority of the increase is related to legal fees incurred in connection with the Bank’s regulatory examinations and the negotiation of the Consent Order as well as disputes with former employees that have either been resolved of for which the Bank believes it has adequate insurance coverage.
In an effort to reduce noninterest expenses in 2012, the Company is considering revoking the REIT’s
status. The Bank’s sole subsidiary is Community First Title, Inc., a Tennessee corporation (“Title”). CFBT Investments, Inc., a Nevada corporation (“Investments”), is a wholly-owned subsidiary of Community First Title, Inc., and is the parent of Community First Properties, Inc., a Maryland corporation, which was established as a real estate investment trust (the “REIT”) pursuant to Internal Revenue Service regulations. The Bank’s principal business is to accept demand and saving deposits from the general public and to make residential mortgage, commercial, and consumer loans. In an effort to reduce overhead expenses and due to the fact that the Company has maximized the tax benefit to be obtained from operating the REIT, management anticipates that the REIT will revoke its REIT status under the IRS rules and regulations prior to March 31, 2012. In addition, management anticipates that in connection with this process, it will dissolve and liquidate two of its subsidiaries, Title and Investments, and distribute those entities’ assets up to the Bank, making the REIT a direct subsidiary of the Bank. This restructuring of the Company’s subsidiaries is expected to be completed during the first quarter of 2012 and is expected to contribute approximately $70 in noninterest expense savings annually following this restructuring.
2010 compared to 2009
Total noninterest expense was $27,808 in 2010, an increase of $4,729 or 20.5% from $23,079 in 2009. The increase is primarily due to goodwill impairment charges of $5,204 and increases in other real estate expense, partially offset by a reduction in securities impairment losses, and regulatory and compliance expense.
Salaries and employee benefits totaled $9,514 in 2010, an increase of $240 or 2.6% from $9,274 in 2009. The increase is primarily due to regular salary increases for employees during 2010.
The Company performs an annual goodwill impairment assessment during the third quarter of each year, or more often if events warrant an interim assessment. The annual analysis performed in the third quarter of 2010 indicated that no impairment existed. Due to events in the fourth quarter of 2010, management determined that another analysis was warranted as of December 31, 2010. The analysis performed at year end indicated that goodwill impairment did exist, resulting in an impairment charge of $5,204.
Goodwill impairment exists when the reporting unit’s carrying value of goodwill exceeds its fair value, which is determined through a two-step impairment test. Step 1 includes the determination of the carrying value of the reporting unit, including the existing goodwill and intangible assets, and estimating the fair value of the reporting unit. We determined the fair value of the reporting unit and compared it to the carrying amount of its common equity. If the carrying amount of the reporting unit exceeds its fair value, we are required to perform the second step of the impairment test.
An impairment analysis as of December 31, 2010, indicated that the Step 2 analysis was necessary. Step 2 of the goodwill impairment test is performed to measure the impairment loss. Step 2 requires that the implied fair value of the reporting unit’s goodwill be compared to the carrying amount of that goodwill. If the carrying amount of the reporting unit’s goodwill exceeds the implied fair value of that goodwill, an impairment loss shall be recognized in an amount equal to that excess. After preparing the Step 2 analysis, management determined that goodwill was fully impaired.
Regulatory and compliance expense was $1,491 in 2010, a decrease of $237 or 13.7% from $1,728 in 2009. The decrease is primarily due to a reduction of FDIC assessments in 2010 compared to 2009. As an FDIC-insured institution, the Bank is required to pay deposit insurance premiums to the FDIC. Because the FDIC’s deposit insurance fund fell below prescribed levels in 2008, the FDIC announced in 2009 increased premiums for all insured depository institutions, including the Bank, in order to begin recapitalizing the fund. The FDIC imposed a 5 basis points emergency assessment on insured depository
institutions which was paid on September 30, 2009, and was based on total assets less tier one capital as of June 30, 2009. The special assessment resulted in additional expense of $337 in the second quarter of 2009. The FDIC did not impose any special assessments in 2010, contributing to the decrease in expense for 2010. That decrease was partially offset by increases in assessment rates during 2010.
In the fourth quarter of 2009, the FDIC adopted a rule that, in lieu of any further special assessment in 2009 and 2010, required all insured depository institutions, with limited exceptions, to prepay their estimated quarterly risk-based assessments for the fourth quarter of 2009, and for all of 2010, 2011, and 2012. The rules adopted in the fourth quarter of 2009 resulted in the Bank paying $4,047 to the FDIC on December 30, 2009. The Bank recorded a prepaid asset of $3,550 as a result of this transaction. Estimates provided by the FDIC project that the prepaid asset will be fully utilized by the end of 2012. Changes in the Bank’s deposit balances as well as rule changes that the FDIC may adopt in the future could impact the period of time over which the prepaid asset will be utilized.
Securities impairment losses were $0 in 2010 compared to $1,338 in 2009. During 2009, the Company experienced losses of $1,338 related to the impairment of common stock held by the Bank and issued by Silverton and trust preferred securities held by the Bank and issued by a trust affiliated with Silverton which securities were guaranteed by Silverton. On May 1, 2009, Silverton’s bank subsidiary, Silverton Bank, was placed into receivership by the Office of the Comptroller of the Currency after Silverton Bank’s capital deteriorated significantly in the first quarter of 2009. Silverton filed for bankruptcy on June 5, 2009. The Company does not anticipate that it will recover any of the Bank’s investment in either the common securities or trust preferred securities issued by Silverton or its affiliated trust. As a result, the Company recorded an impairment charge of $1,338 in the first quarter of 2009, which represents the Company’s full investment in the securities.
The table below shows noninterest expense for each of the three years ended December 31:
Provisions for Loan Losses
The Bank recorded provision for loan losses of $13,029 in 2011, a decrease of $1,405 or 9.7% from $14,434 in 2010. Management’s determination of the appropriate level of the provision for loan losses and the adequacy of the allowance for loan losses is based, in part, on an evaluation of specific loans, as well as the consideration of historical loss, which management believes is representative of probable incurred loan losses. Other factors considered by management include the composition of the loan portfolio, economic conditions, results of regulatory examinations, reviews of updated real estate appraisals, and the creditworthiness of the Bank’s borrowers and other qualitative factors. The allowance for loan losses was 5.13% of gross loans (“AFLL Ratio”) at December 31, 2011 compared to 3.58% at December 31, 2010.
Nonperforming loans decreased from $53,233 at December 31, 2010 to $41,789 at December 31, 2011. The decrease in nonperforming loans is primarily due to foreclosure and charge-off activity during 2011. Management has been focused on reducing the Bank’s overall level of problem assets, particularly during the last half of 2011. Elimination of those problem assets often requires foreclosure of problem loans, resulting in some charge-off and the balance of the loan moving to other real estate owned. Once the Bank has control of the collateral, it is then able to liquidate the assets. This increased focus on eliminating problem assets contributed to the decrease in nonperforming loans and the increase in other real estate owned during 2011. The ratio of allowance to nonperforming loans was 46.77% at December 31, 2011, compared to 34.09% at December 31, 2010. The portion of the allowance attributable to impaired loans was $8,209 at December 31, 2011, an increase of $901 from December 31, 2010. Also included in impaired loans are relationships classified as troubled debt restructurings (“TDRs”) totaling $12,781. The increase in impaired loans was somewhat offset by loan charge offs during 2011. The amounts charged off during 2011 approximated the specific allocations for certain collateral dependent individual impaired loans.
The portion of the allowance attributable to historical and environmental factors has increased on an absolute basis and as a percentage of gross loans during 2011. Management’s evaluation of the allowance for loan losses, in addition to specific loan allocations, is based on volume of non-impaired loans and changes in credit quality and environmental factors. The balance of non-impaired loans decreased during 2011 due to the reduction in gross loans and the transfer of newly impaired relationships to the impaired loans component.
The total allowance for loan losses was $19,546 or 5.13% of gross loans at December 31, 2011 compared to $18,167 or 3.58% of gross loans at December 31, 2010. The increase is due to increases in the impaired loans component and a reduction in gross loans. Management considers the increase in the AFLL ratio to be directionally consistent with changes in risks associated with the loan portfolio as measured by various metrics.
The table below illustrates changes in the AFLL ratio over the past five quarters and the changes in related risk metrics over the same periods:
(1) Historical and environmental component as a percentage of non-impaired loans.
(2) Nonaccrual loans and loans past due 90 or more days still accruing interest as a percentage of gross loans and TDRs still accruing interest.
Income Taxes
During 2011 and per ASC 740-20-45-7, the Company had losses in continuing operations and income in other comprehensive income, resulting in income tax benefit totaling $1,555. This benefit was recorded through current operations and reduced our deferred tax valuation allowance.
The effective income tax rates were (9.4%), (9.8%), and 12.6%, for 2011, 2010 and 2009, respectively. The change in rate for 2011 as compared to 2010 is primarily due to an exception in ASC 740-20-45, Tax Provisions, that required the Company to record a tax benefit of $1,555 through continuing operations related to income from other comprehensive income as a result of an increase in market value of securities available for sale. The Company was required to record a tax benefit equal to what would be realized if the securities in the Bank’s portfolio were to be liquidated and the unrealized gain were to be realized.
Due to the current economic condition and losses recognized over the last three years, the Company established a valuation allowance against all of its deferred tax assets. The Company intends to maintain this valuation allowance until it determines it is more likely than not that the asset can be realized through current and future taxable income. The Company has approximately $48,639 in net operating losses for state tax purposes and $19,493 for federal tax purposes to be utilized by future earnings.
The Company currently has no unrecognized tax benefits that, if recognized, would favorably affect the income tax rate in future periods. The Company does not expect any unrecognized tax benefits to significantly increase or decrease in the next twelve months. It is the Company’s policy to recognize any interest accrued related to unrecognized tax benefits in interest expense, with any penalties recognized as operating expenses.
Analysis of Financial Condition
Total assets at December 31, 2011 were $616,773, a decrease of $50,607 or 7.6% from $667,380 at December 31, 2010. Average assets for 2011 were $639,277, a decrease of $47,108 or 6.9% from $686,385 for 2010. The decrease in total assets in 2011 is primarily due to a decrease in net loans. Total liabilities at December 31, 2011 were $607,198, a decrease of $37,421 or 5.8% from $644,619 at December 31, 2010. The decrease in total liabilities was due to decreases in total deposits. Total shareholder’s equity at December 31, 2011 was $9,575, a decrease of $13,186 or 57.9% from $22,761 at December 31, 2010. The decrease in shareholder’s equity is primarily due to a reduction in retained earnings as a result of the net loss for 2011 and preferred stock dividends partially offset by an increase in other comprehensive income as a result of increasing market values of securities available-for-sale.
Loans
Net loans (excluding loans held for sale) were $361,650 at December 31, 2011, a decrease of $127,157 or 26.0% from $488,807 at December 31, 2010. Loans held for sale, at fair value totaled $5,274 at December 31, 2011, an increase of $992 or 23.2% from $4,282 at December 31, 2010. Loans held for sale net of allowance of $1,084 totaled $53,125 at December 31, 2011 compared to $0 at December 31, 2010. Loans held for sale in secondary market consist of traditional 1-4 family mortgages that have been originated with the intent to sell on the secondary market and the guaranteed portion of Small Business Administration (“SBA”) guaranteed loans, which the Bank intends to sell. Loans held for sale, net of allowance of $1,084 consists of the loans that have been identified to be sold with the two branch sales that are expected to close during 2012. These loans were not originated for sale and were not adjusted to fair value when reclassified as held for sale due to pending branch sales.
The overall decrease in loans, excluding the transfers to held for sale, was primarily due to regular loan payments outpacing demand for new loans for most of 2011, transfer of certain loans to other real estate owned, and continued elevated levels of loan chargeoffs. The decrease in loan demand is due to the continued sluggishness in the economy in the Bank’s market areas and further tightening of the Bank’s lending standards. The most significant decreases in loans were in the 1-4 family residential, real estate construction, and commercial real estate loan segments. The continuing effects of the challenging economic environment in 2011 and 2010 reduced the number of new construction loans during 2011, resulting in a significant drop in real estate construction loans. Decreases in other loan categories are primarily the result of regular loan payments and a significant decrease in loan demand in these categories as well.
Of total loans of $381,196 in the portfolio as of year-end 2011, $112,891, or 29.6% were variable rate loans and $227,474 or 59.7% were fixed rate loans, and $40,831 or 10.7% were nonaccrual.
On December 31, 2011, the Company’s loan to deposit ratio (including loans held for sale in secondary market and loans held for sale net of allowance of $1,084) was 79.2%, compared to 85.9% in 2010. Management expects loan demand to remain low throughout 2012, resulting in further reduction of gross loans, across most of the Bank’s loan categories, though the reduction in 2011 is not expected to be as significant as the decrease in 2011, excluding the loans that will be sold in the branch divestitures. Management anticipates this trend will continue until there are indicators of significant improvements in both the local and national economy, leading customers to begin spending more resulting in increased demand. If the Company’s deposit growth continues to outpace its loan demand, the Company’s net interest margin may be adversely affected as the funds from these deposits may be invested in securities and other interest earning assets that offer lower yields than loans.
The following table presents various categories of loans contained in our loan portfolio for the periods indicated and the total amount of all loans for such period:
The following is a presentation of an analysis of maturities of loans as of December 31, 2011:
The following is a presentation of an analysis of sensitivities of loans to changes in interest rates as of December 31, 2011 for the loan types mentioned above:
As market rates dropped during the economic recession, management implemented rate floors for many variable rate loans in an attempt to protect the Bank’s net interest margin. As of December 31, 2011, $73,727 in variable rate loans have reached their floor rate. As a result, when market rates begin to rise, loans at their floor will not reprice at higher rates until market rates rise above their contractual floor rates. Only the loans noted above that have variable rates not at a floor rate will reprice with the first increase in market rates. The existence of these rate floors may negatively impact our net interest margin when rates begin to rise, at least until rates rise above these floors.
Allowance for Loan Loss and Asset Quality
The allowance for loan losses was $19,546 or 5.13% of gross loans at December 31, 2011 compared to $18,167 or 3.58% of gross loans at December 31, 2010. The increase in the allowance was based on factors indicating deteriorating trends in asset quality including charge offs, past due status, impaired loans, and indicators of environmental factors that can bear an impact on loan losses such as economic conditions in the Bank’s market area.
Management’s determination of the appropriate level of the provision for loan losses and the adequacy of the allowance for loan losses is based, in part, on an evaluation of specific loans, as well as the consideration of historical loss, which management believes is representative of probable incurred loan losses. Other factors considered by management include the composition of the loan portfolio, economic conditions, results of internal and external loan review, regulatory examinations, reviews of updated real estate appraisals, and the creditworthiness of the Bank’s borrowers and other qualitative factors.
The Bank has experienced significant increases in past due loans, impaired loans, adversely classified loans and charge offs as a result of the economic downturn that began in 2008. The Bank and its customers continue to be affected by the impacts of the economic downturn. Historically, more than half of the Bank’s loan portfolio has been secured by real estate of some form, whether residential, commercial, or development, with a significant portion of those loans being residential developments. One of the most significant impacts of the economic downturn in the Bank’s market area has been the collapse of the housing market and subsequent decline in market values for existing properties, particularly higher end properties. Those impacts caused several of the Bank’s borrowers who had proven track records as residential and commercial developers to find themselves owning larger parcels of partially developed land with virtually no demand for finished properties. Developers became unable to service their debt causing the loans to become past due. At the same time, the decline in activity in the housing market caused significant reductions in market values, causing collateral values for many loans to fall below the outstanding loan balance. The Bank has experienced increases in problem loans in virtually all segments of the loan portfolio; however the effect of the economic downturn as the residential real estate market has been the cause of the majority of the Bank’s impaired loans and charge-offs during 2011 and 2010.
Impaired loans totaled $44,849 at December 31, 2011 compared to $52,059 at December 31, 2010, a decrease of $7,210.
Included in the $44,849 of impaired loans at December 31, 2011 are $15,919 of impaired relationships with specific allocations totaling $1,894 that were impaired as of December 31, 2010. At December 31, 2010 the Bank’s total exposure to that group of relationships was $22,150, a reduction of exposure of $6,231. The majority of these relationships are real estate development projects that were severely impacted by the downturn in the economy and housing market. In general, the borrowers are residential developers with a proven track record and the collateral for the loans is raw land that was intended for development. As a result of the collapse of the housing market, lot absorption declined dramatically, reducing cash flow available to service the debt. Many of the borrowers were able to service the debt through cash reserves for a period of time, but the extended period of the economic downturn exhausted their reserve funds, rendering the loans impaired. Management has worked extensively with these borrowers to find ways to liquidate the underlying collateral or stimulate activity within the respective developments in order to avoid foreclosure and/or additional charge offs. The reduction in exposure to this group of borrowers shows that some progress was made, despite continued low activity in the housing market. The relationships in this group as of December 31, 2011 will likely continue to be classified as impaired until there is significant improvement in the housing market and lot absorption improves.
Problem loans that are not impaired are categorized into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. The Company analyzes loans individually by classifying the loans as to credit risk. This analysis is performed on a monthly basis. The Company uses the following definitions for risk ratings:
Watch. Loans characterized by borrowers who have marginal cash flow, marginal profitability, or have experienced operating losses and declining financial condition. The borrower has satisfactorily handled debts with the Bank in the past, but in recent months has either been late, delinquent in making payments, or made sporadic payments. While the Bank continues to be adequately secured, the borrower’s margins have decreased or are decreasing, despite the borrower’s continued satisfactory condition. Other characteristics of borrowers in this class include inadequate credit information, weakness of financial statement and repayment capacity, but with collateral that appears to limit the Bank’s exposure. This classification includes loans to establish borrowers that are reasonably margined by collateral, but where potential for improvement in financial capacity is limited.
Special Mention. Loans with potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deteriorating prospects for the repayment source or in the Bank’s credit position in the future.
Substandard. Loans inadequately protected by the payment capacity of the borrower or the pledged collateral.
Doubtful. Loans with the same characteristics as substandard loans with the added characteristic that the weaknesses make collection or liquidation in full highly questionable and improbable on the basis of currently existing facts, conditions, and values. These are poor quality loans in which neither the collateral nor the financial condition of the borrower presently ensure collectability in full in a reasonable period of time or evidence of permanent impairment in the collateral securing the loan.
Impaired loans are evaluated separately from other loans in the Bank’s portfolio. Credit quality information related to impaired loans was presented above and is excluded from the tables below.
As of December 31, 2011, and based on the most recent analysis performed, the risk category of loans by segment of loans is as follows:
Classified loans, excluding impaired loans, totaled $109,961 at December 31, 2011 compared to $72,344 at December 31, 2010.
The following table presents information regarding impaired, nonaccrual, past due and restructured loans at the dates indicated:
There are no other loans which are not disclosed above where known information about possible credit problems of borrowers causes management to have serious doubts as to the ability of such borrowers to comply with the present loan repayment terms.
As discussed previously, management’s consideration of environmental factors impact the amount of allowance for loan loss that is needed for classified and pass rated loans. Below are some of the factors considered by management:
The commercial real estate market has declined significantly as a result of the local and national economic recession that began during 2008 and the resulting sluggish economic conditions that remained through 2011. Real estate related loans, including commercial real estate loans, residential construction and residential development and 1-4 family residential loans, comprised 87.9% of the Company’s loan portfolio at December 31, 2011. Market conditions for residential development and residential construction have seen substantial declines due to the effects of the recession on individual developers, contractors and builders. In addition, the local market, particularly in Maury County, has seen significantly weaker demand for residential housing.
Although our loan portfolio is concentrated in Middle Tennessee, management does not believe this geographic concentration presents an abnormally high risk. At December 31, 2011 the following loan concentrations exceeded 10% of total loans: 1-4 family residential loans, real estate construction loans, and commercial real estate. Management does not believe that this loan concentration presents an abnormally high risk. Loan concentrations are amounts loaned to a multiple number of borrowers engaged in similar activities which would cause them to be similarly impacted by economic or other conditions.
Interest income on loans is discontinued at the time the loan is 90 days delinquent unless the loan is well-secured and in process of collection. Past due status is based on the contractual terms of the loan. In all cases, loans are placed on nonaccrual or charged-off at an earlier date if collection of principal or interest is considered doubtful.
The following table presents information regarding loans included as nonaccrual and the gross income that would have been recorded in the period if the loans had been current.
Nonperforming loans are defined as nonaccrual loans, loans still accruing but past due 90 days or more, and troubled debt restructured loans still accruing. The following table presents information regarding nonperforming loans at the dates indicated:
Management classifies commercial and commercial real estate loans as nonaccrual loans when principal or interest is past due 90 days or more and the loan is not adequately collateralized. Also loans are classified as nonaccrual when, in the opinion of management, principal or interest is not likely to be paid in accordance with the terms of the obligation and the loan is not in the process of collection. Nonaccrual
loans are not reclassified as accruing until principal and interest payments are brought current and future payments appear reasonably certain. Loans are categorized as restructured if the original interest rate, repayment terms, or both were modified due to deterioration in the financial condition of the borrower.
Other real estate owned increased $10,264 to $22,055 at December 31, 2011 compared to $11,791 at December 31, 2010. The increase in the carrying balance is due to the volume of new foreclosures in 2011 outpacing the volume of sales of other real estate during 2011. The overall level of foreclosures remains high due to the effects of the economic downturn that began during 2008 on individual borrowers, both single family and developers, resulting in an increase in foreclosures. Included in the balance at year end 2011 is one loan totaling $78 that was originated to facilitate the sale of other real estate. Under current accounting rules, loans of this nature must be reported as other real estate owned until the loan to value ratio is below a certain level, depending on the type of loan. The reclassified loan is performing in accordance with the loan agreement. Interest income from this loan is included in loan interest income. At December 31, 2010, loans reclassified as other real estate owned totaled $83. Also included in the balance of other real estate owned is $484 of Bank property that was previously intended to be used as a future branch location. The property is no longer intended to be used for that purpose and is held for disposal as of December 31, 2011 and 2010.
Management is working to sell the properties that are owned in order to recover the Bank’s investment in the loans that ultimately resulted in foreclosure. It is possible that the balance of other real estate owned could increase during 2012 due to the continuing sluggish economic conditions in the Bank’s market areas. Additional foreclosures and low demand for both residential and commercial properties could require the Bank to hold its other real estate owned for a longer period of time, which could lead to increased noninterest expense. The Company makes every effort to avoid foreclosure, particularly for owner occupied residential properties.
Summary of Loan Loss Experience
An analysis of our loss experience is furnished in the following table for each of the periods ended December 31 indicated, as well as a breakdown of the allowance for loan losses:
At December 31, of each period presented below, the allowance was allocated as follows:
At December 31, of each period presented below, loan balances by category as a percentage of gross loans were as follows:
Securities
At December 31, 2011, securities available-for-sale totaled $63,660, an increase of $178 or 0.3% from $63,482 at year end 2010. The Company’s securities portfolio represents 10.3% of total assets at December 31, 2010 compared to 9.4% at December 31, 2010. All of the Company’s securities are classified as available for sale. The Company’s investment portfolio is used to provide interest income and liquidity and for pledging purposes to secure public fund deposits.
Net unrealized gains in the securities portfolio at December 31, 2011 were $2,590 compared to a net unrealized loss of $1,742 at December 31, 2010. The improvement in market value is primarily due to the recognized impairment on one corporate security and significant improvements in mortgage-backed securities and state and municipal securities.
In the third quarter of 2011, the Company experienced losses of $5,000 related to impairment of a trust preferred security held by the Bank and issued by Tennessee Commerce Statutory Trust, an affiliate of Tennessee Commerce Bancorp, Inc. On January 27, 2012, Tennessee Commerce Bancorp, Inc.’s bank subsidiary, Tennessee Commerce Bank, was placed into receivership by the Tennessee Department of Financial Institutions after Tennessee Commerce Bank’s capital deteriorated significantly in the third quarter of 2011. The Company does not anticipate that it will recover any of the Bank’s investment in the trust preferred security. As a result, the Company recorded an impairment charge of $5,000 during the third quarter of 2011, which represents the Company’s full investment in the trust preferred securities.
Unrealized losses on the Bank’s remaining securities have not been recognized into income because the securities are of high credit quality, management does not have the intent to sell and it is more likely than not it will not be required to sell the investment before its anticipated recovery, and the decline in fair value is largely due to changes in market interest rates. The fair value is expected to recover as the securities approach their maturity date and/or normal liquidity returns to the marketplace.
Management evaluates securities for other-than-temporary impairment on at least a quarterly basis and the investment committee makes such an evaluation on an annual basis. These evaluations are made more frequently when economic or market concerns warrant such evaluation. Consideration is given to the length of time and the extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer, and the Company’s intent to sell or it is more likely than not it will be required to sell the security before its anticipated recovery in fair value. In analyzing an issuer’s financial condition, the Company may consider whether the securities are issued by the federal government or its agencies, whether downgrades by bond rating agencies have occurred, and the results of reviews of the issuer’s financial condition.
At year end 2011, the Company’s portfolio consisted of 93 securities, 6 of which were in an unrealized loss position, compared to a total of 89 securities, 36 of which were in an unrealized loss position at December 31, 2010. In the event that securities were to be sold for liquidity purposes, there are sufficient holdings not in an unrealized loss position that could be sold, so that the Company would not be forced to sell the securities reporting an unrealized loss. The Company is further limited in the amount of securities that can be sold due to pledging requirements for Bank liabilities. Management considers security holdings in excess of our pledging requirement to be available for liquidity purposes. Sale of such holdings would not impair our ability to hold the securities reporting an unrealized loss until the loss is recovered or until maturity.
At year end 2011, the Company held securities issued by the following entities for which the aggregate face amount of investments is greater than 10% of shareholders’ equity as of December 31, 2011:
At year end 2010, the Company held securities issued by the following entities for which the aggregate face amount of investments is greater than 10% of shareholders’ equity as of December 31, 2010:
Other than the above investments, the Company did not hold securities of any one issuer, other than U.S. Government sponsored entities, with a face amount greater than 10% of shareholders’ equity as of December 31, 2011 or 2010.
The carrying value of securities at December 31 is summarized as follows:
The following table presents the carrying value by maturity distribution of the investment portfolio, along with weighted average yields thereon, as of December 31, 2011:
Premises and Equipment
Premises and equipment totaled $9,277 at December 31, 2011, a decrease of $5,760 or 38.3% from $15,037 at December 31, 2010. The largest component of the decrease in premises and equipment was classifying $4,982 as premises and equipment held for sale at December 31, 2011, due to the pending sale of the Murfreesboro Branch and Cool Springs Branch. Premises and equipment held for sale was $0 at December 31, 2010. The next largest component of the decrease in premises and equipment was routine depreciation.
Rent expense was $368 in 2011, compared to $373 in 2010. The decrease was primarily due to elimination of two ATM locations at the end of their lease terms during 2010.
Deposits
The following table sets forth the composition of the deposits at December 31:
The majority of deposits continue to be in time deposits, though there was a decrease of $65,348 in total
time deposits during 2011 and an increase in transaction accounts and savings accounts during 2011, marking a significant change in the composition of the Bank’s deposit base. The decrease in time deposits and increases in transaction accounts is due to the Bank’s continued focus on increasing core customer deposits and reducing reliance on wholesale funding sources. Wholesale funding sources are any deposits that are attained through means other than direct customer contact. Wholesale funding sources utilized by the Bank include brokered CDs and national market time deposits. The change in the Bank’s deposit composition was also impacted by historically low market rates for deposit products and excess liquidity in the Bank’s market area.
The following table shows the breakdown of time deposits at year end December 31, 2011 and 2010:
The total of wholesale funding sources at December 31, 2011 was $82,195, a decrease of $18,011 from $100,206 at December 31, 2010. In addition to reducing total wholesale funding during the year, management was able to reposition the majority of the retained deposits in order to significantly reduce cost of funds. The average rate paid for brokered CDs during 2011 was 1.71% compared to 2.08% in 2010. The average rate paid for national market time deposits in 2011 was 1.28% compared to 2.05% in 2010. The decrease in average rate paid on national market time deposits was primarily due to excess liquidity in the national market during the majority of 2010.
Brokered CDs totaled $25,124 with a weighted average rate of 1.49% compared to $32,615 with a weighted average rate of 1.45% at December 31, 2010. Maturities of brokered CDs range from May of 2012 to September of 2015. Two separate brokered CDs are 60 month CDs with call provisions. The first CD is $4,095 with a fixed rate of 2.00% for 60 months and a monthly call option that began March 1, 2011. The second CD is $4,322 with a current rate of 1.70% with an automatic step-up provision for annual rate increases until maturity and a monthly call option that began September 10, 2011. Under the terms of the Consent Order, the Bank is restricted from accepting, renewing or rolling over brokered deposits without prior consent of the FDIC. In 2011, $7,491 of brokered deposits matured. In 2012 $9,648 of brokered deposits are expected to mature. Due to the Bank’s current liquidity position, management does not anticipate that they will seek permission to obtain, renew or rollover brokered deposits during the time that the Consent Order remains in effect. However, if market conditions change, resulting in significant reductions in the Bank’s liquidity, management may decide to seek approval for new brokered deposits or to renew or rollover existing brokered deposits.
The Bank has policies in place to ensure that total wholesale funding is maintained at a reasonable level. The Bank, beginning in 2010, has also experienced pressure from its primary regulators to reduce reliance
on wholesale funding sources. Management made significant reductions in its reliance on wholesale funding during 2010 and that trend continued into 2011, though to a lesser extent. The Bank’s reliance on wholesale funding has decreased to a point that management does not anticipate further criticism from regulators. The Bank’s reliance on wholesale funding should continue to decrease as brokered deposits and additional national market CDs mature during 2012.
The increase in noninterest-bearing deposits, interest-bearing transaction accounts and savings accounts is related to the decrease in personal CDs and to a Bank initiative during the fourth quarter of 2010 to increase deposits in transaction accounts. As market rates for personal CDs reached historic lows during 2010, customers began to move funds from maturing CDs into interest-bearing money market accounts as the immediate availability of funds offered more value to them than the rates that could be earned by locking in time deposits. The shift from time deposits to interest-bearing money market accounts continued into 2011.
At December 31, 2011, we had $270,977 in time deposits maturing within two years, of which $16,707 were brokered deposits. Time deposits maturing within one year of December 31, 2011, excluding deposits to be sold in the branch divestiture, were $217,887, or 74.8% of total time deposits. If we are not able to retain these deposits at maturity, or attract additional deposits at comparable rates, we may be required to seek higher cost deposits to replace these deposits which could negatively impact our net interest margin. Further, because we have entered into the Consent Order we are not able to offer deposit rates above certain regulatory rate caps. If, as a result of these rate caps, we are unable to secure replacement deposits for these maturing deposits, our liquidity could be negatively impacted which could materially and adversely affect our results of operations. The weighted average cost of all deposit accounts was 1.34% in 2011 compared to 1.81% in 2010. The weighted average rate on time deposits was 1.60% in 2011, compared to 2.12% in 2010. Management expects to seek short-term time deposit funding to match variable rate loans. These efforts, if successful, are expected to reduce interest rate risk and expand our net interest margin.
The following tables present, at December 31 for each of the periods indicated, the average amount of and average rate paid on each of the following deposit categories:
Contractual Obligations
The Company has the following contractual obligations as of December 31, 2010:
(1) Reflects only the principal amounts due on the Company’s subordinated debentures. Due to the Company’s deferral of interest payments on the subordinated debentures, the Company has also accrued $1,454 of interest due as of December 31, 2011. The deferred interest amounts will be repaid at such time as the Company is able to obtain approval from the FRB.
(2) Reflects payments due on shares issued through the CPP on February 27, 2009. Amounts presented assume that the Preferred Stock will be fully redeemed on February 26, 2014. In the event that we are unable to redeem the Preferred Stock on or before February 26, 2014, the dividend rate on the shares increases from the current rate of 5% to 9%, which will result in annual required dividends of $1,683 until the shares are redeemed.
Subordinated Debentures
In 2002, the Company issued $3,000 of floating rate mandatory redeemable subordinated debentures through a special purpose entity as part of a private offering of trust preferred securities. The securities mature on December 31, 2032; however, the Company can currently repay the securities at any time without penalty, subject to approval from the Federal Reserve Bank. The interest rate on the subordinated debentures as of December 31, 2011 was 3.75%. The subordinated debentures bear interest at a floating rate equal to the New York Prime rate plus 50 basis points. The Company has the right from time to time, without causing an event of default, to defer payments of interest on the debentures for up to 20 consecutive quarterly periods. These debentures are presented in liabilities on the balance sheet and count as Tier 1 capital for regulatory capital purposes, subject to certain limitations on the amount of these securities that may be counted as Tier 1 capital. Debt issuance costs of $74 have been capitalized and are being amortized over the term of the securities. Principal officers, directors, and their affiliates at year end 2011 and 2010 owned $700 of the $3,000 subordinated debentures. The proceeds from this offering were utilized to increase the Bank’s capital by $3,000.
In 2005, the Company issued $5,000 of floating rate mandatory redeemable subordinated debentures through a special purpose entity as part of a pooled offering of trust preferred securities. These securities mature on September 15, 2035, however, the Company can currently repay the securities at any time without penalty, subject to approval from the Federal Reserve Bank. The interest rate on the subordinated debentures as of December 31, 2011 was 2.05%. The subordinated debentures bear interest at a floating rate equal to the 3-Month LIBOR plus 1.50%. The Company has the right from time to time, without causing an event of default, to defer payments of interest on the debentures for up to 20 consecutive quarterly periods. These debentures are presented in liabilities on the balance sheet and count as Tier 1
capital for regulatory purposes, subject to certain limitations on the amount of these securities that may be counted as Tier 1 captial. There was no debt issuance cost in obtaining the subordinated debentures. The proceeds from the pooled offering were used to increase the Bank’s capital.
In 2007, the Company issued $15,000 of redeemable subordinated debentures through a special purpose entity as part of a pooled offering of trust preferred securities. These subordinated debentures mature in 2037, however, the Company may repay these debentures at any time beginning after December 15, 2012. The interest rate on the subordinated debentures is 7.96% until December 15, 2012, and thereafter the subordinated debentures bear interest at a floating rate equal to the 3-month LIBOR plus 3.0%. The Company has the right from time to time, without causing an event of default, to defer payments of interest on the debentures for up to 20 consecutive quarterly periods. These debentures are presented in liabilities on the balance sheet and $1,900 count as Tier 1 capital and the remaining $3,295 is considered as Tier 2 capital for regulatory purposes. There was no debt issuance cost in obtaining the subordinated debentures. The proceeds were used to help fund the acquisition of First National.
The portion of the subordinated debentures qualifying as Tier 1 capital will not change for existing debentures under the Dodd-Frank Act. The portion of the subordinated debentures qualifying as Tier 1 capital is limited to 25% of total Tier 1 capital. Subordinated debentures in excess of the Tier 1 capital limitation generally qualify as Tier 2 capital.
Distributions on the subordinated debentures are payable quarterly, and the Company has adopted a board resolution at the request of the Federal Reserve Bank of Atlanta (the “FRB”) that it will not pay interest on the subordinated debentures or dividends on its common or preferred stock without the prior consent of the FRB. On January 27, 2011, the FRB denied the Company’s request to make the March 15, 2011 quarterly interest payment due on the subordinated debentures that mature in 2012, and the Company has been unable to pay interest on those subordinated debentures or any of its other subordinated debentures since that date. Under the terms of indentures pursuant to which the debentures were issued, if the Company defers payment of interest on the debentures it may not, during such a deferral period, pay dividends on its common stock or preferred stock or interest on any of the other subordinated debentures issued by the Company. Accordingly, the Company does not expect to be able to pay interest on its other subordinated debentures or dividends on its common stock or preferred stock until such time as it is able to secure the approval of the FRB. Furthermore, the indentures pursuant to which the debentures issued in 2005 and 2007 were issued provide that the Company’s subsidiaries are similarly prohibited from paying dividends on the subsidiaries’ common and preferred stock not held by the Company or its subsidiaries. The Company’s subsidiary Community First Properties, Inc. has issued and outstanding 125 shares of preferred stock totaling $125 in liquidation value, which are held by 125 unaffiliated shareholders. Dividends totaling approximately $16 are payable on these shares annually in two equal installments. Community First Properties, Inc. paid the dividends owed to the preferred stockholders on June 30, 2011 in violation of the terms of the indentures pursuant to which the subordinated debentures that were issued in 2005 and 2007 were issued and as a result has breached its obligations under the terms of those indentures. As a result, holders of the related trust preferred securities, following notice and the lapse of 60 or 90 days, could seek a judicial determination that the Company must cure the covenant breach. The cure would most likely require the Company to seek the contribution of approximately $8 of capital to Community First, Inc. Community First Properties, Inc. deferred the payment of its preferred dividend payment due on December 31, 2011, as permitted under the terms of the documents governing the terms of those shares of preferred stock. Community First Properties, Inc. will not be able to resume dividend payments on its preferred stock or common stock until the Company has resumed the payment of interest on the subordinated debentures issued in 2005 and 2007 and paid in full all unpaid dividends thereon. In the event that the Company is unable to pay interest on the subordinated debentures it has issued for twenty (20) consecutive quarters, the holders of the related trust preferred securities would be able to claim an event of default under the indentures and all amounts then owed on the debentures would be immediately due and payable.
Liquidity
Our liquidity, primarily represented by cash and cash equivalents, is a result of our operating, investing and financing activities. These activities are summarized below for the three years ended December 31:
The significant adjustments to reconcile net loss to net cash from operating activities in 2011 were $13,029 provision for loan losses, a $5,000 securities impairment loss, net write-downs and losses on sale of other real estate of $2,020, and losses on repossessed assets of $1,025. The significant components of investing activities in 2011 were net decrease in loans of $40,010; total securities purchases of $15,181; maturities, prepayments and calls of securities of $13,743; and proceeds from sale of other real estate owned of $7,887. The most significant component of financing activities in 2011 was the decrease in deposits of $40,032.
The adjustments to reconcile net loss to net cash from operating activities in 2010 were a $522 gain on sale of securities, $53,654 of mortgage loans originated for sale and proceeds from the sale of mortgage loans of $54,928 which resulted in a gain of $967, provisions for loan loss of $14,434, goodwill impairment of $5,204 and deferred income tax expense, net of valuation allowance of $1,631. The significant components of operating activities for 2009 were a $1,135 gain on sale of securities, $70,762 of mortgage loans originated for sale and proceeds from the sale of mortgage loans of $71,720 which resulted in a gain of $1,110, and provisions for loan loss of $10,921.
Significant components of investing activities during 2010 were net loan payoffs of $17,006 and purchases of securities available for sale of $88,281, offset by the proceeds from the maturities and redemptions of securities available for sale of $65,696 and sales of $33,174 of investment securities, net maturity of investment in time deposits in other financial institutions of $2,034. Significant components of investing activities during 2009 were net loan payoffs of $15,937 and purchases of securities available for sale of $81,790, offset by the proceeds from the maturities and redemptions of securities available for sale of $38,006 and sales of $44,509 of investment securities, net investment in time deposits in other financial institutions of $3,993.
Significant financing activities during 2010 included net reduction in total deposits of $11,127 and a net repayment of FHLB advances of $1,000. Significant financing activities during 2009 included net repayment of FHLB advances of $15,000, issuance of preferred stock for $17,702, repayment of federal funds purchased of $9,000, net increase in deposits of $6,878, and repayment of other borrowed funds of $4,835.
Liquidity refers to our ability to fund loan demand, meet deposit customers’ withdrawal needs and provide for operating expenses. As summarized in the statement of cash flows, our main sources of cash flow are receipts of deposits from our customers and, to a lesser extent, repayment of loan principal and interest income on loans and securities.
The primary uses of cash are lending to the Company’s borrowers and investing in securities and short-term interest earning assets. In 2011, 2010, and 2009, loan repayments were greater than demand for new loans, which provided additional liquidity to pay off outstanding liabilities such as federal funds purchased, FHLB advances, and other borrowed money. In addition to proceeds from loan repayments, proceeds from issuance of preferred stock also contributed to the Company’s ability to repay the liabilities mentioned.
We consider our liquidity sufficient to meet our outstanding short and long-term needs. We expect to be able to fund or refinance, on a timely basis, our material commitments and long-term liabilities.
Off-Balance Sheet Arrangements
At December 31, 2011, we had unfunded loan commitments outstanding of $29,406 and unfunded letters of credit of $3,416. Because these commitments generally have fixed expiration dates and many will expire without being drawn upon, the total commitment level does not necessarily represent future cash requirements. If we needed to fund these outstanding commitments, we have the ability to liquidate federal funds sold or securities available for sale or on a short-term basis to borrow and purchase federal funds from other financial institutions. Additionally, we could sell participations in these or other loans to correspondent banks.
Capital Resources
Our total shareholders’ equity at December 31, 2011 was $9,575 compared to $22,761 at December 31, 2010, and $43,645 at December 31, 2009. The factors that changed shareholders’ equity in 2011 were the net loss of $15,052 and the other comprehensive income of $2,756.
As of December 31, 2011, the Bank’s capital levels exceeded those required to be considered adequately capitalized under the regulatory framework for prompt corrective action. While the Bank’s capital levels at December 31, 2011, exceeded those necessary to be considered adequately capitalized, our consolidated capital ratios were well below those required by federal regulators and are critically low. Our consolidated total capital to risk-weighted assets ratios for year end 2011 and 2010 were 4.85% and 10.57%. Our consolidated Tier 1 to risk weighted assets ratios were 2.37% and 6.30% at year-end 2011 and 2010, respectively. Also, our Tier 1 to average assets ratios were 1.61% and 4.57% at year-end 2011 and 2010 respectively. In order for the Company to be considered well capitalized, it must have a consolidated total capital to risk weighted assets ratio of at least 10% and a Tier 1 to average assets ratio of at least 6% and not be subject to a written agreement, order, or directive requiring it to maintain capital above specified levels. Furthermore, virtually all of our capital on a consolidated basis consists of preferred stock and subordinated debentures which require repayments.
At December 31, 2011 and December 31, 2010, the Bank’s and the Company’s risk-based capital ratios and the minimums to be considered well-capitalized under applicable regulatory provisions and the ratios required by the Consent Order were as follows:
During the fourth quarter of 2011, the Company was informed that the FRB would be proposing a formal agreement following an offsite examination of the Company that was completed during the third quarter of 2011. Management has not yet been informed as to the provisions of that expected agreement but we expect that it will require, among other things, the Company to achieve, and thereafter maintain, capital levels in excess of those required to be considered well capitalized and prior approval of the FRB before we are permitted to pay dividends on our capital stock or interest payments on our indebtedness.
On September 20, 2011, the Bank consented to the issuance of a consent order (the “Consent Order”) by the Federal Deposit Insurance Corporation (the “FDIC”). The Consent Order replaces the memorandum of understanding (“MOU”) that the Bank had entered into with the FDIC on October 19, 2010. Under the terms of the Consent Order, the Bank has agreed to, among other things, take the following actions:
• Establish, within 30 days after September 20, 2011, a board committee to oversee the Bank’s compliance with the Consent Order;
• Make, within 30 days after September 20, 2011, provisions to its allowance for loan and lease losses (the “ALLL”) in an amount equal to those loans required to be charged off by the Consent Order, and thereafter maintain a reasonable ALLL and quarterly have its board of directors review the adequacy of the ALLL;
• Review, within 30 days after September 20, 2011, the Bank’s Consolidated Reports on Condition and Income filed with the FDIC after December 31, 2010, and amend such reports if necessary to accurately reflect the Bank’s financial condition as of such dates;
• Use, within 30 days after September 20, 2011, Financial Accounting Standards Board Accounting Standards Codification Numbers 450 and 310 for determining the Bank’s ALLL reserve adequacy;
• Retain, within 60 days after September 20, 2011, a bank consultant to develop, within 90 days after September 20, 2011, a written analysis and assessment of the Bank’s management and staffing needs for the purpose of providing qualified management;
• Formulate and submit to the FDIC and the Tennessee Department of Financial Institutions (the “Department”), within 60 days after September 20, 2011, a written policy covering expense reimbursement to the Bank’s directors, officers and employees, and while the Consent Order is in effect have the Board conduct monthly reviews of all expenses submitted for customer entertainment, business development and/or any other expense submitted by the Bank’s officers and directors;
• Prepare and submit, within 120 days after September 20, 2011, to its supervisory authorities a budget and profit plan for calendar year 2012;
• On or before December 31, 2011 achieve, and thereafter, maintain the Bank’s Tier 1 leverage capital ratio, Tier 1 risk-based capital ratio and Total risk-based capital ratios equal to or greater than 8.5%, 10.0% and 12.0%, respectively;
• If the Bank’s capital ratios fall below the minimum levels set out in the previous bullet as of the date of any of the Bank’s Reports on Condition and Income, submit within 30 days of receiving a request to do so, to the FDIC and the Department a capital plan to increase the Bank’s capital to levels above these minimum levels; then initiate action within 30 days after the FDIC and the Department respond to the plan;
• Refrain from paying cash dividends to the Company without the prior written consent of the FDIC and the Department;
• Increase, within 30 days after September 20, 2011, the participation of the Bank’s board of directors in the affairs of the Bank by assuming full responsibility for the approval of the Bank’s policies and objectives and for the supervision of management, including all Bank activities;
• Develop, within 120 days after September 20, 2011, a strategic plan that addresses issues including plans for sustaining adequate liquidity, strategies for pricing policies and asset/liability management, goals for reducing problem loans, plans for attracting and retaining qualified individuals to fill vacancies in the lending and accounting functions, financial goals and formulation of a mission statement;
• Not extend, directly or indirectly, any additional credit to or for the benefit of any borrower whose extension of credit is classified “Doubtful” and/or “Substandard” by the FDIC or the Department unless the Bank’s board of directors has signed a detailed written statement giving reasons why the failure to extend such credit would be detrimental to the Bank;
• Take, within 30 days after September 20, 2011, specific actions to eliminate all assets classified as “Loss” as of March 14, 2011, and, within 60 days of September 20, 2011 submit a written plan to reduce the level of assets classified “Doubtful” or “Substandard” with a balance in excess of $1,000,000, in each case as of March 14, 2011;
• Refrain from extending any additional credit to, or for the benefit of, any borrower who has a loan or other extension of credit from the Bank that has been charged off or classified in a certain specified manner and is uncollected;
• Take, within 120 days after September 20, 2011, specified actions to reduce concentrations of construction and development loans in the Bank’s portfolio to not more than 100% of the Bank’s Tier 1 capital and commercial real estate loans (other than owner-occupied commercial real estate loans) to not more than 300% of the Bank’s Tier 1 capital;
• Take, within 60 days after September 20, 2011, specified action for the reduction and collection of delinquent loans;
• Eliminate, within 30 days after September 20, 2011, and/or correct all applicable violations of law and regulation as discussed in the Bank’s most recent exam report and implement procedures to ensure future compliance with all applicable laws and regulations;
• Refrain from entering into any new line of business without the prior written consent of the FDIC while the Consent Order is in effect;
• Establish, within 30 days after September 20, 2011, a loan review committee (at least two-thirds of the members of which shall be independent directors) to periodically review the Bank’s loan portfolio and identify and categorize problem credits;
• Review, within 90 days after September 20, 2011, and annually thereafter, the Bank’s loan policy and procedures for effectiveness; and
• Furnish, within 30 days following the end of each calendar quarter, quarterly progress reports to the banking regulators.
The Bank’s capital levels as of December 31, 2011 were significantly below those that the Bank agreed to achieve by that date under the terms of the Consent Order. Based on December 31, 2011 levels of average assets and risk-weighted assets, the required amount of additional Tier 1 capital necessary for the Bank to meet the requirements of the Consent Order was approximately $22,413 which would also satisfy the total capital requirement. As a result of entering into the Consent Order, the Bank is subject to additional limitations on its operations including accepting, rolling over, or renewing brokered deposits, which could adversely affect the Bank’s liquidity and/or operating results. By virtue of entering into the Consent Order, the Bank is also limited from paying deposit rates above national rate caps published weekly by the FDIC, unless the Bank is determined to be operating in a high-rate market area. On December 1, 2011, the Bank received notification from the FDIC that it is operating in a high-rate environment, which allows the Bank to pay rates higher than the national rate caps, but continues to limit the Bank to rates that do not exceed the prevailing rate in the Bank’s market by more than 75 basis points. The Bank is also limited, as a result of its condition, in its ability to pay severance payments to its employees and must receive the consent of the FDIC and the Department to appoint new officers or directors.
As of December 31, 2011, we believe that we are in compliance with all provisions of the Consent Order that were required to be completed by December 31, 2011, with the exception of attaining the regulatory capital ratios required by the Consent Order. In accordance with the terms of the Consent Order, management has submitted a capital plan with the objective of attaining the capital ratios required by the Consent Order. The FDIC has not responded as to their acceptance or rejection of the capital plan. In addition to the capital plan, all other plans required by the Consent Order have been prepared and submitted to the FDIC for review.
At the request of the FRB, the board of directors of the Company, on January 18, 2011, adopted a board resolution agreeing that the Company would not incur additional debt, pay common or preferred dividends, or redeem treasury stock without approval from the FRB. The Company requested permission to make dividend payments on its Preferred Stock and interest payments on its subordinated debt that were scheduled for the first quarter of 2011. The FRB granted permission to pay the preferred dividends that were due on February 15, 2011, but denied permission to make interest payments on the Company’s subordinated debt. As a result of the FRB’s decision, the Company was required to begin the deferral of interest payments on each of its three subordinated debentures during the first quarter of 2011. The Company has the right to defer the payment of interest on the subordinated debentures at any time, for a period not to exceed 20 consecutive quarters. During the period in which it is deferring the payment of interest on its subordinated debentures, the Company may not pay any dividends on its common or preferred stock and the Company’s subsidiaries may not pay dividends on the subsidiaries’ common or preferred stock owned by entities other than the Company and its subsidiaries. Accordingly, the Company was required to suspend dividend payments on the Preferred Stock beginning in the second quarter of 2011. At December 31, 2011, the Company has $1,497 of interest accrued for which payment is being deferred. In addition, the Company has accumulated $847 in deferred dividends on its preferred stock. The Company’s subsidiary Community First Properties, Inc. suspended payment of its dividends on its preferred stock beginning with the dividend payment due December 31, 2011. At December 31, 2011, Community First Properties, Inc. has $8 of preferred stock dividends accrued for which payment is being deferred.
As a result of its losses in 2011, 2010 and 2009, the Bank is prohibited under applicable Tennessee law from declaring dividends, without prior approval from the Department. The terms of the Consent Order also prohibit the Bank from paying dividends to the Company without prior approval from the FDIC and the Department. The Company is prohibited from paying any dividends as a result of the board resolution it adopted at the request of the FRB and the suspension of dividends on the Preferred Stock the Company sold the U.S. Treasury and of interest on its subordinated debentures associated with its trust preferred securities. The Bank believes that the pending branch sales, described in Note 2 to the financial statements, if consummated, will improve the Bank’s capital levels. However, the consummation of the pending branch sales may not increase the Bank’s capital levels to those required to be maintained by the Bank in the Consent Order. As a result, and because the Company does not have cash available to contribute to the Bank in an amount sufficient to enable the Bank to achieve the capital levels it committed to maintain in the Consent Order, the Company will have to seek additional alternatives beyond the branch sales to raise capital in order to assist the Bank in meeting its obligations. The Company is currently considering the options available to it to increase capital levels at the Bank, including the sale of common or preferred stock of the Company or the sale of certain branch locations or other assets, or alternatively the sale of the Company. Any sale of the Company’s common stock would likely be at a price that would result in substantial dilution in ownership for the Company’s existing common shareholders and could result in a change in control of the Company.
On October 3, 2008, Congress passed the Emergency Economic Stabilization Act of 2008 (“EESA”), which provides the U. S. Treasury with broad authority to implement certain actions to help restore stability and liquidity to U.S. markets. One of the provisions resulting from the EESA is the CPP, which provided for direct equity investment of perpetual preferred stock by the Treasury in qualified financial institutions. The program is voluntary and requires an institution to comply with a number of restrictions and provisions, including limits on executive compensation, stock redemptions and declaration of dividends.
The Company applied to participate in the program during the fourth quarter of 2008 and received notification of approval for the program in the first quarter of 2009. Under the terms of the program, the U.S. Treasury purchased $17,806 in Senior Preferred shares of the Company on February 27, 2009.
The Senior Preferred shares have a cumulative dividend rate of 5% per year, until the fifth anniversary of the U.S. Treasury’s investment, and a dividend rate of 9% thereafter. In addition, under the terms of the agreement, the Company issued warrants to the U.S. Treasury to purchase additional preferred shares equal to 5% of the investment in Senior Preferred shares at a discounted exercise price. The U.S. Treasury exercised the warrants immediately upon investment in the Senior Preferred shares. The Warrant Preferred shares have a cumulative dividend rate of 9% per year until redeemed. Dividends on both the Senior Preferred and the Warrant Preferred shares are required to be paid quarterly.
Dividend requirement for the preferred shares in years 2012 and 2013 are $970; 2014, $1,564; 2015 through redemption of the shares $1,683 per year. The increase in 2014 is due to the increase in the dividend rate on the Senior Preferred shares from 5% to 9%. The Company is able to redeem all or a portion of the Senior Preferred shares at any time following consultation with its primary regulator, but may not redeem the Warrant Preferred shares unless all of the Senior Preferred shares have been redeemed. The required dividends in future periods would be reduced for any redemptions.
Because the Bank incurred losses in 2011 and 2010, the Bank is currently unable to pay dividends to the Company, including, if necessary, dividends to support the Company’s payment of interest on its subordinated debentures and dividends on the Senior Preferred or Warrant Preferred Shares without prior approval by the Commissioner of the Department. In addition, the Bank is prohibited by the terms of the Consent Order form paying dividends to the Company without the prior approval of the Department and the FDIC.
As mentioned above, in January 2011, the Company adopted a board resolution agreeing that the Company would not pay any dividends on common or preferred stock or any interest payments on outstanding subordinated debentures without the FRB’s prior approval. During the first quarter of 2011, the Company sought such approval from the FRB and was approved to make the dividend payment on the Company’s outstanding Preferred Stock issued to the U.S. Treasury that was due on February 15, 2011. The FRB denied the Company’s request to make interest payments on outstanding subordinated debentures that were due in March 2011 and the Company has not been permitted to pay dividends on its subordinated debentures since that denial. As a result of the FRB’s decision, the Company was required to begin the deferral of interest payments on each of its three subordinated debentures during the first quarter of 2011. The Company has the right to defer the payment of interest on the subordinated debentures at any time, for a period not to exceed twenty (20) consecutive quarters. During the period in which it is deferring the payment of interest on its subordinated debentures, however, the Company may not pay any dividends on its common, or Preferred Stock, and the Company’s subsidiaries may not pay dividends on those subsidiaries’ common or preferred stock owned by entities other than the Company and its subsidiaries. Accordingly, the Company was required to suspend dividend payments on its Preferred Stock beginning in the second quarter of 2011. At December 31, 2011, the Company has $847 of Preferred Stock dividends accrued for which payment is being deferred. The Company’s subsidiary Community First Properties, Inc. suspended the payment of dividends on its preferred stock beginning with the dividend payment due on December 31, 2011. At December 31, 2011, Community First Properties, Inc. has $8 of preferred stock dividends accrued for which payment is being deferred.
Return on Equity and Assets
Returns on average consolidated assets and average consolidated equity and the ratio of average equity to average assets and the dividend payout ratio for the periods indicated are as follows:
ITEM 7A.
ITEM 7A. Quantitative and Qualitative Disclosures About Market Risk
Interest Rate Sensitivity
Management uses a gap simulation model that takes cash flows into consideration. These include mortgage-backed securities, loan prepayments, and expected calls on securities. Non-maturing balances such as money markets, savings, and NOW accounts have no contractual or stated maturities. A challenge in the rate risk analysis is to determine the impact of the non-maturing balances on the net interest margin as the interest rates change. Because these balances do not “mature” it is difficult to know how they will reprice as rates change. It is possible to glean some understanding by reviewing our pricing history on these categories relative to interest rates. Using the interest rate history from the Asset Liability Management software database spanning up to 20 quarters of data, we can derive the relationship between interest rates changes and the offering rates themselves. The analysis uses the T-Bill rate as an indicator of rate changes. The gap analysis uses beta factors to spread balances to reflect repricing speed. In the gap analysis the model considers deposit rate movements to determine what percentage of interest-bearing deposits that is actually repriceable within a year. Our cumulative one year gap position at December 31, 2011, was 1.27% of total assets. Our policy states that our one-year cumulative gap should not exceed 15% of total assets.
At year end 2011, $322,400 of $488,191 of interest earning assets will reprice or mature within one year. Loans maturing or repricing within one year totaled $153,157, or 40.2% of total loans at December 31, 2011. We had $58,672 of loans maturing or repricing after five years. As of December 31, 2011, we had $217,887 in time deposits maturing or repricing within one year.
Gap analysis only shows the dollar volume of assets and liabilities that mature or reprice. It does not provide information on how frequently they will reprice. To more accurately capture the Company’s interest rate risk, we measure the actual effects the repricing opportunities have on earnings through income simulation models such as rate shocks of economic value of equity and rate shock interest income simulations.
To truly evaluate the impact of rate change on income, we believe the rate shock simulation of interest income is the best technique because variables are changed for the various rate conditions. The interest income change in each category of earning assets and liabilities is calculated as rates move up and down. In addition, the prepayment speeds and repricing speeds are changed. Rate shock is a method for stress testing the net interest margin over the next four quarters under several rate change levels. These levels span four 100 basis point increments up and down from the current interest rate. Our policy guideline is that the maximum percentage change in net interest income cannot exceed plus or minus 15% on a 200 basis point interest rate change.
Although interest rates are currently very low, the Company believes a -200 basis point rate shock is an effective and realistic test since interest rates on many of the Company’s loans still have the ability to decline 200 basis points. For those loans that have floors above the -200 basis point rate shock, the interest rate would be at the floor rate. All deposit account rates would likely fall to their floors under the -200 basis point rate shock as well. This simulation analysis assumes that NOW and savings accounts have a lower correlation to changes in market interest rates than do loans, securities, and time deposits.
December 31, 2011
December 31, 2010
Although interest rates are currently very low, the Company believes a -200 bps rate shock is an effective and realistic test since interest rates on many of the Company’s loan still have the ability to decline 200 bps. For those loans that have floors above the -200 bps rate shock, the interest rate would be the floor rate. All deposit account rates would likely fall to their floors under the -200 bps rate shock as well.
Our Economic Value of Equity simulation measures our long-term interest rate risk. The economic value is the difference between the market value of the assets and the liabilities and, technically, it is our liquidation. The technique is to apply rate changes and compute the value. The slope of the change between shock levels is a measure of the volatility of value risk. The slope is called duration. The greater the slope, the greater the impact or rate change on our long-term performance. Our policy guideline is that the maximum percentage change on economic value of equity cannot exceed plus or minus 10% on 100bp change and 20% on 200bp change. The following illustrates our equity at risk in the economic value of equity model.
December 31, 2011
December 31, 2010
One of management’s objectives in managing our balance sheet for interest rate sensitivity is to reduce volatility in the net interest margin by matching, as closely as possible, the timing of the repricing of its interest rate sensitive assets with interest rate sensitive liabilities.
Impact of Inflation
The consolidated financial statements and related notes presented elsewhere in the report have been prepared in accordance with accounting principles generally accepted in the United States. This requires the measurement of financial position and operating results in terms of historical dollars without considering the changes in the relative purchasing power of money over time due to inflation. Unlike most industrial companies, nearly all the assets and liabilities of the Company are monetary in nature. As
a result, interest rates have a greater impact on the Company’s performance than do the effects of general levels of inflation. Interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The following consolidated financial statements of the Company, together with the Notes thereto and the Management Report on Internal Control over Financial Reporting and Reports of Independent Registered Public Accounting Firm thereon, are included on pages to of this Annual Report on Form 10-K and are incorporated herein by reference:
•
Balance Sheets as of December 31, 2011 and 2010
•
Statements of Operations for the three years ended December 31, 2011
•
Statements of Changes in Shareholders’ Equity for the three years ended December 31, 2011
•
Statements of Cash Flows for the three years ended December 31, 2011
•
Notes to Consolidated Financial Statements.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
The Company maintains disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(d) promulgated under the Securities Exchange Act of 1934 (the “Exchange Act”), that are designed to ensure that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and that such information is accumulated and communicated to its management, including its President (the Company’s principal executive officer) and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. The Company carried out an evaluation, under the supervision and with the participation of its management, including its President and its Chief Financial Officer, of the effectiveness of the design and operation of its disclosure controls and procedures as of the end of the period covered by this report. Based on the evaluation of these disclosure controls and procedures, the President and the Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective.
The report of the Company’s management on the Company’s internal control over financial reporting is set forth on page of this Annual Report on Form 10-K.
There were no changes in the Company’s internal controls over financial reporting during the Company’s fiscal quarter ended December 31, 2011 that have materially affected, or are reasonable likely to materially affect, the Company’s internal control over financial reporting.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS, AND CORPORATE GOVERNANCE
The information required by this Item 10 will appear in, and is hereby incorporated by reference to, the information under the headings “Proposal 1: Election of Directors-Directors Standing For Election and-Directors Continuing in Office,” “Executive Officers,” “Corporate Governance-Meetings and Committees of the Board of Directors-Audit Committee,” and “Security Ownership of Certain Beneficial Owners and Management-Section 16(a) Beneficial Ownership Reporting Compliance” in our definitive proxy statement for the 2012 annual meeting of shareholders.
The Company has adopted a code of conduct for its senior executive and financial officers (the “Code of Conduct”), a copy of which is available under the “Disclosures” section on the Company’s website at www.cfbk.com. The Company will make any legally required disclosures regarding amendments to or waivers of, provisions of its Code of Conduct on its website at www.cfbk.com.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this Item 11 will appear in, and is hereby incorporated by reference to, the information under the headings “Executive and Director Compensation” and “Corporate Governance-Compensation Committee Interlocks and Insider Participation” in our definitive proxy statement for the 2012 annual meeting of shareholders.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS
Certain of the information required by this Item 12 will appear in, and is hereby incorporated by referenced from, the information under the heading “Security Ownership of Certain Beneficial Owners and Management” in our definitive proxy statement for the 2012 annual meeting of shareholders.
Equity Compensation Plan Information
The following table set forth certain information as of December 31, 2011 regarding compensation plans under which our equity securities are available for issuance.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
The information required by this Item 13 will appear in, and is hereby incorporated by reference to, the information under the headings “Corporate Governance-Certain Relationships and Related Transactions and -Director Nomination Procedure and Director Independence” in our definitive proxy statement for the 2012 annual meeting of shareholders.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
The information required by this Item 14 will appear in, and is hereby incorporated by reference to, the information under the heading “Proposal 3-Ratification of Appointment of Independent Registered Public Accounting Firm” in our definitive proxy statement for the 2012 annual meeting of shareholders.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) (1) Financial Statements. See Item 8.
(a) (2) Financial Statement Schedule. Not applicable.
(a) (3) Exhibits. See Exhibit Index following the signature pages.
SIGNATURES
In accordance with Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated and on the dates indicated.
COMMUNITY FIRST, INC.
CONSOLIDATED BALANCE SHEETS
December 31
(Dollar amounts in thousands, except per share data)
MANAGEMENT REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
The management of Community First, Inc. (the “Company”) is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended. The Company’s internal control system was designed to provide reasonable assurance to the Company’s management and board of directors regarding the preparation and fair presentation of published financial statements. All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.
The Company’s management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2011. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control-Integrated Framework.
Based on this assessment we believe that, as of December 31, 2011, the Company’s internal control over financial reporting was effective based on those criteria.
This annual report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting because that requirement under Section 404 of the Sarbanes Oxley Act of 2002 was permanently removed for non-accelerated filers pursuant to the provisions of Section 989(G) set forth in the Dodd-Frank Act.
See accompanying notes to consolidated financial statements.
COMMUNITY FIRST, INC.
CONSOLIDATED BALANCE SHEETS
December 31
(Dollar amounts in thousands, except per share data)
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Shareholders
Community First, Inc.
We have audited the accompanying consolidated balance sheets of Community First, Inc. (the “Company”) as of December 31, 2011 and 2010 and the related consolidated statements of operations, changes in shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2011. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform an audit of internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Community First, Inc. as of December 31, 2011 and 2010 and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2011, in conformity with U.S. generally accepted accounting principles.
As discussed in Note 21 of the consolidated financial statements, the Company’s bank subsidiary, Community First Bank & Trust, (‘Bank”) is not in compliance with a regulatory enforcement action issued by its primary federal regulator requiring, among other things, a minimum Tier 1 Leverage capital ratio at the Bank of not less than 8.5%, a minimum Tier 1 capital to risk-weighted assets ratio of not less than 10.0% and a minimum Total capital to risk-weighted assets ratio of not less than 12.0%. The Bank’s Tier 1 Leverage capital ratio was 4.92%, its Tier 1 capital to risk-weighted assets ratio was 7.22% and its Total-capital to risk weighted assets ratio was 8.51% at December 31, 2011. Continued failure to comply with the regulatory enforcement action may result in additional adverse regulatory action. Management’s plans with regards to these matters are also discussed in Note 21 to the consolidated financial statements.
/s/ Crowe Horwath LLP
Brentwood, Tennessee
March 30, 2012
See accompanying notes to consolidated financial statements.
COMMUNITY FIRST, INC.
CONSOLIDATED BALANCE SHEETS
December 31
(Dollar amounts in thousands, except per share data)
See accompanying notes to consolidated financial statements.
COMMUNITY FIRST, INC.
CONSOLIDATED BALANCE SHEETS
December 31
(Dollar amounts in thousands, except per share data)
CONSOLIDATED BALANCE SHEETS
See accompanying notes to consolidated financial statements.
COMMUNITY FIRST, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
Years Ended December 31
(Dollar amounts in thousands, except per share data)
See accompanying notes to consolidated financial statements.
COMMUNITY FIRST, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
Years Ended December 31
(Dollar amounts in thousands, except per share data)
CONSOLIDATED STATEMENTS OF OPERATIONS
See accompanying notes to consolidated financial statements.
COMMUNITY FIRST, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
Years Ended December 31
(Dollar amounts in thousands, except per share data)
CONSOLIDATED STATEMENTS OF OPERATIONS
See accompanying notes to consolidated financial statements.
COMMUNITY FIRST, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
Years Ended December 31
(Dollar amounts in thousands, except per share data)
See accompanying notes to consolidated financial statements.
COMMUNITY FIRST, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
Years Ended December 31
(Dollar amounts in thousands, except per share data)
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
See accompanying notes to consolidated financial statements.
COMMUNITY FIRST, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
Years Ended December 31
(Dollar amounts in thousands, except per share data)
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
See accompanying notes to consolidated financial statements.
COMMUNITY FIRST, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31
(Dollar amounts in thousands, except per share data)
See accompanying notes to consolidated financial statements.
COMMUNITY FIRST, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31
(Dollar amounts in thousands, except per share data)
CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes to consolidated financial statements.
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2011
(Dollar amounts in thousands, except per share data)
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Nature of Operations and Principles of Consolidation: The consolidated financial statements include Community First, Inc. and its wholly-owned subsidiary, Community First Bank & Trust. The Bank’s sole subsidiary is Community First Title, Inc., a Tennessee chartered and regulated title insurance company. CFBT Investments, Inc. is the only subsidiary of Community First Title, Inc. and is the parent of Community First Properties, Inc., which was established as a Real Estate Investment Trust pursuant to Internal Revenue Service regulations. Community First Bank & Trust together with its subsidiaries are referred to as the “Bank”. Community First, Inc., together with the Bank are referred to as the “Company.” Intercompany transactions and balances are eliminated in consolidation.
The Company provides financial services through its offices in Maury, Williamson, Rutherford and Hickman Counties, in Tennessee. Its primary deposit products are checking, savings, and term certificate accounts, and its primary lending products are residential mortgage, commercial, and installment loans. Substantially all loans are secured by specific items of collateral including business assets, consumer assets, and commercial and residential real estate. Commercial loans are expected to be repaid from cash flow from operations of businesses. The significant loan concentrations that exceed 10% of total loans are as follows: commercial real estate loans, 1-4 family residential loans, construction loans, and commercial, financial, and agricultural loans. The customers’ ability to repay their loans is dependent, however, on the real estate and general economic conditions in the Company’s market areas. Other financial instruments, which potentially represent concentrations of credit risk, include deposit accounts in other financial institutions and federal funds sold.
On December 28, 2011, the Bank entered into a Purchase and Assumption Agreement with Southern Community Bank (“Southern Community”), pursuant to which the Bank agreed to sell certain of its loans and deposits of its Murfreesboro, Tennessee branch location to Southern Community. This transaction is expected to close on March 30, 2012. On February 9, 2012, the Bank entered into a Purchase and Assumption Agreement with CapStar Bank (“CapStar”), pursuant to which the Bank agreed to sell certain of its loans and deposits of its Franklin, Tennessee branch location to CapStar Bank. This transaction is expected to close in the second quarter of 2012. Information regarding the pending sale of these branches is discussed in detail below in Note 2.
Use of Estimates: To prepare financial statements in conformity with U.S. generally accepted accounting principles, management makes estimates and assumptions based on available information. These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided, and actual results could differ. The allowance for loan losses, carrying values of other real estate owned, deferred tax assets and related valuation allowance, assumptions for retirement plans, and fair values of financial instruments are particularly subject to change.
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2011
(Dollar amounts in thousands, except per share data)
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Cash Flows: Cash and cash equivalents include cash, demand deposits with other financial institutions, and federal funds sold. Net cash flows are reported for customer loan and deposit transactions, time deposits in other financial institutions, and federal funds purchased and repurchase agreements.
Interest-Earning Time Deposits in Other Financial Institutions: Interest-earning time deposits in other financial institutions mature within one year and are carried at cost.
Securities: Debt securities are classified as available for sale when they might be sold before maturity. Securities available for sale are carried at fair value, with unrealized holding gains and losses reported in other comprehensive income, net of tax.
Interest income includes amortization of purchase premium or discount. Premiums and discounts on securities are amortized on the level-yield method without anticipating prepayments, except for mortgage-backed securities where prepayments are anticipated. Gains and losses on sales are recorded on the trade date and determined using the specific identification method.
Management evaluates securities for other-than-temporary impairment (“OTTI”) on at least a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. For securities in an unrealized loss position, management considers the extent and duration of the unrealized loss, and the financial condition and near-term prospects of the issuer. Management also assesses whether it intends to sell, or it is more likely than not that it will be required to sell, a security in an unrealized loss position before recovery of its amortized cost basis. If either of the criteria regarding intent or requirement to sell is met, the entire difference between amortized cost and fair value is recognized as impairment through earnings. For debt securities that do not meet the aforementioned criteria, the amount of impairment is split into two components as follows: 1) OTTI related to credit loss, which must be recognized in the income statement and 2) OTTI related to other factors, which is recognized in other comprehensive income (loss). The credit loss is defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis.
Loans Held for Sale in secondary market: Loans held for sale in secondary market include mortgage loans originated and intended for sale in the secondary market and carried at fair value. Fair value adjustments, as well as realized gains and loss are recorded in current earnings. Fair value for loans to be sold in the secondary market is determined by outstanding commitments from third party investors and adjusted for certain direct loan origination costs. In the normal course of business, at the time of funding the loan held for sale by the Company, there is a commitment from a third party investor to purchase the loan held for sale. All secondary market mortgage loans are sold servicing released and the service release premium, as well as loan origination fees and discounts on loans sold are recorded in earnings.
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2011
(Dollar amounts in thousands, except per share data)
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Also included in loans held for sale is the guaranteed portion of loans originated with a Small Business Administration (“SBA”) guarantee. SBA guaranteed loans are recorded at contract value. SBA guaranteed loans are generally sold with servicing rights retained.
Loans Held for Sale net of allowance: Loans held for sale net of allowance are loans from the Bank’s existing portfolio that are expected to be sold as part of the sale of the Murfreesboro, Tennessee and Franklin, Tennessee branch sales, which are expected to close in the first and second quarters of 2012, respectively. The loans to be sold as part of the branch sales are reported at net book value, which is the contract value of each respective loan, reduced by the portion of the allowance for loan losses that was attributable to this loan pool.
Loans: Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at the principal balance outstanding, net of purchase discounts and an allowance for loan losses. Interest income is accrued on the unpaid principal balance.
Interest income on loans is discontinued at the time the loan is 90 days delinquent unless the loan is well-secured and in process of collection. Past due status is based on the contractual terms of the loan. In all cases, loans are placed on nonaccrual or charged-off at an earlier date if collection of principal or interest is considered doubtful. Nonaccrual loans and loans past due 90 days still on accrual include both smaller balance homogeneous loans that are collectively evaluated for impairment and individually classified impaired loans. A loan is moved to non-accrual status in accordance with the Company’s policy, typically after 90 days of non-payment.
All interest accrued but not received for loans placed on nonaccrual is reversed against interest income. Interest received on such loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.
Loans originated to facilitate the sale of other real estate owned that exceed a loan balance to collateral value ratio of more than a certain percentage, depending on the loan type, are reclassified as other real estate owned on the balance sheet. When the loan balance to collateral value becomes less than the threshold for that particular loan type, the loans are reported with other loans. Interest income on loans reported in other real estate owned is included in loan interest income.
Concentration of Credit Risk: Most of the Company’s business activity is with customers located within Maury, Williamson, Hickman, and Rutherford Counties of Tennessee. Therefore, the Company’s exposure to credit risk is significantly affected by changes in the economy in those counties.
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2011
(Dollar amounts in thousands, except per share data)
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Allowance for Loan Losses: The allowance for loan losses is a valuation allowance for probable incurred credit losses. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged off.
The allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired.
A loan is impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Loans for which the terms have been modified resulting in a concession, and for which the borrower is experiencing financial difficulties, are considered troubled debt restructurings and classified as impaired.
Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed.
Commercial and commercial real estate loans over $25 are individually evaluated for impairment. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Large groups of smaller balance homogeneous loans, such as consumer and residential real estate loans, are collectively evaluated for impairment, and accordingly, they are not separately identified for impairment disclosures.
Troubled debt restructurings are separately identified for impairment disclosures and are measured at the present value of estimated future cash flows using the loan’s effective rate at inception. If a troubled debt restructuring is considered to be a collateral dependent loan, the loan is reported, net, at the fair value of the collateral. For troubled debt restructurings that subsequently default, the Company determines the amount of reserve in accordance with the accounting policy for the allowance for loan losses.
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2011
(Dollar amounts in thousands, except per share data)
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
The general component covers non-impaired loans and is based on historical loss experience adjusted for current factors. The historical loss experience is determined by portfolio segment and is based on the actual loss history experienced by the Company over the most recent three years. This actual loss experience is supplemented with other economic factors based on the risks present for each portfolio segment. These economic factors include consideration of the following: levels of and trends in delinquencies and impaired loans; levels of and trends in charge-offs and recoveries; trends in volume and terms of loans; effects of any changes in risk selection and underwriting standards; other changes in lending policies, procedures, and practices; experience, ability, and depth of lending management and other relevant staff; national and local economic trends and conditions; industry conditions; and effects of changes in credit concentrations. The following loan portfolio segments have been identified with a discussion of the risk characteristics of these portfolio segments:
Real Estate Construction loans include loans made for both residential and commercial construction and land development. Residential real estate construction loans are loans secured by real estate to build 1-4 family dwellings. These are loans made to borrowers obtaining loans in their personal name for the personal construction of their own dwellings, or loans to builders for the purpose of constructing homes for resale. These loans to builders can be for speculative homes for which there is no specific homeowner for which the home is being built, as well as loans to builders that have a pre-sale contract to another individual. Commercial construction loans are loans extended to borrowers secured by and to build commercial structures such as churches, retail strip centers, industrial warehouses or office buildings. Land development loans are granted to commercial borrowers to finance the improvement of real estate by adding infrastructure so that ensuing construction can take place. Construction and land development loans are generally short term in maturity to match the expected completion of a particular project. These loan types are generally more vulnerable to changes in economic conditions in that they project there will be a demand for the product. They require monitoring to ensure the project is progressing in a timely manner within the expected budgeted amount. This monitoring is accomplished via periodic physical inspections by an outside third party.
1-4 Family Residential loans are both open end and closed end loans secured by first or junior liens on 1-4 family improved residential dwellings. Open end loans are Home Equity Lines of Credit that allow the borrower to use equity in the real estate to borrow and repay as the need arises. First and junior lien residential real estate loans are closed end loans with a specific maturity that generally does not exceed 7 years. Economic conditions can affect the borrower’s ability to repay the loans and the value of the real estate securing the loans can change over the life of the loan.
Commercial Real Estate loans are secured by farmland or by improved commercial property. Farmland includes all land known to be used or usable for agricultural purposes, such as crop and livestock production, grazing, or pasture land. Improved commercial property can be owner occupied or non-owner occupied secured by commercial structures such as churches, retail strip centers, hotels, industrial warehouses or office buildings. The repayment of these loans tends to depend upon the operation and management of a business or lease and therefore adverse economic conditions can affect the ability to repay.
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2011
(Dollar amounts in thousands, except per share data)
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Other Real Estate Secured Loans include those loans secured by five or more multi-family dwelling units. These loans are typically exemplified by apartment buildings or complexes. The ability to manage and rent units affects the income that usually provides repayment for this type of loan.
Commercial, Financial, and Agricultural loans are loans extended for the operation of a business or a farm. They are not secured by real estate. Commercial loans are used to provide working capital, acquire inventory, finance the carrying of receivables, purchase equipment or vehicles, or purchase other capital assets. Agricultural loans are typically for purposes such as planting crops, acquiring livestock, or purchasing farm equipment. The repayment of these loans comes from the cash flow of a business or farm and is generated by sales of inventory or providing of services. The collateral tends to depreciate over time and is difficult to monitor. Frequent statements are required from the borrower pertaining to inventory levels or receivables aging.
Consumer Loans are loans extended to individuals for purposes such as to purchase a vehicle or other consumer goods. These loans are not secured by real estate but are frequently collateralized by the consumer items being acquired with the loan proceeds. This type of collateral tends to depreciate and therefore the term of the loan is tailored to fit the expected value of the collateral as it depreciates, along with specific underwriting policies and guidelines.
Tax exempt loans are loans that are extended to entities such as municipalities. These loans tend to be dependent on the ability of the borrowing entity to continue to collect taxes to repay the indebtedness.
Other Loans are those loans which are not elsewhere classified in these categories and are not secured by real estate.
Other Real Estate Owned: Assets acquired through or instead of loan foreclosure are reported as other real estate owned and initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. If fair value declines subsequent to foreclosure, a valuation allowance is recorded through expense. Operating costs after acquisition are expensed.
Premises and Equipment: Land is carried at cost. Premises and equipment are stated at cost less accumulated depreciation. Buildings and related components are depreciated using the straight-line method with useful lives ranging from 5 to 39 years. Furniture, fixtures and equipment are depreciated using the straight-line method with useful lives ranging from 3 to 7 years. Premises and equipment that have been identified for future sale or other disposal are reported as held for sale at fair value.
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2011
(Dollar amounts in thousands, except per share data)
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Restricted Equity Securities: These securities consist of Federal Home Loan Bank (“FHLB”) stock. The Bank is a member of the FHLB system. Members of the FHLB are required to own a certain amount of stock based on the level of borrowings and other factors, and may invest in additional amounts. These securities are carried at cost, classified as restricted equity securities, and periodically evaluated for impairment based on ultimate recovery of par value. Both cash and stock dividends are reported as income.
Bank Owned Life Insurance: The Bank has purchased life insurance policies on certain key executives. Bank owned life insurance is recorded at the amount that can be realized under the insurance contract at the balance sheet date, which is the cash surrender value adjusted for other charges or other amounts due that are probable at settlement.
Goodwill and Other Intangible Assets: Goodwill resulting from business combinations prior to January 1, 2009 represents the excess of the purchase price over the fair value of the net assets of businesses acquired. Goodwill and intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but tested for impairment at least annually. As a result of the impairment analysis performed for year ended December, 31, 2010, the Company’s recorded goodwill was determined to be fully impaired and is discussed further in Note 6. Intangible assets with definite useful lives are amortized over their estimated useful lives to their estimated residual values. Other intangible assets consist of core deposit and acquired customer relationship intangible assets arising from the Company’s acquisition of the First National Bank of Centerville, in Centerville, Tennessee (“First National”). These assets are initially measured at fair value and then are amortized on an accelerated method over their estimated useful lives, which were determined to be 15 years.
Mortgage Banking Derivatives: Commitments to fund mortgage loans (interest rate locks) to be sold into the secondary market are accounted for as free standing derivatives. Fair values of these mortgage derivatives are estimated based on the anticipated gain from the sale of the underlying loan. Changes in the fair values of these derivatives are included in noninterest income as gain on sale of loans.
Long-Term Assets: Premises and equipment, core deposit and other intangible assets, and other long-term assets are reviewed for impairment when events indicate their carrying amount may not be recoverable from future undiscounted cash flows. If impaired, the assets are recorded at fair value.
Loan Commitments and Related Financial Instruments: Financial instruments include off-balance sheet credit instruments, such as commitments to make loans and standby letters of credit, issued to meet customer financing needs. The face amount for these items represents the exposure to loss, before considering customer collateral or ability to repay. Such financial instruments are recorded when they are funded.
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2011
(Dollar amounts in thousands, except per share data)
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Stock-Based Compensation: Compensation cost is recognized for stock options and restricted stock awards issued to employees, based on the fair value of these awards at the date of grant. A Black-Scholes model is utilized to estimate the fair value of stock options, while the market price of the Company’s common stock at the date of grant is used for restricted stock awards. Compensation cost is recognized over the required service period, generally defined as the vesting period.
Income Taxes: Income tax expense is the total of the current year income tax due or refundable and the change in deferred tax assets and liabilities. Deferred tax assets and liabilities are the expected future tax amounts for the temporary differences between carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized.
A tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded. The Company recognizes interest and/or penalties related to income tax matters in income tax expense.
Retirement Plans: Supplemental employee retirement plan (“SERP”) expense is the net of service and interest cost. Employee 401(k) and profit sharing plan expense is the amount of matching contributions. The Company has matched 100% of the first 3% and 50% of the next 2% the employee contributes to their 401(k) annually.
Employee Stock Purchase Plan: During 2008, the Company approved the Community First, Inc. Employee Stock Purchase Plan (the “Plan”). Under the Plan, eligible employees may elect for the Company to withhold a portion of their periodic compensation and purchase common shares of the Company at a purchase price equal to 95% of the closing market price of the shares of common stock on the last day of the three-month trading period. Expenses for the plan consist of administrative fees from the Company’s transfer agent and are immaterial.
Earnings (loss) per Common Share: Basic earnings (loss) per common share is net income (loss) divided by the weighted average number of common shares outstanding during the period. Diluted earnings per common share includes the dilutive effect of additional potential common shares issuable under stock options. Earnings and dividends per share are restated for all stock splits and stock dividends through the date of issuance of the financial statements.
Comprehensive Income (Loss): Comprehensive income (loss) consists of net income (loss) and other comprehensive income (loss). Other comprehensive income (loss) includes unrealized gains and losses on securities available for sale, which are also recognized as a separate component of equity.
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2011
(Dollar amounts in thousands, except per share data)
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Loss Contingencies: Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. Management does not believe there now are such matters that will have a material effect on the financial statements.
Restrictions on Cash: Cash on hand or on deposit with the Federal Reserve Bank was required to meet regulatory reserve and clearing requirements.
Stock Dividends: A stock dividend of $0.10 per share, which resulted in 15,722 shares or 0.5% of outstanding shares was issued in the second quarter of 2009. All references to common shares and earnings and dividends per share have been restated to reflect the stock dividend as of the beginning of the earliest period presented.
Dividend Restriction: The Company’s primary source of funds to pay dividends to shareholders is the dividends it receives from the Bank. Applicable state laws and the regulations of the Federal Reserve Bank and the Federal Deposit Insurance Corporation regulate the payment of dividends. Under the state regulations, the amount of dividends that may be paid by the Bank to the Company without prior approval of the Commissioner of the Tennessee Department of Financial Institutions is limited in any one year to an amount equal to the net income in the calendar year of declaration plus retained net income for the preceding two years; however, future dividends will be dependent on the level of earnings, capital and liquidity requirements and considerations of the Bank and Company. Currently, the Bank is prohibited from declaring dividends without prior approval from its regulators, as is discussed further in Note 21.
Fair Value of Financial Instruments: Fair value of financial instruments is estimated using relevant market information and other assumptions, as more fully disclosed in Note 8. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments, and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect the estimates.
Operating Segments: While the chief decision-makers monitor the revenue streams of the various products and services, operations are managed and financial performance is evaluated on a Company-wide basis. Operating segments are aggregated into one as operating results for all segments are similar. Accordingly, all of the financial service operations are considered by management to be aggregated in one reportable operating segment.
Reclassifications: Some items in the prior year financial statements were reclassified to conform to the current presentation. These reclassifications did not impact results of operations or shareholders equity.
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2011
(Dollar amounts in thousands, except per share data)
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Adoption of New Accounting Standards:
FASB ASU 2011-2 Troubled Debt Restructurings. In April 2011, the FASB amended existing guidance and clarified when creditors such as banks should classify loan modifications as troubled debt restructurings. Banks will now need to consider all available evidence when evaluating whether a loan modification is a troubled debt restructuring. This new guidance could result in more loan modifications being classified as troubled debt restructurings, which could affect the allowance for loan losses and increase disclosures. This new guidance for identifying and disclosing troubled debt restructurings is effective for interim and annual periods beginning on or after June 15, 2011 and applies retrospectively to troubled debt restructurings occurring after the beginning of the year. See Note 4 to these Consolidated Financial Statements for the required disclosures at December 31, 2011. Adoption of this standard did not have a material effect on the Company’s operating results or financial condition.
Accounting Standards Newly Issued Not Yet Effective
In June 2011, the FASB issued ASU No. 2011-05, “Comprehensive Income (Topic 220) - Presentation of Comprehensive Income.” The ASU requires entities to present items of net income and other comprehensive income either in one continuous statement - referred to as the statement of comprehensive income - or in two separate, but consecutive, statements of net income and other comprehensive income. The ASU is effective for the first interim period beginning after December 15, 2011. The adoption of this guidance is not expected to have a material impact on the Company’s financial statements.
In May, 2011, the FASB issued ASU No. 2011-04, “Fair Value Measurement (Topic 820) - Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.” This ASU represents the converged guidance of the FASB and the IASB (the Boards) on fair value measurement. The collective efforts of the Boards and their staffs, reflected in ASU 2011-04, have resulted in common requirements for measuring fair value and for disclosing information about fair value measurements, including a consistent meaning of the term “fair value.” The Boards have concluded the common requirements will result in greater comparability of fair value measurements presented and disclosed in financial statements prepared in accordance with U.S. GAAP and IFRSs. Included in the ASU are requirements to disclose additional quantitative disclosures about unobservable inputs for all Level 3 fair value measurements, as well as qualitative disclosures about the sensitivity inherent in recurring Level 3 fair value measurements. The ASU is effective during the interim and annual periods beginning after December 15, 2011. The adoption of this ASU is not expected to have a material impact on the Company’s financial statements.
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2011
(Dollar amounts in thousands, except per share data)
NOTE 2 - BRANCH DIVESTITURES
In an effort to comply with the capital requirements set forth in the Consent Order, described in Note 21, the Bank decided to sell two of its branches that are located on the outer limits of its geographic footprint and return focus to the Bank’s core markets. The branch sales will improve the Bank’s capital ratios and concentration levels, both of which are specific requirements of the Consent Order.
The following paragraphs outline certain of the terms of the branch divestitures.
On December 28, 2011, the Bank and Southern Community entered into a Purchase and Assumption Agreement, which provides for the sale of certain assets and the transfer of certain liabilities relative to the Bank’s Murfreesboro, Tennessee branch location (the “Murfreesboro Branch”). Under the terms of the Purchase and Assumption Agreement, Southern Community will purchase certain assets of the Murfreesboro Branch, including approximately $7.9 million in loans and the fixtures and equipment associated with the Murfreesboro Branch. Southern Community will also assume substantially all of the deposit liabilities associated with the Murfreesboro Branch (which totaled approximately $32.9 million as of December 31, 2011) and is expected to assume the Bank’s lease on the Murfreesboro Branch location. The Bank is retaining approximately $6.7 million in loans related to the Murfreesboro Branch. The loans and fixtures and equipment being sold to Southern Community are being sold at the Bank’s book value. Southern Community will pay a premium of 4% on the deposit liabilities assumed. To the extent that the liabilities assumed by Southern Community exceed the value of the assets purchased by Southern Community plus the amount of the deposit premium, the Bank will make a cash payment to Southern Community equal to such difference.
All of the required regulatory approvals for the transaction with Southern Community have been received. The transaction is expected to close on or about March 30, 2012, however it is possible that administrative logistical issues could delay the actual closing date.
On February 9, 2012, the Bank and Capstar entered into a Purchase and Assumption Agreement , which provides for the sale of certain assets and the transfer of certain liabilities relative to the Bank’s branch office located at 9045 Carothers Parkway, Franklin, Tennessee 37067 (the “Cool Springs Branch”). Under the terms of the Purchase and Assumption Agreement, Capstar will purchase certain assets of the Cool Springs Branch, including the real property on which the Cool Springs Branch is located (the “Cool Springs Real Property”), the leases associated with the Cool Springs Real Property, approximately $46.37 million in loans (subject to adjustment between February 9, 2012, and the closing date) and the fixtures and equipment which are associated with the Cool Springs Branch. Capstar will also assume certain liabilities, including substantially all of the deposit liabilities associated with the Cool Springs Branch (which totaled approximately $59.8 million as of December 31, 2011). The purchase price for the assets purchased by Capstar other than the Real Property will be the Bank’s net book value for such assets. The Real Property, however, will be sold at fair market value as determined by a mutually agreed upon independent real estate appraiser. Capstar will pay a premium of 4% on the deposit liabilities assumed. To the extent that the liabilities assumed by Capstar exceed the value of the assets purchased by Capstar plus the amount of the deposit premium, the Bank will make a cash payment to Capstar equal to such difference.
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2011
(Dollar amounts in thousands, except per share data)
NOTE 2 - BRANCH DIVESTITURES (Continued)
The transaction with Capstar is subject to receipt of required regulatory approvals and the satisfaction of other customary closing conditions, and is expected to be completed in the second quarter of 2012.
The Company does not currently have plans to sell any additional branches other than the two discussed above.
NOTE 3 - SECURITIES AVAILABLE FOR SALE
The following table summarizes the amortized cost and fair value of the available for sale securities portfolio at December 31, 2011 and 2010 and the corresponding amounts of gross unrealized gains and losses recognized in accumulated other comprehensive income (loss):
The proceeds from sales of securities and the associated gains and losses for the three most recently completed fiscal years are listed below:
Tax provision related to the net realized gains for 2011, 2010 and 2009 was $0, $0, and $435, respectively.
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2011
(Dollar amounts in thousands, except per share data)
NOTE 3 - SECURITIES AVAILABLE FOR SALE (Continued)
The amortized cost and fair value of the investment securities portfolio are shown by contractual maturity. Expected maturities may differ from contractual maturities if borrowers have the right to call or prepay obligations with or without call or prepayment penalties. Securities not due at a single maturity are shown separately.
Securities pledged at year-end 2011 and 2010 had a carrying amount of $48,408 and $43,279 and were pledged to secure public deposits and repurchase agreements.
At year end 2011, the Company held securities issued by the following entities for which the aggregate face amount of investments is greater than 10% of shareholders’ equity as of December 31, 2011:
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2011
(Dollar amounts in thousands, except per share data)
NOTE 3 - SECURITIES AVAILABLE FOR SALE (Continued)
At year end 2010, the Company held securities issued by the following entities for which the aggregate face amount of investments is greater than 10% of shareholders’ equity as of December 31, 2010:
Other than the above investments, the Company did not hold securities of any one issuer, other than U.S. Government sponsored entities, with a face amount greater than 10% of shareholders’ equity as of December 31, 2011 or 2010.
The following table summarizes the investment securities with unrealized losses at December 31, 2011 and 2010 aggregated by major security type and length of time in a continuous unrealized loss position:
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2011
(Dollar amounts in thousands, except per share data)
NOTE 3 - SECURITIES AVAILABLE FOR SALE (Continued)
As of December 31, 2011, the Company’s security portfolio consisted of 93 securities, 6 of which were in an unrealized loss position. Unrealized losses on U.S. Government Sponsored Entities and State and Municipal bonds have not been recognized into income because the issuer(s) bonds are of high credit quality, management does not intend to sell and it is likely that management will not be required to sell the securities prior to their anticipated recovery, and the decline in fair value is largely due to changes in interest rates. The fair value is expected to recover as the bond(s) approach maturity.
In the third quarter of 2011, the Company experienced losses of $5,000 related to impairment of a trust preferred security held by the Bank and issued by Tennessee Commerce Statutory Trust, an affiliate of Tennessee Commerce Bancorp, Inc. On January 27, 2012, Tennessee Commerce Bancorp, Inc.’s bank subsidiary, Tennessee Commerce Bank, was placed into receivership by the Tennessee Department of Financial Institutions after Tennessee Commerce Bank’s capital deteriorated significantly in the third quarter of 2011. The Company does not anticipate that it will recover any of the Bank’s investment in the trust preferred security. As a result, the Company recorded an impairment charge of $5,000 during the third quarter of 2011, which represents the Company’s full investment in the trust preferred securities.
The Company’s remaining corporate securities are issued by bank holding companies with subsidiary banks that are well capitalized as of December 31, 2011. The Company has considered the capital position and liquidity of the issuers, as well as the existence and severity of any regulatory agreements to which the issuer or its affiliated financial institution is subject. The issuers are not in default, have not elected to defer contractual interest obligations, and appear to have the ability to continue to service the contractual obligations. The decline in fair value is primarily attributable to illiquidity and the financial crisis affecting these markets and not necessarily the expected cash flows of the individual securities. Due to the illiquidity in the market, it is unlikely that the Company would be able to recover its investment in these securities if the Company sold the securities at this time. Management’s analysis concluded that the securities have not had an adverse change in expected cash flows and that the
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2011
(Dollar amounts in thousands, except per share data)
NOTE 3 - SECURITIES AVAILABLE FOR SALE (Continued)
Company does not intend to sell the securities, and it is likely that the Company will not be required to sell the securities prior to their anticipated recovery, therefore the Company does not consider these securities to be other-than-temporarily impaired at December 31, 2011.
The table below presents a rollforward for the years ended December 31, 2011 and 2010 of the credit losses recognized in earnings:
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2011
(Dollar amounts in thousands, except per share data)
NOTE 4 - LOANS
Loans outstanding by category at December 31, 2011 and 2010 were as follows:
Residential mortgage loans intended to be sold to secondary market investors that were not subsequently sold totaled $203 in 2011 and $651 in 2010. As a result, the Bank transferred these loans at fair value to the Bank’s regular loan portfolio. The fair value adjustment resulted in a loss of $11 and $22 in 2011 and 2010, respectively. The principal balance and carrying value of loans reclassified from held for sale to portfolio loans was $2,070 and $2,021 at December 31, 2011.
Changes in the allowance for loan losses were as follows:
Loans that are expected to be sold as part of the branch sales discussed in Note 2 are reported in loans held for sale, net of allowance of $1,084.
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2011
(Dollar amounts in thousands, except per share data)
NOTE 4 - LOANS (Continued)
The following tables present activity in allowance for loan losses and the outstanding loan balance by portfolio segment and based on impairment method as of December 31, 2011. The balances for “recorded investment” in the following tables related to credit quality do not include approximately $1,520 and $2,035 in accrued interest receivable at December 31, 2011 and 2010, respectively. Accrued interest receivable is a component of the Company’s recorded investment in loans.
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2011
(Dollar amounts in thousands, except per share data)
NOTE 4 - LOANS (Continued)
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2010
(Dollar amounts in thousands, except per share data)
NOTE 4 - LOANS (Continued)
Loans individually evaluated for impairment by class of loans at December 31, 2011:
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2010
(Dollar amounts in thousands, except per share data)
NOTE 4 - LOANS (Continued)
Loans individually evaluated for impairment by class of loans at December 31, 2010:
The average recorded investment in impaired loans was $37,519 during 2010. Interest income of $1,117 and cash basis interest income of $1,125 was recognized during 2010.
Troubled Debt Restructurings
The Company has $12,781 of loans with allocated specific reserves of $2,421 to customers whose loan terms have been modified in troubled debt restructurings as of December 31, 2011 compared to $20,235 with allocated specific reserves of $3,261 at December 31, 2010. The Company lost $299 and $198, respectively, of interest income in 2011 and 2010 that would have been recorded in interest income if the specific loans had not been restructured. The Bank had commitments to lend up to $295 and $388 of additional funds to loans classified as troubled debt restructurings at December 31, 2011 and December 31, 2010, respectively.
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2010
(Dollar amounts in thousands, except per share data)
NOTE 4 - LOANS (Continued)
During 2011, the terms of certain loans were modified as troubled debt restructurings. The modification of the terms of such loans included one or a combination of the following: a reduction of the stated interest rate of the loan; or an extension of the maturity date at a stated rate of interest lower than the current market rate for new debt with similar risk.
Modifications involving a reduction of the stated interest rate and extension of the maturity date of the loan were for periods ranging from six months to two years.
The following table presents loans by class modified as troubled debt restructurings that occurred during 2011:
Troubled debt restructurings described above had an outstanding balance of $6,103 at December 31, 2011 and increased the allowance for loan losses by $2,023 and $2,540 in 2011 and 2010, respectively. Troubled debt restructurings still accruing interest totaled $958 and $16,558 at December 31, 2011 and 2010, respectively.
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2010
(Dollar amounts in thousands, except per share data)
NOTE 4 - LOANS (Continued)
The following table presents loans by class modified as troubled debt restructurings for which there was a payment default within twelve months following the modification during 2011.
A loan is considered to be in payment default once it is more than 90 days contractually past due under the modified terms. Troubled debt restructurings that subsequently defaulted described above increased the allowance for loan losses by $848 and resulted in charge-offs of $2,747 during 2011.
In order to determine whether a borrower is experiencing financial difficulty, an evaluation is performed of the probability that the borrower will be in payment default on any of its debt in the foreseeable future without modification. This evaluation is performed under the Company’s internal loan policy.
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2010
(Dollar amounts in thousands, except per share data)
NOTE 4 - LOANS (Continued)
Nonperforming loans include both smaller balance homogeneous loans that are collectively evaluated for impairment and individually classified impaired loans. The following table presents the recorded investment in nonaccrual and loans past due over 90 days still on accrual by class of loans as of December 31, 2011 and 2010:
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2010
(Dollar amounts in thousands, except per share data)
NOTE 4 - LOANS (Continued)
The following table presents the aging of the recorded investment in past due loans, including nonaccrual loans as of December 31, 2011 and 2010 by class of loans:
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2010
(Dollar amounts in thousands, except per share data)
NOTE 4 - LOANS (Continued)
Credit Quality Indicators:
The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. The Company analyzes loans individually by classifying the loans as to credit risk. The Company assigns an initial credit risk rating on every loan. All loan relationships with aggregate debt greater than $250 are reviewed at least annually, or more frequently if performance of the loan or other factors warrant review. Smaller balance loans are reviewed and evaluated based on changes in loan performance, such as becoming past due or upon notifying the Bank of a change in the borrower’s financial status. This analysis is performed on a monthly basis. The Company uses the following definitions for risk ratings:
Watch. Loans characterized by borrowers who have marginal cash flow, marginal profitability, or have experienced operating losses and declining financial condition. The borrower has satisfactorily handled debts with the Bank in the past, but in recent months has either been late, delinquent in making payments, or made sporadic payments. While the Bank continues to be adequately secured, the borrower’s margins have decreased or are decreasing, despite the borrower’s continued satisfactory condition. Other characteristics of borrowers in this class include inadequate credit information, weakness of financial statement and repayment capacity, but with collateral that appears to limit the Bank’s exposure. This classification includes loans to establish borrowers that are reasonably margined by collateral, but where potential for improvement in financial capacity is limited.
Special Mention. Loans with potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deteriorating prospects for the repayment source or in the Bank’s credit position in the future.
Substandard. Loans inadequately protected by the payment capacity of the borrower or the pledged collateral.
Doubtful. Loans with the same characteristics as substandard loans with the added characteristic that the weaknesses make collection or liquidation in full highly questionable and improbable on the basis of currently existing facts, conditions, and values. These are poor quality loans in which neither the collateral nor the financial condition of the borrower presently ensure collectability in full in a reasonable period of time or evidence of permanent impairment in the collateral securing the loan.
Impaired loans are evaluated separately from other loans in the Bank’s portfolio. Credit quality information related to impaired loans was presented above and is excluded from the tables below.
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2010
(Dollar amounts in thousands, except per share data)
NOTE 4 - LOANS (Continued)
Loans not meeting the criteria above that are analyzed individually as part of the above described process are considered to be pass rated loans. As of December 31, 2011 and 2010, and based on the most recent analysis performed, the risk categories of loans by class of loans are as follows:
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2010
(Dollar amounts in thousands, except per share data)
NOTE 5 - PREMISES AND EQUIPMENT
Premises and equipment at December 31, 2011 and 2010 were as follows:
Premises and equipment that are to be sold as part of the branch sales discussed in Note 2 are reported as premises and equipment held for sale. Premises and equipment held for sale are reported at book value. Premises and equipment held for sale consists of assets that are to be sold as part of the branch divestitures discussed in Note 2. Premises and equipment held for sale at December 31, 2011 and 2010 were as follows:
Depreciation expense for the years ended 2011, 2010, and 2009 was $1,067, $1,221, and $1,306, respectively.
The Bank leases certain branch properties and equipment under operating leases. Rent expense for 2011, 2010, and 2009 was $368, $373, and $390, respectively. Rent commitments under noncancelable operating leases including renewal options were as follows:
The Bank leases the branch property for our Murfreesboro Branch. The term of this lease is set to end on September 30, 2012; however, the lease is expected to be assumed by Southern Community upon completion of the sale of the Murfreesboro Branch. The branch sale transaction is expected to close on March 30, 2012. The rent commitment schedule above assumes that we are obligated on the Murfreesboro lease until March 30, 2012.
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2010
(Dollar amounts in thousands, except per share data)
NOTE 6 - INTANGIBLE ASSETS
Acquired intangible assets resulting from the Company’s acquisition of First National in 2007 were as follows at December 31, 2011 and 2010:
Amortization expense of $239, $275 and $318 were recognized in 2011, 2010 and 2009, respectively.
Estimated amortization expense for each of the next five years is as follows:
NOTE 7 - OTHER REAL ESTATE OWNED
The carrying amount of other real estate owned is comprised of foreclosed properties, loans made to facilitate the sale of other real estate owned, and a parcel of land purchased by the Bank for construction of a new branch facility that is now held for disposal. Foreclosed properties totaled $24,896 offset by a valuation allowance of $3,403, and $14,294 offset by a valuation allowance of $3,070 at December 31, 2011 and 2010 respectively. Loans made to facilitate the sale of other real estate owned totaled $78 and $83 at December 31, 2011 and 2010 respectively. Bank properties held for disposal were $484 at December 31, 2011 and 2010.
Expenses related to foreclosed assets include:
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2010
(Dollar amounts in thousands, except per share data)
NOTE 7 - OTHER REAL ESTATE OWNED (Continued)
Activity in the valuation allowance was as follows:
NOTE 8 - FAIR VALUE
Fair value is the exchange price that would be received for an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. There are three levels of inputs that may be used to measure fair values:
Level 1 - Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.
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 company’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.
The Company used the following methods and significant assumptions to estimate the fair value of each type of financial instrument:
Securities: The fair values for securities are determined by quoted market prices, if available (Level 1). For securities where quoted prices are not available, fair values are calculated based on matrix pricing which is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities’ relationship to other benchmark quoted securities (Level 2). For securities where quoted prices or market prices of similar securities are not available, fair values are calculated using discounted cash flows or other market indicators (Level 3). Discounted cash flows are calculated using estimates of current market rates for each type of security. During times when trading is more liquid, broker quotes are used (if available) to validate the model. Rating agency and industry research reports as well as defaults and deferrals on individual securities are reviewed and incorporated into the calculations.
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2010
(Dollar amounts in thousands, except per share data)
NOTE 8 - FAIR VALUE (Continued)
Impaired Loans: The fair value of collateral dependent impaired loans with specific allocations of the allowance for loan losses is generally based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.
Other Real Estate Owned: Nonrecurring adjustments to certain commercial and residential real estate properties classified as other real estate owned are measured at the lower of carrying amount or fair value, less costs to sell. Fair values are generally based on third party appraisals of the property, resulting in a Level 3 classification. In cases where the carrying amount exceeds the fair value, less costs to sell, an impairment loss is recognized.
Mortgage Banking Derivatives: Commitments to fund mortgage loans (interest rate locks) to be sold into the secondary market are accounted for as free standing derivatives. Fair values of these mortgage derivatives are estimated based on the anticipated gain from the sale of the underlying loan. Changes in the fair values of these derivatives are included in noninterest income as gain on sale of loans.
Loans Held For Sale in secondary market: Loans held for sale are carried at fair value, as determined by outstanding commitments, from third party investors (Level 2 inputs).
Assets and Liabilities Measured on a Recurring Basis
Assets and liabilities measured at fair value on a recurring basis are summarized below:
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2010
(Dollar amounts in thousands, except per share data)
NOTE 8 - FAIR VALUE (Continued)
Loans held for sale, at fair value had a carrying amount of $5,274 and $4,282 at December 31, 2011 and 2010, respectively. The carrying amount includes an adjustment to fair value resulting in additional income of $0 and $68 at December 31, 2011 and 2010, respectively.
The table below presents a reconciliation of all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the period ended December 31, 2011 and 2010:
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2010
(Dollar amounts in thousands, except per share data)
NOTE 8 - FAIR VALUE (Continued)
The fair value for eleven state and municipal securities with a fair value of $4,427 as of December 31, 2011 were transferred out of Level 2 and into Level 3 because of a lack of observable market data for these investments due to a decrease in the market activity for these securities. The Company’s policy is to recognize transfers as of the end of the reporting period. As a result, the fair value for these state and municipal securities was transferred on December 31, 2011.
Assets and Liabilities Measured on a Non-recurring Basis
Assets and liabilities measured at fair value on a non-recurring basis are summarized below:
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2010
(Dollar amounts in thousands, except per share data)
NOTE 8 - FAIR VALUE (Continued)
Impaired loans with specific allocations, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had, at December 31, 2011, a principal balance of $29,490 with a valuation allowance of $8,119 resulting in an additional provision for loan losses of $5,203 for the year ended December 31, 2011. At December 31, 2010, impaired loans with specific allocations had a principal balance of $35,860, with a valuation allowance of $6,485 resulting in an additional provision for loan losses of $9,129 for the year ended December 31, 2010.
Other real estate owned, measured at the lower of carrying or fair value less costs to sell, had a net carrying amount of $21,493, which is made up of the outstanding balance of $24,896, net of a valuation allowance of $3,403 at December 31, 2011, resulting in a write-down of $1,578 charged to expense in the year ended December 31, 2011. Net carrying amount was $11,224 at December 31, 2010, which was made up of the outstanding balance of $14,294, net of a valuation allowance of $3,070, resulting in a write-down of $2,318 charged to expense during 2010.
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2010
(Dollar amounts in thousands, except per share data)
NOTE 8 - FAIR VALUE (Continued)
Carrying amount and estimated fair values of significant financial instruments at December 31, 2011 and 2010 were as follows:
The methods and assumptions, not previously presented, used to estimate fair value are described as follows:
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 or deposits that reprice frequently and fully. It was not practicable to determine the fair value of restricted equity securities due to restrictions placed on their transferability. For fixed rate loans or deposits and for variable rate loans or deposits with infrequent repricing or repricing limits, fair value is based on discounted cash flows using current market rates applied to the estimated life and credit risk. For loans held for sale net of allowance of $1,084, fair value is based on the pending sales contract which sets the purchase price at par. Fair value of debt is based on current rates for similar financing. The fair value of off-balance-sheet items is not considered material.
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2010
(Dollar amounts in thousands, except per share data)
NOTE 9 - DEPOSITS
Deposits at December 31, 2011 and 2010, are summarized as follows:
Deposits classified as held for sale are those that are expected to be sold as part of the branch sales discussed in Note 2.
At December 31, 2011, scheduled maturities of time deposits, excluding time deposits held for sale, are as follows:
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2010
(Dollar amounts in thousands, except per share data)
NOTE 9 - DEPOSITS (Continued)
Included in other time deposits above are brokered time deposits of $25,124 with a weighted rate of 1.49% at December 31, 2011 and $32,615 at December 31, 2010, with a weighted rate of 1.45%. These deposits represent funds which the Bank obtained, directly, or indirectly, through a deposit broker. A deposit broker places deposits from third parties with insured depository institutions or places deposits with an institution for the purpose of selling interest in those deposits to third parties. As of December 31, 2011, the Bank has $9,648 of brokered deposits that are scheduled to mature in 2012, $7,059 in 2013 and $8,417 in 2015. As a result of entering into the Consent Order, described in Note 20, the Bank is required to obtain approval from the FDIC prior to accepting, rolling over, or renewing brokered deposits. The Bank does not expect to seek any of the required consents and therefore anticipates that these deposits will not be replaced at maturity.
In addition, the Bank has $57,071 in national market deposits which are purchased by customers through a third-party internet site at December 31, 2011 compared to $67,441 at December 31, 2010. Of these national market time deposits, $37,954 are scheduled to mature in 2012, $15,752 in 2013 and $3,365 in 2014.
NOTE 10 - FEDERAL HOME LOAN BANK ADVANCES
The Bank has established a line of credit with the Federal Home Loan Bank of Cincinnati (“FHLB”), which is secured by a blanket pledge of 1-4 family residential mortgage loans, commercial real estate loans and open end home equity loans. The extent of the line is dependent, in part, on available collateral. The arrangement is structured so that the carrying value of the loans pledged amounts to 125% on residential 1-4 family loans, 300% on commercial real estate, and 400% of open end home equity loans of the principal balance of the advances from the FHLB.
To participate in this program, the Bank is required to be a member of the FHLB and own stock in the FHLB. The Bank held $1,727 of such stock at December 31, 2011 and 2010, to satisfy this requirement.
At December 31, 2011 and 2010, fixed rate advances from the FHLB totaled $16,000. The fixed interest rates on these advances range from 1.91% to 2.71% at December 31, 2011 and December 31, 2010, respectively. The weighted average rate at December 31, 2011 and 2010 was 2.34%. The FHLB advance maturities ranged from June 2012 to May 2013 at December 31, 2011. Each FHLB advance is payable at its maturity, and subject to an early prepayment penalty. At December 31, 2011 and 2010, undrawn standby letters of credit with the FHLB totaled $9,000.
The standby letters of credit will mature in May 2012. The letters of credit are used as a pledge to the State of Tennessee Bank Collateral Pool. Qualifying loans totaling $48,725 were pledged as security under a blanket pledge agreement with the FHLB at December 31, 2011. The Bank is eligible to borrow up to an additional $8,291 as of December 31, 2011.
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2010
(Dollar amounts in thousands, except per share data)
NOTE 10 - FEDERAL HOME LOAN BANK ADVANCES (Continued)
Maturities of the advances from the FHLB are as follows:
The Company also has a cash management line of credit with the FHLB totaling $10,000 that will mature September 2012. At December 31, 2011 and 2010, $0 was drawn on the line. The interest rate on the line varies daily based on the federal funds rate. The rate for the line of credit was 0.14% at December 31, 2011.
NOTE 11 - SUBORDINATED DEBENTURES
In 2002, the Company issued $3,000 of floating rate manditorily redeemable subordinated debentures through a special purpose entity as part of a private offering of trust preferred securities. The securities mature on December 31, 2032; however, the Company can currently repay the securities at any time without penalty, subject to approval from the Federal Reserve Bank. The interest rate on the subordinated debentures as of December 31, 2011 was 3.75%. The subordinated debentures bear interest at a floating rate equal to the New York Prime rate plus 50 basis points. The Company has the right from time to time, without causing an event of default, to defer payments of interest on the debentures for up to 20 consecutive quarterly periods. These debentures are presented in liabilities on the balance sheet and count as Tier 1 capital for regulatory capital purposes. Debt issuance costs of $74 have been capitalized and are being amortized over the term of the securities. Principal officers, directors, and their affiliates at year end 2011 and 2010 owned $700 of the $3,000 subordinated debentures. The proceeds from this offering were utilized to increase the Bank’s capital by $3,000.
In 2005, the Company issued $5,000 of floating rate manditorily redeemable subordinated debentures through a special purpose entity as part of a pool offering of trust preferred securities. These securities mature on September 15, 2035, however, the Company can currently repay the securities at any time without penalty, subject to approval from the Federal Reserve Bank. The interest rate on the subordinated debentures as of December 31, 2011 was 2.05%. The subordinated debentures bear interest at a floating rate equal to the 3-Month LIBOR plus 1.50%. The Company has the right from time to time, without causing an event of default, to defer payments of interest on the debentures for up to 20 consecutive quarterly periods. These debentures are presented in liabilities on the balance sheet and count as Tier 1 capital for regulatory purposes. There was no debt issuance cost in obtaining the subordinated debentures. The proceeds from the pooled offering were used to increase the Bank’s capital.
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2010
(Dollar amounts in thousands, except per share data)
NOTE 11 - SUBORDINATED DEBENTURES (Continued)
In 2007, the Company issued $15,000 of redeemable subordinated debentures through a special purpose entity as part of a pooled offering of trust preferred securities. These subordinated debentures mature in 2037, however, the maturity may be shortened to a date not earlier than December 15, 2012. The interest rate on the subordinated debentures is 7.96% until December 15, 2012, and thereafter the subordinated debentures bear interest at a floating rate equal to the 3-month LIBOR plus 3.0%. The Company has the right from time to time, without causing an event of default, to defer payments of interest on the debentures for up to 20 consecutive quarterly periods. These debentures are presented in liabilities on the balance sheet and $1,900 count as Tier 1 capital and the remaining $3,295 is considered as Tier 2 capital for regulatory purposes. There was no debt issuance cost in obtaining the subordinated debentures. The proceeds were used to help fund the acquisition of First National.
The portion of the subordinated debentures qualifying as Tier 1 capital will not change for existing debentures under the Dodd-Frank Act. The portion of the subordinated debentures qualifying as Tier 1 capital is limited to 25% of total Tier 1 capital. Subordinated debentures in excess of the Tier 1 capital limitation generally qualify as Tier 2 capital.
Interest on the subordinated debentures is payable quarterly, and the Company has adopted a board resolution at the request of the Federal Reserve Bank of Atlanta (the “FRB”) that it will not pay interest on the subordinated debentures or dividends on its common or preferred stock without the prior consent of the FRB. On January 27, 2011, the FRB denied the Company’s request to make the March 15, 2011 quarterly interest payment due on the Company’s subordinated debentures that mature in 2012, and the Company has been unable to pay interest on those subordinated debentures or any of its other subordinated debentures since that date. Under the terms of indentures pursuant to which the debentures were issued, if the Company defers payment of interest on the debentures it may not, during such a deferral period, pay dividends on its common stock or preferred stock or interest on any of the other subordinated debentures issued by the Company. Accordingly, the Company does not expect to be able to pay interest on its other subordinated debentures or dividends on its common stock or preferred stock until such time as it is able to secure the approval of the FRB. Furthermore, the indentures pursuant to which the debentures issued in 2005 and 2007 were issued provided that the Company’s subsidiaries are similarly prohibited from paying dividends on the subsidiaries’ common and preferred stock not held by the Company or its subsidiaries. The Company’s subsidiary Community First Properties, Inc.’s 125 shares of preferred stock issued and outstanding totaling $125 in liquidation value are held by 125 unaffiliated shareholders. Dividends totaling approximately $16 are payable on these shares annually in two equal installments. Community First Properties, Inc. paid the dividends owed to the preferred stockholders on June 30, 2011 in violation of the terms of the indentures pursuant to which the subordinated debentures were issued in 2005 and 2007 and as a result it has breached its obligations under the terms of those indentures. As a result, the holders of the related trust preferred securities, following notice and the lapse of 60 or 90 days, could seek a judicial determination that the Company must cure the covenant breach. The cure would most likely require the Company to seek the contribution of approximately $8 of capital to Community First, Inc. Community First Properties, Inc. deferred the payment of its preferred dividend
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2010
(Dollar amounts in thousands, except per share data)
NOTE 11 - SUBORDINATED DEBENTURES (Continued)
payment due on December 31, 2011, as permitted under the terms of the documents governing the terms of those shares of preferred stock. Community First Properties, Inc. will not be able to resume dividend payments on its preferred stock or common stock until the Company has resumed the payment of interest on the subordinated debentures issued in 2005 and 2007 and paid in full all unpaid dividends thereon. In the event the Company is unable to pay interest on the subordinated debentures it has issued for twenty (20) consecutive quarters, the holders of the related trust preferred securities would be able to claim an event of default under the indentures and all amounts then owed on the debentures would be immediately due and payable.
The Company is not considered the primary beneficiary of the Trusts (variable interest entity), therefore the trusts are not consolidated in the Company’s financial statements, but rather the subordinated debentures are shown as a liability.
NOTE 12 - SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE
Securities sold under agreements to repurchase are secured by pledged securities with a carrying amount of $8,569 and $9,217 at December 31, 2011 and 2010.
Securities sold under agreements to repurchase are financing arrangements that mature on May 27, 2013 and have an interest rate of 3.26%. At maturity, the securities underlying the agreements are returned to the Company.
NOTE 13 - OTHER BENEFIT PLANS
401(k) Plan: A 401(k) benefit plan allows employee contributions up to 15% of their compensation, of which the Company has matched 100% of the first 3% and 50% of the next 2% the employee contributes to their 401(k) annually for all periods presented. Expense for 2011, 2010, and 2009 was $172, $186 and $183, respectively.
Deferred Compensation and Supplemental Retirement Plans: Deferred compensation and supplemental retirement plan (“SERP”) expense allocates the benefits over years of service. The Bank approved the SERP in 2006. The SERP will provide certain Company officers with benefits upon retirement, death, or disability in certain prescribed circumstances. SERP expense was $252 in 2011, $233 in 2010 and $58 in 2009, resulting in a deferred compensation liability of $1,027 and $775 at December 31, 2011 and 2010, respectively.
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2010
(Dollar amounts in thousands, except per share data)
NOTE 14 - PREFERRED STOCK
On February 29, 2009, as part of the Capital Purchase Program (“CPP”) of the Troubled Asset Relief Program (“TARP”), the Company entered into a Letter Agreement and Securities Purchase Agreement (collectively, the “Purchase Agreement”) with the United States Department of the Treasury (“U.S. Treasury”), pursuant to which the Company sold 17,806 shares of newly authorized Fixed Rate Cumulative Perpetual Preferred Stock, Series A, no par value (the “Series A Preferred Stock”) and also issued warrants (the “Warrants”) to the U.S. Treasury to acquire 890 shares of Fixed Rate Cumulative Perpetual Preferred Stock, Series B no par value (the “Series B Preferred Stock” and, together with the Series A Preferred Stock, the “Preferred Stock”) for an aggregate purchase price of $17,806 in cash. Upon closing, the U.S. Treasury exercised the Warrants and the Company issued 890 shares of the Series B Preferred Stock.
The Series A Preferred Stock qualifies as Tier 1 capital and will pay cumulative dividends at a rate of 5.00% per annum for the first five years, and 9.00% per annum thereafter. The Series B Preferred Stock also qualifies as Tier 1 capital and will pay cumulative dividends at a rate of 9.00% per annum. Total required annual dividends for the Preferred Stock are expected to be as follows: 2012 - 2013: $970 per year; 2014: $1,571; 2015 and thereafter: $1,683 per year. The Series B Preferred Stock may be redeemed by the Company at any time after consultation with the Company’s and Bank’s primary federal regulator, but may not be redeemed until all of the Series A Preferred Stock is redeemed. Neither the Series A nor the Series B Preferred Stock is subject to any contractual restrictions on transfer.
As described above in Note 11, the Company may not pay dividends on its Preferred Stock without the approval of the Federal Reserve Bank of Atlanta (the “FRB”). In addition, under the terms of the indentures pursuant to which the Company has issued its subordinated debentures, it may not, at any time when it is deferring the payment of interest on its subordinated debentures, as it has done since March 15, 2011, pay dividends on the Preferred Stock.
Pursuant to the terms of the Purchase Agreement for the Preferred Stock, the ability of the Company to declare or pay dividends or distributions on, or purchase, redeem or otherwise acquire for consideration, shares of its common stock will be subject to restrictions, including a restriction against increasing dividends from the last annual cash dividend per share ($0.05) declared on the common stock prior to February 27, 2009. The redemption, purchase or other acquisition of trust preferred securities of the Company or its affiliates also will be restricted. These restrictions terminated on February 29, 2012, but for so long as the Preferred Stock remains outstanding, the Company may not increase its common dividends per share without obtaining the consent of the U.S. Treasury. Currently, the Company and Bank are prohibited from declaring dividends by its primary regulators.
The Purchase Agreement also subjects the Company to certain of the executive compensation limitations included in the Emergency Economic Stabilization Act of 2008 (the “EESA”), as amended by the American Recovery and Reinvestment Act of 2009 as implemented by the interim final rule on executive compensation and corporate governance issued by the U.S. Treasury on June 15, 2009 (the “June 2009 IFR”). In this connection, as a condition to the
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2010
(Dollar amounts in thousands, except per share data)
NOTE 14 - PREFERRED STOCK (Continued)
closing of the transaction, the Company’s Senior Executive Officers (as defined in the Purchase Agreement) (the “Senior Executive Officers”), (i) voluntarily waived any claim against the U.S. Treasury or the Company for any changes to such officer’s compensation or benefits that are required to comply with the regulation issued by the U.S. Treasury under the CPP and acknowledged that the regulation may require modification of the compensation, bonus, incentive and other benefit plans, arrangements and policies and agreements as they relate to the period the U.S. Treasury owns the Preferred Stock of the Company; and (ii) entered into a letter with the Company amending the Benefit Plans with respect to such Senior Executive Officer, during the period that the Treasury owns the Preferred Stock of the Company, as necessary to comply with Section 111(b) of the EESA including, as implemented by the June 2009 IFR.
At the request of the FRB, the board of directors of the Company, on January 18, 2011, adopted a resolution agreeing that the Company would not incur additional debt, pay common or preferred dividends, or redeem any treasury stock without approval from the FRB. The Company requested permission to make dividend payments on its Preferred Stock and interest payments on its subordinated debt that were scheduled for the first quarter of 2011. The FRB granted permission to pay the preferred dividends that were due on February 15, 2011, but denied permission to make interest payments on the Company’s subordinated debt. As a result of the FRB’s decision, the Company was required to begin the deferral of interest payments on each of its three subordinated debentures during the first quarter of 2011. The Company has the right to defer the payment of interest on the subordinated debentures at any time, for a period not to exceed twenty (20) consecutive quarters. During the period in which it is deferring the payment of interest on its subordinated debentures, however, the Company may not pay any dividends on its common or preferred stock, and the Company’s subsidiaries may not pay dividends on those subsidiaries’ common or preferred stock owned by entities other than the Company and its subsidiaries. Accordingly, the Company was required to suspend dividend payments on the Preferred Stock beginning in the second quarter of 2011. At December 31, 2011, the Company has $847 of Preferred Stock dividends accrued for which payment is being deferred. The Company’s subsidiary Community First Properties, Inc. suspended the payment of dividends on its preferred stock beginning with the dividend payment due on December 31, 2011. At December 31, 2011, Community First Properties, Inc. has $8 of preferred stock dividends accrued for which payment is being deferred.
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2010
(Dollar amounts in thousands, except per share data)
NOTE 15 - STOCK BASED COMPENSATION
Prior to the Company’s bank holding company reorganization, the Bank had in place the Community First Bank & Trust Stock Option Plan for organizers of the Bank and certain members of management and employees. In connection with the bank holding company reorganization, this plan was amended and replaced in its entirety by the Community First, Inc. Stock Option Plan in October 2002. There were 342,000 shares authorized by the Stock Option Plan in 2002. Additionally, the Community First, Inc. 2005 Stock Incentive Plan was approved at the stockholders meeting on April 26, 2005 authorizing shares of 450,000. The plans allow for the grant of options and other equity securities to key employees and directors. The exercise price for stock options is the market price at the date of grant. The organizer options vested ratably over three years and other non-qualified options vest ratably over four years. The employee options vest ratably from two to four years and the management options vest ratably over six years. All options expire within ten years from the date of grant. The Company has 347,559 authorized shares available for grant as of December 31, 2011. The Company recognized $69, $162, and $200 as compensation expense resulting from stock options and $0, $(2), and $30 as compensation expense resulting from restricted stock awards in 2011, 2010, and 2009, respectively. The total income tax benefit from non-qualified stock options was $0 in 2011, $126 in 2010, and $128 in 2009.
The fair value of each option is estimated on the date of grant using a closed form option valuation (Black-Scholes) model that uses the assumptions noted in the table below. Expected volatilities are based on historical volatilities of the Company’s common stock. The expected term of options granted is based on historical data and represents the period of time that options granted are expected to be outstanding, which takes into account that the options are not transferable. The risk-free interest rate for the expected term of the option is based on the U.S. Treasury yield curve in effect at the time of the grant. The Company granted no new options in 2011.
The fair value of options granted was determined using the following weighted average assumptions at grant date.
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2010
(Dollar amounts in thousands, except per share data)
NOTE 15 - STOCK BASED COMPENSATION (Continued)
A summary of option activity under the Company’s stock incentive plans for 2011 is presented in the following table:
Information related to the stock incentive plans during each year is as follows:
Tax benefit realized in 2010 and 2009 from option exercises was due to activity that occurred in prior years in which the Company did not have sufficient taxable income to recognize the benefit.
As of December 31, 2011, there was $17 of total unrecognized compensation cost related to nonvested stock options granted under the Company’s stock incentive plans. The cost is expected to be recognized over a weighted average period of 1.00 years.
The Company has also issued shares of restricted stock under the stock incentive plans. Restricted stock is issued to certain officers on a discretionary basis. Compensation expense is recognized over the vesting period of the awards based on the fair value of the stock at issue date. The fair value of the stock was determined using the market price on the day of issuance.
Restricted stock typically vests over a 2-3 year period. Vesting occurs ratably on the anniversary day of the issuance. At December 31, 2011, there was no unrecognized compensation cost nor any unvested shares of restricted stock.
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2010
(Dollar amounts in thousands, except per share data)
NOTE 16 - EARNINGS (LOSS) PER SHARE
The two-class method is used in the calculation of basic and diluted earnings per share. Under the two-class method, earnings available to common shareholders for the period are allocated between common shareholders and participating securities according to dividends declared (or accumulated) and participation rights in undistributed earnings. The factors used in the earnings per share computation follow:
At years ended 2011, 2010, and 2009 there were 119,550, 213,930, and 215,930 antidilutive stock options, respectively. Due to the net loss for the periods ended December 31, 2011, 2010, and 2009 all outstanding stock options are antidilutive and are excluded from the diluted earnings (loss) per common share calculation.
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2010
(Dollar amounts in thousands, except per share data)
NOTE 17 - LEASE REVENUE
The Bank built a branch at Carothers Parkway, located in Franklin, Tennessee, that was completed in 2006 at cost of $2,370. The Bank’s principal leasing activities consist of 9,550 square feet of office space on the second and third floor of the Carothers Parkway Branch, representing approximately 46% of the branch, under five separate operating leases.
One lessee rents 1,650 square feet or approximately 8% of the branch. The lease term is for five years beginning October 2007 with a renewal term of 36 months upon written notice of 120 days prior to the expiration of the original term. Lessee has five such renewal options. The lease produced revenue totaling $36 recognized in 2011 and $35 recognized in 2010.
The second lessee rents 2,500 square feet or approximately 12% of the branch. The lease term is for five years beginning November 2009 with a renewal term of 36 months upon written notice of 120 days prior to the expiration of the original term. Lessee has five such renewal options. The lease produced revenue of $44 recognized in 2011 and $44 recognized in 2010.
The third lessee rents 1,600 square feet or approximately 8% of the branch. The lease is for a suite consisting of 1,600 square feet, with a lease term of 63 calendar months beginning in June of 2011 with one renewal option for an additional five years. The lease produced revenue of $17 in 2011.
The fourth lessee rents 2,200 square feet or approximately 11% of the branch. The lease term is for 62 calendar months beginning January 2011 with no provision for renewal. The lease produced revenue of $14 in 2011.
The fifth lessee rents 1,600 square feet or approximately 8% of the branch. The lease term is for 25 calendar months beginning November 2011 with no provision for renewal.
As discussed in Note 2, in February of 2012 the Bank agreed to sell the branch building at Carothers Parkway in the transaction with CapStar Bank. Upon completion of the sale, CapStar will become the lessor for each of the above leases.
Approximate minimum rental receipts for the noncancelable leases as of December 31, 2011 was as following, assuming that the branch will be sold on June 30, 2012:
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2010
(Dollar amounts in thousands, except per share data)
NOTE 18 - INCOME TAXES
The components of income tax expense (benefit) are summarized as follows:
A reconciliation of actual income tax expense (benefit) in the financial statements to the expected tax benefit (computed by applying the statutory Federal income tax rate of 34% to income (loss) before income taxes) is as follows:
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2010
(Dollar amounts in thousands, except per share data)
NOTE 18 - INCOME TAXES (Continued)
The tax effect of each type of temporary difference that gives rise to net deferred tax assets and liabilities is as follows:
Due to economic conditions and losses recognized during the past four years, the Company established a valuation allowance against materially all of its deferred tax assets. The Company intends to maintain this valuation allowance until it determines it is more likely than not that the asset can be realized through current and future taxable income. The Company has approximately $48,639 in net operating losses for state tax purposes that begin to expire in 2020 and $19,493 for federal tax purposes that begin to expire in 2029 to be utilized by future earnings.
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2010
(Dollar amounts in thousands, except per share data)
NOTE 18 - INCOME TAXES (Continued)
During 2011 and per ASC 740-20-45-7, the Company had losses in continuing operations and income from other comprehensive income, resulting in income tax benefit totaling $1,555. This benefit was recorded through current operations and reduced the Company’s deferred tax valuation allowance.
The Company currently has no unrecognized tax benefits that, if recognized, would favorably affect the income tax rate in future periods. The Company does not expect any unrecognized tax benefits to significantly increase or decrease in the next twelve months. It is the Company’s policy to recognize any interest accrued related to unrecognized tax benefits in interest expense, with any penalties recognized as operating expenses.
The Company and its subsidiaries are subject to U.S. federal income tax as well as income tax of the state of Tennessee. The Company is no longer subject to examination by taxing authorities for tax years prior to 2008.
NOTE 19 - LOAN COMMITMENTS AND OTHER RELATED ACTIVITIES
Some financial instruments, such as loan commitments, credit lines, letters of credit, and overdraft protection, are issued to meet customer financing needs. These are agreements to provide credit or to support the credit of others, as long as conditions established in the contract are met, and usually have expiration dates. Commitments may expire without being used. Off-balance-sheet risk to credit loss exists up to the face amount of these instruments, although material losses are not anticipated. The same credit policies are used to make such commitments as are used for loans, including obtaining collateral at exercise of the commitment.
The contractual amount of financial instruments with off-balance sheet risk was as follows at year end 2011 and 2010:
These commitments are generally made for periods of one year or less. The fixed rate unused lines of credit have interest rates ranging from 2.90% to 9.50% and maturities ranging from 1 month to 15.25 years.
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2010
(Dollar amounts in thousands, except per share data)
NOTE 20 - RELATED PARTY TRANSACTIONS
Loans to principal officers, directors, and their affiliates in 2011 were as follows:
Deposits from principal officers, directors, and their affiliates at year-end 2011 and 2010 were $3,675 and $3,849, respectively. Principal officers, directors, and their affiliates at year end 2011 and 2010 owned $700 of the $3,000 subordinated debentures due December 31, 2032. At December 31, 2011, the approved available unused lines of credit on related party loans were $1,467.
NOTE 21 - REGULATORY MATTERS AND MANAGEMENT PLANS
Banks and bank holding companies are subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations, involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators. Failure to meet capital requirements can initiate regulatory action.
Prompt corrective action regulations provide five classifications: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized, although these terms are not used to represent overall financial condition. If adequately capitalized, regulatory approval is required to accept, renew or rollover brokered deposits. If undercapitalized, capital distributions are limited, as is asset growth and expansion, and capital restoration plans are required. At year end 2011, the most recent regulatory notifications categorized the Bank as adequately capitalized under the regulatory framework for prompt corrective action.
As a result of the Company’s deteriorating financial condition, during the fourth quarter of 2011, the Company was informed that the FRB would be proposing a formal agreement following an offsite examination of the Company that was completed during the third quarter of 2011. Management has not yet been informed as to the provisions of that expected agreement but we expect that it will, among other things, require the Company to achieve, and thereafter maintain, capital levels in excess of those required to be considered well capitalized.
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2010
(Dollar amounts in thousands, except per share data)
NOTE 21 - REGULATORY MATTERS AND MANAGEMENT PLANS (Continued)
On September 20, 2011, the Bank consented to the issuance of a consent order (the “Consent Order”) by the Federal Deposit Insurance Corporation (the “FDIC”). The Consent Order replaces the memorandum of understanding (“MOU”) that the Bank had entered into with the FDIC on October 19, 2010. Under the terms of the Consent Order, the Bank has agreed to, among other things, take the following actions:
• Establish, within 30 days after September 20, 2011, a board committee to oversee the Bank’s compliance with the Consent Order;
• Make, within 30 days after September 20, 2011, provisions to its allowance for loan and lease losses (the “ALLL”) in an amount equal to those loans required to be charged off by the Consent Order, and thereafter maintain a reasonable ALLL and quarterly have its board of directors review the adequacy of the ALLL;
• Review, within 30 days after September 20, 2011, the Bank’s Consolidated Reports on Condition and Income filed with the FDIC after December 31, 2010, and amend such reports if necessary to accurately reflect the Bank’s financial condition as of such dates;
• Use, within 30 days after September 20, 2011, Financial Accounting Standards Board Accounting Standards Codification Numbers 450 and 310 for determining the Bank’s ALLL reserve adequacy;
• Retain, within 60 days after September 20, 2011, a bank consultant to develop, within 90 days after September 20, 2011, a written analysis and assessment of the Bank’s management and staffing needs for the purpose of providing qualified management;
• Formulate and submit to the FDIC and the Tennessee Department of Financial Institutions (the “Department”), within 60 days after September 20, 2011, a written policy covering expense reimbursement to the Bank’s directors, officers and employees, and while the Consent Order is in effect have the Board conduct monthly reviews of all expenses submitted for customer entertainment, business development and/or any other expense submitted by the Bank’s officers and directors;
• Prepare and submit, within 120 days after September 20, 2011, to its supervisory authorities a budget and profit plan for calendar year 2012;
• On or before December 31, 2011 achieve, and thereafter, maintain the Bank’s Tier 1 leverage capital ratio, Tier 1 risk-based capital ratio and Total risk-based capital ratios equal to or greater than 8.5%, 10.0% and 12.0%, respectively;
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2010
(Dollar amounts in thousands, except per share data)
NOTE 21 - REGULATORY MATTERS AND MANAGEMENT PLANS (Continued)
• If the Bank’s capital ratios fall below the minimum levels set out in the previous bullet as of the date of any of the Bank’s Reports on Condition and Income, submit within 30 days of receiving a request to do so, to the FDIC and the Department a capital plan to increase the Bank’s capital to levels above these minimum levels; then initiate action within 30 days after the FDIC and the Department respond to the plan;
• Refrain from paying cash dividends to the Company without the prior written consent of the FDIC and the Department;
• Increase, within 30 days after September 20, 2011, the participation of the Bank’s board of directors in the affairs of the Bank by assuming full responsibility for the approval of the Bank’s policies and objectives and for the supervision of management, including all Bank activities;
• Develop, within 120 days after September 20, 2011, a strategic plan that addresses issues including plans for sustaining adequate liquidity, strategies for pricing policies and asset/liability management, goals for reducing problem loans, plans for attracting and retaining qualified individuals to fill vacancies in the lending and accounting functions, financial goals and formulation of a mission statement;
• Not extend, directly or indirectly, any additional credit to or for the benefit of any borrower whose extension of credit is classified “Doubtful” and/or “Substandard” by the FDIC or the Department unless the Bank’s board of directors has signed a detailed written statement giving reasons why the failure to extend such credit would be detrimental to the Bank;
• Take, within 30 days after September 20, 2011, specific actions to eliminate all assets classified as “Loss” as of March 14, 2011, and, within 60 days of September 20, 2011 submit a written plan to reduce the level of assets classified “Doubtful” or “Substandard” with a balance in excess of $1,000,000, in each case as of March 14, 2011;
• Refrain from extending any additional credit to, or for the benefit of, any borrower who has a loan or other extension of credit from the Bank that has been charged off or classified in a certain specified manner and is uncollected;
• Take, within 120 days after September 20, 2011, specified actions to reduce concentrations of construction and development loans in the Bank’s portfolio to not more than 100% of the Bank’s Tier 1 capital and commercial real estate loans (other than owner-occupied commercial real estate loans) to not more than 300% of the Bank’s Tier 1 capital;
• Take, within 60 days after September 20, 2011, specified action for the reduction and collection of delinquent loans;
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2010
(Dollar amounts in thousands, except per share data)
NOTE 21 - REGULATORY MATTERS AND MANAGEMENT PLANS (Continued)
• Eliminate, within 30 days after September 20, 2011, and/or correct all applicable violations of law and regulation as discussed in the Bank’s most recent exam report and implement procedures to ensure future compliance with all applicable laws and regulations;
• Refrain from entering into any new line of business without the prior written consent of the FDIC while the Consent Order is in effect;
• Establish, within 30 days after September 20, 2011, a loan review committee (at least two-thirds of the members of which shall be independent directors) to periodically review the Bank’s loan portfolio and identify and categorize problem credits;
• Review, within 90 days after September 20, 2011, and annually thereafter, the Bank’s loan policy and procedures for effectiveness; and
• Furnish, within 30 days following the end of each calendar quarter, quarterly progress reports to the banking regulators.
As a result of entering into the Consent Order, the Bank is subject to additional limitations on its operations including a prohibition on rolling over, or renewing brokered deposits, which could adversely affect the Bank’s liquidity and/or operating results. The existence of the Consent Order also limit the Bank from paying deposit rates above national rate caps published weekly by the FDIC, unless the Bank is determined to be operating in a high-rate market area. On December 1, 2011, the Bank received notification from the FDIC that it is operating in a high-rate environment, which allows the Bank to pay rates higher than the national rate caps, but continues to limit the Bank to rates that do not exceed the prevailing rate in the Bank’s market by more than 75 basis points. The Bank is also limited, as a result of its condition, in its ability to pay severance payments to its employees and must receive the consent of the FDIC and the Department to appoint new officers or directors.
The Consent Order includes time frames to implement the foregoing and on-going compliance requirements for the Bank, including quarterly progress reports to its regulators. At December 31, 2011, the Bank’s regulatory capital ratios did not meet the regulatory capital ratios proscribed by the Consent Order. In accordance with the terms of the Consent Order, management has prepared and submitted a capital plan with the objective of attaining the capital ratios required by the agreement. In addition to the capital plan, all other plans required by the Consent Order have been submitted to and approved by the FDIC.
At the request of the FRB, the board of directors of the Company, on January 18, 2011, adopted a board resolution agreeing that the Company would not incur additional debt, pay common or preferred dividends, or redeem treasury stock without approval from the FRB. The Company requested permission to make dividend payments on its Preferred Stock and interest payments on its subordinated debt that were scheduled for the first quarter of 2011. The FRB granted permission to pay the preferred dividends that were due on February 15, 2011, but denied permission to make interest payments on the Company’s subordinated debt. As a result of the FRB’s decision,
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2010
(Dollar amounts in thousands, except per share data)
NOTE 21 - REGULATORY MATTERS AND MANAGEMENT PLANS (Continued)
the Company was required to begin the deferral of interest payments on each of its three subordinated debentures during the first quarter of 2011. The Company has the right to defer the payment of interest on the subordinated debentures at any time, for a period not to exceed 20 consecutive quarters. During the period in which it is deferring the payment of interest on its subordinated debentures, the Company may not pay any dividends on its common or preferred stock and the Company’s subsidiaries may not pay dividends on the subsidiaries’ common or preferred stock owned by entities other than the Company and its subsidiaries. Accordingly, the Company was required to suspend dividend payments on the Preferred Stock beginning in the second quarter of 2011. At December 31, 2011, the Company has $1,497 of interest accrued for which payment is being deferred. In addition, the Company has accumulated $847 in deferred dividends on Preferred Stock. The Company’s subsidiary Community First Properties, Inc. suspended the payment of dividends on its preferred stock beginning with the dividend payment due on December 31, 2011. At December 31, 2011, Community First Properties, Inc. has $8 of preferred stock dividends accrued for which payment is being deferred.
As a result of its losses in 2011, and 2010, the Bank is prohibited under applicable Tennessee law from declaring dividends without prior approval from the Department. The terms of the Consent Order with the FDIC also prohibit the Bank from paying dividends to the Company without prior approval from the FDIC and the Department. The Company is also restricted in the types and amounts of dividends that can be paid because of its participation in the CPP as described in Note 11 and as a result of the board resolution it adopted at the request of the FRB prohibiting the Company from paying interest or dividends without the FRB’s prior approval.
The board resolution with the FRB prohibits the Company from, among other things, paying interest on its subordinated debentures and dividends on its common and preferred stock without the prior approval of the FRB. The board resolution does not establish any specific capital ratios that must be attained by the Company. During the fourth quarter of 2011, the Company was informed that the FRB would be proposing a formal agreement following an offsite examination of the Company that was completed during the third quarter of 2011. Management has not yet been informed as to the provisions of that expected agreement but management expects that it will require, among other things, the Company to achieve, and thereafter maintain, capital levels in excess of those required to be considered well capitalized and prohibit the payment of dividends on the Company’s Preferred Stock or interest on its subordinated debentures, without, in each case, the prior approval of the FRB.
The Company’s principal source of funds for dividend payments is dividends received from the Bank. Banking regulations limit the amount of dividends that may be paid without prior approval of regulatory agencies. Under these regulations, the amount of dividends that may be paid in any calendar year is limited to the current year’s net profits, combined with the retained net profits of the preceding two years, subject to the capital requirements described above.
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2010
(Dollar amounts in thousands, except per share data)
NOTE 21 - REGULATORY MATTERS AND MANAGEMENT PLANS (Continued)
The Company’s and its subsidiary Bank’s capital amounts and ratios at December 31, 2011 and 2010, were as follows:
The Bank’s capital levels as of December 31, 2011 were below those that the Bank agreed to achieve by that date under the terms of the Consent Order. Based on December 31, 2011 levels of average assets and risk-weighted assets, the required amount of additional Tier 1 capital necessary to meet the requirements of the Consent Order was approximately $22,413 which would also satisfy the total capital requirement. The Company’s capital levels at December 31, 2011 were below those required to be considered well capitalized under applicable regulations.
Management Plans
The Company is currently considering the options available to increase capital levels at the Company and the Bank, including the sale of common or preferred stock of the Company or the sale of certain branch locations or other assets, or alternatively the sale of the Company. Management’s plans include finalizing the pending branch sales, described in Note 2, and if consummated, will improve the Bank’s capital levels. However, the consummation of the pending branch sales may not increase the Bank’s capital levels to those required to be maintained by the Bank in the Consent Order. As a result, and because the Company does not have cash available to contribute to the Bank in an amount sufficient to enable the Bank to achieve the capital levels it committed to maintain in the Consent Order, management will continue to seek additional alternatives beyond the branch sales described in Note 2 (including the issuance of common stock) to raise capital in order to assist the Bank in meeting its required capital levels. Any sale of the Company’s common stock would likely be at a price that would result in substantial dilution in ownership for the Company’s existing common shareholders and could result in a change in control of the Company. Continued failure to comply with the terms of the Consent Order may result in additional adverse regulatory action.
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2010
(Dollar amounts in thousands, except per share data)
NOTE 22 - PARENT COMPANY ONLY CONDENSED FINANCIAL INFORMATION
Condensed financial information of the Company follows:
CONDENSED BALANCE SHEET
December 31
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2010
(Dollar amounts in thousands, except per share data)
NOTE 22 - PARENT COMPANY ONLY CONDENSED FINANCIAL INFORMATION (Continued)
CONDENSED STATEMENTS OF OPERATIONS
Years Ended December 31
CONDENSED STATEMENTS OF CASH FLOWS
Years Ended December 31
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2010
(Dollar amounts in thousands, except per share data)
NOTE 22 - PARENT COMPANY ONLY CONDENSED FINANCIAL INFORMATION (Continued)
COMMUNITY FIRST, INC.
Notes to Consolidated Financial Statements
December 31, 2010
(Dollar amounts in thousands, except per share data)
NOTE 23 - QUARTERLY FINANCIAL DATA (UNAUDITED)
The fourth quarter 2011 net loss was primarily due the result of an increase in provision for loan losses of $4,994 and losses on other repossessed assets of $1,025. $1,375 of the increase in provision for loan losses and all of the loss on other repossessed assets is related to one lending relationship.
The fourth quarter 2010 net loss of $17,110 was primarily the result of an increase in provision for loan losses of $10,141, goodwill impairment charges of $5,204, and increase in tax expense of $1,316.
EXHIBIT INDEX
The following exhibits are filed as a part of or incorporated by reference in this report:
* Incorporated herein by reference to the Company’s Annual Report in Form 10-KSB for the year ended December 31, 2002.
** Incorporated herein by reference to the Company’s Current Report on Form 8-K filed on March 5, 2009.
+ Management compensatory plan or arrangement.