Item 1. Business
Overview
Cardinal Financial Corporation, a financial holding company, was formed in late 1997 as a Virginia corporation, principally in response to opportunities resulting from the consolidation of several Virginia-based banks. These bank consolidations were typically accompanied by the dissolution of local boards of directors and relocation or termination of management and customer service professionals and a general deterioration of personalized customer service.
We own Cardinal Bank, (the "Bank"), a Virginia state-chartered community bank with 25 banking offices located in Northern Virginia and the greater Washington, D.C. metropolitan area. The Bank offers a wide range of traditional bank loan and deposit products and services to both our commercial and retail customers. Our commercial relationship managers focus on attracting small and medium sized businesses as well as government contractors, commercial real estate developers and builders and professionals, such as physicians, accountants and attorneys.
Additionally, we complement our core banking operations by offering a wide range of services through our various subsidiaries, including mortgage banking through George Mason Mortgage, LLC ("George Mason") and Cardinal First Mortgage, LLC ("Cardinal First"), retail securities brokerage through Cardinal Wealth Services, Inc. ("CWS"), asset management through Wilson/Bennett Capital Management, Inc. ("Wilson/Bennett") and trust, estate, custody, investment management and retirement planning through the trust division of Cardinal Bank.
George Mason engages primarily in the origination and acquisition of residential mortgages for sale into the secondary market on a best efforts basis through five branches located throughout the metropolitan Washington, D.C. region. George Mason is one of the largest residential mortgage originators in the greater Washington metropolitan area, generating originations of approximately $2.6 billion in 2009 and $1.4 billion in 2008, excluding advances on construction loans and including loans purchased from other mortgage banking companies owned by local home builders but managed by George Mason.
Cardinal First originates mortgage loans for new homes and refinancing in Virginia, Maryland, and Washington, D.C. principally for existing Cardinal Bank customers.
CWS provides brokerage and investment services through a contract with Raymond James Financial Services, Inc. Under this contract, financial advisors can offer our customers an extensive range of financial products and services, including estate planning, qualified retirement plans, mutual funds, annuities, life insurance, fixed income and equity securities and equity research and recommendations. CWS's principal source of revenue is the net commissions it earns on the purchases and sales of investment products to its customers.
Wilson/Bennett provides professional investment management of financial assets with asset preservation as the primary goal. Clients include individuals, pension plans and medium sized corporations. Wilson/Bennett utilizes a value oriented investment approach and focuses on large capitalization stocks as well as cash management services. Wilson/Bennett earns fees based upon the market value of its clients' portfolios.
Cardinal Bank has a trust division that acts as trustee or custodian for client assets and earns fees primarily based upon balances under management. The trust division diversifies the Bank's sources of non-interest income and allows us to provide additional services to our customers.
Growth Strategy
We believe that the strong demographic characteristics of our market, the ongoing disruption in our market area due to the current financial turmoil affecting the industry, and the relative strength of the metropolitan Washington, D.C. area, particularly Northern Virginia, provide a significant opportunity to continue building a successful community-focused banking franchise. We intend to continue to expand our business through internal growth, as well as selective geographic expansion, while maintaining strong asset quality and achieving increasing profitability. The strategy for achieving these objectives includes the following:
Capitalize on the current market conditions. As the banking industry continues to restrict lending based on industry-wide asset quality limitations and capital constraints, we believe we are well positioned to take advantage of this void based on our strong balance sheet. We continue to see increased opportunities to grow our loan portfolio because the competition is distracted by current market conditions and their credit quality issues. In addition to loan growth, we believe that our margins should be enhanced going forward as risk-based pricing returns to the industry. We also continue to benefit from a move towards quality by well established business owners, including multi-generational businesses, seeking the safe and consistent reliable delivery of service that we are able to provide.
Penetrate our existing markets and further improve our branch positioning. We intend to continue to penetrate our existing markets with increased business development efforts through additional experienced bankers in communities that present attractive growth opportunities within Northern Virginia and other markets in the greater Washington, D.C. metropolitan area. We expect to continue to have opportunities to acquire or lease former branch sites from other financial institutions. As we have done in the past, we may acquire additional sites prior to planned branch openings when we believe the sites are attractive and are available on favorable terms. As we evaluate our branch positioning, we have considered and will continue to consider acquiring branches or deposits in FDIC assisted transactions that occur in our market area. Because the opening of each new branch increases our operating expenses, we intend to stage future branch openings in an effort to minimize the impact of these expenses on our results of operations.
Capitalize on the continued bank consolidation in our market. We anticipate that recently announced bank mergers as well as FDIC assisted transactions will result in further consolidation in our target market and we intend to capitalize on the dislocation of customers resulting from this consolidation. We believe this consolidation creates opportunities for expanding our branch network, as discussed above, as well as to increase our market share of bank deposits within our target market. We focus on building long term relationships with our clients and communities by providing personalized service from local management teams. We also will continue to explore the possibility of further growth through acquisition in Virginia, the metropolitan Washington, D.C. market, or other areas if we believe that such expansion will strengthen the Company by diversifying our customer base and sources of revenue and be accretive to earnings within a reasonable time frame.
Expand our lending activities. As of December 31, 2009, we have increased our legal lending limit to over $30.0 million as a result of retained earnings and our successful capital raise efforts during 2009. The increase in our legal lending limit allows us to further expand our commercial and real estate lending activities. It also improves our ability to seek business from larger government contractors, businesses who we believe are conservatively operated and well capitalized residential homebuilders. According to George Mason University's Center for Regional Analysis, federal government spending in the greater Washington D.C. region was approximately $130 billion in 2008, and we believe there are unique growth opportunities in this sector of our regional economy. Our goal is to aggressively grow our loan portfolio while maintaining superior asset quality through conservative underwriting practices.
Continue to recruit experienced bankers. Historically, we have been successful in recruiting senior bankers with experience in, and knowledge of, our market. We believe current market conditions and consolidation will allow us to continue to find bankers who have been displaced or have grown dissatisfied as a result of consolidation. We intend to continue our efforts to recruit seasoned bankers, particularly experienced lenders, who we expect can immediately generate additional loan volume through their existing credit relationships.
Business Segment Operations
We operate in three business segments, commercial banking, mortgage banking and wealth management and trust services. The commercial banking segment includes both commercial and consumer lending and provides customers such products as commercial loans, real estate loans, and other business financing and consumer loans. In addition, this segment provides customers with several choices of deposit products, including demand deposit accounts, savings accounts and certificates of deposit. The mortgage banking segment engages primarily in the origination and acquisition of residential mortgages for sale into the secondary market on a best efforts basis. The wealth management and trust services segment provides investment and financial advisory services to businesses and individuals, including financial planning, retirement/estate planning, trust, estates, custody, investment management, escrows, and retirement plans.
For financial information about the reportable segments, see "Business Segment Operations" in Item 7 below and Note 22 of the notes to the consolidated financial statements in Item 8 below.
Market Area
We consider our primary target market to include the Virginia counties of Arlington, Fairfax, Loudoun, Prince William, and Stafford and the cities of Alexandria, Fairfax, Falls Church, Fredericksburg, Manassas and Manassas Park; Washington, D.C. and Montgomery County in Maryland. In addition to our primary market, we consider the Virginia counties of Spotsylvania, Culpeper and Fauquier and the Maryland county of Prince George's as secondary markets and the remaining Greater Washington Metropolitan area as a tertiary market. We will, however, consider expansion into other areas if we believe such expansion will strengthen the Company by diversifying its customer base and sources of revenue and be accretive to earnings within a reasonable time frame.
Based on estimates released by the U.S. Census Bureau, the population of the greater Washington metropolitan area was approximately 5.4 million people in 2008, the ninth largest statistical area in the country. The median annual household income for this area in 2009 was approximately $83,000, which makes it one of the wealthiest regions in the country. For 2009, based on estimates released by the Bureau of Labor Statistics of the U.S. Department of Labor, the unemployment rate for the greater Washington metropolitan area was approximately 6.2%, compared to a national unemployment rate of 10.0%. As of June 30, 2009, total deposits in this area were approximately $165 billion as reported by the Federal Deposit Insurance Corporation ("FDIC").
Our headquarters are located in the center of the business district of Fairfax County, Virginia. Fairfax County, with over one million people, is the most populous county in Virginia and the most populous jurisdiction in the Washington, D.C. area. According to the latest U.S. Census Bureau estimates, Fairfax County also has the second highest median household income of any county in the United States of $109,000, surpassed by its neighbor, Loudoun County with $116,000.
We believe the diversity of our economy, including the stability provided by businesses serving the U.S. Government, provides us with the opportunities necessary to prudently grow our business.
Competition
The greater Washington region is dominated by branches of large regional or national banks headquartered outside of the region. Our market area is a highly competitive, highly branched, banking market. We compete as a financial intermediary with other commercial banks, savings and loan associations, savings banks, credit unions, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, mutual fund groups and other types of financial institutions. George Mason faces significant competition from both traditional financial institutions and other national and local mortgage banking operations.
The competition to acquire deposits and to generate loans, including mortgage banking loans, is intense, and pricing is important. Many of our competitors are larger and have substantially greater resources and lending limits than we do. In addition, many competitors offer more extensive branch and ATM networks than we currently have. Larger institutions operating in the greater Washington market have access to funding sources at lower costs than are available to us since they have larger and more diverse fund generating capabilities. However, we believe that we have and will continue to be successful in competing in this environment due to an emphasis on a high level of personalized customer service, localized and more responsive decision making, and community involvement.
Of the $165 billion in bank deposits in the greater Washington region at June 30, 2009, approximately 85% were held by banks that are either based outside of the greater Washington region or are operating wholesale banks that generate deposits nationally. Excluding institutions based outside our region, we have grown to the fifth largest financial institution headquartered in the greater Washington region as measured by total deposits. By providing competitive products and more personalized service and being actively involved in our local communities, we believe we can continue to increase our share of this deposit market.
Customers
We believe that the recent and ongoing bank consolidation within Northern Virginia and the greater Washington region provides a significant opportunity to build a successful, locally-oriented banking franchise. We also believe that many of the larger financial institutions in our area do not emphasize the high level of personalized service to small and medium-sized commercial businesses, professionals or individual retail customers that we emphasize.
We expect to continue serving these business and professional markets with experienced commercial relationship managers, and we have increased our retail marketing efforts through the expansion of our branch network and development of additional retail products and services. We expanded our deposit market share through aggressive marketing of our President's Club, Chairman's Club, Simply Savings and Monster Money Market relationship products and our Totally Free Checking product.
Banking Products and Services
Our principal business is to accept deposits from the public and to make loans and other investments. The principal sources of funds for the Bank's loans and investments are demand, time, savings and other deposits, repayments of existing loans, and borrowings. Our principal source of income is interest collected on loans, investment securities and other investments. Non-interest income, which includes among other things deposit and loan fees and service charges, realized and unrealized gains on mortgage banking activities, investment fee income, and management fee income, is the next largest component of our revenues. Our principal expenses are interest expense on deposits and borrowings, employee compensation and benefits, occupancy-related expenses, and other overhead expenses.
The principal business of George Mason, the Bank's primary mortgage banking subsidiary, is to originate residential loans for sale into the secondary market on a best efforts basis. These loans are closed and serviced by George Mason on an interim basis pending their ultimate sale to a permanent investor. The mortgage subsidiary funds these loans through a line of credit from Cardinal Bank and cash available through its own operations. George Mason's income on these loans is generated from the fees it charges its customers, the gains it recognizes upon the sales of loans and the interest income it earns while the loans are being serviced. Costs associated with these loans are primarily comprised of salaries and commissions paid to loan originators and support personnel, interest expense incurred while the loans are held pending sale and other expenses associated with the origination of the loans. In addition, George Mason generates management fee income by providing specific services to other mortgage banking companies owned by local home builders.
George Mason also offers a construction-to-permanent loan program. This program provides variable rate financing for customers to construct their residences. Once the home has been completed, the loan converts to fixed rate financing and is sold into the secondary market. These construction-to-permanent loans generate fee income as well as net interest income and are classified as loans held for sale.
George Mason's business is both cyclical and seasonal. The cyclical nature of its business is influenced by, among other things, the levels of and trends in mortgage interest rates, national and local economic conditions and consumer confidence in the economy. Historically, George Mason has its lowest levels of quarterly loan closings during the first quarter of the year.
Both Cardinal Bank and George Mason are committed to providing high quality products and services to their customers, and have made a significant investment in their core information technology systems. These systems provide the technology that fully automates the branches, processes bank transactions, mortgage originations, other loans and electronic banking, conducts database and direct response marketing, provides cash management solutions, streamlined reporting and reconciliation support.
With this investment in technology, the Bank offers internet-based delivery of products for both individuals and commercial customers. Customers can open accounts, apply for loans, check balances, check account history, transfer funds, pay bills, download account transactions into Quicken™ and Microsoft Money™, and correspond via e-mail with the Bank over the internet. The internet provides an inexpensive way for the Bank to expand its geographic borders and branch activities while providing services offered by larger banks.
We offer a broad array of products and services to our customers. A description of our products and services is set forth below.
Lending
We offer a full range of short to long-term commercial, real estate and consumer lending products and services, which are described in further detail below. We have established target percentage goals for each type of loan to insure adequate diversification of our loan portfolio. These goals, however, may change from time to time as a result of competition, market conditions, employee expertise, and other factors. Commercial and industrial loans, real estate-commercial loans, real estate-construction loans, real estate-residential loans, home equity loans, and consumer loans account for approximately 12%, 46%, 15%, 17%, 9% and 1%, respectively of our loan portfolio at December 31, 2009.
Commercial and Industrial Loans. We make commercial loans to qualified businesses in our market area. Our commercial lending portfolio consists primarily of commercial and industrial loans for the financing of accounts receivable, property, plant and equipment. Our government contract lending group provides secured lending to government contracting firms and businesses based primarily on
receivables from the federal government. We also offer Small Business Administration (SBA) guaranteed loans and asset-based lending arrangements to our customers. We are certified as a preferred lender by the SBA, which provides us with much more flexibility in approving loans guaranteed under the SBA's various loan guaranty programs.
Historically, commercial and industrial loans generally have a higher degree of risk than residential mortgage loans, but have commensurately higher yields. Residential mortgage loans generally are made on the basis of the borrower's ability to repay the loan from his or her salary and other income and are secured by residential real estate, the value of which generally is readily ascertainable. In contrast, commercial loans typically are made on the basis of the borrower's ability to repay the loan from the cash flow from its business and are secured by business assets, such as commercial real estate, accounts receivable, equipment and inventory, the values of which may fluctuate over time and generally cannot be appraised with as much precision as residential real estate. As a result, the availability of funds for the repayment of commercial loans may be substantially dependent upon the commercial success of the business itself.
To manage these risks, our policy is to secure the commercial loans we make with both the assets of the business, which are subject to the risks described above, and other additional collateral and guarantees that may be available. In addition, for larger relationships, we actively monitor certain attributes of the borrower and the credit facility, including advance rate, cash flow, collateral value and other credit factors that we consider appropriate.
Commercial Mortgage Loans. We originate commercial mortgage loans. These loans are primarily secured by various types of commercial real estate, including office, retail, warehouse, industrial and other non-residential types of properties and are made to the owners and/or occupiers of such property. These loans generally have maturities ranging from one to ten years.
Historically, commercial mortgage lending entails additional risk compared with traditional residential mortgage lending. Commercial mortgage loans typically involve larger loan balances concentrated with single borrowers or groups of related borrowers. Additionally, the repayment of loans secured by income-producing properties is typically dependent upon the successful operation of a business or real estate project and thus may be subject, to a greater extent than has historically been the case with residential mortgage loans, to adverse conditions in the commercial real estate market or in the general economy. Our commercial real estate loan underwriting criteria require an examination of debt service coverage ratios, the borrower's creditworthiness and prior credit history, and we generally require personal guarantees or endorsements with respect to these loans. In the loan underwriting process, we also carefully consider the location of the property that will be collateral for the loan.
Loan-to-value ratios for commercial mortgage loans generally do not exceed 80%. We permit loan-to-value ratios of up to 80% if the borrower has appropriate liquidity, net worth and cash flow.
Residential Mortgage Loans. Residential mortgage loans are originated by Cardinal Bank, Cardinal First and George Mason. Our residential mortgage loans consist of residential first and second mortgage loans, residential construction loans and home equity lines of credit and term loans secured by the residences of borrowers. Second mortgage and home equity lines of credit are used for home improvements, education and other personal expenditures. We make mortgage loans with a variety of terms, including fixed, floating and variable interest rates, with maturities ranging from three months to thirty years.
Residential mortgage loans generally are made on the basis of the borrower's ability to repay the loan from his or her salary and other income and are secured by residential real estate, the value of which is generally readily ascertainable. These loans are made consistent with our appraisal and real estate lending policies, which detail maximum loan-to-value ratios and maturities. Residential mortgage
loans and home equity lines of credit secured by owner-occupied property generally are made with a loan-to-value ratio of up to 80%. Loan-to-value ratios of up to 90% may be allowed on residential owner-occupied property if the borrower exhibits unusually strong creditworthiness. We generally do not make residential loans which, at the time of inception, have loan-to-value ratios in excess of 90%.
Construction Loans. Our construction loan portfolio consists of single-family residential properties, multi-family properties and commercial projects. Construction lending entails significant additional risks compared with residential mortgage lending. Construction loans often involve larger loan balances concentrated with single borrowers or groups of related borrowers. Construction loans also involve additional risks since funds are advanced while the property is under construction, which property has uncertain value prior to the completion of construction. Thus, it is more difficult to accurately evaluate the total loan funds required to complete a project and related loan-to-value ratios. To reduce the risks associated with construction lending, we limit loan-to-value ratios to 80% of when-completed appraised values for owner-occupied residential or commercial properties and for investor-owned residential or commercial properties. We expect that these loan-to-value ratios will provide sufficient protection against fluctuations in the real estate market to limit the risk of loss. Maturities for construction loans generally range from 12 to 24 months for non-complex residential, non-residential and multi-family properties.
Consumer Loans. Our consumer loans consist primarily of installment loans made to individuals for personal, family and household purposes. The specific types of consumer loans we make include home improvement loans, automobile loans, debt consolidation loans and other general consumer lending.
Consumer loans may entail greater risk than residential mortgage loans, particularly in the case of consumer loans that are unsecured, such as lines of credit, or secured by rapidly depreciable assets, such as automobiles. In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation. The remaining deficiency often does not warrant further substantial collection efforts against the borrower. In addition, consumer loan collections are dependent on the borrower's continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Furthermore, the application of various federal and state laws, including federal and state bankruptcy and insolvency laws, may limit the amount that can be recovered on such loans. A loan may also give rise to claims and defenses by a consumer loan borrower against an assignee of such loan, such as the bank, and a borrower may be able to assert against such assignee claims and defenses that it has against the seller of the underlying collateral.
Our policy for consumer loans is to accept moderate risk while minimizing losses, primarily through a careful credit and financial analysis of the borrower. In evaluating consumer loans, we require our lending officers to review the borrower's level and stability of income, past credit history, amount of debt currently outstanding and the impact of these factors on the ability of the borrower to repay the loan in a timely manner. In addition, we require our banking officers to maintain an appropriate differential between the loan amount and collateral value.
We also issue credit cards to certain of our customers. In determining to whom we will issue credit cards, we evaluate the borrower's level and stability of income, past credit history and other factors. Finally, we make additional loans that are not classified in one of the above categories. In making such loans, we attempt to ensure that the borrower meets our loan underwriting standards.
Loan Participations
From time to time we purchase and sell commercial loan participations to or from other banks within our market area. All loan participations purchased have been underwritten using the Bank's standard and customary underwriting criteria and are in good standing.
Deposits
We offer a broad range of interest-bearing and non-interest-bearing deposit accounts, including commercial and retail checking accounts, money market accounts, individual retirement accounts, regular interest-bearing savings accounts and certificates of deposit with a range of maturity date options. The primary sources of deposits are small and medium-sized businesses and individuals within our target market. Senior management has the authority to set rates within specified parameters in order to remain competitive with other financial institutions in our market area. All deposits are insured by the FDIC up to the maximum amount permitted by law. We have a service charge fee schedule, which is generally competitive with other financial institutions in our market, covering such matters as maintenance fees and per item processing fees on checking accounts, returned check charges and other similar fees.
Courier Services
We offer courier services to our business customers. Courier services permit us to provide the convenience and personalized service that our customers require by scheduling pick-ups of deposits and other banking transactions.
Deposit on Demand
We provide our commercial banking customers electronic deposit capability through our Deposit on Demand product. Business customers who sign up for this service can scan their deposits and send electronic batches of their deposits to the Bank. This product reduces or eliminates the need for businesses with daily deposits and high check volume to visit the Bank and provides the benefit of viewing images of deposited checks.
Telephone and Internet Banking
We believe that there is a strong demand within our market for telephone banking and internet banking. These services allow both commercial and retail customers to access detailed account information and execute a wide variety of the banking transactions, including balance transfers and bill payment. We believe that these services are particularly attractive to our customers, as it enables them at any time to conduct their banking business and monitor their accounts. Telephone and internet banking assists us in attracting and retaining customers and encourages our existing customers to consider Cardinal for all of their banking and financial needs.
During 2007, we introduced Cardinal Mobile Banking to our customers. Customers who sign up for this service can access their accounts from any internet-enabled cell phone, PDA or mobile device. Customers can check their balance, view account activity, transfer funds between deposit accounts, and may pay their bill online. Cardinal Mobile Banking is encrypted using the Wireless Transport Layer Security (WTLS) protocol, which provides the highest level of security available today. As part of our Mobile Banking service, customers can also receive text messages about their account balances and recent transaction activity.
Automatic Teller Machines
We have an ATM at each of our branch offices and we make other financial institutions' ATMs available to our customers.
Other Products and Services
We offer other banking-related specialized products and services to our customers, such as travelers' checks, coin counters, wire services, and safe deposit box services. We issue letters of credit
and standby letters of credit for some of our commercial customers, most of which are related to real estate construction loans. We have not engaged in any securitizations of loans.
Credit Policies
Our chief credit officer and senior lending officers are primarily responsible for maintaining both a quality loan portfolio and a strong credit culture throughout the organization. The chief credit officer is responsible for developing and updating our credit policies and procedures, which are approved by the board of directors. The chief credit officer and senior lending officers may make exceptions to these credit policies and procedures as appropriate, but any such exception must be documented and made for sound business reasons.
Credit quality is controlled by the chief credit officer through compliance with our credit policies and procedures. Our risk-decision process is actively managed in a disciplined fashion to maintain an acceptable risk profile characterized by soundness, diversity, quality, prudence, balance and accountability. Our credit approval process consists of specific authorities granted to the lending officers and combinations of lending officers. Loans exceeding a particular lending officer's level of authority, or the combined limit of several officers, are reviewed and considered for approval by an officers' loan committee and, when above a specified amount, by a committee of the Bank's board of directors. Generally, loans of $1,500,000 or more require committee approval. Our policy allows exceptions for very specific conditions, such as loans secured by deposits at our Bank. The chief credit officer works closely with each lending officer at the Bank level to ensure that the business being solicited is of the quality and structure that fits our desired risk profile.
Under our credit policies, we monitor our concentration of credit risk. We have established credit concentration guideline limits for commercial and industrial loans, real estate-commercial loans, real estate-residential loans and consumer purpose loans, which include home equity loans. Furthermore, the Bank has established limits on the total amount of the Bank's outstanding loans to one borrower, all of which are set below legal lending limits.
Loans closed by George Mason are underwritten in accordance with guidelines established by the various secondary market investors to which George Mason sells its loans.
Brokerage and Asset Management Services
CWS provides brokerage and investment services through an arrangement with Raymond James Financial Services, Inc. Under this arrangement, financial advisors can offer our customers an extensive range of investment products and services, including estate planning, qualified retirement plans, mutual funds, annuities, life insurance, fixed income and equity securities and equity research and recommendations. Through Wilson/Bennett, we also offer asset management services to customers using a value-oriented approach that focuses on large capitalization stocks.
The Bank has a trust division, and services provided by our trust division include trust, estates, custody, investment management, escrows, and retirement plans. The addition of trust services diversifies the Bank's sources of non-interest income and allows us to provide additional services to our customers.
Employees
At December 31, 2009, we had 368 full-time equivalent employees. None of our employees are represented by any collective bargaining unit. We believe our relations with our employees are good.
Government Supervision and Regulation
General
As a financial holding company, we are subject to regulation under the Bank Holding Company Act of 1956, as amended, and the examination and reporting requirements of the Board of Governors of the Federal Reserve System. Other federal and state laws govern the activities of our bank subsidiary, including the activities in which it may engage, the investments that it makes, the aggregate amount of loans that it may grant to one borrower, and the dividends it may declare and pay to us. Our bank subsidiary is also subject to various consumer and compliance laws. As a state-chartered bank, the Bank is primarily subject to regulation, supervision and examination by the Bureau of Financial Institutions of the Virginia State Corporation Commission. Our bank subsidiary also is subject to regulation, supervision and examination by the Federal Deposit Insurance Corporation. As part of our bank subsidiary, George Mason and Cardinal First are subject to the same regulations as the Bank.
The following description summarizes the more significant federal and state laws applicable to us. To the extent that statutory or regulatory provisions are described, the description is qualified in its entirety by reference to that particular statutory or regulatory provision.
The Bank Holding Company Act
Under the Bank Holding Company Act, we are subject to periodic examination by the Federal Reserve and required to file periodic reports regarding our operations and any additional information that the Federal Reserve may require. Our activities at the bank holding company level are limited to:
•banking, managing or controlling banks;
•furnishing services to or performing services for our subsidiaries; and
•engaging in other activities that the Federal Reserve has determined by regulation or order to be so closely related to banking as to be a proper incident to these activities.
Some of the activities that the Federal Reserve Board has determined by regulation to be closely related to the business of a bank holding company include making or servicing loans and specific types of leases, performing specific data processing services and acting in some circumstances as a fiduciary or investment or financial adviser.
With some limited exceptions, the Bank Holding Company Act requires every bank holding company to obtain the prior approval of the Federal Reserve before:
•acquiring substantially all the assets of any bank; and
•acquiring direct or indirect ownership or control of any voting shares of any bank if after such acquisition it would own or control more than 5% of the voting shares of such bank (unless it already owns or controls the majority of such shares), or merging or consolidating with another bank holding company.
In addition, and subject to some exceptions, the Bank Holding Company Act and the Change in Bank Control Act, together with their regulations, require Federal Reserve approval prior to any person or company acquiring "control" of a bank holding company. Control is conclusively presumed to exist if an individual or company acquires 25% or more of any class of voting securities of the bank holding company. Control is rebuttably presumed to exist if a person acquires 10% or more, but less than 25%, of any class of voting securities and if the institution has registered securities under Section 12 of the Securities Exchange Act of 1934 or no other person owns a greater percentage of that class of voting securities immediately after the transaction. The regulations provide a procedure for challenging this rebuttable control presumption.
In November 1999, Congress enacted the Gramm-Leach-Bliley Act ("GLBA"), which made substantial revisions to the statutory restrictions separating banking activities from other financial activities. Under the GLBA, bank holding companies that are well-capitalized and well-managed and meet other conditions can elect to become "financial holding companies." As financial holding companies, they and their subsidiaries are permitted to acquire or engage in previously impermissible activities, such as insurance underwriting and securities underwriting and distribution. In addition, financial holding companies may also acquire or engage in certain activities in which bank holding companies are not permitted to engage in, such as travel agency activities, insurance agency activities, merchant banking and other activities that the Federal Reserve determines to be financial in nature or complementary to these activities. Financial holding companies continue to be subject to the overall oversight and supervision of the Federal Reserve, but the GLBA applies the concept of functional regulation to the activities conducted by subsidiaries. For example, insurance activities would be subject to supervision and regulation by state insurance authorities. We became a financial holding company in 2004.
Payment of Dividends
We are a legal entity separate and distinct from Cardinal Bank, CWS, Wilson/Bennett, and Cardinal Statutory Trust I. Virtually all of our cash revenues will result from dividends paid to us by our bank subsidiary and interest earned on short term investments. Our bank subsidiary is subject to laws and regulations that limit the amount of dividends that it can pay. Under Virginia law, a bank may not declare a dividend in excess of its accumulated retained earnings. Additionally, our bank subsidiary may not declare a dividend if the total amount of all dividends, including the proposed dividend, declared by the bank in any calendar year exceeds the total of the bank's retained net income of that year to date, combined with its retained net income of the two preceding years, unless the dividend is approved by the FDIC. Our bank subsidiary may not declare or pay any dividend if, after making the dividend, the bank would be "undercapitalized," as defined in the banking regulations.
The FDIC and the state have the general authority to limit the dividends paid by insured banks if the payment is deemed an unsafe and unsound practice. Both the state and the FDIC have indicated that paying dividends that deplete a bank's capital base to an inadequate level would be an unsound and unsafe banking practice.
In addition, we are subject to certain regulatory requirements to maintain capital at or above regulatory minimums. These regulatory requirements regarding capital affect our dividend policies. Regulators have indicated that financial holding companies should generally pay dividends only if the organization's net income available to common shareholders over the past year has been sufficient to fully fund the dividends, and the prospective rate of earnings retention appears consistent with the organization's capital needs, asset quality and overall financial condition.
Insurance of Accounts, Assessments and Regulation by the FDIC
The deposits of our bank subsidiary are insured by the FDIC up to the limits set forth under applicable law. The deposits of our bank subsidiary are subject to the deposit insurance assessments of the Bank Insurance Fund, or "BIF", of the FDIC.
The FDIC has implemented a risk-based deposit insurance assessment system under which the assessment rate for an insured institution may vary according to regulatory capital levels of the institution and other factors, including supervisory evaluations. In addition to being influenced by the risk profile of the particular depository institution, FDIC premiums are also influenced by the size of the FDIC insurance fund in relation to total deposits in FDIC insured banks. The FDIC has authority to impose special assessments.
In February 2006, The Federal Deposit Insurance Reform Act of 2005 and The Federal Deposit Insurance Reform Conforming Amendments Act of 2005 (collectively, "The Reform Act") was signed into law. This legislation contained technical and conforming changes to implement deposit insurance reform, as well as a number of study and survey requirements.
The Reform Act provides for the following changes:
•Merging the BIF and the Savings Association Insurance Fund ("SAIF") into a new fund, the Deposit Insurance Fund ("DIF"). This change was made effective March 31, 2006.
•Increasing the coverage limit for retirement accounts to $250,000 and indexing the coverage limit for retirement accounts to inflation as with the general deposit insurance coverage limit. This change was made effective April 1, 2006.
•Establishing a range of 1.15 percent to 1.50 percent within which the FDIC Board of Directors may set the Designated Reserve Ratio ("DRR").
•Allowing the FDIC to manage the pace at which the reserve ratio varies within this range.
1.If the reserve ratio falls below 1.15 percent-or is expected to within 6 months-the FDIC must adopt a restoration plan that provides that the DIF will return to 1.15 percent generally within 5 years.
2.If the reserve ratio exceeds 1.35 percent, the FDIC must generally dividend to DIF members half of the amount above the amount necessary to maintain the DIF at 1.35 percent, unless the FDIC Board, considering statutory factors, suspends the dividends.
3.If the reserve ratio exceeds 1.5 percent, the FDIC must generally dividend to DIF members all amounts above the amount necessary to maintain the DIF at 1.5 percent.
•Eliminating the restrictions on premium rates based on the DRR and granting the FDIC Board the discretion to price deposit insurance according to risk for all insured institutions regardless of the level of the reserve ratio.
•Granting a one-time initial assessment credit (of approximately $4.7 billion) to recognize institutions' past contributions to the fund.
•Requiring the FDIC to conduct studies of three issues: (1) further potential changes to the deposit insurance system, (2) the appropriate deposit base in designating the reserve ratio, and (3) the FDIC's contingent loss reserving methodology and accounting for losses.
•Requiring the Comptroller General to conduct studies of (1) federal bank regulators' administration of the prompt corrective action program and recent changes to the FDIC deposit insurance system, and (2) the organizational structure of the FDIC.
Pursuant to the Emergency Economic Stabilization Act of 2008 ("EESA"), the maximum deposit insurance amount per depositor has been increased from $100,000 to $250,000 until December 31, 2013. Additionally, on October 14, 2008, after receiving a recommendation from the boards of the FDIC and the Federal Reserve, and consulting with the President, the Secretary of the Treasury signed the systemic risk exception to the FDIC Act, enabling the FDIC to establish it's Temporary Liquidity Guarantee Program ("TLGP"). Under the transaction account guarantee program of the TLGP, the FDIC will fully guarantee, until December 31, 2013, all non-interest-bearing transaction accounts, including NOW accounts with interest rates of 0.5 percent or less and IOLTAs (lawyer trust accounts). On January 1, 2014, the standard insurance amount will return to $100,000 per depositor for all account categories except for individual retirement accounts and other certain retirement accounts which will remain at $250,000 per depositor. Institutions were required to opt-out of the TLGP if they did not wish to participate. The Company and its applicable subsidiaries elected to participate in this program.
In May 2009, the FDIC adopted a final rule imposing a 5 basis point special assessment on each insured financial institution's total assets minus its tier 1 capital as of June 30, 2009 to be paid on September 30, 2009. This special assessment assisted the FDIC in the replenishment of the Deposit Insurance Fund as a result of the increase in financial institution failures during 2008 and 2009. The special assessment imposed on Cardinal Bank was $844,000. In November 2009, the FDIC adopted a final rule to require insured financial institutions to prepay slightly over three years of estimated insurance assessments. This prepayment allows the FDIC to strengthen the cash position of the Deposit Insurance Fund immediately without immediately impacting earnings of the industry. The payment of the prepaid assessment was due on December 30, 2009. Cardinal Bank's prepaid assessment was $6.7 million.
The FDIC is authorized to prohibit any insured institution from engaging in any activity that the FDIC determines by regulation or order to pose a serious threat to the DIF. Also, the FDIC may initiate enforcement actions against banks, after first giving the institution's primary regulatory authority an opportunity to take such action. The FDIC may terminate the deposit insurance of any depository institution if it determines, after a hearing, that the institution has engaged or is engaging in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, order or any condition imposed in writing by the FDIC. It also may suspend deposit insurance temporarily during the hearing process for the permanent termination of insurance, if the institution has no tangible capital. If deposit insurance is terminated, the deposits at the institution at the time of termination, less subsequent withdrawals, shall continue to be insured for a period from six months to two years, as determined by the FDIC. We are unaware of any existing circumstances that could result in termination of any of our bank subsidiary's deposit insurance.
Capital Requirements
Each of the FDIC and the Federal Reserve Board has issued risk-based and leverage capital guidelines applicable to banking organizations that it supervises. Under the risk-based capital requirements, we and our bank subsidiary are each generally required to maintain a minimum ratio of total capital to risk-weighted assets (including specific off-balance sheet activities, such as standby letters of credit) of 8%. At least half of the total capital must be composed of "Tier 1 Capital," which is defined as common equity, retained earnings, qualifying perpetual preferred stock and minority interests in common equity accounts of consolidated subsidiaries, less certain intangibles. The remainder may consist of "Tier 2 Capital", which is defined as specific subordinated debt, some hybrid capital instruments and other qualifying preferred stock and a limited amount of the loan loss allowance and pretax net unrealized holding gains on certain equity securities. In addition, each of the federal banking regulatory agencies has established minimum leverage capital requirements for banking organizations. Under these requirements, banking organizations must maintain a minimum ratio of Tier 1 capital to adjusted average quarterly assets equal to 3% to 5%, subject to federal bank regulatory evaluation of an organization's overall safety and soundness. In summary, the capital measures used by the federal banking regulators are:
•Total Risk-Based Capital ratio, which is the total of Tier 1 Risk-Based Capital (which includes common shareholders' equity, trust preferred securities, minority interests and qualifying preferred stock, less goodwill and other adjustments) and Tier 2 Capital (which includes preferred stock not qualifying as Tier 1 capital, mandatory convertible debt, limited amounts of subordinated debt, other qualifying term debt and the allowance for loan losses up to 1.25 percent of risk-weighted assets and other adjustments) as a percentage of total risk-weighted assets
•Tier 1 Risk-Based Capital ratio (Tier 1 capital divided by total risk-weighted assets), and
•the Leverage ratio (Tier 1 capital divided by adjusted average total assets).
Under these regulations, a bank will be:
•"well capitalized" if it has a Total Risk-Based Capital ratio of 10% or greater, a Tier 1 Risk-Based Capital ratio of 6% or greater, a Leverage ratio of 5% or greater, and is not subject to any written agreement, order, capital directive, or prompt corrective action directive by a federal bank regulatory agency to meet and maintain a specific capital level for any capital measure
•"adequately capitalized" if it has a Total Risk-Based Capital ratio of 8% or greater, a Tier 1 Risk-Based Capital ratio of 4% or greater, and a Leverage ratio of 4% or greater (or 3% in certain circumstances) and is not well capitalized
•"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 3% in certain circumstances), or a Leverage ratio of less than 4% (or 3% in certain circumstances)
•"significantly undercapitalized" if it has a Total Risk-Based Capital ratio of less than 6%, a Tier 1 Risk-Based Capital ratio of less than 3%, or a Leverage ratio of less than 3%, or
•"critically undercapitalized" if its tangible equity is equal to or less than 2% of tangible assets.
The risk-based capital standards of each of the FDIC and the Federal Reserve Board explicitly identify concentrations of credit risk and the risk arising from non-traditional activities, as well as an institution's ability to manage these risks, as important factors to be taken into account by the agency in assessing an institution's overall capital adequacy. The capital guidelines also provide that an institution's exposure to a decline in the economic value of its capital due to changes in interest rates be considered by the agency as a factor in evaluating a banking organization's capital adequacy.
The FDIC may take various corrective actions against any undercapitalized bank and any bank that fails to submit an acceptable capital restoration plan or fails to implement a plan acceptable to the FDIC. These powers include, but are not limited to, requiring the institution to be recapitalized, prohibiting asset growth, restricting interest rates paid, requiring prior approval of capital distributions by any financial holding company that controls the institution, requiring divestiture by the institution of its subsidiaries or by the holding company of the institution itself, requiring new election of directors, and requiring the dismissal of directors and officers. We are considered "well-capitalized" at December 31, 2009 and, in addition, our bank subsidiary maintains sufficient capital to remain in compliance with capital requirements and is considered "well-capitalized" at December 31, 2009.
Other Safety and Soundness Regulations
There are significant obligations and restrictions imposed on financial holding companies and their depository institution subsidiaries by federal law and regulatory policy that are designed to reduce potential loss exposure to the depositors of such depository institutions and to the FDIC insurance fund in the event that the depository institution is insolvent or is in danger of becoming insolvent. These obligations and restrictions are not for the benefit of investors. Regulators may pursue an administrative action against any financial holding company or bank which violates the law, engages in an unsafe or unsound banking practice, or which is about to engage in an unsafe or unsound banking practice. The administrative action could take the form of a cease and desist proceeding, a removal action against the responsible individuals or, in the case of a violation of law or unsafe and unsound banking practice, a civil monetary penalty action. A cease and desist order, in addition to prohibiting certain action, could also require that certain actions be undertaken. Under the policies of the Federal Reserve Board, we are required to serve as a source of financial strength to our subsidiary depository institution and to commit resources to support the Bank in circumstances where we might not do so otherwise.
The Bank Secrecy Act
Under the Bank Secrecy Act ("BSA"), a financial institution is required to have systems in place to detect certain transactions, based on the size and nature of the transaction. Financial institutions are generally required to report cash transactions involving more than $10,000 to the United States Treasury. In addition, financial institutions are required to file Suspicious Activity Reports for transactions that involve more than $5,000 and which the financial institution knows, suspects or has reason to suspect, involves illegal funds, is designed to evade the requirements of the BSA or has no lawful purpose. The USA PATRIOT Act of 2001, enacted in response to the September 11, 2001 terrorist attacks, requires bank regulators to consider a financial institution's compliance with the BSA when reviewing applications from a financial institution. As part of its BSA program, the USA PATRIOT Act of 2001 also requires a financial institution to follow recently implemented customer identification procedures when opening accounts for new customers and to review U.S. government-maintained lists of individuals and entities that are prohibited from opening accounts at financial institutions.
Monetary Policy
The commercial banking business is affected not only by general economic conditions but also by the monetary policies of the Federal Reserve Board. The instruments of monetary policy employed by the Federal Reserve Board include open market operations in United States government securities, changes in the discount rate on member bank borrowings and changes in reserve requirements against deposits held by federally insured banks. The Federal Reserve Board's monetary policies have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future. In view of changing conditions in the national and international economy and in the money markets, as well as the effect of actions by monetary and fiscal authorities, including the Federal Reserve System, no prediction can be made as to possible future changes in interest rates, deposit levels, loan demand or the business and earnings of our bank subsidiary, its subsidiary, or any of our other subsidiaries.
Federal Reserve System
In 1980, Congress enacted legislation that imposed reserve requirements on all depository institutions that maintain transaction accounts or non-personal time deposits. NOW accounts and demand deposit accounts that permit payments or transfers to third parties fall within the definition of transaction accounts and are subject to these reserve requirements. For net transaction accounts in 2010, the first $10.7 million of balances will be exempt from reserve requirements. A 3% reserve ratio will be assessed on net transaction account balances over $10.7 million to and including $55.2 million. A 10% reserve ratio will be applied to amounts in net transaction account balances in excess of $55.2 million. These percentages are subject to adjustment by the Federal Reserve Board. Because required reserves must be maintained in the form of vault cash or in a non-interest-bearing account at, or on behalf of, a Federal Reserve Bank, the effect of the reserve requirement is to reduce the amount of our interest-earning assets. Beginning October 2008, the Federal Reserve Banks pay financial institutions interest on their required reserve balances and excess funds deposited with the Federal Reserve. The interest rate paid is the targeted federal funds rate.
Transactions with Affiliates
Transactions between banks and their affiliates are governed by Sections 23A and 23B of the Federal Reserve Act. An affiliate of a bank is any bank or entity that controls, is controlled by or is under common control with such bank. Generally, Sections 23A and 23B (i) limit the extent to which the bank or its subsidiaries may engage in "covered transactions" with any one affiliate to an amount equal to 10% of such institution's capital stock and surplus, and maintain an aggregate limit on all such
transactions with affiliates to an amount equal to 20% of such capital stock and surplus, and (ii) require that all such transactions be on terms substantially the same as, or at least as favorable to those that, the bank has provided to a non-affiliate. The term "covered transaction" includes the making of loans, purchase of assets, issuance of a guarantee and similar other types of transactions. Section 23B applies to "covered transactions" as well as sales of assets and payments of money to an affiliate. These transactions must also be conducted on terms substantially the same as, or at least favorable to those that, the bank has provided to non-affiliates.
Loans to Insiders
The Federal Reserve Act and related regulations impose specific restrictions on loans to directors, executive officers and principal shareholders of banks. Under Section 22(h) of the Federal Reserve Act, loans to a director, an executive officer and to a principal shareholder of a bank, and to entities controlled by any of the foregoing, may not exceed, together with all other outstanding loans to such person and entities controlled by such person, the bank's loan-to-one borrower limit. Loans in the aggregate to insiders and their related interests as a class may not exceed two times the bank's unimpaired capital and unimpaired surplus until the bank's total assets equal or exceed $100,000,000, at which time the aggregate is limited to the bank's unimpaired capital and unimpaired surplus. Section 22(h) also prohibits loans above amounts prescribed by the appropriate federal banking agency to directors, executive officers and principal shareholders of a bank or bank holding company, and to entities controlled by such persons, unless such loan is approved in advance by a majority of the board of directors of the bank with any "interested" director not participating in the voting. The FDIC has prescribed the loan amount, which includes all other outstanding loans to such person, as to which such prior board of director approval is required, as being the greater of $25,000 or 5% of capital and surplus (up to $500,000). Section 22(h) requires that loans to directors, executive officers and principal shareholders be made on terms and underwriting standards substantially the same as offered in comparable transactions to other persons.
Community Reinvestment Act
Under the Community Reinvestment Act and related regulations, depository institutions have an affirmative obligation to assist in meeting the credit needs of their market areas, including low and moderate-income areas, consistent with safe and sound banking practice. The Community Reinvestment Act requires the adoption by each institution of a Community Reinvestment Act statement for each of its market areas describing the depository institution's efforts to assist in its community's credit needs. Depository institutions are periodically examined for compliance with the Community Reinvestment Act and are periodically assigned ratings in this regard. Banking regulators consider a depository institution's Community Reinvestment Act rating when reviewing applications to establish new branches, undertake new lines of business, and/or acquire part or all of another depository institution. An unsatisfactory rating can significantly delay or even prohibit regulatory approval of a proposed transaction by a financial holding company or its depository institution subsidiaries.
The Gramm-Leach-Bliley Act ("GLBA") and federal bank regulators have made various changes to the Community Reinvestment Act. Among other changes, Community Reinvestment Act agreements with private parties must be disclosed and annual reports must be made to a bank's primary federal regulator. A financial holding company or any of its subsidiaries will not be permitted to engage in new activities authorized under the GLBA if any bank subsidiary received less than a "satisfactory" rating in its latest Community Reinvestment Act examination.
Consumer Laws Regarding Fair Lending
In addition to the Community Reinvestment Act described above, other federal and state laws regulate various lending and consumer aspects of our business. Governmental agencies, including the
Department of Housing and Urban Development, the Federal Trade Commission and the Department of Justice, have become concerned that prospective borrowers may experience discrimination in their efforts to obtain loans from depository and other lending institutions. These agencies have brought litigation against depository institutions alleging discrimination against borrowers. Many of these suits have been settled, in some cases for material sums of money, short of a full trial.
These governmental agencies have clarified what they consider to be lending discrimination and have specified various factors that they will use to determine the existence of lending discrimination under the Equal Credit Opportunity Act and the Fair Housing Act, including evidence that a lender discriminated on a prohibited basis, evidence that a lender treated applicants differently based on prohibited factors in the absence of evidence that the treatment was the result of prejudice or a conscious intention to discriminate, and evidence that a lender applied an otherwise neutral non-discriminatory policy uniformly to all applicants, but the practice had a discriminatory effect, unless the practice could be justified as a business necessity.
Banks and other depository institutions also are subject to numerous consumer-oriented laws and regulations. These laws, which include the Truth in Lending Act, the Truth in Savings Act, the Real Estate Settlement Procedures Act, the Electronic Funds Transfer Act, the Equal Credit Opportunity Act, and the Fair Housing Act, require compliance by depository institutions with various disclosure requirements and requirements regulating the availability of funds after deposit or the making of some loans to customers.
Gramm-Leach-Bliley Act of 1999
The Gramm-Leach-Bliley Act of 1999 covers a broad range of issues, including a repeal of most of the restrictions on affiliations among depository institutions, securities firms and insurance companies. The following description summarizes some of its significant provisions.
The GLBA repeals sections 20 and 32 of the Glass-Steagall Act, thus permitting unrestricted affiliations between banks and securities firms. It also permits bank holding companies to elect to become financial holding companies. A financial holding company may engage in or acquire companies that engage in a broad range of financial services, including securities activities such as underwriting, dealing, investment, merchant banking, insurance underwriting, sales and brokerage activities. In order to become a financial holding company, the bank holding company and all of its affiliated depository institutions must be well-capitalized, well-managed and have at least a satisfactory Community Reinvestment Act rating. We became a financial holding company in 2004.
The GLBA provides that the states continue to have the authority to regulate insurance activities, but prohibits the states in most instances from preventing or significantly interfering with the ability of a bank, directly or through an affiliate, to engage in insurance sales, solicitations or cross-marketing activities. Although the states generally must regulate bank insurance activities in a nondiscriminatory manner, the states may continue to adopt and enforce rules that specifically regulate bank insurance activities in areas identified under the law. Under the law, the federal bank regulatory agencies adopted insurance consumer protection regulations that apply to sales practices, solicitations, advertising and disclosures.
The GLBA adopts a system of functional regulation under which the Federal Reserve Board is designated as the umbrella regulator for financial holding companies, but financial holding company affiliates are principally regulated by functional regulators such as the FDIC for bank affiliates, the Securities and Exchange Commission for securities affiliates, and state insurance regulators for insurance affiliates. It repeals the broad exemption of banks from the definitions of "broker" and "dealer" for purposes of the Securities Exchange Act of 1934, as amended. It also identifies a set of specific activities, including traditional bank trust and fiduciary activities, in which a bank may engage without being deemed a "broker," and a set of activities in which a bank may engage without being
deemed a "dealer." Additionally, GLBA makes conforming changes in the definitions of "broker" and "dealer" for purposes of the Investment Company Act of 1940, as amended, and the Investment Advisers Act of 1940, as amended.
The GLBA contains extensive customer privacy protection provisions. Under these provisions, a financial institution must provide to its customers, both at the inception of the customer relationship and on an annual basis, the institution's policies and procedures regarding the handling of customers' nonpublic personal financial information. The law provides that, except for specific limited exceptions, an institution may not provide such personal information to unaffiliated third parties unless the institution discloses to the customer that such information may be so provided and the customer is given the opportunity to opt out of such disclosure. An institution may not disclose to a non-affiliated third party, other than to a consumer credit reporting agency, customer account numbers or other similar account identifiers for marketing purposes. The GLBA also provides that the states may adopt customer privacy protections that are stricter than those contained in the act.
Future Regulatory Uncertainty
Because federal and state regulation of financial institutions changes regularly and is the subject of constant legislative debate, we cannot forecast how federal and state regulation of financial institutions may change in the future and, as a result, impact our operations. Although Congress and the state legislature in recent years have sought to reduce the regulatory burden on financial institutions with respect to the approval of specific transactions, we fully expect that the financial institution industry will remain heavily regulated in the near future and that additional laws or regulations may be adopted further regulating specific banking practices.
Additional Information
We file with or furnish to the Securities and Exchange Commission ("SEC") annual, quarterly and current reports, proxy statements, and various other documents under the Securities Exchange Act of 1934, as amended (the "Exchange Act"). The public may read and copy any materials that we file with or furnish to the SEC at the SEC's Public Reference Room, which is located at 100 F Street, NE, Washington, D.C. 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. Also, the SEC maintains an internet website at www.sec.gov that contains reports, proxy and information statements and other information regarding registrants, including us, that file or furnish documents electronically with the SEC.
We also make available free of charge on or through our internet website (www.cardinalbank.com) our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and, if applicable, amendments to those reports as filed or furnished pursuant to Section 13(a) of the Exchange Act as soon as reasonably practicable after we electronically file such materials with, or furnish them to, the SEC.
Item 1A.
Item 1A. Risk Factors
We are subject to various risks, including the risks described below. Our operations, financial condition and performance and, therefore, the market value of our Common Stock could be adversely affected by any of these risks or additional risks not presently known or that we currently deem immaterial.
Difficult market conditions continue to adversely affect our industry.
Dramatic declines in the housing market, with falling home prices and increasing foreclosures, followed by unemployment and under-employment, have negatively impacted the credit performance of real estate related loans and consumer loans and resulted in significant write-downs of asset values by financial institutions. These write-downs spread to other securities and loans and have caused many financial institutions to seek additional capital, to reduce or eliminate dividends, to merge with larger and stronger institutions and, in some cases, to fail. In this environment, many lenders and institutional investors have reduced or ceased providing funding to borrowers, including to other financial institutions. This market turmoil and tightening of credit have led to an increased level of commercial and consumer delinquencies, lack of consumer confidence, increased market volatility and reduction of business activity generally. Continuing economic pressure on consumers may adversely affect our business and results of operations. Market developments may affect consumer confidence levels and may cause adverse changes in payment patterns, causing increases in delinquencies and default rates, which may impact our charge-offs and provision for credit losses. A worsening of these conditions would likely exacerbate the adverse effects of these difficult market conditions on us and others in the financial institutions industry.
Recent levels of market volatility are unprecedented.
The capital and credit markets have recently experienced volatility and disruption. In some cases, the markets have produced downward pressure on stock prices and credit availability for certain issuers without regard to those issuers' underlying financial strength. If recent levels of market disruption and volatility recur, there can be no assurance that we will not experience an adverse effect, which may be material, on our ability to access capital and on our business, financial condition and results of operations.
Our mortgage banking revenue is sensitive to changes in economic conditions, decreased economic activity, a slowdown in the housing market or higher interest rates and may adversely impact our profits.
Our mortgage banking segment is a significant portion of our consolidated business and maintaining our revenue stream in this segment is dependent upon our ability to originate loans and sell them to investors. Loan production levels are sensitive to changes in economic conditions and recently have suffered from a slowdown in the local housing market and tightening credit conditions. Any sustained period of decreased activity caused by further housing price pressure, loan underwriting restrictions or higher interest rates would adversely affect our mortgage originations and, consequently, reduce our income from mortgage banking activities. As a result, these conditions would also adversely affect our net income.
Deteriorating economic conditions may also cause home buyers to default on their mortgages. In certain of these cases where we have originated loans and sold them to investors, we may be required to repurchase loans or provide a financial settlement to investors if it is proven that the borrower failed to provide full and accurate information on or related to their loan application or for which appraisals have not been acceptable or when the loan was not underwritten in accordance with the loan program specified by the loan investor. Such repurchases or settlements would also adversely affect our net income.
George Mason, as part of the service it provides to its managed companies, purchases the loans managed companies originate at the time of origination. These loans are then sold by George Mason to investors. George Mason has agreements with its managed companies requiring that, for any loans that were originated by a managed company and for which investors have requested George Mason to repurchase due to the borrowers failure to provide full and accurate information on or related to their loan application or for which appraisals have not been acceptable or when the loan was not underwritten in accordance with the loan program specified by the loan investor, the managed company be responsible for buying back the loan. In the event that the managed company's financial condition deteriorates and it is unable to fund the repurchase of such loans, George Mason may have to provide the funds to repurchase these loans from investors.
We have goodwill and other intangibles that may become impaired, and thus result in a charge against earnings.
At December 31, 2009, we had $10.1 million and $2.8 million of goodwill related to the George Mason and Wilson/Bennett acquisitions, respectively. In addition, we have identified and recorded other intangible assets, such as customer relationships and trade names, as of the acquisition dates of both George Mason and Wilson/Bennett. The carrying amounts of these intangibles at December 31, 2009 was $742,000 at George Mason and $127,000 at Wilson/Bennett. Goodwill and other intangibles are tested for impairment on an annual basis or when facts and circumstances indicate that impairment may have occurred.
As noted above, our mortgage banking segment is sensitive to changes in economic conditions, decreased economic activity, a slowdown in the housing market and higher interest rates. During the third quarter of 2008, we recorded a noncash impairment charge of $2.8 million in the mortgage banking segment. The aforementioned factors may result in an additional impairment charge related to the goodwill and other intangibles at George Mason if we determine the carrying value of the reporting unit, including its goodwill and other intangible assets, is greater than their fair value.
During 2009, we performed the required annual test for impairment of goodwill related to our acquisition of George Mason, and our analysis showed the current carrying value of goodwill to be less than the fair value. Therefore, no impairment was recorded.
During 2009 and 2008, we performed the required annual test for impairment of goodwill related to our acquisition of Wilson/Bennett, and no goodwill impairment was indicated. However, future decreases in assets managed by Wilson/Bennett as a result of declines in its client base or the lack of success in attracting and maintaining new clients may result in a decline in investment management fees and may result in a future impairment charge.
We may be forced to recognize impairment charges in the future as operating and economic conditions change.
We may be adversely impacted by changes in the condition of financial markets.
We are directly and indirectly affected by changes in market conditions. Market risk generally represents the risk that values of assets and liabilities or revenues will be adversely affected by changes in market conditions. Market risk is inherent in the financial instruments associated with our operations and activities including loans, deposits, securities, short-term borrowings, long-term debt, trading account assets and liabilities, and derivatives. Just a few of the market conditions that may shift from time to time, thereby exposing us to market risk, include fluctuations in interest and currency exchange rates, equity and futures prices, and price deterioration or changes in value due to changes in market perception or actual credit quality of issuers. Accordingly, depending on the instruments or activities impacted, market risks can have adverse effects on our results of operations and our overall financial condition.
Recently, the subprime mortgage market dislocation has also impacted the ratings of certain monoline insurance providers which, in turn, has affected the pricing of certain municipal securities and the liquidity of the short term public finance markets. We have some exposure to monolines and, as a result, are continuing to monitor this exposure as the markets evolve.
We have investments in pooled trust preferred securities, totaling $8.0 million at December 31, 2009. The collateral underlying these structured securities are instruments issued by financial institutions or insurers. We own the A-3 tranches in each issue. Each of these bonds are rated by more than one rating agency. Two of the securities have composite ratings of AA and two of the securities have a composite rating of BBB. These ratings are consistent with the grades from other rating agencies. There is minimal observable trading activity for these types of securities. We have estimated the fair value of the securities through the use of internal calculations and through information provided by external pricing services. Given the level of subordination below our A-3 tranches, and the actual and expected performance of the underlying collateral, we expect to receive all contractual interest and principal payments and concluded that these securities are not other-than-temporarily impaired. These securities are classified as held-to-maturity.
We may be adversely affected by economic conditions in our market area.
We are headquartered in Northern Virginia, and our market is the greater Washington, D.C. metropolitan area. Because our lending and deposit-gathering activities are concentrated in this market, we will be affected by the general economic conditions in the greater Washington area, which may, among other factors, be impacted by the level of federal government spending. Changes in the economy, and government spending in particular, may influence the growth rate of our loans and deposits, the quality of the loan portfolio and loan and deposit pricing. A significant decline in general economic condition caused by inflation, recession, unemployment or other factors, would impact these local economic conditions and the demand for banking products and services generally, and could negatively affect our financial condition and performance.
Our concentration in commercial real estate and business loans may increase our future credit losses, which would negatively affect our financial results.
We offer a variety of secured loans, including commercial lines of credit, commercial term loans, real estate, construction, home equity, consumer and other loans. Approximately 86% of our loans are secured by real estate, both residential and commercial, substantially all of which are located in our market area. A major change in the region's real estate market, resulting in a deterioration in real estate values, or in the local or national economy, including changes caused by raising interest rates, could adversely affect our customers' ability to pay these loans, which in turn could adversely impact us. Risk of loan defaults and foreclosures are inherent in the banking industry, and we try to limit our exposure to this risk by carefully underwriting and monitoring our extensions of credit. We cannot fully eliminate credit risk, and as a result credit losses may occur in the future.
Commercial real estate and business loans increase our exposure to credit risks.
At December 31, 2009, our portfolio of commercial and industrial and commercial real estate (including construction) totaled $945.5 million, or 73% of total loans. We plan to continue to emphasize the origination of loans to small and medium-sized businesses as well as government contractors, professionals, such as physicians, accountants and attorneys, and commercial real estate developers and builders, which generally exposes us to a greater risk of nonpayment and loss than residential real estate loans because repayment of such loans often depends on the successful operations and cash flows of the borrowers. Additionally, such loans typically involve larger loan balances to single borrowers or groups of related borrowers compared to residential real estate loans. Also, many of our borrowers have more than one commercial loan outstanding. Consequently, an
adverse development with respect to one loan or one credit relationship can expose us to a significantly greater risk of loss compared to an adverse development with respect to a residential real estate loan. In addition, these small to medium-sized businesses generally have fewer financial resources in terms of capital or borrowing capacity than larger entities. If general economic conditions negatively impact these businesses, our results of operations and financial condition may be adversely affected. This concentration also exposes us more to the market risks of real estate sales leasing and other activity in the areas we serve. An adverse change in local real estate conditions and markets could materially adversely affect the values of our loans and the real estate held as collateral for such loans, and materially affect our results of operation and financial condition. During 2006, the federal bank regulatory agencies released guidance on "Concentrations in Commercial Real Estate Lending" (the "Guidance"). The Guidance defines commercial real estate ("CRE") loans as exposures secured by raw land, land development and construction (including 1-4 family residential construction), multi-family property, and non-farm nonresidential property where the primary or a significant source of repayment is derived from rental income associated with the property (that is, loans for which 50% or more of the source of repayment comes from third party, non-affiliated, rental income) or the proceeds of the sale, refinancing, or permanent financing of the property. The Guidance requires that appropriate processes be in place to identify, monitor and control risks associated with real estate lending concentrations. This could include enhanced strategic planning, CRE underwriting policies, risk management, internal controls, portfolio stress testing and risk exposure limits as well as appropriately designed compensation and incentive programs. Higher allowances for loan losses and capital levels may also be required. The Guidance is triggered when CRE loan concentrations exceed either:
•Total reported loans for construction, land development, and other land of 100% or more of a bank's total capital; or
•Total reported loans secured by multifamily and nonfarm nonresidential properties and loans for construction, land development, and other land of 300% or more of a bank's capital.
The Guidance applies to our CRE lending activities. Although our regulators have not required us to maintain elevated levels of capital or liquidity due to our CRE concentrations, the regulators may do so in the future, especially if there is a material downturn in our local real estate markets.
If our allowance for loan losses becomes inadequate, our results of operations may be adversely affected.
We maintain an allowance for loan losses that we believe is a reasonable estimate of known and inherent losses in our loan portfolio. Through a periodic review and analysis of the loan portfolio, management determines the adequacy of the allowance for loan losses by considering such factors as general and industry-specific market conditions, credit quality of the loan portfolio, the collateral supporting the loans and financial performance of our loan customers relative to their financial obligations to us. The amount of future losses is impacted by changes in economic, operating and other conditions, including changes in interest rates, which may be beyond our control. Actual losses may exceed our current estimates. Rapidly growing loan portfolios are, by their nature, unseasoned. Estimating loan loss allowances for an unseasoned portfolio is more difficult than with seasoned portfolios, and may be more susceptible to changes in estimates and to losses exceeding estimates. Although we believe the allowance for loan losses is a reasonable estimate of known and inherent losses in our loan portfolio, we cannot fully predict such losses or assert that our loan loss allowance will be adequate in the future. Future loan losses that are greater than current estimates could have a material impact on our future financial performance.
Banking regulators periodically review our allowance for loan losses and may require us to increase our allowance for loan losses or recognize additional loan charge-offs, based on credit judgments different than those of our management. Any increase in the amount of our allowance or loans
charged-off as required by these regulatory agencies could have a negative effect on our operating results.
Our liquidity could be impaired by our inability to access the capital markets on favorable terms.
Liquidity is essential to our business. Under normal business conditions, primary sources of funding for our parent company may include dividends received from banking and nonbanking subsidiaries and proceeds from the issuance of equity capital in the capital markets. The primary sources of funding for our banking subsidiary include customer deposits and wholesale market-based funding. Our liquidity could be impaired by an inability to access the capital markets or by unforeseen outflows of cash, including deposits. This situation may arise due to circumstances that we may be unable to control, such as a general market disruption, negative views about the financial services industry generally, or an operational problem that affects third parties or us.
For further discussion or our liquidity position and other liquidity matters, including policies and procedures we use to manage our liquidity risks, see "Capital Resources" and "Liquidity" in Item 7 of this report.
The impact on us of recently enacted legislation, in particular the Emergency Economic Stabilization Act of 2008 and the American Recovery and Reinvestment Act of 2009 and their implementing regulations, and actions by the FDIC, cannot be predicted at this time.
The programs established or to be established under the EESA, ARRA and Troubled Asset Relief Program may have adverse effects upon us. We may face increased regulation of our industry. Compliance with such regulation may increase our costs and limit our ability to pursue business opportunities. Also, participation in specific programs may subject us to additional restrictions. Similarly, programs established by the FDIC under the systemic risk exception of the FDA, whether we participate or not, may have an adverse effect on us. Continued participation in the FDIC Temporary Liquidity Guarantee Program likely will require the payment of additional insurance premiums to the FDIC. We may be required to pay significantly higher Federal Deposit Insurance Corporation premiums because market developments have significantly depleted the insurance fund of the FDIC and reduced the ratio of reserves to insured deposits. The affects of participating or not participating in any such programs, and the extent of our participation in such programs cannot reliably be determined at this time.
Legislative and regulatory changes could materially change our business and adversely affect our results of operations and financial condition.
Congress and the U.S. government continue to evaluate and develop various programs and initiatives designed to stabilize the financial and housing markets and stimulate the economy, including the Treasury's Financial Stability Plan and various legislation and programs reduce residential mortgage foreclosures and stabilize the housing market. Legislative and regulatory proposals regarding changes in banking, and the regulation of banks, thrifts, mortgage lenders and other financial institutions are being considered by the executive branch of the Federal government, Congress and various state governments. Certain of these proposals, if adopted, could significantly change the regulation or operations of banks and the financial services industry. New regulations and statutes are regularly proposed that contain wide-ranging proposals for altering the structures, regulations and competitive relationships of the nation's financial institutions and markets. Another change under discussion includes the regulation of compensation in the financial services industry, generally. We cannot predict whether or in what form any proposed law or regulation will be adopted or the extent to which our business may be affected by any new law or regulation. The current stresses on the financial system and the economy generally, the powers granted to the Treasury under EESA and the ARRA, the expansion and supervision of government sponsored financial programs make the nature and extent of future
legislative and regulatory changes affecting financial institutions are unpredictable and subject to rapid changes. These changes are rapid and unpredictable. Any of these changes could materially change our business and adversely affect our results of operations and financial condition.
Increases in FDIC insurance premiums may cause our earnings to decrease.
The Emergency Economic Stabilization Act of 2008 temporarily increased the limit on FDIC coverage to $250,000 for all accounts through December 31, 2009. This has subsequently been extended to December 31, 2013. We are participating in the FDIC's Temporary Liquidity Guarantee Program, or TLG, for noninterest-bearing transaction deposit accounts. The FDIC almost doubled its assessment rate on well-capitalized institutions by raising the assessment rate 7 basis points at the beginning of 2009. In May 2009, the FDIC issued a final rule regarding a special assessment of 5 basis points on an institution's total assets minus its Tier 1 capital as of June 30, 2009. The FDIC adopted another final rule effective April 1, 2009, to change the way that the FDIC's assessment system differentiates for risk, make corresponding changes to assessment rates beginning with the second quarter of 2009, as well as other changes to the deposit insurance assessment rules. In November 2009, the FDIC adopted a final rule to require insured financial institutions to prepay slightly over three years of estimated insurance payments on December 20, 2009. The prepayment allows the FDIC to strengthen the cash position of the Deposit Insurance Fund immediately without immediately impacting earnings of the industry. Banks that participate in the TLG's noninterest bearing transaction account guarantee will pay the FDIC an annual assessment of 10 basis points on the amounts in such accounts above the amounts covered by FDIC deposit insurance. To the extent that these TLG assessments are insufficient to cover any loss or expenses arising from the TLG program, the FDIC is authorized to impose an emergency special assessment on FDIC-insured depository institutions. Legislation has been proposed to give the FDIC authority to impose charges for the TLG program upon depository institution holding companies, as well. These changes will cause the premiums and TLG assessments charged by the FDIC to increase. These actions could significantly increase our noninterest expense for the foreseeable future.
A substantial decline in the value of our Federal Home Loan Bank of Atlanta common stock may result in an other-than temporary impairment charge.
We are a member of the Federal Home Loan Bank of Atlanta, or FHLB, which enables us to borrow funds under the Federal Home Loan Bank advance program. As a FHLB member, we are required to own FHLB common stock, the amount of which increases with the level of our FHLB borrowings. The carrying value of our FHLB common stock was $15.7 million as of December 31, 2009. The FHLB has suspended daily repurchases of FHLB common stock, which adversely affects the liquidity of these shares. If the financial condition of FHLB deteriorates, there is a risk that our investment could be deemed other-than-temporarily impaired at some time in the future.
The soundness of other financial institutions could adversely affect us.
Our ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial services institutions are interrelated as a result of trading, clearing, counterparty or other relationships. We have exposure to many different industries and counterparties, and we routinely execute transactions with counterparties in the financial industry. As a result, defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry generally, have led to market-wide liquidity problems and could lead to losses or defaults by us or by other institutions. Many of these transactions expose us to credit risk in the event of default of our counterparty or client. In addition, our credit risk may be exacerbated when the collateral held by us cannot be realized upon or is liquidated at prices not sufficient to recover the full amount of the financial instrument exposure due us. There is no assurance that any such losses would not materially and adversely affect our results of operations.
We may not be able to successfully manage our growth or implement our growth strategies, which may adversely affect our results of operations and financial condition.
During the last five years, we have experienced significant growth, and a key aspect of our business strategy is our continued growth and expansion. Our ability to continue to grow depends, in part, upon our ability to:
•open new branch offices or acquire existing branches or other financial institutions;
•attract deposits to those locations and cross-sell new and existing depositors additional products and services; and
•identify attractive loan and investment opportunities.
We may not be able to successfully implement our growth strategy if we are unable to identify attractive markets, locations or opportunities to expand. Our ability to successfully manage our growth will also depend upon our ability to maintain capital levels sufficient to support this growth, maintain effective cost controls and adequate asset quality such that earnings are not adversely impacted to a material degree.
As we continue to implement our growth strategy by opening new branches or acquiring branches or other banks, we expect to incur increased personnel, occupancy and other operating expenses. In the case of new branches, we must absorb those higher expenses while we begin to generate new deposits, and there is a further time lag involved in redeploying new deposits into attractively priced loans and other higher yielding earning assets. Thus, our plans to branch aggressively could depress our earnings in the short run, even if we efficiently execute our branching strategy.
We rely heavily on our management team and the unexpected loss of any of those personnel could adversely affect our operations; we depend on our ability to attract and retain key personnel.
We are a customer-focused and relationship-driven organization. We expect our future growth to be driven in a large part by the relationships maintained with our customers by our Chairman and Chief Executive Officer, Bernard H. Clineburg, and our other executive and senior lending officers. We have entered into employment agreements with Mr. Clineburg and four other executive officers. The existence of such agreements, however, does not necessarily assure us that we will be able to continue to retain their services. The unexpected loss of Mr. Clineburg or other key employees could have a significant adverse effect on our business and possibly result in reduced revenues and earnings. We maintain bank owned life insurance policies on all of our corporate executives.
The implementation of our business strategy will also require us to continue to attract, hire, motivate and retain skilled personnel to develop new customer relationships, as well as develop new financial products and services. Many experienced banking professionals employed by our competitors are covered by agreements not to compete or solicit their existing customers if they were to leave their current employment. These agreements make the recruitment of these professionals more difficult. While we have been recently successful in acquiring what we consider to be talented banking professionals, the market for talented people is competitive and we may not continue to be successful in attracting, hiring, motivating or retaining experienced banking professionals.
We may incur losses if we are unable to successfully manage interest rate risk.
Our future profitability will substantially depend upon our ability to maintain or increase the spread between the interest rates earned on investments and loans and interest rates paid on deposits and other interest-bearing liabilities. Changes in interest rates will affect our operating performance and financial condition. The shape of the yield curve can also impact net interest income. Changing rates will impact how fast our mortgage loans and mortgage backed securities will have the principal
repaid. Rate changes can also impact the behavior of our depositors, especially depositors in non-maturity deposits such as demand, interest checking, savings and money market accounts. While we attempt to minimize our exposure to interest rate risk, we are unable to eliminate it as it is an inherent part of our business. Our net interest spread will depend on many factors that are partly or entirely outside our control, including competition, federal economic, monetary and fiscal policies, and industry-specific conditions and economic conditions generally.
Our future success is dependent on our ability to compete effectively in the highly competitive banking and financial services industry.
We face vigorous competition from other commercial banks, savings and loan associations, savings banks, credit unions, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market funds and other types of financial institutions for deposits, loans and other financial services in our market area. A number of these banks and other financial institutions are significantly larger than we are and have substantially greater access to capital and other resources, as well as larger lending limits and branch systems, and offer a wider array of banking services. Many of our nonbank competitors are not subject to the same extensive regulations that govern us. As a result, these nonbank competitors have advantages over us in providing certain services. This competition may reduce or limit our margins and our market share and may adversely affect our results of operations and financial condition.
Our businesses and earnings are impacted by governmental, fiscal and monetary policy.
We are affected by domestic monetary policy. For example, the Federal Reserve Board regulates the supply of money and credit in the United States and its policies determine in large part our cost of funds for lending, investing and capital raising activities and the return we earn on those loans and investments, both of which affect our net interest margin. The actions of the Federal Reserve Board also can materially affect the value of financial instruments we hold, such as loans and debt securities, and its policies also can affect our borrowers, potentially increasing the risk that they may fail to repay their loans. Our businesses and earnings also are affected by the fiscal or other policies that are adopted by various regulatory authorities of the United States. Changes in fiscal or monetary policy are beyond our control and hard to predict.
Our profitability and the value of any equity investment in us may suffer because of rapid and unpredictable changes in the highly regulated environment in which we operate.
We are subject to extensive supervision by several governmental regulatory agencies at the federal and state levels. Recently enacted, proposed and future banking and other legislation and regulations have had, and will continue to have, or may have a significant impact on the financial services industry. These regulations, which are generally intended to protect depositors and not our shareholders, and the interpretation and application of them by federal and state regulators, are beyond our control, may change rapidly and unpredictably, and can be expected to influence our earnings and growth. Our success depends on our continued ability to maintain compliance with these regulations. Many of these regulations increase our costs and thus place other financial institutions that may not be subject to similar regulation in stronger, more favorable competitive positions.
If we need additional capital in the future to continue our growth, we may not be able to obtain it on terms that are favorable. This could negatively affect our performance and the value of our common stock.
Our business strategy calls for continued growth. We anticipate that we will be able to support this growth through the generation of additional deposits at existing and new branch locations, as well as expanded loan and other investment opportunities. However, we may need to raise additional capital in the future to support our continued growth and to maintain desired capital levels. Our ability to raise
capital through the sale of additional equity securities or the placement of financial instruments that qualify as regulatory capital will depend primarily upon our financial condition and the condition of financial markets at that time. We may not be able to obtain additional capital in the amounts or on terms satisfactory to us. Our growth may be constrained if we are unable to raise additional capital as needed.
We have extended off-balance sheet commitments to borrowers which expose us to credit and interest rate risk.
We enter into certain off-balance sheet arrangements in the normal course of business to meet the financing needs of our customers. These off-balance sheet arrangements include commitments to extend credit, standby letters of credit and guarantees which would impact our liquidity and capital resources to the extent customers accept or use these commitments. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheet. Our exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit and guarantees written is represented by the contractual or notional amount of those instruments. We use the same credit policies in making commitments and conditional obligations as we do for on-balance-sheet instruments.
We have operational risk that could impact our ability to provide services to our customers.
We have potential operational risk exposure throughout our organization. Integral to our performance is the continued effectiveness and efficiency of our technical systems, operational infrastructure, relationships with third parties and key individuals involved in our ongoing activities. Failure by any or all of these resources subjects us to risks that may vary in size, scale and scope. This includes but is not limited to operational or technical failures, unlawful tampering with our information technology infrastructure, terrorist activities, ineffectiveness or exposure due to interruption in third party support, as well as the loss of key individuals or failure on the part of the key individuals to perform properly.
We may be parties to certain legal proceedings that may impact our earnings.
We face significant legal risks in our businesses, and the volume of claims and amount of damages and penalties claimed in litigation and regulatory proceedings against financial institutions remain high. Substantial legal liability or significant regulatory action against us could have material adverse financial impact or cause significant reputational risk to us, which in turn could seriously harm our business prospects.
Our ability to pay dividends is limited and we may be unable to pay future dividends.
Our ability to pay dividends is limited by regulatory restrictions and the need to maintain sufficient consolidated capital in the Company and in our subsidiaries. The ability of our bank subsidiary to pay dividends to us is limited by their obligations to maintain sufficient capital, earnings and liquidity and by other general restrictions on their dividends under federal and state bank regulatory requirements. In addition, as a bank holding company, our ability to declare and pay dividends is subject to the guidelines of the Board of Governors of the Federal Reserve System, or the Federal Reserve, regarding capital adequacy and dividends. The Federal Reserve guidelines generally require us to review the effects of the cash payment of dividends on common stock and other Tier 1 capital instruments (i.e., perpetual preferred stock and trust preferred debt) on our financial condition. These guidelines also require that we review our net income for the current and past four quarters, and the level of dividends on common stock and other Tier 1 capital instruments for those periods, as well as our projected rate or earnings retention. Under the Federal Reserve's policy, the board of directors of a bank holding company should also consider different factors to ensure that its dividend level is prudent
relative to the organization's financial position and is not based on overly optimistic earnings scenarios such as any potential events that may occur before the payment date that could affect its ability to pay while still maintaining a strong financial position. As a general matter, the Federal Reserve has indicated that the board of directors of a bank holding company should consult with the Federal Reserve and eliminate, defer, or significantly reduce bank holding company's dividends if: (i) its net income available to shareholders for the past four quarters, net of dividends previously paid during that period, is not sufficient to fully fund the dividends; (ii) its prospective rate of earnings retention is not consistent with its capital needs and overall current and prospective financial condition; or (iii) it will not meet, or is in danger of not meeting, its minimum regulatory capital adequacy ratios. If we do not satisfy these regulatory requirements or the Federal Reserve's policies, we will be unable to pay dividends on our common stock.
Item 1B.
Item 1B. Unresolved Staff Comments
None.
Item 2.
Item 2. Properties
Cardinal Bank, excluding its George Mason subsidiary, conducts its business from 25 branch offices. Nine of these facilities are owned and 16 are leased. Leased branch banking facilities range in size from 457 square feet to 11,182 square feet. Our leases on these facilities expire at various dates through 2022, and all but one of our leases have renewal options. The branch that does not have a renewal option is located at the headquarters location of George Mason (see below for additional lease information for George Mason). Fifteen of our branch banking locations have drive-up banking capabilities and all have ATMs.
Cardinal Wealth Services, Inc. conducts its business from one of Cardinal Bank's branch facilities.
George Mason conducts its business from five leased facilities which range in size from 1,476 square feet to 31,520 square feet. The leases have various expiration dates through 2011 and only three of their five locations have renewal options.
Wilson/Bennett conducts its business from office space located in our Tysons Corner, Virginia headquarters facility.
Our headquarters facility in Tysons Corner, Virginia comprises 41,818 square feet of leased office space. This lease expires in January 2022 and has renewal options. In addition to housing various administrative functions-including accounting, data processing, compliance, treasury, marketing, deposit and loan operations-our commercial and industrial and commercial real estate lending functions and various other departments are located there.
We believe that all of our properties are maintained in good operating condition and are suitable and adequate for our operational needs.
Item 3.
Item 3. Legal Proceedings
In the ordinary course of our operations, we become party to various legal proceedings. Currently, we are not party to any material legal proceedings, and no such proceedings are, to management's knowledge, threatened against us.
Item 4.
Item 4. Reserved
PART II
Item 5.
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Market Price for Common Stock and Dividends. Our common stock is currently listed for quotation on the Nasdaq Global Select Market under the symbol "CFNL." As of February 12, 2010, our common stock was held by 627 shareholders of record. In addition, we estimate that there were 5,378 beneficial owners of our common stock who own their shares through brokers or banks.
The high and low sale prices per share for our common stock for each quarter of 2009 and 2008 as reported on the market at the time and dividends declared during those periods were as follows:
Dividend Policy. The board of directors intends to follow a policy of retaining any earnings necessary to operate our business in accordance with all regulatory policies while maximizing the long-term return for the Company's investors. Our future dividend policy is subject to the discretion of the board of directors and future dividend payments will depend upon a number of factors, including future earnings, alternative investment opportunities, financial condition, cash requirements, and general business conditions.
Our ability to distribute cash dividends will depend primarily on the ability of our subsidiaries to pay dividends to us. Cardinal Bank is subject to legal limitations on the amount of dividends it is permitted to pay. Furthermore, neither Cardinal Bank nor we may declare or pay a cash dividend on any of our capital stock if we are insolvent or if the payment of the dividend would render us insolvent or unable to pay our obligations as they become due in the ordinary course of business. For additional information on these limitations, see "Government Regulation and Supervision-Payment of Dividends" in Item 1 above.
Repurchases. On February 26, 2007, we publicly announced that the Board of Directors had adopted a program to repurchase up to 1,000,000 shares of our common stock. The timing and amount of repurchases, if any, will depend on market conditions, share price, trading volume, and other factors, and there is no assurance that we will purchase shares during any period. No termination date was set for the buyback program. Shares may be repurchased in the open market or through privately negotiated transactions.
Since the inception of the program, we have purchased 477,608 shares of our common stock at a total cost of $4.1 million. All of these shares have been cancelled and retired. No shares were repurchased during 2009.
Stock Performance Graph. The graph set forth below shows the cumulative shareholder return on the Company's Common Stock during the five-year period ended December 31, 2009, as compared with: (i) an overall stock market index, the NASDAQ Composite; and (ii) a published industry index, the SNL Bank Index. The stock performance graph assumes that $100 was invested on December 31, 2004 in our common stock and each of the comparable indices and that dividends were reinvested.
Cardinal Financial Corporation
Total Return Performance
Item 6.
Item 6. Selected Financial Data
Selected Financial Data
(In thousands, except per share data)
(1)Tangible book value is calculated as total shareholders' equity, excluding accumulated other comprehensive income, less goodwill and other intangible assets, divided by common shares outstanding.
(2)Net interest margin is calculated as net interest income divided by total average earning assets and reported on a tax equivalent basis at a rate of 34%.
(3)Efficiency ratio is calculated as total non-interest expense divided by the total of net interest income and non-interest income, excluding the impairment loss on Fannie Mae perpetual preferred stock and the settlement with a mortgage correspondent during 2008; the impairment loss on escrow arrangement during 2007; and the litigation recovery during 2008, 2007, and 2006.
(4)The calculation of the efficiency ratio, which is a financial measure not prepared in accordance with generally accepted accounting principles ("GAAP"), and a reconciliation of the efficiency ratio to our GAAP financial information are included in our Table 1 to Item 7
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
The following presents management's discussion and analysis of our consolidated financial condition at December 31, 2009 and 2008 and the results of our operations for the years ended December 31, 2009, 2008 and 2007. The discussion should be read in conjunction with the consolidated financial statements and related notes included in this report.
Caution About Forward-Looking Statements
We make certain forward-looking statements in this Form 10-K that are subject to risks and uncertainties. These forward-looking statements include statements regarding our profitability, liquidity, allowance for loan losses, interest rate sensitivity, market risk, growth strategy, and financial and other goals. The words "believes," "expects," "may," "will," "should," "projects," "contemplates," "anticipates," "forecasts," "intends," or other similar words or terms are intended to identify forward-looking statements.
These forward-looking statements are subject to significant uncertainties because they are based upon or are affected by factors including:
•the risks of changes in interest rates on levels, composition and costs of deposits, loan demand, and the values and liquidity of loan collateral, securities, and interest sensitive assets and liabilities;
•changes in assumptions underlying the establishment of reserves for possible loan losses, reserves for repurchases of mortgage loans sold and other estimates;
•changes in market conditions, specifically declines in the residential and commercial real estate market, volatility and disruption of the capital and credit markets, soundness of other financial institutions we do business with;
•risks inherent in making loans such as repayment risks and fluctuating collateral values;
•declines in the prices of assets and market illiquidity may cause us to record an other-than-temporary impairment or other losses, specifically in our pooled trust preferred securities portfolio resulting from increases in underlying issuers' defaulting or deferring payments.
•changes in operations of Wilson/Bennett Capital Management, Inc., its customer base and assets under management and any associated impact on the fair value of goodwill in the future;
•changes in operations of George Mason Mortgage, LLC as a result of the activity in the residential real estate market and any associated impact on the fair value of goodwill in the future;
•exposure to repurchase loans sold to investors for which borrowers failed to provide full and accurate information on or related to their loan application or for which appraisals have not been acceptable or when the loan was not underwritten in accordance with the loan program specified by the loan investor;
•the risks of mergers, acquisitions and divestitures, including, without limitation, the related time and costs of implementing such transactions, integrating operations as part of these transactions and possible failures to achieve expected gains, revenue growth and/or expense savings from such transactions;
•the ability to successfully manage our growth or implement our growth strategies as we implement new or change internal operating systems or if we are unable to identify attractive markets, locations or opportunities to expand in the future; the effects of future economic, business and market conditions;
•governmental monetary and fiscal policies;
•legislative and regulatory changes, including changes in banking, securities, and tax laws and regulations and their application by our regulators, and changes in the scope and cost of FDIC insurance and other coverages;
•changes in accounting policies, rules and practices;
•maintaining cost controls and asset quality as we open or acquire new branches;
•maintaining capital levels adequate to support our growth;
•reliance on our management team, including our ability to attract and retain key personnel;
•competition with other banks and financial institutions, and companies outside of the banking industry, including those companies that have substantially greater access to capital and other resources;
•risks and uncertainties related to future trust operations;
•demand, development and acceptance of new products and services;
•problems with technology utilized by us;
•changing trends in customer profiles and behavior; and
•other factors described from time to time in our reports filed with the SEC.
Because of these uncertainties, our actual future results may be materially different from the results indicated by these forward-looking statements. In addition, our past results of operations do not necessarily indicate our future results.
In addition, this section should be read in conjunction with the description of our "Risk Factors" in Item 1A above.
Overview
We are a financial holding company formed in 1997 and headquartered in Fairfax County, Virginia. We were formed principally in response to opportunities resulting from the consolidation of several Virginia-based banks. These bank consolidations were typically accompanied by the dissolution of local boards of directors and relocation or termination of management and customer service professionals and a general deterioration of personalized customer service.
We own Cardinal Bank (the "Bank"), a Virginia state-chartered community bank with 25 banking offices located in Northern Virginia and the greater Washington, D.C. metropolitan area. The Bank offers a wide range of traditional bank loan and deposit products and services to both our commercial and retail customers. Our commercial relationship managers focus on attracting small and medium sized businesses as well as government contractors, commercial real estate developers and builders and professionals, such as physicians, accountants and attorneys.
Additionally, we complement our core banking operations by offering a wide range of services through our various subsidiaries, including mortgage banking through George Mason Mortgage, LLC ("George Mason") and Cardinal First Mortgage, LLC ("Cardinal First"), collectively the "mortgage banking segment", retail securities brokerage though Cardinal Wealth Services, Inc. ("CWS"), asset management through Wilson/Bennett Capital Management, Inc. ("Wilson/Bennett"), and trust, estate, custody, investment management and retirement planning through the trust division of Cardinal Bank.
George Mason, based in Fairfax, Virginia, engages primarily in the origination and acquisition of residential mortgages for sale into the secondary market on a best efforts basis through five branches
located throughout the metropolitan Washington, D.C. region. George Mason does business in eight states, primarily Virginia and Maryland, and the District of Columbia. George Mason is one of the largest residential mortgage originators in the greater Washington metropolitan area, generating originations of approximately $2.6 billion and $1.4 billion of loans in 2009 and 2008, respectively, excluding advances on construction loans and including loans purchased from other mortgage banking companies which are owned by local home builders but managed by George Mason (the "managed companies"). George Mason's primary sources of revenue include loan origination fees, net interest income earned on loans held for sale, gains on sales of loans and contractual management fees earned relating to services provided to other mortgage companies owned by local home builders. At the time we enter into an interest rate lock arrangement with the borrower, we enter into a loan forward sale commitment with a third party. Our mortgage loans are then sold servicing released.
George Mason also offers a construction-to-permanent loan program. This program provides variable rate financing for customers to construct their residences. Once the home has been completed, the loan converts to fixed rate financing and is sold into the secondary market. These construction-to-permanent loans generate fee income as well as net interest income for George Mason and are classified as loans held for sale.
George Mason's business is both cyclical and seasonal. The cyclical nature of its business is influenced by, among other factors, the levels of and trends in mortgage interest rates, national and local economic conditions and consumer confidence in the economy. Historically, George Mason has its lowest levels of quarterly loan closings during the first quarter of the year.
Cardinal First originates mortgage loans for new homes and refinancing in Virginia, Maryland, and Washington, D.C. principally for existing Cardinal Bank customers.
Wilson/Bennett provides asset management services to certain of our customers. Wilson/Bennett uses a value-oriented approach that focuses on large capitalization stocks. Wilson/Bennett's primary source of revenue is management fees earned on the assets it manages for its customers. These management fees are generally based upon the market value of managed and custodial assets and, accordingly, revenues from Wilson/Bennett will be, assuming a consistent customer base, more when appropriate indices, such as the S&P 500, are higher and lower when such indices are depressed.
In July 2004, we formed a wholly-owned subsidiary, Cardinal Statutory Trust I, for the purpose of issuing $20.0 million of floating rate junior subordinated deferrable interest debentures ("trust preferred securities"). These trust preferred securities are due in 2034 and pay interest at a rate equal to LIBOR (London Interbank Offered Rate) plus 2.40%, which adjusts quarterly. These securities are redeemable at par beginning September 2009. The interest rate on this debt was 2.65% at December 31, 2009. We have guaranteed payment of these securities. The $20.6 million payable by us to Cardinal Statutory Trust I is included in other borrowed funds in the consolidated statements of condition since Cardinal Statutory Trust I is an unconsolidated subsidiary as we are not the primary beneficiary of this entity. We utilized the proceeds from the issuance of the trust preferred securities to make a capital contribution into the Bank.
Net interest income is our primary source of revenue. We define revenue as net interest income plus non-interest income. As discussed further in the interest rate sensitivity section, we manage our balance sheet and interest rate risk exposure to maximize, and concurrently stabilize, net interest income. We do this by monitoring our liquidity position and the spread between the interest rates earned on interest-earning assets and the interest rates paid on interest-bearing liabilities. We attempt to minimize our exposure to interest rate risk, but are unable to eliminate it entirely. In addition to management of interest rate risk, we also analyze our loan portfolio for exposure to credit risk. Loan defaults and foreclosures are inherent risks in the banking industry, and we attempt to limit our exposure to these risks by carefully underwriting and then monitoring our extensions of credit. In addition to net interest income, non-interest income is an important source of revenue for us and
includes, among other things, service charges on deposits and loans, investment fee income, which includes trust revenues, gains and losses on sales of investment securities available-for-sale, gains on sales of mortgage loans and management fee income.
Net interest income and non-interest income represented the following percentages of total revenue for the three years ended December 31, 2009:
Non-interest income is a lower percentage of our total revenue in 2008 than 2009 and 2007 because mortgage originations were lower due to the cyclical nature of the mortgage banking business.
2009 Economic Environment
2009 was a transition year as the U.S. economy began to stabilize although unemployment continued to rise. Consumer spending, which had declined sharply in the second half of 2008, rose modestly in each quarter of 2009 and received a boost from government sponsored programs such as Cash-for-Clunkers during the third quarter of 2009. Despite this modest rise, consumer spending remained tentative as households saved more and paid down debt. After reaching lows in January, housing activity increased compared to 2008 as home sale and new housing starts rose through the year lifting residential construction. However, large inventories of unsold homes and the increase in foreclosures continued to weigh heavily on the housing sector.
Businesses cut production, inventories, employment and capital spending aggressively in response to the financial crisis in late 2008 continuing into 2009. Despite the modest growth in product demand and output in the second half of the year, job layoffs mounted, and the unemployment rate increased to over 10% in the fourth quarter, its highest level since the early 1980s.
The Federal Reserve lowered the federal funds rate to close to zero percent early in the first quarter of 2009 and in mid-March announced a program whereby the Federal Reserve purchased U. S. Treasury securities, mortgage-backed securities, and the long-term debt of government-sponsored agencies. This program contributed to lower mortgage rates generating an increase in consumer mortgage refinancing which helped homeowners, and along with lower home prices, stimulated activity in the housing market.
In early 2009, the short-term funding markets began to return to normal and the U.S. government began to wind down its alternative liquidity funding facilities and loan and asset guarantee programs. By mid-year, order had been restored to most financial market sectors. The stock market rally through year-end partially restored household net worth and increased consumer confidence.
Despite the aforementioned economic conditions, our credit quality remained strong. At December 31, 2009, we have non-accrual loans totaling $696,000, a decrease of $4.0 million compared to $4.7 million at December 31, 2008. In addition, loans contractually past due 90 days or more as to principal or interest decreased $228,000 from $379,000 at December 31, 2008 to $151,000 at December 31, 2009. Net charge-offs were 0.22% of our average loans receivable for the year ended December 31, 2009 as compared to 0.24% at December 31, 2008. Our mortgage banking segment has profited from the recent actions taken by the Federal Reserve to reduce interest rates, which spurred an increase in mortgage activity as homeowners sought to refinance their current mortgages and other consumers have seen an opportunity to purchase housing as it has become more affordable. In addition, the extension of the first-time home buyers credit to April 30, 2010 has increased the number of homes sold. Net income from our mortgage banking segment was $4.0 million for the year ended
December 31, 2009, compared to a loss of $2.7 million for the year ended December 31, 2008. A majority of the change in net income from our mortgage banking segment was a result of the 2008 goodwill impairment charge and repurchases and settlements of previously sold mortgage loans. Also, during the year ended December 31, 2009, we successfully raised $31.6 million in common equity capital to further capitalize the Company, to further penetrate our existing footprint and take advantage of bank consolidation opportunities.
The market disturbances that have been experienced in the financial markets over the past two years continue to impact our results. Market illiquidity continues to impact certain portions of our investment securities portfolio, specifically the ratings of certain monoline insurance providers, which has affected the pricing of certain municipal securities in our portfolio. In addition, we hold investments of $8.0 million in par value of pooled trust preferred securities, which are significantly below book value as of December 31, 2009 due to the lack of liquidity in the market and investor apprehension for investing in these types of securities.
We expect very challenging economic and operating conditions to continue for the foreseeable future and these conditions will continue to affect the markets in which we do business and could adversely impact our results in 2010. The degree of the impact is dependent upon the duration and severity of the aforementioned conditions.
While our loan growth was strong during 2009, continued negative economic conditions could adversely affect our loan portfolio, including causing increases in delinquencies and default rates, which we expect could impact our charge-offs and provision for loan losses. Continued deterioration in real estate values and household incomes could result in higher credit losses for us. Also, in the ordinary course of business, we may be subject to a concentration of credit risk to a particular industry, counterparty, borrower or issuer. A deterioration in the financial condition or prospects of a particular industry or a failure or downgrade of, or default by, any particular entity or group of entities could negatively impact our businesses, perhaps materially. The systems by which we set limits and monitor the level of our credit exposure to individual entities and industries may not function as we have anticipated.
Liquidity is essential to our business. The primary sources of funding for our Bank include customer deposits and wholesale funding. Our liquidity could be impaired by an inability to access the capital markets or by unforeseen outflows of cash, including deposits. This situation may arise due to circumstances that we may be unable to control, such as general market disruption, negative views about the financial services industry generally, or an operational problem that affects a third party or us. Our ability to borrow from other financial institutions on favorable terms or at all could be adversely affected by further disruptions in the capital markets or other events. While we believe we have a healthy liquidity position, any of the above factors could materially impact our liquidity position in the future.
In addition to the Emergency Economic Stabilization Act of 2008 ("EESA"), the U.S. government has continued to respond to the ongoing financial crisis and economic slowdown by enacting new legislation and expanding or establishing a number of programs and initiatives. The American Recovery and Reinvestment Act ("ARRA") is intended to expand and establish government spending programs and provide tax cuts to stimulate the economy. Congress and the U.S. government continue to evaluate and develop various programs and initiatives designed to stabilize the financial and housing markets and stimulate the economy, including the U.S. Treasury's announced Financial Stability Plan and the U.S. government's announced foreclosure prevention program. There can be no assurance as to the impact these programs will have on the financial markets, including the extreme levels of volatility and limited credit availability currently being experienced. The failure of these efforts to stabilize the financial markets and a continuation or worsening of current or financial market conditions could
materially and adversely affect our business, financial condition, results of operations, access to credit, our regulatory capital position or the trading price of our common stock.
Financial Developments
The year ended December 31, 2009 was a record year of profitability for us. For the year, we reported net income of $10.3 million on a consolidated basis. The Bank recorded net income of $8.4 million and our mortgage banking operations recorded net income of $4.0 million. The wealth management and trust services business segment reported net income of $321,000 for the year ended December 31, 2009. A loss of $2.2 million was recorded in the parent company for the year ended December 31, 2009, as the parent company serves as a source of strength to its subsidiaries and represents an overhead function rather than an operating segment.
For the year ended December 31, 2008, we reported net income of $286,000, which was impacted by several cash and noncash charges. The Bank recorded net income of $5.3 million which was offset by net losses recorded by George Mason of $2.7 million during 2008. George Mason's results for 2008 were impacted by an impairment charge to its goodwill of $2.8 million and a cash settlement of $1.8 million to one of its mortgage correspondents related to the loan purchase agreement between the two parties. In addition, the Bank recorded an other-than-temporary impairment charge of $4.4 million on our investment in Fannie Mae perpetual preferred stock. (See "Financial Overview" below for additional information on these charges). The wealth management and trust services segment, which includes CWS, Wilson/Bennett and our trust division, recorded net income of $47,000 for the year ended December 31, 2008.
Critical Accounting Policies
General
U.S. generally accepted accounting principles are complex and require management to apply significant judgment to various accounting, reporting, and disclosure matters. Management must use assumptions, judgments, and estimates when applying these principles where precise measurements are not possible or practical. These policies are critical because they are highly dependent upon subjective or complex judgments, assumptions and estimates. Changes in such judgments, assumptions and estimates may have a significant impact on the consolidated financial statements. Actual results, in fact, could differ from initial estimates.
The accounting policies we view as critical are those relating to judgments, assumptions and estimates regarding the determination of the allowance for loan losses, the fair value measurements of certain assets and liabilities, accounting for economic hedging activities, accounting for impairment testing of goodwill, accounting for the impairment of amortizing intangible assets and other long-lived assets, the valuation of deferred tax assets.
Allowance for Loan Losses
We maintain the allowance for loan losses at a level that represents management's best estimate of known and inherent losses in our loan portfolio. Both the amount of the provision expense and the level of the allowance for loan losses are impacted by many factors, including general and industry-specific economic conditions, actual and expected credit losses, historical trends and specific conditions of individual borrowers. Unusual and infrequently occurring events, such as weather-related disasters, may impact our assessment of possible credit losses. As a part of our analysis, we use comparative peer group data and qualitative factors such as levels of and trends in delinquencies and non-accrual loans, national and local economic trends and conditions and concentrations of loans exhibiting similar risk profiles to support our estimates.
For purposes of our analysis, we categorize our loans into one of five categories: commercial and industrial, commercial real estate (including construction), home equity lines of credit, residential mortgages, and consumer loans. In the absence of meaningful historical loss factors, peer group loss factors are applied and are adjusted by the qualitative factors mentioned above. The indicated loss factors resulting from this analysis are applied for each of the five categories of loans. In addition, we individually assign loss factors to all loans that have been identified as having loss attributes, as indicated by deterioration in the financial condition of the borrower or a decline in underlying collateral value if the loan is collateral dependent. Since we have limited historical data on which to base loss factors for classified loans, we typically apply, in accordance with regulatory guidelines, a 5% loss factor to loans classified as special mention, a 15% loss factor to loans classified as substandard and a 50% loss factor to loans classified as doubtful. Loans classified as loss loans are fully reserved or charged off. In certain instances, we evaluate the impairment of certain loans on a loan by loan basis. For these loans, we analyze the fair value of the collateral underlying the loan and consider estimated costs to sell the collateral on a discounted basis. If the net collateral value is less than the loan balance (including accrued interest and any unamortized premium or discount associated with the loan) we recognize an impairment and establish a specific reserve for the impaired loan.
Credit losses are an inherent part of our business and, although we believe the methodologies for determining the allowance for loan losses and the current level of the allowance are adequate, it is possible that there may be unidentified losses in the portfolio at any particular time that may become evident at a future date pursuant to additional internal analysis or regulatory comment. Additional provisions for such losses, if necessary, would be recorded in the commercial banking or mortgage banking segments, as appropriate, and would negatively impact earnings.
Fair Value Measurements
We determine the fair values of financial instruments based on the fair value hierarchy, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value. Our investment securities available-for-sale are recorded at fair value using reliable and unbiased evaluations by an industry-wide valuation service. This service uses evaluated pricing models that vary based on asset class and include available trade, bid, and other market information. Generally, the methodology includes broker quotes, proprietary models, vast descriptive terms and conditions databases, as well as extensive quality control programs. For certain of our held-to-maturity investment securities where there is minimal observable trading activity, we use a discounted cash flow approach to estimate fair value based on internal calculations and compare our results to information provided by external pricing sources. Our interest rate swap derivatives are recorded at fair value using observable inputs from a national valuation service. These rates are applied to a third party industry-wide valuation model.
We also fair value our interest rate lock commitments and forwards loan sales commitments. The fair value of our interest rate lock commitments consider the expected premium (discount) to par and we apply certain fallout rates for those rate lock commitments for which we do not close a mortgage loan. In addition, we calculate the effects of the changes in interest rates from the date of the commitment through loan origination, and then period end, using applicable published mortgage-backed investment security prices. The fair value of the forward sales contracts to investors considers the market price movement of the same type of security between the trade date and the balance sheet date. At loan closing, the fair value of the interest rate lock commitment is included in the cost basis of loans held for sale, which are carried at the lower of cost or market value.
Accounting for Economic Hedging Activities
We record all derivative instruments on the statement of condition at their fair values. We do not enter into derivative transactions for speculative purposes. For derivatives designated as hedges, we contemporaneously document the hedging relationship, including the risk management objective and strategy for undertaking the hedge, how effectiveness will be assessed at inception and at each reporting period and the method for measuring ineffectiveness. We evaluate the effectiveness of these transactions at inception and on an ongoing basis. Ineffectiveness is recorded through earnings. For derivatives designated as cash flow hedges, the fair value adjustment is recorded as a component of other comprehensive income, except for the ineffective portion which is recorded in earnings. For derivatives designated as fair value hedges, the fair value adjustments for both the hedged item and the hedging instrument are recorded through the income statement with any difference considered the ineffective portion of the hedge.
We discontinue hedge accounting prospectively when it is determined that the derivative is no longer highly effective. In situations in which cash flow hedge accounting is discontinued, we continue to carry the derivative at its fair value on the statement of condition and recognize any subsequent changes in its fair value in earnings over the term of the forecasted transaction. When hedge accounting is discontinued because it is probable that a forecasted transaction will not occur, we recognize immediately in earnings any gains and losses that were accumulated in other comprehensive income.
In the normal course of business, we enter into contractual commitments, including rate lock commitments, to finance residential mortgage loans. These commitments, which contain fixed expiration dates, offer the borrower an interest rate guarantee provided the loan meets underwriting guidelines and closes within the timeframe established by us. Interest rate risk arises on these commitments and subsequently closed loans if interest rates change between the time of the interest rate lock and the delivery of the loan to the investor. Loan commitments related to residential mortgage loans intended to be sold are considered derivatives and are marked to market through earnings.
To mitigate the effect of interest rate risk inherent in providing rate lock commitments, we economically hedge our commitments by entering into best efforts delivery forward loan sales contracts. During the rate lock commitment period, these forward loan sales contracts are marked to market through earnings and are not designated as accounting hedges. The fair values of loan commitments and the fair values of forward loan sales contracts generally move in opposite directions, and the net impact of changes in these valuations on net income during the loan commitment period is generally inconsequential. At the closing of the loan, the loan commitment derivative expires and we record a loan held for sale and continue to be obligated under the same forward loan sales contract. The forward sales contract is then designated as a hedge against the variability in cash to be received from the loan sale. Loans held for sale are accounted for at the lower of cost or fair value.
Accounting for Impairment Testing of Goodwill
Goodwill is not amortized but is tested on at least an annual basis for impairment.
To test goodwill for impairment, we perform an analysis to compare the fair value of the reporting unit to which the goodwill is assigned to the carrying value of the reporting unit. We make estimates of the discounted cash flows from the expected future operations of the reporting unit. This discounted cash flow analysis involves the use of unobservable inputs including: estimated future cash flows from operations; an estimate of a terminal value; a discount rate; and other inputs. Our estimated future cash flows are largely based on our historical actual cash flows. If the analysis indicates that the fair value of the reporting unit is less than its carrying value, we do an analysis to compare the implied fair value of the reporting unit's goodwill with the carrying amount of that goodwill. The implied fair value of the goodwill is determined by allocating the fair value of the reporting unit to all its assets and
liabilities. If the implied fair value of the goodwill is less than the carrying value, an impairment loss is recognized.
Accounting for the Impairment of Amortizing Intangible Assets and Other Long-Lived Assets
We continually review our long-lived assets for impairment whenever events or changes in circumstances indicate that the remaining estimated useful life of such assets might warrant revision or that the balances may not be recoverable. We evaluate possible impairment by comparing estimated future cash flows, before interest expense and on an undiscounted basis, with the net book value of long-term assets, including amortizable intangible assets. If undiscounted cash flows are insufficient to recover assets, further analysis is performed in order to determine the amount of the impairment.
An impairment loss is recorded for the excess of the carrying amount of the assets over their fair values. Fair value is usually determined based on the present value of estimated expected future cash flows using a discount rate commensurate with the risks involved.
Valuation of Deferred Tax Assets
We record a provision for income tax expense based on the amounts of current taxes payable or refundable and the change in net deferred tax assets or liabilities during the year. Deferred tax assets and liabilities are recognized for the tax effects of differing carrying values of assets and liabilities for tax and financial statement purposes that will reverse in future periods. When substantial uncertainty exists concerning the recoverability of a deferred tax asset, the carrying value of the asset is reduced by a valuation allowance. The amount of any valuation allowance established is based upon an estimate of the deferred tax asset that is more likely than not to be recovered. Increases or decreases in the valuation allowance result in increases or decreases to the provision for income taxes.
New Financial Accounting Standards
Effective January 1, 2009, we adopted new accounting guidance for disclosures about derivative instruments and hedging activities. This guidance requires companies with derivative instruments to disclose information about how and why a company uses derivative instruments, how derivative instruments and related hedged items are accounted for, and how derivative instruments and related hedged items affect a company's financial position, financial performance, and cash flows. The required disclosures include the fair value of derivative instruments and their gains and losses in tabular format, information about credit-risk-related contingent features in derivative agreements, counterparty credit risk, and the Company's strategies and objectives for using derivative instruments. This guidance is effective prospectively for periods beginning on or after November 15, 2008. The adoption provided for enhanced disclosure but otherwise did not have a material impact on our consolidated financial condition or results of operations.
In April 2009, we adopted new accounting guidance for recognition and presentation of other-than-temporary impairments. This standard modified the indicator of other-than-temporary impairment for debt securities. In addition, it amended the amount of an other-than-temporary impairment that is recognized in earnings when there are credit losses on a debt security for which management does not intend to sell and for which it is more likely than not that the entity will not have to sell prior to recovery of the amortized cost basis of the debt security. In those situations, the portion of the total impairment that is attributable to the credit loss would be recognized in earnings, and the remaining difference between the debt security's amortized cost basis and its fair value would be included in other comprehensive income. This guidance is effective for interim and annual periods ending after June 15, 2009. The adoption of this standard did not have a material impact on our consolidated financial condition or results of operations.
In April 2009, we adopted new accounting guidance for determining when a market for an asset or a liability is active or inactive and determining when a transaction is distressed. This standard reaffirmed the exit price objective of fair value measurements and provides guidance on inactive markets and distressed transactions. This standard is to be applied prospectively and is effective for interim and annual periods ending June 15, 2009. The adoption of this standard did not have a material impact on our consolidated financial condition or results of operations.
In April 2009, we adopted new accounting guidance for interim disclosures about fair value of financial instruments. This guidance requires disclosures about fair value of financial instruments for interim reporting periods of publicly traded companies as well as in annual financial statements. This guidance requires those disclosures in summarized financial information at interim reporting periods. This standard is effective for interim reporting periods ending after June 15, 2009. The adoption provided for enhanced disclosure but otherwise did not have a material impact on our consolidated financial condition or results of operations.
On July 1, 2009, we adopted new accounting guidance for the FASB accounting standards codification and the hierarchy of generally accepted accounting principles, the "Codification." The Codification is the exclusive authoritative reference for nongovernmental U.S. GAAP for use in financial statements issued for interim and annual periods ending after September 15, 2009, except for SEC rules and interpretive releases, which are also authoritative GAAP for SEC registrants. The Codification supersedes all existing non-SEC accounting and reporting standards.
Financial Overview
2009 Compared to 2008
At December 31, 2009, total assets were $1.98 billion, an increase of 13.3%, or $232.4 million, from $1.74 billion at December 31, 2008. Total loans receivable, net of deferred fees and costs, increased 13.5%, or $154.1 million, to $1.29 billion at December 31, 2009, from $1.14 billion at December 31, 2008. Total investment securities increased by $63.2 million, or 20.0%, to $378.8 million at December 31, 2009, from $315.5 million at December 31, 2008. Total deposits increased 9.9%, or $117.2 million, to $1.30 billion at December 31, 2009, from $1.18 billion at December 31, 2008. Other borrowed funds, which primarily include fed funds purchased, repurchase agreements and Federal Home Loan Bank ("FHLB") advances, increased $60.4 million to $427.6 million at December 31, 2009, from $367.2 million at December 31, 2008.
Shareholders' equity at December 31, 2009 was $204.5 million, an increase of $46.5 million from $158.0 million at December 31, 2008. The increase in shareholders' equity was primarily attributable to our completion of a common stock offering during May 2009, when we added $31.6 million in capital. In addition, we recorded net income of $10.3 million that further contributed to the increase in our shareholders' equity. Accumulated other comprehensive income increased $3.4 million for the year ended December 31, 2009. Total shareholders' equity to total assets at December 31, 2009 and 2008 was 10.3% and 9.1%, respectively. Book value per share at December 31, 2009 and 2008 was $7.12 and $6.58, respectively. Total risk-based capital to risk-weighted assets was 14.15% at December 31, 2009 compared to 12.72% at December 31, 2008. Accordingly, we were considered "well capitalized" for regulatory purposes at December 31, 2009.
We recorded net income of $10.3 million, or $0.37 per diluted common share, for the year ended December 31, 2009, compared to net income of $286,000, or $0.01 per diluted common share, in 2008. Our results for 2008 were impacted by impairments and nonrecurring noncash expenses which are more fully discussed below. Net interest income increased $7.6 million to $50.5 million for the year ended December 31, 2009, compared to $43.0 million for the year ended December 31, 2008. Provision for loan losses increased $1.3 million to $6.8 million for the year ended December 31, 2009, compared to $5.5 million for the same period of 2008. Non-interest income increased $5.5 million to $23.3 million
for the year ended December 31, 2009 as compared to $17.8 million for the same period of 2008 due primarily to increases in realized and unrealized gains on sales of loans.
The return on average assets for the years ended December 31, 2009 and 2008 was 0.57% and 0.02%, respectively. The return on average equity for the years ended December 31, 2009 and 2008 was 5.53% and 0.18%, respectively.
2008 Compared to 2007
At December 31, 2008, total assets were $1.74 billion, an increase of 3.2%, or $53.7 million, from $1.69 billion at December 31, 2007. Total loans receivable, net of deferred fees and costs, increased 9.6%, or $99.7 million, to $1.14 billion at December 31, 2008, from $1.04 billion at December 31, 2007. Total investment securities decreased by $49.4 million, or 13.5%, to $315.5 million at December 31, 2008, from $364.9 million at December 31, 2007. Total deposits increased 7.6%, or $82.9 million, to $1.18 billion at December 31, 2008, from $1.10 billion at December 31, 2007. Other borrowed funds, which primarily include repurchase agreements and Federal Home Loan Bank ("FHLB") advances, decreased $32.9 million to $367.2 million at December 31, 2008, from $400.1 million at December 31, 2007.
Shareholders' equity at December 31, 2008 was $158.0 million, a decrease of $1.5 million from $159.5 million at December 31, 2007. The decrease in shareholders' equity was primarily attributable to repurchases and retirement of our common stock totaling $1.4 million. In addition, dividends paid during 2008 totaled $966,000. These decreases were offset by net income of $286,000 for the year ended December 31, 2008 and increases in other comprehensive income of $314,000 for the year ended December 31, 2008. Total shareholders' equity to total assets at December 31, 2008 and 2007 was 9.1% and 9.4%, respectively. Book value per share at December 31, 2008 and 2007 was $6.58 and $6.59, respectively. Total risk-based capital to risk-weighted assets was 12.72% at December 31, 2008 compared to 12.98% at December 31, 2007. Accordingly, we were considered "well capitalized" for regulatory purposes at December 31, 2008.
We recorded net income of $286,000, or $0.01 per diluted common share, for the year ended December 31, 2008, compared to net income of $4.5 million, or $0.18 per diluted common share, in 2007. Our operating results for the year ended December 31, 2008 and 2007 were adversely impacted by several events. These events are discussed in detail below:
•During the third quarter of 2008, we performed our annual evaluation of the goodwill associated with our acquisition of George Mason. Goodwill of $12.9 million was recognized as a result of this acquisition. We employed the services of a valuation consultant to assist us with the goodwill evaluation. The analysis included certain valuation techniques, including a discounted cash flow approach. Following the acquisition, George Mason delivered excellent financial results and returns on our investment. Recent and ongoing challenges in the regional residential real estate market have negatively impacted the cash flows expected to be generated by George Mason in the near term. The valuation analysis indicated that the goodwill was impaired and we recorded a noncash impairment charge of $2.8 million in the mortgage banking segment.
•During the third quarter of 2008, we recognized an other-than-temporary impairment charge of $4.4 million on our investment in Fannie Mae perpetual preferred stock. This impairment charge was recorded in the commercial banking segment.
•During the second quarter of 2008, George Mason recorded a cash settlement to one of its mortgage correspondents related to the loan purchase agreement between the two parties. This settlement agreement provided for the release of known and unknown claims by the mortgage correspondent in exchange for a $2.8 million payment to the correspondent. George Mason also entered into similar agreements with certain third party mortgage companies from which George
Mason purchased mortgage loans and subsequently sold to this mortgage correspondent. These settlement agreements provided for a total payment of $1.0 million to George Mason by those third party mortgage companies.
•During the third quarter of 2007, we recorded a $3.5 million loss on an escrow arrangement with Liberty Growth Fund, LP and AIMS Worldwide, Inc. We served as the escrow agent in connection with an equity financing transaction between Liberty Growth Fund and AIMS Worldwide. In that transaction, Liberty Growth Fund had agreed to purchase from AIMS Worldwide shares of its preferred stock for $3.85 million. AIMS Worldwide would then use these proceeds to fund its acquisition of two other companies. As provided in the escrow agreement, Liberty Growth Fund delivered a check to us in the amount of $3.85 million on July 24, 2007. On July 25, 2007, we released funds totaling $3.85 million to AIMS Worldwide and certain of its designated beneficiaries and shares of AIMS Worldwide's preferred stock and warrants to an agent of Liberty Growth Fund. We then learned that Liberty Growth Fund had previously stopped payment on its check. Liberty Growth Fund issued another check in the same amount, but that check was dishonored for lack of sufficient funds. Of the total amount charged-off, we recovered $350,000 from one of the parties involved in the transaction.
Also contributing to our decrease in net income for the year ended December 31, 2008 as compared to the year ended December 31, 2007 was an increase in our provision for loan losses of $3.0 million to $5.5 million for the year ended December 31, 2008 due to the loan growth we had during the year, increase in net loan charge-offs, and changes to certain qualitative factors in our allowance for loan losses estimates, as compared to $2.5 million for the same period of 2007. Non-interest income decreased $1.7 million to $17.8 million for the year ended December 31, 2008 as compared to $19.5 million for the same period of 2007 due primarily to decreases in gains on sales of loans and investment fee income.
The return on average assets for the years ended December 31, 2008 and 2007 was 0.02% and 0.27%, respectively. The return on average equity for the years ended December 31, 2008 and 2007 was 0.18% and 2.85%, respectively.
See Table 1 below for the components of our calculation of our efficiency ratio as of December 31, 2009, 2008 and 2007.
Table 1.
Efficiency Ratio Calculation
Years Ended December 31, 2009, 2008 and 2007
(In thousands, except per share data)
(1)Efficiency ratio is calculated as total non-interest expense divided by the total of net interest income and non-interest income, excluding the impairment loss on Fannie Mae perpetual preferred stock and the settlement with a mortgage correspondent during 2008; the impairment loss on an escrow arrangement during 2007; and litigation recoveries during 2008 and 2007. Statements of Operations
Net Interest Income/Margin
Net interest income is our primary source of revenue, representing the difference between interest and fees earned on interest-bearing assets and the interest paid on deposits and other interest-bearing liabilities. The level of net interest income is affected primarily by variations in the volume and mix of these assets and liabilities, as well as changes in interest rates. We report our net interest income on a tax equivalent basis as a result of certain tax-exempt investments we hold on our balance sheet. During 2007, the Federal Reserve began easing the federal funds rate due to worsening economic conditions related to the tightening credit markets and decreased the rate four times to end at 4.25% at December 31, 2007. This easing continued into 2008, and as the economy continued to slow and go into a recessionary phase, the Federal Reserve continued to decrease the fed funds rate to ultimately 0.25% as of December 31, 2008 where is remained during all of 2009. See "Interest Rate Sensitivity" for further information.
Table 2.
Average Balance Sheets and Interest Rates on Interest-Earning Assets and Interest-Bearing Liabilities
Years Ended December 31, 2009, 2008 and 2007
(In thousands)
(1)Non-accrual loans are included in average balances and do not have a material effect on the average yield. Interest income on non-accruing loans was not material for the years presented.
(2)Interest income for loans receivable, investment securities available-for-sale and fed funds sold (which includes investments in money market preferred stock) is reported on a fully taxable-equivalent basis at a rate of 34.5% for 2009 and 2007 and 34% for 2008.
Table 3.
Rate and Volume Analysis
Years Ended December 31, 2009, 2008 and 2007
(In thousands)
(1)Non-accrual loans are included in average balances and do not have a material effect on the average yield. Interest income on non-accruing loans was not material for the years presented.
(2)Interest income for loans receivable, investment securities available-for-sale and fed funds sold (which includes investments in money market preferred stock) is reported on a fully taxable-equivalent basis at a rate of 34.5% for 2009 and 2007 and 34% for 2008.
(3)Changes attributable to rate/volume have been allocated to volume.
2009 Compared to 2008
For purposes of analyzing the effects of rate and volume on our interest income from loans receivable, investment securities and fed funds sold, we calculate interest income on a tax equivalent basis because of the tax benefit we receive on certain tax-exempt financial instruments. Net interest income on a tax equivalent basis for the year ended December 31, 2009 was $51.1 million, compared to $43.5 million for the year ended December 31, 2008, an increase of $7.6 million, or 17.5%. The increase in net interest income was primarily a result of decreases in the interest rates paid on deposits and other borrowed funds, net of the impact of decreased yields on earning assets during 2009, compared with 2008. In addition, we were able to deploy $31.6 million as a result of our capital raising efforts during 2009 in interest-bearing assets at no cost.
Our net interest margin, on a tax equivalent basis, for the years ended December 31, 2009 and 2008 was 2.94% and 2.78%, respectively, the increase for which was primarily a result of our ability to decrease interest rates on deposits faster than rates decreased on our interest earning assets. In addition, our interest rates on our other borrowed funds decreased due to the significantly low interest rate environment of 2009. The average yield on interest-earning assets decreased to 5.03% in 2009 from 5.70% in 2008, and our cost of interest-bearing liabilities decreased to 2.48% in 2009 from 3.42% in 2008. The cost of other borrowed funds, which generally are shorter term fundings and which we continued to utilize during 2009 to help fund our balance sheet growth, decreased 45 basis points to 3.41% in 2009 from 3.86% in 2008. The cost of deposit liabilities decreased 109 basis points to 2.17% in 2009 from 3.26% for 2008.
Total average earning assets increased by 10.9% to $1.74 billion at December 31, 2009 compared to $1.56 billion at December 31, 2008. The increase in our earnings assets were primarily driven by an increase in average loans receivable of $136.3 million and an increase in our inventory of loans held for sale of $35.8 million and offset by a decrease in investment securities of $19.2 million. These increases were funded by an increase in interest-bearing deposits of $105.8 million, an increase in other borrowed funds of $16.1 million and an increase in noninterest-bearing deposits of $15.9 million.
Average loans receivable increased $136.3 million to $1.21 billion during 2009 from $1.07 million in 2008. Average balances of nonperforming assets, which consist of non-accrual loans, are included in the net interest margin calculation and did not have a material impact on our net interest margin in 2009 and 2008. Additional interest income of approximately $414,000 for 2009 and $59,000 for 2008 would have been realized had all nonperforming assets performed as originally expected. Nonperforming assets exclude loans that are both past due 90 days or more and still accruing interest due to an assessment of collectibility.
Average interest-bearing deposits increased $105.8 million to $1.1 billion in 2009 from $984.6 million in 2008. The largest increase in average interest-bearing deposit balances was in certificates of deposit, which increased $142.2 million compared to 2008. Overall, we saw an increase in our deposits as a result of a "flight to safety" by consumers who were seeking the increase in FDIC insurance protection. Offsetting this increase was a decrease in average statement savings of $49.3 million to $291.8 million for 2009 compared to $341.1 million for 2008.
2008 Compared to 2007
Net interest income on a tax equivalent basis for the year ended December 31, 2008 was $43.5 million, compared to $40.7 million for the year ended December 31, 2007, an increase of $2.8 million, or 6.8%. The increase in net interest income was primarily a result of decreases in the interest rates paid on deposits and other borrowed funds, net of the impact of decreased yields on earning assets during 2008, compared with 2007.
Our net interest margin, on a tax equivalent basis, for the years ended December 31, 2008 and 2007 was 2.78% and 2.63%, respectively, the increase for which was primarily a result of our ability to decrease interest rates on deposits faster than rates decreased on our interest earning assets. In addition, our interest rates on our other borrowed funds decreased due to the significantly low interest rate environment of 2008. The average yield on interest-earning assets decreased to 5.70% in 2008 from 6.40% in 2007, and our cost of interest-bearing liabilities decreased to 3.42% in 2008 from 4.39% in 2007. The cost of other borrowed funds, which generally are shorter term fundings and which we continued to utilize in 2008 to help fund our balance sheet growth, decreased 63 basis points to 3.86% in 2008 from 4.49% in 2007. The cost of deposit liabilities decreased 111 basis points to 3.26% in 2008 from 4.37% for 2007.
Total average earning assets increased by 1.1% to $1.56 billion at December 31, 2008 compared to $1.55 billion at December 31, 2007. The increase in our earnings assets were primarily driven by an increase in average loans receivable of $148.5 million offset by a decrease in our inventory of loans held for sale of $108.5 million and a decrease in investment securities of $35.2 million. These increases were funded by an increase in other borrowed funds of $69.5 million.
Average loans receivable increased $148.5 million to $1.07 billion during 2008 from $922.6 million in 2007. Average balances of nonperforming assets, which consist of non-accrual loans, are included in the net interest margin calculation and did not have a material impact on our net interest margin in 2008 and 2007. Additional interest income of approximately $59,000 for 2008 and $5,000 for 2007 would have been realized had all nonperforming assets performed as originally expected. Nonperforming assets exclude loans that are both past due 90 days or more and still accruing interest due to an assessment of collectability.
Average interest-bearing deposits decreased $61.7 million to $984.6 million in 2008 from $1.05 billion in 2007. The largest decrease in average interest-bearing deposit balances was in certificates of deposit, which decreased $34.8 million compared to 2007.
Interest Rate Sensitivity
We are exposed to various business risks including interest rate risk. Our goal is to maximize net interest income without incurring excessive interest rate risk. Management of net interest income and interest rate risk must be consistent with the level of capital and liquidity that we maintain. We manage interest rate risk through an asset and liability committee ("ALCO"). ALCO is responsible for managing our interest rate risk in conjunction with liquidity and capital management.
We employ an independent consulting firm to model our interest rate sensitivity. We use a net interest income simulation model as our primary tool to measure interest rate sensitivity. Many assumptions are developed based on expected activity in the balance sheet. For maturing assets, assumptions are created for the redeployment of these assets. For maturing liabilities, assumptions are developed for the replacement of these funding sources. Assumptions are also developed for assets and liabilities that could reprice during the modeled time period. These assumptions also cover how we expect rates to change on non-maturity deposits such as interest checking, money market checking, savings accounts as well as certificates of deposit. With the funding markets still lacking liquidity, forecasts for deposit rate movements carry greater uncertainty than when this market is functioning normally. Based on inputs that include the current balance sheet, the current level of interest rates and the developed assumptions, the model then produces an expected level of net interest income assuming that market rates remain unchanged. This is considered the base case. Next, the model determines what net interest income would be based on specific changes in interest rates. The rate simulations are performed for a two year period and include ramped rate changes of down 100 basis points and up 200 basis points. The down 200 basis point scenario was discontinued given the current level of interest
rates. In the ramped down rate change, the model moves rates gradually down 100 basis points over the first year and then rates remain flat in the second year.
For the up 200 basis point scenario, rates are gradually moved up 200 basis points in the first year and then rates remain flat in the second year. In both the up and down scenarios, the model assumes a parallel shift in the yield curve. The results of these simulations are then compared to the base case.
At December 31, 2009, we were asset sensitive for the entire two year simulation period. Asset sensitive means that yields on the Bank's interest-earnings assets will rise faster than interest-bearing liability costs in a rising rate environment. For a declining rate environment, asset yields will fall faster than interest-bearing liability costs. Being asset sensitive our net interest income should increase in a rising rate scenario. In the up 200 basis point scenario, our net interest income would improve by not more than 0.4% for the one year period and by not more than 2.2% over the two year time horizon. In the down 100 basis point scenario the interest rate risk model indicates that our net interest income would decrease by not more than 0.8% for the one year period and by not more than 2.6% over the two year time horizon.
Provision Expense and Allowance for Loan Losses
Our policy is to maintain the allowance for loan losses at a level that represents our best estimate of known and inherent losses in the loan portfolio. Both the amount of the provision and the level of the allowance for loan losses are impacted by many factors, including general and industry-specific economic conditions, actual and expected credit losses, historical trends and specific conditions of individual borrowers.
The provision for loan losses was $6.8 million and $5.5 million for the years ended December 31, 2009 and 2008, respectively. The allowance for loan losses at December 31, 2009 was $18.6 million compared to $14.5 million at December 31, 2008. Our allowance for loan loss ratio at December 31, 2009 was 1.44% compared to 1.27% at December 31, 2008. The increase in the allowance for loan loss ratio is a direct result of increases in non-performing loans and the adverse migration of certain loans through our allowance for loan losses calculation model because of current and ongoing adverse economic conditions. While we continue to report strong credit quality in our loan portfolio, we have experienced increases in our watch list credit and net charge-offs. Our provision was impacted by net new loan growth in addition to our evaluation of the credit quality in our loan portfolio and the qualitative factors we use to determine the adequacy of our loan loss reserves. We recorded net loan charge-offs of $2.6 million for each of the years ended December 31, 2009 and 2008. We charged-off $876,000 in commercial and industrial loans, residential loans of $1.8 million and consumer loans of $6,000. Annualized net charged-off loans was 0.22% of average loans receivable for the year ended December 31, 2009, compared to 0.24% for the year ended December 31, 2008. Non-accrual loans totaled $696,000 at December 31, 2009 compared to $4.7 million at December 31, 2008
While our loan growth was strong during 2009, continued negative economic conditions could adversely affect our home equity line of credit, credit card and other loan portfolios, including causing increases in delinquencies and default rates, which we expect could impact our charge-offs and provision for loan losses. Continued deterioration in commercial and residential real estate values, employment data and household incomes could result in higher credit losses for us. Also, in the ordinary course of business, we may also be subject to a concentration of credit risk to a particular industry, counterparty, borrower or issuer. At December 31, 2009, our commercial real estate portfolio was 46% of our total loan portfolio. A deterioration in the financial condition or prospects of a particular industry or a failure or downgrade of, or default by, any particular entity or group of entities could negatively impact our businesses, perhaps materially, and the systems by which we set limits and monitor the level or our credit exposure to individual entities and industries, may not function as we have anticipated.
The provision for loan losses was $2.5 million for 2007. Net charge-offs for the year ended December 31, 2007 was $545,000, most of which were commercial and industrial loans.
See "Critical Accounting Policies" above for more information on our allowance for loan losses methodology.
The following tables present additional information pertaining to the activity in and allocation of the allowance for loan losses by loan type and the percentage of the loan type to the total loan portfolio.
Table 4.
Allowance for Loan Losses
Years Ended December 31, 2009, 2008, 2007, 2006 and 2005
(In thousands)
Table 5.
Allocation of the Allowance for Loan Losses
At December 31, 2009, 2008, 2007, 2006 and 2005
(In thousands)
*Percentage of loan type to the total loan portfolio.
Non-Interest Income
The following table provides detail for non-interest income for the years ended December 31, 2009, 2008, and 2007.
Table 6.
Non-Interest Income
Years Ended December 31, 2009, 2008 and 2007
(In thousands)
Non-interest income includes service charges on deposits and loans, realized and unrealized gains on mortgage banking activities, investment fee income, management fee income, and gains on sales of investment securities available-for-sale, and continues to be an important factor in our operating results. Non-interest income for the years ended December 31, 2009 and 2008 was $23.3 million and $17.8 million, respectively. The increase in non-interest income for the year ended December 31, 2009, compared to the same period of 2008, is primarily the result of an increase in realized and unrealized gains on mortgage banking activities by George Mason and Cardinal First of $4.7 million. The increase in realized and unrealized gains on mortgage banking activities is directly related to an increase in loan origination and sales volume occurring in the mortgage banking segment as a result of decreased in mortgage rates and more affordable home prices during 2009. Included in realized and unrealized gains on mortgage banking activities are any origination, underwriting, and discount points and other funding fees and gains associated with our sales of loans to third party investors. Costs include direct costs associated with loan origination, such as commissions and salaries that are deferred at the time of origination. Management fee income, which represents the income earned for services George Mason provides to other mortgage companies owned by local home builders and generally fluctuates based on the volume of loan sales, increased $1.1 million during 2009 as compared to 2008, again due to the origination volumes in the residential real estate market.
Another contributing factor to the increase in our non-interest income was an increase in loan service charges of $1.0 million for the year ended December 31, 2009 to $2.6 million, compared to $1.6 million for the same period of 2008. The increase in loan service charges is primarily a result of
fee income earned by George Mason's title company and again a result of an increase in loan origination and sales activity. Total investment fee income increased $137,000 to $3.6 million for the year ended December 31, 2009, compared to $3.5 million for 2008. Investment fee income includes net commissions earned at CWS and income earned at Wilson/Bennett and from our trust division. The increase in the market values of managed and custodial assets and an increase in customer relationships in the wealth management and trust services segment have contributed to the increase in investment fee income during 2009.
Service charges on deposit accounts decreased $121,000 to $2.0 million for the year ended December 31, 2009, compared to $2.1 million for the year ended December 31, 2008. Service charges on deposit accounts include insufficient funds fee income, service charges on deposit accounts, other fee income on deposit accounts and ATM transaction fees as shown in Table 6. For the year ended December 31, 2009, the increase in the cash surrender value of our bank-owned life insurance was $536,000, a decrease of $324,000 when compared to the same period of 2008. This decrease is a result of the decrease in the earnings of the underlying investment assets of our bank-owned life insurance.
For the year ended December 31, 2009, we recorded net gains on the sales of investment securities totaling $760,000 compared to $913,000 for the same period of 2008. Included in our net gains on investment securities available-for-sale were losses totaling $217,000 which were related to our sale of all of our shares of Fannie Mae perpetual preferred stock during the first quarter of 2009. We elected to sell these shares as a result of these shares being traded well below their par value following the placement of Fannie Mae into conservatorship by federal regulators during 2008. In addition, we recorded trading losses of $425,000 for the year ended December 31, 2009. These trading losses were a result of our purchasing investments to economically hedge against fair value changes of our nonqualified deferred compensation plan liability. These investments are designated as trading securities, and as such, the changes in fair value are reflected in earnings. These trading losses were primarily the result of lower stock prices and were partially offset by a reduction in our compensation expense associated with this benefit plan.
Non-interest income for the years ended December 31, 2008 and 2007 was $17.8 million and $19.5 million, respectively. The decrease in non-interest income for the year ended December 31, 2008, compared to the same period of 2007, is primarily the result of decreased realized and unrealized gains on mortgage banking activities by George Mason of $1.0 million. The decrease in realized and unrealized gains on mortgage banking activities was directly related to the deterioration in the residential real estate market. Management fee income decreased $307,000 during 2008 as compared to 2007, again due to the deterioration of the real estate market.
Another contributing factor to the decrease in our non-interest income was the decrease in total investment fee income of $810,000 to $3.5 million for the year ended December 31, 2008, compared to $4.3 million for the year ended December 31, 2007. Investment fee income, which includes net commissions earned at CWS and income earned at Wilson/Bennett, decreased $285,000 to $528,000 as of December 31, 2008 from $813,000 as of December 31, 2007. Trust administration fee income was $2.9 million as of December 31, 2008, a decrease of $525,000 from $3.5 million as of December 31, 2007, mostly due to the loss of low margin custody relationships with two clients. In addition, the decrease in the market values of managed and custodial assets in the wealth management and trust services segment have contributed to the decrease in investment fee income during 2008.
Service charges on deposit accounts increased $144,000 to $2.1 million for the year ended December 31, 2008, compared to $2.0 million for the year ended December 31, 2007. Deposit service charges increased primarily as a result of an increased number of transaction accounts in 2008 compared to 2007. Loan service charges increased $141,000 to $1.6 million for the year ended December 31, 2008, compared to $1.5 million in 2007. For the year ended December 31, 2008, the increase in the cash surrender value of our bank-owned life insurance was $860,000, a decrease of
$810,000 when compared to the same period of 2007. This decrease is a result of the decrease in the earnings of the underlying investment assets of our bank-owned life insurance.
For the year ended December 31, 2008, we recorded gains on the sales of investment securities totaling $913,000 compared to none for the same period of 2007.
For the year ended December 31, 2008 gains related to the extinguishment of four borrowings totaling $275,000. There were no similar transactions for the year ended December 31, 2007.
During the year ended December 31, 2007, we received a litigation settlement from a previously charged off investment of $190,000. For the year ended December 31, 2007, the amount recovered for this same charge-off was $83,000.
Non-Interest Expense
The following table reflects the components of non-interest expense for the years ended December 31, 2009, 2008 and 2007.
Table 7.
Non-Interest Expense
Years Ended December 31, 2009, 2008 and 2007
(In thousands)
Non-interest expense includes, among other things, salaries and benefits, occupancy costs, professional fees, depreciation, data processing, telecommunications and miscellaneous expenses. Non-interest expense was $52.4 million and $55.9 million for the years ended December 31, 2009 and 2008, respectively, a decrease of $3.5 million, or 6.2%. The decrease in non-interest expense for the year ended December 31, 2009, compared to 2008, was primarily the result of the aforementioned other-than temporary impairment charge related to an investment in Fannie Mae perpetual preferred stock, the goodwill impairment charge recorded at George Mason and the cash settlement George Mason made to a mortgage correspondent, all during 2008. See the "Financial Overview" above for additional information on these transactions.
Salaries and benefits expense increased $1.6 million to $23.6 million for the year ended December 31, 2009 as compared to $21.9 million for the same period of 2008. This increase was attributable to an increase in incentive pay at the Bank due to better than expected results for 2009. Depreciation expense decreased $442,000 to $1.9 million for the year ended December 31, 2009 as compared to $2.4 million for the year ended December 31, 2008 due to fixed assets becoming fully depreciated. Data communications expense increased $667,000 to end at $3.4 million for the year ended December 31, 2009 compared to $2.7 million for the same period of 2008. The increase in this expense is directly related to deconversion costs charged by our existing vendor for our upcoming systems conversion to a new applications vendor which will occur during the second quarter of 2010.
FDIC insurance premiums increased $2.0 million to $2.7 million for the year ended December 31, 2009 compared to $721,000 for the same period of 2008. The increase in FDIC insurance premiums is a due to the special assessment imposed during the second quarter of 2009 of $844,000, and changes to the assessment calculation during 2009 all a result of the FDIC's efforts in replenishing the levels of the Deposit Insurance Fund which has been depleted due to increasing levels of bank failures.
Mortgage loan repurchases and settlements decreased to $2.6 million for 2009 compared to $3.8 million for 2008, a result of a decrease in loan repurchase and settlement claims made by third party investors to George Mason during 2009. We have worked over the past twelve months to limit our exposure to loan repurchases and claims from investors and believe that any additional expense recorded will be minimal in future periods. Investors have claimed, for specific loan purchases, that certain representations and warranties in the loan sale agreement were violated. We have denied certain claims and for others, after analyzing all facts surrounding the underwriting of such loans, we have agreed to repurchase the loans or settle the claims.
Non-interest expense was $55.9 million and $51.9 million for the years ended December 31, 2008 and 2007, respectively, an increase of $4.0 million, or 7.8%. The increase in non-interest expense for the year ended December 31, 2008, compared to 2007, was primarily the result of the aforementioned other-than temporary impairment charge related to an investment in Fannie Mae perpetual preferred stock, the goodwill impairment charge recorded at George Mason and the cash settlement George Mason made to a mortgage correspondent, all during 2008. For the year ended December 31, 2007, non-interest expense was impacted by the aforementioned loss of $3.5 million related to our escrow arrangement with Liberty Growth Fund, LP. See the "Financial Overview" above for additional information on these transactions.
Salaries and benefits expense decreased $1.9 million to $21.9 million for the year ended December 31, 2008 as compared to $23.8 million for the same period of 2007. This decrease was attributable to expense control measures put in place at George Mason and at the Bank during 2008 in order to decrease non-interest expense. Depreciation expense decreased $645,000 to $2.4 million for the year ended December 31, 2008 as compared to $3.0 million for the year ended December 31, 2007 due to fixed assets becoming fully depreciated.
Income Taxes
We recorded a provision for income tax expense of $4.4 million for the year ended December 31, 2009, compared to an income tax benefit of $912,000 for the year ended December 31, 2008. The income tax benefit recorded during 2008 was primarily the result of the other-than-temporary impairment of our investment in Fannie Mae perpetual preferred stock and the result of our tax-exempt income from investments being a larger portion of our overall net income. During 2008, the Emergency Economic Stabilization Act was enacted which included a provision permitting banks to recognize the other-than-temporary impairment charge related to Fannie Mae perpetual preferred stock as an ordinary loss rather than a capital loss which allowed us to record an additional benefit for this loss. Our effective tax rate for December 31, 2009 was 29.9%.
We recorded a provision for income tax expense of $885,000 for the year ended December 31, 2007. Our effective tax rate for the year ended December 31, 2007 was 16.5%.
For more information, see "Critical Accounting Policies" above. In addition, Note 10 to the notes to consolidated financial statements provides additional information with respect to the deferred tax accounts and the net operating loss carryforward.
Statements of Condition
Loans Receivable, Net
Total loans receivable, net of deferred fees and costs, were $1.29 billion at December 31, 2009, an increase of $154.1 million, or 13.5%, compared to $1.14 billion at December 31, 2008. During 2009, we achieved growth in all our loan categories. Loans held for sale increased $22.5 million to $179.5 million at December 31, 2009 compared to $157.0 million at December 31, 2008.
At December 31, 2009, we had loans accounted for on a non-accrual basis totaling $696,000. Non-accrual loans at December 31, 2008 totaled $4.7 million. Accruing loans, which are contractually past due 90 days or more as to principal or interest payments, at December 31, 2009 and December 31, 2008 were $151,000 and $379,000, respectively, all of which were determined to be well secured and in the process of collection. The decrease in non-accrual loans from December 31, 2008 was a result of these loans being paid off or charged off during 2009. There were no loans at December 31, 2009 and December 31, 2008 that were "troubled debt restructurings".
Interest income on non-accrual loans, if recognized, is recorded using the cash basis method of accounting. When a loan is placed on non-accrual, unpaid interest is reversed against interest income if it was accrued in the current year and is charged to the allowance for loan losses if it was accrued in prior years. While on non-accrual, the collection of interest is recorded as interest income only after all past-due principal has been collected. When all past contractual obligations are collected and, in our opinion, the borrower has demonstrated the ability to remain current, the loan is returned to an accruing status. At December 31, 2009, the loans on nonaccrual status did not have a valuation allowance as we charged-off $411,000 of the outstanding principal balances which were unsecured based on the estimated values of the underlying collateral. Gross interest income that would have been recorded if our non-accrual loans had been current with their original terms and had been outstanding throughout the period or since origination if held for part of the period for the years ended December 31, 2009 and 2008 was $414,000 and $59,000, respectively. The interest income realized prior to the loans being placed on non-accrual status for the year ended December 31, 2009 and 2008 was $120,000 and $348,000, respectively.
Total loans receivable, net of deferred fees and costs, were $1.14 billion at December 31, 2008, an increase of $99.7 million, or 9.6%, compared to $1.04 billion at December 31, 2007. We achieved growth in all our loan categories with the exception of our residential real estate loans and consumer loans. Residential real estate loans decreased $1.5 million to $211.7 million at December 31, 2008
compared to $213.2 million at December 31, 2007. Consumer loans decreased $736,000 to $2.4 million at December 31, 2008 from $3.1 million at December 31, 2007. Each of these decreases are primarily a result of repayments during 2008. Loans held for sale decreased $13.5 million to $157.0 million at December 31, 2008 compared to $170.5 million at December 31, 2007.
At December 31, 2008 we had one loan accounted for on a non-accrual basis totaling $4.7 million. There were no non-accrual loans at December 31, 2007. Accruing loans, which are contractually past due 90 days or more as to principal or interest payments, at December 31, 2008 and December 31, 2007 were $379,000 and $963,000, respectively, all of which were determined to be well secured and in the process of collection. The decrease in past due loans 90 days or more is a result of loans that were past due at December 31, 2007 being paid off or charged off during 2008. There were no loans at December 31, 2008 and December 31, 2007 that were "troubled debt restructurings".
At December 31, 2008, the one loan on nonaccrual status did not have a valuation allowance as we charged-off $1.1 million of the outstanding principal balance which was unsecured based on the estimated values of the underlying collateral. Gross interest income that would have been recorded if the non-accrual loans had been current with their original terms and had been outstanding throughout the period or since origination if held for part of the period for the years ended December 31, 2008 and 2007 was $59,000 and $5,000, respectively. The interest income realized prior to the loans being placed on non-accrual status for the year ended December 31, 2008 and 2007 was $348,000 and $38,000, respectively.
The ratio of non-performing loans to total loans was 0.05%, 0.41%, and 0.00% at December 31, 2009, 2008 and 2007, respectively.
The following tables present the composition of our loans receivable portfolio at the end of each of the five years ended December 31, 2009 and additional information on non-performing loans receivable.
Table 8.
Loans Receivable
At December 31, 2009, 2008, 2007, 2006 and 2005
(In thousands)
Table 9.
Nonperforming Loans
At December 31, 2009, 2008, 2007, 2006 and 2005
(In thousands)
The following table presents information on loan maturities and interest rate sensitivity.
Table 10.
Loan Maturities and Interest Rate Sensitivity
At December 31, 2009
(Dollars in thousands)
*Payments due by period are based on the repricing characteristics and not contractual maturities. Investment Securities
Our investment securities portfolio is used as a source of income and liquidity. The investment portfolio consists of investment securities available-for-sale, investment securities held-to-maturity and trading securities. Investment securities available-for-sale are those securities that we intend to hold for an indefinite period of time, but not necessarily until maturity. These securities are carried at fair value and may be sold as part of an asset/liability strategy, liquidity management or regulatory capital management. Investment securities held-to-maturity are those securities that we have the intent and ability to hold to maturity and are carried at amortized cost. Investment securities-trading are securities we purchase to economically hedge against fair value changes of our nonqualified deferred compensation plan liability. These securities include cash equivalents, equities and mutual funds. See Note 4 to our notes to consolidated financial statements for additional information on our trading securities. Investment securities were $378.8 million at December 31, 2009, an increase of $63.2 million or 20.0%, from $315.5 million in investment securities at December 31, 2008.
Of the $378.8 million in the investment portfolio at December 31, 2009, $35.2 million were classified as held-to-maturity, and $343.6 million were classified as available-for-sale. At December 31, 2009, the yield on the available-for-sale investment portfolio was 4.55% and the yield on the held-to-maturity portfolio was 3.66%.
We complete reviews for other-than-temporary impairment at least quarterly. As of December 31, 2009, the majority of the investment securities portfolio consisted of securities rated AAA by a leading rating agency. Investment securities which carry a AAA rating are judged to be of the best quality and carry the smallest degree of investment risk. At December 31, 2009, 96% of our mortgage-backed investment securities portfolio are guaranteed by the Federal National Mortgage Association (FNMA), the Federal Home Loan Mortgage Corporation (FHLMC) and the Government National Mortgage Association (GNMA).
We have $9.9 million in non-government non-agency mortgage-backed securities. These securities are rated from AAA to AA. The various protective elements on the non agency securities may change in the future if market conditions or the financial stability of credit insurers changes, which could impact the ratings of these securities.
At December 31, 2009 and 2008, certain of our investment grade securities were in an unrealized loss position. Investment securities with unrealized losses are a result of pricing changes due to recent and negative conditions in the current market environment and not as a result of permanent credit impairment. Contractual cash flows for the agency mortgage-backed securities are guaranteed and/or funded by the U.S. government. Other mortgage-backed securities and municipal securities have third party protective elements and there are no negative indications that the contractual cash flows will not be received when due. We do not intend to sell nor do we believe we will be required to sell any of our temporarily impaired securities.
In addition, our held-to-maturity portfolio includes investments in four pooled trust preferred securities, totaling $8.0 million at December 31, 2009 (each security has a par value of $2.0 million). The collateral underlying these structured securities are instruments issued by financial institutions or insurers. We own the A-3 tranches in each issuance. Each of the bonds are rated by more than one rating agency. Two of the securities have composite ratings of AA and two the securities have a composite rating of BBB. These ratings are consistent with the grades from the other rating agencies. There is minimal observable trading activity for these types of securities. We have estimated the fair value of the securities through the use of internal calculations and through information provided by external pricing services. Given the level of subordination below our A-3 tranches, and the actual and expected performance of the underlying collateral, we expect to receive all contractual interest and principal payments recovering the amortized cost basis of each of the four securities, and concluded that these securities are not other-than-temporarily impaired.
No other-than-temporary impairment was recorded on the securities in our investment portfolio as of December 31, 2009. During 2008, we recognized an other-than-temporary impairment of $4.4 million related to an investment in Fannie Mae perpetual preferred stock. The full amount of this impairment was deemed to be related to credit deterioration of the issuer, and not related to equity market conditions. Because of the minimal likelihood that these shares would recover, we made a decision to exit this type of investment security and no longer own any similar equity investment in our investment securities portfolio. During 2009, we sold all shares of our Fannie Mae perpetual preferred stock for a loss of $217,000. We elected to sell our shares as a result of these shares being traded well below their par value following the placement of Fannie Mae into conservatorship by federal regulators in 2008.
We hold $15.7 million in FHLB stock at December 31, 2009. During 2008, the FHLB of Atlanta announced a change in their dividend declaration and payment schedule beginning during the fourth quarter of 2008. The change was initiated so that the dividend can be declared and paid to member banks after the FHLB has calculated their net income for the preceding quarter. During 2009, the FHLB announced changes to its capital stock requirements. Specifically, the FHLB Board of Directors increased the dollar cap on its stock purchases from $25 million to $26 million and repurchases of member excess stock will be evaluated on a quarterly basis instead of a daily basis. We do not expect the above changes to materially impact our liquidity position.
Investment securities were $315.5 million at December 31, 2008, a decrease of $49.4 million or 13.5%, from $364.9 million in investment securities at December 31, 2007.
Of the $315.5 million in the investment portfolio at December 31, 2008, $50.2 million were classified as held-to-maturity, and $265.4 million were classified as available-for-sale. At December 31, 2008, the yield on the available-for-sale investment portfolio was 4.97% and the yield on the held-to-maturity portfolio was 4.34%.
The following table reflects the composition of the investment portfolio at December 31, 2009, 2008, and 2007.
Table 11.
Investment Securities
At December 31, 2009, 2008 and 2007
(In thousands)
(1)Based on contractual maturities.
(2)Yields for our tax-exempt municipal securities are not reported on a tax-equivalent basis.
Deposits and Other Borrowed Funds
Total deposits were $1.30 billion at December 31, 2009, an increase of $117.2 million, or 9.9%, from $1.18 billion at December 31, 2008. We have had success in attracting deposit balances from customers seeking to deposit their money with smaller, local banks and depositors are increasing balances held with financial institutions as a result of the increased protection of their money by the FDIC. We are a member of the Certificates of Deposit Account Registry Service ("CDARS"). CDARS allows our customers to access FDIC insurance protection on multi-million dollar certificates of deposit through our Bank. When a customer places a large deposit through CDARS, we place their funds into certificates of deposit with other banks in the CDARS network in increments of less than $250,000 so that principal and interest are eligible for FDIC insurance protection. At December 31, 2009, we had brokered certificates of deposit of $87.7 million, of which $59.4 million were placed in the CDARS program. Brokered certificates of deposit at December 31, 2008 were $89.2 million, of which $53.5 million were in the CDARS program.
Other borrowed funds, which primarily include repurchase agreements, FHLB advances and our payable to Cardinal Statutory Trust I, were $427.6 million at December 31, 2009, an increase of $60.4 million, up from $367.2 million at December 31, 2008. The primary reason for the increase in other borrowed funds at December 31, 2009 was an increase in federal funds purchased funding of $45.0 million at December 31, 2009 compared to none at December 31, 2008. Advances from the Federal Home Loan Bank of Atlanta were $280.0 million at each of December 31, 2009 and 2008. These advances primarily leverage some of our larger commercial real estate fundings and assist in financing George Mason's inventory of loans held for sale.
Other borrowed funds at each of December 31, 2009 and 2008, included $20.6 million payable to Cardinal Statutory Trust I, the issuer of our trust preferred securities. This debt had an interest rate of 2.65% and 4.40% at December 31, 2009 and 2008, respectively. Cardinal Statutory Trust I is an unconsolidated entity as we are not the primary beneficiary of the trust.
At December 31, 2009, other borrowed funds also included $80.0 million in customer repurchase agreements and $2.0 million borrowed under the Federal Reserve Treasury, Tax & Loan note option.
The following table reflects the short-term borrowings and other borrowed funds outstanding at December 31, 2009.
Table 12.
Short-Term Borrowings and Other Borrowed Funds
At December 31, 2009
(In thousands)
Total deposits were $1.18 billion at December 31, 2008, an increase of $82.9 million, or 7.6%, from $1.10 billion at December 31, 2007. The increase in our total deposit balances is primarily a result of certain certificates of deposit promotions we had during 2008. At December 31, 2008, we had brokered certificates of deposit of $89.2 million, of which $53.5 million were placed in the CDARS program. Brokered certificates of deposit at December 31, 2007 were $10.0 million.
Other borrowed funds, which primarily include repurchase agreements, FHLB advances and our payable to Cardinal Statutory Trust I, were $367.2 million at December 31, 2008, a decrease of $32.9 million, from $400.1 million at December 31, 2007. The primary reason for the decrease in other borrowed funds at December 31, 2008 was a decrease in federal funds purchased funding. Advances from the Federal Home Loan Bank of Atlanta were $280.0 million at December 31, 2008, compared to $232.5 million at December 31, 2007.
The following table reflects the maturities of the certificates of deposit of $100,000 or more as of December 31, 2009, 2008 and 2007.
Table 13.
Certificates of Deposit of $100,000 or More
At December 31, 2009, 2008 and 2007
(In thousands)
*No-Penalty certificates of deposit can be redeemed at anytime at the request of the depositor. Business Segment Operations
We provide banking and non-banking financial services and products through our subsidiaries. We operate in three business segments, commercial banking, mortgage banking and wealth management and trust services.
The commercial banking segment includes both commercial and consumer lending and provides customers such products as commercial loans, real estate loans, and other business financing and consumer loans. In addition, this segment also provides customers with various deposit products including demand deposit accounts, savings accounts and certificates of deposit.
The mortgage banking segment engages primarily in the origination and acquisition of residential mortgages for sale into the secondary market on a best efforts basis.
The wealth management and trust services segment provides investment and financial services to businesses and individuals, including financial planning, retirement/estate planning, trusts, estates, custody, investment management, escrows, and retirement plans.
Information about the reportable segments, and reconciliation of this information to the consolidated financial statements at December 31, 2009, 2008 and 2007 follows.
Table 14.
Segment Reporting
December 31, 2009, 2008 and 2007
(In thousands)
At and for the Year Ended December 31, 2009:
At and for the Year Ended December 31, 2008:
At and for the Year Ended December 31, 2007:
Charges for mortgage loan repurchases and settlements were $2.6 million and $3.8 million in 2009 and 2008, respectively. During the second quarter of 2008, George Mason recorded a cash settlement to one of its mortgage correspondents related to the loan purchase agreement between the two parties. This settlement totaled $1.8 million pretax ($1.2 million after tax) and was recorded in the mortgage banking segment.
During the third quarter of 2008, we recorded a noncash impairment charge of $2.8 million pretax ($1.8 million after tax) to the goodwill associated with the mortgage banking segment. No such impairments occurred during 2009.
During the third quarter of 2008, we recognized an other-than-temporary impairment charge of $4.4 million pretax ($2.9 million after tax) on our investment in Fannie Mae perpetual preferred stock. This impairment charge was recorded in the commercial banking segment. We recorded no other-than-temporary impairments during 2009.
During the third quarter of 2007, we recorded a loss of $3.5 million pretax ($2.3 million after tax) from our escrow arrangement with Liberty Growth Fund, LP. This loss was recorded in our wealth management and trust services segment.
Capital Resources
Capital adequacy is an important measure of financial stability and performance. Our objectives are to maintain a level of capitalization that is sufficient to sustain asset growth and promote depositor and investor confidence.
Regulatory agencies measure capital adequacy utilizing a formula that takes into account the individual risk profile of a financial institution. The guidelines define capital as both Tier 1 (which includes common shareholders' equity, defined to include certain debt obligations) and Tier 2 (to include certain other debt obligations and a portion of the allowance for loan losses and 45% of unrealized gains in equity securities).
Shareholders' equity at December 31, 2009 was $204.5 million, an increase of $46.5 million, compared to $158.0 million at December 31, 2008. The increase in shareholders' equity was primarily attributable to our completion of a common stock offering during May 2009, for which we added $31.6 million in capital. In addition, for 2009 we recorded net income of $10.3 million. Accumulated other comprehensive income increased $3.4 million for the year ended December 31, 2009. Total shareholders' equity to total assets at December 31, 2009 and 2008 was 10.4% and 9.1%, respectively. Book value per share at December 31, 2009 and 2008 was $7.12 and $6.58, respectively. Total risk-based capital to risk-weighted assets was 14.15% at December 31, 2009 compared to 12.72% at December 31, 2008. Accordingly, we were considered "well capitalized" for regulatory purposes at December 31, 2009.
Shareholders' equity at December 31, 2008 was $158.0 million, a decrease of $1.5 million, compared to $159.5 million at December 31, 2007. The decrease in shareholders' equity was primarily attributable to repurchases and retirement of our common stock totaling $1.4 million. In addition, dividends paid during 2008 totaled $966,000. These decreases were offset by net income of $286,000 for the year ended December 31, 2008 and increases in other comprehensive income of $314,000 for the year ended December 31, 2008. Total shareholders' equity to total assets at December 31, 2008 and 2007 was 9.1% and 9.4%, respectively. Book value per share at December 31, 2008 and 2007 was $6.58 and $6.59, respectively. Total risk-based capital to risk-weighted assets was 12.72% at December 31, 2008 compared to 12.98% at December 31, 2007. Accordingly, we were considered "well capitalized" for regulatory purposes at December 31, 2008.
As noted above, regulatory capital levels for the bank and bank holding company meet those established for well-capitalized institutions. While we are currently considered well-capitalized, we may from time-to-time find it necessary to access the capital markets to meet our growth objectives or capitalize on specific business opportunities.
The following table shows the minimum capital requirement and our capital position at December 31, 2009, 2008, and 2007, for the Company and for the Bank.
Table 15.
Capital Components
At December 31, 2009, 2008 and 2007
(In thousands)
Cardinal Financial Corporation (Consolidated):
Cardinal Bank:
Liquidity
Liquidity in the banking industry is defined as the ability to meet the demand for funds of both depositors and borrowers. We must be able to meet these needs by obtaining funding from depositors or other lenders or by converting non-cash items into cash. The objective of our liquidity management program is to ensure that we always have sufficient resources to meet the demands of our depositors and borrowers. Stable core deposits and a strong capital position provide the base for our liquidity position. We believe we have demonstrated our ability to attract deposits because of our convenient branch locations, personal service and pricing.
In addition to deposits, we have access to the different wholesale funding markets. These markets include the brokered CD market, the repurchase agreement market and the federal funds market. During 2008, we joined the Certificates of Deposit Account Registry Services ("CDARS"). CDARS allows our customers to access FDIC insurance protection on multi-million dollar certificates of deposit through our Bank. When a customer places a large deposit through CDARS, we place their funds into certificates of deposit with other banks in the CDARS network in increments of less than $250,000 so that principal and interest are eligible for FDIC insurance protection. We also maintain secured lines of credit with the Federal Reserve Bank of Richmond and the Federal Home Loan Bank of Atlanta. Having diverse funding alternatives reduces our reliance on any one source for funding.
Cash flow from amortizing assets or maturing assets can also provide funding to meet the needs of depositors and borrowers.
We have established a formal liquidity contingency plan which establishes a liquidity management team and provides guidelines for liquidity management. For our liquidity management program, we first determine our current liquidity position and then forecast liquidity based on anticipated changes in the balance sheet. In this forecast, we expect to maintain a liquidity cushion. We also stress test our liquidity position under several different stress scenarios. Guidelines for the forecasted liquidity cushion and for liquidity cushions for each stress scenario have been established. In addition, one stress test combines all other stress tests to see how liquidity would react to several negative scenarios occurring at the same time. We believe that we have sufficient resources to meet our liquidity needs.
Liquid assets, which include cash and due from banks, federal funds sold and investment securities available for sale, totaled $368.4 million at December 31, 2009, or 18.6% of total assets. We held investments that are classified as held-to-maturity in the amount of $35.2 million at December 31, 2009. To maintain ready access to the Bank's secured lines of credit, the Bank has pledged roughly half of its investment securities and a portion of its residential real estate loan portfolio to the Federal Home Loan Bank of Atlanta with additional investment securities and certain loans in its commercial real estate and commercial & industrial loan portfolios pledged to the Federal Reserve Bank of Richmond. Additional borrowing capacity at the Federal Home Loan Bank of Atlanta at December 31, 2009 was approximately $3 million. Borrowing capacity with the Federal Reserve Bank of Richmond was approximately $333 million at December 31, 2009. These facilities are subject to the FHLB and the Federal Reserve approving disbursement to us. In addition, we have unsecured federal funds purchased lines of $315 million available to us. We anticipate maintaining liquidity at a level sufficient to protect depositors, provide for reasonable growth and fully comply with all regulatory requirements.
Contractual Obligations
We have entered into a number of long-term contractual obligations to support our ongoing activities. These contractual obligations will be funded through operating revenues and liquidity sources held or available to us. The required payments under such obligations excluding interest were as follows:
Table 16.
Contractual Obligations
At December 31, 2009
(In thousands)
Financial Instruments with Off-Balance-Sheet Risk and Credit Risk
We are a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the balance sheet.
The Bank's maximum exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.
We have counter-party risk which may arise from the possible inability of George Mason's third-party investors to meet the terms of their forward sales contracts. George Mason works with third-party investors that are generally well-capitalized, are investment grade and exhibit strong financial performance to mitigate this risk. We do not expect any third-party investor to fail to meet its obligations. In addition, we have derivative counterparty risk relating to three interest rate swaps we have with third parties. This risk may arise from the inability of the third party to meet the terms of the contract. We continuously monitor the financial condition of these third parties. We do not expect these third parties to fail to meet their obligations.
George Mason estimates a reserve (early pay-off reserve) for mortgage loans sold that are repaid by the borrower within a certain number of days following the loan sale, thereby requiring that George Mason refund part of the service release premium and/or premium pricing received from the investor pursuant to the loan sale agreement. The reserve as of December 31, 2009 and 2008 was $25,000 and $9,000, respectively.
George Mason has a reserve for its estimated exposure to repurchase loans previously sold to investors for which borrowers failed to provide full and accurate information on their loan application or for which appraisals have not been acceptable or when the loan was not underwritten in accordance with the loan program specified by the loan investor. During 2009 and 2008, George Mason either repurchased from or settled with investors on such loans for a total of $2.6 million and $3.8 million, respectively. At December 31, 2009 and 2008, the reserve for unresolved claims was $1.7 million and $1.6 million, respectively. We evaluate the merits of each claim and estimate the reserve based on actual and expected claims received and consider the historical amounts paid to settle such claims. We have taken actions with respect to our investor arrangements in an attempt to limit the number of future claims.
In addition, George Mason, as part of the service it provides to its managed companies, purchases the loans originated by managed companies at the time of origination. These loans are then sold by George Mason to investors. George Mason has agreements with its managed companies requiring that the managed company fund the repurchase or settle the claim, for any loans that were originated by the managed company and for which investors have requested George Mason to repurchase due to the borrowers failure to provide full and accurate information on or related to their loan application or for which appraisals have not been acceptable or when the loan was not underwritten in accordance with the loan program specified by the loan investor. In the event that the managed company's financial condition deteriorates and it is unable to fund the repurchase of such loans, George Mason may have to provide the funds to repurchase these loans from investors. In this instance, George Mason would establish an allowance on the receivable from the managed company. There is no such allowance recorded at December 31, 2009 or 2008 as management fully recovered all amounts owed by managed companies as of these same period end dates.
During the second quarter of 2008, George Mason entered into an agreement with a mortgage correspondent related to the loan purchase agreement between the two parties. The agreement provided for the release of known and unknown claims by the mortgage correspondent in exchange for a $2.8 million payment to the correspondent. The terms of this agreement require that we may be obligated to make additional payments to the correspondent in future periods based on certain conditions. We believe the additional exposure under this agreement is not material over the course of the next two years. The amount of the exposure declines with the passage of time. In conjunction with this agreement, George Mason also entered into similar agreements with certain managed companies, from which George Mason purchased mortgage loans and subsequently sold to this mortgage correspondent. These settlement agreements provided for a total payment of $1.0 million to George Mason by those managed companies. The net amount of this settlement is reported in the non-interest expense section of the statement of operations.
A summary of the contract amount of the Bank's exposure to off-balance-sheet risk as of December 31, 2009 and 2008, is as follows:
Commitments to extend credit of $71.0 million as of December 31, 2009 were related to George Mason's pipeline and were of a short-term nature.
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. We evaluate each customer's credit worthiness on a case-by-case basis. The amount of collateral obtained is based on management's credit evaluation of the counterparty. Collateral held varies but may include accounts receivable, inventory, property and equipment, and income-producing commercial properties.
Unfunded commitments under lines of credit are commitments for possible future extensions of credit to existing customers. Those lines of credit may not be drawn upon to the total extent to which we have committed.
Standby letters of credit are conditional commitments we issued to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing, and similar transactions. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. We hold certificates of deposit, deposit accounts, and real estate as collateral supporting those commitments for which collateral is deemed necessary.
Quarterly Data
The following table provides quarterly data for the years ended December 31, 2009 and 2008. Quarterly per share results may not calculate to the year-end per share results due to rounding.
During the second quarter of 2008, George Mason recorded a cash settlement to one of its mortgage correspondents related to the loan purchase agreement between the two parties. This settlement totaled $1.8 million pretax (1.2 million after tax) and was recorded in the mortgage banking segment.
During the third quarter of 2008, we recorded a noncash impairment charge of $2.8 million pretax ($1.8 million after tax) to the goodwill associated with the mortgage banking segment.
During the third quarter of 2008, we recognized an other-than-temporary impairment charge of $4.4 million pretax ($2.9 million after tax) on our investment in Fannie Mae perpetual preferred stock. This impairment charge was recorded in the commercial banking segment.
Table 17.
Quarterly Data
Years ended December 31, 2009 and 2008
(In thousands, except per share data)
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Our Asset/Liability Committee is responsible for reviewing our liquidity requirements and maximizing our net interest income consistent with capital requirements, liquidity, interest rate and economic outlooks, competitive factors and customer needs. Interest rate risk arises because the assets of the Bank and the liabilities of the Bank have different maturities and characteristics. In order to measure this interest rate risk, we use a simulation process that measures the impact of changing interest rates on net interest income. This model is run for the Bank by an independent consulting firm. The simulations incorporate assumptions related to expected activity in the balance sheet. For maturing assets, assumptions are developed for the redeployment of these assets. For maturing liabilities, assumptions are developed for the replacement of these funding sources. Assumptions are also developed for assets and liabilities that reprice during the modeled time period. These assumptions also cover how we expect rates to change on non-maturity deposits such as interest checking, money market checking, savings accounts as well as certificates of deposit. With the funding markets still lacking liquidity, forecasts for deposit rate movements carry greater uncertainty than when this market is functioning normally. Based on inputs that include the most recent period end balance sheet, the current level of interest rates and the developed assumptions, the model then produces an expected level of net interest income assuming that interest rates remain unchanged. This becomes the base case. Next, the model determines what net interest income would be based on specific changes in interest rates. The rate simulations are performed for a two year period and include ramped rate changes of down 100 basis points and up 200 basis points. The down 200 basis point scenario was discontinued given the current level of interest rates. In the ramped down rate change, the model moves rates gradually down 100 basis points over the first year and then rates remain flat in the second year.
For the up 200 basis point scenario, rates are gradually moved up 200 basis points in the first year and then rates remain flat in the second year. In both the up and down scenarios, the model assumes a parallel shift in the yield curve. The results of these simulations are then compared to the base case.
At December 31, 2009, we were asset sensitive for the entire two year simulation period. Asset sensitive means that yields on the Bank's interest-earnings assets will rise faster than interest-bearing liability costs in a rising rate environment. For a declining rate environment, asset yields will fall faster than interest-bearing liability costs. Being asset sensitive our net interest income should increase in a rising rate scenario. In the up 200 basis point scenario, our net interest income would improve by not more than 0.4% for the one year period and by not more than 2.2% over the two year time horizon. In the down 100 basis point scenario the interest rate risk model indicates that our net interest income will decrease by not more than 0.8% over the one year period and the and by not more than 2.6% two year time horizon.
See also "Interest Rate Sensitivity" in Item 2 above for a discussion of our interest rate risk.
We have counter-party risk which may arise from the possible inability of George Mason's third-party investors to meet the terms of their forward sales contracts. George Mason works with third-party investors that are generally well-capitalized, are investment grade and exhibit strong financial performance to mitigate this risk. We do not expect any third-party investor to fail to meet its obligation. In addition, we have derivative counterparty risk relating to certain interest rate swaps we have with third parties. This risk may arise from the inability of the third party to meet the terms of the contract. We monitor the financial condition of these third parties on an annual basis. We do not expect these third parties to fail to meet their obligations.
Item 8.
Item 8. Financial Statements and Supplementary Data
Page
Report of Independent Registered Public Accounting Firm
Consolidated Statements of Condition
Consolidated Statements of Income
Consolidated Statements of Comprehensive Income
Consolidated Statements of Changes in Shareholders' Equity
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
Report of Independent Registered Public Accounting Firm
The Board of Directors and Shareholders
Cardinal Financial Corporation:
We have audited the accompanying consolidated statements of condition of Cardinal Financial Corporation and subsidiaries (the Company) as of December 31, 2009 and 2008, and the related consolidated statements of income, comprehensive income, changes in shareholders' equity and cash flows for each of the years in the three-year period ended December 31, 2009. We also have audited the Company's internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company's management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management's Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on these consolidated financial statements and an opinion on the Company's internal control over financial reporting 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 audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the consolidated financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2009 and 2008, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2009, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
(signed) KPMG LLP
McLean, Virginia
March 15, 2010
PART II
Item 8. Financial Statements and Supplementary Data.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CONDITION
December 31, 2009 and 2008
(In thousands, except share data)
See accompanying notes to consolidated financial statements.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
Years Ended December 31, 2009, 2008 and 2007
(In thousands, except per share data)
See accompanying notes to consolidated financial statements.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
Years ended December 31, 2009, 2008 and 2007
(In thousands)
See accompanying notes to consolidated financial statements.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
Years Ended December 31, 2009, 2008 and
(In thousands)
See accompanying notes to consolidated financial statements.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31, 2009, 2008 and 2007
(In thousands)
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
Years Ended December 31, 2009, 2008 and 2007
(In thousands)
See accompanying notes to consolidated financial statements.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) Organization
Cardinal Financial Corporation (the "Company") is incorporated under the laws of the Commonwealth of Virginia as a financial holding Company whose activities consist of investment in its wholly-owned subsidiaries. The principal operating subsidiary of the Company is Cardinal Bank (the "Bank"), a state-chartered institution and its subsidiary, George Mason Mortgage, LLC ("George Mason"), a mortgage banking company based in Fairfax, Virginia. In January 2009, the Bank organized a second mortgage banking company, Cardinal First Mortgage, LLC ("Cardinal First"), also based in Fairfax, Virginia. The Bank has a Trust division, Cardinal Trust and Investment Services. In addition to the Bank, the Company has two nonbank subsidiaries; Wilson/Bennett Capital Management, Inc. ("Wilson/Bennett"), an asset management firm, and Cardinal Wealth Services, Inc. ("CWS"), an investment services subsidiary.
(2) Summary of Significant Accounting Policies
(a) Use of Estimates
U.S. generally accepted accounting principles are complex and require management to make estimates, judgments and assumptions that affect the reported amounts of assets and liabilities, and disclosures of contingent assets and contingent liabilities, at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Significant estimates affecting the Company's financial statements relate to accounting for business combinations and impairment testing of goodwill, the allowance for loan losses, accounting for impairment of identifiable intangible assets, the valuation of deferred tax assets, fair value measurements of certain assets and liabilities, fair values of derivatives and investment securities and reserves for repurchase of mortgage loans previously sold to investors. Actual results could differ from these estimates.
(b) Principles of Consolidation
The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany transactions and balances have been eliminated in consolidation.
(c) Accounting for Business Combinations
Business combinations are accounted for under the purchase method. The purchase method requires that the cost of an acquired entity be allocated to the assets acquired and liabilities assumed, based on their estimated fair values at the date of acquisition. The excess of the cost of an acquired entity over the net of the amounts assigned to assets acquired and liabilities assumed is recorded as goodwill.
(d) Cash and Cash Equivalents
For the consolidated statements of cash flows, the Company has defined cash and cash equivalents as cash and due from banks and federal funds sold.
(e) Investment Securities
The Company classifies its investment securities in one of three categories: available-for-sale, held-to-maturity or trading. Held-to-maturity securities are those securities for which the Company has the ability and intent to hold until maturity. Trading securities are those securities for which the
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(2) Summary of Significant Accounting Policies (Continued)
Company has purchased and holds for the purpose of selling in the near future. All other securities are classified as available-for-sale.
Held-to-maturity securities are carried at amortized cost. Available-for-sale and trading securities are carried at estimated fair value. Unrealized gains and losses, net of applicable tax, on available-for-sale securities are reported in other comprehensive income (loss). Unrealized market value adjustments, fees and realized gains and losses, on trading securities are reported in non-interest income.
At December 31, 2009, the Company had investment securities classified as trading. These investments were purchased to economically hedge against fair value changes of the Company's nonqualified deferred compensation plan liability. Those investments were designated as trading securities, and as such, the changes in fair value are reflected in earnings. At December 31, 2008, the Company did not have any investment securities classified as trading.
Gains and losses on the sale of securities are determined using the specific identification method.
The Company regularly evaluates its securities whose value have declined below their amortized cost to assess whether the decline in fair value is other-than-temporary. The Company considers various factors in determining whether a decline in fair value is other-than-temporary including the issuer's financial condition and/or future prospects, the effects of changes in interest rates or credit spreads, the expected recovery period and other quantitative and qualitative information. The valuation of securities for impairments process is subject to risks and uncertainties and is intended to determine whether declines in the fair value of investments should be recognized in current period earnings. The risks and uncertainties include changes in general economic conditions and future changes in assessments of the aforementioned factors. It is at least reasonably probable that such factors will change in the future, which may result in other-than-temporary impairments. Beginning in 2009, under new accounting guidance for impairments of debt securities that are deemed to be other-than-temporary, the credit portion of an other-than-temporary impairment loss is recognized in earnings and the non-credit portion is recognized in accumulated other comprehensive income in those situations where the Company does not intend to sell the security and it is more likely than not that the Company will not be required to sell the security prior to recovery. Prior to January 1, 2009, any other-than-temporary impairment recognized was deemed to be credit related and reported in earnings.
Premiums and discounts are recognized in interest income using the effective interest method. Prepayments of the mortgages securing mortgage-backed securities may affect the anticipated maturity date and, therefore, the yield to maturity. The Company uses actual principal prepayment experience and estimates of future principal prepayments in calculating the yield necessary to apply the effective interest method.
(f) Loans Held for Sale
Mortgage loans originated and intended for sale into the secondary market are carried at the lower of cost or estimated fair value, determined on an aggregate loan basis. The Company sells its mortgage loans forward to investors and the estimated fair value is largely dependent upon the terms of these outstanding loan purchase commitments as well as movement in market interest rates. Net unrealized losses, if any, are recognized through a valuation allowance by charges to operations. The carrying amount of loans held for sale includes principal balances, valuation allowances, origination premiums or discounts and fees and direct costs that are deferred at the time of origination.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(2) Summary of Significant Accounting Policies (Continued)
The Company sells its originated mortgage loans to third party investors servicing released. Upon sale and delivery, the loans are legally isolated from the Company and the Company has no ability to restrict or constrain the ability of third-party investors to pledge or exchange the mortgage loans. The Company does not have the entitlement or ability to repurchase the mortgage loans or unilaterally cause third-party investors to put the mortgage loans back to the Company.
(g) Loans Receivable and Allowance for Loan Losses
Loans receivable that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off are reported at their outstanding principal balance adjusted for any charge-offs, and net of the allowance for loan losses and deferred fees and costs. Loan origination fees and certain direct origination costs are deferred and amortized as an adjustment of the yield using the payment terms required by the loan contract.
Loans are generally placed into non-accrual status when they are past-due 90 days as to either principal or interest or when, in the opinion of management, the collection of principal and/or interest is in doubt. A loan remains in non-accrual status until the loan is current as to payment of both principal and interest or past-due less than 90 days and the borrower demonstrates the ability to pay and remain current. Loans are charged-off when a loan or a portion thereof is considered uncollectible. When cash payments are received, they are applied to principal first, then to accrued interest. It is the Company's policy not to record interest income on non-accrual loans until principal has become current. In certain instances, accruing loans that are past due 90 days or more as to principal or interest may not go on non-accrual status if the Chief Credit Officer determines that the loans are well secured and are in the process of collection.
The Company determines and recognizes impairment of certain loans when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the loan agreement. A loan is not considered impaired during a period of delay in payment if the Company expects to collect all amounts due, including past-due interest. An impaired loan is measured at the present value of its expected future cash flows discounted at the loan's coupon rate, or at the loan's observable market price or fair value of the collateral if the loan is collateral dependent. The Company measures the collateral value on impaired loans by obtaining an updated appraisal of the underlying collateral and may discount further the appraised value, if necessary, to an amount equal to the expected cash proceeds in the event the loan is foreclosed upon and the collateral is sold. In addition, an estimate of costs to sell the collateral is assumed.
The allowance for loan losses is increased by provisions for loan losses and recoveries of previously charged-off loans, and decreased by loan charge-offs.
The Company maintains the allowance for loan losses at a level that represents management's best estimate of known and inherent losses in the loan portfolio. Both the amount of the provision expense and the level of the allowance for loan losses are impacted by many factors, including general and industry-specific economic conditions, actual and expected credit losses, historical trends and specific conditions of the individual borrowers. Unusual and infrequently occurring events, such as weather-related disasters, may impact the assessment of possible credit losses. As a part of its analysis, the Company uses comparative peer group data and qualitative factors, such as levels of and trends in delinquencies and non-accrual loans, national and local economic trends and conditions and concentrations of loans exhibiting similar risk profiles to support estimates.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(2) Summary of Significant Accounting Policies (Continued)
For purposes of this analysis, the Company categorizes loans into one of five categories: commercial and industrial, commercial real estate (including construction), home equity lines of credit, residential mortgages, and consumer loans. In the absence of meaningful historical loss factors, peer group loss factors are applied and are adjusted by the qualitative factors mentioned above. The indicated loss factors resulting from this analysis are applied to each of the five categories of loans. In addition, the Company individually assigns loss factors to all loans that have been identified as having loss attributes, as indicated by deterioration in the financial condition of the borrower or a decline in underlying collateral value if the loan is collateral dependent. Since the Company has limited historical data on which to base loss factors for classified loans, the Company generally applies, in accordance with regulatory guidelines, a 5% loss factor to all loans classified as special mention, a 15% loss factor to all loans classified as substandard and a 50% loss factor to all loans classified as doubtful. Loans classified as loss loans are fully reserved or charged off. In certain instances, the Company evaluates the impairment of certain loans on a loan by loan basis. For these loans, the Company analyzes the fair value of the collateral underlying the loan and considers estimated costs to sell the collateral on a discounted basis. If the net collateral value is less than the loan balance (including accrued interest and any unamortized premium or discount associated with the loan) the Company recognizes an impairment and establishes a specific reserve for the impaired loan.
In addition, various regulatory agencies, as part of their examination process, periodically review the Company's allowance for loan losses. These agencies may require the Company to recognize additions to the allowance based on their risk evaluation and credit judgment. Management believes that the allowance for loan losses at December 31, 2009 and 2008 is a reasonable estimate of known and inherent losses in the loan portfolio at those dates.
(h) Premises and Equipment
Land is carried at cost. Premises, furniture, equipment, and leasehold improvements are carried at cost, less accumulated depreciation and amortization. Depreciation of premises, furniture and equipment is computed using the straight-line method over estimated useful lives from three to 25 years. Amortization of leasehold improvements is computed using the straight-line method over the useful lives of the improvements or the lease term, whichever is shorter. Purchased computer software which is capitalized is amortized over estimated useful lives of one to three years. Internally developed software is expensed as incurred.
(i) Goodwill and Other Intangibles
Goodwill, which represents the excess of purchase price over fair value of net assets acquired, is not amortized but is evaluated at least annually for impairment by comparing its fair value with its carrying amount. An impairment loss is recognized to the extent that the carrying amount exceeds fair value.
The Company performs annual impairment evaluations for its reporting units in the calendar quarter as follows: George Mason (3rd quarter), Wilson/Bennett (2nd quarter), and Trust Services (1st quarter) or more frequently as circumstances warrant. Note 8 discusses the impairment charges recorded during the year ended December 31, 2008. No impairment was indicated for 2009 or 2007. The Company also has amortizable intangible assets. These intangible assets are being amortized on a straight-line basis over their estimated useful lives from nine to ten years. These assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount may not be
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(2) Summary of Significant Accounting Policies (Continued)
recoverable. There was no indication that the carrying amounts of the Company's amortizable intangible assets were not recoverable during 2009.
(j) Bank-Owned Life Insurance
Under the Company's bank-owned life insurance policy, executives or other key individuals are the insureds and the Company is the owner and beneficiary of the policy. As such, the insured has no claim to the insurance policy, the policy's cash value, or a portion of the policy's death proceeds. The increase in the cash surrender value over time is recorded as other non-interest income.
(k) Realized and Unrealized Gains on Mortgage Banking Activities
Realized and unrealized gains on mortgage banking activities include income earned by George Mason and Cardinal First for originating loans, the sale of these loans, and other activities incidental to mortgage banking activities.
(l) Management Fee Income
Management fee income represents income earned for the management and operational support provided by George Mason to other mortgage banking companies (the "managed companies") owned by local homebuilders. The relationship of George Mason to these managed companies is solely as service provider and there is no fiduciary relationship. Fees earned by George Mason are accrued based on contractual arrangements with each of the managed companies and are generally determined as a percentage of the managed company's net income before income taxes.
(m) Investment Fee Income
Investment fee income represents commissions paid by customers of CWS and asset management fees paid by the customers of Wilson/Bennett for investment services. Revenue from Trust Services is also a component of investment fee income and is recognized in the period earned in accordance with contractual percentage of assets under management or custody. Trust Services revenue is generally determined based upon the fair value of assets under management or custody at the end of the period. Fees are recognized in income as they are earned.
(n) Income Taxes
Deferred tax assets and liabilities are recognized for the tax effects of differing carrying values of assets and liabilities for tax and financial statement purposes that will reverse in future periods. Deferred tax assets and liabilities are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes.
When uncertainty exists concerning the recoverability of a deferred tax asset, the carrying value of the asset may be reduced by a valuation allowance. The amount of any valuation allowance established is based upon an estimate of the deferred tax asset that is more likely than not to be recovered. Increases or decreases in the valuation allowance result in increases or decreases to the provision for income taxes.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(2) Summary of Significant Accounting Policies (Continued)
As of December 31, 2009 and 2008, the Company had no unrecognized tax benefits. The Company had no interest expense or tax penalties related to uncertain tax positions during the years ended December 31, 2009 and 2008. If the Company had such expenses, they would be classified in the consolidated statements of income as part of the provision for income tax expense.
(o) Earnings Per Common Share
Basic earnings per common share is computed by dividing net income available to common shareholders by the weighted-average number of shares of common stock outstanding during the periods, including shares which will be issued to settle liabilities of the deferred compensation plans. Diluted earnings per share reflects the impact of dilutive potential common shares that would have been outstanding if common stock equivalents had been issued, as well as any adjustment to income that would result from the assumed issuance. Common stock equivalents that may be issued by the Company relate primarily to outstanding stock options, and the dilutive potential common shares resulting from outstanding stock options are determined using the treasury stock method. Common stock equivalents for diluted earnings per share purposes also includes common shares which may be issued, but are not required to be issued, to settle the Company's obligations under its deferred compensation plans. The effects of anti-dilutive common stock equivalents are excluded from the calculation of diluted earnings per share.
(p) Derivative Instruments and Hedging Activities
The Company records its derivatives at their fair values in other assets and other liabilities on the statement of condition. The Company does not enter into derivative transactions for speculative purposes. For derivatives designated as hedges, the Company contemporaneously documents the hedging relationship, including the risk management objective and strategy for undertaking the hedge, how effectiveness will be assessed at inception and at each reporting period and the method for measuring ineffectiveness. The Company evaluates the effectiveness of these transactions at inception and on an ongoing basis. Ineffectiveness is recorded through earnings. For derivatives designated as cash flow hedges, the fair value adjustment is recorded as a component of other comprehensive income, net of tax, except for the ineffective portion. For derivatives designated as fair value hedges, the fair value adjustments for both the hedged item and the hedging instrument are recorded through the income statement with any difference considered the ineffective portion of the hedge. The Company discontinues hedge accounting when i) the hedge is no longer considered highly effective or ii) the derivative matures or is sold or terminates.
In the normal course of business, the Company enters into rate lock commitments to finance residential mortgage loans. These commitments, which contain fixed expiration dates, offer the borrower an interest rate guarantee provided the loan meets underwriting guidelines and closes within the timeframe established by the Company. Interest rate risk arises on these commitments and subsequently closed loans if interest rates change between the time of the interest rate lock and the delivery of the loan to the investor. Loan commitments related to residential mortgage loans intended to be sold are considered derivatives and are marked to market through earnings. These rate lock commitments are considered derivatives and marked to fair value through earnings.
To mitigate the effect of interest rate risk inherent in providing rate lock commitments, the Company economically hedges its commitments by entering into best efforts forward delivery loan sales contracts. During the rate lock commitment period, these forward loan sales contract derivatives are
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(2) Summary of Significant Accounting Policies (Continued)
marked to fair value. The fair values of loan commitments and the fair value of forward sales contracts generally move in opposite directions, and the net impact of the changes in these valuations on net income during the loan commitment period is generally inconsequential. At the closing of the loan, the rate lock commitment derivative matures and the Company records a loan held for sale and continues to be obligated under the same forward loan sales contract. The loans held for sale are then designated as the hedged item in a cash flow hedge. The derivative in this relationship is the forward loan sale commitment.
When hedge accounting is discontinued because it is probable an anticipated loan sale will not occur, the Company recognizes immediately in earnings any gains and losses that were accumulated in other comprehensive income.
(q) Stock-Based Compensation
The Company recognizes in the income statement the grant-date fair value of stock options and other equity-based compensation. The Company classifies stock awards as either an equity award or a liability award. Equity classified awards are valued as of the grant date using either an observable market price or a valuation methodology. Liability classified awards are valued at fair value at each reporting date. All of the Company's stock options are classified as equity awards.
The Company awards stock options with a graded-vesting period and as such has elected to recognize compensation costs over the requisite service period for the entire award. Total compensation cost charged against income for the years ended December 31, 2009, 2008, and 2007 was $374,000, $343,000, and $338,000, respectively. The total income tax benefit related to stock options exercised and recognized in the income statement for share-based compensation arrangements was $65,000, $0 and $20,000 for the years ended December 31, 2009, 2008, and 2007.
At December 31, 2009, the Company had two stock-based employee compensation plans, which are described more fully in Note 18.
Stock options are granted with an exercise price equal to the common stock's fair market value at the date of grant. Director stock options have ten year terms and vest and become fully exercisable at the grant date. Certain employee stock options have ten year terms and vest and become fully exercisable after three years. Other employee stock options have ten year terms and vest and become fully exercisable in 20% increments beginning as of the grant date. In addition, the Company has granted stock options to employees of the Company that have ten year terms and vest and become fully exercisable in 20% increments beginning after their first year of service.
The weighted average per share fair values of stock option grants made in 2009, 2008, and 2007 were $2.92, $3.10, and $4.68, respectively. The fair values of the options granted were estimated on the grant date using the Black-Scholes option-pricing model based on the following weighted average assumptions:
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(2) Summary of Significant Accounting Policies (Continued)
Expected volatility is based upon the average annual historical volatility of the Company's common stock. The estimated option life is derived from the "simplified method" formula as described in Staff Accounting Bulletin No. 110. The risk free interest rate is based upon the seven-year U.S. Treasury note rate in effect at the time of grant. The expected dividend yield is based upon implied and historical dividend declarations.
(r) Reclassifications
Certain amounts in the 2008 and 2007 consolidated financial statements and notes thereto have been reclassified to conform to the 2009 presentation.
(3) Investment Securities and Other Investments
The fair value and amortized cost of investment securities at December 31, 2009 and 2008 are shown below.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(3) Investment Securities and Other Investments (Continued)
The fair value and amortized cost of investment securities by contractual maturity at December 31, 2009 are shown below. Expected maturities may differ from contractual maturities because many issuers have the right to call or prepay obligations with or without call or prepayment penalties.
For the years ended December 31, 2009, 2008, and 2007, proceeds from sales of investment securities available-for-sale amounted to $59.6 million, $37.5 million, and $0 million, respectively. Gross realized gains in 2009, 2008, and 2007, amounted to $977,000, $913,000, and $0, respectively. Gross realized losses for the year ended December 31, 2009 were $217,000 from the sale of Fannie Mae perpetual preferred stock. The Company elected to sell these shares as they were continuing to trade well below par value following the placement of Fannie Mae into conservatorship by federal regulators during 2008. The Company recognized an other-than-temporary impairment of $4.4 million on this investment as of December 31, 2008. The full amount of this impairment was deemed to be related to credit deterioration of the issuer, and not related to equity market conditions. Because of the minimal likelihood that these shares would recover, the Company made the decision to exit this type of investment security and no longer owns any similar equity investment in its investment securities portfolio. There were no realized losses in 2008 and 2007.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(3) Investment Securities and Other Investments (Continued)
The tables below show the Company's investment securities' gross unrealized losses and their fair value, aggregated by investment category and the length of time that individual securities have been in a continuous unrealized loss position at December 31, 2009 and 2008.
Temporarily Impaired Securities
At December 31, 2009
Temporarily Impaired Investment Securities
At December 31, 2008
Investment Securities Available-for-Sale
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(3) Investment Securities and Other Investments (Continued)
Investment Securities Held-to-Maturity
The Company completes reviews for other-than-temporary impairment at least quarterly. As of December 31, 2009, the majority of the investment securities portfolio consisted of securities rated AAA by a leading rating agency. Investment securities which carry a AAA rating are judged to be of the best quality and carry the smallest degree of investment risk. At December 31, 2009, 96% of the Company's mortgage-backed securities are guaranteed by the Federal National Mortgage Association (FNMA), the Federal Home Loan Mortgage Corporation (FHLMC) and the Government National Mortgage Association (GNMA).
The Company has $9.9 million in non-government non-agency mortgage-backed securities. These securities are rated from AAA to AA. The various protective elements on the non agency securities may change in the future if market conditions or the financial stability of credit insurers changes, which could impact the ratings of these securities.
At December 31, 2009, certain of the Company's investment grade securities were in an unrealized loss position. Investment securities with unrealized losses are a result of pricing changes due to recent and negative conditions in the current market environment and not as a result of permanent credit impairment. Contractual cash flows for the agency mortgage-backed securities are guaranteed and/or funded by the U.S. government. Other mortgage-backed securities and municipal securities have third party protective elements and there are no negative indications that the contractual cash flows will not be received when due. The Company does not intend to sell nor does the Company believe it will be required to sell any of the temporarily impaired securities prior to the recovery of amortized cost.
The held-to-maturity portfolio includes investments in four pooled trust preferred securities, totaling $8.0 million of par value at December 31, 2009 (each security has a par value of $2.0 million). These securities are presented as corporate bonds in the above table. The collateral underlying these structured securities are instruments issued by financial institutions or insurers. The Company owns the A-3 tranches in each issuance. Each of the bonds are rated by more than one rating agency. Two of the securities have a composite rating of AA and two of the securities have a composite rating of BBB. These ratings are consistent with the grades from the other rating agencies. There is minimal observable trading activity for these types of securities. The Company has estimated the fair value of the securities through the use of internal calculations and through information provided by external pricing services. Given the level of subordination below the A-3 tranches, and the actual and expected performance of the underlying collateral, the Company expects to receive all contractual interest and principal payments recovering the amortized cost basis of each of the four securities, and concluded that these securities are not other-than-temporarily impaired.
In one of the pooled trust preferred securities issues, 40% of the principal balance is subordinate to our class of ownership, and it is estimated that a break in contractual cash flow would occur if 47% of the performing collateral defaulted or deferred payment. In another of the pooled trust preferred
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(3) Investment Securities and Other Investments (Continued)
securities issues, 38% of the principal balance is subordinate to our class of ownership, and it is estimated that a break in contractual cash flow would occur if 36% of the performing collateral defaulted or deferred payment. In the third of the pooled trust preferred securities issues, 66% of the principal balance is subordinate to our class of ownership, and it is estimated that a break in contractual cash flow would occur if 83% of the performing collateral defaulted or deferred payment. In the fourth of the pooled trust preferred securities issues, 50% of the principal balance is subordinate to our class of ownership, and it is estimated that a break in contractual cash flow would occur if 73% of the performing collateral defaulted or deferred payment.
During 2009, no other-than-temporary impairment has been recognized on the securities in the Company's investment portfolio. During 2008, the Company recognized an other-than-temporary impairment of $4.4 million related to an investment in Fannie Mae perpetual preferred stock as discussed above.
Investment securities that were pledged to secure borrowed funds and other balances as required at December 31, 2009 and 2008 had carrying values of $235.5 million and $222.9 million, respectively.
Other investments at December 31, 2009 include $15.7 million of Federal Home Loan Bank stock and $63,000 of Community Bankers' Bank stock. At December 31, 2008, other investments included $15.6 million of Federal Home Loan Bank stock and $63,000 of Community Bankers' Bank stock. As a member of the Federal Home Loan Bank of Atlanta ("FHLB"), the Company's banking subsidiary is required to hold stock in this entity. Stock membership in Community Bankers' Bank allows the Company to participate in loan purchases and sales. In addition, included in other investments at December 31, 2009 and 2008 is the Company's $619,000 investment in Cardinal Statutory Trust I. At December 31, 2009 the Company had an equity investment in a local bank holding Company of $50,000. These investments are carried at cost since no active trading markets exist.
In February 2009, the FHLB announced changes to its capital stock requirements. Specifically, the FHLB Board of Directors increased the dollar cap on its stock purchases from $25 million to $26 million and repurchases of member excess stock will be evaluated on a quarterly basis instead of a daily basis.
The Company's policy is to review for impairment of FHLB stock at each reporting period. At December 31, 2009, FHLB was in compliance with all of its regulatory capital requirements. The Company believes its holdings in the stock are ultimately recoverable at par value as of December 31, 2009. In addition, the Company has ample liquidity and does not require redemption of its FHLB stock in the foreseeable future. Based on the Company's analysis of positive and negative factors, it believes that as of December 31, 2009 and 2008, its FHLB stock was not impaired.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(4) Investment Securities-Trading
During 2009, we acquired investment assets and designated them as trading to economically hedge against fair value changes of the Company's nonqualified deferred compensation plan liability. Those investments were designated as trading securities, and as such, the changes in fair value are reflected in earnings.
The net unrealized gain on trading securities for the year ended December 31, 2009 was $194,000.
There were no trading securities at December 31, 2008. The net realized loss on trading securities for the years ended December 31, 2009 and 2008 was $619,000 and $9,000, respectively.
(5) Loans Receivable
The loan portfolio at December 31, 2009 and 2008 consists of the following:
Substantially all of the Company's loans, commitments and standby letters of credit have been granted to customers located in the Washington, D.C. metropolitan area. As a matter of regulatory restriction, the Company's banking subsidiary limits the amount of credit extended to any single borrower or group of related borrowers. At December 31, 2009, the amount of credit extended to any single borrower or group of related borrowers was limited to $30.2 million. Loans in process at December 31, 2009 and 2008 were $103,000 and $1,000, respectively.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(5) Loans Receivable (Continued)
An analysis of the change in the allowance for loan losses follows:
At December 31, 2009, 2008, and 2007, the Company had impaired loans on non-accrual status of $696,000, $4.7 million, and $0, respectively. At December 31, 2009, the impaired loans did not have a valuation allowance as the Company charged-off $411,000, which represented the portion of the outstanding principal balance that was in excess of the estimated values of the underlying collateral.
The average balance of impaired loans was $6.6 million, $13,000, and $132,000 for 2009, 2008, and 2007, respectively. For the year ended December 31, 2009, the Company had a loan on nonaccrual of $4.7 million which was foreclosed upon during December 2009, which contributed to the impaired loan average balance for all of 2009. Similarly, this same loan was placed on nonaccrual in December 2008, which is why the average balance for impaired loans was low for the year ended December 31, 2008. Interest income that would have been recorded had these loans been performing for the years ended December 31, 2009, 2008, and 2007 would have been $414,000, $59,000, and $5,000, respectively. The interest income realized prior to these loans being placed on non-accrual status for December 31, 2009, 2008, and 2007 was $120,000, $348,000, and $38,000, respectively. At December 31, 2009 and 2008, the Company had accruing loans past due 90 days or more as to principal or interest payments of $151,000 and $379,000, respectively, all of which were determined to be well-secured and in the process of collection.
Loans totaling $334.7 million serve as collateral for Federal Home Loan Bank advances at December 31, 2009.
(6) Other Real Estate Owned
At December 31, 2009 and 2008, the Company had other real estate owned of $5.0 million and $121,000, respectively. The balances in other real estate owned are recorded at fair value on the statement of condition. The fair value is determined by obtaining an updated appraisal of the foreclosed property which is then discounted for estimated selling costs.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(7) Loans Held for Sale
The loans held for sale portfolio at December 31, 2009 and 2008, consisted of the following:
Loans that are classified as construction-to-permanent are those loans that provide variable rate financing for customers to construct their residences. Once the home has been completed, the loan converts to fixed rate financing and is sold into the secondary market.
(8) Goodwill and Other Intangible Assets
Goodwill is tested for impairment on an annual basis or more frequently if events or circumstances warrant. The Company performs an analysis to compare the fair value of the reporting unit to which the goodwill is assigned to the carrying value of the reporting unit. The Company makes estimates of the discounted cash flows from the expected future operations of the reporting unit. If the analysis indicates that the fair value of the reporting unit is less than its carrying value, the Company completes an analysis to compare the implied fair value of the reporting unit's goodwill with the carrying amount of that goodwill. The implied fair value of the goodwill is determined by allocating the fair value of the reporting unit to all of its assets and liabilities. If the implied fair value of the goodwill is less than the carrying value, an impairment loss is recognized.
The Company continually reviews its identifiable/definite lived intangible assets for impairment whenever events or changes in circumstances indicate that the remaining estimated useful life of such assets might warrant revision or that the balances may not be recoverable. The Company evaluates possible impairment by comparing estimated future cash flows, before interest expense and on an undiscounted basis, with the net book value of the long-term assets, including amortizable intangible assets. If undiscounted cash flows are insufficient to recover assets, further analysis is performed in order to determine the amount of the impairment. An impairment loss is then recorded for the excess of the carrying amount of the assets over their fair values. Fair value is usually determined based on the present value of estimated expected future cash flows using a discount rate commensurate with the risks involved.
Goodwill is reported in two of the Company's reporting units: George Mason (mortgage banking segment) and Wilson/Bennett (wealth management and trust services segment). For the year ended December 31, 2009, no impairment was indicated in either reporting unit. For the year ended December 31, 2008, the Company recorded an impairment of the goodwill associated with George Mason. The Company employed the services of a valuation consultant to assist with the goodwill evaluation for George Mason in both 2009 and 2008. During 2008, ongoing challenges in the regional residential real estate market negatively impacted the forecasted cash flows expected to be generated by George Mason over the near term and the valuation analysis indicated that goodwill was impaired and a non-cash impairment charge of $2.8 million was recognized.
During 2008, the Company evaluated the customer relationship intangibles related to George Mason. These intangible assets are related to the relationships that George Mason has with other
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(8) Goodwill and Other Intangible Assets (Continued)
mortgage lenders and its managed companies. George Mason provides services to these managed companies and earns management fee income, which generally fluctuates based on the volume of loan sales. As a result of the downturn in the regional housing market, fee income from managed companies was adversely impacted. This continued adverse change in the business climate caused the Company to evaluate the intangibles assets related to these managed companies for impairment in both 2008 and 2007. These evaluations did not result in an impairment loss for these intangible assets in either year. No triggering events were indicated during 2009 which would have required an assessment of the recoverability of these and other identified intangibles.
Information concerning amortizable intangibles follows:
The aggregate amortization expense for 2009, 2008, and 2007 was $238,000, $245,000, and $254,000, respectively. The estimated amortization expense for the next five years is as follows:
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(8) Goodwill and Other Intangible Assets (Continued)
The changes in the carrying amount of goodwill for the years ended December 31, 2009 and 2008 were as follows:
(9) Premises and Equipment
Components of premises and equipment at December 31, 2009 and 2008 were as follows:
Depreciation expense for the years ended December 31, 2009, 2008, and 2007 was $1.9 million, $2.4 million, and $3.0 million, respectively.
The Company has entered into operating leases for office space over various terms. The leases generally have options to renew and are subject to annual increases as well as allocations of real estate taxes and certain operating expenses.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(9) Premises and Equipment (Continued)
Minimum future rental payments under the noncancelable operating leases, as of December 31, 2009 were as follows:
The total rent expense was $5.5 million, $5.6 million, and $5.3 million in 2009, 2008, and 2007, respectively and is recorded in occupancy expense in the consolidated statements of income.
The Company subleased excess office space to third parties. Future minimum lease payments under noncancelable subleasing arrangements as of December 31, 2009 were as follows:
The total rent income was $482,000, $434,000, and $409,000 in 2009, 2008, and 2007, respectively, and is recorded as a reduction of occupancy expense in the consolidated statements of income.
(10) Deposits
Deposits consist of the following at December 31, 2009 and 2008:
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(10) Deposits (Continued)
Interest expense by deposit categories is as follows:
The aggregate amount of certificates of deposit, each with a minimum denomination of $100,000 was $388.0 million and $241.3 million at December 31, 2009 and 2008, respectively.
At December 31, 2009, the scheduled maturities of certificates of deposit with a minimum denomination of $100,000 were as follows:
Maturities:
No-Penalty certificates of deposit can be redeemed at anytime at the request of the depositor.
Brokered certificates of deposits at December 31, 2009 and 2008 were $87.7 million and $89.2 million, respectively.
At December 31, 2009, the scheduled maturities of certificates of deposit were as follows:
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(11) Other Borrowed Funds
At December 31, 2009 and 2008, other borrowed funds consisted of the following:
The Company had fixed rate advances from the FHLB totaling $280.0 million at December 31, 2009. These advances mature through 2018 and have interest rates ranging from 2.57% to 5.00%. Certain fixed rate FHLB advances have call options through 2013.
The contractual maturities of the fixed rate FHLB advances for each of December 31, 2009 and 2008 were as follows:
The average balances of FHLB advances for the years ended December 31, 2009 and 2008 were $280.0 million and $273.2 million, respectively. The maximum amount outstanding at any month-end during the years ended December 31, 2009 and 2008 was $280.0 million and $290.0 million, respectively. Total interest expense on FHLB advances for the years ended December 31, 2009, 2008, and 2007 was $11.3 million, $11.0 million, and $7.2 million, respectively.
For the year ended December 31, 2009 there were no extinguishments of FHLB advances. For the year ended December 31, 2008, the Company extinguished four FHLB advances totaling $20.0 million. The net gain on the extinguishment of these advances for the year ended December 31, 2008 was $275,000 and was recorded in other income in the consolidated statements of income.
Securities sold under agreements to repurchase generally mature within one to four days and are reflected in the consolidated statements of condition at the amount of cash received. The Company's deposit customers are the counterparties to these types of financial instruments. At December 31, 2009 and 2008 the Company had repurchase agreements of $80.0 million and $65.9 million, respectively. The weighted-average interest rate of these repurchase agreements was 0.46% and 2.05% at December 31,
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(11) Other Borrowed Funds (Continued)
and 2008, respectively. The average balances of repurchase agreements during 2009 and 2008 were $71.5 million and $58.6 million, respectively, and the maximum amount outstanding at any month-end during 2009 and 2008 was $90.1 million and $70.0 million, respectively. Interest expense on repurchase agreements for 2009, 2008, and 2007 was $326,000, $1.2 million, and $1.7 million, respectively.
At December 31, 2009, the Company had federal funds purchased of $45.0 million. The Company had no outstanding federal funds purchased at December 31, 2008. During 2008, the Company did have federal funds purchased outstanding at certain times during the year. Interest expense on federal funds purchased in 2009, 2008, and 2007 was $9,000, $141,000, and $1.0 million, respectively. The Company had no outstanding short-term dealer repurchase agreements at December 31, 2009 and 2008. However, the Company did have short-term dealer repurchase agreements outstanding at other times during the years 2008 and 2007. Interest Expense on short-term dealer repurchase agreements for the years ended December 31, 2009, 2008, and 2007 was $0, $10,000, and $822,000, respectively.
The Company has a Treasury, Tax, & Loan ("TT&L") note option with the Federal Reserve. At December 31, 2009 and 2008, the outstanding balance in the TT&L note option was $2.0 million and $692,000, respectively. Interest expense related to the TT&L note option in 2009, 2008, and 2007 was $1,000, $27,000, and $206,000, respectively. The Company has a line of credit at the Federal Reserve discount window in the amount of $307.4 million at December 31, 2009, none of which was drawn as of that date. There was no interest expense related to the discount window in 2009, 2008 or 2007.
In July 2004, the Company formed a wholly-owned subsidiary, Cardinal Statutory Trust I (the "Trust"), for the purpose of issuing $20.0 million of floating rate junior subordinated deferrable interest debentures ("trust preferred securities"). These trust preferred securities are due in 2034 and have an interest rate of LIBOR (London Interbank Offered Rate) plus 2.40%, which adjusts quarterly. At December 31, 2009, the interest rate on trust preferred securities was 2.65%. These securities are redeemable at par beginning September 2009. The Company has not redeemed any portion of these securities. The Company has guaranteed payment of these securities. The $20.6 million payable by the Company to the Trust is included in other borrowed funds. The Trust is an unconsolidated subsidiary since the Company is not the primary beneficiary of this entity. The additional $619,000 that is payable by the Company to the Trust represents the Company's unfunded capital investment in the Trust. The Company utilized the proceeds from the issuance of the trust preferred securities to make a capital contribution into the Bank. Interest expense on the trust preferred securities in 2009, 2008, and 2007 was $888,000, $1.2 million and $1.6 million, respectively.
The scheduled maturities of other borrowed funds at December 31, 2009 were as follows:
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(12) Proceeds from Issuance of Common Stock
During 2009, the Company completed a secondary common stock offering. The Company issued 4,378,302 shares of its common stock at $7.75 per share for net proceeds of $31.6 million.
(13) Income Taxes
The Company and its subsidiaries file consolidated federal tax returns on a calendar-year basis. For the years ended December 31, 2009 and 2007, the Company recorded income tax expense of $4.4 million and $885,000, respectively. For the year ended December 31, 2008, the Company recorded an income tax benefit of $912,000.
The provision for income tax expense is reconciled to the amount computed by applying the federal corporate tax rate to income before taxes as follows:
The components of income tax expense (benefit) are as follows:
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(13) Income Taxes (Continued)
The tax effects of temporary differences between the financial reporting basis and income tax basis of assets and liabilities relate to the following:
Deferred tax assets and liabilities are recognized for the tax effects of differing carrying values of assets and liabilities for tax and financial statement purposes that will reverse in future periods. When uncertainty exists concerning the recoverability of a deferred tax asset, the carrying value of the asset may be reduced by a valuation allowance. Valuation allowances of $1.6 million for each of December 31, 2009 and 2008 have been established for deferred tax assets. This valuation allowance relates primarily to the state net operating losses of the parent company, CWS and Wilson/Bennett as realization is dependent upon generating future taxable income within those entities and in the specific jurisdiction. The realization of this deferred tax asset is dependent upon generating future taxable income. There is uncertainty concerning the recoverability of these state net operating losses as the entities which own these losses have never operated profitably and future profitability is uncertain. Management believes that future operations of the Company will generate sufficient taxable income to realize the net deferred tax assets at December 31, 2009 and 2008.
As of December 31, 2009 and 2008, the Company had no unrecognized tax benefits. The Company had no interest expense or tax penalties related to uncertain tax positions during the years ended December 31, 2009 and 2008. If the Company had such expenses, they would be classified in the consolidated statements of income as part of the provision for income tax expense.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(14) Derivative Instruments and Hedging Activities
Forward Mortgage Loan Sales Commitments and Interest Rate Lock Commitments
The Company enters into rate lock commitments with its mortgage customers. The Company is also a party to forward mortgage loan sales contracts to sell loans servicing released. The rate lock commitment and forward sale agreement are undesignated derivatives and marked to fair value through earnings. The fair value of the loan commitment includes the servicing premium and the interest spread for the difference between retail and wholesale mortgage rates. Realized and unrealized gains on mortgage banking activities presents the gain recognized for the period presented and associated with these elements of fair value. On the date the mortgage loan closes, the loan held for sale is designated as the hedged item in a cash flow hedge relationship.
At December 31, 2009 and 2008, accumulated other comprehensive income included an unrealized gain (loss), net of tax, of $6,500 and ($211,500), respectively, related to forward loan sale contracts designated as the hedging instrument in the cash flow hedge. Loans held for sale are generally sold within sixty days of closing and, therefore, substantially all of the amount recorded in accumulated other comprehensive income at December 31, 2009 which is related to the Company's cash flow hedges will be recognized in earnings during the first quarter of 2010. At December 31, 2009 the Company recognized minimal amounts related to hedge ineffectiveness.
At December 31, 2009, the Company had $71.0 million in residential mortgage rate lock commitments and associated forward sales and had $163.4 million in forward loan sales associated with $163.4 million of loans that had closed and were presented as held for sale. At December 31, 2009, the derivative asset was $4.6 million and the derivative liability was $1.6 million.
At December 31, 2008, the Company had $81.6 million in loan commitments and associated forward sales and had $117.6 million in forward loan sales associated with $117.6 million of loans held for sale contracts. At December 31, 2008, the derivative asset was $2.1 million and the derivative liability was $1.4 million.
Interest Rate Risk Management-Cash Flow Hedging Instruments
The Company uses long-term variable rate debt as a source of funds for use in the Company's lending and investment activities and other general business purposes. These debt obligations expose the Company to variability in interest payments due to changes in interest rates. If interest rates increase, interest expense increases. Conversely, if interest rates decrease, interest expense decreases. The Company believes it is prudent to limit the variability of a portion of its interest payments and, therefore, generally hedges a portion of its variable-rate interest payments. To meet this objective and during 2008, the Company entered into interest rate swap agreements whereby the Company receives variable interest rate payments and makes fixed interest rate payments during the contract period.
At December 31, 2009 and 2008, the information pertaining to outstanding interest rate swap agreements used to hedge variable rate debt (trust preferred securities which is included in other borrowed funds on the statement of condition) is as follows:
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(14) Derivative Instruments and Hedging Activities (Continued)
These agreements provided for the Company to receive payments at a variable rate determined by a specific index (three month LIBOR) in exchange for making payments at a fixed rate. At December 31, 2009, the unrealized loss relating to interest rate swaps designated as hedging instruments of the variability of cash flows associated with long-term debt are reported in other comprehensive income. These amounts are subsequently reclassified into interest expense as a yield adjustment in the same period in which the related interest on the long-term debt affects earnings. The cash flow hedging relationships were highly effective during 2009 and the amount of ineffectiveness was de minimus.
Interest Rate Risk Management-Fair Value Hedging Instruments
The Company originates fixed and variable rate loans. Fixed rate loans expose the Company to variability in their fair value due to changes in the level of interest rates. The Company believes it is prudent to limit the variability in the fair value of a portion of its fixed rate loan portfolio. The Company also believes it is economically prudent to keep hedge coverage ratios at acceptable risk levels, which may vary depending on current and expected interest rate movement. It is the Company's objective to hedge the change in fair value of fixed rate loans at coverage levels that are appropriate, given anticipated or existing interest rate levels and other market considerations, as well as the relationship of change in this asset to other assets of the Company. To meet this objective, the Company utilizes interest rate swaps as an asset/liability management strategy to hedge the change in value of the loans due to changes in expected interest rate assumptions. During 2006, the Company entered into an interest rate swap to hedge the change in fair value of one loan receivable. This interest rate swap agreement requires a series of floating rate payments in exchange for receiving a series of fixed rate payments.
At December 31, 2009 and 2008, the information pertaining to outstanding interest rate swap agreements used to hedge fixed-rate loans is as follows:
These agreements provide for the Company to make payments at a variable rate determined by a specified index (one month LIBOR) in exchange for receiving payments at a fixed rate.
At December 31, 2009 and 2008, the unrealized loss relating to use of interest rate swaps was recorded in other income with an equal and offsetting gain for the fair value of the loan. The fair value of the loan is included in loans receivable on the statement of condition. The hedge relationship has been effective since inception and is forcasted to remain effective. Ineffectiveness reflected in earnings has been immaterial for the periods presented.
(15) Fair Value of Derivative Instruments and Hedging Activities
The following tables disclose the derivative instruments' location on the Company's statement of condition and the fair value of those instruments at December 31, 2009 and 2008. In addition, the gains
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(15) Fair Value of Derivative Instruments and Hedging Activities (Continued)
and losses related to these derivative instruments is provided for the years ended December 31, 2009 and 2008. See Note 14 above for a detail of the related hedged items.
Derivative Instruments and Hedging Activities
At of December 31, 2009
(in thousands)
Impact of Derivative Instruments on the Statement of Income
For the Year Ended December 31, 2009
(in thousands)
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(15) Fair Value of Derivative Instruments and Hedging Activities (Continued)
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(15) Fair Value of Derivative Instruments and Hedging Activities (Continued)
Derivative Instruments and Hedging Activities
At of December 31, 2008
(in thousands)
Impact of Derivative Instruments on the Statement of Income
For the Year Ended December 31, 2008
(in thousands)
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(15) Fair Value of Derivative Instruments and Hedging Activities (Continued)
(16) Regulatory Matters
The Bank, as a state-chartered bank, is subject to the dividend restrictions established by the State Corporation Commission of the Commonwealth of Virginia. Under such restrictions, the Bank may not, without the prior approval of the Bank's primary regulator, declare dividends in excess of the sum of the current year's earnings (as defined) plus the retained earnings (as defined) from the prior two years. At December 31, 2009, there were approximately $45.0 million of accumulated earnings at the Bank which could be paid as dividends to the Company.
The Bank is required to maintain a minimum non-interest earning clearing balance with the Federal Reserve Bank. The average amount of the clearing balance was $1.0 million for 2009.
The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") requires banking regulators to stratify banks into five quality tiers based upon their relative capital strengths and increase the regulation of the weaker institutions. The key measures of capital are: (1) total capital (Tier I capital plus the allowance for loan losses up to certain limitations) as a percent of total risk-weighted assets, (2) Tier I capital (as defined) as a percent of total risk-weighted assets (as defined), and (3) Tier I capital (as defined) as a percent of total average assets (as defined).
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(16) Regulatory Matters (Continued)
The regulatory capital of the Company at December 31, 2009 and 2008 is as follows:
The regulatory capital of the Bank at December 31, 2009 and 2008 is as follows:
At December 31, 2009 and 2008, the Company and the Bank met all regulatory capital requirements and are considered "well-capitalized" from a regulatory perspective.
George Mason is also required to maintain defined capital levels under Department of Housing and Urban Development guidelines. At December 31, 2009 and 2008, George Mason maintained capital in excess of these required guidelines.
(17) Related-Party Transactions
Certain directors, officers and employees and/or their related business interests are at present, as in the past, banking customers in the ordinary course of business of the Company. As such, the Company has had, and expects to have in the future, banking transactions in the ordinary course of its business with directors, officers, principal shareholders and their associates, on substantially the same terms, including interest rates and collateral on loans, as those prevailing at the same time for comparable transactions with non-related parties and do not involve more than normal risk of collectibility or present other unfavorable features.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(17) Related-Party Transactions (Continued)
Analysis of activity for loans to related parties follows:
George Mason leases its headquarters office space from a director of the Company who is the manager and a 3.1% owner of the limited liability Company that owns the building in which the space is leased. The lease was renewed during the second quarter of 2007 and will terminate on June 30, 2010 without any option to extend. George Mason has notified the lessor of its intention to renew its lease. The rent that George Mason pays for the use of this space ranges from $737,000 to $1.3 million per year during the term of the lease. Rent payments totaled $1.3 million in 2009, $848,000 in 2008, and $792,000 in 2007.
(18) Earnings Per Common Share
The following is the calculation of basic and diluted earnings per common share.
The following shows the composition of basic outstanding shares for the years ended December 31, 2009, 2008, and 2007:
Weighted average shares for the basic earnings per share calculation is increased by the number of shares required to be issued under the Company's various deferred compensation plans. These plans provide for a Company match. The Company match must be in common stock of the Company.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(18) Earnings Per Common Share (Continued)
The following shows the composition of diluted outstanding shares for the years ended December 31, 2009, 2008, and 2007:
During 2009, the Company issued 4,378,302 shares of its common stock for net proceeds of $31.6 million.
Employees who participate in the Company's deferred compensation plans can allocate, at their discretion, their contributions to various investment options, including an option to invest in Company Common Stock. The incremental weighted average shares attributable to the deferred compensation plans included in diluted outstanding shares assumes the participants opt to invest all of their contributions into the Company's Common Stock investment option.
Antidilutive outstanding stock options excluded from the weighted average shares outstanding for the diluted earnings per share calculation for the years ended December 31, 2009, 2008, and 2007 were 289,894, 319,509, and 51,346. These stock options have exercise prices that were greater than the average market price of the Company's common stock for the year. In addition, for December 31, 2009, 2008, and 2007, there are no incremental shares related to unvested stock options because the addition of these shares to the diluted weighted average share calculation would be antidilutive.
(19) 401(k) Plan
Employees who work twenty (20) hours or more a week and have been employed by the Company for a month can elect to participate in and make contributions into a 401(k) Plan. The Company contributes $0.50 per $1.00 of employee contributions up to a maximum of 3% of the employee's contribution. Expense related to the Company's match in 2009, 2008, and 2007 was $511,000, $495,000, and $567,000, respectively. Employees are immediately vested in the Company's matching contribution.
(20) Deferred Compensation Plans
The Company has deferred compensation plans for its directors and certain employees. Under the directors' plan, a director may elect to defer all or a portion of any director-related fees including fees for serving on board committees. Under the employees' plan, certain employees may defer all or a portion of their compensation including any bonus or commission compensation. Director and employee deferrals, other than employees of George Mason, are matched 50% by the Company. Deferrals made by employees of George Mason are not eligible for the Company match. The amount of the Company match is invested in Company common stock which vests immediately for the directors and after four years for employees. The maximum Company match per employee is $50,000 per year and $10,000 per year per director. Expense relating to the deferred compensation plans for the years ended December 31, 2009, 2008 and 2007 was $206,000, $240,000 and $149,000, the employee portion of which is included in salary and benefits expense and the directors portion of the expense is included in other operating expense in the consolidated statements of income.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(20) Deferred Compensation Plans (Continued)
The deferred compensation plan liability at December 31, 2009 and 2008 was $3.8 million and $4.0 million, respectively. The trust established for the deferred compensation plan is funded as of December 31, 2009. During 2009, the Company issued 287,000 shares of common stock to fund the Company's obligation to its participants that had elected the Cardinal Common Stock investment option in the various nonqualified deferred compensation plans. These shares were issued at $5.45 per share which resulted in an increase of $1.6 million to shareholders' equity.
(21) Director and Employee Stock-Based Compensation Plans
At December 31, 2009, the Company had two stock-based employee compensation plans, the 1999 Stock Option Plan (the "Option Plan") and the 2002 Equity Compensation Plan (the "Equity Plan").
In 1998, the Company adopted the Option Plan pursuant to which the Company may grant stock options for up to 625,000 shares of the Company's common stock to employees and members of the Company's and its subsidiaries' boards of directors. As of November 23, 2008, the Option Plan expired, and therefore, there are no shares of common stock available to grant under this plan.
In 2002, the Company adopted the Equity Plan. The Equity Plan authorizes the granting of options, which may be incentive stock options or non-qualified stock options, stock appreciation rights, restricted stock awards, phantom stock awards or performance share awards to directors, eligible officers and key employees of the Company. In 2006, the shareholders approved an amendment to the Equity Plan to increase the number of shares of common stock reserved for issuance under it from 1,970,000 to 2,420,000. There are 452,558 shares of the Company's common stock available for future grants and awards in the Equity Plan as of December 31, 2009.
The following tables present a summary of the Company's stock option activity for the years ended December 31, 2009, 2008, and 2007:
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(21) Director and Employee Stock-Based Compensation Plans (Continued)
Information pertaining to stock options outstanding at December 31, 2009 is as follows:
At December 31, 2009
Total intrinsic value of options exercised during the years ended December 31, 2009, 2008, and 2007 was $168,000, $10,000, and $80,000, respectively.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(21) Director and Employee Stock-Based Compensation Plans (Continued)
A summary of the status of the Company's non-vested stock options and changes during the year ended December 31, 2009 is as follows:
At December 31, 2009, there was approximately $600,000 of total unrecognized compensation expense related to non-vested share-based compensation arrangements granted under the plans. The expense is expected to be recognized over a weighted average period of 2.2 years. The total fair value of shares that vested during the years ended December 31, 2009, 2008, and 2007 was $295,000, $337,000, and $596,000, respectively.
For the years ended December 31, 2009, 2008 and 2007, the Company received cash for stock options exercised of $178,000, $58,000 and $112,000, respectively. The tax benefit realized as a result of these exercises for the years ended December 31, 2009, 2008 and 2007 was $65,000, $0 and $20,000, respectively.
(22) Segment Reporting
The Company operates in three business segments: commercial banking, mortgage banking, and wealth management and trust services.
The commercial banking segment includes both commercial and consumer lending and provides customers with such products as commercial loans, real estate loans, business financing and consumer loans. In addition, this segment provides customers with various deposit products including demand deposit accounts, savings accounts and certificates of deposit. The mortgage banking segment engages primarily in the origination and acquisition of residential mortgages for sale into the secondary market on a best efforts basis. The wealth management and trust services segment provides investment and financial advisory services to businesses and individuals, including financial planning, retirement/estate planning, trust, estates, custody, investment management, escrows, and retirement plans.
Information about the reportable segments and reconciliation of this information to the consolidated financial statements as of and for the years ended December 31, 2009, 2008 and 2007 follows:
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(22) Segment Reporting (Continued)
(In thousands)
At and for the Year Ended December 31, 2009:
At and for the Year Ended December 31, 2008:
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(22) Segment Reporting (Continued)
At and for the Year Ended December 31, 2007:
During the year ended December 31, 2008, the Company recorded a loss of $4.4 million pretax ($2.9 million after tax) from the impairment of Fannie Mae Perpetual Preferred Stock. This loss was recorded through the commercial banking segment. In the mortgage banking segment, the Company recorded losses of $1.8 million pretax ($1.2 million after tax) and $2.8 million pretax ($1.8 million after tax) from a settlement with a mortgage correspondent and impairment of goodwill, respectively.
During the year ended December 31, 2007, the Company recorded a loss of $3.5 million pretax ($2.3 million after tax) from an escrow arrangement with Liberty Growth Fund, LP. This loss was recorded through the wealth management and trust services segment.
The Company did not have any operating segments other than those reported. Parent company financial information is included in the "Other" category and represents an overhead function rather than an operating segment. The parent company's most significant assets are its net investments in its subsidiaries. The parent company's net interest expense is comprised of interest income from short-term investments and interest expense on trust preferred securities.
(23) Financial Instruments with Off Balance Sheet Risk
The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. Commitments to extend credit are agreements to lend to a customer so long as there is no violation of any condition established in the contract. Commitments usually have fixed expiration dates up to one year 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. These instruments represent obligations of the Company to extend credit or guarantee borrowings and are not recorded on the consolidated statements of financial condition. The rates and terms of these instruments are competitive with others in the market in which the Company operates.
Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of the contractual obligations by a customer to a third party. The majority of these guarantees extend until satisfactory completion of the customer's contractual obligations. All standby letters of credit outstanding at December 31, 2009 are collateralized.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(23) Financial Instruments with Off Balance Sheet Risk (Continued)
Commitments to extend credit of $71.0 million as of December 31, 2009 are related to George Mason's mortgage loan funding commitments and are of a short term nature. Commitments to extend credit of $338.4 million primarily have floating rates as of December 31, 2009. It is uncertain as to the amounts that we will be required to fund on these commitments as many such arrangements expire with no amounts drawn.
Those instruments may involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated statements of financial condition. Credit risk is defined as the possibility of sustaining a loss because the other parties to a financial instrument fail to perform in accordance with the terms of the contract. The Company's maximum exposure to credit loss under standby letters of credit and commitments to extend credit is represented by the contractual amounts of those instruments.
A summary of the contract amount of the Bank's exposure to off-balance-sheet risk as of December 31, 2009 and 2008 is as follows:
The fair value of the liability associated with standby letters of credit at December 31, 2009 and 2008 was immaterial.
George Mason estimates a reserve (early pay-off reserve) for mortgage loans sold that are repaid by the borrower within a certain number of days following the loan sale, thereby requiring that George Mason refund part of the service release premium and/or premium pricing received from the investor pursuant to the loan sale agreement. The reserves as of December 31, 2009 and 2008 were $25,000 and $9,000, respectively.
George Mason has a reserve for its estimated exposure to repurchase loans previously sold to investors for which borrowers failed to provide full and accurate information on their loan application or for which appraisals were not acceptable or where the loan was not underwritten in accordance with the loan program specified by the loan investor. During 2009 and 2008, George Mason either repurchased from or settled with investors on such loans for a total of $2.6 million and $3.8 million, respectively. At December 31, 2009 and 2008, this reserve had a balance of $1.7 million and $1.6 million, respectively. The expense related to this reserve for the years ended December 31, 2009, 2008 and 2007 was $2.6 million, $2.0 million, and $347,000, respectively. The Company evaluates the merits of each claim and estimates its reserve based on actual and expected claims received and considers the historical amounts paid to settle such claims.
George Mason, as part of the service it provides to its managed companies, purchases the loans originated by the managed companies at the time of origination. These loans are then sold by George Mason to investors. George Mason has agreements with its managed companies requiring that, for any loans that were originated by a managed Company and for which investors have requested George Mason to repurchase due to the borrowers failure to provide full and accurate information on or related to their loan application or for which appraisals have not been acceptable or when the loan was not underwritten in accordance with the loan program specified by the loan investor, the managed
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(23) Financial Instruments with Off Balance Sheet Risk (Continued)
company be responsible for buying back the loan. In the event that the managed company's financial condition deteriorates and it is unable to fund the repurchase of such loans, George Mason may have to provide the funds to repurchase these loans from investors. In this instance, George Mason would establish an allowance on the receivable from the managed company. There is no such allowance recorded at December 31, 2009 or 2008 as management fully recovered all amounts owed by managed companies as of these same period end dates.
During 2008, George Mason made a cash settlement to one of its mortgage correspondents related to the loan purchase agreement between the two parties. This settlement agreement provided for the release of known and unknown claims by the mortgage correspondent in exchange for a $2.8 million payment to the correspondent. George Mason also entered into similar agreements with certain third party mortgage companies managed by George Mason and from which George Mason purchased mortgage loans and sold to this mortgage correspondent. These settlement agreements provided for a total payment of $1.0 million to George Mason by these third party mortgage companies. The net amount of this settlement is reported in the non-interest expense section of the statement of operations.
The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. The Company evaluates each customer's creditworthiness on a case-by-case basis and requires collateral to support financial instruments when deemed necessary. The amount of collateral obtained upon extension of credit is based on management's evaluation of the counterparty. Collateral held varies but may include deposits held by the Company, marketable securities, accounts receivable, inventory, property, plant and equipment, and income-producing commercial properties.
The Company has derivative counter-party risk which may arise from the possible inability of George Mason's third-party investors to meet the terms of their forward sales contracts. George Mason works with third-party investors that are generally well-capitalized, are investment grade and exhibit strong financial performance to mitigate this risk. The Company does not expect any third-party investor to fail to meet its obligation.
The Company has guaranteed payment of the $20.0 million debt of Statutory Trust I. See Note 9 for further discussion of this debt.
(24) Fair Value Measurements
The fair value framework under U.S. generally accepted accounting principles defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. It also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring the fair value. There are three levels of inputs that may be used to measure fair value:
Level 1-Quoted prices in active markets for identical assets or liabilities as of the measurement date.
Level 2-Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations in which all significant inputs and significant value drivers are observable in active markets.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(24) Fair Value Measurements (Continued)
Level 3-Valuations derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable.
Recurring Fair Value Measurements
The Company's investment securities available-for-sale are recorded at fair value using reliable and unbiased evaluations by an industry-wide valuation service and therefore fall into the Level 2 category. This service uses evaluated pricing models that vary based on asset class and include available trade, bid, and other market information. Generally, the methodology includes broker quotes, proprietary models, vast descriptive terms and conditions databases, as well as extensive quality control programs.
The Company has an interest rate swap to hedge against the change in fair value of one fixed rate loan. This loan is recorded at fair value using observable rates from a national valuation service. These rates are applied to a third party industry-wide valuation model, and therefore, the valuations fall into a Level 2 category. In addition, loans are evaluated for impairment and the carrying value of such loans is recorded at fair value based on appraisals of the underlying collateral completed by third parties using Level 2 valuation inputs.
The Company's interest rate swap derivatives are recorded at fair value using observable rates from a national valuation service. These rates are applied to a third party industry-wide valuation model, and therefore, the valuations fall into a Level 2 category.
Assets and liabilities measured at fair value on a recurring basis as of December 31, 2009 are shown below:
At December 31, 2009
(in thousands)
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(24) Fair Value Measurements (Continued)
The fair value of the Company's interest rate lock commitments and forward loan sale commitments are included in the above table. In the normal course of business, George Mason and Cardinal First (collectively, the "mortgage companies") enter into contractual interest rate lock commitments to extend credit to borrowers with fixed expiration dates. The commitments become effective when the borrowers "lock-in" a specified interest rate within the time frames established by the mortgage companies. All borrowers are evaluated for credit worthiness prior to the extension of the commitment. Market risk arises if interest rates move adversely between the time of the interest rate lock by the borrower and the sale date of the loan to an investor. To mitigate the effect of the interest rate risk inherent in providing rate lock commitments to borrowers, the mortgage companies enter into best efforts forward sales contracts to sell loans to investors. The forward sales contracts lock in an interest rate and price for the sale of loans similar to the specific rate lock commitments. Both the rate lock commitments to the borrowers and the forward sales contracts to investors through to the date the loan closes are undesignated derivatives and accordingly, are marked to fair value through earnings.
Nonrecurring Fair Value Measurements
Certain assets and liabilities are measured at fair value on a nonrecurring basis and are not included in the tables above. These assets include the Company's valuation of the George Mason and Wilson/Bennett reporting units, the valuation of the Company's corporate bonds held in its held-to-maturity investment securities portfolio, nonaccrual loans and other real estate owned. As no impairment of the reporting units was indicated in 2009, the Company was not required to value the related goodwill.
During the second quarter of 2009, the Company performed its annual assessment of the goodwill related to its Wilson/Bennett subsidiary. The Company estimated the fair value of this using a multi-scenario discounted cash flow approach. Those scenarios that more closely reflect actual results were weighted more heavily than scenarios that vary from recent experience. Cash flows were projected with growth in assets under management being a primary input. Varying levels of expenses were also considered. Additionally, a terminal value, or ending cash value, was assigned to each scenario based upon values of other asset management firms. In particular, the terminal value was projected based upon market values of these other firms as represented by market capitalization multiples of asset under managements, revenues and net income. The average multiples were then applied to Wilson/Bennett's projected assets under management, revenues and net income to estimate a terminal value.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(24) Fair Value Measurements (Continued)
Based upon this analysis, the fair value of Wilson Bennett exceeded it current book value, and no further impairment testing was necessary.
During the third quarter of 2009, the Company performed its annual assessment of the goodwill related to its George Mason mortgage banking subsidiary. The Company employed the services of a valuation consultant to assist with this analysis. The consultant employed both the market approach and income approach of evaluation. The market approach involves a comparison to other companies that have readily available market values or other transactions involving similar companies. The income approach recognizes that most businesses derive their value from their ability to generate future returns, and the cash flow generating power of an operating business is the single most important determinant of value. The income approach utilizes the discounted cash flow method and arrives at a value by discounting estimated future free cash flows and its estimated terminal value at the end of the holding period by a discount rate. In this analysis, cash flows were projected for five years and the terminal value is an estimate of the fair value of the Company at the end of the five year holding period. The discount rate represents the George Mason's equity cost of capital, which is generally defined as the rate of return required by investors for alternate investments of equal risk.
Due to the distressed and disorderly current market for mortgage banking companies and the very limited number of transactions that have occurred over the past year and the even more limited amount of data on these transactions, in determining the fair value of George Mason, considerably more weight was given to the income approach (80%) versus the market approach (20%). Although only a 20% weight was applied to the value generated by the market approach, the income approach includes numerous inputs that are based on the current market, including the revenue and expense assumptions and the underlying discount rates applied to the free cash flows and terminal cash flow. Based upon this analysis, the fair value of George Mason exceeded its carrying value.
The Company's corporate bond portfolio consists of four pooled trust preferred securities, with a total par value of $8.0 million at December 31, 2009 (each security has a par value of $2.0 million). The Company owns senior A-3 tranches of each of these pools and uses the services of a consultant to estimate the projected cash flow of each investment based upon several scenarios regarding likely possible default rates of the underlying issuers of each pool. The analysis yielded a result that fell within the range of values provided by external pricing sources.
Although management uses its best judgment in estimating the fair value of financial instruments, there are inherent limitations in any estimation technique. Because of the wide range of valuation techniques and the numerous estimates and assumptions which must be made, it may be difficult to make reasonable comparisons between the Company's fair value information and that of other banking institutions. It is important that the many uncertainties be considered when using the estimated fair value disclosures and that, because of these uncertainties, the aggregate fair value amount should not be construed as representative of the underlying value of the Company.
Fair Value of Financial Instruments
The assumptions used and the estimates disclosed represent management's best judgment of appropriate valuation methods for estimating the fair value of financial instruments. These estimates are based on pertinent information available to management at the valuation date. In certain cases, fair values are not subject to precise quantification or verification and may change as economic and market factors and management's evaluation of those factors change.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(24) Fair Value Measurements (Continued)
The following summarizes the significant methodologies and assumptions used in estimating the fair values presented in the following table, and not disclosed elsewhere in this footnote.
Cash and Cash Equivalents
The carrying amount of cash and cash equivalents is used as a reasonable estimate of fair value.
Investment Securities Held-to-Maturity and Other Investments
Fair values for investment securities held-to-maturity are based on quoted market prices or prices quoted for similar financial instruments.
Loans Held for Sale
Loans held for sale are carried at the lower of cost or estimated fair value. The estimated fair value is based upon the related purchase price commitments from secondary market investors.
Loans Receivable, Net
In order to determine the fair market value for loans receivable, the loan portfolio was segmented based on loan type, credit quality and maturities. For certain variable rate loans with no significant credit concerns and frequent repricings, estimated fair values are based on current carrying amounts. The fair values of other loans are estimated using discounted cash flow analyses, at interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. This method of estimating fair value does not incorporate the exit-price concept of fair value which is appropriate for this disclosure.
Deposits
The fair values for demand deposits are equal to the carrying amount since they are payable on demand at the reporting date. The carrying amounts of variable rate, fixed-term money market accounts and certificates of deposit (CDs) approximate their fair value at the reporting date. Fair values for fixed-rate CDs are estimated using a discounted cash flow calculation that applies interest rates currently being offered on CDs to a schedule of aggregated expected monthly maturities on time deposits.
Other Borrowed Funds
The fair value of other borrowed funds is estimated using a discounted cash flow calculation that applies interest rates currently available for loans with similar terms.
Other Commitments to Extend Credit
The fair value of these financial instruments is based on the credit quality and relationship, fees, interest rates, probability of funding, compensating balance and other covenants or requirements. These commitments have expiration dates and generally expire within one year. Many commitments are expected to, and typically do, expire without being drawn upon. The rates and terms of these instruments are competitive with others in the market in which the Company operates. The carrying
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(24) Fair Value Measurements (Continued)
amounts are reasonable estimates of the fair value of these financial instruments and are zero at December 31, 2009 and 2008.
Accrued Interest Receivable
The carrying amount of accrued interest receivable approximates its fair value.
The following summarizes the carrying amount of these financial assets and liabilities that the Company has not recorded at fair value on a recurring basis at December 31, 2009 and 2008:
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(25) Parent Company Only Financial Statements
The Cardinal Financial Corporation (Parent Company only) condensed financial statements are as follows:
PARENT COMPANY ONLY CONDENSED STATEMENTS OF CONDITION
December 31, 2009 and 2008
(In thousands)
PARENT COMPANY ONLY CONDENSED STATEMENTS OF OPERATIONS
Years Ended December 31, 2009, 2008, and 2007
(In thousands)
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(25) Parent Company Only Financial Statements (Continued)
PARENT COMPANY ONLY CONDENSED STATEMENTS OF CASH FLOWS
Years ended December 31, 2009, 2008, and 2007
(In thousands)
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(26) Other Operating Expenses
The following shows the composition of other operating expenses for the years ended December 31, 2009, 2008, and 2007:
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
No changes in the Company's independent accountants or disagreements on accounting and financial disclosure required to be reported hereunder have taken place.
Item 9A.
Item 9A. Controls and Procedures
Disclosure Controls and Procedures
The Company maintains disclosure controls and procedures that are designed to provide assurance that information required to be disclosed by the Company in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods required by the Securities and Exchange Commission. An evaluation of the effectiveness of the design and operation of the Company's disclosure controls and procedures as of the end of the period covered by this report was carried out under the supervision and with the participation of management, including the Company's Chief Executive Officer and Chief Financial Officer. Based on the evaluation, the aforementioned officers concluded that the Company's disclosure controls and procedures were effective as of the end of such period.
Management's Report on Internal Control over Financial Reporting
Management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934. The Company's internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of the Company's financial reporting and the preparation of published financial statements in accordance with generally accepted accounting principles.
Management assessed the effectiveness of the Company's internal control over financial reporting as of December 31, 2009. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework. Based on management's assessment, management believes that as of December 31, 2009, the Company's internal control over financial reporting was effective based on criteria set forth by COSO in Internal Control-Integrated Framework.
Management's assessment of the effectiveness of internal control over financial reporting as of December 31, 2009, has been audited by KPMG LLP, the independent registered public accounting firm that also audited the Company's consolidated financial statements. KPMG LLP's attestation report on management's assessment of the Company's internal control over financial reporting appears on page 77 hereof.
Changes in Internal Control Over Financial Reporting
There was no change in the Company's internal control over financial reporting identified in connection with the evaluation of internal controls that occurred during the fourth quarter of 2009 that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting.
Item 9B.
Item 9B. Other Information
None.
PART III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance
Pursuant to General Instruction G(3) of Form 10-K, the information contained in the "Election of Directors" section and under the headings "Executive Officers," "Independence of the Directors," "The Committees of the Board of Directors," "Code of Ethics" and "Section 16(a) Beneficial Ownership Reporting Compliance" in the Company's Proxy Statement for the 2010 Annual Meeting of Shareholders is incorporated herein by reference.
Item 11.
Item 11. Executive Compensation
Pursuant to General Instruction G(3) of Form 10-K, the information contained in the "Executive Compensation" section (except for the "Compensation Committee Report on Executive Compensation") and under the heading "Director Compensation" in the Company's Proxy Statement for the 2010 Annual Meeting of Shareholders is incorporated herein by reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Security Ownership of Certain Beneficial Owners and Management. Pursuant to General Instruction G(3) of Form 10-K, the information contained under the headings "Security Ownership of Directors and Executive Officers" and "Security Ownership of Certain Beneficial Owners" in the Company's Proxy Statement for the 2010 Annual Meeting of Shareholders is incorporated herein by reference.
Equity Compensation Plan Information. The following table sets forth information as of December 31, 2009, with respect to compensation plans under which shares of our Common Stock are authorized for issuance.
(1)Amounts exclude any securities to be issued upon exercise of outstanding options, warrants and rights.
(2)The Company does not have any equity compensation plans that have not been approved by shareholders.
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence
Pursuant to General Instruction G(3) of Form 10-K, the information contained under the heading "Certain Relationships and Related Transactions" in the Company's Proxy Statement for the 2010 Annual Meeting of Shareholders is incorporated herein by reference.
Item 14.
Item 14. Principal Accounting Fees and Services
Pursuant to General Instruction G(3) of Form 10-K, the information contained under the headings "Fees of Independent Public Accountants" and "Audit Committee Pre-Approval Policies and Procedures," in the Company's Proxy Statement for the 2010 Annual Meeting of Shareholders is incorporated herein by reference.
Part IV
Item 15.
Item 15. Exhibits, Financial Statement Schedules
(a)(1) and (2) The response to this portion of Item 15 is included in Item 8 above.
(3)Exhibits
3.1
Articles of Incorporation of Cardinal Financial Corporation (incorporated by reference to Exhibit 3.1 to the Registration Statement on Form SB-2, Registration No. 333-82946 (the "Form SB-2")).
3.2
Articles of Amendment to the Articles of Incorporation of Cardinal Financial Corporation, setting forth the designation for the Series A Preferred Stock (incorporated by reference to Exhibit 3.2 to the Form SB-2).
3.3
Articles of Amendment to the Articles of Incorporation of Cardinal Financial Corporation, setting forth the designation for the Series B Preferred Stock (incorporated by reference to Exhibit 3.1 to the Current Report on Form 8-K filed January 22, 2009).
3.4
Bylaws of Cardinal Financial Corporation (restated in electronic format as of April 24, 2009) (incorporated by reference to Exhibit 3.1 to the Quarterly Report on Form 10-Q for the period ended March 31, 2009).
4.1
Form of Common Stock Certificate (incorporated by reference to Exhibit 4.1 to the Form SB-2).
10.1
Employment Agreement, dated as of February 12, 2002, between Cardinal Financial Corporation and Bernard H. Clineburg (incorporated by reference to Exhibit 10.1 to the Form SB-2).*
10.2
Amendment to Executive Employment Agreement of Bernard H. Clineburg (incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K filed July 23, 2009).*
10.3
Executive Employment Agreement, dated as of February 12, 2002, between Cardinal Financial Corporation and Christopher W. Bergstrom (incorporated by reference to Exhibit 10.5 to the Form SB-2).*
10.4
Cardinal Financial Corporation 1999 Stock Option Plan, as amended (incorporated by reference to Exhibit 10.7 to the Form SB-2).*
10.5
Cardinal Financial Corporation 2002 Equity Compensation Plan, as amended and restated April 21, 2006 (incorporated by reference to Exhibit 4.4 to the Registration Statement on Form S-8, Registration No. 333-134923).*
10.6
Cardinal Financial Corporation Executive Deferred Income Plan, as amended and restated February 25, 2009 (incorporated by reference to Exhibit 10.1 to the Quarterly Report on Form 10-Q for the period ended March 31, 2009).*
10.7
Cardinal Financial Corporation Directors Deferred Income Plan, as amended and restated February 25, 2009 (incorporated by reference to Exhibit 10.2 to the Quarterly Report on Form 10-Q for the period ended March 31, 2009).*
10.8
George Mason Mortgage, LLC Executive Deferred Income Plan, as amended and restated February 25, 2009 (incorporated by reference to Exhibit 10.3 to the Quarterly Report on Form 10-Q for the period ended March 31, 2009).*
10.9
Executive Employment Agreement, dated November 7, 2007, between Cardinal Financial Corporation and Kendal E. Carson (incorporated by reference to Exhibit 10.1 to the Quarterly Report on Form 10-Q for the period ended September 30, 2007).*
10.10
Amendment to Executive Employment Agreement of Kendal E, Carson (incorporated by reference to Exhibit 10.4 to the Quarterly Report on Form 10-Q for the period ended March 31, 2009).*
10.11
Supplemental Executive Retirement Plan, dated November 7, 2007, between Cardinal Financial Corporation and Kendal E. Carson (incorporated by reference to Exhibit 10.2 to the Quarterly Report on Form 10-Q for the period ended September 30, 2007).*
10.12
Form of Incentive Stock Option Agreement*
Subsidiaries of Cardinal Financial Corporation.
Consent of KPMG LLP.
31.1
Rule 13a-14(a) Certification of Chief Executive Officer.
31.2
Rule 13a-14(a) Certification of Chief Financial Officer.
32.1
Statement of Chief Executive Officer Pursuant to 18 U.S.C. § 1350.
32.2
Statement of Chief Financial Officer Pursuant to 18 U.S.C. § 1350.
*Management contracts and compensatory plans and arrangements.
(b)Exhibits
See Item 15(a)(3) above.
(c)Financial Statement Schedules See Item 15(a)(2) above.
SIGNATURES
Pursuant to the requirements of Section 13 and 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.
CARDINAL FINANCIAL CORPORATION
March 15, 2010
By:
/s/ BERNARD H. CLINEBURG
Name: Bernard H. Clineburg
Title: Chairman 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 15, 2010.
Signatures
Titles
/s/ BERNARD H. CLINEBURG
Bernard H. Clineburg
Chairman and Chief Executive Officer
(Principal Executive Officer)
/s/ MARK A. WENDEL
Mark A. Wendel
Executive Vice President and
Chief Financial Officer
(Principal Financial Officer)
/s/ JENNIFER L. DEACON
Jennifer L. Deacon
Senior Vice President and Controller
(Principal Accounting Officer)
/s/ B.G. BECK
B.G. Beck
Director
/s/ WILLIAM G. BUCK
William G. Buck
Director
/s/ SIDNEY O. DEWBERRY
Sidney O. Dewberry
Director
/s/ MICHAEL A. GARCIA
Michael A. Garcia
Director
Signatures
Titles
/s/ J. HAMILTON LAMBERT
J. Hamilton Lambert
Director
/s/ ALAN G. MERTEN
Alan G. Merten
Director
/s/ WILLIAM E. PETERSON
William E. Peterson
Director
/s/ JAMES D. RUSSO
James D. Russo
Director
/s/ GEORGE P. SHAFRAN
George P. Shafran
Director
/s/ ALICE M. STARR
Alice M. Starr
Director
EXHIBIT INDEX
*Management contracts and compensatory plans and arrangements.