ITEM 1 - BUSINESS
General
Crescent Financial Corporation (referred to as the “Registrant,” the “Company” or by the use of “we,” “our” or “us”) was incorporated under the laws of the State of North Carolina on April 27, 2001, at the direction of the Board of Directors of Crescent State Bank (“CSB” or the “Bank”), for the purpose of serving as the bank holding company for CSB and became the holding company for CSB on June 29, 2001. To become CSB’s holding company, Registrant received approval of the Federal Reserve Board as well as CSB’s shareholders. Upon receiving such approval, each share of $5.00 par value common stock of CSB was exchanged on a one-for-one basis for the $1.00 par value common stock of the Registrant. On August 31, 2006, the Registrant acquired Port City Capital Bank (“PCCB”) for cash and stock valued at $40.2 million. The Company was a multi-bank holding company from August 31, 2006 through June 15, 2007. Effective the close of business June 15, 2007, PCCB was merged into CSB and the Company reverted to a one bank holding company.
CSB was incorporated on December 22, 1998 as a North Carolina-chartered commercial bank and opened for business on December 31, 1998. Including its main office, CSB operates fifteen (15) full service branch offices in Cary (2), Apex, Clayton, Holly Springs, Pinehurst, Raleigh (3), Southern Pines, Sanford, Garner, Wilmington (2) and Knightdale, North Carolina. The Southern Pines and Pinehurst offices were acquired through a merger with Centennial Bank of Southern Pines in August, 2003.
The Registrant operates for the primary purpose of serving as the holding company for CSB. The Registrant’s headquarters are located at 1005 High House Road, Cary, North Carolina 27513.
CSB operates for the primary purpose of serving the banking needs of individuals, and small- to medium-sized businesses in its market area. The Bank offers a range of banking services including checking and savings accounts, commercial, consumer and personal loans, on-line banking, mortgage services and other associated financial services.
Lending Activities
General. We provide a wide range of short- to medium-term commercial and personal loans, both secured and unsecured. We also make real estate mortgage and construction loans and Small Business Administration guaranteed loans. Many of our commercial loans are collateralized with real estate in our market but such collateral is mainly a secondary, not primary, source of repayment. We have maintained a balance between variable and fixed rate loans within our portfolio. Variable rate loans accounted for 43% of the loan balances outstanding at December 31, 2009 while fixed rate loans accounted for 57% of the balances.
Our loan policies and procedures establish the basic guidelines governing our lending operations. Generally, the guidelines address the types of loans that we seek, target markets, underwriting and collateral requirements, terms, interest rate and yield considerations and compliance with laws and regulations. All loans or credit lines are subject to approval procedures and amount limitations. These limitations apply to the borrower’s total outstanding indebtedness to us, including the indebtedness of any guarantor. The policies are reviewed and approved annually by the board of directors of the Bank. We supplement our own supervision of the loan underwriting and approval process with annual loan audits by internal loan examiners and quarterly credit reviews performed by outside third party professionals experienced in loan review work.
Commercial Mortgage Loans. Historically we have originated and maintained a significant amount of commercial real estate loans. This lending involves loans secured principally by commercial office buildings, both investment and owner occupied. We require the personal guaranty of principals where prudent and a demonstrated cash flow capability sufficient to service the debt. The real estate collateral is a secondary source of repayment. Loans secured by commercial real estate may be in greater amount and involve a greater degree of risk than one to four family residential mortgage loans. Payments on such loans are often dependent on successful operation or management of the properties. We also make loans secured by commercial/investment properties provided the subject property is typically either pre-leased or pre-sold before the Bank commits to finance its construction.
Construction Loans. Another of our lending focuses has been construction/development lending. We originate one to four family residential construction loans for custom homes (where the home buyer is the borrower and general contractor) and provide financing to builders who construct homes for re-sale. We finance “starter” homes as well as “high-end” homes. We generally receive a pre-arranged permanent financing commitment from an outside banking entity prior to financing the construction of pre-sold homes. The Bank is active in the construction market and makes construction loans to builders of homes that are not pre-sold, but limits the number of such loans to any one builder. This type of lending is only done with local, well-established builders and not with large or national tract builders. We lend to builders in our market who have demonstrated a favorable record of performance and profitable operations. We limit the number of unsold homes for each builder but there is no limit for pre-sold homes. We will also finance small tract developments and sub-divisions; however, we seek to be only one of a number of financial institutions making construction loans in any one tract or sub-division. We endeavor to further limit our construction lending risk through adherence to established underwriting procedures and the requirement of documentation for all draw requests. We require personal guarantees of the principals, when appropriate, and demonstrated secondary sources of repayment on construction loans. Construction loan repayments are sensitive to general economic conditions, the housing market and population migration patterns.
Over the past year we have reduced our concentration in construction and land development lending. The economic conditions and their impact on the one-to-four family residential market has reduced both demand and increased the credit risk for this type of lending. While we continue to evaluate credit opportunities presented in this line of business, we are actively trying to diversify our loan portfolio by being selective and trying to create opportunities in other loan types.
Commercial Loans. Commercial business lending is another focus of our lending activities. Commercial loans include secured loans for working capital, expansion and other business purposes. Short-term working capital loans generally are secured by accounts receivable, inventory and/or equipment. Lending decisions are based on an evaluation of the financial strength, cash flow, management and credit history of the borrower, and the quality of the collateral securing the loan. With few exceptions, we require personal guarantees of the principals and secondary sources of repayment, primarily a deed of trust on local real estate. Commercial loans generally provide greater yields and reprice more frequently than other types of loans, such as commercial mortgage loans. More frequent repricing means that yields on our commercial loans adjust more quickly with changes in interest rates.
Loans to Individuals, Home Equity Lines of Credit and Residential Real Estate Loans. Loans to individuals (consumer loans) include automobile loans, boat and recreational vehicle financing, home equity and home improvement loans and miscellaneous secured and unsecured personal loans. Consumer loans generally can carry significantly greater risks than other loans, even if secured, if the collateral consists of rapidly depreciating assets such as automobiles and equipment. Repossessed collateral securing a defaulted consumer loan may not provide an adequate secondary source of repayment of the loan. Consumer loan collections are sensitive to job loss, illness and other personal factors. We attempt to manage the risks inherent in consumer lending by following established credit guidelines and underwriting practices designed to minimize risk of loss.
Residential real estate loans are made for purchasing and refinancing one to four family properties. We offer fixed and variable rate options, but generally limit the maximum fixed rate term to five years. We provide customers access to long-term conventional real estate loans through our mortgage loan department, which originates loans and brokers them for sale in the secondary market. Such loans are closed by mortgage brokers and are not funded by us. We are currently building our Mortgage Loan Division and anticipate that during 2010 we will move from a pure mortgage broker model to a correspondent model. This will allow us to close loans in CSB’s name and be more competitive with loan pricing. We anticipate that we will be an active originator of mortgage loans and continue to sell loans to national servicers only holding for our own account a small number of well-collateralized, non-conforming residential loans. Residential real estate loan collections are sensitive to economic market conditions, job loss and home valuation pressures.
The following table describes our loan portfolio composition by category, with 2008 and 2009 based on the new loan classifications discussed in Note B to the financial statements and prior periods based on historic classifications:
The following table presents at December 31, 2009 (i) the aggregate maturities of loans in the named categories of our loan portfolio and (ii) the aggregate amounts of such loans, by variable and fixed rates that mature after one year. For purposes of this presentation, all variable rate loans with an interest rate floor that is currently effective are considered fixed:
Loan Approvals. Our loan policies and procedures establish the basic guidelines governing lending operations. Generally, the guidelines address the type of loans that we seek, target markets, underwriting and collateral requirements, terms, interest rate and yield considerations and compliance with laws and regulations. All loans and credit lines are subject to approval procedures and amount limitations. Depending upon the loan requested, approval may be granted by the individual loan officer, our officers’ loan committee or, for the largest relationships, the directors’ loan committee. The Bank’s full board is required to approve any single transaction of $5.0 million or more. The policies are reviewed and approved at least annually by the board of directors.
Responsibility for loan review, underwriting, compliance and document monitoring resides with the senior credit officer. He is responsible for loan processing and approval. On an annual basis, the board of directors of the Bank determines the president’s lending authority, who then delegates lending authorities to the senior credit officer and other lending officers of the bank. Delegated authorities may include loans, letters of credit, overdrafts, uncollected funds and such other authorities as determined by the board of directors or the president within his delegated authority.
Credit Cards. We offer a credit card on an agency basis as an accommodation to our customers. We assume none of the underwriting risk.
Loan Participations. From time to time we purchase and sell loan participations to or from other banks within and outside our market area. All loan participations purchased have been underwritten using our standard and customary underwriting criteria.
Commitments and Contingent Liabilities
In the ordinary course of business, we enter into various types of transactions that include commitments to extend credit. We apply the same credit standards to these commitments as we use in all of our lending activities and have included these commitments in our lending risk evaluations. Our exposure to credit loss under commitments to extend credit is represented by the amount of these commitments. See Note O of the “Notes to Consolidated Financial Statements.”
Asset Quality
We consider asset quality to be of primary importance and employ a third party loan reviewer to ensure adherence to the lending policy as approved by our board of directors. It is the responsibility of each lending officer to assign an appropriate risk grade to every loan originated. Credit administration, through the loan review process, validates the accuracy of the initial risk grade assessment. In addition, as a given loan’s credit quality improves or deteriorates, it is credit administration’s responsibility to change the borrower’s risk grade accordingly. On a quarterly basis, we undergo loan review by an outside third party who evaluates compliance with our underwriting standards and risk grading and provides a report detailing the conclusions of that review to our board of directors and senior management. The Bank’s board requires management to address any criticisms raised during the loan review and to take appropriate actions where warranted.
Investment Activities
Our investment portfolio plays a major role in management of liquidity and interest rate sensitivity and, therefore, is managed in the context of the overall balance sheet. The securities portfolio generates a nominal percentage of our interest income and serves as a necessary source of liquidity. Debt and equity securities that will be held for indeterminate periods of time, including securities that we may sell in response to changes in market interest or prepayment rates, needs for liquidity and changes in the availability of and the yield of alternative investments, are classified as available for sale. We carry these investments at market value, which we generally determine using published quotes or a pricing matrix obtained at the end of each month. Unrealized gains and losses are excluded from our earnings and are reported, net of applicable income tax, as a component of accumulated other comprehensive income in stockholders’ equity until realized.
Deposit Activities
We provide a range of deposit services, including non-interest bearing checking accounts, interest bearing checking and savings accounts, money market accounts and certificates of deposit. These accounts generally earn interest at rates established by management based on competitive market factors and management’s desire to increase or decrease certain types or maturities of deposits. We use brokered deposits to supplement our funding sources, but we have made a strategic decision to reduce our overall reliance on brokered deposits. We strive to establish customer relations to attract core deposits and the establishment or continuity of a core deposit relationship is a key factor in making a credit decision.
The following table sets forth for the years indicated the average balances outstanding and average interest rates for each major category of deposits:
The following table sets forth the amounts and maturities of certificates of deposit with balances of $100,000 or more at December 31, 2009:
Borrowings
As additional sources of funding, we have established arrangements with the Federal Home Loan Bank of Atlanta, the Federal Reserve Bank of Richmond and other correspondent banks.
We use advances from the Federal Home Loan Bank of Atlanta under a line of credit equal to 30% of CSB’s total assets ($309.7 million at December 31, 2009). Outstanding advances at December 31, 2009 were $151.0 million. Pursuant to collateral agreements with the Federal Home Loan Bank, at December 31, 2009 advances were secured by investment securities available for sale with a fair value of $54.7 million and by loans with a carrying amount of $219.2 million, which approximates market value.
We have established a relationship to borrow at the Federal Reserve Bank’s Discount Window. At December 31, 2009 we had pledged $82.8 million of loans to the discount window. The loans pledged are construction loans, commercial and industrial loans and consumer loans. The Federal Reserve Bank has established lending margins on the various collateral types and the loans we have pledged allow us to borrow between 75% and 80% of the collateral value. At December 31, 2009 we had $50.0 million in outstanding discount window borrowings.
We may purchase federal funds through unsecured federal funds lines of credit aggregating $21.5 million. These lines are intended for short-term borrowings and are subject to restrictions limiting the frequency and terms of the advances. These lines of credit are payable on demand and bear interest based upon the daily federal funds rate (between 0.00% and 0.25% at December 31, 2009). There were no federal funds purchased at December 31, 2009.
Junior Subordinated Debt
In August of 2003, $8.3 million in trust preferred securities were placed through Crescent Financial Capital Trust I. The trust has invested the total proceeds from the sale of its trust preferred securities in junior subordinated deferrable interest debentures issued by us. The trust preferred securities pay cumulative cash distributions quarterly at an annual contract rate, reset quarterly, equal to three-month LIBOR plus 310 basis points. The dividends paid to holders of the trust preferred securities, which are recorded as interest expense, are deductible by us for income tax purposes. On June 25, 2009, the Company entered into a derivative financial instrument which effectively swapped the variable rate payments for fixed payments. We entered into a three year and four year swap each for one-half of the notional amount of the trust preferred securities for fixed rates of 5.49% and 5.97%, respectively. The effective interest rate is currently 5.73%. See Note N of the “Notes to Consolidated Financial Statements” for additional information. The trust preferred securities mature on October 7, 2033 and are redeemable, subject to approval by the Federal Reserve, on January 7, April 7, July 7 or October 7 on or after October 7, 2008. We have fully and unconditionally guaranteed the trust preferred securities through the combined operation of the debentures and other related documents. Our obligation under the guarantee is unsecured and subordinate to senior and subordinated indebtedness. The principal reason for issuing trust preferred securities is that the proceeds from their sale qualify as Tier 1 capital for regulatory capital purposes (subject to certain limitations), thereby enabling us to enhance our regulatory capital positions without diluting the ownership of our stockholders.
Subordinated Debt
On September 26, 2008, the Company entered into an unsecured subordinated term loan agreement in the amount of $7.5 million. The agreement calls for the Company to make quarterly payments of interest at an annual contract rate, reset quarterly, equal to three-month LIBOR plus 400 basis points. The subordinated term loan is deemed to be Tier 2 capital for regulatory capital purposes. On June 25, 2009, the Company entered into a derivative financial instrument which effectively swapped the variable rate payments for fixed payments. We entered into a three year and four year swap each for one-half of the notional amount of the trust preferred securities for fixed rates of 6.39% and 6.87%, respectively. The effective interest rate is currently 6.63%. See Note N of the “Notes to Consolidated Financial Statements” for additional information. The subordinated term loan agreement matures on October 18, 2018 and can be prepaid, subject to the approval of the FDIC and other Governmental Authorities (if applicable), in incremental amounts not less than $500,000, by giving five business days notice prior to prepayment. We do not have the right to prepay all or any portion of the loan prior to October 1, 2013 unless the loan ceases to be deemed Tier 2 capital for regulatory capital purposes. Should the loan cease to be considered Tier 2 capital for regulatory capital purposes, the debt can either be structured as senior debt of the Company or be repaid. The principal reason for entering into the subordinated term loan agreement was to enhance our regulatory capital position without diluting our shareholders.
Investment Services
Crescent State Bank has entered into a revenue sharing agreement with Capital Investment Group, Raleigh, North Carolina, under which it receives revenue for securities and annuity sales generated by brokers located in our offices. We offer this investment service under the name “Crescent Investment Services.”
Courier Services
We offer courier services to our customers free-of-charge as a convenience and a demonstration of our commitment to superior customer-service. Our couriers travel to the customer’s location, pick-up non-cash deposits from the customer and deliver those deposits to the bank. We feel our couriers serve as ambassadors for our bank and enhance our presence in the communities we serve.
Banking Technology
Because of the level of sophistication of our markets, we commenced operations with a full array of technology available for our customers. Our customers have the ability to perform on-line banking and bill paying, access on-line check images, make transfers, initiate wire transfers, ACH originations and stop payment orders of checks. We provide our customers with imaged check statements, thereby eliminating the cost of returning checks to customers and eliminating the clutter of canceled checks. Our customers can choose to receive their account statement electronically which we encourage as part of a special relationship deposit account. The account is designed to move customers into a more electronic, paper free environment which enhances fee income on debit card transactions and reduces mailing and other data processing charges. Through branch image capture technology, CSB offers same day credit for deposits made prior to 5:00 pm. We offer remote merchant capture which allows our customers to run check deposits through a scanner and deliver the image to the Bank electronically.
Strategy
Our strategy is three-fold: we are committed to achieving growth and performance through exceptional customer service and sound asset quality; we provide a comprehensive array of products and services; and we are able to adapt to a rapidly changing banking environment. We place the highest priority on providing professional, highly personalized service - it’s the driving force behind our business. Over the first ten years of our Company, we focused on loan growth as being the key to our short-term success, and although we have historically created earnings that compare favorably to a peer group of banks started in the late 1990’s, financial performance was secondary to asset growth. As we begin our twelfth year of business, the Company will continue converting to a more mature bank whose strategy and goals are centered on becoming a high performance bank among our peer group. As we continue along this new direction, asset growth will not be at the levels previously seen, and once we emerge from this global recession which continues to impact our asset quality, performance metrics should begin to improve. We feel the past strategy and actions have helped to create a Company of size which was important in becoming a significant participant in the markets we serve. The future strategy and actions to create a high performing bank will leverage that size to create a Company of exceptional long-term shareholder value.
Primary Market Area
CSB’s market area includes the four central North Carolina counties of Wake, Johnston, Lee and Moore Counties and the coastal county of New Hanover.
According to the U.S. Census Bureau, the estimated 2008 population for the contiguous four county central North Carolina area was nearly 1.2 million reflecting a 34% increase over the last actual census data population conducted in 2000. The largest of the four, Wake County, includes the state capital of Raleigh as well as the area known as Research Triangle Park, one of the nation’s leading technology centers. Our market area is home to several universities and institutions of higher learning, including North Carolina State University. Wake County has a diverse economy centered on state government, the academic community, the technology industry, the medical and pharmaceuticals sectors and the many small businesses that support these enterprises as well as the people that live and work in this area. The estimated 2008 population in Wake County of over 866,000 is the second most populous county in the state and experienced a 4% increase between estimates for 2007 and those for 2008. Johnston County is the second largest county in CSB’s central North Carolina footprint with a population estimate for 2008 of 163,000 and 4% growth over 2007 estimates. Johnston County is one of the fastest growing counties in the state and is contiguous to the southeast of Wake County. Lee and Moore Counties are located to the south of Raleigh in the region referred to as the Sandhills area, which is home to the towns of Pinehurst, Sanford and Southern Pines. Moore County has an estimated 2008 population of 86,000 and Lee County is estimated to have a population of 59,000. Both counties experienced 2% growth compared with 2007 estimates. The region’s economy benefits from an emphasis on the golf industry due to the many world class golf courses located in the vicinity and also from a growing retiree population drawn to the mild climate and recreational activities afforded by the Sandhills area.
CSB is headquartered in Cary, the second largest city in Wake County and the seventh largest in North Carolina. Cary has an estimated population of 136,000 as of June 30, 2009. Cary’ population has increased by 41,000 or 42% since the last actual census was conducted and an increase of 5,000 or 4% since the July 1, 2008 estimate. The Town of Cary is served by several major highways, Interstates 40, 440 and 540, US 1, US 64, and NC 55. International, national, and regional airlines offer service from the Raleigh-Durham International Airport, which is less than five miles from Cary. The people located in CSB’s central North Carolina footprint are relatively diverse, young and highly educated. As of 2000, the latest date for which actual census data is available, over 60% of Cary’s population and over 37% of the estimated four county population 25 years or older had at least a bachelor’s degree. This educational level is due to the number of higher education institutions located in our market area as well as the Research Triangle Park’s high technology employee base.
The economic strength of the area is also reflected by the per capita income. Per capita income for 2008 for the Raleigh-Cary metropolitan statistical area, as estimated by the Bureau of Economic Analysis, was $39,239 compared to $34,439 for North Carolina. The median family income in the Raleigh-Cary metropolitan statistical area in 2009 was $76,900 according to the Federal Reserve Bank of Richmond compared to $62,108 for the State of North Carolina as shown by the Federal Home Loan Mortgage Corporation. Cary is home to the world’s largest privately held software company, SAS Institute, and it has attracted prominent companies such as American Airlines Reservation Center, Western Wake Medical Center, Kellogg’s Snacks and MCI. The Research Triangle Park houses major facilities of IBM, GlaxoSmithKline, Verizon Communications, the U.S. Environmental Protection Agency, Quintiles and numerous other technology and bio-medical firms.
New Hanover County is home to Wilmington, North Carolina as well as the University of North Carolina at Wilmington. According to the Chamber of Commerce, Wilmington has a 2009 estimated population of approximately 101,000 while New Hanover County has a population of approximately 193,000. Wilmington is the eighth largest city in North Carolina. The median family income estimate for 2009 according to the Department of Housing and Urban Development was $57,600 and per capita income per the Bureau of Economic Analysis for 2008 was $33,036. Wilmington has a sizable seaport and is the most eastern point in the United States of Interstate 40. The area has become an important destination for the entertainment industry as over 200 movies or television shows have been produced in Wilmington. The largest employers in Wilmington include the New Hanover Regional Medical Center, New Hanover Public Schools, General Electric, The University of North Carolina at Wilmington and PPD, Inc., a large pharmaceutical and biotech company.
Competition
Commercial banking in North Carolina is extremely competitive in large part due to early adoption of statewide branching. We compete in our market areas with large regional and national banking organizations, other federally and state chartered financial institutions such as savings and loan institutions and credit unions, consumer finance companies, mortgage companies and other lenders engaged in the business of extending credit. Many of our competitors have broader geographic markets and higher lending limits than we do and are also able to provide more services and make greater use of media advertising. All markets in which we have a banking office are also served by branches of the largest banks in North Carolina.
For example, as of June 30, 2009 there were 438 offices of 42 different financial institutions across our five county footprint. CSB ranked ninth in market share across that five county area with a combined 2.89% of the total combined deposit market. There were 253 offices of 31 different financial institutions in Wake County, 79 offices of 20 different financial institutions in New Hanover County, 43 offices of 13 different financial institutions in Johnston County, 41 offices of 12 different financial institutions in Moore County and 22 offices of 11 different financial institutions in Lee County. CSB’s market share in the individual counties we serve was 3.01%, 2.25%, 0.12%, 4.79% and 2.51%, respectively. While we typically do not compete directly for loans with larger banks, they do influence our deposit products. We do compete more directly with mid-size and small community banks that have offices in our market areas.
The enactment of legislation authorizing interstate banking has led to increases in the size and financial resources of some of our competitors. In addition, as a result of interstate banking, out-of-state commercial banks have acquired North Carolina banks and heightened the competition among banks in North Carolina. For example, SunTrust Bank of Georgia, a large multi-state financial institution, has branches throughout our markets.
Despite the competition in our market areas, we believe that we have certain competitive advantages that distinguish us from our competition. We offer customers modern banking services without forsaking prompt, personal service and friendliness. We also have established a local advisory board in each of our communities to help us better understand their needs and to be “ambassadors” of the Bank. It is our intention to further develop advisory boards as we expand into additional communities in our market area. We offer many personalized services and attract customers by being responsive and sensitive to their individualized needs. We believe our approach to business builds goodwill among our customers, stockholders, and the communities we serve that results in referrals from stockholders and satisfied customers. We also rely on traditional marketing to attract new customers. To enhance a positive image in the community, we support and participate in local events and our officers and directors serve on boards of local civic and charitable organizations.
Employees
At December 31, 2009, the Registrant employed 151 full-time and 15 part-time employees. None of the Registrant’s employees are covered by a collective bargaining agreement. The Registrant believes its relations with its employees to be good.
REGULATION
Regulation of the Bank
The Bank is extensively regulated under both federal and state law. Generally, these laws and regulations are intended to protect depositors and borrowers, not shareholders. To the extent that the following information describes statutory and regulatory provisions, it is qualified in its entirety by reference to the particular statutory and regulatory provisions. Any change in applicable law or regulation may have a material effect on the business of the Registrant and the Bank.
State Law. The Bank is subject to extensive supervision and regulation by the North Carolina Commissioner of Banks (the “Commissioner”). The Commissioner oversees state laws that set specific requirements for bank capital and regulate deposits in, and loans and investments by, banks, including the amounts, types, and in some cases, rates. The Commissioner supervises and performs periodic examinations of North Carolina-chartered banks to assure compliance with state banking statutes and regulations, and the Bank is required to make regular reports to the Commissioner describing in detail the resources, assets, liabilities and financial condition of the Bank. Among other things, the Commissioner regulates mergers and consolidations of state-chartered banks, the payment of dividends, loans to officers and directors, record keeping, types and amounts of loans and investments, and the establishment of branches.
Deposit Insurance. The Bank’s deposits are insured up to applicable limits, currently $250,000, by the Deposit Insurance Fund, or DIF, of the FDIC. The DIF is the successor to the Bank Insurance Fund and the Savings Association Insurance Fund, which were merged in 2006. The Bank’s deposits, therefore, are subject to FDIC deposit insurance assessment.
The FDIC amended its risk-based deposit assessment system to implement authority granted by the Federal Deposit Insurance Reform Act of 2005, or the Reform Act. Under the revised system, insured institutions were assigned to one of four risk categories based on supervisory evaluations, regulatory capital levels and certain other factors. An institution’s assessment rate depends upon the category to which it is assigned. Risk Category I, which contains the least risky depository institutions, was expected to include more than 90% of all institutions. Unlike the other categories, Risk Category I contains further risk differentiation based on the FDIC’s analysis of financial ratios, examination component ratings and other information. Assessment rates were determined by the FDIC and for the period effective January 1, 2009 through March 31, 2009 (payment dated June 30, 2009 based on March 31, 2009 data) range from 12 to 14 basis points for the healthiest institutions (Risk Category I) to 50 basis points of assessable deposits for the riskiest (Risk Category IV). On February, 27, 2009, the FDIC Board of Directors adopted a final rule modifying the risk-based assessment system and setting initial base assessment rates beginning April 1, 2009. The FDIC has introduced three adjustments that could be made to an institution's initial base assessment rate: (1) a potential decrease for long-term unsecured debt, including senior and subordinated debt and, for small institutions, a portion of Tier 1 capital; (2) a potential increase for secured liabilities above a threshold amount; and (3) for non-Risk Category I institutions, a potential increase for brokered deposits above a threshold amount. The new rates will range from seven to 24 basis points for the healthiest institutions (Risk Category I) to 40 to 77.5 basis points of assessable deposits for the riskiest (Risk Category IV).
On October 3, 2008, Congress enacted into law the Emergency Economic Stabilization Act of 2008 (EESA). The EESA established two major initiative programs; the Capital Purchase Program (CPP) and the Temporary Liquidity Guarantee Program (TLG). The TLG provided for two separate FDIC guarantee programs in which the Company chose to participate. For the first program, the FDIC guaranteed newly issued senior unsecured debt issued between October 14, 2008, and June 30, 2009, including promissory notes, commercial paper, inter-bank funding, and any unsecured portion of secured debt. The amount of debt covered by the guarantee could not exceed 125 percent of debt that was outstanding as of September 30, 2008 and scheduled to mature before June 30, 2009. If an insured depository institution had no eligible debt outstanding at September 30, 2008, the debt guarantee limit was established at 2% of total liabilities at September 30, 2008. For eligible debt issued on or before June 30, 2009, coverage was only provided until June 30, 2012, even if the liability has not matured. The second program guaranteed non-interest bearing and low interest bearing transaction accounts to an unlimited amount and was initially set to expire on December 31, 2009. The program was extended to provide unlimited FDIC insurance coverage through June 30, 2010. Additional assessment fees apply to funds guaranteed under these programs.
For eligible senior unsecured debt, an annualized fee will be collected equal to 75 basis points multiplied by the amount of debt guaranteed under this program. The Company has not issued any debt under this program. For non-interest bearing transaction deposit accounts, a 10 basis point surcharge on the institution's current assessment rate would be applied to deposits not otherwise covered by the existing deposit insurance limit of $250,000. Fees for the 10 basis point surcharge on the non-interest bearing transaction accounts over $250,000 will be collected through the normal assessment cycle. The Company anticipates paying assessments under this program.
On February 27, 2009, the FDIC proposed amendments to the restoration plan for the DIF. This amendment proposed the imposition of a 20 basis point emergency special assessment on insured depository institutions as of June 30, 2009. On March 5, 2009, the FDIC Chairman announced that the FDIC intended to lower the special assessment from 20 basis points to 10 basis points. On May 22, 2009, the FDIC adopted a final rule imposing a 5 basis point special assessment on each insured depository institution's assets minus Tier 1 capital as of June 30, 2009. The amount of the special assessment for any institution was not to exceed 10 basis points times the institution's assessment base for the second quarter 2009. The assessment was collected on September 30, 2009 and totaled $493,000. The FDIC may impose an emergency special assessment of up to 10 basis points on all insured depository institutions whenever, after June 30, 2009, the FDIC estimates that the fund reserve ratio will fall to a level that the Board believes would adversely affect public confidence or to a level close to zero or negative at the end of a calendar quarter. In addition, the FDIC received approval to require prepayment of the next three years premiums. On December 31, 2009, the Company remitted approximately $4.2 million to prepay its premiums for 2010, 2011 and 2012. Due to the continuing volume of bank failures, it is possible that higher deposit insurance rates or additional special assessments will be required to restore the DIF to the Congressionally established target and could have a significant impact on the financial results of the Company in future years.
The FDIC is authorized to set the reserve ratio for the DIF annually at between 1.15% and 1.5% of estimated insured deposits, in contrast to the statutorily fixed ratio of 1.25% under the old system. The ratio, which is viewed by the FDIC as the level that the funds should achieve, was established by the agency at 1.25% for 2007. The Reform Act also provided for the possibility that the FDIC may pay dividends to insured institutions once the DIF reserve ratio equals or exceeds 1.35% of estimated insured deposits.
Capital Requirements. The federal banking regulators have adopted certain risk-based capital guidelines to assist in the assessment of the capital adequacy of a banking organization’s operations for both transactions reported on the balance sheet as assets and transactions, such as letters of credit, and recourse arrangements, which are recorded as off balance sheet items. Under these guidelines, nominal dollar amounts of assets and credit equivalent amounts of off balance sheet items are multiplied by one of several risk adjustment percentages which range from 0% for assets with low credit risk, such as certain U.S. Treasury securities, to 100% for assets with relatively high credit risk, such as business loans.
A banking organization’s risk-based capital ratios are obtained by dividing its qualifying capital by its total risk- adjusted assets. The regulators measure risk-adjusted assets, which include off balance sheet items, against both total qualifying capital (the sum of Tier 1 capital and limited amounts of Tier 2 capital) and Tier 1 capital. “Tier 1,” or core capital, includes common equity, qualifying noncumulative perpetual preferred stock and minority interests in equity accounts of consolidated subsidiaries, less goodwill and other intangibles, subject to certain exceptions. “Tier 2,” or supplementary capital, includes among other things, limited-life preferred stock, hybrid capital instruments, mandatory convertible securities, qualifying subordinated debt, and the allowance for loan and lease losses, subject to certain limitations and less required deductions. The inclusion of elements of Tier 2 capital is subject to certain other requirements and limitations of the federal banking agencies. Banks and bank holding companies subject to the risk-based capital guidelines are required to maintain a ratio of Tier 1 capital to risk-weighted assets of at least 4% and a ratio of total capital to risk-weighted assets of at least 8%. The appropriate regulatory authority may set higher capital requirements when particular circumstances warrant. As of December 31, 2009, CSB was classified as “well-capitalized” with Tier 1 and Total Risk-Based Capital of 11.16%% and 13.32%%, respectively.
The federal banking agencies have adopted regulations specifying that they will include, in their evaluations of a bank’s capital adequacy, an assessment of the bank’s interest rate risk exposure. The standards for measuring the adequacy and effectiveness of a banking organization’s interest rate risk management include a measurement of board of directors and senior management oversight, and a determination of whether a banking organization’s procedures for comprehensive risk management are appropriate for the circumstances of the specific banking organization.
Failure to meet applicable capital guidelines could subject a banking organization to a variety of enforcement actions, including limitations on its ability to pay dividends, the issuance by the applicable regulatory authority of a capital directive to increase capital and, in the case of depository institutions, the termination of deposit insurance by the FDIC, as well as the measures described under the “Federal Deposit Insurance Corporation Improvement Act of 1991” below, as applicable to undercapitalized institutions. In addition, future changes in regulations or practices could further reduce the amount of capital recognized for purposes of capital adequacy. Such a change could affect the ability of the Bank to grow and could restrict the amount of profits, if any, available for the payment of dividends to the shareholders.
Federal Deposit Insurance Corporation Improvement Act of 1991. In December 1991, Congress enacted the Federal Deposit Insurance Corporation Improvement Act of 1991 (the “FDIC Improvement Act”), which substantially revised the bank regulatory and funding provisions of the Federal Deposit Insurance Act and made significant revisions to several other federal banking statutes. The FDIC Improvement Act provides for, among other things:
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publicly available annual financial condition and management reports for certain financial institutions, including audits by independent accountants,
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the establishment of uniform accounting standards by federal banking agencies,
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the establishment of a “prompt corrective action” system of regulatory supervision and intervention, based on capitalization levels, with greater scrutiny and restrictions placed on depository institutions with lower levels of capital,
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additional grounds for the appointment of a conservator or receiver, and
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restrictions or prohibitions on accepting brokered deposits, except for institutions which significantly exceed minimum capital requirements.
The FDIC Improvement Act also provides for increased funding of the FDIC insurance funds and the implementation of risk-based premiums.
A central feature of the FDIC Improvement Act is the requirement that the federal banking agencies take “prompt corrective action” with respect to depository institutions that do not meet minimum capital requirements. Pursuant to the FDIC Improvement Act, the federal bank regulatory authorities have adopted regulations setting forth a five-tiered system for measuring the capital adequacy of the depository institutions that they supervise. Under these regulations, a depository institution is classified in one of the following capital categories: “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” and “critically undercapitalized.” An institution may be deemed by the regulators to be in a capitalization category that is lower than is indicated by its actual capital position if, among other things, it receives an unsatisfactory examination rating with respect to asset quality, management, earnings or liquidity.
The FDIC Improvement Act provides the federal banking agencies with significantly expanded powers to take enforcement action against institutions which fail to comply with capital or other standards. Such action may include the termination of deposit insurance by the FDIC or the appointment of a receiver or conservator for the institution. The FDIC Improvement Act also limits the circumstances under which the FDIC is permitted to provide financial assistance to an insured institution before appointment of a conservator or receiver.
Community Reinvestment Act. The purpose of the Community Reinvestment Act is to encourage financial institutions to help meet the credit needs of their entire communities, including the needs of low-and moderate-income neighborhoods.
The federal banking agencies have implemented an evaluation system that rates an institution based on its actual performance in meeting community credit needs. Under these regulations, an institution is first evaluated and rated under three categories: a lending test, an investment test and a service test. For each of these three tests, the institution is given a rating of either “outstanding,” “high satisfactory,” “low satisfactory,” “needs to improve,” or “substantial non-compliance.” A set of criteria for each rating has been developed and is included in the regulation. If an institution disagrees with a particular rating, the institution has the burden of rebutting the presumption by clearly establishing that the quantitative measures do not accurately present its actual performance, or that demographics, competitive conditions or economic or legal limitations peculiar to its service area should be considered. The ratings received under the three tests will be used to determine the overall composite CRA rating. The composite ratings currently given are: “outstanding,” “satisfactory,” “needs to improve” or “substantial non-compliance.”
Community Reinvestment Act ratings are a factor considered by the FRB and the FDIC in considering applications to acquire branches or to acquire or combine with other financial institutions and take other actions and, if such rating was less than “satisfactory,” could result in the denial of such applications.
Limits on Loans to One Borrower. FDIC regulations and North Carolina law impose restrictions on the size of loans that may be made to any one borrower, including related entities. Under applicable law, with certain limited exceptions, loans and extensions of credit by a state chartered nonmember bank to a person outstanding at one time and not fully secured by collateral having a market value at least equal to the amount of the loan or extension of credit shall not exceed 15% of the unimpaired capital of the bank. Loans and extensions of credit fully secured by readily marketable collateral having a market value at least equal to the amount of the loan or extension of credit shall not exceed 10% of the unimpaired capital fund of the bank.
Transactions with Related Parties. Transactions between a state nonmember bank and any affiliate are governed by Sections 23A and 23B of the Federal Reserve Act. An affiliate of a state nonmember bank is any company or entity which controls, is controlled by or is under common control with the state nonmember bank. In a holding company context, the parent holding company of a state nonmember bank and any companies which are controlled by such parent holding company are affiliates of the savings institution or state nonmember bank. Generally, Sections 23A and 23B (i) limit the extent to which an institution 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 contain an aggregate limit on all such transactions with all 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, or at least as favorable, to the institution or subsidiary as those 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.
Loans to Directors, Executive Officers and Principal Stockholders. State nonmember banks also are subject to the restrictions contained in Section 22(h) of the Federal Reserve Act and the applicable regulations thereunder on loans to executive officers, directors and principal stockholders. Under Section 22(h), loans to a director, executive officer and to a greater than 10% stockholder of a state nonmember bank and certain affiliated interests of such persons, may not exceed, together with all other outstanding loans to such person and affiliated interests, the institution’s loans-to-one-borrower limit and all loans to such persons may not exceed the institution’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 greater than 10% stockholders of a depository institution, and their respective affiliates, unless such loan is approved in advance by a majority of the board of directors of the institution with any “interested” director not participating in the voting. Regulation O prescribes 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 (or any loans aggregating $500,000 or more). Further, Section 22(h) requires that loans to directors, executive officers and principal stockholders generally be made on terms substantially the same as offered in comparable transactions to other persons. Section 22(h) also generally prohibits a depository institution from paying the overdrafts of any of its executive officers or directors.
State nonmember banks also are subject to the requirements and restrictions of Section 22(g) of the Federal Reserve Act on loans to executive officers. Section 22(g) of the Federal Reserve Act requires approval by the board of directors of a depository institution for such extensions of credit and imposes reporting requirements for and additional restrictions on the type, amount and terms of credits to such officers. In addition, Section 106 of the Bank Holding Company Act of 1956, as amended (“BHCA”) prohibits extensions of credit to executive officers, directors, and greater than 10% stockholders of a depository institution by any other institution which has a correspondent banking relationship with the institution, unless such extension of credit is on substantially the same terms as those prevailing at the time for comparable transactions with other persons and does not involve more than the normal risk of repayment or present other unfavorable features.
Additionally, North Carolina statutes set forth restrictions on loans to executive officers of state chartered banks, which provide that no bank may extend credit to any of its executive officers nor a firm or partnership of which such executive officers is a member, nor a company in which such executive officer owns a controlling interest, unless the extension of credit is made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions by the bank with persons who are not employed by the bank, and provided further that the extension of credit does not involve more than the normal risk of repayment.
International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001. On October 26, 2001, the USA Patriot Act of 2001 was enacted. This act contains the International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001, which sets forth anti-money laundering measures affecting insured depository institutions, broker-dealers and other financial institutions. The Act requires U.S. financial institutions to adopt new policies and procedures to combat money laundering and grants the Secretary of the Treasury broad authority to establish regulations and to impose requirements and restrictions on the operations of financial institutions.
Miscellaneous. The dividends that may be paid by each bank are subject to legal limitations. In accordance with North Carolina banking law, dividends may not be paid unless a bank’s capital surplus is at least 50% of its paid-in capital.
The earnings of the Bank will be affected significantly by the policies of the Federal Reserve Board, which is responsible for regulating the United States money supply in order to mitigate recessionary and inflationary pressures. Among the techniques used to implement these objectives are open market transactions in United States government securities, changes in the rate paid by banks on bank borrowings, and changes in reserve requirements against bank deposits. These techniques are used in varying combinations to influence overall growth and distribution of bank loans, investments, and deposits, and their use may also affect interest rates charged on loans or paid for deposits.
The monetary policies of the Federal Reserve Board 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 economy and money markets, as well as the effect of actions by monetary and fiscal authorities, no prediction can be made as to possible future changes in interest rates, deposit levels, loan demand or the business and earnings of the Bank.
We cannot predict what legislation might be enacted or what regulations might be adopted, or if enacted or adopted, the effect thereof on the Bank’s operations.
Regulation of the Registrant
Federal Regulation. The Registrant is subject to examination, regulation and periodic reporting under the Bank Holding Company Act of 1956, as administered by the Federal Reserve Board. The Federal Reserve Board has adopted capital adequacy guidelines for bank holding companies on a consolidated basis.
The Registrant is required to obtain the prior approval of the Federal Reserve Board to acquire all, or substantially all, of the assets of any bank or bank holding company. Prior Federal Reserve Board approval is required for the Registrant to acquire direct or indirect ownership or control of any voting securities of any bank or bank holding company if, after giving effect to such acquisition, it would, directly or indirectly, own or control more than five percent of any class of voting shares of such bank or bank holding company.
The merger or consolidation of the Bank with another bank, or the acquisition by the Registrant of assets of another bank, or the assumption of liability by the Registrant to pay any deposits in another bank, will require the prior written approval of the primary federal bank regulatory agency of the acquiring or surviving bank under the federal Bank Merger Act. The decision is based upon a consideration of statutory factors similar to those outlined above with respect to the Bank Holding Company Act. In addition, in certain such cases an application to, and the prior approval of, the Federal Reserve Board under the Bank Holding Company Act and/or the North Carolina Banking Commission may be required.
The Registrant is required to give the Federal Reserve Board prior written notice of any purchase or redemption of its outstanding equity securities if the gross consideration for the purchase or redemption, when combined with the net consideration paid for all such purchases or redemptions during the preceding 12 months, is equal to 10% or more of the Registrant’s consolidated net worth. The Federal Reserve Board may disapprove such a purchase or redemption if it determines that the proposal would constitute an unsafe and unsound practice, or would violate any law, regulation, Federal Reserve Board order or directive, or any condition imposed by, or written agreement with, the Federal Reserve Board. Such notice and approval is not required for a bank holding company that would be treated as “well capitalized” and “well managed” under applicable regulations of the Federal Reserve Board, that has received a composite “1” or “2” rating at its most recent bank holding company inspection by the Federal Reserve Board, and that is not the subject of any unresolved supervisory issues.
The status of the Registrant as a registered bank holding company under the Bank Holding Company Act does not exempt it from certain federal and state laws and regulations applicable to corporations generally, including, without limitation, certain provisions of the federal securities laws.
In addition, a bank holding company is prohibited generally from engaging in, or acquiring five percent or more of any class of voting securities of any company engaged in, non-banking activities. One of the principal exceptions to this prohibition is for activities found by the Federal Reserve Board to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. Some of the principal activities that the Federal Reserve Board has determined by regulation to be so closely related to banking as to be a proper incident thereto are:
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making or servicing loans;
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performing certain data processing services;
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providing discount brokerage services;
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acting as fiduciary, investment or financial advisor;
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leasing personal or real property;
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making investments in corporations or projects designed primarily to promote community welfare; and
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acquiring a savings and loan association.
In evaluating a written notice of such an acquisition, the Federal Reserve Board will consider various factors, including among others the financial and managerial resources of the notifying bank holding company and the relative public benefits and adverse effects which may be expected to result from the performance of the activity by an affiliate of such company. The Federal Reserve Board may apply different standards to activities proposed to be commenced de novo and activities commenced by acquisition, in whole or in part, of a going concern. The required notice period may be extended by the Federal Reserve Board under certain circumstances, including a notice for acquisition of a company engaged in activities not previously approved by regulation of the Federal Reserve Board. If such a proposed acquisition is not disapproved or subjected to conditions by the Federal Reserve Board within the applicable notice period, it is deemed approved by the Federal Reserve Board.
However, with the passage of the Gramm-Leach-Bliley Financial Services Modernization Act of 1999, which became effective on March 11, 2000, the types of activities in which a bank holding company may engage were significantly expanded. Subject to various limitations, the Modernization Act generally permits a bank holding company to elect to become a “financial holding company.” A financial holding company may affiliate with securities firms and insurance companies and engage in other activities that are “financial in nature.” Among the activities that are deemed “financial in nature” are, in addition to traditional lending activities, securities underwriting, dealing in or making a market in securities, sponsoring mutual funds and investment companies, insurance underwriting and agency activities, certain merchant banking activities and activities that the Federal Reserve Board considers to be closely related to banking.
A bank holding company may become a financial holding company under the Modernization Act if each of its subsidiary banks is “well capitalized” under the Federal Deposit Insurance Corporation Improvement Act prompt corrective action provisions, is well managed and has at least a satisfactory rating under the Community Reinvestment Act. In addition, the bank holding company must file a declaration with the Federal Reserve Board that the bank holding company wishes to become a financial holding company. A bank holding company that falls out of compliance with these requirements may be required to cease engaging in some of its activities. The Registrant has not yet elected to become a financial holding company.
Under the Modernization Act, the Federal Reserve Board serves as the primary “umbrella” regulator of financial holding companies, with supervisory authority over each parent company and limited authority over its subsidiaries. Expanded financial activities of financial holding companies generally will be regulated according to the type of such financial activity: banking activities by banking regulators, securities activities by securities regulators and insurance activities by insurance regulators. The Modernization Act also imposes additional restrictions and heightened disclosure requirements regarding private information collected by financial institutions.
Sarbanes-Oxley Act of 2002. On July 30, 2002, the Sarbanes-Oxley Act of 2002 was signed into law and became some of the most sweeping federal legislation addressing accounting, corporate governance and disclosure issues. The impact of the Sarbanes-Oxley Act is wide-ranging as it applies to all public companies and imposes significant new requirements for public company governance and disclosure requirements.
In general, the Sarbanes-Oxley Act mandates important new corporate governance and financial reporting requirements intended to enhance the accuracy and transparency of public companies’ reported financial results. It establishes new responsibilities for corporate chief executive officers, chief financial officers and audit committees in the financial reporting process and creates a new regulatory body to oversee auditors of public companies. It backs these requirements with new SEC enforcement tools, increases criminal penalties for federal mail, wire and securities fraud, and creates new criminal penalties for document and record destruction in connection with federal investigations. It also increases the opportunity for more private litigation by lengthening the statute of limitations for securities fraud claims and providing new federal corporate whistleblower protection.
The economic and operational effects of this new legislation on public companies, including us, is significant in terms of the time, resources and costs associated with complying with the new law. Because the Sarbanes-Oxley Act, for the most part, applies equally to larger and smaller public companies, we are presented with additional challenges as a smaller, community-oriented financial institution seeking to compete with larger financial institutions in our market.
Recent Regulatory Initiatives. Beginning in late 2008 and continuing into 2009, the federal government took sweeping actions in response to the deepening economic recession. As mentioned above, President Bush signed the Emergency Economic Stabilization Act of 2008 or “EESA” into law on October 3, 2008. Pursuant to EESA, the Department of the Treasury created the Troubled Asset Relief Program of “TARP” for the purpose of stabilizing the U.S. financial markets. On October 14, 2008, the Treasury announced the creation of the TARP Capital Purchase Program. The Capital Purchase Program was designed to invest up to $250 billion (later increased to $350 billion) in certain eligible financial institutions in the form of nonvoting senior preferred stock initially paying quarterly dividends at a five percent annual rate. In connection with its investment in senior preferred stock, the Treasury also received ten-year warrants to purchase common shares of participating institutions.
The Company applied and was approved for participation in the Capital Purchase Program in late 2008. On January 9, 2009, the Company issued and sold to the Treasury (1) 24,900 shares of the Company’s Fixed Rate Cumulative Perpetual Preferred Stock, Series A, and (2) a warrant to purchase 833,705 shares of the Company’s common stock for an aggregate purchase price of $24.9 million in cash. The preferred stock qualifies as Tier 1 capital.
As a result of its participation in the Capital Purchase Program, the Company has become subject to a number of new regulations and restrictions. The ability of the Company to declare or pay dividends or distributions on, or purchase, redeem or otherwise acquire for consideration shares of its common stock is subject to restrictions. The Company is also required to have in place certain limitations on the compensation of its senior executive officers.
On February 17, 2009, President Obama signed the American Recovery and Reinvestment Act of 2009 into law. This law includes additional restrictions on executive compensation applicable to the Company as a participant in the TARP Capital Purchase Program.
For additional information about this transaction and the Company’s participation in the Capital Purchase Program, please see Note R to the Company’s audited consolidated financial statements included with this report and the Company’s current report on Form 8-K filed with the Securities and Exchange Commission on January 14, 2009.
Capital Requirements. The Federal Reserve Board uses capital adequacy guidelines in its examination and regulation of bank holding companies. If capital falls below minimum guidelines, a bank holding company may, among other things, be denied approval to acquire or establish additional banks or non-bank businesses.
The Federal Reserve Board’s capital guidelines establish the following minimum regulatory capital requirements for bank holding companies:
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a leverage capital requirement expressed as a percentage of adjusted total assets;
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a risk-based requirement expressed as a percentage of total risk-weighted assets; and
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a Tier 1 leverage requirement expressed as a percentage of adjusted total assets.
The leverage capital requirement consists of a minimum ratio of total capital to total assets of 4%, with an expressed expectation that banking organizations generally should operate above such minimum level. The risk-based requirement consists of a minimum ratio of total capital to total risk-weighted assets of 8%, of which at least one-half must be Tier 1 capital (which consists principally of shareholders’ equity). The Tier 1 leverage requirement consists of a minimum ratio of Tier 1 capital to total assets of 3% for the most highly-rated companies, with minimum requirements of 4% to 5% for all others. As of December 31, 2009, the Registrant was classified as “well-capitalized” with Tier 1 and Total Risk-Based Capital of 11.37% and 13.53%, respectively.
The risk-based and leverage standards presently used by the Federal Reserve Board are minimum requirements, and higher capital levels will be required if warranted by the particular circumstances or risk profiles of individual banking organizations. Further, any banking organization experiencing or anticipating significant growth would be expected to maintain capital ratios, including tangible capital positions (i.e., Tier 1 capital less all intangible assets),
well above the minimum levels.
Source of Strength for Subsidiaries. Bank holding companies are required to serve as a source of financial strength for their depository institution subsidiaries, and, if their depository institution subsidiaries become undercapitalized, bank holding companies may be required to guarantee the subsidiaries’ compliance with capital restoration plans filed with their bank regulators, subject to certain limits.
Dividends. As a bank holding company that does not, as an entity, currently engage in separate business activities of a material nature, the Registrant’s ability to pay cash dividends depends upon the cash dividends the Registrant receives from the Bank. At present, the Registrant’s only source of income is dividends paid by the Bank and interest earned on any investment securities the Registrant holds. The Registrant must pay all of its operating expenses from funds it receives from the Bank. Therefore, shareholders may receive dividends from the Registrant only to the extent that funds are available after payment of our operating expenses and the board decides to declare a dividend. In addition, the Federal Reserve Board generally prohibits bank holding companies from paying dividends except out of operating earnings, and the prospective rate of earnings retention appears consistent with the bank holding company’s capital needs, asset quality and overall financial condition. We expect that, for the foreseeable future, any dividends paid by the Bank to us will likely be limited to amounts needed to pay any separate expenses of the Registrant and/or to make required payments on our debt obligations, including the interest payments on our junior subordinated debt.
The FDIC Improvement Act requires the federal bank regulatory agencies biennially to review risk-based capital standards to ensure that they adequately address interest rate risk, concentration of credit risk and risks from non-traditional activities and, since adoption of the Riegle Community Development and Regulatory Improvement Act of 1994, to do so taking into account the size and activities of depository institutions and the avoidance of undue reporting burdens. In 1995, the agencies adopted regulations requiring as part of the assessment of an institution’s capital adequacy the consideration of (a) identified concentrations of credit risks, (b) the exposure of the institution to a decline in the value of its capital due to changes in interest rates and (c) the application of revised conversion factors and netting rules on the institution’s potential future exposure from derivative transactions.
In addition, the agencies in September 1996 adopted amendments to their respective risk-based capital standards to require banks and bank holding companies having significant exposure to market risk arising from, among other things, trading of debt instruments, (1) to measure that risk using an internal value-at-risk model conforming to the parameters established in the agencies’ standards and (2) to maintain a commensurate amount of additional capital to reflect such risk. The new rules were adopted effective January 1, 1997, with compliance mandatory from and after January 1, 1998.
Subsidiary banks of a bank holding company are subject to certain quantitative and qualitative restrictions imposed by the Federal Reserve Act on any extension of credit to, or purchase of assets from, or letter of credit on behalf of, the bank holding company or its subsidiaries, and on the investment in or acceptance of stocks or securities of such holding company or its subsidiaries as collateral for loans. In addition, provisions of the Federal Reserve Act and Federal Reserve Board regulations limit the amounts of, and establish required procedures and credit standards with respect to, loans and other extensions of credit to officers, directors and principal shareholders of the Bank, the Registrant, and any subsidiary of the Registrant and related interests of such persons. Moreover, subsidiaries of bank holding companies are prohibited from engaging in certain tie-in arrangements (with the holding company or any of its subsidiaries) in connection with any extension of credit, lease or sale of property or furnishing of services.
Any loans by a bank holding company to a subsidiary bank are subordinate in right of payment to deposits and to certain other indebtedness of the subsidiary bank. In the event of a bank holding company’s bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank would be assumed by the bankruptcy trustee and entitled to a priority of payment. This priority would also apply to guarantees of capital plans under the FDIC Improvement Act.
Interstate Branching
Under the Riegle-Neal Interstate Banking and Branching Act (the “Riegle-Neal Act”), the Federal Reserve Board may approve bank holding company acquisitions of banks in other states, subject to certain aging and deposit concentration limits. As of June 1, 1997, banks in one state may merge with banks in another state, unless the other state has chosen not to implement this section of the Riegle-Neal Act. These mergers are also subject to similar aging and deposit concentration limits.
North Carolina “opted-in” to the provisions of the Riegle-Neal Act. Since July 1, 1995, an out-of-state bank that did not already maintain a branch in North Carolina was permitted to establish and maintain a de novo branch in North Carolina, or acquire a branch in North Carolina, if the laws of the home state of the out-of-state bank permit North Carolina banks to engage in the same activities in that state under substantially the same terms as permitted by North Carolina. Also, North Carolina banks may merge with out-of-state banks, and an out-of-state bank resulting from such an interstate merger transaction may maintain and operate the branches in North Carolina of a merged North Carolina bank, if the laws of the home state of the out-of-state bank involved in the interstate merger transaction permit interstate merger.
We cannot predict what legislation might be enacted or what regulations might be adopted, or if enacted or adopted, the effect thereof on our operations.
ITEM 1A
ITEM 1A - RISK FACTORS
Item not applicable for smaller companies.
ITEM 2
ITEM 2 - PROPERTIES
The following table sets forth the location of the Registrant’s main office and branch offices, as well as certain information relating to these offices to date.
Office Locations
Year
Opened
Approximate
Square Footage
Owned or Leased
Main Office
High House Road
Cary, NC
8,100
Leased
Cary Office
Kildaire Farm Road
Cary, NC
2,960
Leased
Apex Office
South Salem Street
Apex, NC
3,500
Leased
Clayton Office
East Main Street
Clayton, NC
2,990
Leased
Holly Springs Office
Holly Springs Road
Holly Springs, NC
3,500
Owned
Pinehurst Office
211-M Central Park Avenue
Pinehurst, NC
2,850
Leased
Southern Pines Office
Morganton Road
Southern Pines, NC
3,500
Leased
Sanford Office
Spring Lane
Sanford, NC
3,500
Structure owned with
ground lease
Garner Office
Vandora Springs Road
Garner, NC
3,500
Leased
Falls of Neuse Office
Falls of Neuse Road
Raleigh, NC
2,442
Owned
Wilmington Main Office
Military Cutoff Road
Wilmington, NC 28403
6,634
Leased
Knightdale Office
Knightdale Boulevard
Knightdale, NC
2,518
Owned
Wilmington Independence Office
Independence Boulevard
Wilmington, NC
3,712
Structure owned with
ground lease
Raleigh Creedmoor Office
Creedmoor Road
Raleigh, NC
3,712
Owned
Raleigh Main Office
Six Forks Road
Raleigh, NC
18,250
Leased
Raw land
Zebulon, NC
1.38 acres
Owned
Raw land
Sanford, NC
1.37 acres
Owned
Operations Locations
Year Opened
Approximate
Square Footage
Owned or Leased
High House Road
Cary, NC
12,535
Leased
The total net book value of the Company’s real property used for business purposes, furniture, fixtures, and equipment on December 31, 2009 was $11,861,158. All properties are considered by Company management to be in good condition and adequately covered by insurance.
ITEM 3
ITEM 3 - LEGAL PROCEEDINGS
There are no pending legal proceedings to which the Registrant is a party, or of which any of its property is the subject other than routine litigation that is incidental to its business.
ITEM 4
ITEM 4 - [REMOVED AND RESERVED]
PART II
ITEM 5
ITEM 5 - MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
The Registrant’s stock is listed on the NASDAQ Global Market under the symbol “CRFN.” There were 9,626,559 shares outstanding at December 31, 2009 owned by approximately 2,600 shareholders. The table below lists the high and low prices at which trades were completed during each quarter for the last two years. The Company’s stock is considered thinly traded with less than ten thousand shares traded, on average, per day. Our ability to pay cash dividends depends on the cash dividends we receive from the Bank. However, the Bank is restricted in the amount of dividends it may pay. See the section entitled Regulation in Item 1 for further disclosure regarding cash dividend payments. Moreover, we do not expect to pay cash dividends on our common stock in the foreseeable future, as we intend to retain earnings in order to enhance our capital position.
See Item 12 of this Report for disclosure regarding securities authorized for issuance under equity compensation plans.
ITEM 6
ITEM 6 - SELECTED FINANCIAL DATA
(1)
Adjusted to reflect the 10 % stock dividend distributed in 2007 and stock splits effected in the form of 15% stock dividends in 2006.
(2)
Computed based on the weighted average number of shares outstanding during each period.
(3)
Consists of interest-earning deposits, federal funds sold, investment securities and FHLB stock.
(4)
Net interest spread is the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities.
(5)
Net interest margin is net interest income divided by average interest-earning assets on a tax equivalent basis.
(6) Total revenue consists of net interest income and non-interest income.
(7)
Efficiency ratio is non-interest expense divided by the sum of net interest income and non-interest income.
(8)
Non-performing assets consist of non-accrual loans, accruing loans 90 days or more past due, restructured loans only if in non-accrual status, and foreclosed assets, where applicable.
ITEM 7
ITEM 7 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Management’s discussion and analysis is intended to assist readers in the understanding and evaluation of the financial condition and consolidated results of operations of Crescent Financial Corporation (“Crescent” or the “Company”). The analysis includes detailed discussions for each of the factors affecting Crescent Financial Corporation’s operating results and financial condition for the years ended December 31, 2009 and 2008. It should be read in conjunction with the audited consolidated financial statements and accompanying notes included in this report and the supplemental financial data appearing throughout this discussion and analysis.
The following discussion and analysis contains the consolidated financial results for the Company and Crescent State Bank for the years ended December 31, 2009, 2008 and 2007. The Company had previously discontinued the consolidation of Crescent Financial Capital Trust I and began reporting the junior subordinated debentures that the Company issued in exchange for the proceeds that resulted from the issuance of the trust preferred securities. The trust preferred securities are classified as long-term debt obligations. Except for the accounting treatment, the relationship between the Company and Crescent Financial Capital Trust I has not changed. Crescent Financial Capital Trust I continues to be a wholly owned subsidiary of the Company and the full and unconditional guarantee of the Company for the repayment of the trust preferred securities remains in effect. The financial statements presented contain the consolidation of Crescent Financial Corporation and the Banks only. The Company and its consolidated subsidiaries are collectively referred to herein as the Company unless otherwise noted.
COMPARISON OF FINANCIAL CONDITION AT DECEMBER 31, 2009 AND 2008
At December 31, 2009, the Company reported total assets of $1,032.8 million compared with $968.3 million at December 31, 2008. Total assets increased by $64.5 million or 7% during the twelve month period. Total earning assets increased by $86.5 million or 10% to $984.1 million compared with $897.6 million at the prior year end. Earning assets at December 31, 2009 consisted of $759.3 million in gross loans, $190.5 million in investment securities, $11.8 million in Federal Home Loan Bank (FHLB) stock and $22.4 million in overnight investments and interest bearing deposits. Total deposits increased to $722.6 million at December 31, 2009 from $714.9 million reflecting a $7.7 million or 1% increase. Borrowings increased by $62.2 million or 40% from $154.5 million to $216.7 million. Stockholders’ equity decreased by 6% or $5.6 million to $89.5 million compared with $95.1 million.
Gross loans outstanding declined by $26.0 million or 3% totaling $759.3 million at year end 2009 compared to $785.4 million at December 31, 2008. In conjunction with a core data processing conversion occurring in early March, the Company reclassified certain loans within the portfolio so that reporting is more consistent with the collateral of a particular loan rather than the purpose. For instance, loans secured by homes purchased as investment property or for a commercial business purpose were previously reported as commercial real estate whereas they are now reported as residential real estate mortgages. Loans secured by commercial building lots were previously reported as commercial real estate and are now reported as construction and land development. Reclassifications of loan types through the conversion process resulted in $164.6 million of commercial real estate loans and $2.1 million consumer loans being shifted to $81.8 million of construction and land development, $70.7 million residential mortgages, $9.3 million home equity loans and $4.9 million commercial and industrial.
When considering these reclassifications, the net decrease in the portfolio for 2009, by category and net of unearned income, was comprised of the following changes: the commercial real estate portfolio increased by $53.7 million or 18% to $358.9 million from $305.2 million; residential mortgage loans increased by $6.9 million or 8% to $96.6 million from $89.7 million; home equity lines and loans increased by $.7 million or 1% to $64.5 million from $63.8 million; consumer loans increased by $1.8 million or 55% to $5.0 million from $3.2 million; the construction, land acquisition and development portfolio declined by $63.4 million or 26% to $179.1 million from $242.5 million; and the commercial and industrial portfolio decreased by $25.7 million or 32% to $55.3 million from $81.0 million. The composition of the loan portfolio, by category, as of December 31, 2009 is as follows: 47% commercial mortgage loans, 24% construction/acquisition and development loans, 13% residential mortgage loans, 8% home equity loans and lines of credit, 7% commercial and industrial loans, and 1% consumer loans. The composition of the loan portfolio, by category and as adjusted for the reclassifications, as of December 31, 2008 was 39% commercial mortgage loans, 31% construction loans, 11% residential real estate mortgage loans, 10% commercial loans, 8% home equity loans and lines and 1% consumer loans.
We track each loan we originate using the North American Industry Classification System (NAICS) code. Through the use of this code, we can monitor those industries for which we have a significant concentration of exposure. At December 31, 2009, there was one industry code for which our concentration exposure equaled or exceeded 10% of the total loan portfolio. Loans to investors who lease non-residential buildings other than miniwarehouses comprised 19% of our loan portfolio. We also have significant concentrations of 9% in both the residential land development and residential construction which require continuous monitoring. While the markets we operate in have not experienced the same extent of problems experienced in other markets nationally, the impact of the housing slowdown has and could continue to impact the financial performance of the Company.
The allowance for loan losses was $17.6 million or 2.31% of total outstanding loans at December 31, 2009 compared to $12.6 million or 1.60% of total outstanding loans at December 31, 2008. The current economic climate, and its impact on the housing market and general business conditions, has resulted in some deterioration of quality within the construction, land acquisition, development, commercial and home equity sectors of our loan portfolio. Additionally, management makes adjustments to its loan loss reserve methodology to account for a variety of factors such as loan concentration, current delinquency levels, adverse conditions that might affect a borrower’s ability to repay the loan, prevailing economic conditions and all other relevant factors derived from our history of operations. There is a more detailed discussion of the methodology in the section entitled “Analysis of Allowance for Loan Losses.”
At December 31, 2009, there were sixty eight loans totaling approximately $18.1 million in non-accrual status. Twenty of those loans totaling approximately $6.7 million are in the construction, land acquisition and development sector. Of the remaining $11.4 million, $4.6 million was commercial real estate, $2.8 million was 1-4 family residential loans, $2.7 million was attributable to the commercial loan portfolio, and $1.3 million were home equity lines of credit. The percentage of non-performing loans to total loans at December 31, 2009 was 2.39%. There were twenty-three performing loans aggregating $6.2 million that were 30 days or more past due and of those, two loans with a balance of $381,000 were past due 90 days or more and still accruing interest at December 31, 2009. At December 31, 2008, there were fifty loans totaling $13.1 million in non-accrual status. Of the total $13.1 million, $7.7 million were concentrated in the construction, land acquisition and development sectors and $4.4 million was residential mortgages. Of the original fifty loans, six remain in non-accrual at December 31, 2009 and the remaining loans were paid, charged-off, foreclosed or foreclosed and subsequently sold. The percentage of non-performing loans to total loans at December 31, 2008 was 1.53%. There were twelve loans aggregating $738,000 that were 30 days or more past due and no loans past due 90 days or more and still accruing interest at December 31, 2008. See the section entitled “Non Performing Assets” for more details.
Loans are classified as Troubled Debt Restructurings (“TDRs”) by the Company when certain modifications are made to the loan terms and concessions are granted to the borrowers due to financial difficulty experienced by those borrowers. All $13.7 million of TDRs at December 31, 2009 were accruing interest, were not past due 30 days or more and were not included in nonperforming loans. The Company only restructures loans for borrowers in financial difficulty that have designed a viable business plan to fully pay off all obligations, including outstanding debt, interest, and fees, either by generating additional income from the business or through liquidations of assets. Generally these loans are restructured to provide the borrower additional time to execute their plans. The TDRs were not placed in nonaccrual status prior to the restructuring, and since the Company expects the borrowers to perform after the restructuring (based on modified note terms), the loans continue to accrue interest at the restructured rate. The Company will continue to closely monitor these loans and will cease accruing interest on them if management believes that the borrowers may not continue performing based on the restructured note terms. All TDR’s are considered impaired and at year end there were $3.6 million in TDRs which demonstrated impairment and accordingly were evaluated as such in the allowance calculation. As of December 31, 2009, allowance for loan losses allocated to TDRs totaled approximately $858,000.
The amortized cost and fair market value of the Company’s investment securities portfolio at December 31, 2009 were $190.5 million and $193.1 million, respectively compared to $104.6 million and $105.6 million, respectively, at December 31, 2008. All investments are accounted for as available for sale and are presented at their fair market value. Over the past twelve months, the portfolio experienced a net increase of $87.5 million or 83%. The Company’s investment in debt securities at December 31, 2009, consisted of U.S. Government agency securities, collateralized mortgage obligations (CMOs), mortgage-backed securities (MBSs), municipal bonds and common stock of two publicly traded entities. Increases in the portfolio during 2009 were attributed to new securities purchases of $167.7 million, a $1.6 million increase in the fair market value of the portfolio, and an $870,000 gain on the disposal of available for sale securities. Decreases in the portfolio were attributed to the receipt of $38.7 million in principal re-payments on CMOs and MBSs, a net premium decline of $970,000, a $198,000 impairment on marketable securities, and $42.8 million in proceeds from the disposal of available for sale securities. The Company also owned $11.8 million of Federal Home Loan Bank stock at December 31, 2009 compared with $7.3 million at December 31, 2008.
During the first quarter of 2009 the Company implemented a leverage strategy to offset the impact on earnings per share anticipated as a result of having to pay dividends on the investment made by the US Treasury pursuant to the Capital Purchase Plan (CPP). While the funds received through the CPP have been allocated for the purpose of making loans to purchasers of completed properties held in inventory by our residential construction customers, an amount equal to the CPP funds was leveraged four times and used to purchase investment securities. The additional spread earned on the strategy is meant to offset the reduction in earnings per share for common shareholders due to payment of the preferred dividend.
All of our mortgage-backed and collateralized mortgage obligation securities are issued through either a Government Sponsored Enterprise (GSEs) such as Federal Home Loan Mortgage Corporation (Freddie Mac) or the Federal National Mortgage Association (Fannie Mae) or the government-owned Government National Mortgage Association (Ginnie Mae). Prior to September 7, 2008, only those securities issued by Ginnie Mae were backed by the full faith of the US Government. There was an implied guarantee on securities issued through the other two GSEs, but not an explicit guarantee. On September 7, 2008, the US Department of Treasury and the Federal Housing Finance Agency announced that Freddie Mac and Fannie Mae were being placed into conservatorship. As a result, the US Government effectively has guaranteed the securities issued by the GSEs. Therefore, the credit risk associated with owning debt securities issued through these two entities has been significantly mitigated.
Non-interest earning assets totaled $63.7 million at December 31, 2009, decreasing by $18.6 million or 23% over the past year. The other asset category experiencing the largest increase was other real estate owned which grew by $4.6 million during the year as the Company foreclosed on real estate collateral used to secure certain loans. Prepaid expenses increased by approximately $3.9 million between December 31, 2008 and December 31, 2009 primarily due to the prepayment of three years of FDIC insurance premiums. Premises and equipment experienced a net increase of $1.0 million resulting from the purchase of $1.9 million in new assets less $938,000 of depreciation expense. The net deferred income tax asset increased by $1.6 million due primarily to the significant increase in the loan loss provision. For tax purposes, the amount provided for loan losses is only deductible when a loan is actually charged-off. Therefore, the tax benefit to be derived is deferred. Accrued interest receivable increased by $919,000 due to a higher volume of earning assets. The cash value of bank owned life insurance increased by $846,000 during the period. Cash and due from banks, which represents cash on hand in branches and amounts represented by checks in the process of being collected through the Federal Reserve payment system, declined by $632,000 from $9.9 million to $9.3 million. For more details regarding the decrease in cash and cash equivalents, see the Consolidated Statements of Cash Flows. Goodwill which was valued at $30.2 million at the end of 2008 was deemed totally impaired as of December 31, 2009 and completely written off. See Note F for a more detailed discussion of our Goodwill testing methodology and conclusions.
Total deposits at December 31, 2009 were $722.6 million compared to $714.9 million at December 31, 2008 increasing by $7.7 million or 1% during the past twelve months. We experienced strong growth in our interest bearing demand deposits which increased by $50.6 million or 119% from $42.6 million to $93.2 million at year end. In late 2008, we introduced a checking account product designed to reward customers for modifying the activity related to their account. In return for receiving electronic account statements and performing more debit card and other electronic transactions they receive a premium rate of interest. The response has been very good and has allowed us to increase our core deposit base while reducing our reliance on brokered funds. Time deposits decreased by $24.0 million or 5% from $461.5 million to $437.5 million. Of the total $24.0 million decrease, $52.7 million represented a decline in brokered time deposits with an offsetting $28.7 million net growth in retail time deposits. Money market accounts decreased $15.1 million or 17% to $72.8 million at December 31, 2009 from $87.9 million the prior year. Early in 2009 we lost one large money market relationship of approximately $14.0 million and we had served as the escrow agent for a new financial institution which received approval and withdrew the funds during the first quarter of 2009. Non interest-bearing demand deposits declined by $2.9 million from $63.9 million to $61.0 million and savings account balances declined by $748,000 to $58.1 million at year-end. The statement savings product did suffer some disintermediation into the new interest bearing checking product.
The composition of the deposit base, by category, at December 31, 2009 was as follows: 61% in time deposits, 13% in interest-bearing deposits, 10% in money market, and 8% in both non interest-bearing demand deposits and statement savings. The composition of the deposit base, by category, at December 31, 2008 was as follows: 65% in time deposits, 12% in money market deposits, 9% in non interest-bearing demand deposits, 8% in statement savings, and 6% in interest-bearing deposits.
At December 31, 2009 the Company had $357.4 million in time deposits of $100,000 or more compared to $359.3 million at December 31, 2008. The Company uses brokered certificates of deposit as an alternative funding source. Brokered deposits represent a source of fixed rate funds that do not need to be collateralized like Federal Home Loan Bank borrowings. While we expect to continue to utilize the brokered deposit market in the future, we anticipate being more focused on increasing our market share of local deposits and focusing on improving our earnings. There are times when obtaining money in the brokered arena is less expensive than offering high rate specials in our markets. The Company will aim to balance the need for a higher concentration of local money against the cost of funds. Brokered deposits at December 31, 2009 were $203.3 million compared to $256.1 million at December 31, 2008.
Total borrowings increased by 40% or $62.2 million from $154.5 million at December 31, 2008 to $216.7 million at December 31, 2009 Borrowings at December 31, 2009 consisted of $127.0 million in long-term FHLB advances, $24.0 million in short-term FHLB advances, $50.0 million in short-term Fed Discount Window advances, $8.2 million in junior subordinated debt issued to an unconsolidated subsidiary, and $7.5 million in subordinated term loans secured from a non-affiliated financial institution. Borrowings at December 31, 2008 consisted of $99.0 million in long-term FHLB advances, $29.0 million in short-term FHLB advances, $8.2 million in junior subordinated debt issued to an unconsolidated subsidiary, $7.5 million in subordinated term loans secured from a non-affiliated financial institution, $2.0 million outstanding on a holding company line of credit and $8.7 million in Federal funds purchased from a correspondent bank.
Accrued expenses and other liabilities were $3.9 million at both December 31, 2009 and 2008.
Total stockholders’ equity decreased by $5.6 million between December 31, 2008 and December 31, 2009. The decrease was the net result of the issuance of $24.9 million preferred stock, a $788,000 increase in other comprehensive income and $181,000 in stock based compensation, offset by a net loss for the year of $30.2 million and $1.2 million in preferred stock dividends.
COMPARISON OF RESULTS OF OPERATIONS FOR THE YEARS ENDED
DECEMBER 31, 2009 AND 2008
Net Income. For the year ended December 31, 2009, the Company reported a net loss, before adjusting for the effective dividend on the preferred stock, of $30.2 million compared to net income of $2.0 million for the year ended December 31, 2008. After adjusting for $1.6 million in dividends and discount accretion on preferred stock, the net loss attributable to common shareholders for the current period was $31.8 million or $(3.33) per diluted share compared with net income of $0.21 per diluted share for the year ended December 31, 2008. Annualized return on average assets declined to (2.85)% from 0.22% for the prior period. Earnings in the current period were positively impacted by slightly improved net interest margin, which was more than offset by a higher loan loss provision in response to current economic conditions and an increase in non-interest operating expenses. Additionally, the Company recorded a non-cash goodwill impairment charge of $30.2 million during the fourth quarter. Return on total average equity for the current period was (24.85)% compared to 2.13% for the prior period. The decline in return on average equity is due to the lower level of earnings combined with higher capital from the issuance of the preferred stock.
Net Interest Income. Net interest income was $29.6 million for the current year compared to $25.3 million for the prior year reflecting a 17% increase. The increase in interest income was primarily attributed to the $136.8 million rise in average earning assets and was partially offset by the impact of a 68 basis point decline on the yield on earning assets.
Net interest margin is interest income earned on loans, securities and other earning assets, less interest expense paid on deposits and borrowings, expressed as a percentage of total average earning assets. The tax equivalent net interest margin for the year ended December 31, 2009 was 3.09% compared to 3.05% for the prior year. The average yield on earning assets for the current period was 5.79% compared to 6.47% from the year ended December 31, 2008 and the average cost of interest-bearing funds was 3.05% compared to 3.86%. The positive impact on net interest income margin came in part due to the increase in interest rate spread from 2.61% to 2.74%.
While the interest rate environment in 2009 was stable, it followed a fifteen month period of sharply falling interest rates. Between September 19, 2007 and December 31, 2008, the Federal Reserve (the “Fed”) cut short-term interest rates ten times for a total of 500 basis points. Approximately 42% of the Company’s loan portfolio has variable rate pricing based on the Prime lending rate or LIBOR (London Inter Bank Offered Rate). The percentage of variable rate to total loans has declined from 49% at December 31, 2008. In light of the historically low level of interest rates in conjunction with current economic conditions, for those new variable rate loans and variable rate loans that are renewed we have instituted rate floors in many instances. Approximately 88% of the total variable rate loans have a rate floor with the majority of those floors in the 5.00% to 6.50% range. Therefore, only 5% of the total loan portfolio is variable with no interest rate floors.
The Company has shifted its strategic focus from a growth orientation to a more performance-related, relationship orientation. The Company is being more disciplined with loan pricing and implementing interest rate floors on variable rate loans when feasible. As a result, the loan portfolio will not experience the same growth rates as has been seen in recent years, but should provide better yields. This should also ease reliance on wholesale forms of funding. While there is an attempt to focus on local market relationships, wholesale forms of funding will continue to make more sense from an economic standpoint at certain times.
The Company expects that net interest margin will continue to expand in a stable interest rate environment as approximately 62% of the time deposit portfolio carrying a weighted average rate of 2.97% matures in the next year and is subject to being renewed at lower rates. The Company entered into interest rate swap agreements on $7.5 million subordinated loan agreement and $8.0 million trust preferred securities. These two borrowings carry variable rates of interest based on three-month LIBOR. We have swapped these variable cash flows for fixed rate cash flows for an average period of three and a half years. In addition to adopting a funding strategy that pushes funding maturities further out into the future, these swaps will further protect the Company when rates do begin to rise.
Total average interest earning assets were $985.6 million for the year ended December 31, 2009, increasing by $136.8 million or 16% when compared to an average of $848.8 million for the year ended December 31, 2008. Increases in average balances by earning asset category are as follows: average loans increased by $35.4 million or 5% from $741.8 million for 2008 to $777.3 million for 2009, investment securities grew by $98.1 million or 95% from $103.1 million to $201.2 million and Federal funds sold and other earning assets increased by $3.3 million or 84% from $3.9 million to $7.2 million. Total average interest-bearing liabilities increased by $120.9 million with interest-bearing deposits increasing by $34.7 million or 6% and borrowings increasing by $86.2 million or 61%.
Total interest income for 2009 increased by $1.8 million from $54.4 million to $56.2 million. The increase was the net result of a $7.4 million increase in interest income from the higher volume of earning assets and a $5.6 million decrease due to the falling interest rate environment. Total interest expense declined by $2.4 million which resulted from a net increase of $2.5 million from higher interest bearing liability volumes and a $4.9 million decrease due to lower interest rates.
Provision for Loan Losses. The Company’s provision for loan losses for 2009 was $11.5 million compared to $6.5 recorded in the prior year. The increase in the loan loss provision was attributable completely to the deterioration of loan quality due to current economic conditions as the total loan portfolio actually declined by $26.0 million from December 31, 2008 to December 31, 2009. Economic conditions in communities we serve stemming primarily from the weakening housing market and unemployment have caused us to be more aggressive in monitoring the quality of our loan assets and to take proactive steps to identify loans that are impaired. Once a loan is deemed to be impaired, we must evaluate what degree of impairment exists, if any, and recognize that deficiency as a specific reserve. Provisions for loan losses are charged to income to bring the allowance for loan losses to a level deemed appropriate by management. For a more detailed discussion of the provision of loan losses and the established reserve, see the section entitled “Analysis of Allowance for Loan Losses.”
Non-Interest Income. Non-interest income increased by $523,000 or 14% to $4.3 million for 2009 compared to $3.8 million for the prior year period. The largest components of non-interest income in 2009 were $1.40 million in customer service fees (which include non sufficient funds fees, debit card commissions, ATM surcharges and other deposit account related fees), $886,000 in earnings on cash value of bank owned life insurance, $923,000 in mortgage loan origination fees, and $247,000 in service charges on deposit accounts. For the year ended December 31, 2008, the largest components of non-interest income included $1.4 million in customer service fees, $718,000 in mortgage loan origination fees, $736,000 in earnings on cash value of bank owned life insurance and $254,000 in service charges on deposit accounts. During 2009, the Company recognized $870,000 in gains on the disposal of available for sale securities, a $407,000 impairment on non-marketable securities, a $197,000 impairment on marketable equity securities, a $75,000 gain on sale of a loan and $3,000 in losses on the disposal of fixed assets. The Company recognized $16,000 in gains on the disposal of available for sale securities and $1,000 in losses on the disposal of fixed assets in 2008.
Non-Interest Expenses. Non-interest expenses were $53.9 million for year ended December 31, 2009 compared to $20.0 million for the prior year period. The $33.9 million or 170% increase reflects a $30.2 million write-off of Goodwill, the continuing efforts to expand the Company’s infrastructure and branch network and an increase in FDIC premiums. Of the $3.7 million non-goodwill related increase, $1.5 million is attributed to FDIC premiums and $1.9 million was in personnel, occupancy and data processing which are the areas most impacted by the branch network and infrastructure improvements.
Total compensation for the year ended December 31, 2009 was $11.8 million reflecting a 7% increase when compared to $11.1 million for the year ended December 31, 2008. As of December 31, 2009, the Company employs 158 full-time equivalent employees in fifteen full-service branch offices and various administrative support departments. In comparison, at December 31, 2008, the Company employed 147 full-time equivalent employees in thirteen full-service branch offices, one loan production office and various administrative support departments.
Occupancy expenses were $3.5 million for 2009 compared to $2.7 million in 2008 increasing by $816,000 or 30%. During 2009, the Company opened two new full-service offices in Raleigh. Additionally, in March 2008, one new branch office was opened. There are currently no new de novo branch openings planned for 2010; however, other expansion opportunities might present themselves which would impact occupancy expense.
Data processing expenses were $1.4 million for 2009 increasing by $337,000 or 31%. The Company completed a full data processing system conversion during the first quarter of 2009 and $156,000 of the total increase is attributable to non-recurring expenses. The Company added several new important technologies as part of the data processing conversion such as loan document imaging and a more automated and enhanced credit underwriting tool.
FDIC deposit insurance premiums increased to $1.9 million in 2009 from $402,000 for the prior year. As previously discussed, the Company was subject to both higher regular deposit premiums and a special assessment collected on September 30, 2009 in the amount of $493,000. While there has been no mention of additional special assessments, the FDIC has the authority to levy additional assessments based on the level of the Deposit Insurance Fund. Additional assessments could have a significant impact on the financial results of the Company.
In accordance with Generally Accepted Accounting Principles, the Company had been analyzing for impairment the goodwill created through the prior bank acquisitions in 2003 and 2007. During the fourth quarter, it was determined that the appropriate course of action was to recognize the entire goodwill amount as impaired. This resulted in a non-cash expense of $30.2 million.
The total of all other expenses increased by $271,000 in 2009 compared to 2008. The largest components of other noninterest expenses include professional fees (legal, accounting and audit expenses and director fees), loan related expenses, advertising and marketing related and office supplies. Loan related expenses increased to $725,000 for 2009 from $403,000 the prior year. Expenses increased by $322,000 or 80% as the Company experienced additional legal and appraisal valuation fees related to the foreclosure process. The Company realized a $45,000 loss on the sale and write-down of other real estate owned in 2009. Professional fees and services totaled $1.5 million in 2009, down $155,000 or 10% from the $1.6 million for 2008. The auditor reporting requirements of Section 404 of Sarbanes-Oxley Act (SOX) were delayed for 2009 and therefore the company did not incur additional audit fees as a result. The Company is currently subject to certain provisions of the FDIC Improvement Act related to management’s report of financial results and will be subject to additional provisions beginning in 2010, which will require certification for the effectiveness of internal controls over financial reporting by the external auditors. Office supplies and printing expense increased by $41,000 due to the increased number of offices and advertising and marketing expenses declined by $26,000.
Provision for Income Taxes. For 2009, the Company’s provision for income taxes was $(1.3) million compared to $599,000 for the prior year. The effective tax rates for 2009 and 2008 were 4.21% and 22.9%, respectively. The significant decline in effective tax rate was due to a pre-tax loss and the volume of tax-exempt income.
COMPARISON OF RESULTS OF OPERATIONS FOR THE YEARS ENDED
DECEMBER 31, 2008 AND 2007
Net Income. For the year ended December 31, 2008, the Company reported net income of $2.0 million compared to $6.2 million for the year ended December 31, 2007. The 68% decline in net income resulted in a decrease of diluted earnings per share of $0.44 to $0.21 for the year ended December 31, 2008 compared to $0.65 for the prior year period. The decrease in earnings year over year was primarily the result of a higher provision for loan losses and a compressing net interest rate margin due to the falling interest rate environment. Returns on average assets and average equity were 0.22% and 2.13%, respectively, for the year ended December 31, 2008 compared to 0.80% and 7.15% for the prior year period.
Net Interest Income. Net interest income was $25.3 million for the current year compared to $26.7 million for the prior year reflecting a 5% decrease. Increases to be expected from the significant increase in total earning assets were more than offset by the impact of falling interest rates on the spread between rates earned on the assets and the cost of funding those assets.
The tax equivalent net interest margin for the year ended December 31, 2008 was 3.05% compared to 3.79% for the prior year. The average yield on earning assets for the current period was 6.47% compared to 7.73% from the year ended December 31, 2007 and the average cost of interest-bearing funds was 3.86% compared to 4.58%. The impact on net interest income from the decline in interest rate spread from 3.15% to 2.61% was exacerbated by a decline in the ratio of average interest earning assets to average interest bearing liabilities from 116.21% to 112.74%.
The interest rate environment between September 2007 and December 2008 had a significant impact on the Company’s net interest margin. Beginning on September 19, 2007, the Federal Reserve (the “Fed”) began cutting short-term interest rates. The December 17, 2008 cut was the tenth such reduction since September 2007 and placed the total interest rate cuts at 500 basis points. During the course of 2008, the percentage of our total loan portfolio that carried variable rates of interest based on the Prime rate or LIBOR (London Inter Bank Offered Rate) ranged from a high of 52% a year ago to 49% at December 31, 2008. As short-term rates declined, the interest rates on variable rate loans fell resulting in a lower yield on average earning assets. Whereas this segment of our loan portfolio was subject to immediate repricing, large portions of our funding liabilities were subject to repricing over some length of time. Many of the Company’s borrowings and all time deposits carried a fixed rate of interest to a fixed future maturity date. The rates on those fixed rate, fixed maturity instruments become subject to change only at maturity. Therefore, it takes a longer period of time to realize decreases in our cost of funds. Other non-maturity deposits such as interest-bearing demand deposits, savings and money market carried variable rates of interest which we can change at our discretion. Typically rates on those instruments do not change at the same magnitude as a change in the Prime rate of interest might. These factors resulted in a decline in the net interest margin for 2008.
Total average interest earning assets were $848.8 million for the year ended December 31, 2008, increasing by $132.9 million or 19% when compared to an average of $716.0 million for the year ended December 31, 2007. Increases in average balances by earning asset category are as follows: average loans increased by $126.5 million or 21% from $615.3 million for 2007 to $741.8 million for 2008, investment securities grew by $10.5 million or 11% from $92.6 million to $103.1 million and Federal funds sold and other earning assets decreased from $8.0 million to $3.9 million. Total average interest-bearing liabilities increased by $136.8 million with interest-bearing deposits increasing by $88.6 million or 17% and borrowings increasing by $48.3 million or 51%.
Total interest income for 2008 decreased by $467,000 from $54.9 million to $54.4 million. The decrease was the net result of a $9.6 million increase in interest income from the higher volume of earning asset and a $10.1 million decrease due to the falling interest rate environment. Total interest expense grew by $853,000 which resulted from a net increase of $6.3 million from higher interest bearing liability volumes and a $5.5 million decrease due to lower interest rates.
Provision for Loan Losses. The Company’s provision for loan losses for 2008 was $6.5 million compared to $1.7 recorded in the prior year. The increase in the loan loss provision was due to the net increase in the loan portfolio and the deterioration of loan quality due to current economic conditions. Net loan growth was $109.5 million during 2008 compared to $126.1 million in 2007. Economic conditions in communities we serve stemming primarily from the weakening housing market have caused us to be more aggressive in monitoring the quality of our loan assets and to take proactive steps to identify loans that are impaired.
Non-Interest Income. Non-interest income increased by $1.1 million or 42% to $3.8 million for 2008 compared to $2.7 million for the prior year period. The largest components of non-interest income in 2008 were $1.4 million in customer service fees, $736,000 in earnings on cash value of bank owned life insurance, $718,000 in mortgage loan origination fees, and $254,000 in service charges and fees on deposit accounts. For the year ended December 31, 2007, the largest components of non-interest income included $1.1 million in customer service fees, $512,000 in mortgage loan origination fees, $380,000 in earnings on cash value of bank owned life insurance and $227,000 in service charges and fees on deposit accounts. During 2008, the Company recognized $16,000 in gains on the disposal of available for sale securities and $1,000 in losses on the disposal of fixed assets. The Company recognized net losses on the disposal of other assets of $8,000 in 2007
Non-Interest Expenses. Non-interest expenses were $20.0 million for year ended December 31, 2008 compared to $17.9 million for the prior year period. The $2.1 million or 12% increase reflects the continuing efforts to expand the Company’s infrastructure and branch network. Of the total increase, $1.7 million was in personnel, occupancy and data processing which are the areas most impacted by the branch network and infrastructure improvements.
Total compensation for the year ended December 31, 2008 was $11.1 million reflecting a 13% increase when compared to $9.9 million for the year ended December 31, 2007. As of December 31, 2008, the Company employs 147 full-time equivalent employees in thirteen full-service branch offices, one loan production office and various administrative support departments. In comparison, at December 31, 2007, the Company employed 126 full-time equivalent employees in twelve full-service branch offices, one loan production office and various administrative support departments.
Occupancy expenses were $2.7 million for 2008 compared to $2.3 million in 2007 increasing by $431,000 or 19%. During 2008, the Company opened one new full-service office in March. Additionally, in December 2007, one new branch office was opened and another was relocated to a more desirable location.
Data processing expenses were $1.1 million for 2008 increasing by only $26,000 or 2%. While data processing expense, which includes data lines to new offices, is closely tied to both account volume growth and branch expansion, the introduction of remote merchant capture in 2008 and branch item capture in 2007 helped contain total data processing expenses.
Professional fees and services totaled $1.6 million in 2008, up $109,000 or 7% over the $1.5 million for 2007. The largest components of professional fees and services were directors’ fees, legal expenses, and accounting and audit expenses.
The total of all other non-interest expenses for the year ended December 31, 2008 was $3.5 million compared to $3.1 million for the prior year. The increase was primarily the result of the Company’s continued growth. The largest components of other non-interest expenses include office supplies and printing, advertising, and loan related fees. Management expects that as the Company continues to expand, expenses associated with these categories will increase.
Provision for Income Taxes. For 2008, the Company’s provision for income taxes was $599,000 compared to $3.5 million for the prior year. The effective tax rates for 2008 and 2007 were 22.9% and 36.0%, respectively. The effective tax rate decreased significantly due to a higher percentage of tax-exempt income as a percentage of total income.
NET INTEREST INCOME
Net interest income represents the difference between income derived from interest-earning assets and interest expense incurred on interest-bearing liabilities. Net interest income is affected by both (1) the difference between the rates of interest earned on interest-earning assets and the rates paid on interest-bearing liabilities (“interest rate spread”) and (2) the relative amounts of interest-earning assets and interest-bearing liabilities (“net interest-earning balance”). The following table sets forth information relating to average balances of the Company's assets and liabilities for the years ended December 31, 2009, 2008 and 2007. The table reflects the average tax-equivalent yield on interest-earning assets and the average cost of interest-bearing liabilities (derived by dividing income or expense by the daily average balance of interest-earning assets or interest-bearing liabilities, respectively) as well as the net interest margin. In preparing the table, non-accrual loans are included in the average loan balance.
VOLUME/RATE VARIANCE ANALYSIS
The following table analyzes the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities. The table distinguishes between (i) changes attributable to volume (changes in volume multiplied by the prior period’s rate), (ii) changes attributable to rate (changes in rate multiplied by the prior period’s volume), and (iii) net change (the sum of the previous columns). The change attributable to both rate and volume (changes in rate multiplied by changes in volume) has been allocated proportionately to both the changes attributable to volume and the changes attributable to rate.
NONPERFORMING ASSETS
Our financial statements are prepared on the accrual basis of accounting, including the recognition of interest income on loans, unless we place a loan in nonaccrual status. We account for loans on a nonaccrual basis when we have serious doubts about the collectability of principal or interest. Generally, our policy is to place a loan on nonaccrual status when the loan becomes past due 90 days. We also place loans on nonaccrual status in cases where we are uncertain whether the borrower can satisfy the contractual terms of the loan agreement. Amounts received on nonaccrual loans generally are applied first to principal and then to interest only after all principal has been collected. Restructured loans are those for which concessions, including the reduction of interest rates below a rate otherwise available to that borrower or the deferral of interest or principal have been granted due to the borrower’s weakened financial condition. We accrue interest on restructured loans at the restructured rates when we anticipate that no loss of original principal will occur. Potential problem loans are loans which are currently performing and are not included as nonaccrual or restructured loans above, but about which we have serious doubts as to the borrower’s ability to comply with present repayment terms. These loans are likely to be included later in nonaccrual, past due or restructured loans, so they are considered by our management in assessing the adequacy of our allowance for loan losses. At December 31, 2009, we identified 27 loans in the aggregate amount of $19.5 million as potential problem loans. The loans possess certain unfavorable characteristics which cause management some concern such a past due trends, the deteriorating financial condition of the borrower and softness in the residential real estate market. Of these 27 loans, 15 loans totaling approximately $6.8 million are related to the land acquisition, development and residential construction industries and 5 loans totaling $11.4 million are secured by commercial real estate. These loans will continue to be closely monitored. At December 31, 2008, we identified 34 loans in the aggregate amount of $7.9 million as potential problem loans.
At December 31, 2009, there were thirty-seven foreclosed properties valued at $6.3 million and 68 nonaccrual loans totaling $18.1 million. Foreclosed property is initially recorded at fair value at the date of foreclosure or repossession. Interest foregone on nonaccrual loans for the year ended December 31, 2009 was approximately $928,000. At December 31, 2008, there were eight foreclosed properties valued at $1.7 million and fifty nonaccrual loans totaling $13.1 million. Interest foregone on nonaccrual loans for the year ended December 31, 2008 was approximately $554,500. There were two loans totaling $382,400 at December 31, 2009 and none at 2008 that were 90 days or more past due and still accruing interest. There were no repossessed assets at December 31, 2009 and 2008.
The table sets forth, for the period indicated, information about our nonaccrual loans, loans past due 90 days or more and still accruing interest, total nonperforming loans (nonaccrual loans plus loans past due 90 days or more and still accruing interest), and total nonperforming assets.
ANALYSIS OF ALLOWANCE FOR LOAN LOSSES
The allowance for loan losses is established through periodic charges to earnings in the form of a provision for loan losses. Increases to the allowance for loan losses occur as a result of provisions charged to operations and recoveries of amounts previously charged-off, and decreases to the allowance occur when loans are charged-off. Management evaluates the adequacy of our allowance for loan losses on a monthly basis. The evaluation of the adequacy of the allowance for loan losses involves the consideration of loan growth, loan portfolio composition and industry diversification, historical loan loss experience, current delinquency levels, adverse conditions that might affect a borrower’s ability to repay the loan, estimated value of underlying collateral, prevailing economic conditions and all other relevant factors derived from our history of operations. Additionally, as an important component of their periodic examination process, regulatory agencies review our allowance for loan losses and may require additional provisions for estimated losses based on judgments that differ from those of management.
We use an internal grading system to assign the degree of inherent risk on each individual loan. The grade is initially assigned by the lending officer and reviewed by the loan administration function. The internal grading system is reviewed and tested periodically by an independent third party credit review firm. The testing process involves the evaluation of a sample of new loans, loans having been identified as possessing potential weakness in credit quality, past due loans and nonaccrual loans to determine the ongoing effectiveness of the internal grading system. The loan grading system is used to assess the adequacy of the allowance for loan losses.
Management has developed a model for evaluating the adequacy of the allowance for loan losses. The model uses the Company’s internal loan grading system to segment each category of loans by risk class. The Company’s internal grading system is compromised of nine different risk classifications. Loans possessing a risk class of 1 through 6 demonstrate various degrees of risk, but each is considered to have the capacity to perform in accordance with the terms of the loan. Loans possessing a risk class of 7 to 9 are considered impaired and are individually evaluated for impairment. Additionally, we are evaluating loans that migrate to a risk class 6 status and provide for possible losses if the loan is unsecured or secured by a General Security Agreement on business assets.
The predetermined allowance percentages to be applied to loans possessing risk grade 1 through 6 are determined by using the historical charge-off percentages and adding management’s qualitative factors. For each individual loan type, we calculate the average historical charge-off percentage over a five year period. The current year charge-offs are annualized and included as one of the five years under consideration. The resulting averages represent a charge-off in a more normalized environment. To those averages, management adds qualitative factors which are more a reflection of current economic conditions and trends. Together, these two components comprise the reserve.
Those loans that are identified through the Company’s internal loan grading system as impaired are evaluated individually. Each loan is analyzed to determine the net value of collateral, probability of charge-off and finally a potential estimate of loss. When management believes a real estate collateral-supported loan will move from a risk grade 6 to a risk grade 7, a new appraisal is ordered. The analysis is performed using current collateral values as opposed to values shown on appraisals which were obtained at the time the loan was made. If the analysis of a real estate collateral-supported loan results in an estimated loss, a specific reserve is recorded. Loans with risk grade 7 and 8 are re-evaluated periodically to determine the adequacy of specific reserves. Fair values on real estate collateral are subject to constant change and management makes certain assumptions about how the age of an appraisal impacts current value. Loans with risk grade codes of 7 or 8 that are either unsecured or secured by a general security agreement on business assets are generally reserved for at 100% of the loan balance.
Using the data gathered during the monthly evaluation process, the model calculates an acceptable range for allowance for loan losses. Management and the Board of Directors are responsible for determining the appropriate level of the allowance for loan losses within that range.
The provision for 2009 was primarily the result of credit quality deterioration due to the current economic conditions in our markets. The sectors of the loan portfolio being impacted most by the economic climate are residential construction and land acquisition and development. Other factors influencing the provision include net loan charge-offs. For the year ended December 31, 2009, net loan charge-offs were $6.5 million compared with $2.2 million for the prior year period and non-accrual loans were $18.1 million and $13.1 million at December 31, 2009 and 2008, respectively. The allowance for loan losses at December 31, 2009 was $17.6 million, which represents 2.31% of total loans outstanding compared to $12.6 million or 1.60% as of December 31, 2008.
The allowance for loan losses represents management’s estimate of an amount adequate to provide for known and inherent losses in the loan portfolio in the normal course of business. While management believes the methodology used to establish the allowance for loan losses incorporates the best information available at the time, future adjustments to the level of the allowance may be necessary and the results of operations could be adversely affected should circumstances differ substantially from the assumptions initially used. We believe that the allowance for loan losses was established in conformity with generally accepted accounting principles; however, there can be no assurances that the regulatory agencies, after reviewing the loan portfolio, will not require management to increase the level of the allowance. Likewise, there can be no assurance that the existing allowance for loan losses is adequate should there be deterioration in the quality of any loans or changes in any of the factors discussed above. Any increases in the provision for loan losses resulting from such deterioration or change in condition could adversely affect our financial condition and results of operations.
The following table describes the allocation of the allowance for loan losses among various categories of loans for the dates indicated:
(1)
Represents total of all outstanding loans in each category as a percent of total loans outstanding.
The following table presents information regarding changes in the allowance for loan losses for the years indicated:
INVESTMENT ACTIVITIES
The Company’s investment portfolio plays a major role in management of liquidity and interest rate sensitivity and, therefore, is managed in the context of the overall balance sheet. The securities portfolio generates a nominal percentage of our interest income and serves as a necessary source of liquidity. We account for investment securities as follows:
Available for sale. Debt and equity securities that will be held for indeterminate periods of time, including securities that we may sell in response to changes in market interest or prepayment rates, needs for liquidity and changes in the availability of and the yield of alternative investments are classified as available for sale. The Company carries these investments at market value, which we generally determine using published quotes as of the close of business, information obtained from established third-party pricing vendors or information from matrix pricing methods developed in accordance with Bond Market Association industry standards. Unrealized gains and losses are excluded from our earnings and are reported, net of applicable income tax, as a component of accumulated other comprehensive income in stockholders’ equity until realized.
The following table summarizes the amortized costs and market value of available for sale securities at the dates indicated:
LIQUIDITY AND CAPITAL RESOURCES
Maintaining adequate liquidity while managing interest rate risk is the primary goal of the Company’s asset and liability management strategy. Liquidity is the ability to fund the needs of the Company’s borrowers and depositors, pay operating expenses, and meet regulatory liquidity requirements. Maturing investments, loan and mortgage-backed securities principal repayments, deposit growth, the brokered deposit market, and borrowings from the Federal Home Loan Bank are presently the main sources of the Company’s liquidity. The Company’s primary uses of liquidity are to fund loans and to make investments.
At December 31, 2009, liquid assets (cash and due from banks, interest-earning deposits with banks, federal funds sold and investment securities available for sale) were approximately $224.8 million, which represents 22% of total assets and 31% of total deposits. Supplementing this liquidity, the Company has available lines of credit from various correspondent banks of approximately $393.3 million of which $201.0 million was outstanding. At December 31, 2009, outstanding commitments for undisbursed lines of credit and letters of credit amounted to $127.2 million and outstanding commitments to make additional investments in a Small Business Investment Corporation were $363,000. Management believes that the combined aggregate liquidity position of the Company is sufficient to meet the funding requirements of loan demand and deposit maturities and withdrawals in the near term. Certificates of deposit represented 61% of the Company’s total deposits at December 31, 2009. The Company’s strategy will include efforts focused at increasing the relative volume of transaction deposit accounts. Certificates of deposit of $100,000 or more represented 48% of the Company’s total deposits at year-end. While these deposits are generally considered rate sensitive and the Company will need to pay competitive rates to retain these deposits at maturity, there are other subjective factors that will determine the Company’s continued retention of those deposits.
Under federal capital regulations, the Company must satisfy certain minimum leverage ratio requirements and risk-based capital requirements. At December 31, 2009, the Company’s equity to asset ratio was 8.67%. All capital ratios place the Bank in excess of the minimum required to be deemed a well-capitalized bank by regulatory measures. CSB’s ratio of Tier 1 capital to risk-weighted assets at December 31, 2009 was 11.16%
ASSET/LIABILITY MANAGEMENT
The primary objective of asset and liability management is to provide sustainable and growing net interest income under varying economic environments, while protecting the economic values of our balance sheet assets and liabilities from the adverse effects of changes in interest rates. Our overall interest-rate risk position is maintained within a series of policies approved by the Board and guidelines established and monitored by the Asset Liability Committee (“ALCO”).
Because no one individual measure can accurately assess all of our risks to changes in rates, we use several quantitative measures in our assessment of current and potential future exposures to changes in interest rates and their impact on net interest income and balance sheet values. Net interest income simulation is the primary tool used in our evaluation of the potential range of possible net interest income results that could occur under a variety of interest-rate environments. We also use market valuation and duration analysis to assess changes in the economic value of balance sheet assets and liabilities caused by assumed changes in interest rates. Finally, gap analysis - the difference between the amount of balance sheet assets and liabilities repricing within a specified time period - is used as a measurement of our interest-rate risk position.
To measure, monitor, and report on our interest-rate risk position, we begin with two models: (1) net interest income at risk which measures the impact on net interest income over the next twelve months to immediate, or “rate shock,” and slow, or “rate ramp,” changes in market interest rates; and (2) net economic value of equity that measures the impact on the present value of all net interest income-related principal and interest cash flows of an immediate change in interest rates. Net interest income at risk is designed to measure the potential impact of changes in market interest rates on net interest revenue in the short term. Net economic value of equity, on the other hand, is a long-term view of interest-rate risk, but with a liquidation view of the Company. Both of these models are subject to ALCO-established guidelines, and are monitored regularly.
In calculating our net interest income at risk, we start with a base amount of net interest revenue that is projected over the next twelve months, assuming that the then-current yield curve remains unchanged over the period. Our existing balance sheet assets and liabilities are adjusted by the amount and timing of transactions that are forecasted to occur over the next twelve months. That yield curve is then “shocked,” or moved immediately, ±200 basis points in a parallel fashion, or at all points along the yield curve. Two new twelve-month net interest income projections are then developed using the same balance sheet and forecasted transactions, but with the new yield curves, and compared to the base scenario. We also perform the calculations using interest rate ramps, which are ±100, ±200 and ±300 basis point changes in interest rates that are assumed to occur gradually over the next twelve-month period, rather than immediately as we do with interest-rate shocks.
Net economic value of equity is based on the change in the present value of all net interest income-related principal and interest cash flows for changes in market rates of interest. The present value of existing cash flows with a then-current yield curve serves as the base case. We then apply an immediate parallel shock to that yield curve of ±100 and ±200 basis points and recalculate the cash flows and related present values.
Key assumptions used in the models described above include the timing of cash flows; the maturity and repricing of balance sheet assets and liabilities, especially option-embedded financial instruments like mortgage-backed securities and FHLB advances; changes in market conditions; and interest-rate sensitivities of our customer liabilities with respect to the interest rates paid and the level of balances. These assumptions are inherently uncertain and, as a result, the models cannot precisely calculate future net interest income or predict the impact of changes in interest rates on net interest income and economic value. Actual results could differ from simulated results due to the timing, magnitude and frequency of changes in interest rates and market conditions, changes in spreads and management strategies, among other factors. Projections of potential future streams of net interest income are assessed as part of our forecasting process.
Net Interest Income at Risk Analysis. The following table presents the estimated exposure of net interest income for the next twelve months, calculated as of December 31, 2009 and 2008, due to an immediate and gradual ± 200 basis point shift in then-current interest rates. Estimated incremental exposures set forth below are dependent on management’s assumptions about asset and liability sensitivities under various interest-rate scenarios, such as those previously discussed, and do not reflect any actions management may undertake in order to mitigate some of the adverse effects of interest-rate changes on the Company’s financial performance.
Net Economic Value of Equity Analysis. The following table presents estimated EVE exposures, calculated as of December 31, 2009 and 2008, assuming an immediate and prolonged shift in interest rates, the impact of which would be spread over a number of years.
While the measures presented in the tables above are not a prediction of future net interest income or valuations, they do suggest that if all other variables remained constant, in the short term, falling interest rates would lead to net interest income that is lower than it would otherwise have been, and rising rates would lead to higher net interest income. Other important factors that impact the levels of net interest income are balance sheet size and mix; interest-rate spreads; the slope, how quickly or slowly market interest rates change and management actions taken in response to the preceding conditions.
Interest Rate Gap Analysis. As a part of its interest rate risk management policy, the Company calculates an interest rate “gap.” Interest rate “gap” analysis is a common, though imperfect, measure of interest rate risk, which measures the relative dollar amounts of interest-earning assets and interest-bearing liabilities which reprice within a specific time period, either through maturity or rate adjustment. The “gap” is the difference between the amounts of such assets and liabilities that are subject to repricing. A “positive” gap for a given period means that the amount of interest-earning assets maturing or otherwise repricing within that period exceeds the amount of interest-bearing liabilities maturing or otherwise repricing within the same period. Accordingly, in a declining interest rate environment, an institution with a positive gap would generally be expected, absent the effects of other factors, to experience a decrease in the yield on its assets greater than the decrease in the cost of its liabilities and its net interest income should be negatively affected. Conversely, the yield on its assets for an institution with a positive gap would generally be expected to increase more quickly than the cost of funds in a rising interest rate environment, and such institution’s net interest income generally would be expected to be positively affected by rising interest rates. Changes in interest rates generally have the opposite effect on an institution with a “negative gap.”
The table below sets forth the amounts of interest-earning assets and interest-bearing liabilities outstanding at December 31, 2009 that are projected to reprice or mature in each of the future time periods shown. Except as stated below, the amounts of assets and liabilities shown which reprice or mature within a particular period were determined in accordance with the contractual terms of the assets or liabilities. Loans with adjustable rates are shown as being due at the end of the next upcoming adjustment period. Money market deposit accounts and negotiable order of withdrawal or other transaction accounts are assumed to be subject to immediate repricing and depositor availability and have been placed in the shortest period. In making the gap computations, none of the assumptions sometimes made regarding prepayment rates and deposit decay rates have been used for any interest-earning assets or interest-bearing liabilities. In addition, the table does not reflect scheduled principal payments that will be received throughout the lives of the loans or investments. The interest rate sensitivity of the Company’s assets and liabilities illustrated in the following table would vary substantially if different assumptions were used or if actual experience differs from that indicated by such assumptions. Variable rate loans which have interest rate floors that are currently in effect are presented as if they were fixed rate loans and repricing is presented at maturity.
CRITICAL ACCOUNTING POLICY
The Company's most significant critical accounting policies are the determination of its allowance for loan losses, evaluation of investment securities for other than temporary impairment, valuation of foreclosed assets and the impairment testing of its goodwill. A critical accounting policy is one that is both very important to the portrayal of the Company's financial condition and results, and requires management's most difficult, subjective or complex judgments. What makes these judgments difficult, subjective and/or complex is the need to make estimates about the effects of matters that are inherently uncertain.
QUARTERLY FINANCIAL INFORMATION
The following table sets forth, for the periods indicated, certain of our consolidated quarterly financial information. This information is derived from our unaudited financial statements, which include, in the opinion of management, all normal recurring adjustments which management considers necessary for a fair presentation of the results for such periods. This information should be read in conjunction with our consolidated financial statements included elsewhere in this report. The results for any quarter are not necessarily indicative of results for any future period. Due to rounding, the sum of the results for the four quarters of a given year may not agree with the annual results for that year.
RECENT ACCOUNTING PRONOUNCEMENTS
For recently issued accounting pronouncements that may affect the Company, see Note B of Notes to Consolidated Financial Statements.
OFF-BALANCE SHEET ARRANGEMENTS
The Company has various financial instruments (outstanding commitments) with off-balance sheet risk that are issued in the normal course of business to the meet the financing needs of its customers. See Note O to the consolidated financial statements for more information regarding these commitments and contingent liabilities.
FORWARD-LOOKING INFORMATION
This annual report may contain, in addition to historical information, certain “forward-looking statements” that represent management’s judgment concerning the future and are subject to risks and uncertainties that could cause the Company’s actual operating results and financial position to differ materially from those projected in the forward-looking statements. Such forward-looking statements can be identified by the use of forward-looking terminology such as “may,” “will,” “expect,” “anticipate,” “estimate” or “continue” or the negative thereof or other variations thereof or comparable terminology. Factors that could influence the estimates include changes in national, regional and local market conditions, legislative and regulatory conditions, and the interest rate environment.
ITEM 7A
ITEM 7A - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk reflects the risk of economic loss resulting from adverse changes in market price and interest rates. This risk of loss can be reflected in diminished current market values and/or reduced potential net interest income in future periods. Our market risk arises primarily from interest rate risk inherent in our lending and deposit-taking activities. The structure of our loan and deposit portfolios is such that a significant decline in interest rates may adversely impact net market values and net interest income. We do not maintain a trading account nor are we subject to currency exchange risk or commodity price risk. Interest rate risk is monitored as part of the Bank’s asset/liability management function.
See the section entitled Asset/Liability Management in Item 7 for a more detailed discussion of market risk.
ITEM 8
ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY
CONSOLIDATED FINANCIAL STATEMENTS
Years Ended December 31, 2009, 2008 and 2007
CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY
INDEX TO THE CONSOLIDATED FINANCIAL STATEMENTS
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Stockholders and the Board of Directors
Crescent Financial Corporation and Subsidiary
Cary, North Carolina
We have audited the accompanying consolidated balance sheets of Crescent Financial Corporation and Subsidiary as of December 31, 2009 and 2008, and the related consolidated statements of operations, comprehensive income (loss), changes in stockholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2009. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, as well as the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Crescent Financial Corporation and Subsidiary at 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 accounting principles generally accepted in the United States of America.
Raleigh, North Carolina
March 31, 2010
CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
December 31, 2009 and 2008
See accompanying notes.
CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS
Years Ended December 31, 2009, 2008 and 2007
See accompanying notes.
CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
Years Ended December 31, 2009, 2008 and 2007
See accompanying notes.
CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
Years Ended December 31, 2009, 2008 and 2007
See accompanying notes.
CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (Continued)
Years Ended December 31, 2009, 2008 and 2007
See accompanying notes.
CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31, 2009, 2008 and 2007
See accompanying notes.
CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
Years Ended December 31, 2009, 2008 and 2007
Supplemental information (Notes S and T)
See accompanying notes.
CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements
December 31, 2009, 2008 and 2007
NOTE A - ORGANIZATION AND OPERATIONS
On June 29, 2001, Crescent Financial Corporation (the “Company”) was formed as a holding company for Crescent State Bank (“CSB”) or (the “Bank”). Upon formation, one share of the Company’s $1 par value common stock was exchanged for each of the outstanding shares of CSB’s $5 par value common stock.
CSB was incorporated December 22, 1998 and began banking operations on December 31, 1998. CSB is engaged in general commercial and retail banking in Wake, Johnston, Lee, Moore and New Hanover Counties, North Carolina, operating under the banking laws of North Carolina and the rules and regulations of the Federal Deposit Insurance Corporation and the North Carolina Commissioner of Banks. CSB undergoes periodic examinations by those regulatory authorities. The Bank’s operations in Moore and New Hanover Counties are the result of the 2003 acquisition of Centennial Bank and Trust and the 2006 acquisition of Port City Capital Bank, respectively.
NOTE B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
The accompanying consolidated financial statements include the accounts and transactions of Crescent Financial Corporation and its wholly-owned subsidiary Crescent State Bank. All significant intercompany transactions and balances have been eliminated in consolidation.
Use of Estimates
The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan losses and evaluation of goodwill for impairment.
Cash and Cash Equivalents
For purposes of the consolidated statements of cash flows, cash and cash equivalents include cash and due from banks, interest-earning deposits with banks and federal funds sold.
Securities Available for Sale
Available for sale securities are carried at fair value and consist of bonds, notes, and marketable equity securities not classified as trading securities or as held to maturity securities. Unrealized holding gains and losses on available for sale securities are reported as a net amount in other comprehensive income, net of related tax effects. Gains and losses on the sale of available for sale securities are determined using the specific-identification method. Declines in the fair value of individual held to maturity and available for sale securities below their cost that are other than temporary would result in write-downs of the individual securities to their fair value. Such write-downs would be included in earnings as realized losses. Premiums and discounts are recognized in interest income using the interest method over the period to maturity.
Loans
Loans that management has the intent and ability to hold for the foreseeable future, or until maturity, are reported at their outstanding principal adjusted for any charge-offs, the allowance for loan losses, and any deferred fees or costs on originated loans and unamortized premiums or discounts on purchased or acquired loans. Loan origination fees and certain direct origination costs are capitalized and recognized as an adjustment of the yield of the related loan. Interest on loans is recorded based on the principal amount outstanding. The accrual of interest on impaired loans is discontinued when, in management’s opinion, the future collectability of the recorded loan balance is in doubt. When the future collectability of the recorded loan balance is not in doubt, interest income may be recognized on the cash basis. Generally, loans are placed on nonaccrual when they are past due 90 days. When a loan is place in nonaccrual status, all unpaid accrued interest is reversed.
CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements
December 31, 2009, 2008 and 2007
NOTE B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Loans (Continued)
Subsequent collections of interest and principal are generally applied as a reduction to the principal outstanding.
Allowance for Loan Losses
The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. The provision for loan losses is based upon management’s best estimate of the amount needed to maintain the allowance for loan losses at an adequate level. Loan losses are charged against the allowance when management believes the uncollectability of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.
The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectability of the loans in light of the current status of the portfolio, historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral, and prevailing economic conditions. Management segments the loan portfolio by loan type in considering each of the aforementioned factors and their impact upon the level of the allowance for loan losses.
A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired.
Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent.
Premises and Equipment
Land is carried at cost. Other components of premises and equipment are stated at cost less accumulated depreciation. Depreciation is calculated on the straight-line method over the estimated useful lives of the assets which are 37 - 40 years for buildings and 3 - 10 years for furniture and equipment. Leasehold improvements are amortized over the terms of the respective leases or the estimated useful lives of the improvements, whichever is shorter. Repairs and maintenance costs are charged to operations as incurred, and additions and improvements to premises and equipment are capitalized. Upon sale or retirement, the cost and related accumulated depreciation are removed from the accounts and any gains or losses are reflected in current operations.
Foreclosed Assets
Foreclosed assets includes repossessed assets and other real estate owned. Assets acquired through, or in lieu of, loan foreclosure are held for sale and are initially recorded at fair value at the date of foreclosure, establishing a new cost basis. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less cost to sell. Revenue and expenses from operations and changes in the valuation allowance are included in net expenses from foreclosed assets.
CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements
December 31, 2009, 2008 and 2007
NOTE B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Stock in Federal Home Loan Bank of Atlanta
As a requirement for membership, the Company invests in stock of the Federal Home Loan Bank of Atlanta (“FHLB”). This investment is carried at cost. Due to the redemption provisions of the FHLB, the Company estimated that fair value approximates cost and that this investment was not impaired at December 31, 2009.
Income Taxes
Deferred income taxes are recognized for the tax consequences of temporary differences between financial statement carrying amounts and the tax bases of existing assets and liabilities that will result in taxable or deductible amounts in future years. These temporary differences are multiplied by the enacted income tax rate expected to be in effect when the taxes become payable or receivable. The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. Deferred tax assets are reduced, if necessary, by the amount of such benefits that are not expected to be realized based on available evidence.
The Company adopted the provisions of ASC 740-10 with respect to Accounting for Uncertainty in Income Taxes, on January 1, 2007 with no impact on the consolidated financial statements. The Company did not recognize any interest or penalties related to income tax during the years ended December 31, 2007, 2008 and 2009, and did not accrue any interest or penalties as of December 31, 2009 or 2008. The Company did not have an accrual for uncertain tax positions as deductions taken and benefits accrued are based on widely understood administrative practices and procedures, and are based on clear and unambiguous tax law. Tax returns for all years 2006 and thereafter are subject to possible future examinations by tax authorities.
Goodwill and Other Intangibles
Goodwill and indeterminate lived intangibles are evaluated for impairment at least annually. Based on circumstances which indicated impairment may have taken place, evaluations have been performed on a quarterly basis since October 31, 2008. In the final analysis, a full goodwill impairment charge of $30,233,049 represented the appropriate course of action. Other intangible assets, consisting of premiums on purchased core deposits, are being amortized over ten years principally using the straight-line method. The carrying amount of other intangible assets at December 31, 2009 amounted to $826,291. The carrying amount of goodwill and other intangible assets at December 31, 2008 amounted to $30,233,049 and $959,641, respectively. See Note F for a more detailed discussion of this topic.
Impairment or Disposal of Long-Lived Assets
The Company’s long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used, such as bank premises and equipment, is measured by a comparison of the carrying amount of an asset to future net cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized in the amount by which the carrying amount of the asset exceeds the fair value of the asset. Assets to be disposed of, such as foreclosed properties, are reported at the lower of the carrying amount or fair value less costs to sell.
Stock Compensation Plans
Employee awards of equity instruments are recognized in the financial statements over the period the employee is required to perform the services in exchange for the award. The measurement of the cost of employee services received in exchange for an award is based on the grant-date fair value of the award. ASC 718 amends ASC 230, Statement of Cash Flows, to require that excess tax benefits be reported as financing cash inflows, rather than as a reduction of taxes paid, which is included within operating cash flows.
CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements
December 31, 2009, 2008 and 2007
NOTE B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Per Share Results
Basic and diluted net income per share are computed by dividing net income (loss) attributable to common shareholders by the weighted average number of common shares outstanding during each period. Diluted net income per share reflects the potential dilution that could occur if common stock options and warrants were exercised, resulting in the issuance of common stock that then shared in the net income of the Company.
Basic and diluted net income (loss) per share have been computed based upon net income available (loss attributed) to common shareholders as presented in the accompanying consolidated statements of operations divided by the weighted average number of common shares outstanding or assumed to be outstanding as summarized below:
For the years ended December 31, 2009, there were 430,118 stock options and the warrant for 833,705 shares which were not included in the computation of diluted earnings per share because they had no dilutive effect. For the years ended December 31, 2008 and 2007, there were 90,109 and 62,627 outstanding stock options, respectively, which were not included in the computation of diluted earnings per share because they had no dilutive effect.
Mortgage Loan Origination and Other Fees
Mortgage loan origination fees represent fees received for the origination of loans that are pre-sold in the secondary market through the Company’s relationship with various mortgage brokers. These fees are recognized in income as they are earned upon the closing of each loan.
Brokerage referral fees derived from investment transactions with Capital Investment Group, Inc. are recognized in income as these transactions are consummated.
Segment Reporting
ASC 280. formerly SFAS No. 131, Disclosure about Segments of an Enterprise and Related Information, requires that public entities disclose information about products and services provided by operating segments, geographic areas and major customers, differences between the measurements used in reporting segment information and those used in the entity’s general-purpose financial statements, and changes in the measurement of segment amounts from period to period.
Operating segments are components of an enterprise with separate financial information available for use by the chief operating decision maker to allocate resources and to assess performance. The Company has determined that it has one significant operating segment, the providing of financial services, including commercial and retail banking, mortgage, and investment services, to customers located in its market areas. The various products are those generally offered by community banks, and the allocation of resources is based on the overall performance of the Company, rather than the performance of individual branches or products.
CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements
December 31, 2009, 2008 and 2007
NOTE B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Loan Reclassification
On March 9, 2009, the Company converted all core and ancillary data processing systems. As a result of that conversion, we reclassified certain loans within the portfolio so that reporting is more consistent with the collateral of a particular loan rather than the purpose. Loans secured by homes purchased as investment property or for a commercial business purpose were previously reported as commercial real estate whereas they were reclassified as residential real estate mortgages. Loans secured by commercial building lots were previously reported as commercial real estate and were reclassified as construction and land development. The 2008 loan classification balances as previously reported in Note D have been reclassified through the conversion process as follows: $164.6 million of commercial real estate loans and $2.1 million consumer loans being shifted to $81.8 million of construction and land development, $70.7 million residential mortgages, $9.3 million home equity loans and $4.9 million commercial and industrial.
The Company reclassified approximately $73,000 and $58,000 of net losses on the sale of other real estate owned for the years ended December 31, 2008 and 2007, respectively, from non-interest income to non-interest expense.
Recently Adopted and Issued Accounting Standards
In June 2009, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2009-01, Generally Accepted Accounting Principles (ASC Topic 105), which establishes the FASB Accounting Standards Codification (“the Codification” or “ASC”) as the official single source of authoritative U.S. generally accepted accounting principles (“GAAP”). All existing accounting standards are superseded. All other accounting guidance not included n the Codification will be considered non-authoritative. The Codification also includes all relevant Securities and Exchange Commission (“SEC”) guidance organized using the same topical structure in separate sections within the Codification. The Board will not issue new standards in the form of Statements, FASB Staff Positions or Emerging Issues Task Force Abstracts. Instead, it will issue Accounting Standards Updates (“ASU”) which will serve to update the Codification, provide background information about the guidance and provide the basis for conclusions on the changes to the Codification.
The Codification is not intended to change GAAP, but it will change the way GAAP is organized and presented. The Codification is effective for our year-end 2009 financial statements and the principal impact on the Company’s financial statements is limited to disclosures as all future references to authoritative accounting literature will be referenced in accordance with the Codification.
In December 2007, FASB issued SFAS No. 141(revised 2007), Business Combinations, (“ASC 805-10-65”), which establishes principles and requirements for recognition and measurement of assets, liabilities and any noncontrolling interest acquired due to a business combination. This guidance expands the definitions of a business and a business combination, resulting in an increased number of transactions or other events that will qualify as business combinations. The entity that acquires the business (the “acquirer”) will record 100 percent of all assets and liabilities of the acquired business, including goodwill, generally at their fair values. As such, an acquirer will not be permitted to recognize the allowance for loan losses of the acquiree. This guidance requires the acquirer to recognize goodwill as of the acquisition date, measured as a residual.
In most business combinations, goodwill will be recognized to the extent that the consideration transferred plus the fair value of any noncontrolling interests in the acquiree at the acquisition date exceeds the fair values of the identifiable net assets acquired. Acquisition-related transaction and restructuring costs will be expensed as incurred rather than treated as part of the cost of the acquisition and included in the amount recorded for assets acquired. ASC 805-10-65 is effective for fiscal years beginning after December 15, 2008. The adoption on January 1, 2009, had no effect on the Company’s consolidated financial statements.
CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements
December 31, 2009, 2008 and 2007
NOTE B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Recently Adopted and Issued Accounting Standards (Continued)
In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB 51 (“ASC 810-10-65”), which defines noncontrolling interest as the portion of equity in a subsidiary not attributable, directly or indirectly, to the parent. This guidance requires the ownership interests in subsidiaries held by parties other than the parent (previously referred to as minority interest) to be clearly presented in the consolidated statement of financial position within equity, but separate from the parent’s equity. The amount of consolidated net income attributable to the parent and to any noncontrolling interest must be clearly presented on the face of the consolidated statement of income. Changes in the parent’s ownership interest while the parent retains its controlling financial interest (greater than 50 percent ownership) are to be accounted for as equity transactions. Upon a loss of control, any gain or loss on the interest sold will be recognized in earnings. Additionally, any ownership interest retained will be remeasured at fair value on the date control is lost, with any gain or loss recognized in earnings. ASC 810-10-65 is effective for fiscal years beginning after December 15, 2008. Accordingly, the Company adopted the provisions of this guidance in the first quarter of 2009. The adoption on January 1, 2009, had no effect on the Company’s consolidated financial statements.
In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities, an amendment of FASB Statement No. 133 (“ASC 815-10-65”) which requires entities to provide greater transparency about (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are accounted for its related interpretations, and (c) how derivative instruments and related hedged items affect an entity’s financial position, results of operations and cash flows. To meet those objectives, ASC 815-10-65 requires (1) qualitative disclosures about objectives for using derivatives by primary underlying risk exposure (e.g., interest rate, credit or foreign exchange rate) and by purpose or strategy (fair value hedge, cash flow hedge, net investment hedge, and non-hedges), (2) information about the volume of derivative activity in a flexible format that the preparer believes is the most relevant and practicable, (3) tabular disclosures about balance sheet location and gross fair value amounts of derivative instruments, income statement and other comprehensive income location of gain and loss amounts on derivative instruments by type of contract, and (4) disclosures about credit-risk related contingent features in derivative agreements. ASC 815-10-65 is effective for financial statements issued for fiscal years beginning after November 15, 2008. Accordingly, the Company adopted the provisions of this guidance in the first quarter 2009. The Company provided the required disclosure in Note N.
In April 2009, the FASB issued the following three FSP’s intended to provide additional application guidance and enhance disclosures regarding fair value measurements and impairments of securities:
FSP FAS 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly (“ASC 820-10-65”), provides additional guidance for estimating fair value when the volume and level of activity for the asset or liability have decreased significantly. This update also provides guidance on identifying circumstances that indicate a transaction is not orderly. The provisions of this update are effective for the Company’s interim period ending on June 30, 2009. The adoption of this update did not materially affect the Company’s consolidated financial statements.
FSP FAS 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments (“ASC 825-10-65”), requires disclosures about fair value of financial instruments in interim reporting periods of publicly traded companies that were previously only required to be disclosed in annual financial statements. ASC 825-10-65 is effective for the Company’s interim period ending on June 30, 2009. As ASC 825-10-65 amends only the disclosure requirements about fair value of financial instruments in interim periods, the adoption did not materially affect the Company’s consolidated financial statements.
CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements
December 31, 2009, 2008 and 2007
NOTE B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Recently Adopted and Issued Accounting Standards (Continued)
FSP FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments (“ASC 320-10-65”), amends current other-than-temporary impairment guidance in GAAP for debt securities to make the guidance more operational and to improve the presentation and disclosure of other-than-temporary impairments on debt and equity securities in the financial statements. This FSP does not amend existing recognition and measurement guidance related to other-than-temporary impairments of equity securities. The adoption did not materially affect the Company’s consolidated financial statements.
In May 2009, the FASB issued ASC 855-10-06 through ASC 855-10-55 (“ASC 855-10”), Subsequent Events, which sets forth the circumstances under which an entity should recognize events occurring after the balance sheet date and the disclosures that should be made. The guidance was in effect and adopted for the period ended June 30, 2009.
In June 2009, the FASB issued the following standards:
Statement of Financial Accounting Standards (SFAS) No. 166 “Accounting for Transfer of Financial Assets - an amendment of the FASB Statement No. 140” (“ASC 860”), which eliminates the concept of a qualifying special purpose entity (QSPE), changes the requirements for derecognizing financial assets, and requires additional disclosures including information about continuing exposure to risks related to transferred financial assets. ASC 860 is effective for financial asset transfers occurring after the beginning of fiscal years beginning after November 15, 2009. The disclosure requirements must be applied to transfers that occurred before and after the effective date.
Statement of Financial Accounting Standards (SFAS) No. 167, “Amendments for FASB Interpretation No. 46(R)” (“ASC 810”), which contains new criteria for determining the primary beneficiary, eliminates the exception to consolidating SQPEs, requires continual reconsideration of conclusions reached in determining the primary beneficiary, and requires additional disclosures. ASC 810 is effective as of the beginning of fiscal years beginning after November 15, 2009 and is applied using a cumulative effect adjustment to retained earnings for any carrying amount adjustments (e.g., for newly-consolidated VIEs). Management is currently evaluating any effect this may have on the accounting for the Company’s trust preferred securities though none is expected.
In August 2009, the FASB issued Accounting Standards Update (ASU) No 2009-05, Fair Value Measurements and Disclosures Overall (ASC Topic 820-10) - “Measuring Liabilities at Fair Value”. This ASU clarifies the application of certain valuation techniques in circumstances in which a quoted price in an active market for the identical liability is not available and clarifies that when estimating the fair value of a liability, the fair value is not adjusted to reflect the impact of contractual restrictions that prevent its transfer. The adoption did not materially affect the Company’s consolidated financial statements.
Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected to have a material impact on the Company’s financial position, results of operations and cash flows.
From time to time the FASB issues exposure drafts for proposed statements of financial accounting standards. Such exposure drafts are subject to comment from the public, to revisions by the FASB and to final issuance by the FASB as statements of financial accounting standards. Management considers the effect of the proposed statements on the consolidated financial statements of the Company and monitors the status of changes to and proposed effective dates of exposure drafts.
CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements
December 31, 2009, 2008 and 2007
NOTE C - INVESTMENT SECURITIES
The following is a summary of the securities portfolios by major classification:
Proceeds from sales of available for sale securities in 2009 totaled $42,820,152 resulting in gross gains of $870,072. Proceeds from sales of available for sale securities in 2008 totaled $1,543,197 resulting in gross gains of $15,535 and no losses. There were no sales of available for sale securities in 2007.
The following tables show investments’ gross unrealized losses and fair values, aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position, at December 31, 2009 and 2008. The 2009 unrealized losses on investment securities relate to twelve collateralized mortgage obligations, three mortgage-backed securities, twenty-five municipal securities and two marketable equity securities.
CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements
December 31, 2009, 2008 and 2007
NOTE C - INVESTMENT SECURITIES (Continued)
The 2008 unrealized losses on investment securities relate to two U.S. Government agency securities, nine mortgage-backed securities, twenty-six municipal securities and one marketable equity security. The unrealized losses relate to debt securities that have incurred fair value reductions due to higher market interest rates since the securities were purchased. The unrealized losses will reverse at maturity or prior to maturity if market interest rates decline to levels that existed when the securities were purchased. Since none of the unrealized losses relate to the marketability of the securities or the issuer’s ability to honor redemption obligations, none of the securities are deemed to be other than temporarily impaired.
For the year ended December 31, 2009, the Company determined one marketable equity security was other than temporarily impaired and recognized a $197,575 write-down on the investment. The investment had been carried at a basis of $279,398. The per share basis was well above the trailing fifty-two week range and the prospects of recovery were limited. The fair value of the investment at December 31, 2009 is $73,043. The Company also took an impairment charge of $406,802 on a non-marketable equity security. The investment was written off in its entirety since the issuing company was taken into receivership. There were no investments determined to be other than temporarily impaired during 2008.
At December 31, 2009 and 2008, investment securities with a carrying value of $96,437,558 and $63,602,694, respectively, were pledged to secure public deposits, borrowings and for other purposes required or permitted by law.
CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements
December 31, 2009, 2008 and 2007
NOTE C - INVESTMENT SECURITIES (Continued)
The amortized cost and fair values of securities available for sale at December 31, 2009 by expected maturity are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
The following table presents the carrying values, intervals of maturities or repricings, and weighted average tax equivalent yields of our investment portfolio at December 31, 2009:
CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements
December 31, 2009, 2008 and 2007
NOTE D - LOANS
Following is a summary of loans at December 31, 2009 and 2008. See Note B for a discussion regarding the reclassification of loans that took place during 2009.
Loans are primarily made in the Company’s market area of North Carolina, principally Wake, Johnston, Lee, Moore, and New Hanover counties. Real estate loans can be affected by the condition of the local real estate market. Commercial and consumer and other loans can be affected by the local economic conditions.
At December 31, 2009 there were fifteen restructured loans totaling $13.7 million. Five of these loans totaling $8 million are commercial real estate, three loans totaling $2.8 million are construction, land acquisition and development, one loan for $2.6 million is residential real estate and six loans totaling $372,000 were commercial and industrial. All fifteen loans are accruing interest, are not past due 30 days or more and are performing in accordance with the modified terms. There were no restructured loans as of December 31, 2008. At December 31, 2009, the recorded investment in loans considered impaired totaled $66.1 million. Of the total investment in loans considered impaired, $35.4 million were found to show specific impairment for which $9.1 million in valuation allowance was recorded; no valuation allowance for the other impaired loans was considered necessary. For the year ended December 31, 2009, the average recorded investment in impaired loans was approximately $39.6 million. The amount of interest recognized on impaired loans during the portion of the year that they were considered impaired was approximately $1.3 million.
At December 31, 2008, the recorded investment in loans considered impaired totaled $16.7 million. Of the total investment in loans considered impaired, $11.6 million were found to show specific impairment for which $4.1 million in valuation allowance was recorded; no valuation allowance for the other impaired loans was considered necessary. For the year ended December 31, 2008, the average recorded investment in impaired loans was approximately $3.6 million. The amount of interest recognized on impaired loans during the portion of the year that they were considered impaired was not material.
The Company has granted loans to certain directors and executive officers of the Company and their related interests. Such loans are made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other borrowers and, in management’s opinion, do not involve more than the normal risk of collectability. All loans to directors and executive officers or their related interests are submitted to the Board of Directors for approval. A summary of loans to directors, executive officers and their interests follows:
CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements
December 31, 2009, 2008 and 2007
NOTE D - LOANS (Continued)
At December 31, 2009, the Company had pre-approved but unused lines of credit totaling $3.7 million to executive officers, directors and their related interests. No additional funds were committed to be advanced at December 31, 2009.
An analysis of the allowance for loan losses follows:
NOTE E - PREMISES AND EQUIPMENT
Following is a summary of premises and equipment at December 31, 2009 and 2008:
Depreciation and amortization amounting to $938,178 in 2009, $786,668 in 2008 and $694,559 in 2007 is included in occupancy and equipment expense.
NOTE F - GOODWILL AND OTHER INTANGIBLES
There was no accumulated impairment loss for goodwill as of January 1, 2009 and 2008, respectively. The following is a summary of goodwill and other intangible assets at December 31, 2009 and 2008:
CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements
December 31, 2009, 2008 and 2007
NOTE F - GOODWILL AND OTHER INTANGIBLES (Continued)
Management is required to test goodwill for impairment on an annual basis, or more often if events or circumstances indicate there may be impairment. If the carrying amount of the reporting unit’s goodwill is found to exceed its implied fair value, the Company would recognize an impairment loss in an amount equal to that excess.
The Company completed its annual test of goodwill for impairment as of October 31, 2008 which test indicated that none of the Company's goodwill was impaired. Management updated its test for impairment of goodwill at December 31, 2008 due to the decline in the price of our common stock and the net loss in the fourth quarter of 2008. The results of that test indicated that none of the Company's goodwill was impaired. At both March 31 and June 30, 2009, due to the decline in the price of our common stock and the disparity between the stock price and stated book value, management again tested for impairment of goodwill. The results of these tests indicated that none of the Company's goodwill was impaired.
In early August, management engaged external valuation specialists to assist in its goodwill assessments. At August 31, 2009 the Company again tested its goodwill for impairment due to the continued disparity between the value of the Company's stock and stated book value. The indicative fair value of the Company at August 31, 2009 was determined using two methods. The first is a market approach based on the actual market capitalization of the Company, adjusted for a control premium. The second is an income approach based on discounted cash flow models with estimated cash flows based on internal forecasts of net income. Both methods were considered and weighted to estimate the fair value of the Company. Based on testing, management determined that the indicative fair value of the Company exceeded its carrying value and management performed a second step analysis to compare the implied fair value of the goodwill with the carrying amount of that goodwill. The results of this second step analysis, which were finalized in the fourth quarter of 2009, indicated a range of goodwill impairment that supported a charge of $30.2 million to write off all of its goodwill.
There were several significant assumption changes between the analysis performed at June 30 and August 31, 2009. The discount rate used in the income approach based on discounted cash flows increased from 15% to 18.5%. The external valuation specialist had an established method of determining the discounted rate which considered factors not previously utilized. Between the higher discount rate to compensate for increased risk due to higher levels of nonperforming loans and adjustments made to projected cash flows as we looked forward to the fourth quarter, the indicative value per the income approach declined by $38.1 million. The results of the market approach between June 30 and August 31, 2009 declined by $42.3 million primarily due to a continued drop in control premiums on merger transactions. When considering how to weight the two approaches, greater consideration was given to the market approach during the August analysis. These factors led to a lower estimated fair value of equity at August 31, 2009 compared to June 30, 2009.
This write off of goodwill has no effect on our cash flows, our regulatory capital, and the operation of our business or our ability to service our customers.
Other intangibles amortization expense for the years ended December 31, 2009, 2008 and 2007 amounted to $133,349, $133,349 and $133,349, respectively. The following table presents estimated amortization expense for other intangibles.
CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements
December 31, 2009, 2008 and 2007
NOTE G - DEPOSITS
The weighted average cost of time deposits was 3.12% and 4.54% at December 31, 2009 and 2008, respectively.
At December 31, 2009, the scheduled maturities of certificates of deposit are as follows:
NOTE H - BORROWINGS
Borrowings are comprised of the following at December 31, 2009 and 2008:
Short-term Borrowings
The Company may purchase federal funds through unsecured federal funds guidance lines of credit totaling $21.5 million at December 31, 2009. These lines are intended for short-term borrowings and are subject to restrictions limiting the frequency and terms of advances. These lines of credit are payable on demand and bear interest based upon the daily federal funds rate. The Company had no outstanding balance on the lines of credit as of December 31, 2009 compared to $8,706,000 at December 31, 2008.
The Company may borrow funds through the Federal Reserve Bank’s discount window. These borrowings are secured by a blanket floating lien on qualifying construction, land acquisition and development loans, commercial and industrial loans and consumer loans collateral value of $82.8 million. Depending on the type of loan collateral, the Company may borrow between 75% and 80% of the collateral value pledged. The Company had $50.0 million outstanding as of December 31, 2009.
CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements
December 31, 2009, 2008 and 2007
NOTE H - BORROWINGS (Continued)
A summary of selected data related to short-term borrowed funds follows:
Junior Subordinated Debentures
In 2003, the Company issued $8,248,000 of junior subordinated debentures to Crescent Financial Capital Trust I (the “Trust”) in exchange for the proceeds of trust preferred securities issued by the Trust. The junior subordinated debentures are included in long-term debt and the Company’s equity interest in the trust is included in other assets.
The junior subordinated debentures pay interest quarterly at an annual rate, reset quarterly, equal to three month LIBOR plus 3.10%. On June 25, 2009, the Company entered into a derivative financial instrument which effectively swapped the variable rate payments for fixed payments. We entered into a three year and four year swap each for one-half of the notional amount of the trust preferred securities for fixed rates of 5.49% and 5.97%, respectively. The effective interest rate is currently 5.73%.The debentures are redeemable on October 7, 2008 or afterwards, in whole or in part, on any January 7, April 7, July 7, or October 7. Redemption is mandatory at October 7, 2033. The Company guarantees the trust preferred securities through the combined operation of the junior subordinated debentures and other related documents. The Company’s obligation under the guarantee is unsecured and subordinate to senior and subordinated indebtedness of the Company.
The trust preferred securities presently qualify as Tier 1 regulatory capital and are reported in Federal Reserve regulatory reports as a minority interest in a consolidated subsidiary. The junior subordinated debentures do not qualify as Tier 1 regulatory capital. On March 1, 2005, the Board of Governors of the Federal Reserve issued a final rule stating that trust preferred securities will continue to be included in Tier 1 capital, subject to stricter quantitative and qualitative standards. For Bank Holding Companies, trust preferred securities will continue to be included in Tier 1 capital up to 25% of core capital elements (including trust preferred securities) net of goodwill less any associate deferred tax liability.
Subordinated Term Loan Agreement
On September 26, 2008, the Company entered into a $7.5 million subordinated term loan agreement with a non-affiliated financial institution. The subordinated term loan is included in long-term debt.
CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements
December 31, 2009, 2008 and 2007
NOTE H - BORROWINGS (Continued)
The subordinated term loan pays interest quarterly at an annual rate, reset quarterly, equal to three month LIBOR plus 4.00%. On June 25, 2009, the Company entered into a derivative financial instrument which effectively swapped the variable rate payments for fixed payments. We entered into a three year and four year swap each for one-half of the notional amount of the trust preferred securities for fixed rates of 6.39% and 6.87%, respectively. The subordinated term loan agreement matures on October 18, 2018 and can be prepaid, subject to the approval of the FDIC and other Governmental Authorities (if applicable), in incremental amounts not less than $500,000, by giving five business days notice prior to prepayment. The Company does not have the right to prepay all or any portion of the loan prior to October 1, 2013 unless the loan ceases to be deemed Tier 2 capital for regulatory capital purposes.
Should the loan cease to be considered Tier 2 capital for regulatory capital purposes, the debt can either be structured as senior debt of the Company or be repaid. The principal reason for entering into the subordinated term loan agreement was to enhance our regulatory capital position.
Federal Home Loan Bank Advances
The Company has a $309.7 million credit line available with the Federal Home Loan Bank for advances. These advances are secured by a blanket floating lien on qualifying commercial real estate, first mortgage loans and pledged investment securities with a market value of $273.9 million.
At December 31, 2009 and 2008, the Company had the following advances outstanding from the Federal Home Loan Bank of Atlanta:
CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements
December 31, 2009, 2008 and 2007
NOTE H - BORROWINGS (Continued)
Borrowings maturing on March 9, 2012, May 18, 2012 and August 29, 2012 are fixed rate advances, convertible quarterly, at the discretion of the Federal Home Loan Bank, to a variable rate based on 3-month LIBOR. The borrowing maturing on July 16, 2012 is a fixed rate advance, convertible quarterly to a variable rate based on 3-month LIBOR, only if 3-month LIBOR is greater than or equal to 7%. All other advances are fixed rate facilities.
Holding Company Line of Credit
On June 27, 2008, the Company entered into a $10.0 million holding company line of credit with a correspondent financial institution. There was $2.0 million outstanding on this line at December 31, 2008 and is included in long-term debt. The line was revolving and paid interest quarterly at an annual rate, reset daily, equal to the Prime rate of interest minus 1.125%. The line was secured by 258,000 shares of Crescent State Bank stock. The line was paid in full and cancelled at the Company’s request prior to March 31, 2009.
NOTE I - LEASES
The Company has entered into fourteen non-cancelable operating leases for its main office, operations center, and branch facilities. Future minimum lease payments under these leases for the years ending December 31 are approximately as follows:
The leases contain renewal options for various additional terms after the expiration of the initial term of each lease. The cost of such renewals is not included above. Total rent expense for the years ended December 31, 2009, 2008 and 2007 amounted to $1,650,367, $1,308,210 and $1,090,669, respectively.
Two of the properties used for bank branch operations are leased from related parties. Lease payments made to related parties in 2009, 2008 and 2007 were $242,094, $150,115 and $48,385, respectively.
NOTE J - INCOME TAXES
The significant components of the provision for income taxes for the years ended December 31, 2009, 2008 and 2007 are as follows:
CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements
December 31, 2009, 2008 and 2007
NOTE J - INCOME TAXES (Continued)
The difference between the provision for income taxes and the amounts computed by applying the statutory federal income tax rate of 34% to income before income taxes is summarized below:
Significant components of deferred taxes at December 31, 2009 and 2008 are as follows:
It is management’s opinion that realization of the net deferred tax asset is more likely than not based on the Company’s history of taxable income and estimates of future taxable income.
Effective January 1, 2007, the Company adopted new guidance related to accounting for uncertain income tax positions, which provides guidance on financial statement recognition and measurements of tax positions taken, or expected to be taken, in tax returns. The initial adoption of ASC 740-10 had no impact on the Company’s financial statements. As of January 1, 2009, there were no unrecognized tax benefits.
CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements
December 31, 2009, 2008 and 2007
NOTE J - INCOME TAXES (Continued)
When tax returns are filed, it is highly certain that some positions taken would be sustained upon examination by the taxing authorities, while others are subject to uncertainty about the merits of the position taken or the amount of the position that would be ultimately sustained. The benefit of a tax position is recognized in the financial statements in the period during which, based on all available evidence, management believes it is more likely than not that the position will be sustained upon examination, including the resolution of appeals or litigation processes, if any. Tax positions taken are not offset or aggregated with other positions. Tax positions that meet the more-likely-than-not recognition threshold are measured as the largest amount of tax benefit that is more than 50 percent likely of being realized upon settlement with the applicable taxing authority. The portion of the benefits associated with tax positions taken that exceeds the amount measured as described above is reflected as a liability for unrecognized tax benefits in the accompanying consolidated balance sheet along with any associated interest and penalties that would be payable to the taxing authorities upon examination.
The Company’s federal and state income tax returns are open and subject to examination from the 2006 tax return year and forward.
NOTE K - NON-INTEREST INCOME AND OTHER NON-INTEREST EXPENSE
The major components of other non-interest income for the years ended December 31, 2009, 2008 and 2007 are as follows:
The major components of other non-interest expense for the years ended December 31, 2009, 2008 and 2007 are as follows:
NOTE L - RESERVE REQUIREMENTS
The aggregate net reserve balance maintained under the requirements of the Federal Reserve, which is currently interest bearing, was $351,000 at December 31, 2009. During 2008, Crescent began utilizing a deposit reclassification program. This program, in compliance with Federal Reserve Bank regulations, allowed a portion of Crescent’s reservable transaction accounts to be reclassified as savings which are not subject to reserve requirements.
CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements
December 31, 2009, 2008 and 2007
NOTE M - REGULATORY MATTERS
The Company (on a consolidated basis) and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s and Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Prompt corrective action provisions are not applicable to bank holding companies.
The Bank, as a North Carolina banking corporation, may pay dividends to the Company only out of undivided profits as determined pursuant to North Carolina General Statutes Section 53-87. However, regulatory authorities may limit payment of dividends by any bank when it is determined that such a limitation is in the public interest and is necessary to ensure the financial soundness of the bank.
Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the following table) of total and Tier I capital (as defined) to average assets (as defined). Management believes, as of December 31, 2009 and 2008, that the Company and the Bank met all capital adequacy requirements to which they are subject.
As of December 31, 2009, the most recent notification from the Federal Deposit Insurance Corporation categorized Crescent State Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, an institution must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the following tables. There are no conditions or events since the notification that management believes have changed the Bank’s category. The Banks’ actual capital amounts and ratios as of December 31, 2009 and 2008 are presented in the table below.
The Company is also subject to these requirements. At December 31, 2009, the Company’s total capital to risk-weighted assets, Tier I capital to risk-weighted assets and Tier I capital to average assets were 13.53%, 11.37% and 9.03%, respectively. At December 31, 2008, the Company’s total capital to risk-weighted assets, Tier I capital to risk-weighted assets and Tier I capital to average assets were 10.68%, 8.53% and 7.67%, respectively.
CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements
December 31, 2009, 2008 and 2007
NOTE M - REGULATORY MATTERS (Continued)
On February 27, 2009, the Board of Directors of the FDIC proposed amendments to the restoration plan for the DIF. This amendment proposed the imposition of a 20 basis point emergency special assessment on insured depository institutions as of June 30, 2009.
On March 5, 2009, the FDIC Chairman announced that the FDIC intended to lower the special assessment from 20 basis points to 10 basis points. On May 22, 2009, the FDIC adopted a final rule imposing a 5 basis point special assessment on each insured depository institution's assets minus Tier 1 capital as of June 30, 2009. The amount of the special assessment for any institution was not to exceed 10 basis points times the institution's assessment base for the second quarter 2009. The assessment was collected on September 30, 2009 and totaled $493,000.
In addition, the FDIC received approval to require prepayment of the next three years premiums by December 31, 2009. The Company remitted $4.2 million to prepay its premiums for 2010, 2011 and 2012. The FDIC may impose an emergency special assessment of up to 10 basis points on all insured depository institutions whenever, after June 30, 2009, the FDIC estimates that the fund reserve ratio will fall to a level that the Board believes would adversely affect public confidence or to a level close to zero or negative at the end of a calendar quarter. Additional assessments could have a significant impact on the financial results of the Company in future years. The assessment rates, including any special assessments, are subject to change at the discretion of the Board of Directors of the FDIC.
NOTE N - DERIVATIVE FINANCIAL INSTRUMENTS
The Company uses derivative financial instruments, currently in the form of interest rate swaps, to manage its interest rate risk. These instruments carry varying degrees of credit, interest rate, and market or liquidity risks. Derivative instruments are recognized as either assets or liabilities in the accompanying financial statements and are measured at fair value. Subsequent changes in the derivatives’ fair values are recognized in earnings unless specific hedge accounting criteria are met.
Crescent has established objectives and strategies that include interest-rate risk parameters for maximum fluctuations in net interest income and market value of portfolio equity. Interest rate risk is monitored via simulation modeling reports. The goal of the Company’s asset/liability management efforts is to maintain profitable financial leverage within established risk parameters. Crescent has entered into several financial arrangements using derivatives during 2009 to add stability to interest income and to manage its exposure to interest rate movements.
Cash Flow Hedges
Through a special purpose entity (see Note H) the Company issued trust preferred debentures in 2003. In 2007, the Company entered into a subordinated term loan agreement with a non-affiliated financial institution. These instruments, as more fully described in Note H, were issued as part of its capital management strategy. These instruments are variable rate and expose the Company to interest rate risk caused by the variability of expected future interest expense attributable to changes in 3-month LIBOR. To mitigate this exposure to fluctuations in cash flows resulting from changes in interest rates, the Company entered into four pay-fixed interest rate swap agreements in June 2009.
Based on the evaluation performed at inception and through December 31, 2009, these derivative instruments qualify for cash flow hedge accounting. Therefore, the cumulative change in fair value of the interest rate swaps, to the extent that it is expected to be offset by the cumulative change in anticipated interest cash flows from the hedged trust preferred debenture and subordinated term loan, will be deferred and reported as a component of other comprehensive income (“OCI”). Any hedge ineffectiveness will be charged to current earnings.
Since the floating index and reset dates are based on identical terms, management believes that the hedge relationship of the cumulative changes in expected future cash flows from the interest rate swaps and the cumulative changes in expected interest cash flows from the trust-preferred debentures and subordinated term loan agreement will be highly effective. For the period ended December 31, 2009, management has determined that there is no hedge ineffectiveness.
CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements
December 31, 2009, 2008 and 2007
NOTE N -DERIVATIVE FINANCIAL INSTRUMENTS (Continued)
The notional amount of the debt obligations being hedged was $15.5 million and the fair value of the interest rate swap liability, which is recorded in accrued expenses and other liabilities at December 31, 2009, was an unrealized loss of $294,934.
The following table discloses the location and fair value amounts of derivative instruments designated as hedging instruments under ASC 815 in the consolidated balance sheets.
See Note H for additional information.
The following table discloses activity in accumulated OCI related to the interest rate swaps during the year ended December 31, 2009.
The Company monitors the credit risk of the interest rate swap counterparty. The Company has pledged $310,000 to the counterparty to the swaps.
NOTE O - 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. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheet. The contract or notional amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of conditions established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since some of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank, upon extension of credit is based on management’s credit evaluation of the borrower. Collateral obtained varies but may include real estate, stocks, bonds, and certificates of deposit.
CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements
December 31, 2009, 2008 and 2007
NOTE O - OFF-BALANCE SHEET RISK (Continued)
A summary of the contract amount of the Company’s exposure to off-balance sheet credit risk as of December 31, 2009 is as follows (amounts in thousands):
NOTE P - FAIR VALUE MEASUREMENT
The Company adopted ASC 820 and ASC 825 on January 1, 2008. ASC 820 defines fair value, establishes a framework for measuring fair value under GAAP and expands disclosures about fair value measurements. ASC 820 applies whenever other accounting pronouncements require or permit assets or liabilities to be measured at fair value. Accordingly, ASC 820 does not expand the use of fair value in any new circumstances. ASC 825 provides companies with an option to report selected financial assets and liabilities at fair value. As of December 31, 2009 and 2008, the Company had not elected to measure any financial assets or liabilities using the fair value option under ASC 825; therefore the adoption of ASC 825 had no effect on the Company’s financial condition or results of operations.
Fair value is a market-based measurement and is defined as the price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date. See Note B for discussion concerning recent guidance for transactions that are not orderly. The transaction to sell the asset or transfer the liability is a hypothetical transaction at the measurement date, considered from the perspective of a market participant that holds the asset or owes the liability. In general, the transaction price will equal the exit price and, therefore, represent the fair value of the asset or liability at initial recognition. In determining whether a transaction price represents the fair value of the asset or liability at initial recognition, each reporting entity is required to consider factors specific to the transaction and the asset or liability, the principal or most advantageous market for the asset or liability, and market participants with whom the entity would transact in the market. In order to determine the fair value or the exit price, entities must determine the unit of account, highest and best use, principal market, and market participants. These determinations allow the reporting entity to define the inputs for fair value and level of hierarchy.
Outlined below is the application of the fair value hierarchy established by ASC 820 to the Company’s financial assets that are carried at fair value.
Level 1 - inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets. An active market for the asset or liability is a market in which the transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis. As of December 31, 2009 and 2008, the Company carried certain marketable equity securities at fair value hierarchy Level 1.
Level 2 - inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument. As of December 31, 2009 and 2008, the types of financial assets and liabilities the Company carried at fair value hierarchy Level 2 included securities available for sale, impaired loans secured by real estate and derivative liabilities.
CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements
December 31, 2009, 2008 and 2007
NOTE P - ESTIMATED FAIR VALUES (Continued)
Level 3 - inputs to the valuation methodology are unobservable and significant to the fair value measurement. Unobservable inputs are supported by little or no market activity or by the entity’s own assumptions. As of December 31, 2009 and 2008, while the Company did not carry any financial assets or liabilities, measured on a recurring basis, at fair value hierarchy Level 3, the Company did value certain financial assets, measured on a non-recurring basis, at fair value hierarchy Level 3.
Fair Value on a Recurring Basis. The Company measures certain assets at fair value on a recurring basis, as described below.
Investment Securities Available-for-Sale
Investment securities available-for-sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. Level 1 securities include those traded on an active exchange, such as the New York Stock Exchange, U.S. Treasury securities that are traded by dealers or brokers in active over-the-counter markets and money market funds. Level 2 securities include mortgage-backed securities issued by government sponsored entities, municipal bonds and corporate debt securities. Securities classified as Level 3 include asset-backed securities in less liquid markets.
Derivative Liabilities
Derivative instruments at December 31, 2009 include interest rate swaps and are valued using models developed by third-party providers. This type of derivative is classified as Level 2 within the hierarchy.
The Company utilizes valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs.
Fair Value on a Nonrecurring Basis. The Company measures certain assets at fair value on a nonrecurring basis, as described below.
Loans
The Company does not record loans at fair value on a recurring basis. However, from time to time, a loan is considered impaired and an allowance for loan losses is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. The fair value of impaired loans is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. At December 31, 2009, substantially all of the total impaired loans were evaluated based on the fair value of the collateral. Impaired loans where an allowance is established based on the fair value of collateral require classification in the fair value hierarchy. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the impaired loan as nonrecurring Level 2. When current appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the impaired loan as nonrecurring Level 3. There were $66.1 million in impaired loans at December 31, 2009, of which $35.4 million in loans showed impairment and had a specific reserve of $9.1 million. Impaired loans totaled $16.7 million at December 31, 2008. Of such loans, $11.6 million had specific loss allowances aggregating $4.1 million at that date.
CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements
December 31, 2009, 2008 and 2007
NOTE P - ESTIMATED FAIR VALUES (Continued)
Below is a table that presents information about assets measured at fair value at December 31, 2009 and 2008:
ASC Topic 825 Financial Instruments, requires disclosure of fair value information about financial instruments, whether or not recognized in the balance sheet, for which it is practicable to estimate that value. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques.
Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instruments. ASC Topic 825 excludes certain financial instruments and all nonfinancial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company. In addition to the valuation methods previously described for investments available for sale and derivative assets and
CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements
December 31, 2009, 2008 and 2007
NOTE P - ESTIMATED FAIR VALUES (Continued)
liabilities, the following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments:
Cash and Cash Equivalents
The carrying amounts for cash and cash equivalents approximate fair value because of the short maturities of those instruments.
Investment Securities
See previous discussion in Note P.
Loans
For certain homogenous categories of loans, such as residential mortgages, fair value is estimated using the quoted market prices for securities backed by similar loans, adjusted for differences in loan characteristics. The fair value of other types of loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities.
Federal Home Loan Bank Stock
The carrying value of Federal Home Loan Bank stock approximates fair value based on the redemption provisions of the Federal Home Loan Bank.
Investment in Life Insurance
The carrying value of life insurance approximates fair value because this investment is carried at cash surrender value, as determined by the insurers.
Deposits
The fair value of demand deposits, savings, money market and NOW accounts is the amount payable on demand at the reporting date. The fair value of time deposits is estimated using the rates currently offered for instruments of similar remaining maturities.
Short-term Borrowings and Long-term Debt
The fair value of short-term borrowings and long-term debt are based upon the discounted value when using current rates at which borrowings of similar maturity could be obtained.
Accrued Interest Receivable and Accrued Interest Payable
The carrying amounts of accrued interest receivable and payable approximate fair value, because of the short maturities of these instruments.
Derivative financial instruments
See previous discussion in Note P.
CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements
December 31, 2009, 2008 and 2007
NOTE P - ESTIMATED FAIR VALUES (Continued)
The carrying amounts and estimated fair values of the Company’s financial instruments, none of which are held for trading purposes, are as follows at December 31, 2009 and 2008:
NOTE Q - EMPLOYEE AND DIRECTOR BENEFIT PLANS
During 1999 the Company adopted, with shareholder approval, an Employee Stock Option Plan (the “Employee Plan”) and a Director Stock Option Plan (the “Director Plan”). During 2002 and 2005, with shareholder approval, the Company amended the Employee plan to increase the number of shares available under the plan. In 2003, in conjunction with the merger between Crescent and Centennial Bank of Southern Pines, stock options approved under Centennial’s Plan were acquired by Crescent. Certain of the options granted under the Director Plan vested immediately at the time of grant. All other options granted vested twenty-five percent at the grant date, with the remainder vesting over a three-year period. All unexercised options expire ten years after the date of grant.
At the time of the PCCB merger, PCCB had two stock option plans, the 2002 Incentive Stock Option Plan and the 2002 Nonstatutory Stock Option Plans, whose options were converted to options to purchase Crescent Financial Corporation stock at an exchange rate of 2.5133. There were 225,954 incentive stock options and 228,459 non-statutory stock options converted. Since all options authorized under the PCCB plans had been granted, there will be no more options granted under either of these plans.
At the Company’s annual meeting on July 11, 2006, the shareholders approved the 2006 Omnibus Stock Ownership and Long Term Incentive Plan (the “Omnibus Plan”) to replace the previous plans. This plan authorizes 335,000 shares of the common stock of Crescent to be issued in the form of incentive stock option grants, non-statutory stock option grants, restricted stock grants, long term incentive compensation units, or stock appreciation rights. The company declared and distributed a 10% stock dividend in 2007 which increased the shares available for issuance to 368,500. In the event that the number of shares of common stock that remain available for future issuance under the Plan as of December 31, 2008 and as of the last day of each calendar year commencing thereafter, is less than 1.5% of the total number of shares of common stock issued and outstanding as of such date (the “Replacement Amount”), then the Plan Pool shall be increased as of such date by a number of shares of common stock equal to the Replacement Amount. At December 31, 2009, there were 236,379 unissued options in this plan. Vesting provisions for granted stock options are at the discretion of the Compensation Committee of the Board of Directors. At December 31, 2009, all outstanding options were granted with a three year vesting schedule; 25% at date of grant and 25% at each of the next three grant date anniversaries.
CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements
December 31, 2009, 2008 and 2007
NOTE Q - EMPLOYEE AND DIRECTOR BENEFIT PLANS (Continued)
The share-based awards granted under the aforementioned plans have similar characteristics, except that some awards have been granted in options and certain awards have been granted in restricted stock. Therefore, the following disclosures have been disaggregated for the stock option and restricted stock awards of the plans due to their dissimilar characteristics. Vesting provisions for granted restricted stock awards are at the discretion of the Compensation Committee of the Board of Directors. At December 31, 2009, all outstanding restricted stock awards vest in full at either the three year of five year anniversary date of the grant. The Company funds the option shares and restricted stock from authorized but un-issued shares.
Stock Option Plans
A summary of the Company’s option plans as of and for the year ended December 31, 2009, adjusted for the stock split effected in the form of a 10% stock dividend distributed in May 2007, is as follows:
The weighted average remaining life of options outstanding and options exercisable at December 31, 2009 is 3.92 years and 3.60 years, respectively.
The following table provides the range of exercise prices for options outstanding and exercisable at December 31, 2009:
The fair market value of each option award is estimated on the date of grant using the Black-Scholes option pricing model. The risk-free interest rate is based upon a U.S. Treasury instrument with a life that is similar to the expected life of the option grant. Expected volatility is based upon the historical volatility of the Company’s stock price based upon the previous 3 years trading history. The expected term of the options is based upon the average life of previously issued stock options.
CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements
December 31, 2009, 2008 and 2007
NOTE Q - EMPLOYEE AND DIRECTOR BENEFIT PLANS (Continued)
Stock Option Plans (Continued)
The assumptions used in estimating fair values, together with the estimated per share value of options granted are displayed below:
Compensation cost charged to income was approximately $38,000, $72,000 and $99,000 for the years ended December 31, 2009, 2008 and 2007, respectively. Cash received from options exercised under share-based payment arrangements for the years ended December 31, 2008 and 2007 were $670,000 and $1,214,000, respectively. There were no options exercised for the year ended December 31, 2009 The actual tax benefit in stockholders equity realized for the tax deductions from option exercise of the share-based payment arrangements for the years ended December 31, 2008, and 2007 totaled $95,500 and $452,000, respectively.
The total intrinsic value of options exercised during the years ended December 31, 2008 and 2007 was $650,047 and $1,987,000, respectively. Since all options outstanding under the Company’s stock option plans had an exercise price which exceeded the market price at December 31, 2009, there was no intrinsic value of both total options outstanding and exercisable options. As of December 31, 2009, there was $56,000 of unrecognized compensation cost related to the nonvested stock option plans. That cost is expected to be recognized as follows: $30,000 in 2010, $17,000 in 2011and $9,000 in 2012.
Stock Award Plans
A summary of the status of the Company’s non-vested stock awards as of December 31, 2009, and changes during the year then ended is presented below:
There were no restricted stock grants issued or vested during the year.
As of December 31, 2009, there was $223,445 of unrecognized compensation cost related to the nonvested stock award plan. That cost is expected to be recognized over a weighted average period of 2.09 years.
CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements
December 31, 2009, 2008 and 2007
NOTE Q - EMPLOYEE AND DIRECTOR BENEFIT PLANS (Continued)
Supplemental Retirement
During 2003, the Company adopted a Supplemental Executive Retirement Plan (SERP) for its senior executives. The Company has purchased life insurance policies in order to provide future funding of benefit payments. Plan benefits will accrue and vest during the period of employment and will be paid in monthly benefit payments over the officer’s remaining life commencing with the officer’s retirement at any time after attainment of age sixty to sixty-five, depending on the officer. Expenses for the years ended December 31, 2009, 2008 and 2007 were $435,385, $372,062 and $241,934, respectively. The accrued liability of the plan at December 31, 2009 and 2008 was $1,313,265 and $877,880, respectively. The Company also provides post retirement split dollar life insurance benefits to certain executives. On January 1, 2008, the Company recorded, as an opening adjustment to retained earnings, the cumulative effect of the split dollar liability for future benefits. The adjustment was in the amount of $141,808 which represented the accrued liability from the date of adoption in 2003 through December 31, 2007. Expenses for the years ended December 31, 2009 and 2008 were $37,632 and $21,853, respectively. The accrued liability of the plan at December 31, 2009 and 2008 was $191,035 and $163,661, respectively.
Defined Contribution Plan
The Company sponsors a contributory profit-sharing plan which provides for participation by substantially all employees. Participants may make voluntary contributions resulting in salary deferrals in accordance with Section 401(k) of the Internal Revenue Code. The plans provide for employee contributions up to $15,500 of the participant's annual salary and an employer contribution of 100% matching of the first 6% of pre-tax salary contributed by each participant. Anyone who turned 50 years old in 2009 could also add a catch-up contribution of $5,000 above the normal limit bringing the maximum contribution to $20,500 for those employees. The Company may make additional discretionary profit sharing contributions to the plan on behalf of all participants. There were no discretionary contributions for 2009, 2008 or 2007. Amounts deferred above the first 6% of salary are not matched by the Company. Expenses related to these plans for the years ended December 31, 2009, 2008 and 2007 were $420,513, $369,939 and $286,778, respectively.
Employment Agreements
The Company has entered into employment agreements with certain of its executive officers to ensure a stable and competent management base. The agreements provide for benefits as spelled out in the contracts and cannot be terminated by the Board of Directors, except for cause, without prejudicing the officers’ rights to receive certain vested rights, including compensation. In the event of a change in control of the Company, as outlined in the agreements, the acquirer will be bound to the terms of the contracts.
NOTE R - CUMULATIVE PERPETUAL PREFERRED STOCK
Under the United States Treasury’s Capital Purchase Program (CPP), the Company issued $24.9 million in Fixed Rate Cumulative Perpetual Preferred Stock, Series A, on January 9, 2009. In addition, the Company provided a warrant to the Treasury to purchase 833,705 shares of the Company’s common stock at an exercise price of $4.48 per share. These warrants are immediately exercisable and expire ten years from the date of issuance. The preferred stock is non-voting, other than having class voting rights on certain matters, and pays cumulative dividends quarterly at a rate of 5% per annum for the first five years and 9% per annum thereafter. The preferred shares are redeemable at the option of the Company subject to regulatory approval.
Based on a Black-Scholes option pricing model, the common stock warrants have been assigned a fair value of $2.28 per share or $2.4 million in the aggregate as of January 9, 2009. Based on relative fair value, $2.4 million has been recorded as the discount on the preferred stock and will be accreted as a reduction in net income available for common shareholders over the next five years at approximately $0.5 million per year. Correspondingly, $22.5 million was initially assigned to the preferred stock. Through the discount accretion over the next five years, the preferred stock will be accreted up to the redemption amount of $24.9 million. For purposes of these calculations, the fair value of the common stock warrant as of January 9, 2009 was estimated using the Black-Scholes option pricing model and the following assumptions:
CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements
December 31, 2009, 2008 and 2007
NOTE R - CUMULATIVE PERPETUAL PREFERRED STOCK (Continued)
The Company’s computation of expected volatility is based on daily historical volatility since January 1999. The risk-free interest rate is based on the market yield for ten year U.S. Treasury securities as of January 9, 2009.
As a condition of the CPP, the Company must obtain consent from the United States Department of the Treasury to repurchase its common stock or to pay a cash dividend on its common stock. Furthermore, the Company has agreed to certain restrictions on executive compensation and corporate governance.
NOTE S - PARENT COMPANY FINANCIAL DATA
Condensed balance sheets as of December 31, 2009 and 2008, and related condensed statements of operations and cash flows for each of the years in the three-year period ended December 31, 2009 are as follows:
Condensed Balance Sheets
December 31, 2009 and 2008
CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements
December 31, 2009, 2008 and 2007
NOTE S - PARENT COMPANY FINANCIAL DATA (Continued)
Condensed Statements of Operations
Years Ended December 31, 2009, 2008 and 2007
Condensed Statements of Cash Flows
Years Ended December 31, 2009, 2008 and 2007
CRESCENT FINANCIAL CORPORATION AND SUBSIDIARY
Notes to Consolidated Financial Statements
December 31, 2009, 2008 and 2007
NOTE T - SUPPLEMENTAL DISCLOSURE FOR STATEMENT OF CASH FLOWS
The following information is for the consolidated Statement of Cash Flows
The following information is for the parent company only Statement of Cash Flows
ITEM 9
ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
none.
ITEM 9A(T)
ITEM 9A(T) - CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
The Registrant’s Chief Executive Officer and Chief Financial Officer have conducted an evaluation of the Registrant’s disclosure controls and procedures as of December 31, 2009. Based on their evaluation, the Registrant’s Chief Executive Officer and Chief Financial Officer have concluded that the Registrant’s disclosure controls and procedures are effective to ensure that information required to be disclosed by the Registrant in reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the applicable Securities and Exchange Commission rules and forms.
Management’s Report on Internal Control Over Financial Reporting
Management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended. The Registrant’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 accounting principles generally accepted in the United States of America. The Registrant’s internal control over financial reporting includes those written policies and procedures that:
·
pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of assets;
·
provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America;
·
provide reasonable assurance that receipts and expenditures are being made only in accordance with management and director authorization; and
·
provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of assets that could have a material effect on the consolidated financial statements.
Internal control over financial reporting includes the controls themselves, monitoring and internal auditing practices and actions taken to correct deficiencies as identified.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Management assessed the effectiveness of the Registrant’s internal control over financial reporting as of December 31, 2009. Management based this assessment on criteria for effective internal control over financial reporting described in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Management’s assessment included an evaluation of the design of the Registrant’s internal control over financial reporting and testing of the operational effectiveness of its internal control over financial reporting.
Management reviewed the results of its assessment with the Audit Committee of the Board of Directors. Based on this assessment, management determined that, as of December 31, 2009, it maintained effective internal control over financial reporting.
This annual report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permits the Company to provide only management’s report in this annual report.
Changes in Internal Control Over Financial Reporting
There were no changes in the Registrant’s internal controls or in other factors that could materially affect these controls during the three-month period ended December 31, 2009.
ITEM 9B
ITEM 9B - OTHER INFORMATION
None.
PART III
ITEM 10
ITEM 10 - DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
Incorporated by reference from the discussion under the headings “Proposal 1: Election of Directors,” “Executive Compensation - Executive Officers,” “Director Relationships,” “Director Independence,” “Qualifications of Directors,” “Board Leadership Structure and Role in Risk Oversight,” “Section 16(a) Beneficial Ownership Reporting Compliance” and “Meetings and Committees of the Board of Directors - Audit Committee” in the Registrant’s Proxy Statement for the 2010 Annual Meeting of Shareholders to be filed with the SEC.
The Registrant has adopted a Code of Ethics that applies, among others, to its principal executive officer and principal financial officer. The Registrant’s Code of Ethics is available at www.crescentstatebank.com.
ITEM 11
ITEM 11 - EXECUTIVE COMPENSATION
Incorporated by reference from the discussion under the heading “Executive Compensation,” “Director Compensation,” and “Meetings and Committees of the Board of Directors” in the Registrant’s Proxy Statement for the 2010 Annual Meeting of Shareholders to be filed with the SEC.
ITEM 12
ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
Incorporated by reference from the discussion under the heading “Beneficial Ownership of Voting Securities” in the Registrant’s Proxy Statement for the 2010 Annual Meeting of Shareholders to be filed with the SEC.
Stock Option Plans
Set forth below is certain information regarding the Registrant’s various stock option plans.
See additional information in Note Q under the heading "Employee and Director Benefit Plans - Stock Option Plans" in Item 8 of this report.
ITEM 13
ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
Incorporated by reference from the discussion under the headings “Director Independence,” “Director Relationships” and “Indebtedness of and Transactions with Management” in the Registrant’s Proxy Statement for the 2010 Annual Meeting of Shareholders to be filed with the SEC.
ITEM 14
ITEM 14 - PRINCIPAL ACCOUNTANT FEES AND SERVICES
Incorporated by reference from pages the discussion under the heading “Proposal 4: Ratification of Independent Registered Public Accounting Firm” and “Report of the Audit Committee” in the Registrant’s Proxy Statement for the 2010 Annual Meeting of Shareholders to be filed with the SEC.
ITEM 15
ITEM 15 - EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a)
(1) and (2) Lists of Financial Statements and Schedules
The following consolidated financial statements of the Registrant are filed as a part of this report:
·
Consolidated Balance Sheets as of December 31, 2009 and December 31,
·
Consolidated Statements of Operations for the years ended December 31, 2009, 2008 and
·
Consolidated Statements of Comprehensive Income (Loss) for the years ended December 31, 2009, 2008 and 2007
·
Consolidated Statements of Changes in Stockholders’ Equity for the years ended December 31, 2009, 2008 and 2007
·
Consolidated Statements of Cash Flows for the years ended December 31, 2009, 2008 and
·
Notes to Consolidated Financial Statements
·
Report of Independent Registered Public Accounting Firm
(3) Listing of Exhibits
Exhibits filed with this report are listed in the Index to Exhibits. The following management contracts or compensatory plans or arrangements are required to be filed as exhibits to this report:
·
Incentive Stock Option Plan
·
Nonqualified Stock Option Plan for Directors
·
Form of Employment Agreement between the Registrant and Michael G. Carlton
·
Form of Employment Agreement between the Registrant and Bruce W. Elder
·
Form of Employment Agreement between the Registrant and Thomas E. Holder, Jr.
·
Form of Employment Agreement between the Registrant and Ray D. Vaughn
·
Form of Employment Agreement between the Registrant and W. Keith Betts
·
Form of Salary Continuation Agreement with Michael G. Carlton
·
Salary Continuation Agreement with Bruce W. Elder
·
Salary Continuation Agreement with Thomas E. Holder, Jr.
·
Form of Salary Continuation Agreement with Ray D. Vaughn
·
Salary Continuation Agreement with W. Keith Betts
·
Endorsement Split Dollar Agreement with Michael G. Carlton
·
Endorsement Split Dollar Agreement with Bruce W. Elder
·
Endorsement Split Dollar Agreement with Thomas E. Holder, Jr.
·
Endorsement Split Dollar Agreement with Ray D. Vaughn
·
Endorsement Split Dollar Agreement with W. Keith Betts
·
Crescent State Bank Directors’ Compensation Plan
·
Omnibus Stock Ownership and Long Term Incentive Plan
·
Form of Executive Compensation Modification Agreement
(b) Exhibits
Exhibits filed with this report are listed in the Index to Exhibits.
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
In accordance with the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
/s/ Michael G. Carlton
March 31, 2010
Michael G. Carlton, President and Chief Executive Officer, Director (Principle Executive Officer)
/s/ Bruce W. Elder
March 31, 2010
Bruce W. Elder, Vice President
(Principal Financial Officer and Principle Accounting Officer)
/s/ Brent D. Barringer
March 31, 2010
Brent D. Barringer, Director
/s/ William H. Cameron
March 31, 2010
William H. Cameron, Director
/s/ Bruce I. Howell
March 31, 2010
Bruce I. Howell, Director
/s/ James A. Lucas
March 31, 2010
James A. Lucas, Director
/s/ Kenneth A. Lucas
March 31, 2010
Kenneth A. Lucas, Director
_/s/ Sheila Hale Ogle
March 31, 2010
Sheila Hale Ogle, Director
/s/ Charles A. Paul
March 31, 2010
Charles A. Paul, Director
/s/ Francis R. Quis, Jr.
March 31, 2010
Francis R. Quis, Jr., Director
/s/ Jon S. Rufty
March 31, 2010
Jon S. Rufty, Director
/s/ Stephen K. Zaytoun
March 31, 2010
Stephen K. Zaytoun, Director
10(xxii)
Endorsement Split Dollar Agreement with W. Keith Betts(6)
10(xxiii)
Subordinated Term Loan Agreement dated September 26, 2008, by and between Crescent State Bank and United Community Bank(8)
10(xxiv)
Omnibus Stock Ownership and Long Term Incentive Plan(9)
10(xxv)
Form of Executive Compensation Modification Agreement(11)
Subsidiaries (Filed herewith)
Consent of Dixon Hughes PLLC (Filed herewith)
31(i)
Certification of Principal Executive Officer Pursuant to Section 302 of the Sarbanes Oxley Act (Filed herewith)
31(ii)
Certification of Principal Accounting Officer Pursuant to Section 302 of the Sarbanes Oxley Act (Filed herewith)
32(i)
Certification of Principal Executive Officer Pursuant to Section 906 of the Sarbanes Oxley Act (Filed herewith)
32(ii)
Certification of Principal Accounting Officer Pursuant to Section 906 of the Sarbanes Oxley Act (Filed herewith)
99(i)
Registrant’s Proxy Statement for the 2010 Annual Meeting of Shareholders(5)
99(ii)
Certification pursuant to Emergency Economic Stabilization Act of 2008, as amended (Filed herewith)
99(iii)
Certification pursuant to Emergency Economic Stabilization Act of 2008, as amended (Filed herewith)
1.
Incorporated by reference to the Registrant’s 10-KSB for the year ended December 31, 2001, as filed with the Securities and Exchange Commission on March 27, 2002.
2.
Incorporated by reference to the Registrant’s Registration Statement on Form S-8 as filed with the Securities and Exchange Commission on September 5, 2001.
3.
Incorporated by reference from Annual Report on Form 10-KSB filed with the Securities and Exchange Commission on March 30, 2004.
4.
Incorporated by reference from Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 28, 2006.
5.
Filed with the Securities and Exchange Commission pursuant to Rule 14a-6.
6.
Incorporated by reference from Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 11, 2008.
7.
Incorporated by reference from the Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on December 31, 2008.
8.
Incorporated by reference from the Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on September 30, 2008.
9.
Incorporated by reference from Exhibit 99.1 to the Registration Statement on Form S-8, filed with the Securities and Exchange Commission on August 11, 2006.
10.
Incorporated by reference from Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 27, 2009.
11.
Incorporated by reference from Current Report on Form 8-K filed with the Securities and Exchange Commission on January 14, 2009.