ITEM 1: BUSINESS
GENERAL
Bay Banks of Virginia, Inc. (the “Company”) is a bank holding company that conducts substantially all of its operations through its subsidiaries, Bank of Lancaster (the “Bank”) and Bay Trust Company (the “Trust Company”). Bay Banks of Virginia, Inc. was incorporated under the laws of the Commonwealth of Virginia on June 30, 1997, in connection with the holding company reorganization of the Bank of Lancaster.
The Bank is a state-chartered bank and a member of the Federal Reserve System. The Bank services individual and commercial customers, the majority of which are in the Northern Neck of Virginia, by providing a full range of banking and related financial services, including checking, savings, other depository services, commercial and industrial loans, residential and commercial mortgages, home equity loans, consumer installment loans, investment brokerage services, insurance, credit cards, and electronic banking.
The Bank has two offices located in Kilmarnock, Virginia, and one office each in White Stone, Warsaw, Montross, Heathsville, Callao, Burgess, and Colonial Beach, Virginia. A substantial amount of the Bank’s deposits are interest bearing, and the majority of the Bank’s loan portfolio is secured by real estate. Deposits of the Bank are insured by the Deposit Insurance Fund of the Federal Deposit Insurance Corporation (the “FDIC”). The Bank opened for business in 1930 and has partnered with the community to ensure responsible growth and development since that time.
In August of 1999, Bay Banks of Virginia formed Bay Trust Company. This subsidiary of the Company was created to purchase and manage the assets of the trust department of the Bank of Lancaster. The sale and transfer of assets from the Bank to the Trust Company was completed as of the close of business on December 31, 1999. As of January 1, 2000, the Bank of Lancaster no longer owned or managed the trust function, and thereby no longer receives an income stream from the trust department. Income generated by the Trust Company is consolidated with the Bank’s income and the Company’s income for the purposes of the Company’s consolidated financial statements. The Trust Company opened for business on January 1, 2000, in its permanent location on Main Street in Kilmarnock, Virginia.
The Company’s marketplace is situated on the “Northern Neck” peninsula of Virginia, plus Middlesex County. The “Northern Neck” includes the counties of Lancaster, Northumberland, Richmond, and Westmoreland. Smaller, retired households with relatively high per capita incomes dominate the Company’s primary trading area. Growth in households, employment, and retail sales has slowed, causing a slowdown in growth of the local economy. Health care, tourism, and related services are the major employment sectors in the “Northern Neck.”
The Company had total assets of $327.1 million, deposits of $260.9 million, and shareholders’ equity of $27.3 million as of December 31, 2010. Its headquarters are located in Kilmarnock, Virginia and its telephone number is 804-435-1171 or 800-435-1140. The website is www.baybanks.com. Information contained on the Company’s website is not a part of this report.
Through the Bank of Lancaster and Bay Trust Company, Bay Banks of Virginia provides a wide range of financial services to its customers in its market area. These products and services are summarized as follows.
Real Estate Lending. The Bank’s real estate loan portfolio is the largest segment of the loan portfolio. The majority of the Bank’s real estate loans are mortgages on owner-occupied one-to-four family residential properties, and the majority of these one-to-four family mortgages have adjustable-rate structures. Residential mortgages are underwritten and documented within the guidelines of the regulations of the Board of Governors of the Federal Reserve System (the “Federal Reserve”). The Bank underwrites residential mortgages as the marketplace allows. Home equity lines of credit are also offered. Construction loans with a twelve-month term are another component of the Bank’s portfolio. Underwritten at 80% loan to value, and to qualified builders and individuals, these loans are disbursed as construction progresses and verified by Bank inspection. The Bank also offers commercial loans that are secured by real estate. These loans are typically written at a maximum of 80% loan to value and either vary with the prime rate of interest, or adjust in one, three, or five year terms.
The Company also offers secondary market loan origination. Through the Bank, customers may apply for a home mortgage that will be underwritten in accordance with the guidelines of either the Federal Home Loan Mortgage Corporation (“FHLMC”) or the Federal National Mortgage Association (“FNMA”). These loans are then sold into the secondary market on a loan-by-loan basis. The Bank earns origination fees through offering this service.
Consumer Lending. In an effort to offer a full range of services, the Bank’s consumer lending includes automobile and boat financing, home improvement loans, and unsecured personal loans. These loans historically entail greater risk than loans secured by real estate, but also offer a higher return.
Commercial Lending. Commercial lending activities include small business loans, asset based loans, and other secured and unsecured loans and lines of credit. Commercial lending may entail greater risk than residential mortgage lending, and is therefore underwritten with strict risk management standards. Among the criteria for determining the borrower’s ability to repay is a cash flow analysis of the business and business collateral.
Business Development. The Bank offers several services to commercial customers. These services include analysis checking, cash management deposit accounts, wire services, direct deposit payroll service, internet banking, telephone banking, remote deposit, and a full line of commercial lending options. The Bank also offers Small Business Administration loan products to include the 504 Program, which provides long term funding for commercial real estate and long-lived equipment. This allows commercial customers to apply for favorable rate loans for the development of business opportunities, while providing the Bank with a partial guarantee of the outstanding loan balance.
Bay Services Company, Inc. The Bank has one wholly owned subsidiary, Bay Services Company, Inc., a Virginia corporation organized in 1994 (“Bay Services”). Bay Services owns an interest in a land title insurance agency, Bankers Title of Shenandoah, and an investment and insurance services company, Infinex Investments Inc. Bankers Title of Shenandoah sells title insurance to mortgage loan customers, including customers of the Bank of Lancaster and the other financial institutions that have an ownership interest in the agency. Infinex Investments Inc. provides the Bank’s non-deposit products department with insurance and investment products for marketing within the Bank’s primary marketing area.
Bay Trust Company. The Trust Company offers a broad range of investment services as well as traditional trust and related fiduciary services. Included are estate planning and settlement, revocable and irrevocable living trusts, testamentary trusts, custodial accounts, investment management accounts, and managed, as well as self-directed rollover Individual Retirement Accounts.
COMPETITION
The Company’s marketplace is highly competitive. The Company is subject to competition from a variety of commercial banks and financial service companies, large national and regional financial institutions, large regional credit unions, mortgage companies, consumer finance companies, mutual funds and insurance companies. Competition for loans and deposits is affected by numerous factors, including interest rates and institutional reputation.
SUPERVISION AND REGULATION
Bank holding companies and banks are regulated under both federal and state law. The Company is subject to regulation by the Federal Reserve. Under the Bank Holding Company Act of 1956, the Federal Reserve exercises supervisory responsibility for any non-bank acquisition, merger or consolidation. In addition, the Bank Holding Company Act limits the activities of a bank holding company and its subsidiaries to that of banking, managing or controlling banks, or any other activity that is closely related to banking. In addition, the Company is registered under the bank holding company laws of Virginia, and as such is subject to regulation and supervision by the Virginia State Corporation Commission’s Bureau of Financial Institutions.
The following description summarizes the significant state and federal laws to which the Company and the Bank are subject. To the extent statutory or regulatory provisions or proposals are set forth the description is qualified in its entirety by reference to the particular statutory or regulatory provisions or proposals.
The Bank is supervised and regularly examined by the Federal Reserve and the Virginia State Corporation Commission’s Bureau of Financial Institutions. These on-site examinations verify compliance with regulations governing corporate practices, capitalization, consumer affairs and safety and soundness. Further, the Bank is subject to the requirements of the Community Reinvestment Act (the “CRA”). The CRA requires financial institutions to meet the credit needs of the local community, including low to moderate-income needs. Compliance with the CRA is monitored through regular examination by the Federal Reserve.
Federal Reserve regulations permit bank holding companies to engage in non-banking activities closely related to banking or to managing or controlling banks. These activities include the making or servicing of loans, performing certain data processing services, and certain leasing and insurance agency activities.
The Company owns 100% of the stock of the Bank of Lancaster. The Bank is prohibited by the Federal Reserve from holding or purchasing its own shares except in limited circumstances. Further, the Bank is subject to certain requirements as imposed by state banking statutes and regulations. By statute, the Bank’s dividend payments to the Company are limited to its accumulated undivided profits. As a state member bank, federal regulations limit these dividend payments to the total of the Bank’s net profits for that year plus undistributed retained earnings from the prior two years. An amount in excess of such must be approved by the proper regulatory agencies. Finally, supervisory guidance suggests that the Company should not make dividend payments to shareholders if such payments would cause an unsafe or unsound condition.
As a bank holding company, Bay Banks of Virginia is required to file with the Federal Reserve an annual report and such additional information as it may require pursuant to the Bank Holding Company Act. The Federal Reserve may also conduct examinations of the Company and any or all of its subsidiaries.
Capital Requirements
The Federal Reserve, the Office of the Comptroller of the Currency and the FDIC have issued substantially similar risk-based and leverage capital guidelines applicable to banking organizations. In addition, those regulatory agencies may from time to time require that a banking organization maintain capital above the minimum levels because of its financial condition or actual or anticipated growth. Under the risk-based capital requirements of these federal bank regulatory agencies, the Company and the Bank are required to maintain a minimum ratio of total capital to risk-weighted assets of 8%. At least half of the total capital is required to be “Tier 1 capital”, which consists principally of common and certain qualifying preferred shareholders’ equity, less certain intangibles and other adjustments. The remainder (“Tier 2 capital”) consists of a limited amount of subordinated and other qualifying debt (including certain hybrid capital instruments) and a limited amount of the general loan loss allowance. The total and tier 1 capital to risk-weighted asset ratios of the Company as of December 31, 2010 were 11.99% and 10.73%, respectively.
In addition, each of the federal regulatory agencies has established a minimum leverage capital ratio (Tier 1 capital to adjusted average assets) (“Tier 1 leverage ratio”). These guidelines provide for a minimum Tier 1 leverage ratio of 4% for banks and bank holding companies that meet certain specified criteria, including that they have the highest regulatory examination rating and are not contemplating significant growth or expansion. The Tier 1 leverage ratio of the Company as of December 31, 2010, was 7.54%, which is well above the minimum requirement. The guidelines also provide that banking organizations that are experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels, without significant reliance on intangible assets.
Deposit Insurance
The FDIC insures the deposits of the Bank up to the limits set forth under applicable law. On February 15, 2006, federal legislation to reform federal deposit insurance was enacted. The new law merged the old Bank Insurance Fund and Savings Association Insurance Fund into the single Deposit Insurance Fund (the “DIF”), increased deposit insurance coverage for IRAs to $250,000, provided for the further increase of deposit insurance on all accounts by indexing the coverage to the rate of inflation, authorized the FDIC to set the reserve ratio of the DIF at a level between 1.15% and 1.50%, and permits the FDIC to establish assessments to be paid by insured banks to maintain the minimum ratios.
On November 2, 2006, the FDIC adopted final regulations establishing a risk-based assessment system intended to more closely tie each bank’s deposit insurance assessments to the risk it poses to the DIF. Under this risk-based assessment system, which became effective in the beginning of 2007, the FDIC evaluates each bank’s risk based on three primary factors: (1) its supervisory rating, (2) its financial ratios, and (3) its long-term debt issuer rating, if any. In 2008, this translated to a rate for the Bank of 7 cents for every $100 of domestic deposits.
Until then, most banks, including Bank of Lancaster, had not been required to pay any deposit insurance premiums since 1995. As part of the reform, Congress provided credits to institutions that paid high premiums in the past to bolster the FDIC’s insurance reserves. As a result, in 2007, the Bank had sufficient assessment credits to offset all of its premiums for that year. These assessment credits were recognized going forward to reduce deposit premiums and were exhausted in the fourth quarter of 2008. Had there been no credits available, the Bank’s premium expense, at 7 cents per $100 of domestic deposits, would have totaled approximately $182,000 for the full year 2008. Actual FDIC assessment expense for 2008 was $76 thousand.
The Federal Deposit Reform Act of 2005 requires the FDIC to increase premiums if the DIF balance falls below 1.15% of insurable domestic deposits. As a result, effective March 31, 2009, the Bank’s premium, per $100 of domestic deposits, doubled from 7 cents to 14 cents. Additionally, as a result of further deterioration in the DIF balance, effective June 30, 2009, the FDIC applied a special one-time assessment of up to 20 cents per $100 of domestic deposits. The effect on the Company’s 2009 earnings was total FDIC assessment expense of $679 thousand in 2009, higher than 2008 by $603 thousand.
On December 30, 2009, the FDIC collected three years’ worth of estimated premium payments from every institution holding insured domestic deposits. This resulted in a prepayment balance of $1.5 million as of December 31, 2009. Throughout 2010, this prepayment was reduced by $566 thousand via quarterly assessment expense recognized in the Company’s Statement of Operations, shown in Item 8 of this form 10-K. The balance of this prepayment was approximately $970 thousand on December 31, 2010. Throughout 2011 and 2012, this prepayment balance will continue to be reduced through expense as each quarterly assessment becomes known. The prepayment balance is included in other assets on the Company’s Consolidated Balance Sheets, shown in Item 8 of this Form 10-K.
Effective April 1, 2011, as mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), the FDIC is implementing a new rule which changes the assessment base from domestic deposits to average consolidated total assets minus average tangible equity. This new rule sets a new target size for the DIF at 2% of insured deposits and implements lower assessment rate schedules when the fund achieves 1.15%, 2.00%, and 2.50%, respectively. The rate for smaller institutions, including the Bank, will also be reduced. Management anticipates that FDIC assessment expense will decline by approximately $34 thousand per quarter, beginning with the second quarter of 2011.
Safety and Soundness Regulations
The FDIC has adopted guidelines that establish standards for safety and soundness of banks. They are designed to identify potential safety and soundness problems and ensure that banks address those concerns before they pose a risk to the deposit insurance fund. If the FDIC determines that an institution fails to meet any of these standards, the agency can require the institution to prepare and submit a plan to come into compliance. If the agency determines that the plan is unacceptable or is not implemented, the agency must, by order, require the institution to correct the deficiency. The federal banking agencies have broad powers under current federal law to make insured depository institutions take prompt corrective action to resolve problems. The extent of these powers depends upon whether the institution in question is considered “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized,” or “critically undercapitalized.” All such terms are defined under uniform regulation defining such capital levels issued by each of the federal banking agencies. The Bank is considered well capitalized and therefore not subject to these requirements.
The FDIC also has safety and soundness regulations and accompanying guidelines on asset quality and earnings standards. The guidelines provide six standards for establishing and maintaining a system to identify problem assets and prevent those assets from deteriorating. The guidelines also provide standards for evaluating and monitoring earnings and for ensuring that earnings are sufficient to maintain adequate capital and reserves. If an institution fails to comply with a safety and soundness standard, the agency may require the institution to submit and implement an acceptable compliance plan, or face enforcement action.
The Dodd-Frank Act
On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Dodd-Frank Act will have a significant impact on financial institutions, with increased regulatory and compliance changes. A summary of certain provisions of the Dodd-Frank Act is set forth below:
Increased Capital Standards. The federal banking agencies are required to establish minimum leverage and risk-based capital requirements for banks and bank holding companies. These new standards will be no lower than current regulatory capital and leverage standards and may, in fact, be higher when established by the agencies.
Deposit Insurance. The Dodd-Frank Act makes permanent the $250,000 deposit insurance limit for insured deposits. Amendments to the Federal Deposit Insurance Act also revise the assessment base against which an insured depository institution’s deposit insurance premiums paid to the Deposit Insurance Fund will be calculated. Under the amendments, the assessment base will no longer be the institution’s deposit base, but rather its average consolidated total assets less its average tangible equity during the assessment period. Additionally, the Dodd-Frank Act makes changes to the minimum designated reserve ratio of the DIF, increasing the minimum from 1.15% to 1.35% of the estimated amount of total insured deposits and eliminating the requirement that the FDIC pay dividends to depository institutions when the reserve ratio exceeds certain thresholds. In December 2010, the FDIC increased the reserve ratio to 2.0%. The Dodd- Frank Act also provides that, effective one year after the date of enactment, depository institutions may pay interest on demand deposits.
Enhanced Lending Limits. The Dodd-Frank Act strengthens the existing limits on a depository institution’s credit exposure to one borrower. Current banking law limits a depository institution’s ability to extend credit to one person (or group of related persons) in an amount exceeding certain thresholds.
The Consumer Financial Protection Bureau (“Bureau”). The Dodd-Frank Act creates the Bureau within the Federal Reserve. The Bureau will establish rules and regulations under certain federal consumer protection laws with respect to the conduct of providers of certain consumer financial products and services.
Compensation Practices. The Dodd-Frank Act provides that the appropriate federal regulators must establish standards prohibiting as an unsafe and unsound practice any compensation plan of a bank holding company or bank that provides an insider or other employee with “excessive compensation” or could lead to a material financial loss to such firm. In June 2010, prior to the Dodd-Frank Act, the bank regulatory agencies promulgated the Interagency Guidance on Sound Incentive Compensation Policies, which requires that financial institutions establish metrics for measuring the impact of activities to achieve incentive compensation with the related risk to the financial institution of such behavior.
The requirements of the Dodd-Frank Act will significantly affect banks and other financial institutions. However, because much of these requirements will be phased in over time and will not become effective until federal agency rulemaking initiatives are completed, the Company cannot fully assess the impact of Dodd-Frank Act on the Company. The Company does believe, however, that short- and long-term compliance costs for the Company and the Bank will be greater because of the Dodd-Frank Act.
Emergency Economic Stabilization Act of 2008
In accordance with its stated purpose of restoring liquidity and stability to the financial system of the United States, the Emergency Economic Stabilization Act of 2008 established the Troubled Asset relief Program (“TARP”), under which the U. S. Department of the Treasury was authorized to purchase preferred stock from qualified financial institutions. The Company met the requirements to be considered a qualified financial institution. The Company considered participating in the TARP’s capital purchase program, but determined early in 2009 that it was not in the Company’s best interest.
Temporary Liquidity Guarantee Program
On October 14, 2008, the FDIC enacted the Temporary Liquidity Guarantee Program (“TLGP”) to strengthen confidence and encourage liquidity in the banking system. Pursuant to the TLGP, through the Transaction Account Guarantee (“TAG”) Program, the FDIC provided full FDIC deposit insurance coverage for non-interest bearing transaction accounts at participating FDIC-insured institutions through December 31, 2009. All FDIC-insured institutions were covered under the program until December 5, 2008, at no cost. After December 5, 2008, the cost for institutions electing to participate in TAG was a 10-basis-point surcharge applied to balances covered by the noninterest-bearing deposit transaction account guarantee. The Company elected to participate in TAG. The FDIC extended the TAG program through December 31, 2010. As part of the extensions, insured institutions electing to continue participation faced increased assessments ranging from 15 to 25 basis points depending on the entity’s Risk Category. The Company elected to continue its participation in the TAG Program.
As a result of provisions in the Dodd-Frank Act, noninterest-bearing transaction accounts will receive unlimited FDIC insurance coverage at no charge to financial institutions through December 31, 2012. Consequently, the FDIC terminated the TAG program as of December 31, 2010.
Financial Privacy
In accordance with the GLB Act, federal banking regulators adopted rules that limit the ability of banks and other financial institutions to disclose non-public information about consumers to nonaffiliated third parties. These limitations require disclosure of privacy policies to consumers and, in some circumstances, allow consumers to prevent disclosure of certain personal information to a nonaffiliated third party. The privacy provisions of the GLB Act affect how consumer information is transmitted through diversified financial companies and conveyed to outside vendors.
Anti-Money Laundering Initiatives and the USA Patriot Act
A major focus of governmental policy on financial institutions in recent years has been aimed at combating terrorist financing. This has generally been accomplished by amending existing anti-money laundering laws and regulations. The USA Patriot Act of 2001 (the “USA Patriot Act”) has imposed significant new compliance and due diligence obligations, creating new crimes and penalties. The United States Treasury Department has issued a number of implementing regulations which apply to various requirements of the USA Patriot Act to the Bank. These regulations impose obligations on financial institutions to maintain appropriate policies, procedures and controls to detect, prevent and report money laundering and terrorist financing and to verify the identity of their customers. Failure of a financial institution to maintain and implement adequate programs to combat terrorist financing, or to comply with all of the relevant laws or regulations, could have serious legal and reputational consequences for the institution.
Other Financial Institution Regulation
The Company and the Bank are subject to a variety of other financial institution-related regulation. State and federal laws restrict interest rates on loans, potentially affecting income. The Truth in Lending Act and the Home Mortgage Disclosure Act impose information requirements on the Bank in making loans. The Equal Credit Opportunity Act prohibits discrimination in lending on
the basis of race, creed, or other prohibited factors. The Fair Credit Reporting Act governs the use and release of information to credit reporting agencies. The Truth in Savings Act requires disclosure of yields and costs of deposits and deposit accounts. Other acts govern confidentiality of consumer financial records, automatic deposits and withdrawals, check settlement, endorsement and presentments.
Reporting Obligations under Securities Laws
The Company is subject to the periodic reporting requirements of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), including the filing of annual, quarterly and other reports with the Securities and Exchange Commission (“SEC”). As an Exchange Act reporting company, the Company is directly affected by the Sarbanes-Oxley Act of 2002 and regulations promulgated thereunder by the SEC, which are aimed at improving corporate governance and reporting procedures. The Company is complying with the rules and regulations implemented pursuant to the Sarbanes-Oxley Act and intends to comply with any applicable SEC rules and regulations implemented in the future.
ITEM 1A:
ITEM 1A: RISK FACTORS
Not required.
ITEM 1B:
ITEM 1B: UNRESOLVED STAFF COMMENTS
Not required.
ITEM 2:
ITEM 2: PROPERTIES
The Company, through its subsidiaries, owns or leases buildings that are used in the normal course of business. The main office is located at 100 South Main Street, Kilmarnock, Virginia, in a building owned by the Bank. The Company’s subsidiaries own various other offices in the counties or towns in which they operate.
Unless otherwise noted, the properties listed below are owned by the Company and its subsidiaries as of December 31, 2010.
ITEM 3:
ITEM 3: LEGAL PROCEEDINGS
In the ordinary course of its operations, the Company is a party to various legal proceedings. Based upon information currently available, management believes that such legal proceedings, in the aggregate, will not have a material adverse effect on the business, financial condition, or results of operations of the Company.
ITEM 4:
ITEM 4: REMOVED AND RESERVED
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 trades on the OTC Bulletin Board under the symbol “BAYK” and transactions generally involve a small number of shares. There were 2,605,856 shares of the Company’s stock outstanding at the close of business on December 31, 2010, which were held by 676 shareholders of record.
The following table summarizes the high and low closing sales prices and cash dividends declared for the two years ended December 31, 2010.
Two stock dividends were declared in 2010, where one share was issued for every 25 shares owned; one on April 23, 2010, and one on August 27, 2010. A discussion of certain restrictions and limitations on the ability of the Bank to pay dividends to the Company and the ability of the Company to pay dividends on its common stock, is set forth in Part I, Business, of this Form 10-K under the heading “Supervision and Regulation.”
The dividend type, amount and timing is established by the Board of Directors. In making its decisions regarding the payment of dividends on the Company’s common stock, the Board considers operating results, financial condition, capital adequacy, regulatory requirements, shareholder return, and other factors.
The Company began a share repurchase program in August of 1999 and has continued it into 2010. Under the program, combined plans authorize the repurchase of 180,000 shares. Of the 76,702 shares remaining available for repurchase, the Company repurchased none during 2010.
ITEM 6:
ITEM 6: SELECTED FINANCIAL DATA
Not required.
ITEM 7:
ITEM 7: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion provides information about the major components of the results of operations and financial condition, liquidity and capital resources of Bay Banks of Virginia, Inc., and its subsidiaries. This discussion and analysis should be read in conjunction with the Consolidated Financial Statements and Notes to Consolidated Financial Statements presented in Item 8, Financial Statements and Supplementary Data, in this Form 10-K.
EXECUTIVE SUMMARY
The Company has not been immune to the continued challenges presented by the current economic and financial regulatory environment. However, management is pleased to report earnings growth for 2010. We believe our conservative philosophy is contributing to positive results relative to the community banking industry generally. We are proud of this conservative philosophy and service to our community. The Bank does not invest in non-traditional debt securities, nor does it have programs that originate Sub-Prime, Alt-A, or other types of mortgages that have a high risk profile
The level of non-performing assets and impaired loans remains management’s primary concern. Although significant efforts are made to prevent foreclosures, balances in Other Real Estate Owned (“OREO”) increased to $4.1 million at December 31, 2010 from $2.2 million at December 31, 2009. This increase was materially caused by one foreclosure. Non-accruing loans, which no longer provide interest income, remain elevated at $5.6 million. Balances on loans considered impaired that are not already non-accruing also remain elevated at $2.5 million at December 31, 2010. In consideration of these factors and continued economic uncertainty, management believes the conservative level of Allowance for Loan Losses at a relatively high level of 1.3% of loans is prudent.
Net loan charge-offs were historically high at $1.3 million in 2010, compared to $885 thousand in 2009. Nearly all of the charge-offs recorded in 2010 were included in the ALL as specific reserves on impaired loans at December 31, 2009. Consequently, management was able to materially reduce the provision for loan losses expense by $1.4 million in 2010 compared to 2009 while maintaining a conservative level of ALL. Management is cautiously optimistic that the worst of our foreclosures and charge-off levels is behind is past.
Like all financial institutions holding insured domestic deposits, one of the major challenges to earnings is “FDIC” insurance premiums for those deposits. This insurance remains historically high as the FDIC rebuilds the Deposit Insurance Fund. As a result, the Bank continued to experience elevated levels of FDIC assessment expense in 2010.
Another major challenge to earnings in 2010 was write-downs on the values of OREO properties. The Bank experienced $311 thousand in direct charges to earnings in 2010 as a result of declines in market values of some of these properties.
Interest margins remain a challenge, but they are being managed effectively. Although interest rates remain at near historic lows, declines in net interest income during 2010 have been greatly minimized by reductions in interest expense. Loan yields remain low, contributing to reduced interest income, which is also negatively impacted to a lesser degree by nonaccruing loans. However, management has systematically reduced deposit rates to reflect the current rate environment, creating compensating reductions in costs of funds and interest expense, and therefore minimizing declines in net interest income as noted previously. Looking forward, as time deposits mature and new instruments are issued at lower rates, reductions in interest expense are expected to continue. Combined with the maturation of our largest and costliest Federal Home Loan Bank borrowing, management expects improvements in net interest income in 2011.
The loan portfolio has declined slightly since December 31, 2009. Although the Bank originates millions of dollars in new loans each month, the level of originations has not been sufficient to mitigate loan pay downs, prepayments and foreclosures. This has also contributed to the decline in interest income.
The Company’s liquidity, core capital levels and regulatory ratios remain good. According to the Bank’s regulators, the Bank remains “well capitalized” under supervisory guidelines. Given the challenging economic environment, management is closely guarding the Company’s liquidity and capital. Protection of shareholder value is paramount, as evidenced by the payment of stock dividends instead of cash dividends in 2010.
Management continues efforts to identify and implement earnings opportunities and diligently manage controllable expenses. Evidence of this is the conversion to a cash balance pension plan, which has saved the Company $310 thousand in benefit costs in 2010 compared to 2009, while retaining a valuable retirement benefit for employees.
Our employees participated in more than 150 community events this year, including the community programs and partnerships supported by the Company. All employees pay their ‘civic rent’ and the Bank is committed to investing in the communities it serves. Management is confident that our Company has a bright future as the economy continues its recovery.
For more information, visit the Company’s website at www.baybanks.com. Information contained on the Company’s website is not a part of this report.
CRITICAL ACCOUNTING POLICIES
GENERAL. The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). The financial information contained within our statements is, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. For example, historical loss factors are one factor in determining the inherent loss that may be present in the loan portfolio. Actual losses could differ significantly from the historical factors used. In addition, GAAP itself may change from one previously acceptable method to another method. Although the economics of transactions would be the same, the timing of events that would impact those transactions could change.
ALLOWANCE FOR LOAN LOSSES. ALL is an estimate which reflects management’s judgment of probable losses inherent in the loan portfolio. The ALL is based on two basic principles of accounting: (1) which requires that losses be accrued when they are probable of occurring and estimable and (2) which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance. The ALL is increased by charges to income, through the provision for loan losses expense, and decreased by charge-offs (net of recoveries).
Management calculates the ALL and evaluates it for adequacy every quarter. This process is lengthy and thorough. The calculation is based on information such as past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect a borrower’s ability to repay, the estimated value of any underlying collateral, and current economic conditions. The quarterly process includes consideration of certain borrowers’ payment histories compared to the terms of each loan agreement and other adverse factors such as divorce, loss of employment income, and bankruptcy. Each loan is then given a risk grade which represents the extent (or lack) of weakness. This grading process occurs dynamically throughout each quarter as new information is learned about each borrowing relationship.
During the first quarter of 2010, management enhanced the ALL calculation by increasing the number of segments, modifying the scope of loans evaluated for impairment to include only large adversely classified loans and any large special mention loans on nonaccrual, more than 30 days past due or in bankruptcy, increasing the discount factors applied to some forms of collateral, and shortening the historical loss factor period to six quarters.
The ALL calculation has three main elements. First, large commercial and construction loan relationships with adverse risk rating grades, in bankruptcy, nonaccruing, or more than 30 days past due are evaluated for impairment. For loans determined to be impaired, a specific allowance is provided when the loan balance exceeds its discounted collateral value. Real estate collateral value is determined based on appraisals done by third parties. At such time as a loan is assigned to a ‘watch’ grade, if the most recent appraisal is more than two years old, a new appraisal will generally be ordered. Discounts applied to collateral include estimated realtor commissions on real estate (in consideration of selling costs should the Bank end up owning the property), and industry-standard reductions in values for accounts receivable, inventory and other varying forms of collateral.
Second, loans not deemed impaired under the first element plus smaller commercial loans, residential mortgages and consumer loans are collectively evaluated in groups of homogenous pools called segments, then a historical loss factor is applied to each segment of loans. The historical loss factor for each segment is calculated by averaging the losses over the prior six quarters.
Finally, a set of qualitative factors, such as changes in credit quality, changes in loan staff experience, changes in loan policies and underwriting guidelines, and changes in national and local economic conditions, is used to estimate the value of intrinsic risk in each of the segments.
The summation of these three elements results in the total estimated ALL. Management may also include an unallocated component to cover uncertainties in the level of probable losses. This estimate is inherently subjective and actual losses could be greater or less than the estimates. For a more detailed description of the ALL, see Note 1 to the Consolidated Financial Statements in Item 8 of this Form 10-K.
OVERVIEW
2010 Compared to 2009
Bay Banks of Virginia, Inc. recorded net income for 2010 of $372,269, or $0.14 per basic and diluted share, as compared to a 2009 net loss of ($104,494), or ($0.04) per basic and diluted share. This is an increase in net income of $476,763 as compared to 2009. Net interest income for 2010 decreased 3.4% to $10.1 million, as compared to $10.4 million for 2009. Provision expense for loan losses declined 65.7% from $2.1 million in 2009 to $720 thousand in 2010. Non-interest income declined 12.0% to $3.0 million in 2010 from $3.4 million in 2009. Non-interest expenses decreased 2.1% to $12.0 million, as compared to 2009 non-interest expenses of $12.2 million.
Performance as measured by the Company’s return (loss) on average assets was 0.1% for the year ended December 31, 2010 compared to (0.03%) for 2009. Performance as measured by return (loss) on average equity was 1.4% for the year ended December 31, 2010, compared to (0.4%) for 2009.
Return on Equity and Assets
RESULTS OF OPERATIONS
Net Interest Income
The principal source of earnings for the Company is net interest income. Net interest income is the amount by which interest income exceeds interest expense. The net interest margin is net interest income expressed as a percentage of interest earning assets. Changes in the volume and mix of interest earning assets and interest bearing liabilities, the associated yields and rates, and the volume of non-performing assets have a significant impact on net interest income, the net interest margin, and ultimately net income.
The following table shows details of yields on interest-earning assets (e.g. loans), costs of interest-bearing liabilities (e.g. deposits) and the resulting net interest margins for the years ended December 31, 2010 and 2009.
Average Balances, Income and Expense, Yields and Rates
(Fully taxable equivalent basis)
Years ended December 31,
Notes:
(1) Income and yield is tax-equivalent assuming a federal tax rate of 34%.
(2) Includes Visa credit card program, nonaccrual loans, and fees.
As shown in the table above, net interest income, on a fully tax equivalent basis, which reflects the tax benefits of nontaxable interest income, was $10.2 million in 2010 and $10.8 million in 2009.
The Company’s net interest margin decreased to 3.32% for 2010 as compared to 3.54% for 2009. Simply stated, interest expense on interest-bearing liabilities ($5.5 million for 2010 versus $6.2 million for 2009) did not decrease as much as interest income on earning assets ($15,7 million for 2010 versus $17.0 million for 2009). Although average earning assets increased to $307.7 million for 2010 as compared to $303.7 million for 2009, falling yields contributed to the decrease in interest income. Similarly, although average interest bearing liabilities increased to $260.8 million in 2010 as compared to $257.7 million in 2009, lower rates allowed the decrease in interest expense.
The increase in total earning assets is due mainly to the growth in interest-bearing deposits. This is a consequence of management’s decision to increase cash levels, and hence the liquidity cushion, in these uncertain economic times. The good news is that the vast majority of these balances, which are held in the Bank’s account at the Federal Reserve, began earning interest near the end of 2008. However, the yield on balances held at the Federal Reserve is based on the federal funds target rate, which remains at an historic low of between 0.00% and 0.25%. Also, average loan balances decreased 1.1%, primarily due to decreases in construction and land loans and commercial loans secured by real estate. The change in mix of assets, where balances in higher-yielding assets (loans) decreased and balances in lower-yielding assets (interest-bearing deposits) increased, is part of the explanation for the decrease in earning asset yield.
Another contributor to the decrease in interest income and earning-asset yield has been downward rate adjustments on adjustable-rate mortgages (“ARMs”), caused by historically low prime rates. Most of the Bank’s residential mortgages are ARMs and commercial loans which vary with Prime. Since the Bank is generally not willing to take the interest-rate risk associated with 30-year fixed rate mortgages, which are currently preferred by many customers in this low rate environment, these loans are sold into the secondary market after origination.
For the same period, 2010 compared to 2009, average deposit balances increased 1.3%, mainly due to increases in savings and NOW deposits. However, reductions in deposit rates allowed management to reduce interest expense and reduce the cost of deposits to 1.83% from 2.18%. Hence, much of the decline in interest income was mitigated with reductions in interest expense.
Management also anticipates a significant reduction in interest expense when $15 million of the $30 million in Federal Home Loan Bank of Atlanta (“ FHLB”) advances matures in May of 2011.
Volume and Rate Analysis of Changes in Net Interest Income
Notes:
(1) Changes caused by the combination of rate and volume are allocated based on the percentage caused by each.
(2) Income and yields are reported on a tax-equivalent basis, assuming a federal tax rate of 34%.
Interest Sensitivity
The Company employs a variety of measurement techniques to identify and manage its exposure to changing interest rates and subsequent changes in liquidity. The Company utilizes two simulation models that estimate net interest income volatility and interest rate risk. In addition, the Company utilizes an Asset Liability Committee (the “ALCO”) composed of appointed members from management and the Board of Directors. Through the use of simulations, the ALCO reviews the overall magnitude of interest rate risk and then formulates policy with which to manage asset growth and pricing, funding sources and pricing, and off-balance sheet commitments. These decisions are based on management’s expectations regarding future interest rate movements, economic conditions both locally and nationally, and other business and risk factors.
The simulation models indicate that the Bank’s balance sheet is slightly asset sensitive, which management believes is favorable in the current low interest rate environment. This means that as rates rise, interest-earning assets should reprice faster than interest-bearing liabilities, allowing interest income to rise faster than interest expense. Thus, net interest income and the net interest margin should grow.
In the fourth quarter of 2010, in anticipation of rising rates, the Bank began accepting time deposits on longer maturities whenever possible, which should allow the Bank to reduce the speed of interest expense increases when rates begin to rise and favorably increase asset sensitivity. This can be a win-win for customers, also, as they can earn a better return with a longer-term time deposit.
Non-Interest Income
Total non-interest income decreased by $403 thousand, or 12.0%, in 2010 as compared to 2009. This is primarily due to losses on OREO, which were caused by write-downs of $311 thousand on some of these properties in 2010. However, gains on sales of securities of $188 thousand and gains on sale of other OREO properties of $47 thousand in 2010 partially mitigated those write-downs. Combined, though, changes in OREO gains (losses) and changes in gains on securities represent $397 thousand of the $403 thousand total decline in non-interest income. Increases in VISA credit card usage drove $15 thousand in additional non-interest income, to $803 thousand in fees in 2010, compared to $788 thousand in 2009. The Investment Advantage Program saw declines in 2010, earning $226 thousand in non-deposit income in 2010 compared to $348 thousand in 2009.
However, ATM interchange fee income increased by $61 thousand in 2010 versus 2009, which is related to increased debit card usage by the Bank’s customers and attributable to continued growth in the Score-to-Win program. This program awards points for debit card usage, which can be partly redeemed for a variety of merchandise. Other increases in non-interest income included secondary market lending fees, which increased 28.9% to $286 thousand in 2010 from $222 thousand in 2009. These fees are generated when a loan is sold into the secondary market. When the Bank is evaluating a potential loan, many factors influence the determination of whether that loan will be sold or held in the Bank’s own portfolio, including the size of the desired loan, the term, the rate, the structure and management’s intention to grow the Bank’s loan portfolio or not. Loans are sold into the secondary market on a loan-by-loan basis, some with servicing retained and some with servicing released. Servicing is retained only for loans sold to FNMA. Ongoing fees are earned for servicing of the loans sold to FNMA. These servicing fees are immaterial to the balances of the loans serviced and risks related to these servicing activities are minimal.
Non-Interest Expense
During 2010, total non-interest expense decreased 2.1%, to $12.0 million from $12.2 million in 2009. Non-interest expense is comprised of salaries and benefits, occupancy expense, state bank franchise tax, Visa program expense, telephone expense, FDIC assessments and other operating expense.
By far, the majority of the decrease in non-interest expense was driven by FDIC insurance premium assessments, which decreased 16.6% to $566 thousand in 2010 from $679 thousand in 2009. See Part I, Item 1, “Supervision and Regulation - “Deposit Insurance” earlier in this Form 10-K for a thorough discussion on FDIC assessments.
Salaries and benefits expense continues to be the major component of non-interest expense, and decreased 1.8% to $6.0 million in 2010, as compared to $6.1 million in 2009. The $112 thousand decline is due primarily to a $310 thousand reduction in net periodic benefit cost of the pension plan, which declined to $110 thousand in 2010 from $420 thousand in 2009. This reduction is a result of the conversion to a cash balance plan as of January 1, 2010. Salary expense alone actually decreased by $93 thousand, as net attrition was allowed to occur. However, salary credits related to the origination of real estate loans declined materially by $258 thousand, as fewer of these loans were originated in 2010 compared to 2009.
Occupancy expense decreased by $20 thousand, or 1.0% in 2010, as compared to 2009, due mainly to reduced depreciation expense as short-lived assets reached full amortization.
Bank franchise tax expense decreased 7.6% to $156 thousand in 2010 as compared to $169 thousand in 2009, due to credits for increased real estate taxes related to the newest retail offices in Burgess and Colonial Beach as well as increases in OREO properties. Expenses related to the VISA program increased by 0.8% to $666 thousand in 2010 as compared to $660 thousand in 2009. However, when also considering the interest and non-interest income generated by the VISA program prior to taxes, it provided a net positive contribution to the Company of $110 thousand in 2010, up from $36 thousand in 2009. Telephone expense increased 5.5% to $183 thousand in 2010 as compared to $173 thousand in 2009. Other expense decreased by 0.3% or $8 thousand, as compared to 2009. Management continues identifying expenses that can be reduced or eliminated, especially in this uncertain economy.
Although market capitalization, which is determined by multiplying the Company’s current stock price by the number of shares outstanding, has been noticeably below book value of equity for much of 2010, the independent goodwill impairment analysis resulted in no charge to earnings. Goodwill was created as a result of five branch office purchases made between the years 1994 and 2000. The independent analysis determined that the values of each of the branches were greater on September 30, 2010 than on their respective purchase dates. Also, this analysis indicated that the business combinations would be more accretive to the estimated future earnings per share of Bay Banks of Virginia, Inc. and provide a greater cash flow at September 30, 2010 than at their respective dates of acquisition. Management reviewed the varying assumptions made in this analysis and believes them to be reasonable.
Income Taxes
There was an income tax benefit of $41 thousand in 2010 compared a benefit of $436 thousand in 2009. This represents a decrease in tax benefit of $395 thousand, due mainly to positive net income before income taxes in 2010, compared to negative net income before income taxes in 2009. The 2010 income tax benefit was created because tax-exempt income plus other tax credits were larger than net income before income taxes. Income tax expense (benefit) corresponds to an effective rate of (12.3%) and (80.7%) for the years ended December 31, 2010 and 2009, respectively. Note 14 to the Consolidated Financial Statements provides a reconciliation between the amounts of income tax expense computed using the federal statutory income tax rate and actual income tax expense. Also included in Note 14 to the Consolidated Financial Statements is information regarding deferred taxes for 2010 and 2009.
Loans
The loan portfolio declined slightly during 2010, with balances decreasing by 1.5% to $246.5 million as of December 31, 2010, compared to December 31, 2009 balances of $250.2 million. Loans secured by real estate represent the largest category, comprising 89.1% of the loan portfolio at December 31, 2010. Of these balances, 1-4 family residential loans, which comprise the majority of real estate loan balances at $145.6 million, grew by $4.8 million, or 3.4%. Other loans secured by real estate, the majority of which are commercial in nature, decreased by $4.1 million, or 9.0%, and represent 17.1% of the loan portfolio at year-end 2010 as compared to 18.5% at year-end 2009. Construction and land loans decreased by $2.4 million, or 7.3%. Commercial and Industrial loan balances decreased by $1.3 million, or 6.8%, and represented 7.1% of total loans at year-end 2010 as compared to 3.6% at year-end 2009. Consumer and other loans decreased by $794 thousand, or 8.2% in 2010, and represented 3.6% of total loans at year-end 2010 as compared to 3.9% at year-end 2009.
Types of Loans
Notes:
Deferred loan costs and fees not included.
Allowance for loan losses not included.
Loan Maturity Schedule of Selected Loans
As of December 31, 2010
Note:
Loans with immediate repricing are shown in the ‘One Year Or Less’ category.
Variable rate loans are categorized based on their next repricing date.
Deferred loan costs and fees are not included.
Asset Quality - Provision and Allowance for Loan Losses
The provision for loan losses is a charge against earnings that is necessary to maintain the allowance for loan losses at a level consistent with management’s evaluation of the loan portfolio’s inherent risk. For a detailed description of the ALL calculation, refer to Note 1 of the Consolidated Financial Statements in Item 8 of this Form 10-K.
As shown in the following table, provision for loan losses was $720 thousand in 2010 compared to $2.1 million in 2009, a considerable reduction of $1.4 million. After net charge-offs of $1.3 million, ALL is $3.2 million on December 31, 2010 compared to $3.8 million on December 31, 2009. This level of net charge-offs represents 0.50% of total loans, considerably below the Bank’s peer average of 0.99%. As of December 31, 2010, management considered the allowance for loan losses to be more than sufficient to cover estimated potential loss exposure inherent in the loan portfolio.
Allowance for Loan Losses
The level of net charge-offs in 2010 was $373 thousand higher than in 2009. More than half of balances charged off in 2010 was due to one large commercial mortgage.
As of December 31, 2010, the ratio of the allowance for loan losses to total loans was 1.3% as compared to 1.5% as of December 31, 2009.
Allocation of the Allowance for Loan Losses
Non-Performing Assets
As of December 31, 2010, non-performing assets as a percentage of total loans and other real estate owned was 4.1%, up from 2.9% at year-end 2009. Given recent increases in non-performing assets in the financial industry, this percentage continues to compare favorably with the Bank’s national peer group average of 4.6%. The coverage ratio of allowance to total non-performing assets has decreased to 31.4% at year-end 2010 from 50.6% at year-end 2009. This decrease is due mainly to one large foreclosure and charge-off during 2010, and thus the increase in OREO. Once a property becomes OREO, it creates no further effect on the ALL.
OREO, including foreclosed property, at year-end 2010 increased to $4.1 million from $2.2 million at year-end 2009. The year-end 2010 figure represents six residences, nine separate lots, one former restaurant, one lodging property, one lodging property with a restaurant and one former convenience store. Three OREO properties with a total value of $468 thousand were sold in 2010 for gains of $47 thousand, and eight properties with a total value of $2.6 million from five borrowers were added through foreclosure. After foreclosure, management periodically performs valuations and the real estate is carried at the lower of carrying amount or fair value less estimated costs to sell.
During 2010, nonaccruing loans increased by $317 thousand. The majority of the $5.6 million in non-accruing balances is represented by three commercial borrowers with balances totaling $3.1 million. These loans are also considered impaired with $370 thousand in allowance provided for them.
Non-Performing Assets
Impaired loans not included in the table above totaled $1.6 million at December 31, 2010, and had an associated allowance of $89 thousand. These loans are identified and monitored as part of the risk grading and ALL calculation process.
There is one troubled debt restructuring with a balance of $624 thousand at December 31, 2010, in the loan portfolio.
For more detailed information on non-accrual, past due and impaired loan policies, refer to Note 1 and Note 5 of the Consolidated Financial Statements in Item 8 of this Form 10-K.
Securities
As of December 31, 2010, investment securities totaled $34.1 million, an increase of 0.2% as compared to 2009 year-end balances of $34.0 million.
The Company currently classifies the entire investment portfolio as available-for-sale in order that it may be considered a source of liquidity, if necessary. Securities available for sale are carried at fair market value, with after-tax market value gains or losses disclosed as an “unrealized” component of shareholders’ equity entitled “Accumulated other comprehensive income.” The after-tax unrealized gains or losses are recorded as a portion of other comprehensive income in the equity of the Company, but have no impact on earnings until such time as the gain or loss is realized, typically at the time of sale. As of December 31, 2010, the Company had accumulated other comprehensive gains net of deferred tax related to securities available-for-sale of $298 thousand as compared to $300 thousand at year-end 2009.
The investment portfolio shows a net unrealized gain of $451 thousand on December 31, 2010, essentially unchanged compared to a net unrealized gain of $455 thousand on December 31, 2009. The continued low interest rate environment is generally responsible for these unrealized gains, since bond prices are inversely proportional to bond rates, and the bonds in the Bank’s portfolio were mostly purchased at lower prices. The unfortunate consequence of this market is that it makes the acquisition of additional securities relatively unattractive, as their interest rates are typically low and their prices are typically high.
None of the securities in the investment portfolio are considered other-than-temporarily-impaired. Impairment of securities occurs when the fair value of a security is less than its amortized cost. For debt securities, impairment is considered other-than-temporary and recognized in net income if either (i) we intend to sell the security or (ii) it is more-likely-than-not that we will be required to sell the security before recovery of its amortized cost basis. As a result, temporary impairment can occur with rising interest rates, since the market value of a fixed income investment will fall as interest rates rise. On the other hand, market values will increase as interest rates fall.
None of the unrealized loss positions on December 31, 2010 are considered to be a result of credit deterioration.
The Company seeks to diversify its assets to minimize risk by maintaining a majority of its investment portfolio in securities issued by states and political subdivisions. Many of these types of securities also provide tax benefits. The few mortgage-backed securities and collateralized mortgage obligations held in the investment portfolio are solely issued by agencies of the U.S. government. The Company owns no derivatives, and participates in no hedging activities.
For more information on the Company’s investment portfolio, please refer to Note 3 of the Consolidated Financial Statements, included in Item 8 of this Form 10-K.
Notes:
Yields on tax-exempt securities have been computed on a tax-equivalent basis.
Deposits
During 2010, average total deposits increased 2.3% to $268.0 million as compared to average total 2009 deposits of $262.1 million. Average non-interest bearing demand deposits increased 7.5%, average NOW accounts increased 3.3%, and average savings accounts increased 2.0%, during 2010. Relative to the 0.3% increase in average time deposits during the same period, the shift in deposit mix to less costly deposits is apparent.
Average Deposits & Rates
Maturity Schedule of Time Deposits of $100,000 and over
CAPITAL RESOURCES
Capital resources represent funds, earned or obtained, over which a financial institution can exercise greater long-term control in comparison with deposits and borrowed funds. The adequacy of the Company’s capital is reviewed by management on an ongoing basis with reference to size, composition, and quality of the Company’s resources and consistency with regulatory requirements and industry standards. Management seeks to maintain a capital structure that will assure an adequate level of capital to support anticipated asset growth and to absorb potential losses, yet allow management to effectively leverage its capital to maximize return to shareholders. The Company’s capital, also known as equity, is comprised mainly of outstanding stock and retained earnings. Capital can be increased with stock or private equity offerings or through earnings. Management believes that the Company’s capital level at December 31, 2010, is sufficient to support current economic uncertainty.
In 2009, the parent company obtained its operating funds via dividends paid by the Bank. Banking regulations limit the amount of dividend distributions a bank can make to net undistributed profits of the current year plus two prior years, unless prior regulator approval is granted. Due to the large loan loss provision expense taken in the fourth quarter of 2009, which significantly reduced the Bank’s 2009 earnings, there were no undistributed profits available for distribution from the Bank to the parent. Therefore, in 2010, the parent company obtained its operating funds through fees paid by the Bank and Trust Company.
The Company is required to maintain minimum amounts of capital to total “risk weighted” assets, as defined by Federal Reserve Capital Guidelines. According to Capital Guidelines for Bank Holding Companies, the Company is required to maintain a minimum Total Capital to Risk Weighted Assets ratio of 8.0%, a Tier 1 Capital to Risk Weighted Assets ratio of 4.0% and a Tier 1 Capital to Adjusted Average Assets ratio (Leverage ratio) of 4.0%. As of December 31, 2010, the Company maintained these ratios at 12.0%, 10.7%, and 7.5%, respectively. At year-end 2009, these ratios were 11.4%, 10.2%, and 7.5%, respectively. For more detailed information, refer to Note 15 of the Consolidated Financial Statements in Item 8 of this Form 10-K.
Total capital, before accumulated other comprehensive loss, grew by 1.4% to $27.2 million as of year-end 2010 as compared to $26.8 million at year-end 2009. Accumulated other comprehensive income was $154 thousand at year-end 2010, compared to $96 thousand at year-end 2009, mainly due to declines in unrealized losses on the assets of the Company’s defined benefit pension plan. The Company accounts for other comprehensive income in the investment portfolio by adjusting capital for any after tax effect of unrealized gains and losses on securities at the end of a given accounting period.
LIQUIDITY
Liquidity represents an institution’s ability to meet present and future financial obligations (such as commitments to fund loans) through either the sale or maturity of existing assets or the acquisition of additional funds through liability management. Liquid assets include cash, interest-bearing deposits with other banks, federal funds sold and investments and loans maturing within one year. The Company’s ability to obtain deposits and purchase funds at favorable rates determines its liquidity. Management believes that the Company maintains overall liquidity that is sufficient to satisfy its depositors’ requirements and to meet its customers’ credit needs. Given current economic uncertainty, management is maintaining an historically high level of liquidity.
At December 31, 2010, liquid assets totaled $50.0 million or 15.3% of total assets, up from $45.4 million and 13.7% at December 31, 2009. Additional sources of liquidity available to the Company include its capacity to borrow additional funds when necessary. The Bank maintains federal funds lines with regional banks totaling approximately $20.3 million. In addition, the Bank has borrowing capacity with the FHLB with $25.9 million remaining available as of December 31, 2010. With additional collateral, $33.1 million would be available from the FHLB.
The impact of contractual obligations is limited to three FHLB advances, one for $10 million, which matures in May of 2016, one for $15 million, which matures in September of 2011 and one for $5 million, which matures in May of 2012. For details on these advances, please refer to Note 13 of the Consolidated Financial Statements in Item 8 of this Form 10-K.
OFF BALANCE SHEET COMMITMENTS
In the normal course of business, the Company offers various financial products to its customers to meet their credit and liquidity needs. These instruments frequently involve elements of liquidity, credit and interest rate risk in excess of the amount recognized in the Consolidated Balance Sheets. The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit and standby-letters of credit is represented by the contractual amount of these instruments. Subject to its normal credit standards and risk monitoring procedures, the Company makes contractual commitments to extend credit. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments may expire without being completely drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Conditional commitments are issued by the Company in the form of performance stand-by letters of credit, which guarantee the performance of a customer to a third-party. The credit risk of issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.
Off Balance Sheet Arrangements
The Company maintains liquidity and credit facilities with non-affiliated banks in excess of the total loan commitments and stand-by letters of credit. As these commitments are earning assets only upon takedown of the instrument by the customer, thereby increasing loan balances, management expects the revenue of the Company to be enhanced as these credit facilities are utilized.
STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
This report contains statements concerning the Company’s expectations, plans, objectives, future financial performance and other statements that are not historical facts. These statements may constitute “forward-looking statements” as defined by federal securities laws. These statements may address issues that involve estimates and assumptions made by management, risks and uncertainties, and actual results could differ materially from historical results or those anticipated by such statements. Factors that could have a material adverse effect on the operations and future prospects of the Company include, but are not limited to, changes in: interest rates, general economic conditions, the legislative/regulatory climate, monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury and the Federal Reserve, the quality or composition of the loan or investment portfolios, demand for loan products, deposit flows, competition, demand for financial services in the Company’s market area and accounting principles, policies and guidelines. These risks and uncertainties should be considered in evaluating the forward-looking statements contained herein, and readers are cautioned not to place undue reliance on such statements, which speak only as of the date they are made.
ITEM 7A:
ITEM 7A: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Not required.
ITEM 8:
ITEM 8: FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
CONSOLIDATED BALANCE SHEETS
December 31, 2010 and 2009
See Notes to Consolidated Financial Statements.
CONSOLIDATED STATEMENTS OF OPERATIONS
Years Ended December 31,
* Adjusted for a 1-for-25 stock dividend on April 23, 2010 and August 27, 2010.
See Notes to Consolidated Financial Statements.
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
Years Ended December 31, 2010 and 2009
See Notes to Consolidated Financial Statements.
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31,
See Notes to Consolidated Financial Statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1. Nature of Business and Significant Accounting Policies
Principles of consolidation. The consolidated financial statements of Bay Banks of Virginia, Inc. (the “Company”), include the accounts of Bay Banks of Virginia, Inc. and its subsidiaries, Bank of Lancaster and Bay Trust Company. All significant intercompany balances and transactions have been eliminated in consolidation.
Nature of business. Bay Banks of Virginia, Inc. is a bank holding company that conducts substantially all of its operations through its subsidiaries.
The Bank of Lancaster (the “Bank”) is state-chartered and a member of the Federal Reserve System and serves individual and commercial customers, the majority of which are in the Northern Neck of Virginia. The Bank has offices in the counties of Lancaster, Northumberland, Richmond, and Westmoreland, Virginia. Each branch offers a full range of deposit and loan products to its retail and commercial customers. A substantial amount of the Bank’s deposits are interest bearing. The majority of the Bank’s loan portfolio is secured by real estate.
Bay Trust Company (the “Trust Company”) offers a broad range of investment services, as well as traditional trust and related fiduciary services from its office on Main Street in Kilmarnock, Virginia. Included are estate planning and settlement, revocable and irrevocable living trusts, testamentary trusts, custodial accounts, investment management accounts and managed, as well as self-directed, rollover Individual Retirement Accounts.
Use of estimates. The preparation of the consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions. The amounts recorded in the consolidated financial statements may be affected by those estimates and assumptions. Actual results may vary 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 fair value measurements and deferred taxes.
Cash and Cash Equivalents. For purposes of the consolidated statements of cash flows, cash and cash equivalents include cash and balances due from banks, all of which mature within ninety days.
Interest-Bearing Deposits in Banks. Interest-bearing deposits in banks mature within one year and are carried at cost.
Securities. Investments in debt and equity securities with readily determinable fair values are classified as either held to maturity, available for sale, or trading, based on management’s intent. Currently, all of the Company’s investment securities are classified as available for sale. Securities available for sale are carried at estimated fair value with the corresponding unrealized gains and losses excluded from earnings and reported in other comprehensive income. A gain or loss is recognized in earnings on the trade date based on the amortized cost of the specific security sold. Purchase premiums and discounts are recognized in interest income via amortization or accretion, respectively, using the interest method over the terms of the securities.
Impairment of securities occurs when the fair value of a security is less than its amortized cost. For debt securities, impairment is considered other-than-temporary and recognized in its entirety in net income if either (i) the Company intends to sell the security or (ii) it is more-likely-than-not that the Company will be required to sell the security before recovery of its amortized cost basis. If, however, the Company does not intend to sell the security and it is not more-likely-than-not that it will be required to sell the security before recovery, the Company must determine what portion of the impairment is attributable to a credit loss, which occurs when the amortized cost basis of the security exceeds the present value of the cash flows expected to be collected from the security. If there is a credit loss, the loss must be recognized in net income and the remaining portion of impairment must be recognized in other comprehensive income. For equity securities, impairment is considered to be other-than-temporary based on the Company’s ability and intent to hold the investment until a recovery of fair value. Other-than-temporary impairment of an equity security results in a write-down that must be included in net income. The Company regularly reviews each investment security for other-than-temporary impairment based on criteria that include the extent to which cost exceeds market price, the duration of that market decline, the financial health of and specific prospects for the issuer, the Company’s best estimate of the present value of cash flows expected to be collected from debt securities, the Company’s intention with regard to holding the security to maturity and the likelihood that it would be required to sell the security before recovery.
Securities sold under repurchase agreements. Securities sold under repurchase agreements, which are classified as secured borrowings, generally mature within one year from the transaction date. Securities sold under repurchase agreements are reflected at the amount of cash received in connection with the transaction. The Company is required to provide collateral based on the fair value of the underlying securities.
Loans. The Company grants mortgage, commercial and consumer loans to customers. A substantial portion of the loan portfolio is represented by mortgage loans. The ability of the Company’s debtors to honor their contracts is dependent upon the real estate and general economic conditions in the Company’s market area.
Loans are reported at their recorded investment, which is the outstanding principal balance net of any unearned income, such as deferred fees and costs, and charge-offs. Interest on loans is recognized over the term of the loan and is calculated using the interest method on principal amounts outstanding. Loan origination fees, net of certain direct origination costs, are deferred and recognized as an adjustment of the related loan yield via straight line amortization over the contractual term of the loan, adjusted for early pay-offs.
The accrual of interest is generally discontinued at the time a loan is 90 days or more past due, or earlier, if collection is uncertain based on an evaluation of the net realizable value of the collateral and the financial strength of the borrower. Payments received for loans no longer accruing interest are applied to the unpaid principal balance. Loans greater than 90 days past due may remain on accrual status if the credit is well secured and in process of collection. Credit card loans and other personal loans are typically charged off no later than 180 days past due. Past due status is based on the contractual terms of the loan. In all cases, loans are charged off at an earlier date if collection of principal or interest is considered doubtful. Nonaccrual and past due policies are materially the same for all types of loans.
All interest accrued but not collected for loans that are placed on non-accrual or charged off is reversed against interest income. Any interest received on these loans is accounted for on the cash basis or cost recovery method until qualifying for return to accrual. Generally, a loan is returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured, or it becomes well secured and in the process of collection.
Allowance for loan losses. The allowance for loan losses (“ALL”) reflects management’s judgment of probable loan losses inherent in the portfolio at the balance sheet date. Management uses a disciplined process and methodology to establish the allowance for losses each quarter. To determine the total allowance for loan losses, the Company estimates the reserves needed for each segment of the portfolio, including loans analyzed individually and pools of loans analyzed on a segmented basis. Considerations include historical experience, the nature and volume of the loan portfolio, adverse situations that may affect a borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as additional information becomes available.
During the first quarter of 2010, management enhanced the ALL calculation methodology by 1) increasing the number of homogenous pools (segments); 2) modifying the scope of loans evaluated for impairment to include only large adversely classified loans and any large special mention loans on nonaccrual, more than 30 days past due, or in bankruptcy; 3) increasing the discount factors applied to some forms of collateral; and 4) shortening the historical loss factor period to six quarters. It is estimated that the increased number of segments had no effect on the calculated amount of the allowance, the reduced scope of loans evaluated for impairment reduced the calculated amount of the allowance, and the higher discount factors and shorter historical loss factor period increased the calculated amount of the allowance. Management believes that the overall effect on the calculated amount of the allowance as a result of the change in methodology is immaterial.
The allowance consists of specific, general, and unallocated components. The specific component generally evaluates large commercial and construction loans which are adversely risk rated, in bankruptcy, nonaccruing, or more than 30 days past due to determine which are impaired. The scope of this evaluation can include commercial borrowers utilizing mortgages on their residences for their businesses. For those loans determined to be impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component collectively evaluates smaller commercial loans, residential mortgages and consumer loans, grouped into segments. Historical loss experience is calculated using six quarters and applied to each segment, then adjusted for qualitative factors. Qualitative factors include changes in portfolio balances outstanding, changes in loan seasoning, changes in credit quality, changes in loan staff depth and experience, changes in loan policies and underwriting guidelines, changes in value of underlying collateral, changes in loan review and oversight, and changes in national and local economic conditions. These qualitative adjustments reflect management’s judgment of risks inherent in the segments. An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio. Changes in the allowance for loan losses and the related provision expense can materially affect net income.
Management employs a risk rating system to evaluate and categorize loan portfolio credit risk on a consistent basis. Loans assigned risk rating grades include all commercial loans, commercial loans secured by real estate (commercial mortgages), residential loans secured by real estate (residential mortgages) above $1 million, loans to real estate developers and contractors, and consumer loans greater than $250 thousand with chronic delinquency. Risk rating categories are as follows:
Pass - Borrower is strong or sound and collateral securing the loan, if any, is adequate.
Watch - Borrower exhibits some signs of financial stress but is generally believed to be a satisfactory customer and collateral, if any, may be in excess of 90% of the loan balance.
Special Mention - Adverse trends in the borrower’s financial position are evident and warrant management’s close attention and any collateral may not be fully adequate.
Substandard - A loan in this category has a well-defined weakness in the primary repayment source that jeopardizes the timely collection of the debt. There is a distinct possibility that a loss may result if the weakness is not corrected.
Doubtful - Default has already occurred and it is likely that foreclosure or repossession procedures have begun or will begin in the near future. Weaknesses make collection or liquidation in full, based on currently existing information, highly questionable and improbable.
Loss - Uncollectible and of such little value that continuance as a bankable asset is not warranted.
The specific component of the ALL calculation considers adversely classified loans, as noted above. Adversely classified loans are considered to be those loans risk rated as substandard, doubtful or loss. All other loans not specifically assigned a risk rating are monitored as a discreet pool of loans generally based on delinquency status. A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Accrual of interest may or may not be discontinued for any given impaired loan. Impairment is measured by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent. Because large groups of smaller balance homogeneous loans are collectively evaluated for impairment, the Company does not separately identify smaller balance individual consumer and residential loans for impairment disclosures, unless such loans are the subject of a restructuring agreement.
The general component of the ALL calculation collectively evaluates groups of loans in segments, as noted above. Segments are not aggregated into classes. These segments are 1) Construction, land and land development; 2) Farmland; 3) Residential first mortgages; 4) Residential junior mortgages; 5) Commercial mortgages (non-owner-occupied); 6) Commercial mortgages (owner-occupied); 7) Commercial and industrial; and 8) Consumer. Every loan is assigned to a segment. Segments 1 through 6 are secured by real estate. Segments 7 and 8 are secured by other types of collateral or are unsecured. A given segment may not reflect the purpose of a loan. For example, a business owner may provide his residence as collateral for a loan to his company, in which case the loan would be grouped in a residential mortgage segment.
Construction and development loans carry risks that the project will not be finished according to schedule or according to budget and the value of the collateral, at any point in time, may be less than the principal amount of the loan. These loans also bear the risk that the general contractor may face financial pressure unrelated to the project. Loans secured by land, farmland and residential mortgages carry the risk of continued credit-worthiness of the borrower and changes in value of the underlying real estate collateral. Commercial mortgages and commercial and industrial loans carry risks associated with the profitable operation of a business and its related cash flows. Additionally, commercial and industrial loans carry risks associated with the value of collateral other than real estate which may depreciate over time. Consumer loans carry risks associated with the continuing credit-worthiness of the borrower and are more likely than real estate loans to be adversely affected by divorce, unemployment, personal illness or bankruptcy of an individual. Consumer loans secured by automobiles carry risks associated with rapidly depreciating collateral.
Additions to the allowance for loan losses are made by charges to earnings through the provision for loan losses. Credit exposures deemed to be uncollectible are charged against the allowance for loan losses. Recoveries of previously charged off amounts are credited to the allowance for loan losses. Charge-off policies are materially the same for all types of loans.
Troubled Debt Restructurings. In situations where, for economic or legal reasons related to a borrower’s financial condition, management may grant a concession to the borrower that it would not otherwise consider, the related loan is classified as a troubled debt restructuring. Management strives to identify borrowers in financial difficulty early and work with them to modify their loan to more affordable terms before their loan reaches nonaccrual status. These modified terms may include rate reductions, principal forgiveness, payment forbearance and other actions intended to minimize the economic loss and to avoid foreclosure or repossession of the collateral. In cases where borrowers are granted new terms that provide for a reduction of either interest or principal, management measures any impairment on the restructuring as noted above for impaired loans.
Premises and equipment. Land is carried at cost. Premises and equipment are carried at cost less accumulated depreciation. Depreciation is computed by the straight-line method over the estimated useful lives of the premises and equipment. Estimated useful lives range from 10-40 years for buildings, and from 3-10 years for furniture, fixtures and equipment. Maintenance and repairs are charged to expense as incurred, and major improvements are capitalized.
Other real estate owned. Real estate properties acquired through, or in lieu of, loan foreclosure are to be sold and are initially recorded at the lower of the carrying value or fair value on the date of foreclosure less estimated selling costs, thereby establishing a new cost basis. After acquisition, management periodically performs valuations and the real estate is carried at the lower of carrying amount or fair value less cost to sell. Revenue and expenses from operations and changes in the valuation allowance are included in expenses from foreclosed assets.
Income taxes. Deferred income tax assets and liabilities are determined using the liability (or balance sheet) method. Under this method, the net deferred tax asset or liability is determined based on the tax effects of the temporary differences between the book and tax bases of the various balance sheet assets and liabilities and gives current recognition to changes in tax rates and laws.
When tax returns are filed, it is highly certain that some positions taken would be sustained upon examination by the taxing authorities, while others are subject to uncertainty about the merits of the position taken or the amount of the position that would be ultimately sustained. The benefit of a tax position is recognized in the financial statements in the period during which, based on all available evidence, management believes it is more likely than not that the position will be sustained upon examination, including the resolution of appeals or litigation processes, if any. Tax positions taken are not offset or aggregated with other positions. Tax positions that meet the more-likely-than-not recognition threshold are measured as the largest amount of tax benefit that is more than 50 percent likely of being realized upon settlement with the applicable taxing authority. The portion of the benefits associated with tax positions taken that exceeds the amount measured as described above is reflected as a liability for unrecognized tax benefits in the accompanying balance sheets along with any associated interest and penalties that would be payable to the taxing authorities upon examination.
Interest and penalties, if any, associated with unrecognized tax benefits are classified as additional income taxes in the statements of income.
Pension benefits. The non-contributory defined benefit pension plan covers substantially all full-time employees. The plan accumulates benefits for each covered employee based on annual pay credits, which are based on age and years of service, plus monthly interest credits based on an amount established each year by the Board of Directors.
Post retirement benefits. The Company provides certain health care benefits for all retired employees who meet eligibility requirements.
Trust assets and income. Customer assets held by the Trust Company, other than cash on deposit, are not included in these financial statements, since such items are not assets of the Bank or Trust Company. Trust fees are recorded on the accrual basis.
Earnings per share. Basic earnings per share represents income available to common shareholders divided by the weighted-average number of common shares outstanding during the period. Diluted earnings 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 solely to outstanding stock options.
Off-balance-sheet financial instruments. In the ordinary course of business, the Company has entered into off-balance-sheet financial instruments such as home equity lines of credit, overdraft protection lines of credit, unsecured lines of credit, commitments under credit card arrangements, construction loan commitments and standby letters of credit. Such financial instruments are recorded in the financial statements when they are funded or related fees are incurred or received.
Significant group concentration of credit risk. Most of the Company’s business activity is with customers located in the counties of Lancaster, Northumberland, Richmond and Westmoreland, Virginia. The Company makes residential, commercial and consumer loans and a significant amount of the loan portfolio is comprised of real estate mortgage loans, which primarily are for single-family residences. The adequacy of collateral on real estate mortgage loans is highly dependent on changes in real estate values.
Advertising. Advertising costs are expensed as incurred, and totaled $127 thousand and $174 thousand for the years ended December 31, 2010 and 2009, respectively.
Comprehensive Income. Comprehensive income consists of net income and other comprehensive income. Other comprehensive income includes unrealized gains (losses) on securities available for sale and changes in the funded status of the pension and postretirement plan, which are also recognized as separate components of equity.
Fair Value of Financial Instruments. Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed in Note 20. Fair value estimates involve uncertainties and matters of significant judgment. Changes in assumptions or in market conditions could significantly affect the estimates.
Reclassifications. Certain reclassifications have been made to prior period balances to conform to the current year presentation.
Transfers of Financial Assets. Transfers of financial assets are accounted for as sales when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when 1) the assets have been isolated from the Company - put presumptively beyond reach of the transferor and its creditors, even in bankruptcy or other receivership; 2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets; and 3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity or the ability to unilaterally cause the holder to return specific assets.
Stock-based compensation plans. Authoritative accounting guidance requires companies to recognize the cost of employee services received in exchange for awards of equity instruments, such as stock options and restricted stock, based on the fair value of those awards at the date of grant.
Recent Accounting Pronouncements.
In June 2009, the Financial Accounting Standards Board (“FASB”) issued new guidance relating to the accounting for transfers of financial assets. The new guidance, which was issued as Statement of Accounting Financial Standard (“ SFAS”) No. 166, “Accounting for Transfers of Financial Assets, an amendment to SFAS No. 140,” was adopted into the Accounting Standards Codification (“Codification”) in December 2009 through the issuance of Accounting Standards Update (“ASU”) 2009-16. The new standard provides guidance to improve the relevance, representational faithfulness, and comparability of the information that an entity provides in its financial statements about a transfer of financial assets; the effects of a transfer on its financial position, financial performance, and cash flows; and a transferor’s continuing involvement, if any, in transferred financial assets. ASU 2009-16 was effective for transfers on or after January 1, 2010. The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.
In June 2009, the FASB issued new guidance relating to variable interest entities. The new guidance, which was issued as SFAS No. 167, “Amendments to FASB Interpretation No. 46(R),” was adopted into the Codification in December 2009. The objective of the guidance is to improve financial reporting by enterprises involved with variable interest entities and to provide more relevant and reliable information to users of financial statements. SFAS No. 167 was effective as of January 1, 2010. The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.
In October 2009, the FASB issued ASU 2009-15, “Accounting for Own-Share Lending Arrangements in Contemplation of Convertible Debt Issuance or Other Financing.” ASU 2009-15 amends Subtopic 470-20 to expand accounting and reporting guidance for own-share lending arrangements issued in contemplation of convertible debt issuance. ASU 2009-15 is effective for fiscal years beginning on or after December 15, 2009 and interim periods within those fiscal years for arrangements outstanding as of the beginning of those fiscal years. The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.
In January 2010, the FASB issued ASU 2010-04, “Accounting for Various Topics - Technical Corrections to SEC Paragraphs”. ASU 2010-04 makes technical corrections to existing Securities and Exchange Commission (“SEC”) guidance including the following topics: accounting for subsequent investments, termination of an interest rate swap, issuance of financial statements - subsequent events, use of residual method to value acquired assets other than goodwill, adjustments in assets and liabilities for holding gains and losses, and selections of discount rate used for measuring defined benefit obligation. The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.
In January 2010, the FASB issued ASU 2010-06, “Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements.” ASU 2010-06 amends Subtopic 820-10 to clarify existing disclosures, require new disclosures, and includes conforming amendments to guidance on employers’ disclosures about postretirement benefit plan assets. ASU 2010-06 is effective for interim and annual periods beginning after December 15, 2009, except for disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements. Those disclosures are effective for fiscal years beginning after December 15, 2010 and for interim periods within those fiscal years. The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.
In February 2010, the FASB issued ASU 2010-09, “Subsequent Events (Topic 855): Amendments to Certain Recognition and Disclosure Requirements.” ASU 2010-09 addresses both the interaction of the requirements of Topic 855 with the SEC’s reporting requirements and the intended breadth of the reissuance disclosures provisions related to subsequent events. An entity that is an SEC filer is not required to disclose the date through which subsequent events have been evaluated. ASU 2010-09 was effective immediately. The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.
In July 2010, the FASB issued ASU 2010-20, “Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses.” The new disclosure guidance significantly expands the existing requirements and will lead to greater transparency into a company’s exposure to credit losses from lending arrangements. The extensive new disclosures of information as of the end of a reporting period will become effective for both interim and annual reporting periods ending on or after December 15, 2010. Specific disclosures regarding activity that occurred before the issuance of the ASU, such as the allowance roll forward and modification disclosures will be required for periods beginning on or after December 15, 2010. The Company has included the required disclosures in its consolidated financial statements.
On September 15, 2010, the SEC issued Release No. 33-9142, “Internal Control Over Financial Reporting In Exchange Act Periodic Reports of Non-Accelerated Filers.” This release issued a final rule adopting amendments to its rules and forms to conform them to Section 404(c) of the Sarbanes-Oxley Act of 2002 (“SOX”), as added by Section 989G of the Dodd-Frank Wall Street Reform and Consumer Protection Act. SOX Section 404(c) provides that Section 404(b) shall not apply with respect to any audit report prepared for an issuer that is neither an accelerated filer nor a large accelerated filer as defined in Rule 12b-2 under the Securities Exchange Act of 1934. Release No. 33-9142 was effective September 21, 2010.
On September 17, 2010, the SEC issued Release No. 33-9144, “Commission Guidance on Presentation of Liquidity and Capital Resources Disclosures in Management’s Discussion and Analysis.” This interpretive release is intended to improve discussion of liquidity and capital resources in Management’s Discussion and Analysis of Financial Condition and Results of Operations in order to facilitate understanding by investors of the liquidity and funding risks facing the registrant. This release was issued in conjunction with a proposed rule, “Short-Term Borrowings Disclosures,” that would require public companies to disclose additional information to investors about their short-term borrowing arrangements. Release No. 33-9144 was effective on September 28, 2010.
In January 2011, the FASB issued ASU 2011-01, “Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in Update No. 2010-20.” The amendments in this ASU temporarily delay the effective date of the disclosures about troubled debt restructurings in ASU 2010-20 for public entities. The delay is intended to allow the FASB time to complete its deliberations on what constitutes a troubled debt restructuring. The effective date of the new disclosures about troubled debt restructurings for public entities and the guidance for determining what constitutes a troubled debt restructuring will then be coordinated. Currently, that guidance is anticipated to be effective for interim and annual periods ending after June 15, 2011.
In December 2010, the FASB issued ASU 2010-29, “Disclosure of Supplementary Pro Forma Information for Business Combinations.” The guidance requires pro forma disclosure for business combinations that occurred in the current reporting period as though the acquisition date for all business combinations that occurred during the year had been as of the beginning of the annual reporting period. If comparative financial statements are presented, the pro forma information should be reported as though the acquisition date for all business combinations that occurred during the current year had been as of the beginning of the comparable prior annual reporting period. ASU 2010-29 is effective for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2010. Early adoption is permitted. The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.
In December 2010, the FASB issued ASU 2010-28, “When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts.” The amendments in this ASU modify Step 1 of the goodwill impairment test for reporting units with zero or negative carrying amounts. For those reporting units, an entity is required to perform Step 2 of the goodwill impairment test if it is more likely than not that a goodwill impairment exists. For public entities, the amendments in this Update are effective for fiscal years, and interim periods within those years, beginning after December 15, 2010. Early adoption is not permitted. The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.
The SEC has issued Final Rule No. 33-9002, Interactive Data to Improve Financial Reporting, which requires companies to submit financial statements in XBRL (extensible business reporting language) format with their SEC filings on a phased-in schedule. Large accelerated filers and foreign large accelerated filers using U.S. GAAP were required to provide interactive data reports starting with their first quarterly report for fiscal periods ending on or after June 15, 2010. All remaining filers are required to provide interactive data reports starting with their first quarterly report for fiscal periods ending on or after June 15, 2011.
Note 2. Goodwill
The Company has goodwill recorded on the consolidated financial statements relating to the purchase of five branches during the years 1994 through 2000. The balance of the goodwill at December 31, 2010 and 2009, as reflected on the consolidated balance sheets, was $2,807,842. Management determined that these purchases qualified as acquisitions of businesses and that the related unidentifiable intangibles were goodwill. Therefore, amortization was discontinued effective January 1, 2002. Generally, the goodwill balance is tested for impairment annually. Based on the testing, there were no impairment charges in 2010 or 2009.
Note 3. Investment Securities
The aggregate amortized cost and fair values of the available for sale securities portfolio are as follows:
Gross realized gains and gross realized losses on sales of securities were as follows:
The aggregate amortized cost and market values of the investment securities portfolio by contractual maturity at December 31, 2010 are shown below:
Securities with a market value of $9,889,413 and $11,475,540 at December 31, 2010 and 2009, respectively, were pledged as collateral for public deposits, repurchase agreements and for other purposes as required by law.
Securities in an unrealized loss position at December 31, 2010 and 2009, by duration of the unrealized loss, are shown as follows. Management monitors credit ratings and all securities are investment grade or better. There are 16 municipal and 4 federal agency debt securities totaling $8.6 million considered temporarily impaired at December 31, 2010. The primary cause of the temporary impairments in the Company’s investments in debt securities was fluctuations in interest rates. Because the Company intends to hold these investments in debt securities to maturity and it is more likely than not that the Company will not be required to sell these investments before a recovery of unrealized losses, the Company does not consider these investments to be other-than-temporarily impaired at December 31, 2010 and no impairment has been recognized.
The Company’s investment in Federal Home Loan Bank of Atlanta (“FHLB”) stock totaled $1.9 million at December 31, 2010. FHLB stock is generally viewed as a long-term investment and as a restricted investment security. The investment is carried at cost, because there is no market for the stock, other than the FHLBs or its member institutions. Therefore, when evaluating FHLB stock for impairment, its value is based on the ultimate recoverability of the par value rather than by recognizing temporary declines in value. Despite the FHLB’s temporary suspension of repurchases of excess capital stock in 2010, the Company does not consider this investment to be other-than-temporarily impaired at December 31, 2010 and no impairment has been recognized. FHLB stock is shown in the restricted securities line item on the consolidated balance sheets and is not a part of the available for sale securities portfolio.
Note 4. Loans
The following is a summary of the balances of loans:
The recorded investment in past due and nonaccruing loans is shown in the following table. A loan past due by 90 days or more is generally placed on nonaccrual, unless it is both well secured and in the process of collection.
Loans Past Due and Nonaccruals
As of December 31, 2010
Note 5. Allowance for Loan Losses
An analysis of the change in the allowance for loan losses for 2010 and 2009 follows:
A disaggregation of the allowance for loan losses by segment is shown below.
Internal risk rating grades are assigned to commercial loans not secured by real estate, commercial mortgages, residential mortgages greater than $1 million, loans to real estate developers and contractors, and consumer loans greater than $250,000 with chronic delinquency, as shown in the following table. The grading analysis estimates the capability of the borrower to repay the contractual obligations of the loan agreements as scheduled. Risk grades are evaluated as new information becomes available for each borrowing relationship or at least quarterly.
Loans not assigned internal risk rating grades are comprised of residential mortgages and smaller consumer loans. Payment activity of these loans is reviewed monthly by management. Loans are considered to be nonperforming when they are delinquent by 90 days or more or on nonaccrual, as shown in the table below.
The following table shows the Company’s recorded investment and the customers’ unpaid principal balances for impaired loans, with the associated allowance amount, if applicable. Also shown are the average recorded investments in impaired loans and the related amount of interest recognized and collected during the time the loans were impaired.
(1) Junior mortgages include equity lines.
(2) includes credit cards.
At December 31, 2010, the Bank had one loan that constitutes a troubled debt restructuring and it is included in impaired loans in the Residential First Mortgages segment in the tables above. It is a commercial purpose loan secured by a residence, with a principal balance of $623,692 at December 31, 2010. This loan was modified to extend the amortization period by five years. Additionally, the repayment terms were modified to reflect the seasonal nature of the borrower’s business, to more closely coincide with the borrower’s cash flows. There were no troubled debt restructurings at December 31, 2009.
At December 31, 2010 and 2009, nonaccruing loans excluded from impaired loan disclosure totaled $899,350 and $1,559,174, respectively. If interest on these nonaccruing loans had been accrued, such income would have approximated $34,567 in 2010 and $87,155 in 2009.
Loans past due 90 days or more and still accruing interest totaled $202,349 and $153,468 on December 31, 2010 and 2009, respectively.
Note 6. Foreclosed Assets
Foreclosed assets are presented net of a valuation allowance for losses. An analysis of the valuation allowance on foreclosed assets is shown below.
Expenses applicable to foreclosed assets include the following:
Note 7. Premises and Equipment, net
Components of premises and equipment included in the balance sheets at December 31, 2010 and 2009 were as follows:
Amortization and depreciation expense for the years ended December 31, 2010 and 2009, totaled $876,433 and $925,594, respectively.
Note 8. Deposits
The aggregate amount of time deposits in denominations of $100,000 or more at December 31, 2010 and 2009 was $46,751,822 and $51,259,103, respectively.
At December 31, 2010, the scheduled maturities of time deposits are as follows:
At December 31, 2010 and 2009, overdraft demand deposits reclassified to loans totaled $44,296 and $59,624, respectively.
At December 31, 2010 and 2009, the Company had no brokered deposits.
Note 9. Employee Benefit Plans
The Company has a non-contributory, defined benefit pension plan for all full-time employees over 21 years of age. Historically, benefits were generally based upon years of service and average compensation for the five highest-paid consecutive years of service. Effective December 31, 2009, this plan was converted to a Cash Balance Plan for all full-time employees over 21 years of age. Under the Cash Balance Plan, benefits earned by participants under the prior defined benefit pension plan through December 31, 2009 were converted to an opening account balance for each participant. This account balance for each participant will grow each year with annual pay credits based on age and years of service and monthly interest credits based on an amount established each year by the Board of Directors. The Company funds pension costs in accordance with the funding provisions of the Employee Retirement Income Security Act.
The Company sponsors a postretirement benefit plan covering current and future retirees who acquire age 55 and 10 years of service or age 65 and 5 years of service. The postretirement benefit plan provides coverage toward a retiree’s eligible medical and life insurance benefits expenses.
The following tables provide the reconciliation of changes in the benefit obligations and fair value of assets and a statement of funded status for the pension plan and postretirement plan of the Company.
The accumulated benefit obligation for the defined benefit pension plan was $3,978,778 and $3,559,690 at December 31, 2010 and 2009, respectively.
Long-term rate of return. The pension plan sponsor selects the assumption for the expected long-term rate of return on assets in consultation with their investment advisors and actuary. This rate is intended to reflect the average rate of earnings expected to be earned on the funds invested or to be invested to provide plan benefits. Historical performance is reviewed, especially with respect to real rates of return (net of inflation), for the major asset classes held or anticipated to be held by the trust, and for the trust itself. Undue weight is not given to recent experience that may not continue over the measurement period, with higher significance placed on current forecasts of future long-term economic conditions.
Because assets are held in a qualified trust, anticipated returns are not reduced for taxes. Further, solely for this purpose, the plan is assumed to continue in force and not terminate during the period during which assets are invested. However, consideration is given to the potential impact of current and future investment policy, cash flow into and out of the trust, and expenses (both investment and non-investment) typically paid from plan assets (to the extent such expenses are not explicitly estimated within periodic cost).
The fair value of the Company’s pension plan assets by asset category are as follows:
Asset allocation. The pension plan’s weighted average asset allocations for the plan years ended December 31, 2010 and 2009, by asset category, are as follows:
The trust fund is sufficiently diversified to maintain a reasonable level of risk without imprudently sacrificing return, with a targeted asset allocation of 40% fixed income and 60% equities. The Investment Manager selects investment fund managers with demonstrated experience and expertise, and funds with demonstrated historical performance, for the implementation of the Plan’s investment strategy. The Investment Manager will consider both actively and passively managed investment strategies and will allocate funds across the asset classes to develop an efficient investment structure.
It is the responsibility of the trustee to administer the investments of the trust within reasonable costs, being careful to avoid sacrificing quality. These costs include, but are not limited to, management and custodial fees, consulting fees, transaction costs and other administrative costs chargeable to the trust.
The Company expects to contribute $635,106 to its pension plan for the 2011 plan year. Estimated future benefit payments are, $68,817 for 2012, $978,745 for 2013, $353,834 for 2014, $37,431 for 2015 and $1,753,608 for 2016 through 2020.
Postretirement benefits plan. For measurement purposes, the assumed annual rate of increase in per capita health care costs of covered benefits is 14.0% in 2011, 12.0% in 2012, 10.0% in 2013 and 2014, 8.0% in 2015 and 2016, and 6.0% thereafter. If assumed health care cost trend rates were increased by 1 percentage point each year, the accumulated postretirement benefit obligation at December 31, 2010, would be increased by $3,220, and the aggregate of the service and interest cost components of
net periodic postretirement benefit cost for the year ended December 31, 2010, would be increased by $164. If assumed health care cost trend rates were decreased by 1 percentage point each year, the accumulated postretirement benefit obligation at December 31, 2010, would be decreased by $2,996, and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for the year ended December 31, 2010, would be decreased by $152.
The Company expects to contribute $22,571 to its postretirement plan in 2011.
In addition, as of December 31, 2010 and 2009, the Company paid approximately $13,539 and $12,735, respectively, for employees who retired.
401(k) retirement plan. The Company has a 401(k) retirement plan covering substantially all employees who have completed six months of service. Employees may contribute up to 15% of their salaries. Until December 31, 2009, the Company matched 100% of the first 2% and 25% of the next 2% of an employee’s contributions. Effective January 1, 2010, the Company matches 100% of the first 2% and 25% of the next 4% of an employee’s contributions. Additional contributions can be made at the discretion of the Company’s Board of Directors. Contributions to this plan amounted to $104,830 and $85,460 for the years ended December 31, 2010 and 2009, respectively.
Note 10. Financial Instruments With Off-Balance Sheet Risk
In the normal course of business, the Company offers various financial products to its customers to meet their credit and liquidity needs. These instruments involve elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit and standby letters of credit written is represented by the contractual amount of these instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. The amount of collateral obtained, if deemed necessary by the Company, is based on credit evaluation of the customer.
Subject to its normal credit standards and risk monitoring procedures, the Company makes contractual commitments to extend credit. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments may expire without being completely drawn upon, the total commitment amounts do not necessarily represent future cash requirements. At December 31, 2010 and 2009, the Company had outstanding loan commitments approximating $32,350,533 and $36,714,063, respectively.
Conditional commitments are issued by the Company in the form of performance stand-by letters of credit, which guarantee the performance of a customer to a third party. At December 31, 2010 and 2009, commitments under outstanding performance stand-by letters of credit aggregated $446,146 and $616,737, respectively. The credit risk of issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.
Note 11. Restrictions on Cash and Due From Banks
The Federal Reserve requires banks to maintain cash reserves against certain categories of deposit liabilities. At both December 31, 2010 and 2009, the aggregate amount of daily average required reserves for the final weekly reporting period was $25 thousand.
The Company has approximately $100,000 in deposits in financial institutions in excess of amounts insured by the Federal Deposit Insurance Corporation at December 31, 2010.
Note 12. Short-Term Borrowings
Short-term borrowings include securities sold under agreements to repurchase, which are secured transactions with customers and generally mature the day following the day sold and federal funds purchased. There were no short-term advances from FHLB outstanding on December 31, 2010 or December 31, 2009.
The Company had unused lines of credit with nonaffiliated banks totaling $46,208,515 and $46,384,461 as of December 31, 2010 and 2009.
The Company had undispersed letters of credit with FHLB totaling $2,000,000 as of December 31, 2010.
The table below presents selected information on short-term borrowings:
Note 13. Long-Term Debt
On December 31, 2010, the Bank had FHLB debt consisting of three advances. The FHLB holds an option to terminate any of the advances on any quarterly payment date. All advances have an early conversion option which gives FHLB the option to convert, in whole only, into one-month LIBOR-based floating rate advances, effective on any quarterly payment date. If the FHLB elects to convert, the Company may elect to terminate, in whole or in part, without a prepayment fee.
Advances on the FHLB lines are secured by a blanket lien on qualified 1 to 4 family residential real estate loans with a lendable collateral value of $57.9 million. Immediate available credit, as of December 31, 2010, was $25.9 million. With additional collateral, the total line of credit is worth $65.2 million, with $33.1 million available.
The three advances are shown in the following table.
Note 14. Income Taxes
The Company files income tax returns in the U.S. federal jurisdiction and the state of Virginia. With few exceptions, the Company is no longer subject to U.S. federal, state and local income tax examinations by tax authorities for years prior to 2007.
The provision (benefit) for income taxes consisted of the following for the years ended December 31:
The reasons for the differences between the statutory Federal income tax rates and the effective tax rates are summarized as follows:
The components of the net deferred tax assets and liabilities included in other liabilities are as follows:
Note 15. Regulatory Requirements and Restrictions
The primary source of funds available to the Company is the payment of dividends by the Bank. Banking regulations limit the amount of dividends that may be paid without prior approval of the Bank’s regulators. As of December 31, 2010, there were no unrestricted funds available for transfer from the banking subsidiary to the Company without prior regulatory approval.
The Company (on a consolidated basis) and Bank are subject to various regulatory capital requirements administered by the Commonwealth of Virginia and Federal 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 and Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Prompt corrective action provisions are not applicable to bank holding companies.
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 1 capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital (as defined) to average assets (as defined). Management believes, that as of December 31, 2010 and 2009, the Company and the Bank meet all capital adequacy requirements to which they are subject.
As of December 31, 2010, the most recent notification from the Federal Reserve categorized the Bank as well capitalized under the framework for prompt corrective action. To be categorized as well capitalized, an institution must maintain minimum total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed the Bank’s category.
The Company’s and the Bank’s actual capital amounts and ratios as of December 31, 2010 and 2009, are presented in the tables below:
Note 16. Employee Stock Ownership Plan
The Company has a noncontributory Employee Stock Ownership Plan (“ESOP”) for the benefit of all eligible employees who have completed twelve months of service and who have attained the age of 21 years. Contributions to the plan are at the discretion of the Company’s Board of Directors. Contributions are allocated in the ratio to which the covered compensation of each participant bears to the aggregate covered compensation of all participants for the plan year. Allocations are limited to 25% of eligible participant compensation. Participant accounts are 30% vested after two years, 40% vested after three years with vesting increasing 20% each year thereafter, until 100% vested. The plan had 157,710 allocated shares as of December 31, 2010. Contributions to the plan were $75,000 and $75,000 for 2010 and 2009, respectively. There were no dividends on the Company’s stock held by the ESOP except for $8.24 cash in lieu of dividends related to the stock dividends declared in 2010. Dividends on the Company’s stock held by the ESOP were $52,401 in 2009. Shares held by the ESOP are considered outstanding for purposes of computing earnings per share.
Note 17. Stock-Based Compensation Plans
The Company has four stock-based compensation plans. The 1994 Incentive Stock Option Plan expired and no additional shares may be granted under this plan. The 2003 Incentive Stock Option Plan made 175,000 shares available for grant. Under this plan, the exercise price of each option equals the market price of the Company’s common stock on the date of grant and an option’s maximum term is ten years. Options granted are exercisable only after meeting certain performance targets during a specified time period. If the targets are not met, the options are forfeited. The third plan is the 1998 Non-Employee Directors Stock Option Plan, which has expired and therefore no additional shares may be granted. The fourth plan is the 2008 Non-Employee Directors Stock Option Plan, which grants 500 shares to each non-employee director annually. This plan had 32,199 shares available for grant at December 31, 2010. All information has been adjusted for stock dividends.
A summary of the status of the stock option plans as of December 31, 2010 and changes during the year then ended is presented below:
(1) The aggregate intrinsic value of a stock option in the table above represents the total pre-tax intrinsic value (the amount by which the current market value of the underlying stock exceeds the exercise price of the option) that would have been received by the option holders had all option holders exercised their options on December 31, 2010. This amount changes based on changes in the market value of the Company’s stock.
The fair value (present value of the estimated future benefit to the option holder) of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model.
The weighted average fair value of incentive stock options granted during 2010 and 2009, was $0.54 and $1.41, respectively. The weighted average fair value of non-employee director’s stock options granted during 2010 and 2009 was $0.57and $0.72, respectively.
The fair value of each grant is estimated at the grant date using the Black-Scholes Option-Pricing Model with the following weighted average assumptions:
The expected volatility is based on historical volatility of the Company’s stock price. The risk-free interest rates for the periods within the contractual life of the awards are based on the U.S. Treasury yield curve in effect at the time of the grant. The expected life is based on historical exercise experience. The dividend yield assumption is based on the Company’s history and expectation of dividend payouts.
The status of the options outstanding at December 31, 2010 is as follows:
Note 18. Earnings Per Share
The following shows the weighted average number of shares used in computing earnings per share and the effect on weighted average number of shares of diluted potential common stock dividends.
As of December 31, 2010 and 2009, options on 210,819 shares and 183,056 shares, respectively, were not included in computing diluted earnings per common shares because their effects were anti-dilutive. All shares have been adjusted for stock dividends.
Note 19. Related Parties
The Company has entered into transactions with its directors and principal officers of the Company, their immediate families and affiliated companies in which they are the principal stockholders (related parties). The aggregate amount of loans to such related parties was $3,098,510 and $4,761,123 at December 31, 2010 and 2009, respectively. All such loans, in the opinion of the management, were made in the normal course of business on the same terms, including interest rate and collateral, as those prevailing at the time for comparable transactions.
Commitments to extend credit to directors and their related interests were $1,012,215 and $1,009,666 at December 31, 2010 and 2009, respectively.
The Company also maintains deposit accounts with some of its executive officers, directors and their affiliated entities. The aggregate amount of these deposit accounts at December 31, 2010 and 2009 amounted to $681,737 and $592,951, respectively.
Note 20. Fair Value Measurements
The Company uses fair value to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. Authoritative accounting guidance clarifies that fair value of certain assets and liabilities is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants.
Authoritative accounting guidance specifies a hierarchy of valuation techniques based on whether the inputs to those valuation techniques are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Company’s market assumptions. The three levels of the fair value hierarchy under fair values accounting guidance based on these two types of inputs are as follows:
Level 1
-
Valuation is based on quoted prices in active markets for identical assets and liabilities.
Level 2
-
Valuation is based on observable inputs including quoted prices in active markets for similar assets and liabilities, quoted prices for identical or similar assets and liabilities in less active markets, and model-based valuation techniques for which significant assumptions can be derived primarily from or corroborated by observable data in the market.
Level 3
-
Valuation is based on model-based techniques that use one or more significant inputs or assumptions that are unobservable in the market.
The following describes the valuation techniques used by the Company to measure certain financial assets and liabilities recorded at fair value on a recurring basis in the financial statements:
Securities available for sale: Securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted market prices, when available (Level 1). If quoted market prices are not available, fair values are measured utilizing independent valuation techniques of identical or similar securities for which significant assumptions are derived primarily from or corroborated by observable market data. Third party vendors compile prices from various sources and may determine the fair value of identical or similar securities by using pricing models that consider observable market data (Level 2).
The following table presents the balances of financial assets measured at fair value on a recurring basis as of December 31, 2010 and 2009:
Certain assets are measured at fair value on a nonrecurring basis in accordance with GAAP. Adjustments to the fair value of these assets usually result from the application of lower-of-cost-or-market accounting or write-downs of individual assets.
The following describes the valuation techniques used by the Company to measure certain assets recorded at fair value on a nonrecurring basis in the financial statements:
Impaired Loans: Loans are designated as impaired when, in the judgment of management based on current information and events, it is probable that all amounts due according to the contractual terms of the loan agreement will not be collected. The measurement of loss associated with impaired loans can be based on either the observable market price of the loan or the fair value of the collateral. Fair value is measured based on the value of the collateral securing the loans. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. The vast majority of the collateral is real estate. The value of real estate collateral is determined utilizing an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the Company using observable market data (Level 2). However, if the collateral is a house or building in the process of construction or if an appraisal of the real estate property is over two years old, then the fair value is considered Level 3. The value of business equipment is based upon an outside appraisal if deemed significant, or the net book value on the applicable business’s financial statements if not considered significant using observable market data. Likewise, values for inventory and accounts receivables collateral are based on financial statement balances or aging reports (Level 3). Impaired loans allocated to the Allowance for Loan Losses are measured at fair value on a nonrecurring basis. Any fair value adjustments are recorded in the period incurred as provision for loan losses on the Consolidated Statements of Income.
Other Real Estate Owned: Certain assets such as other real estate owned (“OREO”) are measured at fair value less estimated costs to sell. We believe that the fair value component in its valuation follows the provisions of FASB ASC 820. The Company had other real estate owned in the amount of $4.1 million at December 31, 2010, which consisted of six residences, nine lots, one former restaurant, lodging property, lodging property with a restaurant and one former convenience store.
The following table summarizes the Company’s assets that were measured at fair value on a nonrecurring basis during the period.
The estimated fair values of financial instruments are shown in the following table. The carrying amounts in the table are included in the balance sheets under the applicable captions.
The fair values shown do not necessarily represent the amounts which would be received on immediate settlement of the instruments. Authoritative accounting guidance excludes certain financial instruments and all non-financial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company.
The carrying amounts of cash and due from banks, federal funds sold or purchased, accrued interest, non-interest-bearing deposits, savings, and securities sold under repurchase agreements, represent items which do not present significant market risks, are payable on demand, or are of such short duration that carrying value approximates market value.
Available-for-sale securities are carried at the quoted market prices for the individual securities held. Therefore carrying value equals market value. The carrying value of restricted securities approximates fair value based on the redemption provisions.
The fair value of loans is estimated by discounting future cash flows using the interest rates at which similar loans would be made to borrowers.
Time deposits are presented at estimated fair value using interest rates offered for deposits of similar remaining maturities.
The fair value of the FHLB advances is estimated by discounting the future cash flows using the interest rate offered for similar advances.
The fair value of commitments to extend credit is estimated using the fees currently charged to enter similar agreements, taking into account the remaining terms of the agreements and the present credit worthiness of the counter parties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates.
The fair value of standby letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counter parties at the reporting date.
At December 31, 2010 and 2009, the fair value of loan commitments and standby letters of credit was immaterial. Therefore, they are not included in the table above.
The Company assumes interest rate risk (the risk that general interest rate levels will change) as a result of its normal operations. As a result, the fair value of the Company’s financial instruments will change when interest rate levels change and that change may be either favorable or unfavorable to the Company. Management attempts to match maturities of assets and liabilities to the extent believed necessary to minimize interest rate risk. However, borrowers with fixed rate obligations are less likely to prepay in a rising rate environment. Conversely, depositors who are receiving fixed rates are more likely to withdraw funds before
maturity in a rising rate environment and less likely to do so in a falling rate environment. Management monitors rates and maturities of assets and liabilities and attempts to minimize interest rate risk by adjusting terms of new loans and deposits and by investing in securities with terms that mitigate the Company’s overall interest rate risk.
Note 21. Condensed Financial Information of Parent Company
Financial information pertaining only to Bay Banks of Virginia, Inc. is as follows:
Note 22. Subsequent Events
In accordance with Accounting Standards Codification (“ASC”) 855-10, the Company evaluates subsequent events that have occurred after the balance sheet date but before the financial statements are issued. There are two types of subsequent events: (1) recognized, or those that provide additional evidence about conditions that existed at the date of the balance sheet, including the estimates inherent in the process of preparing financial statements, and (2) nonrecognized, or those that provide evidence about conditions that did not exist at the date of the balance sheet but arose after that date.
Based on the evaluation, the Company did not identify any recognized or nonrecognized subsequent events that would have required adjustment to or disclosure in the financial statements.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders
Bay Banks of Virginia, Inc.
Kilmarnock, Virginia
We have audited the accompanying consolidated balance sheets of Bay Banks of Virginia, Inc. and subsidiaries as of December 31, 2010 and 2009, and the related consolidated statements of operations, changes in shareholders’ equity, and cash flows for the years 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 audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of 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 audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Bay Banks of Virginia, Inc. and subsidiaries as of December 31, 2010 and 2009, and the results of their operations and their cash flows for the years then ended, in conformity with U.S. generally accepted accounting principles.
Winchester, Virginia
March 22, 2011
ITEM 9:
ITEM 9: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A:
ITEM 9A: CONTROLS AND PROCEDURES
EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES
As of the end of the period to which this report relates, the Company has carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Principal Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Rule 13a-14 of the Exchange Act. In designing and evaluating its disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that objectives of the disclosure controls and procedures are met. The design of any disclosure controls and procedures is also based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential conditions. Based upon their evaluation, the Company’s Chief Executive Officer and Principal Financial Officer concluded that the Company’s disclosure controls and procedures are effective in timely alerting them to material information relating to the Company (including its consolidated subsidiaries) required to be included in the Company’s periodic SEC filings as of December 31, 2010.
MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
Management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rule 13a-15(f) of the Exchange Act. 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 the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2010. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations, a.k.a. COSO, of the Treadway Commission in Internal Control - Integrated Framework. Based on the assessment using those criteria, management concluded that the internal control over financial reporting was effective as of December 31, 2010.
This Annual Report on Form 10-K does not include an attestation report from the Company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit the Company to provide only management’s report in this annual report.
ITEM 9B:
ITEM 9B: OTHER INFORMATION
None.
PART III
ITEM 10:
ITEM 10: DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
All required information is detailed in the Company’s 2011 definitive proxy statement for the annual meeting of shareholders (“Definitive Proxy Statement”), which is expected to be filed with the SEC within the required time period, and is incorporated herein by reference.
ITEM 11:
ITEM 11: EXECUTIVE COMPENSATION
Information on executive compensation is provided in the Definitive Proxy Statement and is incorporated herein by reference.
ITEM 12:
ITEM 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
Information on security ownership of certain beneficial owners and management and related stockholder matters is provided in the Definitive Proxy Statement, and is incorporated herein by reference.
The following table summarizes information, as of December 31, 2010, relating to the Company’s stock option plans, pursuant to which grants of options to acquire shares of common stock may be granted from time to time.
(1) Consists of options granted pursuant to the Company’s incentive stock option plan.
ITEM 13:
ITEM 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
Information on certain relationships and related transactions, and director independence, are detailed in the Definitive Proxy Statement and incorporated herein by reference.
ITEM 14:
ITEM 14: PRINCIPAL ACCOUNTANT FEES AND SERVICES
Information on principal accounting fees and services is provided in the Definitive Proxy Statement and is incorporated herein by reference.
PART IV
ITEM 15:
ITEM 15: EXHIBITS, FINANCIAL STATEMENT SCHEDULES.
(a)1. Financial Statements are included in Part II, Item 8, Financial Statements and Supplementary Data
(a)2. All required tables are included in Part II, Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations
(a)3. Exhibits:
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 22nd day of March, 2011.
Bay Banks of Virginia, Inc.
(registrant)
By:
/s/ Austin L. Roberts, III
Austin L. Roberts, III,
President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant, and in the capacities indicated, on the 22nd day of March 2011.
/s/ Robert F. Hurliman
Robert F. Hurliman
Chairman, Board of Directors
Director
/s/ Austin L. Roberts, III
Austin L. Roberts, III
Vice Chairman, President and CEO Director
(Principal Executive Officer)
/s/ Robert C. Berry, Jr.
Robert C. Berry, Jr.
Director
/s/ Richard A. Farmar, III
Richard A. Farmar, III
Director
/s/ Julien G. Patterson
Julien G. Patterson
Director
/s/ Deborah M. Evans
Deborah M. Evans
Treasurer
(Principal Financial Officer)