Item 1. Business
General
Heritage Financial Group, Inc. (“Heritage” or the “Company”), is a $1.4 billion holding company headquartered in Albany, Georgia. Heritage primarily conducts commercial banking, retail banking, mortgage banking and wealth management activities through its wholly owned subsidiary, HeritageBank of the South (“HeritageBank” or the “Bank”). As of December 31, 2013, HeritageBank operated in Georgia, Florida and Alabama through 27 full-service branch locations, 14 mortgage offices and 4 investment offices. HeritageBank provides credit based products, deposit accounts, corporate cash management, investment support and other services to commercial and retail clients.
The Company was formed by its federally chartered predecessor, Heritage Financial Group (the “Predecessor”) in connection with a second-step conversion and public offering conducted in the latter half of 2010, in which the Predecessor merged into the Company and converted from a mutual holding company structure to a stock holding company structure (“Conversion”). In that merger, each public share of common stock of the Predecessor was exchanged for 0.8377 shares of the Company’s common stock. The words “we,” “our” and “us” in this Form 10-K refer to Heritage and HeritageBank on a consolidated basis.
At December 31, 2013, we had total assets of $1.4 billion, loans of $799.0 million, deposits of $1.1 billion and stockholders’ equity of $125.1 million. Our executive offices are located at 721 N. Westover Boulevard, Albany, Georgia 31707. Our common stock is traded on the Nasdaq Global Market under the symbol “HBOS.” For more information about our business, see Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations - General.
Strategy. Our business strategy is to operate a well-capitalized and profitable financial institution dedicated to serving the needs of our customers. We offer a broad range of products and services while stressing personalized and efficient customer service and convenient access to these products and services. We intend to continue to operate as a commercial and consumer lender. We have structured operations around a branch system that is staffed with knowledgeable and well-trained employees. Subject to capital requirements and our ability to grow in a reasonable and prudent manner, we may open or acquire additional branches as opportunities arise. In addition to our branch system, we continue to expand electronic services for our customers. We attempt to differentiate ourselves from our competitors by providing a higher level of customer service.
Expansion Efforts. A key element of our business strategy is increasing our presence and growing the “Heritage” brand in the markets we currently serve and expanding our operations beyond our original Southwest Georgia market by entering new markets in other parts of Georgia, Florida, Alabama and other adjacent communities that present attractive opportunities for expansion consistent with our capital availability. This expansion of our market beyond southwest Georgia began in 2006, when we commenced operating a branch in Ocala, Florida. We have pursued this expansion program through both prudent, disciplined internal growth and strategic acquisitions. We have also hired highly regarded and experienced lending officers and commercial bankers and expanded into new market areas that are contiguous to our existing market areas. These recent activities reflect our ability to take advantage of these expansion opportunities.
During 2011, we completed two FDIC-assisted whole-bank acquisitions near Savannah, Georgia and in Statesboro, Georgia with combined loans of $247.2 million and deposits of $342.3 million. In April 2012, we opened a commercial banking office in Macon, Georgia, and in June 2012, we completed the purchase of a single branch in Auburn, Alabama with $10.9 million in loans and $18.7 million in deposits. In August 2012, we hired a new management team to operate our mortgage division which has led to significant growth in our mortgage business, particularly in the Atlanta, Georgia market. In March 2013, we completed an FDIC-assisted whole-bank purchase of a bank based in LaGrange, Georgia with $98.0 million in loans and $211.6 million in deposits, which were primarily located in Alabama, and in November 2013, we opened a commercial and mortgage banking office in Columbus, Georgia.
Market Area
We intend to continue to be a community-oriented financial institution offering a variety of financial services to meet the needs of the communities we serve. At December 31, 2013, we primarily served our markets in Georgia through offices in Albany, LaGrange, Macon, Savannah, Statesboro, and Valdosta, Florida through offices in Lake City and Ocala and Alabama through offices in Auburn-Opelika, Birmingham-Hoover, Talledega-Sylacauga, and Valley. We occasionally make loans beyond our market area to meet customer needs and to develop new business.
The following table sets forth our deposit market share and information regarding the local economy by market area, including acquisitions, as of June 30, 2013, based on the most recent data available from the Federal Deposit Insurance Corporation (“FDIC”) and SNL Financial. SNL Financial is a provider of news, financial data and analysis on the banking business. Most of our market areas fall within Metropolitan Statistical Areas (“MSA”) and were selected based on the market area’s significance to our operations. The significance of a market area includes such factors as the number of branches, the level of loans and deposits, or the current or potential future contribution to overall net income of Heritage. As of December 2013, the national unemployment rate was 6.7%, and the rates in Georgia, Florida and Alabama were 7.2%, 5.9% and 5.7%, respectively.
Competition
We face strong competition in originating commercial, real estate and other loans and in attracting deposits. Competition in originating real estate loans comes primarily from other banks, credit unions and mortgage bankers. Other banks, credit unions and finance companies also provide vigorous competition in consumer and commercial lending. We attract deposits through our branch office system. Competition for those deposits is principally from other banks and credit unions located in the same community, as well as mutual funds and other alternative investments. We compete for these deposits by offering superior service and a variety of deposit accounts at competitive rates.
Available Information
Heritage maintains a website at www.eheritagebank.com. The Company currently makes available on or through its website its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, amendments to these reports, and all other Securities and Exchange Commission (“SEC”) filings. These materials are also available free of charge on the Securities and Exchange Commission's website at www.sec.gov.
Lending Activities
The following table presents information concerning the composition of HeritageBank’s loan portfolio in dollar amounts and in percentages (before deductions for allowances for losses) as of the dates indicated.
The following table shows the composition of HeritageBank's loan portfolio by fixed- and adjustable-rates at the dates indicated.
(1) Loans acquired through FDIC-assisted transactions are accounted for under ASC 310-30 and are not considered either fixed or variable.
The following schedule illustrates the contractual maturity of HeritageBank's loan portfolio at December 31, 2013, excluding FDIC-acquired loans. Mortgages that have adjustable or renegotiable interest rates are shown as maturing in the period during which the contract is due. The schedule does not reflect the effects of possible prepayments or enforcement of due-on-sale clauses.
(1) Includes demand loans, loans having no stated maturity and overdraft loans.
Lending authority. The Board of Directors has established lending authorities for its officers. Based on individual experience, Market Presidents and Commercial Lenders have established lending authorities for relationships with exposure up to $500,000, and Consumer and Mortgage Lenders have lending authorities for relationships with exposure up to $200,000. The Mortgage Division Co-Presidents have lending authorities for relationships with exposure up to $417,000, and the Regional Managers and Regional Presidents may make and approve secured loans for relationships with exposure up to $1.0 million. Regional Credit Officers or the Chief Banking Officer may approve secured loans for relationships with exposure up to $3.0 million. The Chief Executive Officer or the Chief Credit Officer may approve loans for relationships up to $5.0 million. Relationships and exposures that exceed $5.0 million must be approved by the Board of Directors.
We are subject to lending limits established under Georgia law for loans to one borrower and the borrower's related entities. See Item 1 - How We Are Regulated - HeritageBank of the South for more information. Based on our capital level at December 31, 2013, the maximum amount under Georgia law that we could loan to any one borrower and the borrower's related entities was $21.6 million for fully secured loans (including loans secured by real estate for which we have an independent appraisal) and $13.0 million for all other loans. Internally, we have set a limit of $8.0 million for all loans to any one borrower and the borrower’s related entities. This internal limit may be exceeded with the approval of the Board of Directors.
Major loan customers. Our ten largest lending relationships, excluding FDIC-acquired loans, are with commercial borrowers with total lending exposure, including undrawn lines of credit, of $76.6 million at December 31, 2013. These relationships consist of $10.0 million to a peanut shelling business secured by accounts receivable and inventory located primarily in southwest Georgia; $8.2 million to a specialty chemical business and their related interests in southwest Georgia; $8.0 million to a timber business located primarily in southeast Georgia; $7.9 million to a commercial warehousing and asset inventory management business in north Georgia; $7.7 million to a nursing home secured by real estate located in southwest Georgia; $7.6 million for the permanent financing of a hotel in north central Florida; $7.3 million secured primarily by multifamily and residential rental real estate in central Georgia; $7.0 million secured primarily by multifamily and residential rental real estate in southeast Georgia; $6.9 million to a retail pharmacy business secured by inventory and real estate located primarily in southwest Georgia; and $5.9 million to a nursing home and assisted living secured by real estate located in central Georgia. As of the date of this filing, these major customer relationships were performing and rated as pass credits.
For further information on credit quality, see Item 1 - Asset Quality - Delinquent Loans and - Classified Assets and see Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Residential Real Estate Lending. We originate loans secured by first mortgages on one- to four-family residences, including home equity lines of credit, in our market area and outside our market area for customers whose primary residences are within our lending area. The majority of these loans are originated by us and sold to other lenders. See Item 1 - Loan Originations, Purchases, Sales, Repayments and Servicing for more information. At December 31, 2013, we had $206.6 million, or 26.2% of gross loans, in residential real estate loans including home equity lines of credit, of which $151.9 million were fixed-rate loans and $54.7 million were adjustable rate loans.
Our home equity lines of credit totaled $29.1 million and accounted for 3.6% of gross loans at December 31, 2013. These loans may be originated in amounts, together with the amount of the existing first mortgage, of up to 100% of the value of the property securing the loan. Home equity lines of credit generally have a 3-year to 15-year draw period and require the payment of 1.5% of the outstanding loan balance per month during the draw period, which may be reborrowed at any time during the draw period. We also offer a 3-year to 15-year home equity line of credit that requires interest-only payments for the first five years, then fully amortizing payments over the remaining 10 years of the loan. At December 31, 2013, unfunded commitments on home equity lines of credit totaled $26.3 million. Other consumer loan terms vary according to the type of collateral, length of contract and creditworthiness of the borrower.
We generally underwrite our one- to four-family owner-occupied loans based on the applicant's employment and credit history and the appraised value of the subject property. We typically lend up to 90% of the lesser of the appraised value or purchase price for one- to four-family residential loans. Properties securing our one- to four-family loans are appraised by independent fee appraisers approved by the Board of Directors. We require our borrowers to obtain title insurance, hazard insurance and, if necessary, flood insurance. We currently originate one- to four-family mortgage loans on either a fixed- or adjustable-rate basis, as consumer demand dictates. Our pricing strategy for mortgage loans includes setting interest rates that are competitive with other local financial institutions and consistent with our internal needs. Fixed-rate loans generally have a 15- to 30-year term.
Adjustable-rate mortgage, or ARM, loans are generally offered with annual repricing with a maximum annual rate change of 2% and maximum overall rate change of 6%. We use a variety of indices to reprice our ARM loans. Our ARM loans generally provide for specified minimum and maximum interest rates, with a lifetime cap and floor, and a periodic adjustment of the interest rate over the rate in effect on the date of origination. As a consequence of using caps, the interest rates on these loans may not be as rate sensitive as is our cost of funds. Our ARM loans are written using generally accepted underwriting guidelines. ARM loans generally pose different credit risks than fixed-rate loans, primarily because as interest rates rise, the borrower's payment rise, increasing the potential for default. We do not offer initial discounted rates or “teaser” rates on adjustable-rate mortgage loans. Our real estate loans contain a “due on sale” clause allowing us to declare the unpaid principal balance due and payable upon the sale of the collateral.
We generally underwrite our non-owner-occupied, one- to four-family loans primarily based on a 1.25 times debt service coverage, though we also consider the applicant's creditworthiness and the appraised value of the property. We typically lend up to 85% of the lesser of the appraised value or purchase price for the residence. These loans are offered with a fixed rate or an adjustable rate typically using The Wall Street Journal prime rate as the index. These loans have terms of up to 15 years and are not assumable. We generally obtain title opinions from our counsel regarding these properties.
Commercial Real Estate Lending. We offer a variety of multifamily, nonresidential, and farmland real estate loans. These loans are secured primarily by multifamily dwellings, retail establishments, hotels, motels, warehouses, small office buildings, farmland, and other properties located in our market areas. At December 31, 2013, commercial real estate totaled $302.6 million, or 37.9% of gross loans. Nonresidential real estate totaled $256.6 million, or 32.1% of gross loans, and multifamily real estate totaled $22.7 million, or 2.9% of gross loans as December 31, 2013.
Nonresidential and multifamily loans are originated with either a fixed or adjustable interest rate over various terms and structures. The interest rate on adjustable-rate loans is based on a variety of indices, generally determined through negotiation with the borrower. Loan-to-value ratios on our nonresidential and multifamily real estate loans typically do not exceed 80% of the appraised value of the property securing the loan. Loans secured by nonresidential and multifamily real estate are underwritten based on the income producing potential of the property and the financial strength of the borrower. The net operating income, which is the income derived from the operation of the property less all operating expenses, must be sufficient to cover the payments related to the outstanding debt. We generally require personal guarantees of the borrowers and an assignment of rents or leases in order to be assured that the cash flow from the project will be used to repay the debt. Appraisals on properties securing nonresidential and multifamily real estate loans are performed by independent state certified or licensed fee appraisers approved by the board of directors, with a second independent appraisal review performed if the loan exceeds $500,000.
We generally do not maintain a tax or insurance escrow account for loans secured by nonresidential and multifamily real estate. In order to monitor the adequacy of cash flows on income-producing properties, the borrower is generally required to provide periodic financial information.
Loans secured by nonresidential and multifamily real estate properties generally involve a greater degree of credit risk than single family residential mortgage loans. These loans typically involve large balances to single borrowers or groups of related borrowers. Because payments on loans secured by nonresidential and multifamily real estate properties are often dependent on the successful operation or management of the properties, repayment of these loans may be subject to adverse conditions in the real estate market or the economy. If the cash flow from the project is reduced, or if leases are not obtained or renewed, the borrower's ability to repay the loan may be impaired.
Our loans secured by farmland totaled $23.4 million, or 2.9% of gross loans, and are originated with either a fixed or adjustable interest rate over a three-or five-year term with a balloon payment generally based on a 15-year amortization. The interest rate on adjustable-rate loans is based on a variety of indices, generally determined through negotiation with the borrower. Loan-to-value ratios on our farmland loans typically do not exceed 80% of the appraised value of the property securing the loan. Farmland loans are underwritten based on the income-producing potential of the property and the financial strength of the borrower. In order to monitor the adequacy of cash flows from farm operations, the borrower is required to provide periodic financial information.
Loans secured by farmland generally involve a greater degree of credit risk than one- to four-family residential loans. These loans typically involve large balances, and repayments are often dependent on the successful operation of the farm, making them subject to adverse weather and economic conditions. If the cash flow from the farm operations declines, the borrower’s ability to repay the loan is impaired.
Construction and Land Lending. Our construction loan portfolio consists of loans for the construction of one- to four-family residences, multifamily residences and commercial properties. Construction lending generally affords us an opportunity to receive interest at rates higher than those obtainable from residential lending and to receive higher origination and other loan fees. In addition, construction loans are generally made with adjustable rates of interest for six- to nine-month terms, with interest-only payments due during the construction period. At December 31, 2013, we had $50.2 million in construction loans outstanding, representing 6.3% of gross loans.
Construction loans also involve additional risks because funds are advanced upon the security of the project under construction, which is of uncertain value prior to the completion of construction. Moreover, because of the uncertainties inherent in estimating construction costs, delays arising from labor problems, material shortages, and other unpredictable contingencies, it is relatively difficult to evaluate accurately the total loan funds required to complete a project, and the related loan-to-value ratios. We fund our construction loans based on percentage of completion as determined by physical property inspections. Acquisition and development loans are required to be paid down as lots are sold, though on an accelerated basis so that we are repaid before all the lots are sold. See Item 1 - Asset Quality - Classified Assets for additional information.
Commercial and Industrial Lending. At December 31, 2013, commercial business loans totaled $101.2 million or 12.7% of gross loans. Our commercial business lending activities encompass loans with a variety of purposes and security, including loans to finance accounts receivable, agricultural production, inventory and equipment. Our commercial business lending policy includes credit file documentation and analysis of the borrower's background, capacity to repay the loan, the adequacy of the borrower's capital and collateral as well as an evaluation of other conditions affecting the borrower. Analysis of the borrower's past, present and future cash flows is also an important aspect of our credit analysis.
Commercial business loans are generally secured by business assets, such as accounts receivable, equipment and inventory. This collateral may depreciate over time, may be difficult to appraise and may fluctuate in value based on the success of the business. As a result, the availability of funds for the repayment of commercial business loans may be substantially dependent on the success of the business itself (which, in turn, is often dependent in part upon general economic conditions). We generally obtain personal guarantees on our commercial business loans. Nonetheless, these loans are believed to carry higher credit risk than traditional single family loans.
Consumer and Other Lending. We offer a variety of secured consumer loans, new and used auto loans, boat and recreational vehicle loans, and loans secured by deposit accounts. We also offer low dollar, unsecured loans and consumer credit cards. We originate our consumer and other loans primarily in our market areas. At December 31, 2013, our consumer and other loan portfolio totaled $24.0 million, or 3.0% of gross loans.
We originate auto loans on a direct basis, and auto loans may be written for up to six years and usually have fixed rates of interest. Loan-to-value ratios are up to 100% of the sales price for new autos and 100% of retail value on used autos, based on valuation from official used car guides. Consumer loans generally have shorter terms to maturity, which reduces our exposure to changes in interest rates, and carry higher rates of interest than do one- to four-family residential mortgage loans.
Management believes that offering consumer loan products helps to expand and create stronger ties to our existing customer base by increasing the number of customer relationships and providing cross-market selling opportunities. Consumer loans may entail greater risk than do single family residential mortgage loans, particularly in the case of consumer loans that are secured by rapidly depreciable assets, such as automobiles and recreational vehicles. In these cases, any repossessed collateral for a defaulted loan may not provide an adequate source of repayment of the outstanding loan balance. As a result, consumer loan collections are dependent on the borrower's continuing financial stability and, thus, are more likely to be adversely affected by job loss, divorce, illness, or personal bankruptcy.
Loan Originations, Purchases, Sales, Repayments and Servicing
We originate one- to four-family residential mortgage loans primarily through referrals from real estate agents, builders and from existing customers. Loan origination fees earned totaled $1.4 million, $1.3 million and $814,000 for the years ended December 31, 2013, 2012 and 2011, respectively.
While we originate both adjustable-rate and fixed-rate loans, our ability to originate loans is dependent upon customer demand for loans in our market areas. Demand is affected by competition and the interest rate environment. In periods of economic uncertainty, the ability of financial institutions, including ours, to originate or purchase large dollar volumes of real estate loans may be substantially reduced or restricted, which in turn would lower our interest income.
In addition to the categories of loans originated by us and described above, as of December 31, 2013, $114.2 million, or 14.3% of gross loans, consisted of loans acquired through FDIC-assisted acquisitions, with $50.9 million covered under loss-sharing agreements with the FDIC. Due diligence performed on these loans was limited due to the quick timing required for these transactions; however, the loss-sharing agreements with the FDIC provides coverage for 80% of the covered loan balance, which significantly mitigates the credit risk exposure for these loans. See Item 8 - Note 6 of the Consolidated Financial Statements for additional information about these loans acquired through FDIC-assisted acquisitions.
We have agreements with mortgage lenders, pursuant to which we originate and fund residential mortgage loans for these lenders in accordance with their policies, terms, and conditions. We typically charge the borrower an origination fee for processing the application in accordance with the lender's specifications. We also may earn a premium on these loans based on the difference between carrying value of the loan and the value purchased by a third party. During 2013, we originated $407.4 million of mortgage loans held for sale, generating approximately $12.0 million in mortgage banking income on these loans compared to $137.4 million originated for 2012 generating approximately $5.7 million in mortgage banking income on those loans. We also sold $20.8 million of mortgage loans to the U.S. government sponsored agencies (“GSEs”) during 2013, and, separately, recorded a gain of $202,000 related to the mortgage servicing rights for those loans.
In addition to interest earned on loans and loan origination fees, we receive fees for loan commitments, late payments and other miscellaneous services. The fees vary from time to time, generally depending on the supply of funds and other competitive conditions in the market. Fees for late payments totaled $201,000, $214,000 and $246,000 for the years ended December 31, 2013, 2012 and 2011, respectively.
Asset Quality
When a borrower fails to make a required payment on a loan, we attempt to cure the delinquency by contacting the borrower. Delinquent consumer loan customers are contacted by the lender and a centralized collections department. Delinquent commercial loan customers are contacted by the lender and are turned over to our special assets division if collection efforts by the lender are not successful. If the borrower does not cure the delinquency, we undertake an analysis of the best means to maximize our return through collection efforts, which may include litigation, taking a deed-in-lieu of foreclosure, agreeing to a short sale, and/or initiating foreclosure proceedings. In the event we take title to underlying collateral, we generally seek to sell the asset as soon as practicable.
Delinquent Loans. The table below sets forth the contractual principal balances by category of loans, excluding loans acquired through FDIC-assisted acquisitions, that were 30 to 89 days past due and still accruing interest at December 31, 2013. At all dates presented, we had no accruing loans 90 days or more delinquent.
Nonperforming Assets. The following table sets forth the amounts and categories of nonperforming assets in our loan portfolio. Loans are placed on non-accrual status when the collection of principal and/or interest becomes doubtful. Our FDIC-acquired loans are excluded from the nonperforming loan table below because they are accounted for under ASC Topic 310-30. See Item 8 - Note 6 to the Consolidated Financial Statements. Included in nonaccruing loans at December 31, 2013, are troubled debt restructurings of $5.8 million, which involve forgiving a portion of interest or principal on any loans or making loans at a rate materially less than that of market rates. In addition, at that date we had troubled debt restructurings totaling $1.9 million that were performing in accordance with their modified terms and are not included in nonaccruing loans. Foreclosed assets owned include assets acquired in settlement of loans.
For the year ended December 31, 2013, approximately $462,000 of gross interest income would have been recorded had the non-accruing loans been current in accordance with their original terms. No significant amount was included in interest income on these loans for this period.
See Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations - Comparison of Financial Condition at December 31, 2013 and December 31, 2012 - Delinquencies and Nonperforming Assets for more information on our non-performing assets.
Other Loans of Concern. In addition to the nonperforming assets set forth in the table above, as of December 31, 2013, there was also an aggregate of $11.2 million of loans with respect to which known information about the possible credit problems of the borrowers have caused management to have doubts as to the ability of the borrowers to comply fully with present loan repayment terms and that may result in the future inclusion of those loans in the non-performing asset categories. These loans include all criticized and classified loans and certain other past due loans that are not in a non-performing loan category. These loans have been considered in management's determination of the adequacy of our allowance for loan losses.
At December 31, 2013, we had three other loans of concern of over $1.0 million totaling approximately $5.2 million. The largest was a $2.2 million loan secured by the land used for a recreational vehicles park in Ocala, Florida. The remaining loans of concern at December 31, 2013 consisted of a $2.0 million loan secured by land in Ocala, Florida and a $1.0 million loan secured by residential properties in Albany, Georgia.
Classified Assets. Federal regulations provide for the classification of loans and other assets, such as debt and equity securities considered to be of lesser quality, as substandard, doubtful or loss. An asset is considered substandard if it is inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Substandard assets include those characterized by the distinct possibility that HeritageBank will sustain some loss if the deficiencies are not corrected. Assets classified as doubtful have all of the weaknesses inherent in those classified substandard, with the added characteristic that the weaknesses present make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. Assets classified as loss are those considered uncollectible and of such little value that their continuance as active assets of HeritageBank are not warranted. See Item 8 - Note 5 to the Consolidated Financial Statements for additional information.
When HeritageBank classifies problem assets as either substandard, doubtful, or loss, the loans are charged down to appraised value less selling costs while specific allowances are used for loans that do not qualify for a charge-off but the loss can be reasonably estimated. In addition, we establish general allowances based on historical loss history and migration analysis. General allowances represent loss allowances that have been established to recognize the inherent risk associated with lending activities, but which, unlike specific allowances, have not been allocated to particular problem assets. Our determination as to the classification of its assets and the amount of its valuation allowances is subject to review by the FDIC and the Georgia Department of Banking and Finance (“GDBF”), which may order the establishment of additional general or specific loss allowances.
We regularly review the problem assets in our portfolio to determine whether any assets require classification in accordance with applicable regulations. On the basis of management's review of our assets, at December 31, 2013, we had $19.6 million of our assets internally classified, of which $17.5 million consisted of loans and $2.1 million of other real estate and repossessions. All of these assets were classified as substandard. We had no assets classified as doubtful or loss at December 31, 2013. The total amount classified represented 15.7% of our equity capital and 1.4% of our assets at December 31, 2013. All of our $9.4 million in nonaccruing loans at December 31, 2013, were included in our classified assets at that date, and the allowance for loan losses related to those nonaccruing loans at that date was $1.5 million, or 15.8% of the nonaccruing loan balance.
Allowance for Loan Losses. We maintain an allowance for loan losses to absorb probable incurred losses in the loan portfolio. In evaluating the level of the allowance for loan losses, management considers the types of loans and the amount of loans in the loan portfolio, historical loss experience, migration analysis, probability of default, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral, prevailing economic conditions, and past due status and trends. We analyze the historical migration of loans through each risk rating category and analyze the history of losses as it relates to the various loan types and collateral types in order to evaluate and estimate the volume, magnitude and direction these events. These risk factors and other factors are applied to our review of pass credit loan pools and other assets specially mentioned loan pools. These factors are applied to the substandard loan pool; however, in addition to reviewing the pool, a select group of individual loans are reviewed. The results of the individual review are factored in with the historical loss analysis and applied to the pool. Impaired loans are reviewed individually for specific amounts that are representative of identified credit exposures that are readily predictable by the current performance of the borrower and underlying collateral while impaired loans with balances less than $500,000 typically use a historical loss analysis. See Item 8 - Note 5 to the Consolidated Financial Statements for additional information about our allowance methodology.
At December 31, 2013, our allowance for loan losses was $9.0 million, or 1.1% of the total loan portfolio, compared with a balance of $9.1 million, or 1.4% of total loans at December 31, 2012. Total criticized and classified loans decreased by $4.9 million during the period to $20.6 million at December 31, 2013 from $25.5 million at December 31, 2012. Nonaccrual loans decreased $5.2 million during the period to $9.4 million at December 31, 2013 compared with $14.7 million at December 31, 2012. The decrease in nonaccrual loans from 2012 was primarily driven by improving trends in our loan portfolio. Loans past due thirty days and still accruing decreased by $1.1 million to $1.0 million at December 31, 2013 compared with $2.1 million at December 31, 2012. See Item 8 - Note 5 to the Consolidated Financial Statements for additional information about our loan portfolio.
The allowance for loan losses is maintained at a level which management believes is adequate to absorb all probable losses on loans then present in the loan portfolio. The amount of the allowance is affected by: (1) loan charge-offs, which decrease the allowance; (2) recoveries on loans previously charged-off, which increase the allowance; (3) the provision for possible loan losses charged against income, which increases the allowance; and (4) credit mark transfers as a result of acquired loan pools experiencing credit losses in excess of the fair value discounts established, which increase the allowance. The allowance is discussed further in Item 8 - Notes 1 and 5 to the Consolidated Financial Statements and Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies - Allowance for Loan Losses. The following table sets forth an analysis of our allowance for loan losses.
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(1) Ratios are on an annualized basis and exclude loans accounted for under ASC 310-30.
The distribution of our allowance for losses on loans at the dates indicated is summarized as follows:
Investment Activities
Georgia savings banks have the authority to invest in various types of liquid assets, including United States Treasury obligations, securities of various federal, state and local agencies and jurisdictions, including callable agency securities, certain certificates of deposit of insured banks and savings institutions, certain bankers' acceptances, repurchase agreements, federal funds, and other investments. Subject to various restrictions, Georgia savings banks also may invest their assets in investment grade commercial paper and corporate debt securities and mutual funds whose assets conform to the investments that a Georgia savings bank is otherwise authorized to make directly. See "How We Are Regulated - HeritageBank of the South - Georgia Regulation" for a discussion of additional restrictions on our investment activities.
The Chief Financial Officer and Chief Accounting Officer have the basic responsibility for the management of our investment portfolio. They consider various factors when making decisions, including the marketability, maturity, and tax consequences of the proposed investment. The maturity structure of investments will be affected by various market conditions, including the current and anticipated slope of the yield curve, the level of interest rates, the trend of new deposit inflows, and the anticipated demand for funds via deposit withdrawals and loan originations and purchases. The general objectives of our investment portfolio are to provide liquidity when loan demand is high, to assist in maintaining earnings when loan demand is low and to maximize earnings while satisfactorily managing risk, including credit risk, reinvestment risk, liquidity risk and interest rate risk. See Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations - Asset and Liability Management and Market Risk.
Our investment securities currently consist of mortgage-backed securities, federal agency securities, preferred stocks, state and local government securities, and corporate debt securities. As a member of the Federal Home Loan Bank of Atlanta (“FHLB”), we hold $7.3 million of stock, the minimum amount of stock the FHLB allows based on our level of borrowings. See Item 8 - Note 4 to the Consolidated Financial Statements for more information about our investments.
The following table sets forth the composition of our securities portfolio and other investments at the dates indicated. Our securities portfolio at December 31, 2013, did not contain securities of any single issuer with an aggregate book value in excess of 10% of our equity capital, excluding those issued by the United States Government or GSEs.
The composition and maturities of the securities available for sale portfolio as of December 31, 2013 are indicated in the following table. Yields on tax exempt obligations have been computed on a tax equivalent basis. For further information on the ratings of these securities, see Item 8 - Note 4 to the Consolidated Financial Statements and Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies - Estimates of Fair Value and - Comparison of Financial Condition at December 31, 2013 and December 31, 2012.
Sources of Funds
General. Our sources of funds are deposits, borrowings, payment of principal and interest on loans, interest earned on or maturation of other investment securities and funds provided from operations.
Deposits. We offer a variety of deposit accounts to both consumers and businesses having a wide range of interest rates and terms. Our deposits consist of savings and checking accounts, money market deposit accounts, NOW accounts, demand accounts, and certificates of deposit. We solicit deposits primarily in our market areas and rely on competitive pricing policies, marketing and customer service to attract and retain these deposits. In addition, we solicit brokered deposits when terms and rates are more favorable than those in the markets we serve. At December 31, 2013, we had $111.5 million in brokered deposits, of which $103.3 million were Certificate of Deposit Account Registry Service® or CDARS® One Way Buy deposits, and $8.2 million were customer balances placed in the Reciprocal CDARS® product.
The flow of deposits is influenced significantly by general economic conditions, changes in prevailing interest rates and competition. The variety of deposit accounts we offer has allowed us to be competitive in obtaining funds and to respond with flexibility to changes in consumer demand. We try to manage the pricing of our deposits in keeping with our asset and liability management, liquidity and profitability objectives, subject to competitive factors. Based on our experience, we believe that our deposits are relatively stable sources of funds. Despite this stability, our ability to attract and maintain these deposits and the rates paid on them has been and will continue to be significantly affected by market conditions.
Under regulations of the Board of Governors of the Federal Reserve System (“FRB”), we are required to maintain noninterest-bearing reserves at specified levels against our transaction accounts, primarily checking and NOW accounts. At December 31, 2013, we were in compliance with these federal requirements and, as a result, would have been deemed to be in compliance with a similar reserve requirement under Georgia law.
The following table sets forth our deposit flows during the periods indicated.
The following table indicates the amount of our certificates of deposit and other deposits by time remaining until maturity as of December 31, 2013.
The following tables set forth the average dollar amount of deposits in the various types of non-interest bearing and interest-bearing deposit programs we offered during the periods indicated and the average rate paid on the interest-bearing accounts.
The following table sets forth the dollar amount of deposits in the various types of deposit programs offered at the dates indicated.
The following table shows rate and maturity information for our certificates of deposit at December 31, 2013.
Borrowings. Although deposits are our primary source of funds, we may utilize borrowings when they are a less costly source of funds, when we desire additional capacity to fund loan demand, or when they meet our asset/liability management goals. Our borrowings consist of advances from the FHLB, federal funds purchased, and securities sold under repurchase agreements. See Item 8 - Notes 19 and Note 20 to the Consolidated Financial Statements.
Advances from the FHLB require borrowing capacity supported by the pledging of certain loans or securities. These advances may be made pursuant to several different credit programs, each of which has its own interest rate, range of maturities, and call features. At December 31, 2013, we had $131.4 million in FHLB advances outstanding, including a $4.3 million fair value adjustment for advances acquired with the Frontier acquisition, and the ability to borrow an additional $25.2 million.
We have the ability to borrow from securities broker-dealers and customers by pledging investments. These arrangements are known as securities sold under repurchase agreements. These borrowings can be done on an overnight, short-term or long-term basis. As of December 31, 2013, we had $30.0 million borrowed under long-term agreements with broker-dealers and $5.3 million borrowed under overnight agreements with customers.
We also have the ability to borrow up to $74.0 million from correspondent banks, pursuant to renewable lines of credit. In addition, we also borrow from Chattahoochee Bank of Georgia on an overnight basis, depending on their liquidity needs. At December 31, 2013, we had approximately $2.4 million in federal funds purchased from that bank compared with $417,000 at December 31, 2012.
We are authorized to borrow from the Federal Reserve Bank of Atlanta's “discount window" after we have exhausted other reasonable alternative sources of funds, including FHLB advances.
The following table sets forth the average and weighted average rate paid, period-end balance, maximum month-end balance and average balance of FHLB advances for the periods indicated.
The following table sets forth the maximum month-end balance and average balance of federal funds purchased and securities sold under repurchase agreements for the periods indicated.
Subsidiary and Other Activities
We are engaged in the sale of securities and insurance products to customers through an agreement with a third-party broker-dealer. During the years ended December 31, 2013 and 2012, we earned $2.1 million and $1.8 million, respectively, in gross fees and commissions from this activity. This activity is conducted in accordance with applicable provisions of federal and state insurance and securities laws.
In 2008, we acquired 4.9% of the outstanding shares of Chattahoochee Bank of Georgia, a de novo bank in Gainesville, Georgia, for approximately $1.0 million. This investment provides us with the opportunity to further expand in Northeast Georgia. We also participate in loans generated by Chattahoochee Bank of Georgia that exceed its legal lending limits, allowing us to generate loan volume and exposure to the northeast Georgia market without incurring building and personnel costs. O. Leonard Dorminey, our President and Chief Executive Officer, serves on the board of directors, executive committee and loan committee of Chattahoochee Bank of Georgia. As of December 31, 2013, we had $7.3 million in loan participations and $2.4 million in federal funds purchased from Chattahoochee Bank of Georgia.
Other than HeritageBank, we currently do not have any active subsidiaries.
Employees
At December 31, 2013, we had a total of 426 full-time equivalent employees. Our employees are not represented by any collective bargaining group. Management considers its employee relations to be good.
How We Are Regulated
Set forth below is a brief description of material information regarding certain laws and regulations that are and will be applicable to Heritage and HeritageBank.
Heritage is a savings and loan holding company subject to regulation and supervision by the FRB. The FRB requires that Heritage serve as a source of financial and managerial strength for HeritageBank, particularly when HeritageBank is in financial distress. HeritageBank is a Georgia savings bank subject to regulation and supervision by the GDBF and the FDIC, which also insures our deposits. The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) created the Consumer Financial Protection Bureau (“CFPB”) that has authority to promulgate regulations intended to protect consumers with respect to financial products and services, including those provided by HeritageBank, and to restrict unfair, deceptive or abusive conduct by providers of consumer financial products and services. These regulations had previously been enacted by HeritageBank’s primary federal regulator. As a public company, Heritage is subject to the regulation and reporting requirements of the SEC.
Legislation is introduced from time to time in the United States Congress and Georgia General Assembly that may affect our operations. In addition, the regulations governing Heritage and HeritageBank may be amended from time to time by the GDBF, the FDIC, the FRB, the CFPB or the SEC, as appropriate. Any legislative or regulatory changes, including those resulting from the Dodd-Frank Act, in the future could adversely affect our operations and financial condition. See “The Dodd-Frank Act” below for additional information on its provisions.
The GDBF, the FDIC and the FRB, as appropriate, have extensive enforcement authority over Heritage and HeritageBank. This enforcement authority includes, among other things, the ability to assess civil money penalties, to issue cease-and-desist or removal orders and to initiate injunctive actions. In general, these enforcement actions may be initiated for violations of laws and regulations and unsafe or unsound practices. Other actions or inactions may provide the basis for enforcement action, including misleading or untimely reports filed with the FDIC. Except under certain circumstances, public disclosure of formal enforcement actions by the FDIC and FRB is required by law.
HeritageBank of the South
HeritageBank, as a Georgia savings bank, is subject to regulation and periodic examination by the GDBF and the FDIC. This regulation extends to all aspects of its operations. HeritageBank is required to maintain minimum levels of regulatory capital and is subject to some limitations on the payment of dividends to Heritage. See “Regulatory Capital Requirements for HeritageBank” and “Limitations on Dividends and Other Capital Distributions” below. State and federal laws and regulations prescribe the investment and lending authority and activities of Georgia savings banks. The FDIC also insures the deposits of HeritageBank to the maximum extent permitted by law. This regulation of HeritageBank is generally intended for the protection of depositors and the insurance of accounts fund and not for the purpose of protecting stockholders.
Georgia Regulation. HeritageBank is subject to extensive regulation and supervision by the GDBF. The GDBF regularly examines HeritageBank, often jointly with the FDIC. As a Georgia savings bank, HeritageBank is required to have no more than 50% of its assets in commercial real estate and business loans. HeritageBank is in compliance with this requirement. Our lending and investment authority and other activities are governed by Georgia law and regulations and policies of the GDBF. We are subject to a statutory lending limit for aggregate loans to one person or a group of persons combined because of certain common interests. That limit is 15% of our statutory capital base, except for loans fully secured by good collateral or ample security, which includes real estate with an independent appraisal, in which case that limit is increased to 25%. As of December 31, 2013, we are in compliance with the statutory lending limits. Our statutory capital base consists of our stock, paid-in-capital and surplus, capital debt and appropriated retained earnings, which is that portion of our retained earnings designated by the board of directors as not available for dividends, reduced by intangible assets. We have not appropriated any retained earnings. Georgia law limits our ability to invest in real estate, including a limit on fixed assets of 60% of our statutory capital base, except for temporary grants of authority to exceed that limit granted by the GDBF. We are in compliance with limitations on our fixed assets as of December 31, 2013.
Insurance of Accounts and Regulation by the FDIC. The FDIC regularly examines HeritageBank and prepares reports for the consideration of its board of directors on any deficiencies that it may find in operations. HeritageBank generally must notify or obtain the approval of the FDIC if it or any of its subsidiaries intend to engage in activities not authorized for national banks. During examinations, the FDIC may require the Bank to establish additional reserves for loan losses, which decreases the Company’s net income. The FDIC has adopted guidelines establishing safety and soundness standards on such matters as loan underwriting and documentation, asset quality, earnings standards, internal controls and audit systems, interest rate risk exposure, and compensation and other employee benefits. Any institution that fails to comply with these standards must submit a compliance plan.
HeritageBank’s deposits are insured up to the applicable limits by the FDIC, and such insurance is backed by the full faith and credit of the United States Government. The basic deposit insurance is $250,000 per each separately insured depositor, as defined in FDIC regulations. As insurer, the FDIC imposes deposit insurance premiums and is authorized to conduct examinations of and to require reporting by insured institutions. Our deposit insurance premiums for the year ended December 31, 2013 were approximately $979,000. Those premiums have increased in recent years in conjunction with our growth in total assets and will likely continue to increase in the future. Also, if the Bank experiences financial distress or operates in an unsafe or unsound manner, these deposit premiums will increase based on the formula established by the FDIC.
On February 7, 2011, pursuant to the Dodd-Frank Act, the FDIC adopted new regulations, which became effective April 1, 2011, that redefined the “assessment base” used for calculating deposit insurance assessments. Unlike the previous system, in which the assessment base was calculated by using an insured depository institution’s domestic deposits less a few allowable exclusions, the new assessment base is calculated using the average consolidated total assets of an insured depository institution less the average tangible equity (Tier 1 capital) of such institution. The FDIC continues to utilize a risk-based assessment system in which institutions will be subject to assessment rates ranging from 2.5 to 45 basis points, subject to adjustments for unsecured debt and, in certain cases, brokered deposits. The new rules eliminated adjustments for secured liabilities.
The new rules retain the FDIC’s flexibility to, without further notice-and-comment rulemaking, adopt rates that are higher or lower than the stated base assessment rates, provided that the FDIC cannot (i) increase or decrease the total rates from one quarter to the next by more than two basis points, or (ii) deviate by more than two basis points from the stated base assessment rates. Although the Dodd-Frank Act makes the FDIC’s payment of a dividend to depository institutions discretionary, as opposed to mandatory, when the reserve ratio exceeds a certain threshold, the FDIC’s new rule establishes a decreasing schedule of assessment rates that would take effect when the DIF reserve ratio first meets or exceeds 1.15%. If the DIF reserve ratio meets or exceeds 1.15%, base assessment rates would range from 1.5 to 40 basis points; if the DIF reserve ratio meets or exceeds 2%, base assessment rates would range from 1 to 38 basis points; and if the DIF reserve ratio meets or exceeds 2.5%, base assessment rates would range from 0.5 to 35 basis points. All base assessment rates would continue to be subject to adjustments for unsecured debt and brokered deposits.
The FDIC also collects a deposit-based assessment from insured financial institutions on behalf of The Financing Corporation (“FICO”). The funds from these assessments are used to service debt issued by FICO in its capacity as a financial vehicle for the Federal Savings & Loan Insurance Corporation. The FICO assessment rate is set quarterly and in 2013 it averaged 0.64 cents per $100 of average total assets less average tangible equity. These assessments will continue until the debt matures between 2017 and 2019.
The FDIC also may prohibit any insured institution from engaging in any activity that it determines by regulation or order to pose a serious risk to the deposit insurance fund and may terminate our deposit insurance if it determines we have engaged in unsafe or unsound practices or are in an unsafe or unsound condition.
Heritage
As the holding company of a Georgia savings bank, Heritage is subject to regulation and periodic examination by the GDBF and the FRB. This regulation extends to all aspects of its operations. Our federal and state regulators impose minimum capital requirements on us and the other holding companies and financial institutions they regulate. They also may impose higher capital requirements on an individualized basis if they believe the financial institution or holding company is subject to excessive risk. See “Regulatory Capital Requirements for Heritage” and “Limitations on Dividends and Other Capital Distributions” below.
Heritage is subject to regulation, supervision and examination by the FRB. Applicable federal law and regulations limit the activities of Heritage and require the approval of the FRB for any acquisition or divestiture of a subsidiary, including another financial institution or holding company thereof. Heritage is required to file reports with the FRB and is subject to regulation and examination by the FRB, including regulations requiring that the Company serve as a source of financial and managerial strength for the Bank, particularly when the Bank is in financial distress. Pursuant to the Dodd-Frank Act, the longstanding source of strength policy has been given the force of law and additional regulations promulgated by the FRB to further implement the intent of the statutory provision are possible. As in the past, such financial support from the Company may be required at times when, without this legal requirement, the Company may not be inclined to provide it.
Under federal law, if HeritageBank fails the qualified thrift lender test, Heritage must obtain the approval of the FRB prior to continuing, directly or through other subsidiaries, any business activity other than those approved for multiple savings association holding companies or their subsidiaries. In addition, within one year of such failure, Heritage must register as, and will become subject to, the restrictions applicable to bank holding companies. The qualified thrift lender test requires a savings institution to have at least 65% of its portfolio assets, as defined by regulation, in qualified thrift investments on a monthly average for nine out of every 12 months on a rolling basis. As an alternative, the savings institution may maintain 60% of its assets in those assets specified in Section 7701(a)(19) of the Internal Revenue Code. Under either test, such assets primarily consist of residential housing related loans and investments. At December 31, 2013, HeritageBank met the test.
The GDBF also has supervisory and examination authority over Heritage. Under this authority, there are limits on the amount of debt that can be incurred by Heritage, and Heritage must file periodic reports and annual registration forms.
The Dodd-Frank Act
The Dodd-Frank Act, which was enacted in July 2010, has had a broad impact on the financial services industry. Its provisions include significant regulatory and compliance changes that are designed to improve the supervision, oversight, safety and soundness of the financial services sector. Additionally, the Dodd-Frank Act establishes a new framework for systemic risk oversight within the financial system to be distributed among new and existing federal regulatory agencies, including the Financial Stability Oversight Council, the FRB, the Office of the Comptroller of the Currency and the FDIC.
Uncertainty remains as to the ultimate impact of the Dodd-Frank Act, which could have a material adverse impact on the financial services industry as a whole or on the Company’s and the Bank’s business, results of operations , and financial condition. Many aspects of the Dodd-Frank Act are subject to rulemaking and will take effect over several years, making it difficult to anticipate the overall financial impact on the Company, its customers or the financial industry more generally. However, it is likely that the Dodd-Frank Act will increase the regulatory burden, compliance costs and interest expense for the Company and Bank. Some of the rules that have been adopted to comply with the Dodd-Frank Act's mandates are discussed below.
Consumer Financial Protection Bureau. The Dodd-Frank Act centralized responsibility for consumer financial protection including implementing, examining and enforcing compliance with federal consumer financial laws with the CFPB. Depository institutions with less than $10 billion in assets, such as the Bank, will be subject to rules promulgated by the CFPB but will continue to be examined and supervised by federal banking regulators for consumer compliance purposes.
UDAP and UDAAP. Recently, banking regulatory agencies have increasingly used a general consumer protection statute to address "unethical" or otherwise "bad" business practices that may not necessarily fall directly under the purview of a specific banking or consumer finance law. The law of choice for enforcement against such business practices has been Section 5 of the Federal Trade Commission Act-the primary federal law that prohibits unfair or deceptive acts or practices and unfair methods of competition in or affecting commerce ("UDAP" or "FTC Act"). "Unjustified consumer injury" is the principal focus of the FTC Act. Prior to the Dodd-Frank Act, there was little formal guidance to provide insight to the parameters for compliance with the UDAP law. However, the UDAP provisions have been expanded under the Dodd-Frank Act to apply to "unfair, deceptive or abusive acts or practices" ("UDAAP"), which has been delegated to the CFPB for supervision. The CFPB has published its first Supervision and Examination Manual that addresses compliance with and the examination of UDAAP.
Mortgage Reform. The CFPB has adopted final rules implementing minimum standards for the origination of residential mortgages, including standards regarding a customer's ability to repay, restricting variable-rate lending by requiring that the ability to repay variable-rate loans be determined by using the maximum rate that will apply during the first five years of a variable-rate loan term, and making more loans subject to provisions for higher cost loans, new disclosures, and certain other revisions. In addition, the Dodd-Frank Act provides borrowers with additional defenses to rise against foreclosures.
Interchange Fees. The Federal Reserve has issued final rules limiting the amount of any debit card interchange fee that an issuer may receive or charge with respect to electronic debit card transactions to be reasonable and proportional to the cost incurred by the issuer with respect to the transaction.
Volcker Rule. On December 10, 2013, the federal regulators adopted final regulations to implement the proprietary trading and private fund prohibitions of the Volcker Rule under the Dodd-Frank Act. Under the final regulations, which will become effective on April 1, 2014, banking entities are generally prohibited, subject to significant exceptions from: (i) short-term proprietary trading as principal in securities and other financial instruments, and (ii) sponsoring or acquiring or retaining an ownership interest in private equity and hedge funds. The Federal Reserve has granted an extension for compliance with the Volcker Rule until July 21, 2015. The Company is reviewing the impact of the Volcker Rule on its investment portfolio.
Many of the provisions of the Dodd-Frank Act are subject to delayed effective dates or require the adoption of further implementing regulations and, therefore, their impact on the Company’s operations cannot be fully determined at this time.
Regulatory Capital Requirements for HeritageBank.
HeritageBank is required to maintain minimum levels of regulatory capital under regulations of the FDIC and polices of the GDBF. These regulations established two capital standards, a leverage capital requirement and a risk-based capital requirement. The FDIC also may impose capital requirements in excess of these standards on individual institutions on a case-by-case basis based on the particular circumstances or risk profile of the institution. See Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations - Capital Resources for information on the Bank’s compliance with these capital requirements.
The capital standards generally require Tier 1 capital equal to at least 4.0% of adjusted total assets, deducting most intangibles. The FDIC also requires HeritageBank to have Tier 1 capital of at least 4.0% of risk weighted-assets and total capital of at least 8.0% of risk-weighted assets. In determining the amount of risk-weighted assets, all assets, including certain off-balance sheet items, will be multiplied by a risk weight, ranging from 0% to 100%, based on the risk inherent in the type of asset. Total capital consists of Tier 1 capital, as defined above, and Tier 2 capital, which consists of certain permanent and maturing capital instruments that do not qualify as Tier 1 capital and of the allowance for possible loan and lease losses up to a maximum of 1.25% of risk-weighted assets. Tier 2 capital may be used to satisfy these risk-based requirements only to the extent of Tier 1 capital. The FDIC is authorized to require HeritageBank to maintain an additional amount of total capital to account for concentration of credit risk, level of interest rate risk, equity investments in non-financial companies and the risk of non-traditional activities.
The FDIC is authorized and, under certain circumstances, required to take certain actions against banks that fail to meet their capital requirements. The FDIC is generally required to take action to restrict the activities of an “undercapitalized institution," which is an institution with less than either a 4% leverage capital ratio, a 4% Tier 1 risked-based capital ratio or an 8% total risk-based capital ratio. Any such institution must submit a capital restoration plan and until such plan is approved by the FDIC may not increase its assets, acquire another institution, establish a branch or engage in any new activities, and generally may not make capital distributions. The FDIC is authorized to impose the additional restrictions.
Any institution that fails to comply with its capital plan or has Tier 1 risk-based or leverage capital ratios of less than 3% or a total risk-based capital ratio of less than 6% is considered "significantly undercapitalized" and must be made subject to one or more additional specified actions and operating restrictions that may cover all aspects of its operations and may include a forced merger or acquisition of the institution. An institution with tangible equity to total assets of less than 2% is "critically undercapitalized" and becomes subject to further mandatory restrictions on it. The FDIC generally is authorized to reclassify an institution into a lower capital category and impose the restrictions applicable to such category if the institution is engaged in unsafe or unsound practices or is in an unsafe or unsound condition.
The imposition by the FDIC of any of these measures on HeritageBank may have a substantial adverse effect on our operations and profitability.
Georgia imposes a capital requirement based on the leverage capital requirement of the FDIC. A Georgia savings bank must have at least a 4.5% leverage capital ratio, though the GDBF can impose a higher requirement for the specific circumstances and risks of the institution. Many banks are required to have a 5.5% ratio to address these specific circumstances and risks, and any bank with a less than 5.5% leverage capital ratio must submit a two-year capital plan with the GDBF.
Regulatory Capital Requirements for Heritage. Heritage is required to maintain a certain level of capital under a policy of the GDBF that imposes a Tier 1 capital to total assets capital ratio of 4%, or higher for holding companies engaged in more risky, non-financial businesses. This level is based on the capital requirement imposed on bank holding companies by the FRB and is similar to the Tier 1 leverage ratio imposed on HeritageBank. If Heritage fails to meet this requirement, it must file a capital plan and focus on reducing its more risky operations, and it may be subject to an enforcement action, including a capital directive.
Basel III. On July 2, 2013, the Federal Reserve approved final rules that substantially amend the regulatory risk-based capital rules applicable to Heritage and HeritageBank. On July 9, 2013, the FDIC also approved, as an interim final rule, the regulatory capital requirements for U.S. banks, following the actions of the Federal Reserve. The final rules implement the “Basel III” regulatory capital reforms, as well as certain changes required by the Dodd-Frank Act.
The final rules include new or increased risk-based capital requirements that will be phased in from 2015 to 2019. The rules add a new common equity Tier 1 capital to risk-weighted assets ratio minimum of 4.5%, increase the minimum ratio of Tier 1 capital to risk-weighted assets from 4.0% to 6.0%, and decrease the Tier 2 capital that may be included in calculating total risk-based capital from 4.0% to 2.0%. The final rules also introduce a common equity Tier 1 capital conservation buffer of 2.5% of risk-weighted assets, which is in addition to the Tier 1 and total risk-based capital requirements. The required minimum ratio of total capital to risk-weighted assets will remain 8.0% and the minimum leverage ratio will remain 4.0%. The new risk-based capital requirements (except for the capital conservation buffer) will become effective for the Company on January 1, 2015. The capital conservation buffer will be phased in over four years beginning on January 1, 2016, with a maximum buffer of 0.625% of risk-weighted assets for 2016, 1.25% for 2017, 1.875% for 2018, and 2.5% for 2019 and thereafter. Failure to maintain the required capital conservation buffer will result in limitations on capital distributions and on discretionary bonuses to executive officers.
The following chart compares the risk-based capital ratios required under existing Federal Reserve rules to those prescribed under the new final rules described above:
The final rules also implement revisions and clarifications consistent with Basel III regarding the various components of Tier 1 capital, including common equity, unrealized gains and losses and instruments that will no longer qualify as Tier 1 capital. The final rules also set forth certain changes for the calculation of risk-weighted assets that the Company will be required to implement beginning January 1, 2015.
In addition to the updated capital requirements, the final rules also contain revisions to the prompt corrective action framework. Beginning January 1, 2015, the minimum ratios for the Bank to be considered well-capitalized will be updated as follows:
Management is currently evaluating the provisions of the final rules and their expected impact on the Heritage and HeritageBank. Based on the Heritage and HeritageBank’s current capital composition and levels, management does not presently anticipate that the final rules present a material risk to Heritage or HeritageBank’s financial condition or results of operations.
Limitations on Dividends and Other Capital Distributions
The ability of the Bank to pay dividends depends on its earnings and capital levels and may be limited by FDIC or GDBF directives or orders. Unless it meets certain financial criteria, HeritageBank must obtain the prior written approval of the GDBF before paying any dividend to Heritage. Those financial criteria are having: (1) classified assets of no more than 80% of Tier 1 capital plus an allowance for loan losses at the time of its last examination; (2) paid no more than 50% of last calendar year's net income in dividends in the current calendar year, and (3) a Tier 1 leverage capital ratio of at least 6%. Georgia law prohibits HeritageBank from paying a dividend if its debt to equity ratio is 30% or more or if it is not meeting its capital requirement. HeritageBank paid $3.7 million in dividends in 2013 and $2.2 million in dividends in 2012.
As a subsidiary financial institution of a savings association holding company, any distributions of capital by Heritage, including dividends and stock redemptions or repurchases, are subject to regulation by the FRB. Heritage must file a notice with the FRB before declaring any dividend. The FRB will consult the FDIC about the appropriateness of the proposed dividend, and the FRB may object to any proposed dividend.
Restrictions on Transactions with Affiliates
Heritage and HeritageBank are subject to the provisions of Section 23A of the Federal Reserve Act. Section 23A places limits on the amount of:
· a bank’s loans or extensions of credit to affiliates;
· a bank’s investment in affiliates;
· assets a bank may purchase from affiliates, except for real and personal property exempted by the FRB;
· loans or extensions of credit made by a bank to third parties collateralized by the securities or obligations of affiliates; and
· a bank’s guarantee, acceptance or letter of credit issued on behalf of an affiliate.
The total amount of the above transactions is limited in amount, as to any one affiliate, to 10% of a bank’s capital and surplus and, as to all affiliates combined, to 20% of a bank’s capital and surplus. In addition to the limitation on the amount of these transactions, each of the above transactions must also meet specified collateral requirements. HeritageBank must also comply with other provisions designed to avoid taking low-quality assets.
Heritage and HeritageBank are also subject to the provisions of Section 23B of the Federal Reserve Act, which, among other things, prohibit an institution from engaging in the above transactions with affiliates unless the transactions are on terms substantially the same, or at least as favorable to the institution or its subsidiaries, as those prevailing at the time for comparable transactions with nonaffiliated companies.
The Dodd-Frank Act enhances the requirements for certain transactions with affiliates under Section 23A and 23B, including an expansion of the definition of “covered transactions” and increasing the amount of time for which collateral requirements regarding covered transactions must be maintained.
HeritageBank is also subject to restrictions on extensions of credit to its executive officers, directors, principal shareholders and their related interests. These extensions of credit (1) 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 (2) must not involve more than the normal risk of repayment or present other unfavorable features. Effective July 21, 2011, an insured depository institution is prohibited from engaging in asset purchases or sales transactions with its officers, directors or principal shareholders unless on market terms and, if the transaction represents greater than 10% of the capital and surplus of the bank, it has been approved by a majority of the disinterested directors.
Federal Taxation
Heritage and HeritageBank are subject to federal income taxation in the same general manner as other corporations, with some exceptions discussed below. The following discussion of federal taxation is intended only to summarize certain pertinent federal income tax matters and is not a comprehensive description of the tax rules applicable to Heritage or HeritageBank.
Heritage will file a consolidated federal income tax return with HeritageBank. Accordingly, it is anticipated that any cash distributions made by Heritage to its stockholders would be considered to be taxable dividends and not as a nontaxable return of capital to stockholders for federal and state tax purposes.
Method of Accounting. For federal income tax purposes, HeritageBank currently reports its income and expenses on the accrual method of accounting and uses a fiscal year ending on December 31 for filing its federal income tax return.
Minimum Tax. The Internal Revenue Code imposes an alternative minimum tax at a rate of 20% on a base of regular taxable income plus certain tax preferences, called alternative minimum taxable income. The alternative minimum tax is payable to the extent such alternative minimum taxable income is in excess of an exemption amount. Net operating losses can offset no more than 90% of alternative minimum taxable income. Certain payments of alternative minimum tax may be used as credits against regular tax liabilities in future years.
Net Operating Loss Carryforwards. A financial institution may carryback net operating losses to the preceding two taxable years and forward to the succeeding 20 taxable years. This provision applies to losses incurred in taxable years beginning after August 6, 1997. At December 31, 2013, Heritage did not have any net operating loss carryforwards for federal income tax purposes.
Corporate Dividends-Received Deduction. Because it files a consolidated return with its wholly owned subsidiary, HeritageBank, dividends from HeritageBank are not included as income to Heritage. The corporate dividends-received deduction is 100%, or 80% in the case of dividends received from corporations with which a corporate recipient does not file a consolidated tax return, depending on the level of stock ownership of the payor of the dividend. Corporations that own less than 20% of the stock of a corporation distributing a dividend may deduct 70% of dividends received or accrued on their behalf.
State Taxation
Heritage and HeritageBank are subject to Georgia, Florida, and Alabama corporate income tax, which is assessed at the rate of 6% for Georgia and Florida and 6.5% for Alabama. For this purpose, taxable income generally means federal taxable income subject to certain modifications provided for in Georgia, Florida, and Alabama law. Heritage and HeritageBank also are subject to Georgia business occupation taxes computed on gross receipts after deducting exempt income and interest paid on deposits and other liabilities. The tax rates assessed vary from one municipality to another. The total occupation taxes expensed in 2013 were $384,000.
Item 1A.
Item 1A. Risk Factors
The following are certain risk factors that could impact our business, financial results, and results of operations. Investing in our common stock involves risks, including those described below. These risk factors should be considered by prospective and current investors in our common stock when evaluating the disclosures in this Annual Report on Form 10-K (particularly the forward-looking statements). These risk factors could cause actual results and conditions to differ materially from those projected in forward-looking statements. If any of the events in the following risks actually occur, or if additional risks and uncertainties not presently known to us or that we believe are immaterial do materialize, then our business, financial condition or results of operations could be materially adversely impacted. In addition, the trading price of our common stock could decline due to any of the events described in these risks.
The United States economy has been gradually improving but unemployment is still elevated, and another economic downturn impacting our geographic market areas would adversely affect our business and financial results.
The United States experienced a severe economic recession beginning in 2008 and many of the effects of that recession are expected to continue in 2014. While economic growth has resumed recently, the rate of growth has been slow and unemployment remains at high levels and is not expected to improve greatly in the near future. Although loan portfolio quality has improved, another economic downturn could produce additional losses in our portfolio.
Our expansion efforts, particularly through new and acquired branches, may not be successful if we fail to manage our growth effectively.
A key component of our strategy to grow and improve profitability is to expand our branch network into communities within or adjacent to Georgia, Florida and Alabama markets in which we currently conduct business. Operating branches outside of our original southwest Georgia market and beyond our current market areas may subject us to additional risk, including the local risks related to the new market areas, management of employees from a distance, additional credit risks, logistical operational issues and management time constraints.
We regularly evaluate potential acquisitions and expansion opportunities, and, if appropriate opportunities present themselves, we expect to engage in selected acquisitions of financial institutions in the future. There can be no assurance that we will successfully identify appropriate opportunities, that we will be able to negotiate or finance such activities or that such activities, if undertaken, will be successful. We can provide no assurance that we will be able to manage the costs and implementation risks associated with this strategy so that expansion of our branch network will be profitable. In addition, if we were to conclude that the value of an acquired business had decreased and that the related goodwill had been impaired, that conclusion would result in an impairment of goodwill charge to us, which would adversely affect our results of operations.
Our major expansion efforts into the mortgage business may not be successful if we fail to manage our growth effectively.
Key components of our strategy to grow the mortgage business include significantly growing our mortgage origination volume and selling loans directly to the GSEs. Our agreements with investors to sell our loans generally contain covenants that require us to repurchase loans under certain circumstances, including some delinquencies, or to return premiums paid by those investors if the loans are paid off early. If we are required to repurchase sold loans under these covenants, they may be deemed troubled loans, with the potential for charge-offs and/or loss provision changes, which could impact our earnings and asset quality ratios adversely. During 2013, we originated $407.4 million in mortgage loans held for sale and we hold a mortgage repurchase reserve of $20,000 at December 31, 2013 which may not be enough to satisfy any future losses associated with the repurchase of loans we originated. Separately, we sold $20.8 million directly to the GSEs during 2013 which increases the risk of repurchase because we are held to a higher degree of internal quality assurance for underwriting compliance by the GSEs compared to other buyers of mortgage loans. We did not incur any losses in conjunction with these agreements in 2013. Our ability to sell loans on the secondary mortgage market is impacted by interest rate changes and investor demand or expected return. If this market becomes less liquid, we may not be able to rely as much on loan sales to reduce our interest rate and credit risk. In connection with the GSE sales, we are servicing such loans and at December 31, 2013 mortgage servicing rights (“MSRs”) of $202,000 were recorded and could be subjected to impairment if prepayment speeds are faster than the anticipated speeds at the recording of the asset.
We have engaged in four FDIC-assisted transactions with two subject to loss-sharing agreements which could present additional risks to our financial condition and earnings.
We have engaged in four FDIC-assisted acquisitions with two subject to loss-sharing agreements. These acquisitions involve risks similar to acquiring existing banks, even though the FDIC might provide assistance to mitigate certain risks, such as sharing in exposure to loan losses and providing indemnification against certain liabilities of the failed institution. As is typical in the acquisition of a failed financial institution, many of the loans acquired in these acquisitions were non-performing and had poor documentation, including a lack of current financial information on borrowers and of current evidence of collateral value.
As of December 31, 2013, we held $63.3 million in non-covered FDIC-acquired assets and $50.9 million in covered FDIC-acquired assets at fair value, which includes a non-covered discount of $23.6 million and a covered discount of $51.2 million. These loans are carried on our books at fair value, based on an estimate of future cash flows, which we review and evaluate quarterly. We cannot assure that the asset discount will fully protect us from all future losses.
As of December 31, 2013, we held an FDIC loss-share receivable of $41.3 million associated with our loss-sharing agreements with the FDIC. This receivable is periodically adjusted to reflect the present value of our expected losses reimbursed at 80% related to FDIC-assisted acquisitions covered under a loss-sharing agreement plus 80% of reimbursable expenses less recoveries. The receivable is adjusted for improvements in cash flow by reducing the receivable through negative accretion. Conversely, if losses are greater than anticipated, the receivable would be increased. We cannot assure that the receivable will not incur a future impairment related to the actual reimbursement from the FDIC or improvement in the collected cash flows for the covered assets. Additionally, loss-sharing agreements have limited terms. Therefore, the FDIC will not reimburse us for any charge-offs or related losses that we experience after the term of each loss-sharing agreement expires.
We cannot assure that we will be successful in overcoming all the risks associated with managing the problem loans acquired in connection with FDIC-assisted transactions. Our inability to overcome these risks could have an adverse effect on our ability to achieve our business strategy and maintain our market value and profitability. Moreover, the risk of managing the FDIC loss-share receivable adds increased volatility and risk to our earnings over the period of these loss sharing agreements.
Changes in national and local economic conditions could lead to higher than anticipated loan charge-offs on assets acquired in FDIC-assisted transactions.
The fluctuations in national, regional and local economic conditions, including those related to local residential, commercial real estate and construction markets, may increase the level of charge-offs that we make to our loan portfolio, and, consequently, reduce our net income, and may also increase the level of charge-offs on the loan portfolios that we have acquired in FDIC-assisted acquisitions and correspondingly reduce our net income. These fluctuations are not predictable, cannot be controlled and may have a material adverse impact on our operations and financial condition even if other favorable events occur.
Although we have entered into two loss-share agreements with the FDIC providing that a significant portion of losses related to specified loan portfolios acquired in connection with our two 2011 FDIC-assisted transactions will be borne by the FDIC, we are not protected for all losses resulting from charge-offs with respect to those specified loan portfolios. Additionally, the loss-share agreements have limited terms; therefore, any charge-off of related losses that we experience after the term of the loss-sharing agreements will not be reimbursable by the FDIC and will negatively impact our net income.
Our business may be affected adversely by credit risk associated with residential real estate.
As of December 31, 2013, residential real estate, including home equity loans and lines of credit, totaled $206.6 million, or 25.9%, of total loans excluding FDIC-acquired loans. This type of lending is generally sensitive to regional and local economic conditions that may significantly affect the ability of borrowers to meet their loan payment obligations, making loss levels difficult to predict. Although residential real estate values have stabilized in our local housing markets, if residential values begin to fall again we are exposed to increased losses if borrowers default on their loans. Continued declines in both the volume of real estate sales and sales prices, coupled with high levels of unemployment, may result in higher loan delinquencies or problem assets, a decline in demand for our products and services or a decrease in our deposits. These potential negative events may cause us to incur losses, which would adversely affect our capital and liquidity and could damage our financial condition and business operations. These declines may have a greater impact on our earnings and capital than on the earnings and capital of financial institutions that have more diversified loan portfolios.
We are subject to credit risks in connection with the concentration of adjustable rate loans in our portfolio.
Adjustable rate loans totaled $139.9 million, or 17.5%, of our loan portfolio at December 31, 2013. Borrowers with adjustable rate loans are exposed to increased monthly payments when the related interest rate adjusts upward under the terms of the loan to the rate computed in accordance with the applicable index and margin. Any rise in prevailing market interest rates may result in increased payments for borrowers who have adjustable-rate loans, increasing the possibility of default. Borrowers seeking to avoid these increased monthly payments by refinancing their loans may no longer be able to find available replacement loans at comparably lower interest rates. In addition, declining housing prices may prevent refinancing or a sale of the home because borrowers may then have insufficient equity in their homes. These events, alone or in combination, may contribute to higher delinquency rates and negatively impact our earnings.
If our nonperforming assets increase, our earnings will be negatively impacted.
At December 31, 2013, our nonperforming assets (which consist of non-accrual loans, loans 90 days or more delinquent, nonperforming troubled debt restructurings and foreclosed real estate assets) totaled $11.2 million. Our nonperforming assets adversely affect our net income in various ways. We do not record interest income on non-accrual loans or real estate owned. We must reserve for estimated credit losses, which are established through a current period charge to the provision for loan losses, and from time to time, if appropriate, we must write down the value of properties in our other real estate owned portfolio to reflect changing market values. Additionally, there are legal fees associated with the resolution of problem assets as well as carrying costs including taxes, insurance and maintenance related to our other real estate owned. Further, the resolution of nonperforming assets requires the active involvement of management, potentially distracting them from the overall supervision of our operations and other income-producing activities.
If our allowance for loan losses is not sufficient to cover actual loan losses, our earnings could decrease.
We make various assumptions and judgments about the collectability of our loan portfolio, including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral for the repayment of many of our loans. In determining the amount of the allowance for loan losses, we review our loans and our loss and delinquency experience, and we evaluate economic conditions. Management recognizes that significant new growth in loan portfolios, new loan products, and the refinancing of existing loans can result in portfolios comprised of unseasoned loans that may not perform in a historical or projected manner. If our assumptions are incorrect, our allowance for loan losses may not be sufficient to cover actual losses, resulting in additions to our allowance. Additions to our allowance decrease our net income. Our allowance for loan losses, excluding loans acquired through FDIC-assisted acquisitions, was 1.31% of gross loans, excluding loans acquired through FDIC-assisted acquisitions, and 94.9% of non-performing loans at December 31, 2013, compared to 1.55% of gross loans, excluding loans acquired through FDIC-assisted acquisitions, and 61.7% of nonperforming loans at December 31, 2012.
Our regulators and external auditor periodically review our allowance for loan losses and may require us to recognize additions to the allowance based on their judgments about information available to them at the time of their review. These increases in our allowance for loan losses or loan charge-offs may have a material adverse effect on our financial condition and results of operations.
If our investments in real estate are not properly valued or sufficiently reserved to cover actual losses, or if we are required to increase our valuation reserves, our earnings could be reduced.
We obtain updated valuations in the form of appraisals and broker price opinions when a loan has been foreclosed and the property taken in as other real estate owned (“OREO”) and at certain other times during the asset’s holding period. Our net book value (“NBV”) in the loan at the time of foreclosure and thereafter is compared to the updated market value of the foreclosed property less estimated selling costs (fair value). A charge-off is recorded for any excess in the asset’s NBV over its fair value. If our valuation process is incorrect, the fair value of our investments in real estate may not be sufficient to recover our NBV in such assets, resulting in the need for additional charge-offs. Additional material charge-offs to our investments in real estate could have a material adverse effect on our financial condition and results of operations. Our bank regulator periodically reviews our OREO and may require us to recognize further charge-offs. Any increase in our charge-offs, as required by our regulator, may have a material adverse effect on our financial condition and results of operations.
Our securities portfolio may be negatively impacted by fluctuations in market value and interest rates, which may have an adverse effect on our financial condition.
Our securities portfolio may be impacted by fluctuations in market value, potentially reducing accumulated other comprehensive income and/or earnings. Fluctuations in market value may be caused by decreases in interest rates, lower market prices for securities and limited investor demand. Our securities portfolio is evaluated for other-than-temporary impairment on at least a quarterly basis. If this evaluation shows impairment to the actual or projected cash flows associated with one or more securities, a potential loss to earnings may occur. Changes in interest rates can have an adverse effect on our financial condition, as our available-for-sale securities are reported at their estimated fair value, and therefore are impacted by fluctuations in interest rates. We increase or decrease our stockholders’ equity by the amount of change in the estimated fair value of the available-for-sale securities, net of taxes. At December 31, 2013, the net unrealized loss on securities available for sale was $7.3 million compared to a net unrealized gain of $2.1 million at December 31, 2012.
Changes in interest rates could adversely affect our results of operations and financial condition.
Our results of operations and financial condition are affected significantly by changes in interest rates. Our results of operations depend substantially on our net interest income, which is the difference between the interest income we earn on our interest-earning assets, such as loans and securities, and the interest expense we pay on our interest-bearing liabilities, such as deposits and borrowings. Changes in interest rates may affect the average life of loans and mortgage-related securities. Decreases in interest rates can result in increased prepayments of loans and mortgage-related securities, as borrowers refinance to reduce their borrowing costs. Under these circumstances, we are subject to reinvestment risk to the extent that we are unable to reinvest the cash received from such prepayments at rates that are comparable to the rates on existing loans and securities. Additionally, increases in interest rates may decrease loan demand and make it more difficult for borrowers to repay adjustable-rate loans. Also, increases in interest rates may extend the life of fixed-rate assets, which would limit the funds we have available to reinvest in higher-yielding alternatives, and may result in customers withdrawing certificates of deposit early so long as the early withdrawal penalty is less than the interest they could receive as a result of the higher interest rates. See the Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations - Asset and Liability Management and Market Risk.
Our strategies to modify our interest rate risk profile may be difficult to implement.
Our asset/liability management strategies are designed to decrease our interest rate risk sensitivity. One such strategy is increasing the amount of adjustable rate and/or short-term assets. We offer adjustable rate loan products as a means to achieve this strategy. The availability of lower rates on fixed-rate loans would generally create a decrease in borrower demand for adjustable rate assets. Additionally, these adjustable-rate assets may prepay. At December 31, 2013, 17.5% of our loan portfolio consisted of adjustable-rate loans, compared to 19.4% at December 31, 2012.
We also are managing our liabilities to moderate our interest rate risk sensitivity. Customer demand is primarily for short-term certificates of deposit. Using short-term liabilities to fund long-term, fixed-rate assets will increase the interest rate sensitivity of any financial institution. We are utilizing FHLB advances, brokered deposits and repurchase agreements to mitigate the impact of customer demand by lengthening the maturities of these advances or entering into longer term repurchase agreements, depending on liquidity or investment opportunities.
FHLB advances, brokered deposits and repurchase agreements are entered into as liquidity is needed or to fund assets that provide for a spread considered sufficient by management. If we are unable to originate adjustable rate assets at favorable rates or fund loan originations or securities purchases with long-term advances or structured borrowings, we may have difficulty executing this asset/liability management strategy and/or it may result in a reduction in profitability.
We face significant operational risks.
We operate in many different financial service businesses and rely on the ability of our employees and systems to process a significant number of transactions. Operational risk is the risk of loss from operations, including fraud by employees or outside persons, employees’ execution of incorrect or unauthorized transactions, data processing and technology errors or hacking and breaches of internal control systems.
A tightening of credit markets and liquidity risk could impair our ability to fund operations and jeopardize our financial condition.
Liquidity is essential to our business. A tightening of the credit markets and the inability to obtain adequate funding to replace deposits and fund continued loan growth may affect asset growth, our earnings capability and capital levels negatively. We rely on a number of different sources in order to meet our potential liquidity demands. Our primary sources of liquidity are increases in deposit accounts, including brokered deposits, as well as cash flows from loan payments and our securities portfolio. Borrowings, especially from the FHLB and repurchase agreements, also provide us with a source of funds to meet liquidity demands. An inability to raise funds through deposits, borrowings, the sale of loans, and other sources could have a substantial negative effect on our liquidity.
Our access to funding sources in amounts adequate to finance our activities or on terms that are acceptable to us could be impaired by factors that affect us specifically, or the financial services industry or economy in general. Factors that could detrimentally impact our access to liquidity sources include adverse regulatory action against us or a decrease in the level of our business activity as a result of a downturn in the markets in which our loans are concentrated. Our ability to borrow also could be impaired by factors that are not specific to us, such as a disruption in the financial markets, negative views and expectations about the prospects for the financial services industry in light of the recent turmoil faced by banking organizations, or continued deterioration in credit markets.
We may elect or be compelled to seek additional capital in the future, but that capital may not be available when it is needed.
We are required by federal regulatory authorities to maintain adequate levels of capital to support our operations. Should we be required by regulatory authorities to raise additional capital, we may seek to do so through the issuance of, among other things, our common stock or preferred stock. The issuance of additional shares of common stock or convertible securities to new stockholders would be dilutive to our current stockholders.
Our ability to raise additional capital, if needed, will depend on conditions in the capital markets, economic conditions, our financial performance, and a number of other factors, many of which are outside our control. Accordingly, we cannot assure our ability to raise additional capital if needed or on terms acceptable to us. If we cannot raise additional capital when needed, it may have a material adverse effect on our financial condition, results of operations and prospects.
There may be future sales of additional common stock or preferred stock or other dilution of our equity, which may adversely affect the market price of our common stock.
We are not restricted from issuing additional common stock or preferred stock, including any securities that are convertible into or exchangeable for, or that represent the right to receive, common stock or preferred stock or any substantially similar securities. The market value of our common stock could decline as a result of sales by us of a large number of shares of common stock or preferred stock or similar securities in the market or the perception that such sales could occur.
Our Board of Directors is authorized to issue additional common stock, as well as classes or series of preferred stock, generally without any action on the part of the stockholders. In addition, the board has the power, generally without stockholder approval, to set the terms of any such classes or series of preferred stock that may be issued, including voting rights, dividend rights, and preferences over the common stock with respect to dividends or upon the liquidation, dissolution, or winding-up of our business and other terms. If we issue preferred stock in the future that has a preference over the common stock with respect to the payment of dividends or upon liquidation, dissolution or winding-up, or if we issue preferred stock with voting rights that dilute the voting power of the common stock, the rights of holders of the common stock or the market value of the common stock could be adversely affected.
Anti-takeover provisions could negatively impact our stockholders.
Provisions in our charter and bylaws, the corporate law of the State of Maryland and federal regulations could delay, defer or prevent a third party from acquiring us, despite the possible benefit to our stockholders, or otherwise adversely affect the market price of any class of our equity securities, including our common stock. These provisions include: a prohibition on voting shares of common stock beneficially owned in excess of 10% of total shares outstanding, supermajority voting requirements for certain business combinations with any person who beneficially owns more than 10% of our outstanding common stock; the election of directors to staggered terms of three years; advance notice requirements for nominations for election to our Board of Directors; and for proposing matters that stockholders may act on at stockholder meetings, a requirement that only directors may fill a vacancy in our Board of Directors, supermajority voting requirements to remove any of our directors and the other provisions of our charter. Our charter also authorizes our Board of Directors to issue preferred stock, and preferred stock could be issued as a defensive measure in response to a takeover proposal. In addition, pursuant to federal and state laws and regulations, as a general matter, no person or company, acting individually or in concert with others, may acquire more than 10% of our common stock without prior approval from our regulators.
These provisions may discourage potential takeover attempts, discourage bids for our common stock at a premium over market price or adversely affect the market price of, and the voting and other rights of the holders of, our common stock. These provisions could also discourage proxy contests and make it more difficult for holders of our common stock to elect directors other than the candidates nominated by our Board of Directors.
The voting limitation provision in our charter could limit your voting rights as a holder of our common stock.
Our charter provides that any person or group who acquires beneficial ownership of our common stock in excess of 10% of the outstanding shares may not vote the excess shares. Accordingly, if you acquire beneficial ownership of more than 10% of the outstanding shares of our common stock, your voting rights with respect to the common stock will not be commensurate with your economic interest in our company.
We currently hold a significant amount of bank-owned life insurance.
At December 31, 2013, we held $62.5 million of bank-owned life insurance (“BOLI”) on key employees and executives, with a cash surrender value of $24.2 million. The policies are maintained to fund amounts owed under executive supplemental retirement plans. The eventual repayment of the cash surrender value is subject to the ability of the various insurance companies to pay death benefits or to return the cash surrender value to us if needed for liquidity purposes. We continually monitor the financial strength of the various companies with whom we carry these policies. However, any one of these companies could experience a decline in financial strength, which could impair its ability to pay benefits or return our cash surrender value. If we need to liquidate these policies for liquidity purposes, we would be subject to taxation on the increase in cash surrender value and penalties for early termination, both of which would adversely impact earnings.
Changes in laws and regulations and the cost of regulatory compliance with new laws and regulations may adversely affect our operations and our income.
The Bank and the Company are subject to extensive regulation, supervision, and examination by federal and state regulators, which have extensive discretion in connection with its supervisory and enforcement activities, including the ability to impose restrictions on a bank’s operations, reclassify assets, determine the adequacy of a bank’s allowance for loan losses and determine the level of deposit insurance premiums assessed. Because our business is highly regulated, the laws and applicable regulations are subject to frequent change. Any change in these regulations and oversight, whether in the form of regulatory policy, new regulations, or legislation or additional deposit insurance premiums could have a material impact on our operations.
In response to the recent financial crisis, Congress took actions that are intended to strengthen confidence and encourage liquidity in financial institutions, and the FDIC has taken actions to increase insurance coverage on deposit accounts. The recently enacted Dodd-Frank Act provides for the creation of the CFPB, which has broad authority to issue regulations governing the services and products we provide consumers. This additional regulation could increase our compliance costs and otherwise adversely impact our operations. That legislation also contains provisions that, over time, could result in higher regulatory capital requirements and loan loss provisions for the Company and the Bank and may increase interest expense due to the ability to pay interest on all demand deposits. The potential exists for additional federal or state laws and regulations, or changes in policy, affecting lending and funding practices and liquidity standards. See “How We Are Regulated.”
Strong competition within our market areas may limit our growth and profitability.
Competition in the banking and financial services industry is intense. We compete with numerous commercial banks, savings institutions, mortgage brokerage firms, credit unions, finance companies, mutual funds, insurance companies, securities brokers, and investment banking firms operating locally and elsewhere. Many of our competitors have substantially greater resources and lending limits than we have, have greater name recognition and market presence that benefit them in attracting business, and offer certain services that we do not or cannot provide. In addition, larger competitors may be able to price loans and deposits more aggressively than we do. Our profitability depends upon our continued ability to successfully compete in our market area. The greater resources and deposit and loan products offered by some of our competitors may limit our ability to increase our core deposits and interest earning assets.
Our accounting policies and methods impact how we report our financial condition and results of operations. Application of these policies and methods may require management to make estimates about matters that are uncertain.
Our accounting policies and methods are fundamental to how we record and report our financial condition and results of operations. Our management must exercise judgment in selecting and applying many of these accounting policies and methods so they comply with generally accepted accounting principles and reflect management’s judgment of the most appropriate manner to report our financial condition and results of operations. In some cases, management must select the accounting policy or method to apply from two or more alternatives, any of which might be reasonable under the circumstances yet might result in our reporting materially different amounts than would have been reported under a different alternative. These accounting policies are critical to presenting our financial condition and results of operations. They may require management to make difficult, subjective or complex judgments about matters that are uncertain. Materially different amounts could be reported under different conditions or using different assumptions.
Our controls and procedures may be ineffective.
We regularly review and update our internal controls, disclosure controls, and procedures and corporate governance policies and procedures. As a result, we may incur increased costs to maintain and improve our controls and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of our controls or procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on our business, results of operations or financial condition.
System failure or breaches of our network security could subject us to increased operating costs as well as litigation and other liabilities.
The computer systems and network infrastructure we use could be vulnerable to unforeseen problems. Our operations are dependent upon our ability to protect our computer equipment against damage from physical theft, fire, power loss, telecommunications failure, or a similar catastrophic event, as well as from security breaches and other disruptive problems caused by hackers. Any damage or failure that causes an interruption in our operations could have a material adverse effect on our financial condition and results of operations. Computer break-ins, phishing and other disruptions could jeopardize the security of information stored in and transmitted through our computer systems and network infrastructure, which may result in significant liability to us and cause existing and potential customers to refrain from doing business with us.
Although we, with the help of third-party service providers, intend to continue to implement security technology and establish operational procedures to prevent such damage, there can be no assurance that these security measures will be successful. In addition, advances in computer capabilities, new discoveries in the field of cryptography or other developments could result in a compromise or breach of the algorithms we and our third-party service providers use to encrypt and protect customer transaction data. A failure of such security measures could have a material adverse effect on our reputation, financial condition and results of operations.
We rely on other companies to provide key components of our business infrastructure.
Our business operations rely on third party vendors, which provide services such as data processing, recording and monitoring transactions, online banking interfaces and services, Internet connections and network access. While we have selected these third party vendors carefully, we do not control their actions. Any problems caused by these third parties, including those resulting from disruptions in communication services provided by a vendor, failure of a vendor to handle current or higher volumes, cyber-attacks and security breaches at a vendor, failure of a vendor to provide services for any reason or poor performance of services, could adversely affect our ability to deliver products and services to our customers and otherwise conduct our business. Financial or operational difficulties of a third party vendor could also hurt our operations if those difficulties interfere with the vendor's ability to serve us. Furthermore, our vendors could also be sources of operational and information security risk to us, including from breakdowns or failures of their own systems or capacity constraints. Replacing these third party vendors could also create significant delay and expense. Accordingly, use of such third parties creates an unavoidable inherent risk to our business operations.
Implementation of our stock-based incentive plan may dilute stockholders’ ownership interests.
As of December 31, 2013, there were approximately 44,182 restricted shares and 106,222 stock options reserved for future awards under our two equity incentive plans. These stock-based incentive plans may be funded either through open market purchases or from the issuance of authorized but unissued shares of Heritage common stock. While our intention is to fund this plan through open market purchases, stockholders would experience approximately a 2.0% reduction in ownership interest in the event 150,404 newly issued shares of our common stock are issued upon exercise of stock options or issued as restricted stock under these plans.
Additional compensation and benefit expenses associated with the implementation of our stock-based incentive benefit plans will affect our profitability adversely.
As awards are granted under our two equity incentive plans, our non-interest expenses are likely to increase as we will recognize additional annual employee compensation and benefit expenses related to the shares granted to employees, executives and directors under these plans. We cannot predict the actual amount of these new stock-related compensation and benefit expenses because applicable accounting practices require that expenses be based on the fair market value of the shares of common stock at specific points in the future; however, we expect them to be material. In addition, we will recognize expense for our employee stock ownership plan when shares are committed to be released to participants’ accounts (i.e., as the loan used to acquire these shares is repaid), and we will recognize expense for restricted stock awards and stock options over the vesting period of awards made to recipients.
Our common stock trading volume may not provide adequate liquidity for investors.
Our common stock is listed on the Nasdaq Global Market. However, the average daily trading volume in our common stock is less than that of many larger financial services companies. A public trading market having the desired depth, liquidity, and orderliness depends on the presence of a sufficient number of willing buyers and sellers for our common stock at any given time. This presence is impacted by general economic and market conditions and investors’ views of our Company. Because our trading volume is limited, any significant sale of our shares is subject to significant volatility in the price of our common stock.
Various factors may make takeover attempts more difficult to achieve.
Provisions of our articles of incorporation and bylaws, federal regulations, Georgia and Maryland law, and various other factors may make it more difficult for companies or persons to acquire control of Heritage without the consent of our Board of Directors. Stockholders may want a takeover attempt to succeed because, for example, a potential acquiror could offer a premium over the then-prevailing market price of our common stock.
We may be adversely affected by the lack of soundness of other financial institutions.
Financial services institutions are interrelated as a result of trading, clearing, counterparty, or other relationships. We have exposure to many different industries and counterparties, and routinely execute transactions with counterparties in the financial services industry, including commercial banks, brokers and dealers, investment banks, and other institutional clients. Many of these transactions expose us to credit risk in the event of a default by a counterparty or client. In addition, our credit risk may be exacerbated when the collateral held by Heritage cannot be realized upon or is liquidated at prices not sufficient to recover the full amount of the credit or derivative exposure due to Heritage. Any such losses could have a material adverse effect on our financial condition and results of operations.
Item 1B.
Item 1B. Unresolved Staff Comments
None.
Item 2.
Item 2. Description of Properties
At December 31, 2013, our corporate headquarters is located at 721 N. Westover Boulevard, Albany, Georgia. In addition to our corporate headquarters, we had 27 full-service branch locations, 14 mortgage offices, and 4 investment offices. 25 of the full-service branch locations were owned and eight mortgage offices and three investment offices were located in existing full-service branch locations. Two full-service branch locations, six mortgage offices, and one investment office were leased. A complete list of all branch and ATM locations can be found on the Heritage’s website at www.eheritagebank.com. For more information on our fixed assets, see Item 8 - Note 14 to the Consolidated Financial Statements.
Item 3.
Item 3. Legal Proceedings
The Company is not a party to any pending claims or lawsuits that management believes would have a material effect on the Company's financial condition or results of operations.
Item 4.
Item 4. Mine Safety Disclosures
Not applicable.
PART II
Item 5.
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
The Company’s common stock is traded on the Nasdaq Global Market under the symbol “HBOS.” The shares began trading on November 30, 2010. Prior to that date, the shares of common stock of the Predecessor also traded on that market under the same symbol. As of December 31, 2013, the Company estimates that it had approximately 1,971 stockholders, including approximately 955 beneficial owners holding shares in nominee or “street” name.
The following table sets forth the high and low sales prices of the shares of common stock of the Company and cash dividends paid to public stockholders.
During 2013, the Company did not pay any dividends, because during the fourth quarter of 2012, the Company paid a special one-time dividend of $0.20 in lieu of regular quarterly dividends that would have been anticipated to be paid in 2013. The Company resumed paying regular cash dividends at $0.07 per share on a quarterly basis in 2014. The continued payment of dividends also will depend on a number of factors, including our capital requirements, our financial condition and results of operations, tax considerations, statutory and regulatory limitations, and general economic conditions. No assurance can be given that we will continue to pay dividends or that they will not be reduced or eliminated in the future.
The Company’s ability to pay dividends depends on the Company’s unconsolidated available funds and earnings thereon, as well as dividends from HeritageBank. Under the rules of the FRB, the Company is not permitted to pay dividends on its common stock if its stockholders’ equity would be reduced below the amount of the liquidation account established in connection with the conversion. Similarly, HeritageBank will not be permitted to pay dividends to the Company, its sole stockholder, if HeritageBank’s stockholder’s equity would be reduced below the amount of the liquidation account established in connection with the conversion. In addition, HeritageBank will not be permitted to make a capital distribution if, after making such distribution, capital would be below regulatory capital guidelines or if it does not receive FRB authorization to pay the dividend. Georgia law and regulations imposes limits on dividend payments by HeritageBank and certain levels of dividends require the prior approval of the GDBF. See Item 1 - Business - Limitations on Dividends and other Capital Distributions.
Maryland law generally limits dividends by Heritage to an amount equal to the excess of our capital surplus over payments that would be owed upon dissolution to stockholders whose preferential rights upon dissolution are superior to those receiving the dividend, and to an amount that would not make us insolvent.
The Company has two equity incentive plans providing for the issuance of stock options, restricted stock, restricted share units and stock appreciation rights. The first is a plan that originally was adopted by the Predecessor in May 2006 and became the Company’s plan in the second-step conversion, when awards and available shares under the plan were adjusted to reflect the 0.8377 exchange ratio. In June 2011, the Company’s stockholders approved the second equity incentive plan, which reserved an additional 573,481 shares of common stock for the issuance of stock options, restricted stock, restricted share units and stock appreciation rights. The following table includes certain information with respect to certain awards and remaining shares available for awards under these equity incentive plans as of December 31, 2013:
During 2013, the Company completed the repurchase of 373,912 shares authorized by the stock repurchase programs announced in 2012 and 2013. The Company has remaining authorization to repurchase up to 344,179 shares under the current program, which expires in April 2014 unless completed sooner or otherwise extended.
Information on the shares purchased during 2013 is a follows:
Item 6.
Item 6. Selected Financial Data
SELECTED CONSOLIDATED FINANCIAL AND OTHER DATA OF
HERITAGE FINANCIAL GROUP, INC. AND ITS SUBSIDIARY
The summary financial information presented below is derived in part from the consolidated financial statements of Heritage and its subsidiary. The information at December 31, 2013 and 2012 and for the years ended December 31, 2013, 2012, and 2011 is derived in part from the audited consolidated financial statements of Heritage that are included in Item 8. The information at December 31, 2010 and 2009, and for the years ended December 31, 2010 and 2009, is derived in part from audited consolidated financial statements that are not included in this Form 10-K. However, in the opinion of management, all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of the results of the operations for the unaudited periods have been made. The following information is only a summary, and you should read it in conjunction with Item 7
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
General
General. Heritage Financial Group, Inc. (“Heritage” or the “Company”) is a $1.4 billion holding company headquartered in Albany, Georgia. Heritage primarily conducts commercial banking, retail banking and wealth management activities through its wholly owned subsidiary, HeritageBank of the South (“HeritageBank” or the “Bank”). As of December 31, 2013, HeritageBank operated in Georgia, Florida and Alabama through 27 full-service branch locations, 14 mortgage offices and 4 investment offices. HeritageBank provides credit based products, deposit accounts, corporate cash management, investment support and other services to commercial and retail clients.
Strategy. Our business strategy is to operate a well-capitalized and profitable financial institution dedicated to serving the needs of our customers. We offer a broad range of products and services while stressing personalized and efficient customer service and convenient access to these products and services. We intend to continue to operate as a commercial and consumer lender. We have structured operations around a branch system that is staffed with knowledgeable and well-trained employees. Subject to capital requirements and our ability to grow in a reasonable and prudent manner, we may open or acquire additional branches as opportunities arise. In addition to our branch system, we continue to expand electronic services for our customers. We attempt to differentiate ourselves from our competitors by providing a higher level of customer service.
Expansion Efforts. A key element of our business strategy is increasing our presence and growing the “Heritage” brand in the markets we currently serve and expanding our operations beyond our original Southwest Georgia market by entering new markets in other parts of Georgia, Florida, Alabama and other adjacent communities that present attractive opportunities for expansion consistent with our capital availability. This expansion of our market beyond southwest Georgia began in 2006, when we commenced operating a branch in Ocala, Florida. We have pursued this expansion program through both prudent, disciplined internal growth and strategic acquisitions. We have also hired highly regarded and experienced lending officers and commercial bankers and expanded into new market areas that are contiguous to our existing market areas. These recent activities reflect our ability to take advantage of these expansion opportunities.
During 2011, we completed two FDIC-assisted whole-bank acquisitions near Savannah, Georgia and in Statesboro, Georgia with combined loans of $247.2 million and deposits of $342.3 million. In April 2012, we opened a commercial banking office in Macon, Georgia, and in June 2012, we completed the purchase of a single branch in Auburn, Alabama with $10.9 million in loans and $18.7 million in deposits. In August 2012, we hired a new management team to operate our mortgage division which has led to significant growth in our mortgage business, particularly in the Atlanta, Georgia market. In March 2013, we completed the FDIC-assisted whole-bank purchase of a bank based in LaGrange, Georgia with $98.0 million in loans and $211.6 million in deposits, and in November 2013, we opened a commercial banking office in Columbus, Georgia.
Critical Accounting Policies
We have established certain accounting and financial reporting policies to govern the application of accounting principles generally accepted in the United States of America (“GAAP”) in the preparation of our financial statements. Our significant accounting policies are described in Item 8 - Notes to the Consolidated Financial Statements. Certain accounting policies involve significant judgments and assumptions by management which has a material impact on the carrying value of certain assets and liabilities. The judgments and assumptions used by management are based on historical experience and other factors that are believed to be reasonable under the circumstances. Because of the nature of the judgments and assumptions made by management, actual results could differ from the judgments and estimates adopted by management, which could have a material impact on the carrying values of assets and liabilities and the results of our operations. We believe the following accounting policies applied by us represent critical accounting policies. For more information on our accounting policies, see Item 8 - Note 1 to the Consolidated Financial Statements.
Acquisition Accounting. GAAP requires the use of fair value accounting in determining the carrying values of certain assets and liabilities acquired in business combinations and, accordingly, we record assets purchased and liabilities assumed in our FDIC-assisted acquisitions at their fair values. The fair value of the loan portfolios acquired in these transactions was recorded and is being accounted for under the principles prescribed by ASC 310.
On the date of acquisition all loans acquired are assigned a fair value based on the present value of projected future cash flows. An accretable discount is determined based on the timing of the projected cash flows and is taken into income over the projected life of the loans. Such accretion is included in interest income. Expected cash flows are re-estimated at each reporting date. Subsequent decreases to the expected cash flows will generally result in a provision for loan losses.
Subsequent increases in cash flows result in a reversal of the provision for loan losses to the extent of prior charges and adjusted the accretable discount, which will have a positive effect on interest income. Because we record loans acquired in connection with FDIC-assisted acquisitions at fair value, we record no allowance for loan losses related to the acquired covered loans on the acquisition date, given that the fair value of the loans acquired incorporates assumptions regarding credit risk.
FDIC Receivable for Loss-Share Agreements. A significant portion of our acquired loan and other real estate assets are covered under loss share agreements with the FDIC in which the FDIC has agreed to reimburse us 80% of all losses as well as certain expenses incurred in connection with those assets. We have estimated the amount that we will receive from the FDIC under the loss share agreements that will result from losses incurred on the disposition of covered loans and other real estate assets, and the estimate is booked as a receivable from the FDIC. We discount the receivable for the expected timing and receipt of those cash flows using a risk free rate plus a premium for risk. The accretion of the FDIC receivable discount is recorded into noninterest income using the level yield method over the estimated life of the receivable.
The loss share agreements also include a provision whereby if losses do not exceed a calculated threshold, we are obligated to compensate the FDIC. This is referred to as a clawback liability and, if applicable, is paid ten years after the date of the agreement. The formula for the clawback liability varies from transaction-to-transaction and will be calculated as provided in the individual loss share agreements and will not be consolidated into one calculation. The FDIC receivable for loss-share agreements is measured separately from the related covered assets because it is not contractually embedded in the assets and is not transferable if the assets are sold. We will review and update the fair value of the FDIC receivable at each reporting date in conjunction with the re-estimation of cash flows. The FDIC receivable will fluctuate as loss estimates and expected cash flows related to covered loans and other real estate owned change.
Loans Held for Sale. Loans held for sale consist of one-to-four family residential loans originated for sale in the secondary market and are carried at fair value under ASC 825-10-25. For residential mortgage loans, fair value is determined by outstanding commitments from investors for committed loans and on the basis of current delivery prices in the secondary mortgage market for uncommitted loans, if any. Adjustments to reflect unrealized gains and losses resulting from changes in fair value of residential mortgage loans held-for-sale and realized gains and losses upon ultimate sale of the loans are classified as noninterest income on the Consolidated Statements of Income.
We enter into interest rate lock commitments (“IRLCs”) with customers for mortgage loans that we intend to sell in the secondary market. We classify IRLCs on residential mortgage loans, which are derivatives under ASC 815-10-15, on a gross basis within other liabilities or other assets. The derivatives arising from the IRLCs are recorded at fair value in other assets and liabilities and changes in that fair value are included in mortgage banking activities on the Consolidated Statements of Income.
The fair value of the IRLC derivatives are determined by reference to quoted prices for loans with similar coupon rates and terms. The fair value of these commitments, while based on interest rates observable in the market, is highly dependent on the ultimate closing of the loans. These “pull through” rates are based on both our historical data and the current interest rate environment and reflect our best estimate of the likelihood that a commitment will ultimately result in a closed loan. Gains and losses on the sale of those loans are included in mortgage banking activities on the Consolidated Statements of Income.
As a result of the adoption of SAB No. 109, the loan servicing value is also included in the fair value of IRLCs. For further information on the fair value accounting for residential mortgages held for sale, see Item 8 - Note 9 to the Consolidated Financial Statements.
Mortgage Servicing Rights. When mortgage loans held for sale are sold with servicing retained, servicing rights are initially recorded at the lower of cost or market (“LOCOM”) value with the income statement effect of the sale of the loan recorded in gains on sales of loans. LOCOM value is based on a valuation model that calculates the present value of estimated future net servicing income and cost compared to market value. All classes of servicing assets are subsequently measured using the amortization method, which requires servicing rights to be amortized into non-interest income in proportion to, and over the period of, the estimated future net servicing income of the underlying loans.
Servicing rights are evaluated for impairment based upon the fair value of the rights as compared to carrying amount. Impairment is determined by stratifying rights into groupings based on predominant risk characteristics, such as interest rate, loan type and investor type. To the extent that fair value is less than the carrying amount, impairment is recognized through a valuation allowance for an individual grouping. If we later determine that all or a portion of the impairment no longer exists for a particular grouping, a reduction of the allowance may be recorded as an increase to income. Changes in valuation allowances are reported in mortgage banking activities on the Consolidated Statements of Income. The fair values of servicing rights are subject to significant fluctuations as a result of changes in estimated and actual prepayment speeds and default rates and losses.
Servicing fee income, which is reported in mortgage banking activities on the Consolidated Statements of Income, is recorded for fees earned for servicing loans. The fees are based on a contractual percentage of approximately 0.25% and are recorded as income when earned. The amortization of mortgage servicing rights is netted against loan servicing fee income. For the years ended December 31, 2013, 2012 and 2011, respectively, we did not collect any servicing fees, late fees or ancillary fees related to loan servicing.
Allowance for Loan Losses (ALLL). We establish provisions for loan losses, which are charged to income, at a level Management believes will reflect probable credit losses based on historical loss trends and an evaluation of specific credits in the loan portfolio. For further information on the accounting for Allowance for Loan Losses, see Item 1 - Asset Quality - Allowance for Loan Losses and Item 8 - Note 5 to the Consolidated Financial Statements.
Income Taxes. The income tax accounting guidance results in two components of income tax expense: current and deferred. Current income tax expense reflects taxes to be paid or refunded for the current period by applying the provisions of the enacted tax law to the taxable income or excess of deductions over revenues. We determine deferred income taxes using the liability (or balance sheet) method. Under this method, the net deferred tax asset or liability is based on the tax effects of the differences between the book and tax bases of assets and liabilities, and enacted changes in tax rates and laws are recognized in the period in which they occur.
Deferred income tax expense results from changes in deferred tax assets and liabilities between periods. Deferred tax assets are recognized if it is more-likely-than-not, based on the technical merits, that the tax position will be realized or sustained upon examination. A tax position that meets the more-likely-than-not recognition threshold is initially and subsequently measured as the largest amount of tax benefit that has a greater than 50 percent likelihood of being realized upon settlement with a taxing authority that has full knowledge of all relevant information. The determination of whether or not a tax position has met the more-likely-than-not recognition threshold considers the facts, circumstances, and information available at the reporting date and is subject to management’s judgment. Deferred tax assets may be reduced by deferred tax liabilities and a valuation allowance if, based on the weight of evidence available, it is more-likely-than-not that some portion or all of a deferred tax asset will not be realized.
Estimates of Fair Value. The estimation of fair value is significant to a number of our assets, including, but not limited to, investment securities, goodwill, other real estate owned , mortgage servicing rights and other repossessed assets. These are all recorded at either fair value or at the lower of cost or fair value. Fair values are volatile and may be influenced by a number of factors. Circumstances that could cause estimates of the fair value of certain assets and liabilities to change include a change in prepayment speeds, discount rates, or market interest rates. Our estimates and assumptions are reviewed periodically and the effects of revisions are reflected in the consolidated financial statements in the period in which they are determined to be necessary.
Fair values for most investment securities are based on quoted market prices. If quoted market prices are not available, fair values are based on the quoted prices of similar instruments. The fair values of other real estate owned typically are determined based on appraisals by third parties, less estimated costs to sell. Estimates of fair value also are required in performing an impairment analysis of goodwill. Heritage reviews goodwill for impairment on at least an annual basis and whenever events or circumstances indicate the carrying value may not be recoverable. Impairment would be applicable if the carrying value exceeds the fair value of a reporting unit.
Recent Accounting Standards
For discussion of Recent Accounting Standards, please see Item 8 - Note 1 to the Consolidated Financial Statements.
Comparison of Financial Condition at December 31, 2013 and December 31, 2012
General. Total assets increased by $283.4 million, or 25.8%, to $1.381 billion at December 31, 2013, from $1.098 billion at December 31, 2012. Cash and due from banks increased $10.8 million, or 45.1%, to $34.8 million at December 31, 2013 from $24.0 million at December 31, 2012. Total interest-earning assets increased $280.4 million, or 30.3%, to $1.207 billion at December 31, 2013, from $926.7 million at December 31, 2012. The increase in interest-earning assets was driven by increases in loans of $128.7 million, loans held for sale of $95.1 million and securities available for sale of $72.9 million offset by a decreases in interest bearing deposits in banks of $12.1 million and federal funds sold of $4.2 million. At the same time, interest-bearing deposits increased $174.9 million, other borrowings increased $71.4 million, and federal funds purchased and securities sold under repurchase agreements increased $4.4 million. The growth in securities, loans and deposits for 2013 was primarily driven by the Frontier acquisition, and the growth in loans held for sale was primarily driven by a slowing in loan sales during the fourth quarter of 2013 as we prepared to deliver directly to the GSEs.
Cash and Securities. We increased our liquidity position as a percentage of total assets as a result of the Frontier acquisition because the amount of deposits assumed significantly exceeded the amount of loans and other earning assets acquired. Cash and securities (including bank deposits and federal funds sold) increased in the aggregate $67.4 million, or 25.4%, to $332.5 million, or 24.1% of total assets, at December 31, 2013, from $265.1 million, or 24.2% of total assets, at December 31, 2012.
At December 31, 2013, our securities portfolio consisted of $53.6 million in GSE securities, $189.3 million in GSE residential mortgage-backed securities, $50.8 million in state and municipal securities, and $644,000 in corporate equity securities. We believe it is probable that we will be able to collect the amounts due under the contractual terms of the securities portfolio. Therefore we do not believe any securities experienced other than temporary impairment at December 31, 2013. See Item 8 - Note 4 to the Consolidated Financial Statements for additional information.
We expect to lower our excess liquidity balance on a percent of total assets basis in cash, funds due from banks, federal funds sold, and securities throughout 2014. We believe that utilizing some of our excess liquidity to increase our loan portfolio continues to be a prudent strategy for us to maintain through 2014.
Loans. Our loan portfolio increased $128.8 million, or 19.2%, to $798.8 million at December 31, 2013, from $670.0 million at December 31, 2012. Overall, the change in the loan portfolio was primarily driven by organic loan growth of $99.0 million and FDIC-acquired loan growth of $29.9 million, which is consistent with our strategy to grow loans organically and through FDIC-assisted acquisitions. The growth in FDIC-acquired loans was driven by $73.3 million of non-covered loans acquired from the FDIC-assisted acquisition of Frontier, offset by principal pay downs and resolutions of $21.9 million for non-covered loans and $21.5 million for covered loans. We continue to emphasize commercial lending as noted with the growth in nonresidential and commercial and industrial loan categories coupled with growth in all other major loan categories for the year. We also continue to see more opportunities to take market share from the regional and community banks competing within our market footprint. We continue to seek opportunities to grow our loan portfolio through organic growth, branch acquisitions, loan purchases, FDIC-assisted opportunities, and whole bank acquisitions.
The following table reflects the changes in the types of loans in our portfolio at the end of 2013 as compared to the end of 2012.
At December 31, 2013, we had approximately $110.7 million in loans held for sale, which are mortgage loans generated to be sold to investors, as compared to $15.6 million at December 31, 2012. The increase was driven by our continued focus on this line of business coupled with the slowing of loan sales in the fourth quarter of 2013 in order to prepare for the delivery of loans directly to the GSEs. During 2013 we generated $407.4 million in mortgage loan originations, and we anticipate this positive trend in mortgage loan originations held for sale to continue throughout 2014. We typically hold these loans for less than ninety days and earn the stated rate on the note until they are purchased by the investor. We currently have $22.1 million of mortgage loans held for sale that have been held longer than ninety days as of December 31, 2013. We do not anticipate difficulty in selling the loans we have held greater than ninety days to an investor in the foreseeable future. During the third quarter, we also received approval to sell mortgage loans directly to Fannie Mae, which is a GSE, and sold $20.8 million to Fannie Mae during the fourth quarter of 2013. See Item 8 - Notes 1 and 9 Notes of the Consolidated Financial Statements for additional information.
Delinquencies and Nonperforming Assets. As of December 31, 2013, our total loans delinquent for 30 to 89 days was $1.0 million, or 0.15% of total loans, excluding FDIC-acquired loans, compared to $2.1 million, or 0.32% of total assets, at December 31, 2012. At December 31, 2013, our nonperforming assets, excluding FDIC-acquired, totaled $11.2 million, or 0.81% of total assets, compared to $17.3 million, or 1.58% of total assets, at December 31, 2012. This $6.1 million, or 35.1%, decrease was primarily driven by the positive resolution of non-performing assets migrating back to performing status during 2013. Included in nonaccruing loans at December 31, 2013 are troubled debt restructurings of $5.8 million, which involve forgiving a portion of interest or principal on loans or making loans at a rate materially below market. See Item 1 - Asset Quality - Delinquent Loans and - Classified Assets for additional information.
Our loan portfolio includes FDIC-acquired loans, which are generally recorded at a deep discount from the contractual principal value and accounted for under ASC 310-30. These loans acquired through FDIC-assisted acquisitions are excluded from the delinquent loan tables below. See Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations - Accounting for FDIC-Assisted Acquisitions and Item 8 - Note 6 to the Consolidated Financial Statements for additional information about FDIC-acquired loans.
The table below sets forth the amounts and categories of non-performing assets in our loan portfolio, excluding loans and foreclosed assets acquired through FDIC-assisted acquisitions, at the dates indicated.
Non-performing loans, excluding FDIC-acquired loans, decreased to 1.38% of total loans, excluding FDIC-acquired loans, at December 31, 2013 from 2.51% at December 31, 2012 primarily driven by the positive trends in our non-performing loans migrating back to performing status after six months of payment performance. We are cautiously optimistic that the positive trend of non-performing loans, excluding FDIC-acquired loans, will continue to improve as a percentage of total loans, excluding FDIC-acquired loans, for 2014.
OREO, excluding FDIC-acquired assets, was $1.8 million at December 31, 2013 compared to $2.6 million at December 31, 2012. We continue to aggressively confront credit quality issues in our loan portfolio. OREO experienced a decrease primarily driven by sales and write downs for 2013 in excess of additions. We believe the current value of each OREO property represents our estimated disposition value less estimated selling expenses based on current appraisals and market data. All of these properties are being marketed actively for disposition. As of December 31, 2013, we had gross proceeds on sales of OREO, excluding covered FDIC-acquired assets, of $1.7 million and recorded a net loss of approximately $406,000 on those sales. See Item 1 - Asset Quality - Delinquent Loans and - Classified Assets for additional information and Item 8 - Note 8 to the Consolidated Financial Statements for more information.
Our internally criticized (watch list) and classified assets, excluding FDIC-acquired loans, totaled $22.7 million at December 31, 2013, compared to $28.2 million at December 31, 2012. This includes loans with respect to which known information about the possible credit problems of the borrowers has caused management to have doubts as to the ability of the borrowers to comply with present loan repayment terms and which may result in the future inclusion of such items in the nonperforming asset categories. These balances include the aforementioned non-performing loans, OREO, and repossessed assets. These loans have been considered in management's determination of the adequacy of our allowance for loan losses.
The table below sets forth the amounts of criticized and classified assets in our portfolio, excluding FDIC-acquired loans and OREO, at the dates indicated.
Our internal loan review processes strive to identify weaknesses in loans prior to performance issues. However, our processes do not always provide sufficient time to work out plans with borrowers that would avoid foreclosure and/or losses. We have taken actions to prevent losses in our current portfolio with our special assets committee. We have also taken steps to better evaluate the capital and liquidity positions of our commercial loan guarantors, particularly those involved in commercial real estate construction and development.
Allowance for Loan Losses. Our allowance for loan losses at December 31, 2013 was $8.9 million and at December 31, 2012 was $9.0 million. Excluding FDIC-acquired loans, the allowance for loan losses to total loans was 1.31% at December 31, 2013 and 1.55% at December 31, 2012. This decrease reflects improving credit trends in our loan portfolio, and we are cautiously optimistic the improvement will continue into 2014.
The following table sets forth asset quality information, excluding FDIC-acquired loans for the periods indicated:
We assess the allowance for loan losses on a quarterly basis and make provisions for loan losses as necessary in order to maintain the proper level of allowance. While we use available information to recognize losses on loans, future loan loss provisions may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the allowance for loan losses and may require us to recognize additional provisions based on their judgment of information available to them at the time of their examination. The allowance for loan losses is maintained at a level that represents management's best estimate of inherent losses in the loan portfolio, and such losses were both probable and reasonably estimable. The level of the allowance is based on estimates and the ultimate losses may vary from the estimates. See Item 8 - Note 5 to the Consolidated Financial Statements for additional information.
Premises and Equipment. Premises and equipment increased $5.0 million, or 15.0%, at December 31, 2013 compared to December 31, 2012, primarily driven by the purchase of the real estate, banking facilities, furniture and equipment from the FDIC at fair value in the amount of $5.0 million in connection with the Frontier acquisition. Premises held for sale decreased $1.3 million, or 82.1%, driven by the sale of our former corporate headquarters building in Albany, Georgia carried at $1.1 million and sold for $900,000 which resulted in a loss on sale of $226,000. Additionally, during the fourth quarter of 2013 we recognized impairment charges for premises held for sale related to our former branch buildings in Guyton and Collins, Georgia of $190,000. See Item 8 - Note 14 to the Consolidated Financial Statements for additional information.
Intangible Assets, Goodwill and Other Assets. Intangible assets and goodwill increased $18,000 to $4.3 million at December 31, 2013 compared to $4.2 million at December 31, 2012. The increase was driven by the addition of the core deposit intangible from the Frontier acquisition of $625,000 and the addition of the MSRs of $202,000 offset by the amortization expense of $809,000 related to core deposit intangibles for 2013. See Item 8 - Note 15 to the Consolidated Financial Statements for additional information.
Cash surrender value of bank owned life insurance (“BOLI”) increased $801,000 to $24.2 million at December 31, 2013 from $23.4 million at December 31, 2012, driven by the earnings of the BOLI policies for 2013. Other assets increased $4.9 million to $21.4 million at December 31, 2013 compared to $16.4 million at December 31, 2012 primarily due to increases in the fair market value of the cash flow hedge of $2.4 million, the fair market value of mortgage related interest rate lock commitments and derivative financial instruments used to hedge interest rate risk of $1.5 million and the deferred tax assets of $1.2 million. See Item 7a.
Item 7a. Quantitative and Qualitative Disclosures about Market Risk
Asset and Liability Management and Market Risk
Our Risk When Interest Rates Change. The rates of interest we earn on assets and pay on liabilities generally are established contractually for a period of time. Market rates change over time. Like other financial institutions, our results of operations are impacted by changes in interest rates and the interest rate sensitivity of our assets and liabilities. The risk associated with changes in interest rates and our ability to adapt to these changes is known as interest rate risk and is our most significant market risk.
How We Measure Our Risk of Interest Rate Changes. As part of our attempt to manage our exposure to changes in interest rates and comply with applicable regulations, we monitor our interest rate risk. In doing so, we analyze and manage assets and liabilities based on their interest rates and payment streams, timing of maturities, repricing opportunities, and sensitivity to actual or potential changes in market interest rates.
To manage the potential for adverse effects of material and prolonged increases in interest rates on our results of operations, we adopted asset and liability management policies to understand, measure, monitor, and control the risk. These policies are designed to allow us to implement strategies to minimize the effects of interest rate changes to net income and capital position by properly matching the maturities and repricing terms of our interest earning assets and interest bearing liabilities. These policies are implemented by the ALCO, which is composed of senior management members. The ALCO establishes guidelines for and monitors the volume and mix of assets and funding sources, taking into account relative costs and spreads, interest rate sensitivity and liquidity requirements. The objectives are to manage assets and funding sources to produce results that limit negative changes in net income and capital while supporting liquidity, capital adequacy, growth, risk and profitability goals. Senior managers oversee the process on a daily basis. The ALCO meets monthly to review, among other things, economic conditions and interest rate outlook, current and projected needs and capital position, anticipated changes in the volume and mix of assets and liabilities, interest rate risk exposure, liquidity position and net portfolio present value. The committee also recommends strategy changes, as appropriate, based on their review. The committee is responsible for reviewing and reporting the effects of the policy implementations and strategies to the board of directors on a quarterly basis.
In order to manage our assets and liabilities and achieve the desired liquidity, credit quality, interest rate risk, profitability and capital targets, we have focused our strategies on:
·
Limiting the percentage of long-term fixed-rate loans within our portfolio;
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Originating a mix of variable-rate and shorter term fixed-rate loans;
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Managing deposit relationships for stability and a lower cost of funds position;
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Increasing retail and wholesale time deposit duration; and
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Increasing the origination of mortgage loans to be sold to investors.
The Risk Management Committee has oversight over the asset-liability management of the Company. This committee regularly reviews interest rate risk by forecasting the impact of alternative interest rate environments on net interest income, net income and the market value of portfolio equity. Market value of portfolio equity is a measurement of the value of the balance sheet at a fixed point in time. It is summarized as the fair value of assets less the fair value of liabilities. The committee reviews computations of the value of capital at current interest rates and at alternative interest rates. The variance in the net portfolio value between current interest rate computations and alternative rate computations represents the potential impact on capital if rates were to change.
The Company is directly exposed only to U.S. dollar interest rate changes, and, accordingly, the Company manages exposure by considering the possible changes in the net interest margin. The Company does not have any trading instruments nor does it classify any portion of the investment portfolio as held for trading. The Company monitors its sensitivity to changes in interest rates and may use derivative instruments to hedge this risk. The Company does not enter into derivatives or other financial instruments for trading or speculative purposes. Finally, the Company has no direct exposure to foreign currency exchange rate risk or commodity price risk.
Interest rates play a major part in the net interest income of a financial institution. The sensitivity to rate changes is known as “interest rate risk.” The repricing of interest-earning assets and interest-bearing liabilities can influence the changes in net interest income.
The Company uses simulation analysis to monitor changes in net interest income due to changes in market interest rates. The simulation of rising, declining and flat interest rate scenarios allows management to monitor and adjust interest rate sensitivity to minimize the impact of market interest rate swings. The impact on net interest income over a twelve-month period of a shock of 100, 200, 300, and 400 basis point increase or decrease in market rates is analyzed on a quarterly basis. The Company also monitors regulatory required interest rate risk analysis, which simulates more dramatic changes to rates.
The Company’s strategy is to mitigate interest rate risk to the extent possible as part of the Company’s overall business strategy. Based on our analysis of the Company’s overall risk to changes in interest rates, we structure investment and funding transactions to reduce this risk such as the cash flow hedge executed in 2012. See Item 8
Item 8. Financial Statements and Supplementary Data
See page 75 for our unaudited quarterly results of operations and the pages beginning with for our audited consolidated financial statements.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A.
Item 9A. Controls and Procedures
(a) Evaluation of Disclosure Controls and Procedures
An evaluation of our disclosure controls and procedures (as defined in Rule 13(a)-14(c) under the Securities Exchange Act (the “Exchange Act”)) as of December 31, 2013 was carried out under the supervision and with the participation of our Chief Executive Officer, Chief Financial Officer and several other members of our senior management preceding the filing date of this annual report. Our Chief Executive Officer and Chief Financial Officer concluded that, as of December 31, 2013, the Company’s disclosure controls and procedures were effective in ensuring that the information required to disclosed by the Company in the reports it files or submits under the Exchange Act is: (i) accumulated and communicated to the Company’s management (including its Chief Executive Officer and Chief Financial Officer) in a timely manner; and (ii) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.
The Company does not expect that its disclosure controls and procedures over financial reporting will prevent all errors and all fraud. A control procedure, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control procedure are met. Because of the inherent limitations in all control procedures, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns in controls or procedures can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any control procedure also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of change in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control procedure, misstatements due to error or fraud may occur and not be detected.
(b) Internal Control Over Financial Reporting
There were no changes in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Act) that occurred during the quarter ended December 31, 2013, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Management’s Annual Report on Internal Control Over Financial Reporting
The management of Heritage is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) under the Securities Exchange Act of 1934. The Company’s internal control over financial reporting is a process designed to provide reasonable assurance to the Company’s management and board of directors regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles accepted in the United States of America.
The Company’s 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 the Company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and (iii) 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. All internal control systems, no matter how well designed, have inherent limitations, including the possibility of human error and the circumvention of overriding controls. Accordingly, even effective internal control over financial reporting can provide only reasonable assurance with respect to financial statement preparation. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions or that the degree of compliance with the policies or procedures may deteriorate.
Management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2013. In making the assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework. Based on this assessment and those criteria, management concluded that the Company maintained effective internal control over financial reporting as of December 31, 2013.
The Company’s independent registered public accounting firm has issued an audit report on Heritage’s internal control over financial reporting. This report can be found in Item 8 - Report of Independent Registered Public Accounting Firm.
Item 9B.
Item 9B. Other Information
None.
PART III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance
The information under the captions “Nominees and Directors,” “Business Experience and Qualifications of Directors,” “Executive Officers of the Company Who Are Not Directors,” “Board Meetings, Independence, Ethics and Other Matters,” “Board Leadership Structure and Risk Oversight,” “Board Committees” and “Section 16(a) Beneficial Ownership Reporting Compliance” is incorporated herein by reference from the definitive proxy statement for the annual meeting of stockholders to be held May 28, 2014, a copy of which will be filed not later than 120 days after the close of the 2013 fiscal year.
Item 11.
Item 11. Executive Compensation
The information under the captions “Compensation Committee Report,” “Compensation Discussion and Analysis,” “Director Compensation,” “Compensation Committee Interlocks and Insider Participation” and “Executive Compensation” (including “Grants of Plan-Based Awards,” “Outstanding Equity Awards at Fiscal Year-End,” “Option Exercises and Stock Vested During Fiscal Year,” “2012 Non-Qualified Deferred Compensation,” “Pension Benefits” and “Potential Payments Upon Termination or Change in Control”) is incorporated herein by reference from the definitive proxy statement for the annual meeting of stockholders to be held May 28, 2014, a copy of which will be filed not later than 120 days after the close of the 2013 fiscal year.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The information under the captions “Stock Ownership of Significant Stockholders, Directors and Executive Officers” and “Outstanding Equity Awards at Fiscal Year-End” is incorporated herein by reference from the definitive proxy statement for the annual meeting of stockholders to be held May 28, 2014, a copy of which will be filed not later than 120 days after the close of the 2013 fiscal year.
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence
The information under the captions “Business Relationships and Transactions with Executive Officers, Directors and Related Persons” and “Board Meetings, Independence, Ethics and Other Matters” is incorporated herein by reference from the definitive proxy statement for the annual meeting of stockholders to be held May 28, 2014, a copy of which will be filed not later than 120 days after the close of the 2013 fiscal year.
Item 14.
Item 14. Principal Accounting Fees and Services
The information under the captions “Audit Committee Report,” “Pre-Approval of Audit and Non-Audit Services” and “Payment of Audit Fees” is incorporated herein by reference from the definitive proxy statement for the annual meeting of stockholders to be held May 28, 2014, a copy of which will be filed not later than 120 days after the close of the 2013 fiscal year.
PART IV
Item 15.
Item 15. Exhibits, Financial Statement Schedules
(a)(1) List of Financial Statements
The following are contained in Item 8 of this Form 10-K:
(a)(2) List of Financial Statement Schedules:
All financial statement schedules have been omitted as the information is not required under the related instructions or is not applicable.
(a)(3) List of Exhibits:
a
Filed as an exhibit to the Heritage Financial Group, Inc. Registration Statement on Form S-1 (File No. 333-123581) filed on May 23, 2010.
b
Filed as an exhibit to the Registration Statement of Heritage Financial Group (the Predecessor) on Form SB-2 (File No. 333-123581) filed on March 25, 2005.
c
Included as Exhibit 10.11 to the Form 10-KSB for the year ended December 31, 2006, filed by Heritage Financial Group (the Predecessor) with the SEC on March 27, 2007.
d
Included as an exhibit to the Form 8-K filed by Heritage Financial Group (the Predecessor) with the SEC on December 8, 2009.
e
Included as an exhibit to the Form 8-K filed by Heritage Financial Group (the Predecessor) with the SEC on February 25, 2010.
f
Filed as an exhibit to Pre-Effective Amendment No. 1 to the Heritage Financial Group, Inc. Registration Statement on Form S-1 (File No. 333-123581) filed on August 9, 2010.
g
Included as an exhibit to the Form 8-K filed by Heritage Financial Group, Inc. with the SEC on February 24, 2011.
h
Included as an exhibit to the Form 8-K filed by Heritage Financial Group, Inc. with the SEC on August 22, 2011.
i
Included as an exhibit to the Form 8-K filed by Heritage Financial Group, Inc. with the SEC on April 21, 2011.
j
Included as an exhibit to the Form 10-Q filed by Heritage Financial Group, Inc. with the SEC on August 15, 2011.
k
Included as an exhibit to the Form 10-K filed by Heritage Financial Group, Inc. with the SEC on March 31, 2011.
l
Included as an exhibit to the Form 8-K filed by Heritage Financial Group, Inc. with the SEC on April 11, 2012.
m
Form S-3 was filed by Heritage Financial Group, Inc. with the SEC on October 25, 2012.
n
Included as an exhibit to the Form 8-K filed by Heritage Financial Group, Inc. with the SEC on March 12, 2013.
*
Represents a management contract or compensatory plan or arrangement.
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.
HERITAGE FINANCIAL GROUP, INC.
Date:
March 14, 2014
By:
/s/ O. Leonard Dorminey
O. Leonard Dorminey, President and Chief Executive Officer
(Duly Authorized Representative)
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.
Date:
March 14, 2014
/s/ O. Leonard Dorminey
O. Leonard Dorminey
President, Chief Executive Officer and Director (Principal Executive Officer)
Date:
March 14, 2014
/s/ Antone D. Lehr
Antone D. Lehr, Chairman of the Board
Date:
March 14, 2014
/s/ Joseph C. Burger
Joseph C. Burger, Vice Chairman of the Board
Date:
March 14, 2014
/s/ Douglas J. McGinley
Douglas J. McGinley, Director
Date:
March 14, 2014
/s/ Carol W. Slappey
Carol W. Slappey, Director
Date:
March 14, 2014
/s/ J. Keith Land
J. Keith Land, Director
Date:
March 14, 2014
/s/ J. Lee Stanley
J. Lee Stanley, Director
Date:
March 14, 2014
/s/ T. Heath Fountain
T. Heath Fountain, Executive Vice President
Chief Administrative Officer and Chief Financial Officer
(Principal Financial and Accounting Officer)
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS OF
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
***
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors
Heritage Financial Group, Inc.
and Subsidiary
Albany, Georgia
We have audited the accompanying consolidated balance sheets of Heritage Financial Group, Inc. and Subsidiary as of December 31, 2013 and 2012, and the related consolidated statements of income, comprehensive income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 2013. 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 audits 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 consolidated financial position of Heritage Financial Group, Inc. and Subsidiary as of December 31, 2013 and 2012, and the results of their income and their cash flows for each of the three years in the period ended December 31, 2013, in conformity with accounting principles generally accepted in the United States of America.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of December 31, 2013, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 14, 2014 expressed an unqualified opinion on the Company’s internal control over financial reporting
/s/ Mauldin & Jenkins, LLC
Albany, Georgia
March 14, 2014
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors
Heritage Financial Group, Inc.
and Subsidiary
Albany, Georgia
We have audited the internal control over financial reporting of Heritage Financial Group, Inc. and subsidiary (the “Company”) as of December 31, 2013, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Report of Management 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, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and 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 by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2013, based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended December 31, 2013 of the Company and our report dated March 14, 2014 expressed an unqualified opinion on those consolidated financial statements.
/s/ Mauldin & Jenkins, LLC
Albany, Georgia
March 14, 2014
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
(Dollars in Thousands)
See Notes to Consolidated Financial Statements.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF INCOME
(Dollars in Thousands, except per share data)
See Notes to Consolidated Financial Statements.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Dollars in Thousands)
See Notes to Consolidated Financial Statements.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (Continued)
(Dollars in Thousands, except per share data)
(Continued)
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (Continued)
(Dollars in Thousands, except per share data)
See Notes to Consolidated Financial Statements.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in Thousands)
(Continued)
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in Thousands)
See Notes to Consolidated Financial Statements.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Nature of Business
Heritage Financial Group, Inc. (the “Company”), a Maryland corporation, was incorporated in May 2010 and organized by Heritage MHC (the “MHC”), Heritage Financial Group and Heritage Bank of the South ( the “Bank”) to facilitate the second-step conversion of the Company from the mutual holding company structure to the stock holding company structure (the “Conversion”). Upon consummation of the conversion, which occurred on November 30, 2010, the Company became the holding company for the Bank and a 100% publicly owned stock holding company. As a result of the conversion, each share of Heritage Financial Group’s common stock owned by public shareholders was exchanged for 0.8377 shares of the Company’s common stock, with cash being paid in lieu of issuing fractional shares.
Through the Bank, the Company operates a full service banking business and offers a broad range of retail and commercial banking services to its customers located primarily in central and southern Georgia and north central Florida. The Company and the Bank are subject to the regulations of certain federal and state agencies and are periodically examined by those regulatory agencies.
Basis of Presentation and Accounting Estimates
The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary. Significant intercompany transactions and balances have been eliminated in consolidation.
In preparing the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America (“GAAP”), management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Material estimates that are particularly susceptible to significant change in the near-term relate to the determination of the allowance for loan losses, the valuation of foreclosed real estate, deferred tax assets, other-than-temporary impairments of securities, and the fair value of financial instruments.
Acquisition Accounting
U.S. GAAP requires the use of fair value accounting in determining the carrying values of certain assets and liabilities acquired in business combinations and accordingly the Company recorded assets purchased and liabilities assumed in our FDIC-assisted acquisitions at their fair values. The fair value of the loan portfolios acquired in these transactions was recorded and is being accounted for under the principles prescribed by ASC 310.
On the date of acquisition, all loans acquired are assigned a fair value based on the present value of projected future cash flows. An accretable discount is determined based on the timing of the projected cash flows and is taken into income over the projected life of the loans. Such accretion is included in interest income. Expected cash flows are re-estimated at each reporting date. Subsequent decreases to the expected cash flows will generally result in a provision for loan losses.
Subsequent increases in cash flows result in a reversal of the provision for loan losses to the extent of prior charges and adjusted the accretable discount, which will have a positive effect on interest income. Because the Company records loans acquired in connection with FDIC-assisted acquisitions at fair value, the Company records no allowance for loan losses related to the acquired covered loans on the acquisition date, given that the fair value of the loans acquired incorporates assumptions regarding credit risk.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Acquisition Accounting (Continued)
Acquisitions are accounted for under the purchase method of accounting. Purchased assets and assumed liabilities are recorded at their estimated fair values as of the purchase date. Any identifiable intangible assets are also recorded at fair value. When the fair value of the assets purchased exceed the fair value of liabilities assumed, a "bargain purchase gain" results. If the consideration given exceeds the fair value of the net assets received, goodwill is recognized. Fair values are subject to refinement for up to one year after the closing date of an acquisition as information relative to closing date fair values becomes available.
FDIC Receivable and Clawback Liability for Loss-Share Agreements
A significant portion of the Company’s acquired loan and other real estate assets are covered under loss share agreements with the FDIC in which the FDIC has agreed to reimburse the Company 80% of all losses as well as certain expenses incurred in connection with those assets. The Company estimated the amount that it will receive from the FDIC under the loss share agreements that will result from losses incurred as the Company disposes of covered loans and other real estate assets, and the Company recorded the estimate as a receivable from the FDIC. The Company discounted the receivable for the expected timing and receipt of those cash flows using a risk free rate plus a premium for risk. The accretion of the FDIC receivable discount is recorded into noninterest income using the level yield method over the estimated life of the receivable.
The loss share agreements also include a provision whereby if losses do not exceed a calculated threshold, the Company is obligated to compensate the FDIC. This is referred to as a clawback liability and, if applicable, is paid at the end of ten years. The formula for the clawback liability varies from transaction-to-transaction and will be calculated using the formula provided in the individual loss share agreements and will not be consolidated into one calculation. The FDIC receivable for loss-share agreements is measured separately from the related covered assets because it is not contractually embedded in the assets and is not transferable if the Company sells the assets. The Company will review and update the fair value of the FDIC receivable at each reporting date in conjunction with the re-estimation of cash flows. The FDIC receivable and clawback liability will fluctuate as loss estimates and expected cash flows related to covered loans and other real estate owned change.
Cash Due from Banks and Cash Flows
For purposes of reporting cash flows, cash and due from banks includes cash on hand, cash items in process of collection, and amounts due from banks. Cash flows from loans, loans held for sale, federal funds sold, interest-bearing deposits, interest receivable, deposits, federal funds purchased and securities sold under repurchase agreements, and interest payable are reported net.
The Bank is required to maintain reserve balances in cash or on deposit with the Federal Reserve Bank. The total of those reserve balance requirements was approximately $1.5 million and $18.7 million at December 31, 2013 and 2012, respectively.
Securities
Debt securities that management has the positive intent and ability to hold to maturity are classified as held to maturity and recorded at amortized cost. Management has not classified any of its debt securities as held to maturity. Securities not classified as held to maturity, including equity securities with readily determinable fair values, are classified as available for sale and recorded at fair value with unrealized gains and losses excluded from earnings and reported in accumulated other comprehensive income, net of the related deferred tax effect. Equity securities, including other equity securities, without a readily determinable fair value are classified as available for sale and recorded at cost. Restricted equity securities are recorded at cost.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Securities (Continued)
The amortization of premiums and accretion of discounts are recognized in interest income using the interest method over the life of the securities. Realized gains and losses, determined on the basis of the cost of specific securities sold, are included in earnings on the settlement date.
The Company evaluates investment securities for other-than-temporary impairment using relevant accounting guidance specifying that (a) if a company does not have the intent to sell a debt security prior to recovery and (b) it is more likely than not that it will not have to sell the debt security prior to recovery, the security would not be considered other-than-temporarily impaired unless there is a credit loss. When the Company does not intend to sell the security, and it is more likely than not, the Company will not have to sell the security before recovery of its cost basis, it will recognize the credit component of an other-than-temporary impairment of a debt security in earnings and the remaining portion in other comprehensive income.
Securities purchased under resale agreements and securities sold under repurchase agreements are generally accounted for as collateralized financial transactions as more fully disclosed in Note 19. They are recorded at the amount at which the securities were acquired or sold plus accrued interest. It is the Company’s policy to take possession of securities purchased under resale agreements, which are primarily U.S. Government and Government agency securities. The market value of these securities is monitored, and additional securities are obtained when deemed appropriate to ensure such transactions are adequately collateralized. The Company also monitors its exposure with respect to securities sold under repurchase agreements, and a request for the return of excess securities held by the counterparty is made when deemed appropriate.
Loans Held for Sale
Loans held for sale consist of one-to-four family residential loans originated for sale in the secondary market and are carried at fair value under ASC 825-10-25. For residential mortgage loans, fair value is determined by outstanding commitments from investors for committed loans and on the basis of current delivery prices in the secondary mortgage market for uncommitted loans, if any. Adjustments to reflect unrealized gains and losses resulting from changes in fair value of residential mortgage loans held-for-sale and realized gains and losses upon ultimate sale of the loans are classified as noninterest income on the Consolidated Statements of Income.
The Company enters into interest rate lock commitments (“IRLCs”) with customers on mortgage loans with the intention to sell the loan in the secondary market. The Company classifies IRLCs on residential mortgage loans, which are derivatives under ASC 815-10-15, on a gross basis within other liabilities or other assets. The derivatives arising from the IRLCs are recorded at fair value in other assets and liabilities and changes in that fair value are included in mortgage banking activities on the Consolidated Statements of Income.
The fair value of the IRLC derivatives are determined by reference to quoted prices for loans with similar coupon rates and terms. The fair value of these commitments, while based on interest rates observable in the market, is highly dependent on the ultimate closing of the loans. These “pull through” rates are based on both the Company’s historical data and the current interest rate environment and reflect the Company’s best estimate of the likelihood that a commitment will ultimately result in a closed loan. Gains and losses on the sale of those loans are included in mortgage banking activities on the Consolidated Statements of Income.
As a result of the adoption of SAB No. 109, the loan servicing value is also included in the fair value of IRLCs. For further information on the fair value accounting for residential mortgages held for sale, see Note 9.
Mortgage Servicing Rights
When mortgage loans held for sale are sold with servicing retained, servicing rights are initially recorded at the current lower of cost or market (“LOCOM”) value with the income statement effect recorded in gains on sales of loans. LOCOM value is based on a valuation model that calculates the present value of estimated future net servicing income and cost compared to market value.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
All classes of servicing assets are subsequently measured using the amortization method which requires servicing rights to be amortized into non-interest income in proportion to, and over the period of, the estimated future net servicing income of the underlying loans.
Servicing rights are evaluated for impairment based upon the fair value of the rights as compared to carrying amount. Impairment is determined by stratifying rights into groupings based on predominant risk characteristics, such as interest rate, loan type and investor type. Impairment is recognized through a valuation allowance for an individual grouping, to the extent that fair value is less than the carrying amount. If the Company later determines that all or a portion of the impairment no longer exists for a particular grouping, a reduction of the allowance may be recorded as an increase to income. Changes in valuation allowances are reported in mortgage banking activities on the Consolidated Statements of Income. The fair values of servicing rights are subject to significant fluctuations as a result of changes in estimated and actual prepayment speeds and default rates and losses.
Servicing fee income, which is reported in mortgage banking activities on the Consolidated Statements of Income, is recorded for fees earned for servicing loans. The fees are based on a contractual percentage of approximately 0.25% and are recorded as income when earned. The amortization of mortgage servicing rights is netted against loan servicing fee income. For the years ended December 31, 2013, 2012 and 2011, respectively, the Company did not collect any servicing fees, late fees or ancillary fees related to loan servicing.
Loans
Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off are reported at their outstanding principal balances less unearned income, net deferred fees and costs on originated loans and the allowance for loan losses. Interest income is accrued on the outstanding principal balance. Loan origination fees, net of certain direct origination costs of consumer loans not secured by real estate, are recognized at the time the loan is placed on the books. Loan origination fees and costs for all other loans are deferred and recognized as an adjustment of the yield over the life of the loan using the level yield method without anticipating prepayments.
The accrual of interest on loans is discontinued when, in management's opinion, the borrower may be unable to meet payments as they become due, unless the loan is well-secured. Past due status is based on contractual terms of the loan. Generally, loans are placed on nonaccrual or charged off at an earlier date if collection of principal or interest is considered doubtful. All interest accrued, but not collected for loans that are placed on nonaccrual or charged off, is reversed against interest income, unless management believes that the accrued interest is recoverable through the liquidation of collateral. Interest income on nonaccrual loans is subsequently recognized only to the extent cash payments are received until the loans are returned to accrual status. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and the loan has been performing to contractual terms for a period of not less than six months.
A loan is considered impaired when it is probable, based on current information and events, the Company will be unable to collect all principal and interest payments due in accordance with the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Impaired loans are measured by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price or the fair value of the collateral if the loan is collateral dependent. Interest on accruing impaired loans is recognized as long as such loans do not meet the criteria for nonaccrual status.
Purchased loans acquired in business acquisitions are recorded at the fair value at the acquisition date. Credit discounts are included in the determination of fair value; therefore, an allowance for loan losses is not recorded at the acquisition date.
In determining the acquisition date fair value of purchased loans, and in subsequent accounting, the Company generally aggregates purchased loans into pools of loans with common risk characteristics. Expected cash flows at the acquisition date in excess of the fair value of loans are recorded as interest income over the life of the loans using a level yield method if the timing and amount of the future cash flows of the pool is reasonably estimable.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Subsequent to the acquisition date, increases in cash flows over those expected at the acquisition date are recognized as interest income prospectively. Decreases in expected cash flows after the acquisition date are recognized by recording an allowance for loan losses.
Covered Loans
The portion of the Company’s loan portfolio covered under loss share agreements with the FDIC in which the FDIC has agreed to reimburse the Company 80% of all losses as well as certain expenses incurred in connection with those assets. For further information on accounting for covered loans refer to the Acquisition Accounting and FDIC receivable for Loss Share Agreements sections within this Note 1.
Allowance for Loan Losses
The Company establishes provisions for loan losses, which are charged to income, at a level management believes will reflect probable credit losses based on historical loss trends and an evaluation of specific credits in the loan portfolio. For further information on the accounting for Allowance for Loan Losses, see Note 5 for further information.
Premises and Equipment
Land is carried at cost. Premises and equipment are carried at cost, less accumulated depreciation computed on the straight-line method over the estimated useful lives:
Intangible Assets
Intangible assets consist of core deposit intangibles acquired in connection with business acquisitions and mortgage servicing rights, previously discussed. The core deposit intangibles are initially recognized based on a valuation performed as of the consummation date. The core deposit intangibles are amortized over the average remaining life of the acquired customer deposits, or approximately 7 years. Intangible assets were evaluated for impairment as of December 31, 2013 and based on that evaluation there was no impairment.
Goodwill
Goodwill represents the excess of cost over the fair value of the net assets and liabilities acquired in a business combination or acquisition. Goodwill is not amortized over an estimated useful life, but rather is tested annually for impairment, or whenever events occur that may indicate that the recoverability of the carrying amount is not probable. Current accounting guidance allows the Company to assess qualitative factors to determine whether it is necessary to perform the two-step quantitative goodwill impairment test. The Company is no longer required to calculate the fair value of a reporting unit unless the Company determines, based on a qualitative assessment, that it is more likely than not that its fair value is less than its carrying amount. The Company adopted the standard in 2012.
If necessary, the quantitative goodwill impairment test is performed in two steps. The first step is used to identify potential impairment and the second step, if required, measures the amount of impairment by comparing the carrying amount of goodwill to its implied fair value. In the event of impairment, the amount by which the carrying amount exceeds the fair value would be charged to earnings. The Company assessed the qualitative factors including macroeconomic conditions, market conditions, cost of funds, financial contribution, and any changes in net assets and determined it was not more likely than not that its fair value was less than its carrying account at December 31, 2013.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Other Real Estate Owned (“OREO”)
OREO, consisting of properties obtained through foreclosure or through a deed in lieu of foreclosure in satisfaction of loans, is reported at the lower of cost or fair value, determined on the basis of current appraisals, comparable sales, and other estimates of value obtained principally from independent sources, adjusted for estimated selling costs. Management also considers other factors, including changes in absorption rates, length of time the property has been on the market and anticipated sales values, which have resulted in adjustments to the collateral value estimates indicated in certain appraisals.
At the time of foreclosure or initial possession of collateral, any excess of the loan balance over the fair value of the real estate held as collateral is treated as a charge against the allowance for loan losses.
Subsequent declines in the fair value of OREO below the new cost basis are recorded through valuation adjustments. Significant judgments and complex estimates are required in estimating the fair value of other real estate, and the period of time within which such estimates can be considered current is significantly shortened during periods of market volatility. In response to market conditions and other economic factors, management may utilize liquidation sales as part of its problem asset disposition strategy. As a result of the significant judgments required in estimating fair value and the variables involved in different methods of disposition, the net proceeds realized from sales transactions could differ significantly from appraisals, comparable sales, and other estimates used to determine the fair value of other real estate. Management reviews the value of other real estate periodically and adjusts the values as appropriate. Revenue and expenses from OREO operations as well as gains or losses on sales and any subsequent adjustments to the value are recorded as a component of non-interest expense.
Covered OREO
The portion of OREO covered under loss share agreements with the FDIC in which the FDIC has agreed to reimburse the Company 80% of all losses as well as certain expenses incurred in connection with those assets. For further information of accounting for covered loans refer to the Acquisition Accounting and FDIC receivable for Loss Share Agreements sections within this Note 1.
Transfers of Financial Assets
Transfers of financial assets are accounted for as sales, when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company - put presumptively beyond the reach of the transferor and its creditors even in bankruptcy or other receivership, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity or the ability to unilaterally cause the holder to return specific assets.
Pension Plan
The compensation cost of an employee’s pension benefit is recognized on the projected unit credit method over the employee’s approximate service period. The Company’s funding policy is to contribute annually an amount that satisfies the funding standard account requirements of ERISA.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Employee Stock Ownership Plan ("ESOP")
The cost of shares issued to the ESOP, but not yet allocated to participants, is shown as a reduction of stockholders’ equity. Compensation expense is based on the market price of shares as they are committed to be released to participant accounts. Dividends on allocated ESOP shares reduce retained earnings; dividends on unearned ESOP shares reduce debt and accrued interest.
The Company accounts for its ESOP in accordance with ASC 718-40. Accordingly, since the Company sponsors the ESOP with an employer loan, neither the ESOP’s loan payable or the Company’s loan receivable are reported in the Company’s consolidated balance sheet. Likewise, the Company does not recognize interest income or interest cost on the loan. Unallocated shares held by the ESOP are recorded as unearned ESOP shares in the consolidated statement of changes in stockholders’ equity. As shares are released for allocation, the Company recognizes compensation expense equal to the average market price of the shares for the period.
Income Taxes
The income tax accounting guidance results in two components of income tax expense: current and deferred. Current income tax expense reflects taxes to be paid or refunded for the current period by applying the provisions of the enacted tax law to the taxable income or excess of deductions over revenues. The Company determines deferred income taxes using the liability (or balance sheet) method. Under this method, the net deferred tax asset or liability is based on the tax effects of the differences between the book and tax bases of assets and liabilities, and enacted changes in tax rates and laws are recognized in the period in which they occur. The Company and Bank file consolidated income tax returns but maintain a tax allocation agreement, whereby the Company and Bank calculate their respective amounts of income and expenses and are only responsible for their share of the consolidated income taxes as if they were to file on an unconsolidated basis.
Deferred income tax expense results from changes in deferred tax assets and liabilities between periods. Deferred tax assets are recognized if it is more-likely-than-not, based on the technical merits, that the tax position will be realized or sustained upon examination. A tax position that meets the more-likely-than-not recognition threshold is initially and subsequently measured as the largest amount of tax benefit that has a greater than 50 percent likelihood of being realized upon settlement with a taxing authority that has full knowledge of all relevant information. The determination of whether or not a tax position has met the more-likely-than-not recognition threshold considers the facts, circumstances, and information available at the reporting date and is subject to management’s judgment. Deferred tax assets may be reduced by deferred tax liabilities and a valuation allowance if, based on the weight of evidence available, it is more-likely-than-not that some portion or all of a deferred tax asset will not be realized.
The Company recognizes interest and penalties accrued relative to unrecognized tax benefits in its respective federal or state income taxes accounts. As of December 31, 2013, there were no accruals for uncertain tax positions and no accruals for interest and penalties. The Company and its subsidiary file a consolidated United States federal income tax return, as well as income tax returns in Georgia, Florida, Alabama and Maryland. The Company's filed income tax returns are no longer subject to examination by taxing authorities for years prior to 2010.
Earnings Per Share
Basic earnings per share represent net income available to common shareholders divided by the weighted-average number of common shares outstanding during the period, excluding unearned shares of the Employee Stock Ownership Plan and unvested shares of stock. Diluted earnings per share are computed by dividing net income by the sum of the weighted-average number of shares of common stock outstanding and dilutive potential common shares. Potential common shares consist only of stock options and unvested restricted shares.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Comprehensive Income
Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on securities available for sale, unrealized gains and losses on cash flow hedge, and funded status of pension plan are reported as a separate component of the equity section of the balance sheet, such items, along with net income, are components of comprehensive income.
Advertising Costs
Advertising costs are expensed as incurred.
Derivative Instruments
The Company enters into derivative transactions principally to protect against the risk of adverse price or interest rate movements on the value of certain assets and liabilities and on future cash flows. In addition, certain contracts and commitments are defined as derivatives under generally accepted accounting principles.
All derivative instruments are carried at fair value on the balance sheet. Special hedge accounting provisions are provided, which permit the change in the fair value of the hedged item related to the risk being hedged to be recognized in earnings in the same period and in the same income statement line as the change in the fair value of the derivative, see Note 10 for additional information.
Derivative instruments designated in a hedge relationship to mitigate exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges. Derivative instruments designated in a hedge relationship to mitigate exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges. The Company formally documents all relationships between hedging instruments and hedged items, as well as its risk management objective and strategy for undertaking each hedged transaction.
Reclassification
Certain amounts in the consolidated financial statements presented in the years ended December 31, 2012 and 2011 have been reclassified to conform to the December 31, 2013 presentation, with no effect on total assets or net income.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Recent Accounting Standards
The following are summaries of recently issued accounting pronouncements that impact the accounting and reporting practices of the Company:
In October 2012, ASU 2012-06, “Business Combinations (Topic 805) - Subsequent Accounting for an Indemnification Asset Recognized at the Acquisition Date as a Result of a Government-Assisted Acquisition of a Financial Institution (a consensus of the FASB Emerging Issues Task Force).” ASU 2012-06 clarifies the applicable guidance for subsequently measuring an indemnification asset recognized as a result of a government-assisted acquisition of a financial institution. Under ASU 2012-06, when a reporting entity recognizes an indemnification asset as a result of a government-assisted acquisition of a financial institution and, subsequently, a change in the cash flows expected to be collected on the indemnification asset occurs (as a result of a change in cash flows expected to be collected on the assets subject to indemnification), the reporting entity should subsequently account for the change in the measurement of the indemnification asset on the same basis as the change in the assets subject to indemnification. Any amortization of changes in value should be limited to the contractual term of the indemnification agreement (that is, the lesser of the term of the indemnification agreement and the remaining life of the indemnified assets). The amendments are effective for fiscal years beginning on or after December 15, 2012 and early adoption is permitted. The amendments are to be applied prospectively to any new indemnification assets acquired after the date of adoption and to indemnification assets existing as of the date of adoption arising from a government-assisted acquisition of a financial institution.
In February 2013, ASU 2013-02, “Comprehensive Income (Topic 220) - Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income.” ASU 2013-02 provides disclosure guidance on amounts reclassified out of accumulated other comprehensive income by component. The adoption did not have any impact on the Company’s financial position or results of operations but has impacted the financial statement disclosure. As shown on the Consolidated Statements of Comprehensive Income for the years ended December 31, 2013, 2012 and 2011, the Company reclassified net gains and securities impairment of $51,000, $1.7 million, and $410,000 out of other comprehensive income into gain on the sale of investment securities available for sale.
In January 2014, ASU 2014-04, “Receivables-Troubled Debt Restructurings by Creditors (Topic 310-40): Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure a consensus of the FASB Emerging Issues Task Force.” ASU 2014-04 clarifies that an in substance repossession or foreclosure occurs, and a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan, upon either (1) the creditor obtaining legal title to the residential real estate property upon completion of a foreclosure or (2) the borrower conveying all interest in the residential real estate property to the creditor to satisfy that loan through completion of a deed in lieu of foreclosure or through a similar legal agreement. Additionally, the amendments require interim and annual disclosure of both (1) the amount of foreclosed residential real estate property held by the creditor and (2) the recorded investment in consumer mortgage loans collateralized by residential real estate property that are in the process of foreclosure according to local requirements of the applicable jurisdiction. The amendments are effective for fiscal years and interim periods beginning on or after December 15, 2014. The Company is currently in the process of evaluating the ASU.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 2.
EARNINGS PER SHARE
Basic earnings per share represent income available attributable to common shareholders divided by the weighted-average number of common shares outstanding during the period, excluding unallocated shares of the Employee Stock Ownership Plan and unvested shares of issued restricted stock. For the year ended December 31, 2013, potential common shares of 42,171, respectively, were not included in the calculation of diluted earnings per share because the assumed exercise of such shares would be anti-dilutive.
The components used to calculate basic and diluted earnings per share follows:
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 3.
STOCK PLANS AND STOCK-BASED COMPENSATION
EQUITY INCENTIVE PLANS
On May 17, 2006, the Company’s stockholders approved the 2006 Equity Incentive Plan (the “Plan”). The purpose of the Plan is to promote the long-term growth and profitability of Heritage Financial Group, Inc, to provide directors, advisory directors, officers and employees of Heritage Financial Group, Inc. and its affiliates with an incentive to achieve corporate objectives, to attract and retain individuals of outstanding competence, and to provide such individuals with an equity interest in Heritage Financial Group, Inc. Under the Plan, the Compensation Committee of the Board of Directors has discretion to award up to 645,990 shares, of which 461,422 were available as stock options or stock appreciation rights and 184,568 shares were available as restricted stock awards. As of December 31, 2013, there were approximately 12,800 restricted stock awards and 56,963 options available to be granted from the 2006 Plan.
On June 22, 2011, the Company’s stockholders approved the 2011 Equity Incentive Plan (the “2011 Plan”). Under the 2011 Plan, the Compensation Committee has the discretion to award up to 573,481 shares, of which 409,429 were available as stock options or stock appreciation rights and 163,852 were available as restricted stock awards. As of December 31, 2013, there were approximately 31,382 restricted stock awards and 49,259 options available to be granted from the 2011 Plan.
The Company granted restricted awards that may not be sold or otherwise transferred until certain restrictions have lapsed. The unearned compensation related to these awards is being amortized to compensation expense over the period the restrictions lapse (generally one to five years). The share-based expense for these awards was determined based on the market price of the Company's stock at the date of grant applied to the total number of shares that were anticipated to fully vest, amortized over the vesting period.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 3.
STOCK PLANS AND STOCK-BASED COMPENSATION (Continued)
STOCK OPTIONS
A summary of the status of the two plans, along with changes during the periods then ended, follows:
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 3.
STOCK PLANS AND STOCK-BASED COMPENSATION (Continued)
STOCK OPTIONS (continued)
The following table presents information on stock options outstanding for the period shown, less estimated forfeitures:
A further summary of the options outstanding at December 31, 2013 follows:
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 3.
STOCK PLANS AND STOCK-BASED COMPENSATION (Continued)
STOCK OPTIONS (continued)
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model. Expected volatilities are based on historical volatility of the Company’s stock. Expected dividends are based on expected dividend trends and the expected market price of the Company’s stock price at grant. Historical data is used to estimate option exercises and employee terminations within the valuation model. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant.
No stock options were granted during 2013. The Company granted 31,900 options on October 1, 2012 from the 2011 Equity Incentive Plan. In 2011, the Company granted 12,000 options on January 1, 2011 from the 2006 Equity Incentive Plan, and, on July 1, 2011, the Company granted 334,870 options from the new 2011 Equity Incentive Plan. The assumptions listed in the table below were used for the options granted in the period indicated.
For the years ended December 31, 2013, 2012, and 2011 the Company recognized pre-tax compensation expense related to stock options of approximately $585,000, $549,000, and $392,000, respectively. At December 31, 2013, there was approximately $1.5 million of unrecognized compensation related to stock options.
RESTRICTED STOCK
The Company also grants restricted stock periodically for the benefit of employees and directors. The 2006 plan reserved 184,568 shares of common stock for restricted stock grants and, under the 2011 plan, 163,852 shares of common stock are reserved for restricted stock grants.
At December 31, 2013, restricted stock grants covering 171,768 shares of common stock had been issued leaving 12,800 shares available for grant from the 2006 Equity Incentive Plan. Additionally, at December 31, 2013, restricted stock grants covering 132,770 shares of common stock had been issued, 300 had been forfeited and 31,382 shares were available for grant from the 2011 Equity Incentive Plan
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 3.
STOCK PLANS AND STOCK-BASED COMPENSATION (Continued)
RESTRICTED STOCK (continued)
Restricted stock grants are made at the discretion of the Board of Directors. Compensation expense for restricted stock is based on the market price of the Company stock at the time of the grant and amortized on a straight-line basis over the vesting period which is currently five years for all grants issued. Recipients of restricted stock do not pay any cash consideration to the Company for the shares, have the right to vote all shares subject to such grant and receive all dividends with respect to such shares, whether or not the shares have vested. The restriction is based upon continuous service. The Company did not issue any restricted stock during 2013. The Company awarded 15,600 shares of restricted stock on October 1, 2012 from the 2011 Equity Incentive Plan. In 2011, the Company awarded 4,000 shares of restricted stock on January 1, 2011 from the 2006 Equity Incentive Plan and 117,530 shares of restricted stock from the 2011 Equity Incentive Plan on July 1, 2011. Restricted stock consists of the following:
The balance of unearned compensation related to these restricted shares as of December 31, 2013 is $873,000 which is expected to be recognized over a weighted-average of 2.70 years. Total compensation expense recognized for the restricted shares granted to employees and directors for the year ended December 31, 2013, 2012, and 2011 was approximately $332,000 $309,000 and $336,000, respectively.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 4.
SECURITIES
The amortized cost and fair value of securities available for sale with gross unrealized gains and losses are summarized as follows:
The amortized cost and fair value of debt securities available for sale by contractual maturity are shown below. Maturities may differ from contractual maturities in mortgage-backed securities because the mortgages underlying the securities may be called or repaid without penalty. Therefore, these securities are not included in the maturity categories in the following maturity summary.
Securities with a carrying value of approximately $133.0 million and $94.6 million at December 31, 2013 and December 31, 2012, respectively, were pledged to secure public deposits, repurchase agreements and for other purposes required or permitted by law. The balance of pledged securities in excess of the pledging requirements was $30.9 million and $18.0 million at December 31, 2013 and December 31, 2012, respectively.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 4.
SECURITIES (Continued)
The gross realized gains and losses recognized in income are reflected in the following table:
The following table shows the gross unrealized losses and fair value of securities aggregated by category and length of time that securities have been in a continuous unrealized loss position.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 4.
SECURITIES (Continued)
At December 31, 2013, total unrealized losses increased to $13.2 million, or 5.2% of the temporarily impaired securities, compared to $864,000, or 1.0% of the temporarily impaired securities, at December 31, 2012. The unrealized losses in 2013 relate to 52 agencies, 96 state and municipal obligations, 128 mortgage-backed securities and 1 equity security. In analyzing an issuer's financial condition, management considers whether the securities are issued by the federal government or its agencies, whether downgrades by bond rating agencies have occurred, the results of reviews of the issuer's financial condition, and the issuer's anticipated ability to pay the contractual cash flows of the investments.
The Company does not currently intend to sell the securities within the portfolio and it is not more-likely-than-not that the Company will be required to sell the debt securities; therefore, management does not consider these investments to be other-than-temporarily impaired at December 31, 2013. Management continues to monitor all of these securities with a high degree of scrutiny. There can be no assurance that the Company will not conclude in future periods that conditions existing at that time indicate some or all of these securities may be sold or are other than temporarily impaired, which would require a charge to earnings in such periods. At December 31, 2013, the Company held certain investment securities having continuous unrealized loss positions for more than 12 months. All of these losses were in 19 mortgage-backed securities and 23 municipal securities. The unrealized losses arose from changes in interest rates and market conditions as of December 31, 2013.
Other-Than-Temporary Impairment
The Company reviews its investment portfolio on a quarterly basis judging each investment for other-than-temporary impairment (“OTTI”). Management does not have the intent to sell any of the temporarily impaired investments and believes it is more likely than not that the Company will not have to sell any such securities before a recovery of cost. The OTTI analysis focuses on the duration and amount a security is below book value and assesses a calculation for both a credit loss and a non-credit loss for each measured security considering the security’s type, performance, underlying collateral, and any current or potential debt rating changes. The OTTI calculation for credit loss is reflected in the income statement while the non-credit loss is reflected in other comprehensive income.
The Company holds Freddie Mac (“FHLMC”) preferred stock, and OTTI was recorded in the amount of the investment after the U.S. Government placed the company into conservatorship in September 2008. The preferred stock has been reduced to a nominal book value for tracking purposes. The investment is currently valued at $439,000. During the twelve months ended December 31, 2008, the Company recognized a write-down of $1.5 million through non-interest income representing other-than-temporary impairment on the investment.
The Company holds a single issue trust preferred security issued by Royal Bank of Scotland (“RBS”). The security suspended payments under the EU agreement for 24 months beginning April 1, 2011. The Company valued the security by projecting estimated cash flows using the Moody’s Ba2 marginal default rate. The difference in the present value and the carrying value of the security was the OTTI credit portion. During the twelve months ended December 31, 2011, the Company recognized a write-down of $43,000 through non-interest income representing OTTI on the security. Subsequent to the recorded OTTI on this security, interest payments have resumed and this security is now considered performing. At December 31, 2013, the book value of the security was recorded at $207,000 and the fair value of the security was $205,000 with $2,000 of unrealized loss recorded in other comprehensive income.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 4.
SECURITIES (Continued)
The following table presents more detail on selective Company security holdings as of December 31, 2013. These details are listed separately due to the inherent level of risk for OTTI on these securities.
The following table presents a roll-forward of the cumulative amount of credit losses on the Company’s investment securities that have been recognized through earnings.
Restricted Equity Securities
The investment in the common stock of the Federal Home Loan Bank of Atlanta is accounted for by the cost method, which also represents par value, and is made for long-term business affiliation reasons. In addition, this investment is subject to restrictions relating to sale, transfer or other disposition. Dividends are recognized in income when declared. The carrying value of this investment at December 31, 2013 and 2012 was $7.3 million and $4.3 million, respectively. The estimated fair value of this investment is $7.3 million as of December 31, 2013, and therefore it is not considered impaired.
Other equity securities represent an investment in the common stock of the Chattahoochee Bank of Georgia (“Chattahoochee”), a de novo bank in Gainesville, Georgia. The Company accounts for this investment by the cost method. This investment represents approximately 4.9% of the outstanding shares of Chattahoochee. Since its initial capital raise, Chattahoochee has had limited stock transactions, and therefore, no fair market value is readily available. The carrying value of this investment at December 31, 2013 and 2012 was $1.0 million. The Company plans to hold this investment for the foreseeable future, and did not consider it impaired as of December 31, 2013.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 5.
LOANS AND ALLOWANCE FOR LOAN LOSSES (EXCLUDING FDIC-ACQUIRED LOANS)
The composition of loans is summarized as follows:
Commercial Real Estate
Commercial real estate lending includes real estate loans secured primarily by multifamily dwellings, retail establishments, hotels, motels, warehouses, small office buildings, farmland, and other nonresidential properties located in our market areas.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 5.
LOANS AND ALLOWANCE FOR LOAN LOSSES (EXCLUDING FDIC-ACQUIRED LOANS) (Continued)
These loans typically involve large balances to single borrowers or groups of related borrowers. Because payments on loans secured by nonresidential and multifamily real estate properties are often dependent on the successful operation or management of the properties, repayment of these loans may be subject to adverse conditions in the real estate market or the economy. If the cash flow from the project is reduced, or if leases are not obtained or renewed, the borrower's ability to repay the loan may be impaired.
Loans secured by farmland typically involve large balances, and repayments are often dependent on the successful operation of the farm, making them subject to adverse weather and economic conditions. If the cash flow from the farm operations declines, the borrower’s ability to repay the loan may be impaired.
Construction and Land
Construction and land lending consist of loans for the construction of one- to four-family residences, multifamily residences and commercial properties. Construction loans also involve additional risks because funds are advanced upon the security of the project under construction, which is of uncertain value prior to the completion of construction. Moreover, because of the uncertainties inherent in estimating construction costs, delays arising from labor problems, material shortages, and other unpredictable contingencies, it is relatively difficult to evaluate accurately the total loan funds required to complete a project, and the related loan-to-value ratios.
Residential Real Estate
Residential real estate lending consist of loans secured by first mortgages on one- to four-family residences, including home equity lines of credit, in our lending area, and on occasion, outside our lending area for customers whose primary residences are within the Company’s lending area.
Consumer and Other Lending
Consumer and other lending includes a variety of secured consumer loans, new and used auto loans, boat and recreational vehicle loans, and loans secured by deposit accounts. Consumer loans may entail greater risk, particularly in the case of consumer loans that are secured by rapidly depreciable assets, such as automobiles and recreational vehicles. In these cases, any repossessed collateral for a defaulted loan may not provide an adequate source of repayment of the outstanding loan balance. As a result, consumer loan collections are dependent on the borrower's continuing financial stability and, thus, are more likely to be adversely affected by job loss, divorce, illness, or personal bankruptcy.
Commercial and Industrial Lending
Commercial and industrial lending activities encompass loans with a variety of purposes and security, including loans to finance accounts receivable, inventory and equipment. Commercial business loans are generally secured by business assets, such as accounts receivable, equipment and inventory. This collateral may depreciate over time, may be difficult to appraise and may fluctuate in value based on the success of the business.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 5.
LOANS AND ALLOWANCE FOR LOAN LOSSES (EXCLUDING FDIC-ACQUIRED LOANS) (Continued)
In the ordinary course of business, the Company has granted loans to certain directors, executive officers and their affiliates. Changes in related party loans are summarized as follows:
Activity in the allowance for loan losses and recorded investment in loans by segment:
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 5.
LOANS AND ALLOWANCE FOR LOAN LOSSES (EXCLUDING FDIC-ACQUIRED LOANS) (Continued)
Activity in the allowance for loan losses and recorded investment in loans by segment:
Impaired Loans
A loan is considered impaired, in accordance with the impairment accounting guidance (ASC 310-10-35-16), when based on current information and events, it is probable that the Company will be unable to collect all amounts due from the borrower in accordance with the contractual term of the loan. Impaired loans include loans modified in troubled debt restructuring where concessions have been granted to borrowers experiencing financial difficulties. These concessions could include a reduction in the interest rate on the loan, payment extensions, forgiveness of principal, forbearance or other actions intended to maximize collection.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 5.
LOANS AND ALLOWANCE FOR LOAN LOSSES (EXCLUDING FDIC-ACQUIRED LOANS) (Continued)
Impaired loans by class are presented below for 2013:
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 5.
LOANS AND ALLOWANCE FOR LOAN LOSSES (EXCLUDING FDIC-ACQUIRED LOANS) (Continued)
Impaired loans by class are presented below for 2012:
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 5.
LOANS AND ALLOWANCE FOR LOAN LOSSES (EXCLUDING FDIC-ACQUIRED LOANS) (Continued)
Impaired loans by class are presented below for 2011:
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 5.
LOANS AND ALLOWANCE FOR LOAN LOSSES (EXCLUDING FDIC-ACQUIRED LOANS) (Continued)
Below is an analysis of the age of recorded investment in loans that are past due as of December 31, 2013.
*There were no accruing loans that were greater than 90 days past due at December 31, 2013.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 5.
LOANS AND ALLOWANCE FOR LOAN LOSSES (EXCLUDING FDIC-ACQUIRED LOANS) (Continued)
Below is an analysis of the age of recorded investment in loans that are past due as of December 31, 2012.
*There were no accruing loans that were greater than 90 days past due at December 31, 2012.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 5.
LOANS AND ALLOWANCE FOR LOAN LOSSES (EXCLUDING FDIC-ACQUIRED LOANS) (Continued)
Troubled Debt Restructuring (TDR) Modifications
Impaired loans include loans modified in troubled debt restructuring where concessions have been granted to borrowers experiencing financial difficulties. These concessions are a part of the Company’s loss mitigation activities and could include a reduction in the interest rate on the loan, payment extensions, forgiveness of principal, forbearance or other actions intended to maximize collection. Certain TDR’s are classified as non-performing at the time of restructure and may only be returned to performing status after considering the borrower’s sustained repayment performance for a reasonable period, typically considered six to twelve months.
At December 31, 2013, the Company had troubled debt restructurings totaling $7.7 million, which involve forgiving a portion of interest or principal on any loans or making loans at a rate materially less than that of market rates. Included in nonaccruing loans at December 31, 2013 are troubled debt restructurings of $5.8 million. In addition, at that date the Company had troubled debt restructurings totaling $1.9 million that were performing in accordance with their modified terms and are not included in nonaccruing loans.
The following tables include the recorded investment and number of modifications for modified loans. The Company reports the recorded investment in the loans prior to a modification and also the recorded investment in the loans after the loans were restructured. Management has also disclosed the recorded investment and number of modifications for troubled debt restructurings within the last year where a concession has been made that then defaulted in the current reporting period.
Troubled debt restructurings for the periods ended:
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 5.
LOANS AND ALLOWANCE FOR LOAN LOSSES (EXCLUDING FDIC-ACQUIRED LOANS) (Continued)
Troubled debt restructuring modifications that subsequently defaulted for the periods ended:
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 5.
LOANS AND ALLOWANCE FOR LOAN LOSSES (EXCLUDING FDIC-ACQUIRED LOANS) (Continued)
Allowance for Loan and Lease Losses (ALLL)
The Company establishes provisions for loan losses, which are charged to income, at a level the Company believes will reflect probable credit losses based on historical loss trends and an evaluation of specific credits in the loan portfolio.
In evaluating the level of the allowance for loan losses, the Company considers the types of loans and the amount of loans in the loan portfolio, five year historical loss experience, migration analysis, probability of default, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral, prevailing economic conditions, and past due status and trends.
The Company analyzes the non-FDIC-acquired loan portfolios through the use of pools of homogenous loan types and through a specific quarterly review of larger problem loans. It is expected that a certain percentage of loans will move through the asset quality grades from pass, to classified and ultimately loss. The Company evaluates the non-FDIC loan portfolio through review of four loan pool categories.
1. Pass credits with risk ratings 1-5
2. Special mention with risk ratings 6-7
3. Substandard with risk rating 8 and still accruing
4. Impaired loans 9-11 - Nonaccrual and troubled debt restructurings
Asset quality grades are described in detail subsequently.
The allowance consists of two components:
1. A general amount - The Company analyzes the historical migration of loans through each risk rating category and analyzes the history of losses as it relates to the various loan types and collateral types in order to evaluate and estimate the volume, magnitude and direction of these events. These risk factors and other factors are applied to our review of the Pass credits with risk ratings 1-5 pool and other assets specially mentioned with risk rating 6-7 pool. These factors are also applied to the substandard pool; however, in addition to reviewing the pool, a select group of individual loans are reviewed. The results of the individual review are factored in with the historical loss analysis and applied to the pool.
2. A specific amount - Impaired loans are reviewed individually for specific amounts that are representative of identified credit exposures that are readily predictable by the current performance of the borrower and underlying collateral. Impaired loans with balances lower than $500,000 are not typically reviewed on an individual basis due to their small size. Instead, a historical loss analysis is used for these loans, which assumes the loan migration to default is likely, and the assumed loss is recorded as a specific amount.
Even though the ALLL is composed of two components, the entire ALLL is available to absorb any credit losses.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 5.
LOANS AND ALLOWANCE FOR LOAN LOSSES (EXCLUDING FDIC-ACQUIRED LOANS) (Continued)
The Company assesses the allowance for loan losses on a quarterly basis and we make provisions for loan losses as necessary in order to maintain the proper level of allowance. While the Company uses available information to recognize losses on loans, future loan loss provisions may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the allowance for loan losses and may require the Company to recognize additional provisions based on their judgment of information available to them at the time of their examination. The allowance for loan losses is maintained at a level that represents management's best estimate of inherent losses in the loan portfolio, where such losses were both probable and reasonably estimable. The level of the allowance is based on estimates and the ultimate losses may vary from the estimates.
In September 2012, the Company modified its asset quality grading system by dividing it into eleven categories instead of eight. This modification added one new pass level, an additional criticized level and a new classified level. The new grading system did not cause a change to the allowance methodology for loan losses and was created to help the Company better manage credit quality.
A summary of the asset grading system is as follows:
Pass-1-Exceptional/Highest Quality - Loans in this category are secured by certificates of deposit. There is no credit risk exposure in this category.
Pass-2-Excellent/High Quality - Loans in this category have borrowers with an excellent balance sheet and income statement and improving trends, including net worth, liquidity, working capital, leverage, cash flow and profitability. Financial ratios are superior within industry when industry comparison is available.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 5.
LOANS AND ALLOWANCE FOR LOAN LOSSES (EXCLUDING FDIC-ACQUIRED LOANS) (Continued)
Pass-3-Strong/Above Average - Loans in this category have borrowers with current and complete financial statements; solid balance sheet and income statement with stable to improving trends in areas such as net worth, liquidity, working capital, leverage, cash flow and profitability; leverage and ratios are better than industry standards when industry comparison is available; debt service coverage, both historically and proposed, is more than adequate based on financial analysis; the borrower’s industry is stable to improving; loans are properly structured and documented and require only normal supervision and monitoring; consistently meets debt obligations in a timely manner; individual borrower or guarantor, with above average liquid net worth and minimal contingent liabilities.
Pass-4-Good/Average - Loans in this category have sound risk profiles, good net worth and debt service coverage ratios; financial statements are current and complete; satisfactory balance sheet and income statement reflecting adequate profitability, net worth, working capital, cash flow and leverage position; financial analysis demonstrates adequate debt service coverage; leverage and ratios are in line with industry averages when industry comparison is available; debt service coverage, both historically and proposed, is adequate based on financial analysis; loans are properly structured and documented and require only minimal supervision; contingent liabilities have been thoroughly analyzed and repayment sources are adequate to cover existing debt service; individual borrower or guarantor with acceptable net worth and liquidity.
Pass-5-Acceptable with more than average risk - Loans in this category are those which are acceptable with more than average risk due to one or more factors, which could lead to financial difficulty if not closely managed. This rating may include those credits from higher categories that have declining trends in financial performance or credit quality. This category may also include credits that have previously been criticized or classified, but have improved in credit quality.
Special Mention-6-Special Mention Loans - Loans in this category are not currently adequate. These loans are considered weaker due to less than adequate repayment history, and/or their collateral may not adequately protect the Company from loss in the event of liquidation or foreclosure. If left uncorrected, these weaknesses may result in deterioration of the repayment prospects for the asset or in the Company’s credit position at some future date. As a general rule, credits in this category will be delinquent less than 30 days and will not be chronically past due. Loans in this category are not intended to remain in category 6 permanently as it should become evident fairly quickly whether or not the weaknesses can be cured and the loan upgraded. If the weakness cannot be corrected, the relationship will more than likely need to be downgraded to a 7 or 8.
Special Mention Elevated Risk 7-Special Mention Loans with added risk exposure - Loans in this category have one or more potential weaknesses discussed in asset quality grade 6, but the borrower is still cooperative, satisfactory repayment plans are in place, and file documentation reflects the ability of the borrower to repay the debt as currently structured
Substandard 8-Substandard/Inadequately Protected - Loans in this category are inadequately protected by the current sound net worth and repayment capacity of the borrower or of the collateral pledged, if any. Credit analysis has proven well-defined weaknesses in debt service coverage, net worth and/or poor loan structure. There is a distinct possibility that the Company will sustain some loss if the deficiencies are not corrected. A reserve allocation of the estimated amount of loss or collateral shortfall has been made to the ALLL. These loans are considered to be impaired loans and the chance of a loss is reasonably probable.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 5.
LOANS AND ALLOWANCE FOR LOAN LOSSES (EXCLUDING FDIC-ACQUIRED LOANS) (Continued)
Impaired Loans 9-Nonaccrual Loans - Loans in this category are impaired with a loss potential of either principal or interest that is probable or likely to occur. Once a loan enters this category, the estimated loss will be charged off.
Doubtful 10-Doubtful - Loans in this category have all of the weaknesses inherent in those classified as Substandard, with the additional characteristic that the weaknesses make collection or liquidation in full highly questionable and improbable. This assessment should be made on current facts, conditions and values. The probability of some loss is extremely high, but because of certain important and reasonably specific pending factors (i.e., merger/liquidation, capital injection, refinancing plans, and/or perfection of liens), the amount of loss cannot yet be determined, but may total 50% of the outstanding balance. Determination of the pending factors should generally be resolved within six months and the asset partially, or fully, charged-off or moved to substandard. All doubtful assets must be placed on nonaccrual. A reserve allocation or charge off of at least 50% is normally recommended for such loans.
Loss 11-Loss - Loans in this category are considered uncollectible and of such little value that their continuance as active assets of the Company is not warranted. This classification does not mean that the loss has absolutely no recovery or salvage value, but rather it is not practical or desirable to defer writing it off. Once the loan is placed in this category, any determined loss will be charged-off within 30 days
Credit quality indicators for loans by class are presented below for December 31, 2013 and December 31, 2012.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 5.
LOANS AND ALLOWANCE FOR LOAN LOSSES (EXCLUDING FDIC-ACQUIRED LOANS) (Continued)
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 5.
LOANS AND ALLOWANCE FOR LOAN LOSSES (EXCLUDING FDIC-ACQUIRED LOANS) (Continued)
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 5.
LOANS AND ALLOWANCE FOR LOAN LOSSES (EXCLUDING FDIC-ACQUIRED LOANS) (Continued)
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 6.
FDIC-ACQUIRED LOANS AND ALLOWANCE FOR LOAN LOSSES
The Company elected to account for loans acquired in the Tattnall Bank, Citizens Bank of Effingham (“Citizens”), First Southern National Bank (“First Southern”) and Frontier Bank (“Frontier”) acquisitions under ASC 310-30. ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality, applies to a loan with evidence of deterioration of credit quality since origination, acquired by completion of a transfer for which it is probable, at acquisition, that the investor will be unable to collect all contractually required payments receivable. ASC 310-30 prohibits carrying over or creating an allowance for loan losses upon initial recognition for loans which fall under the scope of this statement. Loans with specific evidence of deterioration in credit quality were accounted for under ASC 310-30. In addition, the Company determined it would not be able to collect all the contractually required principal and interest payments on other loans in the portfolio which did not have specific evidence of credit quality due to multiple factors, including the deterioration of the economy since origination of these loans, the decline in real estate values in the market areas of the loans, and the poor underwriting standards under which these loans were originated. These loans are accounted for by analogy to ASC 310-30. The following tables detail the fair value of loans covered and not covered under loss-share agreements accounted under ASC 310-30.
The Bank entered into loss-sharing agreements as part of the acquisitions of Citizens and First Southern. The covered loans above are covered pursuant to the FDIC loss-share agreements. Those agreements provide for the FDIC to reimburse the Company for 80% of covered losses associated with these loans, pursuant to the terms of the agreements. The FDIC agreement to reimburse is set to expire five years from the acquisition date for non-single family loans and ten years from the acquisition date for single family loans, while recoveries will be shared three years after the reimbursement expiration for the single family loans.
The following table presents the loss-sharing agreement expirations:
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 6.
FDIC-ACQUIRED LOANS AND ALLOWANCE FOR LOAN LOSSES (CONTINUED)
The following table represents the loans receivable as of December 31, 2013 and reflects reclassifications from the balances reported at December 31, 2012:
The following table is a summary of changes in the accretable yields of acquired loans since December 31, 2010 and reflect refinements to the Company's initial estimate:
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 6.
FDIC-ACQUIRED LOANS AND ALLOWANCE FOR LOAN LOSSES (CONTINUED)
The following is a summary of the allowance for loan losses for the FDIC-acquired loans for 2013:
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 6.
FDIC-ACQUIRED LOANS AND ALLOWANCE FOR LOAN LOSSES (CONTINUED)
The following is a summary of the allowance for loan losses for the FDIC-acquired loans for 2012:
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 7.
FDIC LOSS-SHARE RECEIVABLE
A significant portion of the Company’s loan and other real estate assets are covered under loss-share agreements with the FDIC in which the FDIC has agreed to reimburse the Company 80% of all covered losses as well as certain expenses incurred in connection with those assets. The Company estimated the amount that will be received from the FDIC under the loss-share agreements that will result from losses incurred as the Company disposes of covered assets, and the Company has recorded the estimate as a receivable from the FDIC. The Company discounted the receivable for the expected timing and receipt of those cash flows using a risk free rate plus a premium for risk. The accretion of the FDIC receivable discount is recorded into noninterest income using the level yield method over the estimated life of the receivable.
The FDIC receivable for loss-share agreements is measured separately from the related covered assets because it is not contractually embedded in the assets and is not transferable if the Company sells the assets. The Company reviews and updates the fair value of the FDIC receivable at each reporting date in conjunction with the re-estimation of cash flows. Increases in expected cash flows on covered FDIC-acquired loans impact the FDIC loss-share receivable by reducing the receivable over the shorter of the estimated life of the loan or the expected life of the indemnification asset. Conversely, decreases in expected cash flows first impact accretable discounts to the extent available and then impact the allowance for loan losses while also increasing the FDIC loss-share receivable. The FDIC receivable fluctuates as loss estimates and expected cash flows related to covered loans and other real estate owned change.
The following tables provide details of changes in the loss-share receivable from the FDIC for the periods indicated.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 8.
OTHER REAL ESTATE OWNED (OREO)
The following table provides a summary of information pertaining to other real estate owned (“OREO”) for periods ended December 31, 2013 and December 31, 2012.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 9.
FAIR VALUE MEASUREMENTS
Determination of Fair Value
Fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. Current accounting guidance establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (level 1 measurements) and the lowest priority to unobservable inputs (level 3 measurements).
Fair Value Hierarchy
The three levels of the fair value hierarchy are described below:
Level 1 - Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities;
Level 2 - Quoted prices in markets that are not active, or inputs that are observable, either directly, for substantially the full term of the asset or liability. Level 2 inputs may include quoted prices for similar assets and liabilities in active markets, as well as inputs that are observable for the asset or liability (other than quoted prices), such as interest rates, foreign exchange rates and yield curves that are observable at commonly quoted intervals;
Level 3 - Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e., supported by little or no market activity).
The fair value hierarchy is based on the lowest level input that is significant to the fair value measurement of the asset and liability in its entirety. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the asset or liability.
Fair Value Option
Fair Value Measurements and Disclosures (ASC 820) allow companies to report selected financial assets and liabilities at fair value. The changes in fair value are recognized in earnings and the assets and liabilities measured under this methodology are required to be displayed separately on the balance sheet. In certain circumstances, fair value enables a company to more accurately align its financial performance with the economic value of hedged assets. Fair value enables a company to mitigate the non-economic earnings volatility caused from financial assets and financial liabilities being carried at different bases of accounting, as well as to more accurately portray the active and dynamic management of a company’s balance sheet.
On September 30, 2012, the Company made the election to record mortgage loans held for sale at fair value. The following is a description of mortgage loans held for sale including the specific reasons for electing fair value and the strategies for managing these assets on a fair value basis.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 9.
FAIR VALUE MEASUREMENTS (Continued)
Mortgage Loans Held for Sale
The Company records mortgage loans held for sale at fair value in order to eliminate the complexities and inherent difficulties of achieving hedge accounting and to better align reported results with the underlying economic changes in value of the loans and related hedge instruments. This election impacts the timing and recognition of origination fees and costs, as well as servicing value, which are now recognized in earnings at the time of origination. Interest income on mortgage loans held for sale is recorded on an accrual basis in the consolidated statement of income under the heading “Interest income - loans, including fees.” The mark to market adjustments related to loans held for sale and the associated economic hedges are captured in mortgage banking activities.
Assets and Liabilities Measured at Fair Value on a Recurring Basis
The primary financial instruments that the Company carries at fair value include investment securities, derivative instruments, and mortgage loans held for sale.
The Company used the following methods and significant assumptions to estimate fair value for assets and liabilities measured on a recurring basis.
Securities: Securities in an active market where quoted prices are available are classified within Level 1 of the valuation hierarchy. Level 1 securities include highly liquid government securities and certain other financial products. If quoted market prices are not available, then fair values are estimated by using pricing models that use observable inputs or quoted prices of securities with similar characteristics and are classified within Level 2 of the valuation hierarchy. In certain cases where there is limited activity or less transparency around inputs to the valuation and more complex pricing models or discounted cash flows are used.
Mortgage loans held for sale: The fair value of mortgage loans held for sale is based on what secondary markets are currently offering for portfolios with similar characteristics predominantly consisting of those conforming to government sponsored entity or agency standards. The fair value measurements consider observable data that may include market trade pricing from brokers and the mortgage-backed security markets.
The Company classifies interest rate lock commitments (“IRLCs”) on residential mortgage loans held for sale on a gross basis within other liabilities or other assets. The fair value of these commitments, while based on interest rates observable in the market, is highly dependent on the ultimate closing of the loans. Projected “pull-through” rates are determined quarterly by the Mortgage Division, using the Company’s historical data and the current interest rate environment to reflect the Company’s best estimate of the likelihood that a commitment will ultimately result in a closed loan. The loan servicing value is also included in the fair value of IRLCs.
Derivative assets and liabilities: The Company uses derivatives to manage various financial risks. The fair values of derivative financial instruments are determined based on quoted market prices, dealer quotes and internal pricing models that are primarily sensitive to market observable data. The fair value of interest rate lock commitments, which are related to mortgage loan commitments, is based on quoted market prices adjusted for commitments that the Company does not expect to fund.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 9.
FAIR VALUE MEASUREMENTS (Continued)
The credit risk associated with the underlying cash flows of an instrument carried at fair value was a consideration in estimating the fair value of certain financial instruments. Credit risk was considered in the valuation through a variety of inputs, as applicable, including, the actual default and loss severity of the collateral, and level of subordination. The assumptions used to estimate credit risk applied relevant information that a market participant would likely use in valuing an instrument. Because mortgage loans held for sale are sold within a few weeks of origination, they are unlikely to demonstrate any of the credit weaknesses discussed above and as a result, there were no credit related adjustments to fair value during the twelve months ended December 31, 2013 and December 31, 2012.
The following tables present financial assets measured at fair value at December 31, 2013 and December 31, 2012, on a recurring basis and the change in fair value for those specific financial instruments in which fair value has been elected. The changes in the fair value of economic hedges were also recorded in mortgage banking activities and are designed to partially offset the change in fair value of the mortgage loans held for sale and interest rate lock commitments referenced in the following tables.
(1) This amount includes mortgage related interest rate lock commitments and mortgage derivative financial instruments to hedge interest rate risk for mortgage loans held for sale. Interest rate lock commitments were recorded on a gross basis.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 9.
FAIR VALUE MEASUREMENTS (Continued)
(1) This amount includes mortgage related interest rate lock commitments and mortgage derivative financial instruments to hedge interest rate risk for mortgage loans held for sale. Interest rate lock commitments were recorded on a gross basis.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 9.
FAIR VALUE MEASUREMENTS (Continued)
The following tables present a reconciliation of all assets and liabilities measured at fair value on a recurring basis using significant unobservable inputs (level 3) during the years ending December 31, 2013 and 2012. There were no transfers into or out of Level 3, nor were there any transfers between Level 1 and Level 2 during these periods.
(1) Includes mortgage related IRLCs and derivative financial instruments entered into to hedge interest rate risk.
(2) Amounts included in earnings are recorded in mortgage banking activities.
(3) Represents the amount included in earnings attributable to the changes in unrealized gains/losses relating to IRLCs and derivatives still held at period end.
A significant unobservable input utilized in the determination of fair value of other assets was a pull through rate, which was 80% as of December 31, 2013. A pull through rate is management’s assumption as to the percentage of loans in the pipeline that will close and eventually fund. It is based on the Company’s historical fall-out activity. Significant increases in this input in isolation would result in a significantly higher fair value measurement and significant decreases would result in a significantly lower fair value measurement. In addition, the fair value of an IRLC includes mortgage servicing rights that do not trade in an active market with readily observable prices. Accordingly, the fair value is estimated based on a valuation model which calculates the present value of estimated future net servicing income. The model incorporates assumptions that market participants use in estimating future net servicing income, including estimates of prepayment speeds, market discount rates, cost to service, float earnings rates, and other ancillary income, including late fees.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 9.
FAIR VALUE MEASUREMENTS (Continued)
The following tables present the difference between the aggregate fair value and the aggregate unpaid principal balance of loans held for sale including escrow for which the fair value option (“FVO”) has been elected as of December 31, 2013 and December 31, 2012.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 9.
FAIR VALUE MEASUREMENTS (Continued)
Assets Measured at Fair Value on a Non-Recurring Basis
Certain financial assets are measured at fair value on a non-recurring basis. Adjustments to the fair market value of these assets usually result from the application of lower-of-cost-or-market accounting or write-downs of individual assets.
The following is a description of the valuation methodologies used for instruments measured at fair value on a non-recurring basis and recognized in the accompanying consolidated balance sheet, as well as the general classification of such instruments pursuant to the valuation hierarchy.
Impaired Loans: Loan impairment is reported when full payment under the loan terms is not expected. In accordance with the provisions of the loan impairment guidance (ASC 310-10-35), individual loans are carried at their fair value. Write downs of impaired loans are estimated using the present value of expected cash flows or the appraised value of the underlying collateral discounted as necessary due to management’s estimates of changes in economic conditions. A portion of the allowance for loan losses is allocated to impaired loans if the value of such loans is deemed to be less than the unpaid balance. If these allocations cause the allowance for loan losses to require an increase, such increase is reported as a component of the provision for loan losses. Loan losses are charged against the allowance when management believes the uncollectibility of a loan is confirmed. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the loan impairment as non-recurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the loan impairment as non-recurring Level 3.
OREO (including covered): Foreclosed assets are adjusted to fair value upon transfer of the loans to foreclosed assets. Subsequently, foreclosed assets are carried at the lower of carrying value or fair value. Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the foreclosed assets as non-recurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the foreclosed asset as non-recurring Level 3.
Mortgage Servicing Rights (MSR): Mortgage servicing rights are initially recorded at the current LOCOM value when mortgage loans are sold servicing retained. These assets are then amortized in proportion to and over the period of estimated net servicing income. On a quarterly basis these servicing assets are assessed for impairment based on fair value. Management determines fair value by stratifying the servicing portfolio into homogeneous subsets with unique behavior characteristics, converting those characteristics into income and expense streams, adjusting those streams for prepayments, present valuing the adjusted streams, and combining the present values into a total. If the cost basis of any loan stratification tranche is higher than the present value of the tranche, an impairment is recorded.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 9.
FAIR VALUE MEASUREMENTS (Continued)
The following table summarizes financial assets measured at fair value on a non-recurring basis:
(1) Amounts represent the fair value of collateral for impaired loans allocated to the allowance for loan and lease losses. Fair values are determined using independent third party valuations and borrower records, discounted as appropriate (Level 3).
The following table presents quantitative information about financial and nonfinancial assets measured at fair value on a non-recurring basis using Level 3 valuation inputs:
Quantitative Information about Level 3 Fair Value Measurements:
(1) Fair value is generally based on appraisals of the underlying collateral.
(2) Appraisals may be adjusted by management for customized discounting criteria, estimated sales costs, and proprietary qualitative adjustments such as historical loss experience on the type of collateral.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 9.
FAIR VALUE MEASUREMENTS (Continued)
Assets and Liabilities Not Measured at Fair Value on a Recurring or Non-Recurring Basis
The following is a description of the valuation methodologies used for instruments not measured at fair value on a recurring or non-recurring basis and recognized in the accompanying consolidated balance sheet, as well as the general classification of such instruments pursuant to the valuation hierarchy.
Cash and Short-term Investments: The carrying amounts reported in the Consolidated Balance Sheets for cash and short-term investments, such as federal funds sold, approximated the fair value of those instruments. The Company classifies cash and short-term investments in Level 1 of the fair value hierarchy.
Other Investments: The carrying amount of Federal Home Loan Bank stock and other equity securities approximates fair value. The Company classifies Federal Home Loan Bank stock and other equity securities in Level 3 of the fair value hierarchy.
Loans: The carrying amount of variable-rate loans that reprice frequently and have no significant change in credit risk approximates fair value. The fair value of fixed-rate loans is estimated based on discounted contractual cash flows, using interest rates currently being offered for loans with similar terms to borrowers with similar credit quality. The fair value of impaired loans is estimated based on discounted contractual cash flows or underlying collateral values, where applicable.
Covered Loans: Covered loans include loans on which the majority of losses would be covered by loss-sharing agreements with the FDIC. Management initially valued these assets at fair value using mostly unobservable inputs and, as such, has classified these assets as Level 3.
FDIC Loss-Share Receivable: Because the FDIC will reimburse the Company for certain acquired loans, should the Company experience a loss, an indemnification asset is recorded at fair value at the acquisition date. The indemnification asset is recognized at the same time as the indemnified loans and measured on the same basis, subject to collectability or contractual limitations. The shared-loss agreements on the acquisition date reflect the reimbursements expected to be received from the FDIC, using an appropriate discount rate, which reflects counterparty credit risk and other uncertainties. The shared-loss agreements continue to be measured on the same basis as the related indemnified loans, and the loss-share receivable is impacted by changes in estimated cash flows associated with these loans.
Deposits: The carrying amount of demand deposits, savings deposits and variable-rate certificates of deposit approximates fair value. The fair value of fixed-rate certificates of deposit is estimated based on discounted contractual cash flows using interest rates currently being offered for certificates of similar maturities.
Federal Funds Purchased and Securities Sold Under Repurchase Agreements: The fair value of fixed rate federal funds purchased and securities sold under repurchase agreements is estimated based on discounted contractual cash flows using the current incremental borrowing rates for similar type borrowing arrangements.
Other Borrowings: The carrying amount of variable rate advances approximates fair value. The fair value of fixed rate advances is estimated based on discounted contractual cash flows using the current incremental borrowing rates for similar type borrowing arrangements.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 9.
FAIR VALUE MEASUREMENTS (Continued)
The following tables present the assets that are measured at fair value on a non-recurring basis by level within the fair value hierarchy as reported on the consolidated statements of financial position.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 9.
FAIR VALUE MEASUREMENTS (Continued)
Current accounting guidance requires fair value information about financial instruments, whether or not recognized in the balance sheet, for which it is practicable to estimate that value. In cases where quoted market prices are not available, fair values are based on settlements using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets, and, in many cases, could not be realized in immediate settlement of the instrument. Current accounting guidance excludes certain financial instruments and all non-financial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 10.
DERIVATIVE FINANCIAL INSTRUMENTS
The Company’s asset-liability management policy allows the use of certain derivative financial instruments for hedging purposes in managing the Company’s interest rate risk. The Company does not enter into derivatives or other financial instruments for trading or speculative purposes. A derivative is a financial instrument that derives its cash flows, and therefore its value, by reference to an underlying instrument, index or referenced interest rate. The most common derivative instruments include interest rate swaps, caps, floors and collars.
Derivative Instruments - Interest Rate Swap Agreement
The Company is exposed to interest rate risk in the course of its business operations and manages a portion of this risk through the use of a derivative financial instrument, in the form of an interest rate swap (cash flow hedge). The Company accounts for its interest rate swap in accordance with ASC 815, Derivatives and Hedging, which requires that all derivatives be recognized as assets or liabilities in the balance sheet at fair value.
The Company utilizes the interest rate swap agreement to essentially convert a portion of its variable-rate debt to a fixed rate (cash flow hedge). For derivatives designated as hedging exposure to variable cash flows of a forecasted transaction (cash flow hedge), the effective portion of the derivative’s gain or loss is initially reported as a component of other comprehensive income and subsequently reclassified into earnings when the forecasted transaction affects earnings or when the hedge is terminated. The ineffective portion of the gain or loss is reported in earnings immediately. For derivatives that are not designated as hedging instruments, changes in the fair value of the derivatives are recognized in earnings immediately. In applying hedge accounting for derivatives, the Company establishes a method for assessing the effectiveness of the hedging derivative and a measurement approach for determining any ineffective aspect of the hedge upon the inception of the hedge.
Cash Flow Hedge of Interest Rate Risk
During the first quarter 2012, the Company entered into a forward starting interest rate swap agreement with a notional amount of $50.0 million to protect against variability in the expected future cash flows attributed to changes in the benchmark interest rate Libor beginning February 1, 2016 and ending February 1, 2024 on the designated notional amount of variable rate Bank debt.
The Company recognized an after-tax unrealized gain on its cash flow hedge in other comprehensive income of $1.4 million as of December 31, 2013.
The Company recognized a $2.4 million cash flow hedge asset in other assets on the consolidated balance sheet at December 31, 2013. There was no ineffectiveness in the cash flow hedge during the year ended December 31, 2013.
Credit risk related to the derivative arises when amounts receivable from the counterparty (derivative dealer) exceed those payable. The Company controls the risk of loss by only transacting with derivative dealers that are national market makers whose credit ratings are strong. Each party to the interest rate swap is required to provide collateral in the form of cash or securities to the counterparty when the counterparty’s exposure to a mark-to-market replacement value exceeds certain negotiated limits. These limits are typically based on current credit ratings and vary with ratings changes. As of December 31, 2013, the Company was not required to provide collateral for the derivative. Also, the Company has a netting agreement with the counterparty.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 10.
DERIVATIVE FINANCIAL INSTRUMENTS (continued)
Derivative Instruments - Mortgage Lending Activities
The Company maintains a risk management program to manage interest rate risk and pricing risk associated with its mortgage lending activities. The risk management program includes the use of forward contracts and other derivatives that are recorded in the financial statements at fair value and are used to offset changes in value of the mortgage inventory due to changes in market interest rates. As a normal part of its operations, the Company enters into derivative contracts to economically hedge risks associated with overall price risk related to IRLCs and mortgage loans held for sale for which the fair value option has been elected. Fair value changes occur as a result of interest rate movements as well as changes in the value of the associated servicing rights. Derivative instruments used include forward commitments, mandatory commitments and best effort commitments. All derivatives are carried at fair value in the Consolidated Balance Sheets in other assets or other liabilities. A net unrealized gain of $1.5 million respectively, was recorded for all related commitments for the twelve months ended December 31, 2013.
The Company’s risk management derivatives are based on underlying risks primarily related to interest rates and forward sales commitments. Forwards are contracts for the delayed delivery or net settlement of an underlying instrument, such as a mortgage loan, in which the seller agrees to deliver on a specified future date, either a specified instrument at a specified price or yield or the net cash equivalent of an underlying instrument. These hedges are used to preserve the Company’s position relative to future sales of loans to third parties in an effort to minimize the volatility of the expected gain on sale from changes in interest rate and the associated pricing changes, see Note 9 Fair Value Measurements for further information.
Credit and Market Risk Associated with Derivatives
Derivatives expose the Company to credit risk. If the counterparty fails to perform, the credit risk at that time would be equal to the net derivative asset position, if any, for that counterparty. The Company minimizes the credit or repayment risk in derivative instruments by entering into transactions with high quality counterparties that are reviewed periodically by the Company’s Risk Management area. The Company’s derivative positions were as follows:
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 11.
SEGMENT INFORMATION
The Company’s operating segments include banking and mortgage banking. The reportable segments are determined by the products and services offered, and internal reporting. Segment performance is evaluated using net interest income and non-interest income. Income taxes are allocated based on income before income taxes, and indirect expenses (includes management fees) are allocated based on various internal factors for each segment. Transactions among segments are made at fair value. Information reported internally for performance assessment follows:
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 12.
ACQUISITION ACTIVITY
Frontier Bank
On March 8, 2013, HeritageBank of the South entered into a definitive whole-bank purchase and assumption agreement with the FDIC to acquire Frontier Bank, a full-service bank based in LaGrange, Georgia. The Georgia Department of Banking and Finance closed Frontier Bank and, by Order of the Georgia Superior Court, appointed the FDIC as Receiver. The Bank acquired a majority of the assets, with the exception of certain loans and all the OREO as of the bid valuation date of December 19, 2012, and assumed substantially all of the liabilities of Frontier.
The agreement with the FDIC did not involve a loss-sharing agreement but did include an asset purchase discount of $34.8 million. The Bank also received a cash payment from the FDIC in the amount of $97.5 million.
The Company elected to account for loans acquired in the Frontier acquisition under ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality. Topic 310-30 applies to a loan with evidence of deterioration of credit quality since origination, acquired by completion of a transfer for which it is probable, at acquisition, that the investor will be unable to collect all contractually required payments receivable. Topic 310-30 prohibits carrying over or creating an allowance for loan losses upon initial recognition for loans that fall under its scope.
The fair values of the assets acquired and liabilities assumed in conjunction with the acquisition as of the closing date are detailed in the following table:
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 12.
ACQUISITION ACTIVITY (continued)
Explanations
(a) The adjustment represents the cash received from the FDIC to reflect the acquisition of excess liabilities assumed over assets acquired and the asset purchase discount.
(b) The adjustment reflects fair value adjustments based on the evaluation of the acquired loan portfolio. The fair value adjustment includes adjustments for estimated credit losses, liquidity and servicing costs.
(c) The adjustment represents the estimated credit losses in the acquired other real estate owned.
(d) The adjustment represents the consideration paid for the value of the core deposit base assumed in the acquisition. The core deposit asset was recorded as an identifiable intangible asset and will be amortized on an accelerated basis over the average life of the deposit base, estimated to be ten years.
(e) The adjustment is necessary because the weighted average interest rate of the CD's acquired exceeded the cost of similar funding at the time of acquisition. The fair value adjustment will be amortized to reduce interest expense on a declining basis over the average life of the portfolio.
(f) The adjustment is necessary because the weighted average interest rate of the other borrowings assumed exceeded the cost of similar funding at the time of acquisition. The fair value adjustment will be amortized to reduce interest expense on a declining basis over the average life of the borrowings.
(g) The amount respresents the deferred tax liability recorded as a result of the recorded gain on acquisition.
The Company did not immediately acquire the real estate, banking facilities, furniture and equipment of Frontier as part of the purchase and assumption agreement. However, the Company subsequently purchased the real estate, banking facilities, furniture and equipment of Frontier from the FDIC at fair value in the amount of $5.0 million during the second quarter of 2013.
Single Branch of AB&T National Bank
On June 30, 2012, the Company completed an acquisition of a single branch of AB&T National Bank located in Auburn, Alabama. The following table summarizes the estimated fair value of the assets acquired and liabilities assumed at the date of acquisition:
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 12.
ACQUISITION ACTIVITY (continued)
Explanations
(h) The adjustment represents the cash received from AB&T to reflect the acquisition of excess liabilities assumed over assets purchased.
(i) The adjustment represents the adjustment to fair market value of the loans assumed in the transaction.
(j) The adjustment represents the consideration paid for the value of the core deposit base assumed in the acquisition. The core deposit asset was recorded as an identifiable intangible asset and will be amortized on an accelerated basis over the average life of the deposit base, estimated to be ten years.
(k) The adjustment is necessary because the weighted average interest rate of the CD's acquired exceeded the cost of similar funding at the time of acquisition. The fair value adjustment will be amortized to reduce interest expense on a declining basis over the average life of the portfolio.
(l) The difference in total assumed assets and liabilities represents the $34,000 bargain purchase gain recognized in the second quarter 2012.
The Company did not acquire any loans with deteriorated credit quality as of the acquisition date this transaction. Accordingly, the Company accounts for the loans acquired in this transaction under FASB ASC 805, Business Combinations.
Citizens Bank of Effingham
On February 18, 2011, HeritageBank of the South entered into a definitive whole-bank purchase and assumption agreement with the FDIC to acquire Citizens Bank of Effingham (“Citizens”), a full-service bank based in Springfield, Georgia. The Georgia Department of Banking and Finance closed Citizens and, by Order of the Georgia Superior Court, appointed the FDIC as Receiver. The Bank acquired a majority of the assets, including OREO and assumed substantially all of the liabilities of Citizens.
Pursuant to that agreement, the Bank agreed to pay a premium on deposits totaling $1.4 million and to acquire the specified assets, net of liabilities, at a discount to book value of $25.1 million. The Bank also received a cash payment from the FDIC in the amount of $24.0 million.
The Bank and the FDIC also entered into loss-sharing agreements that provide the Bank with significant protection against credit losses on Citizens’ loans and related assets acquired in the Acquisition. Under these agreements, discussed in more detail below, the FDIC will, for a specified number of years, reimburse the Bank for 80% of all losses and related expenses on covered assets, primarily acquired loans and OREO.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 12.
ACQUISITION ACTIVITY (continued)
The fair values of the assets acquired and liabilities assumed in conjunction with the Acquisition as of the Closing Date are detailed in the following table (dollars in thousands):
The following table summarizes the assets covered by the loss-sharing agreements, under the Single Family “SF” and Non-Single Family “Non-SF” certificates, and the amount covered by the FDIC and the estimated fair values (dollars in thousands):
The Company elected to account for loans acquired in the Citizens acquisition under ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality. Topic 310-30 applies to a loan with evidence of deterioration of credit quality since origination, acquired by completion of a transfer for which it is probable, at acquisition, that the investor will be unable to collect all contractually required payments receivable. Topic 310-30 prohibits carrying over or creating an allowance for loan losses upon initial recognition for loans that fall under its scope.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 12.
ACQUISITION ACTIVITY (continued)
The following table presents information regarding the loan portfolio acquired on February 18, 2011 at fair value (dollars in thousands):
The following table presents purchased loans accounted for under ASC Topic 310-30 as of the Closing Date:
February 18, 2011
(dollars in thousands)
The Company did not immediately acquire the real estate, banking facilities, furniture or equipment of Citizens as part of the purchase and assumption agreement. However, the Company subsequently purchased the real estate, banking facilities, furniture or equipment of Citizens from the FDIC at fair value in the amount of $3.2 million during the second quarter of 2011.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 12.
ACQUISITION ACTIVITY (continued)
First Southern National Bank
On August 19, 2011, HeritageBank of the South entered into a definitive whole-bank purchase and assumption agreement with the FDIC to acquire First Southern National Bank (“First Southern”), a full-service bank based in Statesboro, Georgia. The Office of the Comptroller of the Currency closed First Southern and appointed the FDIC as Receiver. The Bank acquired a majority of the assets, including OREO and assumed substantially all of the liabilities of First Southern.
Pursuant to the Agreement, the Bank agreed to pay a premium on deposits totaling $1.2 million and to acquire the specified assets, net of liabilities, at a discount to book value of $16.3 million. The Bank also received a cash payment from the FDIC in the amount of $3.4 million.
The Bank and the FDIC also have entered into loss-sharing agreements that provide the Bank with significant protection against credit losses on First Southern’s loans and related assets acquired in the First Southern Acquisition. Under these agreements, discussed in more detail below, the FDIC will, for a specified number of years, reimburse the Bank for 80% of all losses and related expenses on covered assets, primarily acquired loans and OREO.
The fair values of the assets acquired and liabilities assumed in conjunction with the First Southern Acquisition as of the Closing Date are detailed in the following table (dollars in thousands):
The following table summarizes the assets covered by the loss-sharing agreements, under the Single Family “SF” and Non-Single Family “Non-SF” certificates, and the amount covered by the FDIC and the estimated fair values (dollars in thousands).
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 12.
ACQUISITION ACTIVITY (continued)
The Company elected to account for loans acquired in the First Southern Acquisition under ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality. Topic 310-30 applies to a loan with evidence of deterioration of credit quality since origination, acquired by completion of a transfer for which it is probable, at acquisition, that the investor will be unable to collect all contractually required payments receivable. Topic 310-30 prohibits carrying over or creating an allowance for loan losses upon initial recognition for loans that fall under its scope
The following table presents information regarding the loan portfolio acquired on August 19, 2011 at fair value (dollars in thousands):
The following table presents purchased loans accounted for under ASC Topic 310-30 as of the Closing Date:
August 19, 2011
(dollars in thousands)
The Company did not immediately acquire the real estate, banking facilities, or furniture of First Southern but did purchase some of the equipment as part of the purchase and assumption agreement.
The Company recognizes that the determination of the initial fair value of loans at the acquisition date involves a high degree of judgment and complexity. The carrying value of the acquired loans reflect management’s best estimate of the fair value of these assets as of the acquisition date. However, the amount the Company ultimately recognizes on these assets could differ materially from the value reflected in these financial statements, based upon the timing and amount of collections on the acquired loans in future periods. To the extent the actual values recognized for the acquired loans are less than the Company’s estimate, additional losses will be incurred. These fair value estimates are considered preliminary, and are subject to change for up to one year after the closing date of the acquisition as additional information relative to the closing date fair values becomes available.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 13.
ACCRUED INTEREST RECEIVABLE
Accrued interest receivable consists of the following for the periods indicated:
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 14.
PREMISES AND EQUIPMENT
Premises and equipment are summarized as follows:
The Company purchased real estate, banking facilities, furniture and equipment from the FDIC at fair value in the amount of $5.0 million in connection with the Frontier acquisition. Depreciation and amortization expense was $2.6 million, $2.1 million, $1.5 million for the years ended December 31, 2013, 2012 and 2011, respectively.
During the fourth quarter, the Company sold its former corporate headquarters building in Albany, Georgia which was carried in premises held for sale at a value of $1.1 million and sold for $900,000 resulting in a loss of $226,000. Additionally, during the fourth quarter the Company recognized impairment related to its former branch buildings in Guyton and Collins, Georgia of $190,000. As of December 31, 2013, these premises are carried as held for sale at $275,000.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 14.
PREMISES AND EQUIPMENT (Continued)
Leases
As of December 31, 2013, the Company was leasing 2 full-service branch locations, 6 mortgage offices locations and one investment office. Additionally, as of December 31, 2013, the Company had 2 ATM branding leasing agreements for an ATM in Albany, Georgia and an ATM in Macon, Georgia.
In 2013 the Company entered into 2 lease agreements in Columbus and Johns Creek, Georgia for 5 and 6 year terms as part of the continued mortgage loan production expansion, and renewed the mortgage office location in Alpharetta for an additional 7 years. Additionally, in 2013, the Company entered into an 18 month lease agreement with the FDIC to lease the Childersburg Branch location.
The Company entered into various operating agreements for office equipment, primarily printers, as a result of the increase in operation locations in 2013 and 2012. The average term of these agreements is 36 months.
The Company has a lease agreement for its investment division operations located in Albany, Georgia on a month to month lease.
The Company also has an assignment of a 99 year land lease associated with a branch office in Ocala, Florida with a remaining life of approximately 59 years.
Rental expense under all operating leases amounted to approximately $1.2 million, $986,000 and $543,000 for the years ended December 31, 2013, 2012 and 2011, respectively.
Future minimum lease commitments on noncancelable operating leases, excluding any renewal options, are summarized as follows:
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 15.
GOODWILL AND INTANGIBLE ASSETS
Goodwill
During 2010, the Company recorded goodwill associated with the Lake City branch acquisition. As of December 31, 2013 and 2012, the goodwill was carried at $552,000. The fair value was greater than the carrying amount of goodwill based on the discounted cash flow model, and, as such, resulted in no impairment of the goodwill in 2013. See Note 1 for additional information.
Intangible Assets
Intangible assets consist of core deposit intangibles acquired in connection with business acquisitions and mortgage servicing rights (“MSRs”).
During 2013, the Company sold residential mortgage loans with unpaid principal balances of $20.8 million on which the Company retained the related MSRs and receives servicing fees. At December 31, 2013, the carrying value of the MSRs was $202,000 and the fair value was $208,000 based on the discounted cash flow model, and, as such, resulted in no impairment of the MSRs as of December 31, 2013. At December 31, 2013 the approximate weighted average servicing fee was 0.25% of the outstanding balance of the residential mortgage loans.
In March 2013, the Company recorded $625,000 core deposit intangible with the acquisition of Frontier Bank. In February 2011, the Company recorded $1.8 million core deposit intangible with the FDIC-assisted acquisition of Citizens. Additionally, the Company recorded $850,000 core deposit intangible with the FDIC-assisted acquisition of First Southern Bank in August 2011. In June 2012, the Company recorded $169,000 core deposit intangible with the acquisition of the Auburn branch. Core deposit intangible assets were evaluated for impairment as of December 31, 2013 and, based on that evaluation, there was no impairment.
Following is a summary of information related to the core deposit intangible assets associated with these acquisitions based on the Company's allocations:
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 15.
GOODWILL AND INTANGIBLE ASSETS (Continued)
Intangible Assets (Continued)
The estimated core deposit intangible amortization expense for each of the next five years as of December 31, 2013 is as follows:
There was $809,000, $781,000 and $692,000 of amortization expense recorded during the years ended December 31, 2013, 2012 and 2011, respectively.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 16.
DEPOSITS
The aggregate amount of time deposits in denominations of $100,000 or more at December 31, 2013 and 2012 was $228.4 million and $160.1 million, respectively.
The scheduled maturities of time deposits at December 31, 2013 are as follows:
Overdraft deposit accounts reclassified to loans totaled approximately $574,000 and $316,000 at December 31, 2013 and 2012, respectively.
The Company had $111.5 million and $56.2 million in brokered deposits as of December 31, 2013 and 2012, respectively. The increase in brokered deposits primarily resulted from the Company’s purchase of CDARS One Way Buy deposits of approximately $55.0 million throughout 2013.
The depositors of the Company are insured by the FDIC. This insurance coverage generally insures each depositor up to $250,000. Amounts in excess of $250,000 are generally not insured.
The following table presents the interest expense for each major category of deposits for periods indicated:
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 17.
EMPLOYEE BENEFIT PLANS
Pension Plan
The Company provides pension benefits for eligible employees through a defined benefit pension plan. Effective January 1, 2009, the Board of Directors voted to freeze the plan to new entrants. Participants of the plan prior to January 1, 2009 that meet certain age and service requirements participate in the retirement plan on a noncontributing basis. Information pertaining to the activity in the plan is as follows:
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 17.
EMPLOYEE BENEFIT PLANS (Continued)
Pension Plan (Continued)
Other changes in plan assets and benefit obligations recognized in other comprehensive income (loss):
To determine the expected rate of return on plan assets, the Company considers the current and expected asset allocations, as well as historical and expected returns on various categories of plan assets. The approximate allocation of plan assets as of December 31, 2013 and 2012 is as follows:
Plan fiduciaries set investment policies and strategies for the plan assets. Long-term strategic investment objectives include capital appreciation through balancing risk and return.
The Company expects to contribute $1.0 million to the plan during 2014.
The amounts in accumulated other comprehensive income (loss) that are expected to be recognized as components of net periodic benefit cost during 2013 are as follows:
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 17.
EMPLOYEE BENEFIT PLANS (Continued)
Pension Plan (Continued)
Estimated future benefit payments, which reflect expected future service, as appropriate, are as follows:
401(K) Plan
The Company has also established a salary deferral plan under Section 401(k) of the Internal Revenue Code. The plan allows eligible employees to defer a portion of their compensation up to 25%, subject to certain limits based on federal tax laws. Such deferrals accumulate on a tax deferred basis until the employee withdraws the funds. The Company matches 50% of employee’s contributions up to 4% of their salary. Total expense recorded for the Company’s match was approximately $332,000 and $205,000 and $157,000 for the fiscal years ended December 31, 2013, 2012 and 2011, respectively.
Employee Stock Ownership Plan (ESOP)
In connection with the minority stock offering, the Company established an Employee Stock Ownership Plan (“ESOP”) for the benefit of its employees with an effective date of June 29, 2005. The ESOP purchased 440,700 (369,174 after conversion) shares of common stock from the minority stock offering with proceeds from a ten-year note in the amount of $4.4 million from the Company. After the 2010 Conversion and stock offering, the unearned shares held by the ESOP were adjusted to reflect the 0.8377:1 exchange ratio on publicly traded shares. Additionally, in connection with the 2010 Conversion the stock offering, the ESOP purchased 327,677 shares of common stock with proceeds from a twenty-year note in the amount of $3.3 million.
The Company’s Board of Directors determines the amount of contribution to the ESOP annually, but it is required to make contributions sufficient to service the ESOP’s debt. Shares are released for allocation to employees as the ESOP debt is repaid. Eligible employees receive an allocation of released shares at the end of the calendar year on a relative compensation basis. An employee becomes eligible on January 1st or July 1st immediately following the date they complete one year of service. Company dividends on allocated shares will be paid to employee accounts. Dividends on unallocated shares held by the ESOP will be applied to the ESOP note payable.
Contributions to the ESOP during 2013, 2012 and 2011 amounted to $784,000, $1.0 million and $726,000, respectively.
Compensation expense for shares committed to be released under the Company’s ESOP for the fiscal years ended December 31, 2013, 2012 and 2011 were $853,000, $669,000 and $620,000, respectively. Shares held by the ESOP were as follows:
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 18.
DEFERRED COMPENSATION PLANS
The Company has entered into separate deferred compensation arrangements with certain executive officers and directors. The plans call for certain amounts payable at retirement, death or disability. The estimated present value of the deferred compensation is being accrued over the remaining expected service period. The Company has purchased life insurance policies which they intend to use to finance this liability. Cash surrender value of life insurance of $24.2 million and $23.4 million December 31, 2013 and 2012, respectively, is separately stated on the consolidated balance sheets. The Bank is generally limited by regulatory guidance to an investment in cash surrender value of Bank owned life insurance (“BOLI”) of no more than 25% of Tier I capital at the time of purchase. The Bank was in compliance with this regulatory guidance at the time of purchase. In September of 2007, the Company accelerated vesting under its deferred compensation agreements with each of its currently serving covered directors and executives. Under this acceleration, each covered director and executive is fully vested in their plan balance.
In July 2012, the Company elected to terminate and liquidate the deferred compensation plan agreement. All distributions in connection with the termination of the plan were to be made no earlier than 12 months and no later than 24 months. As of December 31, 2013, $2.8 million had been distributed from the plan with approximately $255,000 to be distributed in 2014.
Accrued deferred compensation $255,000 and $3.1 million at December 31, 2013 and 2012, respectively, is included in other liabilities.
The Company has also entered into deferred salary agreements with certain officers electing to defer a portion of their salary. These amounts are expensed and the plan accumulates the deferred salary plus earnings. At December 31, 2013 and 2012, the liability for these agreements was $923,000 and $814,000 respectively, and is included in other liabilities.
Aggregate compensation expense under the plans was $59,000, $49,000 and $42,000 for the years ended December 31, 2013, 2012 and 2011, respectively.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 19.
FEDERAL FUNDS PURCHASED AND SECURITIES SOLD UNDER REPURCHASE AGREEMENTS
Federal funds purchased represent unsecured borrowings from other banks and generally mature daily. Securities sold under repurchase agreements are secured borrowings and are reflected at the amount of cash received in connection with the transactions. 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. Federal funds purchased and securities sold under repurchase agreements at were as follows:
The federal funds purchased from Chattahoochee are under similar terms and conditions as would be available with other third parties.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 20.
OTHER BORROWINGS
FHLB Advances
The Company has from time-to-time entered into borrowing agreements with the FHLB. Advances from the FHLB require borrowing capacity supported by the pledging of certain loans or securities. These advances may be made pursuant to several different credit programs, each of which has its own interest rate, range of maturities, and call features. Advances under these agreements are collateralized by stock in the FHLB, qualifying first and second mortgage residential loans, and commercial real estate loans under a blanket-floating lien.
(1) FHLB advances acquired with Frontier acquisition hold a fair value credit adjustment of $4.3 million which will reduce future interest expense over the life of the borrowings.
* Advance is convertible from fixed to floating at the FHLB’s discretion.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 20.
OTHER BORROWINGS (Continued)
FHLB Advances (continued)
Net eligible loans of the Company pledged via a blanket lien to the FHLB for advances and letters of credit at December 31, 2013, were approximately $329.5 million which allows the Company a total borrowing capacity at FHLB of approximately $152.3 million. After accounting for outstanding advances totaling $127.1 million, the Company had unused net credit available with the FHLB in the amount of approximately $25.2 million at December 31, 2013.
The FHLB advances at December 31, 2013 have maturities in future years as follows:
The Company and the Bank have available unused lines of credit with various financial institutions, including the FHLB, totaling approximately $99.3 million and $137.4 million December 31, 2013 and 2012, respectively.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 21.
INCOME TAXES
The income tax expense in the consolidated statements of income consists of the following:
The Company's income tax expense differs from the amounts computed by applying the federal income tax statutory rates to income before income taxes. A reconciliation of the differences is as follows:
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 21.
INCOME TAXES (Continued)
The components of deferred taxes are summarized as follows:
Management performed an analysis related to the Company’s deferred tax assets for the year ended December 31, 2013 and 2012. In its analysis, the Company considered all available evidence, both positive and negative, to determine whether estimated future taxable income will be sufficient to realize these assets. The tax operating losses have been carried back against prior years’ taxable income, resulting in the tax benefits from the losses being fully realized. Based on current tax laws, there are no more income taxes that may be recovered from prior years. As a result, the realization of the deferred tax assets is solely dependent upon future taxable income. The primary positive evidence considered was sustained taxable income for both 2013 and 2012, internal projections, economic and industry trends, historical and projected loan loss trends, the impact of regulatory reform and demographic data for the Company’s markets. Based upon this analysis, the Company believes that future taxable income will more likely than not be sufficient to realize these assets, and thus, no valuation allowances were deemed necessary for the periods indicated above. The Company also does not have any NOL carry forwards for federal or state tax reporting as of December 31, 2013.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 22. COMMITMENTS AND CONTINGENCIES
Loan Commitments
The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. They involve, to varying degrees, elements of credit risk and interest rate risk in excess of the amount recognized in the balance sheets.
The Company's exposure to credit loss is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. A summary of the Company's commitments is as follows:
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 amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation of the customer.
Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers. Collateral is required in instances which the Company deems necessary.
At December 31, 2013 and 2012, the carrying amount of liabilities related to the Company’s obligation to perform under financial standby letters of credit was insignificant. The Company has not been required to perform on any financial standby letters of credit and the Company has not incurred any losses on financial standby letters of credit for the year ended December 31, 2013 and 2012.
Contingencies
In the normal course of business, the Company is involved in various legal proceedings. In the opinion of management, any liability resulting from such proceedings would not have a material effect on the Company's financial statements at December 31, 2013.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 23.
CONCENTRATIONS OF CREDIT
The Company makes commercial, residential, construction, agricultural, agribusiness and consumer loans to customers primarily in counties in south and central Georgia and Alabama and north central Florida. A majority of the Company's customers' abilities to honor their contracts is dependent on the business economy in the geographical areas served by the Bank.
A substantial portion of the Company's loans are secured by real estate in the Company's primary market areas. In addition, a substantial portion of the other real estate owned is located in those same markets. Accordingly, the ultimate collectability of a substantial portion of the Company's loan portfolio and the recovery of a substantial portion of the carrying amount of other real estate owned are susceptible to changes in real estate conditions in the Company's primary market area.
Based on the capital level at December 31, 2013, the maximum amount under Georgia law that the Bank could loan to any one borrower and the borrower's related entities was $21.6 million for fully secured loans and $13.0 million for all other loans. Internally, management has set a limit of $8.0 million. These internal limits may be exceeded by approval of the Board of Directors.
NOTE 24.
REGULATORY MATTERS
The Bank is subject to certain restrictions on the amount of dividends that may be declared without prior regulatory approval. At December 31, 2013, there was approximately $6.0 million available for dividend declaration without regulatory approval.
The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company's and Bank's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. Capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios of total and Tier I capital, as defined by the regulations, to risk-weighted assets, as defined, and of Tier I capital to average assets, as defined. Management believes, as of December 31, 2013 and 2012, the Company and the Bank met all capital adequacy requirements to which they are subject.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 24.
REGULATORY MATTERS (Continued)
As of December 31, 2013 and 2012, the most recent notification from the regulatory authorities 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 following table. There are no conditions or events since that notification that management believes have changed the Bank’s category. Prompt corrective action provisions are not applicable to bank holding companies.
The Company and the Bank’s actual capital amounts and ratios are presented in the following table.
Heritage Financial Group, Inc. is subject to Georgia capital requirements for holding companies.
At December 31, 2013, Heritage Financial Group, Inc. had total equity of $125.1 million or 9.1% of total assets as of that date. Under Georgia capital requirements for holding companies, Heritage Financial Group, Inc. had Tier I leverage capital of $128.6 million or 9.5%, which was $74.5 million above the 4.0% requirement.
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 24.
REGULATORY MATTERS (Continued)
Under federal law, the Bank is subject to the qualified thrift lender test. The qualified thrift lender test requires a savings institution to have at least 65% of its portfolio assets in housing related to finance and other specified areas. If this test is not met, limits are placed on growth, branching, new investments, FHLB advances and dividends, or the Bank must convert to a commercial bank charter. Management believes that this test is met.
As a Georgia savings bank, the Bank is subject to less restrictive regulations. Under Georgia regulations, the Bank is required to have no more than 50% of its assets in commercial real estate and business loans.
A reconciliation of the Bank's capital included in its balance sheets and the regulatory capital amounts follows:
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 25.
CONDENSED FINANCIAL INFORMATION OF HERITAGE FINANCIAL GROUP, INC. (PARENT COMPANY ONLY)
CONDENSED BALANCE SHEETS
(Dollars in thousands)
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 25.
CONDENSED FINANCIAL INFORMATION OF HERITAGE FINANCIAL GROUP, INC. (PARENT COMPANY ONLY) (Continued)
CONDENSED STATEMENTS OF INCOME
(Dollars in thousands)
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 25.
CONDENSED FINANCIAL INFORMATION OF HERITAGE FINANCIAL GROUP, INC. (PARENT COMPANY ONLY) (Continued)
CONDENSED STATEMENTS OF CASH FLOWS
HERITAGE FINANCIAL GROUP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 26.
STOCK REPURCHASE PLAN
In April 2013, the Company’s Board of Directors approved a stock repurchase program for 394,000 shares, or 5% of the Company's currently outstanding common stock, which expires in April 2014, unless the program is extended or completed earlier. As of December 31, 2013, the Company had purchased 49,821 shares at an average price of $14.33 per share under the plan for a total of $714,000. As a result, the Company has remaining authorization to repurchase up to approximately 344,179 shares.
In October 2012, the Company's Board of Directors approved a stock repurchase program expiring in October 2013, which authorizes the repurchase of 397,000 shares of common stock, or approximately 5% of the shares currently outstanding. By June 1, 2013, the Company had purchased all 397,000 shares at a weighted average price of $13.95 per share for a total of $5.5 million.
NOTE 27.
SUBSEQUENT EVENTS
Subsequent events and transactions that occurred after December 31, 2013 but prior to March 14, 2013, the date these financial statements were available to be issued, have been evaluated for potential recognition or disclosure in these financial statements. There were no subsequent events that require disclosure in the financial statements.