Item 1. Business.
General
United Security Bancshares, Inc. (“Bancshares”) is a Delaware corporation organized in 1999, as a successor by merger with United Security Bancshares, Inc., an Alabama corporation. Bancshares is a bank holding company registered under the Bank Holding Company Act of 1956, as amended (the “Act”), and it operates one banking subsidiary, First United Security Bank (the “Bank”). Bancshares other wholly-owned subsidiary, First Security Courier Corporation (“First Security”), is an Alabama corporation organized for the purpose of providing certain bank courier services.
The Bank conducts a general commercial banking business and offers banking services such as the receipt of demand, savings and time deposits, personal and commercial loans, credit card and safe deposit box services and the purchase and sale of government securities. The Bank has nineteen banking offices located in Brent, Bucksville, Butler, Calera, Centreville, Coffeeville, Columbiana, Fulton, Gilbertown, Grove Hill, Harpersville, Jackson, Thomasville, Tuscaloosa, and Woodstock, Alabama, and its market area includes Clarke, Choctaw, Bibb, Shelby, Tuscaloosa and portions of Marengo, Sumter, Washington, Wilcox, Chilton, Hale, Monroe, Perry, and Jefferson Counties in Alabama, as well as Clarke, Lauderdale, and Wayne Counties in Mississippi.
The Bank has three wholly-owned subsidiaries: Acceptance Loan Company, Inc. (“ALC”), FUSB Reinsurance, Inc. (“FUSB Reinsurance”), and R2Metrics, Inc. (“R2Metrics”). ALC is an Alabama corporation that makes consumer loans and purchases consumer loans from vendors. FUSB Reinsurance is an Arizona corporation that underwrites credit life and credit accident and health insurance policies sold to the Bank’s and ALC’s consumer loan customers. FUSB Reinsurance is responsible for the first level of risk on these policies up to a specified maximum amount, and a primary third-party insurer retains the remaining risk. The third-party insurer and/or a third-party administrator is responsible for performing most of the administrative functions of FUSB Reinsurance on a contract basis. R2Metrics is an Alabama corporation incorporated in April 2007, that provides investment and asset and liability management software, analytics, and consulting services for the Bank as well as other clients.
See Note 15, “Segment Reporting,” in the “Notes to Consolidated Financial Statements” included in this Annual Report for certain financial information about Bancshares’ and the Bank’s significant subsidiaries.
Employees
Bancshares has no employees, other than the executive officers referenced in Part III, Item 10 of this report. As of December 31, 2007, the Bank had 182 full-time employees, ALC had 99 full-time employees and R2Metrics had 2 full-time employees.
Competition
Bancshares and its subsidiaries encounter strong competition in making loans, acquiring deposits and attracting customers for investment services. Competition among financial institutions is based upon interest rates offered on deposit accounts, interest rates charged on loans, other credit and service charges relating to loans, the quality and scope of the services rendered, the convenience of banking facilities and, in the case of loans to commercial borrowers, relative lending limits. The Bank competes with commercial banks (including at least ten in its service area), online banks, credit unions, finance companies, mutual funds, insurance companies, investment banking companies, brokerage firms, and other financial intermediaries operating in Alabama and elsewhere. Many of these competitors, some of which are affiliated with large bank holding companies, have substantially greater resources and lending limits. In addition, many of the Bank’s non-bank competitors are not subject to the same extensive federal regulations that govern bank holding companies and federally-insured banks.
The financial services industry is likely to become more competitive as further technological advances enable more companies to provide financial services. These technological advances may diminish the importance of depository institutions and other financial intermediaries.
Supervision and Regulation
Bancshares and the Bank are subject to state and federal banking laws and regulations which impose specific requirements and restrictions on, and provide for general regulatory oversight with respect to, virtually all aspects of operations. These laws and regulations are generally intended to protect depositors, not shareholders. To the extent that the following summary describes statutory or regulatory provisions, it is qualified in its entirety by reference to the particular statutory and regulatory provisions. Any change in applicable laws or regulations may have a material effect on the business and prospects of Bancshares and the Bank.
As a bank holding company, Bancshares is subject to regulation under the Act and to inspection, examination and supervision by the Board of Governors of the Federal Reserve System (the “Federal Reserve”). The Bank is subject to supervision, examination and regulation by applicable state and federal banking agencies, including the Federal Reserve and the Federal Deposit Insurance Corporation (the “FDIC”). The Bank also is subject to various requirements and restrictions under federal and state laws, including requirements to maintain allowances against deposits, restrictions on the types and amounts of loans that may be granted and the interest that may be charged thereon, and limitations on the types of investments that may be made and the types of services that may be offered. Various consumer laws and regulations affect the operations of the Bank. In addition to the impact of regulation, commercial banks are affected significantly by the actions of the Federal Reserve as it attempts to control the money supply and credit availability in order to influence the economy.
The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the “IBBEA”) permits adequately capitalized and adequately managed bank holding companies, as determined by the Federal Reserve, to acquire banks in any state subject to concentration limits and other conditions. The IBBEA also generally authorizes the interstate merger of banks. Under the IBBEA, banks are permitted to establish new branches on an interstate basis, provided that the law of the host state specifically authorizes such action.
The Federal Reserve has authority to prohibit bank holding companies from paying dividends if such payment is deemed to be an unsafe or unsound practice. The Federal Reserve has indicated generally that it may be an unsafe or unsound practice for a bank holding company to pay dividends unless the bank holding company’s net income over the preceding year is sufficient to fund the dividends and the expected rate of earnings retention is consistent with the holding company’s capital needs, asset quality and overall financial condition.
In addition to the limitations placed on the payment of dividends at the holding company level, there are various legal and regulatory limits on the extent to which the Bank may pay dividends or otherwise supply funds to Bancshares. Under Alabama law, a bank may not pay a dividend in excess of 90 percent of its net earnings until the bank’s surplus is equal to at least 20 percent of capital. Also, under Alabama law, a
bank is required to obtain approval of the Superintendent of Banking prior to the payment of dividends if the total of all dividends declared by the bank in any calendar year will exceed the total of the bank’s net earnings (as defined by statute) for the year, and its retained net earnings for the preceding two years, less any required transfers to surplus. Also, no dividends may be paid from a bank’s surplus without the prior written approval of the Superintendent of Banking.
In addition, federal and state regulatory agencies have the authority to prevent a bank holding company or a bank from paying dividends or engaging in any other activity that, in the opinion of the agency, would constitute an unsafe or unsound practice. The inability of the Bank to pay dividends may have an adverse effect on Bancshares.
Bancshares and the Bank also are subject to certain restrictions on extensions of credit to executive officers, directors, principal shareholders and their related interests. Such extensions of credit must be made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with third parties and must not involve more than the normal risk of repayment or present other unfavorable features.
The Gramm-Leach-Bliley Act of 2000 (the “GLB Act”) permits bank holding companies that meet certain management, capital and community reinvestment standards to engage in a substantially broader range of non-banking activities that were previously permitted, including insurance underwriting and merchant banking activities. Under the GLB Act, a bank holding company that elects to become a financial holding company may engage in any activity that the Federal Reserve, in consultation with the Secretary of the Department of the Treasury, determines by regulation or order is financial in nature, incidental to such financial activity, or complementary to such financial activity and does not pose a substantial risk to the safety or soundness of depository institutions or the financial system generally. Bancshares elected to be a financial holding company.
The GLB Act preserves the role of the Federal Reserve as the umbrella supervisor for holding companies while at the same time incorporating a system of functional regulation designed to take advantage of the strengths of the various federal and state regulators. In particular, the GLB Act replaces the broad
exemption from Securities and Exchange Commission regulation that banks previously enjoyed with more limited exemptions, and it reaffirms that states are the regulators for the insurance activities of all persons, including federally-chartered banks.
The GLB Act and the applicable regulations issued by the various federal regulatory agencies require financial institutions (including banks, insurance agencies and broker/dealers) to implement policies and procedures regarding the disclosure of nonpublic personal information about their customers with non-affiliated third parties. In general, financial institutions are required to explain to customers their policies and procedures regarding the disclosure of such nonpublic personal information, and, unless otherwise required or permitted by law, financial institutions are prohibited from disclosing such information except as provided in their policies and procedures. Specifically, the Information Security Guidelines established by the GLB Act require each financial institution, under the supervision and ongoing oversight of its Board of Directors or an appropriate committee thereof, to develop, implement and maintain a comprehensive written information security program designed to ensure the security and confidentiality of customer information, to protect against anticipated threats or hazards to the security or integrity of such information, and to protect against unauthorized access to or use of such information that could result in substantial harm or inconvenience to any customer.
Subsidiary banks of a bank holding company are subject to certain restrictions on extensions of credit to the bank holding company or any of its non-bank subsidiaries, investments in the stock or other securities thereof, and the acceptance of such stocks or securities as collateral for loans to any borrower. Among other requirements, transactions between a bank and its affiliates must be on an arm’s-length basis.
The Bank is subject to extensive supervision and regulation by the Alabama State Banking Department and the FDIC. Among other things, these agencies have the authority to prohibit the Bank from engaging in any activity (such as paying dividends) that, in the opinion of the agency, would constitute an unsafe or unsound practice. The Bank also is subject to various requirements and restrictions under federal and state laws. Areas subject to regulation include dividend payments, reserves, investments, loans (including loans to insiders and significant shareholders), mergers, issuance of securities, establishment of branches and
other aspects of operations, including compliance with truth-in-lending laws, usury laws and other consumer protection laws. The GLB Act establishes minimum federal standards of financial privacy pursuant to which financial institutions are required to institute written privacy policies that must be disclosed to customers at certain required intervals.
There are a number of obligations and restrictions imposed on bank holding companies and their depository institution subsidiaries by federal law and regulatory policy that are designed to reduce potential loss exposure to the depositors of such depository institutions and to the FDIC insurance fund in the event a depository institution becomes in danger of default or is in default. For example, under a policy of the Federal Reserve with respect to bank holding company operations, a bank holding company is required to serve as a source of financial strength to its subsidiary depository institutions and to commit resources to support such institutions in circumstances where it might not do so absent such policy. In addition, the “cross-guarantee” provisions of federal law require insured depository institutions under common control to reimburse the FDIC for any loss suffered or reasonably anticipated as a result of the default of a commonly controlled insured depository institution or for any assistance provided by the FDIC to a commonly controlled insured depository institution in danger of default. Although the FDIC’s claim is junior to the claims of non-affiliated depositors, holders of secured liabilities, general creditors and subordinated creditors, it is superior to the claims of shareholders. The Bank is a FDIC insured depository institution. Any capital loans by a bank holding company to its subsidiary banks are subordinate in right of payment to deposits and to certain other indebtedness of such subsidiary banks. 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 will be assumed by the bankruptcy trustee and entitled to a priority of payment.
The federal banking agencies have broad powers under current federal law to take prompt corrective action to resolve problems of insured depository institutions. The extent of these powers depends upon whether the institutions in question are “well-capitalized,” “adequately-capitalized,” “undercapitalized,” “significantly-undercapitalized” or “critically-undercapitalized” as such terms are defined under regulations issued by each of the federal banking agencies. In general, the agencies measure capital adequacy within a
framework that makes capital requirements sensitive to the risk profiles of individual banking companies. The guidelines define capital as either Tier 1 (primarily common shareholders’ equity) or Tier 2 (certain debt instruments and a portion of the allowance for loan losses). Bancshares and the Bank are subject to a minimum Tier 1 capital ratio (Tier 1 capital to risk-weighted assets) of 4%, a total capital ratio (Tier 1 plus Tier 2 to risk-weighted assets) of 8%, and a Tier 1 leverage ratio (Tier 1 to average quarterly assets) of 3%. To be considered a “well-capitalized” institution, the Tier 1 capital ratio, the total capital ratio, and the Tier 1 leverage ratio must equal or exceed 6%, 10% and 5%, respectively.
The Community Reinvestment Act (the “CRA”) requires that, in connection with examinations of a financial institution such as the Bank, the Federal Reserve or the FDIC must evaluate the record of the financial institution in meeting the credit needs of its local communities, including low and moderate income neighborhoods. The CRA does not establish specific lending requirements or programs for a financial institution nor does it limit an institution’s discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with the CRA. These factors are considered in evaluating mergers, acquisitions and applications to open a branch or facility. The CRA requires all institutions to publicly disclose their CRA ratings.
The Bank Secrecy Act is the centerpiece of the federal government’s efforts to prevent banks and other financial institutions from being used to facilitate the transfer or deposit of money derived from criminal activity. Under the Bank Secrecy Act, a financial institution is obligated to file Suspicious Activity Reports, or SARs, on suspicious activities involving the institution, including certain attempted or actual violations of law as well as certain transactions that do not appear to have a lawful purpose or are not the sort of transaction in which a customer would normally be expected to engage.
The Bank Secrecy Act was amended by the USA Patriot Act of 2001 (the “USA Patriot Act”) expanding the important role the government expects banks to play in detecting and reporting suspicious activity. The USA Patriot Act broadened the application of anti-money laundering regulations to apply to additional types of financial institutions, such as broker-dealers, and strengthened the ability of the government to detect and prosecute international money laundering and the financing of terrorism. The
principal provisions of Title III of the USA Patriot Act require that regulated financial institutions: (i) establish an anti-money laundering program that includes training and audit components; (ii) comply with regulations regarding the verification of the identity of any person seeking to open an account; (iii) take additional required precautions with non-U.S. owned accounts; and (iv) perform certain verification and certification of money laundering risk for their foreign correspondent banking relationships. The USA Patriot Act also expanded the conditions under which funds in a U.S. interbank account may be subject to forfeiture and increased the penalties for violation of anti-money laundering regulations.
Failure of a financial institution to comply with the Bank Secrecy Act, as amended by the USA Patriot Act, could have serious legal and reputational consequences for the institution. The Bank has adopted policies, procedures and controls to address compliance with these laws and their regulations, and the Bank will continue to revise and update its policies, procedures and controls to reflect changes required by the USA Patriot Act and applicable implementing regulations.
Supervision, regulation and examination of banks by the bank regulatory agencies are intended primarily for the protection of depositors rather than for the shareholders of the banks.
Available Information
The Bank’s website address is http://www.firstusbank.com (Bancshares does not maintain a website). Bancshares’ annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) of the Securities Exchange Act of 1934 (“Exchange Act”) are not currently available on the Bank’s website; however, Bancshares intends to implement this feature on the Bank’s website. These reports are available on the Securities and Exchange Commission’s website, http://www.sec.gov, and Bancshares will provide paper copies of these reports free of charge upon written request.
Item 1A.
Item 1A. Risk Factors.
Making or continuing an investment in common stock issued by Bancshares involves certain risks that you should carefully consider. The risks and uncertainties described below are not the only risks that may have a material adverse effect on Bancshares. Additional risks and uncertainties also could adversely
affect our business and our results. If any of the following risks actually occur, our business, financial condition or results of operations could be negatively affected, the market price of your common stock could decline, and you could lose all or a part of your investment. Further, to the extent that any of the information contained in this Annual Report on Form 10-K constitutes forward-looking statements, the risk factors set forth below also are cautionary statements identifying important factors that could cause Bancshares’ actual results to differ materially from those expressed in any forward-looking statements made by or on behalf of Bancshares.
The banking industry is highly competitive which could result in loss of market share and adversely affect our business.
We encounter strong competition in making loans, acquiring deposits and attracting customers for investment services. We compete with other commercial banks, online banks, credit unions, finance companies, mutual funds, insurance companies, investment banking companies, brokerage firms, and other financial intermediaries operating in Alabama and elsewhere. Many of these competitors, some of which are affiliated with large bank holding companies, have substantially greater resources and lending limits. In addition, many of our non-bank competitors are not subject to the same extensive federal regulations that govern bank holding companies and federally-insured banks.
We are subject to extensive governmental regulation, which could have an adverse impact on our operations.
The banking industry is extensively regulated and supervised under both federal and state laws. We are subject to the regulation and supervision of the Federal Reserve Board, the FDIC, and the Superintendent of Banking of the State of Alabama. These regulations are intended primarily to protect depositors, the public, and the FDIC insurance funds, and are not intended to protect shareholders. Additionally, Bancshares, the Bank and other subsidiaries are subject to regulation, supervision and examination by other regulatory authorities, such as the Securities and Exchange Commission, the NASDAQ Stock Market, LLC and state securities and insurance regulators. We are subject to changes in federal and state laws, as well as regulations and governmental policies, income tax laws, and accounting principles. Regulations affecting
banks and other financial institutions are undergoing continuous change, and the ultimate effect of such changes cannot be predicted. Regulations and laws may be modified at any time, and new legislation may be enacted that will affect us, the Bank and other subsidiaries. We cannot assure you that any change in regulations or new laws will not adversely affect us. Our regulatory position is discussed in greater detail under “Item 1. Business-Supervision and Regulation.”
Rapid and significant changes in market interest rates may adversely affect our performance.
Most of our assets and liabilities are monetary in nature and subject us to significant risks from changes in interest rates. Our profitability depends to a large extent on our net interest income, and changes in interest rates can impact our net interest income as well as the valuation of our assets and liabilities.
Changes in market interest rates, changes in the relationships between short-term and long-term market interest rates, and changes in the relationships between different interest rate indices can affect the interest rates charged on interest-earning assets differently than the interest rates paid on interest-bearing liabilities. These differences could result in an increase in interest expense relative to interest income or a decrease in our interest rate spread. For a more detailed discussion of these risks and our management strategies for these risks, see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and “Item 7A. Quantitative and Qualitative Disclosures about Market Risk.” Our net interest margin depends on many factors that are partly or completely out of our control, including competition, federal economic monetary and fiscal policies, and general economic conditions. Despite our strategies to manage interest rate risks, changes in interest rates may have a material adverse impact on our profitability.
The performance of our investment portfolio is subject to fluctuations due to changes in interest rates and market conditions.
Changes in interest rates can negatively affect the performance of most of our investments. Interest rate volatility can reduce unrealized gains or create unrealized losses in our portfolios. Interest rates are highly sensitive to many factors, including governmental monetary policies, domestic and international economic and political conditions, and other factors beyond our control. Fluctuations in interest rates affect our returns on, and the market value of, our investment securities.
The fair market value of the securities in our portfolio and the investment income from these securities also fluctuate depending on general economic and market conditions. In addition, actual net investment income and/or cash flows from investments that carry prepayment risk, such as mortgage-backed and other asset-backed securities, may differ from those anticipated at the time of investment as a result of interest rate fluctuations.
Changes in the policies of monetary authorities and other government action could adversely affect our profitability.
The results of operations of Bancshares are affected by credit policies of monetary authorities, particularly the Federal Reserve Board. The instruments of monetary policy employed by the Federal Reserve Board include open market operations in U.S. government securities, changes in the discount rate or the federal funds rate on bank borrowings, and changes in reserve requirements against bank deposits. In view of changing conditions in the national economy and in the money markets, particularly in light of the continuing threat of terrorist attacks and the current military operations in the Middle East, we cannot predict possible future changes in interest rates, deposit levels, loan demand or our business and earnings. Furthermore, the actions of the U.S. government and other governments in responding to such terrorist attacks or the military operations in the Middle East may result in currency fluctuations, exchange controls, market disruption and other adverse effects.
If we experience greater loan losses than anticipated, our earnings may be adversely affected.
As a lender, we are exposed to the risk that our customers will be unable to repay their loans according to their terms and that any collateral securing the payment of their loans may not be sufficient to assure repayment. Credit losses are inherent in the business of making loans and could have a material adverse effect on our operating results. Our credit risk with respect to our real estate and construction loan portfolio will relate principally to the creditworthiness of individuals and the value of the real estate serving as security for the repayment of loans. Our credit risk with respect to our commercial and consumer loan portfolio will relate principally to the general creditworthiness of businesses and individuals within our local markets.
We make various assumptions and judgments about the collectibility of our loan portfolio and provide an allowance for potential loan losses based on a number of factors. We believe that the allowance for loan losses is adequate. However, if our assumptions or judgments are wrong, the allowance for loan losses may not be sufficient to cover actual loan losses. The actual amount of future provisions for loan losses cannot be determined at this time and may vary from the amounts of past provisions.
Our profitability and liquidity may be affected by changes in economic conditions in the areas where our operations or loans are concentrated.
Our success depends to a certain extent on the general economic conditions of the geographic markets served by the Bank and its subsidiaries in the states of Alabama and Mississippi. The local economic conditions in these areas have a significant impact on our commercial, real estate and construction loans, the ability of borrowers to repay these loans, and the value of the collateral securing these loans. Adverse changes in the economic conditions of the southeastern United States in general or any one or more of these local markets could negatively impact the financial results of our banking operations and have a negative effect on its profitability.
A downturn in the real estate market could harm our revenues and profitability.
Our loan portfolio includes a substantial amount of residential real estate loans. In addition, real estate is the collateral source that secures many of our loans. If the real estate market should experience a significant slowdown, it could decrease the demand for real estate loans and impact the value of loan collateral, the ability of borrowers to meet required principal and/or interest payments and, potentially, the volume of loan losses. As a result, a downturn in the real estate market could affect our financial results adversely.
We cannot guarantee that we will pay dividends to shareholders in the future.
Dividends from the Bank are Bancshares’ primary source of funds for the payment of dividends to our shareholders, and there are various legal and regulatory limits regarding the extent to which the Bank may
pay dividends or otherwise supply funds to Bancshares. The ability of the Bank to pay dividends, as well as our ability to pay dividends to our shareholders, will continue to be subject to and limited by the results of operations of the Bank and its subsidiaries and by certain legal and regulatory restrictions. Further, any lenders making loans to us may impose financial covenants that may be more restrictive than the legal and regulatory requirements with respect to our payment of dividends to shareholders. There can be no assurance of whether or when we may pay dividends to our shareholders.
Extreme weather could cause a disruption in our operations which could have an adverse impact on the results of operations.
Some of our operations are located in areas bordering the Gulf of Mexico, a region that is susceptible to hurricanes. Such weather events could cause disruption to our operations and could have a material adverse effect on our overall results of operations. Further, a hurricane in any of our market areas could adversely impact the ability of borrowers to timely repay their loans and may adversely impact the value of any collateral held by us.
We need to stay current on technological changes in order to compete and meet customer demands.
The financial services market, including banking services, is undergoing rapid changes with frequent introductions of new technology-driven products and services. In addition to better serving customers, the effective use of technology increases efficiency and may enable financial institutions to reduce costs. Our future success may depend, in part, on our ability to use technology to provide products and services that provide convenience to customers and create additional efficiencies in our operations.
Securities issued by Bancshares, including our common stock, are not insured.
Securities issued by Bancshares, including our common stock, are not savings or deposit accounts or other obligations of any bank and are not insured by the FDIC, the Bank Insurance Fund, or any other governmental agency or instrumentality, or any private insurer, and are subject to investment risk, including the possible loss of principal.
Future issuances of additional securities could result in dilution of your ownership.
We may determine from time to time to issue additional securities to raise capital, support growth,
or to fund acquisitions. Further, we may issue stock options or other stock grants to retain and motivate our employees. These issuances of our securities will dilute the ownership interests of our shareholders.
Our common stock price is volatile, which could result in substantial losses for individual stockholders.
The market price of our common stock has been volatile, and we expect that it will continue to be volatile. In particular, our common stock may be subject to significant fluctuations in response to a variety of factors, including but not limited to:
•
general economic and business conditions;
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changing market conditions in the financial services industry;
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monetary and fiscal policies, laws and regulations and other activities of the government, agencies and similar organizations;
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actual or anticipated variations in quarterly operating results;
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failure to meet analyst predictions and projections;
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collectibility of loans;
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cost and other effects of legal and administrative cases and proceedings, claims, settlements and judgments;
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additions or departures of key personnel;
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announcements of innovations or new services by us or our competitors;
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our sales of common stock or other securities in the future; and
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other events or factors, many of which are beyond our control.
Due to these factors, you may not be able to sell your stock at or above the price you paid for it, which could result in substantial losses.
Our results of operations depend upon the results of operations of our subsidiaries.
There are various regulatory restrictions on the ability of our subsidiaries to pay dividends or make other payments to us. In addition, our right to participate in any distribution of assets of any of our subsidiaries upon a subsidiary’s liquidation or otherwise, will be subject to the prior claims of creditors of that subsidiary, except to the extent that any of our claims as a creditor of such subsidiary may be recognized.
We may uncover additional losses in our internal investigation of the irregularities at ALC, and ALC personnel turnover could adversely impact ALC’s financial performance.
During the quarter ended June 30, 2007, we discovered irregularities in certain loan transactions within ALC. See “Irregularities at Acceptance Loan Company, Inc.” for a discussion of significant losses recorded at ALC during the quarter ended September 30, 2007, in Item 7 herein. Under the direction of the Audit Committee, we conducted an internal investigation regarding these irregularities, which is substantially complete. We have recorded significant losses from these irregularities, and there is no assurance that additional losses from these irregularities will not be discovered. In addition, due to the turnover in personnel that has resulted from the discovery of these irregularities at ALC, ALC could incur disruptions in its collections area until replacements for certain positions can be filled.
Item 1B.
Item 1B. Unresolved Staff Comments.
None.
Item 2.
Item 2. Properties.
Bancshares, through the Bank, owns all of its offices, including its executive offices, without encumbrances, with the exception of the banking office in Columbiana, office space in Birmingham and parking lot in Brent, which are leased. ALC leases office space throughout Alabama and Southeast Mississippi.
Item 3.
Item 3. Legal Proceedings.
On September 27, 2007, Malcomb Graves Automotive, LLC, Malcomb Graves, and Tina Graves (collectively, “Graves”) filed a lawsuit in the Circuit Court of Shelby County, Alabama against Bancshares, the Bank, ALC, and their respective directors and officers seeking an unspecified amount of compensatory and punitive damages. The complaint alleges that the defendants committed fraud in allegedly misrepresenting to Graves the amounts Graves owed on certain loans and failing to credit Graves properly for certain loans. The defendants deny the allegations and intend to vigorously defend themselves in this action. The defendants are in the process of responding to the complaint, and no discovery has been exchanged between the parties. The defendants have moved to compel arbitration in this matter, but the trial court has not ruled on this motion to date. For this reason, it is too early to assess the likelihood of a resolution of this matter or whether this matter will have a material adverse effect on Bancshares’ financial position or results of operations.
Bancshares and its subsidiaries are parties to other litigation, and Bancshares intends to vigorously defend itself in all such litigation. Although it is not possible to determine at this point in time, in the opinion of management, based on review and consultation with legal counsel, the outcome of such litigation should not have a material adverse effect on Bancshares’ financial condition or results of operations.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders.
None.
PART II
Item 5.
Item 5. Market For Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
Bancshares’ common stock is listed on the Nasdaq Capital Market under the symbol “USBI.” As of March 5, 2008, Bancshares had approximately 899 shareholders of record.
The following table sets forth, for the calendar quarter indicated, the high and low sales prices per share for Bancshares’ common stock as reported on the Nasdaq Capital Market, and the cash dividends declared per share in each such quarter.
The last reported sales price of Bancshares’ common stock as reported on the Nasdaq Capital Market on March 5, 2008, was $18.93.
Dividends are paid at the discretion of Bancshares’ Board of Directors, based on Bancshares’ operating performance and financial position, including earnings, capital and liquidity. Dividends from the Bank are Bancshares’ primary source of funds for the payment of dividends to its shareholders, and there are various legal and regulatory limits regarding the extent to which the Bank may pay dividends or otherwise supply funds to Bancshares. In addition, federal and state regulatory agencies have the authority to prevent Bancshares from paying a dividend to its shareholders. See “Item 1. Business-Supervision and Regulation.”
While Bancshares intends to continue paying dividends, it can make no assurances that it will be able to or be permitted to do so in the future. Bancshares declared a regular dividend of $0.27 per share during the first quarter of 2008, as compared to a regular dividend of $0.26 per share and a special dividend of $0.15 per share during the first quarter of 2007. Bancshares did not declare a special dividend in the first quarter of 2008 due to the losses suffered at ALC in 2007. See Note 14, “Shareholders Equity,” in the “Notes to Consolidated Financial Statements” included in this Annual Report.
The following table sets forth purchases made by or on behalf of Bancshares or any “affiliated purchaser,” as defined in Rule 10b-18(a)(3) of the Exchange Act, of shares of Bancshares’ common stock.
(1) On December 20, 2007, the Board of Directors extended the share repurchase program previously approved by the Board on January 19, 2006. Under the repurchase program, Bancshares is authorized to repurchase up to 642,785 shares of common stock before December 31, 2008, the expiration date of the extended repurchase program.
(2) 100 shares were purchased by a trust, which is part of Bancshares’ general assets, subject to the claims of its creditors, established in connection with the United Security Bancshares, Inc. Non-Employee Directors’ Deferred Compensation Plan, and 22,560 shares were purchased under the share repurchase program.
Item 6.
Item 6. Selected Financial Data.
UNITED SECURITY BANCSHARES, INC. AND SUBSIDIARIES
SELECTED FINANCIAL DATA
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation.
Management’s Discussion and Analysis contains forward-looking statements that involve inherent risks and uncertainties. Actual results may differ materially from those contained in forward-looking statements. For additional information regarding forward-looking statements, see the sections titled “FORWARD-LOOKING STATEMENTS” and “RISK FACTORS.”
Introduction
United Security Bancshares, Inc., a Delaware corporation (“United Security” or the “Company”), is a bank holding company with its principal offices in Thomasville, Alabama. United Security operates one commercial banking subsidiary, First United Security Bank (the “Bank”). At December 31, 2007, the Bank operated nineteen banking offices located in Brent, Bucksville, Butler, Calera, Centreville, Coffeeville, Columbiana, Fulton, Gilbertown, Grove Hill, Harpersville, Jackson, Thomasville, Tuscaloosa, and Woodstock, Alabama. Its market area includes Clarke, Choctaw, Bibb, Shelby, Tuscaloosa and portions of Marengo, Sumter, Washington, Wilcox, Chilton, Hale, Monroe, Perry and Jefferson Counties in Alabama, as well as Clarke, Lauderdale, and Wayne Counties in Mississippi.
United Security is also the parent company of First Security Courier Corporation (“FSCC”), an Alabama corporation. FSCC is a courier service organized to transport items for processing to the Federal Reserve for companies located in Southwest Alabama.
The Bank owns all of the stock of Acceptance Loan Company, Inc. (“ALC”), an Alabama corporation. ALC is a finance company organized for the purpose of making and purchasing consumer loans. ALC has twenty-five offices located in Alabama and Southeast Mississippi. The headquarters of ALC is located in Jackson, Alabama. The Bank is the funding source for ALC.
The Company’s sole business is banking; therefore, loans and investments are its principal sources of income. The Bank contributed approximately $8.9 million to consolidated net income in 2007, while ALC generated a loss of approximately $8.3 million, net of tax. The loss experienced at ALC was due to loan irregularities discovered in 2007. For more information related to these loan irregularities, see the section titled, “Irregularities at Acceptance Loan Company, Inc.” The Bank provides a wide range of commercial banking services to small and medium-sized businesses, real estate developers, property managers, business executives, professionals and other individuals.
FUSB Reinsurance, Inc. (“FUSB Reinsurance”), an Arizona corporation and wholly-owned subsidiary of the Bank, reinsures or “underwrites” credit life and credit accident and health insurance policies sold to the Bank’s and ALC’s consumer loan customers. FUSB Reinsurance is responsible for the first level of risk on these policies up to a specified maximum amount, and a primary third-party insurer retains the remaining risk. The third-party insurer is also responsible for performing most of the administrative functions of FUSB Reinsurance on a contract basis.
R2Metrics, Inc. (“R2Metrics”), an Alabama corporation and wholly-owned subsidiary of the Bank, was incorporated in April 2007. R2Metrics provides investment and asset and liability management software, analytics, and consulting services for the Bank as well as other clients. The company is headquartered in Birmingham, Alabama.
At December 31, 2007, United Security had consolidated assets of $660.0 million, deposits of $478.6 million, and shareholders’ equity of $79.6 million. Total assets increased by $13.6 million, or 2.1%, in 2007. Net income decreased from $14.2 million in 2006 to $349,000 in 2007, primarily due to losses suffered at ALC. Net income per share decreased from $2.24 in 2006 to $0.06 in 2007.
Delivery of the best possible services to customers remains an overall operational focus of the Bank. We recognize that attention to details and responsiveness to customers’ desires are critical to customer satisfaction. The Company continues to employ the most current technology, both in its financial services and in the training of its 283 full-time employees, to ensure customer satisfaction and convenience.
The following discussion and financial information are presented to aid in an understanding of the current financial position and results of operations of United Security, and should be read in conjunction with the Audited Consolidated Financial Statements and Notes thereto included herein. The emphasis of this discussion will be on the years 2007, 2006, and 2005. All yields presented and discussed herein are based on the accrual basis and not on the tax-equivalent basis, unless otherwise indicated.
Forward-Looking Statements
This Annual Report, annual and periodic reports filed by United Security and its subsidiaries under the Securities and Exchange Act of 1934, as amended, and any other written or oral statements made by or on behalf of United Security may include “forward-looking statements,” within the meaning of the Private Securities Litigation Reform Act of 1995, that reflect United Security’s current views with respect to future events and financial performance. Such forward-looking statements are based on general assumptions and are subject to various risks, uncertainties and other factors that may cause actual results to differ materially from the views, beliefs and projections expressed in such statements. These risks, uncertainties and other factors include, but are not limited to:
1. Possible changes in economic and business conditions that may affect the prevailing interest rates, the prevailing rates of inflation, or the amount of growth, stagnation, or recession in the global, U.S., Alabama and Mississippi economies, the value of investments, the collectibility of loans and the ability to retain and grow deposits;
2. Possible changes in monetary and fiscal policies, laws and regulations, and other activities of governments, agencies and similar organizations;
3. The effects of easing of restrictions on participants in the financial services industry, such as banks, securities brokers and dealers, investment companies and finance companies, other potential regulatory changes, and attendant changes in patterns and effects of competition in the financial services industry;
4. The ability of United Security to achieve its expected operating results including the continued growth of the markets in which United Security operates consistent with recent historical experience and United Security’s ability to expand into new markets and to maintain profit margins; and
5. Recently, the residential mortgage market in the United States has experienced a variety of worsening economic conditions that may adversely affect the performance and market value of United Security residential construction and mortgage loans. Across the United States, delinquencies, foreclosures and losses with respect to residential construction and mortgage loans generally have increased in recent months and may continue to increase. In addition, in recent months, housing prices and appraisal values in many states have declined or stopped appreciating; after extended periods of significant appreciation, housing values may remain stagnant or decline in the near term. An extended period of flat or declining housing values may result in increased delinquencies and losses on residential construction and mortgage loans.
In addition, United Security’s business is subject to a number of general and market risks that would affect any forward-looking statements, including the risks discussed under Item 1A herein entitled “Risk Factors.”
The words “believe,” “expect,” “anticipate,” “project,” and similar expressions, signify forward-looking statements. Readers are cautioned not to place undue reliance on any forward-looking statements made by or on behalf of United Security. Any such statements speak only as of the date such statements were made, and United Security undertakes no obligation to update or revise any forward-looking statements.
Irregularities at Acceptance Loan Company, Inc.
As a result of internal procedures of the Company, evidence was discovered during the second quarter of 2007 suggesting irregularities in certain loan transactions within ALC, a subsidiary of the Company. The irregularities have been identified to be primarily related to four out of the twenty-five ALC branches and were largely related to (a) the making of improper or fraudulent loans, (b) techniques used to conceal delinquent loans, (c) the improper or fraudulent handling of repossessed automobiles and (d) the inflation of appraisals on certain real estate collateral. The Company, under the direction of the Audit Committee, has conducted an internal investigation relating to these irregularities with the assistance of outside legal counsel, as well as an outside forensic accounting firm. The internal investigation is substantially complete.
As a result of the investigation, the results of operations for the year ended December 31, 2007, include a charge-off of loans and a write down of real estate collateral values relating to the irregularities of $12.5 million in ALC’s loan and other real estate portfolio. These losses reduced the net income of the Company by $8.3 million, net of tax benefit, or $1.34 per basic and diluted share for the year ended December 31, 2007. The Company believes that it will not need to make any additional loan loss provision related to these irregularities; however, no assurance can be given that any additional loss provision will not be required in the future relating to the irregularities. In addition to these losses, the Company has incurred a substantial amount of legal, accounting and associated expenses relating to the investigation of these irregularities, which expenses are reflected in the Company’s non-interest expense balance for the year ended December 31, 2007. The Company expects to incur additional legal and accounting expenses relating to the irregularities during 2008, although on a smaller scale.
It has been determined that the irregularities were limited to one district of the ALC branch system and were primarily related to four of the branches within that district. The branch managers previously employed at these four branches, the district manager who had been supervising the district in question, and the former CEO of ALC are no longer employed at ALC. Although there is the potential for insurance recovery and recoveries from civil actions, the amounts and timing of such recoveries cannot be estimated at this time. The Company plans to vigorously pursue available avenues of recovery for these losses, including insurance and civil claims.
Since the discovery of the loan irregularities at ALC, internal controls have been revised and additional policies and procedures have been implemented. An in-house internal auditor has been hired by ALC, who reports to the newly formed audit committee. A loan committee was established to help oversee the lending function. With the assistance of the loan committee, the loan policy has been revised and implemented, with continued training a priority.
Critical Accounting Policies and Estimates
The preparation of the Company’s financial statements requires management to make subjective judgments associated with estimates. These estimates are necessary to comply with accounting principles generally accepted in the United States and general banking practices. These areas include accounting for the allowance for loan losses, derivatives, deferred income taxes, and supplemental compensation benefits agreements.
The Company maintains the allowance for loan losses at a level deemed adequate by management to absorb possible losses from loans in the portfolio. In determining the adequacy of the allowance for loan losses, management considers numerous factors, including but not limited to management’s estimate of future economic conditions, the financial condition and liquidity of certain loan customers, and collateral values of property securing certain loans. Because these factors and others involve the use of management’s estimation and judgment, the allowance for loan losses is inherently subject to adjustment at future dates. Unfavorable changes in the factors used by management to determine the adequacy of the allowance, including increased loan delinquencies and subsequent charge-offs, or the availability of new information, could require additional provisions, in excess of normal provisions, to the allowance for loan losses in future periods.
Both fair-value and cash-flow hedges require assumptions related to the impact of changes in interest rates on the fair value of the derivative and the item being hedged. These assumptions are documented at inception to demonstrate effective hedging of the designated risk. If these assumptions do not accurately reflect future changes in the fair value, the Company may be required to discontinue the use of hedge accounting for a derivative. This change in accounting treatment could affect current period earnings.
Management’s determination of the realization of a deferred tax asset is based upon management’s judgment of various future events and uncertainties, including the timing and amount of future income earned by subsidiaries and the implementation of various tax planning strategies to maximize realization of the deferred tax asset. Management believes that the subsidiaries will be able to generate sufficient operating earnings to realize the deferred tax benefits. As management periodically evaluates the ability of the Bank to realize the deferred tax asset, subjective judgments are made that may impact the resulting provision for income tax.
The Company and the Bank have entered into supplemental compensation benefits agreements with the directors and certain executive officers. The measurement of the liability under the agreements includes estimates involving life expectancy, length of time before retirement and the expected returns on the Bank-owned life insurance policies used to fund the agreements. Should these estimates prove materially wrong, the cost of the agreements could change accordingly.
Summary of Operating Results
Net Interest Income
Net interest income is an effective measurement of how well management has matched interest-earning assets and interest-bearing liabilities and is the Company’s principal source of income. Fluctuations in interest rates materially affect net interest income.
Net interest income declined 6.3% to $40.5 million in 2007, compared to an increase of 5.8% and 4.6% in 2006 and 2005, respectively. The decline in net interest income in 2007 is due to a decline in non-interest and lower interest-bearing deposits as compared to higher interest-bearing deposits. Demand deposits, savings, and money market volume decreased by 4.6%, while certificates of deposit increased 18.6%.
The Company’s loan portfolio declined by $14.0 million, or 3.2%, during 2007. However, taxable investments increased by $24.8 million, or 20.7%.
Overall, volume, rate and yield changes in interest-earning assets and interest-bearing liabilities contributed to the decline in net interest income. The Company’s average earning assets increased $22.2 million, or 3.8%, while average interest-bearing liabilities increased $32.7 million, or 7.1%. Thus, growth of average interest-bearing liabilities outpaced growth in average earning assets by $10.6 million during 2007.
The Bank’s ability to produce net interest income is measured by a ratio called the interest margin. The interest margin is net interest income as a percent of average earning assets. The interest margin was 6.7% in 2007, 7.5% in 2006, and 7.4% in 2005.
Interest margins are affected by several factors, one of which is the relationship of rate-sensitive earning assets to rate-sensitive interest-bearing liabilities. This factor determines the effect that fluctuating interest rates will have on net interest income. Rate-sensitive earning assets and interest-bearing liabilities are those which can be repriced to current market rates within a relatively short time. The Bank’s objective in managing interest rate sensitivity is to achieve reasonable stability in the interest margin throughout interest rate cycles by maintaining the proper balance of rate-sensitive assets and interest-bearing liabilities. For further analysis and discussion of interest rate sensitivity, refer to the section entitled, “Liquidity and Interest Rate Sensitivity Management.”
An additional factor that affects the interest margin is the interest rate spread. The interest rate spread measures the difference between the average yield on interest-earning assets and the average rate paid on interest-bearing liabilities. This measurement is a more accurate reflection of the effect market interest rate movements have on interest rate-sensitive assets and liabilities. The interest rate spread was 6.1% in 2007, 6.8% in 2006, and 6.9% in 2005. The average amount of interest-bearing liabilities as noted in the table, “Yields Earned on Average Interest-Earning Assets and Rates Paid on Average Interest-Bearing Liabilities,” increased 7.1% in 2007, while the average rate of interest paid increased from 3.6% in 2006 to 3.9% in 2007. Average interest-earning assets increased 3.8% in 2007, while the average yield on earning assets decreased from 10.2% in 2006 to 10.0% in 2007.
The percentage of earning assets funded by interest-bearing liabilities also affects the Bank’s interest margin. The Bank’s earning assets are funded by interest-bearing liabilities, non-interest-bearing demand deposits, and shareholders’ equity. The net return on earning assets funded by non-interest-bearing demand deposits and shareholders’ equity exceeds the net return on earning assets funded by interest-bearing liabilities. The Bank maintains a relatively consistent percentage of earning assets funded by interest-bearing liabilities. In 2007, 82.6% of the Bank’s average earning assets were funded by interest-bearing liabilities as opposed to 80.1% in 2006 and 80.9% in 2005.
Yields Earned on Average Interest-Earning Assets and Rates Paid on Average Interest-Bearing Liabilities
Note A - For the purpose of these computations, non-accruing loans are included in the average loan amounts outstanding. These loans amounted to $5,555,400, $6,858,270, and $5,662,303 for 2007, 2006, and 2005, respectively.
Note B - Loan fees of $3,837,409, $3,496,765, and $3,205,322 for 2007, 2006, and 2005, respectively, are included in interest income amounts above.
Changes in Interest Earned and Interest Expense Resulting from Changes in Volume and Changes in Rates
The following table sets forth the effect which varying levels of interest-earning assets and interest-bearing liabilities and the applicable rates had on changes in net interest income for 2007 versus 2006, 2006 versus 2005 and 2005 versus 2004.
Provision for Loan Losses
The provision for loan losses is an expense used to establish the allowance for loan losses. Actual loan losses, net of recoveries, are charged directly to the allowance. The expense recorded each year is a reflection of actual net losses experienced during the year and management’s judgment as to the adequacy of the allowance to absorb losses inherent to the portfolio. Charge-offs exceeded recoveries by $20.3 million during the year, and a provision of $21.2 million was expensed for loan losses in 2007, compared to $3.7 million in 2006 and $3.9 million in 2005. Net charge-offs at the Bank were $1.6 million as of December 31, 2007, and $0.7 million at December 31, 2006. ALC had net charge-offs of $18.7 million at December 31, 2007, compared to $3.1 million at December 31, 2006. The large increase in net charge-offs and the provision for loan losses are both attributable to losses sustained as a result of the loan irregularities at ALC. See the section titled, “Irregularities at Acceptance Loan Company, Inc.” Net charge-offs as a percentage of average loans were 4.53%, 0.85%, 0.77%, and 0.90% for the years ended December 31, 2007, 2006, 2005, and 2004, respectively.
The ratio of the allowance to loans net of unearned income at December 31, 2007, was 1.96%. For additional information regarding the Company’s allowance for loan losses, see “Loans and Allowance for Loan Loss.”
Non-Interest Income
The following table presents the major components of non-interest income for the years indicated.
Total non-interest income decreased $55,000, or 1.0% in 2007. This compares to an increase of 6.5% in 2006 and a decrease of 8.3% in 2005. One factor contributing to the decrease in 2007 was a $126,000, or 15.3%, decline in credit insurance commissions and fees, which are generated through the Bank’s subsidiary, FUSB Reinsurance. The reason for the decline is due to a decrease in demand and the retirement of the Bank’s top producers of this product. Efforts are being made to stimulate sales of credit insurance at the Bank.
Non-recurring items of non-interest income include securities gains and losses. Net losses resulting from securities sold amounted to $2,000 in 2007, and $37,000 in 2005. No gains or losses were recognized in 2006. In 2007 the Bank recognized an impairment write-down of $105,000 related to the investment in a preferred stock. Income generated in the area of securities gains and losses is dependent on factors that include investment portfolio strategies, interest rate changes and the short, intermediate, and long-term outlook for the economy.
Service charges and other fees on deposit accounts increased $133,000, or 4.2%, during 2007, compared to a 7.0% increase in 2006 and a decrease of 9.7% in 2005. The 2007 increase is due to increases in customer overdrafts and accounts with non-sufficient funds.
Earnings from the Company’s bank-owned life insurance policies increased $33,000, or 7.4%, during 2007, compared to an increase of 5.7% in 2006 and 13.2% in 2005. These policies were established in 2002 to assist in funding the Bank’s supplemental compensation benefit agreements with directors and certain executive officers.
Other income includes fee income generated from other banking services such as letters of credit, ATM’s, debit and credit cards, check cashing, and wire transfers. Other income increased $12,000, or 1.0%, in 2007, compared to an increase of 1.7% in 2006 and a decrease of 3.4% in 2005.
Non-Interest Expense
The following table presents the major components of non-interest expense for the years indicated.
Non-interest expense increased $2.0 million, or 8.5%, to $25.8 million in 2007, from $23.8 million in 2006. Non-interest expense increased 3.1% in 2006 and 4.6% in 2005. The increase in 2007 is largely due to a $1.4 million increase in the legal and accounting expenses incurred due to the ALC loan irregularities. The legal and accounting expense increase represents 71.4% of the total non-interest expense increase. However, even with the increase, the ratio of non-interest expense to average assets remained stable during 2007 at 3.9%, compared to 3.7% in 2006 and 3.8% in 2005.
Total compensation and benefits decreased $918,000, or 6.4%, in 2007, compared to an increase of 2.0% in 2006 and 9.1% in 2005. The decrease in 2007 is due mainly to decreased incentive awards and officer retirements. Incentive awards declined to $928,000, a 49.1% decrease, from $1.9 million in 2006, because the Bank failed to meet all of its performance objectives, and no incentives were awarded to ALC personnel for 2007. The Bank also experienced the retirement of four long-term officers during the first half of 2007. These officers were primarily replaced by promotions from within the Bank’s staff. The Bank’s health insurance plan increased 8.6%, to $1.0 million, and was offset by a 2.2% decrease in the Company’s sponsored employee stock ownership plan with 401(k) provisions. At December 31, 2007, and 2006, the Company had 286 full-time equivalent employees compared to 282 in 2005.
Occupancy expense increased over the past three years due to continued branch expansion by the Bank, branch renovations, and the effects of inflation on routine expenditures. Occupancy expense includes rents, depreciation, utilities, maintenance, insurance, taxes and other expenses associated with maintaining the nineteen banking offices and twenty-five ALC finance company offices. The Company utilizes both acquired and leased space in operating these locations. The Bank owns all of its banking offices with the exception of the Columbiana office, which is leased. Seven of the Bank’s branch offices were renovated or had some major repairs in 2007. All ALC offices are leased (costs associated with operating lease agreements can be reviewed in detail in Note 17, “Operating Leases,” in the “Notes to Consolidated Financial Statements” included in this Annual Report). Occupancy expense increased by 14.6%, 9.3%, and 3.6% for each of the years ended December 31, 2007, 2006, and 2005, respectively.
Furniture and equipment expense increased 2.4% in 2007, compared to 1.9% in 2006, and decreased 2.4% in 2005.
The Bank invests in limited partnerships that operate qualified affordable housing projects. These partnerships receive tax benefits in the form of tax deductions from operating losses and tax credits. Although the Bank accounts for these investments utilizing the cost method, management analyzes the Bank’s investments in limited partnerships for potential impairment on an annual basis. The investment balances in these partnerships were $2.0 million at December 31, 2007 and 2006, and $2.2 million in 2005. Losses in these investments amounted to $109,000, $240,000, and $357,000 for 2007, 2006, and 2005, respectively.
Provision for Income Taxes
The Company recorded an income tax benefit of $1,219,829 during the year ended December 31, 2007, as compared to an income tax expense of $7,095,281 and $5,579,032 for the years ending December 31, 2006 and 2005, respectively. The income tax benefit recorded during 2007 resulted from significant loan losses and related expenses recorded by ALC. The effective tax rate for 2007 was also affected by the amount of nontaxable income and low income housing tax credits recorded in 2007 as compared to 2006 and 2005. Management projects that the effective income rate in the near future will be approximately 33% of pre-tax income. The calculation of the income tax provision requires the use of estimates and judgments of management. As part of the Company’s overall business strategy, management must take into account tax law and regulations that apply to specific tax issues faced by the Company in each year. This analysis includes an evaluation of the amount and timing of the realization of income tax assets or liabilities. Management closely monitors tax developments and evaluates the effect they may have on the Company’s overall tax position. A more detailed discussion of the Company’s provision for income taxes is included in Note 11, “Income Taxes,” in the “Notes to Consolidated Financial Statements.”
Loans and Allowance for Loan Loss
Total loans outstanding decreased by $13.1 million in 2007 with a loan portfolio totaling $436.1 million as of December 31, 2007. For 2007, on an average basis, loans represent 74.8% of the Company’s earning assets and provide 87.2% of the Company’s interest income.
Real estate loans increased 2.5% to $319.7 million in 2007. The Company’s real estate loan portfolio is comprised of construction loans to both businesses and individuals for commercial and residential development, commercial buildings and apartment complexes, with most of this activity being commercial. Real estate loans also consist of other loans secured by real estate, such as one-to-four family dwellings, including mobile homes, loans on land only, multi-family dwellings, non-farm, non-residential real estate and home equity loans. As in previous years, quality real estate lending continues to be a priority of the Company’s lending team and management. Real estate loans remain the largest component of the Company’s loan portfolio comprising 73.3% of total loans outstanding.
Consumer loans represent the second largest component of the Company’s loan portfolio. These loans include loans to individuals for household, family, and other personal expenditures, including credit cards and other related credit plans. Consumer loans at December 31, 2007, totaled $82.5 million, compared to $109.6 million the prior year. This represents a 24.8% decline. Consumer loans at ALC declined $20.1 million, representing 74.0% of the total decline. The decline at ALC resulted from increased charge-offs as a result of the loan irregularities which occurred in the northern district of ALC. Tighter underwriting standards and enhanced controls put in place as a result of the irregularities also contributed to the decline in consumer loans at ALC.
Commercial, financial and agricultural loans increased by 16.4% during 2007 to $40.6 million at December 31, 2007. The majority of this growth was in tax-exempt loans to municipalities and counties, which increased $3.5 million over year-end 2006.
The allowance for loan losses is maintained at a level, which, in management’s judgment, is adequate to absorb credit losses inherent in the loan portfolio. The amount of the allowance is based on management’s
evaluation of the collectibility of the loan portfolio, including the nature of the portfolio and changes in its risk profile, credit concentrations, historical trends, and economic conditions. This evaluation also considers the balance of impaired loans. Losses on individually identified impaired loans are measured based on the present value of expected future cash flows discounted at each loan’s original effective market interest rate. As a practical expedient, impairment may be measured based on the loan’s observable market price or the fair value of the collateral if the loan is collateral dependent. When the measure of the impaired loan is less than the recorded investment in the loan, the impairment is recorded through the provision added to the allowance for loan losses. Large pools of smaller balance, homogeneous loans are subjected to a collective evaluation for impairment, considering delinquency and repossession statistics, historical loss experience, and other factors. Though management believes the allowance for loan losses to be adequate, taking into consideration the views of regulators and the current economic environment, there can be no assurance that the allowance for loan losses is sufficient and ultimate losses may vary from their estimates. However, estimates are reviewed periodically, and as adjustments become necessary, they are reported in earnings during periods they become known.
The Bank’s loan policy requires immediate recognition of a loss if significant doubt exists as to the repayment of the principal balance of a loan. Consumer installment loans at the Bank and ALC are generally recognized as losses if they become 120 days delinquent. Exceptions are made particularly in loans that are secured by real estate and the borrower is in a repayment plan under the bankruptcy statutes. As long as these loans are paying in accordance with the bankruptcy plan, they are not charged-off.
A credit review of the Bank’s individual loans is conducted periodically by branch and by loan officer. A risk rating is assigned to each loan and is reviewed at least annually. In assigning risk, management takes into consideration the capacity of the borrower to repay, collateral values, current economic conditions and other factors. Management also monitors the credit quality of the loan portfolio through the use of an outside comprehensive loan review.
Loan officers and other personnel handling loan transactions undergo frequent training dedicated to improving the credit quality as well as the yield of the loan portfolio. The Bank utilizes a written loan policy, which attempts to guide lending personnel in applying consistent underwriting standards. This policy is intended to aid loan officers and lending personnel in making sound credit decisions and to assure compliance with state and federal regulations. The Bank’s loan policy is reviewed, at a minimum, on an annual basis to ensure timely modifications to the Bank’s lending standards.
ALC’s management oversees its loan portfolio through a loan committee, comprised of members of ALC’s Board of Directors and ALC’s district and office managers. It is aided by a formal loan policy, which has been revised and expanded as a direct result of the loan irregularities that occurred in the northern district of ALC. Other changes in ALC’s organizational structure were made during 2007 to increase the number of personnel supervising ALC’s operations. A new position of Chief Operating Officer (“COO”), who will report to the Chief Executive Officer of ALC, was created. At the present time, management is evaluating applicants for this important position and expects to fill it soon. The individual twenty-five branches are supervised by three district managers, who will report to the ALC COO.
The following table shows the Company’s loan distribution as of December 31, 2007, 2006, 2005, 2004, and 2003.
The amounts of total loans (excluding installment loans) outstanding at December 31, 2007, which, based on the remaining scheduled repayments of principal, are due in (1) one year or less, (2) more than one year but within five years, and (3) more than five years, are shown in the following table.
Variable rate loans totaled approximately $81.5 million and are included in the one-year category.
Non-Performing Assets
Accruing loans past due 90 days or more at December 31, 2007, totaled $5.2 million. These loans are secured, and, taking into consideration the collateral value and the financial strength of the borrowers, management believes there will be no loss in these accounts and has allowed the loans to continue accruing.
Impaired loans totaled $15.7 million, $7.3 million, and $5.7 million as of December 31, 2007, 2006, and 2005, respectively. Impaired loans at December 31, 2007, consist mainly of ten commercial real estate loans and one commercial loan. Based on management’s analysis, these loans are considered impaired based on current collateral values. There was approximately $1,624,648, $847,676 and $816,283 in the allowance for loan losses specifically allocated to these impaired loans at December 31, 2007, 2006, and 2005, respectively. The average recorded investment in impaired loans for 2007, 2006, and 2005 was approximately $8.8 million, $6.9 million, and $2.5 million, respectively.
Non-performing assets as a percentage of net loans and other real estate was 4.8% at December 31, 2007, compared to 2.4% at December 31, 2006. This increase is due to an increase in real estate acquired in settlement of loans of $9.8 million and loans past due 90 days or more of $3.2 million, which are offset by a decrease of $2.1 million in loans on non-accrual. Other real estate acquired as of December 31, 2007, consists of eight residential properties and eight commercial properties totaling $6.7 million at the Bank and eighty-three residential properties totaling $4.5 million at ALC. The increase at the Bank is due mainly to two large commercial properties totaling $4.8 million. The increase at ALC is a result of the loan irregularities which occurred in the northern district of ALC and the adverse impact of the housing slowdown on this portion of the loan portfolio. Management is making considerable efforts to dispose of these properties in a timely manner, but the apparent slowdown in the housing market will have a negative impact on this process. Management
believes by closely monitoring these loans, and through aggressive collection efforts, non-performing assets can be reduced. Management reviews these loans and reports to the Board of Directors monthly. Loans past due 90 days or more and still accruing are reviewed closely by management and are allowed to continue accruing only when underlying collateral values and management’s belief that the financial strength of the borrowers are sufficient to protect the Bank from loss. If at any time management determines there may be a loss of interest or principal, these loans will be changed to non-accrual and their asset values downgraded.
The following table presents information on non-performing loans and real estate acquired in settlement of loans.
Summarized below is information concerning income on those loans with deferred interest or principal payments resulting from deterioration in the financial condition of the borrower.
Accrual of interest is discontinued on a loan when management believes, after considering economic and business conditions and collection efforts, the borrower’s financial condition is such that collection of interest is doubtful. In addition to consideration of these factors, the Company has a consistent and continuing policy of placing all loans on non-accrual status if they become 90 days or more past due, unless they are in the process of collection. When a loan is placed on non-accrual status, all interest which is accrued on the loan is reversed and deducted from earnings as a reduction of reported interest. No additional interest is accrued on the loan balance until collection of both principal and interest becomes reasonably certain. When a problem loan is finally resolved, there ultimately may be an actual write down or charge-off of the principal balance of the loan which would necessitate additional charges to the allowance for loan losses.
Allocation of Allowance for Loan Losses
The following table shows an allocation of the allowance for loan losses for each of the five years indicated.
In establishing the allowance for loan losses, management created the following risk groups for evaluating the loan portfolio:
•
Large classified loans and impaired loans are evaluated individually with specific reserves allocated based on management’s review, consistent with FAS 114. As a result of the loan irregularities at ALC, management identified a group of smaller-balance consumer loans which were evaluated for impairment under FAS 114.
•
The allowance for large pools of smaller-balance, homogeneous loans is based on such factors as changes in the nature and volume of the portfolio, overall portfolio quality, adequacy of the underlying collateral value, loan concentrations, historical charge-off trends, and economic conditions that may affect the borrowers’ ability to pay, consistent with FAS 5.
Net charge-offs as shown in the “Summary of Loan Loss Experience” table below indicate the trend for the last five years.
Summary of Loan Loss Experience
This table summarizes the Bank’s loan loss experience for each of the five years indicated.
Investment Securities Available-for-Sale and Derivative Instruments
Investment securities, which are classified as available-for-sale, include, as of December 31, 2007, U.S. Treasury securities of $120,140, obligations of U.S. government sponsored agency securities of $5.4 million, mortgage-backed securities of $121.7 million, state, county, and municipal securities of $16.6 million, and other securities of $742,957. The securities portfolio is carried at fair market value, and increased $24.8 million from December 31, 2006, to December 31, 2007.
Because of their liquidity, credit quality and yield characteristics, the majority of the purchases of taxable securities have been purchases of agency guaranteed mortgage-backed obligations and collateralized mortgage obligations (“CMOs”). The mortgage-backed obligations in which the Bank invests represent an undivided interest in a pool of residential mortgages or may be collateralized by a pool of residential mortgages (“mortgage-backed securities”).
Mortgage-backed securities and CMOs present some degree of additional risk in that mortgages collateralizing these securities can be refinanced, thereby affecting the future yield and market value of the portfolio. Management expects the annual repayment of the underlying mortgages to vary as a result of monthly repayment of principal and/or interest required under terms of the underlying promissory notes. Further, the actual rate of repayment is subject to changes depending upon the terms of the underlying mortgages, the relative level of mortgage interest rates, and the structure of the securities. When relative interest rates decline to levels below that of the underlying mortgages, acceleration of principal repayment is expected as some borrowers on the underlying mortgages refinance to lower rates. When the underlying rates on mortgage loans are comparable to, or in excess of, market rates, repayment more closely conforms to scheduled amortization in accordance with terms of the promissory note with additional repayment as a result of sales of homes collateralizing the mortgage loans constituting the security. Although maturities of the underlying mortgage loans may range up to 30 years, scheduled principal and normal prepayments substantially shorten the average maturities.
Interest rate risk contained in the overall securities portfolio is formally monitored on a monthly basis. Management assesses each month how risk levels in the investment portfolio affect overall company-wide interest rate risk. Expected changes in forecasted yield, earnings, and market value of the bond portfolio are generally attributable to fluctuations in interest rates, as well as volatility caused by general uncertainty over the economy, inflation, and future interest rate trends.
The composition of the Bank’s investment portfolio reflects the Bank’s investment strategy of maximizing portfolio yields commensurate with risk and liquidity considerations. The primary objectives of the Bank’s investment strategy are to maintain an appropriate level of liquidity and provide a tool to assist in controlling the Bank’s interest rate position while at the same time producing adequate levels of interest income. As of December 31, 2007, the investment portfolio had an estimated average maturity of 3.4 years.
Fair market values of securities can vary significantly as interest rates change. The gross unrealized gains and losses in the securities portfolio are not expected to have a material impact on liquidity or other funding needs. There were net unrealized gains, net of tax, of $867,500 in the securities portfolio on December 31, 2007, versus $410,000 net unrealized losses, net of tax at year-end 2006.
The Bank has used certain derivative products for hedging purposes. These include interest rate swaps and caps. The use and detail regarding these products are fully discussed in the section entitled “Liquidity and Interest Rate Sensitivity Management” and in Note 2, “Summary of Significant Accounting Policies,” in the “Notes to Consolidated Financial Statements” included in this Annual Report. The Bank adopted the provisions of Statement of Financial Accounting Standards No. 133, as amended (“FASB 133”), effective January 1, 2001, as required by the Financial Accounting Standards Board. On that date, the Bank reassessed and designated derivative instruments used for risk management as fair-value hedges, cash-flow hedges and derivatives not qualifying for hedge accounting treatment, as appropriate.
Investment Securities Available-for-Sale
The following table sets forth the amortized costs of investment securities, as well as their fair value and related unrealized gains or losses on the dates indicated.
Investment Securities Available-for-Sale Maturity Schedule
Available-for-sale securities are stated at market value and tax equivalent market yields.
Condensed Portfolio Maturity Schedule
The following marketable equity securities have been excluded from the above maturity summary due to no stated maturity date.
Condensed Portfolio Repricing Schedule
The tables above reflect all securities at market value on December 31, 2007.
Security Gains and Losses
Non-interest income from securities transactions was a loss for years ended December 31, 2007, 2006, and 2005. Transactions affecting the Bank’s investment portfolio are directed by the Bank’s asset and liability management activities and strategies. Although short-term losses may occur from time to time, the “pruning” of the portfolio is designed to maintain the strength of the investment portfolio.
The table below shows the associated net losses for the periods 2007, 2006, and 2005.
Volumes of sales, as well as other information regarding investment securities is discussed further in Note 3, “Investment Securities,” in the “Notes to Consolidated Financial Statements” included in this Annual Report.
Deposits
Core deposits, which exclude time deposits of $100,000 or more, provide for a relatively stable funding source that supports earning assets. The Company’s core deposits totaled $366.3 million, or 76.5%, of total deposits at December 31, 2007, and totaled $340.9 million, or 75.7%, of total deposits at December 31, 2006.
Deposits, in particular core deposits, have historically been the Company’s primary source of funding and have enabled the Company to successfully meet both short-term and long-term liquidity needs. Management anticipates that such deposits will continue to be the Company’s primary source of funding in the future, although economic and competitive factors could affect this funding source. The Company’s loan-to-deposit ratio was 89.3% at December 31, 2007, and 98.1% at the end of 2006.
Time deposits in excess of $100,000 grew 2.8% to $112.2 million as of December 31, 2007. Included in these large deposits are $20.9 million in brokered certificates of deposits at year-end 2007, compared with $24.8 million at year-end 2006. Management has used brokered deposits as a funding source when rates and terms are more attractive than other funding sources.
The sensitivity of the Bank’s deposit rates to changes in market interest rates is reflected in its average interest rate paid on interest-bearing deposits. During 2007, market interest rates increased, attributable to the movement toward higher yielding time deposits.
Management, as part of an overall program to emphasize the growth of transaction accounts, continues to promote online banking and an online bill paying program, as well as enhancing the telephone-banking product through the use of the employee incentive plan to reward personnel. In addition, continued effort is being placed on deposit promotions, direct-mail campaigns and cross-selling efforts.
Average Daily Amount of Deposits and Rates
The average daily amount of deposits and rates paid on such deposits are summarized for the periods in the following table.
Maturities of time certificates of deposit and other time deposits of $100,000 or more outstanding at December 31, 2007, are summarized as follows:
Other Borrowings
Other interest-bearing liabilities consist of federal funds purchased, securities sold under agreements to repurchase, treasury, tax and loan deposits, and Federal Home Loan Bank (“FHLB”) advances. This category continues to be utilized as an alternative source of funds. During 2007, the average other interest-bearing liabilities represented 16.5% of the average total interest-bearing liabilities compared to 18.7% in 2006 and 20.6% in 2005. The advances from the FHLB are an alternative to funding sources with similar maturities such as certificates of deposit. These advances generally offer more attractive rates when compared to other mid-term financing options. Average federal funds purchased decreased from $953,000 in 2006 to $14,000 in 2007. Average treasury, tax, and loan deposits increased from $629,000 in 2006 to $727,000 in 2007. Securities sold under agreements to repurchase averaged $17,903 in 2006, and $230,000 in 2007. For additional information and discussion of these borrowings, refer to Notes 9 and 10, “Short-Term Borrowings” and “Long-Term Debt,” respectively, in the “Notes to Consolidated Financial Statements” included in this Annual Report.
The following table shows information for the last three years regarding the Bank’s short- and long-term borrowings consisting of treasury, tax, and loan deposits, federal funds purchases, securities sold under agreements to repurchase, and other borrowings from the FHLB.
Shareholders’ Equity
United Security has always placed great emphasis on maintaining its strong capital base. At December 31, 2007, shareholders’ equity totaled $79.6 million, or 12.1% of total assets, compared to 14.2% and 14.1% for year-end 2006 and 2005, respectively. This level of equity indicates to United Security’s shareholders, customers and regulators that United Security is financially sound and offers the ability to sustain an appropriate degree of leverage to provide a desirable level of profitability and growth.
Over the last three years, shareholders’ equity declined from $81.9 million at the beginning of 2005 to $79.6 million at the end of 2007. This reduction is the result of several factors. First, internally retained earnings were dramatically impaired by the losses sustained by ALC due to loan irregularities. Despite the reduction in retained earnings, the Company continued its dividend program in 2007. Additionally, the stock repurchase plan continued throughout 2007. Shareholder’s equity also was impacted by the net change in unrealized gain (loss) on securities available-for-sale and derivatives, net of tax, which decreased shareholder’s equity by $1.3 million in 2005, but increased shareholder’s equity by $109,817 and $1.2 million in 2006 and 2007, respectively.
In connection with the United Security Bancshares, Inc. Non-Employee Directors’ Deferred Compensation Plan, 2,608 shares were purchased in 2007 and 2,450 shares were purchased in 2006. The plan permits non-employee directors to invest their directors’ fees and to receive the adjusted value of the deferred amounts in cash and/or shares of United Security common stock. For more information related to this plan see Note 13, “Long-Term Incentive Compensation Plan,” in the “Notes to Consolidated Financial Statements” included in this Annual Report.
United Security initiated a share repurchase program in 2001 in which it authorized the Company to repurchase up to 1,429,204 shares of common stock (as adjusted for the two-for-one stock split that was effective June 30, 2003); however, no shares were repurchased under the program in 2003, 2004, or 2005. In January 2006, the Board of Directors terminated the repurchase program (which would have expired on June 30, 2006) and approved a new repurchase program, under which the Company was authorized to repurchase up to 642,785 shares of common stock before December 31, 2007. In December 2007 the Board of Directors extended the expiration date of the existing share repurchase program to December 31, 2008. During 2007, 219,052 shares were repurchased under this program for $5.7 million, while 118,547 shares were purchased in 2006 for $3.3 million.
Total cash dividends declared were $7.3 million, or $1.19, per share in 2007, compared to $1.07 per share in 2006 and $0.95 per share in 2005. The continuation of the strong dividend program in 2007, despite the losses at ALC, demonstrates the continued confidence the Board of Directors has in the Company. Calendar year 2007 is the nineteenth consecutive year that United Security has increased cash dividends.
United Security is required to comply with capital adequacy standards established by the Federal Reserve and the Federal Deposit Insurance Corporation. Currently, there are two basic measures of capital adequacy: a risk-based measure and a leverage measure. The risk-based capital standards are designed to make regulatory capital requirements more sensitive to differences in risk profile among banks and bank holding companies, to account for off-balance sheet exposure, and to minimize disincentives for holding liquid assets. Assets and off-balance sheet items are assigned to risk categories, each with a specified risk weight factor. The resulting capital ratios represent capital as a percentage of total risk-weighted assets and off-balance sheet items. The banking regulatory agencies also have adopted regulations which supplement the risk-based guidelines to include a minimum leverage ratio of 3% of Tier 1 Capital (as defined below) to total assets less goodwill (the “leverage ratio”). Depending upon the risk profile of the institution and other factors, the regulatory agencies may require a leverage ratio of 1% or 2% higher than the minimum 3% level.
The minimum standard for the ratio of total capital to risk-weighted assets is 8%. At least 50% of that capital level must consist of common equity, undivided profits, and non-cumulative perpetual preferred stock, less goodwill and certain other intangibles (“Tier 1 Capital”). The remainder (“Tier II Capital”) may consist of a limited amount of other preferred stock, mandatory convertible securities, subordinated debt, and a limited amount of the allowance for loan losses. The sum of Tier 1 Capital and Tier II Capital is “total risk-based capital.”
Risk-Based Capital Requirements
In addition to meeting the minimum regulatory ratios, the regulatory ratios of the Bank exceeded the ratios required for well-capitalized banks as defined by federal banking regulators. To be categorized as well-capitalized, the Bank must maintain Total Qualifying Capital, Tier I Capital and leverage ratios of at least 8%, 4%, and 3%, respectively.
Ratio Analysis
The following table presents operating and equity performance ratios for each of the last three years.
Liquidity and Interest Rate Sensitivity Management
The primary functions of asset and liability management are to (1) assure adequate liquidity, (2) maintain an appropriate balance between interest-sensitive assets and interest-sensitive liabilities, (3) maximize the profit of the Bank and (4) reduce risks to the Bank’s capital. Liquidity management involves the ability to meet day-to-day cash flow requirements of the Bank’s customers, whether they are depositors wishing to withdraw funds or borrowers requiring funds to meet their credit needs. Without proper liquidity management, the Bank would not be able to perform the primary function of a financial intermediary and would, therefore, not be able to meet the needs of the communities it serves. Interest rate risk management focuses on the maturity structure of assets and liabilities and their repricing characteristics during changes in market interest rates. Effective interest rate sensitivity management ensures that both assets and liabilities respond to changes in interest rates within an acceptable time frame, thereby minimizing the effect of such interest rate movements on the net interest margin.
The asset portion of the balance sheet provides liquidity primarily from two sources. These are principal payments, maturities, and sales relating to loans and maturities and principal payments from the investment portfolio. Other short-term investments such as federal funds sold are additional sources of liquidity. Loans maturing or repricing in one year or less amounted to $204.8 million at December 31, 2007.
Investment securities that are forecast to mature or reprice over the next twelve months total $9.6 million, or 6.7% of the investment portfolio as of December 31, 2007. For comparison, principal payments on investment securities totaled $31.0 million in 2007.
Although the majority of the securities portfolio has legal final maturities longer than 10 years, the entire portfolio consists of securities that are readily marketable and easily convertible into cash. As of December 31, 2007, the bond portfolio had an expected average maturity of 3.4 years, and only approximately 75.1% of the $144.8 million in bonds were expected to be repaid within 5 years. However, management does not rely solely upon the investment portfolio to generate cash flows to fund loans, capital expenditures, dividends, debt repayment, and other cash requirements. Instead, these activities are funded by cash flows from operating activities and increases in deposits and short-term borrowings.
The liability portion of the balance sheet provides liquidity through interest-bearing and non-interest- bearing deposit accounts. Federal funds purchased, FHLB advances, securities sold under agreements to repurchase, and short-term and long-term borrowings are additional sources of liquidity. Liquidity management involves the continual monitoring of the sources and uses of funds to maintain an acceptable cash position. Long-term liquidity management focuses on considerations related to the total balance sheet structure.
The Bank, at December 31, 2007, had long-term debt and short-term borrowings that, on average, represented 12.3% of total liabilities and equity, compared to 13.7% at year-end 2006.
The Bank currently has up to $110.1 million in additional borrowing capacity from the FHLB and $25.0 million in established federal funds lines.
Interest rate sensitivity is a function of the repricing characteristics of the portfolio of assets and liabilities. These repricing characteristics are the time frames during which the interest-bearing assets and liabilities are subject to changes in interest rates, either at replacement or maturity, during the life of the instruments. Sensitivity is measured as the difference between the volume of assets and the volume of liabilities in the current portfolio that are subject to repricing in future time periods. These differences are known as interest sensitivity gaps and are usually calculated for segments of time and on a cumulative basis.
Measuring Interest Rate Sensitivity: Gap analysis is a technique used to measure interest rate sensitivity at a particular point in time, an example of which is presented below. Assets and liabilities are placed in gap intervals based on their repricing dates. Assets and liabilities for which no specific repricing dates exist are placed in gap intervals based on management’s judgment concerning their most likely repricing behaviors. Interest rate derivatives used in interest rate sensitivity management also are included in the applicable gap intervals.
A net gap for each time period is calculated by subtracting the liabilities repricing in that interval from the assets repricing. A positive gap - more assets repricing than liabilities - will benefit net interest income if rates are rising and will detract from net interest income in a falling rate environment. Conversely, a negative gap - more liabilities repricing than assets - will benefit net interest income in a declining interest rate environment and will detract from net interest income in a rising interest rate environment.
Gap analysis is the simplest representation of the Bank’s interest rate sensitivity. However, it cannot reveal the impact of factors such as administered rates, pricing strategies on consumer and business deposits, changes in balance sheet mix, or the effect of various options embedded in balance sheet instruments.
The accompanying table shows the Bank’s interest rate sensitive position at December 31, 2007, as measured by gap analysis. Over the next 12 months approximately $98.1 million more interest-bearing liabilities than interest-earning assets can be repriced to current market rates at least once. This analysis indicated that the Bank has a negative gap within the next 12-month range.
Maturity and Repricing Report
Assessing Short-Term Interest Rate Risk - Net Interest Margin Simulation
On a monthly basis, the Bank simulates how changes in short- and long-term interest rates will impact future profitability as reflected by changes in the Bank’s net interest margin. The tables below depict how, as of December 31, 2007, pre-tax net interest margins and pre-tax net income are forecast to change over time frames of six months, one year, two years, and five years under the four listed interest rate scenarios. The interest rate scenarios are immediate and parallel shifts in short- and long-term interest rates.
Assessing Long-Term Interest Rate Risk - Market Value of Equity and Estimating Modified Durations for Assets and Liabilities
On a monthly basis, the Bank calculates how changes in interest rates would impact the market value of its assets and liabilities, as well as changes in long-term profitability. The process is similar to assessing short-term risk but is measured over a five-year time period which allows for a more comprehensive assessment of longer-term repricing and cash flow imbalances that may not be captured by short-term net interest margin simulation. The results of these calculations are representative of long-term interest rate risk, both in terms of changes in the present value of the Bank’s assets and liabilities, as well as long-term changes in core profitability.
Market Value of Equity and Estimated Modified Duration of Assets, Liabilities, and Equity Capital
Contractual Obligations
The Company has contractual obligations to make future payments on debt and lease agreements. Long-term debt is reflected on the consolidated statements of financial condition, whereas, operating lease obligations for office space and equipment are not recorded on the Consolidated Statements of Financial Condition. The Company and its subsidiaries have not entered into any unconditional purchase obligations or other long-term obligations other than as included in the following table. These types of obligations are more fully discussed in Note 10, “Long-Term Debt,” and Note 17, “Operating Leases,” of the “Notes to Consolidated Financial Statements” included in this Annual Report.
Many of the Bank’s lending relationships, including those with commercial and consumer customers, contain both funded and unfunded elements. The unfunded component of these commitments is not recorded in the Consolidated Statements of Financial Condition. These commitments are more fully discussed in Note 18, “Guarantees, Commitments, and Contingencies,” of the “Notes to Consolidated Financial Statements” included in this Annual Report.
The following summarizes the Company’s contractual obligations as of December 31, 2007.
* Long-term debt consists of FHLB advances totaling $77.5 million. $57.0 million are fixed-rate advances, and $20.5 million are convertible. Interest is included and calculated at the current rate for the entire period.
Off-Balance Sheet Obligations
The Company does not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on its financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are considered material, other than “Operating Leases,” included in Note 17, “Guarantees, Commitments, and Contingencies,” included in Note 18, and “Derivative Financial Instruments,” included in Note 19 of the “Notes to Consolidated Financial Statements” included in this Annual Report.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.
The information called for by this Item is contained in Item 7 herein under the headings, “Liquidity and Interest Rate Sensitivity Management,” “Assessing Short-Term Interest Rate Risk-Net Interest Margin Simulation” and “Assessing Long-Term Interest Rate Risk-Market Value of Equity and Estimating Modified Durations for Assets and Liabilities.”
Item 8.
Item 8. Financial Statements and Supplementary Data.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors
United Security Bancshares, Inc.
Thomasville, Alabama
We have audited United Security Bancshares, Inc.’s internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). United Security Bancshares Inc. and Subsidiaries’ management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis. The following material weakness has been identified and included in management’s assessment: a material weakness in the controls over financial reporting relating to the system of monitoring the real estate collateral values of certain impaired loans at Acceptance Loan Company, Inc., a subsidiary of United Security Bancshares, Inc. In certain instances, management has not identified a loss position on a timely basis for impaired loans, based on the current fair market value of the underlying real estate collateral for such loans. This material weakness was considered in determining the nature, timing, and extent of audit tests applied in our audit of the 2007 financial statements, and this report does not affect our report dated March 11, 2008 on those financial statements.
In our opinion, because of the effect of the material weakness described above on the achievement of the objectives of the control criteria, United Security Bancshares Inc., has not maintained effective internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).”
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of United Security Bancshares, Inc. and Subsidiaries as of December 31, 2007 and 2006, and the related consolidated statements of income, changes in stockholders’ equity and comprehensive income and cash flows for each of the three years then ended and our report dated March 11, 2008 expressed an unqualified opinion.
/s/ Mauldin & Jenkins, LLC
Birmingham, Alabama
March 11, 2008
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors
United Security Bancshares, Inc.
Thomasville, Alabama
We have audited the accompanying consolidated balance sheets of United Security Bancshares, Inc. and Subsidiaries as of December 31, 2007 and 2006 and the related consolidated statements of income, comprehensive income, stockholders’ equity and cash flows for each of the three years ended December 31, 2007. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of United Security Bancshares, Inc. and Subsidiaries as of December 31, 2007 and 2006 and the results of their operations and their cash flows for each of the three years ended, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), United Security Bancshares, Inc. and subsidiaries’ internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Our report dated March 11, 2008, expressed an opinion that United Security Bancshares, Inc. and subsidiaries’ had not maintained effective internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
/s/ Mauldin & Jenkins, LLC
Birmingham, Alabama
March 11, 2008
UNITED SECURITY BANCSHARES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CONDITION
DECEMBER 31, 2007 AND 2006
The accompanying notes are an integral part of these consolidated statements.
UNITED SECURITY BANCSHARES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
FOR THE YEARS ENDED DECEMBER 31, 2007, 2006, AND 2005
The accompanying notes are an integral part of these consolidated statements.
UNITED SECURITY BANCSHARES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
FOR THE YEARS ENDED DECEMBER 31, 2007, 2006, AND 2005
The accompanying notes are an integral part of these consolidated statements.
UNITED SECURITY BANCSHARES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
FOR THE YEARS ENDED DECEMBER 31, 2007, 2006, AND 2005
The accompanying notes are an integral part of these consolidated statements.
UNITED SECURITY BANCSHARES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 2007, 2006, AND 2005
The accompanying notes are an integral part of these consolidated statements.
UNITED SECURITY BANCSHARES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2007, 2006, AND 2005
1. DESCRIPTION OF BUSINESS
United Security Bancshares, Inc. (the “Company” or “USB”) and its subsidiary, First United Security Bank (the “Bank” or “FUSB”), provide commercial banking services to customers located primarily in Clarke, Choctaw, Bibb, Shelby, Tuscaloosa, and surrounding counties in Alabama and Mississippi. The Company also owns all of the stock of First Security Courier Corporation (“FSCC”), an Alabama corporation. FSCC is a courier service organized to transport items for processing to the Federal Reserve for financial institutions located in Southwest Alabama.
The Bank owns all of the stock of Acceptance Loan Company, Inc. (“Acceptance” or “ALC”), an Alabama corporation. Acceptance is a finance company organized for the purpose of making consumer loans and purchasing consumer loans from vendors. Acceptance has offices located within the communities served by the Bank as well as offices outside the Bank’s market area in Alabama and Southeast Mississippi. The Bank also owns all of the stock of FUSB Reinsurance, Inc. (“Reinsurance”), an Arizona corporation. Reinsurance is an insurance company that was created to underwrite credit life and accidental death insurance related to loans written by the Bank and ALC. The Bank also invests in limited partnerships that operate qualified affordable housing projects to receive tax benefits. The Bank also owns all of the stock of R2Metrics, Inc. (“R2Metrics”), an Alabama corporation, which was incorporated in April 2007. R2Metrics provides investment and asset and liability management software, analytics, and consulting services for the Bank as well as other clients, and is located in Birmingham, Alabama.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation
The consolidated financial statements include the accounts of the Company, FSCC, the Bank and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated. The Company considers a voting entity to be a subsidiary and consolidates if the Company has controlling financial interest in the entity. Variable Interest Entities (VIE’s) are consolidated if the majority of the expected losses or returns would be absorbed by the Company. Unconsolidated investments in VIE’s in which the Company has significant influence over operating and financing decisions are accounted for using the equity method. See Note 7 for further discussions of VIE’s.
Use of Estimates
The accounting principles and reporting policies of the Company, and the methods of applying these principles, conform with accounting principles generally accepted in the United States (“GAAP”) and with general practices within the financial services industry. In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the statements of condition and revenues and expenses for the period. Actual results could differ from those estimates.
Material estimates that are particularly susceptible to significant changes in the near term relate to the determination of the allowance for loan losses and the valuation of real estate acquired in connection with foreclosures or in satisfaction of loans. In connection with the determination of the allowances for loan losses and real estate owned, in some cases, management obtains independent appraisals for significant properties, evaluates the overall portfolio characteristics and delinquencies, and monitors economic conditions.
A substantial portion of the Company’s loans is secured by real estate in its primary market area. Accordingly, the ultimate collectibility of a substantial portion of the Company’s loan portfolio and the recovery of a portion of the carrying amount of foreclosed real estate are susceptible to changes in economic conditions in the Company’s primary market.
UNITED SECURITY BANCSHARES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)
Cash and Cash Equivalents
For purposes of reporting cash flows, cash and cash equivalents include cash on hand and amounts due from banks. The Company is required to maintain clearing balances at the Federal Reserve Bank. The average amount of this clearing balance was $25,000 for both years ended December 31, 2007, and 2006.
Supplemental disclosures of cash flow information and non-cash transactions related to cash flows for the years ended December 31, 2007, 2006, and 2005 are as follows:
Revenue Recognition
The main source of revenue for the Company is interest revenue, which is recognized on an accrual basis calculated by non-discretionary formulas based on written contracts, such as loan agreements or securities contracts. Loan origination fees are amortized into interest income over the term of the loan. Other types of non-interest revenue such as service charges on deposits are accrued and recognized into income as services are provided and the amount of fees earned is reasonably determinable.
Securities
Securities may be held in three portfolios: trading account securities, held-to-maturity securities, and securities available-for-sale. Trading account securities are carried at market value, with unrealized gains and losses included in earnings. Investment securities held-to-maturity are carried at cost, adjusted for amortization of premiums and accretion of discounts. With regard to investment securities held-to-maturity, management has the intent and the Bank has the ability to hold such securities until maturity. Investment securities available-for-sale are carried at market value, with any unrealized gains or losses excluded from earnings and reflected, net of tax, as a separate component of shareholders’ equity in accumulated other comprehensive income. Investment securities available-for-sale are so classified because management may decide to sell certain securities prior to maturity for liquidity, tax planning, or other valid business purposes. The Company held no securities in its held-to-maturity portfolio or trading account at December 31, 2007, or 2006. Equity securities are classified as available-for-sale and recorded at fair market value.
Interest earned on investment securities available-for-sale is included in interest income. Amortization of premiums and discounts on investment securities is determined by the interest method. Gains and losses on the sale of investment securities available-for-sale, computed principally on the specific identification method, are shown separately in non-interest income in the Consolidated Statements of Income.
Derivatives and Hedging Activities
As part of the Company’s overall interest rate risk management, the Company uses derivative instruments, which can include interest rate swaps, caps, and floors. Statements of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended (Statement 133), requires all derivative instruments to be carried at fair value on the statement of condition. Statement 133 provides special accounting provisions for derivative instruments that qualify for hedge accounting. To be eligible, the Company must specifically identify a derivative as a hedging instrument and identify the risk being hedged. The derivative instrument must be shown to meet specific requirements under Statement 133.
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The Company designates the derivative on the date the derivative contract is entered into as (1) a hedge of the fair value of a recognized asset or liability or of an unrecognized firm commitment (“fair-value” hedge) or (2) a hedge of a forecasted transaction of the variability of cash flows to be received or paid related to a recognized asset or liability (“cash-flow” hedge). Changes in the fair value of a derivative that is highly effective as and that is designated and qualifies as a fair-value hedge, along with the loss or gain on the hedged asset or liability that is attributable to the hedged risk (including losses or gains on firm commitments), are recorded in current-period earnings. The effective portion of the changes in the fair value of a derivative that is highly effective as and that is designated and qualifies as a cash-flow hedge is recorded in other comprehensive income, until earnings are affected by the variability of cash flows (e.g., when periodic settlements on a variable-rate asset or liability are recorded in earnings). The remaining gain or loss on the derivative, if any, in excess of the cumulative change in the present value of future cash flows of the hedged item is recognized in earnings.
The Company formally documents all relationships between hedging instruments and hedged items, as well as its risk-management objective and strategy for undertaking various hedge transactions. This process includes linking all derivatives that are designated as fair-value or cash-flow hedges to specific assets and liabilities on the balance sheet or to specific firm commitments or forecasted transactions. The Company also formally assessed, both at the hedge’s inception and on an ongoing basis (if the hedges do not qualify for short-cut accounting), whether the derivatives that are used in hedging transactions are highly effective in offsetting changes in fair values or cash flows of hedged items. When it is determined that a derivative is not highly effective as a hedge or that it has ceased to be a highly effective hedge, the Company discontinues hedge accounting prospectively, as discussed below. The Company discontinues hedge accounting prospectively when: (1) it is determined that the derivative is no longer effective in offsetting changes in the fair value or cash flows of a hedged item (including firm commitments or forecasted transactions); (2) the derivative expires or is sold, terminated, or exercised; (3) the derivative is redesignated as a hedge instrument, because it is unlikely that a forecasted transaction will occur; (4) a hedged firm commitment no longer meets the definition of a firm commitment; or (5) management determines that designation of the derivative as a hedge instrument is no longer appropriate.
When hedge accounting is discontinued because it is determined that the derivative no longer qualifies as an effective fair-value hedge, hedge accounting is discontinued prospectively and the derivative will continue to be carried on the balance sheet at its fair value with all changes in fair value being recorded in earnings but with no offsetting being recorded on the hedged item or in other comprehensive income for cash-flow hedges.
Loans and Interest Income
Loans are reported at principal amounts outstanding, adjusted for unearned income, deferred loan origination fees and costs, purchase premiums and discounts, write-downs, and the allowance for loan losses. Loan origination fees, net of certain deferred origination costs, and purchase premiums and discounts are recognized as an adjustment to yield of the related loans, on an effective yield basis.
Interest on all loans is accrued and credited to income based on the principal amount outstanding.
The accrual of interest on loans is discontinued when, in the opinion of management, there is an indication that the borrower may be unable to meet payments as they become due. Upon such discontinuance, all unpaid accrued interest is reversed against current income unless the collateral for the loan is sufficient to cover the accrued interest. Interest received on non-accrual loans generally is either applied against principal or reported as interest income, according to management’s judgment as to the collectibility of principal. Generally, loans are restored to accrual status when the obligation is brought current and has performed in accordance with the contractual terms for a reasonable period of time and the ultimate collectibility of the total contractual principal and interest is no longer in doubt.
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Allowance for Loan Losses
The allowance for loan losses is determined based on various components in accordance with Statement of Financial Accounting Standards No. 114 Accounting by Creditors for Impairment of a Loan for individually impaired loans and Statement of Financial Accounting Standards No. 5 Accounting for Contingencies for pools of loans. The allowance for loan losses is increased by a provision for loan losses, which is charged to expense, and reduced by charge-offs, net of recoveries. The allowance for loan losses is maintained at a level, which, in management’s judgment, is adequate to absorb credit losses inherent in the loan portfolio. The amount of the allowance is based on management’s evaluation of the collectibility of the loan portfolio, including the nature of the portfolio, and changes in its risk profile, credit concentrations, historical trends, and economic conditions. This evaluation also considers the balance of impaired loans. Losses on individually identified impaired loans are measured based on the present value of expected future cash flows discounted at each loan’s original effective market interest rate. As a practical expedient, impairment may be measured based on the loan’s observable market price or the fair value of the collateral if the loan is collateral dependent. When the measure of the impaired loan is less than the recorded investment in the loan, the impairment is recorded through the provision added to the allowance for loan losses. One-to-four family residential mortgages and consumer installment loans are subjected to a collective evaluation for impairment, considering delinquency and repossession statistics, historical loss experience, and other factors. Though management believes the allowance for loan losses to be adequate, ultimate losses may vary from their estimates. However, estimates are reviewed periodically, and as adjustments become necessary, they are reported in earnings during periods they become known.
Long-Lived Assets
Premises and equipment are stated at cost less accumulated depreciation. Depreciation is computed using the straight-line and accelerated methods over the estimated useful lives of the assets. Goodwill and core deposit intangibles are included in other assets. The Company adopted SFAS No. 142, Goodwill and Other Intangible Assets, which addresses how intangible assets that are acquired individually or with a group of assets should be accounted for in financial statements upon their acquisition. The statement also requires companies to no longer amortize goodwill and intangible assets with indefinite useful lives, but instead test annually for impairment. The Company had upon adoption of this statement $4.1 million in unamortized goodwill and, in accordance with this statement, performed a transition impairment test and an annual impairment analysis and concluded that no impairment charge was needed.
Other Real Estate
Other real estate consists of properties acquired through a foreclosure proceeding or acceptance of a deed in lieu of foreclosure. These properties are carried at the lower of cost or fair market value based on appraised value less estimated selling costs. Losses arising from the acquisition of properties are charged against the allowance for loan losses. Other real estate aggregated amounted to $11,155,992, $1,317,990 and $1,749,917 at December 31, 2007, 2006, and 2005, respectively, and is included in other assets. Transfers from loans to other real estate amounted to $12,106,416 in 2007. Transfers from other real estate to loans amounted to $477,907.
Income Taxes
The Company accounts for income taxes on the accrual basis through the use of the liability method. Under the liability method, deferred taxes are recognized for the tax consequences of temporary differences by applying enacted statutory tax rates applicable to future years to differences between the financial statement carrying amounts and the basis of existing assets and liabilities. The effect on deferred taxes of a change in tax rates would be recognized in income in the period that includes the enactment date.
Treasury Stock
Treasury stock purchases and sales are accounted for using the cost method.
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Earnings Per Share
Basic earnings per share (“EPS”) are computed by dividing net income by the weighted average number of shares outstanding during the period. Diluted earnings per share are computed based on the weighted average shares outstanding during the period plus the dilutive effect of outstanding stock options. There are no outstanding options as of December 31, 2007.
The following table represents the earnings per share calculations for the years ended December 31, 2007, 2006, and 2005.
New Accounting Standards
In July 2006, the FASB issued Interpretation 48, which requires that only benefits from tax positions that are more-likely-than-not of being sustained upon examination should be recognized in the financial statements. The Company believes all federal and state tax benefits recorded are more-likely-than-not of being sustained upon examination.
In September 2006, the FASB ratified the consensus the Emerging Issues Task Force (“EITF”) reached regarding EITF Issue No. 06-4, “Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements” (“Issue 06-4”), which provides accounting guidance for postretirement benefits related to endorsement split-dollar life insurance arrangements, whereby the employer owns and controls the insurance policies. The consensus concludes that an employer should recognize a liability for the postretirement benefit in accordance with Statement of Financial Accounting Standards No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions” (“Statement 106”) or Accounting Principles Board Opinion No. 12 (“APB 12”). In addition, the consensus states that an employer should also recognize an asset based on the substance of the arrangement with the employee. Issue 06-4 is effective for fiscal years beginning after December 15, 2007, with early application permitted. The Company is in the process of reviewing the potential impact of Issue 06-4.
In September 2006, the FASB issued SFAS Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“Statement 157”), which provides guidance for using fair value to measure assets and liabilities, but does not expand the use of fair value in any circumstance. Statement 157 also requires expanded disclosures about the extent to which a company measures assets and liabilities at fair value, the information used to measure fair value, and the effect of fair value measurements on an entity’s financial statements. The statement applies whenever other standards require or permit assets and liabilities to be measured at fair value. Statement 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years, with early adoption permitted. The Company is in the process of reviewing the potential impact of this statement.
In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“Statement 159”). Statement 159 allows entities to voluntarily choose, at specified election dates, to measure financial assets and financial liabilities (as well as certain nonfinancial instruments that are similar to financial instruments) at fair value (the “fair value option”). The election is made on an instrument-by-instrument basis and is irrevocable. If the fair value option is elected for an instrument, Statement 159 specifies that all subsequent changes in fair value for that instrument be reported in earnings. Statement 159 is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007, and earlier adoption is permitted. The Company is in the process of reviewing the potential impact of this statement.
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In March 2007, the FASB ratified the consensus the EITF reached regarding EITF Issue No. 06-10, “Accounting for Collateral Assignment Split-Dollar Life Insurance Arrangements” (“Issue 06-10”), which provides accounting guidance for postretirement benefits related to collateral assignment split-dollar life insurance arrangements, whereby the employee owns and controls the insurance policies. The consensus concludes that an employer should recognize a liability for the postretirement benefit in accordance with Statement 106 or APB 12, as well as recognize an asset based on the substance of the arrangement with the employee. Issue 06-10 is effective for fiscal years beginning after December 15, 2007, with early application permitted. The Company believes the adoption of this pronouncement will not have a material impact on its financial statements.
In December 2007, the FASB issued SFAS No. 141R, “Business Combinations.” This Statement replaces FASB SFAS No. 141. SFAS 141R establishes principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree. SFAS 141R also provides guidance for recognizing and measuring the goodwill acquired in the business combination and determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. This Statement applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. The Company believes the adoption of this pronouncement will not have a material impact on its financial statements.
In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements- an amendment of ARB No. 51.” This Statement amends ARB 51 to establish accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. It clarifies that a noncontrolling interest in a subsidiary is an ownership interest in the consolidated entity that should be reported as equity in the consolidated financial statements. In addition to the amendments to ARB 51, this Statement amends FASB Statement No. 128, “Earnings per Share,” so that earnings-per-share data will continue to be calculated the same way those data were calculated before this Statement was issued. This Statement is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. The Company believes the adoption of this pronouncement will not have a material impact on its financial statements.
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3. INVESTMENT SECURITIES
Details of investment securities available-for-sale at December 31, 2007, and 2006 are as follows:
The scheduled maturities of investment securities available-for-sale at December 31, 2007, are presented in the following table:
For purposes of the maturity table, mortgage-backed securities, which are not due at a single maturity date, have been allocated over maturity groupings based on the weighted-average contractual maturities of underlying collateral. The mortgage-backed securities generally mature earlier than their weighted-average contractual maturities because of principal prepayments.
The following table reflects the Company’s investments’ gross unrealized losses and market value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2007, and 2006. The Company does not believe any individual unrealized loss represents an other-than-temporary impairment. The Company has the intent and ability to hold these securities until such time as the value recovers or the securities mature.
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Management evaluates securities for other-than-temporary impairment no less frequently than quarterly, and more frequently when economic or market concerns warrant such evaluation. Consideration is given to (1) the length of time and the extent to which fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Company to retain its investments in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.
As of December 31, 2007, thirty-seven debt securities have been in a loss position for more than twelve months and eleven debt securities have been in a loss position for less than twelve months. The losses for all securities are considered to be a direct result of rising interest rates and the effect that rising rates has on the value of debt securities and not related to the credit worthiness of the issuers. Further, the Company has the current intent and ability to hold the securities to an expected recovery in market value. Therefore, the Company has not recognized any other-than-temporary impairments.
Investment securities available-for-sale with a carrying value of $95.2 million and $85.8 million December 31, 2007, and 2006, respectively, were pledged to secure public deposits and for other purposes.
Net losses on securities available-for-sale were $107,156, $268, and $37,232 in 2007, 2006, and 2005, respectively. Net losses from the sale of securities were $2,156 in 2007. In addition, a $105,000 impairment loss was recorded related to the investment in preferred stock. The following chart represents the gross gains and losses for the years 2005 through 2007.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)
4. LOANS AND ALLOWANCE FOR LOAN LOSS
At December 31, 2007, and 2006, the composition of the loan portfolio was as follows:
The Company grants commercial, real estate, and installment loans to customers primarily in Clarke, Choctaw, Bibb, Shelby, Tuscaloosa, and surrounding counties in Alabama, and Southeast Mississippi. Although the Company has a diversified loan portfolio, 73.3% of the portfolio is concentrated in loans secured by real estate.
In the ordinary course of business, the Bank makes loans to certain officers and directors of the Company and the Bank, including companies with which they are associated. These loans are made on the same terms as those prevailing for comparable transactions with others. Such loans do not represent more than normal risk of collectibility nor do they present other unfavorable features. The amounts of such related party loans and commitments at December 31, 2007, and 2006, were $1,360,729 and $1,096,183, respectively. During the year ended December 31, 2007, new loans to these parties totaled $1,995,450 and repayments were $1,730,904.
A summary of the transactions in the allowance for loan losses follows:
Impaired loans totaled $15,720,232, $7,318,047, and $5,662,303 as of December 31, 2007, 2006, and 2005, respectively. There was approximately $1,624,648, $847,676 and $816,283 in the allowance for loan losses specifically allocated to these impaired loans at December 31, 2007, 2006, and 2005, respectively. The average recorded investment in impaired loans for 2007, 2006, and 2005 was approximately $8,809,856, $6,858,270, and $2,509,750, respectively.
Loans on which the accrual of interest has been discontinued amounted to $5,252,597, $7,318,047, and $5,662,303 at December 31, 2007, 2006, and 2005, respectively. If interest on those loans had been accrued, such income would have approximated $501,003, $874,319, and $701,191 for 2007, 2006, and 2005, respectively. Interest income actually recorded on those loans amounted to $169,941, $186,344, and $49,361 for 2007, 2006, and 2005, respectively. Accruing loans past due 90 days or more amounted to $5,239,547, $2,033,326, and $1,203,027 for 2007, 2006, and 2005, respectively.
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5. PREMISES AND EQUIPMENT
Premises and equipment and their depreciable lives are summarized as follows:
Depreciation expense of $953,871, $957,428, and $931,272 was recorded in 2007, 2006, and 2005, respectively, on premises and equipment.
6. GOODWILL AND INTANGIBLE ASSETS
The Company has goodwill assets of $4,097,773 and $4,097,773 included in other assets as of December 31, 2007, and 2006. Management conducted its annual impairment testing June 30, 2007, and determined that there was no impairment.
7. INVESTMENT IN LIMITED PARTNERSHIPS
The Company has limited partnership investments in affordable housing projects, for which it provides funding as a limited partner and receives tax credits related to its investments in the projects based on its partnership share. The Company has invested in limited partnerships of affordable housing projects, both as direct investments and investments in funds that invest solely in affordable housing projects. The Company has determined that these structures meet the definition of a variable interest entity. The Company has determined that it needs to consolidate one of the funds in which it is the sole limited partner. The Company also has determined that this fund is required to consolidate one of the affordable housing projects the fund invests in. The resulting financial impact to the consolidation of the Company is a net increase to total assets of approximately $3.2 million. This includes $8.1 million in premises and equipment less a loan totaling $5.5 million. This loan payable by the partnership to the Company was eliminated as a result of this consolidation. Unconsolidated investments in these partnerships are accounted for under the cost method as allowed under EITF 94-1. The Company amortizes the excess of carrying value of the investment over its estimated residual value during the period in which tax credits are allocated to the investors. The Company’s maximum exposure to future loss related to these limited partnerships is limited to the $2.0 million recorded investment.
The assets and liabilities of these partnerships consist primarily of apartment complexes and related mortgages. The Bank’s carrying value approximates cost or its underlying equity in the net assets of the partnerships. Market quotations are not available for any of the aforementioned partnerships.
The Bank had no remaining cash commitments to these partnerships at December 31, 2007.
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8. DEPOSITS
At December 31, 2007, the scheduled maturities of the Bank’s time deposits are as follows:
At December 31, 2007, and 2006, the Company had brokered certificates of deposit totaling $20,870,721 and $24,795,081, respectively.
9. SHORT-TERM BORROWINGS
Short-term borrowings consist of federal funds purchased, thirty-day Federal Home Loan Bank (“FHLB”) advances, treasury tax and loan deposits and securities sold under repurchase agreements. Federal funds purchased generally mature within one to four days. None were outstanding at year-end 2007 or 2006. Treasury tax and loan deposits totaled $930,257 and $1,463,338 at year-end 2007 and 2006, respectively. These deposits are withdrawable on demand. A $10.0 million FHLB advance, with a maturity date of January 14, 2008, was outstanding at December 31, 2007.
Securities sold under repurchase agreements, which are secured borrowings, generally are reflected at the amount of cash received in connection with the transaction. The Company may be required to provide additional collateral based on the fair value of the underlying securities. The Company monitors the fair value of the underlying securities on a daily basis. Securities sold under repurchase agreements at December 31, 2007, and 2006, were $281,692 and $293,650, respectively.
At December 31, 2007, the Bank has $25.0 million in available federal fund lines from correspondent banks.
10. LONG-TERM DEBT
The Company uses FHLB advances as an alternative to funding sources with similar maturities such as certificates of deposit or other deposit programs. These advances generally offer more attractive rates when compared to other mid-term financing options. They are also flexible, allowing the Company to quickly obtain the necessary maturities and rates that best suit its overall asset/liability strategy. At December 31, 2007, and 2006, investment securities and mortgage loans amounting to $85,401,505 and $89,099,490, respectively, were pledged to secure these borrowings.
The following summarizes information concerning FHLB advances and other borrowings:
Interest rates on FHLB advances ranged from 4.18% to 6.40% and from 5.07% to 6.40% at December 31, 2007, and 2006, respectively.
UNITED SECURITY BANCSHARES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)
Scheduled maturities of FHLB advances are approximately $7.5 million for 2008, $15.0 million for 2009, and $35.0 million for 2010. In 2011 there are no scheduled maturities. In 2012 there are $20.0 million in scheduled maturities. In 2013 and thereafter, there are no scheduled maturities.
At December 31, 2007, the Bank has $110.1 million in available credit from the FHLB.
11. INCOME TAXES
The consolidated provisions for and (benefits from) income taxes for the years ended December 31 were as follows:
The consolidated tax provision differed from the amount computed by applying the federal statutory income tax rate of 35.0% to pretax earnings for the following reasons:
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The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2007, and 2006, are presented below:
Management has determined that a valuation allowance should not be recorded on its deferred tax assets as of December 31, 2007 and 2006, based on its projection of future taxable income and other relevant considerations.
12. EMPLOYEE BENEFIT PLANS
The Company sponsors an employee stock ownership plan, the United Security Bancshares, Inc. Employee Stock Ownership Plan (With 401(k) Provisions). This plan covers substantially all employees and allows employees to contribute up to 15% of their compensation on a before-tax basis. The Company makes safe harbor contributions on behalf of all participants equal to the sum of 100% of an employee’s elective deferrals that do not exceed 3% of compensation, plus 50% of the employee’s elective deferrals that exceed 3% but that do not exceed 5% of compensation. The Company also made a discretionary contribution in the amount of 2% of an employee’s compensation in 2006. Employees have the option to allocate some or all of their contributions towards the purchase of Company stock. The Company made matching contributions totaling $438,069 and $448,041 in 2007 and 2006, respectively. The plan held 267,981 and 299,999 shares at December 31, 2007, and 2006, respectively. These shares are included in the earnings per share calculations because they are all allocated to the participants.
13. LONG-TERM INCENTIVE COMPENSATION PLAN
The Bank has entered into supplemental compensation benefits agreements with the directors and certain executive officers. The measurement of the liability under these agreements includes estimates involving life expectancy, length of time before retirement and the expected returns on the Bank-owned life insurance policies used to fund those agreements. Should these estimates prove materially wrong, the cost of these agreements could change accordingly. The related deferred compensation obligation to these directors and executive officers totaled $2,333,240 and $1,878,854 as of December 31, 2007, and 2006, respectively. These amounts are included in other liabilities.
Under the United Security Bancshares, Inc. Non-Employee Directors’ Deferred Compensation Plan, participants may elect to defer all or a portion of their directors’ fees and to receive the adjusted value of the deferred amounts in cash and/or to receive the adjusted value of the deferred amounts as if the deferred amounts were invested in shares of USB stock. In the event a participant elects to defer amounts as if the deferred amounts were invested in USB stock, the participant does not have any rights as a shareholder of the common stock deferred under the plan until the termination date on which the participant’s account is distributed in accordance with terms of the plan. Neither the Company nor the Bank makes any contribution to participants’ accounts under the plan.
UNITED SECURITY BANCSHARES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)
While not required by the plan, the Company established a grantor trust (Rabbi Trust) as an instrument to fund the stock portion of the plan. At December 31, 2007, and 2006, the grantor trust held 9,483 and 6,875 shares of the Company’s common stock. These shares have been classified in equity as treasury stock. The related deferred compensation obligation included in other liabilities was $256,350 and $193,950 as of December 31, 2007, and 2006, respectively.
14. SHAREHOLDERS’ EQUITY
Dividends paid by the Company are primarily from dividends received from the Bank. However, certain restrictions exist regarding the ability of the Bank to transfer funds to the Company in the form of cash dividends, loans, or advances. Due to reduced earnings as a result of losses suffered at ALC in 2007, and dividends paid to fund the stock repurchase program over the last several years, approval from the State Banking Department was required to pay dividends in 2008. This approval was granted January 28, 2008.
The Company is subject to various regulatory capital requirements that prescribe quantitative measures of the Company’s assets, liabilities, and certain off-balance sheet items. The Company’s regulators also have imposed qualitative guidelines for capital amounts and classifications such as risk weightings, capital components, and other details. The quantitative measures to ensure capital adequacy require that the Company maintain amounts and ratios, as set forth in the schedule below, of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined in the regulations) and of Tier I capital to average total assets (as defined in the regulations). Failure to meet minimum capital requirements can initiate certain actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements. Management believes, as of December 31, 2007, and 2006, that the Company met all capital adequacy requirements imposed by its regulators.
As of December 31, 2007, and 2006, the most recent notification from the Federal Deposit Insurance Corporation categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Bank must maintain minimum total risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the table. There have been no conditions or events since that notification that management believes have changed the institution’s category.
UNITED SECURITY BANCSHARES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)
Actual capital amounts as well as required and well capitalized total risk-based, Tier I risk-based, and Tier I leverage ratios as of December 31, 2007, and 2006, for the Company and the Bank are as follows:
15. SEGMENT REPORTING
Under SFAS No. 131, Disclosure about Segments of an Enterprise and Related Information, certain information is disclosed for the three reportable operating segments of the Company. The reportable segments were determined using the internal management reporting system. They are composed of the Company’s and Bank’s significant subsidiaries. The accounting policies for each segment are the same as those described in Note 2, Summary of Significant Accounting Policies. The segment results include certain overhead allocations and intercompany transactions that were recorded at current market prices. All intercompany transactions have been eliminated to determine the consolidated balances. The results for the three reportable segments of the Company are included in the following table:
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16. OTHER OPERATING EXPENSES
Other operating expenses for the years 2007, 2006, and 2005 consist of the following:
17. OPERATING LEASES
The Company leases equipment and office space under noncancellable operating leases and also month-to-month rental agreements.
The following is a schedule, by years, of future minimum rental payments required under operating leases having initial or remaining noncancellable terms in excess of one year as of December 31, 2007:
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Total rental expense under all operating leases was $566,204, $543,495, and $521,098 in 2007, 2006, and 2005, respectively.
18. GUARANTEES, COMMITMENTS, AND CONTINGENCIES
The Bank’s exposure to credit loss in the event of nonperformance by the other party for commitments to make loans and standby letters of credit is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making these commitments as it does for on-balance sheet instruments. For interest rate swap transactions, and commitments to purchase or sell securities for forward delivery, the contract or notional amounts do not represent exposure to credit loss. The Bank controls the credit risk of these derivative instruments through credit approvals, limits, and monitoring procedures. Certain derivative contracts have credit risk for the carrying value plus the amount to replace such contracts in the event of counter party default. All of the Bank’s financial instruments are held for risk management and not for trading purposes. During the years ended December 31, 2007, 2006, and 2005, there were no credit losses associated with derivative contracts.
In the normal course of business there are outstanding commitments and contingent liabilities, such as commitments to extend credit, letters of credit, and others, which are not included in the consolidated financial statements. The financial instruments involve, to varying degrees, elements of credit and interest rate risk in excess of amounts recognized in the financial statements. A summary of these commitments and contingent liabilities is presented below:
Standby letters of credit are contingent commitments issued by the Company generally to guarantee the performance of a customer to a third party. The Company has recourse against the customer for any amount it is required to pay to a third party under a standby letter of credit. Revenues are recognized over the lives of the standby letters of credit. The potential amount of future payments the Company could be required to make under its standby letters of credit at December 31, 2007, is $620,000 and represents the Company’s total credit risk.
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation of the counter party. Collateral held varies but may include accounts receivable, inventory, property, plant, and equipment, and income-producing commercial properties.
Commitments to purchase securities for delayed delivery require the Bank to purchase a specified security at a specified price for delivery on a specified date. Similarly, commitments to sell securities for delayed delivery require the Bank to sell a specified security at a specified price for delivery on a specified date. Market risk arises from potential movements in security values and interest rates between the commitment and delivery dates. At December 31, 2007, there were no outstanding commitments to purchase and sell securities for delayed delivery.
UNITED SECURITY BANCSHARES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)
In January 2006, the Company sold its credit card portfolio in the amount of approximately $575,000. To facilitate this sale, the Company was required to guarantee certain accounts. The current balance of these accounts at December 31, 2007, was $19,444. The maximum exposure under this guaranty, which includes the credit limit on these accounts, amounts to $22,500.
Litigation
On September 27, 2007, Malcomb Graves Automotive, LLC, Malcomb Graves, and Tina Graves (collectively, “Graves”) filed a lawsuit in the Circuit Court of Shelby County, Alabama against the Company, the Bank, ALC and their respective directors and officers seeking an unspecified amount of compensatory and punitive damages. The complaint alleges that the defendants committed fraud in allegedly misrepresenting to Graves the amounts Graves owed on certain loans and failing to credit Graves properly for certain loans. The defendants deny the allegations. The defendants are in the process of responding to the complaint, and no discovery has been exchanged between the parties. The defendants have moved to compel arbitration in this matter, but the trial court has not ruled on this motion to date. For this reason, it is too early for management to assess the likelihood of a resolution of this matter or whether this matter will have a material adverse effect on the Company’s consolidated financial condition or results of operations.
The Company and its subsidiaries are parties to other litigation arising in the normal course of business. In the opinion of management, based on review and consultation with legal counsel, the ultimate disposition of such litigation is not expected to have a material adverse effect on the consolidated financial condition or results of operations.
19. DERIVATIVE FINANCIAL INSTRUMENTS
The Bank is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers and in connection with its interest rate risk management, investing, and trading activities. These financial instruments include commitments to extend credit and standby letters of credit.
The Bank’s principal objective in holding derivative financial instruments is asset-liability management. The operations of the Bank are subject to a risk of interest rate fluctuations to the extent that there is a difference between the amount of the Bank’s interest-earning assets and the amount of interest-bearing liabilities that mature or reprice in specified periods. The principal objective of the Bank’s asset-liability management activities is to provide maximum levels of net interest income while maintaining acceptable levels of interest rate and liquidity risk and facilitating the funding needs of the Bank. To achieve that objective, the Bank uses a combination of derivative financial instruments, including interest rate swaps. Note 2 to the Consolidated Financial Statements includes a summary of how derivative instruments used for interest rate risk management are accounted for in the financial statements.
Interest rate swaps acquired for other than trading purposes are used to help reduce the risk of interest rate movements for specific categories of assets and liabilities. At December 31, 2007, no interest rate swaps were outstanding.
Two cash-flow hedges with a notional amount of $18.0 million were terminated during the first quarter of 2005 that resulted in a $592,000 gain, which is reported in other comprehensive income. This gain will be reclassified from other comprehensive income to income over the original remaining term of the swaps. During 2007 and 2006, $203,306 and $215,018, respectively, were reclassified into income. The remaining balance not reclassified into income was $12,411 at December 31, 2007. This remaining balance will be reclassified into income in 2008.
Two interest rate swaps with a total notional amount of $10.0 million were used to convert fixed-rate brokered certificates of deposit to floating-rate. On January 1, 2006, the Company began accounting for these interest rate swaps under hedge accounting. Net cash flows from these swaps increased interest expense on certificates of deposit by $108,972 for the year ended December 31, 2007, and $143,524 for the year ended December 31, 2006. Both swaps were terminated in the third quarter of 2007, resulting in a change to other non-interest expense of $72,564.
All of the Bank’s derivative financial instruments were over-the-counter instruments and were not exchange traded. Market values are obtained from the counter parties to each instrument. The Bank only uses other commercial banks as a counter party to their derivative activity. The Bank performs stress tests and other models to assess risk exposure.
20. FAIR VALUE OF FINANCIAL INSTRUMENTS
SFAS No. 107, Disclosures About Fair Value of Financial Instruments, requires disclosure of fair value information about financial instruments, whether or not recognized on the face of the statement of condition, for which it is practicable to estimate that value. The assumptions used in the estimation of the fair value of the Company’s financial instruments are detailed below. Where quoted prices are not available, fair values are based on estimates using discounted cash flows and other valuation techniques. The use of discounted cash flows can be significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. The following disclosures should not be considered a surrogate of the liquidation value of the Company, but rather represent a good-faith estimate of the increase or decrease in value of financial instruments held by the Company since purchase, origination, or issuance.
UNITED SECURITY BANCSHARES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)
The following methods and assumptions were used by the Company in estimating the fair value of its financial instruments:
Cash, due from banks, and federal funds sold: The carrying amount of cash, due from banks, and federal funds sold approximates fair value.
Federal Home Loan Bank: The carrying amount of Federal Home Loan Bank stock approximates fair value.
Securities: Fair values of securities are based on available quoted market prices. The carrying amount of equity securities with no readily determined fair value approximates fair value.
Accrued interest: The carrying amount of accrued interest approximates their fair value.
Loans, net: For variable-rate loans, fair values are based on carrying values. Fixed-rate commercial loans, other installment loans, and certain real estate mortgage loans were valued using discounted cash flows. The discount rate used to determine the present value of these loans was based on interest rates currently being charged by the Bank on comparable loans as to credit risk and term.
Derivative instruments: Fair values of the Company’s derivative instruments are based on values obtained from counter parties, or other quotations received from third parties. The Company’s loan commitments are negotiated at current market rates and are relatively short-term in nature. As a matter of policy, the Company generally makes commitments for fixed-rate loans for relatively short periods of time. Because of this policy and the absence of any known credit exposure, the estimated value of the Company’s loan commitments is nominal.
Demand and savings deposits: The fair values of demand deposits are equal to the carrying value of such deposits. Demand deposits include non-interest bearing demand deposits, savings accounts, NOW accounts, and money market demand accounts.
Time deposits: The fair value of relatively short-term time deposits is equal to their carrying values. Discounted cash flows have been used to value long-term time deposits. The discount rate used is based on interest rates currently being offered by the Bank on comparable deposits as to amount and term.
Short-term borrowings: These borrowings may consist of federal funds purchased, securities sold under agreements to repurchase, floating rate borrowings from the FHLB and the U.S. Treasury Tax and Loan account. Due to the short-term nature of these borrowings, fair values approximate carrying values.
Long-term debt: The fair value of this debt is estimated using discounted cash flows based on the Company’s current incremental borrowing rate for similar types of borrowing arrangements as of December 31, 2007, and 2006:
Off-balance sheet instruments: The carrying amount of commitments to extend credit and standby letters of credit approximates fair value. The carrying amount of the off-balance sheet financial instruments is based on fees currently charged to enter into such agreements.
UNITED SECURITY BANCSHARES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)
21. UNITED SECURITY BANCSHARES, INC. (PARENT COMPANY ONLY) FINANCIAL INFORMATION
Statements of Condition
UNITED SECURITY BANCSHARES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)
Statements of Cash Flows
22. QUARTERLY DATA (UNAUDITED)
Item 9.
Item 9. Changes In and Disagreements With Accountants on Accounting and Financial Disclosure.
None.
Item 9A.
Item 9A. Controls and Procedures.
Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures and Changes in Internal Control over Financial Reporting
Bancshares maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in Bancshares’ Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to Bancshares’ management, including its Chief Executive Officer and Principal Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives.
The management of Bancshares carried out an evaluation, under the supervision and with the participation of the Chief Executive Officer and the Principal Financial Officer, of the effectiveness of the design and operation of Bancshares’ disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934) as of December 31, 2007, pursuant to the evaluation of these controls and procedures required by Rule 13a-15 of the Securities Exchange Act of 1934.
Based upon that evaluation, Bancshares’ management concluded as of the end of the period covered by this Annual Report on Form 10-K that Bancshares’ disclosure controls and procedures were ineffective due to the material weakness that existed in our internal control over financial reporting.
Changes in Internal Control Over Financial Reporting.
During the quarter ended December 31, 2007, the Bank’s ALC subsidiary created the new position of internal auditor for ALC. The ALC internal auditor reports directly to the ALC Audit Committee. In addition, a central loan committee was established during the quarter at ALC to oversee the ALC lending function. With the assistance of the new loan committee, the ALC loan policy has been revised and implemented, with continued training a priority.
Management’s Report on Internal Control Over Financial Reporting
Management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934). Bancshares’ internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Bancshares’ internal control over financial reporting includes those policies and procedures that:
(i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of Bancshares;
(ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of Bancshares are being made only in accordance with authorizations of management and directors of Bancshares; and
(iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of Bancshares’ assets that could have a material effect on the financial statements.
Management assessed the effectiveness of Bancshares’ internal control over financial reporting as of December 31, 2007. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework. A material weakness is a significant deficiency (within the meaning of PCAOB Auditing Standard No. 5, or combination of significant deficiencies, that results in there being more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected on a timely basis by employees in the normal course of their assigned functions. In connection with management’s assessment of Bancshares’ internal control over financial reporting described above, management has identified a material weakness in Bancshares’ internal control over financial reporting relating to the system of monitoring the real estate collateral values of certain impaired loans at the Bank’s ALC subsidiary. In certain instances, management had not identified a loss position on a timely basis for impaired loans, based on the current fair market value of the underlying real estate collateral for such loans.
Because of the material weakness described above, based on its assessment, management believes that, as of December 31, 2007, Bancshares did not maintain effective internal control over financial reporting based on the criteria established in Internal Control - Integrated Framework, issued by COSO.
To remediate the material weakness in Bancshares’ internal control over financial reporting described above, additional procedures have been implemented to reinforce the requirement that once a loan meets the impairment criteria, such loan is deemed impaired and the amount of the impairment is based on the current appraisal of the collateral securing that loan. Management has discussed this corrective action with the Audit Committee of Bancshares and with its auditors, Mauldin & Jenkins, LLC (“Mauldin & Jenkins”). The Company believes that its consolidated financial statements included in the Annual Report on Form 10-K fairly present, in all material respects, Bancshares’ financial condition, results of operations and cash flows as of, and for, the periods presented.
Mauldin & Jenkins, under Auditing Standard No. 5, does not express an opinion on management’s assessment as required under Auditing Standard No. 2. Under Auditing Standard No. 5, management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Mauldin & Jenkins’ responsibility is to express an opinion on the effectiveness of Bancshares’ internal control over financial reporting based on their audit.
Item 9B.
Item 9B. Other Information.
Not applicable.
PART III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance.
Bancshares has adopted a Code of Business Conduct and Ethics for directors, officers (including Bancshares’ Chief Executive Officer and Principal Financial Officer) and employees. The Code of Business Conduct and Ethics is incorporated herein by reference to the Exhibits to Form 10-K for the year ended December 31, 2003. Bancshares will provide any interested person a copy of the Code of Business Conduct and Ethics free of charge, upon written request, as follows: United Security Bancshares, Inc., Attention: Larry M. Sellers, Secretary, 131 West Front Street, Post Office Box 249, Thomasville, Alabama 36784, (334) 636-5424.
Other information required by this Item is incorporated by reference pursuant to General Instruction G(3) of Form 10-K from Bancshares’ definitive Proxy Statement for the 2008 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission pursuant to Regulation 14A.
Item 11.
Item 11. Executive Compensation.
The information required by this Item is incorporated by reference pursuant to General Instruction G(3) of Form 10-K from Bancshares’ definitive Proxy Statement for the 2008 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission pursuant to Regulation 14A.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
Securities Authorized for Issuance Under Equity Compensation Plans
The following table summarizes, as of December 31, 2007, the securities that have been authorized for issuance under Bancshares’ equity compensation plan, the United Security Bancshares, Inc. Non-Employee Directors’ Deferred Compensation Plan (the “Directors’ Plan”). The Directors’ Plan permits non-employee directors to defer their directors’ fees and receive the adjusted value of the deferred amounts in cash and/or in Bancshares’ common stock and was approved by shareholders in 2004.
Equity Compensation Plan Information
(1) Does not include shares reserved for future issuance under the United Security Bancshares, Inc. Non-Employee Directors’ Deferred Compensation Plan.
(2) Does not include amounts deferred pursuant to the United Security Bancshares, Inc. Non-Employee Directors’ Deferred Compensation Plan, as there is no exercise price associated with these deferred amounts.
Other information required by this Item is incorporated by reference pursuant to General Instruction G(3) of Form 10-K from Bancshares’ definitive Proxy Statement for the 2008 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission pursuant to Regulation 14A.
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence.
The information required by this Item is incorporated by reference pursuant to General Instruction G(3) of Form 10-K from Bancshares’ definitive Proxy Statement for the 2008 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission pursuant to Regulation 14A.
Item 14.
Item 14. Principal Accounting Fees and Services.
The information required by this Item is incorporated by reference pursuant to General Instruction G(3) of Form 10-K from Bancshares’ definitive Proxy Statement for the 2008 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission pursuant to Regulation 14A.
PART IV
Item 15.
Item 15. Exhibits, Financial Statement Schedules.
(a)(1) Financial Statements.
The consolidated financial statements of Bancshares and its subsidiaries, included herein in Item 8, are as follows:
Report of Independent Registered Public Accounting Firm - Mauldin & Jenkins, LLC
Report of Independent Registered Public Accounting Firm on Internal Control Over Financial Reporting - Mauldin & Jenkins, LLC
Consolidated Statements of Condition - December 31, 2007 and 2006
Consolidated Statements of Income - December 31, 2007, 2006 and 2005
Consolidated Statements of Shareholders’ Equity - December 31, 2007, 2006 and 2005
Consolidated Statements of Comprehensive Income - December 31, 2007, 2006 and 2005
Consolidated Statements of Cash Flows - December 31, 2007, 2006 and 2005
Notes to Consolidated Financial Statements - December 31, 2007, 2006 and 2005
(a)(2) Financial Statement Schedules.
The financial statement schedules required to be included pursuant to this Item are not included herein because they are not applicable or the required information is shown in the financial statements or notes thereto, which are incorporated by reference at subsection (a)(1) of this Item above.
(a)(3)&(b) Exhibits.
The exhibits listed on the Exhibit Index beginning on page 83 of this Form 10-K are filed herewith or are incorporated herein by reference.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on this 5th day of March, 2008.
UNITED SECURITY BANCSHARES, INC.
By:
/s/ R. Terry Phillips
R. Terry Phillips
President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
EXHIBIT INDEX
ITEM 15(a)(3)
* Indicates a management contract or compensatory plan or arrangement.