Item 1.
Business
We are a Texas-based savings and loan holding company with approximately $4.5 billion in assets, $2.1 billion in deposits and $332.8 million in stockholders’ equity as of December 31, 2005. Through our wholly-owned subsidiary, Franklin Bank, S.S.B., a Texas state savings bank, we provide community banking products and services and commercial banking services to corporations and other business clients and originate single family residential mortgage loans. As of December 31, 2005, in addition to our corporate offices in Houston, Texas, where we provide many of our banking services, we had 35 community banking offices in Texas, five regional commercial lending offices in Florida, Arizona, Michigan, Pennsylvania and Texas, and mortgage origination offices in 24 states throughout the United States.
Our Strategy
Our principal growth and operating strategy is to:
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expand our community banking business, The Franklin Family of Community Banks, by acquiring financial institutions in growing Texas markets outside of metropolitan areas and by establishing new banking offices to complement our existing banking network;
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increase the scope and profitability of our product lines by expanding our markets and operating in a low cost environment; and
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continue to build our franchise by providing superior service through qualified and relationship-oriented employees who are “Trusted Financial Advisors” to the communities in which we offer our products.
History
In August 2001, our founders organized Franklin Bank Corp. as a new Delaware holding company, formerly known as BK2 Inc., for the purpose of creating a Texas based community bank that concentrates on markets outside of the major metropolitan areas of Texas. On April 9, 2002, we acquired our first community bank by acquiring all of the outstanding capital stock of Franklin Bank, S.S.B., which was engaged in traditional community banking activities in the greater Austin, Texas market.
In December 2003, we completed our initial public offering and began trading on the NASDAQ National Market under the symbol, FBTX. We are currently included in the Russell 2000, Russell 3000, Russell Microcap, Standard and Poor’s SmallCap 600 and the American Community Bankers indexes.
Acquisitions
Since our formation in August 2001, we have completed the following acquisitions:
We continue to seek opportunities to expand our community banking business by acquiring financial institutions in growing Texas markets outside of metropolitan areas. We believe that these markets have less competition for loans and deposits than the large metropolitan areas. Our focus is on community banks that have a significant share of the market in the communities that they serve. We believe that acquisitions such as these complement our asset strategy and provide an excellent source of deposits, a key component of our growth. When we acquire a financial institution we integrate it as soon as practical. During the integration, we convert their technology platform to ours, expand their products to include those offered by us, reorganize their processes into ours and incorporate them into our marketing strategy.
Business Activities
Our banking services are concentrated in community banking, commercial lending and mortgage banking product lines. We believe that our profitability and growth is dependent on the growth of our community bank and our commercial lending products. In order to facilitate the expansion of these businesses, we offer a wide variety of community banking and commercial products that allows us to serve our customers both in our communities as well as on a national basis. Our mortgage banking product supports our community banking business. Additionally, we maintain a portfolio of single family mortgages that provides high quality liquid assets for us while we develop our community banking and commercial product lines.
Community Banking
Our community banking philosophy focuses on relationship banking with an emphasis on lending. A key part of our community banking business is to utilize experienced bankers with extensive ties to the communities that they serve. We focus on providing high-quality personalized service through our bankers, whose goal is to become trusted financial advisors to our customers.
Our community banking operation offers a wide variety of business and consumer banking products, including checking, money market and savings accounts, certificates of deposit, auto loans, home improvement loans, home equity loans, business loans, commercial real estate loans, construction loans and mortgage loans. We also offer investment services through a relationship with a third party. Currently, our banking network consists of 36 banking offices, 17 in the central Texas area, 18 in east Texas and one in Houston, Texas.
We intend to grow our community banking activities through acquisitions and the establishment of new banking offices in and around our current communities. We employ competitive pricing targeting individual markets, a full range of lending products that can be tailored to our customers needs and superior service to attract and retain customers. As a result, we have experienced a steady growth in deposits. As of December 31, 2005, total deposits from our community banking products totaled $1.3 billion. Interest expense relating to those deposits represented approximately 15.4% of our total interest expense for the year ended December 31, 2005. Interest income on our community banking products was approximately 11.8% of our total interest income for the same period.
Commercial Lending
We provide commercial banking services to corporations and other larger business clients that are not in our community banking area. We offer financing for single family builders, commercial real estate, including retail, industrial, office buildings and multi-family properties and mortgage banking warehouse lines. These products are offered through our corporate office in Houston, Texas and regional lending offices located in Dallas, Detroit, Orlando, Philadelphia, and Phoenix. For the year ended December 31, 2005, we derived approximately 22.4% of our total interest income from these lending products. We intend to extend our commercial lending operations to other desirable markets in order to further diversify our portfolio geographically.
Builder Finance. The focus of our builder lending business is financing of residential development and construction of single-family detached dwellings in established market areas. We have expanded our geographical scope from Texas to include Arizona, California, Colorado, Florida, Georgia, Illinois, Michigan, Nevada, New Jersey, New York, North Carolina, Pennsylvania and Washington. We provide builder lines from our corporate offices in Houston, Texas, and our regional lending offices.
The customers we target for financing are medium to large builders and developers. In order to be approved for a builder line, we require that customers satisfy specific qualification requirements, including reputation in the community, unsold inventory levels, geographic area concentration and other factors. As of December 31, 2005, we had $1.2 billion in committed lines, of which $671.1 million were outstanding.
This type of lending generally entails a higher degree of risk, including the risk of a general downturn in the local economy where the customer is operating, increases in interest rates and misrepresentation by the builders of the completion status of the home against which loan funds have been drawn.
We utilize certain lending practices to reduce these risks, including pricing all builder lines based on a risk adjusted return on capital and underwriting them based on debt/net worth, cash flow coverage, loan-to-value and loan-to-cost ratios, interest reserve coverage, experience of management, inventory turnover by subdivision and guarantees. We monitor the ongoing financial condition of the builder and the status of construction by regular review of periodic builder reports and financials and site inspection of the actual construction. We approve draws only after third party on-site inspections and review of subdivision performance and borrowers’ inventory. We believe these requirements reduce the potential for misdirected advances to other areas of the builder’s business.
Commercial Real Estate. We provide commercial real estate loans, including interim construction loans, for retail, industrial, office buildings, multi-family and other types of income producing properties.
We have established certain lending practices to reduce our risks relating to these types of loans. These include, but are not limited to, maximum loan-to-value, minimum debt service coverage, physical inspections and the operating experience of the borrower. As of December 31, 2005, we had $179.5 million in commercial real estate loans outstanding.
Mortgage Banker Finance. We provide small- and medium-sized mortgage companies with credit facilities, including secured warehouse lines of credit and working capital credit lines. Additionally, through our mortgage banking group we may purchase originations by our mortgage banker finance customers for sale into the secondary market. We also offer these companies a complete line of cash management products tailored to their business, including online banking, cash management and custody services. In addition to providing interest income, we expect the mortgage banker finance business to give us a source of deposits generated by our cash management products.
These loans are subject to the risk that the collateral may be fraudulently or improperly documented. Additionally, mortgage banking companies are generally more thinly capitalized than other commercial borrowers.
To reduce these risks we have assembled a team of experienced mortgage banker finance professionals to manage this business. We have established the necessary procedures, controls, and systems to operate this business, including taking control of the mortgage collateral, monitoring the age of the collateral supporting the line and requiring paydowns on the line when the collateral on the line exceeds a specified age. As of December 31, 2005, we had $418.3 million in warehouse lines committed of which $173.8 million was outstanding.
Our target customers are existing mortgage banking companies that have an excellent track record in the mortgage business. We approve potential mortgage banker finance customers and determine advance rates for loans based on a number of factors, including credit performance, experience, perceived interest rate risk, liquidity risk, and risks associated with the particular mortgage loans originated by the mortgage banking firm.
Mortgage Banking
Through our mortgage banking activities we originate mortgage loans through two channels, retail and wholesale, and provide support to our community banking business by originating mortgage loans for our customers. The earnings that we derive from our origination channels are based on the interest spread on our mortgage loans held for sale and the gain from the subsequent sale of these loans into the secondary market. For the year ended December 31, 2005, approximately 9.9% of our interest income came from mortgage banking activities.
Retail Mortgage Origination. We currently originate mortgage loans directly to borrowers through our community banking locations and through our 45 retail mortgage offices located in 24 states throughout the United States. We believe that our retail mortgage office structure provides us with a low fixed cost method of originating mortgage loans. This structure is set up so that each mortgage loan manager is compensated based solely on the mortgage office’s profitability. Through these offices we originated $385.7 million in mortgage loans for the year ended December 31, 2005.
Wholesale Mortgage Origination. Wholesale mortgage origination refers to the origination of mortgage loans with the assistance of mortgage companies or mortgage brokers. The loans are originated and closed in either our name or, under certain circumstances, the assisting entity’s name with immediate assignment to us. We originate wholesale residential mortgage loans in Texas, California and Tennessee. We believe the wholesale origination of loans represents an efficient way for us to originate loans. During the year ended December 31, 2005, we originated $479.9 million in mortgage loans through our wholesale offices.
Loan Disposition. We currently sell a majority of the mortgage loans we originate into the secondary market under normal customary terms, and through securitizations. We typically sell fixed-rate loans into the secondary market, but may also from time to time sell adjustable-rate loans. The majority of our sales are made under mandatory delivery agreements with major financial institutions, including FNMA, for whom we are an approved seller/servicer, and Countrywide Home Loans Inc. We generally sell the servicing rights to our loans when we sell the loans, except where there are cross-selling opportunities to community banking customers. During the year ended December 31, 2005, we sold into the secondary market $709.6 million in originated single family mortgage loans.
Single Family Mortgage Portfolio
Our single family mortgage portfolio provides high quality liquid assets for us while we develop our community banking and commercial product lines. We acquire mortgage loans through correspondent relationships we have with financial institutions, mortgage companies and mortgage brokers. When acquiring loans on a correspondent basis, we commit to purchase the loans based upon predetermined and agreed upon criteria. For the year ended December 31, 2005, we purchased approximately $1.2 billion of single family mortgage loans and intend to continue to purchase on an opportunistic basis recently originated loans from larger financial institutions, mortgage companies and investment banks. These purchases allow us to obtain high quality liquid residential mortgage loans for our portfolio that can be reduced as our community banking and commercial loans increase. For the year ended December 31, 2005, approximately 49.8% of our interest income came from this portfolio.
Underwriting and Risk Management
We originate and purchase loans in accordance with the underwriting criteria described below. Generally, our underwriting guidelines are designed to help us evaluate a borrower’s credit history and capacity to repay the loan, the value of the property, if any, that will secure the loan, and the adequacy of such property as collateral for the loan.
Currently, we underwrite every loan we originate or purchase, other than certain purchased single family loans that contain homogeneous characteristics and representations and warranties from the seller/servicer. This means we thoroughly review the borrower’s credit history, financial documents and appraisal for accuracy and completeness. Our underwriting standards are applied in accordance with applicable federal and state laws and regulations.
For builder lines, commercial real estate loans and commercial loans, we focus on a borrower’s ability to make principal and interest payments and the value of the collateral securing the underlying loans using underwriting criteria such as debt/net worth, cash flow coverage, experience of management and guarantees. Independent appraisers generally perform on-site inspections and valuations of the collateral for commercial real estate loans.
We underwrite our consumer loans for vehicles and other consumer durables using credit scoring, collateral value and relationships. We utilize the same underwriting standards for home equity, home improvement and lot loans as we do for our residential mortgages.
For originated residential mortgage loans, we use standardized secondary market underwriting and credit criteria in order to ensure the quality of the asset. In addition, we review credit scores derived from the application of one or more nationally recognized credit scoring models. We also require a qualified appraisal of the mortgaged property, conforming to FNMA and FHLMC standards. The appraisal may not be more than 180 days old on the day the loan is originated.
Purchased single family mortgage loan packages are reviewed through an internally developed report that identifies risk factors for each loan included in the loan package. Included in the data elements that are viewed as risk factors; loans with loan-to-value, or LTV, greater than 80% with no mortgage insurance, LTV greater than 90%, loan amount greater than $650,000 with LTV greater than 65%, condominium with LTV greater than 75%, cash out refinances with LTV greater than 75%, 3 or 4 unit properties, second liens and borrowers with Fair Isaac & Co., or FICO, scores less than 660. Individual loans in a loan package where multiple risk factors are identified with no mitigating factors will be underwritten to determine if any mitigating factors exist or will be removed from the loan package. Any loan with a principal balance equal to or greater than $1.0 million will be underwritten. Additionally, loans where property values have increased by 15% over the past one to two years will be reviewed for mitigating factors, such as LTV and FICO scores. Our management credit committee is presented with and approves the level of underwriting on each loan package.
A management credit committee appointed by the bank’s board of directors sets our underwriting guidelines and credit policies. The bank’s management credit committee consists of the bank’s Chief Executive Officer, the Chief Credit Officer, the Chief Financial Officer, the Managing Director - Mortgage Banking, the Managing Director - Commercial Lending, the Managing Director - Administration, the Managing Director - Central Texas, the Managing Director - East Texas, the Senior Vice President - Underwriting, the Senior Vice President - Deputy Credit Officer, Senior Vice President - Regional Credit Officer, Senior Vice President - Commercial Real Estate and one rotating loan officer. The committee approves or ratifies all loans except for single family originated loans, approves all other loan funding or loan packages exceeding certain dollar amounts and reports to the board of directors at regularly scheduled meetings.
Generally, loans to community banking customers can be approved by the loan officer and the Managing Director of the region up to $250,000 if secured and $100,000 if unsecured. Builder lines, commercial real estate and mortgage banker finance lines less than $5 million and business loans less than $2 million can be approved by the individual loan officer or senior underwriter, the product’s managing director plus either the bank’s Chief Executive Officer or the Chief Credit Officer. All loans that are approved outside of the management credit committee must be ratified the month following approval at a regularly scheduled meeting.
All loans exceeding the above limits, except for single family loans, must be recommended by the loan officer and the relevant managing director and be approved by the regional management credit committee or the management credit committee. Loans greater than $5 million, except for builder lines, commercial real estate, mortgage banker finance lines and consumer loans where the limit is $15.0 million, $10.0 million, $15.0 million and $1 million, respectively, must be approved by the bank’s board of directors’ credit committee. Additionally, single family mortgage loan packages greater than $50.0 million must be approved by the bank’s board of directors. The Chief Credit Officer or any two members of the management credit committee may nevertheless disapprove a loan that satisfied the bank’s general underwriting standards.
The bank’s board of directors credit committee is comprised of Lewis S. Ranieri, Alan E. Master, John B. Selman, David M. Golush and Anthony J. Nocella.
In addition to applying standard criteria and a centralized approval process to ensure loans are thoroughly underwritten, we also tie our loan production managers’ compensation to profitability by compensating them for profitability and not just the volume of the loans they originate. We believe this will result in our originated loans being of a higher quality than if the managers’ compensation were tied solely to loan volume.
Finally, in order to monitor our overall credit exposure, we have established a bank risk management committee that is appointed by the bank’s board of directors to provide an oversight function for the credit review and risk management process. The bank’s risk management committee is comprised of the bank’s Chief Executive Officer, the Chief Credit Officer, the Chief Financial Officer, the Managing Director - Mortgage Banking, the Managing Director - Administration, the Managing Director - Commercial Lending, the Managing Director - Central Texas, the Managing Director - East Texas, the Vice-President - Administration and a Senior Vice President - Finance. This committee is charged with the review of asset classifications, review of individual portfolio risks (including loan type concentrations, loan size, geographic concentrations, and demographic and economic conditions), and approval of the methodology and level of the allowance for loan losses. This committee monitors delinquencies, specific loan performance and negative or adverse economic trends. The committee monitors our geographic limitation policy that limits the amount of assets that can be in any one state to 25% of total assets, except for California, which is limited to the lesser of 35% of assets or 600% of regulatory capital, and Texas, which is unlimited. This policy is designed to limit the exposure that we have to any one region other than Texas. The committee also monitors the interest rate resets and periodic interest rate caps on our adjustable single family mortgage loans.
Competition
We face substantial competition for loans and deposits as well as other sources of funding in our markets. We compete in all of our lending lines of business with thrifts, commercial banks, credit unions, mortgage companies and specialty finance companies, many of which operate nationwide lending networks. In each case we must compete on the basis of service quality, product offerings and rates.
We also compete for funding. We compete at our 35 banking offices for loans and deposits from local customers. We also must compete nationwide for deposits to fund our lending activities. We compete for deposits with thrifts, commercial banks and credit unions and our deposit products must compete with the investment products offered by a broad variety of financial institutions including thrifts, commercial banks, credit unions, brokerage firms, investment banks, insurance companies and other financial services companies, many of which are substantially larger and have more resources than us.
Economic factors, along with legislative and technological changes, will have an ongoing impact on the competitive environment within the financial services industry. As an active participant in the financial markets, we strive to anticipate and adapt to dynamic and competitive conditions, but there can be no assurances as to their impact on our future business. In order to compete with other competitors in our markets, we attempt to use to the fullest extent possible the flexibility which our independent status permits, including an emphasis on personalized service, local promotional activity and community involvement.
Regulation and Supervision
The company and FBC Holdings, LLC (formerly BK2 Holdings, Inc.), its intermediate subsidiary, are registered savings and loan holding companies and are subject to Office of Thrift Supervision, or OTS, and Texas Department of Savings and Mortgage Lending, or TDSML, regulation, examination, supervision and reporting requirements.
The bank is a Texas-chartered, federally-insured state savings bank and is subject to the regulation, examination and reporting requirements of the TDSML. The Federal Deposit Insurance Corporation, or FDIC, also has regulatory and examination authority respecting the bank. The bank’s deposits are insured by the FDIC through the Bank Insurance Fund, or BIF. As a subsidiary of a savings and loan holding company, the bank is also subject to certain federal and state restrictions in its dealings with the company and affiliates thereof.
The bank is a member of the Federal Home Loan Bank, or FHLB, of Dallas, which is one of 12 regional FHLBs that administer programs in support of the home financing credit function of savings institutions and commercial banks. Each FHLB serves as a source of liquidity for its members within its assigned region. It makes loans (i.e., advances) to members in accordance with policies and procedures established by its Board of Directors. The bank is required to maintain between 0.05% and 0.30% of its assets at each December 31 in FHLB of Dallas capital stock, which is a member’s minimum required investment, plus between 3.50% and 5.00% of its
advances outstanding. At December 31, 2005, the FHLB of Dallas had set the minimum required investment at 0.09% of assets and the advance requirement at 4.10%. At December 31, 2005, the bank held $80.3 million in FHLB of Dallas capital stock, compared to its requirement of $79.4 million.
The supervision and regulation of savings and loan holding companies and their subsidiaries is intended primarily for the protection of depositors, the deposit insurance funds of the FDIC and the banking system as a whole, and not for the protection of the shareholders or creditors of savings and loan holding companies. The banking agencies have broad enforcement power over savings and loan holding companies and banks, including the power to restrict operations and impose substantial fines and other penalties for violations of laws and regulations.
Below is a brief description of certain laws and regulations which relate to the regulation of the company and the bank. The description does not purport to be complete and is qualified in its entirety by reference to the applicable laws and regulations.
The Company
Overview. The company has elected to treat the bank as a “savings association” for purposes of Section 10 of the Home Owners’ Loan Act, or HOLA. As a result, the company is a registered savings and loan holding company and subject to the regulation, examination, supervision and reporting requirements of the OTS and TDSML. The company must file a quarterly report with the OTS that describes its financial condition.
For the company to continue to be regulated as a savings and loan holding company, the bank must continue to be a “qualified thrift lender.” Otherwise, the company could be required to register as a bank holding company and become subject to regulation by the Federal Reserve Board under the Bank Holding Company Act of 1956, as amended. Regulation as a bank holding company could be adverse to the company’s business plans and impose additional and possibly more burdensome regulatory requirements on the company. See “- The Bank - Qualified Thrift Lender Test.”
Scope of Permissible Activities. As a savings and loan holding company, the company is permitted to engage in activities considered to be “financial in nature,” incidental to such financial activity or complementary to a financial activity. Activities that are considered to be financial in nature include lending activities, insurance underwriting, insurance agency activity, investment advisory services, securities underwriting, merchant banking activities and activities authorized by the Board of Governors of the Federal Reserve System as permissible for bank holding companies under the Bank Holding Company Act (subject, in the case of bank holding company activities, to OTS approval). The company is also permitted to engage in additional activities listed in HOLA or OTS regulations, the most significant of which relate to real estate ownership, development and management activities.
If the OTS determines that there is reasonable cause to believe that the continuation by a savings and loan holding company of an activity constitutes a serious risk to the financial safety, soundness or stability of its subsidiary savings institution (i.e., a savings association or savings bank), the OTS may impose such restrictions as it deems necessary to address such risk, including limiting:
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payment of dividends by the savings institution;
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transactions between the savings institution and its affiliates; and
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any activities of the savings institution that might create a serious risk that the liabilities of the holding company and its affiliates may be imposed on the savings institution.
Restrictions on Acquisitions. Except under limited circumstances, savings and loan holding companies are prohibited from acquiring, without prior approval of the OTS:
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control of any other savings institution or savings and loan holding company or all or substantially all the assets thereof; or
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more than 5% of the voting shares of a savings institution or holding company of a savings institution which is not a subsidiary.
In evaluating an application by a holding company to acquire a saving association, the OTS must consider the financial and managerial resources and future prospects of the holding company and savings association involved, the effect of the acquisition on the risk to the insurance fund, the convenience and needs of the community and competitive factors. Acquisitions which result in a savings and loan holding company controlling savings associations in more than one state are generally prohibited, except in supervisory transactions involving failing savings associations or based on specific state authorization of such acquisitions. Except with the prior approval of the OTS, no director or officer of a savings and loan holding company or person owning or controlling by proxy or otherwise more than 25% of such company’s voting stock may acquire control of any savings institution, other than a subsidiary savings institution, or of any other savings and loan holding company.
Capital and Indebtedness. The OTS does not impose either consolidated or unconsolidated regulatory capital requirements on thrift holding companies but rather evaluates capital adequacy on a case-by-case basis. The OTS identifies in its examination process the extent to which the holding company utilizes debt (including hybrid instruments, such as trust preferred securities) to fund the financial institution’s operations and the degree to which the parent thrift holding company relies upon the financial institution to provide cash flow for debt service. The holding company used trust preferred securities as a source of funding during 2005, and is now required to notify the OTS prior to any proposed issuance or renewal of any current lines of credit (including hybrid securities), or guarantee of any debt. Upon notification, the holding company must wait 30 days, or until the OTS advises the holding company that it does not object, before proceeding. This requirement only applies to borrowings having specific terms and not to liabilities incurred in the ordinary course.
Change of Control. Federal law requires, with few exceptions, OTS approval (or, in some cases, notice and effective clearance) prior to any acquisition of control of the company. Among other criteria, under OTS regulations, “control” is conclusively presumed to exist if a person or company acquires, directly or indirectly, more than 25% of any class of voting stock of the savings association or holding company. Control is also presumed to exist, subject to rebuttal, if an acquiror acquires more than 10% of any class of voting stock (or more than 25% of any class of stock) and is subject to any of several “control factors,” including, among other matters, the relative ownership position of a person, the existence of control agreements and board composition.
Change in Management. If a savings and loan holding company is in a “troubled condition,” as defined in the OTS regulations, it is required to give 30 days’ prior written notice to the OTS before adding or replacing a director, employing any person as a senior executive officer or changing the responsibility of any senior executive officer so that such person would assume a different senior executive position. The OTS then has the opportunity to disapprove any such appointment.
Limitations on Dividends. The company is a legal entity separate and distinct from the bank. The company’s principal source of revenue consists of dividends from the bank. The payment of dividends by the bank is subject to various regulatory requirements, including a minimum of 30 days’ advance notice to the OTS of any proposed dividend to the company.
Other limitations may apply depending on the size of the proposed dividend and the condition of the bank. See “- The Bank - Restrictions on Capital Distributions.”
Texas Regulations. Under the Texas Savings Bank Act, or TSBA, each registered holding company, such as the company, is required to file reports with the TDSML as required by the Texas Savings and Mortgage Lending Commissioner, or the Commissioner, and is subject to such examination as the Commissioner may prescribe.
The Bank
The bank is required to file reports with the TDSML and the FDIC concerning its activities and financial condition, in addition to obtaining regulatory approvals prior to entering into certain transactions, such as any merger or acquisition with another institution. The regulatory system to which the bank is subject is intended primarily for the protection of the deposit insurance fund and depositors, not stockholders. The regulatory structure also provides the TDSML and the FDIC with substantial discretion in connection with their supervisory and enforcement functions. The TDSML and the FDIC conduct periodic examinations of the bank in order to
assess its compliance with federal and state regulatory requirements. As a result of such examinations, the TDSML and the FDIC may require various corrective actions.
Virtually every aspect of the bank’s business is subject to numerous federal and/or state regulatory requirements and restrictions with respect to such matters as the nature and amounts of loans and investments that may be made, the issuance of securities, the amount of cash reserves that must be established against deposits, the establishment of branches, mergers, non-banking activities and other operations. Numerous laws and regulations also set forth special restrictions and procedural requirements with respect to the extension of credit, credit practices, the disclosure of credit terms and discrimination in credit transactions.
Regulatory Capital Requirements. Federally insured, state-chartered banks are required to maintain minimum levels of regulatory capital. These standards generally are as stringent as the comparable capital requirements imposed on national banks. The FDIC also is authorized to impose capital requirements in excess of these standards on individual banks on a case-by-case basis.
Under current FDIC regulations, the bank is required to comply with three separate minimum capital adequacy requirements: a “Tier 1 capital ratio” and two “risk-based” capital requirements. “Tier 1 capital” generally includes common stockholders’ equity (including retained earnings), qualifying noncumulative perpetual preferred stock and any related surplus, and minority interests in the equity accounts of fully consolidated subsidiaries, minus intangible assets, other than properly valued mortgage servicing assets, nonmortgage servicing assets and purchased credit card relationships up to certain specified limits and minus net deferred tax assets in excess of certain specified limits.
Leverage Capital Ratio. FDIC regulations establish a minimum 3.0% ratio of Tier 1 capital to total assets, as defined, for the most highly-rated, state-chartered, FDIC-supervised banks and a minimum 4.0% ratio of Tier 1 capital to total assets, as defined, for all other state-chartered, FDIC-supervised banks. Under FDIC regulations, highly-rated banks are those that the FDIC determines are not anticipating or experiencing significant growth and have well diversified risk, including no undue interest rate risk exposure, excellent asset quality, high liquidity and good earnings. As of December 31, 2005, the minimum leverage capital ratio for capital adequacy purposes for the bank was 4.0% and its actual leverage capital ratio was 6.33%.
Risk-Based Capital Requirements. The risk-based capital requirements contained in FDIC regulations generally require the bank to maintain a minimum ratio of Tier 1 capital to risk-weighted assets of at least 4.0% and a ratio of total capital to risk-weighted assets of at least 8.0%.
For purposes of the risk-based capital requirements, “total capital” means Tier 1 capital plus supplementary (or Tier 2) capital, so long as the amount of supplementary (or Tier 2) capital that is used to satisfy the requirement does not exceed the amount of Tier 1 capital. Supplementary (or Tier 2) capital includes, among other things, cumulative perpetual preferred stock, non-cumulative perpetual preferred stock where the dividend is reset periodically, long-term preferred stock (original maturity of at least 20 years), mandatory convertible subordinated debt, perpetual subordinated debt and mandatory redeemable preferred stock. Intermediate-term preferred stock and other subordinated debt is includable in Tier 2 capital up to 50% of Tier 1 capital. The allowance for loan and lease losses up to a maximum of 1.25% of risk-weighted assets is included in Tier 2 capital, as are certain unrealized gains in equity securities and unrealized gains or losses in other assets. To determine the amount of capital required, assets and certain off-balance sheet items are assigned to various categories, with each category having a different “risk weighting.” As of December 31, 2005, the bank’s Tier 1 capital to risk-weighted assets ratio was 9.92% and its total risk-based capital to risk weighted assets ratio was 10.41 %.
Corrective Measures for Capital Deficiencies. The Prompt Corrective Action regulations, which were promulgated to implement certain provisions of the Federal Deposit Insurance Corporation Improvement Act of 1991, or FDICIA, also effectively impose capital requirements on state-chartered banks, by subjecting banks with less capital to increasingly stringent supervisory actions. For purposes of the Prompt Corrective Action regulations, a bank is “undercapitalized” if it has a total risk-based capital ratio of less than 8%, a Tier 1 risk-based capital ratio of less than 4%, or a leverage capital ratio of less than 4% (or less than 3% if the bank has received a composite rating of 1 in its most recent examination report and is not experiencing significant growth).
A bank is “adequately capitalized” if it has a total risk-based capital ratio of 8% or higher, a Tier 1 risk-based capital ratio of 4% or higher, a leverage ratio of 4% or higher (3% or higher if the bank received a composite rating of 1 in its most recent examination report and is not experiencing significant growth), and does not meet the definition of a “well capitalized” bank. A bank is “well capitalized” if it has a total risk-based capital ratio of 10% or higher, a Tier 1 risk-based capital ratio of 6% or higher, a leverage capital ratio of 5% or higher, and is not subject to any written requirement to meet and maintain any higher capital level(s).
Under the regulation, “well capitalized” institutions are not subject to any brokered deposit limitations, while “adequately capitalized” institutions are able to accept, renew or roll over brokered deposits only (i) with a waiver from the FDIC, and (ii) subject to the limitation that they do not pay an effective yield on any such deposit which exceeds by more that 75 basis points (a) the effective yield paid on deposits accepted in its normal market area, or (b) the national rate paid on deposits of comparable maturity for deposits accepted outside the institution’s normal market area. “Undercapitalized” institutions will not be permitted to accept brokered deposits and are subject to certain limitations on interest rates that may be paid in connection with any deposit solicitation.
Under the provisions of the Federal Deposit Insurance Corporation Improvement Act, or FDICIA, and the Prompt Corrective Action regulations, an “undercapitalized” bank is subject to a limit on the interest it may pay on deposits. Also, an undercapitalized bank cannot make any capital distribution, including paying a dividend (with some exceptions), or pay any management fee (other than compensation to an individual in his or her capacity as an officer or employee of the bank). Such a bank also must submit a capital restoration plan to the FDIC for approval, restrict total asset growth and obtain regulatory approval prior to making any acquisition, opening any new branch office or engaging in any new line of business. An undercapitalized bank may also be subject to other, discretionary, regulatory actions. Additional mandatory and discretionary regulatory actions apply to “significantly undercapitalized” and “critically undercapitalized” banks. Failure of a bank to maintain the required capital could result in such bank being transferred to new owners in a supervisory transaction or being declared insolvent and closed.
FDIC Insurance Premiums. The deposits of the bank are insured to the maximum extent permitted by the BIF. As the insurer, the FDIC is authorized to conduct examinations of, and to require reporting by, FDIC-insured institutions. It also may prohibit any FDIC-insured institution from engaging in any activity the FDIC determines by regulation or order to pose a serious threat to the FDIC. The FDIC also has the authority to initiate enforcement actions against savings institutions.
The FDIC has implemented a risk-based assessment system under which FDIC-insured depository institutions pay annual premiums at rates based on their risk classification. A bank’s risk classification is based on its capital levels and the level of supervisory concern the bank poses to the regulators. Institutions assigned to higher risk classifications (that is, institutions that pose a greater risk of loss to their respective deposit insurance funds) pay assessments at higher rates than institutions that pose a lower risk. A decrease in the bank’s capital ratios or the occurrence of events that have an adverse effect on the bank’s asset quality, management, earnings or liquidity could result in a substantial increase in deposit insurance premiums paid by the bank, which would adversely affect the bank’s earnings. In addition, the FDIC can impose special assessments in certain instances. The range of assessments in the risk-based system is a function of the reserve ratio in the BIF. The current range of BIF assessments is between 0% and 0.27% of deposits because the BIF reserve ratio was greater than 1.25% when the ratios were set. The BIF reserve ratio was 1.26% as of June 30, 2005, the latest date for which complete data is available. If the ratio were to fall below 1.25%, the FDIC would consider whether to levy higher assessments. In February 2006 the Deposit Insurance Reform Act of 2005, or Deposit Reform Act, was enacted. The Deposit Reform Act consolidates the BIF and Savings Association Insurance Fund, or SAIF, into the Deposit Insurance Fund, or DIF, effective June 1, 2006, establishes a range for reserves levels for the DIF of 1.15% to 1.50% and creates a mechanism for raising the ceiling on deposit insurance coverage to offset future inflation. The FDIC must adopt new regulations or revise existing regulations to implement the Deposit Reform Act. Current regulations will remain valid until they are replaced.
Federal law aimed at recapitalizing the SAIF requires, among other things, that banks insured under the BIF pay a portion of the interest due on bonds that were issued to replace funds paid out for the failure of insured
thrifts by the Federal Savings and Loan Insurance Corporation in 1987. With respect to the assessment of the bond obligations, the BIF rate was 0.0134% of deposits for the fourth quarter of 2005 and is adjusted quarterly to reflect changes in the assessment bases of the respective funds based on quarterly Call Report submissions.
Safety and Soundness Standards. The FDIC and the other federal bank regulatory agencies have established guidelines for safety and soundness, addressing operational and managerial standards, as well as compensation matters for insured financial institutions. Institutions failing to meet these standards are required to submit compliance plans to their appropriate federal regulators. The FDIC and the other agencies have also established guidelines regarding asset quality and earnings standards for insured institutions. The bank believes that it is in compliance with these guidelines and standards.
Activities and Investments of Insured State-Chartered Banks. The activities and equity investments of FDIC-insured, state-chartered banks are presumptively limited by federal law to those that are permissible for national banks. An insured state bank generally may not acquire or retain any equity investment of a type, or in an amount, that is not permissible for a national bank. The FDIC has authority, however, to allow a state-chartered non-member bank to engage in activities or make investments not permissible for national banks. An insured state bank is permitted to, among other things:
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acquire or retain a majority interest in a subsidiary;
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invest as a limited partner in a partnership, the sole purpose of which is direct or indirect investment in the acquisition, rehabilitation or new construction of a qualified housing project, provided that such limited partnership investments may not exceed 2% of the bank’s assets;
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acquire up to 10% of the voting stock of a company that solely provides or reinsures directors’ and officers’ liability insurance; and
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acquire or retain the voting shares of a depository institution if certain requirements are met.
Qualified Thrift Lender Test. The bank is required to meet a qualified thrift lender test under both federal and state law. This test requires a savings bank to have at least 65% of its portfolio assets, as defined by regulation, in qualified thrift investments on a monthly average for nine out of every 12 months on a rolling basis. As an alternative, the savings bank may maintain 60% of its assets in those assets specified in Section 7701(a)(19) of the Internal Revenue Code of 1986, as amended. Under either test, such assets primarily consist of residential housing related loans and investments. As of December 31, 2005, the bank met the test.
Under federal law, any savings association (including a state savings bank that is treated as a savings association under Section 10 of HOLA) that fails to meet the qualified thrift lender test must convert to a bank charter, other than a savings bank charter, unless it requalifies as a qualified thrift lender and thereafter remains a qualified thrift lender. However, any savings bank which the OTS has deemed to be a savings association upon application by such bank, such as the bank, is precluded from requalifying for five years. Because of the five-year ban on requalification, a state savings bank that fails the OTS test must divest all investments and cease all activities not permissible for a national bank within three years. Within one year after such failure, the holding company of a state savings bank must register with the Federal Reserve Board as a bank holding company and become subject to all restrictions on bank holding companies administered by the Federal Reserve Board. New investments and activities are immediately limited to those permissible for both a savings association and a national bank. The savings bank is also limited to national bank branching rights in its home state. In addition, the savings bank is immediately ineligible to receive any new FHLB borrowings and is subject to national bank limits on payment of dividends.
Restrictions on Acquisitions. There are restrictions under federal and Texas law regarding the acquisition of control of the bank. Federal and Texas laws generally provide that no company, directly or indirectly or acting in concert with one or more persons, or through one or more subsidiaries, or through one or more transactions, may acquire control of a savings bank at any time without prior approval of the appropriate regulatory agencies. The concept of acting in concert is very broad under these laws. In addition, federal and state laws require that, prior to obtaining control of a savings bank, a person, other than a company, must give prior notice and have
received no objection to such acquisition of control and/or make an application to the appropriate regulatory agencies and receive approval to effect the acquisition.
Potential Enforcement Actions. Insured depository institutions and their institution-affiliated parties may be subject to potential enforcement actions by the FDIC and the TDSML for unsafe or unsound practices in conducting their businesses or for violations of any law, rule, regulation or any condition imposed in writing by the agency or any written agreement with the agency. The OTS may also bring enforcement actions based on its supervision of the company as a savings and loan holding company or on its regulation of capital distributions by the bank. Enforcement actions may include the appointment of a conservator or receiver, the issuance of a cease-and-desist order that can be judicially enforced, the termination of insurance of deposits (in the case of the bank), the imposition of civil money penalties, the issuance of directives to increase capital, the issuance of formal and informal agreements, the issuance of removal and prohibition orders against institution-affiliated parties and the imposition of restrictions and sanctions under the prompt corrective action provisions of the FDICIA.
Liquidity. The bank is required to maintain a balance of “liquid assets” (cash, excess balances in a Federal Reserve Bank, and other readily marketable investments, including unencumbered federal government sponsored enterprises) equal to 10% of average daily deposits for the most recently completed calendar quarter. As of December 31, 2005, the bank was in compliance with this requirement.
Restrictions on Capital Distributions. The bank is required to provide to the OTS not less than 30 days’ advance notice of the proposed declaration by its board of directors of any dividend on its capital stock. The OTS may object to the payment of the dividend on safety and soundness grounds. In addition, the bank would be subject to a more stringent OTS review if a proposed distribution would cause the bank to become under-capitalized or would exceed current net income plus retained net income for the previous two years or if the OTS did not regard the bank as well capitalized or well managed. The bank is currently not subject to this more stringent review.
Texas law permits the bank to pay dividends out of current or retained income in cash or additional stock so long as the savings bank meets its capital requirements.
The FDIC prohibits an insured depository institution from paying dividends on its capital stock or interest on its capital notes or debentures (if such interest is required to be paid only out of net profits) or distributing any of its capital assets while it remains in default in the payment of any assessment due the FDIC. The bank is not in default in any assessment payment to the FDIC.
Federal Reserve System. The Federal Reserve Board requires all depository institutions to maintain reserves against their transaction accounts (primarily checking accounts) and non-personal time deposits. As of December 31, 2005, the bank was in compliance with such requirements.
Because required reserves must be maintained in the form of vault cash or a non-interest-bearing account at a Federal Reserve Bank, the effect of this reserve requirement is to reduce a bank’s earning assets. The amount of funds necessary to satisfy this requirement has not had a material effect on the bank’s operations.
Restrictions on Transactions with Affiliates and Insiders. Transactions between the bank and its nonbanking affiliates, including the company, are subject to Sections 23A and 23B of the Federal Reserve Act and Federal Reserve Regulation W. In general, Section 23A imposes limits on the amount of such transactions, and also requires certain levels of collateral for loans to affiliated parties. It also limits the amount of advances to third parties which are collateralized by any securities or obligations or the securities or obligations of any of the company’s nonbanking subsidiaries.
Affiliate transactions are also subject to Section 23B of the Federal Reserve Act which generally requires that certain transactions between the bank and its affiliates be on terms substantially the same, or at least as favorable to the bank, as those prevailing at the time for comparable transactions with or involving other nonaffiliated persons.
The restrictions on loans to directors, executive officers, principal shareholders and their related interests (collectively referred to herein as “insiders”) contained in the Federal Reserve Act and Federal Reserve Regulation O apply to all insured institutions and their subsidiaries and holding companies. These restrictions
include limits on loans to one borrower and conditions that must be met before such a loan can be made. There is also an aggregate limitation on all loans to insiders and their related interests. Insiders are subject to enforcement actions for knowingly accepting loans in violation of applicable restrictions.
The USA PATRIOT Act of 2001. The USA PATRIOT Act requires financial institutions to prohibit correspondent accounts with foreign shell banks, establish an anti-money laundering program that includes employee training and an independent audit, follow minimum standards for identifying customers and maintaining records of the identification information and make regular comparisons of customers against agency lists of suspected terrorists, their organizations and money launderers.
Privacy Regulation. The company and its subsidiaries are subject to numerous privacy-related laws and their implementing regulations, including but not limited to Title V of the Gramm-Leach-Bliley Act, the Fair Credit Reporting Act, the Electronic Fund Transfer Act, the Right to Financial Privacy Act, the Children’s Online Privacy Protection Act, and other federal and state privacy and consumer protection laws. Those laws and the regulations promulgated under their authority can limit, under certain circumstances, the extent to which financial institutions may disclose nonpublic personal information that is specific to a particular individual to affiliated companies and nonaffiliated third parties. Moreover, the bank is required to establish and maintain a comprehensive Information Security Program in accordance with the Interagency Guidelines Establishing Standards for Safeguarding Customer Information. The program must be designed to:
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insure the security and confidentiality of customer information;
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protect against any anticipated threats or hazards to the security or integrity of such information; and
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protect against unauthorized access to or use of such information that could result in substantial harm or inconvenience to any customer.
In addition, the Federal Trade Commission has implemented a nationwide “do not call” registry that allows consumers to prevent unsolicited telemarketing calls. Millions of households have placed their telephone numbers on this registry.
Texas Savings Bank Law. As a Texas-chartered savings bank, the bank is subject to regulation and supervision by the TDSML under the TSBA. The TSBA contains provisions governing the incorporation and organization, location of offices, rights and responsibilities of directors and officers as well as the corporate powers, savings, lending, capital and investment requirements and other aspects of the bank and its affairs. In addition, the TDSML is given extensive rulemaking power and administrative discretion under the TSBA, including authority to enact and enforce rules and regulations.
The bank is required under the TSBA to comply with certain capital requirements established by the TDSML. The TSBA also restricts the amount the bank can lend to one borrower to that permitted to national banks, which is generally not more than 15% of the bank’s unimpaired capital and unimpaired surplus and, if such loans are fully secured by readily marketable collateral, an additional 10% of unimpaired capital and unimpaired surplus. The TDSML generally examines the bank once every year and the current practice is for the TDSML to conduct a joint examination with the FDIC. The TDSML monitors the activities of the bank by requiring that the bank seek the TDSML’s approval for certain transactions, such as the establishment of additional offices, a reorganization, merger or purchase and assumption transaction, changes of control, or the issuance of capital obligations. The TDSML may intervene in the affairs of a savings bank if the savings bank, or its director, officer or agent has engaged in an unsafe and unsound practice, violated the savings bank’s articles of incorporation, violated a statute or regulation, filed materially false or misleading information, committed a criminal act or a breach of fiduciary duty, or if the savings bank is, or is in imminent danger of becoming, insolvent.
Consumer Protection Regulations
The bank is subject to many federal consumer protection statutes and regulations including, but not limited to, the following:
The Truth-in-Lending Act. The Truth-in-Lending Act, or TILA, is designed to ensure that credit terms are disclosed in a way that permits consumers to compare credit terms more readily and knowledgeably. As a result of the TILA, all creditors must use the same credit terminology and expressions of rates, the annual percentage rate, the finance charge, the amount financed, the total of payments, and the payment schedule.
The Fair Housing Act. The Fair Housing Act regulates many practices, including making it unlawful for any lender to discriminate in its housing-related lending activities against any person because of race, color, religion, national origin, sex, handicap, or familial status.
The Fair Credit Reporting Act. The Fair Credit Reporting Act, or FCRA, includes extensive rules governing credit reporting agencies and entities that collect information from consumers in connection with extensions of credit.
The Fair and Accurate Credit Transactions Act of 2003. The Fair and Accurate Credit Transactions Act of 2003, or FACT, makes permanent the preemption of state laws contained in FCRA. In addition to preemption, FACT also imposes new requirements, including new restrictions on information sharing with affiliates for the purpose of making marketing solicitations, new consumer protection measures in the area of identity theft, and a new requirement to provide a notice of action taken when a consumer is offered credit that is materially less favorable than the most favorable terms available to a substantial proportion of a lender’s customers. FACT also gives consumers the right to see their credit score and to receive a free annual copy of their credit report.
The Equal Credit Opportunity Act. The Equal Credit Opportunity Act prohibits discrimination in any credit transaction, whether for consumer or business purposes, on the basis of race, color, religion, national origin, sex, marital status, age (except in limited circumstances), receipt of income from public assistance programs, or good faith exercise of any rights under the Consumer Credit Protection Act.
The Real Estate Settlement Procedures Act. The Real Estate Settlement Procedures Act, or RESPA, requires lenders to provide borrowers with disclosures regarding the nature and cost of real estate settlements. The RESPA is applicable to all federally related mortgage loans. A “federally related mortgage loan” includes any loan secured by a first or subordinate lien on residential real property designed for occupancy by one-to-four families, including a refinancing of an existing loan secured by the same property, if:
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the loan is made by any lender, the deposits of which are federally insured, or any lender that is regulated by a federal agency;
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the loan is insured, guaranteed or supplemented by a federal agency;
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the loan is intended to be sold to the FNMA, the Government National Mortgage Association, or GNMA, or the FHLMC; or
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the loan is made by any creditor who makes or invests in residential real estate loans aggregating more than $1 million per year.
The Department of Housing and Urban Development, or HUD, undertook to substantially revise the rules implementing the RESPA, which specifies disclosures and procedures for mortgage lenders to provide their customers, in 2002. It is uncertain whether new rules will be proposed and whether any revised RESPA rules adopted will be favorable or adverse to us.
The Home Mortgage Disclosure Act. The Home Mortgage Disclosure Act is intended to provide public information that can be used to help determine whether financial institutions are serving the housing credit needs of the neighborhoods and communities in which they are located and to assist in identifying possible discriminatory lending patterns.
The Community Reinvestment Act. The Community Reinvestment Act, or CRA, is intended to encourage insured depository institutions, while operating safely and soundly, to help meet the credit needs of their
communities. The CRA specifically directs the federal regulatory agencies, in examining insured depository institutions, to assess the institution’s record of helping to meet the credit needs of their entire community, including low- and moderate-income neighborhoods, consistent with safe and sound banking practices. The CRA further requires the agencies to take a financial institution’s record of meeting its community credit needs into account when evaluating applications for, among other things, domestic branches, mergers or acquisitions, or holding company formations. To evaluate large retail institutions, the agencies apply three tests - the lending, investment, and service tests - to determine an overall CRA rating for the financial institution. The ratings range from a high of “outstanding” to a low of “substantial noncompliance.” A bank receiving a “satisfactory” or better rating is deemed in compliance with the CRA.
The bank’s last public evaluation dated January 4, 2005, issued by its primary federal regulator, the FDIC, rated the bank “satisfactory.”
The Bank Secrecy Act and Money Laundering Laws. The Bank Secrecy Act, or BSA, requires every financial institution within the United States to file a Currency Transaction Report with the Internal Revenue Service, or IRS, for each transaction in currency of more than $10,000 not exempted by the Treasury Department.
The Money Laundering Prosecution Improvements Act requires financial institutions, typically banks, to verify and record the identity of the purchaser upon the issuance or sale of bank checks or drafts, cashier’s checks, traveler’s checks, or money orders involving $3,000 or more in cash. Institutions must also verify and record the identity of the originator and beneficiary of certain funds transfers.
Electronic Fund Transfer Act. The Electronic Fund Transfer Act, or EFTA, provides a basic framework establishing the rights, liabilities, and responsibilities of participants in “electronic fund transfer systems,” defined to include automated teller machine transfers, telephone bill-payment services, point-of-sale terminal transfers, and preauthorized transfers from or to a consumer’s account (for example, direct deposit of social security payments). Its primary objective is to protect the rights of individuals using these systems. The EFTA limits a consumer’s liability for certain unauthorized electronic fund transfers and requires certain error resolution procedures.
The Expedited Funds Availability Act. The Expedited Funds Availability Act seeks to insure prompt availability of funds deposited into a customer’s account and to expedite the return of checks.
The Truth-in-Savings Act. The Truth-in-Savings Act, or TISA, is principally a disclosure law, the purpose of which is to encourage comparative shopping for deposit products. The common denominator used by the TISA to facilitate comparison shopping of interest payable on deposit accounts is the annual percentage yield.
The bank attempts in good faith to assure compliance with the requirements of the consumer protection statutes to which it is subject, as well as the regulations that implement the statutory provisions. The requirements are complex, however, and even inadvertent non-compliance could result in civil and, in some cases, criminal liability.
Legislative and Regulatory Proposals. Proposals to change the laws and regulations governing the capital, operations and taxation of, and federal insurance premiums paid by, savings banks and other financial institutions and companies that control such institutions are frequently raised in Congress, state legislatures and before the FDIC and other bank regulatory authorities. The likelihood of any major changes in the future and the impact such changes might have on us or the bank are impossible to determine. Similarly, proposals to change the accounting treatment applicable to savings banks and other depository institutions are frequently raised by the Securities and Exchange Commission, or SEC, the FDIC, the Internal Revenue Service, or IRS, and other appropriate authorities, including, among others, proposals relating to fair market value accounting for certain classes of assets and liabilities. The likelihood and impact of any additional future accounting rule changes and the impact such changes might have on us or the bank are impossible to determine at this time.
Employees
As of December 31, 2005, all of our 710 employees were employed by the bank. We have entered into an arrangement with Administaff Companies II, L.P., to provide personnel management services to us. This service
is provided through a co-employment relationship between us and Administaff, under which all of our employees are employed by both us and Administaff, and we have outsourced our human resources function to Administaff.
Executive Officers of the Registrant
The names, ages as of December 31, 2005, recent business experience and positions or offices held by each of the executive officers of Franklin Bank Corp are as follows:
Available Information
The company makes available, free of charge through its website, its reports on Forms 10-K, 10-Q and 8-K, and amendments to those reports as soon as reasonably practicable after such reports are filed with or furnished to the SEC. Additionally, we have adopted and posted on our website a code of ethics that applies to our directors, executive officers and employees, including our principal executive officer and principal financial officer. Our website also includes our corporate governance guidelines, code of ethics and business conduct and the charters for our audit committee, compensation committee and our corporate governance and nominating committee. The address for our website is http://www.bankfranklin.com. The contents of our website are not part of this report.
Item 1A.
Item 1A.
Risk Factors
An investment in our common stock involves a number of risks. We describe below the material risks and uncertainties that affect our business. Before making an investment decision, you should carefully consider all of these risks and all other information included or incorporated in this report. Additional risks and uncertainties that management is not aware of or that management currently deems immaterial may also impair the Corporation’s business operations. This report is qualified in its entirety by these risk factors. If any of the following risks occur, our financial condition, liquidity, and results of operations could be materially and adversely affected. If this were to happen, the value of our common stock could decline significantly, and you could lose all or a part of your investment.
Risks Associated with Franklin
We may be unable to successfully continue to implement our growth business strategy, which may adversely affect our future prospects and financial performance.
Our strategic plan is directed toward enhancement of our return to our stockholders through a significant increase in our asset size, the increase in new customer deposit accounts, the expansion of our niche loan products and expansion into growing markets outside metropolitan areas in Texas. This requires:
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that we find attractive market opportunities so that we may profitably execute our strategic plan;
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that we continue to profitably build our products to provide us with the revenue to support our expansion;
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the use of a substantial amount of more rate sensitive “brokered” deposits to fund our asset growth. Brokered deposits are deposits that we obtain from or through a deposit broker. Such deposits constituted approximately 41% of our total deposits as of December 31, 2005;
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that we identify, hire and retain qualified employees, and maintain the information systems, necessary to manage our growth; and
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continued compliance with regulatory requirements applicable to our business.
Changes in the general and regional economic environment, such as an increase in mortgage rates or a decline in the housing market, may prevent us from originating or purchasing loans in volumes and on terms sufficient to support our strategic plan. Changes in general market conditions may materially and adversely affect our ability to find the necessary funding to support our growth. In addition, we may be unable to find and retain additional staff necessary to support our anticipated growth in our business activities, and the information systems supplied by our vendors may be inadequate to support this growth. Finally, because we are a highly regulated institution, our growth strategy could raise regulatory concerns that could in turn prevent us from implementing all or part of our strategic plan.
Any of these developments could have a material adverse effect on our financial condition, results of operations and cash flows.
If we are unable to identify and acquire other financial institutions and successfully integrate our business with those of the companies that we have acquired or acquire in the future, our business and earnings may be adversely affected.
We intend to grow by acquisitions, including but not limited to the acquisition of other financial institutions, branch offices and loan portfolios. Since our acquisition of Franklin Bank, we have considered and entered into discussions regarding potential acquisitions. On April 30, 2003, we completed the acquisition of Highland Lakes Bancshares Corporation, located in Kingsland, Texas. On December 30, 2003, we completed the acquisition of Jacksonville Bancorp, Inc. for approximately $67.7 million in cash. On February 29, 2004, we completed the acquisition of Lost Pines Bancshares, Inc. for approximately $6.9 million in cash. On December 4, 2004, we completed the acquisition of Cedar Creek Bancshares, Inc. for approximately $11.3 million in cash and $12.3 million in our common stock. On May 9, 2005, we completed the acquisition of The First National Bank of Athens for approximately $43.5 million in cash and $14.3 million in our common stock. On July 15, 2005, we
completed the acquisition of Elgin Bank of Texas for approximately $11.7 million in cash and $11.9 million in our common stock. On December 2, 2005, we completed the purchase of five banking offices located in the following Texas cities: Beaumont, Groves, Nederland, El Campo and Wharton for a purchase premium of approximately $33.6 million. We intend to continue to consider other potential acquisition opportunities in the future. Other potential future transactions may be effected quickly, may occur at any time and may be significant in size relative to our existing assets and operations. However, no assurance can be given that we will be able to successfully make such acquisitions on terms acceptable to us.
The market for acquisition targets is highly competitive, which may adversely affect our ability to find acquisition candidates that fit our growth strategy. To the extent that we are unable to find suitable acquisition targets, an important component of our growth strategy may not be realized. Acquisitions will be subject to regulatory approval, and we may be unable to obtain such approvals. In addition, some acquisitions will likely require us to consolidate data processing operations, combine employee benefit plans, create joint account and lending products and develop unified marketing plans, which could increase our operating costs significantly.
Furthermore, our ability to grow through acquisitions will depend on our maintaining sufficient regulatory capital levels and on general and regional economic conditions. We may also elect to finance future acquisitions with debt financings, which would increase our debt service requirements, or through the issuance of additional common or preferred stock, which could result in dilution to our stockholders. There can be no assurance that we will be able to arrange adequate financing for any acquisitions on acceptable terms.
Our ability to successfully integrate the Athens transaction and other future transactions, will depend primarily on our ability to consolidate operations, systems and procedures and to eliminate redundancies and costs. We cannot assure you that we will be able to integrate our operations without encountering difficulties, such as the loss of key employees and customers, the imposition of regulatory restrictions, the disruption of our ongoing business or possible inconsistencies in standards, controls, procedures and policies. The integration process also may require significant time and attention from our management that would otherwise be directed at developing our existing business. Estimated cost savings projected to come from various areas that we identified through our due diligence and integration planning process may not materialize. If we have difficulties with any of these integrations, we might not achieve the economic benefits we expect to result from these acquisitions and this would likely hurt our business and our earnings. In addition, we may experience greater than expected costs or difficulties relating to the integration of these operations, and may not realize expected cost savings from these acquisitions within the expected time frames.
We have a limited operating history, which makes it difficult to predict our future prospects and financial performance.
We have only been operating as the holding company for Franklin Bank since April 10, 2002. Due to this limited operating history, it may be difficult to evaluate our business prospects.
We rely, in part, on external financing to fund our operations and the unavailability of such funds in the future could adversely affect our growth strategy and prospects.
Our ability to implement our business strategy will depend on our ability to obtain funding for acquisitions, loan originations, working capital and other general corporate purposes.
We do not anticipate that our community banking and commercial deposits will be sufficient to meet our funding needs. We therefore rely on wholesale and brokered deposits, Federal Home Loan Bank advances and other wholesale funding sources to obtain the funds necessary to implement our growth strategy. Because these funds generally are more sensitive to rates than community banking deposits, they are more likely to move to the highest rate available.
To the extent we are not successful in obtaining such funding, we will be unable to implement our strategy as planned, which could have a material adverse effect on our financial condition, results of operations and cash flows.
Our reliance on brokered deposits to fund our growth may substantially increase our funding costs. In addition, regulatory constraints may limit our ability to acquire these deposits.
Brokered deposits, which are more sensitive to changes in interest rates than are community banking deposits, constituted approximately 41% of our total deposits at December 31, 2005. Brokered deposits are priced based on the current general level of interest rates and, unlike retail deposits, do not take into account regional pricing. Our ability to continue to acquire brokered deposits is subject to our ability to price these deposits at competitive levels, which may substantially increase our funding costs. In addition, if our capital levels were to fall below “well capitalized” under the Prompt Corrective Action standards of the Federal Deposit Insurance Corporation, or FDIC, our ability to accept, renew or roll over these deposits would be subject to our receiving a waiver from the FDIC. Furthermore, we would be limited on the rate that we could pay for these deposits to 75 basis points over the effective yield on deposits that we offer in our normal market area or the national rate for deposits of comparable maturity. Failure to receive a waiver from the FDIC, if required, would have a material adverse impact on our financial condition, results of operations and cash flows.
Our small business, commercial real estate and consumer loan portfolios have significant geographic concentration and an economic slowdown or depressed real estate market in our primary markets could be detrimental to our financial condition.
A substantial portion of our small business, commercial real estate and consumer loans are to customers located in Travis, Bastrop, Llano, Cherokee, Gregg, Henderson, Panola and Smith Counties in Texas. Most of these loans are secured by real estate in these counties. In addition, since the completion of the purchase in December 2005 of five banking offices in Jefferson and Wharton counties located near the Texas Gulf Coast, our operations in those areas are susceptible to damage associated with hurricanes, such as high winds, flooding, tornados and similar risks. The occurrence of a major hurricane on the Texas Gulf Coast could materially and adversely affect our business and results of operations in the areas affected by such storm.
A deterioration in economic conditions in these counties could have a material adverse effect on the quality of these portfolios and the demand for our products and services. In addition, during periods of economic recession, we may experience a decline in collateral values and an increase in delinquencies. Accordingly, the ultimate collectability of a substantial portion of our commercial loan portfolio is susceptible to economic changes in these markets. A significant downturn in the real estate market in these areas would be detrimental to our financial condition.
In addition, if any of these developments were to result in losses that materially and adversely affected Franklin Bank’s capital, we and Franklin Bank might be subject to regulatory restrictions on operations and growth and to a requirement to raise additional capital.
Our loan portfolio may be significantly affected by the economy of California.
As of December 31, 2005, approximately 26.6% of the principal amount of our loan portfolio was secured by properties located in California. Consequently, our financial condition, results of operations and cash flows are likely to be significantly affected by economic conditions in California, particularly those affecting the residential real estate markets. In addition, mortgaged properties in California may be particularly susceptible to certain types of uninsurable hazards, such as earthquakes, floods, mudslides or other natural disasters. An overall decline in the economy or the residential real estate market, or the occurrence of a natural disaster, in California could materially and adversely affect the value of the mortgaged properties located there and increase the risk of delinquency, foreclosure, bankruptcy or loss on mortgage loans in our portfolio. These events could have a material adverse effect on our financial condition, results of operations and cash flows.
If we are unable to continue to purchase single family loans in bulk from the entities with which we currently have correspondent relationships, or other entities, our business and financial results may suffer.
Our single family mortgage loans held for investment grew by $283.2 million to $2.6 billion at December 31, 2005, from $2.3 billion at December 31, 2004. This growth is attributable to the purchase of
$1.2 billion, and the origination of $865.6 million, of single family mortgage loans. The single family loan purchases were primarily through correspondent relationships with Countrywide Home Loans Inc., which accounted for approximately 67% of total purchases, Residential Funding Corp., which accounted for 15%, and Morgan Stanley, which accounted for approximately 12% of total purchases, during the year ended December 31, 2005. We are not contractually obligated to purchase loans from any of these entities on an ongoing basis. If we are unable to continue to purchase single family loans in bulk from these or other entities our business and financial results may suffer.
The majority of our single family loan portfolio consists of newly originated loans which may cause our loan portfolio to experience increased losses as the loans season.
At December 31, 2005, approximately 89% of our single family loan portfolio was comprised of single family mortgage loans that are less than three years old. Losses on single family mortgage loans generally occur after the loans are three years old. Therefore, we may experience a significant increase in losses on our single family mortgage loans as these loans age, and we may have to increase our allowance for credit losses accordingly. This may have a material adverse impact on our financial condition, results of operations and cash flows.
We are subject to losses resulting from fraudulent and negligent acts on the part of loan applicants, mortgage brokers, correspondents or other third parties.
We rely heavily upon information supplied by third parties, including the information contained in loan applications, property appraisals, title information and employment and income documentation, in deciding which loans we will originate, as well as the terms of those loans. Additionally, our mortgage banker finance product poses a particular risk of losses due to fraudulently or improperly documented collateral. If any of the information upon which we rely is misrepresented, either fraudulently or inadvertently, and the misrepresentation is not detected prior to loan funding, the value of the loan may be significantly lower than we had expected, or we may fund a loan that we would not have funded or on terms we would not have extended. Whether a misrepresentation is made by the loan applicant, the mortgage broker or another third party, we generally bear the risk of loss associated with the misrepresentation. A loan subject to a material misrepresentation is typically unsellable or subject to repurchase if it has been sold prior to detection of the misrepresentation. After a loss from a misrepresentation occurs, the source is often difficult to locate, and it is often difficult to recover any of the monetary losses we have suffered.
Although we have controls and processes designed to help us identify misrepresentations contained in information furnished to us in our loan origination operations, we cannot assure you that we have detected or will detect all misrepresentations in our loan origination operations.
We are subject to losses resulting from the nature of our mortgage banker finance borrowers.
The small- and medium-sized mortgage companies to which we market our mortgage banker finance products generally tend to be more thinly capitalized than are other commercial borrowers, which increases the risk that these borrowers will become over-leveraged or experience cash flow difficulties. Therefore, our lending in this product exposes us to an increased risk that our borrowers may experience financial difficulties and be unable to perform as required under their loans, which could have a material adverse effect on our financial condition, results of operations and cash flows. As of December 31, 2005, we had $418.3 million in warehouse lines committed, of which $173.8 million was outstanding.
Our business is subject to interest rate risk and variations in interest rates may adversely affect our financial performance.
The majority of our assets and liabilities are monetary in nature and subject us to significant risk from changes in interest rates. Like most financial institutions, changes in interest rates can impact our net interest income as well as the valuation of our assets and liabilities. Based on our one-year cumulative interest rate gap at December 31, 2005 of negative $231.6 million, an increase in the general level of interest rates may adversely
affect our net yield on interest-earning assets since our interest-bearing liabilities reprice faster than our interest earning assets. In addition, due to the periodic caps which limit interest rate changes on our mortgage-backed securities and loans that pay interest at adjustable rates, an increase in rates greater than the periodic interest rate caps on these loans, usually 2% per year, may adversely affect our interest income earned on these assets. It is quite possible that significant changes in interest rates may take place in the future, although we cannot predict the nature or magnitude of such changes or how such changes may affect our business.
Additionally, an increase in interest rates may, among other things, reduce the demand for loans and our ability to originate loans. A decrease in the general level of interest rates may affect us through, among other things, increased prepayments on our loan and mortgage-backed securities portfolios and increased competition for deposits. Accordingly, changes in the level of market interest rates affect our net yield on interest-earning assets, loan origination volume, loan and mortgage-backed securities portfolios, and our overall results.
Our profitability is dependent to a large extent on our net interest income. Net interest income is the difference between:
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interest income on interest-earning assets, such as loans and investment securities; and
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interest expense on interest-bearing liabilities, such as deposits.
Fluctuations in interest rates are not predictable or controllable. Changes in interest rates can have differing effects on various aspects of our business, particularly on our net interest income and the cost of purchasing residential mortgage loans in the secondary market. In particular, changes in market interest rates, changes in the relationships between short-term and long-term market interest rates, or changes in the relationships between different interest rate indices, can affect the interest rates charged on interest-earning assets differently than the interest rates paid on interest-bearing liabilities. This difference could result in an increase in interest expense relative to interest income and therefore reduce our net interest income.
Additionally, in periods of rising interest rates mortgage loan originations typically decline, depending on the overall performance of the economy. To the extent that our mortgage originations decline, our income from mortgage originations may also decline.
Our mortgage origination activities are subject to interest rate risk that may adversely affect our earnings.
We originate single family mortgage loans to be sold into the secondary market. As part of this process we may commit to an interest rate to the borrower prior to selling the loan into the secondary market. In order to mitigate the risk that a rise in market interest rates will cause a decline in the value of the loan, we may enter into forward sales agreements at the time the loan’s interest rate is set. We enter into these forward sales agreements based on the amount of the loans we have committed to make at a particular interest rate and the amount of these commitments we expect to fund. Because we use an estimate of the amount of loans that we expect to close, actual funding amounts may vary. We tend to close a higher percentage of loans with committed interest rates lower than the current market and lower percentages of loans that have a committed interest rate greater than the current market. These variances may have a negative effect on our earnings. In addition, because the forward sales agreements may be executed at different rates than the loan commitment, these agreements may not respond to changes in interest rates to the same degree as the mortgage loan. As of December 31, 2005, we had $26.3 million in fixed rate mortgage loans with committed rates that had not closed and $29.2 million in forward sales agreements allocated to these commitments based on an expected close rate of 65%.
We face strong competition from other financial institutions and financial service companies offering services similar to those offered by us, which could hurt our business.
The banking business is highly competitive, and our profitability will depend principally upon our ability to compete in the markets in which our banking operations are located. We compete with thrifts, commercial banks, credit unions, mortgage companies, specialty finance companies, brokerage firms, investment banks, insurance companies and other financial services companies which may offer more favorable financing than we offer. Most
of these competitors are more established than we are and have greater financial and other resources. We can give you no assurance that we will be able to compete effectively as we seek to implement our growth strategy.
Federal statutes and rules governing federally chartered banks and thrifts allow those entities to engage in mortgage and other lending in multiple states on a substantially uniform basis and without the need to comply with state licensing and other laws affecting mortgage lenders, including so-called state “predatory lending” laws directed at certain residential mortgage loans that are defined as “high cost” and that have other features found objectionable in such state legislation. Accordingly, Franklin Bank, as a state chartered savings bank, may be subject to state legal requirements and legal risks under state laws to which federally chartered competitors are not subject and this disparity may have the effect of giving those entities legal and competitive advantages.
We are subject to extensive regulation and supervision that could materially and adversely affect our financial performance.
Savings and loan holding companies and Texas state savings banks operate in a highly regulated environment and are subject to extensive supervision and examination by several state and federal agencies.
We are subject to examination and supervision by the Office of Thrift Supervision, or OTS, since we elected to be treated as a savings and loan holding company. It is possible that the OTS may adopt additional limitations on savings and loan holding companies, although the OTS has not proposed any specific limitations at this time.
Franklin Bank, as a Texas state savings bank, is subject to regulation and supervision by the Texas Savings and Loan Department, or TSLD. Franklin Bank is also regulated by the FDIC, as administrator of the Bank Insurance Fund, or BIF, and with respect to capital distributions, by the OTS. These regulations are intended primarily for the protection of depositors and customers, rather than for the benefit of investors.
We are subject to changes in federal and state laws, as well as changes in regulations and governmental policies, income tax laws and accounting principles. The effects of any potential changes cannot be predicted but could materially and adversely affect our business and operations. In particular, because we have a high-growth strategy, this regulatory environment could have a material adverse effect on our financial condition, results of operations and cash flows if any of these agencies determines that we must change our strategy or otherwise imposes additional restrictions or requirements that limit our business flexibility.
We are dependent on key individuals and on our continued ability to attract qualified and experienced personnel. The loss of one or more of these key individuals, or our inability to continue to attract such personnel, could curtail our growth and materially and adversely affect our prospects.
We are dependent on certain members of our management, including Anthony J. Nocella, our President and Chief Executive Officer, Daniel E. Cooper, our Managing Director of Mortgage Banking, and Michael Davitt, our Managing Director of Commercial Lending. The unexpected loss of any of these members of management could have a material adverse effect on us.
Our success also depends on our continued ability to attract and retain experienced loan officers and support staff, as well as other management personnel. We currently do not have employment agreements or non-competition agreements with any of our existing loan officers and the loss of the services of several of such key personnel could materially and adversely affect our growth strategy and prospects to the extent we are unable to replace such personnel. Competition for loan officers is strong within builder finance, mortgage banker finance and mortgage banking industries and we may not be successful in attracting or retaining the personnel we require.
Our allowance for credit losses may be insufficient to cover actual losses, which could materially and adversely affect our financial performance.
Our allowance for credit losses was $13.4 million, or 0.35% of total loans outstanding and 51.3% of non-performing loans, as of December 31, 2005. Significant increases to the allowance for credit losses may be necessary if material adverse changes in general economic conditions occur and the performance of our loan portfolio deteriorates.
In addition, if we had to foreclose on assets, additional adjustments may be necessary to ensure that the foreclosed assets are carried at the lower of cost or fair value, less estimated cost to dispose of the foreclosed assets. As a part of their examinations, the FDIC and TDSML periodically review Franklin Bank’s estimated losses on loans and the carrying value of our assets. Increases in the provision for credit losses and other real estate owned could materially and adversely affect our financial condition, results of operations and cash flows.
An interruption in or breach of our information systems may result in lost business.
We rely heavily on communications and information systems furnished by third party service providers to conduct our business. Any failure or interruption or breach in security of these systems could result in failures or interruptions in our customer relationship management, general ledger, deposit, servicing and/or loan origination systems. We cannot assure you that such failures or interruptions will not occur or, if they do occur, that they will be adequately addressed by us or the third parties on which we rely. The occurrence of any failures or interruptions could have a material adverse effect on our financial condition, results of operations and cash flows.
We rely on information system technology from third party service providers, and we may not be able to obtain substitute providers on terms that are as favorable if our relationships with our existing service providers are interrupted.
We rely on third party service providers for much of our information technology systems, including customer relationship management, general ledger, deposit, servicing and loan origination systems. If any of these third party service providers experience financial, operational or technological difficulties, or if there is any other disruption in our relationships with them, we may be required to locate alternative sources of such services, and we cannot assure you that we could negotiate terms that are as favorable to us, or could obtain services with similar functionality as found in our existing systems without the need to expend substantial resources, if at all.
We are exposed to environmental liabilities with respect to properties to which we take title.
In the course of our business, we may foreclose on and take title to residential and commercial properties and could be subject to environmental liabilities with respect to these properties. We may be held liable to a governmental entity or to third parties for property damage, personal injury and investigation and clean-up costs incurred by these parties in connection with environmental contamination, or may be required to investigate or clean up hazardous or toxic substances or chemical releases at a property. The costs associated with investigation or remediation activities could be substantial. In addition, as the owner or former owner of a contaminated site, we may be subject to common law claims by third parties based on damages and costs resulting from environmental contamination emanating from the property. If we ever become subject to significant environmental liabilities, our financial condition, results of operations and cash flows could be materially and adversely affected.
Risks Associated with an Investment in Our Common Stock
The market price and trading volume of our common stock may be volatile.
On December 18, 2003, we completed an initial public offering of our common stock, which is listed on the Nasdaq National Market. While there has been an active trading market in our common stock since the initial public offering, we cannot assure you that an active trading market in our common stock will be sustained.
Even if active trading of our common stock continues, the market price of the common stock may be highly volatile and subject to wide fluctuations. In addition, the trading volume in our common stock may fluctuate and cause significant price variations to occur. If the market price of our common stock declines significantly, you may be unable to resell your shares at or above the price at which the shares were acquired. We cannot assure you that the market price of our common stock will not fluctuate or decline significantly in the future. Some of the factors that could adversely affect our share price or result in fluctuations in the price or trading volume of our common stock include:
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actual or anticipated fluctuations in our results of operations;
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failure to be covered by securities analysts, or failure by us to meet securities analysts’ expectations;
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success of our operating strategies;
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realization of any of the risks described in this section;
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prevailing interest rates;
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decline in the stock price of companies that are our peers; or
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general market and economic conditions.
Because we are a relatively new public company, and prior to our initial public offering there was no active trading market in our common stock, these fluctuations may be more significant for us than they would be for a company whose stock has been publicly traded over an extended period of time.
In addition, the stock market has experienced in the past, and may in the future experience extreme price and volume fluctuations. These market fluctuations may materially and adversely affect the trading price of our common stock, regardless of our actual operating performance.
We currently do not intend to pay any dividends on our common stock. In addition, our future ability to pay dividends is subject to restrictions. As a result, capital appreciation, if any, of our common stock will be your sole source of gains for the foreseeable future.
We currently do not intend to pay any dividends on our common stock. In addition, since we are a holding company with no significant assets other than Franklin Bank, we depend upon dividends from Franklin Bank for all of our revenues. Accordingly, our ability to pay dividends depends upon our receipt of dividends or other capital distributions from Franklin Bank.
Additionally, we are restricted from paying any dividends on our common stock if an event of default has occurred on our junior subordinated notes.
Franklin Bank’s ability to pay dividends or make other capital distributions to us is subject to the regulatory authority of the TDSML, the OTS and the FDIC. Under Texas law, a Texas state savings bank is permitted to pay dividends out of current or retained income, although the TDSML reserves the right to restrict dividends for safety and soundness reasons. As of December 31, 2005, Franklin Bank could have paid approximately $61.0 million in dividends without the prior approval of the OTS.
“Capital distributions” regulated by the OTS include:
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distributions of cash or other property to owners made because of their ownership (but not including stock dividends);
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payments by a savings association or savings bank holding company to repurchase or otherwise acquire its shares or debt instruments included in total capital;
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direct or indirect payments of cash or property made in connection with a restructuring, including payments to stockholders of another entity in a cash merger; and
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other distributions charged against capital accounts of an association if, as a result, the savings association would not be well-capitalized.
Franklin Bank’s ability to make capital distributions is subject to regulatory limitations. Generally, Franklin Bank may make a capital distribution without prior OTS review or approval in an amount equal to Franklin Bank’s net income for the current calendar year to date, plus retained net income for the previous two years, provided that Franklin Bank does not become less than well-capitalized as a result of the distribution. Franklin Bank’s ability to make such distributions depends on maintaining eligibility for “expedited status.” Franklin Bank currently qualifies for expedited status, but there can be no assurance that it will maintain its current status.
Additionally, although no prior OTS approval may be necessary, Franklin Bank is required to give the OTS 30 days’ notice before making any capital distribution to us. The OTS may object to any capital distribution if it
believes the distribution will be unsafe and unsound. Additional capital distributions above the limit for an expedited status institution are possible but require the prior approval of the OTS. An application to the FDIC is also necessary if any distribution would cause Franklin Bank to become less than adequately capitalized. Neither the OTS nor the FDIC is likely to approve any distribution that would cause Franklin Bank to fail to meet its capital requirements or to become under-capitalized on a pro forma basis after giving effect to the proposed distribution. The FDIC has back-up authority to take enforcement action if it believes that a capital distribution by Franklin Bank constitutes an unsafe or unsound action or practice, even if the OTS has approved the distribution.
Our corporate organizational documents and the provisions of Delaware law to which we are subject may delay or prevent a change in control of us that you may favor.
Our certificate of incorporation and bylaws contain provisions that, either alone or in combination with the provisions of Delaware law described below, may have the effect of delaying or making it more difficult for another person to acquire us by means of a hostile tender offer, open market purchases, a proxy contest or otherwise. These provisions include:
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A board of directors classified into three classes of directors with each class having staggered, three-year terms. As a result of this provision, at least two annual meetings of stockholders may be required for the stockholders to change a majority of our board of directors.
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The board’s authority to issue shares of preferred stock without stockholder approval, which preferred stock could have voting, liquidation, dividend or other rights superior to those of our common stock. To the extent any such provisions are included in any preferred stock, they could have the effect of delaying, deferring or preventing a change of control.
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Our stockholders cannot act by less than unanimous written consent and must comply with the provisions of our bylaws requiring advance notification of stockholder nominations and proposals. These provisions could have the effect of delaying or impeding a proxy contest for control of us.
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Provisions of Delaware law, which we did not opt out of in our certificate of incorporation, that restrict business combinations with “interested stockholders” and provide that directors serving on staggered boards of directors, such as ours, may be removed only for cause.
Any or all of these provisions could discourage tender offers or other business combination transactions that might otherwise result in our stockholders receiving a premium over the then current market price of our common stock.
Item 1B.
Item 1B.
Unresolved Staff Comments
We have no unresolved comments with the staff.
Item 2.
Item 2.
Properties
We lease our home office located at 9800 Richmond Avenue, Houston, Texas, our community banking operations center at 4515 Seton Center Parkway, Austin, Texas and our mortgage operations center at 100 N. 6th Street, Waco, Texas. We also lease banking offices located at 3720 Jefferson Street, 3401 Northland Drive, 3103 Bee Caves Road in Austin, Texas, 109 Cypress Creek Road in Cedar Park, Texas, 4410 Williams Dr. in Georgetown, Texas, 1007 RR 620 South, Lakeway, Texas, 721 Highway 290, Dripping Springs, Texas and at 515 E Loop 28, Longview, Texas. We own banking offices located at 203 Neches Street, Jacksonville, Texas, 4803 Old Bullard Road and 2507 University in Tyler, Texas, 107 E. South St., Rusk, Texas, 1412 Judson Rd., Longview, Texas, 617 S. Palestine and 125 N. Prairieville in Athens, Texas, 121 S. Market St., Carthage, Texas, 1015 N. Church St., Palestine, Texas, 499 Hwy. 71 W., Bastrop, Texas, 406 Main Street, Smithville, Texas, 601 E. Cedar Creek Parkway, Seven Points, Texas, 1101 N.W. 2nd Street, Kerens, Texas, 1716 W. Main Street, Hwy 175 West and 127 South Gun Barrel Lane, Gun Barrel City, Texas, Highway 274 South, Tool, Texas, 207 S. Athens, Canton, Texas, 210 Hwy 175 West, Eustace, Texas, 1022 Nederland Avenue, Nederland, Texas, 3434 Twin Cities Highway, Groves, Texas, 104 West Caney Street, Wharton, Texas, 201 West Jackson Street, El Campo, Texas, 6150 Eastex Freeway, Beaumont, Texas, 31 North Main and 106 Roy River Road in Elgin, Texas.
We lease commercial lending offices located at 151 S. Wymore Road, Altamonte, Florida, 6991 E. Camelback Rd., Scottsdale, Arizona, 4521 Hulen Street, Fort Worth, Texas, 39111 W. Six Mile Road, Livonia, Michigan and 1730 Walton Rd., Blue Bell, Pennsylvania. We also own a shopping center in Kingsland, Texas that has approximately 50,000 square feet of which the bank occupies approximately 16,000 square feet. We believe that suitable alternative or additional space will be available in the future on commercially reasonable terms as needed.
Item 3.
Item 3.
Legal Proceedings
The bank is involved in legal proceedings occurring in the normal course of business that management believes, after reviewing such claims with outside counsel, are not material to the financial condition, results of operations or cash flows of the bank or the company.
In November 2005, the Company was named in a lawsuit, filed by G.M. Sign, Inc. in Illinois State Court, where the plaintiff alleges that the company sent faxes in violation of the Telephone Consumer Protection Act. The plaintiff has filed a motion for class certification. The plaintiff alleges unspecified damages. The company has filed a motion for removal to Federal court and a motion to dismiss. Because this action is in the early stages, we are unable to estimate the possible range of loss, if any.
Item 4.
Item 4.
Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of security holders during the fourth quarter of 2005.
PART II
Item 5.
Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Common Stock Market Prices and Dividends
Our stock trades on the NASDAQ National Market System under the symbol “FBTX”. The following table sets forth the high and low sales prices of our stock for each quarter for the last two years.
As of March 1, 2006, there were 23,401,620 shares issued and outstanding held by approximately 4,200 beneficial owners. The last reported sales price of our common stock on March 1, 2006 was $17.31 per share.
There were no dividends declared during 2005 or 2004. We currently do not intend to pay dividends on our common stock.
Recent Sales of Unregistered Securities
There were no transactions by the company during the period covered by this report and not previously reported on Form 8-K or Form 10-Q involving sales of the company’s securities that were not registered under the Securities Act of 1933, as amended, or Securities Act.
Stock-Based Compensation
Information regarding stock-based compensation awards outstanding and available for future grants as of December 31, 2005, segregated between stock-based compensation plans approved by shareholders and stock-based compensation plans not approved by shareholders, is presented in the table below. Additional information regarding stock-based compensation plans is presented in Note 14, Employee Benefits, and Note 15, Related Parties, in the notes to the consolidated financial statements included in Item 8. Financial Statements and Supplementary Data, all of which is included elsewhere in this report.
Item 6.
Item 6.
Selected Financial Data
You should read the selected financial data in conjunction with “Item 7.
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Cautionary Note Regarding Forward-Looking Information
A number of the presentations and disclosures in this report, including any statements preceded by, followed by or which include the words “may,” “could,” “should,” “will,” “would,” “hope,” “might,” “believe,” “expect,” “anticipate,” “estimate,” “intend,” “plan,” “assume” or similar expressions constitute forward-looking statements. These forward-looking statements, implicitly and explicitly, include information concerning possible or assumed future results of operations, trends, financial results and business plans, including those relating to:
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earnings growth;
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revenue growth;
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future acquisitions;
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origination volume in our commercial and mortgage businesses;
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seasonality in our mortgage business;
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non-interest income levels, including fees from product sales;
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credit performance on loans made or acquired by us;
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tangible capital generation;
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margins on sales or securitizations of loans;
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cost and mix of deposits;
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market share;
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expense levels;
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results from new business initiatives in our community banking business; and
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other business operations and strategies.
Forward-looking statements involve inherent risks and uncertainties that are subject to change based on various important factors, some of which are beyond our control. We caution you that a number of important factors could cause actual results to differ materially from those contained in any forward-looking statement. Such factors include, but are not limited to:
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risks and uncertainties related to acquisitions and divestitures, including related integration and restructuring activities, and changes in our mix of product offerings;
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prevailing economic conditions;
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changes in interest rates, loan demand, real estate values, and competition, which can materially affect origination levels and gains on sale results in our mortgage business, as well as other aspects of our financial performance;
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the level of defaults, losses and prepayments on loans made or acquired by us, whether held in portfolio, sold in the whole loan secondary markets or securitized, which can materially affect charge-off levels, require credit loss reserve levels and our periodic valuation of our retained interests from securitizations we may engage in;
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changes in accounting principles, policies and guidelines;
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adverse changes or conditions in capital or financial markets, which can adversely affect our ability to sell or securitize loan originations on a timely basis or at prices which are acceptable to us, as well as other aspects of our financial performance;
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actions by rating agencies and the effects of these actions on our businesses, operations and funding requirements;
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changes in applicable laws, rules, regulations or practices with respect to tax and legal issues, whether of general applicability or specific to us and our subsidiaries; and
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other economic, competitive, governmental, regulatory, and technological factors affecting our operations, pricing, products and services.
In addition, we regularly explore opportunities for acquisitions of and hold discussions with financial institutions and related businesses, and also regularly explore opportunities for acquisitions of liabilities and assets of financial institutions and other financial services providers. Discussions regarding potential acquisitions may be commenced at any time, may proceed rapidly and agreements may be concluded and announced at any time. Any potential acquisition, and any combination of potential acquisitions, may be material in size relative to our existing assets and operations. We routinely analyze our lines of business and from time to time may increase, decrease or terminate one or more activities.
If one or more of the factors affecting our forward-looking information and statements proves incorrect, then our actual results, performance or achievements could differ materially from those expressed in, or implied by, the forward-looking information and statements contained in this report. Therefore, we caution you not to place undue reliance on our forward-looking information and statements. The forward-looking statements are made as of the date of this report, and we do not intend, and assume no obligation, to update the forward-looking statements or to update the reasons why actual results could differ from those projected in the forward-looking statements. All forward-looking statements contained in this report are expressly qualified by these cautionary statements.
Overview
We were formed in August 2001 and began our banking operations in April 2002 with our acquisition of the bank. Since April 2002, we have grown from $61.3 million in assets to $4.5 billion at December 31, 2005, expanded our community banking offices to 36 from two, established our corporate office where we provide many of our banking services, expanded our commercial lending regional offices to Arizona, Florida, Pennsylvania, Michigan, and Dallas, Texas, and initiated a mortgage banking business with retail mortgage offices in 24 states throughout the United States and three wholesale offices in Texas, California and Tennessee.
Our historical financial results reflect the development of our business. During 2002, we incurred the non-interest expense related to our expansion and the infrastructure cost necessary to support the expansion. At the end of 2002 and throughout 2003, we began to acquire and originate loans and other earning assets, which have increased our revenues to a level commensurate with the expenses that we incurred in our development stage. During 2004 and 2005, we have continued to see the results from the execution of our business strategy as our asset and revenue growth have offset the ongoing cost of executing our business strategy. We have achieved improved levels of profitability as our businesses have begun to generate earning assets and revenues that exceed their ongoing operating expenses. We will continue to make additional investments in our businesses to expand the range of our product lines and services.
Critical Accounting Policies
Our significant accounting policies are described in the notes to our consolidated financial statements which are included elsewhere in this report. Certain of these accounting policies, by their nature, involve a significant amount of subjective and complex judgment by our management. These policies relate to our allowance for credit losses, rate lock commitments and goodwill and other intangible assets. We believe that our estimates, judgments and assumptions are reasonable given the circumstances existing at the time such estimates, judgments and assumptions are made. However, actual results could differ significantly from these estimates and assumptions which could have a material impact on our financial condition and results of operations and cash flows. Our critical accounting policies are described below.
Allowance for Credit Losses
We maintain our allowance for credit losses at the amount estimated by management to be sufficient to absorb probable losses inherent in our loan portfolios based on available information. Our estimates of credit losses meet the criteria for accrual of loss contingencies in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 5, “Accounting for Contingencies,” as amended by SFAS No. 114, “Accounting by Creditors for Impairment of a Loan.” When analyzing the appropriateness of the allowance for credit losses, we consider such factors as historical loss experience, delinquency status, identification of adverse situations that may affect the ability of obligors to repay, known and inherent risks in the portfolio, assessment of economic conditions, regulatory policies and the estimated value of the underlying collateral, if any. Single family mortgages and consumer loans are evaluated as a group. Builder lines, commercial real estate, commercial business, mortgage banker finance and multi-family loans are evaluated individually. The allowance for credit losses is based principally on the frequency and severity of losses for an asset class, the historical loss experience for the type of loan and the delinquency status. The process of evaluating the adequacy of the allowance for credit losses has two basic elements: first, the identification of problem loans based on current operating financial information and fair value of the underlying collateral property; and second, a methodology for estimating general credit losses. For loans classified as “watch,” “special mention,” “substandard” or “doubtful,” whether analyzed and provided for individually or as part of pools, we record all estimated credit losses at the time the loan is classified. In order to facilitate the establishment of our general allowance for credit losses, we have established a risk grade classification system for components of our loan portfolio that do not have homogeneous terms, such as commercial loans. This system grades loans based on credit and collateral support for each loan. The grades range from one, which represents the least possible risk to us, to eight, for doubtful loans. Each credit grade has a general minimum credit allowance factor established for each type of loan. We use this general credit allowance factor in establishing our allowance for credit losses. We establish the credit loss allowance through a systematic methodology whereby each loan is assigned a credit grade at origination. We establish the allowance for credit losses by using the credit allowance factor for the individual loan, based on the risk classification, and providing as the allowance for credit loss the product of the loan balance times the credit allowance factor over the initial twelve months of the loan’s term. For homogeneous loans, such as single-family mortgage and consumer loans, we utilize the frequency and severity of losses for the asset class and the delinquency status in determining the credit allowance factor. The allowance for credit losses is determined by multiplying the portfolio balance by the credit allowance factor for the portfolio and providing the resulting amount ratably over twelve months. When available information confirms specific loans, or portions of those loans, to be uncollectible, we charge off those amounts against the allowance for credit losses. Even after loans are charged off, we continue reasonable collection efforts until the potential for recovery is exhausted. See “- Credit Quality - Allowance for Credit Losses.”
Rate Lock Commitments
In connection with our mortgage banking activities, we enter into interest rate lock commitments with loan applicants whereby the interest rate on the loan is guaranteed for a certain period of time while the application is in the approval process, which we refer to as the “locked pipeline.” In accordance with SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended by SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities,” interest rate lock commitments are derivative financial instruments and changes in their fair value are required to be reported in current earnings. The fair value of interest rate lock commitments is determined as of the date the interest rate is locked and is based on the estimated fair value of the underlying mortgage loans, including the value of the servicing when selling the loans with the servicing in the same transaction to the same party. When the loans are sold and the servicing is retained by the company, the fair value of the interest rate lock commitments is based on the estimated fair value of the underlying mortgages, excluding the value of the servicing. Generally, we base the change in the value of the underlying mortgages on quoted market prices of publicly traded mortgage backed securities. Management estimates the amount of loans expected to close by applying a “fall-out” ratio for commitments that expire. This estimate is based on the historical data for loans with similar characteristics as well as current market conditions. We record changes in the fair value as gains or losses on sales of single family loans on the consolidated statements of operations.
Impairment of Goodwill
Goodwill represents the excess of the purchase price over the fair value of net assets acquired. In accordance with SFAS No. 142 “Goodwill and Other Intangible Assets,” goodwill is not amortized but is evaluated for impairment at least annually. Goodwill is tested for impairment using quoted market prices and transactions involving similar types of institutions to determine if the fair value of our assets, net of liabilities, exceeds the carrying amount. If the fair value of our net assets is determined to be less than the carrying amount, goodwill would be written down through a charge to operations.
Significant Transactions
On December 2, 2005 we acquired five banking offices from Washington Mutual for a purchase premium of approximately $33.6 million and $461,000 in direct acquisition costs through December 31, 2005. These five banking offices added approximately $274.7 million in deposits and $10.1 million in loans. The addition of these offices expanded our central Texas market to include the upper gulf coast region of Texas.
In August 2005, we formed Franklin Capital Trust IV, or Trust IV, a wholly owned subsidiary. Trust IV issued, in a private offering, $25 million of variable rate trust preferred securities that currently pay 5.98% annually and resets quarterly to 3-month LIBOR plus 1.60%, and invested the proceeds in variable rate junior subordinated notes, or junior notes, issued by us. In addition, we invested $774,000 in variable rate common securities of the trust. We can redeem the junior notes at our option at par plus accrued and unpaid interest beginning in November 2010. The junior notes mature in November 2035.
On July 15, 2005, we acquired Elgin for approximately $23.9 million, including $11.7 million in cash, $11.9 million in shares of our common stock, valued at $18.97 per share, and $303,000 in direct acquisition costs through December 31, 2005. Elgin was a Texas based state bank with approximately $83.7 million in assets and $73.7 million in deposits at the time of the acquisition. The acquisition of Elgin added two banking offices to our central Texas market and made us the second largest bank in Bastrop County.
In May 2005, we formed Franklin Capital Trust III, or Trust III, a wholly owned subsidiary. Trust III issued, in a private offering, $40 million of variable rate trust preferred securities that currently pay 6.39% annually and resets quarterly to 3-month LIBOR plus 1.90%, and invested the proceeds in variable rate junior subordinated notes, or junior notes, issued by us. In addition, we invested $1.2 million in variable rate common securities of the trust. We can redeem the junior notes at our option at par plus accrued and unpaid interest beginning in June 2010. The junior notes mature in June 2035.
On May 9, 2005, we acquired Athens for approximately $58.3 million, including $43.5 million in cash, $14.4 million in shares of our common stock, valued at $17.25 per share, and $411,000 in direct acquisition costs through December 31, 2005. At the time of the acquisition, Athens had approximately $206.6 million in assets and $184.9 million in deposits. The acquisition of Athens added four banking offices in our east Texas market and increased our market share to the largest bank in Henderson County.
In February 2005, we formed Franklin Capital Trust II, or Trust II, a wholly owned subsidiary. Trust II issued, in a private offering, $20 million of variable rate trust preferred securities that currently pay 6.39% annually and resets quarterly to 3-month LIBOR plus 1.90%, and invested the proceeds in variable rate junior subordinated notes, or junior notes, issued by us. In addition, we invested $619,000 in variable rate common securities of the trust. We can redeem the junior notes at our option at par plus accrued and unpaid interest beginning in March 2010. The junior notes mature in March 2035.
On December 4, 2004, we acquired Cedar Creek for approximately $24.1 million, including $11.3 million in cash, $12.3 million in shares of our common stock, valued at $18.37 per share, and $450,000 in direct acquisition costs. Cedar Creek was a Texas-based bank holding company with approximately $108.1 million in assets and $96.7 million in deposits at the time of acquisition. The acquisition of Cedar Creek expanded our presence in our east Texas market.
On February 29, 2004, we acquired Lost Pines for approximately $7.2 million including $306,000 in direct acquisition costs. Lost Pines was a Texas-based bank holding company with approximately $40.6 million in
assets and $36.3 million in deposits at the date of the acquisition. The acquisition of Lost Pines expanded our presence in our central Texas market.
On December 30, 2003, we acquired Jacksonville for approximately $68.6 million in cash, including $1.7 million in direct acquisition costs. Jacksonville was a Texas-based savings and loan holding company with approximately $468.0 million in assets and $399.8 million in deposits at the time of the acquisition. Jacksonville operated nine community banking branches in east Texas.
In December 2003, the company sold 10,508,016 shares of common stock at an initial offering price of $14.50 per share. Underwriting discounts and other issuance costs totaling $12.1 million are included as a reduction to paid-in capital on our consolidated statement of stockholders’ equity. Of the proceeds, approximately $67.7 million was used to acquire Jacksonville, approximately $52.3 million was contributed to the capital of the bank for general corporate purposes and approximately $6.9 million was used to fund the acquisition of Lost Pines.
On April 30, 2003, we completed our acquisition of Highland. Total consideration for Highland included $15.0 million in cash, $2.7 million in shares of our common stock, valued at $10.00 per share, and $1.1 million in direct acquisition costs. At the time of the acquisition, Highland’s total assets were approximately $83.6 million and deposits were approximately $72.9 million. The acquisition of Highland complemented our existing community banking branches and expanded our presence in our central Texas market.
In November 2002, we issued 8,000,000 shares of our common stock at $10.00 per share in an offering that was exempt from the registration requirements of the Securities Act. Related issuance costs of $5.6 million are included as a reduction to paid-in capital on our consolidated statement of stockholders’ equity. In connection with the offering, 2,353,320 shares of our outstanding common stock were classified as Class B common stock and the shares issued in the offering were classified as Class A common stock. We used the net proceeds from the offering for general corporate purposes. On November 4, 2003, our Class B common stock was converted into Class A common stock. All of the Class A common stock was classified into common stock at the time of our initial public offering in December 2003.
Also in November 2002, we formed Franklin Bank Capital Trust I. The trust issued, in a private offering, $20 million of variable rate trust preferred securities that currently pays 7.69% annually and resets quarterly to 3-month LIBOR plus 3.35%, and invested the proceeds in variable rate junior subordinated notes, or junior notes, issued by us. In addition, we invested $619,000 in variable rate common securities of the trust. We can redeem the junior notes at our option at par plus accrued and unpaid interest beginning in November 2007. The junior notes mature in November 2032.
On April 9, 2002, we acquired Franklin Bank for total consideration of $11.2 million, including $1.4 million in cash, $8.9 million in shares of our common stock valued at $10.00 per share, and $905,000 in acquisition costs. Prior to our acquisition of the bank, we had assets of approximately $488,000. After the acquisition we had assets of approximately $61.3 million, deposits of $47.3 million and stockholders’ equity of $14.3 million. This acquisition gave us the platform on which we have built our business.
Results of Operations
The company derives a majority of its income from interest earned on its loan portfolio. Funding for these assets was sourced from the cash raised in the private stock offering completed in November 2002 and from community banking deposits, brokered deposits and borrowings from the Federal Home Loan Bank. The funds raised in the company’s initial public offering in December 2003 were utilized to acquire Jacksonville and Lost Pines and to purchase single family loans. The company’s mortgage banking activities, which generate gains on sales of single family loans and mortgage-backed securities and loan fees, also contribute to our net income.
The results from operations for the years ended December 31, 2005, 2004, 2003 and 2002 include Elgin beginning July 16, 2005, Athens beginning May 9, 2005, Cedar Creek beginning on December 4, 2004, Lost Pines beginning March 1, 2004, Jacksonville beginning on December 31, 2003, Highland beginning on May 1, 2003 and Franklin Bank beginning on April 10, 2002. The results of operations for the year ended December 31,
2001 is the results of Franklin Bank prior to our acquisition. During these periods, the bank operated as a local community bank.
For the Year Ended December 31, 2005 Compared to the Year Ended December 31, 2004
Net income was $26.3 million, or $1.13 per diluted share, for the year ended December 31, 2005, compared to $23.1 million, or $1.07 per diluted share, for the year ended December 31, 2004. This increase was due to growth in our commercial and single family loan portfolios. Net income for the year ended December 31, 2005 was adversely affected by a $2.8 million, after tax, allowance for credit losses related to a mortgage banker finance line, litigation costs of $449,000, after tax, for the settlement of a claim against Franklin Bank relating to a construction loan to a homebuilder that occurred prior to its acquisition by us and the initial integration costs in our east Texas regions of $177,000, net of tax.
Net interest income. Net interest income is the amount of interest earned on our assets in excess of interest incurred on our liabilities. The net yield on interest-earning assets, or net yield, represents net interest income expressed as a percentage of our average interest-earning assets. The table below sets forth information regarding our average interest-earning assets and average interest-bearing liabilities and the related income and expense and weighted average yields. Average balances for the years ended December 31, 2005 and 2004 are based on daily average balances, except for Athens for the period May 9, 2005 through December 31, 2005, Elgin for the period July 16, 2005 until it was converted to our system on August 5, 2005, Cedar Creek for the period December 4, 2004 until it was converted to our system on May 20, 2005, Lost Pines for the period March 1, 2004 until it was converted to our systems on July 23, 2004 and Jacksonville for the period January 1, 2004 until it was converted to our systems on March 12, 2004.
Interest income and interest expense are impacted both by changes in the volume of interest-earning assets and interest-bearing liabilities and by changes in yields and rates. The table below analyzes the impact of changes in volume (changes in average outstanding balances multiplied by the prior period’s rate) and changes in rate (changes in rate multiplied by the prior period’s average balance) from 2004 to 2005. Changes that are impacted by a combination of rate and volume are allocated proportionately to both changes in volume and changes in rate.
For purposes of calculating the changes in our net interest income, non-performing assets are included in the appropriate balance and shown as a rate difference.
Net interest income increased $18.3 million to $84.0 million for the year ended December 31, 2005, from $65.7 million for the year ended December 31, 2004. The increase was due to a $1.2 billion increase in average interest-earning assets, resulting primarily from purchases and originations of single family loans, an increase in builder lines and the acquisition of Athens and Elgin. Purchases of single family loans totaled $1.2 billion during 2005 and are primarily made up of adjustable rate mortgages with an initial interest rate reset of one to three years and annual resets thereafter. Additionally, our commercial lending offices funded $3.0 billion in new loans during the year ended December 31, 2005 compared to $1.2 billion in 2004. The net yield decreased 23 basis points, from 2.35% for the year ended December 31, 2004 to 2.12% for the year ended December 31, 2005. This decrease was caused by the flattening of the yield curve during 2005 that reduced our net spread on our single family mortgage loans held for sale portfolio.
The following table details our interest income and non-interest expense by product:
Of our products, only the community banking products incur interest expense. Community banking accounted for $17.4 million, or 15.4%, of total interest expense for the year ended December 31, 2005 and $10.5 million, or 20%, of our total interest expense for the year ended December 31, 2004.
Provision for credit losses. The provision for credit losses is the periodic cost of maintaining an adequate allowance to cover probable losses. The table below sets forth the activity in our allowance for credit losses.
The provision for credit losses increased $2.8 million, to $4.9 million for the year ended December 31, 2005, as compared to $2.1 million for the year ended December 31, 2004. The increase in the allowance for credit losses was primarily due to a provision of $4.4 million for a mortgage banker finance customer that ceased operations in the fourth quarter of 2005. The principals are the subject of a federal investigation for possible fraud and other claims. The decrease in the single family loan provision is due to the results of our migration analysis on our single family loans that showed that the loss exposure had decreased from our analysis in the prior year. Management believes that the allowance for credit losses is adequate to cover known and inherent risks in the loan portfolio.
Net charge-offs for the year ended December 31, 2005 were $414,000 and primarily relate to single family mortgage loans that were foreclosed during 2005.
See Note 1 to the consolidated financial statements for a further discussion of our allowance for credit losses.
Non-interest income. The following table sets forth the composition of our non-interest income.
Non-interest income increased $6.2 million, to $18.8 million, for the year ended December 31, 2005, compared to $12.6 million for the year ended December 31, 2004. This increase was primarily due to an increase in deposit fees from the growth of our community bank and fees from our mortgage banking business.
Gains on sales of single family loans increased $567,000 during the year ended December 31, 2005 as compared to the same period a year ago. We originate loans through our retail and wholesale mortgage offices, as described under “Item 1. Business-Business Activities-Mortgage Banking,” with the intention of selling the majority of loans originated, including the related servicing. During the year ended December 31, 2005, we sold $737.3 million of single family loans, resulting in a gain of $4.2 million. We had gains totaling $175,000 on interest rate lock commitments during the year ended December 31, 2005 related to commitments totaling $46.9 million, excluding loans expected to be transferred to our portfolio and after considering the amount of interest rate lock commitments expected to expire prior to closing the related mortgage loan. See “- Critical Accounting Policies - Rate Lock Commitments” above. Additionally, we had a loss of $102,000 on forward delivery contracts, totaling $14.3 million, entered into to hedge the interest rate lock commitments. Loans sold
totaling $27.7 million were from our held for investment portfolio to reduce the re-pricing risk on single family loans. Sales of single family loans during the year ended December 31, 2004, totaled $825.5 million, resulting in a gain of $3.6 million. The gain on sale of securities for the year ended December 31, 2005 totaled $974,000, including $921,000 related to the sale of $50.5 million of mortgage-backed securities created through the securitization of single family loans and $44,000 related to the sale of $5.8 million of mortgage-backed securities from our portfolio. The gain on sale of securities for the year ended December 31, 2004 totaled $229,000, of which $137,000 related to the sale of $15.8 million of mortgage-backed securities and $92,000 related to the sale of a $15.3 million of agency notes.
Loan fee income increased $1.9 million during the year ended December 31, 2005 to $6.9 million, from $5.0 million during the year ended December 31, 2004. Under certain circumstances we will act as a mortgage broker to facilitate the origination of single family loans in the name of other financial institutions for a fee. Mortgage broker fees totaled $5.9 million during the year ended December 31, 2005, as compared to $4.4 million during the year ended December 31, 2004. Loan servicing fees increased during the year ended December 31, 2005 as compared to the year ended December 31, 2004 due to an increase in the size of the portfolio of loans we service for other institutions, from $168.3 million at December 31, 2004 to $340.1 million at December 31, 2005.
Deposit fees and charges, which are primarily comprised of fees and service charges on community banking deposit accounts, increased $2.4 million during the year ended December 31, 2005, to $4.9 million, from $2.5 million during the year ended December 31, 2004. This increase relates to overdraft fees, services charges on checking accounts and fees charged for other banking related services and is directly related to an increase in our customer base. The number of transaction accounts rose from 25,407 at December 31, 2004 to 48,090 at December 31, 2005. This growth came from our acquisitions of Athens on May 9, 2005, Elgin on July 15, 2005, the purchase of five branches on December 2, 2005 and successful marketing efforts including competitive pricing, newspaper advertising and direct mail. Additionally, we opened two new community banking offices in central Texas during the year ended December 31, 2005. Transaction accounts for the year ended December 31, 2005 include those acquired in the branch purchase on December 2, 2005.
Other non-interest income is primarily comprised of ancillary income on non-deposit services provided, rental income earned on owned properties and income related to mortgage banker finance activities. Income related to mortgage banker finance activities increased $305,000 during the year ended December 31, 2005, compared to 2004. Additionally, non-interest income includes agent fees on syndicated builder lines of $183,000.
Non-interest expense. The following table details the components of our non-interest expense (in thousands).
Non-interest expense increased $16.0 million during the year ended December 31, 2005, to $56.7 million, from $40.7 million during the year ended December 31, 2004. This increase is due to the acquisitions of Athens and Elgin, the full year effect of Cedar Creek and the overall growth of the bank.
Salaries and benefits increased $8.4 million during the year ended December 31, 2005, to $28.5 million, from $20.1 million during the year ended December 31, 2004. The number of full time equivalent employees at December 31, 2005 totaled 710, compared to 548 at December 31, 2004. The increase in headcount during the
year ended December 31, 2005 includes 114 from the Athens, Elgin and branch acquisitions, 12 from growth in commercial lending and 22 operations staff to support the growth in our community banking and commercial businesses. In addition, the increase in loan fees from brokered loans also increased salaries and benefits, as a substantial portion of these fees are paid to the retail mortgage office as compensation.
Data processing expense increased $1.9 million during the year ended December 31, 2005, to $5.5 million, from $3.6 million during the year ended December 31, 2004. Higher data processing costs represent the increase in data processing services from the growth in our community banking deposit accounts and the number of banking locations. Additionally, depreciation on computer hardware and software increased to support the growth of our community banking and commercial lending business.
Occupancy expense increased $1.8 million during the year ended December 31, 2005, to $5.4 million, from $3.5 million for the year ended December 31, 2004. This increase is due to the acquisitions of Athens and Elgin, which added four and two community banking offices, respectively. Additionally, we had the full year effect of our acquisition of Cedar Creek, in December 2004, that added five community banking offices and the addition of two regional commercial lending offices at the end of 2004. We also added two community banking offices in central Texas during 2005.
Professional fees are primarily comprised of legal fees, directors’ fees and expenses, fees incurred for our outside auditors and fees paid for our outsourced mortgage banking activities, including appraisals, underwriting and post-closing services. Also included in professional fees are consulting fees paid to Ranieri & Co., Inc. Our consulting agreement with Ranieri & Co. expired at the end of October 2005. Professional fees increased $1.2 million during the year ended December 31, 2005, to $5.0 million, from $3.8 million during the year ended December 31, 2004. This increase primarily relates to higher legal fees and the settlement during 2005 of a lawsuit relating to construction lending activities that occurred prior to our acquisition of Franklin.
Loan expense decreased slightly during the year ended December 31, 2005, to $2.3 million, from $2.4 million during the year ended December 31, 2004. This decrease is due to lower purchases of single family loans during 2005 as compared to 2004.
Amortization of intangibles increased $716,000 during the year ended December 31, 2005, to $1.3 million, compared to $588,000 during the year ended December 31, 2004. The amortization of intangibles increased during the year ended December 31, 2005, as compared to the year ended December 31, 2004, due to the amortization of the core deposit intangible from the Cedar Creek, Athens and Elgin acquisitions.
Other non-interest expense increased $2.1 million during the year ended December 31, 2005, to $8.7 million, compared to $6.6 million during the year ended December 31, 2004. This increase includes higher marketing, insurance, office supplies, postage and courier expenses incurred to support our growth and expansion.
For the Year Ended December 31, 2004 Compared to the Year Ended December 31, 2003
Net income was $23.1 million, or $1.07 per diluted share, for the year ended December 31, 2004, compared to $3.2 million, or $0.29 per diluted share, for the year ended December 31, 2003. This increase is due to growth in our commercial and single family loan portfolios, a higher net yield on interest-earning assets, and the acquisition of Jacksonville.
Net interest income. Net interest income is the amount of interest earned on our assets in excess of interest incurred on our liabilities. The net yield on interest-earning assets, or net yield, represents net interest income expressed as a percentage of our average interest-earning assets. The table below sets forth information regarding our average interest-earning assets and average interest-bearing liabilities and the related income and expense and weighted average yields. Average balances for the years ended December 31, 2004 and 2003 are based on daily average balances, except for Cedar Creek for the period December 4, 2004 through December 31, 2004, Lost Pines for the period March 1, 2004 until it was converted to our systems on July 23, 2004, Jacksonville for the period January 1, 2004 until it was converted to our systems on March 12, 2004 and Highland for the period May 1, 2003 until it was converted to our general systems on May 23, 2003, whose average balances are calculated using average monthly balances.
Interest income and interest expense are impacted both by changes in the volume of interest-earning assets and interest-bearing liabilities and by changes in yields and rates. The table below analyzes the impact of changes in volume (changes in average outstanding balances multiplied by the prior period’s rate) and changes in rate (changes in rate multiplied by the prior period’s average balance) from 2003 to 2004. Changes that are impacted
by a combination of rate and volume are allocated proportionately to both changes in volume and changes in rate. For purposes of calculating the changes in our net interest income, non-performing assets are included in the appropriate balance and shown as a rate difference.
Net interest income increased $46.3 million to $65.7 million for the year ended December 31, 2004, from $19.4 million for the year ended December 31, 2003. The increase was due to a $1.7 billion increase in average interest-earning assets, resulting primarily from purchases and originations of single family loans, an increase in builder lines and the acquisition of Jacksonville. Purchases of single family loans totaled $1.8 billion during 2004 and are primarily made up of adjustable rate mortgages with an initial interest rate reset of three to five years and annual resets thereafter. Additionally, during 2004 we opened three regional commercial lending offices, bringing our total commercial lending offices to six at December 31, 2004. Through our commercial lending offices we originated $1.2 billion in new loans during the year ended December 31, 2004. The net yield rose 58 basis points, from 1.77% for the year ended December 31, 2003 to 2.35% for the year ended December 31, 2004. This increase was due to the acquisition of Jacksonville, an increase in commercial and consumer loans, and higher yields on our single family mortgage portfolio.
The following table details our interest income and non-interest expense by product:
Of our products, only the community banking products incur interest expense. Community banking accounted for $10.5 million, or 20%, of total interest expense for the year ended December 31, 2004 and $2.6 million, or 12%, of our total interest expense for the year ended December 31, 2003.
Provision for credit losses. The provision for credit losses increased $1.1 million, to $2.1 million for the year ended December 31, 2004, as compared to $1.0 million for the year ended December 31, 2003. The increase was primarily due to the increase in the size of the commercial loan portfolio. The decrease in the single family loan provision is due to the results of our migration analysis on our single family loans that showed that the loss exposure had decreased from our analysis in the prior year. We base our provision for loan losses on single family loans from this analysis. Management believes that the allowance for credit losses is adequate to cover known and inherent risks in the loan portfolio.
Non-interest income. The following table sets forth the composition of our non-interest income.
Non-interest income increased $7.8 million to $12.6 million for the year ended December 31, 2004, compared to $4.8 million for the year ended December 31, 2003. This increase was primarily due to the expansion of our mortgage banking activities, the acquisitions of Highland, Jacksonville and Lost Pines and the overall growth of the bank.
Gains on sales of single family loans increased $1.6 million during the year ended December 31, 2004 as compared to the same period a year ago. We originate loans through our retail and wholesale mortgage offices, as
described under “Item 1. Business-Business Activities-Mortgage Banking,” with the intention of selling the majority of loans originated, including the related servicing. During the year ended December 31, 2004, we sold $825.5 million of single family loans, resulting in a gain of $3.6 million. We had gains totaling $98,000 on interest rate lock commitments during the year ended December 31, 2004 related to commitments totaling $25.6 million, excluding loans expected to be transferred to our portfolio and after considering the amount of interest rate lock commitments expected to expire prior to closing the related mortgage loan. See “- Critical Accounting Policies - Rate Lock Commitments” above. Additionally, we had a gain totaling $58,000 on forward delivery contracts, totaling $16.9 million, entered into to hedge the interest rate lock commitments. Loans sold totaling $459.5 million were from our held for investment portfolio to reduce the re-pricing risk on single family loans whose first interest rate repricing is five years after origination in this portfolio and to reduce our exposure in California. Sales of single family loans during the year ended December 31, 2003, totaled $149.6 million, resulting in a gain of $2.1 million. The gain on sale of securities for the year ended December 31, 2004 totaled $229,000, including $137,000 related to the sale of $15.8 million of mortgage-backed securities and $92,000 related to the sale of $15.3 million of agency notes. Mortgage-backed securities sold totaling $6.8 million and the agency notes sold came from the Jacksonville acquisition. The gain on sale of securities for the year ended December 31, 2003 totaled $859,000, of which $748,000 related to the sale of $36.2 million of mortgage-backed securities and $111,000 related to the sale of a $10.0 million U.S. Treasury security.
Loan fee income increased $3.9 million during the year ended December 31, 2004 to $5.0 million, from $1.1 million during the year ended December 31, 2003. Under certain circumstances we will act as a mortgage broker to facilitate the origination of single family loans in the name of other financial institutions for a fee. Mortgage broker fees totaled $4.4 million during the year ended December 31, 2004, as compared to $1.1 million during the year ended December 31, 2003. Loan servicing fees increased during the year ended December 31, 2004 as compared to the year ended December 31, 2003 due to an increase in the size of the portfolio of loans we service for other institutions, from $117.8 million at December 31, 2003 to $168.3 million at December 31, 2004.
Deposit fees and charges, which are primarily comprised of fees and service charges on community banking deposit accounts, increased $2.3 million during the year ended December 31, 2004, to $2.5 million, from $191,000 during the year ended December 31, 2003. This increase relates to overdraft fees, services charges on checking accounts and fees charged for other banking related services and is directly related to an increase in our customer base. The number of transaction accounts rose from 13,158 at December 31, 2003 to 25,407 at December 31, 2004. This growth came from our acquisitions of Lost Pines on February 29, 2004 and Cedar Creek on December 4, 2004 and successful marketing efforts including competitive pricing, newspaper advertising and direct mail. Additionally, we opened two new community banking offices in central Texas during the year ended December 31, 2004. Transaction accounts for the year ended December 31, 2003 include those acquired from Jacksonville on December 30, 2003. We did not realize any fees or service charges from these accounts until 2004.
Other non-interest income is primarily comprised of ancillary income on non-deposit customer services provided, rental income earned on owned properties and income related to mortgage banker finance activities. The increase in other non-interest income was due to the acquisitions of Jacksonville and Highland, which contributed an additional $268,000 during the year ended December 31, 2004 as compared to the year ended December 31, 2003. Income related to mortgage banker finance activities increased during the year ended December 31, 2004, which was the first full year we offered this product. Additionally, non-interest income includes the reversal of the credit mark for $227,000 on a loan acquired in the Franklin acquisition due to the loan’s payment in full during the year ended December 31, 2004.
Non-interest expense. The following table details the components of our non-interest expense (in thousands).
Non-interest expense increased $22.5 million during the year ended December 31, 2004, to $40.7 million, from $18.2 million during the year ended December 31, 2003. This increase is due to the acquisitions of Jacksonville, Lost Pines and Highland and the overall growth of the bank.
Salaries and benefits increased $11.0 million during the year ended December 31, 2004, to $20.1 million, from $9.1 million during the year ended December 31, 2003. The number of full time equivalent employees at December 31, 2004 totaled 548, compared to 399 at December 31, 2003. Included in headcount for the year ended December 31, 2003 were 100 employees acquired with the Jacksonville merger on December 30, 2003, for which we did not incur any compensation expense during 2003. The increase in headcount during the year ended December 31, 2004 includes 69 from the Lost Pines and Cedar Creek acquisitions, 41 from our mortgage production offices and 15 from growth in our commercial lending business. Partially offsetting the increase in compensation expense was $1.9 million in restricted stock compensation awarded to certain key employees in connection with our initial public offering during 2003.
Data processing expense increased $2.3 million during the year ended December 31, 2004, to $3.6 million, from $1.3 million during the year ended December 31, 2003. Higher data processing costs represent the increase in outsourced data processing services and depreciation on computer hardware and software incurred to support our expansion and growth and due to the acquisition and conversion of Jacksonville and Lost Pines.
Occupancy expense increased $1.8 million during the year ended December 31, 2004, to $3.5 million, from $1.7 million for the year ended December 31, 2003. This increase is due to the acquisitions of Jacksonville, Lost Pines and Highland, which added nine, two and one community banking offices, respectively. Additionally, we expanded our corporate offices in Houston, Texas, added two community banking offices in central Texas, added three commercial lending offices and expanded our mortgage banking business, increasing the number of retail and wholesale offices from 36 at December 31, 2003 to 59 at December 31, 2004.
Professional fees are primarily comprised of legal fees, directors’ fees and expenses, fees incurred for our outside auditors and fees paid for our outsourced mortgage banking activities, including appraisals, underwriting and post-closing services. Also included in professional fees are consulting fees paid to Ranieri & Co., Inc. In November 2002, we entered into a three-year consulting agreement with Ranieri & Co., Inc., as part of which we granted it an option to purchase 570,000 shares of our common stock and agreed to pay a $500,000 annual fee for consulting activities. See Note 15 to the Notes to the Consolidated Financial Statements under Item 8. The fair value of the options were recognized over the life of the consulting agreement pursuant to SFAS No. 123, “Accounting for Stock Based Compensation.” Professional fees increased $701,000 during the year ended December 31, 2004, to $3.8 million, from $3.1 million during the year ended December 31, 2003. This increase primarily relates to higher audit fees resulting from increased services, including compliance with the Sarbanes-Oxley Act of 2002. Additionally, legal fees have increased due to a lawsuit relating to construction lending activities that occurred prior to our acquisition of Franklin. Partially offsetting this increase was a decline in costs associated with the consulting agreement with Ranieri & Co, Inc. Pursuant to the consulting agreement, the
options fully vested upon the completion of the registration of our common stock during December 2003 and the remaining fair value of the option was recognized in the consolidated statement of operations during the year ended December 31, 2003.
Loan expense increased $1.5 million during the year ended December 31, 2004, to $2.4 million, from $913,000 during the year ended December 31, 2003. This increase is due to an increase in mortgage banking activity from originations, purchases and sales of single family loans during 2004 as compared to 2003.
Amortization of intangibles increased $733,000 during the year ended December 31, 2004, to $588,000, compared to a reduction in expense of $145,000 during the year ended December 31, 2003. The reduction in expense during 2003 includes the reversal of $237,000 of estimated core deposit intangible amortization. During 2003, the core deposit intangible study related to the Franklin acquisition, which was originally estimated on the asset and liability tables for the first quarter of 2002 published by the OTS, was finalized, based on the actual deposits acquired. The estimate using the OTS tables valued the core deposit intangible at $1.6 million, as compared to the core deposit intangible study valuation of $204,000. Goodwill was adjusted for the difference between the estimated and the amount that resulted from the core deposit intangible study. Additionally, amortization of intangibles increased during the year ended December 31, 2004, as compared to the year ended December 31, 2003, due to the amortization of the core deposit intangible from the Jacksonville, Lost Pines and Highland acquisitions.
Other non-interest expense increased $4.4 million during the year ended December 31, 2004, to $6.6 million, compared to $2.2 million during the year ended December 31, 2003. This increase includes higher marketing, insurance, office supplies, postage and courier expenses incurred to support our growth and expansion.
Financial Condition
General
Total assets increased $1.0 billion to $4.5 billion at December 31, 2005, from $3.5 billion at December 31, 2004. The increase in assets was primarily attributable to new builder lines, purchases and originations of single family loans and the acquisitions of Athens and Elgin, which added approximately $206.6 million and $83.7 million in assets, respectively.
Total assets were $3.5 billion at December 31, 2004, compared to $2.3 billion at December 31, 2003. The increase in assets was primarily attributable to purchases and originations of single family loans, new builder lines, growth in the mortgage banker finance portfolio and the acquisitions of Cedar Creek and Lost Pines, which added approximately $108.1 million and $40.6 million in assets, respectively.
Investment Portfolio
Our objective in the management of our investment portfolio is to maintain a portfolio that provides for liquidity needs, provides a profitable interest rate spread over liabilities with similar maturities, includes assets that can be pledged as collateral for borrowings, meets regulatory requirements and enhances the utilization of our capital.
Our investment portfolio primarily consists of mortgage-backed securities, mutual funds, stock of the FHLB and other debt securities. Our investment portfolio contains no investments in any one issuer in excess of 10% of our total equity, except for FHLB stock, which is a required investment, and a mutual fund investment, in which we look at the underlying investments in the fund. Exempt from this calculation are U.S. Treasury and U.S. government agency securities.
The following tables set forth the composition and fair value of our investment portfolio as of the dates indicated. At these dates, there were no securities held-to-maturity.
At December 31, 2005, our investment portfolio totaled $282.1 million, compared to $257.4 million at December 31, 2004. The increase in the investment portfolio was due to purchases totaling $86.2 million offset by sales of $56.3 million and principal repayments. During 2005, $53.8 million of single family loans were securitized into FNMA securities. The Athens and Elgin acquisitions added approximately $55.4 million to our investment portfolio, the majority of which matured the month following these acquisitions.
At December 31, 2004, our total investment portfolio was $257.4 million, compared to $301.6 million at December 31, 2003. The decline in the investment portfolio was due to sales totaling $31.1 million and principal repayments. Sales during the year ended December 31, 2004 included $22.0 million acquired from Jacksonville. The Cedar Creek and Lost Pines acquisitions added $12.0 million and $10.4 million to our investment portfolio, respectively.
The following table presents a summary of yields and maturities or repricing for our available-for-sale investment portfolio at December 31, 2005:
(1)
Yields on municipal securities are included on the actual book basis.
Loan Portfolio
Our loan portfolio, excluding allowance for credit losses, premiums and deferred fees and costs, totaled $3.8 billion at December 31, 2005, and was comprised of $2.6 billion of single family mortgage loans, of which $264.6 million was held for sale, $671.1 million of builder lines, $173.8 million of mortgage banker finance lines, $220.7 million of commercial real estate, commercial business and multi-family loans and $92.7 million of consumer loans. This compares to a total loan portfolio of $3.0 billion at December 31, 2004, that was comprised of $2.3 billion of single family mortgage loans, of which $198.7 million was held for sale, $336.3 million of builder lines, $138.1 million of mortgage banker finance lines, $118.8 million of commercial real estate, commercial business and multi-family loans, and $55.2 million of consumer loans.
Single family mortgages grew by $283.2 million to $2.6 billion at December 31, 2005, from $2.3 billion at December 31, 2004. This growth is attributable to the purchase of $1.2 billion, and the origination of $865.6 million, of single family mortgage loans. The single family loan purchases were primarily through correspondent relationships with Countrywide Home Loans Inc., which accounted for 67% of total purchases, Residential Funding Corp., which accounted for 15% and Morgan Stanley, which accounted for 12% of total purchases during the year ended December 31, 2005. We are not contractually obligated to purchase loans from any of these entities on an ongoing basis. The loan packages we purchase are underwritten in accordance with the bank’s underwriting criteria outlined in “Item 1. Business - Underwriting and Risk Management.” Single family mortgage loan originations for the year ended December 31, 2005 came from our community banking offices, our wholesale origination offices in California, Texas and Tennessee and our 45 retail mortgage offices. See “Item 1. Business - Business Activities - Mortgage Banking.” During the year ended December 31, 2005, we also sold into the secondary market $737.3 million of single family loans, of which $27.7 million were from our held for investment portfolio. Principal repayments were $1.1 billion for the year ended December 31, 2005. Additionally, $27.5 million of single family loans were acquired in the Athens and Elgin acquisitions.
Builder lines increased $334.8 million, to $671.1 million at December 31, 2005, from $336.3 million at December 31, 2004. This increase is due to the growth from our existing offices in Arizona, Florida, Michigan,
Philadelphia and Houston and Dallas, Texas. Builder line fundings totaled $1.4 billion and principal repayments were $1.1 billion during the year ended December 31, 2005. Additionally, $15.5 million of builder lines were acquired from Athens and Elgin.
Mortgage banker finance lines increased $35.7 million, to $173.8 million at December 31, 2005, from $138.1 million at December 31, 2004. Fundings were $1.6 billion and paydowns were $1.6 billion during the year ended December 31, 2005.
Commercial real estate, commercial business and multi-family loans increased $101.9 million, to $220.7 million at December 31, 2005, from $118.8 million at December 31, 2004. This increase was due to originations totaling $153.4 million and $55.6 million of such loans acquired from Athens and Elgin during the year ended December 31, 2005. Principal repayments totaled $93.1 million during the year ended December 31, 2005.
Consumer loans increased $37.5 million, to $92.7 million at December 31, 2005, from $55.2 million at December 31, 2004. This increase was from originations of consumer loans totaling $18.7 million and $46.7 million acquired from Athens and Elgin acquisitions and the branch purchase during the year ended December 31, 2005. Principal repayments totaled $28.0 million during the year ended December 31, 2005.
The following tables show the geographic distribution of our loan portfolio at December 31, 2005 and 2004:
(1)
Includes states for which aggregate loans were less than 1% of total loans at December 31, 2005 and 2004.
We maintain a geographic limitation policy that limits the amount of assets that can be in any one state to 25% of total assets, except for California, which is limited to 35% of total assets, and Texas, which is unlimited. This policy is designed to limit the exposure that we have to any one region other than Texas. Approximately 38% of the total of all single family mortgages purchased by us during 2005 were from California. We expect that single family loans from California will continue to be a significant percentage of our loan portfolio.
At December 31, 2004, our loan portfolio, excluding allowance for credit losses, premiums and deferred fees and costs, totaled $3.0 billion, and was comprised of $2.3 billion of single family mortgage loans, of which $198.7 million was held for sale, $138.1 million of mortgage banker finance lines, $336.3 million of builder lines, $118.8 million of commercial real estate, commercial business and multi-family loans and $55.2 million of consumer loans. This compares to a total loan portfolio of $1.8 billion at December 31, 2003, that was comprised of $1.5 billion of single family mortgage loans, of which $112.7 million was held for sale, $3.7 million of mortgage banker finance lines, $161.8 million of builder lines, $51.6 million of commercial real estate, commercial business and multi-family loans, and $66.8 million of consumer loans.
Single family mortgages grew by $831.6 million to $2.3 billion at December 31, 2004, from $1.5 billion at December 31, 2003. This growth is attributable to the purchase of $1.8 billion, and the origination of $632.1 million, of single family mortgage loans. The single family loan purchases were primarily through correspondent relationships with Countrywide Home Loans Inc., which accounted for 75% of total purchases and Morgan Stanley, which accounted for 10% of total purchases during the year ended December 31, 2004. We are not contractually obligated to purchase loans from any of these entities on an ongoing basis. The loan packages we purchase are underwritten in accordance with the bank’s underwriting criteria outlined in “Item 1. Business - Underwriting and Risk Management.” Single family mortgage loan originations for the year ended December 31, 2004 came from our wholesale origination offices in California, Texas and Tennessee and our 56
retail mortgage offices. See “Item 1. Business - Business Activities - Mortgage Banking.” During the year ended December 31, 2004, we also sold into the secondary market $825.5 million of single family loans, of which $459.5 million were from our held to maturity portfolio. Principal repayments were $819.3 million for the year ended December 31, 2004. Additionally, $15.2 million of single family loans were acquired in the Cedar Creek and Lost Pines acquisitions.
Mortgage banker finance lines increased $134.4 million, to $138.1 million at December 31, 2004, from $3.7 million at December 31, 2003. Originations were $625.5 million and paydowns were $491.1 million during the year ended December 31, 2004. Mortgage banker finance activity increased during the year ended December 31, 2004, as this was the first full year that we offered this product.
Builder lines increased $174.5 million, to $336.3 million at December 31, 2004, from $161.8 million at December 31, 2003. This increase is due to the opening of three new commercial lending offices in Pennsylvania, Michigan and Dallas, Texas during the year ended December 31, 2004, and growth from our existing offices in Florida, Arizona and Houston, Texas. Originations of builder lines totaled $536.2 million and principal repayments were $367.1 million during the year ended December 31, 2004. Additionally, $5.4 million of builder lines were acquired from Cedar Creek and Lost Pines.
Commercial real estate, commercial business and multi-family loans increased $67.2 million, to $118.8 million at December 31, 2004, from $51.6 million at December 31, 2003. This increase is due to originations totaling $51.5 million and $39.5 million of such loans acquired from Cedar Creek and Lost Pines during the year ended December 31, 2004. Principal repayments totaled $23.9 million during the year ended December 31, 2004.
Consumer loans decreased $11.6 million, to $55.2 million at December 31, 2004, from $66.8 million at December 31, 2003. This decrease is due to principal repayments of $34.2 million during the year ended December 31, 2004. Originations of consumer loans totaled $15.3 million and $7.3 million were acquired from Cedar Creek and Lost Pines during the year ended December 31, 2004.
The following table presents the maturity or repricing characteristics of our loan portfolio at December 31, 2005.
(1)
Includes single family loans held for sale.
Deposits and Borrowings
Deposits. The market for deposits is competitive. We offer a line of traditional deposit products that currently includes non-interest-bearing checking, interest-bearing checking, money market checking, commercial checking, money market accounts and certificates of deposit. We compete for deposits through our community banking branches with competitive pricing, advertising, direct mail, telemarketing and online banking.
We also utilize wholesale and brokered deposits and will continue to utilize these sources for deposits when they can be cost-effective. At December 31, 2005, wholesale and brokered deposits constituted approximately 40.9% of our total deposits.
The following table shows the distribution of and certain other information relating to our deposits at the end of each period indicated.
The following table presents a summary of our average deposits and average rates paid as of the dates indicated:
The following table presents as of December 31, 2005, certificates of deposit in amounts of $100,000 or more by their maturity (in thousands):
Deposits increased $619.1 million during the year ended December 31, 2005, to $2.1 billion, compared to $1.5 billion at December 31, 2004. This increase was due to a $532.2 million increase in community banking deposits and a $86.9 million increase in wholesale and brokered deposits. The increase in community banking deposits includes $184.9 million acquired from Athens, $73.7 million acquired from Elgin and $274.7 million acquired in the branch purchase. We expect that brokered and wholesale deposits will remain a significant source of our deposit funding.
Deposits increased $242.6 million during the year ended December 31, 2004, to $1.5 billion, compared to $1.3 billion at December 31, 2003. This increase was due to a $149.2 million increase in community banking
deposits and a $96.1 million increase in wholesale and brokered deposits. The increase in community banking deposits includes $96.7 million acquired from Cedar Creek and $36.3 million acquired from Lost Pines.
Borrowings. The following table shows certain information regarding our borrowings:
At December 31, 2005, our borrowings were $1.8 billion, compared to $1.7 billion at December 31, 2004 and $713.1 million at December 31, 2003. The increase in borrowings were utilized to fund part of our asset growth. At December 31, 2005, borrowings were 45.2% of our funding liabilities. The Federal Home Loan Bank advances are collateralized by our single family mortgage portfolio and are expected to continue to be a significant part of our funding in the future. During 2005, we established an unsecured line of credit in the amount of $15 million for liquidity purposes that matures in October 2006.
The following table shows the maturity or repricing of our borrowings at December 31, 2005:
Junior Subordinated Notes
At December 31, 2005, the company had four issues of junior subordinated notes outstanding as follows (in thousands):
In November 2002, the company formed Franklin Bank Capital Trust I (the “Trust”), a wholly owned subsidiary. The Trust issued $20 million of variable rate trust preferred securities and invested the proceeds in variable rate junior subordinated notes (the “junior notes”) issued by the company. The company guarantees that payments will be made to the holders of the trust preferred securities, if the Trust has the funds available for payment. The rate on the junior notes resets quarterly at a base rate of 3-month LIBOR plus 3.35%. The junior
notes first call date is in November 2007 and the notes mature in November 2032. The interest rate was 7.69% and 5.64% at December 31, 2005 and 2004, respectively. The company’s investment in the Trust was $619,000 at December 31, 2005 and 2004. The company also entered into an interest rate swap agreement in order to reduce the impact of interest rate changes on future income. The notional amount of the swap is $20 million and has been designated as a cash flow hedge to effectively convert the junior notes to a fixed rate basis. The agreement involves the receipt of floating rate amounts in exchange for fixed interest rate payments at an interest rate of 3.425% over the life of the agreement without an exchange of the underlying principal amounts.
In February 2005, the company formed Franklin Capital Trust II (“Trust II”), a wholly owned subsidiary. Trust II issued $20 million of variable rate trust preferred securities and invested the proceeds in junior notes issued by the company. The company guarantees that payments will be made to the holders of the trust preferred securities, if Trust II has the funds available for payment. If we were to default in payment of these securities, we would be unable to make any cash dividends on our common stock until such default was cured. The rate on these junior notes resets quarterly, at a base rate of 3-month LIBOR plus 1.90%. The first call date for these junior notes is March 15, 2010 and they mature in March 2035. At December 31, 2005, the interest rate was 6.39% and the company’s investment in Trust II was $619,000. The company also entered into an interest rate swap agreement in order to reduce the impact of interest rate changes on future income. The notional amount of the swap is $20 million and has been designated as a cash flow hedge to effectively convert the junior notes to a fixed rate basis. The agreement involves the receipt of floating rate amounts in exchange for fixed interest rate payments at an interest rate of 4.29% over the life of the agreement without an exchange of the underlying principal amounts.
In May 2005, the company formed Franklin Capital Trust III (“Trust III”), a wholly owned subsidiary. Trust III issued $40 million of variable rate trust preferred securities and invested the proceeds in junior notes issued by the company. The company guarantees that payments will be made to the holders of the trust preferred securities, if Trust III has the funds available for payment. The rate on these junior notes resets quarterly, at a base rate of 3-month LIBOR plus 1.90%. The first call date for these junior notes is June 15, 2010 and they mature in June 2035. At December 31, 2005, the interest rate was 6.39% and the company’s investment in Trust III was $1.2 million.
In August 2005, the company formed Franklin Capital Trust IV (“Trust IV”) a wholly owned subsidiary. Trust IV issued $25 million of variable rate trust preferred securities and invested the proceeds in junior notes issued by the company. The company guarantees that payments will be made to the holders of the trust preferred securities, if Trust IV has the funds available for payment. The rate on these junior notes resets quarterly at a base rate of 3-month LIBOR plus 1.60%. The first call date for these junior notes is November 2010 and they mature in November 2035. At December 31, 2005, the interest rate was 5.98% and the company’s investment in Trust IV was $774,000.
Credit Quality
Non-Performing Assets and Impaired Loans
Non-performing assets are comprised of non-performing loans and real estate owned. At December 31, 2005, we had $31.0 million in non-performing assets. This is comprised of $20.3 million in loans that were four payments or more delinquent in nonaccrual status, a $5.8 million mortgage banker finance loan where the customer ceased operations in the fourth quarter of 2005 and $4.9 million of real estate owned. This compares to $8.3 million in non-performing assets at December 31, 2004, comprised of $4.9 million in loans that were in nonaccrual status, and $3.4 million of real estate owned.
Loans are generally placed on nonaccrual status upon becoming four payments past due as to interest or principal. Generally, consumer loans that are not secured are placed in nonaccrual status when deemed uncollectible. Such loans are charged off when they reach 120 days past due.
At the time a loan is placed in nonaccrual status, the accrued but uncollected interest receivable is reversed and accounted for on a cash or recovery method thereafter, until qualifying for return to accrual status.
Management’s classification of a loan as nonaccrual does not necessarily indicate that the principal of the loan is uncollectible in whole or in part.
Additional interest income of $1.3 million, $180,000 and $125,000 would have been recorded for the years ended December 31, 2005, 2004 and 2003, respectively, had the loans been accruing according to their original terms. Interest income of $884,000, $115,000 and $129,000 was recorded on loans subsequently transferred to nonaccrual status for the years ended December 31, 2005, 2004 and 2003, respectively. On December 31, 2005, we had $26.1 million of loans in non-accrual status, compared to $4.9 million on December 31, 2004 and $5.5 million on December 31, 2003. At December 31, 2005, we had $1.8 million of restructured loans and $21.4 million of impaired loans. There were no restructured or impaired loans at December 31, 2004 and 2003.
The recorded investment in impaired loans were as follows (in thousands):
The average balance of impaired loans and the related interest income recognized were as follows (in thousands):
Non-performing loans and real estate owned consisted of the following:
Beginning in 2004, we changed our methodology for determining non-accrual loans from those 90 days or more delinquent to four payments or more delinquent. Non-performing loans at December 31, 2003, 2002 and 2001 are based on those 90 days or more delinquent.
At December 31, 2005 and 2004, we had $12.3 million and $9.0 million in loans that were classified as potential problem loans that are not included in non-performing assets. These are loans that management believes may in the future become non-performing loans.
Allowance for Credit Losses
We establish an allowance for credit losses based on management’s periodic evaluation of the loan portfolio and consider such factors as historical loss experience, delinquency status, identification of adverse situations that may affect the ability of obligors to repay, known and inherent risks in the portfolio, assessment of economic conditions, regulatory policies and the estimated value of the underlying collateral, if any. Single family mortgages and consumer loans are evaluated as a group. Builder lines, commercial real estate, commercial business, mortgage banker finance and multi-family loans are evaluated individually. The allowance for credit losses is based principally on the frequency and severity of losses for an asset class, the historical loss experience for the type of loan and the delinquency status.
Our process for evaluating the adequacy of the allowance for credit losses has two basic elements: first, the identification of problem loans based on current operating information and fair value of the underlying collateral property; and second, a methodology for estimating general credit loss reserves. For loans classified as “watch,” “special mention,” “substandard” or “doubtful,” whether analyzed and provided for individually or as part of pools, all estimated credit losses are recorded at the time the loan is classified.
In order to facilitate the establishment of our general allowance for credit losses, we have established a risk grade classification system for components of our loan portfolio that do not have homogeneous terms, such as commercial loans. This system grades loans based on credit and collateral support for each loan. The grades range from one, which represents the least possible risk to us, to eight, for doubtful loans. Each credit grade has a general minimum credit allowance factor established for each type of loan. In determining our credit allowance factors we utilized various studies, including the OTS historical charge-off percentages and the National Association of Home Builders study of construction lending charge-offs from 1990 to 2002. We use this general credit allowance factor in establishing our allowance for credit losses. We establish the credit loss allowance through a systematic methodology whereby each loan is assigned a credit grade at origination. We establish the allowance for credit losses by using the credit allowance factor for the individual loan, based on the risk classification, and providing as the allowance for credit loss the product of the loan balance times the credit allowance factor over the initial twelve months of the loan’s term.
For homogeneous loans, such as single family mortgages and consumer loans, we utilize the frequency and severity of losses for the asset class in determining the credit allowance factor. The allowance for credit losses is determined by multiplying the portfolio balance by the credit allowance factor for the portfolio and providing the resulting amount ratably over twelve months.
When a borrower’s ability to repay a loan under the original terms is uncertain, our risk management committee or loan officer may downgrade the loan to a “classified” status. When a loan is classified, the credit allowance expected to be required on the loan that is in excess of the general allowance is immediately charged to operations. When available information confirms specific loans, or portions of those loans, to be uncollectible, such amounts are charged off against the allowance for credit losses.
The bank’s risk management committee reviews on a quarterly basis the adequacy of the allowance for credit losses and reports its findings to the board of directors at its next scheduled meeting. The risk management committee is also responsible for approving upgrades to a loan’s grade.
The allowance for credit losses at December 31, 2005 was $13.4 million, or 0.35% of total loans outstanding, an increase of $6.0 million from December 31, 2004. The increase in the allowance for credit losses is primarily due to a $4.4 million allowance on a mortgage banker finance loan where the customer ceased operations in the fourth quarter of 2005. Management believes that the allowance for credit losses is adequate to cover known and inherent risks in the loan portfolio.
The following table allocates the allowance for credit losses based on management’s judgment of potential losses in the respective areas based on our systematic method. While management has allocated the allowance to various portfolios, the allowance for credit losses is general and is available for the portfolio in its entirety.
Off-Balance Sheet Arrangements, Guarantees and Contractual Obligations
The following table sets forth our significant contractual obligations as of December 31, 2005:
(1)
We can redeem the junior subordinated notes at our option at par plus accrued unpaid interest beginning in November 2007 for Trust I and March, June and November 2010 for Trust II, Trust III and Trust IV, respectively. The notes mature in November 2032 for the first note issuance, and 2035 for the second through fourth issuances.
(2)
Includes estimated cash payments for interest expense on FHLB advances. Interest expense related to the junior subordinated notes has been excluded as the amount of cash owed depends on changes in market interest rates.
We are a party to interest rate swap agreements whereby we receive a floating rate of interest in exchange for fixed interest rate payments, without an exchange of the underlying principal amounts. The net amount of cash owed or received depends on changes in market interest rates. The interest rate swaps mature in November 2007.
The following table sets forth our other significant commitments as of December 31, 2005:
(1)
Adjusted for estimated commitments expected to expire prior to the closing of the mortgage loan.
We had no commitments to purchase single family loans at December 31, 2005 and we had commitments to purchase $180.0 million of single family loans at December 31, 2004. We had no obligations to purchase mortgage-backed securities at December 31, 2005 and 2004.
Capital Resources
Federally insured, state-chartered banks are required to maintain minimum levels of regulatory capital. These standards generally are as stringent as the comparable capital requirements imposed on national banks. The FDIC also is authorized to impose capital requirements in excess of these standards on individual banks on a case-by-case basis. For an insured institution to be considered “well capitalized,” it must maintain a minimum leverage ratio of 5% and a minimum risk-based capital ratio of 10%, of which at least 6% must be Tier 1 capital.
The following table presents the bank’s regulatory capital and the regulatory capital requirements at December 31, 2005:
The bank’s regulatory capital at December 31, 2005 was in excess of the “well capitalized” levels. See “Regulation and Supervision” for a discussion of the regulatory capital requirements for federally insured, state-chartered banks.
Liquidity
Liquidity is the measurement of our ability to meet our cash needs. Our objective in managing our liquidity is to maintain the ability to meet loan commitments, purchase investments, meet deposit withdrawals and pay other liabilities in accordance with their terms, without an adverse impact on our current or future earnings. Our liquidity management is guided by policies developed and monitored by the bank’s asset/liability committee, which is comprised of members of our senior management. These policies take into account the marketability of assets, the sources and stability of funding and the amount of loan commitments. For the years ended December 31, 2005 and 2004, a significant source of funding has been from our deposits, both community banking and brokered.
Additionally, we have borrowing sources available to supplement deposits. These borrowing sources include the FHLB of Dallas, a short-term line of credit and securities sold under repurchase agreements. Credit availability at the FHLB is based on our financial condition, asset size and the amount of collateral we hold at the FHLB. At December 31, 2005, our borrowings from the FHLB were $1.8 billion and our additional borrowing
capacity was approximately $391.8 million. At December 31, 2005, we had borrowed $5.0 million on our $15 million line of credit and had no securities sold under agreement to repurchase. See Note 9 to the consolidated financial statements.
We are a holding company without any significant assets other than our equity interest in the bank. Our ability to pay dividends on our common stock or to meet our other cash obligations, including the servicing of our junior notes, is subject to the amount of liquid assets that we maintain on a separate basis from the bank and the receipt of dividends from the bank. At December 31, 2005, we had approximately $11.4 million in available cash and the bank had the ability to pay approximately $61.0 million in dividends to us without prior regulatory approval.
Item 7A.
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk
Market risk is defined as the sensitivity of income, fair market values and capital to changes in interest rates, foreign currency exchange rates, commodity prices and other relevant market prices and rates. The primary market risk that we are exposed to is interest rate risk inherent in our lending, deposit taking and borrowing activities. Substantially all of our interest rate risk arises from these activities entered into for purposes other than trading.
The principal objective of our asset/liability management is to manage the sensitivity of net income to changing interest rates. Asset/liability management is governed by a policy approved annually by our board of directors. Our board of directors has delegated the oversight of the administration to the bank’s asset/liability committee. The overall interest rate risk position and strategies are reviewed by executive management and the bank’s board of directors on an ongoing basis.
Interest Rate Risk Management
The asset/liability committee manages our interest rate risk through structuring the balance sheet to seek to maximize net interest income while maintaining an acceptable level of risk to changes in market interest rates. The achievement of this goal requires a balance between profitability, liquidity and interest rate risk.
The asset/liability committee formulates strategies based on appropriate levels of interest rate risk. In determining the appropriate level of risk within the guidelines approved by the board of directors, the asset/liability committee considers the impact on earnings and capital of the current outlook on interest rates, potential changes in interest rates, regional economies, liquidity, business strategies, and other factors. The asset/liability committee meets regularly to review the sensitivity of assets and liabilities to interest rate changes, the book and market values of assets and liabilities, unrealized gains and losses, purchase and sale activity and the maturities of investments and borrowings. Additionally, the asset/liability committee reviews liquidity, cash flow flexibility, maturities of deposits, consumer and commercial deposit activity, current market conditions, and interest rates both on a local and national level.
We use various asset/liability strategies to manage the interest rate sensitivity of our assets and liabilities to ensure that our exposure to interest rate fluctuations is limited within our guidelines of acceptable levels of risk-taking. These strategies include adjusting the terms and pricing of our loans, deposits and borrowings and managing the deployments of our securities and short term assets to reduce or increase the mismatches in interest rate repricing. When appropriate, our management may utilize instruments such as interest rate swaps, floors and caps to hedge our interest rate position. As of December 31, 2005, we had entered into interest swaps to adjust the repricing characteristics of $40 million of our junior notes from a floating rate to a fixed rate.
We also manage the risks associated with our mortgage warehouse and pipeline. Our mortgage warehouse consists of fixed-rate single family mortgage loans that are to be sold in the secondary market. Our pipeline consists of commitments to originate single family mortgage loans, both fixed and adjustable rate. The fixed rate loans in the pipeline will be sold in the secondary market. The risk associated with the pipeline is the potential for changes in interest rates on these types of loans from the time the customer locks in the rate on the loan and the time we sell the loan in the secondary market. To manage this risk, we enter into forward sales agreements to protect us from rising interest rates. On a forward sales agreement the sales price and delivery date are established
at the time the agreement is entered into. In determining the amount of forward commitments to enter into, we consider the amount of loans with interest rate locks, the level of current market rates for similar products and the amount of commitments that are not expected to close before the expiration of the rate lock.
One way to measure the impact that future changes in interest rates will have is through an interest rate sensitivity gap measure. The “interest rate sensitivity gap” is defined as the difference between interest-earning assets and interest-bearing liabilities maturing or re-pricing within a given time period. A gap is considered positive when the amount of interest rate sensitive assets exceeds the amount of interest rate sensitive liabilities. A gap is considered negative when the amount of interest rate sensitive liabilities exceeds interest rate sensitive assets. During a period of rising interest rates, a negative gap would tend to affect net interest income adversely, while a positive gap would tend to result in an increase in net interest income. During a period of falling interest rates, a negative gap would tend to result in an increase in net interest income, while a positive gap would tend to affect net interest income adversely. Different types of assets and liabilities with the same or similar maturities may react differently to changes in overall market rates or conditions, thus changes in interest rates may affect net interest income positively or negatively even if an institution were perfectly matched in each maturity category. Our one year cumulative interest rate gap position at December 31, 2005 was a negative gap of $231.6 million, or 5.18%, of total assets. This is a one-day position which is continually changing and is not necessarily indicative of our position at any other time. Additionally, the gap analysis does not consider the many factors accompanying interest rate moves. While the interest rate sensitivity gap is a useful measurement and contributes toward effective asset and liability management, it is difficult to predict the effect of changing interest rates solely on that measure, without accounting for alterations in the maturity or re-pricing characteristics of the balance sheet that occur during changes in market interest rates. During periods of rising interest rates, our assets tend to have prepayments that are slower than those in an interest rate sensitivity gap and would increase our negative gap position. Conversely, during a period of falling interest rates, our assets would tend to prepay faster than expected thus decreasing the negative gap.
Interest Rate Sensitivity
We use interest management contracts as tools to manage our interest rate risk. The following table summarizes the key contractual terms associated with these contracts:
The following table represents the expected repricing characteristics of our assets and liabilities at December 31, 2005, utilizing the assumptions noted below:
(1)
Based on scheduled maturity or scheduled repricing and estimated prepayments of principal.
(2)
Includes mortgage warehouse loans held for sale.
(3)
Based on projected decay rates and/or repricing.
To effectively measure and manage interest rate risk, we use simulation analysis to determine the impact on net interest income under various interest rate scenarios, balance sheet trends and strategies. Based on these simulations, we quantify interest rate risk and develop and implement strategies we consider to be appropriate. At December 31, 2005, we used a simulation model to analyze net interest income sensitivity to an immediate parallel and sustained shift in interest rates derived from the current treasury and LIBOR yield curves. For both the rising rate and falling rate scenarios, the base market interest rate forecast was increased or decreased by 100 and 200 basis points. At December 31, 2005, our net interest income exposure was within the guidelines established by our board of directors.
The following table indicates the sensitivity of net interest income to the interest rate movements described above:
We also measure the impact of market interest rate changes on the net present value of our assets and liabilities and off-balance sheet items, defined as market value of equity, using a simulation model. At December 31, 2005, we used a simulation model to analyze the market value of equity sensitivity to an immediate parallel and sustained shift in interest rates derived from the current treasury and LIBOR yield curves. For both the rising rate and falling rate scenarios, the base market interest rate forecast was increased or decreased by 100 and 200 basis points. At December 31, 2005, our market value exposure was within the guidelines established by our board of directors.
The following table indicates changes to the market value of our equity as a result of the interest rate movements described above:
The computation of prospective effects of hypothetical interest rate changes are based on numerous assumptions, including relative levels of interest rate, asset prepayments, deposit decay and changes in re-pricing levels of deposits to general market rates, and should not be relied upon as indicative of actual results. Further, the computations do not take into account any actions that we may undertake in response to changes in interest rates.
Item 8.
Item 8.
Financial Statements and Supplementary Data
Management’s Report Regarding Responsibility for Financial Reporting
To the Stockholders of
Franklin Bank Corp.:
The management of Franklin Bank Corp. is responsible for the preparation of the financial statements, related financial data and other information in this annual report. The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America.
In meeting its responsibility both for the integrity and fairness of these financial statements and information, management depends on the accounting systems and related internal accounting controls that are designed to provide reasonable assurances that transactions are authorized and recorded in accordance with established procedures, that assets are safeguarded and that proper and reliable records are maintained.
The concept of reasonable assurance is based on the recognition that the cost of a system of internal controls should not exceed the related benefits. As an integral part of the system of internal controls, Franklin Bank Corp. maintains an internal audit function, which monitors compliance with and evaluates the effectiveness of the system of internal controls.
The Audit Committee of Franklin Bank Corp.’s board of directors, is composed of at least three directors who meet the independence requirement of the Nasdaq National Market and the federal securities laws and one director who qualifies as an audit committee financial expert. Our Audit Committee is appointed by our board of directors to assist the board in monitoring the integrity of our financial statements, our independent auditor’s qualifications and independence, the performance of our audit function and independent auditors, and our compliance with legal and regulatory requirements. Our internal auditors and independent auditors report directly to the audit committee.
/s/ Anthony J. Nocella
Anthony J. Nocella
President and Chief Executive Officer
/s/ Russell McCann
Russell McCann
Chief Financial Officer and Treasurer
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of Franklin Bank Corp.
Houston, Texas
We have audited the accompanying consolidated balance sheets of Franklin Bank Corp. and subsidiaries (the “company”) as of December 31, 2005 and 2004, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2005. These financial statements are the responsibility of the company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. 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, such financial statements present fairly, in all material respects, the financial position of Franklin Bank Corp. and subsidiaries as of December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2005, in conformity with accounting principles generally accepted in the United State of America.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the company’s internal control over financial reporting as of December 31, 2005, based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 1, 2006, expressed an unqualified opinion on management’s assessment of the effectiveness of the company’s internal control over financial reporting and an unqualified opinion on the effectiveness of the company’s internal control over financial reporting.
DELOITTE & TOUCHE LLP
Houston, Texas
March 1, 2006
FRANKLIN BANK CORP.
CONSOLIDATED BALANCE SHEETS
See notes to the consolidated financial statements
FRANKLIN BANK CORP.
CONSOLIDATED STATEMENTS OF OPERATIONS
See notes to the consolidated financial statements
FRANKLIN BANK CORP.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
See notes to the consolidated financial statements
FRANKLIN BANK CORP.
CONSOLIDATED STATEMENTS OF CASH FLOWS
See notes to consolidated financial statements
FRANKLIN BANK CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the Years Ended December 31, 2005, 2004 and 2003
1.
Summary of Significant Accounting Policies
Organization and Principles of Consolidation
Franklin Bank Corp., (the “parent company”), is a Texas-based savings and loan holding company that offers mortgage banking, commercial banking and community banking products through its subsidiary, Franklin Bank (the “bank”). As of December 31, 2005, in addition to our corporate office in Houston, Texas, where we provide many of our banking services, we had 35 banking offices in Texas, five regional construction lending offices in Florida, Arizona, Pennsylvania, Michigan and Texas, 45 retail mortgage offices in 24 states throughout the United States, and regional wholesale origination offices located in California and Tennessee.
Franklin Bank Corp. was formed in August, 2001 for the purpose of acquiring all of the outstanding stock of the bank. The acquisition of the bank was completed on April 9, 2002. Since that date, the company has completed six additional acquisitions including Highland Lakes Bancshares Corporation (“Highland”) on April 30, 2003, Jacksonville Bancorp, Inc. (“Jacksonville”) on December 30, 2003, Lost Pines Bancshares, Inc. (“Lost Pines”) on February 29, 2004, Cedar Creek Bancshares, Inc. (“Cedar Creek”) on December 4, 2004, First National Bank of Athens (“Athens”) on May 9, 2005 and Elgin State Bank (“Elgin”) on July 15, 2005. In addition, the company acquired five community banking branches on December 2, 2005 through a purchase and assumption agreement. These acquisitions were accounted for as purchases in accordance with Statement of Financial Accounting Standard (“SFAS”) No. 141, “Business Combinations.”
The accompanying consolidated financial statements include the accounts of the parent company, a subsidiary of the parent company, the bank and a subsidiary of the bank (collectively known as the “company”). The consolidated statements of operations and cash flows as for the year ended December 31, 2005, include activity for Athens beginning May 10, 2005 and Elgin beginning July 16, 2005. The consolidated statements of operations and cash flows for the year ended December 31, 2004, include activity for Lost Pines beginning March 1, 2004 and Cedar Creek beginning December 4, 2004. The consolidated statements of operations and cash flows for the year ended December 31, 2003 include activity for Highland beginning May 1, 2003 and Jacksonville beginning December 31, 2003. All significant intercompany accounts have been eliminated in consolidation. The majority of the company’s assets and operations are derived from the bank.
Certain reclassifications have been made to the December 31, 2004 and 2003 financial statements to conform to the December 31, 2005 presentation.
Use of Estimates
The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the financial statements. Actual results could differ from these estimates and assumptions.
Cash and Cash Equivalents
Cash and cash equivalents are comprised of amounts due from depository institutions and interest-earning and non-interest-earning deposits in other banks.
Securities
Debt, equity and mutual fund securities, including mortgage-backed securities, are classified into one of three categories: held to maturity, available for sale or trading.
FRANKLIN BANK CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
Trading account assets are carried at fair value, with any realized or unrealized gains or losses recognized in current operations. Trading account assets are those that are actively and frequently bought and sold with the objective of generating income on short-term changes in price.
Securities that the company would have the positive intent and ability to hold to maturity are classified as held to maturity and carried at cost, adjusted for the amortization of premiums and the accretion of discounts. Under certain circumstances (including the deterioration of the issuer’s creditworthiness or a change in the tax law or statutory or regulatory requirements), securities may be sold or transferred to another portfolio.
Declines in fair value of individual held-to-maturity securities below their amortized cost that would be other than temporary may result in write-downs of the individual securities to their fair values and would be included in the consolidated statements of operations as realized losses.
Securities not classified as held-to-maturity or trading are classified as available-for-sale. Securities available-for-sale are carried at fair value with any unrealized gains or losses reported net of tax as other comprehensive income in stockholders’ equity until realized. The specific identification method of accounting is used to calculate gains or losses on the sales of these assets.
Premiums and discounts are recognized to income using the level yield method, adjusted for prepayments as necessary.
Federal Home Loan Bank Stock and Other Investments
Federal Home Loan Bank (“FHLB”) stock is carried at cost and can only be sold back to the FHLB at par value or to other member banks. Other investments is comprised of an equity investment in another institution, Texas Independent Bank, which can only be sold back to Texas Independent Bank on a formula basis and is carried at cost. Dividends on FHLB and Texas Independent Bank Stock are included in interest income on the consolidated statements of operations.
Loans Held for Sale
Loans held for sale include originated and purchased single-family mortgage loans intended for sale in the secondary market. The company enters into forward sales agreements to manage the risk of changing interest rates on loans held for sale. Loans held for sale that are not effectively hedged with forward sales agreements are carried at the lower of cost or market value. Market value is determined based on quoted market prices. Premiums, discounts and loan fees (net of certain direct loan origination costs) on loans held for sale are deferred until the related loans are sold or repaid. Gains and losses on loan sales are recognized at the time of sale and are determined using the specific identification method.
Loans Held for Investment
Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff generally are reported at their outstanding unpaid principal balances adjusted for premiums, discounts, charge-offs, the allowance for credit losses and any deferred fees or costs on originated loans. Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and recognized as an adjustment of the related loan yield using the level yield method.
Nonaccrual, Past Due and Restructured Loans
Loans are normally placed on nonaccrual status by management when the payment of interest or principal on a loan becomes four payments past due, or earlier, in some cases, when the collection of interest or principal is doubtful. Generally, consumer loans that are not secured by real property are placed on nonaccrual status when deemed uncollectible, such loans are charged off when they reach 120 days past due.
FRANKLIN BANK CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
When a loan is placed on nonaccrual status, interest accrued and uncollected is reversed by a charge to current operations. Generally, any payments received on nonaccrual loans are applied first to outstanding loan amounts and next to the recovery of charged-off loan amounts. Any excess is treated as a recovery of loan interest. Nonaccrual loans are returned to accrual status when the loan becomes current and the borrower demonstrates the ability to repay the loan. Management’s classification of a loan as nonaccrual does not necessarily indicate that the principal of the loan is uncollectible in whole or in part.
Restructured loans are those loans for which concessions in terms have been granted because of a borrower’s financial difficulty. Interest is generally accrued on such loans in accordance with the new terms.
Impaired Loans
SFAS No. 114, “Accounting by Creditors for Impairment of a Loan” as amended by SFAS No. 118, “Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosures,” states that a loan is considered “impaired” when it is probable that the creditor will be unable to collect all principal and interest amounts due according to the contractual terms of the loan agreement. Smaller balance homogeneous loans, including single-family residential and consumer loans, are excluded from the scope of SFAS No. 114. These loans, however, are considered when determining the adequacy of the allowance for credit losses.
Impaired loans are identified and measured in conjunction with management’s review of nonperforming loans, classified assets and the allowance for credit losses. Impairment of large non-homogeneous loans is measured one of three ways: discounting estimated future cash flows, the loan’s market price or the fair value of the collateral, if the loan is collateral-dependent. If the measurement of the loan is less than the book value of the loan, excluding any allowance for credit losses and including accrued interest, then the impairment is recognized by a charge to operations or an allocation of the allowance for credit losses.
Allowance for Credit Losses
We maintain our allowance for credit losses at the amount estimated by management to be sufficient to absorb probable losses based on available information. Our estimates of credit losses meet the criteria for accrual of loss contingencies in accordance with SFAS No. 5, “Accounting for Contingencies,” as amended by SFAS No. 114, “Accounting by Creditors for Impairment of a Loan.” When analyzing the appropriateness of the allowance for credit losses we segment the loan portfolio into as many components as practical, each of which will normally have similar characteristics, such as risk classification, delinquency statistics, type of loan, industry, location of collateral property, loan-to-value ratios or type of collateral. The process of evaluating the adequacy of the allowance for credit losses has two basic elements: first, the identification of problem loans based on current operating financial information and fair value of the underlying collateral property and second, a methodology for estimating general loan losses. For loans classified as “watch,” “special mention,” “substandard” or “doubtful,” whether analyzed and provided for individually or as part of pools, we record all estimated credit losses at the time the loan is classified. For components of the loan portfolio that are not homogenous, such as commercial loans, and are not classified, we establish the credit loss allowance based on a credit grade that is assigned to the loan at origination on a formula basis and provide for these over the first year of the loan. For homogenous loans, such as single-family mortgage and consumer loans, we utilize the frequency and severity of losses for the asset class and the delinquency status. When available information confirms specific loans, or portions of those loans, to be uncollectible, we charge off those amounts against the allowance for credit losses. Even after loans are charged-off, we continue reasonable collection efforts until the potential for recovery is exhausted.
Estimates of credit losses involve an exercise of judgment. While it is possible that in the near term the bank may sustain losses which are substantial relative to the allowance for credit losses, it is the judgment of management that the allowance for credit losses is adequate to absorb losses which may exist in the current loan portfolio.
FRANKLIN BANK CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
Sales of Single Family Loans
Gains and losses on loan sales are recognized at the time of sale and are determined using the specific identification method. At the time of sale, control over the assets is transferred to the purchaser and all rights and beneficial interests in the transferred assets are relinquished by the bank and its creditors to the purchaser. The bank is not entitled or obligated to repurchase or redeem sold loans except under general representations and warranties included in the sales agreement, whereby the bank may be required to repurchase certain loans if they do not meet certain conditions specified in the sales agreement. Typically, when loans are sold, the associated servicing rights are released with the principal of the loan and any other retainable interests. Servicing rights that are retained are included in other intangible assets on the balance sheet.
The company did not sell any loans to related or affiliated parties during the years ended December 31, 2005, 2004 or 2003.
Goodwill
Goodwill represents the excess of the purchase price over the fair value of net assets acquired and the purchase premium on branch acquisitions, adjusted for core deposit premiums, which are included in intangible assets. In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” goodwill will not be amortized but will be evaluated for impairment at least annually. Goodwill will be tested for impairment using quoted market prices and transactions involving similar private institutions to determine if the fair value of our assets, net of liabilities, exceeds the carrying amount. If the fair value of our net assets is determined to be less than the carrying amount, goodwill will be written down through a charge to current operations.
Other Intangible Assets
Other intangible assets are made up of core deposit premiums paid and mortgage servicing rights. The core deposit premiums are amortized on an accelerated basis over the estimated lives of the deposit relationships acquired.
Mortgage servicing rights are created when the company sells loans and retains the right to service the loans. When servicing assets are retained in connection with the sale of loans they are allocated at their previous carrying amount based on relative fair values at the date of sale. Servicing rights are amortized in proportion to, and over the period of, the estimated net servicing revenue of the underlying mortgages, which are secured by single family properties, and is included in loan fee income on the consolidated statements of operations. The amortization of servicing rights is periodically evaluated and adjusted, if necessary, to reflect changes in prepayment rates or other related factors.
Servicing assets are periodically evaluated for impairment based on their fair value. The fair value of servicing assets is determined by discounting the estimated future cash flows using a discount rate commensurate with the risks involved. This method of valuation incorporates assumptions that market participants would use in estimating future servicing income and expense, including assumptions about prepayment, default and interest rates. For purposes of measuring impairment, the loans underlying the servicing assets are stratified by type (conventional fixed rate, conventional adjustable rate, and government), interest rate, date of origination and term. Impairment is measured by the amount the book value of the servicing rights exceeds their fair value. Impairment, if any, is recognized through a valuation allowance and a charge to current operations.
Premises and Equipment
Land is carried at cost. Buildings, furniture and equipment and leasehold improvements are carried at cost, or fair value at acquisition, less accumulated depreciation and amortization. Depreciation expense is computed using the straight-line method over the estimated useful lives of the assets. Leasehold improvements are amortized over the remaining life of the original lease term or remaining lease renewal period.
FRANKLIN BANK CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
Real Estate Owned (“REO”)
Real estate acquired through foreclosure is accounted for at the lower of carrying value or fair value less estimated costs to sell at the time of foreclosure. Declines in a property’s fair value below its carrying value subsequent to foreclosure would be charged to current operations. Revenues, expenses, gains or losses on sales, and increases or decreases in the allowance for REO losses are included in current operations in non-interest expense in the consolidated statements of operations.
Investment in real estate is recorded at cost. Costs related to development and improvement of property are capitalized, whereas costs relating to holding property are expensed to current operations.
Federal Income Taxes
The parent company and its subsidiaries file a consolidated tax return. Each entity within the consolidated group computes its tax on a separate-company basis, and the results are combined for purposes of preparing the consolidated financial statements. Deferred tax assets and liabilities are recognized for the estimated tax consequences due to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases.
Realization of net deferred tax assets is dependent on generating sufficient future taxable income. Although realization is not assured, management believes it is more likely than not that all of the net deferred tax assets will be realized. The amount of the net deferred tax assets considered realizable, however, could be reduced in the near term if estimates of future taxable income are reduced.
Earnings Per Common Share
Basic earnings per share (“EPS”) is computed by dividing net income by the weighted-average number of common shares outstanding during the period. Diluted EPS is computed by dividing net income by the weighted-average number of common shares and potentially dilutive common shares outstanding during the period. Potentially dilutive common shares are computed using the treasury stock method.
Stock-Based Compensation
The company measures its employee stock-based compensation using the intrinsic value based method of accounting under the provisions of AICPA Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees”. Accordingly, no compensation cost has been recognized for the company’s stock options. Pro forma information regarding net income is required under SFAS No. 123 Revised, “Accounting for Stock-Based Compensation” and has been determined as if the company accounted for its employee stock-option plans under the fair value method of SFAS No. 123 Revised. The fair value of options at the date of grant was estimated using a Black-Scholes option-pricing model, which requires use of highly subjective assumptions. Also, employee stock options have characteristics that are significantly different from those of traded options, including vesting provisions and trading limitations that impact their liquidity. Because employee stock options have differing characteristics, and changes in the subjective input assumptions can materially affect the fair-value estimate, the Black-Scholes valuation model does not necessarily provide a reliable measure of the fair value of
FRANKLIN BANK CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
the employee stock options. The following table shows the pro forma amounts attributable to stock-based employee compensation cost for the periods presented (dollars in thousands except per share data):
The company adopted the provisions of SFAS No. 123, “Share-Based Payment (Revised 2004)”, on January 1, 2006.
Derivatives and Hedging Activities
The company enters into derivative contracts in order to hedge the risk of market interest rate changes on certain assets and liabilities and other firm commitments. On the date a derivative contract is entered into, it is designated as either a fair-value hedge or a cash-flow hedge in accordance with SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” as amended by SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” A fair value hedge hedges exposure to changes in the fair value of an asset, liability or firm commitment due to their fixed rate terms. Changes in the fair value of the hedging instrument are included in current operations and are offset by changes in the fair value of the hedged item. The net effect resulting from the ineffective portion of a hedging instrument is reflected in earnings. A cash flow hedge hedges exposure to the variability in cash flows associated with an existing recognized asset or liability or a forecasted transaction due to their variable terms. The effective portion of changes in the fair value of the hedging instrument is included in accumulated other comprehensive income and is subsequently reclassified into earnings as the hedged item impacts earnings. Any ineffective portion is recognized in current operations.
In connection with our mortgage banking activities, we enter into interest rate lock commitments with loan applicants, whereby the interest rate on the loan is guaranteed for a certain period of time while the application is in the approval process. In accordance with SFAS No. 133, interest-rate lock commitments are derivative financial instruments, and changes in their fair value are required to be reported in current earnings. The fair value of interest rate lock commitments is determined as of the date the interest rate is locked and is based on the estimated fair value of the underlying mortgage loans, including the value of the servicing when selling the loans with the servicing in the same transaction to the same party. When the loans are sold and the servicing is retained by the company, the fair value of the interest rate lock commitments is based on the estimated fair value of the underlying mortgages, excluding the value of the servicing. Generally, the change in the value of the underlying mortgages is based on quoted market prices of publicly traded mortgage-backed securities. Management estimates the amount of loans expected to close by applying a fall-out ratio for commitments that are expected to
FRANKLIN BANK CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
expire. This estimate is based on the historical data for loans with similar characteristics as well as current market conditions. We record changes in the fair value as gains on sales of single family loans in the consolidated statements of operations.
In order to manage the risk that changes in interest rates would decrease the value of interest rate lock commitments and loans included in the held for sale portfolio, the company enters into forward sales agreements. Forward sales agreements are considered fair value hedges and any changes in fair value are included in gains on sales of single family loans in the consolidated statements of operations.
The company has entered into interest rate swap agreements in order to hedge the variable rate junior subordinated notes. These swaps qualify as cash flow hedges in accordance with SFAS No. 133. Hence, the swaps are included in the balance sheet at market value and changes in market value are included, net of tax, as a component of “other comprehensive income” in the statement of stockholders’ equity.
As of December 31, 2005, accumulated other comprehensive income included $551,000 of deferred after-tax net gains related to derivative instruments designated as cash flow hedges of our junior subordinated notes, none of which is expected to be reclassified into earnings during the next twelve months.
Off-Balance Sheet Financial Instruments
The company has entered into certain off-balance sheet financial instruments consisting of commitments to extend credit. Such financial instruments are recorded in the financial statements when funded.
Recent Accounting Standards
In March 2005, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 47, Accounting for Conditional Asset Retirement Obligations. Interpretation No. 47 clarifies that a conditional asset retirement obligation, as used in FASB Statement No. 143, Accounting for Asset Retirement Obligations, is considered unconditional when the timing and/or settlement of a legal obligation is conditional on a future event, even when it may or may not be under the control of the entity. If an entity has sufficient information to reasonably estimate the fair value of an asset retirement obligation, it must recognize a liability at the time the liability is incurred. If sufficient information is not available at the time the liability is incurred, a liability must be recognized at the time the sufficient information becomes available. The uncertainty about the timing and (or) method of settlement should be factored into the measurement of the liability when sufficient information exists. Interpretation No. 47 also clarifies when an entity would have sufficient information to reasonably estimate the fair value of an asset retirement obligation. Interpretation No. 47 is effective for fiscal years ending after December 15, 2005 and did not have a material impact on the company’s financial condition, results of operations or cash flows.
In December, 2004, the Financial Accounting Standards Board (“FASB”) issued Statement No. 123 (revised 2004), Share-Based Payment. This Statement is a revision of FASB Statement No. 123, Accounting for Stock-Based Compensation and supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees. Under the provisions of this Statement, a company is required to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. The cost will be recognized over the period during which an employee is required to provide service in exchange for the award. The grant-date fair value of employee share options will be estimated using option-pricing models adjusted for the unique characteristics of those instruments. If an equity award is modified after the grant date, incremental compensation cost will be recognized in an amount equal to the excess of the fair value of the modified award over the fair value of the original award immediately before the modification. Excess tax benefits, as defined by the Statement, will be recognized as an addition to paid-in capital. This statement applies to all awards granted after the required effective date and to awards modified, repurchased, or cancelled after that date and to the unvested portion of previously granted awards that remain outstanding at the date of adoption. Upon adoption of this Statement, the company plans to use the modified prospective method of transition. Under this method, the
FRANKLIN BANK CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
company will record compensation expense for the unvested portion of awards granted prior to the initial adoption of this Statement and for any awards issued, modified or settled after the effective date of this Statement. This Statement is effective as of the beginning of the first annual reporting period that begins after June 15, 2005. The company adopted the provisions of this Statement on January 1, 2006. The implementation of this Statement will reduce 2006 earnings by approximately $520,000, net of tax, based on the outstanding options at December 31, 2005.
In December 2003, the Accounting Standards Executive Committee of the AICPA issued Statement of Position No. 03-3 (“SOP 03-3”), Accounting for Certain Loans or Debt Securities Acquired in a Transfer. SOP 03-3 addresses the accounting for differences between the contractual cash flows and the cash flows expected to be collected from purchased loans or debt securities if those differences are attributable, in part, to credit quality. SOP 03-3 requires purchased loans and debt securities with evidence of credit deterioration to be recorded initially at fair value based on the present value of the cash flows expected to be collected with no carryover of any valuation allowance previously recognized by the seller. Interest income should be recognized based on the effective yield from the cash flows expected to be collected. To the extent that the purchased loans experience subsequent deterioration in credit quality, a valuation allowance would be established for any additional cash flows that are not expected to be received. However, if more cash flows subsequently are expected to be received than originally estimated, the effective yield would be adjusted on a prospective basis. SOP 03-3 became effective for loans and debt securities acquired after December 31, 2004. The requirements of SOP 03-3 did not have a material impact on the company’s financial condition, results of operations or cash flows.
In March 2004, the SEC Staff Accounting Bulletin (SAB) No. 105, Application of Accounting Principles to Loan Commitments (“SAB 105”) was issued, which addresses the application of generally accepted accounting principles to loan commitments accounted for as derivative instruments. SAB 105 provides that the fair value of recorded loan commitments to be held for sale that are accounted for as derivatives should not incorporate the expected future cash flows related to the associated servicing of the future loan. In addition, SAB 105 requires registrants to disclose their accounting policy for loan commitments. The provisions of SAB 105 must be applied to loan commitments accounted for as derivatives that are entered into after March 31, 2004. The company measures the fair value of interest rate lock commitments based on the estimated fair value of the underlying mortgages, including the value of the servicing, when selling the loans with the servicing in the same transaction to the same party. When the loans are sold and the servicing is retained by the company, the fair value of the interest rate lock commitments is based on the estimated fair value of the underlying mortgages, excluding the value of the servicing. SAB 105 did not have a material impact on the company’s financial condition, results of operations or cash flows.
In March 2004, the Emerging Issues Task Force reached a consensus on Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. This Issue provides guidance for determining when an investment is other-than-temporarily impaired. This Issue specifically addresses whether an investor has the ability and intent to hold an investment until recovery. In addition, Issue 03-1 contains disclosure requirements that provide useful information about impairments that have not been recognized as other-than-temporary for investments within the scope of this Issue. On November 3, 2005, FASB Staff Position (“FSP”) FAS 115-1 and FAS 124-1 was issued to address the determination of when an investment is considered impaired and whether that impairment is other than temporary. The guidance in the FSP is effective for reporting periods beginning after December 15, 2005. The company believes the FSP on FAS 115-1 and FAS 124-1 will not have a material impact on the company’s financial condition, results of operations or cash flows.
FRANKLIN BANK CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
2.
Acquisitions
The following table summarizes our completed acquisitions since December 2002:
In addition, the company purchased five community banking branches on December 2, 2005 in a purchase and assumption agreement. As of the purchase date, total assets were $11.9 million and $274.7 million of deposits were assumed for a purchase premium of $33.6 million.
We acquired 100% of the assets and liabilities of each of these institutions, except for the branch purchase in December 2005, which were accounted for as purchases in accordance with SFAS No. 141, “Business Combinations.” Jacksonville and Lost Pines were acquired in cash only transactions. The acquisition of Franklin Bank gave us the platform on which we have built our business. The Jacksonville acquisition gave us our entry into the east Texas market. The Highland, Lost Pines and Elgin acquisitions expanded our central Texas market and the Cedar Creek and Athens acquisitions expanded our east Texas market. The branch purchase added a new market that complements both our central and east Texas markets. Pursuant to SFAS No. 142, “Goodwill and Other Intangible Assets,” goodwill will be tested at least annually for impairment. The core deposit intangibles are being amortized on an accelerated basis over the estimated lives of the underlying deposit relationships acquired. The goodwill related to the Jacksonville, Lost Pines, Cedar Creek, Athens and Elgin acquisitions as well as the purchased branches are not deductible for tax purposes. The goodwill related to the Highland acquisition is deductible for tax purposes. The consolidated financial statements include the operating results and cash flows for Highland beginning May 1, 2003, Jacksonville beginning December 31, 2003, Lost Pines beginning March 1, 2004, Cedar Creek beginning December 4, 2004, Athens beginning May 10, 2005, and Elgin beginning July 16, 2005.
The estimated fair value of tangible assets acquired and liabilities assumed related to the Elgin, Athens, Cedar Creek, Lost Pines, Jacksonville and Highland acquisitions were as follows (in thousands):
FRANKLIN BANK CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
(1)
Includes purchase adjustments on certificates of deposits totaling $48,000, $(84,000), $63,000, $29,000, $3.8 million, and $1.4 million for Elgin, Athens, Cedar Creek, Lost Pines, Jacksonville, and Highland, respectively. The certificates of deposit acquired were marked to market value at the acquisition date (A) for certificates of deposit with similar remaining maturities.
On December 2, 2005, we acquired five community banking branches from another financial institution. In this acquisition we assumed $274.7 million in deposits for a purchase premium of $33.6 million and purchased $10.1 million in loans. Of the purchase premium, $2.8 million was allocated to core deposit intangibles and $30.8 million to goodwill. Included in goodwill is $461,000 of direct acquisition costs. Included in deposits is $759,000 of purchase adjustments on certificates of deposits. The certificates of deposits acquired were marked to market value at the acquisition date for certificates of deposit with similar remaining maturities.
The purchase price for Elgin, Athens, Cedar Creek, Lost Pines, Jacksonville, and Highland were allocated as follows (in thousands):
Included in the purchase price allocations are direct acquisition costs totaling $303,000 for Elgin, $411,000 for Athens, $450,000 for Cedar Creek, $306,000 for Lost Pines, $1.7 million for Jacksonville, and $1.1 million for Highland.
The allocation of the purchase price of the branch acquisition, Elgin and Athens at December 31, 2005 is preliminary. These amounts will be finalized as certain valuations and information are available in order to make a definitive allocation.
FRANKLIN BANK CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
The table below presents the actual and unaudited pro forma consolidated statements of operations for the year ended December 31, 2003 (in thousands):
Actual results for the year ended December 31, 2003 include Highland beginning May 1, 2003 and Jacksonville beginning December 31, 2003. Pro forma results for the year ended December 31, 2003 include Highland and Jacksonville as though their acquisitions occurred on January 1, 2003. The pro forma amounts take into account the purchase accounting adjustments resulting from the mergers. Pro forma consolidated financial information for the Cedar Creek, Lost Pines, Athens, Elgin and the branches purchased completed during the years ended December 31, 2004 and 2005, have been excluded because these acquisitions combined were immaterial.
3.
Securities
The amortized cost and estimated fair value of securities are as follows (in thousands):
FRANKLIN BANK CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
There were no securities held-to-maturity at December 31, 2005 or 2004.
The unrealized losses and the fair value of securities that have been in a continuous loss position for less than 12 months and 12 months or greater were as follows (in thousands):
During the years ended December 31, 2005, 2004 and 2003 the company had gains on sales of mortgage-backed securities totaling $965,000, $137,000 and $728,000 related to sales of $56.3 million, $15.8 million and $36.2 million, respectively. Gains on sales of securities totaled $92,000 and $111,000 related to sales of $15.3 million and $10.0 million during the years ended December 31, 2004 and 2003, respectively. There were no sales of securities during the year ended December 31, 2005. Purchases of mortgage-backed securities totaled $65.0 million, $3.5 million and $104.2 million during the years ended December 31, 2005, 2004 and 2003, respectively, as well as the securitization of $53.8 million of single family loans into FNMA securities during the year ended December 31, 2005. Mortgage-backed securities acquired from Jacksonville totaled $111.3 million
FRANKLIN BANK CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
and securities, FHLB stock and other investments acquired from Jacksonville totaled $42.5 million during the year ended December 31, 2003. The Athens and Elgin acquisitions added approximately $55.4 million to our investment portfolio, the majority of which matured the month following these acquisitions.
The company does not own any securities of any one issuer (other than the U.S. government and its agencies) of which the aggregate adjusted cost exceeds 10% of consolidated stockholders’ equity at December 31, 2005 or 2004, except for FHLB stock, which is a required investment, and the mutual fund security investment, in which we look at the underlying investments in the fund which is primarily comprised of adjustable-rate mortgage-backed securities issued by a U.S. Government agency or are rated in the highest category by Moody’s Investor Service or Standard & Poor’s.
Securities with amortized costs totaling $66.2 million and fair values totaling $65.8 million at December 31, 2005, were pledged to secure public deposits.
Securities outstanding at December 31, 2005 are scheduled to mature as follows (dollars in thousands):
FRANKLIN BANK CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
4.
Loans
The loan portfolio by major type is as follows (dollars in thousands):
FRANKLIN BANK CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
The following tables set forth the geographic distribution of loans by state for the periods indicated (dollars in thousands):
FRANKLIN BANK CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
(1)
Includes states for which aggregate loans were less than 1% of total loans at December 31, 2005 and 2004.
Loan maturity and interest rate sensitivity of the loan portfolio at December 31, 2005 are as follows (in thousands):
(1)
Includes single family loans held for sale.
At December 31, 2005 and 2004, single-family mortgage loans totaling $1.8 billion and $2.1 billion, respectively, were pledged collateralizing advances from the Federal Home Loan Bank of Dallas.
At December 31, 2005, the company had impaired loans totaling approximately $21.4 million. There were no impaired loans at December 31, 2004. Additionally, at December 31, 2005, the company had $9.0 million of loans that were four payments or more delinquent and still accruing interest which are comprised of single family loans serviced by others, which are under an agreement with the servicer whereby we receive scheduled payments until foreclosure.
Non-accrual loans, net of related purchase premiums and discounts, totaled $26.1 million and $4.9 million at December 31, 2005 and 2004, respectively. If the non-accrual loans as of December 31, 2005 and 2004 had been performing in accordance with their original terms throughout the years ended December 31, 2005 and 2004, interest recognized on these loans would have been $1.3 million and $180,000, respectively. The actual interest income recognized on these loans for the years ended December 31, 2005 and 2004 was $884,000 and $115,000, respectively. As of December 31, 2005, the company had $1.8 million of restructured loans. There were no restructured loans at December 31, 2004 or 2003.
An analysis of activity in the allowance for credit losses for the periods ended December 31, 2005, 2004 and 2003 is as follows (in thousands):
FRANKLIN BANK CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
The recorded investment in impaired loans and the related allowance were as follows (in thousands):
The average balance of impaired loans and the related interest income recognized were as follows (in thousands):
5.
Goodwill and Intangible Assets
Pursuant to SFAS No. 142, “Goodwill and Other Intangible Assets”, goodwill and intangible assets with indefinite lives are not amortized for acquisitions initiated after June 2001. Therefore, no goodwill amortization is presented in the consolidated statements of operations. Instead, goodwill will be tested at least annually for impairment. The company completed its latest impairment test as of September 30, 2005 and concluded there was no impairment. The company will review goodwill on an annual basis for impairment or as events occur or circumstances change that would potentially reduce the fair value below its carrying amount. The changes in goodwill for the years ended December 31, 2005 and 2004 are as follows (in thousands):
FRANKLIN BANK CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
Intangible assets other than goodwill include core deposit premiums paid and mortgage servicing rights. The changes in other intangible assets are as follows (in thousands):
(1)
Preliminary core deposit intangible estimated based on deposits with similar characteristics. Final core deposit intangible will be determined using actual deposit data from Athens and the branch acquisition.
At December 31, 2005 and 2004, the fair value of servicing rights retained from single family loan sales totaled $6.0 million and $2.2 million related to $340.1 million and $168.3 million, respectively, of principal serviced for others. The bank did not securitize any financial assets during the year ended December 31, 2004.
The projected amortization of other intangible assets as of December 31, 2005 is as follows (in thousands):
FRANKLIN BANK CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
6.
Premises and Equipment
Premises and equipment are summarized as follows (in thousands):
Depreciation expense was $1.8 million, $1.1 million and $412,000 for the years ended December 31, 2005, 2004 and 2003, respectively.
7.
Deposits
The composition of deposits is as follows (in thousands):
Included in deposits are certificates of deposit in amounts of $100,000 or more. The remaining maturities of these certificates as of December 31, 2005 are summarized as follows (in thousands):
Interest expense for certificates of deposits in excess of $100,000 approximated $5.1 million, $2.8 million, and $726,000 for the years ended December 31, 2005, 2004 and 2003, respectively.
FRANKLIN BANK CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
The company had wholesale and brokered deposits of $868.6 million and $780.9 million December 31, 2005 and 2004, respectively, that were not greater than $100,000, and $794,000 of wholesale deposits that were greater than $100,000 at December 31, 2004. As of December 31, 2005, the company did not have any wholesale deposits greater than $100,000.
8.
Federal Home Loan Bank Advances
Information concerning Federal Home Loan Bank advances is summarized as follows (dollars in thousands):
Scheduled maturities for Federal Home Loan Bank advances outstanding at December 31, 2005, were as follows (dollars in thousands):
Federal Home Loan Bank advances totaling $2.5 million are subject to early call features.
At December 31, 2005, our additional borrowing capacity at the FHLB was $391.8 million.
9.
Short-Term Borrowings
The company entered into a $15.0 million unsecured revolving line of credit facility in October 2005. The term of the agreement is from October 2005 until October 2006, unless terminated earlier upon occurrence of default under the agreement. The interest rate will range from 1.25% over one, two or three month LIBOR as quoted by the lender at the time of borrowing. The interest rate to be charged will correspond with the duration of the outstanding balance of the line. As of December 31, 2005, the outstanding balance of the short-term borrowing was $5.0 million and the interest rate was 5.77%.
FRANKLIN BANK CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
10. Junior Subordinated Notes
At December 31, 2005, the company had four issues of junior subordinated notes outstanding as follows (in thousands):
In November 2002, the company formed Franklin Bank Capital Trust I (the “Trust”), a wholly owned subsidiary. The Trust issued $20 million of variable rate trust preferred securities and invested the proceeds in variable rate junior subordinated notes (the “junior notes”) issued by the company. The company guarantees that payments will be made to the holders of the trust preferred securities, if the Trust has the funds available for payment. The rate on the junior notes resets quarterly at a base rate of 3-month LIBOR plus 3.35%. The junior notes first call date is in November 2007 and the notes mature in November 2032. The interest rate was 7.69% and 5.64% at December 31, 2005 and 2004, respectively. The company’s investment in the Trust was $619,000 at December 31, 2005 and 2004. The company also entered into an interest rate swap agreement in order to reduce the impact of interest rate changes on future income. The notional amount of the swap is $20 million and has been designated as a cash flow hedge to effectively convert the junior notes to a fixed rate basis. The agreement involves the receipt of floating rate amounts in exchange for fixed interest rate payments at an interest rate of 3.425% over the life of the agreement without an exchange of the underlying principal amounts
In February 2005, the company formed Franklin Capital Trust II (the “Trust II”), a wholly owned subsidiary. The Trust II issued $20 million of variable rate trust preferred securities and invested the proceeds in junior notes issued by the company. The company guarantees that payments will be made to the holders of the trust preferred securities, if the Trust II has the funds available for payment. If we were to default in payment of these securities, we would be unable to make any cash dividends on our common stock until such default was cured. The rate on these junior notes resets quarterly, at a base rate of 3-month LIBOR plus 1.90%. The first call date for these junior notes is March 15, 2010 and they mature in March 2035. At December 31, 2005, the interest rate was 6.39% and the company’s investment in the Trust II was $619,000. The company also entered into an interest rate swap agreement in order to reduce the impact of interest rate changes on future income. The notional amount of the swap is $20 million and has been designated as a cash flow hedge to effectively convert the junior notes to a fixed rate basis. The agreement involves the receipt of floating rate amounts in exchange for fixed interest rate payments at an interest rate of 4.29% over the life of the agreement without an exchange of the underlying principal amounts.
In May 2005, the company formed Franklin Capital Trust III (the “Trust III”), a wholly owned subsidiary. The Trust III issued $40 million of variable rate trust preferred securities and invested the proceeds in junior notes issued by the company. The company guarantees that payments will be made to the holders of the trust preferred securities, if the Trust III has the funds available for payment. The rate on these junior notes resets quarterly, at a base rate of 3-month LIBOR plus 1.90%. The first call date for these junior notes is June 15, 2010 and they mature in June 2035. At December 31, 2005, the interest rate was 6.39% and the company’s investment in the Trust III was $1.2 million.
In August 2005, the company formed Franklin Capital Trust IV (the “Trust IV”) a wholly owned subsidiary. The Trust IV issued $25 million of variable rate trust preferred securities and invested the proceeds in junior notes issued by the company. The company guarantees that payments will be made to the holders of the trust preferred securities, if the Trust IV has the funds available for payment. The rate on these junior notes resets quarterly at a
FRANKLIN BANK CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
base rate of 3-month LIBOR plus 1.60%. The first call date for these junior notes is November 2010 and they mature in November 2035. At December 31, 2005, the interest rate was 5.98% and the company’s investment in the Trust IV was $774,000.
11.
Commitments and Contingencies
Legal Proceedings
The bank is involved in legal proceedings occurring in the normal course of business that management believes, after reviewing such claims with outside counsel, are not material to the financial condition, results of operations or cash flows of the bank or the company.
In November 2005, the Company was named in a lawsuit, filed in Illinois State Court, where the plaintiff alleges violation of the Telephone Consumer Protection Act. The plaintiff has filed a motion for class certification. The plaintiff alleges unspecified damages. The company has filed a motion for removal to Federal court and a motion to dismiss. Because this action is in the early stages, we are unable to estimate the possible range of loss, if any.
Facilities Operations
A summary as of December 31, 2005, of non-cancelable future operating lease commitments follows (in thousands):
Total lease expense for all operating leases approximated $2.2 million, $1.8 million and $955,000 for the years ended December 31, 2005, 2004 and 2003, respectively.
12.
Financial Instruments With Off-Balance Sheet Risk
The company is party to various financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and letters of credit, which are not included in the accompanying consolidated financial statements. The company’s exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit and letters of credit is represented by the contractual notional amount of the instruments. The company uses the same credit policies in making such commitments as it does for instruments that are included in the consolidated balance sheet.
The principal commitments of the company are as follows (in thousands):
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.
FRANKLIN BANK CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
The company evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the company upon extension of credit, is based on management’s credit evaluation. Collateral held varies but may include single family homes under construction, accounts receivable, inventory, property and equipment, and income-producing commercial properties.
Letters of credit are conditional commitments issued by the company to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to its customers.
The company had $68.0 million and $86.0 million of commitments to sell loans at December 31, 2005 and 2004, respectively. The company had $180.0 million of commitments to purchase loans at December 31, 2004 and did not have a commitment to purchase loans at December 31, 2005.
13.
Disclosures About Fair Value of Financial Instruments
The following disclosure of the estimated fair value of financial instruments is made in accordance with SFAS No. 107, “Disclosures About Fair Value of Financial Instruments.” The estimated fair value amounts have been determined by the company using available market information and appropriate valuation methodologies. Considerable judgment is necessary to develop the fair value estimates, and accordingly, may not necessarily be 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 following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate:
Cash and Cash Equivalents - The carrying amount approximates fair value due to the short-term nature of these assets.
Securities, Other Investments and Mortgage-Backed Securities - The fair values of securities, other investments and MBS are estimated based on bid quotations received from securities dealers. For FHLB stock, the carrying amount approximates its fair value because it is redeemable at its par value.
Loans - Fair values are estimated for portfolios of loans with similar characteristics and include the value of related servicing rights, if appropriate. Loans are segregated by type, by rate, and by performing and nonperforming categories. The fair values of loans held for sale are based on quoted market prices. The fair values of loans held for investment are based on contractual cash flows discounted at secondary market rates, adjusted for prepayments. For adjustable-rate commercial and consumer loans held for investment that reprice frequently, fair values are based on carrying values. The fair value of nonperforming loans is estimated using the book value, which is net of any related allowance for credit losses.
Deposits - The estimated value of deposits with no stated maturity, which includes demand deposits, money market, and other savings accounts, is equal to the amount payable on demand or the carrying value. Although market premiums paid for depository institutions include an additional value for these deposits, SFAS No. 107 prohibits adjusting fair value for any value expected to be derived from retaining those deposits for a future period of time or from the benefit that results from the ability to fund interest-earning assets with these deposit liabilities. The fair value of fixed-maturity deposits is estimated using a discounted cash flow model with rates currently offered by the company for deposits of similar remaining maturities.
FHLB Advances - The fair value of FHLB advances is estimated based on the discounted value of contractual cash flows using rates currently available to the company for borrowings with similar terms and remaining maturities.
Short-Term Borrowings - The carrying amount approximates fair value due to the short-term nature of this liability.
FRANKLIN BANK CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
Junior Subordinated Notes - The carrying amount of these adjustable rate instruments is considered a reasonable estimate of their fair value as the notes reprice at market rates at each reset date.
Other Assets and Liabilities - The carrying amount of these instruments is considered a reasonable estimate of their fair value due to their short-term nature.
Commitments to Extend Credit, Standby Letters of Credit and Financial Guarantees Written - The fair value of commitments is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair value of guarantees and letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counterparties at the reporting date.
The carrying values and estimated fair values of the company’s financial instruments at December 31, 2005 and 2004 are as follows (in thousands):
14.
Employee Benefits
Savings Plans
During 2005 and 2004, the company participated in a tax deferred savings plan, available to all eligible employees, that qualifies as a 401(k) plan. Under the provisions of the plan, eligible employees can make contributions, through salary deductions, of up to 80% of their gross salary, subject to Internal Revenue Service maximum requirements. The company made matching contributions of 100% of the first 3% and 50% of the next 2% of gross compensation contributed by eligible employees. Employee and employer contributions vest immediately. During 2003, the company participated in a 401(k) plan that allowed employees to make contributions up to 25% of their gross salary, subject to Internal Revenue Service maximum requirements. Under the provisions of the plan the company would make matching contributions of $0.50 for every $1 contributed by
FRANKLIN BANK CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
the employee, up to 6% of eligible compensation, provided there was at least 80% participation by all eligible employees. During the years ended December 31, 2005 and 2004 the company made matching contributions totaling $338,000 and $162,000, respectively. During the year ended December 31 2003, the company did not make any matching contributions as the 80% participation requirement was not met.
During 2005, a deferred compensation plan was created in which the board of directors of company may participate. Employees are not eligible for this deferred compensation plan. The directors may defer up to 100% of their director’s fees and the interest rate accrued on the deferred fees is based on three year LIBOR as of the end of each quarter. As of December 31, 2005, the deferred compensation plan had two participants with a total deferral of $58,000 in fees earning interest of 4.75%.
Stock Incentive Plan
The company has established the 2002 Stock Option Plan which authorizes a committee of not less than two of our non-employee directors to grant options to purchase a maximum of 775,000 shares of common stock. Options are granted to certain employees and directors at exercise prices set by the compensation committee of the company’s board of directors and vest over a period of three years from the date of grant. The exercise price of an option cannot be less than the fair market value of a common stock on the date such option is granted and the term of any option granted under the plan cannot exceed ten years. Effective December 17, 2003, no additional option grants may be granted under this plan.
During 2003, the company’s 2004 Long Term Incentive Plan was approved by the stockholders to become effective at the close of the company’s initial public offering. This plan is administered by the Compensation Committee of the company’s board of directors. Directors, officers, employees and consultants of, and prospective employees and consultants of, us and our subsidiaries and affiliates are eligible to participate in the plan. The terms and conditions of each award are set by the Compensation Committee. The maximum number of shares of common stock that may be delivered to participants and their beneficiaries under the plan is 1,000,000. The plan includes stock options, stock appreciation rights, restricted stock, performance units and other stock-based awards. No participant may be granted stock options and stock appreciation rights covering in excess of 50,000 shares of common stock in any calendar year. No more than 500,000 shares of restricted stock may be issued during the term of the plan.
The company had no options outstanding prior to January 1, 2002. A summary of stock option activity was as follows:
FRANKLIN BANK CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
In December 2005, 26,544 shares of restricted common stock were authorized to be issued under the company’s 2004 Long Term Incentive Plan at $18.33 per share.
The fair value of options at date of grant was estimated using the Black-Scholes option-pricing model with the following weighted average assumptions:
The following table presents information relating to the company’s stock options at December 31, 2005:
15.
Related Parties
On November 4, 2002, the company entered into a three year consulting agreement with Ranieri & Co., Inc. (“Ranieri & Co.”) pursuant to which Ranieri & Co. will provide, among other services, strategic planning advice and guidance, asset and liability management advice, advice regarding capital market transactions and issues and advice regarding merger and acquisition opportunities in the financial services industry. In exchange for these services, the company paid a fee to Ranieri & Co. totaling $500,000 per year and granted Ranieri & Co. a 10 year option to purchase 570,000 shares of our common stock at an exercise price of $10.00 per share. At the date of the grant, the fair value of the option was estimated based on the assumptions of a stock price of $9.00, volatility of 6.1%, risk-free rate of 2.93%, dividend yield of 0.00%, an estimated life of 5 years and a marketability discount of 15.0%. A marketability discount was applied based on restrictions regarding resale contained in the consulting agreement and the absence of any market for the option instruments. At the date of grant, the fair value of the option was $1.79 per share. Pursuant to SFAS No. 123, “Accounting for Stock-Based Compensation”, the fair value of the options were recognized over the life of the consulting agreement, or upon a change of control, as defined in the agreement, if such change of control occurs prior to the end of the three year vesting period. Upon the completion of the company’s initial public offering in December 2003, the options became fully vested and the remaining fair value of the options was recognized in current earnings on the consolidated statements of operations. The consolidated statements of operations include $500,000 for the years ended December 31, 2004 and 2003 and $417,000 for the year ended December 31, 2005 related to the annual consulting fee and $953,000 related to the option agreement for the year ended December 31, 2003. On October 31, 2005, the consulting agreement with Ranieri & Co. expired.
In June 2003, Ranieri & Co. sold most of its options under this agreement to certain equity holders and employees of Ranieri & Co. and Hyperion BK2 Ventures, L.P., and certain of the company’s directors and officers, at a price of $1.52 per option.
FRANKLIN BANK CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
16.
Income Taxes
The components of income taxes for the years ended December 31, 2004, 2003 and 2002 are as follows (in thousands):
Significant deferred tax assets and deferred tax liabilities at December 31, 2005 and 2004 were as follows (in thousands):
17.
Stockholders’ Equity
Issued and outstanding shares of stock at December 31, 2005 include 23,375,076 shares of $.01 par value common stock.
In December 2005, 26,544 shares of restricted common stock were authorized to be issued under the company’s 2004 Long Term Incentive plan. In May 2005, in connection with the acquisition of Athens, 831,913 shares of common stock were issued at a price of $17.25 per share. In July 2005, in connection with the acquisition of Elgin, 628,698 shares of common stock were issued at a price of $18.97 per share.
FRANKLIN BANK CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
In December 2004, in connection with the acquisition of Cedar Creek, 670,522 shares of common stock were issued at a price of $18.37 per share.
In December 2003, the company sold 10,508,016 shares of common stock at an initial offering price of $14.50 per share. Underwriting discounts and other issuance costs totaling $12.1 million were included as a reduction to paid-in capital on the consolidated statements of stockholders’ equity at December 31, 2003. Of the proceeds, $67.7 million was used to acquire Jacksonville, $6.9 million was used to acquire Lost Pines and $52.3 million was contributed to the capital of the bank for general corporate purposes.
Also in December 2003, 93,927 shares of restricted stock were awarded to certain executives and key employees. Related compensation expense totaling $1.9 million was recognized on the consolidated statements of operations during the fourth quarter of 2003.
On November 4, 2003, all outstanding shares of Class B common stock automatically converted into a like number of Class A common stock. The amended and restated certificate of incorporation renames the Class A common stock as “common stock”.
In April 2003, in connection with the acquisition of Highland, 270,000 shares of Class A common stock were issued at a price of $10.00 per share.
18.
Earnings Per Share
Basic and diluted earnings per share were computed as follows (in thousands, except share data):
Options to purchase 178,100 and 240,700 shares of common stock at exercise prices of $18.60 and $12.00 were excluded from the computation of diluted EPS for the years ended December 31, 2005 and 2003, respectively, because their inclusion would have had an anti-dilutive effect as the options’ exercise prices were greater than the average market price of the common stock. The company did not have any anti-dilutive shares during the year ended December 31, 2004.
19.
Regulatory Matters
The bank is subject to various regulatory capital requirements administered by state and federal banking agencies. Any institution that fails to meet minimum capital requirements is subject to actions by regulators that could have a direct material effect on the institution’s financial statements. Under capital adequacy guidelines and regulatory framework for prompt corrective action, the bank must meet specific capital guidelines based on its assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices.
FRANKLIN BANK CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
To meet the capital adequacy requirements, the bank must maintain minimum capital amounts and ratios as defined in the regulations. Management believes that as of December 31, 2005 and 2004 the bank met all capital adequacy requirements.
The most recent notification from the Texas Savings & Loan Department and the FDIC categorized the bank 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 below. There have been no conditions or events since that notification which management believes would have changed the bank’s category.
The following is a summary of the bank’s capital ratios for the periods presented (dollars in thousands):
FRANKLIN BANK CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
20.
Quarterly Financial Results (unaudited)
The following table presents summarized data for each of the quarters during the years ended December 31, 2005 and 2004 (in thousands):
FRANKLIN BANK CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
21.
Financial Statements of the Parent Company
PARENT COMPANY
CONDENSED BALANCE SHEETS
FRANKLIN BANK CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
PARENT COMPANY
CONDENSED STATEMENTS OF OPERATIONS
FRANKLIN BANK CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, continued
PARENT COMPANY
CONDENSED STATEMENTS OF CASH FLOWS
See notes to consolidated financial statements
Item 9.
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A.
Item 9A.
Controls and Procedures
An evaluation was performed under the supervision and with the participation of the company’s management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this report. Based on this evaluation, the company’s management, including the Chief Executive Officer and Chief Financial Officer, concluded that the company’s disclosure controls and procedures were effective.
No changes were made to the company’s internal control over financial reporting (as defined in Rule 13a-15(f) and 15d-15(f) under the Exchange Act) during the last fiscal quarter that materially affected, or are reasonably likely to materially affect the company’s internal control over financial reporting.
Management’s Report on Internal Control Over Financial Reporting
The management of Franklin Bank Corp and its subsidiaries (the “company”) is responsible for establishing and maintaining adequate internal control over financial reporting. The company’s internal control system was designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the company’s financial statements for external purposes in accordance with generally accepted accounting principles.
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.
As of December 31, 2005, management assessed the effectiveness of the company’s internal control over financial reporting based on the criteria for effective internal control over financial reporting established in “Internal Control-Integrated Framework,” issued by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission. Based on the assessment, management determined that the company maintained effective internal control over financial reporting as of December 31, 2005, based on those criteria.
Deloitte & Touche LLP, the independent registered public accounting firm that audited the consolidated financial statements of the company included in this Annual Report on Form 10-K, has issued an attestation report on management’s assessment of the effectiveness of the company’s internal control over financial reporting as of December 31, 2005. The report is included in this Item under the heading “Attestation Report of Independent Registered Public Accounting Firm.”
Attestation Report of Independent Registered Public Accounting Firm
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of Franklin Bank Corp.
Houston, Texas
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that Franklin Bank Corp. and subsidiaries (the “Company”) maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Because management’s assessment and our audit were conducted to meet the reporting requirements of Section 112 of the Federal Deposit Insurance Corporation Improvement Act (FDICIA), management’s assessment and our audit of the Company’s internal control over financial reporting included controls over the preparation of the schedules equivalent to the basic financial statements in accordance with the instructions for the Consolidated Financial Statements for Bank Holding Companies (Form FR Y-9C). 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. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of 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, evaluating management’s assessment, testing, and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel 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 the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the 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, management’s assessment that the company maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also, in our opinion, the company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended December 31, 2005 of the company and our report dated March 1, 2006, expressed an unqualified opinion on those financial statements.
DELOITTE & TOUCHE LLP
Houston, Texas
March 1, 2006
Item 9B.
Item 9B. Other Information
Not applicable.
PART III
Item 10.
Item 10.
Directors and Executive Officers of the Registrant
Information about our directors is contained in the sections entitled “Election of Class III Directors” and “Certain Relationships and Related Transactions” in our Proxy Statement for the Annual Meeting of Stockholders to be filed not later than 120 days following December 31, 2005, which sections are incorporated herein by reference. For information regarding our executive officers, see “Item 1. Business - Executive Officers of the Registrant” in this annual report on Form 10-K. Information about our Audit Committee, our Audit Committee Financial Expert and the procedures by which stockholders may recommend nominees to our board of directors is contained in the section entitled “Governance of the Company” in our Proxy Statement for the Annual Meeting of Stockholders to be filed not later than 120 days following December 31, 2005, which section is incorporated herein by reference. Additional information regarding compliance by our directors and executive officers with Section 16(a) of the Exchange Act is contained in the section entitled “Section 16(a) Beneficial Ownership Reporting Compliance” in our Proxy Statement for the Annual Meeting of Stockholders to be filed not later than 120 days following December 31, 2005, which section is incorporated herein by reference.
We have adopted both a code of ethics and business conduct applicable to all of our directors, officers, and employees as well as corporate governance guidelines. Both of these documents are available on our website at www.bankfranklin.com. In addition, any amendments to or waivers from the code of ethics and business conduct will be posted on the website. Any such amendment or waiver would require the prior consent of our board of directors or an applicable committee thereof.
Item 11.
Item 11.
Executive Compensation
Information for this item is contained in the sections entitled “Executive Compensation,” “Compensation Committee Interlocks and Insider Participation” and “Stock Performance Graph” in our Proxy Statement for the Annual Meeting of Stockholders to be filed not later than 120 days following December 31, 2005, which sections are incorporated herein by reference.
Item 12.
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
For information about securities authorized for issuance under equity compensation plans, see “Item 5. Market for Registrant’s Common Equity and Related Stockholder Matters - Stock-Based Compensation” in this annual report on Form 10-K. Information concerning security ownership of certain beneficial owners and management is contained in the section entitled “Ownership of Common Stock” in our Proxy Statement for the Annual Meeting of Stockholders to be filed not later than 120 days following December 31, 2005, which section is incorporated herein by reference.
Item 13.
Item 13.
Certain Relationships and Related Transactions
Information concerning certain relationships and related transactions with our management is contained in the section entitled “Certain Relationships and Related Transactions” in our Proxy Statement for the Annual Meeting of Stockholders to be filed not later than 120 days following December 31, 2005, which section is incorporated herein by reference.
Item 14.
Item 14.
Principal Accountant Fees and Services
Information concerning principal accounting fees and services is contained in the section entitled “Item 3 - Ratification of Appointment of Independent Auditors” in our Proxy Statement for the Annual Meeting of Stockholders to be filed not later than 120 days following December 31, 2005, which section is incorporated herein by reference.
PART IV
Item 15.
Item 15.
Exhibits and Financial Statement Schedules
(a) The following documents are filed as part of this Annual Report on Form 10-K:
1. Consolidated Financial Statements. Reference is made to Part II, Item 8, of this Annual Report on Form 10-K.
2. Consolidated Financial Statement Schedules. These schedules are omitted as the required information is inapplicable or the information is presented in the consolidated financial statements or related notes.
3. Exhibits. The exhibits to this Annual Report on Form 10-K listed below have been included only with the copy of this report filed with the SEC. Copies of individual exhibits will be furnished to shareholders upon written request to Franklin Bank Corp. and payment of a reasonable fee.
*
Previously filed as an exhibit of even number to the Registration Statement on Form S-1 (File No. 333-108026) filed by the Registrant on October 14, 2003.
**
Previously filed as an exhibit of even number to the Registration Statement on Form S-1 (File No. 333-108026) filed by the Registrant on November 14, 2003.
***
Previously filed as an exhibit of even number to the Registration Statement on Form S-1 (File No. 333-108026) filed by the Registrant on December 17, 2003.
****
Previously filed as an exhibit of even number to the Registration Statement on Form S-1 (File No. 333-112856) filed by the Registrant on February 13, 2004.
*****
Previously filed as an exhibit to the Company’s Annual Report on Form 10-K filed by the Registrant on March 11, 2004.
******
Previously filed on the Company’s Current Report on Form 8-K filed by the Registrant on September 3, 2004.
*******
Previously filed on the Company’s Current Report on Form 8-K filed by the Registrant on December 23, 2004.
********
Previously filed on the Company’s Current Report on Form 8-K filed by the Registrant on May 13, 2005.
*********
Previously filed on the Company’s Current Report on Form 8-K filed on January 28, 2005.
**********
Previously filed on the Company’s Current Report on Form 8-K filed by the Registrant on June 23, 2005.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the city of Houston, state of Texas, on March 14, 2006.
FRANKLIN BANK CORP.
By:
/s/ Anthony J. Nocella
Name: Anthony J. Nocella
Title:
President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on March 14, 2006.
EXHIBIT INDEX