ITEM 1. BUSINESS
Forward Looking Statements
Certain statements contained herein are “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Such forward-looking statements may be identified by reference to a future period or periods, or by the use of forward-looking terminology, such as “may,” “will,” “believe,” “expect,” “estimate,” “anticipate,” “continue,” or similar terms or variations on those terms, or the negative of those terms. Forward-looking statements are subject to numerous risks and uncertainties, including, but not limited to, those related to the economic environment, particularly in the market areas in which the Company operates, competitive products and pricing, fiscal and monetary policies of the U.S. Government, changes in government regulations affecting financial institutions, including regulatory fees and capital requirements, changes in prevailing interest rates, acquisitions and the integration of acquired businesses, credit risk management, asset-liability management, the financial and securities markets and the availability of, and costs associated with, sources of liquidity.
Cape Bancorp wishes to caution readers not to place undue reliance on any such forward-looking statements, which speak only as of the date made. The Company wishes to advise readers that the factors listed above could affect the Company’s financial performance and could cause the Company’s actual results for future periods to differ materially from any opinions or statements expressed with respect to future periods in any current statements.
Overview
Cape Bancorp, Inc. (“Cape Bancorp” or the “Company”) is a Maryland corporation that was incorporated on September 14, 2007 for the purpose of becoming the holding company of Cape Bank (formerly Cape Savings Bank) (the “Bank”) in connection with Cape Bank’s mutual-to-stock conversion, Cape Bancorp’s initial public offering and simultaneous acquisition of Boardwalk Bancorp, Inc. (“Boardwalk Bancorp”), Linwood, New Jersey and its wholly-owned New Jersey chartered bank subsidiary, Boardwalk Bank.
The merger of Cape Bank and Boardwalk Bank on January 31, 2008 resulted in a well-capitalized community oriented bank with a significant commercial loan presence. For the three years prior to the merger both banks had experienced strong asset quality and financial performance. At the time of this merger the United States was in the early stages of what has become one of the most severe recessions in its history. Interest rates have subsequently dropped to historically low levels, the national unemployment rate increased to above 9% and has remained at elevated levels for an extended period of time. The federal government provided direct financial assistance to major corporations as well as provided significant liquidity to the financial markets.
At December 31, 2012, the Company had total assets of $1.041 billion compared to $1.071 billion at December 31, 2011. For the years ended December 31, 2012 and 2011, the Company had total revenues of $51.5 million and $51.8 million, respectively. Net income for the year ended December 31, 2012 totaled $4.6 million compared to $8.0 million for the year ended December 31, 2011. At December 31, 2012, the Company had total deposits of $784.6 million and total stockholders’ equity of $150.8 million, compared to total deposits of $774.4 million and total stockholders’ equity of $145.7 million at December 31, 2011. Results of operations differ from the results reported in the Company’s press release of February 1, 2013 due to new information related to the financial condition of a customer at December 31, 2012. This change resulted in an additional $823,000 loan loss provision arising from the placing of $2.2 million in loans on non-accrual status and the subsequent charge-off of $1.1 million of that exposure. Management became aware of the change in the customer’s financial status at the end of February 2013. The change resulted in a decrease in net income from the previously reported amount of $551,000, or $0.04 per common and fully diluted share, for the year ended December 31, 2012. All applicable financial information has been updated to reflect this change.
Cape Bank
General
Cape Bank is a New Jersey chartered savings bank originally founded in 1923. We are a community bank focused on providing deposit and loan products to retail customers and to small and mid-sized businesses from our main office located at 225 North Main Street, Cape May Court House, New Jersey 08210, our 14 branch offices located in Atlantic and Cape May Counties, New Jersey and our market development offices (“MDOs”). We attract deposits from the general public and use those funds to originate a variety of loans, including commercial mortgages, commercial business loans, residential mortgage loans, home equity loans and lines of credit and construction loans. Our retail and business banking deposit products include checking accounts, money market accounts, certificates of deposit with terms ranging from 30 days to 84 months and savings accounts. At December 31, 2012, 92.4% of our loan portfolio was secured by real estate and 60.9% of our portfolio was commercial related loans. We also maintain an investment portfolio.
We offer banking services to individuals and businesses predominantly located in our primary market area of Cape May and Atlantic Counties, New Jersey and through our MDOs located in Burlington and Mercer Counties, New Jersey. The Mercer County MDO opened in November 2012. In addition, in March 2013, the Company opened a MDO in Radnor, PA to service the five county Philadelphia market area. Our business and results of operations are significantly affected by local and national economic conditions, as well as market interest rates. The severe recession of 2008 and 2009, and the continued economic weakness through 2012 in the local and national economies significantly affected our level of non-performing assets and loan foreclosure activity. However, we have made progress in improving our credit quality ratios. Non-performing loans as a percentage of total gross loans decreased to 2.67% at December 31, 2012 from 3.77% at December 31, 2011. The Company’s Adversely Classified Asset Ratio (Classified Assets/Tier I Capital plus the allowance for loan losses) at December 31, 2012 was 30%, a significant improvement from 57% at December 31, 2011. Non-performing assets (non-performing loans, other real estate owned and non-accruing investment securities) as a percentage of total assets decreased to 2.61% at December 31, 2012 from 3.38% at December 31, 2011. For the periods ended, and as of December 31, 2012 and December 31, 2011, loans held for sale (“HFS”) are excluded from delinquencies, non-performing loans, non-performing assets, impaired loans and all related ratio calculations. The ratio of our allowance for loan losses to total loans decreased to 1.36% at December 31, 2012, from 1.74% at December 31, 2011, while the ratio of our allowance for loan losses to non-performing loans increased to 50.86% at December 31, 2012 from 46.10% at December 31, 2011. For the year ended December 31, 2012, loan charge-offs totaled $7.5 million compared to loan charge-offs and write-downs of loans transferred to loans held for sale of $19.7 million for the year ended December 31, 2011. Of the $7.5 million of loan charge-offs during 2012, none of these were fully reserved for as of December 31, 2011. Our total loan portfolio decreased from $729.0 million at December 31, 2011 to $724.5 million at December 31, 2012. Commercial loans increased $13.7 million, net of $10.2 million of commercial loans transferred to OREO throughout the year and $7.5 million of charge-offs, while residential mortgage loans declined $16.5 million and consumer loans declined $1.7 million. The decline in mortgage loans resulted from normal amortizations, payoffs and the Bank selling approximately 54% of originations made during the year in an effort to manage interest rate risk. We believe our existing loan underwriting practices are appropriate in the current market environment while continuing to address the local credit needs. Total deposits increased $10.2 million from $774.4 million at December 31, 2011 to $784.6 million at December 31, 2012. Increases in NOW and money market deposits of $42.0 million, non-interest bearing accounts of $10.5 million and savings deposits of $8.2 million more than offset a reduction in certificates of deposit of $50.5 million.
Our principal business is acquiring deposits from individuals and businesses in the communities surrounding our offices and using these deposits to fund loans and other investments. We offer personal and business checking accounts, commercial mortgage loans, residential mortgage loans, construction loans, home equity loans and lines of credit and other types of commercial and consumer loans. At December 31, 2012, our market area primarily included the area surrounding our 15 offices located in Cape May and Atlantic Counties, New Jersey and our MDOs located in Burlington and Mercer Counties, New Jersey.
Our website address is www.capebanknj.com. Information on our website is not and should not be considered a part of this Annual Report on Form 10-K. Our website contains a direct link to our filings with the Securities and Exchange Commission, including copies of Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to these filings, if any. Copies may also be obtained, without charge, by written request to Investor Relations, 225 Main Street, Cape May Court House, New Jersey 08210. The telephone number at our main office is (609) 465-5600.
Market Area
Our primary market area consists of Cape May and Atlantic Counties, which includes communities along the barrier islands of the southern New Jersey shore and the mainland areas. While the economies along the New Jersey shore are more seasonal in nature, the mainland areas are comprised of year-round communities. The economy of our market area is impacted by the gaming industry, a variety of service businesses, vacation-related businesses concentrated along the coastal areas and, to a lesser degree, commercial fishing and agriculture. In addition, nearby Atlantic City is a major tourist destination, centered around its large gaming industry, and is an important regional economic hub. The opening of our MDO in Mercer County, New Jersey in November 2012 is an effort to expand the Bank’s presence and diversify its customer base in the central region of the State. The severe national and local economic recession that began in late 2007 has had a significant negative impact on our market area. Unemployment rates have risen steadily in both Atlantic and Cape May Counties, reaching levels of 14.3% and 16.2% respectively at December 2012. This persistent increase in the unemployment rates was inconsistent with the State of New Jersey that had seen unemployment level off between 2010 and 2011, yet increase again in 2012 to 9.3% as of December 2012. The national trend of unemployment has seen declines from 9.4% at December 2010 to 8.5% at December 2011 to 7.8% at December 2012. Both residential and commercial real estate values have declined during this recession. Residential real estate median sales prices have decreased 1.2% in Atlantic County and increased 32.0% in Cape May County when comparing the quarter ended September 30, 2012 to the same period in 2011. Additionally, the number of residential building permits issued in 2012 increased from 2011, by 18% and 11% in Atlantic County and Cape May County, respectively. The gaming industry in New Jersey continues to be adversely affected by the recession and gaming competition from neighboring states. Commercial real estate (industrial, office and retail) values remain depressed on a national level compared to 2007 levels, commercial real estate rents have declined since 2007 and commercial real estate vacancy rates have increased since 2007. However, the improvement in the commercial real estate market (industrial, office and retail) that began in 2011 continues during 2012 with improving values, rents and occupancy rates consistent with improvements within the economy. The Company believes that this information, both nationally and regionally, is consistent with the Atlantic City metropolitan area.
The gaming industry is a significant economic force in our market and has already suffered a serious decline in revenues due to the economy and increased regional competition. The Atlantic City casino industry has experienced mixed results through the first three quarters of 2012. The items below reflect changes excluding the Revel which opened in April 2012.
Gross operating profit up 9% for the nine month period;
Nine casinos had revenue declines during the period;
Occupancy rate in the casino hotels was up slightly to 86.2% from 85.2% the previous year.
Competition from neighboring states has played an important role in this decline. Pennsylvania now has 11 operating casinos representing an addition of one from the previous year. These casinos offer both table games and slots. Delaware has only three casinos, but in 2012 began offering table games in addition to their historic slot offerings. In an attempt to revitalize Atlantic City, the State of New Jersey has worked on several initiatives:
The Tourism District Law led to a $30 million marketing plan and realigned State gaming agencies to reduce bureaucracy.
In 2011, a second casino related law was passed with a comprehensive overhaul of casino regulations. This was the first major revision since 1977.
In February 2013, the State passed a law permitting online gaming in the state if the customer registers with an existing casino.
Notwithstanding the recession, the year-round residency has remained relatively unchanged in both Cape May and Atlantic Counties from 2010 to 2012. Median household income has remained relatively stable in each county during the past three years, and was $54,993 for Atlantic County and $55,114 for Cape May County during 2012. For the State of New Jersey, median household income during 2012 was $66,950.
Competition
We face significant competition in attracting deposits and originating loans. Our most direct competition for deposits historically has come from the many financial institutions operating in our market area, including commercial banks, savings banks, savings and loan associations and credit unions, and, to a lesser extent, from other financial service companies such as brokerage firms and insurance companies. Several large holding companies operate banks in our market area, and these institutions are significantly larger than Cape Bank and, therefore, have significantly greater resources. We also face competition for investors’ funds from money market funds, mutual funds and other corporate and government securities. At June 30, 2012, which is the most recent date for which data is available from the Federal Deposit Insurance Corporation (“FDIC”), we held approximately 14.0% of the deposits in Cape May County, which was the 2nd largest market share out of the 14 financial institutions with offices in Cape May County, and we held approximately 8.1% of the deposits in Atlantic County, which was the 6th largest market share of the 16 financial institutions with offices in Atlantic County. On a combined market basis we held approximately 10.1% of the deposits which was the 3rd largest market share of 21 financial institutions.
Our competition for loans comes primarily from financial institutions in our market area and, to a lesser extent, from other financial service providers, such as mortgage companies. Our market area has a large number of competitors offering real estate lending products. Data is not available to determine our competitive position among this group. Competition for deposits and the origination of loans could limit our growth in the future.
Lending Activities
We offer a variety of loans, including commercial mortgages, commercial loans, residential mortgage loans, home equity loans and lines of credit, and construction loans. Our commercial mortgage loan portfolio at December 31, 2012, comprised 53.0% of our total loan portfolio, which was greater than any other loan category.
Loans are presented in Management’s Discussion and analysis according to type of loan utilized for management reporting purposes, whereas certain disclosures within Note 4 - Loans Receivable are presented in accordance with FASB issued ASU No. 2010-20, “Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses”.
Loan Portfolio Composition. The following table sets forth the composition of our loan portfolio, excluding loans held for sale, by type of loan at the dates indicated.
Loan Portfolio Maturities and Yields. The following tables summarize the scheduled maturities of our loan portfolio at December 31, 2012 and December 31, 2011. Demand loans, loans having no stated repayment schedule at maturity and overdraft loans are reported as being due in one year or less. Maturities are based on final contractual payment date and do not reflect the effect of prepayments and scheduled principal amortization.
(1) Includes overdrawn DDA accounts.
(1) Includes overdrawn DDA accounts.
The following table sets forth the scheduled repayments of fixed and adjustable rate loans at December 31, 2012 and December 31, 2011 that are contractually due within one year and after one year.
The following table sets forth fixed and adjustable rate loans at December 31, 2012 and at December 31, 2011 as a percentage of the total loan portfolio.
The Bank’s fixed rate loans decreased as a percentage of total loans to 36.7% at December 31, 2012 from 38.9% at December 31, 2011. This decrease in fixed rate loans as a percentage of total loans resulted from the predominately fixed rate residential loan portfolio decreasing at a faster rate than the predominately adjustable rate commercial loan portfolio. Having a larger percentage of the loan portfolio in adjustable rate loans helps us better manage interest rate risk. During the past two years while market interest rates fell to historically low levels, we were able to maintain a net interest margin of 3.75% and 3.60% for 2012 and 2011, respectively. This increase in net interest margin during 2012 resulted from a decline of 36 basis points in the cost of interest-bearing liabilities partially offset by a 17 basis point decrease in the yield on interest-earning assets. The net interest margin for 2012 benefitted from the previously disclosed debt extinguishment in the second quarter of 2012, and the further restructuring of debt in the third quarter of 2012. Based on our interest rate risk modeling, when market interest rates rise our net interest income will be negatively affected based on the assumptions used in our analysis located in the section within this report entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Management of Market Risk”.
The following table sets forth fixed and adjustable rate loans at December 31, 2012 maturing within ten years, twenty years and over twenty years as a percentage of the total loan portfolio.
The following table sets forth fixed and adjustable rate loans at December 31, 2011 maturing within ten years, twenty years and over twenty years as a percentage of the total loan portfolio.
Fixed rate long-term loans present interest rate risk to the Bank and will constrain net income in a rising interest rate environment. The magnitude of this long-term risk associated with fixed rate long-term loans is factored into our Management of Market Risk analysis provided in “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Management of Market Risk”. The Bank’s Cumulative Gap Analysis with assumptions results in the Bank being liability sensitive through 5 years.
The following table indicates our commercial loan portfolio concentrations sorted by the North American Industry Classification System (NAICS) code as of December 31, 2012.
Commercial Loan Concentrations
December 31, 2012
Commercial Mortgage Loans. At December 31, 2012, commercial mortgage loans totaled $383.6 million, or 53.0%, of our total loan portfolio, which was greater than any other loan category, including one-to-four family residential mortgage loans. Commercial mortgage loans totaled $374.3 million, or 51.4%, of the total loan portfolio at December 31, 2011.
We offer commercial mortgage loans secured by real estate primarily with interest rates that reset every five to ten years and are generally based on an amortization schedule of up to 25 years. Commercial construction loans also are originated for the acquisition and development of land as part of a full construction project and are typically based upon the prime interest rate as published in The Wall Street Journal with interest rate floors. These loans typically are paid off by permanent mortgages obtained by the buyers; commercial construction loans convert to a commercial mortgage loan once construction is completed. Commercial construction/mortgage loans for the development of non- owner occupied real estate are originated with loan-to-value ratios of up to 75%. Commercial mortgage loans for owner occupied real estate are originated with loan-to-value ratios of up to 80%. The loan-to-value ratio is defined as the lesser of the actual acquisition cost or the estimated value determined by an independent appraisal.
Loans secured by commercial real estate generally have larger balances and involve a greater degree of risk than one-to-four family residential mortgage loans. Of primary concern in commercial mortgage lending is the borrower’s creditworthiness and cash flow. Repayments of loans secured by income-producing properties often depend on the successful operation and management of the properties. As a result, repayment of such loans may be subject to adverse conditions in the real estate market or the economy, to a greater extent than residential mortgage loans. See “Risk Factors - Our Emphasis on Commercial Real Estate and Commercial Business Loans May Continue to Expose the Bank to Increased Lending Risks”. To monitor cash flows on income-producing properties, we require borrowers and loan guarantors, if any, to provide annual financial statements and rent rolls where applicable. In reaching a decision whether to make a commercial mortgage loan, we consider and review a cash flow analysis of the borrower and consider the net operating income of the property, the borrower’s expertise, credit history and profitability and the value of the underlying property.
An environmental report from a third party is obtained on all commercial real estate loans up to $1 million. Loans in excess of $1 million may require a Phase I or Phase II analysis when the possibility exists that hazardous materials may have existed on the site, or the site may have been affected by adjoining properties that handled hazardous materials. It is the practice of the Company that for commercial real estate loans to obtain appraisals for the collateral securing the loan at origination and when the loan has become 90 days delinquent or if information is obtained indicating insufficient cash flow to support the loan. For these collateral dependent loans an FASB ASC Topic No. 310 Receivables analysis is performed and any resulting collateral shortfall is charged-off. It is not the Company’s practice to test collateral value to loan balance for loans that are performing consistent with contractual terms or are less than 90 days delinquent, as the value of collateral does not necessarily affect the repayment capacity of the borrower.
In addition, if loans that are collateralized by real estate become troubled and the value of the real estate has been significantly impaired from the time of origination or most recent appraisal, then the Company may not be able to recover the full contractual amount of principal and interest that we anticipated at the time we originated the loan, which could cause us to increase our provision for loan losses and adversely affect our operating results and financial condition. At December 31, 2012, the Company had, 30 unsecured commercial loans totaling $2.5 million, of which the largest was $1.0 million. The Company’s current practice when originating a commercial real estate loan is to use the commercial real estate as collateral, but, as noted above, the extension of credit is based on many other factors in addition to the value of the collateral. As a matter of practice, loan-to-value ratios on non-owner occupied real estate seldom exceed 75% and seldom exceed 80% on owner occupied real estate. If a loan is in a performing status it is not the practice of this Company to obtain updated appraised values of the collateral. The Company’s practice regarding loans delinquent 90 days or greater is discussed previously within this document.
Delinquencies in the commercial mortgage loan portfolio showed significant improvement at year-end 2012. At December 31, 2012, 29 commercial mortgage loans totaling $9.6 million were 31 days or more delinquent and 25 of such commercial mortgage loans totaling $7.8 million were more than 90 days or more delinquent. By comparison, at December 31, 2011, 36 commercial mortgage loans totaling $16.8 million were 30 days or more delinquent with 34 of such commercial mortgage loans totaling $15.5 million being more than 90 days delinquent.
One-to-Four Family Residential Mortgage Loans. At December 31, 2012, one-to-four family residential mortgage loans totaled $235.9 million, or 32.6%, of our total loan portfolio compared to $252.5 million, or 34.6%, of the total loan portfolio at December 31, 2011.
We offer two types of residential mortgage loans: fixed rate loans and adjustable rate loans. We offer fixed rate mortgage loans with terms of up to 30 years. We offer adjustable rate mortgage loans with interest rates and payments that adjust annually after an initial fixed period of one, three, five, seven or 10 years. Interest rates and payments on our adjustable rate loans generally are adjusted to a rate equal to a percentage above the U.S. Treasury Bill Constant Maturity Index or the LIBOR Index. The maximum amount by which the interest rate may be increased or decreased is generally 2.0% per adjustment period and the maximum interest rate increase over the life of the loan is generally 6.0% over the initial interest rate on the loan. We have the facility to sell, and will sell, conforming fixed rate loans, FHA/VA, USDA loans, we originate with terms of up to 30 years with servicing released to manage interest rate risk.
Borrower demand for adjustable rate loans compared to fixed rate loans is a function of the level of market interest rates, the expectations of changes in interest rates, and the difference between the interest rates and loan fees offered for fixed rate mortgage loans as compared to adjustable rate mortgage loans. The relative amount of fixed rate and adjustable rate mortgage loans that can be originated at any time is largely determined by the demand for each in a competitive environment. The loan fees, interest rates and other provisions of mortgage loans are determined by us on the basis of our own pricing criteria and competitive market conditions.
Our general policy is not to make high loan-to-value loans (defined as loans with a loan-to-value ratio of 80% or more) without mortgage insurance; however, we do offer loans with loan-to-value ratios of up to 95% with mortgage insurance. We require all properties securing residential mortgage loans to be appraised. We adhere to the Appraisal Independence Requirements, as established by the secondary market, for appraiser selection and independence. We require title insurance on all first mortgage loans secured by a residence, and borrowers must obtain hazard insurance. Additionally, we require flood insurance for loans on properties located in a flood zone.
As a result of our lending standards we do not offer, or have, any payment option adjustable rate loans or sub-prime loans.
Generally, adjustable rate loans may better insulate Cape Bank from interest rate risk as compared to fixed rate loans. In a rising interest rate environment, however, the monthly mortgage payment on adjustable rate loans would also increase which could cause an increase in delinquencies and defaults. To mitigate the risk associated with increases in monthly mortgage payments on adjustable rate loans, we adhere to underwriting guidelines by initially qualifying each borrower at a higher interest rate. In addition, although adjustable rate mortgage loans make our assets more responsive to changes in interest rates, the extent of this interest rate sensitivity is limited by the annual and lifetime interest rate adjustment limits.
The following table indicates the amount and percent of residential mortgage loans that are single family and multi-family as of December 31, 2012 and 2011.
The following table segregates loans with original loan-to-value ratios greater than 80% and less than 80%.
(1) All loans with an original loan-to-value greater than 80% were single family loans for both periods presented.
Commercial Business Loans. At December 31, 2012, commercial business loans totaled $56.6 million, or 7.8%, of our total loan portfolio compared to $41.8 million, or 5.7%, of the total loan portfolio at December 31, 2011.
We offer commercial business loans to professionals, sole proprietorships and small businesses in our market area. We offer term lines of credit for working capital and term loans for capital improvements and equipment acquisition. These loans are typically based on a competitive variable rate over a published Wall Street Journal Rate or a fixed market rate. These loans may be secured by business assets other than real estate, such as business equipment and inventory and are backed by personal guarantees.
When making commercial business loans, we consider the financial statements of the borrower and guarantors, the borrower’s payment history of both corporate and personal debt, the debt service capabilities of the borrower and guarantors, the projected cash flows of the business, the viability of the industry in which the customer operates and the value of the collateral, if any.
Unlike residential mortgage loans, which generally are made on the basis of the borrower’s ability to repay from his or her employment or other income, and which are secured by residential real property, the value of which tends to be more easily ascertainable, commercial business loans have greater risk and typically are made on the basis of the borrower’s ability to repay from the cash flow of the borrower’s business. As a result, the availability of funds for the repayment of commercial business loans may depend substantially on the success of the business itself. Further, any collateral securing such loans may depreciate over time, may be difficult to appraise and may fluctuate in value. We have generally required these loans to have debt service coverage of at least 1.20, and we generally require personal guarantees. See “Risk Factors - Our Emphasis on Commercial Real Estate and Commercial Business Loans May Continue to Expose us to Increased Lending Risks.”
Construction Loans. Construction loans totaled $1.8 million, or 0.2%, of our total loan portfolio at December 31, 2012 compared to $12.4 million, or 1.7%, of the total loan portfolio at December 31, 2011.
We offer interim construction financing secured by residential property for the purpose of constructing a primary or secondary residence. Our construction program offers construction/permanent loans. The short-term loans require monthly interest only payments based on the amount of funds disbursed. The construction/permanent loans require interest-only payments during the construction phase, and convert to a fully amortized fixed rate loan at the end of the interest-only period. Under both programs, construction must be completed within 12 months of the initial disbursement. The maximum loan-to-value ratio for residential construction will be 80% of the appraised value. For commercial construction loans, the term is a maximum of 24 months. While providing us with a comparable, and in some cases, higher yield than conventional mortgage loans, construction loans may involve a higher level of risk. With a commercial loan, for example, if a project is not completed and the borrower defaults, we may have to hire another contractor to complete the project at a higher cost. Also, a project may be completed, but may not be saleable, resulting in the borrower defaulting and Cape Bank taking title to the property.
Home Equity Loans and Lines of Credit. Home equity loans and lines of credit totaled $45.3 million, or 6.2%, of the total loan portfolio at December 31, 2012 compared to $47.2 million, or 6.5%, of the total loan portfolio at December 31, 2011.
We generally offer home equity loans and lines of credit with a maximum combined loan-to-value ratio of 80%. Home equity loans have fixed rates of interest and are originated with terms of up to 15 to 20 years. Home equity lines of credit have adjustable interest rates and are based upon the prime interest rate as published in The Wall Street Journal, plus a margin, with a floor of 3.75% on lines up to $500,000 on primary residences and second homes. The floor for investment property lines is 3.75% up to $250,000 and 5.5% on lines over $250,000. We hold a first or second mortgage position on the homes that secure our home equity loans and lines of credit.
Other Consumer Loans. Other consumer loans totaled $1.3 million, or 0.2%, of our total loan portfolio at December 31, 2012 compared to $1.0 million, or 0.1%, of the total loan portfolio at December 31, 2011.
We offer consumer loans secured by certificates of deposit held at Cape Bank, the pricing of which is based upon the rate of the certificate of deposit. We will offer such loans up to 90% of the principal balance of the certificate of deposit. For more information on our loan commitments, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Management of Market Risk.”
The procedures for underwriting consumer loans include an assessment of the applicant’s payment history on other debts and ability to meet existing obligations and payments on the proposed loan. Although the applicant’s creditworthiness is a primary consideration, the underwriting process also includes a comparison of the value of the collateral, if any, to the proposed loan amount.
Loan Originations, Sales, Purchases and Participations. Loan originations come from a number of sources, including direct calling on commercial prospects, existing customers, advertising, referrals from customers and walk-in traffic. From time to time, we will participate in loans originated by other banks to supplement our loan portfolio. During 2012, we participated in a loan originated by another bank and at December 31, 2012, the balance totaled $900,000. There were no such loans in our portfolio at December 31, 2011. We are permitted to review all of the documentation relating to any loan in which we participate. However, in a purchased participation loan, we do not service the loan and thus are subject to the policies and practices of the lead lender with regard to monitoring delinquencies, pursuing collections and instituting foreclosure proceedings. Cape Bank services loans for other financial institutions, which generally consists of collecting loan payments, disbursing payments to investors and, where necessary, instituting foreclosure proceedings. A loan servicing asset of approximately $26,000 and $5,000 as of December 31, 2012 and December 31, 2011, respectively, was recorded relating to the servicing of loans for others, and is included in other assets on our balance sheet.
Loan Underwriting. The Company adheres to underwriting guidelines that provide for continuity and completeness of process and are summarized as follows: a comprehensive and thorough review of (i) the financial information of applicant(s) and any guarantor(s), including current and historical balance sheet and income data, (at least two (2) years), balance sheet and income projections, when appropriate, and credit checks; (ii) collateral valuation, including appraisals (based on regulatory requirements) on real estate-based loans; (iii) loan terms, pricing and covenants appropriate to risk; (iv) a review of the character and integrity of the borrower, including interviews of the proposed borrower if warranted, and (v) analysis of relevant industry data. We also review the purpose of a proposed loan which assists the Company in determining the terms of such loan, i.e. short-term notes should not be utilized to finance long-term investments or capital expenditures.
The Company’s general practice is not to make new loans or additional loans to a borrower or related interest of a borrower who is past due in principal or interest more than 90 days. In limited circumstances, the Company would advance an existing borrower new money to facilitate the completion of a project, with expectations that the full amount of the new advance plus reduction of the delinquent outstanding principal and interest would occur within one year of granting the additional funds.
The Company assesses a borrower’s income or cash flow expectations, its collateral position and a borrower’s financial outlook when temporarily restructuring loan terms. Based on that assessment the Company would then determine its course of action. Generally, in a troubled situation, on a loan with a long-term maturity, the maturity date is more often shortened or left unchanged than it is extended. An exception to this would be when a loan either has matured or is near maturity, the maturity date would be extended, but not for more than twelve months. Because cash flow is often a problem for a struggling borrower, the interest rate is usually reduced for a period of time, typically twelve months. Occasionally, the Company splits the loan into two separate notes: one note structured on terms that are supported by the borrower’s ability to repay and the other note structured on more lenient terms and/or possibly partially for fully written-down.
Correspondent Lending Relationships. Cape Bank has residential correspondent banking relationships with other financial institutions and mortgage banks, which enables us to sell conforming loans, FHA/VA and USDA loans that we originate on a servicing-released, non-recourse basis that we would normally not retain in our loan portfolio because of interest rate risk or because the loans do not conform to our standard underwriting guidelines. These correspondent relationships enable us to offer a full range of residential loan products and compete more effectively for residential loans within our market area. During the year ended December 31, 2012, Cape Bank sold approximately $49.4 million of loans to correspondents. The amount of loans sold varies according to market pricing and the portfolio needs of Cape Bank.
Loan Approval Procedures and Authority. Our lending activities follow written, non-discriminatory, underwriting standards and loan origination procedures recommended by management and reviewed and approved by our Board of Directors and management. The Board of Directors has granted loan approval authority to certain officers or groups of officers up to prescribed limits, based on the type of loan, whether the loan is secured or unsecured and the officer’s position and experience. Individuals have joint authority up to assigned levels. The Management Loan Committee approves loans for borrowing relationships from $1.5 million up to $5 million, the Directors Loan Committee approves loans for borrowing relationships up to $10 million and the Bank’s Board of Directors approves loans for borrowing relationships over $10 million. All loans extended to Regulation O defined parties are approved by the Bank’s Board of Directors.
Loans-to-One Borrower. The maximum amount that we may lend to one borrower and the borrower’s related entities is limited by regulation to generally 15% of our stated capital and reserves. At December 31, 2012, our regulatory limit on loans-to-one borrower was $17.1 million. At that date, our largest lending relationship was $10.6 million, consisting of 6 loans and secured by commercial real estate and residential real estate. At December 31, 2012 these loans were performing in accordance with their terms.
Loan Commitments. We issue commitments for fixed and adjustable rate mortgage loans conditioned upon the occurrence of certain events. Commitments to originate mortgage loans are legally binding agreements to lend to our customers. Generally, our loan commitments expire after 60 days. At December 31, 2012, the reserve for unfunded commitments totaled $89,000.
Non-Performing and Problem Assets
When a loan is 15 days past due, we send the borrower a late charge notice. If the loan delinquency is not corrected, other collection procedures are implemented, including telephone calls and collection letters. We attempt personal, direct contact with the borrower to determine the reason for the delinquency, to ensure that the borrower correctly understands the terms of the loan and to emphasize the importance of making payments on or before the due date. If necessary, subsequent late charges and delinquency notices are issued and the account will be monitored on a regular basis thereafter. By the 90th day of delinquency, we send the borrower a demand for payment. If the account is not made current by the 120th day of delinquency, we may refer the loan to legal counsel. Any of our loan officers can shorten these time frames in consultation with Executive Management.
A commercial loan is classified as non-accrual when the loan is 90 days or more delinquent, or when in the opinion of management, the collectability of such loan is in doubt. Commercial loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.
Consumer and residential loans are classified as non-accrual when the loan is 90 days or more delinquent with a loan to value ratio greater than 60 percent. Consumer and residential loans are returned to accrual status when their delinquency becomes less than 90 days and/or the loan to value ratio is less than 60 percent.
All interest accrued, but not received, for loans placed on non-accrual, is reversed against interest income. Interest received on such loans is accounted for as a reduction of the principal balance until qualifying for return to accrual. Payments are generally applied to reduce the principal balance but, in certain situations, the application of payments may vary.
In analyzing whether to restructure a loan that would be designated as a troubled debt restructuring (“TDR”), the Bank comes to an agreement with the borrower that would restructure the repayment terms. The Bank analyzes the borrower’s cash flow to determine what level of debt service the cash flow will support, and the collateral to determine how much equity is in the collateral. If the cash flow supports repaying part of the loan, but not all of it, typically the Bank will write-down the loan to the value supported by the cash flow and the loan will be restructured as a TDR in accordance with the agreed upon terms. Our management presents reports to the Board of Directors on a monthly basis on all loans Risk Rated 6 or higher.
Year-end 2012 non-performing loans showed a significant decrease as a result of charge-offs totaling $7.5 million and $10.5 million of loans being transferred to OREO. At December 31, 2012, non-performing loans totaled $19.4 million, or 2.67%, of total loans compared to $27.4 million, or 3.77%, of total loans at December 31, 2011.
Non-Performing Assets. The table below sets forth the amounts and categories of our non-performing assets at the dates indicated.
(1) includes $3.1 million in commercial mortgage TDRs, $363,000 in residential mortgage TDRs and $45,000 in commercial business TDRs.
For the years ended December 31, 2012, 2011 and 2010, gross interest income that would have been recorded had our non-accruing loans been current in accordance with their original terms was $1.3 million, $2.1 million and $1.9 million, respectively. Income recorded for such loans was $311,000, $649,000 and $383,000 for the years ended December 31, 2012, 2011 and 2010, respectively.
The following table sets forth certain information with respect to our loan portfolio delinquencies at the dates indicated.
Classification of Loans. Our policies provide for the classification of commercial loans based on an analysis of the credit conditions of the borrower and the value of the collateral when appropriate. There is no specific credit metrics used to determine the risk rating.
Risk Rating 1-5-Acceptable credit quality ranging from High Pass (cash or near cash as collateral) to Management Attention/Pass (acceptable risk) with some deficiency in one or more of the following areas: management experience, debt service coverage levels, balance sheet leverage, earnings trends, the industry of the borrower and annual receipt of current borrower financial information.
Risk Rating 6 - Special Mention reflects loans that management believes warrant special consideration and may be loans that are delinquent or current in their payments. These loans have potential weakness which increases their risk to the bank and have shown some signs of weakness but have fallen short of being a Substandard loan.
Management believes that the Substandard category is best considered in four discrete classes: RR 7.0 “performing substandard loans”; RR 7.5, RR 7.8, and RR 7.9.
Risk Rating 7.0-The class is mostly populated by customers that have a history of repayment (less than 2 delinquencies in the past year) but exhibit a well defined weakness.
Risk Rating 7.5-These are loans that share many of the characteristics of the RR 7.0 loans as they relate to cash flow and/or collateral, but have the further negative of chronic delinquencies. These loans have not yet declined in quality to require a FASB ASC Topic No. 310 Receivables analysis, but nonetheless this class has a greater likelihood of migration to a more negative risk rating.
Risk Rating 7.8 - These loans are impaired loans, are current and accruing, and in some cases are TDRs. They have had a FASB ASC Topic No. 310 Receivables analysis completed.
Risk Rating 7.9-These loans have undergone a FASB ASC Topic No. 310 Receivables analysis. For those that have a FASB ASC Topic No. 310 Receivables analysis, no general reserve is allowed. More often than not, those loans in this class with specific reserves have had the reserve placed by Management pending information to complete a FASB ASC Topic No. 310 Receivables analysis. Upon completion of the FASB ASC Topic No. 310 Receivables analysis reserves are adjusted or charged-off.
Our classified assets total includes $19.4 million of non-performing loans at December 31, 2012.
Other Real Estate Owned (“OREO”). Real estate acquired as a result of foreclosure or by deed in lieu of foreclosure is classified as other real estate owned and is initially recorded at the lower of cost or estimated fair market value, less the estimated cost to sell, at the date of foreclosure, thereby establishing a new cost basis. If fair value declines subsequent to foreclosure, an OREO write-down is recorded through expense and the OREO balance is lowered to reflect the current fair value. Operating costs after acquisition are expensed. At December 31, 2012, the Company had $7.2 million in OREO compared to $8.4 million at December 31, 2011.
Allowance for Loan Losses
The allowance for loan losses is maintained at an amount management deems appropriate to cover probable incurred losses. In determining the level to be maintained, management considers the losses inherent in our loan portfolio and changes in the type and volume of loan activities, along with the general economic and real estate market conditions. A description of our methodology in establishing our allowance for loan losses is set forth in the section “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Critical Accounting Policies-Allowance for Loan Losses.” The allowance for loan losses as of December 31, 2012 was maintained at a level that represents management’s best estimate of losses inherent in the loan portfolio, and such losses were both probable and reasonably estimable. However, this analysis process is inherently subjective, as it requires us to make estimates that are susceptible to revisions as more information becomes available. Although we believe that we have established the allowance at levels to absorb probable and estimable losses, future additions may be necessary if economic or other conditions in the future differ from the current environment. The economic information located within the Market Area section of this report was considered by management and used as a factor in our analysis of determining the adequacy of our general allowance for loan losses.
In addition, as an integral part of their examination process, the Federal Deposit Insurance Corporation and the New Jersey Department of Banking and Insurance have authority to periodically review our allowance for loan losses. Such agencies may require that we recognize additions to the allowance based on their judgment of information available to them at the time of their examination. The following table sets forth activity in our allowance for loan losses for the periods indicated.
Allocation of Allowance for Loan Losses. The following table sets forth the allowance for loan losses allocated by loan category, the total loan balances by category, and the percent of loans in each category to total loans at the dates indicated. The allowance for loan losses allocated to each category is not necessarily indicative of future losses in any particular category and does not restrict the use of the allowance to absorb losses in other categories.
Investment Activities
We have authority to invest in various types of liquid assets, including U.S. Treasury obligations, securities of various U.S. Government sponsored enterprises, federal agencies and state and municipal governments, school districts and utility authorities, mortgage-backed securities and certificates of deposit of federally insured institutions. Within certain regulatory limits, we also may invest a portion of our assets in corporate securities (equity as well as debt) and mutual funds. As a member of the Federal Home Loan Bank of New York, we also are required to maintain an investment in Federal Home Loan Bank of New York stock.
At December 31, 2012, our investment portfolio, excluding Federal Home Loan Bank stock, totaled $170.9 million and consisted of mortgage-backed securities (including collateralized mortgage obligations), U.S. Government and agency securities (including securities issued by U.S. Government sponsored enterprises), municipal bonds, corporate bonds,, collateralized debt obligations, and equity securities. Our entire investment portfolio is classified as available-for-sale (“AFS”).
Our investment objectives are to provide and maintain liquidity, to establish an acceptable level of interest rate and credit risk, to provide an alternate source of low-risk investments when demand for loans is weak and to generate a favorable return on our investment. Our Board of Directors has the overall responsibility for the investment portfolio, including approval of our investment policy, which is reviewed and approved annually. The Investment Committee (a subcommittee of the Asset Liability Committee (“ALCO”)), meets on a monthly basis and is responsible for implementation of the investment policy and monitoring our investment performance. Our Board of Directors reviews the status of our investment portfolio on a monthly basis.
Municipal Securities. We invest in municipal bonds issued by counties, cities, school districts and utility authorities; primarily general obligation and some revenue bonds. Our policy allows us to purchase such securities rated “A-” or higher. No more than 20% of our investment portfolio can be invested in obligations of local or municipal entities without approval of our Board of Directors. As of December 31, 2012, our municipal securities portfolio consisted of issuers within the State of New Jersey in the amount of $2.2 million and issuers within other states consisted of $18.6 million.
U.S. Government and Federal Agency Obligations. While U.S. Government and federal agency securities generally provide lower yields than other investments in our securities investment portfolio, we maintain these investments, to the extent appropriate, for liquidity purposes, as collateral for borrowings and as an interest rate risk hedge in the event of significant mortgage loan prepayments.
Mortgage-Backed Securities. We invest in mortgage-backed securities insured or guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae. Investment in mortgage-backed securities enables us to achieve positive interest rate spreads with minimal administrative expense, and lower our credit risk as a result of the guarantees provided by Fannie Mae, Freddie Mac and Ginnie Mae.
Mortgage-backed securities are created by pooling mortgages and issuing a security with an interest rate that is less than the interest rate on the underlying mortgages. Mortgage-backed securities typically represent a participation interest in a pool of single family or multi-family mortgages, although we invest primarily in mortgage-backed securities backed by one-to-four family mortgages. The issuers of such securities pool and resell the participation interests in the form of securities to investors such as Cape Bank. Some securities pools are guaranteed as to payment of principal and interest to investors. Mortgage-backed securities generally yield less than the loans that underlie such securities because of the cost of payment guarantees and credit enhancements. In addition, mortgage-backed securities may be used to collateralize our specific liabilities and obligations. Finally, mortgage-backed securities are assigned lower risk weightings for purposes of calculating our risk-based capital level.
Investments in mortgage-backed securities involve a risk that actual payments will be greater or less than the prepayment rate estimated at the time of purchase, which may require adjustments to the amortization of any premium or acceleration of any discount relating to such interests, thereby affecting the net yield on our securities. We periodically review current prepayment speeds to determine whether prepayment estimates require modification that could cause amortization or accretion adjustments. Aside from this traditional risk, the current economic environment and resulting decline in real estate values has created additional risks. Mortgage backed securities may have individual loans in which the outstanding balance due is greater than the current value of the home. This could result in the borrower defaulting.
Collateralized Mortgage Obligations. Collateralized Mortgage Obligations (“CMOs”) are debt securities issued by a special-purpose entity that aggregates pools of mortgages and mortgage-backed securities and creates different classes of securities with varying maturities and amortization schedules, as well as a residual interest, with each class possessing different risk characteristics. The cash flows from the underlying collateral are generally divided into “tranches” or classes that have descending priorities with respect to the distribution of principal and interest cash flows, while cash flows on pass-through mortgage-backed securities are distributed pro rata to all security holders. With the exception of one private label (non-agency) security which totaled $7,000 at December 31, 2012, all of the CMOs are backed by U.S. Government agencies or Government sponsored enterprises. The non-agency CMO was performing according to its contractual terms at December 31, 2012 and was called in January 2013. See the Securities Impairment section of Item 7, Management’s Discussion and Analysis of Financial Condition and Result of Operations for information related to the risks associated with non-agency CMOs.
Collateralized Debt Obligations. We own 22 collateralized debt obligation securities (“CDOs”) that are backed by trust preferred securities, 14 of which have been principally issued by bank holding companies and 8 of which have been principally issued by insurance companies. All of the CDO securities have below investment grade credit ratings. During 2012, we recorded an $8,000 charge to earnings for the credit-related portion of other-than-temporary impairment (“OTTI”). Given the current illiquidity in the market for these securities, determining their estimated fair value requires substantial judgment and estimation of factors that are not currently observable. Because of changes in the creditworthiness of the underlying financial institutions, market conditions, and other factors, it is possible that, in future reporting periods, we could deem more of our CDOs to be OTTI. Such a determination would require us to write down their value and incur a non-cash OTTI charge. See Note 3-Investment Securities of the Notes to Consolidated Financial Statements for more information related to our CDO portfolio.
Investment Securities Portfolio. The following tables set forth the composition of our investment securities portfolio.
Portfolio Maturities and Yields. The composition and maturities of the investment securities portfolio at December 31, 2012 are summarized in the following table. Maturities are based on the final contractual payment dates, and do not reflect the impact of prepayments or early redemptions that may occur. State and municipal securities yields have not been adjusted to a tax-equivalent basis, which as of December 31, 2012 was 2.76%.
Deposit Activities and Other Sources of Funds
General. Deposits, borrowings and loan repayments are the major sources of our funds for lending and other investment purposes. Scheduled loan repayments are a relatively stable source of funds, while deposit inflows and outflows and loan prepayments are significantly influenced by general interest rates and money market conditions.
Deposit Accounts. We obtain deposits within our market area primarily by offering a broad selection of deposit accounts, including non-interest-bearing demand deposits (such as checking accounts), interest-bearing demand accounts (such as NOW and money market accounts), savings accounts and certificates of deposit. Included in interest-bearing demand deposits at December 31, 2012 were balances from a variety of local municipal relationships totaling $79.4 million, or 10.1%, of total deposits. At December 31, 2012, we had $19.4 million of brokered deposits, or 2.5%, of our total deposits. Included in the brokered deposits were $9.2 million of reciprocal certificates of deposits offered under the Certificate of Deposit Account Registry Service® (“CDARS”), a program in which Cape Bank participates. Under CDARS, participating banks are able to match customer’s deposits that would otherwise exceed the limits for FDIC insurance with certificates of deposits offered at other participating banks and thereby provide FDIC insurance to these excess deposits.
We also offer a variety of deposit accounts designed for the businesses operating in our market area. Our business banking deposit products include a commercial checking account, a commercial money market account and a checking account specifically designed for small businesses. We offer bill paying and cash management services through our online banking system. Additionally we offer commercial customers our remote deposit capture product.
Deposit account terms vary according to the minimum balance required, the time periods the funds must remain on deposit and the interest rate, among other factors. In determining the terms of our deposit accounts, we consider the interest rates offered by our competition, the interest rates available on borrowings, rates on brokered deposits, our liquidity needs, and customer preferences. We generally review our deposit mix and deposit pricing weekly. Our deposit pricing strategy generally has been to offer competitive rates on all types of deposit products, and to periodically offer special rates in order to attract deposits of a specific type or term.
The following table sets forth the distribution of our average total deposit accounts, by account type, for the periods indicated.
The following table sets forth certificates of deposit classified by interest rate as of the dates indicated.
The following table sets forth the amount and maturities of certificates of deposit at December 31, 2012.
As of December 31, 2012, the aggregate amount of outstanding certificates of deposit in amounts greater than or equal to $100,000 was approximately $108.9 million. The following table sets forth the maturity of these certificates as of December 31, 2012.
Borrowings. We have the ability to borrow from the Federal Home Loan Bank of New York to supplement our investable funds. The Federal Home Loan Bank functions as a central credit bank providing credit for member financial institutions. As a member, we are required to own capital stock in the Federal Home Loan Bank and are authorized to apply for advances on the security of such stock and certain of our mortgage loans and other assets (principally securities which are obligations of, or guaranteed by, the United States), provided certain standards related to creditworthiness have been met. Advances are made under several different programs, each having its own interest rate and range of maturities. Depending on the program, limitations on the amount of advances are based either on a fixed percentage of an institution’s net worth or on the Federal Home Loan Bank’s assessment of the institution’s creditworthiness.
Our borrowings consist of advances from the Federal Home Loan Bank of New York totaling $88.0 million at December 31, 2012. Additionally, we had $9.9 million in repurchase agreements through another party at December 31, 2012. At December 31, 2012, we had access to additional Federal Home Loan Bank advances of up to $148.2 million based on our unused qualifying collateral available to support such advances. Access to these funds in the future assumes that the Federal Home Loan Bank’s evaluation of our creditworthiness will not change. In addition, we have access to funding of $10.0 million through the discount window at the Federal Reserve Bank of Philadelphia based on qualifying collateral that has been pledged to support such borrowings. The following table sets forth information concerning balances and interest rates on all of our borrowings at the dates and for the period indicated.
Personnel
As of December 31, 2012, we had 173 full-time employees and 39 part-time employees, none of whom is represented by a collective bargaining unit. We believe we have a good relationship with our employees.
SUPERVISION AND REGULATION
General
Federal law allows a state savings bank that qualifies as a “qualified thrift lender” (discussed below), such as Cape Bank, to elect to be treated as a savings association for purposes of the savings and loan holding company provisions of the Home Owners’ Loan Act, as amended (“HOLA”). Such an election results in the Company being regulated as a savings and loan holding company rather than as bank holding company, by the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”). At the time of its mutual to stock conversion, Cape Bank elected to be treated as a savings association under the applicable provisions of the HOLA. Accordingly, Cape Bancorp is a savings and loan holding company and is required to file certain reports with, is subject to examination by, and otherwise must comply with the rules and regulations of, the Federal Reserve Board. Cape Bancorp is also subject to the rules and regulations of the Securities and Exchange Commission (the “SEC”) under the federal securities laws.
Cape Bank is a New Jersey-chartered savings bank, and its deposit accounts are insured up to applicable limits by the FDIC. Cape Bank is subject to extensive regulation, examination and supervision by the Commissioner of the New Jersey Department of Banking and Insurance (the “Commissioner”) as its chartering authority, and by the FDIC, as the Bank’s deposit insurer and primary federal regulator. Cape Bank must file reports with the Commissioner and the FDIC concerning its activities and financial condition, and it must obtain regulatory approval prior to entering into certain transactions, such as mergers with, or acquisitions of, other depository institutions and opening or acquiring branch offices. The Commissioner and the FDIC conduct periodic examinations to assess Cape Bank’s compliance with various regulatory requirements. This regulation and supervision establishes a comprehensive framework of activities in which a savings bank may engage and is intended primarily for the protection of the deposit insurance fund and depositors. The regulatory structure also gives the regulatory authorities extensive discretion in connection with their supervisory and enforcement activities and examination policies, including policies with respect to the classification of assets and the establishment of adequate loan loss reserves for regulatory purposes.
Any change in these laws or regulations, whether by the New Jersey Department of Banking and Insurance (the “Department”), the FDIC, the Federal Reserve Board, the SEC or the U.S. Congress, could have a material adverse impact on Cape Bancorp, Cape Bank and our operations.
The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”) made extensive changes in the regulation of depository institutions. The Dodd-Frank Act eliminated the Office of Thrift Supervision (the “OTS”). Responsibility for the supervision and regulation of federal savings banks was transferred to the Office of the Comptroller of the Currency, the agency primarily responsible for the regulation and supervision of national banks. The transfer of regulatory functions took place on July 21, 2011. At the same time, responsibility for the regulation and supervision of savings and loan holding companies, such as Cape Bancorp, was transferred from the OTS to the Federal Reserve Board, which also supervises bank holding companies. Additionally, the Dodd-Frank Act created a new Consumer Financial Protection Bureau (the “CFPB”) as an independent bureau of the Federal Reserve Board. The CFPB has assumed responsibility for the implementation of the federal financial consumer protection and fair lending laws and regulations, a function previously assigned to prudential regulators, and will have authority to impose new requirements. However, institutions of less than $10 billion in assets, such as Cape Bank, will continue to be examined for compliance with consumer protection and fair lending laws and regulations by, and be subject to the primary enforcement authority of, their prudential regulator rather than the CFPB.
In addition to eliminating the OTS and creating the CFPB, the Dodd-Frank Act, among other things, changed the way that institutions are assessed for deposit insurance, mandated the imposition of consolidated capital requirements on savings and loan holding companies, required originators of securitized loans to retain a percentage of the risk for the transferred loans, provided for regulatory rate-setting for certain debit card interchange fees, repealed restrictions on the payment of interest on commercial demand deposits and established a number of reforms related to mortgage originations. Many of the provisions of the Dodd-Frank Act are subject to delayed effective dates and/or require the issuance of implementing regulations. Their impact on operations cannot yet be fully assessed. However, there is significant possibility that the Dodd-Frank Act will, at a minimum, result in increased regulatory burden, compliance costs and interest expense for Cape Bank and Cape Bancorp.
Certain of the regulatory requirements that are or will be applicable to Cape Bank and Cape Bancorp are described below. This description of statutes and regulations is not intended to be a complete explanation of such statutes and regulations and their effects on Cape Bank and Cape Bancorp and is qualified in its entirety by reference to the actual statutes and regulations.
New Jersey Banking Regulation
Activities Powers. Cape Bank derives its lending, investment and other powers primarily from the applicable provisions of the New Jersey Banking Act and its related regulations. Under these laws and regulations, New Jersey savings banks, including Cape Bank, generally may invest in: real estate mortgages; consumer and commercial loans; specific types of debt securities, including certain corporate debt securities and obligations of federal, state and local governments and agencies; certain types of corporate equity securities and certain other assets.
A savings bank may also invest pursuant to a “leeway” power that permits investments not otherwise permitted by the New Jersey Banking Act. “Leeway” investments must comply with a number of limitations on the individual and aggregate amounts of “leeway” investments. A savings bank may also exercise trust powers upon approval of the Department. New Jersey savings banks may exercise those powers, rights, benefits or privileges authorized for national banks or out-of-state banks or for federal or out-of-state savings banks or savings associations, provided that prior approval by the Department is required before exercising any such power, right, benefit or privilege. The exercise of these lending, investment and activity powers is further limited by federal law and the related regulations. Cape Bank does not have any investments due to provisions provided under leeway powers. See “-Federal Banking Regulation-Activity Restrictions on State-Chartered Banks” below.
Loan-to-One Borrower Limitations. With certain specified exceptions, a New Jersey chartered savings bank may not make loans or extend credit to a single borrower and to entities related to the borrower in an aggregate amount that would exceed 15% of the bank’s capital funds. A savings bank may lend an additional 10% of the bank’s capital funds if secured by collateral meeting the requirements of the New Jersey Banking Act. Cape Bank currently complies with applicable loans-to-one borrower limitations.
Dividends. Under the New Jersey Banking Act, a stock savings bank may declare and pay a dividend on its capital stock only to the extent that the payment of the dividend would not impair the capital stock of the savings bank. In addition, a stock savings bank may not pay a dividend unless the savings bank would, after the payment of the dividend, have a surplus of not less than 50% of its capital stock, or the payment of the dividend would not reduce the surplus. Federal law may also limit the amount of dividends that may be paid by Cape Bank. See “-Federal Banking Regulation-Prompt Corrective Action” below.
Minimum Capital Requirements. Regulations of the Department impose on New Jersey chartered depository institutions, including Cape Bank, minimum capital requirements similar to those imposed by the FDIC on insured state banks. See “-Federal Banking Regulation-Capital Requirements.”
Examination and Enforcement. The Department may examine Cape Bank whenever it deems an examination advisable. The Department examines Cape Bank at least once every two years. The Department may order any savings bank to discontinue any violation of law or unsafe or unsound business practice and may direct any director, officer, attorney or employee of a savings bank engaged in an objectionable activity, after the Department has ordered the activity to be terminated, to show cause at a hearing before the Commissioner of the Department why such person should not be removed. The Department may also appoint a receiver for a savings bank under certain conditions, including insolvency.
Federal Banking Regulation
Banks and their holding companies are subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations, involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators. Failure to meet capital requirements can initiate regulatory action. Management believes that as of December 31, 2012, the Company and Bank has met all capital adequacy requirements to which it is subject.
Capital Requirements. FDIC regulations require banks to maintain minimum levels of capital. The FDIC regulations define two tiers, or classes, of capital.
Tier 1 capital is comprised of the sum of:
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common stockholders’ equity, excluding the unrealized appreciation or depreciation, net of tax, from available-for-sale securities;
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non-cumulative perpetual preferred stock, including any related retained earnings; and
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minority interests in consolidated subsidiaries minus all intangible assets, other than qualifying servicing rights and any net unrealized loss on marketable equity securities.
The components of Tier 2 capital currently include:
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cumulative perpetual preferred stock;
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certain perpetual preferred stock for which the dividend rate may be reset periodically;
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hybrid capital instruments, including mandatory convertible securities;
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term subordinated debt;
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intermediate term preferred stock;
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allowance for loan losses; and
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up to 45% of pre-tax net unrealized holding gains on available-for-sale equity securities with readily determinable fair market values.
The allowance for loan losses includible in Tier 2 capital is limited to a maximum of 1.25% of risk-weighted assets (as discussed below). Overall, the amount of Tier 2 capital that may be included in total capital cannot exceed 100% of Tier 1 capital.
The FDIC regulations establish a minimum leverage capital requirement for banks in the strongest financial and managerial condition, with a rating of 1 (the highest examination rating of the FDIC for banks) under the Uniform Financial Institutions Rating System, of not less than 3% of Tier 1 capital to total assets. For all other banks, the minimum leverage capital requirement is 4%, unless a higher leverage capital ratio is warranted by the particular circumstances or risk profile of the depository institution.
The FDIC regulations also require that banks meet a risk-based capital standard. The risk-based capital standard requires the maintenance of a ratio of total capital, which is defined as the sum of Tier 1 capital and Tier 2 capital, to risk-weighted assets of at least 8% and a ratio of Tier 1 capital to risk-weighted assets of at least 4%. In determining the amount of risk-weighted assets, all assets, plus certain off balance sheet items, are multiplied by a risk-weight of 0% to 100%, based on the risks the FDIC believes are inherent in the type of asset or item.
The federal banking agencies, including the FDIC, have also adopted regulations to require an assessment of an institution’s exposure to declines in the economic value of a bank’s capital due to changes in interest rates when assessing the bank’s capital adequacy. Under such a risk assessment, examiners evaluate a bank’s capital for interest rate risk on a case-by-case basis, with consideration of both quantitative and qualitative factors. According to the agencies, applicable considerations include:
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the quality of the bank’s interest rate risk management process;
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the overall financial condition of the bank; and
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the level of other risks at the bank for which capital is needed. Institutions with significant interest rate risk may be required to hold additional capital. The agencies also issued a joint policy statement providing guidance on interest rate risk management, including a discussion of the critical factors affecting the agencies’ evaluation of interest rate risk in connection with capital adequacy.
As of December 31, 2012, Cape Bank complied with applicable FDIC minimum capital requirements.
On June 6, 2012, the FDIC and the other federal bank regulatory agencies issued a series of proposed rules that would revise their leverage and risk-based capital requirements and the method for calculating risk-weighted assets to make them consistent with agreements that were reached by the Basel Committee on Banking Supervision and certain provisions of the Dodd-Frank Act. The proposed rules would apply to all depository institutions, top-tier bank holding companies with total consolidated assets of $500 million or more and top-tier savings and loan holding companies. Among other things, the proposed rules establish a new common equity Tier 1 minimum capital requirement (4.5% of risk-weighted assets) and a higher minimum Tier 1 capital to risk-based assets requirement (6% of risk-weighted assets) and assign higher risk weight (150%) to exposures that are more than 90 days past due or are on nonaccrual status and certain commercial real estate facilities that finance the acquisition, development or construction of real property. The proposed rules also require unrealized gains and losses on certain securities holdings to be included for purposes of calculating regulatory capital requirements. The proposal limits a banking organization’s capital distributions and certain discretionary bonus payments if the banking organization does not hold a “capital conservation buffer” consisting of a specified amount of common equity Tier 1 capital in addition to the amount necessary to meet its minimum risk-based capital requirements. The proposed rules indicated that the final rules would become effective on January 1, 2013, and the changes set forth in the final rules will be phased in from January 1, 2013 through January 1, 2019. However, the agencies have recently indicated that, due to the volume of public comments received, the final rule would be delayed past January 1, 2013.
Activity Restrictions on State-Chartered Banks. Federal law and FDIC regulations generally limit the activities and equity investments of state-chartered FDIC insured banks and their subsidiaries to those permissible for national banks and their subsidiaries, unless such activities and investments are specifically exempted by law or consented to by the FDIC.
Before engaging as principal in a new activity that is not permissible for a national bank or otherwise permissible under federal law or FDIC regulations, an insured bank must seek approval from the FDIC. The FDIC will not approve the activity unless the bank meets its minimum capital requirements and the FDIC determines that the activity does not present a significant risk to the FDIC deposit insurance fund. Certain activities of subsidiaries that are engaged in activities permitted for national banks only through a “financial subsidiary” are subject to additional restrictions. Equity investments by state banks are generally limited to those permissible for national banks but bank subsidiaries may seek FDIC approval to engage in a broader range of equity investments.
Federal law permits a state-chartered savings bank to engage, through financial subsidiaries, in any activity in which a national bank may engage through a financial subsidiary and on substantially the same terms and conditions. In general, the law permits a national bank that is well-capitalized and well-managed to conduct, through a financial subsidiary, any activity permitted for a financial holding company other than insurance underwriting, insurance investments, real estate investment or development or merchant banking. The total assets of all such financial subsidiaries may not exceed the lesser of 45% of the bank’s total assets or $50 million. The bank must have policies and procedures to assess the financial subsidiary’s risk and protect the bank from such risk and potential liability, must not consolidate the financial subsidiary’s assets with the bank’s and must exclude from its own assets and equity all equity investments, including retained earnings, in the financial subsidiary. Cape Bank is not currently engaging in such activities and has no plans to do so.
Federal Home Loan Bank System. Cape Bank is a member of the Federal Home Loan Bank System, which consists of 12 regional Federal Home Loan Banks. The Federal Home Loan Bank System provides a central credit facility primarily for member institutions. As a member of the Federal Home Loan Bank of New York, Cape Bank is required to acquire and hold shares of capital stock in the Federal Home Loan Bank in specified amounts. As of December 31, 2012, Cape Bank was in compliance with this requirement.
Enforcement. The FDIC has extensive enforcement authority over insured savings banks, including Cape Bank. This enforcement authority includes, among other things, the ability to assess civil money penalties, issue cease and desist orders and remove directors and officers. In general, these enforcement actions may be initiated in response to violations of laws and regulations and unsafe or unsound practices.
Prompt Corrective Action. The Federal Deposit Improvement Act established a system of prompt corrective action to resolve the problems of undercapitalized institutions. The FDIC, as well as the other federal banking regulators, adopted regulations governing the supervisory actions that may be taken against undercapitalized institutions. The regulations establish five categories, consisting of “well capitalized”, “adequately capitalized”, “undercapitalized”, “significantly undercapitalized” and “critically undercapitalized”. The FDIC’s regulations define the five capital categories as follows:
An institution will be treated as “well-capitalized” if:
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its ratio of total capital to risk-weighted assets is at least 10%;
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its ratio of Tier 1 capital to risk-weighted assets is at least 6%; and
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its ratio of Tier 1 capital to total assets is at least 5%, and it is not subject to any order or directive by the FDIC to meet a specific capital level.
An institution will be treated as “adequately capitalized” if:
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its ratio of total capital to risk-weighted assets is at least 8%;
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its ratio of Tier 1 capital to risk-weighted assets is at least 4%; and
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its ratio of Tier 1 capital to total assets is at least 4% (3% if the bank receives the highest rating under the Uniform Financial Institutions Rating System) and it is not a well-capitalized institution.
An institution will be treated as “undercapitalized” if:
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its ratio of total capital to risk-based capital is less than 8%;
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its ratio of Tier 1 capital to risk-weighted assets is less than 4%; and
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its ratio of Tier 1 capital to total assets is less than 4% (or less than 3% if the institution receives the highest rating under the Uniform Financial Institutions Rating System).
An institution will be treated as “significantly undercapitalized” if:
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its ratio of total capital to risk-weighted assets is less than 6%;
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its ratio of Tier 1 capital to risk-weighted assets is less than 3%; or
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its leverage ratio is less than 3%.
An institution that has a tangible capital to total assets ratio equal to or less than 2% would be deemed to be “critically undercapitalized.”
“Undercapitalized” institutions are subject to various restrictions, such as on dividends and growth. They must also file an acceptable capital restorations plan that must be guaranteed by any controlling holding company in an amount up to the lesser of 5% of the institution’s assets or the amount of capital needed to achieve compliance with capital standards. Various other supervisory restrictions may apply. The FDIC is required, with some exceptions, to appoint a receiver or conservator for an insured state bank if that bank is “critically undercapitalized.” For this purpose, “critically undercapitalized” means having a ratio of tangible capital to total assets of less than 2%. The FDIC may also appoint a conservator or receiver for a state bank on the basis of the institution’s financial condition or upon the occurrence of certain events, including:
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insolvency, or when the assets of the bank are less than its liabilities;
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substantial dissipation of assets or earnings through violations of law or unsafe or unsound practices;
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existence of an unsafe or unsound condition to transact business;
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likelihood that the bank will be unable to meet the demands of its depositors or to pay its obligations in the normal course of business; or
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insufficient capital, or the incurring or likely incurring of losses that will deplete substantially all of the institution’s capital with no reasonable prospect of replenishment of capital without federal assistance.
Cape Bank is classified as “well-capitalized” under the Prompt Corrective Action rules.
The recently proposed rules that would increase regulatory capital requirements would adjust the prompt corrective action categories accordingly.
Insurance of Deposit Accounts. Cape Bank is a member of the Deposit Insurance Fund, which is administered by the FDIC. Deposit accounts in Cape Bank are insured up to a maximum of $250,000 for each separately insured depositor. In addition, pursuant to the Dodd-Frank Act, certain non-interest-bearing transaction accounts were fully insured, regardless of the dollar amount, until December 31, 2012.
The FDIC imposes an assessment for deposit insurance on all insured depository institutions. Under the FDIC’s risk-based assessment system, insured institutions are assigned to risk categories based on supervisory evaluations, regulatory capital levels and certain other factors. An institution’s assessment rate depends upon the category to which it is assigned and certain adjustments specified by FDIC regulations, with less risky institutions paying lower rates. Assessment rates (inclusive of possible adjustments) currently range from 21/2 to 45 basis points of each institution’s total assets less tangible capital. The FDIC may increase or decrease the scale uniformly, except that no adjustment can deviate more than two basis points from the base scale without notice and comment rulemaking. The FDIC’s current system represents a change, required by the Dodd-Frank Act, from its prior practice of basing the assessment on an institution’s volume of deposits.
On May 22, 2009, the FDIC issued a final rule that imposed a special five basis point assessment on each FDIC-insured depository institution’s assets minus its Tier 1 capital, as of June 30, 2009, which was collected on September 30, 2009. The special assessment was capped at 10 basis points of an institution’s domestic deposits.
Subsequently the FDIC adopted a rule pursuant to which all insured depository institutions were required to prepay their estimated assessments for the fourth quarter of 2009, and for all of 2010, 2011 and 2012. That pre-payment, which was due on December 30, 2009, amounted to $4.7 million for the Bank. The amount of prepayment was determined based on certain assumptions, including an annual 5% growth rate in the assessment base through the end of 2012. The pre-payment was recorded as a prepaid expense asset at December 31. 2009 and has been amortized to expense over three years.
The Dodd-Frank Act increased the minimum target Deposit Insurance Fund ratio from 1.15% of estimated insured deposits to 1.35% of estimated insured deposits. The FDIC must seek to achieve the 1.35% ratio by September 30, 2020. Insured institutions with assets of $10 billion or more are supposed to fund the increase. The Dodd-Frank Act eliminated the 1.5% maximum fund ratio, instead leaving it to the discretion of the FDIC. The FDIC has exercised that discretion by establishing a long-range fund ratio of 2.00%.
The FDIC has authority to increase insurance assessments. A significant increase in insurance premiums would likely have an adverse effect on the operating expenses and results of operations of the Bank. Management cannot predict what insurance assessment rates will be in the future.
Insurance of deposits may be terminated by the FDIC upon a finding that an institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC. We do not currently know of any practice, condition or violation that might lead to termination of our deposit insurance.
In addition to the FDIC assessments, the Financing Corporation (“FICO”) is authorized to impose and collect, with the approval of the FDIC, assessments for anticipated payments, issuance costs and custodial fees on bonds issued by the FICO in the 1980s to recapitalize the former Federal Savings and Loan Insurance Corporation. The bonds issued by the FICO are due to mature in 2017 through 2019. For the quarter ended December 31, 2012, the annualized FICO assessment was equal to 0.64 basis points of an institution’s total assets less tangible equity.
Transactions with Affiliates of Cape Bank. Transactions between an insured bank, such as Cape Bank, and any of its affiliates is governed by Sections 23A and 23B of the Federal Reserve Act and implementing regulations. An affiliate of a bank is any company or entity that controls, is controlled by or is under common control with the bank. For example, Cape Bancorp is an affiliate of Cape Bank. Generally, a subsidiary of a bank that is not also a depository institution or financial subsidiary is not treated as an affiliate of the bank for purposes of Sections 23A and 23B.
Section 23A:
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limits the extent to which the Bank or its subsidiaries may engage in “covered transactions” with any one affiliate to 10% of such bank’s capital stock and surplus, and limits all such transactions with all affiliates to an amount equal to 20% of such capital stock and surplus; and
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requires that all such transactions be on terms that are consistent with safe and sound banking practices.
The term “covered transaction” includes the making of loans, purchase of assets, issuance of guarantees and other similar types of transactions. Further, most loans by a Bank to any of its affiliates must be secured by collateral ranging from 100 to 130 percent of the loan amount, depending upon the type of collateral. In addition, transactions with Bank affiliates, including covered transactions must be on terms that are substantially the same, or at least as favorable to the Bank, as those that would be provided to a non-affiliate.
Prohibitions Against Tying Arrangements. Banks are prohibited, subject to some exceptions, from extending credit to or offering any other service, or fixing or varying the consideration for such extension of credit or service, on the condition that the customer obtain some additional service from the bank or its affiliates or not obtain services of a competitor of the institution.
Community Reinvestment Act and Fair Lending Laws. All FDIC insured banks have a responsibility under the Community Reinvestment Act and related regulations to help meet the credit needs of their communities, including low and moderate income neighborhoods. In connection with its examination of a state chartered savings bank, the FDIC is required to assess the bank’s record of compliance with the Community Reinvestment Act. In addition, the Equal Credit Opportunity Act and the Fair Housing Act prohibit lenders from discriminating in their lending practices on the basis of characteristics specified in those statutes. A savings bank’s failure to comply with the provisions of the Community Reinvestment Act could, at a minimum, result in denial of certain corporate applications such as branches or mergers, or in restrictions on its activities. The failure to comply with the Equal Credit Opportunity Act and the Fair Housing Act could result in enforcement actions by the FDIC, as well as other federal regulatory agencies and the Department of Justice. Cape Bank received a Community Reinvestment Act rating of “satisfactory” in its most recent federal examination.
Loans to Insiders. A bank’s loans to its executive officers, directors, any owner of 10% or more of its stock (each, an insider) and any of certain entities affiliated with any such person (an insider’s “related interest”) are subject to the conditions and limitations imposed by Sections 22(g) and 22(h) of the Federal Reserve Act and its implementing regulations. Under these restrictions, the aggregate amount of the loans to any insider and the insider’s related interests may not exceed the loans to one borrower limit applicable to national banks, which is comparable to the loans to one borrower limit applicable to Cape Bank. See “-New Jersey Banking Regulation-Loans to One Borrower Limitation”. Aggregate loans by a bank to all insiders and insiders’ related interests may not exceed the bank’s unimpaired capital and unimpaired surplus. With certain exceptions, loans to an executive officer, other than loans for the education of the officer’s children and certain loans secured by the officer’s primary residence, may not exceed $100,000. Federal regulation also requires that any proposed loan to an insider or an insider’s related interest be approved in advance by a majority of the board of directors of the bank, with any interested directors not participating in the voting, if such loan, when aggregated with any existing loans to that insider his or her related interests, would exceed either (i) $500,000 or (ii) the greater of $25,000 or 5% of the bank’s unimpaired capital and surplus. Generally, such loans must be made on substantially the same terms as, and follow credit underwriting procedures that are not less stringent than, those that are prevailing at the time for comparable transactions with non-insiders.
An exception is made for extensions of credit made pursuant to a benefit or compensation plan of a bank that is widely available to employees of the bank and that does not give any preference to insiders of the bank over other employees of the bank.
In addition, federal law prohibits extensions of credit to a bank’s insiders and their related interests by any other institution that has a correspondent banking relationship with the bank, unless such extension of credit is on substantially the same terms as those prevailing at the time for comparable transactions with other persons and does not involve more than the normal risk of repayment or present other unfavorable features.
New Jersey Regulation. Provisions of the New Jersey Banking Act impose conditions and limitations on the liabilities to a savings bank of its directors and executive officers and of corporations and partnerships controlled by such persons, that are comparable in many respects to the conditions and limitations imposed on the loans and extensions of credit to insiders and their related interests under federal law, as discussed above. The New Jersey Banking Act also provides that a savings bank that is in compliance with federal law is deemed to be in compliance with such provisions of the New Jersey Banking Act.
The USA PATRIOT Act
The USA PATRIOT Act of 2001 (the “PATRIOT Act”) gave the federal government new powers to address terrorist threats through enhanced domestic security measures, expanded surveillance powers, increased information sharing and broadened anti-money laundering requirements. The PATRIOT Act also required the federal banking agencies to take into consideration the effectiveness of controls designed to combat money laundering activities in determining whether to approve a merger or other acquisition application of a member institution. Accordingly, if we engage in a merger or other acquisition, our controls designed to combat money laundering would be considered as part of the application process. We have established policies, procedures and systems designed to comply with these regulations.
Sarbanes-Oxley Act of 2002
The Sarbanes-Oxley Act of 2002 addressed, among other issues, corporate governance, auditing and accounting, executive compensation, and enhanced and timely disclosure of corporate information. As directed by the Sarbanes-Oxley Act, our Chief Executive Officer and Chief Financial Officer are required to certify that our quarterly and annual reports do not contain any untrue statement of a material fact. The rules adopted by the Securities and Exchange Commission under the Sarbanes-Oxley Act have several requirements, including having these officers certify that: they are responsible for establishing, maintaining and regularly evaluating the effectiveness of our internal control over financial reporting; they have made certain disclosures to our auditors and the audit committee of the Board of Directors about our internal control over financial reporting; and they have included information in our quarterly and annual reports about their evaluation and whether there have been changes in our internal control over financial reporting or in other factors that could materially affect internal control over financial reporting. We have policies, procedures and systems designed to ensure compliance with these regulations.
Holding Company Regulation
General. Cape Bancorp is a unitary savings and loan holding company subject to Federal Reserve Board regulations, examinations, supervision, reporting requirements and regulations concerning activities. In addition, the Federal Reserve Board has enforcement authority over Cape Bancorp’s non-savings institution subsidiaries. Among other things, this authority permits the Federal Reserve Board to restrict or prohibit activities that are determined to be a serious risk to Cape Bank.
Pursuant to the Dodd-Frank Act regulatory restructuring, the Federal Reserve Board assumed the Office of Thrift Supervision’s authority over savings and loan holding companies on July 21, 2011.
As a unitary savings and loan holding company, Cape Bancorp is permitted to engage in those activities permissible for financial holding companies (if certain criteria are met) or for multiple savings and loan holding companies. A financial holding company may engage in activities that are financial in nature, including underwriting equity securities and insurance as well as activities that are incidental to financial activities or complementary to a financial activity. A multiple savings and loan holding company is generally limited to activities permissible for bank holding companies under Section 4(c)(8) of the Bank Holding Company Act and certain additional activities authorized by federal regulations, subject to the approval of the Federal Reserve Board.
Federal law requires subsidiary institutions of savings and loan holding companies, such as Cape Bank, to provide prior notice to the Federal Reserve Board of proposed dividends. In the event Cape Bank’s capital fell below its regulatory requirements or the FDIC notified it that it was in need of increased supervision, Cape Bank’s ability to make capital distributions could be restricted. In addition, the Federal Reserve Board could deny a proposed dividend by any institution, if the Federal Reserve Board determines that such dividend would be unsafe or unsound.
Unlike bank holding companies, savings and loan holding companies are not currently subject to specific regulatory capital requirements. The Dodd-Frank Act, however, requires the Federal Reserve Board to promulgate consolidated capital requirements for depository institution holding companies that are no less stringent, both quantitatively and in terms of components of capital, than those applicable to institutions themselves. That would exclude from tier 1 capital instruments such as trust preferred securities and cumulative preferred stock that are currently permitted for bank holding companies. The Dodd-Frank Act provides that instruments issued before May 19, 2010 will be grandfathered for companies of consolidated assets of $15 billion or less. The Dodd-Frank Act further provides that holding companies that were not regulated by the Federal Reserve Board as of May 19, 2010 (which would include most savings and loan holding companies) are subject to a five-year transition period from the July 21, 2010 date of enactment of the Dodd-Frank Act before such capital requirements apply. The proposed capital rules discussed earlier would implement the consolidated capital requirements for savings and loan holding companies. However, notwithstanding the Dodd-Frank statutory language, the proposed rules did not incorporate the referenced grandfather for instruments issued before May 19, 2010 or the transition period, and it is uncertain whether any final rule will do so.
The Dodd-Frank Act also extends the “source of strength” doctrine to savings and loan holding companies. The regulatory agencies must promulgate regulations implementing the “source of strength” policy that requires holding companies act as a source of strength to their subsidiary depository institutions by providing capital, liquidity and other support in times of financial stress.
The Federal Reserve Board has issued a policy statement regarding the payment of dividends and other capital distributions by bank holding companies that it has also made applicable to savings and loan holding companies. In general, the policy provides that dividends should be paid only out of current earnings and only if the prospective rate of earnings retention by the holding company appears consistent with the organization’s capital needs, asset quality and overall financial condition. Regulatory guidance provides for prior regulatory consultation concerning capital distributions in certain circumstances such as where the company’s net income for the past four quarters, net of dividends previously paid over that period, is insufficient to fully fund the dividend or the company’s overall rate of earnings retention is inconsistent with the company’s capital needs and overall financial condition. The ability of a holding company to pay dividends may be restricted if a subsidiary bank becomes undercapitalized. These regulatory policies could affect the ability of Cape Bancorp, Inc. to pay dividends, repurchase shares of common stock or otherwise engage in capital distributions.
Qualified Thrift Lender Test. In order for Cape Bancorp to be regulated as a savings and loan holding company, rather than as a bank holding company by the Federal Reserve Board, Cape Bank must qualify as a “qualified thrift lender” under regulations or satisfy the “domestic building and loan association” test under the Internal Revenue Code. Under the qualified thrift lender test, a savings institution is required to maintain at least 65% of its “portfolio assets” (total assets less: (i) specified liquid assets up to 20% of total assets; (ii) intangible assets, including goodwill; and (iii) the value of property used to conduct business) in certain “qualified thrift investments” (primarily residential mortgages and related investments, including certain mortgage-backed and related securities) in at least nine out of each 12 month period. At December 31, 2012, Cape Bank maintained 72.4% of its portfolio assets in qualified thrift investments. Cape Bank also met the Qualified Thrift Lender test in each of the prior four quarters.
Acquisitions and Control. Federal law prohibits a savings and loan holding company, directly or indirectly, or through one or more subsidiaries, from acquiring control of another savings institution or holding company thereof, without prior written approval of the Federal Reserve Board. It also prohibits the acquisition or retention of, with specified exceptions, more than 5% of the equity securities of any company engaged in activities that are not closely related to banking or financial in nature or acquiring or retaining control of an institution that is not federally insured. In evaluating applications by holding companies to acquire savings institutions, the Federal Reserve Board must consider factors such as the financial and managerial resources and future prospects of the savings institution involved, the effect of the acquisition on the risk to the insurance fund, the convenience and needs of the community, the effectiveness of each parties’ anti-money laundering program and competitive factors.
Under the Federal Change in Bank Control Act, a notice must be submitted to the Federal Reserve Board if any person (including a company), or group acting in concert, seeks to acquire “control” of a savings and loan holding company. An acquisition of “control” can occur upon the acquisition of 10% or more of the voting stock of a savings and loan holding company under certain circumstances, such as where a savings and loan holding company has registered securities under Section 12 of the Securities Exchange Act of 1934, which is the case with Cape Bancorp. Under the Change in Bank Control Act, the Federal Reserve Board has 60 days from the filing of a complete notice to act, taking into consideration certain factors, including the financial and managerial resources of the acquirer and the anti-trust effects of the acquisition. Any company that so acquires control would then be subject to regulation as a savings and loan holding company.
Federal Securities Laws
Cape Bancorp’s common stock is registered with the Securities and Exchange Commission under the Securities Exchange Act of 1934, as amended. Cape Bancorp is subject to the information, proxy solicitation, insider trading restrictions and other requirements under the Securities Exchange Act of 1934.
Cape Bancorp common stock held by persons who are affiliates (generally officers, directors and principal stockholders) of Cape Bancorp may not be resold without registration or unless sold in accordance with certain resale restrictions. If Cape Bancorp meets specified current public information requirements, each affiliate of Cape Bancorp is able to sell in the public market, without registration, a limited number of shares in any three month period.
ITEM 1A.
ITEM 1A. RISK FACTORS
The risks set forth below, in addition to the other risks described in this Annual Report on Form 10-K, may adversely affect our business, financial condition and operating results. In addition to the risks set forth below and the other risks described in this annual report, there may also be additional risks and uncertainties that are not currently known to us or that we currently deem to be immaterial that could materially and adversely affect our business, financial condition or operating results. As a result, past financial performance may not be a reliable indicator of future performance, and historical trends should not be used to anticipate results or trends in future periods. Further, to the extent that any of the information contained in this Annual Report on Form 10-K constitutes forward-looking statements, the risk factors set forth below also are cautionary statements identifying important factors that could cause our actual results to differ materially from those expressed in any forward-looking statements made by or on behalf of us.
Our Continuing Concentration of Loans in Our Primary Market Area May Increase Our Risk.
Our success depends primarily on the general economic conditions in the counties in which we conduct business, and in the southern New Jersey shore communities in general. Our portfolio primarily consists of loans made to businesses in this area. While our MDOs are helping to diversify this risk, the largest geographic concentration remains in our historic markets. As a result, the local economic conditions have a significant impact on our loans and the ability of the borrowers to repay and on the value of the collateral that may secure these loans. A significant decline in general economic conditions caused by inflation, recession, unemployment, or poor weather for the summer season could adversely affect our financial condition and results of condition. Further, because we have a significant amount of commercial real estate loans, decreases in tenant occupancy may have a negative effect on the ability of many of our borrowers to make timely loan payments thus adversely impacting our earnings.
The gaming industry is a significant economic force in our market and has already suffered a serious decline in revenues due to the economy and increased regional competition. The Atlantic City casino industry has experienced mixed results through the first three quarters of 2012. The items below reflect changes excluding the Revel which opened in April 2012.
Gross operating profit up 9% for the nine month period;
Nine casinos had revenue declines during the period;
Occupancy rate in the casino hotels was up slightly to 86.2% from 85.2% the previous year.
Competition from neighboring states has played an important role in this decline. Pennsylvania now has 11 operating casinos representing an addition of one from the previous year. These casinos offer both table games and slots. Delaware has only three casinos, but in 2012 began offering table games in addition to their historic slot offerings. In an attempt to revitalize Atlantic City, the State of New Jersey has worked on several initiatives:
The Tourism District Law led to a $30 million marketing plan and realigned State gaming agencies to reduce bureaucracy.
In 2011, a second casino related law was passed with a comprehensive overhaul of casino regulations. This was the first major revision since 1977.
In February 2013, the State passed a law permitting online gaming in the state if the customer registers with an existing casino.
Future Changes in Interest Rates Could Reduce Our Profits.
Our ability to make a profit largely depends on our net interest income which could be negatively affected by changes in interest rates. Net interest income is the difference between the interest income earned on our interest-earning assets (such as loans and securities) and the interest expense paid on our interest-bearing liabilities (such as deposits and borrowings).
Short term interest rates have been maintained at very low levels since the recession and the Federal Reserve Open Market Committee (“FOMC”) has consistently communicated their desire to keep these rates low. In addition, through asset purchase programs such as Quantitative Easing, they have also had a significant impact on keeping longer term rates low. Such policies are subject to change should the FOMC believe that the economy has sufficient strength and if there were fears of building inflationary pressure. Raising short term rates or ending asset purchase programs would raise rates. It would be difficult to predict how rapidly such changes could take place, nor to gauge the potential magnitude of rate increases.
Increased rates could have a significant impact on the Bank’s net interest income. The section, “Net Interest Income Analysis” relays the negative results of a rate increase illustrated under standard financial models. We evaluate interest rate sensitivity by estimating the change in Cape Bank’s net portfolio value over a range of interest rate scenarios. Net portfolio value is the discounted present value of expected cash flows from assets and liabilities. At December 31, 2012, in the event of an immediate 100 basis point increase in interest rates, we would experience a 1.9% decrease in net portfolio value and a $3.4 million decrease in net interest income. See “Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations-Management of Market Risk”.
Changes in interest rates can affect the average life of loans and mortgage-backed and related securities. Historically low residential mortgage rates over the recent past may significantly increase the average life of residential mortgage loans as borrowers would be incented to keep low rate mortgages in a rising interest rate environment. Rising rates may dampen the demand for loans from both the consumer and commercial customer as the economy adjusts to higher interest costs. Rising rates would also reduce the value of securities held in the Bank’s investment portfolio. Generally, the value of fixed income securities moves inversely with changes in interest rates. At December 31, 2012, the fair value of our available for sale investment securities totaled $170.9 million and the amortized cost of such securities was $172.0 million. Decreases in the fair value of securities available for sale in future periods would have an adverse effect on stockholders’ equity.
Should rates rise, management would take steps to mitigate the loss of income by lengthening the term of liabilities and borrowings, and shortening the average life of assets. We would also work to increase higher yielding assets. Such steps could fail through poor execution or inaccurate timing.
Our Emphasis on Commercial Real Estate Loans and Commercial Business Loans May Continue to Expose us to Increased Credit Risks.
At December 31, 2012, $386.5 million, or 53.3% or our loan portfolio consisted of commercial real estate loans and represented the largest percentage of our loan portfolio. Residential mortgage loans totaled $235.9 million or 32.5% of the total loan portfolio at December 31, 2012. In addition, at December 31, 2012, $56.6 million, or 7.8% of our loan portfolio consisted of commercial business loans.
Commercial real estate loans and commercial business loans generally expose a lender to a greater risk of loss than one-to-four family residential loans. Repayment of commercial real estate and commercial business loans generally depends, in large part, on sufficient income from the property or the borrower’s business to cover operating expenses and debt service. Commercial real estate loans typically involve larger loan balances to single borrowers or groups of related borrowers compared to one-to-four family residential mortgage loans. Changes in economic conditions that are beyond the control of the borrower and lender could affect the value of the security for the loan, the future cash flow of the affected property, or the marketability of a construction project with respect to loans originated for the acquisition and development of property. See “Business-Lending Activities.”
The National Economy is Experiencing a Modest/Fragile Recovery
The recession ended in 2009 although its effects continued. The economy has generated growth in GDP of 1.8% in 2011 and 2.2% in 2012. These data point to a modest recovery despite an accommodative Federal Reserve interest rate policy meant to stimulate the economy. The results have been reflected in the employment statistics which reflect a persistently high level of unemployment.
The modest recovery has negatively impacted many segments of the economy including community banking. Higher unemployment strains household income and contributes to delinquent payments. Collateral values have risen, albeit slowly. The Federal Reserve may have achieved the maximum benefit from it strategies and thus have a limited arsenal should the current recovery drift back into recession. Political gridlock further hampers the ability of the government to implement fiscal strategies to head off a recession.
Should a recession re-occur, or should the current modest recovery continue for an extended period, the Bank could face low demand for loans and an increase in credit problems. A deteriorating credit situation might necessitate an increase in loan loss provisions and charge-offs related to declining asset values.
We Are Subject to Extensive Regulatory Oversight That Could Limit Our Operations, Products and Services, and Make Regulatory Compliance Expensive.
We and our subsidiaries are subject to extensive regulation and supervision. Regulators have intensified their focus on Bank lending criteria and controls, and on the USA PATRIOT Act’s anti-money laundering and Bank Secrecy Act compliance requirements. Under Dodd-Frank, the structure of Bank regulation was changed and the Consumer Financial Protection Bureau (“CFFB”) was created. The CFPB is under development and more extensive regulation over consumer financial products is anticipated. There is also increased scrutiny of our compliance with the rules enforced by the Office of Foreign Assets Control (“OFAC”). In order to comply with regulations, guidelines and examination procedures in the anti-money laundering area, we have been required to adopt new policies and procedures and to install new systems. We cannot be certain that the policies, procedures and systems we have in place meet every aspect of current regulation. Therefore, there is no assurance that in every instance we are in full compliance with these requirements. Our failure to comply with these and other regulatory requirements can lead to, among other remedies, administrative enforcement actions, and legal proceedings. In addition, recently enacted, proposed and future legislation and regulations have had, will continue to have, or may have significant impact on the financial services industry. Regulatory or legislative changes could make regulatory compliance more difficult or expensive for us, and could cause us to change or limit some of our products and services, or the way we operate our business.
An Inadequate Allowance for Loan Losses Would Negatively Affect Our Results of Operations.
We are exposed to the risk that our customers will be unable to repay their loans according to their terms and that any collateral securing the payment of their loans will not be sufficient to avoid losses. Credit losses are inherent in the lending business and could have a material adverse effect on our operating results. Volatility and deterioration in the broader economy may also increase our risk of credit losses. The determination of an appropriate level of allowance for loan losses is an inherently uncertain process and is based on numerous assumptions. The amount of future losses is susceptible to changes in economic, operating and other conditions, including changes in interest rates, that may be beyond our control, and charge-offs may exceed current estimates. We evaluate the collectability of our loan portfolio and provide an allowance for loan losses that we believe is appropriate based upon such factors as, including, but not limited to: the risk characteristics of various classifications of loans; previous loan loss experience; specific loans that have loss potential; delinquency trends; the estimated fair market value of the collateral; current economic conditions; the views of our regulators; and geographic and industry loan concentrations. If any of our evaluations are incorrect and borrower defaults result in losses exceeding our allowance for loan losses, our results of operations could be significantly and adversely affected. We cannot be certain that our allowance is appropriate to cover probable loan losses inherent in our portfolio.
A Breach of Information Security Could Negatively Affect Our Earnings.
Increasingly, we depend upon data processing, communication and information exchange on a variety of computing platforms and networks, and over the internet. We cannot be certain all our systems are entirely free from vulnerability to attack, despite safeguards we have instituted. In addition, we rely on the services of a variety of vendors to meet our data processing and communication needs. Disruptions to our vendors’ systems may arise from events that are wholly or partially beyond our vendors’ control (including, for example, computer viruses or electrical or telecommunications outages). If information security is breached, despite the controls we have instituted, information can be lost or misappropriated, resulting in financial loss or costs to us or damages to others. Further, such breaches could cause harm to the Bank’s reputation. These costs or losses could materially exceed the amount of insurance coverage, if any, which would adversely affect our earnings.
Other-Than-Temporary Impairment (“OTTI”) Could Reduce Our Earnings.
We evaluate our investment securities for OTTI as required by FASB ASC Topic No. 320, “Investments - Debt and Equity Securities”. When a decline in fair value below cost is deemed to be OTTI, the impairment must be recognized as a charge to earnings to the extent it is related to credit losses. In determining whether or not OTTI exists, management considers several factors, including the length of time and extent that fair value has been less than cost, the financial condition and near term prospects of the issuer, adverse changes to projected cash flows, credit rating downgrades, and our intentions with regard to selling the securities or whether it is more likely than not that we will be required to sell the securities prior to the anticipated recovery in fair value. The greatest risk of OTTI exists in our investment securities portfolio and in particular with the CDO and non-agency CMO securities that we own. As of December 31, 2012, if these securities were deemed to be OTTI and the entire amount was related to credit losses, the pro forma reduction to our net income would be approximately $0.29 per fully diluted share.
The Need to Account for Assets at Market Prices May Adversely Affect Our Results of Operations.
We report certain assets, including investments and securities, at fair value. Generally, for assets that are reported at fair value, we use quoted market prices or valuation models that utilize market data inputs to estimate fair value. Because we carry these assets on our books at their fair value, we may incur losses even if the asset in question presents minimal credit risk. Given the continued disruption in the capital markets, we may be required to recognize OTTI in future periods with respect to securities in our portfolio. The amount and timing of any impairment recognized will depend on the severity and duration of the decline in fair value of the securities and our estimation of the anticipated recovery period.
Changes in the Value of Goodwill and Intangible Assets Could Reduce Our Earnings.
We are required by U.S. generally accepted accounting principles to test goodwill and other intangible assets for impairment at least annually. Testing for impairment of goodwill and intangible assets involves the identification of reporting units and the estimation of fair values. The estimation of fair values involves a high degree of judgment and subjectivity in the assumptions used. As of December 31, 2012, if our goodwill and intangible assets were fully impaired and we were required to charge-off all of our goodwill, the pro forma reduction to our net income would be approximately $1.83 per fully diluted share.
Our Expenses May Increase as a Result of Possible Increases in Federal Deposit Insurance Corporation (“FDIC”) Premiums.
The FDIC imposes an assessment against financial institutions for deposit insurance. The FDIC has authority to increase insurance assessments. A significant increase in insurance premiums would likely have an adverse effect on the operating expenses and results of operations of the Bank. Management cannot predict what insurance assessment rates will be in the future.
If the Federal Home Loan Bank of New York Stops Paying Dividends, This Will Negatively Affect Our Earnings.
We recorded dividend income of $332,000 on our Federal Home Loan Bank of New York stock in 2012. However, no assurances can be given that these dividends will continue to be paid in the future. The failure of the Federal Home Loan Bank to pay dividends in the future will cause our earnings to decrease.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
ITEM 2.
ITEM 2. PROPERTIES
The Company currently conducts business from its main office located at 225 North Main Street, Cape May Court House, New Jersey, 08210, from its additional 14 branch offices located throughout Atlantic and Cape May Counties, New Jersey, and from MDOs located in Burlington and Mercer Counties, New Jersey and a MDO located in Radnor, PA to serve the Philadelphia five county region. At December 31, 2012, the aggregate net book value of premises and equipment was $20.3 million. With the exception of the potential remodeling of certain facilities to provide for the efficient use of work space and/or to maintain an appropriate appearance, each property is considered reasonably adequate for current and anticipated needs.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
Periodically, there have been various claims and lawsuits against us, such as claims to enforce liens, condemnation proceedings on properties in which we hold security interests, claims involving the making and servicing of real property loans and other issues incident to our business. We are not a party to any pending legal proceedings that we believe would have a material adverse effect on our financial condition, results of operations or cash flows.
ITEM 4.
ITEM 4. MINE SAFETY DISCLOSURES
None.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
(a) No equity securities were sold during the year ended December 31, 2012 that were not registered under the Securities Act.
Stock Performance Graph
The following Performance Graph and related information shall not be deemed “soliciting material” or to be “filed” with the Securities and Exchange Commission, nor shall such information be incorporated by reference into any future filing under the Securities Act of 1933 or Securities Exchange Act of 1934, each as amended, except to the extent that the Company specifically incorporates it by reference into such filing.
Our common stock began trading on the Nasdaq Stock Market under the symbol “CBNJ” on February 1, 2008, and the per share closing price of one share of the Company’s common stock on that date was $10.05. The following graph represents $100 invested in our common stock at the $10.05 per share closing price on February 1, 2008. The graph illustrates the comparison of the cumulative total returns on the common stock of the Company with (a) the cumulative total return on stocks included in the NASDAQ Composite Index; and (b) the cumulative total return on stocks included in the SNL Mid-Atlantic Thrift Index.
There can be no assurance that our stock performance will continue in the future with the same or similar trend depicted in the graph below. We will not make or endorse any predictions as to future stock performance.
The following table sets forth the range of high and low bid information for the Company’s common stock as reported on NASDAQ for the period beginning January 1, 2011. Quotations reflect inter-dealer prices, without retail mark-up, markdown or commissions and may not represent actual transactions. In the fourth quarter of 2012, the Company paid its first cash dividend at $0.05 per common share.
(b) Not applicable
(c) There were no issuer repurchases of securities during the fourth quarter of the December 31, 2012 fiscal year.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following information is derived from the audited consolidated financial statements of Cape Bancorp. For additional information, reference is made to “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the Consolidated Financial Statements of Cape Bancorp and related notes included elsewhere in this Annual Report.
(1) Represents the difference between the weighted average yield on average interest-earning assets and the weighted average cost of interest-bearing liabilities.
(2) Represents net interest income as a percent of average earning assets.
(3) Recalculating the 2008 efficiency ratio excluding the Goodwill Impairment ($31.751 million) and Cape Charitable Foundation
Contribution ($6.2 million) results in an efficiency ratio of 69.2%.
ITEM 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Overview/Business Strategy
Cape Bank was organized in 1923. Over the years, we have expanded primarily through internal growth. On January 31, 2008, we completed our mutual-to-stock conversion and initial public stock offering, and our acquisition of Boardwalk Bancorp and Boardwalk Bank. The merger of Cape Savings Bank (now Cape Bank) and Boardwalk Bancorp on January 31, 2008 created the largest community bank headquartered in Atlantic and Cape May Counties, with a total of 20 locations providing complimentary branch coverage. At December 31, 2012, we had total assets of $1.041 billion. The merger resulted in a well-capitalized community oriented bank with a significant commercial loan presence and an experienced executive management team. For the three years prior to the merger both banks had experienced strong asset quality and financial performance. The severe economic recession has affected the merged financial institution as a whole, as well as the loan portfolios of each of the constituent banks to the merger.
Our principal business is acquiring deposits from individuals and businesses in the communities surrounding our offices and using these deposits to fund loans and other investments. More specifically, we offer personal and business checking accounts, commercial mortgage loans, residential mortgage loans, construction loans, home equity loans and lines of credit and other types of commercial and consumer loans. Our customers consist primarily of individuals and small and mid-sized businesses. At December 31, 2012, our retail market area primarily included the area surrounding our 15 offices located in Cape May and Atlantic Counties, New Jersey.
During 2013, Cape Bank will focus on the following initiatives:
• Continue efforts to effectively manage the Bank’s capital
• Build core earnings
• Continue efforts to reduce nonperforming assets
• Complete the transition to a new core processing provider and broaden digital delivery
Continue efforts to effectively manage the Company’s capital:
Despite the Company’s problems with credit since the recession, we were able to maintain a strong capital position. With troubled assets posing a reduced concern, the Company reassessed the level of capital and believed a more active management was called for. In the fourth quarter of 2012, the Company paid its first cash dividend of $0.05 per common share. In addition, on February 22, 2013, the Company, with the approval of the regulators, declared a $0.05 per common share cash dividend to shareholders of record on March 8, 2013. The dividend is expected to be paid on March 22, 2013.
For 2013, current levels of equity appear to be higher than projected growth would require. As a result, uses of capital beyond the continued payment of a cash dividend have been considered.
Build core earnings:
During the economic downturn, Bank values were often a reflection of the perceived adequacy of equity often through the metric of tangible book value. Uncertainty with the economy in general, and with credit in particular, made capital a handy heuristic to gauge the soundness of a Bank.
These macro concerns have been receding as more institutions have gotten on sounder footing. As a result, valuations have begun to focus on earnings as a driver of value. In particular, core earnings are becoming an increasingly important metric.
Management recognizes this development and has made growth in core earnings an integral part of the 2013 Strategic Plan.
Continue efforts to reduce non-performing assets:
Management was able to reduce the level of non-performing assets during 2012 and believes that continued efforts to reduce them further will provide value to the shareholders. Several of the larger troubled credits have moved to OREO as the Bank attempts to move these properties promptly. This area will continue to get attention in 2013.
Complete the transition to a new core processing provider and broaden digital delivery:
The contract with the Bank’s core processor ends in October 2013. Throughout 2012 the Bank conducted a review of processors and systems features, and in late 2012 signed a contract with FISERV. Work has begun on orchestrating a smooth transition to this new system and we expect completion in October. As consumers increasingly embrace digital channels, we focused our due diligence on systems that will further digital delivery.
2013 Outlook
Our market area has been affected by the recession and the modest recovery. Unemployment in Atlantic and Cape May County was 14.3% and 16.2% respectively as of December 2012. Residential real estate values decreased in 2011 in both Atlantic and Cape May counties by 4.1% and 5.2% respectively. Additionally, the number of residential building permits issued declined from 2008 to 2009, leveled off during 2010 and declined again in 2011.
Income. Our primary source of income is net interest income. Net interest income is the difference between interest income (which is the income that we earn on our loans and investments) and interest expense (which is the interest that we pay on our deposits and borrowings). Changes in levels of market interest rates affect our net interest income.
The Bank’s net interest margin is 3.75% for 2012. This has been achieved through active management of deposit pricing and steps taken to restructure borrowings. Throughout the recession and the recovery, FOMC policy has been effective in keeping interest rates low and the yield curve relatively flat. We have taken advantage of these lower rates and have reduced deposit costs on both term deposits and transaction accounts. For the year ended December 31, 2012, the Bank’s cost of deposits was 0.65%, down from 2.68% for the year ended December 31, 2008, the start of the recession. While we anticipate some further reduction in the cost attendant to our CD portfolio as some remaining higher rate CDs mature in 2013, we recognize that much of the dramatic change has taken place and there is limited room to lower deposit rates in 2013. We remain committed to pricing transaction accounts to the low end of the market.
In June 2012, the Bank extinguished $20.0 million of fixed rate term FHLB borrowings prior to their scheduled maturity. In connection with the early repayment of these borrowings, the Bank incurred a charge of $921,000 to extinguish the debt which was recorded as other expense in the consolidated statements of income. In August 2012, the Company restructured $54.0 million in fixed rate FHLB borrowings, lowering the cost of funds. The replacement borrowings are adjustable rate, non-callable FHLB advances with maturities ranging from 5 years to 7 years. The interest rate is indexed to the 1 month LIBOR, with spreads that range from 0.42% to 0.52%. A prepayment penalty of $6.4 million was incurred related to the restructuring of the old debt and is being amortized as an adjustment to interest expense over the terms of the new borrowings using the interest method. As a result of both restructurings, net interest income is projected to increase by $1.3 million annually and the net interest margin is expected to benefit by 22 basis points annually. Management does not plan on any further restructuring of advances in 2013. There are $20.0 million in longer term fixed rate advances maturing in 2013 which we anticipate will be replaced by lower costing liabilities.
While the yield curve afforded opportunity to dramatically reduce the cost of liabilities, it also had the impact of reducing the yield on earning assets. From 2008 to 2012, the yield on earning assets declined from 5.98% for the year ended December 31, 2008 to 4.62% for the year ended December 31, 2012. Simultaneously, the level of non-earning assets increased as troubled credits moved into non-accrual status. We plan on growing the Bank’s commercial loan portfolio and thus increasing earning assets in 2013. The very competitive market will lessen our ability to price loans at the levels we would prefer.
The Bank’s non-interest income comes predominately from fees on deposit products. We expect to maintain our current fee structure in 2013 and anticipate a level of income comparable to our 2012 performance.
Allowance for Loan Losses. The amount of the allowance for loan losses is based on management’s judgment of probable losses, and the ultimate losses may vary from such estimates as more information becomes available or conditions change.
Expenses. The non-interest expenses we incur in operating our business consist of salaries and employee benefits expenses, data processing expenses, occupancy expenses, depreciation, amortization and maintenance expenses and other miscellaneous expenses, such as advertising, insurance, professional services and printing and supplies expenses.
Our largest non-interest expense is salaries and employee benefits, which consist primarily of salaries and wages paid to our employees, payroll taxes, and expenses for health insurance, retirement plans and other employee benefits. We will recognize additional annual employee compensation expenses from our employee stock ownership plan, our Equity Incentive Plan and any additional stock-based benefit plans that we may adopt in the future.
We will be converting the Bank’s core processing system in 2013, moving to FISERV. We will also be replacing the telephone system for the Bank and introducing a Call Center. We expect to cover the costs of the Call Center through a redeployment of costs from the branch network. The results of the above will provide a better opportunity to utilize multiple channels and more sophisticated digital delivery for our retail and commercial customers.
Growth and Expansion. In 2013, we will be expanding the Bank’s reach through Market Development Offices (“MDOs”). The Bank has enjoyed success from the opening of a MDO in Burlington County, New Jersey in late 2010. This office has become the prototype for MDOs. The targeted market is the small business operator or professional with a focus on asset generation rather than deposits. The MDO will offer several services and products through multiple professionals, although these employees may not work from a common location. This expansion is important. Our traditional markets have not experienced growth since the recession and the new locations provide a geographic and industry diversification for the loan portfolio. In addition to our Burlington MDO, we have opened MDOs in Mercer County, New Jersey (November 2012) and in Radnor, Pennsylvania (March 2013).
In 2012, we had a change in the management of the residential mortgage department which resulted in a different focus. Greater emphasis was placed on the origination and sale of loans. For the year ended December 31, 2012, gains on the sale of residential mortgage loans totaled $591,000, an increase of 161% over the full year 2011 gains of $227,000. Residential mortgage closings for the year ended December 31, 2012 topped $90 million with a goal of $140 million for 2013. Some of the production is maintained in portfolio, although awareness of potential interest rate risk issues limits the Bank’s appetite for this product.
Critical Accounting Policies
In the preparation of our consolidated financial statements, we have adopted various accounting policies that govern the application of accounting principles generally accepted in the United States. Our significant accounting policies are described in Note 2 of the Notes to Consolidated Financial Statements.
Certain accounting policies involve significant judgments and assumptions by us that have a material impact on the carrying value of certain assets and liabilities. We consider these accounting policies to be critical accounting policies. The judgments and assumptions we use are based on historical experience and other factors, which we believe to be reasonable under the circumstances. Actual results could differ from these judgments and estimates under different conditions, resulting in a change that could have a material impact on the carrying values of our assets and liabilities and our results of operations.
Allowance for Loan Losses. We consider the allowance for loan losses to be a critical accounting policy. The allowance for loan losses is the amount estimated by management as necessary to cover losses inherent in the loan portfolio at the balance sheet date. The allowance is established through the provision for loan losses, which is charged to income. Determining the amount of the allowance for loan losses necessarily involves a high degree of judgment.
In evaluating the allowance for loan losses, management considers historical loss factors, the mix of the loan portfolio (types of loans and amounts), geographic and industry concentrations, current national and local economic conditions and other factors related to the collectability of the loan portfolio, including underlying collateral values and estimated future cash flows. All of these estimates are susceptible to significant change. Groups of homogenous loans are evaluated in the aggregate under FASB ASC Topic No. 450 Contingencies, using historical loss factors adjusted for economic conditions and other environmental factors. Other environmental factors include trends in delinquencies and classified loans, loan concentrations by loan category and by property type, seasonality of the portfolio, internal and external analysis of credit quality, and single and total credit exposure. Certain loans that indicate underlying credit or collateral concerns may be evaluated individually for impairment in accordance with FASB ASC Topic No. 310 Receivables. If a loan is impaired and repayment is expected solely from the collateral, the difference between the outstanding balance and the value of the collateral will be charged off. For potentially impaired loans where the source of repayment may include other sources of repayment, the evaluation may factor these potential sources of repayment and indicate the need for a specific reserve for any potential shortfall. This evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as more information becomes available or as projected events change.
Management reviews the level of the allowance quarterly. Although we believe that we use the best information available to establish the allowance for loan losses, future adjustments to the allowance may be necessary if economic conditions differ substantially from the assumptions used in making the evaluation. In addition, the FDIC and the New Jersey Department of Banking and Insurance, as an integral part of their examination process, periodically review our allowance for loan losses. Such agencies may require us to recognize adjustments to the allowance based on judgments about information available to them at the time of their examination. A large loss could deplete the allowance and require increased provisions to replenish the allowance, which would adversely affect earnings. See Note 2 - Summary of Significant Accounting Policies of the Notes to Consolidated Financial Statements.
Securities Impairment. The Company’s investment portfolio includes twenty-two securities in pooled trust preferred collateralized debt obligations, fourteen of which have been principally issued by bank holding companies, and eight of which have been principally issued by insurance companies. The portfolio also includes one private label (non-agency) collateralized mortgage obligation (“CMO”). With the exception of the non-agency collateralized mortgage obligation, all of the aforementioned securities have below investment grade credit ratings. These investments may pose a higher risk of future impairment charges by the Company in a weakened U.S. economy and its potential negative effect on the future performance of the bank issuers and underlying mortgage loan collateral.
Through December 31, 2012, all fourteen of the bank-issued pooled trust preferred collateralized debt obligation securities have had OTTI recognized in earnings due to credit impairment. Of those securities, eleven have been completely written-off and the three remaining bank-issued CDOs have a total book value of $524,000 and a fair value of $564,000 at December 31, 2012. These write-downs were a direct result of the impact that the credit crisis has had on the underlying collateral of the securities. Consequently many bank issuers have failed causing them to default on their security obligations while recent stress tests and potential recommendations by the U.S. Government and the banking regulators have resulted in some bank trust preferred issuers electing to defer future payments of interest on such securities. At December 31, 2012, the CDO securities principally issued by insurance companies, none of which have been OTTI, had an aggregate book value of $7.7 million and a fair value of $4.1 million. A continuation of issuer defaults and elections to defer payments could adversely affect valuations and result in future impairment charges.
Income Taxes. The Company is subject to the income and other tax laws of the United States and the State of New Jersey. These laws are complex and are subject to different interpretations by the taxpayer and the various taxing authorities. In determining the provisions for income and other taxes, management must make judgments and estimates about the application of these inherently complex laws, related regulations and case law. In the process of preparing the Company provision and tax returns, management attempts to make reasonable interpretations of applicable tax laws. These interpretations are subject to challenge by the taxing authorities upon audit or to reinterpretation based on management’s ongoing assessment of facts and evolving case law.
The Company and its subsidiaries file a consolidated federal income tax return and separate entity state income tax returns. The provision for federal and state income taxes is based on income and expenses, as reported in the consolidated financial statements, rather than amounts reported on the Company’s federal and state income tax returns. When income and expenses are recognized in different periods for tax purposes than for book purposes, applicable deferred tax assets and liabilities are recognized for the future tax consequences attributable to the differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized as income or expense in the period that includes the enactment date. Deferred federal and state tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. During 2011, $12.2 million of the valuation allowance was released and was based on a pattern of sustained earnings exhibited by the Company over the most recent 7 quarters through September 30, 2011, projected future taxable income and a tax strategy to facilitate ordinary loss treatment by the Company of certain investment losses when such losses are recognized for tax purposes. As of December 31, 2012, a valuation allowance in the amount of approximately $1.9 million had been established against the Company’s deferred tax assets.
On a quarterly basis, management assesses the reasonableness of its effective federal and state tax rate based upon its current best estimate of net income and the applicable taxes expected for the full year.
Comparison of Financial Condition at December 31, 2012 and December 31, 2011
The Company’s total assets at December 31, 2012 totaled $1.041 billion, a decrease of $30.3 million, or 2.83%, from the December 31, 2011 level of $1.071 billion. The decrease was primarily attributable to a $19.9 million decrease in investment securities.
Cash and cash equivalents decreased $1.3 million or 4.89%, to $24.2 million at December 31, 2012 from $25.5 million at December 31, 2011. A decline in interest-bearing bank balances of $2.1 million was partially offset by an increase of $800,000 in cash and due from financial institutions. The increase was primarily attributable to a large deposit that was made at the end of the year that, due to the timing, was not reinvested.
Interest-bearing time deposits decreased $569,000, or 5.79%, to $9.3 million at December 31, 2012 from $9.8 million at December 31, 2011. The Company invests in time deposits of other banks generally for terms ranging from one to two years and not to exceed $250,000, which is the amount currently insured by the Federal Deposit Insurance Corporation.
Total loans decreased $4.8 million, or 0.65%, to $724.2 million at December 31, 2012 from $729.0 million at December 31, 2011. Net loans decreased $1.9 million, net of a decrease in the allowance for loan losses of $2.8 million. An increase in commercial loans was more than offset by decreases in mortgage and consumer loans. Mortgage loans decreased $16.5 million as a result of early payoffs and the Bank selling approximately 54% of originations made during the year in an effort to manage interest rate risk. An increase in commercial loan activity within our market resulted in net growth of $13.4 million. Consumer loans declined $1.7 million. Loan charge-offs for the year ended December 31, 2012 totaled $7.5 million and $10.2 million of loans were transferred to OREO. Delinquent loans decreased $14.7 million to $15.98 million or 2.20% of total gross loans at December 31, 2012 from $30.6 million, or 4.20% of total loans at December 31, 2011. Total delinquent loans by portfolio at December 31, 2012 were $9.6 million of commercial mortgages, $4.3 million of residential mortgages, $141,000 of construction loans, $681,000 of commercial business loans, $1.1 million of home equity loans, and $44,000 of other consumer loans. Delinquent loan balances by number of days delinquent were: 31 to 59 days - $1.8 million; 60 to 89 days - $1.2 million; and 90 days and greater - $12.9 million.
At December 31, 2012, the Company had $19.4 million in non-performing loans, or 2.67% of total loans, compared to $27.4 million, or 3.77% of total loans, at December 31, 2011. Included in non-performing loans are troubled debt restructurings totaling $3.5 million at December 31, 2012 and $405,000 at December 31, 2011, respectively. At December 31, 2012, non-performing loans by loan portfolio category were as follows: $14.2 million of commercial mortgage loans; $3.5 million of residential mortgage loans; $141,000 of construction loans; $681,000 of commercial business loans; and $842,000 of home equity loans.
At December 31, 2012, commercial non-performing loans had collateral type concentrations of $3.5 million (13 loans or 24%) secured by commercial buildings and equipment, $4.1 million (15 loans or 28%) secured by retail stores, $1.5 million (11 loans or 10%) secured by residential, duplex and multi-family properties, $2.9 million (7 loans or 19%) secured by B&B and hotels, $1.4 million (2 loans or 10%) secured by restaurant properties, $1.3 million (1 loan or 8%) secured by marinas and $172,000 (1 loan or 1%) secured by land and building lots. The three largest relationships in this category of non-performing loans are $2.8 million, $1.7 million, and $1.3 million.
We believe we have appropriately charged-off, written-down or established adequate loss reserves on problem loans that we have identified. For 2013, we anticipate a gradual decrease in the amount of problem assets. This improvement is due, in part, to our disposing of assets collateralizing loans that have gone through foreclosure. We are aggressively managing all loan relationships, and where necessary, we will continue to apply our loan work-out experience to protect our collateral position and actively negotiate with mortgagors to resolve these non-performing loans.
Total investment securities decreased $19.8 million, or 10.40%, to $170.9 million at December 31, 2012 from $190.7 million at December 31, 2011. At December 31, 2012 and December 31, 2011 all of the Company’s investment securities were classified as available-for-sale (AFS). The decrease in the portfolio is primarily a result of investment security sales. A portion of these proceeds were used by the Company to restructure the balance sheet as $20.0 million in FHLB fixed rate term borrowings were extinguished. The Company also experienced additional OTTI related to its bank-issued CDOs portfolio during the year ended December 31, 2012 and recorded an $8,000 charge to earnings related to the credit loss portion of impairment.
Total deposits increased $10.2 million, or 1.32%, to $784.6 million at December 31, 2012, from $774.4 million at December 31, 2011. The increase is attributable to a $61.9 million, or 12.88%, increase in core deposits, partially offset by a decrease of $50.5 million in certificates of deposit. NOW and money market accounts increased $42.0 million, or 13.06%, to $363.5 million at December 31, 2012 from $321.5 million at December 31, 2011. This increase was primarily attributable to increases in municipal accounts of $17.3 million, or 27.78%, commercial money market accounts of $14.3 million, or 35.04%, and increases in personal interest bearing checking accounts of $13.6 million, or 17.55%. Non-interest bearing checking accounts increased $11.7 million, or 16.48%, to $82.7 million at December 31, 2012 from $71.0 million at December 31, 2011, and savings deposits increased $8.2 million or 9.29% to $96.2 million at December 31, 2012 from $88.0 million at December 31, 2011. Certificates of deposit totaled $238.6 million at December 31, 2012, a decline of $50.5 million or 17.46%, from $289.1 million at December 31, 2011. Total borrowings decreased $46.0 million, or 31.98%, to $98.0 million at December 31, 2012 from $144.0 million at December 31, 2011. The Company extinguished $20.0 million in FHLB of NY fixed rate term borrowings which had a weighted average rate of 3.44% and maturity dates ranging from August 2013 through February 2014. The prepayment of these borrowings will be accretive to net interest income through the first quarter of 2014. In addition, in August 2012, the Company restructured an additional $54.0 million in borrowings, significantly lowering the cost of funds. As a result of both restructurings, net interest income is projected to increase by $1.3 million annually and the net interest margin will benefit by 22 basis points annually. In addition, the increase in deposits discussed previously enabled the Company to replace borrowings with lower costing funding sources such as interest bearing demand deposits and non- interest bearing deposits. At December 31, 2012, our borrowings to assets ratio decreased to 9.4% from 13.4% at December 31, 2011. Borrowings to total liabilities decreased to 11.0% at December 31, 2012 from 15.6% at December 31, 2011.
Stockholders’ equity increased $5.1 million, or 3.50%, to $150.8 million at December 31, 2012, from $145.7 million at December 31, 2011. The increase in equity was primarily attributable to the net income of $4.6 million. At December 31, 2012, stockholders’ equity totaled $150.8 million, or 14.49% of total assets, and tangible equity totaled $128.0 million or 12.57% of total tangible assets.
Comparison of Operating Results for the Years Ended December 31, 2012 and 2011
General. The Company recorded net income of $4.6 million, or $0.37 per common and fully diluted share for the year ended December 31, 2012 compared to net income of $8.0 million, or $0.64 per common and fully diluted share for the year ended December 31, 2011. Included in the full year operating results for 2011 were tax benefits totaling $12.2 million representing the reversal of a portion of the deferred tax valuation allowance. Pre-tax income increased $17.6 million year-over-year primarily resulting from a reduction in the loan loss provision of $15.1 million, a reduced year-over-year OTTI charge of $1.4 million, an increase in net gains on the sale of investment securities of $1.5 million, an increase in net interest income of $644,000, lower OREO expenses of $450,000 and lower loan related expenses of $213,000. In addition, the Company recorded net gains on loan sales of $423,000 for the year ended December 31, 2012 compared to net losses of $67,000 for the twelve month period ended December 31, 2011. These positive factors were partially offset by a reduction in the gain on sale of bank premises of $1.4 million, and a $921,000 prepayment penalty of related to the previously disclosed debt extinguishment in the second quarter of 2012.
Interest Income. Interest income decreased $2.8 million, or 5.99%, to $43.7 million for the year ended December 31, 2012, from $46.5 million for the year ended December 31, 2011. The decrease for the year resulted from a $2.7 million, or 6.55%, decrease in interest income on loans. Average loan balances for the year ended December 31, 2012 decreased $32.3 million, or 4.21% to $735.4 million from $767.7 million for the year ended December 31, 2011. Loan demand has not been sufficient to offset monthly principal reductions, pay-offs, charge-offs, and the transfer of loans to OREO. For the year ended December 31, 2012, loan charge-offs totaled $7.5 million and loans transferred to OREO totaled $10.2 million. The average yield on the loan portfolio decreased 13 basis points to 5.29% for the year ended December 31, 2012 from 5.42% for the year ended December 31, 2011, reflecting a lower interest rate environment and the impact of non-accruing loans on interest income. The amount of interest income that would have been recorded had our non-accruing loans been current in accordance with their original terms approximated $1.3 million for the year ended December 31, 2011 compared to $2.1 million for the year ended December 31, 2011.
The average balance of the investment portfolio increased $2.1 million, or 1.16%, to $183.0 million for the year ended December 31, 2012 from $180.9 million for the year ended December 31, 2011. The slight increase in the average balance of investments occurred in conjunction with a reduction in agency securities and an increase in mortgage backed securities. The average yield on the investment portfolio decreased 6 basis points to 2.55% for the year ended December 31, 2012 from 2.61% for the year ended December 31, 2011. The decrease in the investment portfolio yield was a result of the proceeds from higher yielding securities being reinvested into securities that have lower coupon rates.
Interest Expense. Interest expense decreased $3.4 million, or 29.34%, to $8.2 million for the year ended December 31, 2012, from $11.6 million for the year ended December 31, 2011. The decrease in interest expense resulted from lower rates on interest-bearing deposit products, particularly certificates of deposit and money market accounts.
Interest expense on certificates of deposit decreased $1.4 million, or 31.65%, to $3.1 million for the year ended December 31, 2012, from $4.5 million for the year ended December 31, 2011. The average rate paid on certificates of deposit decreased 30 basis points to 1.19% for the year ended December 31, 2012, from 1.49% for the year ended December 31, 2011, while the average balance of certificates of deposit decreased $43.0 million, or 14.21% to $259.4 million for the year ended December 31, 2012, from $302.4 million for the year ended December 31, 2011. Interest expense on NOW (interest-bearing demand accounts) and money market accounts decreased $502,000, or 28.85%, to $1.2 million for the year ended December 31, 2012, from $1.7 million for the year ended December 31, 2011. The average rate paid on NOW and money market accounts decreased 20 basis points to 0.37% for the year ended December 31, 2012, from 0.57% for the year ended December 31, 2011. The average balance of NOW and money market accounts increased $27.6 million, or 9.07%, to $332.6 million for the year ended December 31, 2012, from $305.0 million for the year ended December 31, 2011. Interest expense on savings accounts decreased $61,000 to $154,000 for the year ended December 31, 2012, from $215,000 for the year ended December 31, 2011. The average rate paid on savings deposits decreased 8 basis points to 0.17% for the year ended December 31, 2012, from 0.25% for the year ended December 31, 2011, while the average balance of savings accounts increased $7.1 million, or 3.97% to $92.5 million for the year ended December 31, 2012, from $85.4 million for the year ended December 31, 2011. The average balance of NOW and money market accounts includes both indexed priced and fixed rate municipal account relationships for the year ended December 31, 2012, with an average balance of $62.8 million and an average rate of 0.61%, compared to an average balance of $50.8 million and an average rate of 0.60% for the year ended December 31, 2011. Interest expense on borrowings (primarily Federal Home Loan Bank of New York advances) decreased $1.4 million, or 27.53%, to $3.7 million for the year ended December 31, 2012 from $5.1 million for the year ended December 31, 2011. The average balance of borrowings declined $25.4 million, or 16.66%, to $126.8 million for the year ended December 31, 2012, from $152.2 million for the year ended December 31, 2011. The average rate paid on borrowings decreased 44 basis points to 2.94% for the year ended December 31, 2012, from 3.38% for the year ended December 31, 2011. The decreases in both the average balance and average rate paid on borrowings primarily resulted from the previously mentioned debt extinguishment in the second quarter of 2012 and the further restructuring of debt in the third quarter of 2012.
Net Interest Income. Net interest income increased $624,000, or 1.79%, to $35.5 million for the year ended December 31, 2012, from $34.8 million for the year ended December 31, 2011. The net interest margin increased by 15 basis points to 3.75% for the year ended December 31, 2012, from 3.60% for the year ended December 31, 2011. The yield on interest-earning assets declined 17 basis points to 4.62% for the year ended December 31, 2012 compared to 4.79% for the year ended December 31, 2011, while the cost of interest-bearing liabilities declined 36 basis points to 1.01% for the year ended December 31, 2012 compared to 1.37% for the same period last year. The net interest margin benefited from the previously mentioned debt extinguishment and restructuring of debt. Significant interest expense savings were realized from certificates of deposits and money market accounts as pricing strategies implemented during the year reflected the current interest rate environment and competition. The ratio of average interest earning assets to average interest bearing liabilities increased to 116.52% during the year ended December 31, 2012, from 114.71% for the year ended December 31, 2011.
Provision for Loan Losses. In accordance with FASB ASC Topic No. 450 Contingencies, we establish provisions for loan losses which are charged to operations in order to maintain the allowance for loan losses at a level we consider necessary to absorb credit losses incurred in the loan portfolio that are both probable and reasonably estimable at the balance sheet date. In determining the level of the allowance for loan losses, we consider, among other things, past and current loss experience, evaluations of real estate collateral, current economic conditions, volume and type of lending, external factors such as competition and regulatory, adverse situations that may affect a borrower’s ability to repay a loan and the levels of delinquent loans.
The amount of the allowance is based on management’s judgment of probable losses, and the ultimate losses may vary from such estimates as more information becomes available or conditions change. We assess the allowance for loan losses and make provisions for loan losses on a quarterly basis.
The Company recorded a provision for loan losses of $4.5 million for the year ended December 31, 2012 compared to $19.6 million for the year ended December 31, 2011 resulting from charge-offs totaling $7.5 million in 2012 compared to charge-offs and write-downs of loans transferred to held for sale totaling $19.7 million in 2011. The ratio of the allowance for loan losses to non-performing loans (coverage ratio) increased to 50.86% at December 31, 2012, from 46.10% at December 31, 2011 primarily due an $8.0 million reduction in non-performing loans. Included in the 2012 charge-offs of $7.5 million were partial charge-offs totaling $6.1 million. The amount of non-performing loans for which the full loss has been charged-off to total loans is 0.19%. The amount of non-performing loans for which the full loss has been charged-off to total non-performing loans is 7.01%. Loan loss recoveries were $228,000 for the year ended December 31, 2012 compared to $221,000 for the year ended December 31, 2011.
Our allowance for loans losses decreased $2.8 million or 22.14%, to $9.9 million at December 31, 2012, from $12.7 million at December 31, 2011. The ratio of our allowance for loan losses to total loans decreased to 1.36% at December 31, 2012, from 1.74% at December 31, 2011.
Non-Interest Income. Non-interest income increased $2.5 million, or 47.13%, to $7.8 million for the year ended December 31, 2012, from $5.3 million for the year ended December 31, 2011. The increase resulted from net gains on sales of investment securities totaling $1.6 million for the year ended December 31, 2012 compared to $149,000 for the year ended December 31, 2011 and the Company recognizing a reduced OTTI charge on investment securities which totaled $8,000 for the year ended December 31, 2012 compared to an OTTI charge of $1.5 million for the year ended December 31, 2011. Net gains on the sale of loans totaled $423,000 for the year ended December 31, 2012 compared to net losses on the sale of loans totaling $67,000 for the year ended December 31, 2011 Included in the twelve month period of 2012 was a gain on the sale of the Company’s merchant card business. The year ended December 31, 2012 included the recognition of a deferred gain related to the sale of bank premises of $425,000 compared to the initial $1.8 million gain recorded in the second quarter of 2011. The additional gain of $425,000 resulted from vacating leased space in the second quarter of 2012 which accelerated the recognition of a portion of the deferred gain. The Company recorded net losses on the sale of OREO of $260,000 for the 2012 twelve month period compared to net losses on OREO sales of $218,000 for the year ended December 31, 2011.
Non-Interest Expense. Non-interest expense increased $694,000, or 2.24%, to $31.6 million for the year ended December 31, 2012 from $30.9 million for the year ended December 31, 2011. The year ended December 31, 2012 included a prepayment penalty of $921,000 related to the previously disclosed debt extinguishment in the second quarter of 2012. OREO expenses declined $450,000 to $2.1 million for the year ended December 31, 2012 compared to $2.5 million for the twelve month period of 2011. Included in these expenses were OREO write-downs totaling $1.1 million compared to $1.8 million for the year ended December 31, 2011. Loan related expenses totaled $2.1 million for the year ended December 31, 2012 compared to $2.4 million for the year ended December 31, 2011 resulting from decreased expenses related to non-performing loans. Year-over-year, advertising expenses increased $137,000 reflecting the Company’s aggressive approach to increase market share and Federal deposit insurance premiums increased $139,000. Telecommunications costs increased $150,000 year-over-year primarily resulting from increased contractual service provider costs and an increase in the transactional volume of our on-line banking solutions. Salaries and benefits declined $68,000. Increases in compensation costs (salaries and incentive compensation) were more than offset by reductions in healthcare costs, stock-based compensation plan expenses and the elimination of the Company’s contributions to the 401K plan in 2012.
Income Tax Expense. For the year ended December 31, 2012 income tax expense totaled $2.7 million compared to a tax benefit of $18.4 million for the year ended December 31, 2011. Income tax expense for the year ended December 31, 2012 was negatively impacted by approximately $358,000 of deferred tax asset valuation allowance related to the Cape Charitable Foundation. The 2011 tax benefit is primarily attributable to the reversal of $12.2 million of the deferred tax valuation allowance and a pre-tax loss of $10.4 million. The release of a portion of the valuation allowance was based on a pattern of sustained earnings exhibited by the Company over the most recent 7 quarters through September 30, 2011, projected future taxable income and a tax strategy to facilitate ordinary loss treatment by the Company of certain investment losses when such losses are recognized for tax purposes. Based on these factors management has determined that it is more likely than not that a greater portion of its deferred tax assets are realizable and has adjusted the valuation allowance accordingly.
Comparison of Operating Results for the Years Ended December 31, 2011 and 2010
General. The Company recorded net income of $8.0 million, or $0.64 per common and fully diluted share for the year ended December 31, 2011 compared to net income of $4.0 million, or $0.33 per common and fully diluted share for the year ended December 31, 2010. The year-over-year increase in net income was primarily attributable to the reversal of $12.2 million of a deferred tax valuation allowance, a $2.0 million reduction in OTTI charges and the $1.8 million gain on the sale of bank premises recorded in the second quarter of 2011. These positive factors were partially offset by a $12.1 million increase in the loan loss provision, an increase of $1.5 million in other real estate owned (OREO) expenses (primarily resulting from an increase of $1.3 million in OREO write-downs), a reduction of $489,000 in gains on the sale of OREO, and reduced gains on the sale of investment securities of $683,000. In addition, the Company recorded a net loss on loan sales of $67,000 for the year ended December 31, 2011 compared to net gains of $168,000 for the twelve month period ended December 31, 2010. Net interest income decreased $874,000, or 2.45%, to $34.9 million for the year ended December 31, 2011 compared to $35.7 million for the year ended December 31, 2010. The decline in net interest income was primarily attributable to the yield on interest-earning assets decreasing 36 points compared to the cost of interest-bearing liabilities which decreased 32 basis points. The net interest margin decreased to 3.60% for the year ended December 31, 2011 from 3.66% for the year ended December 31, 2010.
Interest Income. Interest income decreased $3.8 million, or 7.56%, to $46.5 million for the year ended December 31, 2011, from $50.3 million for the year ended December 31, 2010. The decrease for the year resulted from a $3.5 million, or 7.82%, decrease in interest income on loans, and a decrease of $272,000, or 5.30%, in interest income on investment securities. Average loan balances for the year ended December 31, 2011 decreased $21.4 million, or 2.71% to $767.7 million from $789.1 million for the year ended December 31, 2010. Due to the economic downturn, loan demand was not sufficient enough to offset monthly principal reductions, pay-offs, charge-offs, the reclassification of loans to held for sale, and the transfer of loans to OREO. For the year ended December 31, 2011, loan charge-offs and write-downs totaled $19.7 million, loans transferred to OREO totaled $10.5 million, and, in the third quarter of 2011, $11.9 million of non-performing commercial loans were reclassified to loans held for sale at their fair market value. The average yield on the loan portfolio decreased 30 basis points to 5.42% for the year ended December 31, 2011 from 5.72% for the year ended December 31, 2010, reflecting a lower interest rate environment and the impact of non-accruing loans on interest income. The amount of interest income that would have been recorded had our non-accruing loans been current in accordance with their original terms approximated $2.1 million for the year ended December 31, 2011 compared to $1.9 million for the year ended December 31, 2010.
The average balance of the investment portfolio increased $9.7 million, or 5.67%, to $180.9 million for the year ended December 31, 2011 from $171.2 million for the year ended December 31, 2010. The average yield on investments decreased 30 basis points to 2.61% for the year ended December 31, 2011 from 2.91% for the year ended December 31, 2010. The average balance of investments increased primarily due to reinvesting cash flow from the loan portfolio, which experienced marginal new loan volume during the year and $7.1 million in proceeds from the sale of bank premises in May 2011. The decline in yield was largely due to proceeds from higher yielding securities being reinvested in securities that had lower coupon rates. The Company prefers to maintain an effective duration for the portfolio of approximately 3 years. This strategy, while helpful from a liquidity standpoint, adversely impacts the investment portfolio yield as the Company foregoes purchasing securities with a longer term to maturity and higher coupon rates.
Interest Expense. Interest expense decreased $2.9 million, or 20.14%, to $11.6 million for the year ended December 31, 2011, from $14.5 million for the year ended December 31, 2010. The decrease in interest expense resulted from lower rates on all interest-bearing deposit products, particularly certificates of deposit.
Interest expense on certificates of deposit decreased $1.6 million, or 26.54%, to $4.5 million for the year ended December 31, 2011, from $6.1 million for the year ended December 31, 2010. The average rate paid on certificates of deposit decreased 28 basis points to 1.49% for the year ended December 31, 2011, from 1.77% for the year ended December 31, 2010, while the average balance of certificates of deposit decreased $43.9 million, or 12.68% to $302.4 million for the year ended December 31, 2011, from $346.3 million for the year ended December 31, 2010. Interest expense on NOW (interest-bearing demand accounts) and money market accounts decreased $428,000, or 19.74%, to $1.7 million for the year ended December 31, 2011, from $2.2 million for the year ended December 31, 2010. The average rate paid on NOW and money market accounts decreased 23 basis points to 0.57% for the year ended December 31, 2011, from 0.80% for the year ended December 31, 2010. The average balance of NOW and money market accounts increased $34.8 million, or 12.87%, to $305.0 million for the year ended December 31, 2011, from $270.2 million for the year ended December 31, 2010. Interest expense on savings accounts decreased $101,000 to $215,000 for the year ended December 31, 2011, from $316,000 for the year ended December 31, 2010. The average rate paid on savings deposits decreased 13 basis points to 0.25% for the year ended December 31, 2011, from 0.38% for the year ended December 31, 2010, while the average balance of savings accounts increased $3.3 million, or 3.97% to $85.4 million for the year ended December 31, 2011, from $82.1 million for the year ended December 31, 2010. The average balance of NOW and money market accounts included both indexed priced and fixed rate municipal account relationships for the year ended December 31, 2011, with an average balance of $50.8 million and an average rate of 0.60%, compared to an average balance of $28.5 million and an average rate of 0.49% for the year ended December 31, 2010. Interest expense on borrowings (primarily Federal Home Loan Bank of New York advances) decreased $770,000, or 13.01%, to $5.1 million for the year ended December 31, 2011 from $5.9 million for the year ended December 31, 2010. The average balance of borrowings declined $8.7 million, or 5.41%, to $152.2 million for the year ended December 31, 2011, from $160.9 million for the year ended December 31, 2010. The average rate paid on borrowings decreased 30 basis points to 3.38% for the year ended December 31, 2011, from 3.68% for the year ended December 31, 2010. The decreases in both the average balance and average rate paid on borrowings occurred as $25.0 million in fixed term advances with a weighted average rate of 3.80% matured during the year and were replaced as a funding source with lower costing deposits.
Net Interest Income. Net interest income decreased $874,000, or 2.45%, to $34.8 million for the year ended December 31, 2011, from $35.7 million for the year ended December 31, 2010. Our net interest margin decreased by 6 basis points to 3.60% for the year ended December 31, 2011, from 3.66% for the year ended December 31, 2010. The decrease in net interest income resulted from the yield on total interest-earning assets decreasing 36 basis points to 4.79% for the year ended December 31, 2011, from 5.15% for the year ended December 31, 2010. The decline in yield was primarily a result of cash flows from the loan portfolio being reinvested in lower yielding investments due to marginal new loan volume, the impact of non-accruing loans and the interest rate environment. This decline was partially offset by the cost of total interest-bearing liabilities decreasing 32 basis points to 1.37% for the year ended December 31, 2011, from 1.69% for the year ended December 31, 2010. Significant interest expense savings were realized from certificates of deposits and money market accounts as pricing strategies implemented during the year reflected the interest rate environment and competition. The ratio of average interest earning assets to average interest bearing liabilities increased to 114.71% during the year ended December 31, 2011, from 113.67% for the year ended December 31, 2010.
Provision for Loan Losses. We recorded a provision for loan losses of $19.6 million for the year ended December 31, 2011 compared to $7.5 million for the year ended December 31, 2010 resulting from charge-offs and write-downs of loans transferred to held for sale totaling $19.7 million in 2011 compared to charge-offs of $8.8 million in 2010. The ratio of the allowance for loan losses to non-performing loans (coverage ratio) increased to 46.10% at December 31, 2011, from 28.84% at December 31, 2010 primarily due a $16.1 million reduction in non-performing loans primarily resulting from the reclassification in the third quarter of 2011 of $11.9 million of non-performing commercial loans to loans held for sale at their fair market value. For the year ended December 31, 2011, charge-offs were $15.7 million compared to $8.8 million for the year ended December 31, 2010, resulting primarily from higher charge-offs on real estate-related loans. Included in the 2011 charge-offs of $15.7 million were partial charge-offs totaling $13.3 million. The amount of non-performing loans for which the full loss has been charged-off to total loans is 0.32%. The amount of non-performing loans for which the full loss has been charged-off to total non-performing loans is 8.52%. The coverage ratio is already net of loan charge-offs. Loan loss recoveries were $221,000 for the year ended December 31, 2011 compared to $568,000 for the year ended December 31, 2010.
Our allowance for loans losses increased $115,000 or 0.92%, to $12.6 million at December 31, 2011, from $12.5 million at December 31, 2010. The ratio of our allowance for loan loss to total loans increased to 1.74% at December 31, 2011, from 1.60% at December 31, 2010.
Non-Interest Income. Non-interest income increased $2.5 million, or 86.29%, to $5.3 million for the year ended December 31, 2011, from $2.8 million for the year ended December 31, 2010. The increase resulted from the $1.8 million gain on the sale of bank premises recorded in the second quarter of 2011 and the Bank recognizing a reduced other-than-temporary impairment charge on investment securities which totaled $1.5 million for the year ended December 31, 2011 compared to an impairment charge of $3.4 million for the year ended December 31, 2010. Net gains on sales of investment securities totaled $149,000 for the year ended December 31, 2011 compared to $832,000 for the year ended December 31, 2010. Net losses on the sale of loans totaled $67,000 for the year ended 2011 compared to net gains on the sale of loans totaling $168,000 for the year ended December 31, 2010. The Company recorded net losses on the sale of OREO of $218,000 for the 2011 period compared to net gains on OREO sales of $$271,000 for the year ended December 31, 2010.
Non-Interest Expense. Non-interest expense increased $2.4 million, or 8.39%, to $30.9 million for the year ended December 31, 2011 from $28.5 million for the year ended December 31, 2010. In 2011, OREO expenses increased $1.5 million over the 2010 period primarily resulting from an increase of $1.3 million in OREO write-downs. Loan related expenses increased $325,000 for the year ended December 31, 2011 resulting from increased expenses related to non-performing loans. Salaries and employee benefits increased $454,000 year-over-year. Increases in healthcare costs, stock-based compensation and pension plan funding costs were partially offset by reduced compensation expense. Occupancy and equipment expenses decreased $590,000, reflecting reduced depreciation and operating expenses as a result of the sale of bank premises in the second quarter of 2011. Year-over-year, advertising expenses increased $161,000 reflecting the Company’s aggressive approach to increase market share. Costs related to professional services (audit and legal) increased $160,000, primarily resulting from costs associated with tax planning strategies and compliance issues.
Income Tax Expense. For the year ended December 31, 2011 income tax expense was a benefit of $18.4 million, compared to a tax benefit of $1.5 million for the year ended December 31, 2010. The 2011 tax benefit was primarily attributable to the reversal of $12.2 million of the deferred tax valuation allowance and a pre-tax loss of $10.4 million. The release of a portion of the valuation allowance was based on a pattern of sustained earnings exhibited by the Company over the most recent 7 quarters through September 30, 2011, projected future taxable income and a tax strategy to facilitate ordinary loss treatment by the Company of certain investment losses when such losses are recognized for tax purposes. Based on these factors management had determined that it was more likely than not that a greater portion of its deferred tax assets were realizable and adjusted the valuation allowance accordingly. The 2010 tax benefit was primarily due to the release of $2.0 million of the deferred tax valuation allowance. The release of the valuation allowance was due to estimated taxable income through 2010 and the anticipated implementation of a business planning strategy which would result in the recognition of a capital gain.
The following tables set forth average balance sheets, average yields and costs, and certain other information for the periods indicated. All average balances are daily average balances. Non-accrual loans were included in the computation of average balances, but have been reflected in the table as loans carrying a zero yield. The yields set forth below include the effect of deferred fees, discounts and premiums that are amortized or accreted to interest income or expense.
(1) In order to present pre-tax income and resultant yields on tax-exempt investments on a basis comparable to those on taxable investments, a tax equivalent yield adjustment is made to interest income. The tax equilvalent adjustment has been computed using a Federal income tax rate of 35%, and has the effect of increasing interest income by $397,000, $465,000 and $584,000 for the years ended December 31, 2012, 2011 and 2010 respectively. The average yield on investments decreased to 2.55% for the year ended December 31, 2012, from 2.61% for the year ended December 2011, and 2.91% for the year ended December 31, 2010.
Rate/Volume Analysis
The following table presents the effects of changing rates and volumes on our net interest income for the periods indicated. The rate column shows the effects attributable to changes in rate (changes in rate multiplied by prior volume). The volume column shows the effects attributable to changes in volume (changes in volume multiplied by prior rate). The total column represents the sum of the prior columns. For purposes of this table, changes attributable to both rate and volume, which cannot be segregated, have been allocated proportionately, based on the changes due to rate and the changes due to volume.
Management of Market Risk
General. The majority of our assets and liabilities are monetary in nature. Consequently, interest rate risk is a significant risk to our net interest income and earnings. Our assets, consisting primarily of mortgage-related assets, have longer maturities than our liabilities, consisting primarily of deposits. As a result, a principal part of our business strategy is to manage interest rate risk and limit the exposure of our net interest income to changes in market interest rates. Accordingly, we have an Interest Rate Risk Committee of the Board, which meets quarterly, as well as a management level Asset/Liability Committee which meets monthly. The Interest Rate Risk Committee is responsible for evaluating the interest rate risk inherent in our assets and liabilities, for recommending to our Board of Directors the level of risk that is appropriate, given our business strategy, operating environment, capital, liquidity and performance objectives, and for managing this risk consistent with the guidelines approved by the Board of Directors.
We have sought to manage our interest rate risk in order to minimize the exposure of our earnings and capital to changes in interest rates. As part of our ongoing asset-liability management, we currently use the following strategies to manage our interest rate risk:
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originating commercial loans that generally tend to have shorter maturity or repricing periods and higher interest rates than residential mortgage loans;
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investing in shorter duration investment grade corporate securities, U.S. Government agency obligations and collateralized mortgage-backed securities;
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obtaining general financing through lower cost deposits, brokered deposits and advances from the Federal Home Loan Bank;
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selling a portion of our long-term residential mortgage loans; and
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lengthening the terms of borrowings and deposits.
By shortening the average maturity of our interest-earning assets by increasing our investments in shorter term loans, as well as loans with variable interest rates, it helps to better match the maturities and interest rates of our assets and liabilities, thereby reducing the exposure of our net interest income to changes in market interest rates.
Net Portfolio Value Analysis. We compute amounts by which the net present value of our interest-earning assets and interest-bearing liabilities (net portfolio value or “NPV”) would change in the event of a range of assumed changes in market interest rates. Our simulation model uses a discounted cash flow analysis to measure the interest rate sensitivity of net portfolio value. We estimate the economic value of these assets and liabilities under the assumption that interest rates experience an instantaneous and sustained increase of 100 or 200 basis points or decrease of 100 or 200 basis points.
Net Interest Income Analysis. In addition to NPV calculations, we analyze our sensitivity to changes in interest rates through our net interest income model. Net interest income is the difference between the interest income we earn on our interest-earning assets, such as loans and securities, and the interest we pay on our interest-bearing liabilities, such as deposits and borrowings. In our model, we estimate what our net interest income would be for a twelve-month period. We then calculate what the net interest income would be for the same period under the assumption that interest rates experience an instantaneous and sustained increase of 100 or 200 basis points or decrease of 100 or 200 basis points.
The table below sets forth, as of December 31, 2012, our calculation of the estimated changes in our net portfolio value and net interest income that would result from the designated instantaneous and sustained changes in interest rates. Computations of prospective effects of hypothetical interest rate changes are based on numerous assumptions, including relative levels of market interest rates, loan prepayments and deposit decay, and should not be relied upon as indicative of actual results.
(1) Assumes an instantaneous and sustained uniform change in interest rates at all maturities.
(2) NPV is the discounted present value of expected cash flows from interest-earning assets and interest-bearing liabilities.
The table above indicates that at December 31, 2012, in the event of a 100 basis point increase in interest rates, we would experience a 1.9% decrease in net portfolio value and a $1.3 million decrease in net interest income. In the event of a 100 basis point decrease in interest rates, we would experience an 8.1% decrease in net portfolio value and a $978,000 decrease in net interest income.
Certain shortcomings are inherent in the methodologies used in determining interest rate risk through changes in net portfolio value and net interest income. Modeling changes require making certain assumptions that may or may not reflect the manner in which actual yields and costs respond to changes in market interest rates. In this regard, the net portfolio value and net interest income information presented assume that the composition of our interest-sensitive assets and liabilities existing at the beginning of a period remains constant over the period being measured, and assume that a particular change in interest rates is reflected uniformly across the yield curve regardless of the duration or repricing of specific assets and liabilities. Accordingly, although interest rate risk calculations provide an indication of our interest rate risk exposure at a particular point in time, such measurements are not intended to and do not provide a precise forecast of the effect of changes in market interest rates on our net interest income and will differ from actual results.
Liquidity and Capital Resources
Liquidity refers to our ability to meet the cash flow requirements of depositors and borrowers as well as our operating cash needs with cost-effective funding. We generate funds to meet these needs primarily through our core deposit base and the maturity or repayment of loans and other interest-earning assets, including investments. Proceeds from the call, maturity, redemption, and return of principal of investment securities totaled $55.2 million during 2012 and were used either for liquidity, to reduce borrowings, or to invest in securities of similar quality as our current investment portfolio. We also have available unused wholesale sources of liquidity, including overnight federal funds and repurchase agreements, advances from the FHLB of New York, borrowings through the discount window at the Federal Reserve Bank of Philadelphia and access to certificates of deposit through brokers. We can also raise cash through the sale of earning assets, such as loans and marketable securities. As of December 31, 2012, the Company’s entire investment portfolio, with a fair market value of $170.9 million, was classified as available-for-sale. The company has no intention to sell these securities, nor is it more likely than not that we will be required to sell any securities prior to their recovery in fair market value.
Liquidity risk arises from the possibility that we may not be able to meet our financial obligations and operating cash needs or may become overly reliant upon external funding sources. In order to manage this risk, our Board of Directors has approved a Liquidity Management Policy and Contingency Funding Plan that identifies primary sources of liquidity, establishes procedures for monitoring and measuring liquidity, and quantifies minimum liquidity requirements based on approved limits. This policy designates our Asset/Liability Committee (“ALCO”) as the body responsible for meeting these objectives. The ALCO, which includes members of executive management, reviews liquidity on a periodic basis and approves significant changes in strategies that affect balance sheet or cash flow positions. Liquidity is centrally managed on a daily basis by our Chief Financial Officer and our Treasury function. Liquidity stress testing is performed annually, unless circumstance dictates more frequently, and all testing results are reported to the Board of Directors through the ALCO minutes.
Cape Bank’s long-term liquidity source is a large core deposit base and a strong capital position. Core deposits are the most stable source of liquidity a bank can have due to the long-term relationship with a deposit customer. The level of deposits during any period is sometimes influenced by factors outside of management’s control, such as the level of short-term and long-term market interest rates and yields offered on competing investments, such as money market mutual funds. Deposits increased $10.5 million, or 1.32%, during 2012, and comprised 88.16% of total liabilities at December 31, 2012, as compared to 83.68% at December 31, 2011.
Cape Bank is subject to various regulatory capital requirements, including a risk-based capital measure. The risk-based capital guidelines include both a definition of capital and a framework for calculating risk-weighted assets by assigning balance sheet assets and off-balance sheet items to broad risk categories. At December 31, 2012, Cape Bank exceeded all regulatory capital requirements. Cape Bank is considered “well capitalized” under regulatory guidelines. Capital stress testing is performed quarterly, unless circumstance dictates more frequently, and all testing results are reported to the Board of Directors. See “Supervision and Regulation-Federal Banking Regulation-Capital Requirements” and Note 15, “Regulatory Matters” of the Notes to Consolidated Financial Statements.
Off-Balance Sheet Arrangements and Aggregate Contractual Obligations
Commitments. As a financial services provider, we routinely are a party to various financial instruments with off-balance sheet risks, such as commitments to extend credit and unused lines of credit. While these contractual obligations represent our potential future cash requirements, a significant portion of commitments to extend credit may expire without being drawn upon. Such commitments are subject to the same credit policies and approval process accorded to loans we originate. In addition, we routinely enter into commitments to sell mortgage loans; such amounts are not significant to our operations. For additional information, see Note 12, “Financial Instruments with Off-Balance Sheet Risk and Concentrations of Credit Risk” of the Notes to Consolidated Financial Statements.
Contractual Obligations. In the ordinary course of our operations, we enter into certain contractual obligations. Such obligations include operating leases for premises and equipment, agreements with respect to borrowed funds and deposit liabilities and agreements with respect to investments.
The following table summarizes our significant fixed and determinable contractual obligations and other funding needs by payment date at December 31, 2012. The payment amounts represent those amounts due to the recipient and do not include any unamortized premiums or discounts or other similar carrying amount adjustments.
Impact of Inflation and Changing Prices
Our consolidated financial statements and related notes have been prepared in accordance with generally accepted accounting principles. Generally accepted accounting principles generally requires the measurement of financial position and operating results in terms of historical dollars without consideration for changes in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of our operations. Unlike industrial companies, our assets and liabilities are primarily monetary in nature. As a result, changes in market interest rates have a greater impact on our performance than the effects of inflation.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
For information regarding market risk see Item 7 - “Management’s Discussion and Analysis of Financial Condition and Results of Operation”.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The information required by this item begins on page.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
(a) Evaluation of Disclosure Controls and Procedures
Under the supervision and with the participation of our management, including our Principal Executive Officer and Principal Financial Officer, we evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the fiscal year (the “Evaluation Date”). Based upon that evaluation, the Principal Executive Officer and Principal Financial Officer concluded that, as of the Evaluation Date, our disclosure controls and procedures were effective in timely alerting them to the material information relating to us (or our consolidated subsidiaries) required to be included in our periodic SEC filings.
(b) Changes in internal controls
There were no significant changes made in our internal control over financial reporting during the Company’s fourth fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
(c) Management report on internal control over financial reporting
Management is responsible for establishing and maintaining adequate internal control over financial reporting. Our internal control system is a process designed to provide reasonable assurance to the Company’s management and Board of Directors regarding the preparation and fair presentation of published financial statements.
Our internal control over financial reporting includes policies and procedures that pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect transactions and dispositions of assets; provide reasonable assurances that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that receipts and expenditures are being made only in accordance with authorizations of management and the Directors of the Company: and provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on our financial statements.
All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation. 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.
Cape Bancorp, Inc.’s management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2012. In making this assessment, we used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on our assessment we believe that, as of December 31, 2012, the Company’s internal control over financial reporting is effective based on those criteria.
Cape Bancorp’s independent registered public accounting firm that audited the consolidated financial statements has issued an audit report on the effectiveness of the Company’s internal control over financial reporting as of December 31, 2012. This report appears on page.
The Sarbanes-Oxley Act Section 302 Certifications have been filed with the SEC as exhibit 31.1 and exhibit 31.2 to this Annual Report on Form 10-K.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
Not Applicable.
PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
The information required by this item is incorporated by reference from the Proxy Statement, specifically the section captioned “Proposal I-Election of Directors”.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this item is incorporated by reference from the Proxy Statement specifically the section captioned “Executive Compensation”.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The information required by this item is incorporated by reference from the Proxy Statement, specifically the section captioned “Voting Securities and Principal Holder Thereof”.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
The information required by this item is incorporated by reference from the Proxy Statement, specifically the section captioned “Transactions with Certain Related Persons”.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information required by this item is incorporated by reference from the Proxy Statement, specifically the section captioned “Proposal II-Ratification of Appointment of Auditors”.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a)(1) Financial Statements
The following documents are filed as part of this Form 10-K.
(A) Report of Independent Registered Public Accounting Firm
(B) Consolidated Balance Sheets as of December 31, 2012 and 2011
(C) Consolidated Statements of Income for the years ended December 31, 2012, 2011 and 2010
(D) Consolidated Statements of Comprehensive Income for the years ended December 31, 2012, 2011 and 2010
(E) Consolidated Statements of Changes in Stockholders’ Equity for the years ended December 31, 2012, 2011 and 2010
(F) Consolidated Statements of Cash Flows for the years ended December 31, 2012, 2011 and 2010
(G) Notes to Consolidated Financial Statements
(a)(2) Financial Statement Schedules
None.
(a)(3) Exhibits
3.1 Articles of Incorporation of Cape Bancorp, Inc. (1)
3.2 Amended and Restated Bylaws of Cape Bancorp, Inc. (2)
Form of Common Stock Certificate of Cape Bancorp, Inc. (1)
10.1 Form of Employee Stock Ownership Plan (1)
10.2 Employment Agreement for Michael D. Devlin (5)
10.3 Change in Control Agreement for Guy Hackney (3)
10.4 Change in Control Agreement for James McGowan, Jr. (3)
10.5 Change in Control Agreement for Michele Pollack (3)
10.6 Change in Control Agreement for Charles L. Pinto (4)
10.7 Form of Director Retirement Plan (1)
10.8 2008 Equity Incentive Plan (6)
Code of Ethics (7)
Subsidiaries of Registrant
23.1 Consent of KPMG LLP
31.1 Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2 Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
The following materials from Cape Bancorp, Inc.’s Annual Report on From 10-K for the year ended December 31, 2012 formatted in XBRL (eXtensible Business Reporting Language): (i) the Consolidated Balance Sheets, (ii) the Consolidated Statements of Income, (iii) the Consolidated Statements of Changes in Equity, (iv) the Consolidated Statements of Cash Flows, and (v) related notes to these financial statements - Furnished herewith.(8)
(1) Incorporated by reference to the Registration Statement on Form S-1 of Cape Bancorp, Inc. (file no. 333-146178), originally filed with the Securities and Exchange Commission on September 19, 2007.
(2) Incorporated by reference to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on July 18, 2008.
(3) Incorporated by reference to the Company’s Current Report on Form 8-K filed on October 6, 2010.
(4) Incorporated by reference to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on July 7, 2011.
(5) Incorporated by reference to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on September 25, 2012.
(6) Incorporated by reference to the Company’s Definitive Proxy Statement filed with the Securities and Exchange Commission on July 16, 2008.
(7) Incorporated by reference to the Company’s Annual Report on Form 10-K for the Year ended December 31, 2007 filed with the Securities and Exchange Commission on March 31, 2008.
(8) Pursuant to Rule 406T of Regulation S-T, the XBRL-related information in Exhibit 101 to this Annual Report on Form 10-K is furnished and not filed for purposes of Sections 11 and 12 of the Securities Act of 1933 and Section 18 of the Securities and Exchange Act of 1934.
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.
CAPE BANCORP, INC.
Date: March 14, 2013
By:
/s/ Michael D. Devlin
Michael D. Devlin
Chief Executive Officer and President
(Duly Authorized Representative)
Pursuant to the requirements of the Securities Exchange of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS OF
CAPE BANCORP, INC. AND SUBSIDIARIES
* * *
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
Cape Bancorp, Inc.:
We have audited Cape Bancorp, Inc. and subsidiaries’ (the Company) internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
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.
In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of the Company as of December 31, 2012 and 2011, and the related consolidated statements of operations, comprehensive income, changes in stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2012, and our report dated March 14, 2013 expressed an unqualified opinion on those consolidated financial statements.
Philadelphia, Pennsylvania
March 15, 2013
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
Cape Bancorp, Inc.:
We have audited the accompanying consolidated balance sheets of Cape Bancorp, Inc. and subsidiaries (the Company) as of December 31, 2012 and 2011, and the related consolidated statements of income, comprehensive income, changes in stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2012. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated 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. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2012 and 2011, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2012, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 14, 2013 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
Philadelphia, Pennsylvania
March 15, 2013
CAPE BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
See accompanying notes to consolidated financial statements.
CAPE BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
See accompanying notes to consolidated financial statements.
CAPE BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
See accompanying notes to consolidated financial statements.
CAPE BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
Years ended December 31, 2012, 2011 and 2010
See accompanying notes to consolidated financial statements.
CAPE BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes to consolidated financial statements.
NOTES TO AUDITED FINANCIAL STATEMENTS
NOTE 1 - ORGANIZATION
Cape Bancorp Inc., (the “Company”) is a Maryland corporation that was incorporated on September 14, 2007 for the purpose of becoming the holding company of Cape Bank (formerly Cape Savings Bank) in connection with Cape Bank’s mutual-to-stock conversion, the Company’s initial public offering and simultaneous acquisition of Boardwalk Bancorp, Inc. (“Boardwalk Bancorp”), Linwood, New Jersey and its wholly-owned New Jersey chartered bank subsidiary, Boardwalk Bank.
Cape Bank (the “Bank”) is a New Jersey-chartered stock savings bank. The Bank provides a complete line of business and personal banking products through its fifteen full service offices located throughout Atlantic and Cape May counties in southern New Jersey and three market development offices (“MDOs”) located in Burlington and Mercer Counties, New Jersey and in Radnor, PA, which the company opened in March 2013 to service the five county Philadelphia market area. The Bank received regulatory approval for the closing of one branch in Atlantic County which was effective as of the close of business March 16, 2012.
The Bank competes with other banking and financial institutions in its primary market areas. Commercial banks, savings banks, savings and loan associations and credit unions actively compete for savings and time certificates of deposit and all types of loans.
The Bank is subject to regulations of certain state and federal agencies, and accordingly, the Bank is periodically examined by such regulatory authorities. As a consequence of the regulation of commercial banking activities, the Bank’s business is particularly susceptible to future state and federal legislation and regulations.
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Financial Statement Presentation: The accounting and reporting policies of the Company conform to accounting principles generally accepted in the United States of America (US GAAP).
We have prepared the consolidated financial statements included herein pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”).
The consolidated financial statements include the accounts of Cape Bancorp, Inc. and its subsidiaries, all of which are wholly-owned. Significant intercompany balances and transactions have been eliminated. Certain prior period amounts have been reclassified to conform to current year presentations. In the opinion of management, all accounting entries and adjustments, including normal recurring accruals, necessary for a fair presentation of the financial position and the results of operations for the periods presented have been made. Events occurring subsequent to the date of the balance sheet have been evaluated for potential recognition or disclosure in the consolidated financial statements through the date of the filing of the consolidated financial statements with the SEC.
Use of Estimates: To prepare financial statements in conformity with GAAP, management makes estimates and assumptions based on available information. These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided, and actual results could differ. The allowance for loan losses, deferred taxes, evaluation of investment securities for other-than-temporary impairment and fair values of financial instruments are particularly subject to change.
Cash and Cash Equivalents: For purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks, overnight deposits, federal funds sold and interest bearing bank balances. The Federal Reserve Bank required reserves of $515,000 as of December 31, 2012, and $760,000 as of December 31, 2011, are included in these balances.
Interest-Bearing Time Deposits: Interest-bearing time deposits are held to maturity, are carried at cost and have original maturities greater than three months.
Investment Securities: Investment securities classified as available for sale are carried at fair value with unrealized gains and losses excluded from earnings and reported in a separate component of equity, net of related income tax effects. Gains and losses on sales of investment securities are recognized upon realization utilizing the specific identification method.
When the fair value of a debt security has declined below the amortized cost at the measurement date, an entity that intends to sell a security or is more likely than not to sell the security before the recovery of the security’s cost basis, the entity must recognize the other-than-temporary impairment (OTTI) in earnings. For a debt security with a fair value below the amortized cost at the measurement date where it is more likely than not that an entity will not sell the security before the recovery of its cost basis, but an entity does not expect to recover the entire cost basis of the security, the security is classified as OTTI. The related OTTI loss on the debt security will be recognized in earnings to the extent of the credit losses, with the remaining impairment loss recognized in accumulated other comprehensive income. In estimating OTTI losses, management considers: the length of time and extent that fair value of the security has been less than the cost of the security, the financial condition and near term prospects of the issuer, cash flow, stress testing analysis on securities, when applicable, and the Company’s ability and intent to hold the security for a period sufficient to allow for any anticipated recovery in fair value.
Loans Held for Sale (“HFS”): HFS consists of residential mortgage loans originated and intended for sale in the secondary market and, from time to time, certain loans transferred from the loan portfolio to HFS, all of which are carried at the lower of aggregate cost or fair market value. The fair value of residential mortgage loans is based on the price secondary markets are currently offering for similar loans using observable market data. The fair values of loans transferred from the loan portfolio to HFS are based on the amounts offered for these loans in currently pending sales transactions or as determined by outstanding commitments from investors. Write-downs on loans transferred to HFS are charged to the allowance for loan losses. Subsequent declines in fair value, if any, are charged to operating income and the HFS balance is reduced. Gains and losses on sales of loans are based on the difference between the selling price and the carrying value of the related loans sold.
Loans and Allowance for Loan Losses: Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are stated at the amount of unpaid principal, net of unearned interest, deferred loan fees and costs, and reduced by an allowance for loan losses. Interest on loans is accrued and credited to operations based upon the principal amounts outstanding. The allowance for loan losses is established through a provision for loan losses charged to operations. Loans are charged against the allowance for loan losses when management believes that the collectability of the principal is unlikely.
Recognition of interest income is discontinued when, in the opinion of management, the collectability of such interest becomes doubtful. A commercial loan is classified as non-accrual when the loan is 90 days or more delinquent, or when in the opinion of management, the collectability of such loan is in doubt.
Consumer and residential loans are classified as non-accrual when the loan is 90 days or more delinquent with a loan to value ratio greater than 60 percent. Loan origination fees and certain direct origination costs are deferred and amortized over the life of the related loans as an adjustment to the yield on loans receivable in a manner which approximates the interest method.
All interest accrued, but not received, for loans placed on non-accrual, is reversed against interest income. Interest received on such loans is accounted for as a reduction of the principal balance until qualifying for return to accrual. Commercial loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured. Payments are generally applied to reduce the principal balance but, in certain situations, the application of payments may vary. Consumer and residential loans are returned to accrual status when their delinquency becomes less than 90 days and/or the loan to value ratio is less than 60 percent.
The allowance for loan losses is maintained at an amount management deems appropriate to cover probable incurred losses. In determining the level to be maintained, management evaluates many factors including historical loss experience, the borrowers’ ability to repay and repayment performance, current economic trends, estimated collateral values, industry experience, industry loan concentrations, changes in loan policies and procedures, changes in loan volume, delinquency and troubled asset trends, loan management and personnel, internal and external loan review, total credit exposure of the individual or entity, and external factors including competition, legal, regulatory and seasonal factors. In the opinion of management, the allowance is appropriate to absorb probable loan losses. While management uses the best information available to make such evaluations, future adjustments to the allowance may be necessary. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank’s allowance for losses on loans. Such agencies may require the Bank to recognize additions to the allowance based on their judgment about information available to them at the time of their examination. Charge-offs to the allowance are made when the loan is transferred to other real estate owned or a determination of loss is made.
A loan is impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. Loans are individually evaluated for impairment. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Included in the Company’s loan portfolio are modified loans. Per the Financial Accounting standards Board (‘FASB”) Accounting Standards Codification (“ASC”), Topic 310-40, “Troubled Debt Restructurings by Creditors”, (“FASB ASC 310-40”), a restructuring is one in which the creditor, for economic or legal reasons related to the debtor’s financial difficulties, grants a concession to the debtor that the creditor would not otherwise consider, such as providing for a below market interest rate and/or forgiving principal or previously accrued interest. This restructuring may stem from an agreement or may be imposed by law, and may involve a multiple note structure. Prior to the restructuring, if the loans which are modified as a troubled debt restructuring (“TDR”) are already classified as non-accrual, these loans may only be returned to performing (i.e. accrual status) after considering the borrower’s sustained repayment performance for a reasonable amount of time, generally six months. This sustained repayment performance may include the period of time just prior to the restructuring. At December 31, 2012, TDRs totaled $7.0 million, of which $3.5 million were accruing TDRs and $3.5 million were non-accruing TDRs. This compares to $11.2 million of TDRs at December 31, 2011, of which $10.8 million were accruing TDRS and $405,000 were non-accruing TDRs. (See Note 4 - Loans Receivable)
Other Real Estate Owned (“OREO”): Real estate acquired as a result of foreclosure or by deed in lieu of foreclosure is classified as other real estate owned and is initially recorded at the lower of cost or estimated fair market value, less the estimated cost to sell at the date of foreclosure, thereby establishing a new cost basis. If fair value declines subsequent to foreclosure, an OREO write-down is recorded through expense and the OREO balance is lowered to reflect the current fair value. Operating costs after acquisition are expensed.
Premises and Equipment: Land is carried at cost. Premises and equipment are stated at cost less accumulated depreciation. Buildings and related components are depreciated using the straight-line method with useful lives ranging from 10 to 39 years. Furniture, fixtures and equipment are depreciated using the straight-line (or accelerated) method with useful lives ranging from 3 to 7 years. (See Note 18 - Sale of Bank Premises)
Federal Home Loan Bank of New York (“FHLB”) Stock: The Bank is a member of the FHLB of New York. Members are required to own a certain amount of stock based on the level of borrowings and other factors. FHLB stock is carried at cost, classified as a restricted security, and periodically evaluated for impairment based on ultimate recovery of par value. Cash dividends are reported as income.
Goodwill and Other Intangible Assets: Goodwill results from business acquisitions and represents the excess of the purchase price over the fair value of acquired tangible assets and liabilities and identifiable intangible assets. Goodwill is assessed at least annually for impairment and any such impairment will be recognized in the period identified. The annual goodwill assessment for 2012 was performed in the fourth quarter at which time there was no impairment to be recognized.
Other intangible assets consist of core deposit and acquired customer relationship intangible assets arising from whole bank acquisitions. They are initially measured at fair value and then are amortized on an accelerated method over their estimated useful lives, which range from 5 to 13 years. Other intangible assets are assessed at least annually for impairment and any such impairment will be recognized in the period identified.
Bank Owned Life Insurance (“BOLI”): The Bank has an investment of bank owned life insurance. BOLI involves the purchasing of life insurance by the Bank on a chosen group of employees and directors. The Bank is the owner and beneficiary of the policies and in accordance with FASB ASC Topic 325 “Investments in Insurance Contracts”, the amount recorded is the cash surrender value, which is the amount realizable.
Loan Commitments and Related Financial Instruments: Financial instruments include off-balance sheet credit instruments, such as commitments to make loans and commercial letters of credit, issued to meet customer financing needs. The face amount for these items represents the exposure to loss, before considering customer collateral or ability to repay. Such financial instruments are recorded when they are funded.
Defined Benefit Plan: The Bank participates in the Pentegra Defined Benefit Plan for Financial Institutions (The “Pentegra DB Plan”), a tax-qualified defined benefit pension plan. The Pentegra DB Plan’s Employer Identification Number is 13-5645888 and the Plan Number is 333. The Pentegra DB Plan operates as a multi-employer plan for accounting purposes and as a multiple-employer plan under the Employee Retirement Income Security Act of 1974 and the Internal Revenue Code. There are no collective bargaining agreements in place that require contributions to the Pentegra DB Plan. (See Note 13 - Benefit Plans)
The plan was amended to freeze participation to new employees commencing January 1, 2008. Employees who became eligible to participate prior to January 1, 2008, will continue to accrue a benefit under the plan. The Bank accrues pension costs as incurred. The plan was further amended to freeze benefits as of December 31, 2008 for all employees eligible to participate prior to January 1, 2008.
401(k) Plan: The Bank maintains a tax-qualified defined contribution plan for all salaried employees of Cape Bank who have satisfied the 401(k) Plan’s eligibility requirements. Effective, January 1, 2012, the Bank eliminated the matching contribution formula and replaced it with a discretionary form of matching contribution.
Employee Stock Ownership Plan (“ESOP”): The cost of shares issued to the ESOP, but not yet earned is shown as a reduction of equity. Compensation expense is based on the market price of shares as they are committed to be released to participant accounts and the shares become outstanding for earnings per share computations. (See Note 13 - Benefit Plans).
Stock Benefit Plan: The Company has an Equity Incentive Plan (the “Stock Benefit Plan”) under which incentive and non-qualified stock options, stock appreciation rights (SARs) and restricted stock awards (RSAs) may be granted periodically to certain employees and directors. The fair value of the restricted stock is the market value of the stock on the date of grant. Under the fair value method of accounting for stock options, the fair value is measured on the date of grant using the Black-Scholes option pricing model with market assumptions. This amount is amortized as salaries and employee benefits expense on a straight-line basis over the vesting period. Option pricing models require the use of highly subjective assumptions, including expected stock price volatility, which, if changed, can significantly affect fair value estimates.
Income Taxes: Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. The principal types of accounts resulting in differences between assets and liabilities for financial statement and tax purposes are the allowance for loan losses, deferred compensation, deferred loan fees, charitable contributions, depreciation and other-than-temporary impairment charges. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is recorded against net deferred tax assets when management has concluded that it is not more likely than not that a portion or all will be realized. Management considers several factors in determining whether a portion of or all of the valuation allowance should be reversed such as the level of historical taxable income, projections for future taxable income over the periods in which the deferred tax assets are deductible and tax planning strategies.
Under FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, included in FASB ASC Subtopic 740-10-Income Taxes-Overall, the Company recognizes the effect of income tax positions only if those positions are more likely than not of being sustained. Recognized income tax positions are measured at the largest amount that is greater than 50% likely of being realized. Changes in recognition or measurement are reflected in the period in which the change in judgment occurs.
The Company records interest and penalties related to uncertain tax positions as non-interest expense.
Earnings Per Share: Basic earnings (loss) per common share is the net income (loss) divided by the weighted average number of common shares outstanding during the period. ESOP shares are not considered outstanding for this calculation unless earned. Diluted earnings per share includes the dilutive effect of additional potential common shares issuable under stock option and restricted stock awards, if any.
Comprehensive Income (Loss): Comprehensive income (loss) includes net income as well as certain other items which result in a change to equity during the period. Other comprehensive income includes unrealized gains and losses on securities available for sale which are also recognized as separate components of equity. See the Consolidated Statement of Changes in Comprehensive Income.
Operating Segments: While the chief decision makers monitor the revenue streams of the various products and services, operations are managed and financial performance is evaluated on a Company-wide basis. Operating segments are aggregated into one as operating results for all segments are similar. Accordingly, all of the financial service operations are considered by management to be aggregated in one reportable operating segment.
Effect of Newly Issued Accounting Standards:
In April 2011, the FASB issued ASU 2011-03, Transfers and Servicing (Topic 860): Reconsideration of Effective Control for Repurchase Agreements. The ASU is intended to improve financial reporting of repurchase agreements (“repos”) and other agreements that both entitle and obligate a transferor to repurchase or redeem financial assets before their maturity. The amendments to the Codification in this ASU are intended to improve the accounting for these transactions by removing from the assessment of effective control the criterion requiring the transferor to have the ability to purchase or redeem the financial assets. The amendments in this update apply to all entities, both public and nonpublic. This ASU is effective for the first interim or annual periods beginning on or after December 15, 2011. The guidance should be applied prospectively to transactions or modification of existing transactions that occur on or after the effective date. Early adoption is not permitted. The Company has complied with guidance for the period ended December 31, 2012.
In May 2011, the FASB issued ASU 2011-04, Fair Value Measurement (Topic 820): Amendments to achieve Common Fair Value Measurement (Topic 820) and Disclosure Requirement in US GAAP and IFRSs. The amendments were issued to achieve convergence between US GAAP and IFRS. The guidance clarifies how a principal market is determined, addresses the fair value measurement of instruments with offsetting market or counterparty credit risks and the concept of valuation premise and highest and best use, extends the prohibition on blockage factors to all three levels of the fair value hierarchy, and requires additional disclosures. ASU No. 2011-04 was effective for the Company on January 1, 2012 and was to be applied prospectively. Adoption of this update did not have a material impact on the Company’s financial position or results of operations but did result in additional disclosures within the fair value footnote.
In September 2011, the FASB issued ASU 2011-08, Intangibles - Goodwill and Other (Topic 350). The amendments in this update will allow an entity to first assess qualitative factors to determine whether it is necessary to perform the two-step quantitative goodwill impairment test. Under these amendments, an entity would not be required to calculate the fair value of a reporting unit unless the entity determines, based on qualitative assessment, that it is more likely than not that its fair value is less than its carrying amount. The amendments include a number of events and circumstances for an entity to consider in conducting the qualitative assessment. These amendments are effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. Early adoption is permitted, including for annual and interim goodwill impairment tests performed as of a date before September 15, 2011, if an entity’s financial statements for the most recent annual or interim period have not been issued. The Company early adopted the amendments of this update during the fourth quarter of 2011 (See Note 10).
In September 2011, the FASB issued ASU 2011-09, Compensation-Retirement Benefits-Multiemployer Plans (Subtopic 715-80). The amendments in this ASU require additional disclosures about an employer’s participation in a multiemployer plan. For public entities, such as Cape Bancorp, this ASU is effective for annual periods for fiscal years ending after December 15, 2011. The adoption of this ASU in the fourth quarter of 2011 did not have a material impact on the Company’s consolidated financial statements. The presentation of the additional disclosures relating to the multiemployer retirement plan (sponsored by the Pentegra Defined Benefit Plan for Financial Institutions (The “Pentegra DB Plan”) in which the Company participates is included in Note 13 - Benefit Plans of the Notes to Consolidated Financial Statements.
In December 2011, the FASB issued ASU 2011-10, Property, Plant and Equipment (Topic 360): The objective of this update is to resolve the diversity in practice about whether the guidance in the Subtopic 360-20, Property, Plant and Equipment - Real Estate Sales, applies to a parent that ceases to have a controlling financial interest (as described in Subtopic 810-10 Consolidation - Overall) in a subsidiary that is in substance real estate as a result of default on the subsidiary’s nonrecourse debt. This update does not address whether the guidance in Subtopic 360-20 would apply to other circumstances when parent ceases to have a controlling financial interest in a subsidiary that is in substance real estate. An entity is required to apply the amendments for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods. The Company does not anticipate any material impact to the consolidated financial statements related to this guidance.
In December 2011, the FASB issued ASU 2011-11, Balance Sheet, Disclosure about Offsetting Assets and Liabilities (Topic 210). The objective of this update is to provide enhanced disclosures that will enable users of its financial statements to evaluate the effect or potential effect of netting arrangements on an entity’s financial position. This includes the effect or potential effect of rights of setoff associated with an entity’s recognized assets and recognized liabilities within the scope of this Update. The amendments require enhancement disclosures by requiring improved information about financial instruments and derivative instruments that are either (1) offset in accordance with either Section 210-20-45 or Section 815-10-45 or (2) subject to an enforceable master netting arrangement or similar agreement, irrespective of whether they offset in accordance with either Section 210-20-45 or Section 815-10-45. These amendments are effective for annual periods beginning on or after January 3, 2013, and interim periods within those annual periods. An entity should provide the disclosures required by those amendments retrospectively for all comparative periods presented. The Company does not anticipate any material impact to the consolidated financial statements related to this guidance.
In December 2011, the FASB issued ASU 2011-12, Comprehensive Income (Topic 220). The amendments in this update supersede certain pending paragraphs in ASU No. 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income, to effectively defer only those changes in ASU 2011-05 that relate to the presentation of reclassification adjustments out of accumulated other comprehensive income. The amendments will be temporary to allow the Board time to deliberate the presentation requirements for reclassifications out of accumulated other comprehensive income for annual and interim financial statements for public, private and non-profit entities. The amendments in this update are effective for public entities for fiscal years, and interim annual periods within those years, beginning after December 15, 2011, consistent with ASU 2011-05. The Company adopted the guidance on January 1, 2012.
In January 2013, the FASB issued ASU 2013-01, Balance Sheet, Clarifying the Scope of Disclosures about Offsetting Assets and Liabilities (Topic 210): The amendments in this update clarify that the scope of Update 2011-11 applies to derivatives accounted for in accordance with Topic 815, Derivatives and Hedging, including bifurcated embedded derivatives, repurchase agreements and reverse repurchase agreements, and securities borrowing and securities lending transactions that are either offset in accordance with Section 210-20-45 or Section 815-10-45 or subject to an enforceable master netting arrangement or similar agreement. An entity is required to apply the amendments for fiscal years beginning on or after January 1, 2013, and interim periods within those annual periods. An entity should provide the required disclosures retrospectively for all comparative periods presented. The Company does not anticipate any material impact to the consolidated financial statements related to this guidance.
In February 2013, the FASB issued ASU 2013-02, Comprehensive Income, Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income (Topic 220): The amendments in this update aim to improve the reporting of reclassifications out of accumulated other comprehensive income. The amendments in this update seek to attain that objective by requiring an entity to report the effect of significant reclassifications out of accumulated other comprehensive income on the respective line items in net income if the amount being reclassified is required under U.S. GAAP to be reclassified in its entirety to net income. For other amounts that are not required under U.S. GAAP to be reclassified in their entirety to net income in the same reporting period, an entity is required to cross-reference other disclosures required under U.S. GAAP that provide additional detail about those amounts. This would be the case when a portion of the amount reclassified out of accumulated other comprehensive income is reclassified to a balance sheet account instead of directly to income or expense in the same reporting period. For public entities, the amendments are effective prospectively for reporting periods beginning after December 15, 2012. The Company adopted the amendments of ASU 2011-12 effective January 1, 2012 and has applied the amendments retrospectively. As a result, the Company has presented comprehensive income in two separate but consecutive statements for the years ended December 31, 2012, 2011 and 2010.
NOTE 3 - INVESTMENT SECURITIES
The amortized cost, gross unrealized gains or losses and the fair value of the Company’s investment securities available for sale at December 31, 2012 and December 31, 2011 are as follows:
The table below indicates the length of time individual securities have been in a continuous unrealized loss position at December 31, 2012.
The table below indicates the length of time individual securities have been in a continuous unrealized loss position at December 31, 2011.
Management evaluates investment securities to determine if they are other-than-temporarily impaired on at least a quarterly basis. The evaluation process applied to each security includes, but is not limited to, the following factors: whether the security is performing according to its contractual terms, determining if there has been an adverse change in the expected cash flows for investments within the scope of FASB Accounting Standards Codification (ASC) Topic 325, “Investments Other”, the length of time and the extent to which the fair value has been less than cost, whether the Company intends to sell, or would more likely than not be required to sell an impaired debt security before a recovery of its amortized cost basis, credit rating downgrades, the percentage of performing collateral that would need to default or defer to cause a break in yield and/or a temporary interest shortfall, and a review of the underlying issuers.
At December 31, 2012, the Company’s investment securities portfolio consisted of 296 securities, 31 of which were in an unrealized loss position. The gross unrealized losses in the Company’s investment securities portfolio related primarily to the collateralized debt obligation securities, which are discussed in detail below, and accounted for 97.9% of the gross unrealized losses at December 31, 2012 compared to 91.6% of the gross unrealized losses at December 31, 2011. The remaining securities consist of investments that are backed by the U.S. Government or U.S. sponsored agencies which the government has affirmed its commitment to support, municipal obligations and corporate bonds which had unrealized losses that were caused by changing credit spreads in the market as a result of the current economic environment. Because the Company has no intention to sell these securities, nor is it more likely than not that we will be required to sell these securities, the Company does not consider those investments to be OTTI.
As of December 31, 2012, the book value of our pooled trust preferred collateralized debt obligations (CDO) totaled $8.3 million with an estimated fair value of $4.7 million and is comprised of 22 securities. Of those, 14 have been principally issued by bank holding companies (PreTSL deals, and Alesco VI), and 8 have been principally issued by insurance companies (I-PreTSL deals). All of our pooled securities are mezzanine tranches and possess credit ratings below investment grade. As of December 31, 2012, 14 of our securities had no excess subordination and 8 of our securities had excess subordination which ranged from 10.43% to 17.11% of the current performing collateral. Excess subordination is the amount by which the underlying performing collateral exceeds the outstanding bonds in the current class, plus all senior classes. It is a static measure of credit enhancement, but does not incorporate structural elements of the CDO. Management utilizes excess subordination as a measure to identify which tranches are at a greater risk for a future break in cash flows. However, a current subordination deficit or “zero excess subordination” does not indicate the tranche will not ultimately receive all principal and interest due. For example, this measure does not consider the potential for recovery of issuers that are currently deferring payments. Some issuers have elected to defer payments, which contractually they are permitted to do for a period of up to 5 years, even though going concern issues may not exist. This supports management’s position that a deferral is not necessarily indicative of a default or that a default is imminent. On average, deferring issuers within our CDO portfolio comprise approximately 60% of the total dollar value related to issuer defaults and deferrals. As such, our assumptions used in the calculation of discounted cash flows anticipate a 15% recovery rate on deferring issuers as compared to no recovery of issuers that have defaulted. The recovery rate assumption represents management’s best estimate based on current facts and circumstances. In addition, due to projected discounted cash flows that do not support the receipt of interest, the Company is not accruing interest on any of the bank-issued CDO securities. Accordingly, these securities are considered non-performing assets.
The following table provides additional information related to our pooled trust preferred collateralized debt obligations as of December 31, 2012:
Pooled Trust Preferred Collateralized Debt Obligations
(dollars in thousands)
The following table provides additional information related to our pooled trust preferred collateralized debt obligations as of December 31, 2011:
Pooled Trust Preferred Collateralized Debt Obligations
(dollars in thousands)
Lack of liquidity in the market for trust preferred collateralized debt obligations, credit rating downgrades and market uncertainties related to the financial industry are factors contributing to the impairment on these securities. The table above excludes 11 CDO securities which have been completely written-off and, therefore, have no book value. The realized loss associated with these securities is $14.5 million.
On a quarterly basis, we evaluate our investment securities for other-than-temporary impairment. As required by FASB ASC Topic No. 320, “Investments - Debt and Equity Securities”, if we do not intend to sell a debt security, and it is not more likely than not that we will be required to sell the security, an OTTI write-down is separated into a credit loss portion and a portion related to all other factors. The credit loss portion is recognized in earnings as net OTTI losses, and the portion related to all other factors is recognized in accumulated other comprehensive income, net of taxes. The credit loss portion is defined as the difference between the amortized cost of the security and the present value of the expected future cash flows for the security. If the intent is to sell a debt security or if it is more likely than not that we will be required to sell the security, then the security is written down to its fair market value as a net OTTI loss in earnings. The Company has evaluated these securities and determined that the decreases in estimated fair value are temporary with the exception of 14 bank issued pooled trust preferred CDO securities. The Company’s estimate of projected cash flows it expected to receive was less than the securities’ carrying value resulting in a net credit impairment charge to earnings for the year ending December 31, 2012 of $8,000.
Our CDOs are beneficial interests in securitized financial assets within the scope of FASB ASC Topic No. 325, “Investments - Other”, and are therefore evaluated for OTTI using management’s estimate of future cash flows. If these estimated cash flows determine that it is probable an adverse change in cash flows has occurred, then OTTI would be recognized in accordance with FASB ASC Topic No. 320. The Company uses a third party model (“model”) to assist in calculating the present value of current estimated cash flows to the previous estimate. The present value of the expected cash flows is calculated based on the contractual terms of the security, and is discounted at a rate equal to the effective interest rate implicit in the security at the date of acquisition.
The model also takes into account individual defaults and deferrals that have already occurred by any participating issuer within the pool of entities that make up the security’s underlying collateral. With regard to expected defaults and deferrals, the Company performs an ongoing analysis of these securities utilizing both readily available market data and analytical models obtained from the third party. On a quarterly basis we evaluate the underlying collateral of each pooled trust preferred security in our portfolio to determine the appropriate default/deferral assumptions to use in our calculation of discounted cash flows. This process entails obtaining each security’s issuer list which include the most recent financial and credit quality metrics. We then identify issuers that have metrics that are similar to those that have defaulted or are deferring payments. As part of our evaluation we consider such measures as liquidity, capital adequacy, profitability, and credit quality and analyze ratios such as ROAA, net interest margin, tier 1 risk based capital, tangible equity to tangible assets, Texas ratio, reserves to loans and non-performing loans to loans. Our evaluation also takes into consideration current economic indicators as well as recent default/deferral trends of underlying issuers. Management then develops a projected default/deferral rate for each security based on this analysis. This rate is then applied to the cash flow model developed by the third party to calculate the present value of discounted cash flows for each security. The model assumptions relative to expected recoveries of defaulted issuers and deferring issuers were discussed earlier in this Note. Furthermore, we periodically perform back-testing by comparing actual default/deferral rates to previous projections. The results are used to refine future projections on a continuous basis. Lastly, we continually evaluate the securities for the potential of future impairment by reviewing the FDIC failed bank list and deferral announcements made by the underlying issuers of each CDO security in our portfolio.
In general, CDOs are callable within five to ten years of issuance with a quarterly call frequency. Due to current market conditions, the cost to refinance or issue capital at a lower rate than what is currently outstanding, and the limited history of CDOs, prepayments are difficult to predict. The model assumes that prepayments will be limited to those issuers that are acquired by large banks with low financing costs. A 1% annual prepayment assumption has been used in the model and is indicative of management’s belief that consolidation in the banking industry will occur over the next several years as market conditions begin to improve. Additionally, commencing with a date ten years from the issuance date, the Trustee can solicit bids in an auction format for the purchase of all the outstanding collateral securities. The highest bid will be accepted that is at least equal to the sum of the outstanding liabilities at par plus accrued and unpaid interest. However, given the uncertain future of the CDO market, credit quality issues with the underlying issuers, and a decline in market value, the model assumes that a successful call auction is highly unlikely. Therefore, the model expects that the securities will extend through their full 30-year maturity.
The amortized cost and fair value of debt, equity, and mortgage-backed securities available for sale at December 31, 2012, by contractual maturities, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
The following table presents a summary of the cumulative credit related OTTI charges recognized as components of earnings for CDO securities still held by the Company at December 31, 2012 and 2011 (in thousands):
Gross realized gains on sales of investment securities during 2012 were $1,726,000, compared to $474,000 during 2011. The Company also realized gross losses of $122,000 during 2012 compared to $325,000 during 2011 as it sold securities that it viewed as having a greater than acceptable level of potential risk in the future. Proceeds were $67.4 million in 2012 compared $12.4 million in 2011.
As of December 31, 2012, the fair value of all securities available for sale that were pledged to secure public fund deposits, short-term borrowings, repurchase agreements, and for other purposes required by law, was $28.5 million. At December 31, 2011 the corresponding amount was $59.7 million.
NOTE 4 - LOANS RECEIVABLE
Loans receivable consist of the following:
Activity in the allowance for losses is as follows:
(1) The Company reclassified $11.9 million of loans to held for sale in the third quarter of 2011.
The following summarizes activity related to the allowance for loan losses by category for the years ended December 31, 2012 and 2011:
(1) includes commercial lines of credit
Impaired loans at December 31, 2012 and 2011 were as follows:
(1) Non-accrual loans in the table above include TDRs totaling $3.5 million at December 31, 2012 and $405,000 at December 31, 2011. Total impaired loans do not include loans held for sale. Loans held for sale include $911,000 of loans that are on non-accrual status.
As of December 31, 2012 and 2011, non-performing loans had a principal balance of approximately $19.4 million and $27.4 million, respectively. Loan balances past due 90 days or more and still accruing interest, but which management expects will eventually be paid in full, amounted to approximately $1.6 million and $2.0 million at December 31, 2012 and 2011, respectively. The amount of interest income that would have been recorded had our non-accruing loans been current in accordance with their original terms was $1.3 million, $2.1 million, and $1.9 million for the years ended December 31, 2012, 2011 and 2010, respectively.
Impaired loans include loans whose contractual terms have been restructured in a manner that grants a concession to a borrower experiencing financial difficulties. In accordance with applicable accounting guidance (FASB ASC 310-40), these modified loans are considered TDRs. See Note 2 of the Notes to Consolidated Financial Statements for further information regarding TDRs.
The following table provides a summary of TDRs by performing status:
(1) Excludes non-accruing HFS TDRs of $2.0 million at December 31, 2011.
There were no non-accruing HFS TDRs at December 31, 2012.
The following presents new TDRs for the years ended December 31, 2012 and 2011:
The following presents, by class of loans, information regarding the types of concessions granted on accruing and non-accruing loans that were restructured during the years ended December 31, 2012 and 2011:
(1) Excludes non-accruing HFS TDRs of $2.0 million at December 31, 2011. There were no non-accruing HFS TDRs at December 31, 2012.
The following presents TDRs that subsequently defaulted for the years ended December 31, 2012 and 2011:
Some loan modifications classified as TDRs may not ultimately result in the full collection of principal and interest, as modified, and result in potential incremental losses. These potential incremental losses have been factored into our overall allowance for loan losses estimate. The level of any re-defaults will likely be affected by future economic conditions. Once a loan becomes a TDR, it will continue to be reported as a TDR until it is ultimately repaid in full, reclassified to loans held for sale, foreclosed, sold, or it meets criteria to be removed from TDR status. At December 31, 2012 and 2011, the allowance for loan losses included an impairment reserve for TDRs in the amount of $79,000 and $215,000, respectively.
The following table presents impaired loans at December 31, 2012:
(1) excludes HFS non-accruing loans of $911,000.
(2) the difference between the recorded investment and unpaid principal balance primarily results from partial charge-offs.
The following table presents impaired loans at December 31, 2011:
(1) excludes HFS non-accruing loans of $3.6 million of which $2.0 million are TDRs.
(2) the difference between the recorded investment and unpaid principal balance primarily results from partial charge-offs
The following table presents loans by past due status at December 31, 2012:
(1) excludes $911,000 of loans held for sale.
The following table presents loans by past due status at December 31, 2011:
(1) excludes $3.6 million of loans held for sale.
Our policies provide for the classification of loans based on an analysis of the credit conditions of the borrower and the value of the collateral when appropriate. There is no specific credit metrics used to determine the risk rating.
Risk Rating 1-5-Acceptable credit quality ranging from High Pass (cash or near cash as collateral) to Management Attention/Pass (acceptable risk) with some deficiency in one or more of the following areas: management experience, debt service coverage levels, balance sheet leverage, earnings trends, the industry of the borrower and annual receipt of current borrower financial information.
Risk Rating 6- Special Mention reflects loans that management believes warrant special consideration and may be loans that are delinquent or current in their payments. These loans have potential weakness which increases their risk to the bank and have shown some signs of weakness but have fallen short of being a Substandard loan.
Management believes that the Substandard category is best considered in four discrete classes: RR 7.0 “performing substandard loans;” RR 7.5; and RR 7.9
Risk Rating 7.0-The class is mostly populated by customers that have a history of repayment (less than 2 delinquencies in the past year) but exhibit a well defined weakness
Risk Rating 7.5-These are loans that share many of the characteristics of the RR 7.0 loans as they relate to cash flow and/or collateral, but have the further negative of chronic delinquencies. These loans have not yet declined in quality to require a FASB ASC Topic No. 310 Receivables analysis, but nonetheless this class has a greater likelihood of migration to a more negative risk rating.
Risk Rating 7.8 - These loans are impaired loans, are current and accruing, and in some cases are TDRs. They have had a FASB ASC Topic No. 310 Receivables analysis completed.
Risk Rating 7.9-These loans have undergone a FASB ASC Topic No. 310 Receivables analysis. For those that have a FASB ASC Topic No. 310 Receivables analysis, no general reserve is allowed. More often than not, those loans in this class with specific reserves have had the reserve placed by Management pending information to complete a FASB ASC Topic No. 310 Receivables analysis. Upon completion of the FASB ASC Topic No. 310 Receivables analysis reserves are adjusted or charged off.
The following tables present commercial loans by credit quality indicator:
The following tables present consumer loans by credit quality indicator:
Mortgage loans serviced for others are not reported as assets. The principal balances of these loans at December 31, 2012 and 2011 are as follows:
Custodial escrow balances maintained in connection with serviced loans were $18,000 and $19,000, respectively at December 31, 2012 and 2011.
Loans to principal officers, directors, and their affiliates were as follows:
NOTE 5 - FAIR VALUE
FASB ASC Topic No. 820, “Fair Value Measurements and Disclosures” establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:
Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.
Level 2: Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.
Level 3: Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.
Fair value measurement of securities available for sale is based upon quoted prices, if available. If quoted prices are not available, fair values are generally measured using independent pricing models or other model-based valuation techniques that include market inputs, such as benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, reference data and industry and economic events. Level 1 securities include an investment fund that is traded by dealers or brokers in active over-the-counter markets. Level 2 securities include securities issued by government sponsored agencies, securities issued by certain state and political subdivisions, residential mortgage-backed securities, collateralized mortgage obligations, and corporate bonds.
The Company obtained the pricing for collateralized debt obligation securities, which are issued by financial institutions and insurance companies, from an independent third party who prepared the valuations using a market valuation approach. Information such as historical and current performance of the underlying collateral, deferral/default rates, collateral coverage ratios, break in yield calculations, cash flow projections, liquidity and credit premiums required by a market participant, and financial trend analysis with respect to the individual issuing financial institutions and insurance companies, is utilized in determining individual security valuations. Due to current market conditions, as well as the limited trading activity of these securities, the market value of the securities is highly sensitive to assumption changes and market volatility.
Assets and Liabilities Measured on a Recurring Basis
Assets and liabilities measured at fair value on a recurring basis are summarized below:
The fair value of the collateralized debt obligation securities in the table above was determined by utilizing Level 3 inputs. The value was derived from a discounted cash flow model using significant unobservable inputs such as, a discount margin to present value the cash flows, and assumptions about the underlying collateral including default rate, recovery rate for deferring issuers, and prepayment speeds. The discount margin used for each security ranged from 2.2% to 9.5%, while the range for the default rate was 0.25% to 2.00% and a 15% recovery rate for deferring issuers has been assumed. An annual prepayment speed of 1.00% was assumed. Significant increases in any of the rates, with the exception of the recovery rate, would result in a significantly lower fair value measurement.
The table below presents a reconciliation and income statement classification of gains and losses for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the years ended December 31, 2012 and 2011:
Assets and Liabilities Measured on a Non-Recurring Basis
Assets and liabilities measured at fair value on a non-recurring basis are summarized below:
(1) Includes loans delinquent 90 days, loans less than 90 days delinquent but not accruing and troubled debt restructured loans.
The fair value of impaired loans with specific allocations of the allowance for loan losses is generally based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. When the fair value of the collateral is based on an observable market price or current appraised value, the Company records the impaired loans as a Level 2 valuation. When management determines the fair value of the collateral is further impaired below the appraised value, or there is no observable market price or appraised value, the Company records the loan as a Level 3 valuation. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are typically significant and result in a Level 3 classification of the inputs for determining fair value.
Other real estate owned properties are recorded at the lower of cost or estimated fair market value, less the estimated cost to sell, at the date of foreclosure. Fair market value is estimated by using professional real estate appraisals and may be subsequently adjusted based upon real estate broker opinions.
As discussed above, the fair value of impaired loans and other real estate owned is generally determined through independent appraisals of the underlying collateral, which may include Level 3 inputs that are not identifiable, or by using the discounted cash flow method if the loan is not collateral dependent.
The following disclosure of estimated fair value amounts has been determined by the Company using available market information and appropriate valuation methodologies. However, considerable judgment is required to interpret market data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts.
The carrying amount is the estimated fair value for cash and cash equivalents, interest bearing deposits, and accrued interest receivable and payable. Noninterest-bearing cash and cash equivalents and noninterest-bearing deposit liabilities are classified as Level 1, whereas interest-bearing cash and cash equivalents and interest-bearing deposit liabilities are classified as Level 2. Accrued interest receivable and payable are classified as either Level 2 or Level 3 based on the classification level of the asset or liability with which the accrued interest is associated.
Loans held for sale - The fair value of residential mortgage loans is based on the price secondary markets are currently offering for similar loans using observable market data. The fair value is equal to the carrying value, since the time from when a loan is closed and settled is generally not more than two weeks. The fair values of loans transferred from the loan portfolio are based on the amounts offered for these loans in currently pending sales transactions or as determined by outstanding commitments from investors. Loans held for sale are not included in non-performing loans.
Loans - The fair values of all loans are estimated by discounting the estimated future cash flows using the Company’s interest rates currently offered for loans with similar terms to borrowers of similar credit quality which is not an exit price under FASB ASC Topic No. 820, “Fair Value Measurements and Disclosures”. The carrying value and fair value of loans are net of the allowance for loan losses.
FHLB stock - Ownership in equity securities of FHLB of New York is restricted and there is no established market for their resale. The carrying amount is a reasonable estimate of fair value.
Bank owned life insurance (BOLI) - The fair value of BOLI approximates the carrying amount, because upon liquidation of these investments, the Corporation would receive the cash surrender value which equals the carrying amount.
Deposits - The fair value of deposits with no stated maturity, such as money market deposit accounts, checking accounts and savings accounts, is equal to the amount payable on demand. The fair value of certificates of deposit is based on the discounted value of contractual cash flows. The discount rate is equivalent to the rate currently offered by the Company for deposits of similar size, type and maturity.
Borrowings - The fair value of borrowings, which includes Federal Home Loan Bank of New York advances and securities sold under agreement to repurchase, is based on the discounted value of contractual cash flows. The discount rate is equivalent to the rate currently offered for borrowings of similar maturity and terms.
The Company’s unused loan commitments, standby letters of credit and undisbursed loans have no carrying amount and have been estimated to have no realizable fair value. Historically, a majority of the unused loan commitments have not been drawn upon. See Note 12, “Financial Instruments with Off-Balance Sheet Risk and Concentrations of Credit Risk” of Notes to Consolidated Financial Statements, for additional information.
The fair value estimates presented herein are based on pertinent information available to management as of December 31, 2012. Although management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued for purposes of these financial statements since that date; and therefore, current estimates of fair value may differ significantly from the amounts presented herein.
NOTE 6 - OTHER REAL ESTATE OWNED
At December 31, 2012, other real estate owned totaled $7.2 million and consisted of thirty-five residential properties and thirteen commercial properties. At December 31, 2011, other real estate owned totaled $8.4 million and consisted of two residential properties and fifteen commercial properties.
For the year ended December 31, 2012, the Company added $10.2 million of property to OREO and sold fourteen commercial OREO properties and thirteen residential OREO properties with an aggregate carrying value totaling $10.2 million, including three commercial OREO properties and four residential OREO properties with an aggregate carrying value of $868,000 sold in the fourth quarter of 2012. Net losses on the sale of OREO totaled $260,000 for the year ended December 31, 2012, of which $3,000 was recorded in the fourth quarter, compared to net losses on OREO sales of $218,000 for the year ended December 31, 2011.
For the year ended December 31, 2012, net expenses applicable to OREO totaled $2.0 million which included OREO valuation write-downs of $1.1 million, taxes and insurance totaling $456,000, net losses on the sale of OREO totaling $260,000 and miscellaneous expenses, net of rental income totaling $241,000. For the year ended December 31, 2011, net expenses applicable to OREO totaled $2.6 million which included OREO valuation write-downs of $1.8 million, taxes and insurance totaling $428,000, net losses on the sale of OREO totaling $218,000 and miscellaneous expenses, net of rental income totaling $132,000.
As of the date of this filing, the Company has agreements of sale for eight OREO properties, including five residential building lots, with an aggregate carrying value totaling $1.7 million. In 2013, the Company has added one commercial property with a carrying value of $168,000. In addition, in 2013, the company has sold three residential OREO properties with an aggregate carrying value of $1.4 million. The Company recorded a net gain of $22,000 related to the 2013 sales.
NOTE 7 - PREMISES AND EQUIPMENT
Premises and equipment, summarized by major classification, are as follows:
Depreciation expense for the years ended December 31, 2012, 2011, and 2010 was approximately $1.0 million, $1.2 million, and $1.4 million, respectively.
NOTE 8 - GOODWILL AND INTANGIBLE ASSETS
The change in the balance for goodwill during the year is as follows:
FASB ASC Topic No. 350-20, “Goodwill” requires a company to perform an impairment test on goodwill annually, or more frequently if events or changes in circumstance indicate that the asset might be impaired, by computing the fair value of such goodwill to its recorded or carrying amount. If the carrying amount of goodwill exceeds the fair value, an impairment charge must be recorded in an amount equal to the excess.
The Company tested goodwill for impairment during the fourth quarter of 2012. The Company has one reporting unit, Community Banking, and as such evaluated goodwill at the Community Banking reporting unit level. This test involved estimating the fair value of the Company using financial data and market prices as of December 31, 2012 and utilizing the control premium approach. The results of this test indicated that goodwill was not impaired. The Company continues to evaluate goodwill on a quarterly basis.
Acquired intangible assets at year end are as follows:
The aggregate amortization expense for the years ended December 31, 2012, 2011 and 2010 was $97,000, $111,000 and $140,000, respectively.
The estimated amortization expense for each of the next five years and thereafter is as follows:
NOTE 9 - DEPOSITS
Deposits are as follows:
Interest expense by deposit type was as follows:
Certificates of deposit were scheduled to mature contractually within the following periods:
Deposits held at the Bank by related parties, which include officers, directors, and companies in which directors of the Board have a significant ownership interest, approximated $6.0 million at December 31, 2012 and $7.0 million at December 31, 2011.
NOTE 10 - BORROWINGS
At December 31, 2012, the Bank had available borrowing capacity under a continuing borrowing agreement with the Federal Home Loan Bank of New York (FHLB) to borrow up to 100% of the book value of qualified 1 to 4 family loans secured by residential properties and various commercial loans secured by commercial real estate subject to FHLB approval. At December 31, 2012, none of these advances were callable. At December 31, 2011, $11.5 million of these advances were callable on various dates. Interest rates ranged from 1.10% to 3.85% at December 31, 2012, and from 1.11% to 5.31% at December 31, 2011.
In June 2012, the Company extinguished $20.0 million of fixed rate term FHLB borrowings prior to their scheduled maturity. In connection with the early repayment of these borrowings, the Company incurred a charge of $921,000 to extinguish the debt which was recorded as other expense in the consolidated statements of income. In August 2012, the Company restructured $54.0 million in borrowings, lowering the cost of funds. This action represents a continuation of the balance sheet restructuring the Company began in the second quarter of 2012. The replacement borrowings are adjustable rate, non-callable FHLB advances with maturities ranging from 5 years to 7 years. A prepayment penalty of $6.4 million was incurred related to the restructuring of the old debt and is being amortized as an adjustment to interest expense over the terms of the new borrowings using the interest method.
Outstanding borrowings mature as follows:
At December 31, 2012 and 2011, the Bank had qualified 1 to 4 family loans and commercial loans of approximately $242.2 million and $237.8 million, respectively, which served as collateral to cover outstanding advances on the Federal Home Loan Bank of New York borrowings.
Securities sold under agreement to repurchase totaled $9.9 million at December 31, 2012 are fixed rate, and are collateralized by securities with a carrying amount of $13.0 million. At December 31, 2011, securities sold under agreements to repurchase totaled $37.5 million, were fixed rate, and were collateralized by securities with a carrying amount of $43.9 million. At maturity, the securities underlying the agreement are returned to the Company. At December 31, 2012 and 2011, repurchase agreements totaling $9.9 million and $37.5 million, respectively were callable on various dates, at par by the repurchase agreement counter-party.
The following table sets forth fixed and variable rate FHLB borrowings and the respective weighted average interest rate at December 31, 2012 and 2011:
Additional information regarding FHLB Borrowings and securities sold under agreements to repurchase is as follows:
NOTE 11 - INCOME TAXES
Income tax benefit for the year ended December 31, 2011 was primarily impacted by the reversal of $12.2 million of the deferred tax asset valuation allowance. There was a deferred tax valuation allowance reversal in 2012 in the amount of $358,000. The balance of the valuation allowance remaining was approximately $1.9 million at December 31, 2012. The release of a portion of the valuation allowance in 2011was based on a pattern of sustained earnings exhibited by the Company over the most recent 7 quarters through September 30, 2011, projected future taxable income and a tax strategy to facilitate ordinary loss treatment by the Company of certain investment losses when such losses are recognized for tax purposes. Based on these factors management has determined that it is more likely than not that a greater portion of its deferred tax assets are realizable and adjusted the valuation allowance accordingly.
Income tax expense (benefit) was as follows:
Effective tax rate differs from the federal statutory rate of 34% applied to income before income taxes due to the following:
Year-end deferred tax assets and liabilities were due to the following:
During the third quarter of 2009, the Company established a valuation allowance of approximately $16.0 million against a significant portion of its deferred tax assets after concluding that it was more likely than not that a portion of the deferred tax asset would not be realized. A valuation allowance was not deemed necessary for the deferred tax asset related to the unrealized investment losses as the realization of this component of the deferred tax asset is not dependent on future taxable income. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities (including the impact of available carryback and carryforward periods), projected future taxable income, and tax-planning strategies in making this assessment. In recording the valuation allowance in the third quarter of 2009, Management considered both the positive and negative evidence available related to these factors and the cumulative loss position for the most recent three years ended December 31, 2009. This cumulative loss was primarily caused by the significant loan loss provisions and OTTI charges made during recent periods.
At December 31, 2011, based upon the level of historical taxable income, projections for future taxable income over the periods in which the deferred tax assets are deductible and a recent tax strategy to facilitate ordinary loss treatment by the Company of certain investment losses when such losses are recognized for tax purposes, management believes it is more likely than not that the Company will realize the benefits of these deductible differences, net of the existing valuation allowances.
At December 31, 2012, the Company has approximately $4.5 million of federal net operating losses and $16.2 million of state net operating losses. The state net operating losses will expire between 2015 and 2030. Additionally, the Company has approximately $716,000 of AMT tax credits, which do not expire to offset the difference between regular tax and alternative minimum tax.
Pursuant to FASB ASC Topic No. 740, “Income Taxes” the Company is not required to provide deferred taxes on its tax loan loss reserve as of the base year. The amount of this reserve on which no deferred taxes have been provided is $7,878,000 for 2011 and 2010. This reserve could be recognized as taxable income and create a current and/or deferred tax liability using the income tax rates then in effect if any portion of this tax reserve is subsequently used for purposes other than to absorb loan losses.
The following is a roll-forward of the Bank’s FASB ASC Topic No. 740 unrecognized tax benefits:
As of December 31, 2012, the Company did not have any unrecognized tax benefits. As of December 31, 2011, $256,000 represents the amount of unrecognized tax benefits that, if recognized, would favorably affect the effective income tax rate in future periods. The Bank does not expect the total amount of unrecognized tax benefits to significantly increase or decrease in the next twelve months.
The Company recorded a net benefit of $44,000 and $64,000 related to interest and penalties in the income statement for the year ended December 31, 2012 and 2011, respectively were reversed due to the reduction of unrecognized tax benefits resulting from the expiration of the statute of limitations.
The Bank is subject to U.S. federal income tax as well as income tax of the state of New Jersey. The Bank is no longer subject to examination by the Internal Revenue Service (“IRS”) for years before 2009 and by the state of New Jersey for years before 2008. The Bank has currently finalized an examination by the IRS for tax years 2009 and 2010. No significant issues were raised.
NOTE 12 -FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK AND CONCENTRATIONS OF CREDIT RISK
The Bank is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments are commitments to extend credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized in the balance sheets.
The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit is represented by the contractual notional amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on balance sheet instruments.
At December 31, 2012 and 2011, the Bank had outstanding commitments (substantially all of which expire within one year) to originate residential mortgage loans, construction loans, commercial real estate and consumer loans. These commitments were comprised of fixed and variable rate loans.
Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support contracts entered into by customers. Most guarantees extend for one year. The credit risk involved in issuing standby letters of credit is essentially the same as that involved in extending loan facilities to customers. At December 31, 2012 the Bank had $111,000 of letters of credit outstanding to borrowers of non-performing loans. The Bank defines the fair value of these letters of credit as the fees paid by the customer or similar fees collected on similar instruments.
The Bank amortizes the fees collected over the life of the instrument. The Bank generally obtains collateral, such as real estate or liens on customer assets for these types of commitments. The Bank’s potential liability would be reduced by proceeds obtained in liquidation of the collateral held.
The Bank had the following off-balance sheet financial instruments whose contract amounts represent credit risk:
Commitments to make loans are generally made for periods of 60 days or less. The fixed rate loan commitments have interest rates ranging from 2.70% to 5.50% and maturities ranging from one to thirty years.
The Bank provides loans primarily in Atlantic and Cape May Counties, New Jersey, to borrowers that share similar attributes. In addition, the Bank opened an MDO in Burlington County, New Jersey in February 2011 and an MDO in Mercer County, New Jersey in November 2012. A substantial portion of the Bank’s debtors’ ability to honor their contracts is dependent upon the economic conditions of these regions of New Jersey.
NOTE 13 - BENEFIT PLANS
Defined Benefit Plan
The Bank participates in the Pentegra Defined Benefit Plan for Financial Institutions (The “Pentegra DB Plan”), a tax-qualified defined benefit pension plan. The Pentegra DB Plan’s Employer Identification Number is 13-5645888 and the Plan Number is 333. The Pentegra DB Plan operates as a multi-employer plan for accounting purposes and as a multiple-employer plan under the Employee Retirement Income Security Act of 1974 and the Internal Revenue Code. There are no collective bargaining agreements in place that require contributions to the Pentegra DB Plan.
The Pentegra DB Plan is a single plan under Internal Revenue Code Section 413(c) and, as a result, all of the assets stand behind all of the liabilities. Accordingly, under the Pentegra DB Plan contributions made by a participating employer may be used to provide benefits to participants of other participating employers. As of July 1, 2012 and 2011, the Cape Bank funded status was 91.99% and 80.00%, respectively.
Total contributions to the Pentegra DB Plan, as reported on Form 5500, totaled $299.7 million and $203.6 million for the plan years ended June 30, 2012 and June 30, 2011, respectively. Contributions to this plan by Cape Bank during the years ended December 31, 2012, 2011 and 2010 were $310,000, $542,000, and $195,000, respectively. Cape Bank’s contributions to the Pentegra DB Plan are not more than 5% of the total contributions to the Pentegra DB Plan. Total compensation expense recorded under the Pentegra DB Plan during the years ended December 31, 2012, 2011 and 2010, was approximately $371,000, $419,000, and $219,000, respectively.
The Pentegra DB Plan was amended to freeze benefits as of December 31, 2008 for all employees eligible to participate prior to January 1, 2008.
401K Plan
The Bank maintains a tax-qualified defined contribution plan for all salaried employees of Cape Bank who have satisfied the 401(k) Plan’s eligibility requirements. Effective, January 1, 2012, the Bank eliminated the matching contribution formula and replaced it with a discretionary form of matching contribution and, as a result, there was no employer contribution to the 401(k) plan for the year ended December 31, 2012. The Bank charged approximately $287,000 to employer contribution expense for the 401(k) plan for both years ended December 31, 2011 and 2010.
Employee Stock Ownership Plan
On January 1, 2008, the Bank adopted an Employee Stock Ownership Plan (“ESOP”). The ESOP borrowed $10.7 million from the Company and used the funds to purchase 1,065,082 shares of the Company. The loan has an interest rate that is determined January 1st of each year and is based on the prime rate as published in The Wall Street Journal on the first business day of the calendar year. The interest rate for 2012 and 2011 was 3.25% and has an amortization schedule of 25 years. The loan is secured by the shares. Shares purchased are held by the trustee in a loan suspense account and are released from the suspense account on a pro rata basis as the loan is repaid by the Bank over a period not to exceed 25 years. The trustee allocates shares to participants based on compensation as described in the Cape Bank Employee Stock Ownership Plan, in the year of allocation. Employees are eligible to participate in the ESOP after attainment of age 21 and completion of one year of service.
The ESOP recorded dividend income of $45,000 for the year ended December 31, 2012. Since the Company had not declared a dividend prior to 2012, no dividend income was recorded for the years ended December 31, 2011 and 2010. The Company recorded ESOP compensation expense of $365,000, $383,000 and $319,000 for the years ended December 31, 2012, 2011 and 2010, respectively.
Shares held by the ESOP were as follows
Director Retirement Plan
The Bank maintains an amended and restated director retirement plan for its directors, represented by individual agreements with the directors. In accordance with each director’s retirement agreement, the director is entitled to a normal retirement benefit upon termination of service on or after the director’s normal retirement age, equal to 2.5% times the director’s years of service with Cape Bank (not to exceed a benefit equal to 50%) of the average of the greatest fees earned by a director during any five consecutive calendar years. This benefit was payable to the director in equal monthly installments for a period of 10 years or the director’s lifetime, whichever is greater. In December 2008, the individual agreements were amended to comply with the final regulations issued under Section 409A of the Internal Revenue Code and to freeze future benefit accruals as of October 31, 2008. In accordance with these amendments, the agreements were modified to require a specified dollar amount to be paid to the director in January 2009, in complete satisfaction of all rights under the director retirement plan. Accordingly, in January 2009, the directors received $8,604 from the plan. In addition, the individual agreements were also modified to specify the total benefit that would be paid to each director and to specify that the total benefit would be paid in 120 monthly installments upon the occurrence of retirement, death or a change in control. The director could elect a lump sum benefit in the event of death or a change in control if such election was made prior to December 31, 2008.
Expense for these plans related to both active and retired participants totaled $39,000, $41,000, and $46,000, for the years ended December 31, 2012, 2011 and 2010, respectively. The total compensation liability for these plans was $864,000 and $957,000 at December 31, 2012 and 2011, respectively. Payments made under the Plan totaled $94,000 and $98,000 for the years ended December 31, 2012 and 2011, respectively.
Equity Incentive Plan
The Company has an Equity Incentive Plan under which incentive and non-qualified stock options, stock appreciation rights (SARs), and restricted stock awards (RSAs) may be granted periodically to certain employees and directors. Generally, stock options are granted with an exercise price equal to fair market value at the date of grant and expire in 10 years from the date of grant. Generally, stock options granted vest over a five-year period commencing on the first anniversary of the date of grant. Under the plan, 1,331,352 stock options are available to be issued.
During 2012, the Company issued 25,000 incentive stock options to certain employees at prices ranging from $8.43 per share to $9.10 per share. During 2011, the Company issued 80,000 incentive stock options to certain employees at prices ranging from $7.51 per share to $10.19 per share. The following table presents the weighted average per share fair value of options granted and the assumptions used, based on the Black-Scholes option pricing methodology:
Stock option activity for the years ended December 31, 2012 and 2011 was as follows:
The expected average risk-free rate is based on the U.S. Treasury yield curve on the day of grant. The expected average life represents the weighted average period of time that options granted are expected to be outstanding giving consideration to vesting schedules and expected option exercise activity. Expected volatility is based on historical volatilities of the Company’s common stock as well as the historical volatility of the stocks of the Company’s peer banks. The expected dividend yield is based on the expected dividend yield over the life of the option and the Company’s historical information.
On July 1, 2010, the Company issued 11,000 restricted stock awards to directors at a price of $7.68 per share. The restricted stock awards vest in five equal annual installments, with the first installment becoming exercisable on the first anniversary of the date of grant, or July 1, 2011. During 2012 and 2011, 1,925 restricted stock awards and 2,200 restricted stock awards, respectively, vested at a fair value of $7.68 per share. At December 31, 2012, there were 4,950 non-vested restricted stock awards at a fair value of $7.68 per share.
Restricted stock activity for the years ended December 31, 2012 and 2011 was as follows:
At December 31, 2012, unrecognized compensation costs on unvested stock options and restricted stock awards was $1.4 million which will be amortized on a straight-line basis over the remaining vesting period.
Stock-based compensation expense and related tax effects recognized for the years ended December 31, 2012, 2011 and 2010 was as follows:
At December 31, 2012, 868,600 options were issued, leaving 594,882 options available to be issued. Forfeited options are returned to the plan, available for re-issuance. Based on the option agreements, there were 251,316 incentive stock options exercisable.
NOTE 14 - COMMITMENTS AND CONTINGENCIES
Leases: Lessee - As a result of the sale of the Cape Bank main office complex on May 31, 2011, (See Note 17 - Sale of Bank Premises), the Bank entered into six separate lease agreements, each for a discrete portion of the original complex, all with initial three-year terms ending on May 31, 2014. In accordance with ASC Section 840-40 Sale Leaseback Transactions, the deferred gain on the sale is recognized evenly over the initial three-year lease period as a credit to rent expense. Further, the Bank has the option to exit a certain amount of square footage within the first year of the lease incurring a penalty of three months of lease payments for the space exited. Also, in doing so, the Bank would recognize a portion of the remaining deferred gain proportionate to the amount of space exited. In the second quarter of 2012, the Bank vacated additional leased space, resulting in the recognition of an additional gain of $425,000.
In addition, the Bank leases office space for the Burlington and Mercer County MDOs. The Company’s total minimum lease payments for the years 2013 and 2014 total $377,000 and, $141,000, respectively. Rent expense for the years ended December 31, 2012, 2011 and 2010 approximated $90,000, $28,000 and $10,000, respectively.
Litigation - From time to time, the Bank may be a defendant in legal proceedings arising out of the normal course of business. In management’s opinion, the financial position and results of operations of the Bank would not be affected materially by the outcome of such legal proceedings.
NOTE 15 - REGULATORY MATTERS
Banks and bank holding companies are subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations, involve quantitative measures of assets, liabilities, and certain off-balance sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators. Failure to meet capital requirements can initiate regulatory action. Management believes as of December 31, 2012, the Company and Bank meet all capital adequacy requirements to which it is subject.
The Bank is subject to various regulatory capital requirements administered by the 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 Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined).
As of December 31, 2012 and 2011, the Bank was categorized as well-capitalized under the regulatory framework for prompt corrective action. To be categorized as well-capitalized, the Bank must maintain minimum total risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed the institution’s category.
The Company, with the approval of the regulators, paid a $0.05 per common share cash dividend in December 2012. In addition, on February 22, 2013, the Company, with the approval of the regulators, declared a $0.05 per common share cash dividend to shareholders of record on March 8, 2013. The dividend is expected to be paid on March 22, 2013.
The actual capital amounts, ratios and minimum regulatory guidelines for Cape Bank are as follows:
Management believes that under the current regulations, the Bank will continue to meet its minimum capital requirements in the foreseeable future.
Regulatory capital levels for Cape Bank differ from its total capital computed in accordance with accounting principles generally accepted in the United States (GAAP), as follows:
NOTE 16 - EARNINGS PER SHARE
Earnings Per Common Share: Basic earnings per common share is the net income (loss) divided by the weighted average number of common shares outstanding during the period. ESOP shares are not considered outstanding for this calculation unless earned. Diluted earnings per share includes the dilutive effect of additional potential common shares issuable under stock option and restricted stock awards, if any.
The following is the earnings per share calculation for the periods ended December 31, 2012, 2011 and 2010, respectively. At December 31, 2012, options to purchase 711,290 shares were outstanding and dilutive, and accordingly were included in determining diluted earnings per common share. In addition, 4,950 shares of restricted stock were dilutive, and accordingly were included in determining diluted earnings per common share. At December 31, 2011, options to purchase 833,010 shares were outstanding and dilutive, and accordingly were included in determining diluted earnings per common share. Restricted stock was dilutive and is included in the earnings per share calculation for the period ended December 31, 2011. At December 31, 2010, options to purchase 763,600 shares were outstanding and dilutive, and accordingly were included in determining diluted earnings per common share. Restricted stock was dilutive and is included in the earnings per share calculation for the period ended December 31, 2010.
NOTE 17 - SALE OF BANK PREMISES
On April 11, 2011, the Company entered into an Agreement of Sale to sell the Cape Bank main office complex and an adjoining vacant lot located in Cape May Court House, NJ. The sale was consummated on May 31, 2011. The selling price of the properties was $7.2 million with net cash proceeds of $6.8 million received at time of sale. The Bank entered into six separate lease agreements, each for a discrete portion of the original complex with initial three year terms, all ending in 2014. The net book value of the property at the time of closing was $3.8 million resulting in a gain of $3.4 million. This gain is being recognized under the full accrual method and as an operating lease in accordance with ASC Section 840-40 Sale Leaseback Transactions which allowed $1.8 million of the gain to be recognized at the time of sale and the remaining portion of the gain, $1.6 million, to be recognized evenly over the initial three-year lease period. The Company recognized an additional gain of $425,000 resulting from the vacating of additional leased space in the second quarter of 2012, which accelerated the recognition of a portion of the deferred gain. At December 31, 2012, the balance of the deferred gain to be recognized totaled $459,000.
NOTE 18 - CAPE BANCORP (PARENT COMPANY)
The Parent Company’s condensed balance sheets at December 31, 2012 and 2011 and the related condensed statements of income and cash flows for the years ended December 31, 2012, 2011 and 2010 follow:
Condensed Balance Sheets
Condensed Statements of Income
Condensed Statements of Cash Flows
Under the New Jersey Banking Act, a stock savings bank may declare and pay a dividend on its capital stock only to the extent that the payment of the dividend would not impair the capital stock of the savings bank. In addition, a stock savings bank may not pay a dividend unless the savings bank would, after the payment of the dividend, have a surplus of not less than 50% of its capital stock, or the payment of the dividend would not reduce the surplus. Federal law may also limit the amount of dividends that may be paid by Cape Bank.
NOTE 19 - SELECTED QUARTERLY DATA (UNAUDITED)
EXHIBIT INDEX
(1) Incorporated by reference to the Registration Statement on Form S-1 of Cape Bancorp, Inc. (file no. 333-146178), originally filed with the Securities and Exchange Commission on September 19, 2007.
(2) Incorporated by reference to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on July 18, 2008.
(3) Incorporated by reference to the Company’s Current Report on Form 8-K filed on October 6, 2010.
(4) Incorporated by reference to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on July 7, 2011.
(5) Incorporated by reference to the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on September 25, 2012.
(6) Incorporated by reference to the Company’s Definitive Proxy Statement filed with the Securities and Exchange Commission on July 16, 2008.
(7) Incorporated by reference to the Company’s Annual Report on Form 10-K for the Year ended December 31, 2007 filed with the Securities and Exchange Commission on March 31, 2008.
(8) Pursuant to Rule 406T of Regulation S-T, the XBRL-related information in Exhibit 101 to this Annual Report on Form 10-K is furnished and not filed for purposes of Sections 11 and 12 of the Securities Act of 1933 and Section 18 of the Securities and Exchange Act of 1934.