ITEM 1. BUSINESS
CAUTIONARY NOTE ABOUT FORWARD-LOOKING STATEMENTS
This Annual Report on Form 10-K contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements represent expectations and beliefs of 1st Financial Services Corporation (1st Financial or the Company) including but not limited to 1st Financial’s operations, performance, financial condition, growth or strategies. These forward-looking statements are identified by words such as “expects”, “anticipates”, “should”, “estimates”, “believes” and variations of these words and other similar statements. For this purpose, any statements contained in this Annual Report on Form 10-K that are not statements of historical fact may be deemed to be forward-looking statements. Readers should not place undue reliance on forward-looking statements as a number of important factors could cause actual results to differ materially from those in the forward-looking statements. These forward-looking statements involve estimates, assumptions, risks and uncertainties that could cause actual results to differ materially from current projections depending on a variety of important factors, including without limitation:
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there is substantial doubt about the ability of 1st Financial to continue as a going concern;
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1st Financial and its subsidiary, Mountain 1st Bank and Trust Company (the Bank) may be subject to additional, heightened enforcement actions, and ultimately the Bank may be placed under conservatorship or receivership if we do not raise additional capital or otherwise comply with the Consent Order (the Consent Order) with the Federal Deposit Insurance Corporation (FDIC) and the North Carolina Commissioner of Banks (the Commissioner) and the Written Agreement (the Written Agreement) with the Federal Reserve Bank of Richmond (Federal Reserve Bank), or if our condition continues to deteriorate;
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difficult market conditions and economic trends have adversely affected our industry and our business;
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financial reform legislation enacted by Congress and resulting regulations have increased, and are expected to continue to increase our costs of operations;
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our participation in the TARP Capital Purchase Program imposes restrictions and obligations on us that may limit our ability to access the capital markets and reduce our liquidity;
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we are restricted from paying any dividends or repurchasing any shares of our common stock until we pay all accrued and unpaid dividends on our preferred stock;
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the limitations on incentive compensation contained in the American Recovery and Reinvestment Act of 2009 and subsequent regulations may adversely affect our ability to retain our highest performing employees;
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the soundness of other financial institutions could adversely affect us;
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increases in FDIC insurance premiums may adversely affect our net income and profitability;
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1st Financial relies on dividends from the Bank for most of 1st Financial’s revenue;
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we need to raise additional capital in the future in order to satisfy regulatory requirements, but that capital may not be available when it is needed;
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our allowance for loan losses may prove to be insufficient to absorb probable losses in our loan portfolio;
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we continue to hold and acquire a significant amount of other real estate, which has led to increased operating expense and vulnerability to additional declines in real property values;
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a significant percentage of our loans are secured by real estate. Adverse conditions in the real estate market in our banking markets might adversely affect our loan portfolio;
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our commercial real estate lending may expose us to risk of loss and hurt our earnings and profitability;
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our construction loans and land development loans involve a higher degree of risk than other segments of our loan portfolio;
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our lending on vacant land may expose us to a greater risk of loss and may have an adverse effect on results of operations;
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the Company will be unable to grow in the short term;
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our business depends on the condition of the local and regional economies where we operate;
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our profitability is subject to interest rate risk and changes in interest rates could have an adverse effect on our operating results;
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competition from financial institutions and other financial service providers may adversely affect our profitability;
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we are subject to extensive regulation that could limit or restrict our activities and adversely affect our earnings;
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if the Bank loses key employees with significant business contacts in its market areas, its business may suffer;
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we may face increasing deposit-pricing pressures, which may, among other things, reduce our profitability;
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negative publicity could damage our reputation;
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the Bank is subject to environmental liability risk associated with lending activities;
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financial services companies depend on the accuracy and completeness of information about customers and counterparties;
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liquidity risk could impair our ability to fund operations and jeopardize our financial condition, results of operations, and cash flows;
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changes in our accounting policies or in accounting standards could materially affect how we report our financial results and condition;
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impairment of investment securities could require charges to earnings, which could result in a negative impact on our results of operations;
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premiums for D&O insurance may increase; we may be unable to renew our D&O insurance policy on acceptable terms;
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we rely on other companies to provide key components of our business infrastructure;
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our information systems may experience an interruption or breach in security;
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unpredictable catastrophic events could have a material adverse effect on 1st Financial;
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we may need to invest in new technology to compete effectively, and that could have a negative effect on our operating results and the value of our common stock;
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our ability to pay dividends is limited and we may be unable to pay future dividends;
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there may be future sales of additional common stock or preferred stock or other dilution of our equity, which may adversely affect the market price of our common stock;
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the trading volume in our common stock has been relatively low, and the sale of a substantial number of shares in the public market could adversly impact the price of our stock and make it difficult for you to sell your shares;
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our management beneficially owns a substantial percentage of our common stock, so our directors and executive officers can significantly affect voting results on matters voted on by our stockholders;
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1st Financial has issued preferred stock, which ranks senior to our common stock;
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our preferred stock reduces net income available to holders of our common stock and earnings per common share and the warrant may be dilutive to holders of our common stock;
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our stock price can be volatile;
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our common stock is not FDIC insured; and
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other risks and uncertainties detailed in Part I, Item 1A
ITEM 1A. RISK FACTORS
An investment in our securities is subject to certain risks. You should carefully review the following risk factors and other information contained in this report and the documents incorporated by reference before deciding whether an investment in our securities is suited to your particular circumstances. Other risks and uncertainties not presently known to us or that we currently deem immaterial or unlikely also may impair our business operations. If any of the following risks actually occur, our business, results of operations and financial condition could suffer. In that event, the value of our securities could decline, and you may lose all or part of your investment. The risks discussed below also include forward-looking statements, and our actual results may differ materially from those discussed in these forward-looking statements.
Risks Related to Recent Economic Conditions and Governmental Response Efforts
There is substantial doubt about the ability of 1st Financial to continue as a going concern.
In connection with its annual audit, the Company’s independent auditors issued an opinion stating the consolidated financial statements were prepared assuming the Company will continue as a going concern, but that substantial doubt has been raised about its ability to continue as a going concern because the Company has suffered recurring losses that have eroded regulatory capital ratios, and the Company’s sole asset, the Bank, is under the Consent Order that requires among other provision, capital ratios to be maintained at certain heightened levels. In addition the Company is under the Written Agreement that requires, among other provisions, the submission and implementation of a capital plan to improve the Company’s and the Bank’s capital levels. As of December 31, 21011, both the Company and the Bank are considered “significantly undercapitalized” based on their respective regulatory capital levels. Meanwhile, the Bank continues to have high levels of nonperforming and impaired assets. The future of the Company is dependent on its ability to address these matters. If the Company fails to do so for any reason, the banking regulators may place the Bank into conservatorship or receivership, with the FDIC or the Commissioner appointed as conservator or receiver. If the Bank was placed into conservatorship or receivership, 1st Financial would probably suffer a complete loss of the value of its ownership interest in the Bank, be exposed to significant claims by the FDIC and/or the Commissioner, and would not be able to continue as a going concern. Accordingly, such conservatorship or receivership of the Bank would almost certainly also result in a complete loss of your investment in 1st Financial.
1st Financial and the Bank may be subject to additional, heightened enforcement actions, and ultimately the Bank may be placed under conservatorship or receivership if we do not raise additional capital or otherwise comply with the Consent Order and the Written Agreement, or if our condition continues to deteriorate.
The Consent Order and Written Agreement require us to take certain actions and to implement certain action plans, including a plan to materially improve the Bank’s capital ratios. In the event we do not raise additional capital or otherwise comply with the Consent Order and the Written Agreement, or if our condition continues to deteriorate, the banking regulators may place the Bank under conservatorship or receivership, and/or force the sale or merger of the Bank. Unexpected events or circumstances could further prejudice our ability to achieve the minimum capital ratios required under the Consent Order. For example, the Bank increased its loan loss provision by $6.0 million during the third quarter, 2011, and a further $7.1 million during the fourth quarter, 2011. In addition, during 2011, the Bank increased its provision for income taxes by $14.0 million to establish a full valuation allowance for the Bank’s deferred tax asset. Both sets of actions had an adverse impact on our capital ratios. If we fail to comply with the requirements of the Consent Order or the Written Agreement for any reason or our condition continues to deteriorate, the banking regulators may impose additional, heightened enforcement actions against us, keep the Consent Order and Written Agreement in place longer than they may otherwise have been, and/or require the preparation of a plan to sell or merge the Bank. Ultimately, the Bank may be placed into conservatorship or receivership by the FDIC or the Commissioner, with the FDIC or the Commissioner appointed as conservator or receiver. If the Bank was placed into conservatorship or receivership, 1st Financial would probably suffer a complete loss of the value of its ownership interest in the Bank and be exposed to significant claims by the FDIC and/or the Commissioner. Such conservatorship or receivership of the Bank would almost certainly also result in a complete loss of your investment in 1st Financial.
Difficult market conditions and economic trends have adversely affected our industry and our business.
Since 2008, dramatic declines in the housing market, with decreasing home prices and increasing delinquencies and foreclosures, have negatively affected the credit performance of mortgage and construction loans and resulted in significant write-downs of assets by many financial institutions, including 1st Financial. In addition, the values of other real estate collateral supporting many loans have declined and may continue to decline. General downward economic trends, reduced availability of commercial credit and increasing unemployment have negatively affected the credit performance of commercial and consumer credit, resulting in additional write-downs. Concerns over the stability of the financial markets and the economy caused a decrease in lending by financial institutions to their customers and to each other. This market turmoil and tightening of credit led to increased commercial and consumer loan delinquencies, lack of consumer confidence, increased market volatility and widespread reduction in general business activity. Financial institutions have experienced decreased access to capital and to deposits or borrowings. The resulting economic pressure on consumers and businesses and the lack of confidence in the financial markets has adversely affected most businesses and the prices of securities in general, and financial institutions in particular, and it will continue to adversely affect our business, financial condition, results of operations and stock price for the foreseeable future.
We do not believe these difficult conditions are likely to improve in the near future. A sustained weakness or worsening of these conditions would likely exacerbate the adverse effects of these difficult market and economic conditions on us, our customers, and the other financial institutions in our market. Specifically, it could have one or more of the following adverse effects on our business:
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A decrease in the demand for loans or other products and services offered by us;
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A decrease in the value of our loans or other assets secured by consumer or commercial real estate;
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A decrease in deposit balances due to overall reductions in the accounts of customers;
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An impairment of investment securities;
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A decreased ability to raise additional capital on terms acceptable to us or at all; or
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An increase in the number of borrowers who become delinquent, file for protection under bankruptcy laws or default on their loans or other obligations to us. An increase in the number of delinquencies, bankruptcies, or defaults could result in a higher level of nonperforming assets, net charge-offs, and provision for loan losses, which would reduce our earnings.
Until conditions improve, our business, financial condition and results of operations may continue to be adversely affected.
Financial reform legislation enacted by Congress and resulting regulations have increased, and are expected to continue to increase our costs of operations.
Congress enacted the Dodd-Frank Act in 2010. This law has significantly changed the structure of the bank regulatory system and affects the lending, deposit, investment, trading, and operating activities of financial institutions and their holding companies. The Dodd-Frank Act requires various federal agencies to adopt a broad range of new implementing rules and regulations, and to prepare numerous studies and reports for Congress. The federal agencies are given significant discretion in drafting the implementing rules and regulations. Although some of these regulations have been promulgated, many additional regulations are expected to be issued in 2012 and thereafter. Consequently, many of the details and much of the impact of the Dodd-Frank Act may not be known for many months or years.
Certain provisions of the Dodd-Frank Act are having an effect on us. For example, a provision eliminates the federal prohibitions on paying interest on demand deposits, thus allowing businesses to have interest-bearing checking accounts. Although not currently quantifiable, this significant change to existing law could have an adverse effect on our interest expense.
The Dodd-Frank Act also broadens the base for FDIC insurance assessments. Assessments are now being based on the average consolidated total assets less tangible equity capital of a financial institution. The Dodd-Frank Act also permanently increases the maximum amount of deposit insurance for banks, savings institutions, and credit unions to $250,000 per depositor, retroactive to January 1, 2008, and non-interest bearing transaction accounts have unlimited deposit insurance through December 31, 2012.
The Dodd-Frank Act requires publicly traded companies to give stockholders a non-binding vote on executive compensation and so-called “golden parachute” payments, and authorizes the SEC to promulgate rules that would allow stockholders to nominate their own candidates using a company’s proxy materials. The legislation also directs the Federal Reserve to promulgate rules prohibiting excessive compensation paid to bank holding company executives, regardless of whether the company is publicly traded or not.
The Dodd-Frank Act created the Consumer Financial Protection Bureau with broad powers to supervise and enforce consumer protection laws. The Bureau has broad rule-making authority for a wide range of consumer protection laws that apply to all banks and savings institutions, including the authority to prohibit “unfair, deceptive, or abusive” acts and practices. It also has examination and enforcement authority over all banks and savings institutions with more than $10 billion in assets. Banks and savings institutions with $10 billion or less in assets will be examined by their applicable bank regulators. The Dodd-Frank Act also weakens the federal preemption rules that have been applicable for national banks and federal savings associations, and gives state attorneys general the ability to enforce federal consumer protection laws.
It is difficult to quantify what specific impact the Dodd-Frank Act and related regulations have had on the Company to date and what impact yet to be written regulations will have on us in the future. However, it is expected at a minimum, they will increase our operating and compliance costs and could increase our interest expense.
Our participation in the CPP imposes restrictions and obligations on us that may limit our ability to access the capital markets and reduce our liquidity.
In November 2008, we issued Preferred Stock and a Warrant to the U.S. Treasury as part of its CPP. The Securities Purchase Agreement, pursuant to which such securities were sold, among other things, grants the holders of such securities certain registration rights which, in certain circumstances, impose lock-up periods during which we would be unable to issue equity securities. In addition, unless we are able to redeem the Preferred Stock during the first five years, the dividends on this capital will increase substantially at that point, from 5% to 9%. Depending on market conditions at the time, this increase in dividends could significantly impact our liquidity.
We are restricted from paying any dividends or repurchasing any shares of our common stock until we pay all accrued and unpaid dividends on our Preferred Stock.
So long as the Preferred Stock remains outstanding, no dividend or distribution may be declared or paid on our common stock (other than dividends payable solely in shares of common stock), and no common stock, may be, directly or indirectly, purchased, redeemed or otherwise acquired for consideration by 1st Financial or the Bank, unless all accrued and unpaid dividends for all past dividend periods, including the latest completed dividend period, on all outstanding shares of Preferred Stock have been or are contemporaneously declared and paid in full (or have been declared and a sum sufficient for the payment thereof has been set aside for the benefit of the holders of shares of Preferred Stock on the applicable record date). We have not paid dividends on the Preferred Stock since May 2010, and expect to again defer the $205,000 quarterly payment of the preferred dividend in May 2012. As a consequence, it is unlikely 1st Financial will be permitted to pay any dividends on its common stock for at least the foreseeable future.
The limitations on incentive compensation contained in the ARRA and subsequent regulations may adversely affect our ability to retain our highest performing employees.
In the case of a company such as 1st Financial that received CPP funds, the ARRA, and subsequent regulations issued by the U.S. Treasury, contain restrictions on bonus and other incentive compensation payable to the Company’s senior executive officers. As a consequence, we may be unable to create a compensation structure that permits us to retain our highest performing employees and attract new employees of a high caliber. If this were to occur, our businesses and results of operations could be adversely affected.
The soundness of other financial institutions could adversely affect us.
In recent years, the financial services industry as a whole has been materially and adversely affected by significant declines in the value of real estate and other asset classes, as well as reduced capital levels and lack of liquidity. Financial institutions have been subject to increased volatility and an overall loss in investor confidence, caused in large part by the unprecedented level of bank failures.
Our ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions, including the failure of other financial institutions, locally and nationally. Financial services companies are interrelated as a result of trading, clearing, counterparty, or other relationships. We have exposure to many different industries and counterparties, and we routinely execute transactions with counterparties in the financial services industry, including brokers and dealers, commercial banks, and other institutional clients.
Increases in FDIC insurance premiums may adversely affect our net income and profitability.
Since 2008, higher levels of bank failures have dramatically increased resolution costs of the FDIC and depleted the deposit insurance fund. In addition, the FDIC instituted two temporary programs to further ensure customer deposits at FDIC insured banks: deposit accounts are now insured up to $250,000 per customer (up from $100,000), made permanent in 2010 and noninterest-bearing transactional accounts are currently fully insured (unlimited coverage). These programs have placed additional stress on the deposit insurance fund. In order to maintain a strong funding position and restore reserve ratios of the deposit insurance fund, the FDIC has increased assessment rates of insured institutions. We are generally unable to control the amount of premiums the Bank is required to pay for FDIC insurance, which is determined, in part, by the risk profile of each depository institution. If there are additional financial institution failures, the cost of resolving prior failures exceeds expectations, or the Bank’s risk profile further deteriorates, the Bank may be required to pay even higher FDIC premiums. Any future increases or required prepayments of FDIC insurance premiums may adversely impact our earnings and financial condition.
Risks Associated to Our Business
1st Financial relies on dividends from the Bank for most of 1st Financial’s revenue.
1st Financial is a separate and distinct legal entity from the Bank. Historically, 1st Financial has received substantially all of its revenue from dividends received from the Bank. These dividends have been the principal source of funds to pay dividends on 1st Financial’s common and preferred stock, and operating expense. Various federal and/or state laws and regulations limit the amount of dividends the Bank may pay to 1st Financial, and the Bank is now further restricted with respect to the payment of dividends under the terms of the Consent Order, and by virtue of it being deemed to be “significantly undercapitalized.” In the event the Bank continues to be unable to pay dividends to 1st Financial, 1st Financial may not be able to pay obligations, or pay dividends on its common and preferred stock. The continuing inability to receive dividends from the Bank could have a material adverse effect on 1st Financial’s business, financial condition, and results of operations. As discussed elsewhere, the Bank is not permitted to pay dividends to 1st Financial under the terms of the Consent Order without the prior consent of the FDIC and the Commissioner.
We need to raise additional capital in the future in order to satisfy regulatory requirements, but that capital may not be available when it is needed.
Federal and state banking regulators require us to maintain adequate levels of capital to support our operations. On December 31, 2011, we were deemed “significantly undercapitalized” under bank regulatory guidelines and, in addition, our capital ratios were below the minimum levels required in the Consent Order and Written Agreement. We need to increase our capital to satisfy regulatory requirements. Management and our Board continue to pursue plans to improve our capital levels, including seeking to raise additional capital. However, our ability to raise that additional capital depends on conditions at that time in the capital markets, economic conditions, our financial performance and condition, and other factors, many of which are outside our control. Given the state of the equity markets and our financial performance and condition, our ability to raise capital in the foreseeable future is unknown. If additional equity cannot be secured, or can only be secured at an unexpectedly high cost, this could adversely affect the Company, and could result in the Bank being placed in conservatorship or receivership by the FDIC or the Commissioner.
Our allowance for loan losses may prove to be insufficient to absorb probable losses in our loan portfolio.
Lending money is a substantial part of our business. Every loan carries a degree of risk that it will not be repaid in accordance with its terms or that any underlying collateral will not be sufficient to assure repayment. This risk is affected by, among other things:
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cash flows of the borrower and/or the business activity being financed;
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in the case of a collateralized loan, changes in and uncertainties regarding future values of collateral;
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the credit history of a particular borrower;
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changes in economic and industry conditions; and
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the duration of the loan.
We use underwriting procedures and criteria we believe minimize the risk of loan delinquencies and losses, but banks routinely incur losses in their loan portfolios. However, regardless of the underwriting criteria we use, we will experience loan losses from time to time in the ordinary course of our business, and some of those losses will result from factors beyond our control. These factors include, among other things, changes in market, economic, business or personal conditions, or other events (including changes in market interest rates), that affect our borrowers’ abilities to repay their loans and the value of properties that collateralize loans. Recent difficulties in the national economy and housing market, declining real estate values, high unemployment, and loss of consumer confidence, have resulted and will continue to result in increasing loan delinquencies and loan losses for all financial institutions.
We maintain an allowance for loan losses based on our current judgments about the credit quality of our loan portfolio. The amount of our allowance is determined by our management through a periodic review and consideration of internal and external factors that affect loan collectability, including, but not limited to:
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an ongoing review of the quality, size, and diversity of our overall loan portfolio;
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evaluation of nonperforming loans;
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historical default and loss experience;
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historical recovery experience;
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existing economic conditions;
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risk characteristics of various classifications of loans; and
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the amount and quality of collateral, including guarantees, securing the loans.
There is no precise method of predicting credit losses since any estimate of loan losses is necessarily subjective and the accuracy of the estimate depends on the outcome of future events. Therefore, we face the risk that charge-offs in future periods will exceed our allowance for loan losses and that additional increases in the allowance for loan losses will be required. Additions to the allowance for loan losses would adversely affect our results of operations and financial condition, and possibly cause a decrease in our capital.
We continue to hold and acquire a significant amount of other real estate, which has led to increased operating expense and vulnerability to additional declines in real property values.
We foreclose on and take title to real estate serving as collateral for many of our loans as part of our business. Real estate owned by us and not used in the ordinary course of our operations is referred to as “real estate acquired in settlement of loans” or “foreclosed real estate”. At December 31, 2011, we had foreclosed real estate with an aggregate book value of $19.3 million, compared to $7.3 million at December 31, 2010. We obtain appraisals prior to taking title to real estate and periodically thereafter. However, due to the continued deterioration in real estate prices in our market, there can be no assurance that such valuations will reflect the amount which may be paid by a willing purchaser in an arms-length transaction at the time of the final sale. Moreover, we cannot provide assurance the losses associated with foreclosed real estate will not exceed the estimated amounts, which would adversely affect future results of our operations.
The calculation for the adequacy of write-downs of our foreclosed real estate is based on several factors, including the appraised value of the real property, economic conditions in the property’s sub-market, comparable sales, current buyer demand, availability of financing, entitlement and development obligations and costs and historic loss experience. All of these factors have caused further write-downs in recent periods and can change without notice based on market and economic conditions. High levels of nonperforming assets indicate that foreclosed real estate balances will continue to be high for the foreseeable future. Increased foreclosed real estate balances have led to greater expense as we incur costs to manage and dispose of the properties. We expect our earnings will continue to be negatively affected by various expenses associated with foreclosed real estate, including personnel costs, insurance, and taxes, completion and repair costs, valuation adjustments and other expenses associated with property ownership, as well as by the funding costs associated with assets that are tied up in foreclosed real estate. Moreover, our ability to sell foreclosed real estate is affected by public perception that banks are inclined to accept large discounts from market value in order to quickly liquidate properties. Any further decrease in market prices may lead to further write-downs, with a corresponding expense in our statement of operations. Further write-downs on foreclosed real estate or an inability to sell foreclosed real estate could have a material adverse effect on our results of operations and financial conditions. Furthermore, the management and resolution of nonperforming assets, which include foreclosed real estate, increases our costs and requires significant commitments of time from our management and directors, which can be detrimental to the performance of their other responsibilities. The expenses associated with foreclosed real estate and any further property write-downs could have a material adverse effect on our financial condition and results of operations.
A significant percentage of our loans are secured by real estate. Adverse conditions in the real estate market in our banking markets might adversely affect our loan portfolio.
While we do not have a subprime lending program, a significant percentage of our loans are secured by real estate. Our management believes, in the case of many of those loans, the real estate collateral is not being relied upon as the primary source of repayment, and the level of our real estate loans reflects, at least in part, our policy to take real estate whenever possible as primary or additional collateral rather than other types of collateral. However, adverse conditions in the real estate market and the economy in general have decreased real estate values in our banking markets. If the value of our collateral for a loan falls below the outstanding balance of that loan, our ability to collect the balance of the loan by selling the underlying real estate in the event of a default will be diminished, and we would be more likely to suffer a loss on the loan. An increase in our loan losses could have a material adverse effect on our operating results and financial condition.
The FDIC adopted rules aimed at placing additional monitoring and management controls on financial institutions whose loan portfolios are deemed to have concentrations in commercial real estate (CRE). At December 31, 2011, our loan portfolio exceeded thresholds established by the FDIC for CRE concentrations and for additional regulatory scrutiny. Indications from regulators are that strict limitations on the amount or percentage of CRE within any given portfolio are not expected, but, rather, that additional reporting and analysis will be required to document management’s evaluation of the potential additional risks of such concentrations and the impact of any mitigating factors. These rules could increase the costs of monitoring and managing this component of our loan portfolio. This could have an adverse impact on our operating results and financial condition.
Our commercial real estate lending may expose us to risk of loss and hurt our earnings and profitability.
We regularly make loans secured by commercial real estate (CRE). These types of loans generally have higher risk-adjusted returns and shorter maturities than traditional one-to-four family residential mortgage loans. Further, loans secured by CRE properties are generally for larger amounts and involve a greater degree of risk than one-to-four family residential mortgage loans. Payments on loans secured by these properties are often dependent on the income produced by the underlying properties which, in turn, depends on the successful operation and management of the properties. Accordingly, repayment of these loans is subject to adverse conditions in the real estate market or the local economy. In addition, many economists believe deterioration in income- producing CRE is likely to worsen as vacancy rates continue to rise and absorption rates of existing square footage continue to decline. Because of the current general economic slowdown, these loans represent higher risk, could result in an increase in our total net-charge offs and could require us to increase our allowance for loan losses, which could have a material adverse effect on our financial condition or results of operations. At December 31, 2011, our loans secured by CRE totaled $159.1 million, which represented 38.0% of total loans. For 2011, we had net charge-offs of $2.0 million, an increase of $1.2 million when compared to $808,000 in 2010. While we seek to minimize these risks in a variety of ways, there can be no assurance that these measures will protect against credit-related losses.
Our construction loans and land development loans involve a higher degree of risk than other segments of our loan portfolio.
Construction financing typically involves a higher degree of credit risk than financing on improved, owner-occupied real estate. Risk of loss on a construction loan is largely dependent upon the accuracy of the initial estimate of the property’s value at completion of construction and the bid price and estimated cost (including interest) of construction. If the estimate of construction costs proves to be inaccurate, we may be required to advance funds beyond the amount originally committed to permit completion of the project. If the estimate of the value proves to be inaccurate, we may be confronted, at or prior to the maturity of the loan, with a project whose value is insufficient to assure full repayment. When lending to builders, the cost of construction breakdown is provided by the builder, as well as supported by the appraisal. Although our underwriting criteria are designed to evaluate and minimize the risks of each construction loan, there can be no guarantee that these practices will safeguard against material delinquencies and losses to our operations. Construction and land development loans are dependent on the successful completion of the projects they finance, however, in many cases such construction and development projects in our primary market areas are not being completed in a timely manner, if at all. At December 31, 2011, we had loans of $87.1 million, or 20.8% of total loans, outstanding to finance construction and land development. For 2011, we had net charge-offs of $9.4 million, a decrease of $6.2 million when compared to $15.6 million in 2010.
Our lending on vacant land may expose us to a greater risk of loss and may have an adverse effect on results of operations.
A portion of our residential and commercial lending is secured by vacant or unimproved land. Loans secured by vacant or unimproved land are generally more risky than loans secured by improved property for one-to-four-family residential mortgage loans. Since vacant or unimproved land is generally held by the borrower for investment purposes or future use, payments on loans secured by vacant or unimproved land will typically rank lower in priority to the borrower than a loan the borrower may have on their primary residence or business. These loans are susceptible to adverse conditions in the real estate market and local economy. At December 31, 2011, loans secured by vacant or unimproved property totaled $44.9 million, or 10.7% of our loan portfolio.
The Company will be unable to grow in the short term.
As a strategy, the Company seeks to increase the size of its franchise by pursuing business development opportunities. However, by virtue of being deemed undercapitalized under the FDIC’s framework for prompt corrective action, the Bank may not permit its average total assets during any calendar quarter to exceed its average total assets during the preceding calendar quarter. The Consent Order also places restrictions on asset growth. As such, it is anticipated the Company will be unable to grow until it improves its capital condition, and will not be able to grow significantly until the Consent Order is removed. Such restrictions on the Company’s growth are expected to adversely affect our revenue, operating results, and financial condition.
Our business depends on the condition of the local and regional economies where we operate.
We currently have offices only in western North Carolina. Consistent with our community banking philosophy, our customer base is located in that region, and we lend a substantial portion of our capital and deposits to commercial and consumer borrowers in our local banking markets. Therefore, our local and regional economy has a direct impact on our ability to generate deposits to support loan growth, the demand for loans, the ability of borrowers to repay loans, the value of collateral securing our loans (particularly loans secured by real estate), and our ability to collect, liquidate, and restructure possible problem loans. The local economies of the communities in our banking markets are relatively dependent on the tourism industry and the retirement and second home real estate market. The economies of our banking markets have been adversely affected by a general economic downturn and this downturn has affected the tourism industry and real estate values in our communities, which has adversely affected our operating results. Further deterioration of economic conditions in our banking markets could further affect our ability to generate new loan production, adversely affect the ability of our customers to repay their loans to us, and generally affect our financial condition and operating results. We are less able than larger institutions to spread risks of unfavorable local economic conditions across a large number of diversified economies. And, we cannot assure you we will benefit from any market growth or favorable economic conditions in our banking markets even if they do occur.
Adverse market and economic conditions in North Carolina, particularly in the real estate, agricultural or tourism industries, disproportionately increase the risk our borrowers will be unable to make their loan payments and the risk the market value of real estate securing our loans will not be sufficient collateral. On December 31, 2011, 88.1% of the total dollar amount of our loan portfolio was secured by liens on real estate, with 6.7% of our portfolio representing home equity lines of credit. Our management believes, in the case of many of those loans, the real estate collateral is not being relied upon as the primary source of repayment, and those relatively high percentages reflect, at least in part, our policy to take real estate whenever possible as primary or additional collateral. However, any sustained period of increased payment delinquencies, foreclosures or losses caused by adverse market or economic conditions in North Carolina could adversely affect the value of our assets, revenue, operating results, and financial condition.
Our profitability is subject to interest rate risk. Changes in interest rates could have an adverse effect on our operating results.
Changes in interest rates can have different effects on various aspects of our business, particularly our net interest income. Our profitability depends, to a large extent, on our net interest income, which is the difference between our income on interest-earning assets and our expense on interest-bearing deposits and other liabilities. Like most financial institutions, we are affected by changes in general interest rate levels and by other economic factors beyond our control. Interest rate risk arises in part from the mismatch (i.e., the interest rate sensitivity “gap”) between the dollar amounts of repricing or maturing interest-earning assets and interest-bearing liabilities, and is measured in terms of the ratio of the interest rate sensitivity gap to total assets. When more interest-earning assets than interest-bearing liabilities will reprice or mature over a given time period, a bank is considered asset-sensitive and has a positive gap. When more liabilities than assets will reprice or mature over a given time period, a bank is considered liability-sensitive and has a negative gap. A liability-sensitive position (i.e., a negative gap) may generally enhance net interest income in a falling interest rate environment and reduce net interest income in a rising interest rate environment. An asset-sensitive position (i.e., a positive gap) may generally enhance net interest income in a rising interest rate environment and reduce net interest income in a falling interest rate environment. Our ability to manage our gap position determines to a great extent our ability to operate profitably. However, fluctuations in interest rates are not predictable or controllable, and we cannot assure you we will be able to manage our gap position in a manner that will allow us to be profitable.
At December 31, 2011, the Bank remained in an asset-sensitive position. This reflects the construct of the Bank’s balance sheet whereby our interest-earning assets generally would be expected to reprice at a faster rate than our interest-bearing liabilities. Therefore, a rising rate environment would generally be expected to have a positive effect on our earnings, while a falling rate environment generally would be expected to have a negative effect on our earnings. In our interest rate gap analysis, money market deposit accounts are spread over two years as they are considered more rate sensitive. Savings accounts and NOW accounts have been evaluated and are deemed to be less rate sensitive than money market deposit accounts and consequently are spread over four years and five years, respectively. Our management’s historical experience has shown that changes in market interest rates have a lesser effect on these type deposits within a given time period and, for that reason, those liabilities could be considered much less rate sensitive.
If our historical experience with the relative insensitivity of these deposits to changes in market interest rates does not continue in the future and we experience more rapid repricing of interest-bearing liabilities than interest-earning assets in a near term rising interest rate environment, our net interest margin and net income may decline.
Competition from financial institutions and other financial service providers may adversely affect our profitability.
Commercial banking in our banking markets and in North Carolina as a whole is extremely competitive. In addition to community, super-regional, national, and international commercial banks, we compete against credit unions, savings and loan associations, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market funds and other mutual funds. We compete with these institutions in attracting deposits and in making loans, and we have to attract our customer base from other existing financial institutions and from new residents. Our larger competitors have greater resources, broader geographic markets and higher lending limits than we do, and they may be able to offer more products and services and better afford and more effectively use media advertising, support services, and electronic technology than we can. While we believe we compete effectively with other financial institutions, we may face a competitive disadvantage as a result of our size, lack of geographic diversification and inability to spread marketing costs across a broader market. Although we compete by concentrating our marketing efforts in our primary markets with local advertisements, personal contacts, and greater flexibility and responsiveness in working with local customers, we cannot assure you we will continue to be an effective competitor in our banking markets.
We are subject to extensive regulation that could limit or restrict our activities and adversely affect our earnings.
We operate in a highly regulated industry and are subject to examination, supervision, and comprehensive regulation by various federal and state agencies. Our compliance with these regulations is costly and restricts certain of our activities, including payment of dividends, possible mergers and acquisitions, investments, loans and interest rates charged thereon, interest rates paid on deposits, and locations of offices. We also are subject to capitalization guidelines established by our regulators, which require us to maintain adequate capital. Most of these regulations are primarily intended to protect depositors, the public and the FDIC’s deposit insurance fund, rather than stockholders.
The Sarbanes-Oxley Act of 2002, and the related rules and regulations issued by the SEC that are applicable to us, have vastly increased the scope, complexity and cost of corporate governance, reporting and disclosure practices, including the costs of completing our audit and maintaining our internal controls. The laws and regulations that apply to us could change at any time, and we cannot fully predict the effects of those changes on our business and profitability. However, virtually any newly imposed governmental regulation is highly likely to create additional expense to the Bank and in cases such as Sarbanes-Oxley noted above, the cost can be very significant. Implementation and adoption of regulatory and accounting rules greatly affects the business and financial results of all commercial banks and bank holding companies, and our cost of compliance would be expected to adversely affect our earnings.
If the Bank loses key employees with significant business contacts in its market areas, its business may suffer.
The Bank is largely dependent on the personal contacts of our officers and employees in its market areas. If the Bank loses key employees temporarily or permanently, this could have a material adverse effect on the business. The Bank could be particularly affected if its key employees go to work for competitors. The Bank’s future success depends on the continued contributions of its existing senior management personnel, many of whom have significant local experience and contacts in its market areas. The Bank has employment agreements or noncompetition agreements with several of its senior and executive officers in an attempt to partially mitigate this risk.
We may face increasing deposit-pricing pressures, which may, among other things, reduce our profitability.
Checking and savings account balances and other forms of deposits can decrease when our deposit customers perceive alternative investments, such as the stock market or other non-depository investments, as providing superior expected returns or seek to spread their deposits over several banks to maximize FDIC insurance coverage. Furthermore, technology and other changes have made it more convenient for bank customers to transfer funds into alternative investments, including products offered by other financial institutions or non-bank service providers. Increases in short-term interest rates could increase transfers of deposits to higher yielding deposits. Efforts and initiatives we undertake to retain and increase deposits, including deposit pricing, can increase our costs. When bank customers move money out of bank deposits in favor of alternative investments or into higher yielding deposits, or spread their accounts over several banks, we can lose a relatively inexpensive source of funds, thus increasing our funding costs.
Negative publicity could damage our reputation.
Reputation risk, or the risk to our earnings and capital from negative public opinion, is inherent in our business. Negative public opinion could adversely affect our ability to keep and attract customers and expose us to adverse legal and regulatory consequences. Negative public opinion could result from our actual or alleged conduct in any number of activities, including lending practices, corporate governance, regulatory compliance, mergers and acquisitions, and disclosure, sharing or inadequate protection of customer information, and from actions taken by government regulators and community organizations in response to that conduct.
The Bank is subject to environmental liability risk associated with lending activities.
A significant portion of the Bank’s loan portfolio is secured by real property. During the ordinary course of business, the Bank may foreclose on and take title to properties securing certain loans. In doing so, there is a risk hazardous or toxic substances could be found on these properties. If hazardous or toxic substances are found, the Bank may be liable for remediation costs, as well as for personal injury and property damage. Environmental laws may require the Bank to incur substantial expenses and may materially reduce the affected property’s value or limit the Bank’s ability to use or sell the affected property. In addition, future laws or more stringent interpretations of enforcement policies with respect to existing laws may increase the Bank’s exposure to environmental liability. Although the Bank has policies and procedures to perform an environmental review before initiating any foreclosure action on real property, these reviews may not be sufficient to detect all potential environmental hazards. The remediation costs and any other financial liabilities associated with an environmental hazard could have a material adverse effect on the Company’s financial condition and results of operations.
Financial services companies depend on the accuracy and completeness of information about customers and counterparties.
In deciding whether to extend credit or enter into other transactions, we may rely on information furnished by or on behalf of customers and counterparties, including financial statements, credit reports, and other financial information. We may also rely on representations of those customers, counterparties, or other third parties, such as independent auditors, as to the accuracy and completeness of that information. Reliance on inaccurate or misleading financial statements, credit reports, or other financial information could cause us to enter into unfavorable transactions, which could have a material adverse effect on our financial condition and results of operations.
Liquidity risk could impair our ability to fund operations and jeopardize our financial condition, results of operations, and cash flows.
Liquidity is essential to our business. Our ability to implement our business strategy will depend on our ability to obtain funding for loan originations, working capital, possible acquisitions, and other general corporate purposes. An inability to raise funds through deposits, borrowings, securities sold under repurchase agreements, the sale of loans and other sources could have a substantial negative effect on our liquidity. Our retail and commercial deposits may not be sufficient to meet our funding needs in the foreseeable future. We therefore may have to increase our reliance on funding obtained through FHLB advances, securities sold under agreements to repurchase, and other wholesale funding sources.
Our access to funding sources in amounts adequate to finance our activities or on terms, which are acceptable to us could be impaired by factors that affect us specifically or the financial services industry or economy in general, including a decrease in the level of our business activity as a result of a downturn in the markets in which our loans are concentrated, financial condition, including capitalization and asset quality, or adverse regulatory action against us. Under our Consent Order, we are not permitted to accept, renew, or rollover brokered deposits. Such restriction requires us to seek other permissible funding sources. Our ability to borrow could also be impaired by factors that are not specific to us, such as a disruption in the financial markets or negative views and expectations about the prospects for the financial services industry in light of the recent turmoil faced by banking organizations and continued deterioration in credit markets. To the extent we are not successful in obtaining such funding, we will be unable to implement our strategy as planned, which could have a material adverse effect on our financial condition, results of operations and cash flows.
Changes in our accounting policies or in accounting standards could materially affect how we report our financial results and condition.
Our accounting policies are fundamental to understanding our financial results and condition. Some of these policies require use of estimates and assumptions that may affect the value of our assets or liabilities and financial results. Some of our accounting policies are critical because they require management to make difficult, subjective, and complex judgments about matters that are inherently uncertain and because it is likely materially different amounts would be reported under different conditions or using different assumptions.
From time to time the Financial Accounting Standards Board (the FASB) and the SEC change the financial accounting and reporting standards or the interpretation of those standards that govern the preparation of our external financial statements. These changes are beyond our control, can be hard to predict and could materially impact how we report our results of operations and financial condition. We could be required to apply a new or revised standard retroactively, resulting in our restating prior period financial statements in material amounts.
Impairment of investment securities could require charges to earnings, which could result in a negative impact on our results of operations.
In assessing the impairment of investment securities, management considers the length of time and extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuers, and the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value in the near term. The impact of an other-than-temporary impairment could have a material adverse effect on our business, results of operations, and financial condition.
Premiums for D&O insurance may increase; We may be unable to renew our D&O insurance policy on acceptable terms.
Since 2008, higher levels of bank failures and the associated heightened risk of regulatory action and litigation against directors and officers of failed banks have increased the cost of directors and officers liability insurance ( D&O insurance ) premiums for many financial institutions. Because of our recent losses and financial condition, it is likely that the cost of D&O insurance will increase when we seek to renew our coverage. Any future increases in D&O insurance premiums will likely adversely impact our earnings and financial condition. In addition, we may be unable to renew our D&O insurance coverage in the future, or we may be unable to obtain adequate replacement policies on acceptable terms. If we are not able to secure appropriate D&O insurance coverage, we may be unable to retain our current officers and directors, or attract additional officers and directors.
We rely on other companies to provide key components of our business infrastructure.
Third-party vendors provide key components of our business infrastructure such as internet connections, network access and core application processing. While we have selected these third-party vendors carefully, we do not control their actions. Any problems caused by these third parties, including as a result of their not providing us their services for any reason or their performing their services poorly, could adversely affect our ability to deliver products and services to our customers and otherwise to conduct our business. Replacing these third-party vendors could also entail significant delay and expense.
Our information systems may experience an interruption or breach in security.
We rely heavily on communications and information systems to conduct our business. Any failure, interruption, or breach in security or operational integrity of these systems could result in failures or disruptions in our customer relationship management, general ledger, deposit, loan, and other systems. While we have policies and procedures designed to prevent or limit the effect of the failure, interruption, or security breach of our information systems, we cannot assure you any such failures, interruptions, or security breaches will not occur or, if they do occur, that they will be adequately addressed. The occurrence of any failures, interruptions, or security breaches of our information systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our financial condition and results of operations.
Unpredictable catastrophic events could have a material adverse effect on 1st Financial.
The occurrence of catastrophic events such as hurricanes, tropical storms, earthquakes, pandemic disease, windstorms, floods, severe winter weather (including snow, freezing water, ice storms, and blizzards), fires and other catastrophes could adversely affect 1st Financial’s consolidated financial condition or results of operations. Unpredictable natural and other disasters could have an adverse effect on the Bank in that such events could materially disrupt its operations or the ability or willingness of its customers to access the financial services offered by the Bank. The incidence and severity of catastrophes are inherently unpredictable. Although the Bank carries insurance to mitigate its exposure to certain catastrophic events, these events could nevertheless reduce the Company’s earnings and cause volatility in its financial results for any fiscal quarter or year and have a material adverse effect on the Company’s financial condition and/or results of operations.
We may need to invest in new technology to compete effectively, and that could have a negative effect on our operating results and the value of our common stock.
The market for financial services, including banking services, is increasingly affected by advances in technology, including developments in telecommunications, data processing, computers, automation, and Internet-based banking. We depend on third-party vendors for portions of our data processing services. In addition to our ability to finance the purchase of those services and integrate them into our operations, our ability to offer new technology-based services depends on our vendors’ abilities to provide and support those services. Future advances in technology may require us to incur substantial expense that adversely affects our operating results, and our small size and limited resources may make it impractical or impossible for us to keep pace with our larger competitors. Our ability to compete successfully in our banking markets may depend on the extent to which we and our vendors are able to offer new technology-based services and on our ability to integrate technological advances into our operations.
Risks Related to Our Common Stock
Our ability to pay dividends is limited and we may be unable to pay future dividends.
As discussed above under “Supervision and Regulation” in Item 1, our ability to pay cash dividends is limited by regulatory restrictions as well as the need to maintain sufficient capital. So long as our capital ratios and regulatory requirements are not satisfied, we will be unable to pay cash dividends on our common and preferred stock.
There may be future sales of additional common stock or preferred stock or other dilution of our equity, which may adversely affect the market price of our common stock.
We are not restricted from issuing additional common stock or preferred stock, including any securities that are convertible into or exchangeable for, or that represent the right to receive, common stock or preferred stock or any substantially similar securities. The market value of our common stock could decline as a result of sales by us of a large number of shares of common stock or preferred stock or similar securities in the market or the perception that such sales could occur.
The trading volume in our common stock has been relatively low, and the sale of a substantial number of shares in the public market could depress the price of our stock and make it difficult for you to sell your shares.
Our common stock has been quoted “over-the-counter” on the Pink Sheets Electronic Quotation Service and the OTC Bulletin Board since August 2004. However, our common stock is still relatively thinly traded. Thinly traded stocks can be more volatile than stock trading in an active public market. We cannot predict the extent to which an active public market for our common stock will develop or be sustained. In recent years, the stock market has experienced a high level of price and volume volatility, and market prices for the stock of many companies have experienced wide price fluctuations that have not necessarily been related to operating performance.
We cannot predict what effect future sales of our common stock in the market, or the availability of shares of our common stock for sale in the market, will have on the market price of our common stock. So, we cannot assure you that of substantial amounts of our common stock in the market, or the potential for large amounts of market sales, would not cause the price of our common stock to decline or potentially impair our ability to raise capital in the future.
Our management beneficially owns a substantial percentage of our common stock, so our directors and executive officers can significantly affect voting results on matters voted on by our stockholders.
On March 15, 2012, our current directors and executive officers, as a group, had the sole or shared right to vote, or to direct the voting of, an aggregate of 642,828 shares, or 12.4%, of our outstanding common stock. This group could purchase 446,472 additional shares under currently exercisable stock options they hold. Because of their voting rights, in matters put to a vote of our stockholders, it could be difficult for any group of our other stockholders to defeat a proposal favored by our management (including the election of one or more of our directors) or to approve a proposal opposed by management.
1st Financial has issued preferred stock, which ranks senior to our common stock.
The Company has issued 16,369 shares of Preferred Stock. This series of preferred stock ranks senior to shares of our common stock. As a result, 1st Financial must make dividend payments on the Preferred Stock before any dividends can be paid on the common stock and, in the event of our bankruptcy, dissolution or liquidation, the holders the preferred stock must be satisfied before any distributions can be made on the common stock. Through the date of this report, the Company has deferred the payment of the last seven quarterly preferred dividends, with the total amount deferred of $1.4 million. Until 1st Financial pays in full, these deferred Preferred Stock dividends, no dividends may be paid on the common stock.
Our Preferred Stock reduces net income available to holders of our common stock and earnings per common share and the Warrant may be dilutive to holders of our common stock.
Any dividends, whether declared or not, on our Preferred Stock will reduce any net income available to holders of common stock and our earnings per common share. The Preferred Stock will also receive preferential treatment in the event of sale, merger, liquidation, dissolution or winding up of our company. Additionally, the ownership interest of holders of our common stock will be diluted to the extent the Warrant is exercised.
Our stock price can be volatile.
Stock price volatility may make it more difficult for you to resell your common stock when you want and at prices you find attractive. Our stock price can fluctuate significantly in response to a variety of factors including, among other things:
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actual or anticipated variations in quarterly results of operations;
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operating results and stock price performance of other companies that investors deem comparable to us;
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news reports relating to trends, concerns, and other issues in the financial services industry;
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perceptions in the marketplace regarding us and/or our competitors;
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new technology used or services offered by competitors;
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regulatory actions against us;
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significant acquisitions or business combinations, strategic partnerships, joint ventures, or capital commitments by or involving us or our competitors; and
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changes in government regulations.
General market fluctuations, industry factors, and general economic and political conditions and events, such as economic slowdowns or recessions, interest rate changes, or credit loss trends, could also cause our stock price to decrease regardless of operating results.
Our common stock is not FDIC insured.
The Company’s common stock is not a savings or deposit account or other obligation of any bank and is not insured by the FDIC or any other governmental agency and is subject to investment risk, including the possible loss of principal. Investment in our common stock is inherently risky for the reasons described in this “Risk Factors” section and elsewhere in this report and is subject to the same market forces that affect the price of common stock in any company. As a result, holders of our common stock may lose some or all of their investment.
ITEM 2.
ITEM 2. PROPERTIES
The Company’s corporate offices are located in Hendersonville, North Carolina. At December 31, 2011, the Company maintained 12 full service banking offices and an operations center. The following table contains information about our banking offices.
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(1)
Leased from an unrelated third party.
(2)
Leased from a related party on terms comparable to third-party leases.
(3)
Corporate Headquarters and Main Office
All the Company’s existing banking offices are in good condition and fully equipped for the Company’s purposes. At December 31, 2011, the total net book value (cost less accumulated depreciation) of the Company’s premises, leasehold improvements, furniture, fixtures, and equipment was $4.9 million. See Notes 9 and 12 to the accompanying consolidated financial statements for additional information about the Company’s property and lease obligations.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
In the ordinary course of business, the Company and its subsidiaries are often involved in legal proceedings. In the opinion of management, except as disclosed in Item 1 hereof, under the caption "Business - Enforcement Actions", neither the Company nor its subsidiaries is a party to, nor is their property the subject of, any material pending legal proceedings, other than ordinary routine litigation incidental to their business, nor has any such proceeding been terminated during the fourth quarter of the Company’s fiscal year ended December 31, 2011.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
The Company’s common stock is traded over-the-counter with quotations available on the OTC Bulletin Board and the Pink Sheets Electronic Quotation Service under the symbol “FFIS.” There were approximately 2,838 stockholders of record as of December 31, 2011, not including the persons or entities whose stock is held in nominee or “street” name and by various banks and brokerage firms.
The table below presents the reported high and low closing prices for the Company’s common stock along with the actual closing price for the previous eight quarters. These quotations reflect inter-dealer prices, without retail mark up, mark down or commission and may not represent actual transactions. No common stock dividend was declared or paid during any of the fiscal quarters listed.
Securities Authorized for Issuance Under Equity Compensation Plans. The following table summarizes all compensation plans and individual compensation arrangements which were in effect on December 31, 2011, and under which shares of the Company's common stock have been authorized for issuance.
Dividends. See “Item 1. Description of Business - Supervision and Regulation” above for regulatory and CPP restrictions, which limit the ability of 1st Financial to pay dividends.
Recent Sales of Unregistered Securities. The Company did not sell any securities within the last three fiscal years that were not registered under the Securities Act.
Purchases of Equity Securities by the Issuer and Affiliated Purchasers. The Company did not repurchase any shares of its common stock during the fourth quarter of 2011.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
Not applicable.
ITEM 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Introduction
1st Financial Services Corporation (the Company) is a North Carolina corporation headquartered in Hendersonville, North Carolina that when it was formed in May 2008 became the sole owner of all of the capital stock of Mountain 1st Bank & Trust Company (the Bank). The Bank is a North Carolina state chartered, non-member bank, which was organized and incorporated under the laws of the State of North Carolina on April 30, 2004, and began operations on May 14, 2004. As of December 31, 2011, the Bank conducted business through 12 full-service branch offices located in nine western North Carolina counties.
Because the Company has no separate operations and conducts no business on its own other than owning the Bank, the discussion contained in this Management’s Discussion and Analysis concerns primarily the business of the Bank. However, because the financial statements are presented on a consolidated basis, the Company and the Bank are collectively referred to herein as the “Company” unless otherwise noted.
The Bank competes for loans and deposits throughout the markets it serves. The Bank, like other financial institutions, derives most of its revenue from net interest income, which is the difference between the income it earns from loans and securities minus the interest expense it incurs on deposits and borrowings.
Management has provided the following discussion and analysis to address information about the Company’s financial condition and results of operations which may not otherwise be apparent from the consolidated financial statements included in this Report. Reference should be made to those statements for an understanding of the following discussion and analysis.
Factors That May Affect Future Results
The discussion and analysis that follows is intended to assist readers in the understanding and evaluation of the financial condition and results of operations of the Company. It should be read in conjunction with the audited consolidated financial statements and accompanying notes included in this Annual Report on Form 10-K and the supplemental financial data appearing throughout this discussion and analysis.
The following discussion contains certain forward-looking statements about the Company’s financial condition and results of operations, which are subject to certain risks and uncertainties that could cause actual results to differ materially from those reflected in the forward-looking statements. See also “Cautionary Note About Forward-Looking Statements” and “Risk Factors’, which begin on pages 3 and 21, respectively.
Enforcement Policies and Actions
Federal law gives the Federal Reserve and the FDIC substantial powers to enforce compliance with laws, rules, and regulations. Banks or individuals may be ordered to cease and desist from violations of law or other unsafe and unsound practices. The agency has the power to impose civil money penalties against individuals or institutions for certain violations.
Persons who are affiliated with depository institutions and their holding companies can be removed from any office held in that institution and banned from participating in the affairs of any financial institution. The banking regulators frequently employ the enforcement authorities provided in federal law.
During early 2010, the Bank entered into the Stipulation agreeing to the issuance of the Consent Order with the FDIC and the Commissioner. Although the Bank neither admitted nor denied any unsafe or unsound banking practices or violations of law or regulation, it agreed to the Consent Order, which requires the Board of Directors and the Bank to undertake a number of actions, including implementing plans to improve documentation regarding risk management and compliance systems, oversight and review functions, operating and financial management, and capital plans. As a result, the Company expects to continue its focus on improving asset quality and profitability until capital levels increase.
As a direct consequence of the issuance of the Consent Order and the requirement the Company serve as a source of strength for the Bank, in October 2010, the Company entered into the Written Agreement with the Federal Reserve Bank.
At December 31, 2011, the Bank was deemed "significantly undercapitalized". As such, the Bank is subject to certain additional restrictions, as discussed under ""Significantly Undercapitalized" Capital Category" in Item 1. Also, as a consequence of the Consent Order, the Bank is deemed to be in a "troubled condition," as defined under the FDIC's rules and regulations, which further prohibits or limits certain golden parachute agreements and payments to management.
There can be no assurance we will be able to comply fully with the provisions of the Consent Order and the Written Agreement. We need additional capital in order to improve the Bank’s capital ratios and satisfy the heightened capital requirements set out in the Consent Order, and to continue to absorb the write-downs needed to reduce nonperforming assets on our balance sheet in a relatively short time frame, given the particularly challenging real estate market. We are actively seeking to raise additional capital and pursuing a number of balance sheet management strategies to ensure our projected level of regulatory capital can support our balance sheet and meet or exceed the minimum requirements set forth in the Consent Order.
Currently, the Company also has to obtain the prior written approval of the Federal Reserve Bank before (1) declaring or paying any dividends, (2) directly or indirectly accepting dividends or any other form of payment representing a reduction in capital from the Bank, (3) making any distributions of interest, principal or other sums on subordinated debentures or trust preferred securities, (4) directly or indirectly, incurring, increasing or guaranteeing any debt, and (5) directly or indirectly, purchasing or redeeming any shares of its stock. Pursuant to our plans to preserve capital, the Company has no plans to undertake any of the foregoing activities.
Going Concern Considerations
As discussed in Item 7 of this report under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations, and in Note 2 to the accompanying consolidated financial statements, the Company has suffered recurring losses that have eroded regulatory capital ratios, and the Bank is under a Consent Order that requires, among other provisions, capital ratios to be maintained at certain heightened levels. In addition, the Company is under a Written Agreement that requires, among other provisions, the submission of a capital plan to improve the Company’s and the Bank’s capital levels. As of December 31, 2011, both the Bank and the Company are considered “significantly undercapitalized” based on their respective regulatory capital levels. These considerations raise substantial doubt about the Company's ability to continue as a going concern. Management’s plans are further discussed in Note 2 to the accompanying consolidated financial statements. These financial statements do not include any adjustments that would be necessary should the Company be unable to continue as a going concern.
Recent Regulatory Developments
The following is a summary of recently enacted laws and regulations that could materially impact our business, financial condition, or results of operations. This discussion should be read in conjunction with the remainder of the “Supervision and Regulation” section of this Form 10-K.
Markets in the United States and elsewhere have experienced extreme volatility and disruption over the past three plus years. These circumstances have exerted significant downward pressure on prices of equity securities and virtually all other asset classes, and have resulted in substantially increased market volatility and severely constrained credit and capital markets, particularly for financial institutions, and an overall loss of investor confidence. Loan portfolio performances have deteriorated at many institutions resulting from, among other factors, a weak economy and a decline in the value of the collateral supporting their loans. Dramatic slowdowns in the housing industry, due in part to falling home prices and increasing foreclosures and unemployment, have created strains on financial institutions. Many borrowers are now unable to repay their loans, and the collateral securing these loans has, in some cases, declined below the loan balance. In response to the challenges facing the financial services sector beginning in 2008 a multitude of new regulatory and governmental actions have been announced including the Emergency Economic Stabilization Act, approved by Congress and signed by President Bush on October 3, 2008, and the American Recovery and Reinvestment Act on February 17, 2009, among others. Some of the more recent actions include:
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On July 21, 2010, the U.S. President signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the Dodd-Frank Act), a comprehensive regulatory framework that will likely result in dramatic changes across the financial regulatory system, some of which became effective immediately and some of which will not become effective until various future dates. Implementation of the Dodd-Frank Act will require many new rules to be made by various federal regulatory agencies over the next several years. Uncertainty remains as to the ultimate impact of the Dodd-Frank Act until final rulemaking is complete, which could have a material adverse impact either on the financial services industry as a whole or on our business, financial condition, results of operations, and cash flows. Provisions in the legislation that affect consumer financial protection regulations, deposit insurance assessments, payment of interest on demand deposits, and interchange fees could increase the costs associated with deposits and place limitations on certain revenues those deposits may generate. The Dodd-Frank Act includes provisions that, among other things, have or will:
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centralize responsibility for consumer financial protection by creating a new agency, the Bureau of Consumer Financial Protection, responsible for implementing, examining, and enforcing compliance with federal consumer financial laws;
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create the Financial Stability Oversight Council that will recommend to the Federal Reserve increasingly strict rules for capital, leverage, liquidity, risk management and other requirements as companies grow in size and complexity;
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provide mortgage reform provisions regarding a customer’s ability to repay, restricting variable-rate lending by requiring that the ability to repay variable-rate loans be determined by using the maximum rate that will apply during the first five years of a variable-rate loan term, and making more loans subject to provisions for higher cost loans, new disclosures, and certain other revisions;
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change the assessment base for federal deposit insurance from the amount of insured deposits to consolidated assets less tangible capital, eliminate the ceiling on the size of the Deposit Insurance Fund ( DIF ), and increase the floor on the size of the DIF, which generally will require an increase in the level of assessments for institutions with assets in excess of $10 billion;
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make permanent the $250,000 limit for federal deposit insurance and provide unlimited federal deposit insurance until December 31, 2012, for noninterest-bearing demand transaction accounts at all insured depository institutions;
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implement corporate governance revisions, including with regard to executive compensation and proxy access by shareholders, which apply to all public companies, not just financial institutions;
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repeal the federal prohibitions on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transactions and other accounts;
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amend the Electronic Fund Transfer Act ( EFTA ) to, among other things, give the Federal Reserve the authority to establish rules regarding interchange fees charged for electronic debit transactions by payment card issuers having assets over $10 billion and to enforce a new statutory requirement that such fees be reasonable and proportional to the actual cost of a transaction to the issuer;
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eliminate the Office of Thrift Supervision ( OTS ) on July 21, 2011. The Office of the Comptroller of the Currency ( OCC ), which is the primary federal regulator for national banks, now has become the primary federal regulator for federal thrifts. In addition, the Federal Reserve now supervises and regulates all savings and loan holding companies that were formerly regulated by the OTS.
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On September 27, 2010, the U.S. President signed into law the Small Business Jobs Act of 2010. The Small Business Lending Fund (the SBLF), which was enacted as part of the Act, is a $30 billion fund that encourages lending to small businesses by providing Tier 1 capital to qualified community banks with assets of less than $10 billion. We did not participate in the SBLF.
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Internationally, both the Basel Committee on Banking Supervision (the Basel Committee) and the Financial Stability Board (established in April 2009 by the Group of Twenty ( G-20 ) Finance Ministers and Central Bank Governors to take action to strengthen regulation and supervision of the financial system with greater international consistency, cooperation, and transparency) have committed to raise capital standards and liquidity buffers within the banking system (Basel III). On September 12, 2010, the Group of Governors and Heads of Supervision agreed to the calibration and phase-in of the Basel III minimum capital requirements (raising the minimum Tier 1 common equity ratio to 4.5% and minimum Tier 1 equity ratio to 6.0%, with full implementation by January 2015) and introducing a capital conservation buffer of common equity of an additional 2.5% with full implementation by January 2019. The U.S. federal banking agencies support this agreement. In December 2010, the Basel Committee issued the Basel III rules text, outlining the details and time-lines of global regulatory standards on bank capital adequacy and liquidity. According to the Basel Committee, the framework sets out higher and better-quality capital, better risk coverage, the introduction of a leverage ratio as a backstop to the risk-based requirement, measures to promote the build-up of capital that can be drawn down in periods of stress, and the introduction of two global liquidity standards. Although the U.S. banking agencies have not yet published a notice of proposed rulemaking to implement Basel III in the United States, they are likely to do so (at least with respect to the Basel III capital framework) during the first half of 2012.
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In November 2010, the Federal Reserve's monetary policymaking committee, the Federal Open Market Committee (FOMC), decided that further support to the economy was needed. With short-term interest rates already nearing 0%, the FOMC agreed to deliver that support by committing to purchase additional longer-term U.S. Treasury securities, as it had in 2008 and 2009. The FOMC announced that it intended to purchase an additional $600 billion of longer-term U.S. Treasury securities by the end of the second quarter of 2011, at a pace of about $75 billion per month. In addition, the FOMC stated that it would maintain its existing policy of reinvesting principal payments from its securities holdings.
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In November 2010, the FDIC approved two proposals that amend the deposit insurance assessment regulations. The first proposal implements a provision in the Dodd-Frank Act that changes the assessment base from one based on domestic deposits (as it has been since 1935) to one based on assets. The assessment base changes from adjusted domestic deposits to average consolidated total assets minus average tangible equity. The second proposal changes the deposit insurance assessment system for large institutions in conjunction with the guidance given in the Dodd-Frank Act. In February 2011, the FDIC approved the final rules that change the assessment base from domestic deposits to average assets minus average tangible equity, adopt a new scorecard-based assessment system for financial institutions with more than $10 billion in assets, and finalize the designated reserve ratio target size at 2.0% of insured deposits. We elected to voluntarily participate in the unlimited deposit insurance component of the U.S Treasury’s Transaction Account Guarantee Program (TAGP) through December 31, 2010. Coverage under the program was in addition to and separate from the basic coverage available under the FDIC’s general deposit insurance rules. As a result of the Dodd-Frank Act, the program ended on December 31, 2010, and all institutions are now required to provide full deposit insurance on noninterest-bearing transaction accounts until December 31, 2012. There will not be a separate assessment for this as there was for institutions participating in the deposit insurance component of the TAGP.
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In June 2011, the Federal Reserve approved a final debit card interchange rule in accordance with the Dodd-Frank Act. The final rule caps an issuer’s base fee at $0.21 per transaction and allows an additional 5 basis point charge per transaction to help cover fraud losses. Though the rule technically does not apply to institutions with less than $10 billion in assets, such as the Bank, there is concern that the price controls may harm community banks, which could be pressured by the marketplace to lower their own interchange rates. The Federal Reserve also adopted requirements for issuers to include two unaffiliated networks for debit card transactions - one signature-based and one PIN-based. The effective date for the final rules on the pricing and routing restrictions was October 1, 2011. The results of these final rules may impact our interchange income from debit card transactions in the future. Thus far, the Bank has not experienced a material impact on its interchange fees.
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On September 21, 2011, the FOMC announced that, in order to support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with its statutory mandate, it had decided to extend the average maturity of its holdings of securities. In addition, the FOMC announced that it intended to purchase, by the end of June 2012, $400 billion of U.S Treasury securities with remaining maturities of three years or less in order to put downward pressure on longer-term interest rates and help make broader financial conditions more accommodative. Further, to help support conditions in mortgage markets, the FOMC intends to now reinvest in agency mortgage-backed securities the principal payments from its holdings of agency debt and agency mortgage-backed securities.
Although it is likely further regulatory actions will arise as the Federal government attempts to address the economic situation, we cannot predict the effect that fiscal or monetary policies, economic control, or new federal or state legislation may have on our business and earnings in the future.
Proposed Legislation and Regulatory Action
From time to time, various legislative and regulatory initiatives are introduced in Congress and state legislatures, as well as by regulatory agencies. Such initiatives may include proposals to expand or contract the powers of bank holding companies and depository institutions or proposals to substantially change the financial institution regulatory system. Such legislation could change banking statutes and the operating environment of the Company in substantial and unpredictable ways. If enacted, such legislation could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance among banks, savings associations, credit unions, and other financial institutions. We cannot predict whether any such legislation will be enacted, and, if enacted, the effect that it, or any implementing regulations, would have on the financial condition or results of operations of the Company. A change in statutes, regulations, or regulatory policies applicable to the Company or the Bank could have a material effect on the business of the Company.
General Economic Conditions
Western North Carolina is undergoing one of the most severe economic recessions in our history. Unemployment is at record levels and both residential and commercial real estate values have been adversely impacted. With the slowing economy, falling real estate values and reducing interest rates, our Company experienced severe stress on our earnings from both depressed margins and worsening asset quality. These conditions led to our providing an increase to the allowance for loan losses of $12.5 million in 2010 and suffering a net loss of $5.3 million. During 2011, the Company recorded a $15.8 million provision for loan losses and incurred a net loss of $20.5 million. Continued weakness in the Western North Carolina real estate markets was the primary reason for the Bank’s increased provision for loan losses and loan charge-offs in 2011. While we saw some net interest margin improvement in 2011, we expect it to moderate into 2012, as we may be unable to reinvest proceeds from loan repayments at the same yields. We also expect to incur increased expense as we manage our troubled assets. Our markets continue to feel the effects of the recession and we do not foresee substantial improvements in either unemployment or real estate values until late 2012, at the earliest.
Overview
The Company’s primary market area is located in the mountain region of southwestern North Carolina. The principal business sectors in this region include service companies directly or indirectly linked to tourism, which is one of the largest economic drivers of the region, small to mid-sized manufacturing companies, real estate development, particularly relating to the ongoing growth of the area as a retirement and second home destination, the arts and crafts industry, and to a lesser degree, agriculture.
The Bank believes its current base of business is relatively well diversified as is the general economic base of the region as a whole. The only concentration identified by management within the Bank’s lending portfolio is in loans secured by real estate. At December 31, 2011, loans collateralized by real estate, comprise approximately 88% of the Banks’ total loan portfolio. Management believes concentration risk within this sector of the loan portfolio is mitigated by the mix of different types of real estate held as collateral. These include residential, multifamily, and both income-producing and owner-occupied commercial properties. The Bank’s loan portfolio includes $87.1 million in loans classified as construction or acquisition and development (of which $44.9 million are land loans) and $159.1 million in loans classified as commercial real estate (CRE), representing 20.8% and 38.0%, respectively of the total portfolio. By way of comparison, at December 31, 2010, the Bank’s loan portfolio included $114.5 million in loans classified as construction or acquisition and development (of which $49.9 million were land loans) and $173.3 million in loans classified as CRE, representing 23.6% and 35.7%, respectively, of the total portfolio.
In addition to monitoring potential concentrations of loans to particular borrowers or groups of borrowers, industries, geographic regions and loan types, management monitors exposure to credit risk from other lending practices such as loans with high loan-to-value ratios. At December 31, 2011, loans exceeding regulatory loan-to-value guidelines represented 124.6 % of risk-based capital, primarily due to market value declines on the underlying collateral of the Company’s real estate loan portfolio, combined with lower risk-based capital due to losses incurred during the past three years.
Banking regulators have continued to issue guidance to banks concerning their perception of general risk levels associated with higher concentrations of CRE as a proportion of total loans and as a percentage of capital within bank loan portfolios. It remains management’s understanding that regulatory interpretations of this guidance would not necessarily prohibit future growth for banks with concentrations of CRE, however, additional monitoring and risk management procedures are likely to be required for portfolios with higher levels of CRE and additional CRE lending may also be curtailed. Management has continued efforts to refine enhanced monitoring systems pertaining to the Bank’s CRE portfolio, with particular emphasis on construction and acquisition and development lending, which comprises a material portion of the Bank’s CRE portfolio. In addition to continued enhanced monitoring of this portion of the loan portfolio, management has curtailed lending to new acquisition and development projects and anticipates this component of the portfolio will decline substantially over time.
The Company’s total assets were $700.0 million at December 31, 2011, a decrease of $24.8 million, from $724.8 million at December 31, 2010. The Company’s total deposits were $672.6 million at December 31, 2011, down slightly from $674.3 million at December 31, 2010. Proceeds from loan repayments and cash on deposit with the Federal Reserve were used to purchase investment securities and to repay brokered deposits. As evidenced by the balance sheet contraction in 2010 and 2011, overall growth plans have now been purposely slowed in response to the Bank’s asset quality deterioration, uncertainties with respect to the national economy, regional and local real estate markets, the domestic interest rate environment and global currency markets and in order to maintain satisfactory capital requirements. The Company expects total assets to remain stable throughout 2012.
For the first five years of operation, management’s business plan was predicated on the relatively rapid growth and establishment of an initial branch network within the Company’s primary delineated market area. However, due to the current economic environment and the financial condition of the Company, management does not expect to open any new branch offices to augment the current branch network for the foreseeable future. The Bank closed two offices in February 2011 to improve operating efficiencies. Instead, management will focus on reducing its nonperforming loan portfolio and its other real estate owned, while simultaneously growing existing branches in its primary markets.
The Company’s primary source of revenue is derived from interest income produced through traditional banking activities, such as generating loans and earning interest on securities. Additional sources of income are derived from fees on deposit accounts, Small Business Administration (SBA) and USDA loan originations and sales, and residential mortgage origination services.
Maintaining sound asset quality is another key focal point for the Company. As a result of the current economic environment, the Bank experienced an increase in nonperforming assets (nonaccruing loans and accruing loans past due 90 or more days) beginning in 2009, which resulted in significant provisions to increase our allowance for loan losses during the past three years. This development is further discussed under the heading “Asset Quality” below. The business of lending to small businesses and consumers carries with it significant credit risks, which must be continually managed. Management monitors asset quality and credit risk on an ongoing basis and fully expects to experience credit losses in the future, but we believe we have made substantial progress in identifying and quantifying the impact of the current economic environment on our loan portfolio and overall financial condition. Management continues to engage third-party consultants to assist in monitoring and evaluating the quality of the loan portfolio.
Financial Condition
December 31, 2011, Compared to December 31, 2010
The Company’s total assets were $700.0 million at December 31, 2011, a decrease of $24.8 million, from $724.8 million at December 31, 2010. Investment securities increased by $66.5 million, or 49.9%, from $133.2 million at December 31, 2010, to $199.7 million at December 31, 2011. During 2011, gross loans decreased by $69.6 million, or 14.0%, from $497.2 million at December 31, 2010, to $427.6 million at December 31, 2011, as management purposely slowed loan growth in response to current economic conditions and charged off $21.4 million of loans, net. Although the mix of deposits continued to shift from time deposits to transaction accounts, total deposits at December 31, 2011, were $672.6 million, essentially unchanged from $674.3 million at December 31, 2010. Excluding the reduction in brokered certificates of deposit of $39.8 million, retail deposits increased $38.1 million, or 6.0%. Borrowings from the Federal Home Loan Bank remained constant at $4.0 million, while other borrowings decreased $3.6 million. The Company’s loan-to-asset ratio decreased from 67.1% at December 31, 2010, to 59.8% at December 31, 2011, principally reflecting an increase in loan repayments over loan production.
As noted above, the Company experienced a decline in assets during 2011. Overall growth plans for the Bank have been purposely slowed in response to the Consent Order and Written Agreement, the Bank’s reduced capital levels, and uncertainties with respect to the national economy, regional and local real estate markets, and the domestic interest rate environment. Until the Bank’s capital levels are restored, the Bank may not increase its assets. The Company may achieve this through a capital raise, reducing the size of the Company’s consolidated balance sheet, or a combination of the two methods. Management and the Board continue to pursue plans to achieve and maintain the regulatory directed capital levels. During 2011, gross loans decreased $69.6 million, or 14.0%. The reduction in loans included declines totaling $27.5 million, or 24.0%, in construction and land development loans, $19.4 million, or 29.3%, in commercial and industrial loans, $965,000, or 100% in farmland loans, $599,000, or 9.3%, in multifamily residential loans, $1.5 million, or 33.4%, in consumer loans, $14.2 million, or 8.2%, in commercial real estate loans, $2.1 million, or 6.9%, in home equity loans, and $3.2 million, or 3.3%, in first liens on one-to-four family residential properties, including mortgage loans held for sale.
Investment securities increased during the period by $66.5 million, or 49.9%. At December 31, 2011, cash and cash equivalents decreased by $20.1 million, compared with December 31, 2010. Liquid assets, consisting of cash and demand balances due from banks, interest-earning deposits in other banks, balances due from Federal Reserve banks and available for sale investment securities totaled $232.8 million at December 31, 2011, constituting 33.3% of total assets. This compares with $187.8 million, or 25.9% of total assets, at year-end 2010.
Foreclosed real estate increased from $7.3 million at December 31, 2010, to $19.3 million at December 31, 2011, as the Company managed a larger volume of problem assets through the foreclosure process. Included in foreclosed real estate at December 31, 2011, was a $6.4 million asset, which was classified as "Investment in Real Estate Partnership" at December 31, 2010. Further discussion is contained in Note 8 to the accompanying consolidated financial statements.
Other assets decreased from $13.2 million at December 31, 2010, to $2.3 million at December 31, 2011, principally as a result of the Company’s decision in 2011 to establish a full valuation allowance against its deferred tax asset. At December 31, 2010, the Company’s net deferred tax asset totaled $10.1 million.
Deposits decreased $1.7 million during 2011, during which time the composition of the Bank’s deposits shifted from certificates of deposit toward core transaction accounts, including checking, savings, and money market accounts. At year-end 2011, noninterest-bearing demand accounts had increased $11.5 million, or 17.5%, to $76.9 million. Other transaction accounts, including NOW, money market and savings accounts increased $28.6 million, or 12.6%. At December 31, 2011, transaction accounts accounted for 49.5% of the Company’s total deposits, compared to 43.4% at December 31, 2010. Certificates of deposit under $100,000 decreased $29.4 million, or 14.7%, while certificates of deposits over $100,000 decreased $12.4 million, or 6.8%. The decrease in certificates of deposits was attributable to the decrease in brokered certificates of deposit, including certificates of deposits, which the Company first began using as an additional funding source in 2008. Brokered certificates of deposit totaled $2.6 million at December 31, 2011, and were comprised entirely of internet certificates of deposits, compared to $42.4 million at December 31, 2010, of which $8.0 million were internet certificates of deposits. Management’s funding strategy remains centered around balanced growth in deposits generated through the Company’s retail branch network, supplemented through the selective use of permissible wholesale funding when such sources present a lower cost alternative to certificates of deposit pricing in the local markets in which the Company operates. Under the Consent Order, and as a consequence of the Bank’s reduced capital levels, the Company may not attract, renew, or rollover brokered certificates of deposit, unless it first receives an appropriate waiver from the FDIC. Accordingly, as the existing brokered certificates of deposit mature, funds are being returned to the depositors.
Stockholders’ equity decreased by $18.8 million, or 50.3%, during 2011, primarily as a result of the Company’s net loss for the period. At December 31, 2011, the Company’s capital ratios classified it as a “significantly undercapitalized” institution by regulatory measures.
Results of Operations
Summary
For 2011, the Company’s net loss totaled $20.5 million, representing an increase of $15.2 million, or 286.8%, as compared with 2010’s net loss of $5.3 million. The larger net loss was driven primarily by a $12.9 million increase in income tax expense related to the Company’s establishment of a full allowance against its deferred tax asset and a$3.3 million incremental provision for loan loss expense in 2011 (total of $15.8 million), compared to 2010 (total of $12.5 million).
For 2011, the Company’s net interest margin increased to 3.06%, compared with 2.72% for 2010, primarily as a result of a 9-basis point increase in the average yield on earning assets, combined with a 30-basis-point decrease in the average cost of funds. Despite the improvement in the Company’s net interest margin, net interest income for 2011 remained relatively constant at $20.5 million, compared with $20.4 million for 2010 due to the adverse impact of nonaccrual loans, reduced loans outstanding and the historically low interest rate environment. Noninterest income for 2011 totaled $8.7 million, compared to $8.3 million recorded during 2010, driven by increased gains on securities sold, partially offset by decreases in mortgage services revenue. Noninterest expense decreased $600,000 to $24.5 million for 2011, compared with $25.1 million for 2010.
Net Interest Income
The primary component of earnings for the Company is net interest income. Net interest income is defined as the difference between interest income, principally from the loan and investment securities portfolios, and interest expense, principally on deposits and borrowings. Changes in net interest income result from changes in volume, spread, and margin. For this purpose, “volume” refers to the average dollar level of interest-earning assets and interest-bearing liabilities, “spread” refers to the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities and “margin” refers to net interest income divided by average interest-earning assets. Margin is influenced by the level and relative mix of interest-earning assets and interest-bearing liabilities, as well as levels of noninterest-earning assets and noninterest-bearing liabilities. During 2011 and 2010, average interest-earning assets were $669.6 million and $750.4 million, respectively.
The components of the increase in net interest income for 2011 were a decrease in interest income of $2.7 million, or 8.8%, which was more than offset by a decrease in interest expense of $2.8 million, or 27.0%. Interest on loans decreased by $4.2 million, or 15.3%, as a result of significantly reduced balances from loan repayments, an increase in nonaccrual loans, and lower yields on the loan portfolio. Nonaccrual loans averaged $45.9 million in 2011, compared to $32.0 million in 2010 and the foregone interest on these loans increased from $1.8 million in 2010 to $2.8 million in 2011. Interest on deposits decreased by $2.4 million, or 24.1%, primarily due to the downward repricing of the Bank’s higher-costing time deposits during 2011, combined with a reduction in average balances, as customers moved their funds from maturing certificates of deposits into more liquid transactional accounts, such as savings and money market accounts, to maintain flexibility in their reinvesement options.
For 2011, the Company’s net interest margin was 3.06%, compared with 2.72% for 2010. Management strives to maintain a high interest-earning asset ratio so as to maximize net interest income. To that end, management targets an earning-asset ratio at or above 93%. For 2011, that ratio was 93.1%, compared to 95.7% for 2010. Average interest-earning assets for 2011 decreased $80.8 million, or 10.8%, as compared to 2010, while the average yield increased by 9 basis points from 4.10% to 4.19%. Higher levels of and rates on investment securities in 2011 compared to 2010, combined with reduced levels of cash overnight funds at the Federal Reserve helped to lessen the negative impact of reduced loan yields, including the impact of nonaccrual loans. Average interest-bearing liabilities decreased by $64.4 million, or 9.6%, primarily as a result of $42.6 million decrease in average wholesale borrowings combined with a $36.2 million decrease in brokered certificates of deposit, which averaged $28.6 million in 2011 compared to $64.8 million in 2010. These factors, along with the downward repricing of the Company’s retail certificates of deposit portfolio were the primary drivers of the decrease in the average cost of interest-bearing liabilities, which fell by 30 basis points from 1.54% in 2010 to 1.24% in 2011.
Average Balances, Income and Expenses, and Rates. The following table sets forth, certain information related to our average balance sheet and our average yields on earning assets and average costs of interest-bearing liabilities. Such yields are derived by dividing income or expense by the average daily balance of the corresponding assets or liabilities.
(1) Interest income includes amortization of deferred loan fees, net.
(2) Nonaccrual loans are included in gross loans but interest is not included in interest income.
Rate/Volume Analysis. The following table shows changes in interest income, interest expense, and net interest income arising from volume and rate changes for major categories of earning assets and interest-bearing liabilities. The change in interest not solely due to changes in volume or rates has been allocated in proportion to the absolute dollar change in both.
Provision for Loan Losses
Provisions for loan losses are charged to income to bring the allowance for loan losses to a level deemed appropriate by management. In evaluating the allowance for loan losses, management considers factors that include growth, composition, diversification, or conversely, concentrations by industry, geography or collateral within the portfolio, historical loan loss experience, current seasoning of the portfolio, current delinquency levels, adverse situations that may affect a borrower’s ability to repay, estimated value of any underlying collateral, prevailing economic conditions and other relevant factors.
Provision for loan losses for 2011 totaled $15.8 million, up $3.3 million from $12.5 million in 2010. The provision remains at a historically high level, reflecting continued deterioration in real estate values, weak economic conditions, and high unemployment and underemployment in western North Carolina. At December 31, 2011, the allowance for loan losses was $10.7 million, representing a decrease of $5.5 million, or 34%, from $16.2 million at the end of 2010. The allowance represented 2.54% and 3.33%, respectively, of loans outstanding at the end of 2011 and 2010, excluding loans held for sale. As of December 31, 2010, the Company had boosted its reserves on impaired loans. During 2011, charge-offs were taken on impaired loans that were reserved for at December 31, 2010, thus, leading to the decline in the allowance between year ends. At December 31, 2011, the Company had $61.7 million of impaired loans, compared to $88.7 million at December 31, 2010.
Noninterest Income
Noninterest income increased to $8.7 million for 2011, compared to $8.3 million for 2010, representing an increase of $412,000, or 5.0%. The principal component of this increase was realized gains on the sales of investment securities, which totaled $2.5 million in 2011, compared to $1.7 million in 2010. Income generated from the sale and servicing of SBA loans decreased to $629,000 in 2011, compared to $875,000 in 2010, due to the expiration of certain government-provided incentives to borrowers. Mortgage services revenue, which totaled $2.0 million in 2011, decreased $385,000 compared to 2010 primarily due to decreased residential loan demand. Also during 2011, service charges on deposit accounts and other service charges and fees increased by $57,000 and $116,000, respectively, while increases in the cash surrender value of bank-owned life insurance decreased by $27,000, due to declines in interest crediting rates on the underlying policies.
The following table is a comparative analysis of the components of noninterest income for 2011 and 2010.
Noninterest Expense
Noninterest expense includes all of the operating costs of the Company, excluding interest, provision, and tax expense. Noninterest expense totaled $24.5 million in 2011, down $602,000, or 2.4%, from $25.1 million in 2010. Cost reduction initiatives undertaken in late 2010 and throughout 2011, including the closure of two branches in the first quarter of 2011, were the principal reason the Company was able to hold operating expenses at slightly below 2010 levels. Declines in most operating expense categories including salary, occupancy, and equipment costs, which decreased $1.9 million, $634,000, and $282,000, respectively, were partially offset by significantly higher problem asset management costs. These costs, which are principally appraisal and legal fees, and holding costs of and losses on the sale of foreclosed assets totaled $6.4 million in 2011, up $3.6 million, from $2.8 million in 2010. The largest components of the problem asset costs were write-downs on real estate owned, which totaled $3.1 million in 2011, compared to $1.5 million in 2010, followed by acquisition and maintenance costs on other foreclosed assets, which totaled $1.1 million in 2011 compared to only $9,000 in 2010. Deposit insurance premiums, which remained constant at $2.2 million, was positively affected by the change in the assessment base in 2011 but negatively impacted by higher assessments due to the Bank’s capital and asset quality deterioration.
The following table presents a comparison of the components of noninterest expense for 2011 and 2010.
Income Taxes
The Company recorded an income tax expense of $9.4 million for 2011, compared to an income tax benefit of $3.5 million for 2010. During 2011, management determined it was appropriate to provide a full valuation allowance against its deferred tax asset based on its projections of future operating results over the next several years, cumulative tax losses over the previous three years, tax loss deductibility limitations, and available tax planning strategies. See further discussion in Note 13 to the Company’s consolidated financial statements.
Liquidity
A function of the Bank’s Asset/Liability Management Committee is evaluating the current liquidity of the Bank and identifying and planning for future liquidity needs. Such needs primarily consist of ensuring sufficient liquidity to meet current or expected needs for deposit withdrawals and the funding of investing activities, principally the making of loans and purchasing of securities. Liquidity is provided by cash flows from maturing investments, loan payments and maturities, federal funds sold, and unpledged investment securities. On the liability side of the balance sheet, liquidity sources include core deposits, the ability to increase large denomination certificates of deposit and borrowings from the Federal Home Loan Bank (FHLB), as well as the ability to generate funds through the issuance of long-term debt and equity. The Bank’s ratio of “on balance sheet” liquidity to total deposits was 31.3% at December 31, 2011. Management considers this ratio to be more than adequate to meet known or anticipated liquidity needs. The Company, however, has limited sources of revenue, and the Consent Order does not permit the payment of dividends by the Bank to the Company. Without this primary source of revenue from the Bank, the Company expects to continue to defer the payment of dividends on its preferred stock.
As a result of the Company’s negative financial performance during the past three years, some of the Company’s liquidity sources have been restricted. In addition, the Consent Order prohibits the Company from soliciting and accepting brokered certificates of deposit (including the renewal of existing brokered certificates of deposit) without prior approval from the FDIC and limits the rates the Company can offer on its deposit products. During 2011, the Company maintained high levels of liquidity, yet was able to deploy excess funding into the purchase of investment securities, and funded the maturities of brokered deposits.
Total deposits were $672.6 million at December 31, 2011, down slightly from $674.3 million at December 31, 2010. Deposit growth and retention within the Company’s retail branch bank network was sufficient to meet the Company’s funding requirements during 2011. In prior years, the Company used brokered deposits as a supplemental liquidity source. At December 31, 2011, brokered deposits totaled $2.6 million, compared to $42.4 million at December 31, 2010. Cash on hand, investment security repayments, and loan repayments were sufficient to fund repayment of maturing brokered certificates of deposit. At December 31, 2011, time deposits represented 50.5% of the Company’s total deposits, compared to 56.6% at December 31, 2010. Certificates of deposit of $100,000 or more represented 25.2% of the Company’s total deposits at December 31, 2011, down from 26.9% at year-end 2010. Management believes a sizeable portion of the Company’s time deposits are relationship-oriented, and based upon prior experience, anticipates a substantial portion of outstanding certificates of deposit will renew upon maturity or be retained in other deposit products at the Bank. Deposit retention is also influenced by limits on the rates the company can, or is willing to offer. Management anticipates that certain interest sensitive customers may not renew their certificate of deposits upon maturity, but rather maintain their funds in more liquid deposit products, such as savings or money market accounts, to maintain flexibility in their reinvestment options..
Wholesale borrowings, an additional source of liquidity for the Company, totaled $4.0 million at December 31, 2011, and were comprised solely of advances from the FHLB. Management expects to continue to use wholesale borrowings and potentially other wholesale sources of funding, allowed under the Consent Order, to supplement deposits generated from the Company’s branch network and assist in managing the overall cost of funds. As of December 31, 2011, loan collateral has been pledged to the FHLB to borrow an additional $9.7 million. Additional collateral could be provided to increase the borrowing line at the FHLB if additional liquidity is needed. Secured borrowings lines with two financial institutions totaling $12.0 million are also available to meet liquidity needs.
Capital Resources
At December 31, 2011 and 2010, the Company’s equity totaled $18.5 million and $37.3 million, respectively. The $18.8 million decrease in equity is primarily attributable to the Company’s 2011 net loss, partially offset by a $1.7 million increase in the unrealized gains on the investment securities portfolio. The Company’s equity-to-assets ratio on those dates was 2.65% and 5.15%, respectively. The Company is subject to minimum capital requirements, which are further discussed in “PART 1, Item 1 - Business - Supervision and Regulation.”
The Company was deemed “significantly undercapitalized” by regulatory measures at December 31, 2011. The Company’s regulatory capital ratios as of that date consisted of a Tier 1 leverage ratio of 2.48%, a Tier I risk-based capital ratio of 4.14%, and a total risk-based capital ratio of 5.41%. At December 31, 2010, these ratios were 4.30%, 6.76% and 8.04%, respectively. Pursuant to the Consent Order and Written Agreement, the Bank is required to develop and adopt a plan for achieving and maintaining capital ratios in excess of the minimum thresholds for the Bank to be well-capitalized, specifically Tier 1 capital of at least 8% of total assets and a total risk based capital ratio of at least 12%. Management and the Board continue to pursue plans to improve the Company’s capital levels, including a possible equity infusion. Our ability to raise capital in the foreseeable future is unknown. If additional equity cannot be secured, or can only be secured at an unexpectedly high cost, this could adversely affect the Company and the Bank.
Note 17 to the accompanying consolidated financial statements presents an analysis of the Company’s and Bank’s regulatory capital position as of December 31, 2011 and 2010.
Asset/Liability Management
Market risk refers to the risk of loss arising from adverse changes in interest rates, foreign exchange rates, commodity prices, and other relevant market rates and prices such as equity prices. Due to the nature of our operations, we are primarily exposed to interest rate risk and liquidity risk.
Interest rate risk within our consolidated balance sheets consists of reprice, option, and basis risks. Reprice risk results from differences in the maturity, or repricing, of asset and liability portfolios. Option risk arises from “embedded options” present in many financial instruments, such as loan prepayment options, deposit early withdrawal options, and interest rate options. These options allow customers opportunities to benefit when market interest rates change, which typically results in higher expense or lower income for us. Basis risk refers to the potential for changes in the underlying relationship between market rates and indices, which subsequently result in a narrowing of the profit spread on an interest-earning asset or interest-bearing liability. Basis risk is also present in administered-rate liabilities, such as savings accounts, NOW accounts, and money market accounts with respect to which historical pricing relationships to market rates may change due to the level or directional change in market interest rates.
We seek to avoid fluctuations in our net interest margin and to maximize net interest income within acceptable levels of risk through periods of changing interest rates. Accordingly, our Asset/Liability Committee (ALCO) and the Board of Directors monitor our interest rate sensitivity and liquidity on an ongoing basis. The Board of Directors and ALCO oversee market risk management and establish risk measures, limits, and policy guidelines for managing the amount of interest rate risk and its impact on net interest income and capital. ALCO uses a variety of measures to gain a comprehensive view of the magnitude of interest rate risk, the distribution of risk, the level of risk over time, and the exposure to changes in certain interest rate relationships.
We use a simulation model as the primary quantitative tool in measuring the amount of interest rate risk associated with changing market rates. The model measures the impact on net interest income relative to a base case scenario of hypothetical fluctuations in interest rates over the upcoming 12 and 24-month periods. These simulations incorporate assumptions regarding balance sheet growth and mix, pricing, and the repricing and maturity characteristics of the existing and projected consolidated balance sheets. Other interest rate related risks, such as prepayment, basis, and option risk, are also considered in the model.
ALCO continuously monitors and manages the volume of interest-sensitive assets and interest-sensitive liabilities. Interest-sensitive assets and liabilities are those that reprice or mature within a given timeframe. The objective is to manage the impact of fluctuating market rates on net interest income within acceptable levels. In order to meet this objective and mitigate potential market risk, management develops and implements investment, lending, funding, and pricing strategies.
As of December 31, 2011, the following table summarizes the forecasted impact on net interest income using a base case scenario given upward and downward movements in interest rates of 200, 300, and 400 basis points based on forecasted assumptions of prepayment speeds, nominal interest rates and loan and deposit repricing rates. Estimates are based on current economic conditions, historical interest rate cycles and other factors deemed to be relevant. However, underlying assumptions may be impacted in future periods which were not known to management at the time of the issuance of the consolidated financial statements. Therefore, management’s assumptions may or may not prove valid. No assurance can be given that changing economic conditions and other relevant factors impacting our net interest income will not cause actual occurrences to differ from underlying assumptions. Although measured, we believe the downward movements included below are neither realistic nor anticipated in the current historically low interest rate environment.
(1)
The rising and falling interest rate scenarios in the first two columns assume an immediate and parallel change in interest rates along the entire yield curve. The gradual ramp scenarios presented in the third and fourth columns assume a gradual rise or fall in interest rates during the periods indicated.
There are material limitations with the model presented above, which include, but are not limited to:
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It presents the balance sheet in a static position. When assets and liabilities mature or reprice, they do not necessarily keep the same characteristics.
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The computation of prospective impacts of hypothetical interest rate changes are based on numerous assumptions and should not be relied upon as indicative of actual results.
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The computations do not contemplate any additional actions we could undertake in response to changes in interest rates.
The following “Interest Rate Sensitivity Analysis” table sets forth the amounts of interest-earning assets and interest-bearing liabilities outstanding at December 31, 2011, which are projected to reprice or mature in each of the future time periods shown. Except as stated below, the amounts of assets and liabilities shown, which reprice or mature within a particular period were determined in accordance with the contractual terms of the assets or liabilities. Loans with adjustable rates are shown as being due at the end of the next upcoming adjustment period. Money market deposit accounts are spread over two years as they are considered more rate sensitive. Savings accounts and NOW accounts have been evaluated and are deemed to be less rate sensitive than money market deposit accounts and accordingly are spread over four years and five years, respectively. In making the gap computations, none of the assumptions sometimes made regarding prepayment rates and deposit decay rates are used for any interest-earning assets or interest-bearing liabilities. In addition, the table does not reflect scheduled principal payments that will be received throughout the lives of the loans. The interest rate sensitivity of the Company’s assets and liabilities illustrated in the table would vary substantially if different assumptions were used or if actual experience differs from that indicated by such assumptions.
Lending Activities
General
The Company provides a full range of short to medium-term commercial, mortgage, construction and personal loans, both secured and unsecured through conventional products and government guaranteed lending programs. The Company’s loan policies and procedures establish the basic guidelines governing its lending operations. Generally, the guidelines address the types of loans that the Company seeks, target markets, underwriting and collateral requirements, terms, interest rate and yield considerations and compliance with laws and regulations. All loans or credit lines are subject to approval procedures and amount limitations. These limitations apply to the borrower’s total outstanding indebtedness to the Company, including the indebtedness of any guarantor. The policies are reviewed and approved at least annually by the Board of Directors of the Company. The Company supplements its own supervision of the loan underwriting and approval process with periodic loan audits by internal loan examiners as well as by third-party professionals experienced in loan review work. The Company has focused its portfolio lending activities on typically higher yielding commercial, construction and consumer loans. The Company also originates one-to-four family mortgages that are typically sold into the secondary market.
The following tables provide additional information regarding the Company’s loan portfolio as of December 31 of each year indicated. The “Loan Summary” table provides an analysis of the composition of the loan portfolio by type of loan. The “Loan Maturity Schedule” presents (i) the aggregate contractual maturities of commercial, industrial and commercial mortgage loans and of real estate constructions loans and (ii) the aggregate amounts of such loans by variable and fixed rates as of December 31, 2011.
(1) Excluding loans held for sale
Commercial and Industrial Loans
Commercial business lending is another component of the Company’s lending activities. At December 31, 2011, the Company’s commercial and industrial loan portfolio equaled $46.9 million, or 11.2% of total loans, as compared with $66.3 million, or 13.6% of total loans at year-end 2010. Commercial and industrial loans include both secured and unsecured loans for working capital, expansion and other business purposes. Short-term working capital loans generally are secured by accounts receivable, inventory and/or equipment. The Company also makes term commercial loans secured by equipment and real estate. Lending decisions are based on an evaluation of the financial strength, management, and credit history of the borrower, and the quality of the collateral securing the loan. With few exceptions, the Company requires personal guarantees and secondary sources of repayment for commercial and industrial loans.
Although the outstanding commercial and industrial loans balance is down between year ends, the Company is focused on originating commercial and industrial loans in an effort to diversify credit risk and decrease our concentration of loans secured primarily by real estate.
Commercial and industrial loans generally provide greater yields and reprice more frequently than other types of loans, such as real estate loans, as most commercial loan yields are tied to the prime rate index. Therefore, yields on most commercial loans adjust with changes in the prime rate.
General Economic Lending and Real Estate Conditions
Since 2008, dramatic declines in the housing market, with decreasing home prices and increasing delinquencies and foreclosures, have negatively affected the credit performance of mortgage and construction loans and resulted in significant write-downs of assets by many financial institutions, including the Company. In addition, the values of other real estate collateral supporting many loans have declined and may continue to decline. General downward economic trends, reduced availability of commercial credit and increasing unemployment have negatively affected the credit performance of commercial and consumer credit, resulting in additional write- downs. Concerns over the stability of the financial markets and the economy caused a decrease in lending by financial institutions to their customers and to each other. This market turmoil and tightening of credit has led to increased commercial and consumer loan delinquencies, lack of consumer confidence, increased market volatility and widespread reduction in general business activity. The resulting economic pressure on consumers and businesses and the lack of confidence in the financial markets has adversely affected most businesses, and financial institutions in particular, and it will continue to adversely affect our business, financial condition, results of operations, and stock price for the foreseeable future.
Our ability to assess the creditworthiness of customers and to estimate the losses inherent in our credit exposure is made more complex by these difficult market and economic conditions. As a result of these factors, bank regulatory agencies have been, and are expected to continue to be very aggressive in responding to concerns and trends identified in examinations. This increased government action has, and is expected to continue to increase our costs and limit our ability to pursue certain business opportunities.
Commitments to Extend Credit
In the ordinary course of business, the Company enters into various types of transactions that include commitments to extend credit that are not included in loans presented on the Company’s balance sheets. The Company applies the same credit standards to these commitments as it uses in all its lending activities and has included these commitments in its lending risk evaluations. The Company’s exposure to credit loss under commitments to extend credit is represented by the amount of these commitments. Other than these commitments to extend credit, the Company does not have any other off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on its financial condition, changes in financial condition, revenue or expense, results of operation, liquidity, capital expenditures, or capital resources that is material to investors. See Note 16 to the Company’s consolidated financial statements and the table above for “Financial Instruments with Off-Balance-Sheet-Risk.”
Asset Quality
Over the course of the past three years, credit quality has deteriorated as real estate markets have been hit with slowing sales and declining prices. The market in which the Company operates has also been affected by such downturns. The longer the current real estate market downturn persists, the more vulnerable sales volume and prices become. A future scenario of protracted real estate market problems, especially if they become more severe, could produce portfolio underperformance as compared to the first five years of the Company’s existence.
The provision for loan losses was $15.8 million for 2011, compared to $12.5 million for 2010, while net charge-offs were $21.4 million in 2011, compared to net charge-offs of $24.5 million in 2010. Although management believes the Company appropriately reserved for our problem assets at year-end 2011, we nonetheless continue to experience the effects of asset devaluation in our markets as the economy and local businesses struggle to recover. We have allocated significant additional resources toward expeditious resolution of our nonperforming loans and those assets we have foreclosed upon. We anticipate additional provisioning and charge-offs during 2012 to stay ahead of this resolution process. As of December 31, 2011, nonperforming assets were $54.7 million, up $9.6 million from $45.1 million at December 31, 2010. As a percentage of period-end portfolio loans and foreclosed assets, nonperforming assets were 12.43% at December 31, 2011, versus 9.14% at December 31, 2010. The allowance for loan losses as a percentage of period-end portfolio loans stood at 2.54% at December 31, 2011, down from 3.33% at December 31, 2010, reflecting the charge offs of reserves on loans specifically evaluated for impairment. Management expects the level of nonperforming assets to remain at elevated levels through 2012 and into 2013.
As of December 31, 2011, the Company had $6.2 million in loans 30 to 89 days delinquent, no loans 90 or more days delinquent and still accruing interest, and nonaccruing loans totaling $33.7 million, compared to $7.2 million in loans 30 to 89 days delinquent, $5,000 of loans 90 or more days delinquent and still accruing interest, and nonaccruing loans of $33.8 million at December 31, 2010. In addition, the Company had $19.3 million in foreclosed real estate, and $1.6 million in repossessed personal property, as compared to $7.3 million in foreclosed assets and $6,500 in repossessed personal property at December 31, 2010.
Nonperforming Assets
Potential problem loans are defined as loans currently performing that are not included in nonaccrual or loans management has concerns as to the borrower’s ability to comply with present repayment terms. These loans could deteriorate to nonaccrual or past due status. Therefore, management quantifies the risk associated with problem loans in assessing the adequacy of the allowance for loan losses. The following table provides additional information about the Bank’s nonperforming assets.
Included in foreclosed real estate at December 31, 2011, was a $6.4 million asset, which was classified as "Investment in Real Estate Partnerships" in the December 31, 2010, consolidated balance sheet. Further discussion is contained in Note 8 to the accompanying consolidated financial statements.
Troubled Debt Restructurings (TDRs)
On a case-by-case basis, management determines whether an account that experiences financial difficulties should be modified as to its interest rate or repayment terms to maximize the Company’s collection of its balance. Loans restructured at a rate equal to or greater than that of a new loan with comparable risk at the time the contract is modified are excluded from restructured loans once repayment performance, in accordance with the modified agreements, has been demonstrated over several payment cycles. Loans that have interest rates reduced below comparable market rates remain classified as restructured loans; however, interest income is accrued at the reduced rate as long as the customer complies with the revised terms and conditions. Restructured loans totaled $40.2 million at December 31, 2011, compared to $9.4 million at December 31, 2010, of which $15.8 million and $4.5 million were accruing interest at the respective period ends. Restructured loans not accruing interest are included in nonaccrual loans in the above table. The increase in restructured loans resulted from increased demand for modifications or renewals of loans in 2011, during a period of continued economic downturn, in which many borrowers have experienced financial challenges.
Analysis of Allowance for Loan Losses
The level of the allowance for loan losses is established based upon management’s evaluation of portfolio composition, current and projected national and local economic conditions, and results of independent reviews of the loan portfolio by internal and external examination. Management recognizes the inherent risk associated with commercial and consumer lending, including whether or not a borrower’s actual results of operations will correspond to those projected by the borrower when the loan was funded; economic factors such as the number of housing starts and fluctuations in interest rates; possible further depression of collateral values; and completion of projects within the original cost and time estimates. As a result, management continues to actively monitor the Company’s asset quality and lending policies.
Management is currently making efforts to alter the composition of its loan portfolio so a further downturn in a particular market or industry will not have a material impact on the loan portfolio as a whole or the Company’s financial condition. Given the current condition of the real estate markets in the Company’s footprint, real estate loans have been significantly curtailed. The Company continues to focus its lending effort toward providing credit to small businesses and consumers who are creditworthy.
Since late 2009, management has taken what it believes to be an aggressive stance on identifying problems with credits and placing them on nonaccruing status relatively early in its evaluation process. Management evaluates these credits and their ultimate collectability using both internal and external portfolio loan reviews, so that any potential losses which may be incurred on these credits in the future are incorporated into its analysis of the adequacy of the Bank’s existing allowance for loan losses. Notwithstanding the Company’s conservative approach, over the past few years, the continuing effects of the economic recession, high unemployment and a soft real estate market have caused the Company to periodically increase its provision for loan losses.
We calculate our general allowance by applying our historical loss factors to each sector of the loan portfolio. We use a rolling sixteen-quarter look-back period when computing historical annualized loss rates.
We adjust these historical loss percentages for qualitative environmental factors derived from macroeconomic indicators and other factors. Qualitative factors we considered in the determination of the December 31, 2011, allowance for loan losses include pervasive factors that generally impact borrowers across the loan portfolio (such as unemployment and consumer price index) and factors that have specific implications to particular loan portfolios (such as residential home sales or commercial development). Factors evaluated may include changes in delinquent, nonaccrual and troubled debt restructured loan trends, trends in risk ratings and net loans charged-off, concentrations of credit, competition and legal and regulatory requirements, trends in the nature and volume of the loan portfolio, national and local economic and business conditions, collateral valuations, the experience and depth of lending management, lending policies and procedures, underwriting standards and practices, the quality of loan review systems and degree of oversight by the Board of Directors, and other external factors. The general reserve calculated using the historical loss rates and qualitative factors is then combined with the specific allowance on loans individually evaluated for impairment to determine the total allowance for loan losses.
Portions of the allowance for loan losses may be allocated for specific loans or portfolio segments. However, the entire allowance for loan losses is available for any loan that, in our judgment, should be charged-off. In addition to our portfolio review process, various regulatory agencies periodically review our allowance for loan losses. These agencies may require us to recognize additions to the allowance for loan losses based on their judgments and information available to them at the time of their examinations. While we use available information to recognize inherent losses on loans, future adjustments to the allowance for loan losses may be necessary based on changes in economic conditions and other factors and the impact of such changes and other factors on our borrowers.
We believe the allowance for loan losses at December 31, 2011, is appropriate and adequate to cover probable inherent losses in the loan portfolio. However, underlying assumptions may be impacted in future periods by changes in economic conditions, the impact of regulatory examinations, and the discovery of information with respect to borrowers which was not known to us at the time of the issuance of our consolidated financial statements. Therefore, our assumptions may or may not prove valid. Thus, there can be no assurance loan losses in future periods will not exceed the current allowance for loan losses amount or that future increases in the allowance for loan losses will not be required. Furthermore, while management believes it has established the allowance for loan losses in conformity with generally accepted accounting principles, there can be no assurance that regulators, in reviewing our portfolio, will not require adjustment to the allowance for loan losses. Additionally, no assurance can be given that our ongoing evaluation of the loan portfolio, in light of changing economic conditions and other relevant factors, will not require significant future additions to the allowance for loan losses, thus adversely impacting our business, financial condition, results of operations, and cash flows.
The following table presents the allocation of the allowance for loan losses at the end of each of the last five years. The allocation is based on an evaluation of defined loan problems, historical ratios of loan losses, and other factors that may affect future loan losses in the categories of loans shown.
(1) Percent of loans in each category to total loans
The following table summarizes information regarding changes in the Company’s allowance for loan losses for the following years ended December 31.
Investment Activities
The Bank’s portfolio of investment securities consists primarily of debt instruments of U.S. government agencies or of government-sponsored enterprises, and mortgage-backed securities. Securities to be held for indefinite periods of time and not intended to be held to maturity are classified as available for sale (AFS) and carried at fair value, with any unrealized gains or losses reflected as an adjustment to stockholders’ equity. Securities held for indefinite periods of time include securities that management intends to use as part of its asset/liability management strategy and that may be sold in response to changes in interest rates and/or significant prepayment risks. Securities for which the Bank has the ability and intent to hold the securities to maturity are classified as held to maturity securities (HTM). HTM securities are carried at amortized cost. It is the Bank’s policy to classify most investment securities as AFS. The following table summarizes investment securities by type.
The following table summarizes the amortized cost, fair value, and weighted-average yield of securities by contractual maturity groups.
The Company does not engage in, nor does it presently intend to engage in, securities trading activities and therefore does not maintain a trading account. At December 31, 2011, there were no securities of any issuer (other than governmental agencies or government-sponsored enterprises) that exceeded 10% of the Company’s stockholders’ equity.
Sources of Funds
Deposit Activities
The Bank provides a range of deposit services, including noninterest-bearing checking accounts, interest-bearing checking and savings accounts, money market accounts, IRAs and certificates of deposit. These accounts generally earn interest at rates established by management based on asset/liability planning, earnings budgets, competitive market factors and management’s desire to increase or decrease certain types or maturities of deposits. Management believes one of the primary keys to the long-term success of the Company is the acquisition of demand deposit accounts and other transaction accounts. Accordingly, we strive to establish relationships with customers, which will facilitate and attract core deposits. While certificates of deposit are certainly a significant component in the funding of the Company, management endeavors to use these instruments as an entrée into a full relationship with each customer resulting in a complete banking relationship inclusive of the customer’s transaction accounts.
The following table summarizes the average balances outstanding and average interest rates for each major category of deposits for the following years.
The following table presents information regarding maturities of certificates of deposit with balances of $100,000 or more at December 31, 2011.
Recent Accounting Pronouncements
See Note 1 to the Company’s consolidated financial statements for a full description of recent accounting pronouncements, including the respective expected dates of adoption and effects on results of operations and financial condition.
Inflation and Other Issues
Because our assets and liabilities are primarily monetary in nature, the effect of inflation on our assets is less significant compared to most commercial and industrial companies. However, inflation does have an impact on the growth of total assets in the banking industry and the resulting need to increase capital at higher than normal rates in order to maintain an appropriate equity-to-assets ratio. Inflation also has a significant effect on other expenses, which tend to rise during periods of general inflation. Notwithstanding these effects of inflation, management believes our financial results are influenced more by our ability to react to changes in interest rates and general economic conditions impacting the creditworthiness of customers than directly by inflation.
Except as discussed above, management is not aware of trends, events, or uncertainties that will have or that are reasonably likely to have a material adverse effect on the Company’s liquidity, capital resources, or operations.
Critical Accounting Policies and Estimates
General. The Company’s accounting and financial reporting policies are in conformity, in all material respects, to accounting principles generally accepted in the U.S. and to general practices within the financial services industry. The preparation of financial statements in conformity with such principles requires management to make estimates and assumptions that impact the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities during the reporting period, and the reported amounts of income and expense during the reporting period. While we base estimates on historical experience, current information, and other factors deemed to be relevant, actual results could differ from those estimates. Management, in conjunction with the Company’s independent registered public accounting firm, has discussed the development and selection of the critical accounting estimates discussed herein with the Audit Committee of our Board of Directors.
We consider accounting policies and estimates to be critical to our financial condition, results of operations, or cash flows if the accounting policy or estimate requires management to make assumptions about matters that are highly uncertain and for which different estimates that management reasonably could have used for the accounting estimate in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, could have a material impact on our financial condition, results of operations, or cash flows.
Our significant accounting policies are discussed in Note 1 to our consolidated financial statements. Of those significant accounting policies, we have determined that accounting for our allowance for loan losses, foreclosed real estate, the realization of our deferred tax asset, and the determination of fair value of financial instruments are deemed critical because of the valuation techniques used and the sensitivity of the amounts recorded in our consolidated financial statements to the methods, assumptions, and estimates underlying these balances. Accounting for these critical areas requires subjective and complex judgments and could be subject to revision as new information becomes available.
Allowance for Loan Losses. We consider our accounting policies related to the allowance for loan losses to be critical, as these policies involve considerable subjective judgment and estimation by management. The allowance for loan losses is a reserve established through a provision for loan losses charged to expense. The allowance for loan losses represents our best estimate of probable inherent losses that have been incurred within the existing portfolio of loans. The allowance for loan losses is necessary to reserve for estimated probable loan losses inherent in the loan portfolio. Our allowance for loan losses methodology is based on historical loss experience by loan type, specific homogeneous risk pools, and specific loss allocations. Our process for determining the appropriate level of the allowance for loan losses is designed to account for asset deterioration as it occurs. The provision for loan losses reflects loan quality trends, including the levels of and trends related to nonaccrual loans, potential problem loans, criticized loans, and loans charged-off or recovered, among other factors.
The level of the allowance for loan losses reflects our continuing evaluation of specific lending risks; loan loss experience; current loan portfolio quality; present economic, political, and regulatory conditions; and unidentified losses inherent in the current loan portfolio. Portions of the allowance for loan losses may be allocated for specific loans. However, the entire allowance for loan losses is available for any loan that, in our judgment, should be charged-off. While we use our best judgment and information available, the ultimate adequacy of the allowance for loan losses is dependent upon a variety of factors beyond our control, including the performance of our loan portfolio, the economy, changes in interest rates, and the view of the regulatory authorities toward loan classifications and collateral valuation.
We record allowances for loan losses on specific loans when, based on current information and events, it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan. Specific allowances for loans considered individually significant and that exhibit probable or observed weaknesses are determined by analyzing, among other things, the borrower’s ability to repay amounts owed, guarantor support, collateral deficiencies, the relative risk rating of the loan, and economic conditions impacting the borrower’s industry.
The starting point for the general component of the allowance is the historical loss experience of specific types of loans. We calculate historical loss ratios for pools of similar loans with similar characteristics based on the proportion of actual loan net charge-offs to the total population of loans in the pool. We use a sixteen-quarter look-back period when computing historical annualized loss rates.
We adjust these historical loss percentages for qualitative environmental factors derived from macroeconomic indicators and other factors. Qualitative factors we considered in the determination of the December 31, 2011, allowance for loan losses include pervasive factors that generally impact borrowers across the loan portfolio (such as unemployment and consumer price index) and factors that have specific implications to particular loan portfolios (such as residential home sales or commercial development). Factors evaluated may include, without limitation, changes in delinquent, nonaccrual and troubled debt restructured loan trends, trends in risk ratings and net loans charged-off, concentrations of credit, competition and legal and regulatory requirements, trends in the nature and volume of the loan portfolio, national and local economic and business conditions, collateral valuations, the experience and depth of lending management, lending policies and procedures, underwriting standards and practices, the quality of loan review systems and degree of oversight by the Board of Directors, and other external factors. The general reserve portion of the allowance for loan losses calculated using the historical loss rates and qualitative factors is then combined with the specific allowance on loans individually evaluated for impairment to determine the total allowance for loan losses.
Loans identified as losses by management, internal loan review, and/or bank examiners are charged-off. We review each impaired loan on a loan-by-loan basis to determine whether the impairment should be recorded as a charge-off or a reserve based on our assessment of the status of the borrower and the underlying collateral. In general, for collateral dependent loans, the impairment is recorded as a charge-off unless the fair value was based on an internal valuation pending receipt of a third party appraisal or other extenuating circumstances. Consumer loan accounts are charged-off generally based on pre-defined past due time periods.
Foreclosed Real Estate. The value of our foreclosed real estate portfolio represents another accounting estimate that depends heavily on current economic conditions. Foreclosed real estate is carried at fair value less estimated selling costs, establishing a new cost basis. Fair value of such real estate is reviewed regularly and writedowns are recorded when it is determined that the carrying value of the real estate exceeds the fair value less estimated selling costs. Writedowns resulting from the periodic reevaluation of such properties, costs related to holding such properties, and gains and losses on the sale of foreclosed properties are charged against income. Costs relating to the development and improvement of such properties are capitalized.
The fair value of properties in the foreclosed real estate portfolio is generally determined from appraisals obtained from independent appraisers. We review the appraisal assumptions for reasonableness and may make adjustments when necessary to reflect current market conditions. Such assumptions may not prove to be valid. Moreover, no assurance can be given that changing economic conditions and other relevant factors impacting our foreclosed real estate portfolio will not cause actual occurrences to differ from underlying assumptions thus adversely impacting our business, financial condition, results of operations, and cash flows.
Realization of Net Deferred Tax Asset. We use certain assumptions and estimates in determining income taxes payable or refundable, deferred income tax liabilities and assets for events recognized differently in our financial statements and income tax returns, and income tax expense. Determining these amounts requires analysis of certain transactions and interpretation of tax laws and regulations. We exercise considerable judgment in evaluating the amount and timing of recognition of the resulting income tax liabilities and assets. These judgments and estimates are reevaluated on a periodic basis as regulatory and business factors change.
We include the current and deferred tax impact of our tax positions in the consolidated financial statements only when it is more likely than not (likelihood of greater than 50%) that such positions will be sustained by taxing authorities, with full knowledge of relevant information, based on the technical merits of the tax position. While we support our tax positions by unambiguous tax law, prior experience with taxing authorities, and analysis that considers all relevant facts, circumstances and regulations, we must still rely on assumptions and estimates to determine the overall likelihood of success and proper quantification of a given tax position.
Based on our projections of future operating results over the next several years, cumulative tax losses over the previous three years, tax loss deductibility limitations as discussed below and available tax planning strategies, we have a full valuation allowance against the net deferred tax asset at December 31, 2011.
Analysis of our ability to realize deferred tax assets requires us to apply significant judgment and is inherently subjective because it requires the future occurrence of circumstances that cannot be predicted with certainty. While we recorded a full valuation allowance against our net deferred tax asset for financial reporting and regulatory capital purposes at December 31, 2011, the net operating losses are able to be carried forward for income tax purposes for up to twenty years. Thus, to the extent we return to profitability and generate sufficient taxable income in the future, we will be able to use a portion of the net operating losses for income tax purposes and reverse a portion of the valuation allowance for financial reporting purposes. The determination of how much of the net operating losses we will be able to use and, therefore, how much of the valuation allowance that may be reversed and the timing is based on our future results of operations and the amount and timing of actual loan charge-offs and asset writedowns.
Fair Value Measurements. We use fair value measurements to record fair value adjustments to certain financial instruments and to determine fair value disclosures. Additionally, we may be required to record other assets at fair value on a nonrecurring basis. These nonrecurring fair value adjustments typically involve application of lower-of-cost-or-market accounting or writedowns of individual assets. Further, we include in the notes to the consolidated financial statements information about the extent to which fair value is used to measure assets and liabilities, the valuation methodologies used, and the related impact to income. Additionally, for financial instruments not recorded at fair value, we disclose the estimate of their fair value.
Fair value is defined as the price that would be received to sell the asset or paid to transfer the liability in an orderly transaction between market participants at the measurement date. Accounting standards establish a three-level hierarchy for disclosure of assets and liabilities recorded at fair value. The classification of assets and liabilities within the hierarchy is based on whether the inputs to the valuation methodology used for measurement are observable or unobservable. Observable inputs reflect market-derived or market-based information obtained from independent sources, while unobservable inputs reflect our estimates about market data. The three levels of inputs that are used to classify fair value measurements are as follows:
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Level 1 - Valuation is based upon quoted prices for identical instruments traded in active markets. Level 1 instruments generally include securities traded on active exchange markets, such as the New York Stock Exchange, as well as securities that are traded by dealers or brokers in active over-the-counter markets. Instruments we classify as Level 1 are instruments that have been priced directly from dealer trading desks and represent actual prices at which such securities have traded within active markets. Level 1 instruments also include commercial loans held for sale for which binding sales contracts have been entered into as of the balance sheet date.
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Level 2 - Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques, such as matrix pricing, for which all significant assumptions are observable in the market. Instruments we classify as Level 2 include securities that are valued based on pricing models that use relevant observable information generated by transactions that have occurred in the market place that involve similar securities. Level 2 instruments also include mortgage loans held for sale that are valued based on prices for other mortgage whole loans with similar characteristics and commercial loans held for sale that are based on independent collateral appraisals.
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Level 3 - Valuation is generated from model-based techniques that use significant assumptions not observable in the market. These unobservable assumptions reflect the Company’s estimates of assumptions market participants would use in pricing the asset or liability. Valuation techniques include use of option pricing models, discounted cash flow models, and similar techniques.
We attempt to maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements. When available, we use quoted market prices to measure fair value. If market prices are not available, fair value measurement is based upon models that use primarily market-based or independently-sourced market parameters. Most of our financial instruments use either of the foregoing methodologies, collectively Level 1 and Level 2 measurements, to determine fair value adjustments recorded to our financial statements. However, in certain cases, when market observable inputs for model-based valuation techniques may not be readily available, we are required to make judgments about assumptions market participants would use in estimating the fair value of the financial instrument.
The degree of management judgment involved in determining the fair value of an instrument is dependent upon the availability of quoted market prices or observable market parameters. For instruments that trade actively and have quoted market prices or observable market parameters, there is minimal subjectivity involved in measuring fair value. When observable market prices and parameters are not fully available, management judgment is necessary to estimate fair value. In addition, changes in the market conditions may reduce the availability of quoted prices or observable data. For example, reduced liquidity in the capital markets or changes in secondary market activities could result in observable market inputs becoming unavailable. When significant adjustments are required to available observable inputs, it may be appropriate to utilize an estimate based primarily on unobservable inputs. When an active market for a security does not exist, the use of management estimates that incorporate current market participant expectations of future cash flows, and include appropriate risk premiums, is acceptable.
Significant judgment may be required to determine whether certain assets measured at fair value are included in Level 2 or Level 3. If fair value measurement is based upon recent observable market activity of such assets or comparable assets (other than forced or distressed transactions) that occur in sufficient volume and do not require significant adjustment using unobservable inputs, those assets are classified as Level 2. If not, they are classified as Level 3. Making this assessment requires significant judgment.
ITEM 8.
ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
1ST FINANCIAL SERVICES CORPORATION
CONSOLIDATED FINANCIAL STATEMENTS
For the Years Ended December 31, 2011 and 2010
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
1st Financial Services Corporation
Hendersonville, North Carolina
We have audited the accompanying consolidated balance sheet of 1st Financial Services Corporation and subsidiary (the Company) as of December 31, 2011 and the related consolidated statements of operations, changes in stockholders' equity and comprehensive loss, and cash flows for the year then ended. 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 audit.
We conducted our audit 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 its 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 also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides 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 1st Financial Services Corporation and subsidiary as of December 31, 2011, and the results of their operations and their cash flows for the year then ended, in conformity with U.S. generally accepted accounting principles.
The accompanying consolidated financial statements have been prepared assuming the Company will continue as a going concern. As discussed in Note 2 to the financial statements, the Company has suffered recurring losses that have eroded regulatory capital ratios, and the Company’s wholly owned subsidiary, Mountain First Bank & Trust Company (the "Bank"), is under a regulatory Consent Order with the Federal Deposit Insurance Corporation and the North Carolina Commissioner of Banks that requires, among other provisions, capital ratios to be maintained at certain heightened levels. In addition, the Company is under a Written Agreement with the Federal Reserve Bank of Richmond that requires, among other provisions, the submission and implementation of a capital plan to improve the Company and the Bank's capital levels. As of December 31, 2011, both the Bank and the Company are considered "significantly undercapitalized" based on their respective regulatory capital levels. These considerations raise substantial doubt about the Company's ability to continue as a going concern. Management’s plans are further discussed in Note 2. These financial statements do not include any adjustments that would be necessary should the Company be unable to continue as a going concern.
/s/ Elliott Davis PLLC
Greenville, South Carolina
March 28, 2012
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
1st Financial Services Corporation
Hendersonville, North Carolina
We have audited the accompanying consolidated balance sheet of 1st Financial Services Corporation and Subsidiary as of December 31, 2010, and the related consolidated statements of operations, changes in stockholders’ equity and other comprehensive income (loss), and cash flows for the year then ended. The Company’s management is responsible for these consolidated financial statements. Our responsibility is to express an opinion on these consolidated financial statements based on our audit.
We conducted our audit 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 its 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 also 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 audit provides 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 1st Financial Services Corporation and Subsidiary as of December 31, 2010, and the results of its operations and its cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America.
/s/ Brown, Edwards & Company, LLP
CERTIFIED PUBLIC ACCOUNTANTS
Christianburg, VA
April 4, 2011
1st Financial Services Corporation Consolidated Balance Sheets December 31, 2011 and 2010
See accompanying notes to consolidated financial statements
1st Financial Services Corporation Consolidated Statements of Operations For the Years Ended December 31, 2011 and 2010
See accompanying notes to consolidated financial statements
1st Financial Services Corporation Consolidated Statements of Changes in Stockholders’ Equity and Comprehensive Income (Loss) For the Years Ended December 31, 2011 and 2010
See accompanying notes to consolidated financial statements
1st Financial Services Corporation
Consolidated Statements of Cash Flows For the Years Ended December 31, 2011 and 2010
See accompanying notes to consolidated financial statements
1st Financial Services Corporation
Notes to Consolidated Financial Statements
Note 1 - Summary of Significant Accounting Policies
Business and Basis of Presentation
1st Financial Services Corporation (1st Financial or the Company), a bank holding company registered under the Bank Holding Company Act of 1956, as amended, is the parent company for Mountain 1st Bank & Trust Company (the Bank). The Company essentially has no other assets or liabilities other than its investment in the Bank. Clear Focus Holdings, LLC is a wholly owned real estate holdings subsidiary of the Bank. The Company is regulated, supervised, and examined by the Board of Governors of the Federal Reserve System (the Federal Reserve), and the North Carolina Commissioner of Banks (the Commissioner). The Company’s business activity consists of directing the activities of the Bank. Accordingly, the information set forth in this report, including financial statements and related data, relates primarily to the Bank.
The Bank is a federally insured non-member commercial bank, incorporated under the laws of North Carolina on April 30, 2004. The Bank commenced operations on May 14, 2004. The Bank provides financial services through its branch network located in western North Carolina and operates under the banking laws of North Carolina and the rules and regulations of the Federal Deposit Insurance Corporation (FDIC). The Bank competes with other financial institutions and numerous other non-financial services commercial entities offering financial services products. The Bank is further subject to the regulations of certain federal and state agencies and undergoes periodic examinations by those regulatory authorities. The Bank’s customers are principally located in western North Carolina.
The accounting and reporting policies of the Company and the Bank follow generally accepted accounting principles and general practices within the financial services industry. Following is a summary of the more significant policies.
Business Segments
The Company reports its activities as a single business segment. In determining proper segment definition, the Company considers the materiality of a potential segment and components of the business about which financial information is available and regularly evaluated, relative to resource allocation and performance assessment.
Principles of Consolidation
The consolidated financial statements include the accounts of the Company, the Bank, and the Bank’s wholly owned subsidiary, Clear Focus Holdings, LLC. All intercompany transactions and balances have been eliminated in consolidation.
Estimates
The preparation of financial statements in conformity with generally accepted accounting principles in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the balance sheets and the reported amounts of income and expense for the periods presented. Actual results could differ significantly from those estimates.
Material estimates that are particularly susceptible to significant change in the near-term relate to the determination of the allowance for loan losses, the valuation of foreclosed real estate, the realization of the deferred tax asset, and the determination of the fair value of financial instruments.
Cash and Cash Equivalents
For the purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks, and short-term interest-bearing deposits. Cash and cash equivalents have maturities of three months or less. Accordingly, the carrying amount of such instruments is considered to be a reasonable estimate of fair value.
Investment Securities
Management determines the appropriate classification of investment securities at the time of purchase. Securities are classified as held to maturity when the Company has both the positive intent and ability to hold the securities to maturity. Held-to-maturity securities are stated at amortized cost. Securities that are bought and held principally for the purpose of selling in the near term are classified as trading securities and reported at fair value, with unrealized gains and losses included in earnings. Securities not classified as held to maturity or trading are classified as available for sale. Available-for-sale securities are stated at fair value, with the unrealized gains and losses, net of income taxes, reported as a separate component of stockholders’ equity.
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
The fair value of securities is based on quoted market prices or dealer quotes. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. A decline in the market value of any available-for-sale or held-to-maturity security below cost that is deemed to be other-than-temporary results in a reduction in carrying amount to fair value. The impairment is charged to earnings and a new cost basis for the security is established. To determine whether an impairment is other than temporary, the Company considers whether it has the ability and intent to hold the investment until a market price recovery and considers whether evidence indicating the cost of the investment is recoverable outweighs evidence to the contrary. Evidence considered in this assessment includes the reasons for the impairment, the severity, and duration of the impairment, changes in value subsequent to year-end, and forecasted performance of the investee.
At December 31, 2011 and 2010, the Company had no trading securities. At those dates, all of the Company’s investment securities were classified as available for sale or held to maturity.
Premiums and discounts are amortized or accreted over the life of the related security as an adjustment to yield using the effective-interest method. Dividend and interest income are recognized when earned. The cost of securities sold is based on the specific identification method. Gains and losses are recorded on the trade date.
Other Investments
The Bank accounts for its investments in a real estate partnership and restricted equity securities using either the cost or the equity method of accounting. The accounting treatment depends upon the Bank’s percentage ownership and degree of management influence.
Under the cost method of accounting, the Bank records an investment in stock at cost and generally recognizes cash dividends received as income. If cash dividends received exceed the investee’s earnings since the investment date, these payments are considered a return of investment and reduce the cost of the investment.
Under the equity method of accounting, the Bank records its initial investment at cost. Subsequently, the carrying amount of the investment is increased or decreased to reflect the Bank’s share of income or loss of the investee. The Bank’s recognition of earnings or losses from an equity method investment is based on the Bank’s ownership percentage in the investment and the investee’s earnings.
Bank Owned Life Insurance
In December 2007, the Bank purchased $6.0 million in life insurance policies on certain key employees and in January 2008 purchased an additional $5.0 million. These policies are recorded on the Company’s consolidated balance sheet at their cash surrender value, or the amount that can be realized, and any income from these policies and changes in the net cash surrender values are recorded in Other Noninterest Income on the Company’s Consolidated Statement of Operations.
Loans Held for Sale
The Company originates single family, residential first mortgage loans on a pre-sold, flow basis. Loans held for sale are carried at the lower of cost or fair value in the aggregate as determined by outstanding commitments from investors. At closing, these loans, together with their servicing rights, are sold to other financial institutions under prearranged terms. The Company recognizes certain origination and service release fees upon the sale, which are classified as mortgage services revenue in the Company’s Consolidated Statements of Operations.
Loans
Loans are generally reported at their outstanding principal balances net of any unearned income, charge-offs, and unamortized deferred fees and costs on originated loans. Unearned income, deferred fees and costs, and discounts and premiums are amortized to income over the contractual life of the loan.
Past due and delinquent status is based on contractual terms. Interest on loans deemed past due continues to accrue until the loan is placed in nonaccrual status.
The accrual of interest is discontinued when it is determined there is a more than normal risk of future uncollectability. In most cases, loans are automatically placed in nonaccrual status by the loan system when the loan payment becomes 90 days delinquent and no acceptable arrangement has been made between the Company and the borrower. The accrual of interest on some loans, however, may continue even after the loan becomes 90 days delinquent in special circumstances deemed appropriate by the Company. Loans may be manually placed in nonaccrual status if it is determined that some factor other than delinquency (such as imminent foreclosure or bankruptcy proceedings) causes the Company to believe that more than a normal amount of risk exists with regard to collectability. When the loan is placed in nonaccrual status, accrued interest receivable is reversed. Thereafter, any cash payments received on the nonaccrual loan are applied as a principal reduction until the entire amortized cost has been recovered. Any additional amounts received are reflected in interest income. Loans are returned to accrual status when the loan is brought current and ultimate collectability of principal and interest is no longer in doubt.
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
Nonrefundable fees and certain direct costs associated with the origination of loans are deferred and recognized as a yield adjustment over the contractual life of the related loans, or if the related loan is held for sale, until the loan is sold. Recognition of deferred fees and costs is discontinued on nonaccrual loans until they return to accrual status or are charged-off.
Allowance for Loan Losses
The allowance for loan losses represents an amount that the Company believes will be adequate to absorb probable losses inherent in the loan portfolio as of the balance sheet date. Assessing the adequacy of the allowance for loan losses is a process requiring considerable judgment. Such judgment is based on evaluations of the collectability of loans, including consideration of factors such as the balance of impaired loans, the quality, mix, and size of the overall loan portfolio; economic conditions that may impact the overall loan portfolio or an individual borrower’s ability to repay; the amount and quality of collateral securing the loans; its historical loan loss experience; and borrower and collateral specific considerations for loans individually evaluated for impairment.
The allowance for loan losses is a reserve established through a provision for loan losses charged to expense. The allowance for loan losses represents the Company’s best estimate of probable losses that have been incurred within the existing portfolio of loans. The Company’s allowance methodology is based on historical loss experience by loan type, specific homogeneous risk pools, and specific loss allocations. The Company’s process for determining the appropriate level of the allowance for loan losses is designed to account for asset deterioration as it occurs. The provision for loan losses reflects loan quality trends, including the levels of and trends related to nonaccrual loans, loan payment delinquencies, potential problem loans, criticized loans, and loans charged-off or recovered, among other factors.
The level of the allowance for loan losses reflects the Company’s continuing evaluation of specific lending risks; loan loss experience; current loan portfolio quality; present economic, political, and regulatory conditions; and unidentified losses inherent in the current loan portfolio. Lending risks are driven primarily by the type of loans within the portfolio.
Portions of the allowance for loan losses may be allocated to specific loans. However, the entire allowance for loan losses is available for any loan that, in the Company’s judgment, should be charged-off. While the Company utilizes its best judgment and information available, the ultimate adequacy of the allowance for loan losses is dependent upon a variety of factors beyond its control, including the performance of the loan portfolio, the economy, changes in interest rates, and the view of the regulatory authorities toward loan classifications and collateral valuation.
An allowance for loan losses on specific loans is recorded for an impaired loan when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan. Specific allowances for loans considered individually significant and that exhibit probable or observed weaknesses are determined by analyzing the borrower’s ability to repay amounts owed, guarantor support, collateral deficiencies, the relative risk rating of the loan, and economic conditions impacting the borrower’s industry, among other things.
The starting point for the general component of the allowance is the historical loss experience of specific types of loans. The Company calculates historical loss ratios for pools of similar loans with similar characteristics based on the proportion of actual loan net charge-offs to the total population of loans in the pool. The Company uses a rolling sixteen-quarter look-back period when computing annualized historical loss rates.
Historical loss percentages are adjusted for qualitative environmental factors derived from macroeconomic indicators and other factors. Qualitative factors considered in the determination of the December 31, 2011 and 2010, allowance for loan losses include pervasive factors that generally impact the borrowers across the loan portfolio (such as unemployment and consumer price index) and factors that have specific implications to particular loan portfolios (such as residential home sales or commercial development). Factors evaluated may include changes in delinquent, nonaccrual and troubled debt restructuring loan trends, trends in risk ratings and net loans charged-off, concentrations of credit, competition, and legal and regulatory requirements, trends in the nature and volume of the loan portfolio, national and local economic and business conditions, collateral valuations, the experience and depth of lending management, lending policies and procedures, underwriting standards and practices, the quality of loan review systems and degree of oversight by the Board of Directors, peer comparisons, and other external factors. The general reserve calculated using the historical loss rates and qualitative factors is then combined with the specific allowance on loans individually evaluated for impairment to determine the total allowance for loan losses.
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
Loans identified as losses by management, internal loan review, and/or bank examiners are charged-off. Each impaired loan is reviewed on a loan-by-loan basis to determine whether the impairment should be recorded as a charge-off or a reserve based on an assessment of the status of the borrower and the underlying collateral. In general, for collateral dependent loans, any impairment is recorded as a charge-off unless the fair value was based on an internal valuation pending receipt of a third party appraisal or other extenuating circumstances. Consumer loan accounts are generally charged-off on pre-defined past due time periods.
A loan is considered impaired when full payment according to the terms of the loan agreement is not probable or when the terms of a loan are modified. The portion of the allowance related to loans that are deemed impaired is based on discounted cash flows using the loan’s initial effective interest rate, the loan’s observable market price, or the fair value of the collateral for collateral dependent loans. At December 31, 2011, the Company had impaired loans of $61.7 million, which included $33.7 million in nonaccrual loans and $15.8 million in performing restructured loans. At December 31, 2010, the Company had impaired loans of $88.7 million, which included $37.8 million in nonaccrual loans and $4.5 million in performing restructured loans.
Troubled Debt Restructurings
In situations where, for economic or legal reasons related to a borrower’s financial difficulties, a concession to the borrower is granted that the Company would not otherwise consider, the related loan is classified as a troubled debt restructuring. The restructuring of a loan may include the transfer from the borrower to the Company of real estate, receivables from third parties, other assets, or an equity interest in the borrower in full or partial satisfaction of the loan, a modification of the loan terms, or a combination of the above. The accrual of interest continues on a troubled debt restructuring as long as the loan is performing in accordance with the restructured terms.
A troubled debt restructured loan (TDR), which was on nonaccrual status prior to being restructured remain on nonaccrual status until six months of satisfactory borrower performance has been experienced, at which time management would consider it return to accrual status. Loans that are considered TDRs are classified as performing, unless they are either on nonaccrual status or 90 days or more delinquent, in which case they are considered nonperforming. The balance of nonperforming TDRs was $24.4 million, representing 91 loans at December 31, 2011. If a restructured loan was on accrual status prior to being restructured, the restructured loan is reviewed, based on current information and events surrounding the loan and the borrower, to determine whether it should remain on accrual status. The Company computes impairment on TDRs that are on nonaccrual status and charges off the impairment when identified against the allowance for loan losses. Performing TDRs are not considered impaired for this analysis purpose. The balance of accruing restructured loans was $15.8 million, representing 27 loans at December 31, 2011. On a quarterly basis, the Company individually reviews all TDRs to determine whether they ought to be reclassified, based on the above criteria.
Foreclosed Real Estate
Foreclosed real estate consists of property acquired through a foreclosure proceeding or acceptance of a deed-in-lieu of foreclosure. Foreclosed real estate is recorded initially at estimated fair value of the property less estimated selling costs at the date of foreclosure. The initial recorded value may be subsequently reduced by additional write-downs, which are charged to earnings if the estimated fair value of the property less estimated selling costs declines below the initial recorded value. Costs related to the improvement of the property are capitalized, whereas those related to holding the property are expensed. Such properties are held for sale, and accordingly, no depreciation or amortization expense is recognized. As of December 31, 2011, the Company held $19.3 million of foreclosed real estate, compared to $7.3 million at December 31, 2010. Included in foreclosed real estate at December 31, 2011, was a $6.4 million asset, which was classified as "Investment in Real Estate Partnership" at December 31, 2010. See Note 8.
Reclassifications
Certain amounts in the 2010 consolidated financial statements were reclassified to conform to the 2011 presentation. These reclassifications had no effect on shareholders’ equity or results of operations as previously presented.
Property and Equipment
Property and equipment are stated at cost less accumulated depreciation. Depreciation is computed by the straight-line method and is charged to operations over the estimated useful lives of the assets. Useful lives for buildings are 40 years and range from 3 to 12 years for leasehold improvements, 5 to 15 years for furniture and fixtures and 3 to 5 years for computer and telecommunications equipment.
Maintenance, repairs, renewals, and minor improvements are charged to expense as incurred. Major improvements are capitalized and depreciated.
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
Advertising Costs
Advertising, promotional, and other business development costs are generally expensed as incurred. External costs incurred in producing media advertising are expensed the first time the advertising takes place. External costs relating to direct mailing costs are expensed in the period in which the direct mailings are sent.
Income Taxes
The provision for income taxes consists of amounts currently payable to taxing authorities and the net change in income taxes payable or refundable in future years. Income taxes deferred to future years are determined using the asset and liability method. Under this method, deferred income taxes are determined based on temporary differences between the financial statement and tax bases of assets and liabilities using enacted tax rates expected to be in effect when such amounts are realized or settled.
In the event the future tax consequences of differences between the financial reporting base and the tax bases of the Company’s assets and liabilities results in deferred tax assets, an evaluation of the probability of being able to realize the future benefits indicated by such asset is required. A valuation allowance is provided for the portion of the deferred tax asset when it is more likely than not that some portion or all of the deferred tax asset will not be realized. In assessing the realizability of the deferred tax assets, management considers the scheduled reversals of deferred tax liabilities, projected future taxable income, and tax planning strategies.
Net Income (Loss) Per Share
Basic income (loss) per share represents the net income or loss available to common stockholders divided by the weighted-average number of common shares outstanding during the period. Dilutive income per share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued. Potential common shares that may be issued by the Company relate to outstanding stock options and warrants, and are determined using the treasury stock method. For 2011, basic weighted-average shares and diluted weighted-average shares outstanding totaled 5,142,174 which resulted in basic earnings (loss) per share and diluted earnings (loss) per share of $(4.18). For 2010, basic weighted-average shares and diluted weighted-average shares outstanding totaled 5,077,111 resulting in basis earnings (loss) per share and diluted earnings (loss) per share of $(1.25). No stock options or warrants were included in the computation for 2011 or 2010 as their effect would have been anti-dilutive.
Comprehensive Income (Loss)
Comprehensive income (loss) consists of net income and other comprehensive income (loss). Other comprehensive income (loss) consists of unrealized gains and losses on investment securities available for sale, net of taxes. Comprehensive income (loss) is presented in the statements of stockholders’ equity and comprehensive income (loss).
Stock Compensation
The Company’s stock option plans, which are stockholder-approved, provide for stock options to be granted primarily to directors, officers and other key associates. Options granted under the 2004 Directors’ Stock Option Plan (the Directors Plan) are non-qualified stock options, while options granted under the 2004 Employee Stock Option Plan (the Employee Plan) may be either incentive stock options or non-qualified stock options. In 2008, the Company’s stockholders approved the 2008 Omnibus Equity Plan (the Omnibus Plan), pursuant to which incentive stock options, non-qualified stock options, performance shares, stock appreciation rights and restricted stock may be granted to officers and employees of the Company and the Bank, and non-qualified stock options and restricted stock awards may be granted to directors of the Company and the Bank.
Stock option awards are granted with an exercise price equal to, or higher than, the market price of the Company’s shares at the date of grant. Options vest ratably over a pre-determined period, generally five years, and expire after ten years from the date of grant, except that awards provide for accelerated vesting if there is a change in control, as defined in the stock option plan. At December 31, 2011, no shares were available to be granted under the Directors Plan, 270,469 shares remained available for award under the Employee Plan, and 134,069 shares remained available for award under the Omnibus Plan. All of the options outstanding at December 31, 2011 were fully vested.
The Company recognizes compensation costs related to share-based payment transactions over the period that an employee provides service in exchange for the award. The fair value at the date of grant of the stock option is estimated using the Black-Scholes option-pricing model based on the following assumptions. The dividend yield is based on estimated future dividend yields. The risk-free rate for periods within the contractual term of the share option is based on the U.S. Treasury yield curve in effect at the time of grant. Expected volatilities are generally based on historical volatilities. The expected term of share options granted is generally derived from historical experience. Compensation expense is recognized on a straight-line basis over the stock option vesting period.
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
Management believes that the over-the-counter (OTC) quoted market prices of the Company’s stock do not reflect an accurate value of the stock since the stock is not traded in large volumes and the OTC bid and ask quotes are for very small share lots. The Plans themselves contemplate that there is no efficient market unless the stock is listed on an exchange. The Plans assign the responsibility to value the stock at each grant date to the Board of Directors, until such time as the Company’s stock trades on a stock exchange.
Fair Valuation Measurements
The Company provides disclosures about the fair value of assets and liabilities recognized in the consolidated balance sheets in periods subsequent to initial recognition, including whether the measurements are made on a recurring basis (for example, investment securities available-for-sale) or on a nonrecurring basis (for example, impaired loans).
Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an 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. Under the fair value hierarchy, the Company is required to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. Three levels of inputs are used to measure fair value:
●
Level 1 - quoted prices in active markets for identical assets or liabilities;
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Level 2 - 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 for substantially the full term of the assets or liabilities; and
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Level 3 - unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.
Disclosures about the fair value of all financial instruments whether or not recognized in the consolidated balance sheets for which it is practicable to estimate that value are required. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly impacted by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized through immediate settlement of the instrument. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company. For additional information regarding fair value estimates and methodologies, see Note 20, Fair Value of Financial Instruments.
Derivative Instruments and Hedging Activities
Generally accepted accounting principles require an entity to recognize all derivatives as either assets or liabilities in the balance sheet, and measure those instruments at fair value. Changes in the fair value of those derivatives are reported in current earnings or other comprehensive income depending on the purpose for which the derivative is held and whether the derivative qualifies for hedge accounting. The Company does not currently engage in any activities that qualify for hedge accounting. Accordingly, changes in fair value of these derivative instruments are included in gain on sales of loans held for sale in the consolidated statement of operations.
Risk and Uncertainties
In the normal course of business, the Company encounters two significant types of overall risk: economic and regulatory. There are three main components of economic risk: credit risk, market risk, and concentration of credit risk. Credit risk is the risk of default on the Company’s loan portfolios that results from borrowers’ inability or unwillingness to make contractually required payments, or default on repayment of investments securities. Market risk includes primarily interest rate risk. The Company is exposed to interest rate risk to the degree that its interest-bearing liabilities mature or reprice at different speeds, or different bases, than its interest-earning assets. Market risk also reflects the risk of declines in the valuation of loans held for sale and in the value of the collateral underlying loans and the value of real estate held by the Company. Concentration of credit risk refers to the risk that, if the Company extends a significant portion of its total outstanding credit to borrowers in a specific geographical area or industry or on the security of a specific form of collateral, the Company may experience disproportionately high levels of default and losses if those borrowers, or the value of such type of collateral, is adversely impacted by economic or other factors that are particularly applicable to such borrowers or collateral. Concentration of credit risk is also similarly applicable to the investment securities portfolio.
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
The Company and the Bank are subject to the regulations of various government agencies: regulatory risk. These regulations can and do change significantly from period to period. The Company and the Bank also undergo periodic examinations by regulatory agencies, which may subject them to changes with respect to asset valuations, amount of required allowance for loan losses, or operating restrictions.
Subsequent Events
In preparing these financial statements, the Company has evaluated events and transactions through our filing date for potential recognition or disclosure in the consolidated financial statements.
Recently Issued Accounting Pronouncements
The following is a summary of recent authoritative pronouncements that could impact the accounting, reporting and/or disclosure of financial information by the Company.
In July 2010, the Receivables topic of the Accounting Standards Codification ( ASC ) was amended by Accounting Standards Update ( ASU ) 2010-20 to require expanded disclosures related to a company’s allowance for credit losses and the credit quality of its financing receivables. The amendments require the allowance disclosures to be provided on a disaggregated basis. The Company is required to include these disclosures in its interim and annual financial statements. See Note 5, Loans.
Disclosures about Troubled Debt Restructurings ( TDRs ) required by ASU 2010-20 were deferred by the Financial Accounting Standards Board ( FASB ) in ASU 2011-01 issued in January 2011. In April 2011 the FASB issued ASU 2011-02 to assist creditors with their determination of when a restructuring is a TDR. The determination is based on whether the restructuring constitutes a concession and whether the debtor is experiencing financial difficulties as both events must be present. Disclosures related to TDRs under ASU 2010-20 have been presented in Note 5.
In April 2011, the criteria used to determine effective control of transferred assets in the Transfers and Servicing topic of the ASC was amended by ASU 2011-03. The requirement for the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms and the collateral maintenance implementation guidance related to that criterion were removed from the assessment of effective control. The other criteria to assess effective control were not changed. The amendments are effective for the Company beginning January 1, 2012, but are not expected to have a material effect on the financial statements.
ASU 2011-04 was issued in May 2011 to amend the Fair Value Measurement topic of the ASC by clarifying the application of existing fair value measurement and disclosure requirements and by changing particular principles or requirements for measuring fair value or for disclosing information about fair value measurements. The amendments will be effective for the Company beginning January 1, 2012, but are not expected to have a material effect on the financial statements.
The Comprehensive Income topic of the ASC was amended in June 2011. The amendment eliminates the option to present other comprehensive income as a part of the statement of changes in stockholders’ equity. The amendment requires consecutive presentation of the statement of net income and other comprehensive income and requires an entity to present reclassification adjustments from other comprehensive income to net income on the face of the financial statements. The amendments will be applicable to the Company on January 1, 2012, and will be applied retrospectively. The amendments are not expected to have a material effect on the financial statements.
Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected to have a material impact on the Company’s financial position, results of operations or cash flows.
Note 2 - Enforcement Actions and Going Concern Considerations
Consent Order. During 2009, the FDIC conducted a periodic examination of the Bank. As a consequence of this examination, effective February 25, 2010, the Bank entered into a Stipulation to the Issuance of a Consent Order (the Stipulation) agreeing to the issuance of a Consent Order (the Consent Order) with the FDIC and the Commissioner.
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
Although the Bank neither admitted nor denied any unsafe or unsound banking practices or violations of law or regulation, it agreed to the Consent Order, which requires the Bank or its Board of Directors to undertake a number of actions:
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enhance its supervision of the Bank’s activities.
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assess the management team to ensure executive officers have the skills, training, abilities, and experience needed.
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develop and implement a plan for achieving and maintaining Tier 1 Capital of at least 8% of total assets, a Total Risk Based Capital Ratio of at least 12%, and a fully funded allowance for loan and lease losses.
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strengthen the Allowance policy of the Bank.
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develop and implement a strategic plan.
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not extend additional credit to any borrower who had a loan with the Bank that was charged off or who has a current loan that is classified “Loss” or “Doubtful”.
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formulate a detailed plan to collect, charge off or improve the quality of each of its “Substandard” or “Doubtful” loans.
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reduce loans in excess of $250,000 and classified as “Substandard” or “Doubtful” in accordance with a schedule required by the supervisory authorities.
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cause full implementation of its loan underwriting, loan administration, loan documentation, and loan portfolio management policies.
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adopt a loan review and grading system.
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develop a plan to systematically reduce the concentration in a limited group of borrowers.
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enhance its review of its liquidity and implement a liquidity contingency and asset/liability management plan.
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implement a plan and 2010 budget designed to improve and sustain earnings.
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implement internal routine and control policies addressing concerns to enhance its safe and sound operation.
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implement a comprehensive internal audit program and cause an effective system of internal and external audits to be in place.
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implement a policy for managing its “owned real estate”.
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forebear from soliciting and accepting “brokered deposits” without approval.
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limit growth to 10% per year.
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not pay dividends without prior approval.
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implement policies to enhance the handling of transactions with officers and directors.
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correct any violations of laws and regulations.
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make quarterly progress reports.
The foregoing description is a summary of the material terms of the Consent Order and is qualified in its entirety by reference to the Consent Order. The Consent Order will remain in effect until modified or terminated by the FDIC and the Commissioner.
The plans, policies, and procedures which the Bank is required to prepare under the Consent Order are subject to approval by the supervisory authorities before implementation. During the period a consent order, having the general provisions discussed above, is in effect, the financial institution is discouraged from requesting approval to either expand through acquisitions or open additional branches. Accordingly, the Bank will defer expanding its current markets or entering into new markets through acquisition or branching until the Consent Order is terminated.
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
Written Agreement. As a direct consequence of the issuance of the Consent Order and the requirement the Company serve as a source of strength for the Bank, the Company executed a written agreement (the Written Agreement) with the Federal Reserve Bank of Richmond (Federal Reserve Bank), effective October 13, 2010.
Although the Company neither admitted nor denied any unsafe or unsound banking practices or violations of law or regulation, it agreed to the Written Agreement, which requires it to undertake a number of actions, including, among other things that the Company or its Board of Directors shall:
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take appropriate steps to fully utilize the Company’s financial and managerial resources, to serve as a source of strength to the Bank.
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not declare or pay any dividends without approval.
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not directly or indirectly take dividends from the Bank without approval.
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not directly or indirectly, incur, increase, or guarantee any debt without approval.
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not directly or indirectly, purchase or redeem any shares of its stock without approval.
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comply with the notice provisions of the Federal Deposit Insurance Act and Regulation Y of the Federal Reserve related to changes in executive officers and compensation matters.
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submit a written capital plan that is acceptable to the Federal Reserve Bank, implement the approved plan, and thereafter fully comply with it.
The Company and the Bank have taken and continue to take action to respond to the issues raised in the Consent Order and the Written Agreement.
Going Concern Considerations
The going concern assumption is a fundamental principle in the preparation of financial statements. It is the responsibility of management to assess the Company’s ability to continue as a going concern. In assessing this assumption, the Company has taken into account all available information about the future, which is at least, but is not limited to, 12 months from the balance sheet date of December 31, 2011. The Bank has suffered recurring losses that have eroded regulatory capital ratios during the past three years, resulting from the extraordinary effects of what may ultimately be the worst economic downturn since the Great Depression.
The effects of the current economic environment are being felt across many industries, with financial services and residential real estate being particularly hard hit. The effects of the economic downturn have been particularly severe during the last 27 months. The Bank, with a loan portfolio consisting of a concentration in commercial real estate loans, has seen a decline in the value of the collateral securing its portfolio, as well as rapid deterioration in its borrowers’ cash flow and ability to repay their outstanding loans to the Bank. As a result, the Bank’s level of nonperforming assets has increased substantially during 2010 and 2011. As of December 31, 2011, the Bank’s nonperforming assets equaled $ 54.7 million, or 7.81% of total assets, as compared to $45.1 million, or 6.23% of total assets, as of December 31, 2010. The Bank’s impaired loans were $61.7 million at December 31, 2011, and $88.7 million at December 31, 2010. For 2011, the Bank recorded a $15.8 million provision to increase the allowance for loan losses to a level which, in management’s best judgment, adequately reflected the risk inherent in the loan portfolio as of December 31, 2011. Nevertheless, given the current economic climate, management recognizes the possibility of further deterioration in the loan portfolio during 2012. For 2011, the Bank recorded net loan charge-offs of $21.4 million, or 4.66% of average loans, as compared to net loan charge-offs of $24.5 million, or 4.71% of average loans, for 2010.
The Company and the Bank operate in a highly regulated industry and must plan for the liquidity needs of each entity separately. A variety of sources of liquidity are available to the Bank to meet its short-term and long-term funding needs. Although a number of these sources have been limited following execution of the Consent Order with the FDIC and the Commissioner and the Written Agreement with the Federal Reserve Bank, management has prepared forecasts of these sources of funds and the Bank’s projected uses of funds during 2012 in an effort to ensure the sources available are sufficient to meet the Bank’s projected liquidity needs for this period. Management believes the Bank’s liquidity sources are adequate to meet its needs for at least the next 12 months, but if the Bank is unable to meet its liquidity needs, then the Bank may be placed into a federal conservatorship or receivership by the FDIC, with the FDIC appointed conservator or receiver.
The Company relies on dividends from the Bank as its primary source of liquidity. The Company is a legal entity separate and distinct from the Bank. Various legal limitations restrict the Bank from lending or otherwise supplying funds to the Company to meet its obligations, including paying dividends. In addition, the terms of the Consent Order described below further limits the Bank’s ability to pay dividends to the Company to satisfy its funding needs. Management believes the Bank's liquidity sources are adequate to meet its needs for at least the next 12 months, but if the Bank is unable to meet its liquidity needs, then the Bank may be placed into federal conservatorship or receivership by the FDIC, with the FDIC appointed conservator or receiver.
The Company will also need to raise substantial additional capital to increase capital levels to meet the standards set forth by the Consent Order and Written Agreement. There can be no assurances the Company will be successful in its efforts to raise additional capital in 2012 or at all. Should these efforts be unsuccessful, due to the regulatory restrictions, which exist that restrict cash payments between the Bank and the Company, the Company may be unable to realize its assets and discharge its liabilities in the normal course of business.
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
These matters raise substantial doubt about the Company’s ability to continue as a going concern. As a result of management’s assessment of the Company’s ability to continue as a going concern, the accompanying consolidated financial statements for the Company have been prepared on a going concern basis, which contemplates the realization of assets and the discharge of liabilities in the normal course of business for the foreseeable future, and does not include any adjustments to reflect the possible future effects on the recoverability or classification of assets.
Note 3 - Restrictions on Cash
The Company is required to maintain average reserve balances, computed by applying prescribed percentages to its various types of deposits, either at the Company or on deposit with the Federal Reserve Bank. At December 31, 2011 and 2010, all required reserves were met by the Company’s vault cash.
At December 31, 2011 and 2010, cash and cash equivalents totaling $6.9 million were pledged as collateral against the Bank’s check clearing and debit card activity.
Note 4 - Investment Securities
The Company maintains a portfolio of investment securities as part of its asset/liability and liquidity management program, which emphasizes effective yields and maturities to match its funding needs. The composition of the investment portfolio is examined periodically and appropriate realignments are initiated to meet liquidity and interest-rate sensitivity needs for the Company.
Unrealized gains and losses on available-for-sale securities are reported net of tax as a separate component of stockholders’ equity. Realized gains and losses on the sale of available-for-sale securities are determined using the specific-identification method. Premiums and discounts are recognized in interest income using the effective interest rate method over the period to maturity or call date.
Available-for-sale securities are reported at fair value and consist of bonds, notes, debentures, and certain equity securities not classified as trading securities or as held-to-maturity securities. The Company held no private-label mortgage-backed securities; the mortgage-backed securities owned by the Company have been issued by governmental entities, such as Ginnie Mae, Freddie Mac, and Fannie Mae. Investments in available-for-sale securities are as follows:
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
At December 31, 2011 and 2010, investment securities with an amortized cost of $28.8 million and $9.8 million and a fair value of $29.2 million and $9.7 million, respectively, were pledged as collateral for public deposits, securities sold under agreements to repurchase and other banking purposes. Gross proceeds from the sale of investment securities totaled $96.6 million and $101.4 million for the years ended December 31, 2011 and 2010, respectively. The gross realized gain on the sale of investment securities totaled $2.5 million and $1.7 million for the years ended December 31, 2011and 2010, respectively. During the years ended December 31, 2011 and December 31, 2010, U.S. government-sponsored securities totaling $52.1 million and $23.7 million, respectively, were called.
Held-to-maturity securities are bonds, notes and debentures, for which the Company has the positive intent and ability to hold to maturity and are reported at cost, adjusted by premiums and discounts that are recognized in interest income using the effective interest rate method over the period to maturity or call date. Investments in held-to-maturity securities are as follows:
Declines in the fair value of individual held-to-maturity and available-for-sale securities below cost that are other than temporary are reflected as write-downs of the individual securities to fair value. Related write-downs are included in earnings as realized losses. The Company experienced no declines in the value of securities that were considered to be other than temporary in nature during 2011 or 2010.
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
The following tables detail the gross unrealized losses and related fair values in the Company’s available-for-sales and held-to-maturity investment securities. This information is aggregated by the length of time that individual securities have been in a continuous unrealized loss position.
As of December 31, 2011, a total of three individual U.S. government agency securities (two U.S. Department of Agriculture securities and one Small Business Administration security) were in a continuous loss position for 12 months or more. By contrast, a total of seven U.S. government agency securities were in a continuous loss position for 12 months or more at December 31, 2010. The Company has the ability and intent to hold these three securities until such time as the value recovers or the security matures. The Company believes, based on their credit ratings, that the deterioration in value is attributable to changes in market interest rates and not in the credit quality of the issuer and therefore, these losses are not considered to be other than temporary.
The following table details the gross unrealized losses and related fair values in the Company’s held-to-maturity investment securities portfolio. This information is aggregated by the length of time that individual securities have been in a continuous unrealized loss position as of December 31, 2010. No held-to-maturity securities were in an unrealized loss position at December 31, 2011.
The aggregate amortized cost and fair value of available-for-sale and held-to-maturity investment securities by remaining contractual maturity are shown below. Actual expected maturities differ from contractual maturities because issuers may have the right to call or prepay obligations.
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
Note 5 - Loans
Following is a summary of the major components of loans, excluding loans held for sale.
At December 31, 2011, the Company had $33.7 million in nonaccruing loans, compared to $37.8 million at December 31, 2010. The year-to-date foregone interest associated with these loans, which averaged $45.9 million for the year ended December 31, 2011 and $32.0 million for the comparable period in 2010, was $2.8 million and $1.7 million for the respective periods.
Credit Quality Indicators. As part of the on-going monitoring of the credit quality of the Company’s loan portfolio, management tracks certain credit quality indicators including trends related to (i) the weighted-average risk grade of commercial loans, (ii) the level of classified commercial loans, (iii) net charge-offs, (iv) non-performing loans and (v) the general economic conditions in the State of North Carolina.
The Company uses a risk grading matrix to assign a risk grade to each of its commercial loans. Loans are graded on a scale of 1 to 9. A description of the general characteristics of the nine risk grades is as follows:
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Rating 1 -Extremely Low Risk. Low Risk Assets are of the highest quality with an unquestioned capacity for repayment. These borrowers are generally international, national, or regional in scope and the debt rating, if available, is AAA (S&P) or Aaa (Moody’s). The borrower has ready access to all public financing markets. Management has a demonstrated successful track record and a succession plan is in place for highly qualified replacements. Financial statements are audited without qualification by reputable CPA firms. Loans are also considered extremely low risk prime when the collateral consists of properly margined bank certificate of deposits and shorter-term U.S. government securities.
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Rating 2 -Minimal Risk. Minimal Risk Assets have a history of consistently superior earnings and cash flow. Very strong liquidity and low leverage. The balance sheet is well capitalized and the secondary source of repayment is well defined and of unquestioned quality. These borrowers also have ready access to all public finance markets as evidenced by debt ratings, if available, of AA (S&P) or Aaa (Moody’s). These assets can also be those secured by properly margined long term U.S. government bonds.
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Rating 3 -Moderate Risk. Moderate Risk assets have consistently satisfactory earnings and cash flow. They possess no disclosed weaknesses; however, financial analysis reveals factors such as leverage, liquidity, or debt service to be less than optimal or susceptible to changes in the business cycle. Access to other financing sources exists and private placement may be possible. Unqualified audited statements are preferred; however reviewed statements are also acceptable. The borrower may not be able to survive a significant downturn; however, the debt is supported by high quality unrestricted liquid collateral.
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Rating 4 -Satisfactory Risk. Satisfactory Risk assets possess adequate earnings, cash flow, leverage, and capital when compared to their industry. Debt service does not place an undue strain on the business. The borrower is not strong enough to sustain major financial setbacks. The asset has a readily apparent weakness such as being relatively new, new management with an unproven track record, low liquidity or equity, volatile profitability and cash flow. Guarantor(s) and collateral that provide an acceptable and readily quantifiable secondary source of repayment always support these assets.
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
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Rating 5 -Acceptable Risk -“Management Watch.” Acceptable Risk Assets are those that warrant closer than normal attention due to adverse conditions affecting the borrower, the borrowers industry, or the general economic environment. Above average risk is reflected through erratic earnings and cash flow, inconsistent debt service coverage, or strained liquidity or leverage. Uncertain events may have taken place such as unanticipated management changes or pending litigation that could have a significant negative impact. Collateral and/or guarantor(s) adequately protect these assets.
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Rating 6 -Special Mention. A Special Mention asset has potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the institution’s credit position at some future date. Special Mention assets are not adversely classified and do not expose the Bank to sufficient risk to warrant adverse classification.
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Rating 7 -Substandard. Loans with a well-defined weakness, some loss may be possible, though not anticipated. A substandard asset is inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Assets so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility the Bank will sustain some loss if the deficiencies are not corrected. Loss potential, while existing in the aggregate amount of substandard assets, does not have to exist in individual assets classified substandard.
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Rating 8 -Doubtful. A doubtful asset has all the weaknesses inherent in an asset 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. The possibility of loss is extremely high, but because of certain important and reasonable specific pending factors that may work to the advantage and strengthening of the asset, its classification as an estimated loss is deferred until its more exact status may be determined. Pending factors include proposed merger, acquisition, or liquidation procedures, capital injection, perfecting liens on additional collateral and refinancing plans. A substandard credit with 50 percent or more liquidated collateral value shortfall would generally be considered doubtful, unless other substantive credit factors justified otherwise.
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Rating 9 -Loss. Assets classified as loss are considered uncollectible and of such little value that their continuance as bankable assets is not warranted. This classification does not mean the asset 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. Losses are taken in the period in which they determined to be uncollectible.
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
Commercial loans with a risk rating of 1 through 5 are classified as “Pass” rated credits in the following tables. Nonrated consumer loans are also classified as “Pass.” The following is a summary of information pertaining to credit quality.
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
The following is a summary loan aging analysis.
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
The following tables outline the changes in the allowance for loan losses by collateral type, the allowances for loans individually and collectively evaluated for impairment, and the amount of loans individually and collectively evaluated for impairment.
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
The following table summarizes information relative to impaired loans.
As a result of adopting the amendments in ASU 2011-02, the Company reassessed all restructurings that occurred on or after the beginning of the fiscal year of adoption (January 1, 2011) to determine whether they are considered troubled debt restructurings (TDRs) under the amended guidance. The Company identified as TDRs certain loans for which the allowance for loan losses had previously been measured under a general allowance methodology. Upon identifying those loans as TDRs, the Company identified them as impaired under the guidance in ASC 310-10-35. The amendments in ASU 2011-02 require prospective application of the impairment measurement guidance in ASC 310-10-35 for those loans newly identified as impaired. The majority of the loans identified as TDRs had previously been considered impaired and subject to impairment measurement guidance. For the year ended December 31, 2011, the recorded investment in loans for which the allowance was previously measured under a general allowance methodology and are now impaired under ASC 310-10-35 was $7.6 million, and the allowance for loan losses associated with those loans, on the basis of a current evaluation of loss was $428,000. Total loans considered TDRs, under the amended guidance, as of December 31, 2011, were $40.2 million, and the allowance for loan losses associated with those loans, on the basis of a current evaluation of loss was $313,000. Of the $40.2 million of TDRs, $15.8 million were accruing interest.
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
The following tables summarize information relative to loan modifications determined to be TDRs. As of December 31, 2011 and 2010, all TDRs are included in impaired loans.
During the year end December 31, 2011, the Bank modified 118 loans that were considered to be TDRs, 56 of which were in default on December 31, 2011, including three loans that went in to default in the 2011 fourth quarter. Of the 118 loans restructured, 43 loans were related to foreclosures, while the modifications on the remaining 75 loans were comprised of a combination of rate increases or decreases, term extensions or reductions, and payment restructures or principal deferments.
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
The following table provides information about the Bank’s nonperforming assets as of December 31, 2011 and 2010.
Note 6 - Foreclosed Real Estate and Repossessed Assets
The following table shows the composition of foreclosed real estate.
The following table summarizes the activity in foreclosed real estate for the years ended December 31, 2011 and 2010.
As of December 31, 2011, repossessed assets totaled $1.6 million and were comprised of three aircraft. As of December 31, 2010, repossessed assets totaled $6,500.
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
Note 7 - Restricted Equity Securities
The Bank, as a member institution is required to own stock in the Federal Home Loan Bank of Atlanta (FHLB). No ready market exists for this stock and it has no quoted market value; however, redemption of this stock has historically been at par. At December 31, 2011 and 2010, the Bank owned $2,088,600 and $3,951,500, respectively, in FHLB stock. As of December 31, 2011, the Bank maintained an investment in FHLB stock which was $816,000 in excess of the minimum amount required by the FHLB. The FHLB redeems stock at its discretion. Also included in restricted equity securities at December 31, 2011 and 2010, was an investment in the Senior Housing Crime Prevention Fund of $500,000, an investment in Pacific Coast Bankers Bank stock of $102,000, and an investment in Capital South Partners, LLC (a Small Business Investment Corporation), which totaled $1.2 million at December 31, 2011, compared to $962,500 at December 31, 2010.
Note 8 - Investment in Real Estate Partnership
During 2009, the Bank became a member in a limited liability corporation (LLC). The Bank contributed two nonperforming loans with an aggregate principal amount outstanding of $6.7 million to the LLC, while the other members contributed professional real estate development experience and cash sufficient to carry the properties’ operating costs for an extended period of time. The LLC is designed to hold the real estate until such time as market values return to normalized levels at which point it is anticipated that the properties will be marketed by seasoned real estate developers with the proceeds of the sale being distributed based on contractual formulas to members of the LLC. During 2010, the Bank received $311,000 as reduction of principal from the sale of a sub-parcel of one of the two properties. As of December 31, 2011 and December 31, 2010, the Bank’s investment in the LLC was $6.4 million.
During the second quarter of 2011, the Bank purchased the interest of the other LLC member for $850,000. This cost was included as other loan and real estate related expense in the Consolidated Statement of Operations. In late July 2011, the LLC began foreclosure proceedings against the remaining loan in the LLC. Accordingly, this investment is classified as foreclosed real estate at December 31, 2011.
Note 9 - Property and Equipment
The following table highlights the components of property and equipment and accumulated depreciation for the years ended December 31, 2011 and 2010.
Depreciation was $1.0 million and $1.3 million for 2011 and 2010, respectively.
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
Note 10 - Time Deposits
Time deposits totaled $340.0 million at December 31, 2011, compared to $381.8 million at December 31, 2010. Of that total, time deposits in denominations of $100,000 or more were $169.3 million and $181.7 million at December 31, 2011 and December 31, 2010, respectively. Interest expense on deposits of $100,000 or more aggregated $2.6 million and $2.1 million for the year ended December 31, 2011 and 2010, respectively. Time deposits maturing subsequent to December 31, 2011, are as follows:
At December 31, 2011 and 2010, the Company had $2.6 million in brokered certificates of deposit, down from $42.4 million at December 31, 2010. Under the terms of the Consent Order, the Bank is prohibited from soliciting and accepting brokered certificates of deposit (including the renewal of existing brokered certificates of deposits), unless it first receives an appropriate waiver from the FDIC. Accordingly, as brokered certificates of deposit mature, the certificates are not being rolled over into another certificate.
Note 11 - Borrowings
At December 31, 2011, the Company’s borrowings consisted of $4.0 million in advances from the FHLB, and securities sold under agreements to repurchase of $605,000. At December 31, 2010, the Company’s borrowings consisted of $4.0 million in FHLB advances, securities sold under agreements to repurchase of $704,000 and $3.6 million of SBA loans sold in the fourth quarter of 2010 whose sales were completed in the first quarter of 2011 after expiration of the 90-day guarantee period. Additional information on borrowings as of December 31, 2011 and 2010 is summarized below:
The FHLB advance outstanding at December 31, 2011, was paid off in January 2012. The securities sold under agreements to repurchase are considered overnight secured borrowing arrangements and are collateralized by investment securities.
As of December 31, 2011, the Company had lines of credit from unrelated banks totaling $12.0 million. These lines of credit, which are at the lender’s discretion and may be canceled at any time, are available on a one-day basis and are secured by investment securities. As of December 31, 2011, the Company had no outstanding balances on these lines.
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
Note 12 - Leases
As of December 31, 2011, the Company leases office space under non-cancelable operating leases. Future minimum lease payments required under the leases are as follows:
The leases contain options for renewals after the expiration of the current lease terms. The cost of such renewals is not included above.
In February 2011, the Company closed two of its branches. In conjunction with the closing, in 2010, the Company expensed the remaining carrying value of the leasehold improvements totaling $62,000 and the remaining obligations under the leases of $169,000, of which both costs are included in occupancy expense in the consolidated statements of operations.
Total rent expense for 2011 and 2010 was $560,000 and $979,000, respectively.
Note 13 - Income Taxes
The following tables present the Company’s current and deferred income tax provision (benefit) at and for the years ended December 31, 2011 and 2010.
The components of income tax expense (benefit) are as follows:
Reconciliation between the income tax expense (benefit) and the amount computed by applying the statutory federal income tax rate of 34% to loss before income tax benefit is as follows:
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
The significant components of deferred tax assets and liabilities are summarized as follows:
Deferred tax assets represent the future tax benefit of deductible differences and, if it is more likely than not that a tax asset will not be realized, a valuation allowance is required to reduce the recorded deferred tax assets to net realizable value. During 2011 and 2010, in consideration of uncertainties regarding the timing of improvements in current economic conditions, management provided allowances of $18.0 million and $4.0 million to reflect its estimate of net realizable value as of the financial statement date. A valuation allowance is recognized against deferred tax assets when, based on the consideration of all available evidence using a more likely that not criteria, it is determined that some portion of these tax benefits may not be realized. This assessment requires consideration of all sources of taxable income available to realize the deferred tax asset, including, taxable income in prior carryback years, future reversals of existing temporary differences, tax planning strategies and future taxable income exclusive of reversing temporary differences and carryforwards. The predictability that future taxable income, exclusive of reversing temporary differences, will occur is the most subjective of these four sources. The presence of cumulative losses in recent years is considered significant negative evidence, making it difficult for a company to rely on future taxable income, exclusive of reversing temporary differences and carryforwards, as a reliable source of taxable income to realize a deferred tax asset. Judgment is a critical element in making this assessment.
During 2010, the Company reached a three-year cumulative pre-tax loss position. At that time, a partial valuation allowance was recorded. During 2011, based upon additional losses and the weighting ascribed to this evidence, the Company determined that a full valuation allowance is necessary under the accounting standards.
Pursuant to accounting pronouncement ASC 740-10, the Company has reviewed its income tax positions and specifically considered the recognition and measurement requirements of the benefits recorded in its financial statements for tax positions taken or expected to be taken in its tax returns. Based on its evaluation of these tax positions for its open tax years, the Company has not recorded any tax liability or uncertain tax positions as of December 31, 2011 and 2010. Federal tax returns have been examined by the Internal Revenue Service through 2008.
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
Note 14 - Retirement Plans
The Company has a 401(k)/Profit Sharing Plan (401(k) Plan), which is available to all full-time employees and part-time employees working more than 1,000 hours per year. The 401(k) Plan provides that employee contributions are 100% vested at all times. In 2010, the Company matched employee contributions in an amount equal to 100% of employee contributions, which did not exceed 3% of compensation and 50% of employee contributions over 3% and up to 5% of compensation. Under the 401(k) Plan, the initial 3% Company matching contribution under the 401(k) Plan was 100% vested at all times. The additional 2% match under the 401(k) Plan, as well as any discretionary Company contributions under the Profit Sharing Plan, was fully vested after three years.
In 2010, the Company’s matching contributions under the 401(k) Plan totaled $231,000. In an effort to reduce salary and benefit costs, the Company’s matching contributions were suspended in 2011. There were no discretionary contributions made in 2011 or 2010.
The Company also has a Supplemental Executive Retirement Plan, which provides certain officers of the Company post-retirement cash payment for 15 years following their normal retirement age, stated to be 62. Expense related to this Plan totaled $88,000 in 2011, compared to $249,000 in 2010 due to the forfeiture of a $169,000 accrued benefit by a former executive officer of the Company. At December 31, 2011 and 2010, the Company had accrued liabilities of $1.0 million and $914,000, respectively, related to this Plan. The discount rate used by the Company to determine the present value of the normal retirement benefit was 6.17% and 6.00% at December 31, 2011 and 2010, respectively.
Note 15 - Stock Based Compensation
Stock Option Plans
The Employee Stock Option Plan and the Director Stock Option Plan provide up to 497,110 shares (adjusted for all stock splits) of the Company’s common stock may be issued under each of these plans for a combined total of 994,220 shares. Options granted under the Employee Stock Option Plan and the Director Stock Option Plan may be vested immediately and expire no more than 10 years from date of grant. The exercise price for any options granted under these plans is set by the Board of Directors at the date of grant (and is adjusted on a pro rata basis for any subsequent stock split). No options were granted under either the Director Stock Option Plan or the Employee Stock Option Plan in 2011 or 2010. During 2011, no options were granted under the Employee Stock Option Plan. Forfeited options totaled 92,224 and 81,212 for 2011 and 2010, respectively. The total number of options outstanding at December 31, 2011 under each Plan was 497,110 in the Director Stock Option Plan and 196,709 in the Employee Stock Option Plan.
The Company recognized $1,000 and $27,000 in stock compensation expense in 2011 and 2010, respectively, related to the vesting of stock options. Separately, $40,000 of stock compensation expense was reversed upon the forfeiture of nonvested stock options. It is the Company’s policy to issue shares to satisfy option exercises. There were no options exercised during 2011 or 2010 and as of December 31, 2011, there was no unrecognized compensation cost related to the outstanding stock options. There is no intrinsic value in the stock options as of December 31, 2011, as the exercise prices are greater that the last traded price of the Company’s common stock.
A summary of the activity in the Company’s Stock Option Plans and related information for 2011 and 2010 is as follows:
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
Additional information concerning outstanding options under the Company’s Plans as of December 31, 2011 is as follows:
Service-Based Awards
In 2008, the Company’s stockholders approved the Omnibus Plan, pursuant to which incentive stock options, nonqualified stock options, performance shares, stock appreciation rights, and restricted stock may be granted to officers and employees of the Company and the Bank, and nonqualified stock options and restricted stock awards may be granted to directors of the Company and the Bank. An additional 250,000 shares of the Company’s common stock was reserved and made available for awards under the Omnibus Plan. The shares granted generally vest ratably over a period of three or five years.
Nonvested share activity under the Plan for 2011 and 2010 is as follows:
Compensation expense recognized for nonvested service-based shares in 2011 and 2010 totaled $49,000 and $81,000 respectively. Separately, $12,000 of stock compensation expense was reversed upon the forfeiture of nonvested service-based shares. As of December 31, 2011, there was $34,000 of total unrecognized compensation cost related to service-based nonvested share-based compensation arrangements granted under the Omnibus Plan. This cost is expected to be recognized over a remaining weighted-average period of 12.8 months.
Note 16 - Contingent Liabilities, Commitments, and Uncertainties
Litigation
In the normal course of business, the Company is often involved in various legal proceedings. Management believes any liability resulting from such proceedings will not be material to the consolidated financial statements.
Risks and Uncertainties
In the normal course of its business, the Company encounters numerous risks. Two of the most significant of these types of risk are economic and regulatory. There are three main components of economic risk; interest rate risk, credit risk, and market risk. The Company is subject to interest rate risk to the degree that its interest-bearing liabilities mature or reprice at different speeds, or on different bases, than its interest-earning assets. Credit risk is the risk of default on the Company’s loan portfolio that results from borrowers’ inability or unwillingness to make contractually required payments. Market risk reflects changes in the value of collateral underlying loans receivable, the valuation of real estate held by the Company, and the valuation of loans held for sale and investment securities available for sale.
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
The Company is subject to the regulations of various governmental agencies. These regulations can and do change significantly from period to period. The Company also undergoes periodic examinations by the regulatory agencies, which may subject it to further changes with respect to asset valuations, amounts of required loss allowances, and operation restrictions, resulting from the regulators’ judgments based on information available to them at the time of their examination. See Note 2 - Enforcements Actions for discussion of the Consent Order and the Written Agreement entered into by the Bank and the Company, respectively, during 2010.
Financial Instruments with Off-Balance-Sheet-Risk
The Company is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, credit risk in excess of the amount recognized in the balance sheets. The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as for on-balance-sheet instruments. A summary of the Company’s commitments are as follows:
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation of the party. Collateral held varies, but may include accounts receivable, inventory, property and equipment, residential real estate and income-producing commercial properties.
Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Collateral held varies as specified above, and is required in instances which the Company deems necessary. Since most of the letters of credit are expected to expire without being drawn upon, they do not necessarily represent future cash requirements. The Company has not recorded a liability for the current carrying amount of the obligation to perform as a guarantor, and no contingent liability was considered necessary, as such amounts were not considered material.
Concentrations of Credit Risk
Financial instruments, which potentially subject the Company to concentrations of credit risk, consist principally of loans, investment securities, federal funds sold and amounts due from banks with loans accounting for the most significant risk.
The Company makes loans to individuals and small businesses for various personal and commercial purposes primarily in western North Carolina. Management does not consider the loan portfolio to be significantly concentrated in loans to any single borrower or a relatively small number of borrowers. Additionally, management is not aware of any concentrations of loans to classes of borrowers or industries that would be similarly affected by economic conditions.
Recently, banking regulators have raised concern and have heightened regulatory scrutiny regarding loan portfolios with concentrations of loans collateralized by real estate, particularly commercial real estate (CRE). They have defined CRE to include construction loans, acquisition and development loans, loans collateralized with tracts of raw land for speculative purposes, any sort of commercial premise unless it is owner occupied and a number of other subcategories. Slightly more than 88% of the Bank’s loan portfolio is collateralized by real estate.
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
In addition to monitoring potential concentrations of loans to particular borrowers or groups of borrowers, industries, geographic regions and loan types, management monitors exposure to credit risk from other lending practices such as loans that subject borrowers to substantial payment increases (e.g. principal deferral periods, loans with initial interest-only periods, etc.) and loans with high loan-to-value ratios (LTV). Regulatory guidelines state that the total amount of all loans in excess of the regulatory loan-to-value ratio limits should not exceed 100% of a bank’s total risk-based capital. These types of loans totaled $28.9 million at December 31, 2011, representing 124.6% of the Company’s total risk-based capital.
The Company’s investment portfolio consists principally of obligations of the United States, its agencies, government sponsored enterprises and general obligation municipal securities. In the opinion of management, there is no concentration of credit risk in the Company’s investment portfolio.
The Company places its deposits and correspondent accounts with and sells its federal funds to high quality institutions. Management believes credit risk associated with correspondent accounts is not significant.
Note 17 - Stockholders’ Equity
Preferred Stock
In November 2008, under the U.S. Department of the Treasury (U.S. Treasury) TARP Capital Purchase Program (CPP), 1st Financial issued to the U.S. Treasury 16,369 shares of Fixed Rate Cumulative Perpetual Preferred Stock, Series A (Preferred Stock), and a 10-year warrant to purchase up to 276,815 shares of common stock at an exercise price of $8.87 per share (Warrant), for aggregate proceeds of $16,369,000. The allocated carrying values of the Warrant and the Preferred Stock on the date of issuance (based on their relative fair values) were $1,016,000 and $15,353,000, respectively. Cumulative dividends on the Preferred Stock are payable at 5% per annum through November 14, 2013, and at a rate of 9% per annum thereafter. The Preferred Stock will be accreted to the redemption price of $16,369,000 over five years. The Warrant is exercisable at any time until November 14, 2018, and the number of shares of common stock underlying the Warrant and the exercise price are subject to adjustment for certain dilutive events.
Each share of Preferred Stock issued and outstanding has a liquidation preference of $1,000 and is redeemable at the Company’s option, subject to prior regulatory approval, at a redemption price equal to $1,000 plus accrued and unpaid dividends.
The Preferred Stock has a preference over the Company’s common stock upon liquidation. Dividends on the Preferred Stock, if declared, are payable quarterly in arrears. The Company’s ability to declare or pay dividends on, or purchase, redeem or otherwise acquire, its common stock is subject to certain restrictions in the event the Company fails to pay or set aside full dividends on the preferred stock for the latest completed dividend period. In addition, pursuant to the U.S. Treasury’s CPP, until all of the Preferred Stock has been redeemed or transferred by the U.S. Treasury to third parties, the Company must obtain the consent of the U.S. Treasury to raise its common stock dividend or to repurchase any shares of common stock or other preferred stock, with certain exceptions.
Due to insufficient funding at the holding company level and restrictions placed on it under the Consent Order and the Written Agreement, as of December 31, 2011, the Company had deferred the payment of the last six quarterly dividends on the Preferred Stock, with the total amount deferred equaling $1.2 million. The Company subsequently deferred payment of the quarterly dividend in February, 2012. Until the Company pays in full these deferred Preferred Stock dividends, no dividends may be paid on the common stock.
Restriction on Dividends
As a North Carolina banking corporation, the Bank may pay cash dividends only out of undivided profits as determined pursuant to North Carolina banking laws. However, regulatory authorities may limit payment of dividends when it is determined that such a limitation is in the public interest and is necessary to ensure a bank’s financial soundness. As discussed in Note 2, the Bank is restricted from paying dividends without the approval of the FDIC and the Commissioner.
As discussed in Note 2, the Company is also restricted from paying dividends without the approval of the Federal Reserve Bank and the Director of the Division of Banking Supervision and Regulation of the Federal Reserve.
Capital Requirements
The Company and the Bank are subject to various regulatory capital requirements administered by federal and state banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory (and possibly additional discretionary) actions by regulators that, if undertaken, could have a direct material effect on the Company’s and the Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier I capital to risk-weighted assets, and of Tier I capital to average assets, as all those terms are defined in the applicable regulations.
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
As of December 31, 2011, the most recent notification from the Bank’s primary regulator categorized the Bank as “significantly undercapitalized” under the regulatory framework for prompt corrective action. Since that date, no conditions or events have occurred, of which the Company is aware, that have resulted in a material change in the Company’s or the Bank’s category.
The table below summarizes the Company and the Bank’s capital ratios at December 31, 2011 and 2010:
Note 18 - Employee Stock Purchase Plan
During 2008, the Board of Directors and Stockholders approved a ten year non-compensatory Employee Stock Purchase Plan for the benefit of officers and employees of the Bank. Beginning January 1, 2009, officers and employees were allowed to have the Company make payroll withholdings for the purpose of buying Company stock. Under the provisions of the Plan, shares for the quarter were purchased during the first month of the following quarter at a purchase price of 95 percent of the closing quoted market price on the last business day of the quarter.
During 2010, the Company issued 26,775 shares under this plan and paid $2,250 in administrative costs prior to the termination of the plan in October of 2010.
Note 19 - Related Party Transactions
The Company has deposit and loan relationships with most of its directors and executive officers and with companies with which certain directors and executive officers are associated. Deposits held at the Bank by directors, executive officers and their associated companies were $2.8 million and $2.0 million at December 31, 2011 and 2010, respectively. The following is a reconciliation of loans directly outstanding to executive officers, directors and their affiliates.
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
The Company also enters into other transactions in the ordinary course of business with affiliates. The following transactions were entered into with affiliates.
The Company leased the site for its Fletcher branch from a company owned by a former director of the Company. The initial lease term was ten years, with options to renew the lease for up to three successive five-year renewal terms. The terms of the lease called for a $3,200 per month rental payment during the first five years of the initial term. Payments for each successive five year term may be adjusted by the aggregate increase in the Chained Consumer Price Index for all Urban Consumers during the previous five years. Rental payments during each renewal term will not exceed 118% of the monthly rental amount of the original five year term and increases in the amount of the subsequent renewal terms will not exceed 115% of the immediately preceding renewal term. Lease payments under this lease totaled $39,321 in 2010. During late 2010, after obtaining a current market appraisal, the Company purchased the Fletcher branch and an adjoining piece of property for $575,000.
The Company leases the site for its Marion branch from a company of which a director of the Company is a member. The initial lease term was for five years, with options to renew the lease for up to four successive three-year renewal terms. The terms of the lease call for a $3,500 per month rental payment during the initial term. Rental payments for each renewal term will be adjusted by the aggregate increase in the Consumer Price Index for all Urban Consumers for the immediately preceding lease term. During 2011, the Company exercised its option to renew the lease for three years at the same $3,500 monthly rental amount. Lease payments under this lease totaled $42,000 in both 2011 and 2010.
Note 20 - Fair Value of Financial Instruments
Fair value estimates are made at a specific point in time based on relevant market information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holding of a particular financial instrument. In cases where quoted market prices are not available, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect the estimates. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in the estimates. Finally, the fair value estimates presented herein are based on pertinent information available to management as of December 31, 2011 and 2010, respectively.
The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:
Cash and Noninterest Bearing Bank Deposits, Federal Funds Sold, Interest Bearing Deposits with Banks, and Due from Federal Reserve Banks
The carrying amounts for cash and noninterest bearing bank deposits, federal funds sold, interest bearing deposits with banks and due from Federal Reserve banks approximate fair value because of the short maturities of those instruments. These instruments are considered cash and cash equivalents.
Investment Securities
Fair values for investment securities are based on quoted market price if such information is available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities.
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
Investment in Real Estate Partnership
During 2009, the Bank became a member in a limited liability corporation (LLC). The Bank contributed two nonperforming loans with an aggregate principal amount outstanding of $6.7 million to the LLC, while the other members contributed professional real estate development experience and cash sufficient to carry the properties’ operating costs for an extended period of time. The LLC is designed to hold the real estate until such time as market values return to normalized levels at which point it is anticipated that the properties will be marketed by seasoned real estate developers with the proceeds of the sale being distributed based on contractual formulas to members of the LLC. During 2010, the Bank received $311,000 as reduction of principal from the sale of sub-parcels of one of the two properties. As of December 31, 2010, the Bank’s investment in the LLC was $6.4 million.
During the second quarter of 2011, the Bank purchased the interest of the other LLC members for $850,000. This cost was included as other loan and real estate related expense in the Consolidated Statement of Operations. In late July 2011, the LLC began foreclosure proceedings against the remaining loan in the LLC. Accordingly, this investment is classified as foreclosed real estate at December 31, 2011.
Loans Held for Sale
Fair values of mortgage loans held for sale are based on commitments on hand from investors or prevailing market prices.
Loans
For certain homogenous categories of loans, such as residential mortgages, fair value is estimated using the quoted market prices for securities backed by similar loans, adjusted for differences in loan characteristics. The fair value of other types of loans is estimated by discounting the future cash flows using the current rate at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities.
Bank Owned Life Insurance
The carrying value of life insurance approximates fair value since this investment is carried at cash surrender value, as determined by the insurer.
Deposits, Short-term Borrowings and Long-term Debt
The fair value of demand deposits and savings accounts is the amount payable on demand at the reporting date. The fair value of time deposits, short-term borrowings, and long-term debt is estimated based upon the discounted value of projected future cash outflows using the rates currently offered for instruments of similar remaining maturities.
Accrued Interest Receivable and Accrued Interest Payable
The carrying amounts of accrued interest receivable and accrued interest payable are assumed to approximate fair values.
Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an 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. ASC Topic 820 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:
Level 1
Valuation can be based on quoted prices in active markets for identical assets or liabilities.
Level 2
Valuation can be based on quoted prices for similar assets or liabilities; quoted prices in markets that are not active/or models using inputs that are observable or can be corroborated by observable market data of substantially the full term or the assets or liabilities.
Level 3
Valuation can be based on using pricing models, discounted cash flow methodologies or similar techniques and at least one significant model assumption or input is unobservable and when determination of the fair value requires significant management judgment or estimation.
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
The following table presents the carrying values and estimated fair values of the Company’s financial instruments at December 31, 2011 and 2010.
Assets and liabilities measured at fair value on a recurring basis as of December 31, 2011 and 2010 are as follows:
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
The Company had no liabilities carried at fair value or measured at fair value on a recurring basis as of December 31, 2011 or 2010.
Assets measured at fair value on a non-recurring basis as of December 31, 2011 and 2010 are as follows:
The Company had no liabilities carried at fair value or measured at fair value on a nonrecurring basis as of December 31, 2011 or 2010.
The Company is predominantly an asset based lender with real estate serving as collateral on a substantial majority of loans. Loans which are deemed to be impaired are primarily valued on a nonrecurring basis at the fair values of the underlying real estate collateral Such fair values are obtained using independent appraisals, which the Company considers to be level 2 inputs.
Real estate acquired in settlement of loans is adjusted to fair value upon transfer of the loans. Subsequently, the assets are carried at the lower of carrying value or fair value less costs to sell. Fair value is based upon independent market prices, fair values of the collateral or management’s estimation of the value of the collateral. When the fair value of the collateral is based on an observable market price or current appraised value, the Company records the asset as non-recurring level 2 inputs.
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
Mortgage loans held for sale are carried at the lower of cost or fair value. The fair value of mortgage loans held for sale is based on what secondary markets are currently offering for portfolios with similar characteristics and accordingly, considered non-recurring level 2 inputs.
There were no transfers of assets measured at fair value between Level 1 and Level 2 measurements during the year ended December 31, 2011.
The Company had no assets or liabilities whose fair values are measured using Level 3 inputs during the year ended December 31, 2011.
1st Financial Services Corporation
Notes to Consolidated Financial Statements (cont.)
Note 21 - Parent Company Financial Information
Following is condensed financial information of 1st Financial Services, Inc. (parent company only).
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
Our management, under the supervision and with the participation of our principal executive and principal financial officer, has concluded based on its evaluation as of the end of the period covered by this report, that our disclosure controls and procedures (as defined in Rule 13a-15(e) of the Exchange Act) are effective to ensure that information required to be disclosed by 1st Financial in the reports filed or submitted by it under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the applicable rules and forms.
Management’s Report on Internal Control Over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting for 1st Financial. Our internal control over financial reporting is a process designed under the supervision of our principal executive and principal financial officer to provide reasonable assurance regarding the reliability of financial reporting and the preparation of our financial statements for external reporting purposes in accordance with U.S. generally accepted accounting principles. Management has made a comprehensive review, evaluation, and assessment of our internal control over financial reporting as of December 31, 2011. In making its assessment of internal control over financial reporting, management used the criteria issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control- Integrated Framework. Based on the evaluation, management determined that there were no material weaknesses in internal control and concluded that internal control over financial reporting for 1st Financial as of December 31, 2011, is effective.
In accordance with Section 404 of the Sarbanes-Oxley of 2002, management makes the following assertions:
●
Management has implemented a process to monitor and assess both the design and operating effectiveness of internal control over financial reporting.
●
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
This Annual Report on Form 10-K does not include an attestation report of our registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by our registered public accounting firm pursuant to rules of the SEC that permit us to provide only management’s report in this Annual Report on Form 10-K.
Changes In Internal Control Over Financial Reporting
There was no change in our internal control over financial reporting that occurred during the fourth quarter of 2011 that has materially affected or is reasonably likely to materially affect, our internal control over financial reporting.
PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
Directors and Executive Officers. The information regarding our directors and executive officers is incorporated by reference from the information under the headings "Proposal 1: Election of Directors” and “Executive Officers" in our definitive Proxy Statement to be distributed in connection with our 2012 annual meeting of stockholders.
Audit Committee. Information regarding our audit committee is incorporated by reference from the information under the captions “Committees of Our Board - General” and “Audit Committee” in our definitive Proxy Statement to be distributed in connection with our 2012 annual meeting of stockholders.
Audit Committee Financial Expert. Information about our Board of Directors' determination as to whether the Company has a financial expert serving on its audit committee is incorporated by reference from the information under the caption "Committees of Our Board -- Audit Committee -- Audit Committee Financial Expert" in our definitive proxy statement to be distributed in connection with our 2012 annual meeting of stockholders.
Section 16(a) Beneficial Ownership Reporting Compliance. Information regarding compliance by our directors, executive officers and principal stockholders with the reporting requirements of Section 16(a) of the Securities Exchange Act of 1934 is incorporated by reference from the information under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” in our definitive Proxy Statement to be distributed in connection with our 2012 annual meeting of stockholders.
Code of Ethics. Our Board of Directors has adopted a Code of Ethics that applies to the Company's directors and to all our executive officers, including without limitation, our chief executive officer and principal accounting officer. A copy will be provided without charge to any person upon request. Requests for copies should be directed by mail to Janet King, Corporate Secretary at 101 Jack Street, Hendersonville, North Carolina 28792, or by telephone to (828) 697-3100.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Information regarding compensation paid or provided to our executive officers and directors is incorporated by reference from the information under the headings “Executive Compensation,” and “Director Compensation” in our definitive Proxy Statement to be distributed in connection with our 2012 annual meeting of stockholders.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
Beneficial Ownership of Securities. Information regarding the beneficial ownership of our common stock by our directors, executive officers and principal stockholders is incorporated by reference from the information under the caption “Beneficial Ownership of Our Common Stock” in our definitive Proxy Statement to be distributed in connection with our 2012 annual meeting of stockholders.
Securities Authorized for Issuance Under Equity Compensation Plans. Information regarding securities authorized for issuance under our equity compensation plans is incorporated by reference from Item 5.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information regarding transactions between us and our directors and executive officers is incorporated by reference from the information under the caption “Transactions with Related Persons” of our definitive Proxy Statement to be distributed in connection with our 2012 annual meeting of stockholders.
Information regarding our independent directors is incorporated by reference from the information under the caption “Corporate Governance - Director Independence” in our definitive Proxy Statement to be distributed in connection with our 2012 annual meeting of stockholders.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
The information required by this Item is incorporated by reference from the information under the caption “Services and Fees During 2011 and 2010” in our definitive Proxy Statement to be distributed in connection with our 2012 annual meeting of stockholders.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a)
Financial statements. The following financial statements are included in Item 8 of this Report:
●
Reports of Independent Registered Public Accounting Firms
●
Consolidated Balance Sheets as of December 31, 2011 and 2010
●
Consolidated Statements of Operations for the Years Ended December 31, 2011 and 2010
●
Consolidated Statements of Changes in Stockholders’ Equity and Comprehensive Income (Loss) for the Years Ended December 31, 2011 and 2010
●
Consolidated Statements of Cash Flows for the Years Ended December 31, 2011 and 2010
●
Notes to Financial Statements - December 31, 2011 and 2010
(b)
Exhibits. An exhibit index listing exhibits that are being filed or furnished with, or incorporated by reference into, this Report appears immediately following the signature page and is incorporated herein by reference.
(c)
Financial statement schedules. No separate financial statement schedules are being filed as all required schedules either are not applicable or are contained in the financial statements listed above or in Item 7 of this Report.
SIGNATURES
In accordance with Section 13 or 15(d) of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
In accordance with the Exchange Act, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Signature
Title
Date
/s/ Michael G. Mayer
Director, Chief Executive Officer
March 29, 2012
Michael G. Mayer
(Principal Executive Officer)
/s/ Holly L. Schreiber
Executive Vice President and Chief Financial Officer
March 29 2012
Holly L. Schreiber
(Principal Financial Officer)
/s/ Mary K. Dopko
Senior Vice President and Controller
March 29 2012
Mary K. Dopko
(Principal Accounting Officer)
/s/ Bradley B. Schnyder
Director
March 29, 2012
Bradley B. Schnyder
/s/ William H. Burton
Chairman and Director
March 29, 2012
William H. Burton
/s/ Michael D. Foster
Director
March 29, 2012
Michael D. Foster
/s/ James C. Kirkpatrick
Director
March 29, 2012
James C. Kirkpatrick
/s/ Van F. Phillips
Director
March 29, 2012
Van F. Phillips
/s/ Vincent K. Rees
President and Director
March 29, 2012
Vincent K. Rees
EXHIBITS