Item 1. Business
Overview
Cardinal Financial Corporation, a financial holding company, was formed in late 1997 as a Virginia corporation, principally in response to opportunities resulting from the consolidation of several Virginia-based banks. These bank consolidations were typically accompanied by the dissolution of local boards of directors and relocation or termination of management and customer service professionals and a general deterioration of personalized customer service.
We own Cardinal Bank (the "Bank"), a Virginia state-chartered community bank with 31 banking offices located in Northern Virginia, Maryland and the greater Washington, D.C. metropolitan area. The Bank offers a wide range of traditional bank loan and deposit products and services to both our commercial and retail customers. Our commercial relationship managers focus on attracting small and medium sized businesses as well as government contractors, commercial real estate developers and builders and professionals, such as physicians, accountants and attorneys.
On January 16, 2014, we announced the completion of our acquisition of United Financial Banking Companies, Inc. ("UFBC"), the holding company of The Business Bank ("TBB"), pursuant to a previously announced definitive merger agreement. The merger of UFBC into Cardinal was effective January 16, 2014. Under the terms of the merger agreement, UFBC shareholders received $19.13 in cash and 1.154 shares of our common stock in exchange for each share of UFBC common stock they owned immediately prior to the merger. TBB, which was headquartered in Vienna, Virginia, merged into Cardinal Bank effective March 8, 2014.
Additionally, we complement our core banking operations by offering a wide range of services through our various subsidiaries, including mortgage banking through George Mason Mortgage, LLC ("George Mason") and retail securities brokerage through Cardinal Wealth Services, Inc. ("CWS").
George Mason engages primarily in the origination and acquisition of residential mortgages for sale into the secondary market on a best efforts and mandatory basis through 17 offices located throughout the metropolitan Washington, D.C. region. George Mason is one of the largest residential mortgage originators in the greater Washington metropolitan area, generating originations of approximately $3.6 billion in 2015 and $3.0 billion in 2014. George Mason sells its mortgage loans to third party investors servicing released. The profitability of George Mason is cyclical as loan production levels are sensitive to changes in the level of interest rates and changes in local home buying activity, which may be seasonal or may be caused by tightening credit conditions or a deteriorating local economy.
George Mason offers a construction-to-permanent loan program. This program provides variable rate financing for customers to construct their residences. Once the home has been completed, the loan converts to fixed rate financing and is sold into the secondary market. These construction-to-permanent loans generate fee income as well as net interest income for George Mason and are classified as loans held for sale.
CWS provides brokerage and investment services through a contract with Raymond James Financial Services, Inc. Under this contract, financial advisors can offer our customers an extensive range of financial products and services, including estate planning, qualified retirement plans, mutual funds, annuities, life insurance, fixed income and equity securities and equity research and recommendations. CWS's principal source of revenue is the net commissions it earns on the purchases and sales of investment products to its customers.
Growth Strategy
We believe that the strong demographic characteristics of our market and the relative strength of the metropolitan Washington, D.C. area, particularly Northern Virginia, provide a significant opportunity to continue building a successful community-focused banking franchise. We intend to continue to expand our business through organic growth, as well as selective geographic expansion through de novo banking offices and/or acquisition, while maintaining strong asset quality and achieving increasing profitability. The strategy for achieving these objectives includes the following:
Capitalize on the current market conditions. As the banking industry continues to restrict lending based on industry-wide asset quality limitations and capital constraints, we believe we are well positioned to take advantage of this void based on our strong balance sheet. We continue to see increased opportunities to grow our loan portfolio and benefit from demand by high quality borrowers, particularly well established business owners, including multi-generational businesses, seeking the safe and consistent reliable delivery of service that we are able to provide.
Penetrate our existing markets and further improve our branch positioning. We intend to continue to penetrate our existing markets with increased business development efforts by adding experienced bankers in communities that present attractive growth opportunities within Northern Virginia and other markets in the greater Washington, D.C. metropolitan area. We expect to continue to have opportunities to acquire or lease former branch sites from other financial institutions. As we have done in the past, we may acquire additional sites prior to planned branch openings when we believe the sites are attractive and are available on favorable terms. Because the opening of each new branch increases our operating expenses, we intend to stage future branch openings in an effort to minimize the impact of these expenses on our results of operations. Our commercial banking segment has leveraged the office expansion of George Mason through their entrance into new markets such as the Richmond and Virginia Beach areas of the Commonwealth of Virginia.
Capitalize on the continued bank consolidation in our market. We anticipate that bank mergers will result in further consolidation in our target market and we intend to capitalize on the dislocation of customers resulting from this consolidation. We believe this consolidation creates opportunities for expanding our branch network, as discussed above, as well as to increase our market share of bank deposits within our target market. We focus on building long term relationships with our clients and communities by providing personalized service from local management teams. We also will continue to explore the possibility of further growth through acquisition in Virginia, the metropolitan Washington, D.C. market, or other areas if we believe that such expansion will strengthen the Company by diversifying our customer base and sources of revenue and be accretive to earnings within a reasonable time frame.
Expand our lending activities. As of December 31, 2015, we have increased our legal lending limit to over $63.6 million as a result of retained earnings and our successful capital raise efforts during 2009. The increase in our legal lending limit allows us to further expand our commercial and real estate lending activities. It also improves our ability to seek business from larger government contractors, businesses who we believe are conservatively operated, and well capitalized residential homebuilders. Our goal is to aggressively grow our loan portfolio while maintaining superior asset quality through conservative underwriting practices as we operate in this challenging economic environment.
Continue to recruit experienced bankers. Historically, we have been successful in recruiting senior bankers with experience in, and knowledge of, our market. We believe current market conditions and consolidation will allow us to continue to find bankers who have been displaced or have grown dissatisfied as a result of consolidation. We intend to continue our efforts to recruit seasoned bankers, particularly experienced lenders, who we expect can immediately generate additional loan volume through their existing credit relationships.
Business Segment Operations
We operate in three business segments, commercial banking, mortgage banking and wealth management services. The commercial banking segment includes both commercial and consumer lending and provides customers such products as commercial loans, real estate loans, and other business financing and consumer loans. In addition, this segment provides customers with several choices of deposit products, including demand deposit accounts, savings accounts and certificates of deposit. The mortgage banking segment engages primarily in the origination and acquisition of residential mortgages for sale into the secondary market. The wealth management services segment provides investment and financial advisory services to businesses and individuals, including financial planning, retirement/estate planning, and investment management.
For financial information about the reportable segments, see "Business Segment Operations" in Item 7 below and Note 22 of the notes to the consolidated financial statements in Item 8 below.
Market Area
We consider our primary target market to include the Virginia counties of Arlington, Fairfax, Loudoun, Prince William, and Stafford and the cities of Alexandria, Fairfax, Falls Church, Fredericksburg, Manassas and Manassas Park; Washington, D.C. and Montgomery County in Maryland. In addition to our primary market, we consider the Virginia counties of Spotsylvania, Culpeper and Fauquier and the Maryland county of Prince George's as secondary markets and the remaining Greater Washington Metropolitan area as a tertiary market. In addition, the metropolitan statistical areas of Richmond, Charlottesville, and Virginia Beach as well as Rappahannock, Madison, and Orange counties in Virginia plus the metropolitan statistical areas of Baltimore-Towson and California-Lexington Park in Maryland are also considered tertiary markets. We will, however, consider expansion into other areas if we believe such expansion will strengthen the Company by diversifying our customer base and sources of revenue and be accretive to earnings within a reasonable time frame.
Based on 2014 estimates released by the U.S. Census Bureau, the population of the greater Washington metropolitan area was approximately 6.03 million people, the seventh largest statistical area in the country. The median annual household income for this area in 2013 was approximately $90,149, which makes it one of the wealthiest regions in the country. For 2015, based on estimates released by the Bureau of Labor Statistics of the U.S. Department of Labor, the unemployment rate for the greater Washington metropolitan area was approximately 3.8%, compared to a national unemployment rate of 5.0%. As of June 30, 2015, total deposits in this area were approximately $214.7 billion as reported by the Federal Deposit Insurance Corporation ("FDIC").
Our headquarters are located in the center of the business district of Fairfax County, Virginia. Fairfax County, with over one million people, is the most populous county in Virginia and the most populous jurisdiction in the Washington, D.C. area. According to the latest U.S. Census Bureau estimates, Fairfax County also has the second highest median household income of any county in the United States of $111,079, surpassed only by its neighbor, Loudoun County with $119,134.
We believe the diversity of our economy, including the stability provided by businesses serving the U.S. Government, provides us with the opportunities necessary to prudently grow our business.
Competition
The greater Washington region is dominated by branches of large regional or national banks headquartered outside of the region. Our market area is a highly competitive, highly branched, banking market. We compete as a financial intermediary with other commercial banks, savings and loan associations, savings banks, credit unions, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, mutual fund groups and other types of financial
institutions. George Mason faces significant competition from both traditional financial institutions and other national and local mortgage banking operations.
The competition to acquire deposits and to generate loans, including mortgage loans, is intense, and pricing is important. Many of our competitors are larger and have substantially greater resources and lending limits than we do. In addition, many competitors offer more extensive branch and ATM networks than we currently have. Larger institutions operating in the greater Washington market have access to funding sources at lower costs than are available to us since they have larger and more diverse fund generating capabilities. However, we believe that we have and will continue to be successful in competing in this environment due to an emphasis on a high level of personalized customer service, localized and more responsive decision making, and community involvement.
Of the $215 billion in bank deposits in the greater Washington region at June 30, 2015, approximately 82% were held by banks that are either based outside of the greater Washington region or are operating wholesale banks that generate deposits nationally. Excluding institutions based outside our region, we have grown to the fourth largest financial institution headquartered in the greater Washington region as measured by total deposits. By providing competitive products and more personalized service and being actively involved in our local communities, we believe we can continue to increase our share of this deposit market.
Customers
We believe that the recent and ongoing bank consolidation within Northern Virginia and the greater Washington, D.C. region provides a significant opportunity to build a successful, locally-oriented banking franchise. We also believe that many of the larger financial institutions in our area do not emphasize the high level of personalized service to small and medium-sized commercial businesses, professionals or individual retail customers that we emphasize.
We expect to continue serving these business and professional markets with experienced commercial relationship managers, and we have increased our retail marketing efforts through the expansion of our branch network (both through acquisition and de novo office expansion) and through the development of additional retail products and services. We expanded our deposit market share through aggressive marketing of our First Choice Checking, President's Club, Chairman's Club, Simply Savings and Monster Money Market relationship products and our Simply Checking product.
Banking Products and Services
Our principal business is to accept deposits from the public and to make loans and other investments. The principal sources of funds for the Bank's loans and investments are demand, time, savings and other deposits, repayments of existing loans, and borrowings. Our principal source of income is interest collected on loans, investment securities and other investments. Non-interest income, which includes among other things deposit and loan fees and service charges, realized and unrealized gains on mortgage banking activities, and investment fee income, is the next largest component of our revenues. Our principal expenses are interest expense on deposits and borrowings, employee compensation and benefits, occupancy-related expenses, and other overhead expenses.
The principal business of George Mason is to originate residential loans for sale into the secondary market. These loans are closed and serviced by George Mason on an interim basis pending their ultimate sale to a permanent investor. The mortgage subsidiary funds these loans through a line of credit from Cardinal Bank and cash available through its own operations. George Mason's income on these loans is generated from the fees it charges its customers, the gains it recognizes upon the sales of loans and the interest income it earns prior to the delivery of the loan to the investor. Costs associated with these loans are primarily comprised of salaries and commissions paid to loan originators and
support personnel, interest expense incurred on funds borrowed to hold the loans pending sale and other expenses associated with the origination of the loans.
George Mason also offers a construction-to-permanent loan program. This program provides variable rate financing for customers to construct their residences. Once the home has been completed, the loan converts to fixed rate financing and is sold into the secondary market. These construction-to-permanent loans generate fee income as well as net interest income and are classified as loans held for sale.
The mortgage banking segment's business is both cyclical and seasonal. The cyclical nature of its business is influenced by, among other things, the levels of and trends in mortgage interest rates, national and local economic conditions and consumer confidence in the economy. Historically, the mortgage banking segment has its lowest levels of quarterly loan closings during the first quarter of the year. However, the decrease in mortgage interest rates during the first quarter of 2015 increased refinancing activity for George Mason as it did for other mortgage banking entities, and contributed to our increased loan origination activity for the full 2015 year as compared to 2014.
Both Cardinal Bank and George Mason are committed to providing high quality products and services to their customers, and have made a significant investment in their core information technology systems. These systems provide the technology that fully automates the branches, processes bank transactions, mortgage originations, other loans and electronic banking, conducts database and direct response marketing, provides cash management solutions, streamlined reporting and reconciliation support.
With this investment in technology, the Bank offers internet-based delivery of products for both individuals and commercial customers. Customers can open accounts, apply for loans, check balances, check account history, transfer funds, pay bills, download account transactions into various third party software solutions, and correspond via e-mail with the Bank over the internet. The internet provides an inexpensive way for the Bank to expand its geographic borders and branch activities while providing services offered by larger banks.
We offer a broad array of products and services to our customers. A description of our products and services is set forth below.
Lending
We offer a full range of short to long-term commercial, real estate and consumer lending products and services, which are described in further detail below. We have established target percentage goals for each type of loan to insure adequate diversification of our loan portfolio. These goals, however, may change from time to time as a result of competition, market conditions, employee expertise, and other factors. Commercial and industrial loans, real estate-commercial loans, real estate-construction loans, real estate-residential loans, home equity loans, and consumer loans account for approximately 12%, 49%, 19%, 15%, 5% and less than 1%, respectively of our loan portfolio at December 31, 2015.
Commercial and Industrial Loans. We make commercial loans to qualified businesses in our market area. Our commercial lending portfolio consists primarily of commercial and industrial loans for the financing of accounts receivable, property, plant and equipment. Our government contract lending group provides secured lending to government contracting firms and businesses based primarily on receivables from the federal government. We also offer Small Business Administration (SBA) guaranteed loans and asset-based lending arrangements to our customers. We are certified as a preferred lender by the SBA, which provides us with much more flexibility in approving loans guaranteed under the SBA's various loan guaranty programs.
Historically, commercial and industrial loans generally have a higher degree of risk than residential mortgage loans. Residential mortgage loans generally are made on the basis of the borrower's ability to
repay the loan from his or her salary and other income and are secured by residential real estate, the value of which generally is readily ascertainable. In contrast, commercial loans typically are made on the basis of the borrower's ability to repay the loan from the cash flow from its business and are secured by business assets, such as commercial real estate, accounts receivable, equipment and inventory, the values of which may fluctuate over time and generally cannot be appraised with as much precision as residential real estate. As a result, the availability of funds for the repayment of commercial loans may be substantially dependent upon the commercial success of the business itself.
To manage these risks, our policy is to secure the commercial loans we make with both the assets of the business, which are subject to the risks described above, and other additional collateral and guarantees that may be available. In addition, for larger relationships, we actively monitor certain attributes of the borrower and the credit facility, including advance rate, cash flow, collateral value and other credit factors that we consider appropriate.
Commercial Mortgage Loans. We originate commercial mortgage loans. These loans are primarily secured by various types of commercial real estate, including office, retail, warehouse, industrial and other non-residential types of properties and are made to the owners and/or occupiers of such property. These loans generally have maturities ranging from one to ten years.
Historically, commercial mortgage lending entails additional risk compared with traditional residential mortgage lending. Commercial mortgage loans typically involve larger loan balances concentrated with single borrowers or groups of related borrowers. Additionally, the repayment of loans secured by income-producing properties is typically dependent upon the successful operation of a business or real estate project and thus may be subject, to a greater extent than has historically been the case with residential mortgage loans, to adverse conditions in the commercial real estate market or in the general economy. Our commercial real estate loan underwriting criteria require an examination of debt service coverage ratios, the borrower's creditworthiness and prior credit history, and we generally require personal guarantees or endorsements with respect to these loans. In the loan underwriting process, we also carefully consider the location of the property that will be collateral for the loan.
Loan-to-value ratios for commercial mortgage loans generally do not exceed 80%. We permit loan-to-value ratios of up to 80% if the borrower has appropriate liquidity, net worth and cash flow.
Residential Mortgage Loans. Residential mortgage loans are originated by Cardinal Bank and George Mason. Our residential mortgage loans consist of residential first and second mortgage loans, residential construction loans and home equity lines of credit and term loans secured by the residences of borrowers. Second mortgage and home equity lines of credit are used for home improvements, education and other personal expenditures. We make mortgage loans with a variety of terms, including fixed, floating and variable interest rates, with maturities ranging from three months to thirty years.
Residential mortgage loans generally are made on the basis of the borrower's ability to repay the loan from his or her salary and other income and are secured by residential real estate, the value of which is generally readily ascertainable. These loans are made consistent with our appraisal and real estate lending policies, which detail maximum loan-to-value ratios and maturities. Residential mortgage loans and home equity lines of credit secured by owner-occupied property generally are made with a loan-to-value ratio of up to 80%. Loan-to-value ratios of up to 90% may be allowed on residential owner-occupied property if the borrower exhibits unusually strong creditworthiness. We generally do not make residential loans which, at the time of inception, have loan-to-value ratios in excess of 90%.
Construction Loans. Our construction loan portfolio consists of single-family residential properties, multi-family properties and commercial projects. Construction lending entails significant additional risks compared with residential mortgage lending. Construction loans often involve larger loan balances concentrated with single borrowers or groups of related borrowers. Construction loans
also involve additional risks since funds are advanced while the property is under construction, which property has uncertain value prior to the completion of construction. Thus, it is more difficult to accurately evaluate the total loan funds required to complete a project and related loan-to-value ratios. To reduce the risks associated with construction lending, we limit loan-to-value ratios to 80% of when-completed appraised values for owner-occupied residential or commercial properties and for investor-owned residential or commercial properties. We expect that these loan-to-value ratios will provide sufficient protection against fluctuations in the real estate market to limit the risk of loss. Maturities for construction loans generally range from 12 to 24 months for non-complex residential, non-residential and multi-family properties.
Construction loan agreements may include provisions which allow for the payment of contractual interest from an interest reserve. Amounts drawn from an interest reserve increase the amount of the outstanding balance of the construction loan. This is an industry standard practice.
Consumer Loans. Our consumer loans consist primarily of installment loans made to individuals for personal, family and household purposes. The specific types of consumer loans we make include home improvement loans, automobile loans, debt consolidation loans and other general consumer lending.
Consumer loans may entail greater risk than residential mortgage loans, particularly in the case of consumer loans that are unsecured, such as lines of credit, or secured by rapidly depreciable assets, such as automobiles. In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation. The remaining deficiency often does not warrant further substantial collection efforts against the borrower. In addition, consumer loan collections are dependent on the borrower's continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Furthermore, the application of various federal and state laws, including federal and state bankruptcy and insolvency laws, may limit the amount that can be recovered on such loans. A loan may also give rise to claims and defenses by a consumer loan borrower against an assignee of such loan, such as the bank, and a borrower may be able to assert against such assignee claims and defenses that it has against the seller of the underlying collateral.
Our policy for consumer loans is to accept moderate risk while minimizing losses, primarily through a careful credit and financial analysis of the borrower. In evaluating consumer loans, we require our lending officers to review the borrower's level and stability of income, past credit history, amount of debt currently outstanding and the impact of these factors on the ability of the borrower to repay the loan in a timely manner. In addition, we require our banking officers to maintain an appropriate differential between the loan amount and collateral value.
We also issue credit cards to certain of our customers. In determining to whom we will issue credit cards, we evaluate the borrower's level and stability of income, past credit history and other factors.
Finally, we make additional loans that are not classified in one of the above categories. In making such loans, we attempt to ensure that the borrower meets our loan underwriting standards.
Loan Participations
From time to time we purchase and sell commercial loan participations to or from other banks within our market area. All loan participations purchased have been underwritten using the Bank's standard and customary underwriting criteria and are in good standing.
Deposits
We offer a broad range of interest-bearing and non-interest-bearing deposit accounts, including commercial and retail checking accounts, money market accounts, individual retirement accounts, regular interest-bearing savings accounts and certificates of deposit with a range of maturity date options. The primary sources of deposits are small and medium-sized businesses and individuals within our target market. Senior management has the authority to set rates within specified parameters in order to remain competitive with other financial institutions in our market area. All deposits are insured by the FDIC up to the maximum amount permitted by law. We have a service charge fee schedule, which is generally competitive with other financial institutions in our market, covering such matters as maintenance fees and per item processing fees on checking accounts, returned check charges and other similar fees.
Courier Services
We offer courier services to our business customers. Courier services permit us to provide the convenience and personalized service that our customers require by scheduling pick-ups of deposits and other banking transactions.
Deposit on Demand
We provide our commercial banking customers electronic deposit capability through our Deposit on Demand product. Business customers who sign up for this service can scan their deposits and send electronic batches of their deposits to the Bank. This product reduces or eliminates the need for businesses with daily deposits and high check volume to visit the Bank and provides the benefit of viewing images of deposited checks.
Internet and Mobile Banking
We believe that there is a strong demand within our market for internet banking and to a much lesser extent telephone banking. These services allow both commercial and retail customers to access detailed account information and execute a wide variety of the banking transactions, including balance transfers and bill payment. We believe that these services are particularly attractive to our customers, as it enables them at any time to conduct their banking business and monitor their accounts. Internet banking assists us in attracting and retaining customers and encourages our existing customers to consider Cardinal for all of their banking and financial needs.
We offer Cardinal Mobile Banking to our customers. Customers who sign up for this service can access their accounts from any internet-enabled mobile device. Customers can check their balance, view account activity, make deposits to their account through Mobile Deposit, transfer funds between deposit accounts, and may pay their bill online. Cardinal Mobile Banking is encrypted using the Wireless Transport Layer Security (WTLS) protocol, which provides the highest level of security available today. Additionally, all data that passes between the wireless gateway and Cardinal Bank's web servers is encrypted using Secure Socket Layer (SSL).
Automatic Teller Machines
We have an ATM at each of our branch offices and we make other financial institutions' ATMs available to our customers.
Other Products and Services
We offer other banking-related specialized products and services to our customers, such as travelers' checks, coin counters, wire services, and safe deposit box services. We issue letters of credit for some of our commercial customers, most of which are related to real estate construction loans. We have not engaged in any securitizations of loans.
Credit Policies
Our chief credit officer and senior lending officers are primarily responsible for maintaining both a quality loan portfolio and a strong credit culture throughout the organization. The chief credit officer is responsible for developing and updating our credit policies and procedures, which are approved by the board of directors. The chief credit officer and senior lending officers may make exceptions to these credit policies and procedures as appropriate, but any such exception must be documented and made for sound business reasons.
Credit quality is controlled by the chief credit officer through compliance with our credit policies and procedures. Our risk-decision process is actively managed in a disciplined fashion to maintain an acceptable risk profile characterized by soundness, diversity, quality, prudence, balance and accountability. Our credit approval process consists of specific authorities granted to the lending officers and combinations of lending officers. Loans exceeding a particular lending officer's level of authority, or the combined limit of several officers, are reviewed and considered for approval by an officers' loan committee and, when above a specified amount, by a committee of the Bank's board of directors. Generally, loans of $1,500,000 or more require committee approval. Our policy allows exceptions for very specific conditions, such as loans secured by deposits at our Bank. The chief credit officer works closely with each lending officer at the Bank level to ensure that the business being solicited is of the quality and structure that fits our desired risk profile.
Under our credit policies, we monitor our concentration of credit risk. We have established credit concentration guideline limits for commercial and industrial loans, real estate-commercial loans, real estate-residential loans and consumer purpose loans, which include home equity loans. Furthermore, the Bank has established limits on the total amount of the Bank's outstanding loans to one borrower, all of which are set below legal lending limits.
Loans closed by George Mason are underwritten in accordance with guidelines established by the various secondary market investors to which George Mason sells its loans.
Brokerage and Asset Management Services
CWS provides brokerage and investment services through an arrangement with Raymond James Financial Services, Inc. Under this arrangement, financial advisors can offer our customers an extensive range of investment products and services, including estate planning, qualified retirement plans, mutual funds, annuities, life insurance, fixed income and equity securities and equity research and recommendations.
Employees
At December 31, 2015, we had 851 full-time equivalent employees. None of our employees are represented by any collective bargaining unit. We believe our relations with our employees are good.
Government Supervision and Regulation
General
As a financial holding company, we are subject to regulation under the Bank Holding Company Act of 1956, as amended, and the examination and reporting requirements of the Board of Governors of the Federal Reserve System. Other federal and state laws govern the activities of our bank subsidiary, including the activities in which it may engage, the investments that it makes, the aggregate amount of loans that it may grant to one borrower, and the dividends it may declare and pay to us. Our bank subsidiary is also subject to various consumer and compliance laws. As a state-chartered bank, the Bank is primarily subject to regulation, supervision and examination by the Bureau of Financial Institutions of the Virginia State Corporation Commission. The Bank and its' subsidiary, George Mason, are also subject to regulation, supervision and examination by the Federal Deposit Insurance Corporation.
The following description summarizes the more significant federal and state laws applicable to us. To the extent that statutory or regulatory provisions are described, the description is qualified in its entirety by reference to that particular statutory or regulatory provision.
The Bank Holding Company Act
Under the Bank Holding Company Act, we are subject to periodic examination by the Federal Reserve and required to file periodic reports regarding our operations and any additional information that the Federal Reserve may require. Our activities at the bank holding company level are limited to:
• banking, managing or controlling banks;
• furnishing services to or performing services for our subsidiaries; and
• engaging in other activities that the Federal Reserve has determined by regulation or order to be so closely related to banking as to be a proper incident to these activities.
Some of the activities that the Federal Reserve Board has determined by regulation to be closely related to the business of a bank holding company include making or servicing loans and specific types of leases, performing specific data processing services and acting in some circumstances as a fiduciary or investment or financial adviser.
With some limited exceptions, the Bank Holding Company Act requires every bank holding company to obtain the prior approval of the Federal Reserve before:
• acquiring substantially all the assets of any bank; and
• acquiring direct or indirect ownership or control of any voting shares of any bank if after such acquisition it would own or control more than 5% of the voting shares of such bank (unless it already owns or controls the majority of such shares), or merging or consolidating with another bank holding company.
In addition, and subject to some exceptions, the Bank Holding Company Act and the Change in Bank Control Act, together with their regulations, require Federal Reserve approval prior to any person or company acquiring 25% or more of any class of voting securities of the bank holding company. Prior notice to the Federal Reserve is required before a person acquires 10% or more, but less than 25%, of any class of voting securities and if the institution has registered securities under Section 12 of the Securities Exchange Act of 1934 or no other person owns a greater percentage of that class of voting securities immediately after the transaction.
In November 1999, Congress enacted the Gramm-Leach-Bliley Act ("GLBA"), which made substantial revisions to the statutory restrictions separating banking activities from other financial
activities. Under the GLBA, bank holding companies that are well-capitalized and well-managed and meet other conditions can elect to become "financial holding companies." As financial holding companies, they and their subsidiaries are permitted to acquire or engage in previously impermissible activities, such as insurance underwriting and securities underwriting and distribution. In addition, financial holding companies may also acquire or engage in certain activities in which bank holding companies are not permitted to engage in, such as travel agency activities, insurance agency activities, merchant banking and other activities that the Federal Reserve determines to be financial in nature or complementary to these activities. Financial holding companies continue to be subject to the overall oversight and supervision of the Federal Reserve, but the GLBA applies the concept of functional regulation to the activities conducted by subsidiaries. For example, insurance activities would be subject to supervision and regulation by state insurance authorities. We became a financial holding company in 2004.
Payment of Dividends
Regulators have indicated that financial holding companies should generally pay dividends only if the organization's net income available to common shareholders is sufficient to fully fund the dividends, and the prospective rate of earnings retention appears consistent with the organization's capital needs, asset quality and overall financial condition.
We are a legal entity separate and distinct from Cardinal Bank, CWS, Cardinal Statutory Trust I and UFBC Capital Trust I. Virtually all of our cash revenues will result from dividends paid to us by our bank subsidiary and interest earned on short term investments. Our bank subsidiary is subject to laws and regulations that limit the amount of dividends that it can pay. Under Virginia law, a bank may not declare a dividend in excess of its accumulated retained earnings. Additionally, our bank subsidiary may declare a dividend out of undivided earnings, but not if the total amount of all dividends, including the proposed dividend, declared by the bank in any calendar year exceeds the total of the bank's retained net income of that year to date, combined with its retained net income of the two preceding years, unless the dividend is approved by the FDIC. Our bank subsidiary may not declare or pay any dividend if, after making the dividend, the bank would be "undercapitalized," as defined in the banking regulations.
The FDIC and the state have the general authority to limit the dividends paid by insured banks if the payment is deemed an unsafe and unsound practice. Both the state and the FDIC have indicated that paying dividends that deplete a bank's capital base to an inadequate level would be an unsound and unsafe banking practice.
In addition, we are subject to certain regulatory requirements to maintain capital at or above regulatory minimums. These regulatory requirements regarding capital affect our dividend policies. Our regulators also may restrict our ability to repurchase securities.
Insurance of Accounts, Assessments and Regulation by the FDIC
The deposits of our bank subsidiary are insured by the FDIC up to the limits set forth under applicable law. The deposits of our bank subsidiary are subject to the deposit insurance assessments of the Deposit Insurance Fund, or "DIF", of the FDIC.
The FDIC has implemented a risk-based deposit insurance assessment system under which the assessment rate for an insured institution may vary according to regulatory capital levels of the institution and other factors, including supervisory evaluations. In addition to being influenced by the risk profile of the particular depository institution, FDIC premiums are also influenced by the size of the FDIC insurance fund in relation to total deposits in FDIC insured banks. The FDIC has authority to impose special assessments.
The FDIC is required to maintain a designated minimum ratio of the DIF to insured deposits in the United States. In July 2010, the Dodd Frank Wall Street Reform and Consumer Protection Act (the "Financial Reform Act") was signed into law. The Financial Reform Act requires the FDIC to achieve a DIF ratio of at least 1.35 percent by September 30, 2020. The FDIC has also adopted new regulations that establish a long-term target DIF ratio of greater than two percent. Deposit insurance assessment rates are subject to change by the FDIC and will be impacted by the overall economy and the stability of the banking industry as a whole.
Pursuant to the Financial Reform Act, FDIC insurance coverage limits were permanently increased to $250,000 per customer.
The Financial Reform Act also changed the methodology for calculating deposit insurance assessments by changing the assessment base from the amount of an insured depository institution's domestic deposits to its total assets minus tangible equity. The new regulation implementing revisions to the assessment system mandated by the Financial Reform Act was effective April 1, 2011 and was reflected in the June 30, 2011 FDIC fund balance and the invoices for assessments due September 30, 2011. While the burden on replenishing the DIF will be placed primarily on institutions with assets of greater than $10 billion, any future increases in required deposit insurance premiums or other bank industry fees could have a significant adverse impact on our financial condition and results of operations.
The FDIC is authorized to prohibit any insured institution from engaging in any activity that the FDIC determines by regulation or order to pose a serious threat to the DIF. Also, the FDIC may initiate enforcement actions against banks, after first giving the institution's primary regulatory authority an opportunity to take such action. The FDIC may terminate the deposit insurance of any depository institution if it determines, after a hearing, that the institution has engaged or is engaging in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, order or any condition imposed in writing by the FDIC. It also may suspend deposit insurance temporarily during the hearing process for the permanent termination of insurance, if the institution has no tangible capital. If deposit insurance is terminated, the deposits at the institution at the time of termination, less subsequent withdrawals, shall continue to be insured for a period from six months to two years, as determined by the FDIC. We are unaware of any existing circumstances that could result in termination of any of our bank subsidiary's deposit insurance.
Consumer Financial Protection Bureau. The Financial Reform Act created a new, independent federal agency, the Consumer Financial Protection Bureau ("CFPB") having broad rulemaking, supervisory and enforcement powers under various federal consumer financial protection laws, including the Equal Credit Opportunity Act, Truth in Lending Act, Real Estate Settlement Procedures Act, Fair Credit Reporting Act, Fair Debt Collection Act, the Consumer Financial Privacy provisions of the Gramm-Leach-Bliley Act and certain other statutes. The CFPB has examination and primary enforcement authority with respect to depository institutions with $10 billion or more in assets. Smaller institutions, including the Bank, are subject to rules promulgated by the CFPB but continue to be examined and supervised by federal banking regulators for consumer compliance purposes. The CFPB has authority to prevent unfair, deceptive or abusive practices in connection with the offering of consumer financial products. The Financial Reform Act permits states to adopt consumer protection laws and standards that are more stringent than those adopted at the federal level and, in certain circumstances, permits state attorneys general to enforce compliance with both the state and federal laws and regulations.
In 2013, the CFPB adopted a rule, effective in January 2014, to implement certain sections of the Dodd-Frank Act requiring creditors to make a reasonable, good faith determination of a consumer's ability to repay any closed-end consumer credit transaction secured by a 1-4 family dwelling. The rule also establishes certain protections from liability under this requirement to ensure a borrower's ability
to repay for loans that meet the definition of "qualified mortgage." Loans that satisfy this "qualified mortgage" safe harbor will be presumed to have complied with the new ability-to-repay standard.
Capital Requirements
In 2013, the Federal Reserve, the FDIC and the OCC approved a new rule that substantially amended the regulatory risk-based capital rules applicable to us. The final rule implemented the "Basel III" regulatory capital reforms and changes required by the Financial Reform Act. The final rule includes new minimum risk-based capital and leverage ratios which were effective for us on January 1, 2015, and refines the definition of what constitutes "capital" for purposes of calculating these ratios.
Under the risk-based capital requirements, we and our bank subsidiary are each generally required to maintain a minimum ratio of total capital to risk-weighted assets (including specific off-balance sheet activities, such as standby letters of credit) of 8%. At least half of the total capital must be composed of "Tier 1 Capital," which is defined as common equity, retained earnings, qualifying perpetual preferred stock and minority interests in common equity accounts of consolidated subsidiaries, less certain intangibles. The remainder may consist of "Tier 2 Capital", which is defined as specific subordinated debt, some hybrid capital instruments and other qualifying preferred stock and a limited amount of the loan loss allowance and pretax net unrealized holding gains on certain equity securities. In addition, each of the federal banking regulatory agencies has established minimum leverage capital requirements for banking organizations. In summary, the capital measures used by the federal banking regulators are:
• Total Risk-Based Capital ratio, which is the total of Tier 1 Risk-Based Capital (which includes common shareholders' equity, trust preferred securities, minority interests and qualifying preferred stock, less goodwill and other adjustments) and Tier 2 Capital (which includes preferred stock not qualifying as Tier 1 capital, mandatory convertible debt, limited amounts of subordinated debt, other qualifying term debt and the allowance for loan losses up to 1.25 percent of risk-weighted assets and other adjustments) as a percentage of total risk-weighted assets
• Tier 1 Risk-Based Capital ratio (Tier 1 capital divided by total risk-weighted assets)
• A new Common Equity Tier I ("CET1") Capital ratio (which includes common shareholders' equity less disallowed intangibles adjusted for associated deferred tax liabilities) as a percentage of total risk-weighted assets and
• the Leverage ratio (Tier 1 capital divided by adjusted average total assets).
The new minimum capital requirements under Basel III are: (i) a new common equity Tier 1 capital ratio of 4.5%; (ii) a Tier 1 to risk-based assets capital ratio of 6%, which is increased from 4%; (iii) a total capital ratio of 8%, which is unchanged from the current rules; and (iv) a Tier 1 leverage ratio of 4%.
The Financial Reform Act contains a number of provisions dealing with capital adequacy of insured depository institutions and their holding companies, which result in more stringent capital requirements. Under the Collins Amendment to the Financial Reform Act, federal regulators have been directed to establish minimum leverage and risk-based capital requirements for, among other entities, bank holding companies on a consolidated basis. These minimum requirements cannot be less than the generally applicable leverage and risk-based capital requirements established for insured depository institutions nor quantitatively lower than the leverage and risk-based capital requirements established for insured depository institutions that were in effect as of July 21, 2010. These requirements in effect create capital level floors for bank holding companies similar to those in place currently for insured depository institutions. The Collins Amendment also excludes trust preferred
securities issued after May 19, 2010 from being included in Tier 1 capital unless the issuing company is a bank holding company with less than $500 million in total assets. Trust preferred securities issued prior to that date will continue to count as Tier 1 capital for bank holding companies with less than $15 billion in total assets, and such securities will be phased out of Tier 1 capital treatment for bank holding companies with over $15 billion in total assets over a three-year period beginning in 2013. Accordingly, our trust preferred securities will continue to qualify as Tier 1 capital.
The final rule also establishes a "capital conservation buffer" of 2.5% above the new regulatory minimum capital ratios, and when fully effective in 2019, will result in the following minimum ratios: (a) a CET1 capital ratio of 7.0%; (b) a Tier 1 to risk-based assets capital ratio of 8.5%; and (c) a total capital ratio of 10.5%. The new capital conservation buffer requirement would be phased in beginning in January 2016 at 0.625% of risk-weighted assets and would increase each year until fully implemented in January 2019. An institution will be subject to limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses if its capital level falls below the buffer amount. These limitations will establish a maximum percentage of eligible retained income that can be utilized for such activities.
The final rule also provides for a number of new deductions from and adjustments to CET1. These include, for example, the requirement that mortgage servicing assets, deferred tax assets related to temporary differences that could not be realized through net operating loss carrybacks, and significant investments in non-consolidated financial entities be deducted from CET1 to the extent that any one such category exceeds 10% of CET1 or all such categories in the aggregate exceed 15% of CET1.
The final rule prescribes a standardized approach for risk weightings that expand the risk-weighting categories from the current four Basel I-derived categories (0%, 20%, 50% and 100%) to a much larger and more risk-sensitive number of categories, depending on the nature of the assets, generally ranging from 0% for U.S. government and agency securities, to 600% for certain equity exposures, and resulting in higher risk weights for a variety of asset categories.
The risk-based capital standards of each of the FDIC and the Federal Reserve Board explicitly identify concentrations of credit risk and the risk arising from non-traditional activities, as well as an institution's ability to manage these risks, as important factors to be taken into account by the agency in assessing an institution's overall capital adequacy. The capital guidelines also provide that an institution's exposure to a decline in the economic value of its capital due to changes in interest rates be considered by the agency as a factor in evaluating a banking organization's capital adequacy.
The FDIC may take various corrective actions against any undercapitalized bank and any bank that fails to submit an acceptable capital restoration plan or fails to implement a plan acceptable to the FDIC. These powers include, but are not limited to, requiring the institution to be recapitalized, prohibiting asset growth, restricting interest rates paid, requiring prior approval of capital distributions by any financial holding company that controls the institution, requiring divestiture by the institution of its subsidiaries or by the holding company of the institution itself, requiring new election of directors, and requiring the dismissal of directors and officers.
At December 31, 2015, the Company and its banking subsidiary met all capital adequacy requirements under the Basel III capital rules. We are considered "well-capitalized" at December 31, 2015 and, in addition, our bank subsidiary maintained sufficient capital to remain in compliance with capital requirements and is considered "well-capitalized" at December 31, 2015.
Other Safety and Soundness Regulations
There are significant obligations and restrictions imposed on financial holding companies and their depository institution subsidiaries by federal law and regulatory policy that are designed to reduce
potential loss exposure to the depositors of such depository institutions and to the FDIC insurance fund in the event that the depository institution is insolvent or is in danger of becoming insolvent. These obligations and restrictions are not for the benefit of investors. Regulators may pursue an administrative action against any financial holding company or bank which violates the law, engages in an unsafe or unsound banking practice, or which is about to engage in an unsafe or unsound banking practice. The administrative action could take the form of a cease and desist proceeding, a removal action against the responsible individuals or, in the case of a violation of law or unsafe and unsound banking practice, a civil monetary penalty action. A cease and desist order, in addition to prohibiting certain action, could also require that certain actions be undertaken. Under the Financial Reform Act and longstanding policies of the Federal Reserve Board, we are required to serve as a source of financial strength to our subsidiary depository institution and to commit resources to support the Bank in circumstances where we might not do so otherwise.
The Bank Secrecy Act
Under the Bank Secrecy Act ("BSA"), a financial institution is required to have systems in place to detect certain transactions, based on the size and nature of the transaction. Financial institutions are generally required to report cash transactions involving more than $10,000 to the United States Treasury. In addition, financial institutions are required to file Suspicious Activity Reports for transactions that involve more than $5,000 and which the financial institution knows, suspects or has reason to suspect, involves illegal funds, is designed to evade the requirements of the BSA or has no lawful purpose. The USA PATRIOT Act of 2001, enacted in response to the September 11, 2001 terrorist attacks, requires bank regulators to consider a financial institution's compliance with the BSA when reviewing applications from a financial institution. As part of its BSA program, the USA PATRIOT Act of 2001 also requires a financial institution to follow customer identification procedures when opening accounts for new customers and to review U.S. government-maintained lists of individuals and entities that are prohibited from opening accounts at financial institutions.
Monetary Policy
The commercial banking business is affected not only by general economic conditions but also by the monetary policies of the Federal Reserve Board. The instruments of monetary policy employed by the Federal Reserve Board include open market operations in United States government securities, changes in the discount rate on member bank borrowings and changes in reserve requirements against deposits held by federally insured banks. The Federal Reserve Board's monetary policies have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future. In view of changing conditions in the national and international economy and in the money markets, as well as the effect of actions by monetary and fiscal authorities, including the Federal Reserve System, no prediction can be made as to possible future changes in interest rates, deposit levels, loan demand or the business and earnings of our bank subsidiary, its subsidiary, or any of our other subsidiaries.
Federal Reserve System
In 1980, Congress enacted legislation that imposed reserve requirements on all depository institutions that maintain transaction accounts or non-personal time deposits. NOW accounts and demand deposit accounts that permit payments or transfers to third parties fall within the definition of transaction accounts and are subject to these reserve requirements. Effective January 2016, the first $15.2 million of balances will be exempt from reserve requirements. A 3% reserve ratio will be assessed on net transaction account balances over $15.2 million to and including $110.2 million. A 10% reserve ratio will be applied to amounts in net transaction account balances in excess of $110.2 million. These percentages are subject to adjustment by the Federal Reserve Board. Because required reserves must
be maintained in the form of vault cash or in a non-interest-bearing account at, or on behalf of, a Federal Reserve Bank, the effect of the reserve requirement is to reduce the amount of our interest-earning assets. Beginning October 2008, the Federal Reserve Banks pay financial institutions interest on their required reserve balances and excess funds deposited with the Federal Reserve. The interest rate paid is the targeted federal funds rate.
Transactions with Affiliates
Transactions between banks and their affiliates are governed by Sections 23A and 23B of the Federal Reserve Act. An affiliate of a bank is any bank or entity that controls, is controlled by or is under common control with such bank. Generally, Sections 23A and 23B (i) limit the extent to which the bank or its subsidiaries may engage in "covered transactions" with any one affiliate to an amount equal to 10% of such institution's capital stock and surplus, and maintain an aggregate limit on all such transactions with affiliates to an amount equal to 20% of such capital stock and surplus, and (ii) require that all such transactions be on terms substantially the same as, or at least as favorable to those that, the bank has provided to a non-affiliate. Certain covered transactions also must be adequately secured by eligible collateral. The term "covered transaction" includes the making of loans, purchase of assets, issuance of a guarantee and similar other types of transactions. Section 23B applies to "covered transactions" as well as sales of assets and payments of money to an affiliate. These transactions must also be conducted on terms substantially the same as, or at least favorable to those that, the bank has provided to non-affiliates.
The Financial Reform Act also provides that banks may not "purchase an asset from, or sell an asset to" a bank insider (or their related interests) unless (i) the transaction is conducted on market terms between the parties, and (ii) if the proposed transaction represents more than 10 percent of the capital stock and surplus of the bank, it has been approved in advance by a majority of the bank's non-interested directors.
Loans to Insiders
The Federal Reserve Act and related regulations impose specific restrictions on loans to directors, executive officers and principal shareholders of banks. Under Section 22(h) of the Federal Reserve Act, loans to a director, an executive officer and to a principal shareholder of a bank, and to entities controlled by any of the foregoing, may not exceed, together with all other outstanding loans to such person and entities controlled by such person, the bank's loan-to-one borrower limit. Loans in the aggregate to insiders and their related interests as a class may not exceed two times the bank's unimpaired capital and unimpaired surplus until the bank's total assets equal or exceed $100,000,000, at which time the aggregate is limited to the bank's unimpaired capital and unimpaired surplus. Section 22(h) also prohibits loans above amounts prescribed by the appropriate federal banking agency to directors, executive officers and principal shareholders of a bank or bank holding company, and to entities controlled by such persons, unless such loan is approved in advance by a majority of the board of directors of the bank with any "interested" director not participating in the voting. The FDIC has prescribed the aggregate loan amount to such person for which prior board of director approval is required, as being the greater of $25,000 or 5% of capital and surplus (up to $500,000). Section 22(h) requires that loans to directors, executive officers and principal shareholders be made on terms and underwriting standards substantially the same as offered in comparable transactions to other persons.
Community Reinvestment Act
Under the Community Reinvestment Act and related regulations, depository institutions have an affirmative obligation to assist in meeting the credit needs of their market areas, including low and moderate-income areas, consistent with safe and sound banking practice. The Community Reinvestment Act requires the adoption by each institution of a Community Reinvestment Act statement for each of its market areas describing the depository institution's efforts to assist in its community's credit needs. Depository institutions are periodically examined for compliance with the Community Reinvestment Act and are periodically assigned ratings in this regard. Banking regulators consider a depository institution's Community Reinvestment Act rating when reviewing applications to establish new branches, undertake new lines of business, and/or acquire part or all of another depository institution. An unsatisfactory rating can significantly delay or even prohibit regulatory approval of a proposed transaction by a financial holding company or its depository institution subsidiaries.
GLBA and federal bank regulators have made various changes to the Community Reinvestment Act. Among other changes, Community Reinvestment Act agreements with private parties must be disclosed and annual reports must be made to a bank's primary federal regulator. A financial holding company or any of its subsidiaries will not be permitted to engage in new activities authorized under the GLBA if any bank subsidiary received less than a "satisfactory" rating in its latest Community Reinvestment Act examination.
Consumer Laws Regarding Fair Lending
In addition to the Community Reinvestment Act described above, other federal and state laws regulate various lending and consumer aspects of our business. Governmental agencies, including the Department of Housing and Urban Development, the Federal Trade Commission and the Department of Justice, have become concerned that prospective borrowers may experience discrimination in their efforts to obtain loans from depository and other lending institutions. These agencies have brought litigation against depository institutions alleging discrimination against borrowers. Many of these suits have been settled, in some cases for material sums of money, short of a full trial.
These governmental agencies have clarified what they consider to be lending discrimination and have specified various factors that they will use to determine the existence of lending discrimination under the Equal Credit Opportunity Act and the Fair Housing Act, including evidence that a lender discriminated on a prohibited basis, evidence that a lender treated applicants differently based on prohibited factors in the absence of evidence that the treatment was the result of prejudice or a conscious intention to discriminate, and evidence that a lender applied an otherwise neutral non-discriminatory policy uniformly to all applicants, but the practice had a discriminatory effect, unless the practice could be justified as a business necessity.
Banks and other depository institutions also are subject to numerous consumer-oriented laws and regulations. These laws, which include the Truth in Lending Act, the Truth in Savings Act, the Real Estate Settlement Procedures Act, the Electronic Funds Transfer Act, the Equal Credit Opportunity Act, and the Fair Housing Act, require compliance by depository institutions with various disclosure requirements and requirements regulating the availability of funds after deposit or the making of some loans to customers.
Gramm-Leach-Bliley Act of 1999
The Gramm-Leach-Bliley Act of 1999 covers a broad range of issues, including a repeal of most of the restrictions on affiliations among depository institutions, securities firms and insurance companies. The following description summarizes some of its significant provisions.
The GLBA repealed sections 20 and 32 of the Glass-Steagall Act, thus permitting unrestricted affiliations between banks and securities firms. It also permits bank holding companies to elect to become financial holding companies. A financial holding company may engage in or acquire companies that engage in a broad range of financial services, including securities activities such as underwriting, dealing, investment, merchant banking, insurance underwriting, sales and brokerage activities. In order to become a financial holding company, the bank holding company and all of its affiliated depository institutions must be well-capitalized, well-managed and have at least a satisfactory Community Reinvestment Act rating. We became a financial holding company in 2004.
The GLBA provides that the states continue to have the authority to regulate insurance activities, but prohibits the states in most instances from preventing or significantly interfering with the ability of a bank, directly or through an affiliate, to engage in insurance sales, solicitations or cross-marketing activities. Although the states generally must regulate bank insurance activities in a nondiscriminatory manner, the states may continue to adopt and enforce rules that specifically regulate bank insurance activities in areas identified under the law. Under the law, the federal bank regulatory agencies adopted insurance consumer protection regulations that apply to sales practices, solicitations, advertising and disclosures.
The GLBA adopts a system of functional regulation under which the Federal Reserve Board is designated as the umbrella regulator for financial holding companies, but financial holding company affiliates are principally regulated by functional regulators such as the FDIC for bank affiliates, the Securities and Exchange Commission for securities affiliates, and state insurance regulators for insurance affiliates. It repeals the broad exemption of banks from the definitions of "broker" and "dealer" for purposes of the Securities Exchange Act of 1934, as amended. It also identifies a set of specific activities, including traditional bank trust and fiduciary activities, in which a bank may engage without being deemed a "broker," and a set of activities in which a bank may engage without being deemed a "dealer." Additionally, GLBA makes conforming changes in the definitions of "broker" and "dealer" for purposes of the Investment Company Act of 1940, as amended, and the Investment Advisers Act of 1940, as amended.
The GLBA contains extensive customer privacy protection provisions. Under these provisions, a financial institution must provide to its customers, both at the inception of the customer relationship and on an annual basis, the institution's policies and procedures regarding the handling of customers' nonpublic personal financial information. The law provides that, except for specific limited exceptions, an institution may not provide such personal information to unaffiliated third parties unless the institution discloses to the customer that such information may be so provided and the customer is given the opportunity to opt out of such disclosure. An institution may not disclose to a non-affiliated third party, other than to a consumer credit reporting agency, customer account numbers or other similar account identifiers for marketing purposes. The GLBA also provides that the states may adopt customer privacy protections that are stricter than those contained in the act.
The Financial Reform Act
On July 21, 2010, the Financial Reform Act was signed into law. The Financial Reform Act provides for sweeping financial regulatory reform and will alter the way in which we conduct certain businesses.
The Financial Reform Act contains a broad range of significant provisions that could affect our businesses, including, without limitation, the following:
• Mandating that the Federal Reserve limit debit card interchange fees;
• Changing the assessment base used in calculating FDIC deposit insurance fees from assessable deposits to total assets less tangible capital;
• Creating a new regulatory body to set requirements around the terms and conditions of consumer financial products and expanding the role of state regulators in enforcing consumer protection requirements over banks;
• Increasing the minimum reserve ratio of the DIF to 1.35 percent and eliminating the maximum reserve ratio;
• Making permanent the $250,000 limit for federal deposit insurance;
• Allowing depository institutions to pay interest on business demand deposits effective July 21, 2011;
• Imposing new requirements on mortgage lending, including new minimum underwriting standards, prohibitions on certain yield-spread compensation to mortgage originators, special consumer protections for mortgage loans that do not meet certain provision qualifications, prohibitions and limitations on certain mortgage terms and various new mandated disclosures to mortgage borrowers;
• Establishing minimum capital levels for holding companies that are at least as stringent as those currently applicable to banks;
• Allowing national and state banks to establish de novo interstate branches outside of their home state, and mandating that bank holding companies and banks be well-capitalized and well managed in order to acquire banks located outside their home state;
• Enhancing the requirements for certain transactions with affiliates under Section 23A and 23B of the Federal Reserve Act, 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;
• Placing restrictions on certain asset sales to and from an insider to an institution, including requirements that such sales be on market terms and, in certain circumstances, approved by the institution's board of directors;
• Including a variety of corporate governance and executive compensation provisions and requirements.
The Financial Reform Act is expected to have a negative impact on our earnings through fee reductions, higher costs and new restrictions. The Financial Reform Act may have a material adverse impact on the value of certain assets and liabilities on our balance sheet.
Most provisions of the Financial Reform Act require various federal banking and securities regulators to issue regulations to clarify and implement its provisions or to conduct studies on significant issues. These proposed regulations and studies are generally subject to a public notice and comment period. The timing of issuance of final regulations, their effective dates and their potential impacts to our businesses will be determined over the coming months and years. As a result, the ultimate impact of the Financial Reform Act's final rules on our businesses and results of operations will depend on regulatory interpretation and rulemaking, as well as the success of any of our actions to mitigate the negative earnings impact of certain provisions.
Future Regulatory Uncertainty
Because federal and state regulation of financial institutions changes regularly and is the subject of constant legislative debate, we cannot forecast how federal and state regulation of financial institutions may change in the future and, as a result, impact our operations. We fully expect that the financial institution industry will remain heavily regulated in the near future and that additional laws or regulations may be adopted further regulating specific banking practices. Congress and the federal
government have continued to evaluate and develop legislation, programs, and initiatives designed to, among other things, stabilize the financial and housing markets, stimulate the economy, including the federal government's foreclosure prevention program, and prevent future financial crises by further regulating the financial services industry. As a result of the recent financial crisis and the ongoing challenging economic environment, we anticipate additional legislative and regulatory proposals and initiatives as well as continued legislative and regulatory scrutiny of the financial services industry. At this time, we cannot determine the final form of any proposed programs or initiatives or related legislation, the likelihood and timing of any other future proposals or legislation, and the impact they might have on us.
Additional Information
We file with or furnish to the Securities and Exchange Commission ("SEC") annual, quarterly and current reports, proxy statements, and various other documents under the Securities Exchange Act of 1934, as amended (the "Exchange Act"). The public may read and copy any materials that we file with or furnish to the SEC at the SEC's Public Reference Room, which is located at 100 F Street, NE, Washington, D.C. 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. Also, the SEC maintains an internet website at www.sec.gov that contains reports, proxy and information statements and other information regarding registrants, including us, that file or furnish documents electronically with the SEC.
We also make available free of charge on or through our internet website (www.cardinalbank.com) our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and, if applicable, amendments to those reports as filed or furnished pursuant to Section 13(a) of the Exchange Act as soon as reasonably practicable after we electronically file such materials with, or furnish them to, the SEC.
Item 1A.
Item 1A. Risk Factors
We are subject to various risks, including the risks described below. Our operations, financial condition and performance and, therefore, the market value of our Common Stock could be adversely affected by any of these risks or additional risks not presently known or that we currently deem immaterial.
Difficult conditions in the economy and the capital markets continue to adversely affect our industry.
In recent years during the financial crisis, dramatic declines in the housing market, with falling home prices and increasing foreclosure rates, followed by unemployment and under-employment, negatively impacted the credit performance of real estate related loans and consumer loans and resulted in significant write-downs of asset values by financial institutions. These write-downs spread to other securities and loans and have caused many financial institutions to seek additional capital, to reduce or eliminate dividends, to merge with larger and stronger institutions and, in some cases, to fail. Lenders and institutional investors have reduced or ceased providing funding to borrowers, including to other financial institutions. This market turmoil and tightening of credit led to an increased level of commercial and consumer delinquencies, lack of consumer confidence, increased market volatility and reduction of business activity generally. While we have seen an improvement in economic trends, future economic pressure on consumers may adversely affect our business and results of operations. Market developments may affect consumer confidence levels and may cause adverse changes in payment patterns, causing increases in delinquencies and default rates, which may impact our charge-offs and provision for loan losses. A worsening of these conditions would likely exacerbate the adverse effects of these current market conditions on us and others in the financial institutions industry.
The capital and credit markets have experienced volatility and disruption in recent years. In some cases, the markets have produced downward pressure on stock prices and credit availability for certain issuers without regard to those issuers' underlying financial strength. If these levels of market disruption and volatility recur, there can be no assurance that we will not experience an adverse effect, which may be material, on our ability to access capital and on our business, financial condition and results of operations.
Our mortgage banking revenue is cyclical and is sensitive to the level of interest rates, changes in economic conditions, decreased economic activity, a slowdown in the housing market, any of which could adversely impact our profits.
Recently, we have significantly expanded our mortgage banking operations by adding mortgage loan officers and support staff, and this segment has become a larger portion of our consolidated business. Maintaining our revenue stream in this segment is dependent upon our ability to originate loans and sell them to investors at or near current volumes. Loan production levels are sensitive to changes in the level of interest rates and changes in economic conditions. Loan production levels may also suffer if we experience a slowdown in the local housing market or tightening credit conditions. Any sustained period of decreased activity caused by less refinancing transactions, higher interest rates, housing price pressure or loan underwriting restrictions would adversely affect our mortgage originations and, consequently, could significantly reduce our income from mortgage banking activities. As a result, these conditions would also adversely affect our net income. In addition, the effect of any such slowdown in volume on our net income could be exacerbated by accounting rules which require mortgage revenues to be realized prior to certain associated expenses. See Note 2(p) to our consolidated financial statements for a summary of this accounting policy.
Deteriorating economic conditions may also cause home buyers to default on their mortgages. In certain cases where we have originated loans and sold them to investors, we may be required to repurchase loans or provide a financial settlement to investors if it is proven that the borrower failed to provide full and accurate information on or related to their loan application or for which appraisals have not been acceptable or when the loan was not underwritten in accordance with the loan program specified by the loan investor. Such repurchases or settlements would also adversely affect our net income.
George Mason, as part of the service it previously provided to its managed companies, purchased the loans managed companies originate at the time of origination. These loans were then sold by George Mason to investors. George Mason has agreements with these managed companies requiring that, for any loans that were originated by a managed company and for which investors have requested George Mason to repurchase due to the borrowers failure to provide full and accurate information on or related to their loan application or for which appraisals have not been acceptable or when the loan was not underwritten in accordance with the loan program specified by the loan investor, the managed company be responsible for buying back the loan. In the event that the managed company's financial condition deteriorates and it is unable to fund the repurchase of such loans, George Mason may have to provide the funds to repurchase these loans from investors.
We may be adversely affected by economic conditions in our market area.
We are headquartered in Northern Virginia, and our market is the greater Washington, D.C. metropolitan area. Because our lending and deposit-gathering activities are concentrated in this market, we will be affected by the general economic conditions in the greater Washington area, which may, among other factors, be impacted by the level of federal government spending. Federal government cuts in spending could severely impact negatively the unemployment rate in our region and business development activity. Changes in the economy, and government spending in particular, may influence the growth rate of our loans and deposits, the quality of the loan portfolio and loan and deposit
pricing. A significant decline in general economic conditions caused by inflation, recession, unemployment or other factors, would impact these local economic conditions and the demand for banking products and services generally, and could negatively affect our financial condition and performance.
Government measures to regulate the financial industry, including the Financial Reform Act, could require us to change certain of our business practices, impose significant additional costs on us, limit the products that we offer, limit our ability to pursue business opportunities in an efficient manner, require us to increase our regulatory capital, impact the value of the assets we hold, significantly reduce our revenues or otherwise materially affect our businesses, financial condition or results of operations.
As a financial institution, we are heavily regulated at the state and federal levels. As a result of the financial crisis and related global economic downturn that began in 2007, we have faced, and expect to continue to face, increased public and legislative scrutiny as well as stricter and more comprehensive regulation of our financial services practices. In July 2010, the Financial Reform Act was signed into law. Many of the provisions of the Financial Reform Act have begun to be or will be phased in over the next several months or years and will be subject both to further rulemaking and the discretion of applicable regulatory bodies. Although we cannot predict the full effect of the Financial Reform Act on our operations, it could, as well as the future rules implementing its reforms, impose significant additional costs on us, limit the products we offer, could limit our ability to pursue business opportunities in an efficient manner, require us to increase our regulatory capital, impact the values of assets that we hold, significantly reduce our revenues or otherwise materially and adversely affect our businesses, financial condition, or results of operations.
The ultimate impact of the final rules on our businesses and results of operations, however, will depend on regulatory interpretation and rulemaking, as well as the success of any of our actions to mitigate the negative earnings impact of certain provisions.
We may be subject to more stringent capital requirements, which could adversely affect our results of operations and future growth.
In 2013, the Federal Reserve, the FDIC and the OCC approved a new rule that substantially amended the regulatory risk-based capital rules applicable to us. The final rule implements the "Basel III" regulatory capital reforms and changes required by the Financial Reform Act. The final rule includes new minimum risk-based capital and leverage ratios which became effective for us on January 1, 2015, and refines the definition of what constitutes "capital" for purposes of calculating these ratios. The new minimum capital requirements will be: (i) a new common equity Tier 1 ("CET1") capital ratio of 4.5%; (ii) a Tier 1 to risk-based assets capital ratio of 6%, which is increased from 4%; (iii) a total capital ratio of 8%, which is unchanged from the current rules; and (iv) a Tier 1 leverage ratio of 4%. The final rule also establishes a "capital conservation buffer" of 2.5% above the new regulatory minimum capital ratios, and when fully effective in 2019, will result in the following minimum ratios: (a) a common equity Tier 1 capital ratio of 7.0%; (b) a Tier 1 to risk-based assets capital ratio of 8.5%; and (c) a total capital ratio of 10.5%. The new capital conservation buffer requirement would be phased in beginning in January 2016 at 0.625% of risk-weighted assets and would increase each year until fully implemented in January 2019. An institution will be subject to limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses if its capital level falls below the buffer amount. These limitations will establish a maximum percentage of eligible retained income that can be utilized for such activities. In addition, the final rule provides for a number of new deductions from and adjustments to capital and prescribes a revised approach for risk weightings that could result in higher risk weights for a variety of asset categories.
The application of these more stringent capital requirements for us could, among other things, result in lower returns on equity, require the raising of additional capital, adversely affect our future growth opportunities, and result in regulatory actions such as a prohibition on the payment of dividends or on the repurchase shares if we were unable to comply with such requirements.
At December 31, 2015, the Company and its banking subsidiary met all capital adequacy requirements under the Basel III capital rules.
We may not be able to successfully manage our growth or implement our growth strategies, which may adversely affect our results of operations and financial condition.
During the last five years, we have experienced significant growth, and a key aspect of our business strategy is our continued growth and expansion. Our ability to continue to grow depends, in part, upon our ability to:
• open new branch offices or acquire existing branches or other financial institutions;
• attract deposits to those locations and cross-sell new and existing depositors additional products and services; and
• identify attractive loan and investment opportunities.
We may not be able to implement our growth strategy successfully if we are unable to identify attractive markets, locations or opportunities to expand. Our ability to successfully manage our growth will also depend upon our ability to maintain capital levels sufficient to support this growth, maintain effective cost controls and adequate asset quality such that earnings are not adversely impacted to a material degree.
As we implement our growth strategy by opening new branches or acquiring branches or other banks, we expect to incur increased personnel, occupancy and other operating expenses. In the case of new branches, we must absorb those higher expenses while we begin to generate new deposits, and there is a further time lag involved in redeploying new deposits into attractively priced loans and other higher yielding earning assets. Thus, our plans to branch aggressively could depress our earnings in the short run, even if we efficiently execute our branching strategy. In addition, failure to properly integrate or manage our expanded business could adversely affect our financial condition.
Our potential inability to integrate companies we may acquire in the future could have a negative effect on our expenses and results of operations.
On occasion, we may engage in a strategic acquisition when we believe there is an opportunity to strengthen and expand our business. To fully benefit from such acquisition, however, we must integrate the administrative, financial, lending, and retail functions of the acquired company. If we are unable to successfully integrate an acquired company, our financial condition, results of operations and capital may be negatively affected. Completed acquisitions may also lead to significant unexpected liabilities.
Difficulties in combining the operations of acquired entities with our own operations may prevent us from achieving the expected benefits from acquisitions.
We may not be able to achieve fully the strategic objectives and operating efficiencies expected in our acquisition of UFBC. Inherent uncertainties exist in integrating the operations of an acquired entity. In addition, the markets and industries in which we operate are highly competitive. We may lose customers or the customers of acquired entities as a result of an acquisition; we may lose key personnel, either from the acquired entity or from us; and we may not be able to control the incremental increase in noninterest expense arising from thethethe acquisition in a manner that improves our overall operating efficiencies. These factors could contribute to our not achieving the
expected benefits from acquisitions within desired time frames, if at all. Future business acquisitions could be material to us and we may issue additional shares of common stock to pay for those acquisitions, which would dilute current shareholders' ownership interests. Acquisitions also could require us to use substantial cash or other liquid assets or to incur debt; we could therefore become more susceptible to economic downturns and competitive pressures.
We have goodwill and other intangibles that may become impaired, and thus result in a charge against earnings.
At December 31, 2015, we had $10.1 million of goodwill related to the George Mason acquisition and $24.9 million related to acquisitions that occurred within the commercial banking segment of our Company. Goodwill and other intangibles are tested for impairment on an annual basis or when facts and circumstances indicate that impairment may have occurred.
We may be forced to recognize impairment charges in the future as operating and economic conditions change.
We may be adversely impacted by changes in the condition of financial markets.
We are directly and indirectly affected by changes in market conditions. Market risk generally represents the risk that values of assets and liabilities or revenues will be adversely affected by changes in market conditions. Market risk is inherent in the financial instruments associated with our operations and activities including loans, deposits, securities, short-term borrowings, long-term debt, trading account assets and liabilities, and derivatives. Just a few of the market conditions that may shift from time to time, thereby exposing us to market risk, include fluctuations in interest and currency exchange rates, equity and futures prices, and price deterioration or changes in value due to changes in market perception or actual credit quality of issuers. Accordingly, depending on the instruments or activities impacted, market risks can have adverse effects on our results of operations and our overall financial condition.
The subprime mortgage market dislocation which occurred in prior years has impacted the ratings of certain monoline insurance providers which, in turn, has affected the pricing of certain municipal securities and the liquidity of the short term public finance markets. We have some exposure to monolines and, as a result, are continuing to monitor this exposure. Additionally, unfavorable economic or political conditions and changes in government policy could impact the operating budgets or credit ratings of U.S. states and U.S. municipalities and expose us to credit risk.
At December 31, 2015, we owned two pooled trust preferred securities which are classified as held-to-maturity within the investment securities portfolio. The par and carrying values of these securities were each $3.8 million at December 31, 2015. The collateral underlying these structured securities are instruments issued by financial institutions. We own the A-3 tranches in each issuance. Each of the bonds is rated by more than one rating agency. One security has a composite rating of AA and the other security has a composite rating of A. Observable trading activity remains limited for these types of securities. We have estimated the fair value of the securities through the use of internal calculations and through information provided by external pricing services. Given the level of subordination below the A-3 tranches, and the actual and expected performance of the underlying collateral, we expect to receive all contractual interest and principal payments recovering the amortized cost basis of each of the securities, and concluded that these securities are not other-than-temporarily impaired. However, if there are additional deferrals or defaults that impact the contractual cash flows within the tranches we own, we may be required to record an other-than-temporary impairment related to these securities, which could adversely affect our results of operations and financial condition.
Our concentration in commercial real estate and business loans may increase our future credit losses, which would negatively affect our financial results.
We offer a variety of secured loans, including commercial lines of credit, commercial term loans, real estate, construction, home equity, consumer and other loans. Approximately 87% of our loans are secured by real estate, both residential and commercial, substantially all of which are located in our market area. A major change in the region's real estate market, resulting in a further deterioration in real estate values, or in the local or national economy, including changes caused by raising interest rates, could adversely affect our customers' ability to pay these loans, which in turn could adversely impact us. Risk of loan defaults and foreclosures are inherent in the banking industry, and we try to limit our exposure to this risk by carefully underwriting and monitoring our extensions of credit. We cannot fully eliminate credit risk, and as a result credit losses may occur in the future.
Commercial real estate and business loans increase our exposure to credit risks.
At December 31, 2015, our portfolio of commercial and industrial and commercial real estate (including construction) totaled $2.5 billion, or 80% of total loans. We plan to continue to emphasize the origination of loans to small and medium-sized businesses as well as government contractors, professionals, such as physicians, accountants and attorneys, and commercial real estate developers and builders, which generally exposes us to a greater risk of nonpayment and loss than residential real estate loans because repayment of such loans often depends on the successful operations and cash flows of the borrowers. Additionally, such loans typically involve larger loan balances to single borrowers or groups of related borrowers compared to residential real estate loans. Also, many of our borrowers have more than one commercial loan outstanding. Consequently, an adverse development with respect to one loan or one credit relationship can expose us to a significantly greater risk of loss compared to an adverse development with respect to a residential real estate loan. In addition, these small to medium-sized businesses generally have fewer financial resources in terms of capital or borrowing capacity than larger entities. If general economic conditions negatively impact these businesses, our results of operations and financial condition may be adversely affected. This concentration also exposes us more to the market risks of real estate sales leasing and other activity in the areas we serve. An adverse change in local real estate conditions and markets could materially adversely affect the values of our loans and the real estate held as collateral for such loans, and materially affect our results of operations and financial condition.
Federal bank regulatory agencies have released guidance on "Concentrations in Commercial Real Estate Lending" (the "Guidance"). The Guidance defines commercial real estate ("CRE") loans as exposures secured by raw land, land development and construction (including 1-4 family residential construction), multi-family property, and non-farm nonresidential property where the primary or a significant source of repayment is derived from rental income associated with the property (that is, loans for which 50% or more of the source of repayment comes from third party, non-affiliated, rental income) or the proceeds of the sale, refinancing, or permanent financing of the property. The Guidance requires that appropriate processes be in place to identify, monitor and control risks associated with real estate lending concentrations. This could include enhanced strategic planning, CRE underwriting policies, risk management, internal controls, portfolio stress testing and risk exposure limits as well as appropriately designed compensation and incentive programs. Higher allowances for loan losses and capital levels may also be required. The Guidance is triggered when CRE loan concentrations exceed either:
• Total reported loans for construction, land development, and other land of 100% or more of a bank's total capital; or
• Total reported loans secured by multifamily and nonfarm nonresidential properties and loans for construction, land development, and other land of 300% or more of a bank's capital.
The Guidance applies to our CRE lending activities. Although our regulators have not required us to maintain elevated levels of capital or liquidity due to our CRE concentrations, the regulators may do so in the future, especially if there is a material downturn in our local real estate markets.
If our allowance for loan losses is not appropriate, our results of operations may be affected.
We maintain an allowance for loan losses that we believe is a reasonable estimate of known and inherent losses in our loan portfolio. Through a periodic review and analysis of the loan portfolio, management determines the appropriateness of the allowance for loan losses by considering such factors as general and industry-specific market conditions, credit quality of the loan portfolio, the collateral supporting the loans and financial performance of our loan customers relative to their financial obligations to us. The amount of future losses is impacted by changes in economic, operating and other conditions, including changes in interest rates, which may be beyond our control. Actual losses may exceed our current estimates. Rapidly growing loan portfolios are, by their nature, unseasoned. Estimating loan loss allowances for an unseasoned portfolio is more difficult than with seasoned portfolios, and may be more susceptible to changes in estimates and to losses exceeding estimates. Although we believe the allowance for loan losses is a reasonable estimate of known and inherent losses in our loan portfolio, we cannot fully predict such losses or assert that our loan loss allowance will be appropriate in the future. Future loan losses that are greater than current estimates could have a material impact on our future financial performance.
Banking regulators periodically review our allowance for loan losses and may require us to increase our allowance for loan losses or recognize additional loan charge-offs, based on credit judgments different than those of our management. Any increase in the amount of our allowance or loans charged-off as required by these regulatory agencies could have a negative effect on our operating results.
Our liquidity could be impaired by our inability to access the capital markets on favorable terms.
Liquidity is essential to our business. Under normal business conditions, primary sources of funding for our parent company may include dividends received from banking and nonbanking subsidiaries and proceeds from the issuance of equity capital in the capital markets. The primary sources of funding for our banking subsidiary include customer deposits and wholesale market-based funding. Our liquidity could be impaired by an inability to access the capital markets or by unforeseen outflows of cash, including deposits. This situation may arise due to circumstances that we may be unable to control, such as a general market disruption, negative views about the financial services industry generally, or an operational problem that affects third parties or us.
For further discussion on our liquidity position and other liquidity matters, including policies and procedures we use to manage our liquidity risks, see "Capital Resources" and "Liquidity" in Item 7 of this report.
Increases in FDIC insurance premiums may cause our earnings to decrease.
Since the financial crisis began several years ago, an increasing number of bank failures have imposed significant costs on the FDIC in resolving those failures, and the regulator's deposit insurance fund has been depleted. In order to maintain a strong funding position and restore reserve ratios of the deposit insurance fund, the FDIC has increased, and may increase in the future, assessment rates of insured institutions, including Cardinal Bank.
Deposits are insured by the FDIC, subject to limits and conditions or applicable law and the FDIC's regulations. Pursuant to the Financial Reform Act, FDIC insurance coverage limits were permanently increased to $250,000 per customer. The FDIC administers the deposit insurance fund, and all insured depository institutions are required to pay assessments to the FDIC that fund the DIF.
The Financial Reform Act changed the methodology for calculating deposit insurance assessments by changing the assessment base from the amount of an insured depository institution's domestic deposits to its total assets minus tangible equity. The new regulation implementing revisions to the assessment system mandated by the Financial Reform Act was effective April 1, 2011 and was reflected in the June 30, 2011 FDIC fund balance and the invoices for assessments due September 30, 2011. As a result of the new regulations, we expect higher annual deposit insurance assessments than we historically incurred before the financial crisis began several years ago. While the burden of replenishing the DIF will be placed primarily on institutions with assets of greater than $10 billion, any future increases in required deposit insurance premiums or other bank industry fees could have a significant adverse impact on our financial condition and results of operations.
The soundness of other financial institutions could adversely affect us.
Our ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial services institutions are interrelated as a result of trading, clearing, counterparty or other relationships. We have exposure to many different industries and counterparties, and we routinely execute transactions with counterparties in the financial industry. As a result, defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry generally, have led to market-wide liquidity problems and could lead to losses or defaults by us or by other institutions. Many of these transactions expose us to credit risk in the event of default of our counterparty or client. There is no assurance that any such losses would not materially and adversely affect our results of operations.
We rely heavily on our management team and the unexpected loss of any of those personnel could adversely affect our operations; we depend on our ability to attract and retain key personnel.
We are a customer-focused and relationship-driven organization. We expect our future growth to be driven in a large part by the relationships maintained with our customers by our Executive Chairman, Bernard H. Clineburg, and our other executive and senior lending officers. We have entered into employment agreements with Mr. Clineburg and several other executive officers. The existence of such agreements, however, does not necessarily assure us that we will be able to continue to retain their services. The unexpected loss of Mr. Clineburg or other key employees could have a significant adverse effect on our business and possibly result in reduced revenues and earnings. We maintain bank owned life insurance policies on all of our corporate executives, of which we are the beneficiary.
The implementation of our business strategy will also require us to continue to attract, hire, motivate and retain skilled personnel to develop new customer relationships, as well as develop new financial products and services. Many experienced banking professionals employed by our competitors are covered by agreements not to compete or solicit their existing customers if they were to leave their current employment. These agreements make the recruitment of these professionals more difficult. While we have been recently successful in acquiring what we consider to be talented banking professionals, the market for talented people is competitive and we may not continue to be successful in attracting, hiring, motivating or retaining experienced banking professionals.
Failure to maintain effective systems of internal and disclosure control could have a material adverse effect on our results of operation and financial condition.
Effective internal and disclosure controls are necessary for us to provide reliable financial reports and effectively prevent fraud, and to operate successfully as a public company. If we cannot provide reliable financial reports or prevent fraud, our reputation and operating results would be harmed. As part of our ongoing monitoring of internal control, we may discover material weaknesses or significant deficiencies in internal control that require remediation. A "material weakness" is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable
possibility that a material misstatement of a company's annual or interim financial statements will not be prevented or detected on a timely basis.
We have in the past discovered, and may in the future discover, areas of our internal controls that need improvement. Even so, we continue to work to improve our internal controls. We cannot be certain that these measures will ensure that we implement and maintain adequate controls over our financial processes and reporting in the future. Any failure to maintain effective controls or to timely implement any necessary improvement of our internal and disclosure controls could, among other things, result in losses from fraud or error, harm our reputation, or cause investors to lose confidence in the reported financial information, all of which could have a material adverse effect on our results of operations and financial condition.
We may incur losses if we are unable to successfully manage interest rate risk.
Our future profitability will substantially depend upon our ability to maintain or increase the spread between the interest rates earned on investments and loans and interest rates paid on deposits and other interest-bearing liabilities. Changes in interest rates will affect our operating performance and financial condition. The shape of the yield curve can also impact net interest income. Changing rates will impact how fast our mortgage loans and mortgage backed securities will have the principal repaid. Rate changes can also impact the behavior of our depositors, especially depositors in non-maturity deposits such as demand, interest checking, savings and money market accounts. While we attempt to minimize our exposure to interest rate risk, we are unable to eliminate it as it is an inherent part of our business. Our net interest spread will depend on many factors that are partly or entirely outside our control, including competition, federal economic, monetary and fiscal policies, and industry-specific conditions and economic conditions generally.
Our future success is dependent on our ability to compete effectively in the highly competitive banking and financial services industry.
We face vigorous competition from other commercial banks, savings and loan associations, savings banks, credit unions, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market funds and other types of financial institutions for deposits, loans and other financial services in our market area. A number of these banks and other financial institutions are significantly larger than we are and have substantially greater access to capital and other resources, as well as larger lending limits and branch systems, and offer a wider array of banking services. Many of our nonbank competitors are not subject to the same extensive regulations that govern us. As a result, these nonbank competitors have advantages over us in providing certain services. This competition may reduce or limit our margins and our market share and may adversely affect our results of operations and financial condition.
Changes in accounting standards could impact reported earnings.
The authorities that promulgate accounting standards, including the FASB, SEC, and other regulatory authorities, periodically change the financial accounting and reporting standards that govern the preparation of our consolidated financial statements. These changes are difficult to predict and can materially impact how we record and report our financial condition and results of operations. In some cases, we could be required to apply a new or revised standard retroactively, resulting in the restatement of financial statements for prior periods. Such changes could also require us to incur additional personnel or technology costs.
Our businesses and earnings are impacted by governmental, fiscal and monetary policy.
We are affected by domestic monetary policy. For example, the Federal Reserve Board regulates the supply of money and credit in the United States and its policies determine in large part our cost of funds for lending, investing and capital raising activities and the return we earn on those loans and investments, both of which affect our net interest margin. The actions of the Federal Reserve Board also can materially affect the value of financial instruments we hold, such as loans and debt securities, and its policies also can affect our borrowers, potentially increasing the risk that they may fail to repay their loans. Our businesses and earnings also are affected by the fiscal or other policies that are adopted by various regulatory authorities of the United States. Changes in fiscal or monetary policy are beyond our control and hard to predict.
Our information systems may experience an interruption or breach in security.
We rely heavily on communications and information systems to conduct our business. In addition, as part of our business, we collect, process and retain sensitive and confidential client and customer information. Our facilities and systems, and those of our third party service providers, may be vulnerable to security breaches, acts of vandalism, computer viruses, misplaced or lost data, programming and/or human errors, or other similar events. Any failure, interruption or breach in security of these systems could result in failures or disruptions in customer relationship management, general ledger, deposit, loan and other systems. While we have policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of our information systems, there can be no assurance that any such failures, interruptions or security breaches will not occur or, if they do occur, that they will be adequately addressed. The occurrence of any failures, interruptions or security breaches of our information systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our financial condition and results of operations.
The operational functions of business counterparties over which we may have limited or no control may experience disruptions that could adversely impact us.
Multiple major U.S. retailers have recently experienced data systems incursions reportedly resulting in the thefts of credit and debit card information, online account information, and other financial data of tens of millions of the retailers' customers. Retailer incursions affect cards issued and deposit accounts maintained by many banks, including our subsidiary Bank. Although our systems are not breached in retailer incursions, these events can cause us to reissue a significant number of cards and take other costly steps to avoid significant theft loss to the Bank and its customers. In some cases, the Bank may be required to reimburse customers for the losses they incur. Other possible points of intrusion or disruption not within our control include internet service providers, electronic mail portal providers, social media portals, distant-server ("cloud") service providers, electronic data security providers, telecommunications companies, and smart phone manufacturers.
Our profitability and the value of any equity investment in us may suffer because of rapid and unpredictable changes in the highly regulated environment in which we operate.
We are subject to extensive supervision by several governmental regulatory agencies at the federal and state levels. Recently enacted, proposed and future banking and other legislation and regulations have had, and will continue to have, or may have a significant impact on the financial services industry. These regulations, which are generally intended to protect depositors and not our shareholders, and the interpretation and application of them by federal and state regulators, are beyond our control, may change rapidly and unpredictably, and can be expected to influence our earnings and growth. Our success depends on our continued ability to maintain compliance with these regulations. Many of these
regulations increase our costs and thus place other financial institutions that may not be subject to similar regulation in stronger, more favorable competitive positions.
If we need additional capital in the future to continue our growth, we may not be able to obtain it on terms that are favorable. This could negatively affect our performance and the value of our common stock.
Our business strategy calls for continued growth. We anticipate that we will be able to support this growth through the generation of additional deposits at existing and new branch locations, as well as expanded loan and other investment opportunities. However, we may need to raise additional capital in the future to support our continued growth and to maintain desired capital levels. Our ability to raise capital through the sale of additional equity securities or the placement of financial instruments that qualify as regulatory capital will depend primarily upon our financial condition and the condition of financial markets at that time. We may not be able to obtain additional capital in the amounts or on terms satisfactory to us. Our growth may be constrained if we are unable to raise additional capital as needed.
We have extended off-balance sheet commitments to borrowers which expose us to credit and interest rate risk.
We enter into certain off-balance sheet arrangements in the normal course of business to meet the financing needs of our customers. These off-balance sheet arrangements include commitments to extend credit, standby letters of credit and guarantees which would impact our liquidity and capital resources to the extent customers accept or use these commitments. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheet. Our exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit and guarantees written is represented by the contractual or notional amount of those instruments. We use the same credit policies in making commitments and conditional obligations as we do for on-balance-sheet instruments.
We have operational risk that could impact our ability to provide services to our customers.
Third parties provide key components of our business operations 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 problem caused by these third parties, including poor performance of services failure to provide services, disruptions in communication services provided by a vendor and failure to handle current or higher volumes, could adversely affect our ability to deliver products and services to our customers and otherwise conduct our business, and may harm our reputation. Financial or operational difficulties of a third party vendor could also hurt our operations if those difficulties affect the vendor's ability to serve us. 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.
We may be parties to certain legal proceedings that may impact our earnings.
We face significant legal risks in our businesses, and the volume of claims and amount of damages and penalties claimed in litigation and regulatory proceedings against financial institutions remain high. Substantial legal liability or significant regulatory action against us could have material adverse financial impact or cause significant reputational risk to us, which in turn could seriously harm our business prospects.
Our ability to pay dividends is limited and we may be unable to pay future dividends.
Our ability to pay dividends is limited by banking laws and regulations and the need to maintain sufficient consolidated capital in the Company and in our subsidiaries. The ability of our bank subsidiary to pay dividends to us is limited by its obligations to maintain sufficient capital, earnings and liquidity and by other general restrictions on its dividends under federal and state bank regulatory requirements. In addition, as a bank holding company, our ability to declare and pay dividends is subject to the guidelines of the Federal Reserve regarding capital adequacy and dividends. The Federal Reserve guidelines generally require us to review the effects of the cash payment of dividends on common stock and other Tier 1 capital instruments (i.e., perpetual preferred stock and trust preferred debt) on our financial condition. These guidelines also require that we review our net income for the current and past four quarters, and the level of dividends on common stock and other Tier 1 capital instruments for those periods, as well as our projected rate or earnings retention. Under the Federal Reserve's policy, the board of directors of a bank holding company should also consider different factors to ensure that its dividend level is prudent relative to the organization's financial position and is not based on overly optimistic earnings scenarios such as any potential events that may occur before the payment date that could affect its ability to pay while still maintaining a strong financial position. As a general matter, the Federal Reserve has indicated that the board of directors of a bank holding company should consult with the Federal Reserve and eliminate, defer, or significantly reduce bank holding company's dividends if: (i) its net income available to shareholders for the past four quarters, net of dividends previously paid during that period, is not sufficient to fully fund the dividends; (ii) its prospective rate of earnings retention is not consistent with its capital needs and overall current and prospective financial condition; or (iii) it will not meet, or is in danger of not meeting, its minimum regulatory capital adequacy ratios. If we do not satisfy these regulatory requirements or the Federal Reserve's policies, we will be unable to pay dividends on our common stock.
Consumers may increasingly decide not to use the Bank to complete their financial transactions, which would have a material adverse impact on our financial condition and operations.
Technology and other changes are allowing parties to complete financial transactions through alternative methods that historically have involved banks. For example, consumers can now maintain funds that would have historically been held as bank deposits in brokerage accounts, mutual funds or general-purpose reloadable prepaid cards. Consumers can also complete transactions such as paying bills and/or transferring funds directly without the assistance of banks. The process of eliminating banks as intermediaries, known as "disintermediation," could result in the loss of fee income, as well as the loss of customer deposits and the related income generated from those deposits. The loss of these revenue streams and the lower cost of deposits as a source of funds 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. Properties
Cardinal Bank, excluding its George Mason subsidiary, conducts its business from 31 branch offices. Nine of these facilities are owned and 22 are leased. Leased branch banking facilities range in size from 457 square feet to 9,000 square feet. Our leases on these facilities expire at various dates through 2025, and all but three of our leases have renewal options. Seventeen of our branch banking locations have drive-up banking capabilities and all have ATMs.
Cardinal Wealth Services, Inc. conducts its business from one of Cardinal Bank's branch facilities.
George Mason conducts its business from 16 leased facilities which range in size from 4,079 square feet to 44,322 square feet. The leases have various expiration dates through 2019 and 10 of their 16 locations have renewal options.
Our headquarters facility in Tysons Corner, Virginia comprises 41,818 square feet of leased office space. This lease expires in January 2022 and has renewal options. In addition to housing various administrative functions-including accounting, data processing, compliance, treasury, marketing, deposit and loan operations-certain members of our commercial and industrial and commercial real estate lending functions and various other departments are located there.
We believe that all of our properties are maintained in good operating condition and are suitable and adequate for our operational needs.
Item 3.
Item 3. Legal Proceedings
In the ordinary course of our operations, we become party to various legal proceedings. Currently, we are not party to any material legal proceedings, and no such proceedings are, to management's knowledge, threatened against us.
Item 4.
Item 4. Mine Safety Disclosures
None.
PART II
Item 5.
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Market Price for Common Stock and Dividends. Our common stock is currently listed for quotation on the Nasdaq Global Select Market under the symbol "CFNL." As of March 4, 2016, our common stock was held by 628 shareholders of record. In addition, we estimate that there were 8,360 beneficial owners of our common stock who own their shares through brokers or banks.
The high and low sale prices per share for our common stock for each quarter of 2015 and 2014 as reported on the market at the time and dividends declared during those periods were as follows:
Dividend Policy. The board of directors intends to follow a policy of retaining any earnings necessary to operate our business in accordance with all regulatory policies while maximizing the long-term return for the Company's investors. Our future dividend policy is subject to the discretion of the board of directors and future dividend payments will depend upon a number of factors, including future earnings, alternative investment opportunities, financial condition, cash requirements, and general business conditions.
Our ability to distribute cash dividends will depend primarily on the ability of our subsidiaries to pay dividends to us. Cardinal Bank is subject to legal limitations on the amount of dividends it is permitted to pay. Furthermore, neither Cardinal Bank nor we may declare or pay a cash dividend on any of our capital stock if we are insolvent or if the payment of the dividend would render us insolvent or unable to pay our obligations as they become due in the ordinary course of business. For additional information on these limitations, see "Government Regulation and Supervision-Payment of Dividends" in Item 1 above.
Repurchases. On February 26, 2007, we publicly announced that the Board of Directors had adopted a program to repurchase up to 1,000,000 shares of our common stock. The timing and amount of repurchases, if any, will depend on market conditions, share price, trading volume, and other factors, and there is no assurance that we will purchase shares during any period. No termination date was set for the buyback program. Shares may be repurchased in the open market or through privately negotiated transactions.
Since the inception of the program, we have purchased 477,608 shares of our common stock at a total cost of $4.1 million. All of these shares have been cancelled and retired. No shares were repurchased during 2015.
Stock Performance Graph. The graph set forth below shows the cumulative shareholder return on the Company's Common Stock during the five-year period ended December 31, 2015, as compared with: (i) an overall stock market index, the NASDAQ Composite; and (ii) a published industry index, the SNL Bank Index. The stock performance graph assumes that $100 was invested on December 31, 2010 in our common stock and each of the comparable indices and that dividends were reinvested.
Total Return Performance
Item 6.
Item 6. Selected Financial Data
Selected Financial Data
(In thousands, except per share data)
(1)Tangible book value is calculated as total shareholders' equity, less goodwill and other intangible assets, divided by common shares outstanding.
(2)Net interest margin is calculated as net interest income divided by total average earning assets and reported on a tax equivalent basis at a rate of 35%.
(3)Efficiency ratio is calculated as total non-interest expense divided by the total of net interest income and non-interest income.
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
The following presents management's discussion and analysis of our consolidated financial condition at December 31, 2015 and 2014 and the results of our operations for the years ended December 31, 2015, 2014, and 2013. The discussion should be read in conjunction with the consolidated financial statements and related notes included in this report.
Caution About Forward-Looking Statements
We make certain forward-looking statements in this Form 10-K that are subject to risks and uncertainties. These forward-looking statements include statements regarding our profitability, liquidity, allowance for loan losses, interest rate sensitivity, market risk, growth strategy, and financial and other goals. The words "believes," "expects," "may," "will," "should," "projects," "contemplates," "anticipates," "forecasts," "intends," or other similar words or terms are intended to identify forward-looking statements.
These forward-looking statements are subject to significant uncertainties because they are based upon or are affected by factors including:
• the risks of changes in interest rates on levels, composition and costs of deposits, loan demand, and the values and liquidity of loan collateral, securities, and interest sensitive assets and liabilities;
• changes in assumptions underlying the establishment of reserves for possible loan losses, reserves for repurchases of mortgage loans sold and other estimates;
• changes in market conditions, specifically declines in the residential and commercial real estate market, volatility and disruption of the capital and credit markets, soundness of other financial institutions we do business with;
• decrease in the volume of loan originations at our mortgage banking subsidiary as a result of the cyclical nature of mortgage banking, changes in interest rates, economic conditions, decreased economic activity, and slowdowns in the housing market which would negatively impact the income recorded on the sales of loans held for sale.
• risks inherent in making loans such as repayment risks and fluctuating collateral values;
• declines in the prices of assets and market illiquidity may cause us to record an other-than-temporary impairment or other losses, specifically in our pooled trust preferred
securities portfolio resulting from increases in underlying issuers' defaulting or deferring payments;
• changes in operations within the wealth management services segment, its customer base and assets under management;
• changes in operations of George Mason Mortgage, LLC as a result of the activity in the residential real estate market and any associated impact on the fair value of goodwill in the future;
• legislative and regulatory changes, including the Financial Reform Act and implementation of the Volcker Rule, and other changes in banking, securities, and tax laws and regulations and their application by our regulators, and changes in scope and cost of FDIC insurance and other coverages;
• exposure to repurchase loans sold to investors for which borrowers failed to provide full and accurate information on or related to their loan application or for which appraisals have not been acceptable or when the loan was not underwritten in accordance with the loan program specified by the loan investor;
• the risks of mergers, acquisitions and divestitures, including, without limitation, the related time and costs of implementing such transactions, integrating operations as part of these transactions and possible failures to achieve expected gains, revenue growth and/or expense savings from such transactions;
• the ability to successfully manage our growth or implement our growth strategies as we implement new or change internal operating systems or if we are unable to identify attractive markets, locations or opportunities to expand in the future;
• the effects of future economic, business and market conditions;
• governmental monetary and fiscal policies;
• changes in accounting policies, rules and practices;
• maintaining cost controls and asset quality as we open or acquire new branches;
• maintaining capital levels adequate to support our growth;
• reliance on our management team, including our ability to attract and retain key personnel;
• competition with other banks and financial institutions, and companies outside of the banking industry, including those companies that have substantially greater access to capital and other resources;
• demand, development and acceptance of new products and services;
• problems with technology utilized by us;
• changing trends in customer profiles and behavior; and
• other factors described from time to time in our reports filed with the SEC.
Because of these uncertainties, our actual future results may be materially different from the results indicated by these forward-looking statements. In addition, our past results of operations do not necessarily indicate our future results.
In addition, this section should be read in conjunction with the description of our "Risk Factors" in Item 1A above.
Overview
We are a financial holding company formed in 1997 and headquartered in Fairfax County, Virginia. We were formed principally in response to opportunities resulting from the consolidation of several Virginia-based banks. These bank consolidations were typically accompanied by the dissolution of local boards of directors and relocation or termination of management and customer service professionals and a general deterioration of personalized customer service.
On January 16, 2014, we announced the completion of our acquisition of United Financial Banking Companies, Inc. ("UFBC"), the holding company of The Business Bank ("TBB"), pursuant to a previously announced definitive merger agreement. The merger of UFBC into Cardinal was effective January 16, 2014. Under the terms of the merger agreement, UFBC shareholders received $19.13 in cash and 1.154 shares of our common stock in exchange for each share of UFBC common stock they owned immediately prior to the merger. TBB, which was headquartered in Vienna, Virginia, merged into Cardinal Bank effective March 8, 2014.
We own Cardinal Bank (the "Bank"), a Virginia state-chartered community bank with 31 banking offices located in Northern Virginia and the greater Washington, D.C. metropolitan area. The Bank offers a wide range of traditional bank loan and deposit products and services to both our commercial and retail customers. Our commercial relationship managers focus on attracting small and medium sized businesses as well as government contractors, commercial real estate developers and builders and professionals, such as physicians, accountants and attorneys.
Additionally, we complement our core banking operations by offering a wide range of services through our various subsidiaries, including mortgage banking through George Mason Mortgage, LLC ("George Mason") and retail securities brokerage though Cardinal Wealth Services, Inc. ("CWS").
Prior to June 30, 2013, the Bank had a trust division, Cardinal Trust and Investment Services. This division merged its remaining operations as of June 30, 2013 into CWS. In addition, as of June 30, 2013, Wilson/Bennett Capital Management, Inc., formerly the Company's second nonbank subsidiary, merged its operations into CWS. During the second quarter of 2013, we exited the third party institutional custody and trustee component of our trust services division due to our limited opportunity to leverage this platform. As a result of our reorganization of the wealth management business segment, the remaining personal and commercial trust area of this business consolidated into CWS. Results for the year ended December 31, 2013 include six months of operations of these subsidiaries.
We had a second mortgage subsidiary, Cardinal First Mortgage, LLC ("Cardinal First") based in Fairfax, Virginia, but as of June 30, 2013, this subsidiary merged into George Mason to improve operational efficiency. Results for the year ended December 31, 2013 include six months of operations of these subsidiaries.
George Mason, based in Fairfax, Virginia, engages primarily in the origination and acquisition of residential mortgages for sale into the secondary market on a best efforts basis through 17 offices located throughout the metropolitan Washington region. George Mason does business in eight states, primarily Virginia and Maryland, and the District of Columbia. George Mason is one of the largest residential mortgage originators in the greater Washington, D.C. metropolitan area, generating originations of approximately $3.6 billion in 2015 and $3.0 billion in 2014. George Mason's primary sources of revenue include loan origination fees, net interest income earned on loans held for sale, and gains on sales of loans. At the time we enter into an interest rate lock arrangement with the borrower, we enter into a loan forward sale commitment with a third party. Our mortgage loans are then sold servicing released.
George Mason also offers a construction-to-permanent loan program. This program provides variable rate financing for customers to construct their residences. Once the home has been completed, the loan converts to fixed rate financing and is sold into the secondary market. These
construction-to-permanent loans generate fee income as well as net interest income for George Mason and are classified as loans held for sale.
The mortgage banking segment's business is both cyclical and seasonal. The cyclical nature of its business is influenced by, among other factors, the levels of and trends in mortgage interest rates, national and local economic conditions and consumer confidence in the economy. Historically, the mortgage banking segment has its lowest levels of quarterly loan closings during the first quarter of the year. However, the decrease in mortgage interest rates during the first quarter of 2015 increased refinancing activity for George Mason as it did for other mortgage banking entities, and contributed to our increased loan origination activity for the full 2015 year as compared to 2014.
Wilson/Bennett provided asset management services to certain of our customers. Wilson/Bennett's primary source of revenue was management fees earned on the assets it managed for its customers. These management fees were generally based upon the market value of managed and custodial assets. As part of our reorganization of the wealth management services business segment, we merged Wilson/Bennett operations into CWS as of June 30, 2013.
We formed a wholly-owned subsidiary, Cardinal Statutory Trust I, for the purpose of issuing $20.0 million of floating rate junior subordinated deferrable interest debentures ("trust preferred securities"). These trust preferred securities are due in 2034 and pay interest at a rate equal to LIBOR (London Interbank Offered Rate) plus 2.40%, which adjusts quarterly. These securities are redeemable at par. The interest rate on this debt was 2.91% at December 31, 2015. We have guaranteed payment of these securities. The $20.6 million payable by us to Cardinal Statutory Trust I is included in other borrowed funds in the consolidated statements of condition since Cardinal Statutory Trust I is an unconsolidated subsidiary as we are not the primary beneficiary of this entity. We utilized the proceeds from the issuance of the trust preferred securities to make a capital contribution into the Bank.
In connection with the UFBC acquisition, we acquired all of the voting and common shares of UFBC Capital Trust I (the "UFBC Trust"), which is a wholly-owned subsidiary established for the sole purpose of issuing $5.0 million of floating rate junior subordinated deferrable interest debentures. These trust preferred securities are due in 2035 and have an interest rate of LIBOR plus 2.10%, which adjusts quarterly. At December 31, 2015, the interest rate on trust preferred securities was 2.61%. The UFBC Trust is an unconsolidated subsidiary since we are not the primary beneficiary of this entity. The additional $155,000 that is payable by us to the UFBC Trust represents the unfunded capital investment in the UFBC Trust.
Net interest income is our primary source of revenue. We define revenue as net interest income plus non-interest income. As discussed further in the interest rate sensitivity section, we manage our balance sheet and interest rate risk exposure to maximize, and concurrently stabilize, net interest income. We do this by monitoring our liquidity position and the spread between the interest rates earned on interest-earning assets and the interest rates paid on interest-bearing liabilities. We attempt to minimize our exposure to interest rate risk, but are unable to eliminate it entirely. In addition to managing interest rate risk, we also analyze our loan portfolio for exposure to credit risk. Loan defaults and foreclosures are inherent risks in the banking industry, and we attempt to limit our exposure to these risks by carefully underwriting and then monitoring our extensions of credit. In addition to net interest income, non-interest income is an important source of revenue for us and includes, among other things, service charges on deposits and loans, investment fee income, gains and losses on sales of investment securities available-for-sale, and gains on sales of mortgage loans.
Net interest income and non-interest income represented the following percentages of total revenue, which is calculated as net interest income plus non-interest income, for the three years ended December 31, 2015:
Non-interest income represented a larger portion of our total revenue for 2015 relative to 2014 as a result of a significant increase in gains realized and unrealized on mortgage loans held for sale. In addition to an increase in originations in 2015 compared to 2014, we also experienced an increase in gain on sale margins of approximately 20 basis points which was result of implementing our mandatory delivery loan sale program during the last six months of 2015. For 2014, non-interest income was a larger portion of our total revenue base compared to 2013 as the rate compression we experienced on gain on sale margins for loans sold during 2013 subsided during 2014 as the interest rate environment was not as volatile during 2014 as compared to 2013.
2015 Economic Environment
The banking environment and the markets in which we conduct our businesses will continue to be strongly influenced by developments in the U.S. and global economies, as well as the continued implementation of rulemaking from recent financial reforms. The U.S. economy grew during 2015 for the seventh consecutive year. While economic growth struggled to reach 2% during 2015, the labor market continued to improve. Employment gains were generally steady as the national unemployment rate fell to 5.0% by year end. With steady employment gains and continued low oil prices, consumer spending increased at a strong pace for most of 2015 and residential construction gained momentum. Nationally, home prices continued to rise by more than 5% during 2015 as equity markets remained fairly unchanged. U.S. Treasury yields were unstable during 2015 but began to rise modestly over the year as a Federal Reserve rate increase was expected. At its final meeting in 2015, the Federal Open Market Committee raised its targeted Federal funds rate by 25 basis points, its first rate increase in over nine years.
Although global economic conditions remain unsettled, the metropolitan Washington, D.C. area, the region we operate in, continued to perform relatively well, compared to other regions. As we believe that our region has weathered the recession better than most over the past several years, a protracted low interest rate environment, and the burden of regulatory requirements enacted in response to the recent financial crisis made for a challenging 2015. The housing industry and unemployment indicators improved during 2015 compared to 2014, where the effect of federal sequestration and spending cuts dampened economic growth and employment in defense-related professional and business service sectors. Progress in the near future for employment and the housing industry is uncertain given the prospect for higher long-term interest rates. We continue to consider future economic events and their impact on our performance.
The unemployment rate in the Washington, D.C. metropolitan area decreased in tandem to the national unemployment rate to 3.8%, and commercial and residential real estate values held up well compared to other regions.
Our credit quality continues to remain strong despite the challenging economic environment. At December 31, 2015, we had nonaccrual loans totaling $451,000 and no loans contractually past due 90 days or more as to principal or interest and still accruing. We recorded annualized net recoveries of 0.07% of our average loans receivable for the year ended December 31, 2015. As a result of a decrease in mortgage interest rates during the first quarter of 2015, refinancing originations from our mortgage
banking segment increased significantly during 2015 to 31% of total originations for the full year 2015 compared to 21% of total originations for 2014.
Market illiquidity and concerns over credit risk continue to impact the ratings of our pooled trust preferred securities. We hold investments of $3.8 million in par value of pooled trust preferred securities, which are significantly below book value as of December 31, 2015 due to the lack of liquidity in the market, deferrals and defaults of issuers, and continued investor apprehension for investing in these types of investments.
We expect challenging economic and operating conditions and an evolving regulatory regime to continue for the foreseeable future. These conditions could continue to affect the markets in which we do business and could adversely impact our results for 2016. The degree of the impact is dependent upon the duration and severity of the aforementioned conditions and the nature of new banking regulations.
While our loan growth has continued to be strong, continued uncertainty and sluggish economic growth could adversely affect our loan portfolio, including causing increases in delinquencies and default rates, which would adversely impact our charge-offs and provision for loan losses. Deterioration in real estate values and household incomes may also result in higher credit losses for us. Also, in the ordinary course of business, we may be subject to a concentration of credit risk to a particular industry, counterparty, borrower or issuer. A deterioration in the financial condition or prospects of a particular industry or a failure or downgrade of, or default by, any particular entity or group of entities could negatively impact our businesses, perhaps materially. The systems by which we set limits and monitor the level of our credit exposure to individual entities and industries also may not function as we have anticipated.
Liquidity is essential to our business. The primary sources of funding for our Bank include customer deposits and wholesale funding. Our liquidity could be impaired by an inability to access the capital markets or by unforeseen outflows of cash, including deposits. This situation may arise due to circumstances that we may be unable to control, such as general market disruption, negative views about the financial services industry generally, or an operational problem that affects a third party or us. Our ability to borrow from other financial institutions on favorable terms or at all could be adversely affected by disruptions in the capital markets or other events. While we believe we have a healthy liquidity position, any of the above factors could materially impact our liquidity position in the future.
The U.S. government continues to enact legislation and develop various programs and initiatives designed to stabilize the financial services industry, stabilize the housing markets and stimulate the economy. The banking industry is awaiting many of the regulations resulting from the implementation of the Financial Reform Act. We remain unsure of the full impact this legislation will have on our business, operations or our financial condition.
Critical Accounting Policies
General
U.S. generally accepted accounting principles are complex and require management to apply significant judgment to various accounting, reporting, and disclosure matters. Management must use assumptions, judgments, and estimates when applying these principles where precise measurements are not possible or practical. These policies are critical because they are highly dependent upon subjective or complex judgments, assumptions and estimates. Changes in such judgments, assumptions and estimates may have a significant impact on the consolidated financial statements. Actual results, in fact, could differ from initial estimates.
The accounting policies we view as critical are those relating to judgments, assumptions and estimates regarding the determination of the allowance for loan losses, accounting for purchased credit-impaired loans, the fair value measurements of certain assets and liabilities, accounting for economic hedging activities, accounting for impairment testing of goodwill, accounting for the impairment of amortizing intangible assets and other long-lived assets, and the valuation of deferred tax assets.
Allowance for Loan Losses
We maintain the allowance for loan losses at a level that represents management's best estimate of known and inherent losses in our loan portfolio. Both the amount of the provision expense and the level of the allowance for loan losses are impacted by many factors, including general and industry-specific economic conditions, actual and expected credit losses, historical trends and specific conditions of individual borrowers. Unusual and infrequently occurring events, such as weather-related disasters, may impact our assessment of possible credit losses. As a part of its analysis, we use our historical losses, loss emergence experience and qualitative factors, such as levels of and trends in delinquencies, nonaccrual loans, charged-off loans, changes in volume and terms of loans, effects of changes in lending policy, experience and ability and depth of management, national and local economic trends and conditions and concentrations of credit, competition, and loan review results to support estimates.
The allowance for loan losses is based first on a segmentation of the loan portfolio by general loan type, or portfolio segments. For originated loans, certain portfolio segments are further disaggregated and evaluated collectively for impairment based on class segments, which are largely based on the type of collateral underlying each loan. For purposes of this analysis, we categorize loans into one of five categories: commercial and industrial, commercial real estate (including construction), home equity lines of credit, residential mortgages, and consumer loans. We also maintain an allowance for loan losses for acquired loans when: (i) for loans accounted for under ASC 310-30, there is deterioration in credit quality subsequent to acquisition, and (ii) for loans accounted for under ASC 310-20, the inherent losses in the loans exceed the remaining credit discount recorded at the time of acquisition.
During the fourth quarter of 2014, we transitioned to using its historical loss experience and trends in losses for each category which were then adjusted for portfolio trends and economical and environmental factors in determining the allowance for loan losses. The indicated loss factors resulting from this analysis are applied to each of the five categories of loans. Prior to the fourth quarter of 2014, the allowance model used the average loss rates of similar institutions based on its custom peer group as a baseline, which was adjusted for its particular loan portfolio characteristics and environmental factors. These changes did not have an impact to the overall allowance.
The allowance for loan losses consists of specific and general components. The specific component relates to loans that are determined to be impaired and, therefore, individually evaluated for impairment. We individually assigns loss factors to all loans that have been identified as having loss attributes, as indicated by deterioration in the financial condition of the borrower or a decline in underlying collateral value if the loan is collateral dependent. In certain cases, we apply, in accordance with regulatory guidelines, a 5% loss factor to all loans classified as special mention, a 15% loss factor to all loans classified as substandard and a 50% loss factor to all loans classified as doubtful. Loans classified as loss loans are fully reserved or charged-off. However, in most instances, we evaluate the impairment of certain loans on a loan by loan basis for those loans that are adversely risk rated. For these loans, we analyze the fair value of the collateral underlying the loan and considers estimated costs to sell the collateral on a discounted basis. If the net collateral value is less than the loan balance (including accrued interest and any unamortized premium or discount associated with the loan) we recognize an impairment and establish a specific reserve for the impaired loan. Because of the limited number of impaired loans within the portfolio, we are able to evaluate each impaired loan individually and therefore specific reserves for impaired loans are generally less than those recommended by the listed regulatory guidelines above.
The general component relates to groups of homogeneous loans not designated for a specific allowance and are collectively evaluated for impairment. The general component is based on historical loss experience adjusted for qualitative factors. To arrive at the general component, the loan portfolio is grouped by loan type. A weighted average historical loss rate is computed for each group of loans over the trailing seven year period. We selected a seven year evaluation period as a result of the limited historical loss experience we have incurred, even during the recent economic downturn. We also believe that a seven year time horizon represents a full economic cycle. The historical loss factors are updated at least annually, unless a more frequent review of such factors is warranted. In addition to the use of historical loss factors, a qualitative adjustment factor is applied. This qualitative adjustment factor, which may be favorable or unfavorable, represents management's judgment that inherent losses in a given group of loans are different from historical loss rates due to environmental factors unique to that specific group of loans. These factors may relate to growth rate factors within the particular loan group; whether the recent loss history for a particular group of loans differs from its historical loss rate; the amount of loans in a particular group that have recently been designated as impaired and that may be indicative of future trends for this group; reported or observed difficulties that other banks are having with loans in the particular group; changes in the experience, ability, and depth of lending personnel; changes in the nature and volume of the loan portfolio and in the terms of loans; and changes in the volume and severity of past due loans, nonaccrual loans, and adversely classified loans. The sum of the historical loss rate and the qualitative adjustment factor comprise the estimated annual loss rate. To adjust for inherent loss levels within the loan portfolio, a loss emergence factor is estimated based on an evaluation of the period of time it takes for a loan within each of our loan segments to deteriorate to the point an impairment loss is recorded within the allowance. The loss emergence factor is applied to the estimated annual loss rate to determine the expected annual loss amount.
Credit losses are an inherent part of our business and, although we believe the methodologies for determining the allowance for loan losses and the current level of the allowance are appropriate, it is possible that there may be unidentified losses in the portfolio at any particular time that may become evident at a future date pursuant to additional internal analysis or regulatory comment. Additional provisions for such losses, if necessary, would be recorded in the commercial banking or mortgage banking segments, as appropriate, and would negatively impact earnings.
Allowance for Loan Losses-Acquired Loans
Acquired loans accounted for under ASC 310-30
For our acquired loans, to the extent that we experience a deterioration in borrower credit quality resulting in a decrease in our expected cash flows subsequent to the acquisition of the loans, an allowance for loan losses would be established based on our estimate of future credit losses over the remaining life of the loans.
Acquired loans accounted for under ASC 310-20
Subsequent to the acquisition date, we establish our allowance for loan losses through a provision for loan losses based upon an evaluation process that is similar to our evaluation process used for originated loans. This evaluation, which includes a review of loans on which full collectability may not be reasonably assured, considers, among other factors, the estimated fair value of the underlying collateral, economic conditions, historical net loan loss experience, carrying value of the loans, which includes the remaining net purchase discount or premium, and other factors that warrant recognition in determining our allowance for loan losses.
Purchased Credit-Impaired Loans
Purchased credit-impaired (PCI) loans, which are the loans acquired in our acquisition of UFBC, are loans acquired at a discount (that is due, in part, to credit quality). These loans are initially recorded at fair value (as determined by the present value of expected future cash flows) with no allowance for loan losses. We account for interest income on all loans acquired at a discount (that is due, in part, to credit quality) based on the acquired loans' expected cash flows. The acquired loans may be aggregated and accounted for as a pool of loans if the loans being aggregated have common risk characteristics. A pool is accounted for as a single asset with a single composite interest rate and an aggregate expectation of cash flow. The difference between the undiscounted cash flows expected at acquisition and the investment in the loans, or the "accretable yield," is recognized as interest income utilizing the level-yield method over the life of each pool. Increases in expected cash flows subsequent to the acquisition are recognized prospectively through adjustment of the yield on the pool over its remaining life, while decreases in expected cash flows are recognized as impairment through a loss provision and an increase in the allowance for loan losses. Therefore, the allowance for loan losses on these impaired pools reflect only losses incurred after the acquisition (representing the present value of all cash flows that were expected at acquisition but currently are not expected to be received). At December 31, 2015, there was no reserve for impairment of PCI loans within our allowance for loan losses.
We periodically evaluate the remaining contractual required payments due and estimates of cash flows expected to be collected. These evaluations, performed quarterly, require the continued use of key assumptions and estimates, similar to the initial estimate of fair value. Changes in the contractual required payments due and estimated cash flows expected to be collected may result in changes in the accretable yield and non-accretable difference or reclassifications between accretable yield and the non-accretable difference. On an aggregate basis, if the acquired pools of PCI loans perform better than originally expected, we would expect to receive more future cash flows than originally modeled at the acquisition date. For the pools with better than expected cash flows, the forecasted increase would be recorded as an additional accretable yield that is recognized as a prospective increase to our interest income on loans.
Fair Value Measurements
We determine the fair values of financial instruments based on the fair value hierarchy, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value. Our investment securities available-for-sale are recorded at fair value using reliable and unbiased evaluations by an industry-wide valuation service. This service uses evaluated pricing models that vary based on asset class and include available trade, bid, and other market information. Generally, the methodology includes broker quotes, proprietary models, vast descriptive terms and conditions databases, as well as extensive quality control programs. For certain of our held-to-maturity investment securities where there is minimal observable trading activity, we use a discounted cash flow approach to estimate fair value based on internal calculations and compare our results to information provided by external pricing sources.
We also fair value our interest rate lock commitments and forward loan sales commitments. The fair value of our interest rate lock commitments considers the expected premium (discount) to par and we apply certain fallout rates for those rate lock commitments for which we do not close a mortgage loan. In addition, we calculate the effects of the changes in interest rates from the date of the commitment through loan origination, and then period end, using applicable published mortgage-backed investment security prices. The fair value of the forward sales contracts to investors considers the market price movement of the same type of security between the trade date and the balance sheet date. At loan closing, the fair value of the interest rate lock commitment is included in the cost basis of loans held for sale, which are carried at the lower of cost or fair value.
Accounting for Economic Hedging Activities
We record all derivative instruments on the statement of condition at their fair values. We do not enter into derivative transactions for speculative purposes. For derivatives designated as hedges, we contemporaneously document the hedging relationship, including the risk management objective and strategy for undertaking the hedge, how effectiveness will be assessed at inception and at each reporting period and the method for measuring ineffectiveness. We evaluate the effectiveness of these transactions at inception and on an ongoing basis. Ineffectiveness is recorded through earnings. For derivatives designated as cash flow hedges, the fair value adjustment is recorded as a component of other comprehensive income, except for the ineffective portion which is recorded in earnings. For derivatives designated as fair value hedges, the fair value adjustments for both the hedged item and the hedging instrument are recorded through the income statement with any difference considered the ineffective portion of the hedge.
We discontinue hedge accounting prospectively when it is determined that the derivative is no longer highly effective. In situations in which cash flow hedge accounting is discontinued, we continue to carry the derivative at its fair value on the statement of condition and recognize any subsequent changes in fair value in earnings over the term of the forecasted transaction. When hedge accounting is discontinued because it is probable that a forecasted transaction will not occur, we recognize immediately in earnings any gains and losses that were accumulated in other comprehensive income.
In the normal course of business, we enter into contractual commitments, including rate lock commitments, to finance residential mortgage loans. These commitments, which contain fixed expiration dates, offer the borrower an interest rate guarantee provided the loan meets underwriting guidelines and closes within the timeframe established by us. Interest rate risk arises on these commitments and subsequently closed loans if interest rates change between the time of the interest rate lock and the delivery of the loan to the investor. Loan commitments related to residential mortgage loans intended to be sold are considered derivatives and are marked to market through earnings.
To mitigate the effect of interest rate risk inherent in providing rate lock commitments, we economically hedge our commitments by entering into best efforts delivery forward loan sales contracts. During the rate lock commitment period, these forward loan sales contracts are marked to market through earnings and are not designated as accounting hedges. Exclusive of the fair value elements of the rate lock commitment related to servicing and the wholesale and retail rate spread, the changes in fair value related to movements in market rates of the rate lock commitments and the forward loan sales contracts generally move in opposite directions, and the net impact of changes in these valuations on net income during the loan commitment period is generally inconsequential. At the closing of the loan, the loan commitment derivative expires and we record a loan held for sale and continue to be obligated under the same forward loan sales contract. The forward sales contract is then designated as a hedge against the variability in cash to be received from the loan sale. Loans held for sale are accounted for at the lower of cost or fair value.
Accounting for Impairment Testing of Goodwill
We have adopted Accounting Standards Update 2011-08 ("ASU 2011-08"), Testing Goodwill for Impairment. This ASU permits an entity to make a qualitative assessment of whether it is more likely than not that a reporting unit's fair value is less than its carrying amount before applying the two-step goodwill impairment test. If an entity concludes it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, it need not perform the two-step impairment test. We perform our annual review of the goodwill during the third quarter.
In the event we are required to perform a Step 1 fair value evaluation of the reporting unit, we make estimates of the discounted cash flows from the expected future operations of the reporting unit. This discounted cash flow analysis involves the use of unobservable inputs including: estimated future
cash flows from operations; an estimate of a terminal value; a discount rate; and other inputs. Our estimated future cash flows are largely based on our historical actual cash flows. If the analysis indicates that the fair value of the reporting unit is less than its carrying value, we do an analysis to compare the implied fair value of the reporting unit's goodwill with the carrying amount of that goodwill. The implied fair value of the goodwill is determined by allocating the fair value of the reporting unit to all its assets and liabilities. If the implied fair value of the goodwill is less than the carrying value, an impairment loss is recognized.
Accounting for the Impairment of Amortizing Intangible Assets and Other Long-Lived Assets
We continually review our long-lived assets for impairment whenever events or changes in circumstances indicate that the remaining estimated useful life of such assets might warrant revision or that the balances may not be recoverable. We evaluate possible impairment by comparing estimated future cash flows, before interest expense and on an undiscounted basis, with the net book value of long-term assets, including amortizable intangible assets. If undiscounted cash flows are insufficient to recover assets, further analysis is performed in order to determine the amount of the impairment.
An impairment loss is recorded for the excess of the carrying amount of the assets over their fair values. Fair value is usually determined based on the present value of estimated expected future cash flows using a discount rate commensurate with the risks involved.
Valuation of Deferred Tax Assets
We record a provision for income tax expense based on the amounts of current taxes payable or refundable and the change in net deferred tax assets or liabilities during the year. Deferred tax assets and liabilities are recognized for the tax effects of differing carrying values of assets and liabilities for tax and financial statement purposes that will reverse in future periods. When substantial uncertainty exists concerning the recoverability of a deferred tax asset, the carrying value of the asset is reduced by a valuation allowance. The amount of any valuation allowance established is based upon an estimate of the deferred tax asset that is more likely than not to be recovered. Increases or decreases in the valuation allowance result in increases or decreases to the provision for income taxes.
New Financial Accounting Standards
The Financial Accounting Standards Board ("FASB") issued ASU No. 2014-04, Receivables-Troubled Debt Restructurings by Creditors (Subtopic 310-40): Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure ("ASU No. 2014-04"), which clarifies when an in-substance repossession or foreclosure occurs, and when a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan. An in-substance repossession or foreclosure occurs upon either the creditor obtaining legal title to the residential real estate property upon completion of a foreclosure, or 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, this ASU requires interim and annual disclosure of both the amount of foreclosed residential real estate property held by the creditor and 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. ASU No. 2014-04 is effective for annual and interim periods beginning after December 15, 2014. Our adoption of ASU No. 2014-04 did not have a significant impact on our consolidated financial statements.
The FASB issued ASU No. 2014-01, Investments-Equity Method and Joint Ventures (Topic 323): Accounting for Investments in Qualified Affordable Housing Projects ("ASU No. 2014-01"), which amends existing guidance to permit reporting entities to make an accounting policy election to account for their
investments in qualified affordable housing projects using the proportional amortization method if certain conditions are met. Under the proportional amortization method, an entity amortizes the initial cost of the investment in proportion to the tax credits and other tax benefits received and recognizes the net investment performance in the income statement as a component of income tax expense or benefit. For those investments in qualified affordable housing projects not accounted for using the proportional amortization method, the investment should be accounted for as an equity method investment or a cost method investment in accordance with Subtopic 970-323. ASU No. 2014-01 is effective for annual and interim reporting periods beginning after December 15, 2014. Our adoption of ASU No. 2014-01 did not have a significant impact on our consolidated financial statements.
The FASB issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606). This ASU provides a framework that replaces the existing revenue recognition guidance and is effective for annual periods and interim periods within that reporting period beginning after December 15, 2016, for public entities. We are currently assessing the impact of the adoption of this standard on our consolidated financial statements.
The FASB issued ASU No. 2014-11, Transfers and Servicing (Topic 860) Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures. This ASU changes the accounting for repurchase-to-maturity transactions to secured borrowing accounting. Additionally, for repurchase financing arrangements, the amendments of this ASU require separate accounting for a transfer of a financial asset executed contemporaneously with a repurchase agreement with the same counterparty, which will result in secured borrowing accounting for the repurchase agreement. The requirements are effective for public entities for the first interim or annual period beginning after December 15, 2014. The disclosure of certain transactions accounted for as a sale is required to be presented for interim and annual periods beginning after December 15, 2014, and the disclosure for repurchase agreements, securities lending transactions, and repurchase-to-maturity transactions accounted for as securities borrowings is required to be presented for annual periods beginning after December 15, 2014. Our adoption of ASU No. 2014-01 did not have a significant impact on our consolidated financial statements.
The FASB issued ASU No. 2014-17, Business Combinations (Topic 805): Pushdown Accounting. This ASU provides an acquired entity an option to apply pushdown accounting in its separate financial statements upon occurrence of an event in which an acquirer obtains control of the acquired entity. This ASU is effective for public business entities on November 18, 2014. There was no impact on our consolidated financial statements as a result of the adoption of this guidance.
Financial Overview
For the year ended December 31, 2015, we reported net income of $47.3 million on a consolidated basis. The commercial banking segment recorded net income of $39.2 million and our mortgage banking segment recorded net income of $9.2 million. The wealth management services business segment reported net income of $37,000 for the year ended December 31, 2015.
For the year ended December 31, 2014, we reported net income of $32.7 million on a consolidated basis. The commercial banking segment recorded net income of $34.4 million and our mortgage banking segment recorded a net loss of $2.7 million. The wealth management services business segment reported net income of $135,000 for the year ended December 31, 2014.
2015 Compared to 2014
At December 31, 2015, total assets were $4.03 billion, an increase of 18.6%, or $630.8 million, from $3.40 billion at December 31, 2014. Total loans receivable, net of deferred fees and costs, increased 18.4%, or $475.2 million, to $3.06 billion at December 31, 2015, from $2.58 billion at December 31, 2014. Total investment securities increased by $75.6 million, or 21.7%, to $423.8 million
at December 31, 2015, from $348.2 million at December 31, 2014. Total deposits increased 19.6%, or $497.4 million, to $3.03 billion at December 31, 2015, from $2.54 billion at December 31, 2014. Other borrowed funds, which primarily include customer repurchase agreements, federal funds sold and Federal Home Loan Bank ("FHLB") advances, increased $100.0 million to $538.0 million at December 31, 2015, from $438.0 million at December 31, 2014.
Shareholders' equity at December 31, 2015 was $413.1 million, an increase of $35.8 million from $377.3 million at December 31, 2014. The increase in shareholders' equity was attributable to the recognition of net income of $47.3 million less dividends paid to shareholders totaling $14.2 million for the year ended December 31, 2015. Changes in accumulated other comprehensive income decreased shareholders' equity $3.1 million during 2015. Accumulated other comprehensive income decreased for the year ended December 31, 2015 primarily as a result of the decrease in market value of our available-for-sale investment securities portfolio. Total shareholders' equity to total assets for December 31, 2015 and 2014 was 10.3% and 11.1%, respectively. Book value per share at December 31, 2015 and 2014 was $12.76 and $11.76, respectively. Total risk-based capital to risk-weighted assets was 11.37% at December 31, 2015 compared to 11.78% at December 31, 2014. Accordingly, we were considered "well capitalized" for regulatory purposes at December 31, 2015.
We recorded net income of $47.3 million, or $1.43 per diluted common share, for the year ended December 31, 2015, compared to net income of $32.7 million, or $1.00 per diluted common share, in 2014. Net interest income increased $8.7 million to $116.4 million for the year ended December 31, 2015, compared to $107.7 million for the year ended December 31, 2014, a result of increase in interest earning assets. Provision for loan losses was $1.4 million for the year ended December 31, 2015, compared to $1.9 million for 2014. Non-interest income increased $13.5 million to $52.7 million for the year ended December 31, 2015 as compared to $39.2 million for 2014 due primarily to an increase in realized and unrealized gains on mortgage banking activities from our mortgage banking business segment. Non-interest expense was $96.3 million for the year ended December 31, 2015 compared to $96.2 million for the year ended December 31, 2014. An increase in salaries and benefits expense during 2015 was offset by a decrease in merger and acquisition expense as we added to the sales and operational staffing areas of the Company over the past year as a result of our continued growth and increased regulatory environment in addition to an increase in the variable component of compensation expense.
The return on average assets for the years ended December 31, 2015 and 2014 was 1.29% and 1.02%, respectively. The return on average equity for the years ended December 31, 2015 and 2014 was 11.76% and 8.82%, respectively.
2014 Compared to 2013
At December 31, 2014, total assets were $3.40 billion, an increase of 17.5%, or $504.9 million, from $2.89 billion at December 31, 2013. Total loans receivable, net of deferred fees and costs, increased 26.5%, or $540.9 million, to $2.58 billion at December 31, 2014, from $2.04 billion at December 31, 2013. Total investment securities decreased by $11.5 million, or 3.2%, to $348.2 million at December 31, 2014, from $359.7 million at December 31, 2013. Total deposits increased 23.1%, or $476.5 million, to $2.54 billion at December 31, 2014, from $2.06 billion at December 31, 2013. Other borrowed funds decreased $37.2 million to $438.0 million at December 31, 2014, from $475.2 million at December 31, 2013.
Shareholders' equity at December 31, 2014 was $377.3 million, an increase of $56.8 million from $320.5 million at December 31, 2013. The increase in shareholders' equity was attributable to the recognition of net income of $32.7 million for the year ended December 31, 2014 and the shares issued as a result of our acquisition of UFBC. For each share of UFBC common stock outstanding, the shareholders of UFBC received a fixed exchange ratio of $19.13 in cash and 1.154 shares of our
common stock. We issued 1.6 million shares of our common stock and added $25.2 million in additional paid in capital for a total of $26.8 million in additional capital. Changes in accumulated other comprehensive income added $5.3 million in capital offset by dividends paid to common shareholders of $10.9 million during 2014. Accumulated other comprehensive income increased for the year ended December 31, 2014 primarily as a result of the increase in market value of our available-for-sale investment securities portfolio. Total shareholders' equity to total assets for each of December 31, 2014 and 2013 was 11.1%. Book value per share at December 31, 2014 and 2013 was $11.76 and $10.57, respectively. Total risk-based capital to risk-weighted assets was 11.78% at December 31, 2014 compared to 12.89% at December 31, 2013. Accordingly, we were considered "well capitalized" for regulatory purposes at December 31, 2014.
We recorded net income of $32.7 million, or $1.00 per diluted common share, for the year ended December 31, 2014, compared to net income of $25.5 million, or $0.82 per diluted common share, in 2013. Net interest income increased $15.4 million to $107.7 million for the year ended December 31, 2014, compared to $92.3 million for the year ended December 31, 2013, a result of increase in interest earning assets and strategically decreasing the rates we pay on our deposits. Provision for loan losses was $1.9 million for the year ended December 31, 2014, compared to a benefit of $32,000 for 2013. Non-interest income increased $9.3 million to $39.2 million for the year ended December 31, 2014 as compared to $29.9 million for 2013 due primarily to an increase in realized and unrealized gains on mortgage banking activities from our mortgage banking business segment. Non-interest expense was $96.2 million for the year ended December 31, 2014, an increase of $11.6 million, or 13.7%, compared to $84.6 million for the year ended December 31, 2013. The increase in non-interest expense was primarily related to increases in salaries and benefits expense, occupancy expense, and expenses attributable to our acquisition of UFBC.
The return on average assets for the years ended December 31, 2014 and 2013 was 1.02% and 0.92% , respectively. The return on average equity for the years ended December 31, 2014 and 2013 was 8.82% and 7.96%, respectively.
Efficiency Ratio
The efficiency ratio measures the costs expended to generate a dollar of revenue. It represents non-interest expense as a percentage of net interest income and non-interest income. The lower the percentage, the more efficient we are operating. We believe use of the efficiency ratio, which is a non-GAAP financial measure, provides additional clarity in assessing our operating results.
See the table below for the components of our calculation of our efficiency ratio as of December 31, 2015, 2014, and 2013. Our efficiency ratio decreased during 2015 as compared to 2014 because of a combined increase in net interest income and non-interest income, specifically income related to our mortgage banking business segment, while maintaining non-interest expense during 2015 at the same level as for 2014.
Efficiency Ratio Calculation
Years Ended December 31, 2015, 2014, and 2013
(In thousands, except per share data)
(1)Efficiency ratio is calculated as total non-interest expense divided by the total of net interest income and non-interest income
Statements of Income
Net Interest Income/Margin
Net interest income is our primary source of revenue, representing the difference between interest and fees earned on interest-earning assets and the interest paid on deposits and other interest-bearing liabilities. The level of net interest income is affected primarily by variations in the volume and mix of these assets and liabilities, as well as changes in interest rates. Interest rates have remained at historic lows for the last several years as the Federal Reserve has had an extremely accommodative policy. We expect this low interest rate environment to discontinue during 2016 as the Federal Reserve has begun to gradually increase the targeted federal funds rate with its first rate increase of 0.25% in nearly a decade in December 2015. See "Interest Rate Sensitivity" for further information.
Average Balance Sheets and Interest Rates on Interest-Earning Assets and Interest-Bearing Liabilities
Years Ended December 31, 2015, 2014, and 2013
(In thousands)
(1)Non-accrual loans are included in average balances and do not have a material effect on the average yield. Interest income on non-accruing loans was not material for the years presented.
(2)Interest income for loans receivable and investment securities available-for-sale is reported on a fully taxable-equivalent basis at a rate of 34% for 2015, 35% for 2014 and 32% for 2013.
Rate and Volume Analysis
Years Ended December 31, 2015, 2014, and 2013
(In thousands)
(1)Non-accrual loans are included in average balances and do not have a material effect on the average yield. Interest income on non-accruing loans was not material for the years presented.
(2)Interest income for loans receivable and investment securities available-for-sale is reported on a fully taxable-equivalent basis at a rate of 34% for 2015 and 33% for 2014.
(3)Changes attributable to rate/volume have been allocated to volume.
2015 Compared to 2014
Net interest income for the year ended December 31, 2015 was $116.4 million, compared to $107.7 million for the year ended December 31, 2014, an increase of $8.7 million, or 8.1%. The increase in net interest income was primarily a result of an increase in the volume of interest-earning assets during 2015 compared to 2014. The yield on interest-earning assets decreased 23 basis points to 4.06% for the year ended December 31, 2015 compared to 4.29% for the same period of 2014. To offset this decrease in yield, during the first quarter of 2015, we reduced our wholesale funding costs related to other borrowed funds by 30 basis points as we restructured a portion of our fixed rate FHLB advance portfolio. This restructuring reduced our FHLB advance funding costs from 3.33% to 2.80%.
Our net interest margin, on a tax equivalent basis, for the years ended December 31, 2015 and 2014 was 3.37% and 3.59%, respectively. The decrease in our net interest margin was primarily a result
of a decrease in the yields on our interest-earning assets partially offset by a slight decrease in the costs related to our interest-bearing liabilities during 2015. Net interest income, on a tax equivalent basis, is a financial measure that we believe provides a more accurate picture of the interest margin for comparative purposes. To derive our net interest margin on a tax equivalent basis, net interest income is adjusted to reflect tax-exempt income on an equivalent before tax basis with a corresponding increase in income tax expense. For purposes of this calculation, we use our federal statutory tax rates for the periods presented. This measure ensures comparability of net interest income arising from taxable and tax-exempt sources.
Average yields on interest-earning assets decreased to 4.06% in 2015 from 4.29% in 2014. Total average earning assets increased by 15.5% to $3.51 billion at December 31, 2015 compared to $3.04 billion at December 31, 2014 which resulted in an increase in total interest income on a tax equivalent basis of $12.1 million to $142.4 million for the year ended December 31, 2015 compared to $130.3 million 2014. The increase in our earning assets was primarily driven by an increase in average loans receivable of $397.3 million, which contributed to an additional $17.5 million in interest income on a tax equivalent basis for 2015. This increase in interest income was offset by a decrease in yields earned on the loan portfolio which decreased interest income $6.4 million on a tax equivalent basis. The increase in loans receivable during 2015 was attributable to organic growth. Average balances of nonperforming loans, which consist of nonaccrual loans, are included in the net interest margin calculation and did not have a material impact on our net interest margin in 2015 and 2014. Additional interest income of approximately $201,000 for 2015 and $866,000 for 2014 would have been realized had all nonperforming loans performed as originally expected. Nonperforming loans exclude those loans that are both past due 90 days or more and still accruing interest due to an assessment of collectibility.
As a result of the significant increase in loan origination activity that occurred at George Mason during 2015, average balances for loans held for sale increased $56.2 million to $344.5 million and resulted in an increase in interest income from loans held for sale of $1.1 million to $13.3 million for the year ended December 31, 2015 from $12.2 million for the year ended December 31, 201. The increase in outstanding balances in the loans held for sale portfolio during 2015 contributed to the increase in other borrowed funds as we use wholesale funding in the form of brokered certificates of deposits and FHLB advances to help fund this loan portfolio.
Total average interest-bearing deposits increased $361.7 million to $2.21 billion at December 31, 2015 compared to $1.85 billion at December 31, 2014. Average non-interest-bearing deposits increased $65.1 million to $619.0 million at December 31, 2015 compared to $553.9 million at December 31, 2014. The largest increase in average interest-bearing deposit balances was in our certificates of deposit, which increased $261.2 million compared to 2014. Average brokered certificates of deposit increased $120.9 million during 2015. This change in the mix of our interest-bearing liabilities increased our cost of interest-bearing deposits to 0.73% in 2015 from 0.66% in 2014. The cost of other borrowed funds, which generally are shorter term fundings used to help fund our balance sheet growth and support our loans held for sale portfolio, decreased 30 basis points to 2.00% in 2015 from 2.30% in 2014, a result of the aforementioned FHLB advance restructuring we completed during the first quarter of 2015. The cost of interest-bearing liabilities decreased 3 basis points to 0.92% in 2015 from 0.95% in 2014 as a result of the aforementioned changes in funding sources.
2014 Compared to 2013
Net interest income for the year ended December 31, 2014 was $107.7 million, compared to $92.3 million for the year ended December 31, 2013, an increase of $15.4 million, or 16.6%. The increase in net interest income was primarily a result of the interest-earning assets we acquired from UFBC in addition to the organic growth that occurred during 2014. We also continued to strategically decrease rates on our deposit products as a result of the low interest rate environment during 2014.
Our net interest margin, on a tax equivalent basis, for the years ended December 31, 2014 and 2013 was 3.59% and 3.52%, respectively. The increase in our net interest margin was primarily a result of a decrease in the yields on our interest-bearing liabilities offset partially by a slight decrease in the yields over our interest-earning assets.
Average yields on interest-earning assets decreased to 4.29% in 2014 from 4.33% in 2013. Total average earning assets increased by 14.4% to $3.04 billion at December 31, 2014 compared to $2.66 billion at December 31, 2013 which resulted in an increase in total interest income on a tax equivalent basis of $15.1 million to $130.3 million for the year ended December 31, 2014 compared to $115.2 million for the same period of 2013. The increase in our earnings assets was primarily driven by an increase in average loans receivable of $516.7 million, which contributed to an additional $23.3 million in interest income on a tax equivalent basis for 2014. This increase in interest income was offset by a decrease in yields earned on the loan portfolio which decreased interest income $5.2 million on a tax equivalent basis. The increase in loans receivable during 2014 was a combination of loans acquired of $238.3 million during the year with the remaining increase in loans attributable to organic growth. Average balances of nonperforming loans, which consist of nonaccrual loans, are included in the net interest margin calculation and did not have a material impact on our net interest margin in 2014 and 2013. Additional interest income of approximately $866,000 for 2014 and $626,000 for 2013 would have been realized had all nonperforming loans performed as originally expected.
As a result of the significant decrease in loan origination activity that occurred at George Mason during 2014, average balances for loans held for sale decreased $118.4 million to $288.3 million and resulted in a decrease in interest income from loans held for sale of $4.5 million to $12.2 million for the year ended December 31, 2014 from $16.7 million for the year ended December 31, 2013. As a result of the decrease in our loans held for sale portfolio, we invested the excess cash (which was earning 0.25% in federal funds sold) through purchases of $47.7 million in investment securities during 2014. The decrease in outstanding balances in the loans held for sale portfolio during 2014 contributed to the decrease in other borrowed funds.
Total average interest-bearing deposits increased $142.4 million to $1.85 billion at December 31, 2014 compared to $1.71 billion at December 31, 2013. Average non-interest-bearing deposits increased $139.8 million to $553.9 million at December 31, 2014 compared to $414.2 million at December 31, 2013. The largest increase in average interest-bearing deposit balances was in our interest checking, which increased $52.8 million compared to 2013. Average brokered certificates of deposit decreased $27.3 million during 2014. These changes in the mix of our interest-bearing liabilities assisted in us decreasing our cost of interest-bearing deposits to 0.66% in 2014 from 0.76% in 2013. The cost of other borrowed funds, decreased 68 basis points to 2.30% in 2014 from 2.98% in 2013, a result of our paying off certain FHLB advances at maturity as the loans held for sale portfolio decreased. The cost of interest-bearing liabilities decreased 14 basis points to 0.95% in 2014 from 1.09% in 2013 as a result of the aforementioned changes in funding sources.
Interest Rate Sensitivity
We are exposed to various business risks including interest rate risk. Our goal is to maximize net interest income without incurring excessive interest rate risk. Management of net interest income and interest rate risk must be consistent with the level of capital and liquidity that we maintain. We manage interest rate risk through an asset and liability committee ("ALCO"). ALCO is responsible for managing our interest rate risk in conjunction with liquidity and capital management.
We employ an independent consulting firm to model our interest rate sensitivity. We use a net interest income simulation model as our primary tool to measure interest rate sensitivity. Many assumptions are developed based on expected activity in the balance sheet. For maturing assets, assumptions are created for the redeployment of these assets. For maturing liabilities, assumptions are
developed for the replacement of these funding sources. Assumptions are also developed for assets and liabilities that could reprice during the modeled time period. These assumptions also cover how we expect rates to change on non-maturity deposits such as interest checking, money market checking, savings accounts as well as certificates of deposit. Based on inputs that include the current balance sheet, the current level of interest rates and the developed assumptions, the model then produces an expected level of net interest income assuming that market rates remain unchanged. This is considered the base case. Next, the model determines what net interest income would be based on specific changes in interest rates. The rate simulations are performed for a two year period and include ramped rate changes of down 100 basis points and up 200 basis points. The down 200 basis point scenario was discontinued given the current level of interest rates. In the ramped down rate change, the model moves rates gradually down 100 basis points over the first year and then rates remain flat in the second year.
For the up 200 basis point scenario, rates are gradually moved up 200 basis points in the first year and then rates remain flat in the second year. In both the up and down scenarios, the model assumes a parallel shift in the yield curve. The results of these simulations are then compared to the base case.
At December 31, 2015, our asset/liability position was slightly asset sensitive based on our interest rate sensitivity model. Our net interest income would decrease by less than 1.5% in a down 100 basis point scenario and would increase by less than 2.0% in an up 200 basis point scenario over a one-year time frame. In the two-year time horizon, our net interest income would decrease by less than 2.5% in a down 100 basis point scenario and would increase by less than 2.9% in an up 200 basis point scenario.
Provision Expense and Allowance for Loan Losses
Our policy is to maintain the allowance for loan losses at a level that represents our best estimate of known and inherent losses in the loan portfolio. Both the amount of the provision and the level of the allowance for loan losses are impacted by many factors, including general and industry-specific economic conditions, actual and expected credit losses, historical trends and specific conditions of individual borrowers.
We recorded a provision of $1.4 million for our loan loss provisioning for the year ended December 31, 2015 compared to $1.9 million for the year ended December 31, 2014. The allowance for loan losses at December 31, 2015 was $31.7 million compared to $28.3 million at December 31, 2014. Our allowance for loan loss ratio as a percent of total loans at December 31, 2015 was 1.04% compared to 1.10% at December 31, 2014. The decrease in the allowance for loan loss ratio is a result of improved credit quality during 2015.
During 2015 the credit quality in our loan portfolio remained strong, as we have experienced decreases in our nonperforming assets as compared to historical periods and net recoveries as we work out our problem credits. During 2014, our level of nonperforming assets increased as we acquired several impaired loans that were held within the UFBC loan portfolio. These impaired loans had been on nonaccrual status prior to the acquisition date or had demonstrated that there was with limited possibility for improvement and therefore we placed such loans on nonaccrual. The decrease in nonperforming loans at December 31, 2015 was a result of three nonperforming loans paying off in total and selling three nonperforming loan relationships. For the year ended December 31, 2015, we recorded charge-offs of $291,000 related to commercial, residential and consumer loans. Recoveries from previously charged-off loans totaled $2.4 million for the year ended December 31, 2015, most of which were related to commercial loans. Of the recoveries recorded, one was previously a troubled debt restructuring.
Annualized net loan recoveries was 0.07% of average loans receivable for the year ended December 31, 2015, compared to annualized net loan charge-offs of 0.06% of average loans receivable
for the year ended December 31, 2014. Nonaccrual loans (less interest and credit marks assigned to PCI loans) totaled $451,000 at December 31, 2015 compared to $3.4 million at December 31, 2014.
A sluggish job market and declining home values could adversely affect our home equity lines of credit, credit card and other loan portfolios, including causing increases in delinquencies and default rates, which could impact our charge-offs and provision for loan losses. Deterioration in commercial and residential real estate values, employment data and household incomes may also result in higher credit losses in our commercial loan portfolio. Also, in the ordinary course of business, we may also be subject to a concentration of credit risk to a particular industry, counterparty, borrower or issuer. At December 31, 2015, our commercial real estate portfolio (including construction lending) portfolio was 67.8% of our total loan portfolio. A deterioration in the financial condition or prospects of a particular industry or a failure or downgrade of, or default by, any particular entity or group of entities could negatively impact our business, perhaps materially, and the systems by which we set limits and monitor the level or our credit exposure to individual entities and industries, may not function as we have anticipated.
The provision for loan losses was a benefit of $32,000 for 2013. We recorded net recoveries for the year ended December 31, 2013 totaling $496,000.
See "Critical Accounting Policies" above for more information on our allowance for loan losses methodology.
The following tables present additional information pertaining to the activity in and allocation of the allowance for loan losses by loan type and the percentage of the loan type to the total loan portfolio.
Allowance for Loan Losses
Years Ended December 31, 2015, 2014, 2013, 2012, and 2011
(In thousands)
Allocation of the Allowance for Loan Losses
At December 31, 2015, 2014, 2013, 2012, and 2011
(In thousands)
*Percentage of loan type to the total loan portfolio.
Non-Interest Income
The following table provides detail for non-interest income for the years ended December 31, 2015, 2014, and 2013.
Non-Interest Income
Years Ended December 31, 2015, 2014, and 2013
(In thousands)
Non-interest income includes service charges on deposits and loans, realized and unrealized gains on mortgage banking activities, investment fee income, and gains on sales of investment securities available-for-sale, and continues to be an important factor in our operating results. Non-interest income for the years ended December 31, 2015 and 2014 was $52.7 million and $39.2 million, respectively.
The increase in non-interest income for the year ended December 31, 2015, compared to the same period of 2014, is primarily the result of an increase in realized and unrealized gains on mortgage banking activities from our mortgage banking segment. Realized and unrealized gains on mortgage banking activities increased $11.4 million to $43.5 million for the year ended December 31, 2015, compared to $32.1 million for 2014. For the year ended December 31, 2015, gains on sales of mortgage loans totaled $43.5 million, which was comprised of $39.7 million in realized gains and a $3.8 million increase in the fair value of rate lock commitments. For the year ended December 31, 2014, gains on sales of mortgage loans totaled $32.1 million, which was comprised of $28.7 million in realized gains and a $3.4 million increase in the fair value of rate lock commitments. In addition to the increase in origination activity, the increase in realized and unrealized gains on mortgage banking activities was impacted by an increase in gain on sale margins during 2015 as compared to 2014. For the year ended December 31, 2015, we closed $3.6 billion in mortgage originations compared to $3.0 billion in 2014. Refinance activity represented approximately 31% of the originations during 2015, an increase from 21% experienced during 2014.
In accordance with GAAP, if a lender enters into a mortgage loan commitment with a customer and intends to sell the mortgage loan after it is funded, the written loan commitment is to be accounted for as a derivative instrument and is to be recorded at fair value through earnings. George Mason enters into commitments where individual loans are "locked in" at a specified interest rate for a
fixed period. At the time of commitment, George Mason also enters into a "best efforts" forward contract with an investor to sell the loan at an agreed upon price if, and after, the loan is closed. This price represents the fair value of the "interest rate lock commitment" (IRLC) and is an unrealized gain that is included in earnings during the period of the IRLC. This gain is also recognized earlier in earnings than the expenses associated with originating, underwriting and closing the loan, which, under GAAP, are recognized and deferred by the Company at the time of loan sale to the investor. When the loan actually closes, the unrealized gain is added to the basis of the ensuing loan held for sale (LHFS). At any point in time (e.g. quarter end) the fair value of the existing IRLCs (not yet closed) and the premium to the basis of existing LHFS (loans closed but not yet purchased by investors) represent unrealized gains that have been recognized in income, either in the current period or prior periods. At the time the loan is sold to investors, the "investor buy price" is equal to the basis of the loan held for sale, and there is no gain or loss recognized. This accounting creates a mismatch between the income recognition on loan production and the expense recognition for those same loans. Direct costs associated with the loan origination, such as commissions and salaries, are recorded as a reduction to realized and unrealized gains on mortgage banking activities.
Maintaining our revenue stream in the mortgage banking segment is dependent upon our ability to originate loans and sell them to investors at or near current volumes. Over the last several years, we have increased our mortgage banking presence to include the Richmond and Virginia Beach areas of the Commonwealth of Virginia. However, loan production levels are sensitive to changes in the level of interest rates and changes in economic conditions. Loan production levels may also suffer if we experience a slowdown in the local housing market or tightening credit conditions. Any sustained period of decreased activity caused by less refinancing transactions, higher interest rates, housing price pressure or loan underwriting restrictions would adversely affect our mortgage originations and, consequently, could significantly reduce our income from mortgage banking activities. As a result, these conditions would also adversely affect our net income.
Investment fee income decreased $227,000 to $489,000 for the year ended December 31, 2015, compared to $716,000 for 2014. Investment fee income includes net commissions earned at CWS during 2015 and 2014.
Service charges on deposit accounts increased $124,000 to $2.3 million for the year ended December 31, 2015, compared to $2.2 million for the year ended December 31, 2014. Service charges on deposit accounts include insufficient funds fee income, service charges on deposit accounts, other fee income on deposit accounts and ATM transaction fees as shown in the table above. Loan fees totaled $1.6 million for the year ended December 31, 2015, a decrease of $399,000, compared to $2.0 million for the year ended December 31, 2014. The decrease in loan fee income is a result of a decrease in prepayment penalties during 2015 as compared to the same period of 2014.
For the year ended December 31, 2015, income from bank-owned life insurance was $433,000, a decrease of $50,000 when compared to the same period of 2014. The decrease is a result of the decrease in the earnings of the underlying investment assets of our bank-owned life insurance.
We recorded trading gains of $240,000 for the year ended December 31, 2015, compared to trading gains of $478,000 for the year ended December 31, 2014. We have purchased investments to economically hedge against fair value changes of our nonqualified deferred compensation plan liability. These investments are designated as trading securities, and as such, the changes in fair value are reflected in earnings. These trading gains were primarily the result of increased stock prices and were mostly offset by a compensation expense associated with this benefit plan.
For each of the years ended December 31, 2015 and 2014, we recorded gains on the sales of investment securities available-for-sale of $1.2 million.
During 2015, we recorded a litigation settlement of $3.0 million which also contributed to the increase in noninterest income for 2015.
Non-interest income for the years ended December 31, 2014 and 2013 was $39.2 million and $29.9 million, respectively. The increase in non-interest income for the year ended December 31, 2014, compared to the same period of 2013, is primarily the result of an increase in realized and unrealized gains on mortgage banking activities from our mortgage banking segment. Realized and unrealized gains on mortgage banking activities increased $10.4 million to $39.2 million for the year ended December 31, 2014, compared to $21.6 million for 2013. For the year ended December 31, 2014, gains on sales of mortgage loans totaled $32.1 million, which was comprised of $28.7 million in realized gains and a $3.4 million increase in the fair value of rate lock commitments. For the year ended December 31, 2013, gains on sales of mortgage loans totaled $21.6 million, which was comprised of $36.7 million in realized gains and a $15.1 million decrease in the fair value of rate lock commitments. For the year ended December 31, 2014, we closed $3.0 billion in mortgage originations compared to $5.8 billion in 2013. Refinance activity represented approximately 21% of the originations during 2014, a decrease from 33% experienced during 2013.
The increase in realized and unrealized gains on mortgage banking activities is a result of the increase in gain on sale margins we experienced during 2014 as compared to 2013. In addition, the change in the unrealized portion of our gains on loan sales was an increase of $3.4 million for the year ended December 31, 2014 compared to a decrease of $15.1 million for the year ended December 31, 2013.
Management fee income, which represented the income earned for services George Mason provided to other mortgage companies owned by local home builders and generally fluctuated based on the volume of loan sales, decreased to $21,000 during 2014 compared to $2.0 million in 2013. The decrease in management fee income is a result of the discontinuation of all of our remaining managed company relationships within the last year.
Investment fee income decreased $621,000 to $716,000 for the year ended December 31, 2014, compared to $1.3 million for 2013. Investment fee income includes net commissions earned at CWS during 2014 and for 2013, income earned at Wilson/Bennett and from our trust division prior to the completion of the aforementioned wealth management reorganization as of June 30, 2013.
Service charges on deposit accounts increased $178,000 to $2.2 million for the year ended December 31, 2014, compared to $2.0 million for the year ended December 31, 2013. Loan fees totaled $2.0 million for the year ended December 31, 2014, an increase of $548,000, compared to $1.4 million for the year ended December 31, 2013. Title insurance and other income totaled $0 for the year ended December 31, 2014, compared to $987,000 for the year ended December 31, 2013. The decrease in title insurance and other income is primarily a result of our closing George Mason's title company as new regulations impaired our ability to maintain a level of profitability within this subsidiary.
For the year ended December 31, 2014, income from bank-owned life insurance was $483,000, an decrease of $72,000 when compared to the same period of 2013. The increase is a result of the increase in the earnings of the underlying investment assets of our bank-owned life insurance.
We recorded trading gains of $478,000 for the year ended December 31, 2014, compared to trading gains of $68,000 for the year ended December 31, 2013.
For the year ended December 31, 2014, we recorded gains on the sales of investment securities available-for-sale of $1.2 million compared to none for the year ended December 31, 2013.
Non-Interest Expense
The following table reflects the components of non-interest expense for the years ended December 31, 2015, 2014 and 2013.
Non-Interest Expense
Years Ended December 31, 2015, 2014, and 2013
(In thousands)
Non-interest expense includes, among other things, salaries and benefits, occupancy costs, professional fees, depreciation, data processing, telecommunications and miscellaneous expenses. Non-interest expense was $96.3 million and $96.2 million for the years ended December 31, 2015 and 2014, respectively.
Salaries and benefits expense increased $5.8 million to $51.8 million for the year ended December 31, 2015 compared to $46.0 million for 2014. The increase in salaries and benefits expense is primarily related to increases in our business development personnel in our commercial banking and mortgage banking segments. We added commercial lenders at the Bank and increased back office staffing levels due to our increased regulatory environment. In addition, the variable component of our compensation expense increased during 2015 as a result of our 2015 performance.
Occupancy expense decreased $480,000 to $9.8 million for the year ended December 31, 2015 compared to $10.3 million for 2014. The decrease in occupancy expense during 2015 as compared to 2014 is primarily attributable to the closing of several branch office locations during 2014 and one in 2015. As a result of our UFBC acquisition, we had five branch offices that overlapped existing markets. Decreases in depreciation expense of $324,000, data processing and communications of $840,000, and merger and acquisitions expense of $5.3 million for the year ended December 31, 2015 as compared to the same period of 2014 can be attributed to the acquisition of UFBC during 2014 and the cost savings we received post acquisition.
Professional fees increased $1.5 million to $4.6 million for 2015 compared to $3.1 million for 2014. The increase in professional fees during 2015 as compared to 2014 is primarily attributable to an increase in legal fees as a result of litigation which was settled during the second quarter of 2015 and an increase in external audit and accounting fees from prior year's engagement.
Advertising and marketing expense decreased $906,000 to $4.2 million for the year ended December 31, 2015 as compared to $5.1 million for the same period of 2014. The decrease in marketing and advertising expense was a result of the branch expansion that occurred during 2014 as a result of branch acquisitions and de novo growth. No similar expansion occurred during 2015.
Mortgage loan repurchases and settlements for 2015 was $397,000 compared to $83,000 for the year ended December 31, 2014. The increase is primarily attributable to one settlement related to the previous financial crisis. Over the last few years, we have taken steps to limit our exposure to loan repurchases through agreements entered into with various investors. Given the steps that have been taken to limit our exposure coupled with the passage of time and the expiration of the statute of limitations for loans originated in certain prior years, our current expectation is that future putback claims will be limited in number. We evaluate the individual merits of each claim, and recognize an expense when settlement is deemed probable and the amount of such a settlement is estimable.
Non-interest expense was $96.2 million and $84.6 million for the years ended December 31, 2014 and 2013, respectively, an increase of $11.6 million, or 13.7%. The increase in non-interest expense for the year ended December 31, 2014, compared to 2013, was primarily the result of increases in salary and benefits costs, occupancy expense, and expenses related to the acquisition of UFBC during 2014.
Salaries and benefits expense increased $4.4 million to $46.0 million for the year ended December 31, 2014 compared to $41.5 million for 2013. The increase in salaries and benefits expense is primarily related to increases in our business development personnel in our commercial banking and mortgage banking segments. We added commercial lenders at the Bank and opened one de novo banking offices during 2014. In addition, the variable component of our compensation expense increased during 2014 as a result of our 2014 performance.
Occupancy expense increased $1.9 million to $10.3 million for the year ended December 31, 2014 compared to $8.4 million for 2013. The increase in occupancy expense during 2014 as compared to 2013 is primarily attributable to an increase in mortgage origination offices and acquired and de novo banking offices as we strategically increase our market share. Data processing and communications expense increased $1.7 million to $6.4 million for the year ended December 31, 2014 compared to $4.7 million, a result of the aforementioned increase in locations.
Professional fees decreased $643,000 to $3.1 million for 2014 compared to $3.8 million for 2013. The decrease in professional fees during 2014 as compared to 2013 is primarily attributable to a decrease in temporary staffing that was allocated to George Mason to handle the increase in loan origination volume during the 2013 refinance boom. The level of temporary staffing was maintained at George Mason until the beginning of the third quarter of 2013 when loan origination volume dropped significantly due to the current mortgage market conditions.
Advertising and marketing expense increased slightly by $376,000 to $5.1 million for the year ended December 31, 2014 as compared to $4.7 million for the same period of 2013. The increase in marketing and advertising expense was a result of the branch expansion that occurred during 2014 as a result of branch acquisitions and de novo growth.
Mortgage loan repurchases and settlements for 2014 was $83,000 compared to a benefit of $49,000 for the year ended December 31, 2013.
Merger and acquisition expense was $5.8 million for the year ended December 31, 2014 compared to $464,000 for the year ended December 31, 2013 as a result of our acquisition of United Financial Banking Companies, Inc. Merger and acquisition related expenses primarily include expenses related to staff reductions, branch office consolidations, contract termination payments and back office systems consolidations.
We recorded an other-than-temporary-impairment of $300,000 for the year ended December 31, 2013 as a result of the issuance of the Final Rules required by the Financial Reform Act which were released by federal banking agencies in late 2013. The impairment recorded brought the book value of these investments in line with their fair value as of December 31, 2013. As of December 31, 2015, we have recorded in full the impairment loss recorded in 2013.
Income Taxes
We recorded a provision for income tax expense of $24.1 million for the year ended December 31, 2015, compared to $16.0 million for the year ended December 31, 2014. Our effective tax rate for December 31, 2015 was 33.7%, compared to 32.9% for 2014. Our effective tax rate is less than the statutory rate because of income we receive on tax-exempt investments and tax credits we have related to low income housing investments.
We recorded a provision for income tax expense of $12.2 million for the year ended December 31, 2013. Our effective tax rate for December 31, 2013 was 32.3%. See also "Critical Accounting Policies-Valuation of Deferred Tax Assets".
Statements of Condition
Loans Receivable, Net
Total loans receivable, net of deferred fees and costs, were $3.06 billion at December 31, 2015, an increase of $475.2 million, or 18.4%, compared to $2.58 billion at December 31, 2014. Loans held for sale increased $68.4 million to $383.8 million at December 31, 2015 compared to $315.3 million at December 31, 2014. The increase in our inventory of loans held for sale during 2015 compared to 2014 is primarily due to the significant increase in loan origination and sales volume, a result of increases in loan originators during 2015 in addition to preferential market conditions during 2015.
At December 31, 2015, we had loans accounted for on a nonaccrual basis (less interest and credit marks for PCI loans) totaling $451,000. Nonaccrual loans at December 31, 2014 totaled $3.4 million. We had no accruing loans contractually past due 90 days or more as to principal or interest payments at December 31, 2015 and December 31, 2014. During 2015, our level of nonperforming loans decreased as a result of three nonperforming loans paying off in total and selling three nonperforming loan relationships. Loans that are classified as "troubled debt restructurings" at December 31, 2015 totaled $365,000 compared to $289,000 at December 31, 2014.
Interest income on nonaccrual loans, if recognized, is recorded when cash is received. When a loan is placed on nonaccrual, unpaid interest is reversed against interest income if it was accrued in the current year and is charged to the allowance for loan losses if it was accrued in prior years. While on nonaccrual, the collection of interest is recorded as interest income only after all past-due principal has been collected. When all past contractual obligations are collected and, in our opinion, the borrower has demonstrated the ability to remain current, the loan is returned to an accruing status. At December 31, 2015, the loans on nonaccrual status did not have a valuation allowance. Gross interest income that would have been recorded if our nonaccrual loans had been current with their original terms and had been outstanding throughout the period or since origination if held for part of the period for the years ended December 31, 2015 and 2014 was $201,000 and $8666,000, respectively. The interest income realized prior to loans being placed on nonaccrual status for the year ended December 31, 2015 and 2014 was $6,000 and $80,000, respectively.
Total loans receivable, net of deferred fees and costs, were $2.58 billion at December 31, 2014, an increase of $540.9 million, or 26.5%, compared to $2.04 billion at December 31, 2013. Loans held for sale decreased $58.7 million to $315.3 million at December 31, 2014 compared to $374.0 million at December 31, 2013. The decrease in our inventory of loans held for sale during 2014 compared to 2013
is primarily due to the significant decrease in loan origination and sales volume, as mortgage rates have increased as a result of market concerns over the ending of quantitative easing by the Federal Reserve, which had kept interest rate at historic lows.
At December 31, 2014, we had loans accounted for on a nonaccrual basis totaling $3.4 million (less interest and credit marks for PCI loans). Nonaccrual loans at December 31, 2013 totaled $2.3 million. We had no accruing loans contractually past due 90 days or more as to principal or interest payments at December 31, 2014 and December 31, 2013. During 2014, our level of nonperforming loans increased as we acquired several impaired loans that were held within the UFBC loan portfolio. These impaired loans had been on nonaccrual status prior to the acquisition date or had demonstrated that there was limited possibility for improvement and therefore we placed such loans on nonaccrual during 2014. Loans that are classified as "troubled debt restructurings" at December 31, 2014 totaled $289,000 compared to $2.3 million at December 31, 2012.
The ratio of nonperforming loans to total loans was 0.02%, 0.17%, and 0.11% at December 31, 2015, 2014 and 2013, respectively.
The following tables present the composition of our loans receivable portfolio at the end of each of the five years ended December 31, 2015 and additional information on nonperforming loans receivable.
Loans Receivable
At December 31, 2015, 2014, 2013, 2012, and 2011
(In thousands)
Nonperforming Loans
At December 31, 2015, 2014, 2013, 2012, and 2011
(In thousands)
The following table presents information on loan maturities and interest rate sensitivity.
Loan Maturities and Interest Rate Sensitivity
At December 31, 2015
(Dollars in thousands)
*Payments due by period are based on the repricing characteristics and not contractual maturities.
Investment Securities
Our investment securities portfolio is used as a source of income and liquidity. The investment portfolio consists of investment securities available-for-sale, investment securities held-to-maturity and trading securities. Investment securities available-for-sale are those securities that we intend to hold for an indefinite period of time, but not necessarily until maturity. These securities are carried at fair value and may be sold as part of an asset/liability strategy, liquidity management or regulatory capital management. Investment securities held-to-maturity are those securities that we have the intent and ability to hold to maturity and are carried at amortized cost. Investment securities-trading are securities we purchase to economically hedge against fair value changes of our nonqualified deferred compensation plan liability. These securities include cash equivalents, equities and mutual funds. Investment securities were $423.8 million at December 31, 2015, an increase of $75.6 million or 21.7%, from $348.2 million at December 31, 2014. We purchased $144.0 million in investment securities during 2015 as a result of an excess cash position we had at the Bank and to help enhance our net interest margin by investing in higher yielding earning assets.
Of the $423.8 million in the investment portfolio at December 31, 2015, $3.8 million were classified as held-to-maturity, $414.1 million were classified as available-for-sale, and $5.9 million were
classified as trading securities. At December 31, 2015, the yield on the available-for-sale investment portfolio was 3.20% and the yield on the held-to-maturity portfolio was 1.19%.
We complete reviews for other-than-temporary impairment at least quarterly. As of December 31, 2015, the majority of the investment securities portfolio consisted of securities rated AAA by a leading rating agency. Investment securities which carry a AAA rating are judged to be of the best quality and carry the smallest degree of investment risk. At December 31, 2015, 99% of our mortgage-backed securities are guaranteed by the Federal National Mortgage Association (FNMA), the Federal Home Loan Mortgage Corporation (FHLMC) and the Government National Mortgage Association (GNMA).
We have $947,000 in non-government non-agency mortgage-backed securities in our available-for-sale portfolio. The various protective elements on the non agency securities may change in the future if market conditions or the financial stability of credit insurers changes, which could impact the ratings of these securities.
At December 31, 2015, certain of our investment grade securities were in an unrealized loss position. Investment securities with unrealized losses are a result of pricing changes due to recent and negative conditions in the current market environment and not as a result of permanent credit impairment. Contractual cash flows for the agency mortgage-backed securities are guaranteed and/or funded by the U.S. government. Other mortgage-backed securities and municipal securities have third party protective elements and there are no negative indications that the contractual cash flows will not be received when due. We do not intend to sell nor do we believe we will be required to sell any of our temporarily impaired securities prior to the recovery of the amortized cost.
At December 31, 2015, we owned two pooled trust preferred securities classified as held-to-maturity. The par and carrying values of these securities were each $3.8 million at December 31, 2015. The collateral underlying these structured securities are instruments issued by financial institutions. We own the A-3 tranches in each issuance. Each of the bonds is rated by more than one rating agency. One security has a composite rating of AA and the other security has a composite rating of A. Observable trading activity remains limited for these types of securities. We have estimated the fair value of the securities through the use of internal calculations and through information provided by external pricing services. Given the level of subordination below the A-3 tranches, and the actual and expected performance of the underlying collateral, we expect to receive all contractual interest and principal payments recovering the amortized cost basis of each of the securities, and concluded that these securities are not other-than-temporarily impaired. We continuously monitor the financial condition of the underlying issues and the level of subordination below the A-3 tranches. We also utilize a multi-scenario model which assumes varying levels of additional defaults and deferrals and the effects of such adverse developments on the contractual cash flows for the A-3 tranches. In each of the adverse scenarios, there was no indication of a break to the A-3 contractual cash flows.
No other-than-temporary impairment has been recognized for the securities in our investment portfolio as of December 31, 2015 and 2014.
We hold $18.1 million in FHLB stock at December 31, 2015 which is included in other investments on the statement of condition.
Investment securities were $348.2 million at December 31, 2014, a decrease of $11.5 million or 3.2%, from $359.7 million at December 31, 2013. We purchased $48.0 million in investment securities during 2014 as a result of an excess cash position we had at the Bank due to the decrease in our loans held for sale portfolio.
Of the $348.2 million in the investment portfolio at December 31, 2014, $4.0 million were classified as held-to-maturity, $339.1 million were classified as available-for-sale, and $5.1 million were classified as trading securities. At December 31, 2014, the yield on the available-for-sale investment portfolio was 3.44% and the yield on the held-to-maturity portfolio was 1.13%.
The following table reflects the composition of the investment portfolio at December 31, 2015, 2014, and 2013.
Investment Securities
At December 31, 2015, 2014, and 2013
(In thousands)
Deposits and Other Borrowed Funds
Total deposits were $3.03 billion at December 31, 2015, an increase of $497.4 million, or 19.6%, from $2.54 billion at December 31, 2014. The increase in total deposits during 2015 as compared to 2014 was primarily due to our deposit gathering efforts and in increase in wholesale deposit fundings during 2015. We have had success in attracting deposit balances from customers seeking to deposit their money with smaller, local banks and depositors are increasing balances held with financial institutions as a result of the increased protection of their money by the FDIC.
We use short term brokered CDs to assist us in funding our loans held for sale portfolio. Brokered certificates of deposit increased to $407.0 million at December 31, 2015, of which $67.0 million were placed in the CDARS program. We are a member of the Certificates of Deposit Account Registry Service ("CDARS"). CDARS allows banking customers to access FDIC insurance protection on multi-million dollar certificates of deposit. When a customer places a large deposit through CDARS, funds are placed into certificates of deposit with other banks in the CDARS network in increments of less than $250,000 so that principal and interest are eligible for FDIC insurance protection. Brokered certificates of deposit at December 31, 2014 were $310.4 million, of which $32.3 million were in the CDARS program.
Other borrowed funds, which primarily include federal funds purchased, customer repurchase agreements, FHLB advances and our payable to Cardinal Statutory Trust I, were $538.0 million at December 31, 2015, an increase of $100.0 million, from $438.0 million at December 31, 2014. The primary reason for the increase in other borrowed funds at December 31, 2015 was due to an increase in advances from the Federal Home Loan Bank of Atlanta of $115.0 million to $355.0 million at December 31, 2015 compared to $240.0 million at December 31, 2013. These advances were primarily used to assist in funding loans receivable originations at the Bank during 2015.
Other borrowed funds at each of December 31, 2015 and 2014, included $20.6 million payable to Cardinal Statutory Trust I, the issuer of our trust preferred securities. This debt had an interest rate of 2.91% and 2.64% at December 31, 2015 and 2014, respectively. Cardinal Statutory Trust I is an unconsolidated entity as we are not the primary beneficiary of the trust.
In connection with the UFBC acquisition, we acquired all of the voting and common shares of UFBC Capital Trust I (the "UFBC Trust"), which is a wholly-owned subsidiary established for the sole purpose of issuing $5.0 million of floating rate junior subordinated deferrable interest debentures. These trust preferred securities are due in 2035 and have an interest rate of LIBOR plus 2.10%, which adjusts quarterly. At December 31, 2015 and 2014, the interest rate on trust preferred securities was 2.61% and 2.34%, respectively. The UFBC Trust is an unconsolidated subsidiary since we are not the primary beneficiary of this entity.
At December 31, 2015, other borrowed funds also included $113.6 million in customer repurchase agreements compared to $103.7 million at December 31, 2014. Federal funds purchased at December 31, 2015 was $45.0 million compared to $70.0 million at December 31, 2014.
The following table reflects the short-term borrowings and other borrowed funds outstanding at December 31, 2015.
Short-Term Borrowings and Other Borrowed Funds
At December 31, 2015
(In thousands)
Total deposits were $2.54 billion at December 31, 2014, an increase of $476.5 million, or 23.1%, from $2.06 billion at December 31, 2013. The increase in total deposits during 2014 as compared to 2013 was primarily due the deposits we acquired in our acquisition of UFBC of $295.2 million, and $64.6 million in deposits from a branch office acquisition in Gainesville, Virginia, in addition to organic growth that occurred during the year. We have had success in attracting deposit balances from customers seeking to deposit their money with smaller, local banks and depositors are increasing balances held with financial institutions as a result of the increased protection of their money by the FDIC.
Brokered certificates of deposit increased to $310.4 million at December 31, 2014, of which $32.3 million were placed in the CDARS program. Brokered certificates of deposit at December 31, 2013 were $301.2 million, of which $72.7 million were in the CDARS program.
Other borrowed funds, which primarily include federal funds purchased, customer repurchase agreements, FHLB advances and our payable to Cardinal Statutory Trust I, were $438.0 million at December 31, 2014, a decrease of $37.2 million, from $475.2 million at December 31, 2013. The primary reason for the decrease in other borrowed funds at December 31, 2014 was due to a decrease in advances from the Federal Home Loan Bank of Atlanta of $75 million to $240.0 million at December 31, 2014 compared to $315.0 million at December 31, 2012. These advances were primarily used to assist in funding loans receivable originations at the Bank during 2013.
Other borrowed funds at each of December 31, 2014 and 2013, included $20.6 million payable to Cardinal Statutory Trust I, the issuer of our trust preferred securities. This debt had an interest rate of 2.64% at each of December 31, 2014 and 2013. Cardinal Statutory Trust I is an unconsolidated entity as we are not the primary beneficiary of the trust.
At December 31, 2014, other borrowed funds also included $103.7 million in customer repurchase agreements compared to $94.6 million at December 31, 2013. Federal funds purchased at December 31, 2014 was $70.0 million compared to $45.0 million at December 31, 2013.
Certificates of Deposit that Meet or Exceed FDIC Insurance Limit
At December 31, 2015, 2014, and 2013
(In thousands)
*No-Penalty certificates of deposit can be redeemed at anytime at the request of the depositor.
Business Segment Operations
We provide banking and non-banking financial services and products through our subsidiaries. We operate in three business segments, commercial banking, mortgage banking and wealth management services. As of June 30, 2013, we merged operations of our trust division and Wilson/Bennett into CWS, both of which had been included in the wealth management services segment. In addition, as of June 30, 2013, we merged operations of Cardinal First Mortgage, LLC, and merged this subsidiary into George Mason. Results for the year ended December 31, 2013 include six months of operations of these subsidiaries prior to their closure.
The commercial banking segment includes both commercial and consumer lending and provides customers such products as commercial loans, real estate loans, and other business financing and consumer loans. In addition, this segment also provides customers with various deposit products including demand deposit accounts, savings accounts and certificates of deposit.
The mortgage banking segment engages primarily in the origination and acquisition of residential mortgages for sale into the secondary market on a best efforts basis.
The wealth management services segment provides investment and financial services to businesses and individuals, including financial planning, retirement/estate planning, investment management.
Information about the reportable segments, and reconciliation of this information to the consolidated financial statements at December 31, 2015, 2014 and 2013 follows.
Segment Reporting
December 31, 2015, 2014, and 2013
(In thousands)
At and for the Year Ended December 31, 2015:
At and for the Year Ended December 31, 2014:
At and for the Year Ended December 31, 2013:
Capital Resources
Capital adequacy is an important measure of financial stability and performance. Our objectives are to maintain a level of capitalization that is sufficient to sustain asset growth and promote depositor and investor confidence.
Regulatory agencies measure capital adequacy utilizing a formula that takes into account the individual risk profile of a financial institution. The guidelines define capital as both Tier 1 (which includes common shareholders' equity, defined to include certain debt obligations) and Tier 2 (to include certain other debt obligations and a portion of the allowance for loan losses and 45% of unrealized gains in equity securities).
On January 1, 2015, the new Basel III regulatory risk-based capital rules became effective. Basel III includes new minimum risk-based capital and leverage ratios and refines the definition of what constitutes "capital" for purposes of calculating these ratios. The new minimum capital requirements are: (i) a new common equity Tier 1 ("CET1") capital ratio of 4.5%; (ii) a Tier 1 to risk-based assets capital ratio of 6%, which is increased from 4%; (iii) a total capital ratio of 8%, which is unchanged from the current rules; and (iv) a Tier 1 leverage ratio of 4%.
This new regulatory standard also provides for a number of new deductions from and adjustments to CET1. These include, for example, the requirement that mortgage servicing assets, deferred tax assets related to temporary differences that could not be realized through net operating loss carrybacks, and significant investments in non-consolidated financial entities be deducted from CET1 to the extent that any one such category exceeds 10% of CET1 or all such categories in the aggregate exceed 15% of CET1.
Basel III prescribes a standardized approach for risk weightings that expand the risk-weighting categories from the current four Basel I-derived categories (0%, 20%, 50% and 100%) to a much larger and more risk-sensitive number of categories, depending on the nature of the assets, generally ranging from 0% for U.S. government and agency securities, to 600% for certain equity exposures, and resulting in higher risk weights for a variety of asset categories.
Shareholders' equity at December 31, 2015 was $413.1 million, an increase of $35.8 million, compared to $377.3 million at December 31, 2014. The increase in shareholders' equity was attributable to the recognition of net income of $47.3 million less dividends paid to shareholders of $14.2 million for the year ended December 31, 2015. Changes in accumulated other comprehensive income decreased $3.1 million during 2015. Total shareholders' equity to total assets for each of December 31, 2015 and 2014 was 10.3% and 11.1%, respectively. Book value per share at December 31, 2015 and 2014 was $12.76 and $11.76, respectively. Total risk-based capital to risk-weighted assets was 11.37% at December 31, 2015 compared to 11.78% at December 31, 2014 (which was calculated under the previous regulatory capital rules). Accordingly, we were considered "well capitalized" for regulatory purposes at December 31, 2015.
Shareholders' equity at December 31, 2014 was $377.3 million, an increase of $56.8 million, compared to $320.5 million at December 31, 2013. The increase in shareholders' equity was attributable to the recognition of net income of $32.7 million for the year ended December 31, 2014 and the shares issued as a result of our acquisition of UFBC. For each share of UFBC common stock outstanding, the shareholders of UFBC received a fixed exchange ratio of $19.13 in cash and 1.154 shares of our common stock. We issued 1.6 million shares of our common stock and added $25.2 million in additional paid in capital for a total of $26.8 million in additional capital. Changes in accumulated other comprehensive income added $5.3 million in capital offset by dividends paid to common shareholders of $10.9 million during 2014. Total shareholders' equity to total assets for each of December 31, 2014 and 2013 was 11.1%. Book value per share at December 31, 2014 and 2013 was $11.76 and $10.57, respectively. Total risk-based capital to risk-weighted assets was 11.78% at
December 31, 2014 compared to 12.89% at December 31, 2013. Accordingly, we were considered "well capitalized" for regulatory purposes at December 31, 2014.
As noted above, regulatory capital levels for the bank and bank holding company meet those established for "well-capitalized" institutions. While we are currently considered "well-capitalized," we may from time-to-time find it necessary to access the capital markets to meet our growth objectives or capitalize on specific business opportunities.
The following table shows the minimum capital requirement and our capital position at December 31, 2015, 2014, and 2013 for the Company and for the Bank.
Capital Components
At December 31, 2015, 2014, and 2013
(In thousands)
Cardinal Financial Corporation (Consolidated):
Cardinal Bank:
Liquidity
Liquidity in the banking industry is defined as the ability to meet the demand for funds of both depositors and borrowers. We must be able to meet these needs by obtaining funding from depositors or other lenders or by converting non-cash items into cash. The objective of our liquidity management program is to ensure that we always have sufficient resources to meet the demands of our depositors and borrowers. Stable core deposits and a strong capital position provide the base for our liquidity position. We believe we have demonstrated our ability to attract deposits because of our convenient branch locations, personal service and pricing.
In addition to deposits, we have access to the different wholesale funding markets. These markets include the brokered CD market, the repurchase agreement market and the federal funds market. We are a member of the Certificates of Deposit Account Registry Services ("CDARS"). CDARS allows banking customers to access FDIC insurance protection on multi-million dollar certificates of deposit through our Bank. When a customer places a large deposit through CDARS, we place their funds into certificates of deposit with other banks in the CDARS network in increments of less than $250,000 so that principal and interest are eligible for FDIC insurance protection. We also maintain secured lines of credit with the Federal Reserve Bank of Richmond and the Federal Home Loan Bank of Atlanta for which we can borrow up to the allowable amount for the collateral pledged. Having diverse funding alternatives reduces our reliance on any one source for funding.
Cash flow from amortizing assets or maturing assets can also provide funding to meet the needs of depositors and borrowers.
We have established a formal liquidity contingency plan which establishes a liquidity management team and provides guidelines for liquidity management. For our liquidity management program, we first determine our current liquidity position and then forecast liquidity based on anticipated changes in the balance sheet. In this forecast, we expect to maintain a liquidity cushion. We also stress test our liquidity position under several different stress scenarios, from moderate to severe. Guidelines for the forecasted liquidity cushion and for liquidity cushions for each stress scenario have been established. We believe that we have sufficient resources to meet our liquidity needs.
Liquid assets, which include cash and due from banks, federal funds sold and investment securities available for sale, totaled $453.4 million at December 31, 2015, or 11.3% of total assets. We held investments that are classified as held-to-maturity in the amount of $3.8 million at December 31, 2015. To maintain ready access to the Bank's secured lines of credit, the Bank has pledged roughly half of its investment securities and a portion of its commercial real estate and residential real estate loan portfolios to the Federal Home Loan Bank of Atlanta with additional investment securities and certain loans in its commercial & industrial loan portfolios pledged to the Federal Reserve Bank of Richmond. Additional borrowing capacity at the Federal Home Loan Bank of Atlanta at December 31, 2015 was approximately $678.5 million. Borrowing capacity with the Federal Reserve Bank of Richmond was approximately $164.8 million at December 31, 2015. These facilities are subject to the FHLB and the Federal Reserve approving disbursement to us. In addition, we have unsecured federal funds purchased lines of $315 million available to us. We anticipate maintaining liquidity at a level sufficient to protect depositors, provide for reasonable growth and fully comply with all regulatory requirements.
Contractual Obligations
We have entered into a number of long-term contractual obligations to support our ongoing activities. These contractual obligations will be funded through operating revenues and liquidity sources held or available to us and exclude contractual interest costs, where applicable.
The required payments under such obligations excluding interest were as follows:
Contractual Obligations
At December 31, 2015
(In thousands)
Financial Instruments with Off-Balance-Sheet Risk and Credit Risk
We are a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the balance sheet.
The Bank's maximum exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. We evaluate each customer's credit worthiness on a case-by-case basis and require collateral to support financial instruments when deemed necessary. The amount of collateral obtained upon extension of credit is based on management's evaluation of the counterparty. Collateral held varies but may include deposits
held by us, marketable securities, accounts receivable, inventory, property, plant and equipment, and income-producing commercial properties.
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 up to one year or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. These instruments represent obligations to extend credit or guarantee borrowings and are not recorded on the consolidated statements of financial condition. The rates and terms of these instruments are competitive with others in the market in which we do business.
Unfunded commitments under lines of credit are commitments for possible future extensions of credit to existing customers. Those lines of credit may not be drawn upon to the total extent to which we have committed.
Standby letters of credit are conditional commitments we issued to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing, and similar transactions. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. We hold certificates of deposit, deposit accounts, and real estate as collateral supporting those commitments for which collateral is deemed necessary.
A summary of the contract amount of the Bank's exposure to off-balance-sheet risk as of December 31, 2015 and 2014, is as follows:
Commitments to extend credit of $247.4 million as of December 31, 2015 were related to George Mason's mortgage loan funding commitments and were of a short-term nature. Commitments to extend credit of $1.2 billion primarily have floating rates as of December 31, 2015. It is uncertain as to the amount that we will be required to fund on these commitments as many such arrangements expire with no amount drawn.
We have counter-party risk which may arise from the possible inability of George Mason's third-party investors to meet the terms of their forward sales contracts. George Mason works with third-party investors that are generally well-capitalized, are investment grade and exhibit strong financial performance to mitigate this risk. We do not expect any third-party investor to fail to meet its obligation. We continuously monitor the financial condition of these third parties. We do not expect these third parties to fail to meet their obligations.
George Mason provides for its estimated exposure to repurchase loans previously sold to investors for which borrowers failed to provide full and accurate information on their loan application or for which appraisals have not been acceptable or when the loan was not underwritten in accordance with the loan program specified by the loan investor, and for other exposure to its investors related to loan sales activities. We evaluate the merits of each claim and estimate the reserve based on actual and expected claims received and consider the historical amounts paid to settle such claims. We have taken steps to limit our exposure to such loan repurchases through agreements entered into with various investors. As a result, we received a limited number of additional claims.
During 2015 and 2014, George Mason settled with investors on such loans for a total of $0 and $194,000, respectively. This reserve had a balance of $500,000 and $150,000 at December 31, 2015 and 2014, respectively. The expense (benefit) related to this reserve for the years ended December 2015, 2014, and 2013 was $397,000, $83,000, and ($49,000), respectively.
Quarterly Data
The following table provides quarterly data for the years ended December 31, 2015 and 2014. Quarterly per share results may not calculate to the year-end per share results due to rounding.
Quarterly Data
Years ended December 31, 2015 and 2014
(In thousands, except per share data)
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Our Asset/Liability Committee is responsible for reviewing our liquidity requirements and maximizing our net interest income consistent with capital requirements, liquidity, interest rate and economic outlooks, competitive factors and customer needs. Interest rate risk arises because the assets of the Bank and the liabilities of the Bank have different maturities and characteristics. In order to measure this interest rate risk, we use a simulation process that measures the impact of changing interest rates on net interest income. This model is run for the Bank by an independent consulting firm. The simulations incorporate assumptions related to expected activity in the balance sheet. For maturing assets, assumptions are developed for the redeployment of these assets. For maturing liabilities, assumptions are developed for the replacement of these funding sources. Assumptions are also developed for assets and liabilities that reprice during the modeled time period. These assumptions also cover how we expect rates to change on non-maturity deposits such as interest checking, money market checking, savings accounts as well as certificates of deposit. Based on inputs that include the most recent period end balance sheet, the current level of interest rates and the developed assumptions, the model then produces an expected level of net interest income assuming that interest rates remain unchanged. This becomes the base case. Next, the model determines the impact on net interest income given specified changes in interest rates. The rate simulations are performed for a two year period and include ramped rate changes of down 100 basis points and up 200 basis points. The down 200 basis point scenario was discontinued given the current level of interest rates. In the ramped down rate change, the model moves rates gradually down 100 basis points over the first year and then rates remain flat in the second year.
For the up 200 basis point scenario, rates are gradually moved up 200 basis points in the first year and remain flat in the second year. In both the up and down scenarios, the model assumes a parallel shift in the yield curve. The results of these simulations are then compared to the base case.
At December 31, 2015, our asset/liability position was slightly asset sensitive based on our interest rate sensitivity model. Our net interest income would decrease by less than 1.5% in a down 100 basis point scenario and would increase by less than 2.0% in an up 200 basis point scenario over a one-year time frame. In the two-year time horizon, our net interest income would decrease by less than 2.5% in a down 100 basis point scenario and would increase by less than 2.9% in an up 200 basis point scenario.
See also "Interest Rate Sensitivity" in Item 2 above for a discussion of our interest rate risk.
We have counter-party risk which may arise from the possible inability of George Mason's third-party investors to meet the terms of their forward sales contracts. George Mason works with third-party investors that are generally well-capitalized, are investment grade and exhibit strong financial performance to mitigate this risk. We do not expect any third-party investor to fail to meet its obligation. We monitor the financial condition of these third parties on an annual basis. We do not expect these third parties to fail to meet their obligations.
PART II
Item 8.
Item 8. Financial Statements and Supplementary Data
Page
Reports of Independent Registered Public Accounting Firm
Consolidated Statements of Condition
Consolidated Statements of Income
Consolidated Statements of Comprehensive Income
Consolidated Statements of Changes in Shareholders' Equity
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
Cardinal Financial Corporation:
We have audited Cardinal Financial Corporation and subsidiaries (the Company) internal control over financial reporting as of December 31, 2015, based on criteria established in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). 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 Management's Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company's annual or interim financial statements will not be prevented or detected on a timely basis. Management identified the following deficiencies in the operating effectiveness of certain controls relating to the process of estimating the allowance for loan losses that in aggregate were determined to be a material weakness and are included in Management's Report on Internal Control over Financial Reporting: i) controls over recording specific reserves on impaired loans in the general ledger; ii) controls over the accuracy of data used to develop historical loss factors; and iii) controls over the support to develop loss factors and the use of loss factors that are in accordance with the approved allowance for loan losses policy.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the 2015 consolidated financial statements of the Company. This material weakness was considered in determining the nature, timing, and extent of audit tests applied in
our audit of the 2015 consolidated financial statements, and this report does not affect our report dated March 15, 2016, which expressed an unqualified opinion on those consolidated financial statements.
In our opinion, because of the effect of the aforementioned material weakness on the achievement of the objectives of the control criteria, the Company has not maintained effective internal control over financial reporting as of December 31, 2015, based on criteria established in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
We do not express an opinion or any other form of assurance on management's statements referring to corrective actions taken after December 31, 2015, relative to the aforementioned material weakness in internal control over financial reporting.
/s/ KPMG LLP
McLean, Virginia
March 15, 2016
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
Cardinal Financial Corporation:
We have audited the accompanying consolidated statements of condition of Cardinal Financial Corporation and subsidiaries (the Company) as of December 31, 2015 and 2014, and the related consolidated statements of income, and statements of comprehensive income, changes in shareholders' equity, and cash flows for each of the years in the three-year period ended December 31, 2015. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Cardinal Financial Corporation and subsidiaries as of December 31, 2015 and 2014, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2015, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company's internal control over financial reporting as of December 31, 2015, based on criteria established in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 15, 2016 expressed an adverse opinion on the effectiveness of the Company's internal control over financial reporting.
/s/ KPMG LLP
McLean, Virginia
March 15, 2016
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CONDITION
December 31, 2015 and 2014
(In thousands, except share data)
See accompanying notes to consolidated financial statements.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
Years Ended December 31, 2015, 2014, and 2013
(In thousands, except per share data)
See accompanying notes to consolidated financial statements.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
Years Ended December 31, 2015, 2014, and 2013
(In thousands)
See accompanying notes to consolidated financial statements.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
Years Ended December 31, 2015, 2014, and
(In thousands)
See accompanying notes to consolidated financial statements.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31, 2015, 2014, and 2013
(In thousands)
See accompanying notes to consolidated financial statements.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(1) Organization
Cardinal Financial Corporation (the "Company" or "Cardinal") is incorporated under the laws of the Commonwealth of Virginia as a financial holding company whose activities consist of investment in its wholly-owned subsidiaries. The principal operating subsidiary of the Company is Cardinal Bank (the "Bank"), a state-chartered institution and its subsidiary, George Mason Mortgage, LLC ("George Mason"), a mortgage banking company based in Fairfax, Virginia. In addition to the Bank, the Company has one nonbank subsidiary, Cardinal Wealth Services, Inc. ("CWS"), an investment services subsidiary.
On January 16, 2014, the Company announced the completion of its acquisition of United Financial Banking Companies, Inc. ("UFBC"), the holding company of The Business Bank ("TBB"), pursuant to a previously announced definitive merger agreement. The merger of UFBC into Cardinal was effective January 16, 2014. Under the terms of the merger agreement, UFBC shareholders received $19.13 in cash and 1.154 shares of the Company's common stock in exchange for each share of UFBC common stock they owned immediately prior to the merger. TBB, which was headquartered in Vienna, Virginia, merged into Cardinal Bank effective March 8, 2014.
(2) Summary of Significant Accounting Policies
(a)Use of Estimates
U.S. generally accepted accounting principles are complex and require management to make estimates, judgments and assumptions that affect the reported amounts of assets and liabilities, and disclosures of contingent assets and contingent liabilities, at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Significant estimates affecting the Company's financial statements relate to accounting for business combinations and impairment testing of goodwill, the allowance for loan losses, accounting for impairment of identifiable intangible assets, the valuation of the deferred tax assets, other-than-temporary impairment assessments for investment securities, fair value measurements of certain assets and liabilities, fair values of derivatives and investment securities and reserves for repurchase of mortgage loans previously sold to investors. Actual results could differ from these estimates.
(b)Principles of Consolidation
The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany transactions and balances have been eliminated in consolidation.
(c)Accounting for Business Combinations
Business combinations are accounted for under the purchase method. The purchase method requires that the cost of an acquired entity be allocated to the assets acquired and liabilities assumed, based on their estimated fair values at the date of acquisition. The excess of the cost of an acquired entity over the net of the amounts assigned to assets acquired and liabilities assumed, including identifiable intangibles, is recorded as goodwill.
(d)Cash and Cash Equivalents
For the consolidated statements of cash flows, the Company has defined cash and cash equivalents as cash and due from banks and federal funds sold.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(2) Summary of Significant Accounting Policies (Continued)
(e)Investment Securities
The Company classifies its investment securities into one of three categories: available-for-sale, held-to-maturity or trading. Held-to-maturity securities are those securities for which the Company has the ability and intent to hold until maturity. Trading securities are those securities for which the Company has purchased and holds for the purpose of selling in the near future. All other securities are classified as available-for-sale.
Held-to-maturity securities are carried at amortized cost. Available-for-sale and trading securities are carried at estimated fair value. Unrealized gains and losses, net of applicable tax, on available-for-sale securities are reported in other comprehensive income (loss). Unrealized market value adjustments, fees and realized gains and losses, on trading securities are reported in non-interest income.
At December 31, 2015 and 2014, the Company had certain of its investment securities classified as trading. These investments were purchased to economically hedge against fair value changes of the Company's nonqualified deferred compensation plan liability. Those investments were designated as trading securities, and as such, the changes in fair value are reflected in earnings.
Gains and losses on the sale of securities are determined using the specific identification method.
The Company regularly evaluates its securities whose values have declined below their amortized cost to assess whether the decline in fair value is other-than-temporary. The Company considers various factors in determining whether a decline in fair value is other-than-temporary including the issuer's financial condition and/or future prospects, the effects of changes in interest rates or credit spreads, the expected recovery period and other quantitative and qualitative information. The valuation of securities for impairment is a process subject to estimation, judgment and uncertainty and is intended to determine whether declines in the fair value of investments should be recognized in current period earnings. The risks and uncertainties include changes in general economic conditions and future changes in assessments of the aforementioned factors. It is expected that such factors will change in the future, which may result in future other-than-temporary impairments. For impairments of debt securities that are deemed to be other-than-temporary, the credit portion of an other-than-temporary impairment loss is recognized in earnings and the non-credit portion is recognized in accumulated other comprehensive income in those situations where the Company does not intend to sell the security and it is more likely than not that the Company will not be required to sell the security prior to recovery.
On December 10, 2013, the Office of the Comptroller of the Currency, the FDIC, the Board of Governors of the Federal Reserve System, the SEC, and the Commodity Futures Trading Commission (collectively, "the Agencies"), released final rules (the "Final Rules") to implement Section 619 of the Financial Reform Act, commonly known as the "Volcker Rule". The Volcker Rule, among other things, prohibits banking entities from engaging in proprietary trading and from sponsoring, having an ownership interest in or having certain relationships with hedge funds or private equity funds (referred to in the Final Rules as a covered fund), subject to certain exemptions. The Final Rules impact certain investments held by banks in collateralized debt obligations backed by trust preferred securities, which may constitute ownership interests in covered funds as those terms are defined in the Final Rules. On January 14, 2014, an interim rule was issued by the federal banking regulators to exempt certain of these trust preferred securities from the covered fund definition as issued in the Final Rules.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(2) Summary of Significant Accounting Policies (Continued)
At December 31, 2013, the Company owned four pooled trust preferred securities which were all previously classified as held-to-maturity within the investment securities portfolio. Based on the interim rule, only two of the four investments were exempt from the covered fund definition. For the two investments that were not exempt as a result of the interim rule, the Company would have been required to divest its investment in these particular pooled trust preferred securities prior to the effectiveness of the Final Rule, July 21, 2017. As a result of this new regulation, these two investments were reclassified to the available-for-sale investment securities portfolio and an other-than-temporary impairment of $300,000 was recognized as of December 31, 2013. During the fourth quarter of 2014, one of these available-for-sale pooled trust preferred investments paid off early, and the Company recognized a gain of $120,000 from the other-than-temporary impairment charge recorded as of December 31, 2013. During the second quarter of 2015, the remaining available-for-sale pooled trust preferred investments paid off early, and the Company recognized a gain of $180,000 from the other-than-temporary impairment charge recorded as of December 31, 2013.
Interest income and dividends on securities are recognized in interest income on an accrual basis. Premiums and discounts are recognized in interest income using the effective interest method. Prepayments of the mortgages securing mortgage-backed securities may affect the yield to maturity. The Company uses actual principal prepayment experience and estimates of future principal prepayments in calculating the yield necessary to apply the effective interest method.
(f)Loans Held for Sale
Mortgage loans originated and intended for sale into the secondary market are carried at the lower of cost or estimated fair value, determined on an aggregate loan basis. The Company sells its mortgage loans forward to investors and the estimated fair value is largely dependent upon the terms of these outstanding loan purchase commitments as well as movement in market interest rates. Net unrealized losses, if any, are recognized through a valuation allowance by charges to operations. The carrying amount of loans held for sale includes principal balances, valuation allowances, origination premiums or discounts and fees and direct costs that are deferred at the time of origination.
The Company sells its originated mortgage loans to third party investors servicing released. Upon sale and delivery, the loans are legally isolated from the Company and the Company has no ability to restrict or constrain the ability of third-party investors to pledge or exchange the mortgage loans. The Company does not have the entitlement or ability to repurchase the mortgage loans or unilaterally cause third-party investors to put the mortgage loans back to the Company.
(g)Loans Receivable and Allowance for Loan Losses
Loans receivable that management has the intent and ability to hold for the foreseeable future or until loan maturity or pay-off are reported at their outstanding principal balance adjusted for any charge-offs, and net of the allowance for loan losses and deferred fees and costs. Loan origination fees and certain direct origination costs are deferred and amortized as an adjustment of the yield using the payment terms required by the loan contract.
During 2014, as a result of the Company's acquisition of UFBC, the loan portfolio was segregated between loans initially accounted for under the amortized cost method (referred to as "originated" loans) and loans acquired (referred to as "acquired" loans). The loans segregated to the acquired loan
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(2) Summary of Significant Accounting Policies (Continued)
portfolio were initially measured at fair value and subsequently accounted for under either Accounting Standards Codification ("ASC") Topic 310-30 or ASC Topic 310-20.
Purchased credit-impaired (PCI) loans, which are the loans acquired in the Company's acquisition of UFBC, are loans acquired at a discount (that is due, in part, to credit quality). These loans are initially recorded at fair value (as determined by the present value of expected future cash flows) with no allowance for loan losses. The Company accounts for interest income on all loans acquired at a discount (that is due, in part, to credit quality) based on the acquired loans' expected cash flows. The acquired loans may be aggregated and accounted for as a pool of loans if the loans being aggregated have common risk characteristics. A pool is accounted for as a single asset with a single composite interest rate and an aggregate expectation of cash flow. The difference between the undiscounted cash flows expected at acquisition and the investment in the loans, or the "accretable yield," is recognized as interest income utilizing the level-yield method over the life of each pool. Increases in expected cash flows subsequent to the acquisition are recognized prospectively through adjustment to any previously recognized allowance for loan loss for that pool of loans and then through an increase in the yield on the pool over its remaining life, while decreases in expected cash flows are recognized as impairment through a loss provision and an increase in the allowance for loan losses. Therefore, the allowance for loan losses on these impaired pools reflect only losses incurred after the acquisition (representing the present value of all cash flows that were expected at acquisition but currently are not expected to be received).
The Company periodically evaluates the remaining contractual required payments due and estimates of cash flows expected to be collected for PCI loans. These evaluations, performed quarterly, require the continued use of key assumptions and estimates, similar to the initial estimate of fair value. Changes in the contractual required payments due and estimated cash flows expected to be collected may result in changes in the accretable yield and non-accretable difference or reclassifications between accretable yield and the non-accretable difference. On an aggregate basis, if the acquired pools of PCI loans perform better than originally expected, we would expect to receive more future cash flows than originally modeled at the acquisition date. For the pools with better than expected cash flows, the forecasted increase would be recorded as an additional accretable yield that is recognized as a prospective increase to our interest income on loans.
Loans are generally placed into nonaccrual status when they are past-due 90 days as to either principal or interest or when, in the opinion of management, the collection of principal and/or interest is in doubt. A loan remains in nonaccrual status until the loan is current as to payment of both principal and interest or past-due less than 90 days and the borrower demonstrates the ability to pay and remain current. Loans are charged-off when a loan or a portion thereof is considered uncollectible. When cash payments are received, they are applied to principal first, then to accrued interest. It is the Company's policy not to record interest income on nonaccrual loans until principal has become current. In certain instances, accruing loans that are past due 90 days or more as to principal or interest may not go on nonaccrual status if the Chief Credit Officer determines that the loans are well secured and are in the process of collection.
The Company determines and recognizes impairment of certain loans when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the loan agreement. A loan is not considered impaired during a period of delay in payment if the Company expects to collect all amounts due, including past-due interest. An impaired
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(2) Summary of Significant Accounting Policies (Continued)
loan is measured at the present value of its expected future cash flows discounted at the loan's coupon rate, or at the loan's observable market price or fair value of the collateral if the loan is collateral dependent. Because substantially all of the Company's loans are collateral dependent, the Company generally measures impairment based on the estimated fair value of the collateral. The Company measures the collateral value on impaired loans by obtaining an updated appraisal of the underlying collateral and may discount further the appraised value, if necessary, to an amount equal to the expected cash proceeds in the event the loan is foreclosed upon and the collateral is sold. In addition, an estimate of costs to sell the collateral is assumed.
Nonperforming assets include nonaccrual loans, loans past due 90 days or more and other real estate owned.
The allowance for loan losses is increased by provisions for loan losses and recoveries of previously charged-off loans, and decreased by loan charge-offs.
The Company maintains the allowance for loan losses at a level that represents management's best estimate of known and inherent losses in the loan portfolio. Both the amount of the provision expense and the level of the allowance for loan losses are impacted by many factors, including general and industry-specific economic conditions, actual and expected credit losses, historical trends and specific conditions of the individual borrowers including the value of the underlying collateral. Unusual and infrequently occurring events, such as weather-related disasters, may impact the assessment of possible credit losses. As a part of its analysis, the Company uses its historical losses, loss emergence experience and qualitative factors, such as levels of and trends in delinquencies, nonaccrual loans, charged-off loans, changes in volume and terms of loans, effects of changes in lending policy, experience and ability and depth of management, national and local economic trends and conditions and concentrations of credit, competition, and loan review results to support estimates.
The Company's allowance for loan losses is based first on a segmentation of its loan portfolio by general loan type, or portfolio segments. For originated loans, certain portfolio segments are further disaggregated and evaluated collectively for impairment based on class segments, which are largely based on the type of collateral underlying each loan. For purposes of this analysis, the Company categorizes loans into one of five categories: commercial and industrial, commercial real estate (including construction), home equity lines of credit, residential mortgages, and consumer loans. The Company also maintains an allowance for loan losses for acquired loans when: (i) for loans accounted for under ASC 310-30, there is deterioration in credit quality subsequent to acquisition, and (ii) for loans accounted for under ASC 310-20, the inherent losses in the loans exceed the remaining credit discount recorded at the time of acquisition.
During the fourth quarter of 2014, the Company transitioned to using its historical loss experience and trends in losses for each category which were then adjusted for portfolio trends and economical and environmental factors in determining the allowance for loan losses. The indicated loss factors resulting from this analysis are applied to each of the five categories of loans. Prior to the fourth quarter of 2014, the Company's allowance model used the average loss rates of similar institutions based on its custom peer group as a baseline, which was adjusted for its particular loan portfolio characteristics and environmental factors. These changes did not have an impact to the overall allowance.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(2) Summary of Significant Accounting Policies (Continued)
The allowance for loan losses consists of specific and general components. The specific component relates to loans that are determined to be impaired and, therefore, individually evaluated for impairment. The Company individually assigns loss factors to all loans that have been identified as having loss attributes, as indicated by deterioration in the financial condition of the borrower or a decline in underlying collateral value if the loan is collateral dependent. In certain cases, the Company applies, in accordance with regulatory guidelines, a 5% loss factor to all loans classified as special mention, a 15% loss factor to all loans classified as substandard and a 50% loss factor to all loans classified as doubtful. Loans classified as loss loans are fully reserved or charged-off. However, in most instances, the Company evaluates the impairment of certain loans on a loan by loan basis for those loans that are adversely risk rated. For these loans, the Company analyzes the fair value of the collateral underlying the loan and considers estimated costs to sell the collateral on a discounted basis. If the net collateral value is less than the loan balance (including accrued interest and any unamortized premium or discount associated with the loan) the Company recognizes an impairment and establishes a specific reserve for the impaired loan. Because of the limited number of impaired loans within its portfolio, the Company is able to evaluate each impaired loan individually and therefore specific reserves for impaired loans are generally less than those recommended by the listed regulatory guidelines above.
The general component relates to groups of homogeneous loans not designated for a specific allowance and are collectively evaluated for impairment. The general component is based on historical loss experience adjusted for qualitative factors. To arrive at the general component, the loan portfolio is grouped by loan type. A weighted average historical loss rate is computed for each group of loans over the trailing seven year period. The Company selected a seven year evaluation period as a result of the limited historical loss experience it has incurred, even during the recent economic downturn. The Company also believes that a seven year time horizon represents a full economic cycle. The historical loss factors are updated at least annually, unless a more frequent review of such factors is warranted. In addition to the use of historical loss factors, a qualitative adjustment factor is applied. This qualitative adjustment factor, which may be favorable or unfavorable, represents management's judgment that inherent losses in a given group of loans are different from historical loss rates due to environmental factors unique to that specific group of loans. These factors may relate to growth rate factors within the particular loan group; whether the recent loss history for a particular group of loans differs from its historical loss rate; the amount of loans in a particular group that have recently been designated as impaired and that may be indicative of future trends for this group; reported or observed difficulties that other banks are having with loans in the particular group; changes in the experience, ability, and depth of lending personnel; changes in the nature and volume of the loan portfolio and in the terms of loans; and changes in the volume and severity of past due loans, nonaccrual loans, and adversely classified loans. The sum of the historical loss rate and the qualitative adjustment factor comprise the estimated annual loss rate. To adjust for inherent loss levels within the loan portfolio, a loss emergence factor is estimated based on an evaluation of the period of time it takes for a loan within each of our loan segments to deteriorate to the point an impairment loss is recorded within the allowance. The loss emergence factor is applied to the estimated annual loss rate to determine the annual loss amount.
In addition, various regulatory agencies, as part of their examination process, periodically review the Company's allowance for loan losses. These agencies may require the Company to recognize additions to the allowance based on their risk evaluation and credit judgment. Management believes
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(2) Summary of Significant Accounting Policies (Continued)
that the allowance for loan losses at December 31, 2015 and 2014 is a reasonable estimate of known and inherent losses in the loan portfolio at those dates.
Loans considered to be troubled debt restructuring ("TDRs") are loans that have their terms restructured (e.g., interest rates, loan maturity date, payment and amortization period, etc.) in circumstances that provide payment relief to a borrower experiencing financial difficulty. All restructured loans are considered impaired loans and may either be in accruing status or nonaccruing status. Nonaccruing restructured loans may return to accruing status provided doubt has been removed concerning the collectability of principal and interest as evidenced by a sufficient period of payment performance in accordance with the restructured terms. Loans may be removed from the restructured category in the year subsequent to the restructuring if their revised loan terms are considered to be consistent with terms that can be obtained in the credit market for loans with comparable risk and if they meet certain performance criteria.
(h)Premises and Equipment
Land is carried at cost. Premises, furniture, equipment, and leasehold improvements are carried at cost, less accumulated depreciation and amortization. Depreciation of premises, furniture and equipment is computed using the straight-line method over estimated useful lives from three to 25 years. Amortization of leasehold improvements is computed using the straight-line method over the useful lives of the improvements or the lease term, whichever is shorter. Purchased computer software which is capitalized is amortized over estimated useful lives of one to three years. Rent expense on operating leases is recorded using the straight-line method over the appropriate lease term.
(i)Goodwill and Other Intangibles
Goodwill, which represents the excess of purchase price over fair value of net assets acquired, is not amortized but is evaluated at least annually for impairment by comparing its fair value with its carrying amount. Impairment is indicated when the carrying amount of a reporting unit exceeds its estimated fair value.
ASC Topic 350 states that an entity is not required to calculate the fair value of a reporting unit unless the entity determines that it is more likely than not that its fair value is less than its carrying value. If an entity can qualitatively demonstrate that a reporting unit's fair value is more likely than not greater than its carrying value, then it would not be required to perform the quantitative two-step goodwill impairment test.
When required, the goodwill impairment test involves a two-step valuation process. In Step 1, each reporting unit's fair value is determined based on three metrics: (1) a primary market approach, which measures fair value based on trading multiples of independent publicly traded financial institutions of comparable size and character to the reporting units, (2) a secondary market approach, which measures fair value based on acquisition multiples of publicly traded financial institutions of comparable size and character which were recently acquired, and (3) an income approach, which estimates fair value based on discounted cash flows. If the fair value of any reporting unit exceeds its adjusted net book value, no write-down of goodwill is necessary. If the fair value of any reporting unit is less than its adjusted net book value, a Step 2 valuation procedure is required to assess the proper carrying value of the goodwill allocated to that reporting unit. The valuation procedures applied in a Step 2 valuation are similar to
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(2) Summary of Significant Accounting Policies (Continued)
those that would be performed upon an acquisition, with the Step 1 fair value representing a hypothetical reporting unit purchase price.
No impairment was recorded for 2015, 2014, and 2013.
(j)Bank-Owned Life Insurance
Under the Company's bank-owned life insurance policy, executives or other key individuals are the insureds and the Company is the owner and beneficiary of the policy. As such, the insured has no claim to the insurance policy, the policy's cash value, or a portion of the policy's death proceeds. The increase in the cash surrender value over time is recorded as other non-interest income. The Company monitors the financial strength and condition of the counterparty.
(k)Other Real Estate Owned
Assets acquired through, or in lieu of, loan foreclosure are held for sale and are initially recorded at fair value less selling costs at the date of foreclosure, establishing a new cost basis. Subsequent to foreclosure, valuations are periodically performed by the Company and the assets are carried at the lower of carrying value or fair value less any costs to sell. The fair value is determined by obtaining an updated appraisal of the foreclosed property which is then discounted for estimated selling costs. Revenue and expenses from operations and changes in the valuation allowance are included in other real estate owned and loan expenses, disclosed in a separate line item on the consolidated statements of income.
(l)Realized and Unrealized Gains on Mortgage Banking Activities
Realized and unrealized gains on mortgage banking activities include income earned by George Mason from the origination and sale of mortgage loans to third party investors, and other activities incidental to mortgage banking activities. The Company enters into interest rate lock commitments to sell and deliver the mortgage loans, servicing released, to third party investors. Unrealized gains include the recognition of the fair value of the rate lock commitment derivative, which approximates the differential between the par value of the loan and the amount that will be received upon the delivery of the loan to the third party investor.
(m)Investment Fee Income
Investment fee income represents commissions paid by customers of CWS for the years ended December 31, 2015 and 2014. Fees are recognized in income as they are earned. For 2013, investment fee income also included asset management fees and revenue from the Company's former asset management and trust services businesses. Such revenue was recognized in the period earned in accordance with contractual percentage of assets under management or custody. Trust Services revenue is generally determined based upon the fair value of assets under management or custody at the end of the period. As of June 30, 2013, the Company merged the remaining operations of its trust division and asset management business, both of which had been included in the wealth management services segment, into CWS. Results for the year ended December 31, 2013 include six months of operations of these merged subsidiaries.
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Notes to Consolidated Financial Statements (Continued)
(2) Summary of Significant Accounting Policies (Continued)
(n)Management Fee Income
Management fee income represents income earned for the management and operational support provided by George Mason to other mortgage banking companies (the "managed companies") owned by local homebuilders. During 2014, the Company ceased providing such operational support and therefore income from this activity decreased significantly during 2014. The relationship of George Mason to these managed companies was solely as a service provider and there was no fiduciary relationship or equity investment involved. Fees earned by George Mason were accrued based on contractual arrangements with each of the managed companies and were generally recorded on a per loan basis.
(o)Income Taxes
Deferred tax assets and liabilities are recognized for the tax effects of differing carrying values of assets and liabilities for tax and financial statement purposes that will reverse in future periods. Deferred tax assets and liabilities are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes.
When uncertainty exists concerning the recoverability of a deferred tax asset, the carrying value of the asset may be reduced by a valuation allowance. The amount of any valuation allowance established is based upon an estimate of the deferred tax asset that is more likely than not to be recovered. Increases or decreases in the valuation allowance result in increases or decreases to the provision for income taxes.
Uncertain tax positions, if any, are accounted for by applying a recognition threshold and measurement attributable for tax positions taken or expected to be taken on a tax return. Recognition and measurement of tax positions is based on management's evaluations of relevant tax code and appropriate industry information about audit proceedings for comparable positions at other organizations. Increases to unrecognized tax benefits will occur as a result of accruing for the nonrecognition of the position for the current year. Decreases will occur as a result of the lapsing of the statute of limitations for the oldest outstanding year which includes the position.
(p)Earnings Per Common Share
Basic earnings per common share is computed by dividing net income available to common shareholders by the weighted-average number of shares of common stock outstanding during the periods, including shares which will be issued to settle liabilities of the deferred compensation plans. Diluted earnings per share reflects the impact of dilutive potential common shares that would have been outstanding if common stock equivalents had been issued, as well as any adjustment to income that would result from the assumed issuance. Common stock equivalents that may be issued by the Company relate primarily to outstanding stock options, and the dilutive potential common shares resulting from outstanding stock options are determined using the treasury stock method. Common stock equivalents for diluted earnings per share purposes also includes common shares which may be issued, but are not required to be issued, to settle the Company's obligations under its deferred compensation plans. The effects of anti-dilutive common stock equivalents are excluded from the calculation of diluted earnings per share.
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Notes to Consolidated Financial Statements (Continued)
(2) Summary of Significant Accounting Policies (Continued)
(q)Derivative Instruments and Hedging Activities
The Company records its derivatives at their fair values in other assets and other liabilities on the statement of condition. The Company does not enter into derivative transactions for speculative purposes. For derivatives designated as hedges, the Company contemporaneously documents the hedging relationship, including the risk management objective and strategy for undertaking the hedge, how effectiveness will be assessed at inception and at each reporting period and the method for measuring ineffectiveness. The Company evaluates the effectiveness of these transactions at inception and on an ongoing basis. Ineffectiveness is recorded through earnings. For derivatives designated as cash flow hedges, the fair value adjustment is recorded as a component of other comprehensive income, net of tax, except for the ineffective portion which is recorded in earnings. For derivatives designated as fair value hedges, the fair value adjustments for both the hedged item and the hedging instrument are recorded through the income statement with any difference considered the ineffective portion of the hedge. The Company discontinues hedge accounting when i) the hedge is no longer considered highly effective or ii) the derivative matures or is sold or terminates.
In the normal course of business, the Company enters into rate lock commitments to finance residential mortgage loans. These commitments, which contain fixed expiration dates, offer the borrower an interest rate guarantee provided the loan meets underwriting guidelines and closes within the timeframe established by the Company. Interest rate risk arises on these commitments and subsequently closed loans if interest rates change between the time of the interest rate lock and the delivery of the loan to the investor. Loan commitments related to residential mortgage loans intended to be sold are considered derivatives and are marked to market through earnings. In addition to the effects of the change in market interest rate, the fair value measurement of the derivative also contemplates the expected cash flows to be received from the counterparty to the future sale of the loan. For purposes of calculating the aggregate fair value of the rate lock derivatives at year end, the Company assumes an estimated loan closing and investor delivery rate based on historical experience. The measurement of the estimated fair value of the rate lock derivatives is presented as realized and unrealized gains from mortgage banking activities.
The Company sells residential mortgage loans on either a best efforts or mandatory delivery basis. The Company mitigates the effect of the interest rate risk inherent in providing rate lock commitments through an economic hedge by entering into either a best efforts delivery forward loan sales contract or a trade of mortgage-backed securities for mandatory delivery (the "residual hedge"). During the rate lock commitment period, these forward loan sales contracts and the residual hedge are marked to market through earnings and are not designated as accounting hedges. Exclusive of the fair value component associated with the projected cash flows from the loan delivery to the investor, the changes in fair value related to movements in market rates of the rate lock commitments and the forward loan sales contracts and residual hedge generally move in opposite directions, and the net impact of changes in these valuations on net income during the loan commitment period is generally inconsequential. At the closing of the loan, the loan commitment derivative expires and the Company records a loan held for sale and continues to be obligated under the same forward loan sales contract under best efforts. For mandatory delivery, the Company closes out of the trading mortgage-backed securities assigned within the residual hedge and replaces them with a forward sales contract once a price has been accepted by an investor. The forward sales contract is then designated as a hedge against the variability in cash to be received from the loan sale. Loans held for sale are accounted for at the lower of cost or fair value.
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Notes to Consolidated Financial Statements (Continued)
(2) Summary of Significant Accounting Policies (Continued)
When hedge accounting is discontinued because it is probable an anticipated loan sale will not occur, the Company recognizes immediately in earnings any gains and losses that were accumulated in other comprehensive income.
(r)Stock-Based Compensation
The Company recognizes in the income statement the grant-date fair value of stock options and other equity-based compensation. The Company classifies stock awards as either an equity award or a liability award. Equity classified awards are valued as of the grant date using either an observable market price or a valuation methodology. Liability classified awards are valued at fair value at each reporting date. For the periods presented, all of the Company's stock options are classified as equity awards.
The Company awards stock options with a graded-vesting period and as such has elected to recognize compensation costs over the requisite service period for the entire award. Total compensation costs charged against income for the years ended December 31, 2015, 2014, and 2013 was $2.0 million, $1.1 million, and $687,000, respectively. The total income tax benefit related to stock options exercised and recognized in the income statement for share-based compensation arrangements was $1.0 million, $357,000, and $287,000, for the years ended December 31, 2015, 2014, and 2013, respectively.
At December 31, 2015, the Company had two stock-based employee compensation plans, which are described more fully in Note 21.
Stock options are granted with an exercise price equal to the fair market value of the Company's common stock on the date of grant. Director stock options have ten year terms and vest and become fully exercisable on the grant date. Certain employee stock options have ten year terms and vest and become fully exercisable in 25% increments beginning as of the date of grant. In addition, the Company has granted stock options to employees of the Company that have ten year terms and vest and become fully exercisable in 20% increments beginning after their first year of service. Other grants have ten year terms and vest and become fully exercisable in one-third increments beginning as of the grant date.
During 2015, the Company began granting restricted stock awards which are granted at the fair market value of the Company's common stock on the grant date. Most restricted stock grants vest in one-third increments on the anniversary date of the grant. Certain restricted stock awards granted to executive officers vest one-third immediately on the grant date with the remaining shares vesting over the next two years.
The weighted average per share fair values of stock option grants made in 2015, 2014, and 2013, were $5.95, $5.64, and $5.83, respectively. The fair values of the options granted were estimated on the grant date using the Black-Scholes option-pricing model based on the following weighted average assumptions:
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Notes to Consolidated Financial Statements (Continued)
(2) Summary of Significant Accounting Policies (Continued)
Expected volatility is based upon the average annual historical volatility of the Company's common stock. The estimated option life is derived from the "simplified method" as described in ASC Subtopic 718-10-599-1. The risk free interest rate is based upon the seven-year U.S. Treasury note rate in effect at the time of grant. The expected dividend yield is based upon implied and historical dividend declarations.
(3) Business Combinations
UFBC Acquisition
On January 16, 2014, the Company acquired UFBC, the holding company for The Business Bank, a commercial bank with approximately $356 million in assets, after purchase accounting adjustments. For each share of UFBC common stock outstanding, the shareholders of UFBC received a fixed exchange ratio of $19.13 in cash and 1.154 shares of the Company's common stock. The total consideration for the acquisition was $54.3 million, which was comprised of $26.8 million in cash and 1.6 million shares of the Company's common stock.
In connection with the acquisition, the Company acquired all of the voting and common shares of UFBC Capital Trust I (the "UFBC Trust"), which is a wholly-owned subsidiary established for the sole purpose of issuing $5.0 million of floating rate junior subordinated deferrable interest debentures ("trust preferred securities"). These trust preferred securities are due in 2035 and have an interest rate of LIBOR (London Interbank Offering Rate) plus 2.10%, which adjusts quarterly. The UFBC Trust is an unconsolidated subsidiary since the Company is not the primary beneficiary of this entity. The additional $155,000 that is payable by the Company to the UFBC Trust represents the Company's unfunded capital investment in the UFBC Trust.
Merger and acquisition expense was $472,000, $5.8 million and $464,000 for the years ended December 31, 2015, 2014, and 2013, respectively, which are primarily related to legal and accounting costs, contract termination expenses, system conversion and integration expenses, employee retention and severance payments.
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Notes to Consolidated Financial Statements (Continued)
(3) Business Combinations (Continued)
The following table sets forth the assets acquired and liabilities assumed in the acquisition at their estimated fair values as of the closing date of the transaction:
Fair Value Measurement of Assets Acquired and Liabilities Assumed
Below are the methods used to determine the fair values of the significant assets acquired and liabilities assumed in the acquisition.
Cash and cash equivalents. The carrying amount of cash and cash equivalents was used as a reasonable estimate of fair value.
Investment securities available for sale. The estimated fair values of investment securities available-for-sale was based on reliable and unbiased evaluations by an industry-wide valuation service. This service uses evaluated pricing models that vary based on asset class and include available trade, bid, and other market information. Generally, the methodology includes broker quotes, proprietary models, vast descriptive terms and conditions databases, as well as extensive quality control programs.
Loans. The acquired loan portfolio was segregated into one of two categories for valuation purposes: purchased credit impaired loans and performing loans. Purchased credit impaired loans were identified as those loans that were nonaccrual prior to the business combination and those loans that had been identified as potentially impaired. Potentially impaired loans were those loans that were identified during the credit review process where there was an indication that the borrower did not
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(3) Business Combinations (Continued)
have sufficient cash flows to service the loan in accordance with its terms. Performing loans were those loans that were currently performing in accordance with the loan contract and do not appear to have any significant credit issues.
For loans that were identified as performing, the fair values were determined using a discounted cash flow analysis (the "income approach"). Performing loans were segmented into pools based on loan type (1-4 family residential, commercial, commercial owner occupied, construction and development), and further segmented based on payment type (fully amortizing, non-fully amortizing balloon, or interest only), rate type (fixed versus variable), and remaining maturity. The estimated cash flows expected to be collected for each loan was determined using a valuation model that included the following key assumptions: prepayment speeds, expected credit loss rates and discount rates. Prepayment speeds were influenced by many factors including, but not limited to, current yields, historic rate trends, payment types, interest rate type, and the duration of the individual loan. Expected credit loss rates were based on recent and historical default and loss rates observed for loans with similar characteristics, and further influenced by a credit review by management and a third party consultant on a selection of loans within the acquired portfolio. The discount rates used were based on rates market participants might charge for cash flows with similar risk characteristics at the acquisition date. The market rates were estimated using a build up approach which included assumptions with respect to loan servicing costs, interest rate volatility, and systemic risk, among other factors.
For loans that were identified as purchased credit impaired ("PCI"), either the above income approach was used or the asset approach was used. The income approach was used for PCI loans where there was an expectation that the borrower would more likely than not continue to pay based on the current terms of the loan contract. Management used the asset approach for all nonaccrual loans to reflect market participant assumptions. Under the asset approach, the fair value of each loan was determined based on the estimated values of the underlying collateral.
The methods used to estimate the Level 3 fair values of loans are extremely sensitive to the assumptions and estimates used. While management attempted to use assumptions and estimates that best reflected the acquired loan portfolios and current market conditions, a greater degree of subjectivity is inherent in these values than in those determined in active markets.
The difference between the fair value and the expected cash flows from acquired loans will be accreted to interest income over the remaining term of the loans in accordance with ASC topic 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality." See Note 6 for further details.
Premises and equipment. The land and buildings acquired were recorded at fair value as determined by third party appraisals.
Other intangible assets. Other intangible assets consisting of core deposit intangibles ("CDI") are measures of the value of non-interest checking, savings, interest-bearing checking, and money market deposits that are acquired in a business combination excluding certificates of deposit with balances over $250,000 and high yielding interest bearing deposit accounts, which the Company determines customer related intangible assets as non-existent. The fair value of the CDI stemming from any given business combination is based on the present value of the expected cost savings attributable to the core deposit funding, relative to an alternative funding source. The CDI is being amortized over an estimated useful life of 6.7 years to approximate the existing deposit relationships acquired.
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Notes to Consolidated Financial Statements (Continued)
(3) Business Combinations (Continued)
Deposits. The fair values of deposit liabilities with no stated maturity (non-interest checking, savings, interest-bearing checking, and money market deposits) are equal to the carrying amounts payable on demand. The fair values of the certificates of deposit represent contractual cash flows, discounted to present value using interest rates currently offered by market participants on deposits with similar characteristics and remaining maturities.
Junior subordinated debentures issued to Trust. There is no active market for trust preferred securities issued by UFBC Capital Trust I; therefore, the fair value of junior subordinated debentures was estimated utilizing the income approach. Under the income approach, the expected cash flows over the remaining estimated life of the debentures were discounted at the prevailing market rate. The prevailing market rate was based on: (i) a third-party broker opinion; (ii) implied market yields for recent trust preferred sales; and (iii) new trust preferred issuances for instruments with similar long durations.
Gainesville Branch Acquisition
On November 7, 2014, the Company acquired a branch location in Gainesville, VA, with approximately $66.3 million in assets, after purchase accounting adjustments. The total consideration for the acquisition was $195,000 in cash.
The following table sets forth the assets acquired and liabilities assumed in the acquisition at their estimated fair values as of the closing date of the transaction:
Fair Value Measurement of Assets Acquired and Liabilities Assumed
Below are the methods used to determine the fair values of the significant assets acquired and liabilities assumed in the acquisition.
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Notes to Consolidated Financial Statements (Continued)
(3) Business Combinations (Continued)
Cash. The carrying amount of the cash received was used as a reasonable estimate of fair value.
Other intangible assets. Other intangible assets consisting of core deposit intangibles ("CDI") are measures of the value of non-interest checking, savings, interest-bearing checking, and money market deposits that are acquired in a business combination excluding certificates of deposit with balances over $250,000 and high yielding interest bearing deposit accounts, which the Company determines customer related intangible assets as non-existent. The fair value of the CDI stemming from any given business combination is based on the present value of the expected cost savings attributable to the core deposit funding, relative to an alternative funding source. The CDI is being amortized over an estimated useful life of 5.9 years to approximate the existing deposit relationships acquired.
Deposits. The fair values of deposit liabilities with no stated maturity (non-interest checking, savings, interest-bearing checking, and money market deposits) are equal to the carrying amounts payable on demand. The fair values of the certificates of deposit represent contractual cash flows, discounted to present value using interest rates currently offered by market participants on deposits with similar characteristics and remaining maturities.
Other borrowed funds. Other borrowed funds consist of one customer repurchase agreement. The fair value of this repurchase agreement is equal to the carrying amount payable on demand as the stated maturity for customer repurchases agreements is between one and four days.
(4) Investment Securities and Other Investments
The approximate fair value and amortized cost of investment securities at December 31, 2015 and 2014 are shown below.
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Notes to Consolidated Financial Statements (Continued)
(4) Investment Securities and Other Investments (Continued)
The fair value and amortized cost of investment securities by contractual maturity at December 31, 2015 are shown below. Expected maturities may differ from contractual maturities because many issuers have the right to call or prepay obligations with or without call or prepayment penalties.
For the years ended December 31, 2015, 2014, and 2013, proceeds from sales of investment securities available-for-sale amounted to $15.0 million, $29.5 million, and $0, respectively. Gross realized gains in 2015, 2014, and 2013, amounted to $971,000, $1.1 million, and $0, respectively. Gross realized losses for each of the years ended December 31, 2015, 2014, and 2013, were $0, $19,000, and $0, respectively.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(4) Investment Securities and Other Investments (Continued)
The table below shows the Company's investment securities' gross unrealized losses and their fair value, aggregated by investment category and the length of time that individual securities have been in a continuous unrealized loss position at December 31, 2015 and 2014.
The Company estimates the fair value of its pooled trust preferred securities portfolio by using third party projected cash flows for each of the issuances in the portfolio, and a discount rate that is commensurate with the risk inherent in the expected cash flows is applied to arrive at the estimated fair value.
The Company completes reviews for other-than-temporary impairment at least quarterly. As of December 31, 2015, the majority of the investment securities portfolio consisted of securities rated AAA by a leading rating agency. Investment securities which carry a AAA rating are judged to be of
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(4) Investment Securities and Other Investments (Continued)
the best quality and carry the smallest degree of investment risk. At December 31, 2015, 99% of the Company's mortgage-backed securities are guaranteed by the Federal National Mortgage Association (FNMA), the Federal Home Loan Mortgage Corporation (FHLMC) and the Government National Mortgage Association (GNMA).
At December 31, 2015, the Company has $947,000 in non-government non-agency mortgage-backed securities in its available-for-sale portfolio. The various protective elements on the non-agency securities may change in the future if market conditions or the financial stability of credit insurers changes, which could impact the ratings of these securities.
At December 31, 2015, certain of the Company's investment grade securities were in an unrealized loss position. Investment securities with unrealized losses are a result of pricing changes due to recent and negative conditions in the current market environment and not as a result of permanent credit impairment. Contractual cash flows for the agency mortgage-backed securities are guaranteed and/or funded by the U.S. government. Other mortgage-backed securities and municipal securities have third party protective elements and there are no negative indications that the contractual cash flows will not be received when due. The Company does not intend to sell nor does the Company believe it will be required to sell any of its temporarily impaired securities prior to the recovery of the amortized cost.
At December 31, 2013, the Company owned four pooled trust preferred securities which were all previously classified as held-to-maturity within the investment securities portfolio. Based on the interim rule, only two of the four investments were exempt from the covered fund definition. For the two investments that were not exempt as a result of the interim rule, the Company would have been required to divest its investment in these particular pooled trust preferred securities prior to the effectiveness of the Final Rule, July 21, 2017. As a result of this new regulation, these two investments were reclassified to the available-for-sale investment securities portfolio and an other-than-temporary impairment of $300,000 was recognized as of December 31, 2013. During the fourth quarter of 2014, one of these available-for-sale pooled trust preferred investments paid off early, and the Company recognized a gain of $120,000 from the other-than-temporary impairment charge recorded as of December 31, 2013. During the second quarter of 2015, the remaining available-for-sale pooled trust preferred investments paid off early, and the Company recognized a gain of $180,000 from the other-than-temporary impairment charge recorded as of December 31, 2013.
The par and carrying values of the two pooled trust preferred securities still classified as held-to-maturity were each $3.8 million at December 31, 2015. The collateral underlying these structured securities are instruments issued by financial institutions. The Company owns the A-3 tranches in each issuance. Each of the bonds is rated by more than one rating agency. One security has a composite rating of AA and the other security has a composite rating of A. Observable trading activity remains limited for these types of securities. The Company has estimated the fair value of the securities through the use of internal calculations and through information provided by external pricing services. Given the level of subordination below the A-3 tranches, and the actual and expected performance of the underlying collateral, the Company expects to receive all contractual interest and principal payments recovering the amortized cost basis of each of the securities, and concluded that these securities are not other-than-temporarily impaired. The Company continuously monitors the financial condition of the underlying issues and the level of subordination below the A-3 tranches. The Company also utilizes a multi-scenario model which assumes varying levels of additional defaults and deferrals and the effects of such adverse developments on the contractual cash flows for the A-3
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(4) Investment Securities and Other Investments (Continued)
tranches. In each of the adverse scenarios, there was no indication of a break to the A-3 contractual cash flows.
With the exception of the aforementioned impairment recorded on the Company's pooled trust preferred securities, no other-than-temporary impairment has been recognized for the remaining securities in the Company's investment portfolio as of December 31, 2015, 2014, and 2013.
Investment securities that were pledged to secure borrowed funds and other balances as required at December 31, 2015 and 2014 had carrying values of $349.1 million and $192.9 million, respectively. The market values of these pledged securities at December 31, 2015 and 2014 were $360.9 million and $203.6 million, respectively. They were pledged as follows:
Investment securities are pledged against certain customer deposit accounts (referred to as customer repurchase agreements). See Note 12 to the notes to consolidated financial statements for additional information.
The Company has other investments totaling $21.0 million and $15.9 million at December 31, 2015 and 2014, respectively. The following table discloses the types of investments included in other investments:
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(4) Investment Securities and Other Investments (Continued)
As a member of the Federal Home Loan Bank of Atlanta ("FHLB"), the Company's banking subsidiary is required to hold stock in this entity. Stock membership in Community Bankers' Bank allows the Company to participate in loan purchases and sales. These investments are carried at cost since no active trading markets exist.
The Company's policy is to review for impairment of FHLB stock at each reporting period. At December 31, 2015, FHLB was in compliance with all of its regulatory capital requirements. The Company believes its holdings in the stock are ultimately recoverable at par value as of December 31, 2015. In addition, the Company has ample liquidity and does not require redemption of its FHLB stock in the foreseeable future. Based on the Company's analysis of positive and negative factors, it believes that as of December 31, 2015 and 2014, its FHLB stock was not impaired.
(5) Investment Securities-Trading
The Company acquired investment assets and designated them as trading to economically hedge against fair value changes of the Company's nonqualified deferred compensation plan liability. Those investments were designated as trading securities, and as such, the changes in fair value are reflected in earnings. Trading securities at December 31, 2015 and 2014 are as follows:
The net realized gain on trading securities for the years ended December 31, 2015, 2014, and 2013, was $240,000, $478,000, and $68,000, respectively.
(6) Loans Receivable and Allowance for Loan Losses
The loan portfolio at December 31, 2015 and 2014 consists of the following:
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(6) Loans Receivable and Allowance for Loan Losses (Continued)
The loan portfolio is segregated into two components; loans accounted for under the amortized cost method (referred to as "originated" loans) and loans acquired (referred to as "acquired" loans).
The loans segregated to the acquired loan portfolio were initially measured at fair value and subsequently accounted for under either ASC Topic 310-30 or ASC Topic 310-20. The outstanding principal balance and related carrying amount of acquired loans included in the consolidated statements of condition at December 31, 2015 and 2014, respectively, are as follows:
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(6) Loans Receivable and Allowance for Loan Losses (Continued)
The following table presents changes in the accretable discount, which includes income recognized from contractual interest cash flows.
Loans totaling $1.1 billion serve as collateral for the Company's Federal Home Loan Bank advance capacity at December 31, 2015. Loans held as collateral at the Federal Reserve for use of the Company's discount window line of credit total $240.4 million at December 31, 2015.
For purposes of monitoring the performance of the loan portfolio and estimating the allowance for loan losses, the Company's loans receivable portfolio is segmented as follows: commercial and industrial, real estate-commercial, real estate-construction, real estate-residential, home equity lines and consumer loans.
Commercial and Industrial Loans. The Company makes commercial loans to qualified businesses within its market area. The commercial lending portfolio consists primarily of commercial and industrial loans for the financing of accounts receivable, property, plant and equipment. The Company has a government contract lending group which provides secured lending to government contracting firms and businesses based primarily on receivables from the federal government. In addition, the Company, which is certified as a preferred lender by the Small Business Administration (SBA), offers SBA guaranteed loans and asset-based lending arrangements to its customers.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(6) Loans Receivable and Allowance for Loan Losses (Continued)
Commercial and industrial loans generally have a higher degree of risk than other certain types of loans. Commercial loans typically are made on the basis of the borrower's ability to repay the loan from the cash flow from its business and are secured by business assets, such as commercial real estate, accounts receivable, equipment and inventory, the values of which may fluctuate over time and generally cannot be appraised with as much precision as residential real estate. As a result, the availability of funds for the repayment of commercial loans may be substantially dependent upon the commercial success of the business itself. To manage these risks, the Company's policy is to secure commercial loans originated with both the assets of the business, which are subject to the risks described above, and other additional collateral and guarantees that may be available.
Real Estate-Commercial Loans. Real estate-commercial loans are primarily secured by various types of commercial real estate, including office, retail, warehouse, industrial and other non-residential types of properties and are made to the owners and/or occupiers of such property.
These loans typically involve larger loan balances concentrated with single borrowers or groups of related borrowers. Additionally, the repayment of loans secured by income-producing properties is typically dependent upon the successful operation of a business or real estate project and thus may be subject to adverse conditions in the commercial real estate market or in the general economy. The Company generally requires personal guarantees or endorsements with respect to these loans and loan-to-value ratios for real estate-commercial loans generally do not exceed 80%.
Real Estate-Construction Loans. The Company's real estate-construction loan portfolio consists of single-family residential properties, multi-family properties and commercial projects. Construction lending entails significant additional risks as they often involve larger loan balances concentrated with single borrowers or groups of related borrowers. Construction loans also involve additional risks since funds are advanced while the property is under construction, which property has uncertain value prior to the completion of construction. Thus, it is more difficult to accurately evaluate the total loan funds required to complete a project and related loan-to-value ratios. To reduce the risks associated with construction lending, the Company generally limits loan-to-value ratios to 80% of when-completed appraised values for owner-occupied residential or commercial properties and for investor-owned residential or commercial properties. Construction loan agreements may include provisions which allow for the payment of contractual interest from an interest reserve. Amounts drawn from an interest reserve increase the amount of the outstanding balance of the construction loan. This is an industry standard practice.
Real Estate-Residential and Home Equity Loans. Real estate-residential loans are originated by Cardinal Bank and George Mason. This portfolio consists of residential first and second mortgage loans, residential construction loans and home equity lines of credit and term loans secured primarily by the residences of borrowers.
Residential mortgage loans and home equity lines of credit secured by owner-occupied property generally are made with a loan-to-value ratio of up to 80%. Loan-to-value ratios of up to 90% may be allowed on residential owner-occupied property if the borrower exhibits unusually strong creditworthiness.
Consumer Loans. The Company's consumer loans consist primarily of installment loans made to individuals for personal, family and household purposes. The specific types of consumer loans
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(6) Loans Receivable and Allowance for Loan Losses (Continued)
originated include home improvement loans, automobile loans, debt consolidation loans and other general consumer lending.
Consumer loans may entail greater risk than certain other types of loans, particularly in the case of consumer loans that are unsecured, such as lines of credit, or secured by rapidly depreciable assets, such as automobiles.
The Company's policy for consumer loans is to accept moderate risk while minimizing losses, primarily through a careful credit and financial analysis of the borrower. In evaluating consumer loans, the Company requires its lending officers to review the borrower's collateral and stability of income, past credit history, amount of debt currently outstanding and the impact of these factors on the ability of the borrower to repay the loan in a timely manner.
The Company also issues credit cards to certain of its customers. In determining to whom the Company will issue credit cards, the Company evaluates the borrower's level and stability of income, past credit history and other factors. Credit card receivables are included in the consumer loan portfolio.
Substantially all of the Company's loans, commitments and standby letters of credit have been granted to customers located in the Washington, D.C. metropolitan area. As a matter of regulatory restriction, the Company's banking subsidiary limits the amount of credit extended to any single borrower or group of related borrowers. At December 31, 2015, the amount of credit extended to any single borrower or group of related borrowers was limited to $63.6 million. Loans in process at December 31, 2015 and 2014 were $175,000 and $857,000, respectively.
The Company's allowance for loan losses is based first, on a segmentation of its loan portfolio by general loan type, or portfolio segments, as presented in the preceding table. Certain portfolio segments are further disaggregated and evaluated collectively for impairment based on class segments, which are largely based on the type of collateral underlying each loan.
An analysis of the change in the allowance for loan losses follows:
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(6) Loans Receivable and Allowance for Loan Losses (Continued)
An analysis of the allowance for loan losses based on loan type, or segment, and the Company's loan portfolio, which identifies certain loans that are evaluated for individual or collective impairment, is below:
Allowance for Loan Losses
For the Year Ended December 31, 2015
(In thousands)
Loans Receivable
At December 31, 2015
(In thousands)
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(6) Loans Receivable and Allowance for Loan Losses (Continued)
Allowance for Loan Losses
For the Year Ended December 31, 2014
(In thousands)
Loans Receivable
At December 31, 2014
(In thousands)
The accounting policy related to the allowance for loan losses is considered a critical policy given the level of estimation, judgment and uncertainty in evaluating the levels of the allowance required for the inherent probable losses in the loan portfolio and the material effect such estimation, judgment and uncertainty can have on the consolidated financial results.
The Company's ongoing credit quality management process relies on a system of activities to assess and evaluate various factors that impact the estimation of the allowance for loan losses. These factors include, but are not limited to: current economic conditions; loan concentrations, collateral adequacy and value; past loss experience for particular types of loans, size, composition and nature of loans; migration of loans through the Company's loan rating methodology; trends in charge-offs and recoveries. This process also contemplates a disciplined approach to managing and monitoring credit exposures to ensure that the structure and pricing of credit is always consistent with the Company's assessment of the risk. The loan officer has frequent contact with the borrower and is a key player in
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(6) Loans Receivable and Allowance for Loan Losses (Continued)
the credit management process and must develop and diligently practice sound credit management skills and habits to ensure effectiveness. Under the direction of the Company's loan committee and the chief credit officer, the credit risk management function works with the loans officers and other groups within the Company to monitor the loan portfolio, maintain the watch list, and compile the analysis necessary to determine the allowance for loan losses.
Loans are added to the watch list when circumstances appear to warrant the inclusion of the relationship. As a general rule, loans are added to the watch list when they are deemed to be problem assets. Problem assets are defined as those that have been risk rated substandard or lower. Successful problem asset management requires early recognition of deteriorating credits and timely corrective or risk management actions. Generally, risk ratings are either approved or amended by the loan committee accordingly. Problem loans are maintained on the watch list until the loan is either paid off or circumstances around the borrower's situation improve to the point that the risk rating on the loan is adjusted upward.
In addition to internal activities, the Company also engages an external consultant on a quarterly basis to review the Company's loan portfolio. This external loan review function helps to ensure the soundness of the loan portfolio through a third party review of existing exposures in the portfolio, supporting the commercial loan officers in the execution of its credit management responsibilities, and monitoring the adherence to the Company's credit risk management standards.
The following tables report the Company's nonaccrual and past due loans at December 31, 2015 and 2014. In addition, the credit quality of the loan portfolio is provided as of December 31, 2015 and 2014.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(6) Loans Receivable and Allowance for Loan Losses (Continued)
Nonaccrual and Past Due Loans-Originated Loan Portfolio
At December 31, 2015
(In thousands)
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(6) Loans Receivable and Allowance for Loan Losses (Continued)
Nonaccrual and Past Due Loans-Acquired Loan Portfolio
At December 31, 2015
(In thousands)
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(6) Loans Receivable and Allowance for Loan Losses (Continued)
Nonaccrual and Past Due Loans-Originated Loan Portfolio
At December 31, 2014
(In thousands)
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(6) Loans Receivable and Allowance for Loan Losses (Continued)
Nonaccrual and Past Due Loans-Acquired Loan Portfolio
At December 31, 2014
(In thousands)
At December 31, 2015, 2014, and 2013, the Company had impaired loans on nonaccrual status of $451,000, $3.4 million, and $2.3 million, respectively. These impaired loans did not have a valuation allowance for each of the years ended December 31, 2015 and 2014. For the years ended December 31, 2015, 2014, and 2013, the Company charged-off $22,000, $814,000, and $0, respectively, related to impaired loans for the portion of the outstanding principal balance which was unsecured based on the estimated fair value of the underlying collateral.
The average balance of impaired loans was $1.7 million, $4.7 million, and $4.2 million, for 2015, 2014, and 2013, respectively. Interest income that would have been recorded had these loans been performing for the years ended December 31, 2015, 2014, and 2013, would have been $201,000, $866,000, and $626,000, respectively. The interest income realized prior to these loans being placed on nonaccrual status for December 31, 2015, 2014, and 2013, was $6,000, $129,000, and $5,000, respectively. For each of the years ended December 31, 2015 and 2014, the Company did not have any accruing loans past due 90 days or more as to principal or interest payments.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(6) Loans Receivable and Allowance for Loan Losses (Continued)
Additional information on the Company's impaired loans that were evaluated for specific reserves as of December 31, 2015 and 2014, including the recorded investment on the statement of condition and the unpaid principal balance, is shown below:
Impaired Loans-Originated Loan Portfolio
At December 31, 2015
(In thousands)
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(6) Loans Receivable and Allowance for Loan Losses (Continued)
The difference between the recorded investment and the unpaid principal balance in the above table is a result of partial loan charge-offs that the Company has recorded on these impaired loans.
Impaired Loans-Acquired Loan Portfolio
At December 31, 2015
(In thousands)
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(6) Loans Receivable and Allowance for Loan Losses (Continued)
Impaired Loans-Originated Loan Portfolio
At December 31, 2014
(In thousands)
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(6) Loans Receivable and Allowance for Loan Losses (Continued)
Impaired Loans-Acquired Loan Portfolio
At December 31, 2014
(In thousands)
In order to maximize the collection of certain loans, the Company will attempt to work with borrowers when necessary to extend or modify loan terms to better align with the borrower's ability to
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(6) Loans Receivable and Allowance for Loan Losses (Continued)
repay. Extensions and modifications to loans are made in accordance with the Company's policy and conform to regulatory guidance. Each occurrence is unique to the borrower and is evaluated separately. The Company considers regulatory guidelines when restructuring a loan to ensure that prudent lending practices are followed. As such, qualification criteria and payment terms consider the borrower's current and prospective ability to comply with the modified terms of the loan.
A modification is classified as a troubled debt restructuring ("TDR") if both of the following exist: (1) the borrower is experiencing financial difficulty and (2) the Company has granted a concession to the borrower. The Company determines that a borrower may be experiencing financial difficulty if the borrower is currently in default on any of its debt, or if the Company is concerned that the borrower may not be able to perform in accordance with the current terms of the loan agreement in the foreseeable future. Many aspects of the borrower's financial situation are assessed when determining whether they are experiencing financial difficulty, particularly as it relates to commercial borrowers due to the complex nature of the loan structure, business/industry risk, and borrower/guarantor structures. Concessions may include the reduction of an interest rate at a rate lower than current market rate for a new loan with similar risk, extension of the maturity date, reduction of accrued interest, or principal forgiveness. When evaluating whether a concession has been granted, the Company also considers whether the borrower has provided additional collateral or guarantors and whether such additions adequately compensate the Company for the restructured terms, or if the revised terms are consistent with those currently being offered to new loan customers. The assessments of whether a borrower is experiencing (or is likely to experience) financial difficulty and whether a concession has been granted is subjective in nature and management's judgment is required when determining whether a modification is a TDR.
Although each occurrence is unique to the borrower and is evaluated separately, for all portfolio segments, TDRs are typically modified through reductions in interest rates, reductions in payments, changing the payment terms from principal and interest to interest only, and/or extensions in term maturity.
Nonaccruing loans that are modified can be placed back on accrual status when both the principal and interest are current and it is probable that the Company will be able to collect all amounts due (both principal and interest) according to the terms of the loan agreement. The Company modified two loans (which are related to one borrower) as TDRs and one previously reported TDR paid off during
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(6) Loans Receivable and Allowance for Loan Losses (Continued)
the year ended December 31, 2015. The following table reconciles the beginning and ending balances on TDRs for the years ended December 31, 2015 and 2014, respectively:
Troubled Debt Restructurings
At December 31, 2015
(In thousands)
Troubled Debt Restructurings
At December 31, 2014
(In thousands)
Loans reported as TDRs as of December 31, 2015 are not on nonaccrual. While the borrower is having financial difficulty, the borrower has not missed a scheduled payment under the terms of the loan agreement. The Company did not place these TDRs on nonaccrual as the only concession granted to the borrower was an extension of the maturity date to provide the borrower additional time needed to sell the collateral associated with these two loans. Loans reported as TDRS as of December 31, 2014 are on nonaccrual status. Nonaccrual TDRs that are reasonably assured of repayment according to their modified terms may be returned to accrual status by the Company upon a detailed credit evaluation of the borrower's financial condition and prospects for repayment under the revised terms. Consistent with regulatory guidance, upon sustained performance and classification as a TDR over the Company's year-end, the loan will be removed from TDR status as long as the modified terms were market-based at the time of the modification.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(6) Loans Receivable and Allowance for Loan Losses (Continued)
As of December 31, 2015 and 2014, the TDRs make up one relationship with the Bank. These loans are performing as expected post-modification. For restructured loans in the portfolio, the Company had no loan loss reserves for each of the years ended December 31, 2015 and 2014, respectively. There were no outstanding commitments to advance additional funds to customer relationships whose loans had been restructured for each of the years ended December 31, 2015 and 2014.
Loans modified as TDRs within the previous 12 months and for which there was a payment default during the period are calculated by first identifying TDRs that defaulted during the period and then determining whether they were modified within the 12 months prior to the default. For the years ended December 31, 2015 and 2014, respectively, no loans identified as TDRs had a payment default within the last twelve months.
One of the most significant factors in assessing the credit quality of the Company's loan portfolio is the risk rating. The Company uses the following risk ratings to manage the credit quality of its loan portfolio: pass, other loans especially mentioned ("OLEM"), substandard, doubtful and loss. OLEM are those loans in which the borrower exhibits potential weakness that may, if not corrected or reversed, weaken the Bank's credit position at some future date. These loans may not show problems as yet due to the borrower's apparent ability to service the debt, but special circumstances surround the loans of which the Bank's management should be aware. Substandard risk rated loans are those loans whose full final collectability may not appear to be a matter for serious doubt, but which nevertheless have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt and require close supervision by management. Loans that have a risk rating of doubtful have all the weakness inherent in one graded substandard with the added provision that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and value, highly questionable. A loss loan is one that is considered uncollectible and will be charged-off immediately. All other loans not rated OLEM, substandard, doubtful or loss are considered to have a pass risk rating. Substandard and doubtful risk rated loans are evaluated for impairment. The following table presents a summary of the risk ratings by portfolio segment and class segment at December 31, 2015 and 2014, respectively.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(6) Loans Receivable and Allowance for Loan Losses (Continued)
Internal Risk Rating Grades-Originated Loan Portfolio
At December 31, 2015
(In thousands)
Internal Risk Rating Grades-Acquired Loan Portfolio
At December 31, 2015
(In thousands)
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(6) Loans Receivable and Allowance for Loan Losses (Continued)
Internal Risk Rating Grades-Originated Loan Portfolio
At December 31, 2014
(In thousands)
Internal Risk Rating Grades-Acquired Loan Portfolio
At December 31, 2014
(In thousands)
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(6) Loans Receivable and Allowance for Loan Losses (Continued)
Loans rated substandard and doubtful totaled $8.2 million and $4.9 million at December 31, 2015 and 2014, respectively. For each of the years ended December 31, 2015 and 2014, there was no related allowance for impaired loans. Loans receivable-evaluated for impairment and measured at fair value on a non-recurring basis, net of the related allowance is $7.1 million and $1.9 million for the years ended December 31, 2015 and 2014, respectively (see Note 24 to the notes to consolidated financial statements for additional information).
(7) Other Real Estate Owned
The Company had other real estate owned of $253,000 and $0 at December 31, 2015 and 2014, respectively. The balances in other real estate owned are at the lower of carrying value or fair value less any costs to sell on the statement of condition. The fair value is determined by obtaining an updated appraisal of the foreclosed property which is then discounted for estimated selling costs.
The Company recorded no impairment charges related to other real estate owned during 2015 and 2014. The Company recorded a net gain on the sales of real estate of $0, $0, and $30,000 for the years ended December 31, 2015, 2014, and 2013, respectively.
(8) Loans Held for Sale
The loans held for sale portfolio at December 31, 2015 and 2014, consisted of the following:
Loans that are classified as construction-to-permanent are those loans that provide variable rate financing for customers to construct their residences. Once the home has been completed, the loan converts to fixed rate financing and is sold into the secondary market.
(9) Goodwill and Other Intangible Assets
The Company performs its annual recoverability assessment during the third calendar quarter for its commercial banking and mortgage banking reporting units.
For purposes of the annual impairment test, the Company assessed qualitative factors including macroeconomic conditions, industry and market conditions, cost factors, and overall financial performance in 2015. After evaluating all relevant facts and circumstances, the Company determined that it is more likely than not that the fair value of each of the reporting units exceeds its carrying value and no goodwill impairment was indicated for the year ended December 31, 2015.
The Company did not perform the two-step impairment test for any of its reporting units in 2015 and 2014.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(9) Goodwill and Other Intangible Assets (Continued)
Information concerning amortizable intangibles follows:
The aggregate amortization expense for 2015, 2014, and 2013, was $736,000, $775,000, and $148,000, respectively. The estimated amortization expense for the next five years and thereafter is as follows:
The carrying amount of goodwill for the years ended December 31, 2015 and 2014 were as follows:
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(10) Premises and Equipment
The components of premises and equipment at December 31, 2015 and 2014 were as follows:
Depreciation expense for the years ended December 31, 2015, 2014, and 2013, was $3.4 million, $3.7 million, and $3.2 million, respectively.
The Company has entered into operating leases for office space over various terms. The leases generally have options to renew and are subject to annual increases as well as allocations of real estate taxes and certain operating expenses.
Minimum future rental payments under the non-cancelable operating leases, as of December 31, 2015 were as follows:
The total rent expense was $9.0 million, $9.5 million, and $7.9 million, for the years ended December 31, 2015, 2014, and 2013, respectively, and is recorded in occupancy expense on the consolidated statements of income.
The Company subleased excess office space to third parties. Future minimum lease payments under noncancelable subleasing arrangements as of December 31, 2015 were as follows:
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(10) Premises and Equipment (Continued)
The total rent income was $133,000, $186,000, and $158,000, in 2015, 2014, and 2013, respectively, and is recorded as a reduction of occupancy expense in the consolidated statements of income.
(11) Deposits
Deposits consist of the following at December 31, 2015 and 2014:
Interest expense by deposit categories is as follows:
The aggregate amount of certificates of deposit, each with a minimum denomination of $250,000 was $299.7 million and $171.5 million at December 31, 2015 and 2014, respectively.
At December 31, 2015, the scheduled maturities of certificates of deposit with a minimum denomination of $250,000 were as follows:
Maturities:
No-penalty certificates of deposit can be redeemed at anytime at the request of the depositor.
Brokered certificates of deposits at December 31, 2015 and 2014 were $407.0 million and $310.4 million, respectively.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(11) Deposits (Continued)
At December 31, 2015, the scheduled maturities of certificates of deposit were as follows:
(12) Other Borrowed Funds
At December 31, 2015 and 2014, other borrowed funds consisted of the following:
The Company had fixed rate advances from the FHLB totaling $355.0 million and $240.0 million at December 31, 2015 and 2014, respectively. These advances mature through 2022 and have interest rates ranging from 0.35% to 4.01%.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(12) Other Borrowed Funds (Continued)
The contractual maturities of the fixed rate advances for each of December 31, 2015 and 2014 were as follows:
(In thousands)
(In thousands)
The average balances of FHLB advances for the years ended December 31, 2015 and 2014 were $262.1 million and $262.8 million, respectively. The maximum amount outstanding at any month-end for each of the years ended December 31, 2015 and 2014 were $355.0 million and $315.0 million, respectively. Total interest expense on FHLB advances for the years ended December 31, 2015, 2014, and 2013, was $7.0 million, $8.0 million, and $7.9 million, respectively.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(12) Other Borrowed Funds (Continued)
Customer repurchase agreements generally mature within one to four days and are reflected in the consolidated statements of financial condition at the amount of cash received. The Company's deposit customers are the counterparties to these types of funding arrangements. The Company pledges investment securities to collateralize these borrowings. At December 31, 2015 and 2014, the Company had repurchase agreements of $113.6 million and $103.7 million, respectively. The weighted-average interest rate of these customer repurchase agreements was 0.12%, 0.15%, and 0.16%, at December 31, 2015, 2014, and 2013, respectively. The average balances of customer repurchase agreements during 2015, 2014, and 2013, were $107.0 million, $101.4 million, and $104.8 million, respectively, and the maximum amount outstanding at any month-end during 2015, 2014, and 2013, was $136.5 million, $116.8 million, and $148.1 million, respectively. Interest expense on customer repurchase agreements for 2015, 2014, and 2013, was $131,000, $142,000, and $165,000, respectively.
At December 31, 2015 and 2014, the Company had federal funds purchased of $45.0 million and $70.0 million, respectively, outstanding with a weighted average interest rate of 0.37% and 0.34%, respectively. Interest expense on federal funds purchased in 2015, 2014, and 2013, was $42,000, $34,000, and $24,000, respectively.
The Company has a line of credit at the Federal Reserve discount window in the amount of $164.8 million at December 31, 2015, none of which was drawn as of that date. There was no interest expense related to the discount window in 2015, 2014, and 2013.
In July 2004, the Company formed a wholly-owned subsidiary, Cardinal Statutory Trust I (the "Trust"), for the purpose of issuing $20.0 million of floating rate junior subordinated deferrable interest debentures ("trust preferred securities"). These trust preferred securities are due in 2034 and have an interest rate of LIBOR plus 2.40%, which adjusts quarterly. At December 31, 2015, the interest rate on trust preferred securities was 2.91%. These securities are redeemable at par. The Company has guaranteed payment of these securities. The $20.6 million payable by the Company to the Trust is included in other borrowed funds. The Trust is an unconsolidated subsidiary since the Company is not the primary beneficiary of this entity. The additional $619,000 that is payable by the Company to the Trust represents the Company's unfunded capital investment in the Trust. The Company utilized the proceeds from the issuance of the trust preferred securities to make a capital contribution into the Bank. Interest expense on the trust preferred securities in 2015, 2014, and 2013, was $564,000, $551,000, and $693,000, respectively.
In connection with the UFBC acquisition, the Company acquired all of the voting and common shares of UFBC Capital Trust I (the "UFBC Trust"), which is a wholly-owned subsidiary established for the sole purpose of issuing $5.0 million of floating rate junior subordinated deferrable interest debentures. These trust preferred securities are due in 2035 and have an interest rate of LIBOR plus 2.10%, which adjusts quarterly. At December 31, 2015, the interest rate on trust preferred securities was 2.61%. The UFBC Trust is an unconsolidated subsidiary since the Company is not the primary beneficiary of this entity. The additional $155,000 that is payable by the Company to the UFBC Trust represents the Company's unfunded capital investment in the UFBC Trust. Interest expense on the trust preferred securities in 2015 and 2014 was $170,000 and $152,000, respectively.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(12) Other Borrowed Funds (Continued)
The scheduled maturities of other borrowed funds at December 31, 2015 were as follows:
(13) Income Taxes
The Company and its subsidiaries file consolidated federal tax returns on a calendar-year basis. For the years ended December 31, 2015, 2014, and 2013, the Company recorded income tax expense of $24.1 million, $16.0 million, and $12.2 million, respectively.
The provision for income tax expense is reconciled to the amount computed by applying the federal corporate tax rate to income before taxes as follows:
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(13) Income Taxes (Continued)
The components of income tax expense are as follows:
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(13) Income Taxes (Continued)
The tax effects of temporary differences between the financial reporting basis and income tax basis of assets and liabilities relate to the following:
Deferred tax assets and liabilities are recognized for the tax effects of differing carrying values of assets and liabilities for tax and financial statement purposes that will reverse in future periods. When uncertainty exists concerning the recoverability of a deferred tax asset, the carrying value of the asset may be reduced by a valuation allowance. Valuation allowances of $2.4 million and $2.7 million for December 31, 2015 and 2014, respectively, have been established for deferred tax assets. This valuation allowance relates primarily to the state net operating losses and other net deductible temporary differences of the parent company and CWS as realization is dependent upon generating future taxable income within those entities and in the specific jurisdiction. There is uncertainty concerning the recoverability of these state net operating losses and other net deductible temporary differences as the entities which own these losses have never operated profitably and future profitability is uncertain. Management believes that future operations of the Company will generate sufficient taxable income to realize the net deferred tax assets at each of December 31, 2015 and 2014. The Company has state net operating loss carryforwards of $43.4 million that begin to expire in 2017.
As of December 31, 2015 and 2014, the Company had no unrecognized tax benefits. The Company had no interest expense or tax penalties related to uncertain tax positions during the years ended December 31, 2015 and 2014. If the Company had such expenses, they would be classified in the consolidated statements of income as part of the provision for income tax expense.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(14) Derivative Instruments and Hedging Activities
Forward Mortgage Loan Sales Commitments and Interest Rate Lock Commitments
The Company enters into rate lock commitments with its mortgage customers. The Company is also a party to forward mortgage loan sales contracts to sell loans servicing released. The rate lock commitment and forward sale agreement are undesignated derivatives and marked to fair value through earnings. The fair value of the rate lock derivative includes the servicing premium and the interest spread for the difference between retail and wholesale mortgage rates. Realized and unrealized gains on mortgage banking activities presents the gain recognized for the period presented and associated with these elements of fair value. On the date the mortgage loan closes, the loan held for sale is designated as the hedged item in a cash flow hedge relationship and the forward loan sale commitment is designated as the hedging instrument.
At December 31, 2015 and 2014, accumulated other comprehensive income included unrealized losses, net of tax, of $64,000 and $411,000, respectively, related to forward loan sale contracts designated as the hedging instrument in the cash flow hedge. Loans held for sale are generally sold within sixty days of closing and, therefore, substantially all of the amount recorded in accumulated other comprehensive income at December 31, 2015 which is related to the Company's cash flow hedges will be recognized in earnings during the first quarter of 2016. For the year ended December 31, 2015, the Company recognized income of $108,000 related to hedge ineffectiveness. For the years ended December 31, 2014, and 2013, the Company recognized minimal amounts due to hedge ineffectiveness.
At December 31, 2015, the Company had $247.4 million in residential mortgage rate lock commitments and associated forward sales and $337.2 million in forward loan sales associated with $383.8 million of loans that had closed and were presented as held for sale. At December 31, 2015, the derivative asset was $19.1 million and the derivative liability was $2.5 million.
At December 31, 2014, the Company had $194.9 million in residential mortgage rate lock commitments and associated forward sales and $269.4 million in forward loan sales associated with $315.3 million of loans that had closed and were presented as held for sale. At December 31, 2014, the derivative asset was $15.1 million and the derivative liability was $2.8 million.
(15) Fair Value of Derivative Instruments and Hedging Activities
The following tables disclose the derivative instruments' location on the Company's statement of condition and the fair value of those instruments at December 31, 2015 and 2014. In addition, the gains and losses related to these derivative instruments is provided for the years ended December 31, 2015 and 2014.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(15) Fair Value of Derivative Instruments and Hedging Activities (Continued)
Derivative Instruments and Hedging Activities
At December 31, 2015
(in thousands)
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(15) Fair Value of Derivative Instruments and Hedging Activities (Continued)
Derivative Instruments and Hedging Activities
At December 31, 2014
(in thousands)
Impact of Derivative Instruments on the Statement of Income
For the Year Ended December 31, 2015
(in thousands)
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(15) Fair Value of Derivative Instruments and Hedging Activities (Continued)
Impact of Derivative Instruments on the Statement of Income
For the Year Ended December 31, 2014
(in thousands)
(16) Regulatory Matters
The Bank, as a state-chartered bank, is subject to the dividend restrictions established by the State Corporation Commission of the Commonwealth of Virginia. Under such restrictions, the Bank may not, without the prior approval of the Bank's primary regulator, declare dividends in excess of the sum of the current year's earnings (as defined) plus the retained earnings (as defined) from the prior two years. At December 31, 2015, there were approximately $212.4 million of accumulated earnings at the Bank which could be paid as dividends to the Company.
The Bank is required to maintain a minimum non-interest earning clearing balance with the Federal Reserve Bank. The average amount of the clearing balance was $1.0 million for 2015.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(16) Regulatory Matters (Continued)
Regulatory agencies measure capital adequacy utilizing a formula that takes into account the individual risk profile of the financial institution. On January 1, 2015, the new Basel III regulatory risk-based capital rules became effective. Basel III includes new minimum risk-based capital and leverage ratios and refines the definition of what constitutes "capital" for purposes of calculating these ratios. The new minimum capital requirements are: (i) a new common equity Tier 1 ("CET1") capital ratio of 4.5%; (ii) a Tier 1 to risk-based assets capital ratio of 6%, which is increased from 4%; (iii) a total capital ratio of 8%, which is unchanged from the current rules; and (iv) a Tier 1 leverage ratio of 4%.
This new regulatory standard also provides for a number of new deductions from and adjustments to CET1. These include, for example, the requirement that mortgage servicing assets, deferred tax assets related to temporary differences that could not be realized through net operating loss carrybacks, and significant investments in non-consolidated financial entities be deducted from CET1 to the extent that any one such category exceeds 10% of CET1 or all such categories in the aggregate exceed 15% of CET1.
Basel III prescribes a standardized approach for risk weightings that expand the risk-weighting categories from the previous four Basel I-derived categories (0%, 20%, 50% and 100%) to a much larger and more risk-sensitive number of categories, depending on the nature of the assets, generally ranging from 0% for U.S. government and agency securities, to 600% for certain equity exposures, and resulting in higher risk weights for a variety of asset categories. The regulatory capital ratios shown for December 31, 2015 are calculated under the new Basel III standards.
Prior to January 1, 2015, the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") required banking regulators to stratify banks into five quality tiers based upon their relative capital strengths and increase the regulation of the weaker institutions. The key measures of capital were: (1) total capital (Tier I capital plus the allowance for loan losses up to certain limitations) as a percent of total risk-weighted assets, (2) Tier I capital (as defined) as a percent of total risk-weighted assets (as defined), and (3) Tier I capital (as defined) as a percent of total average assets (as defined). The regulatory capital ratios shown for December 31, 2014 are calculated using these standards.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(16) Regulatory Matters (Continued)
The regulatory capital of the Company at December 31, 2015 and 2014 is as follows:
The regulatory capital of the Bank at December 31, 2015 and 2014 is as follows:
At December 31, 2015 and 2014, the Company and the Bank met all regulatory capital requirements and are considered "well-capitalized" from a regulatory perspective.
George Mason is also required to maintain defined capital levels under Department of Housing and Urban Development guidelines. At December 31, 2015 and 2014, George Mason maintained capital in excess of these required guidelines.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(17) Related-Party Transactions
Certain directors, officers and employees and/or their related business interests are at present, as in the past, banking customers in the ordinary course of business of the Company. As such, the Company has had, and expects to have in the future, banking transactions in the ordinary course of its business with directors, officers, principal shareholders and their associates, on substantially the same terms, including interest rates and collateral on loans, as those prevailing at the same time for comparable transactions with non-related parties and do not involve more than normal risk of collectability or present other unfavorable features.
Analysis of activity for loans to related parties follows:
George Mason leases its headquarters office space from a director of the Company who is the manager and a 3.1% owner of the limited liability company that owns the building in which the space is leased. The lease was extended during 2013 so that it now expires June 30, 2019. The rent that George Mason pays for the use of this space under the existing lease ranges from $1.0 to $1.2 million annually over the next four years. Common area expense reimbursements to the lessor are included in the lease. Rent payments and common area maintenance reimbursements totaled $1.3 million in 2015, $1.2 million in 2014, and $789,000 in 2013. George Mason also leases a loan origination office from this same director. He is a minority owner of limited liability company that owns the building in which the space is leased. The rent that George Mason pays for this office for the use of this space under existing lease arrangements ranges from $172,000 to $179,000 annually over the next three years. Rent payments totaled $149,000 in 2015, $126,000 in 2014 and $62,000 in 2013. The Company also leases branch office space from a director who has an indirect ownership in the building. Certain of his immediate family members own a minority interest in the limited liability company that owns the building. The rent the Bank pays for the use of this space under the existing lease is $32,000 annually with the lease set to expire in September 2016. Rent payments totaled $32,000 in 2015, $31,000 in 2014 and $30,000 in 2013.
(18) Earnings Per Common Share
The following is the calculation of basic and diluted earnings per common share.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(18) Earnings Per Common Share (Continued)
The following shows the composition of basic outstanding shares for the years ended December 31, 2015, 2014, and 2013:
Weighted average shares for the basic earnings per share calculation is increased by the number of shares required to be issued under the Company's various deferred compensation plans. These plans provide for a Company match. The Company match must be in common stock of the Company.
The following shows the composition of diluted outstanding shares for the years ended December 31, 2015, 2014, and 2013:
Employees and directors who participate in the Company's deferred compensation plans can allocate, at their discretion, their contributions to various investment options, including an option to invest in Company Common Stock. The incremental weighted average shares attributable to the deferred compensation plans included in diluted outstanding shares assumes the participants opt to invest all of their contributions into the Company's Common Stock investment option.
There were no antidilutive outstanding stock options excluded from the weighted average shares outstanding for the diluted earnings per share calculation for each of the years ended December 31, 2015, 2014, and 2013. There were 438 shares of antidilutive restricted stock grants that were excluded from the weighted average shares outstanding for the diluted earnings per share calculation for the year ended December 31, 2015. The Company did not have restricted stock grants for 2014 and 2013 and therefore there were no antidilutive restricted stock grants for those years. These stock options and restricted stock grants have exercise prices that were greater than the average market price of the Company's common stock for the years presented. In addition, there were 5,948, 0, and 26,995 incremental shares related to unvested stock options added to the diluted weighted average share calculation for the years ended December 31, 2015, 2014, and 2013, respectively. For the year ended December 31, 2015, there were 624 incremental shares related to unvested restricted stock grants added to the diluted weighted average share calculation.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(19) 401(k) Plan
Employees who work twenty (20) hours or more a week and have been employed by the Company for a month can elect to participate in and make contributions into a 401(k) Plan. The Company contributes $0.50 for $1.00 of employee contributions up to a maximum of 3% of the employee's contribution. Expense related to the Company's match in 2015, 2014, and 2013, was $1.3 million, $ 1.2 million, and $1.3 million, respectively. Employees are immediately vested in the Company's matching contribution.
(20) Deferred Compensation Plans
The Company has deferred compensation plans for its directors and certain employees. Under the directors' plan, a director may elect to defer all or a portion of any director-related fees including fees for serving on board committees. Under the employees' plan, certain employees may defer all or a portion of their compensation including any bonus or commission compensation. Director and employee deferrals, other than employees of George Mason, are matched 50% by the Company. Deferrals made by employees of George Mason are not eligible for the Company match. The amount of the Company match is deemed invested in Company common stock which vests immediately for the directors and over three years for employees. The maximum Company match is $50,000 per year per participant eligible to receive the match. Expense relating to the deferred compensation plans for the years ended December 31, 2015, 2014, and 2013, was $394,000, $351,000, and $286,000, respectively.
The deferred compensation plan liability at December 31, 2015 and 2014 was $13.0 million and $10.5 million, respectively. The trust established for the deferred compensation plan is funded.
The Company has a supplemental executive retirement plan (SERP) that covers certain executive officers. Under the plan, the Company pays each participant, or their beneficiary, the amount of compensation deferred plus accrued interest beginning with the individual's retirement. A liability is accrued for the obligation under these plans. The expense incurred for the SERP in 2015, 2014, and 2013, was $207,000, $210,000, and $210,000, respectively. The SERP liability was $7.4 million and $7.2 million at December 31, 2015 and 2014, respectively.
(21) Director and Employee Stock-Based Compensation Plans
At December 31, 2015, the Company had two stock-based employee compensation plans, the 1999 Stock Option Plan (the "Option Plan") and the 2002 Equity Compensation Plan (the "Equity Plan").
In 1998, the Company adopted the Option Plan pursuant to which the Company may grant stock options for up to 625,000 shares of the Company's common stock to employees and members of the Company's and its subsidiaries' boards of directors. As of November 23, 2008, the Option Plan expired, and therefore, there are no shares of common stock available to grant under this plan.
In 2002, the Company adopted the Equity Plan. The Equity Plan authorizes the granting of options, which may be incentive stock options or non-qualified stock options, stock appreciation rights, restricted stock awards, phantom stock awards or performance share awards to directors, eligible officers and key employees of the Company. In 2011, the shareholders approved an amendment to the Equity Plan to increase the number of shares of common stock reserved for issuance under it from 2,420,000 to 3,170,000, an increase of 750,000 shares. In addition, the amendment extended the term of the Equity Plan to February 21, 2021. There are 198,523 shares of the Company's common stock available for future grants and awards in the Equity Plan as of December 31, 2015.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(21) Director and Employee Stock-Based Compensation Plans (Continued)
The following tables present a summary of the Company's stock option activity for the years ended December 31, 2015, 2014, and 2013:
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(21) Director and Employee Stock-Based Compensation Plans (Continued)
Information pertaining to stock options outstanding at December 31, 2015 is as follows:
At December 31, 2015
Total intrinsic value of options exercised during the years ended December 31, 2015, 2014, and 2013, was $3.0 million, $1.0 million, and $875,000, respectively.
A summary of the status of the Company's non-vested stock options and changes during the years ended December 31, 2015, 2014, and 2013 is as follows:
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(21) Director and Employee Stock-Based Compensation Plans (Continued)
A summary of the Company's restricted stock grant activity during the year ended December 31, 2015 is shown below. Prior to January 1, 2015, the Company had no restricted stock grants outstanding.
At December 31, 2015, there was $897,000 of unrecognized compensation expense related to non-vested stock options and $1.2 million of unrecognized compensation expense related to restricted stock grants under the plans. The expense is expected to be recognized over a weighted average period of 1.9 years for stock options and 3.6 years for restricted stock. The total fair value of shares from stock options that vested during the years ended December 31, 2015, 2014, and 2013, was $1.1 million, $1.2 million, and $765,000, respectively. The total fair value of restricted stock grants that vested during the year ended December 31, 2015 was $536,000.
(22) Segment Reporting
The Company operates in three business segments: commercial banking, mortgage banking, and wealth management services. As of June 30, 2013, the Company merged the remaining operations of its trust division and Wilson/Bennett Capital Management, Inc., both of which had been included in the wealth management services segment, into CWS. In addition, as of June 30, 2013, the Company merged the operations of Cardinal First Mortgage, LLC into George Mason. Results for the year ended December 31, 2013 include six months of operations of these subsidiaries.
The commercial banking segment includes both commercial and consumer lending and provides customers with such products as commercial loans, real estate loans, business financing and consumer loans. In addition, this segment provides customers with several choices of deposit products including demand deposit accounts, savings accounts and certificates of deposit. The mortgage banking segment engages primarily in the origination and acquisition of residential mortgages for sale into the secondary market. The wealth management services segment provides investment and financial advisory services to businesses and individuals, including financial planning, retirement/estate planning, and investment management.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(22) Segment Reporting (Continued)
Information about the reportable segments and reconciliation of this information to the consolidated financial statements at and for the years ended December 31, 2015, 2014, and 2013, follows:
(In thousands)
At and for the Year Ended December 31, 2015:
At and for the Year Ended December 31, 2014:
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(22) Segment Reporting (Continued)
At and for the Year Ended December 31, 2013:
The Company did not have any operating segments other than those reported. Parent company financial information is included in the "Other" category and represents an overhead function rather than an operating segment. The parent company's most significant assets are its net investments in its subsidiaries. The parent company's net interest expense is comprised of interest income from short-term investments and interest expense on trust preferred securities.
(23) Financial Instruments with Off Balance Sheet Risk
The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. Commitments to extend credit are agreements to lend to a customer so long as there is no violation of any condition established in the contract. Commitments usually have fixed expiration dates up to one year or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. These instruments represent obligations of the Company to extend credit or guarantee borrowings and are not recorded on the consolidated statements of financial condition. The rates and terms of these instruments are competitive with others in the market in which the Company operates.
The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. The Company evaluates each customer's creditworthiness on a case-by-case basis and requires collateral to support financial instruments when deemed necessary. The amount of collateral obtained upon extension of credit is based upon management's evaluation of the counterparty. Collateral held varies but may include deposits held by the Company, marketable securities, accounts receivable, inventory, property, plant and equipment, and income-producing commercial properties.
Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of the contractual obligations by a customer to a third party. The majority of these guarantees extend until satisfactory completion of the customer's contractual obligations. All standby letters of credit outstanding at December 31, 2015 are collateralized.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(23) Financial Instruments with Off Balance Sheet Risk (Continued)
Commitments to extend credit of $247.4 million as of December 31, 2015 are related to George Mason's mortgage loan funding commitments and are of a short term nature. Commitments to extend credit of $1.2 billion primarily have floating rates as of December 31, 2015.
These off-balance sheet financial instruments may involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated statements of financial condition. Credit risk is defined as the possibility of sustaining a loss because the other parties to a financial instrument fail to perform in accordance with the terms of the contract. The Company's maximum exposure to credit loss under standby letters of credit and commitments to extend credit is represented by the contractual amounts of those instruments. It is uncertain as to the amount, if any, that the Company will be required to fund on these commitments as many such arrangements expire with no amounts drawn.
A summary of the contract amount of the Bank's exposure to off-balance-sheet risk as of December 31, 2015 and 2014 is as follows:
The fair value of the liability associated with standby letters of credit and commitments to extend credit for the years ended December 31, 2015 and 2014 were $449,000 and $586,000, respectively.
George Mason provides for its estimated exposure to repurchase loans previously sold to investors for which borrowers failed to provide full and accurate information on their loan application or for which appraisals were not acceptable or where the loan was not underwritten in accordance with the loan program specified by the loan investor, and for other exposure to its investors related to loan sales activities. The Company evaluates the merits of each claim and estimates its reserve based on actual and expected claims received and considers the historical amounts paid to settle such claims. The Company recognizes an expense when settlement is deemed probable and the amount of such a settlement is estimable. Given the steps that have been taken to limit the exposure coupled with the passage of time and the expiration of the statute of limitations for loans originated in certain prior years, the Company's current expectation is that future putback claims will be limited in number.
During 2015 and 2014, George Mason settled with investors on such loans for a total of $0 and $194,000, respectively. This reserve had a balance of $500,000 and $150,000 for the years ended December 31, 2015 and 2014, respectively. The expense (benefit) related to this reserve for the years ended December 31, 2015, 2014, and 2013, was $397,000, 83,000, and ($49,000), respectively.
The Company has derivative counter-party risk which may arise from the possible inability of George Mason's third-party investors to meet the terms of their forward sales contracts. George Mason works with third-party investors that are generally well-capitalized, are investment grade and exhibit strong financial performance to mitigate this risk. The Company does not expect any third-party investor to fail to meet its obligation.
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(23) Financial Instruments with Off Balance Sheet Risk (Continued)
The Company has guaranteed payment of $20.0 million for the debt of Statutory Trust I and $5.0 million for the debt of UFBC Capital Trust I. See Note 12 for further discussion of this debt.
(24) Fair Value Measurements
The fair value framework under U.S. generally accepted accounting principles defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. It also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring the fair value. There are three levels of inputs that may be used to measure fair value:
Level 1-Quoted prices in active markets for identical assets or liabilities as of the measurement date.
Level 2-Quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; and model-derived valuations in which all significant inputs and significant value drivers are observable in active markets.
Level 3-Valuations derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable.
Recurring Fair Value Measurements
All classes of the Company's investment securities available-for-sale with the exception of its treasury securities, the Company's trading investment securities, which include cash equivalents and mutual funds, and bank-owned life insurance are recorded at fair value using reliable and unbiased evaluations by an industry-wide valuation service and therefore fall into the Level 2 category. This service uses evaluated pricing models that vary based on asset class and include available trade, bid, and other market information. Generally, the methodology includes broker quotes, proprietary models, vast descriptive terms and conditions databases, as well as extensive quality control programs. The Company's treasury securities are recorded at fair value using the unadjusted quoted market prices for identical securities and therefore fall under the Level 1 category.
The Company records its interest rate lock commitments and forward loan sales commitments at fair value determined as the amount that would be required to settle each of these derivative financial instruments at the balance sheet date. In the normal course of business, George Mason enters into contractual interest rate lock commitments to extend credit to borrowers with fixed expiration dates. The commitments become effective when the borrowers "lock-in" a specified interest rate within the time frames established by the mortgage company. All borrowers are evaluated for credit worthiness prior to the extension of the commitment. Market risk arises if interest rates move adversely between the time of the interest rate lock by the borrower and the sale date of the loan to an investor. To mitigate the effect of the interest rate risk inherent in providing rate lock commitments to borrowers, George Mason enters into either a forward sales contract to sell loans to investors when using best efforts or a TBA mortgage-backed security under mandatory delivery. As a TBA mortgage-backed securities are actively traded in an open market, the TBA mortgage-backed securities fall into a Level 1 category. The forward sales contracts lock in an interest rate and price for the sale of loans similar to the specific rate lock commitments. Both the rate lock commitments to the borrowers and the forward
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(24) Fair Value Measurements (Continued)
sales contracts to the investors through to the date the loan closes are undesignated derivatives and accordingly, are marked to fair value through earnings. These valuations fall into a Level 2 category.
There were no significant transfers into and out of Level 1, Level 2 and Level 3 measurements in the fair value hierarchy during the year ended December 31, 2015. Transfers between levels are recognized at the end of each reporting period. The valuation technique used for fair value measurements using significant other observable inputs (Level 2) is the market approach for each class of assets and liabilities.
Assets and liabilities measured at fair value on a recurring basis as of December 31, 2015 and 2014 are shown below:
At December 31, 2015
(In thousands)
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(24) Fair Value Measurements (Continued)
At December 31, 2014
(In thousands)
Nonrecurring Fair Value Measurements
Certain assets and liabilities are measured at fair value on a nonrecurring basis and are not included in the tables above. These assets include the valuation of the Company's pooled trust preferred securities held in its held-to-maturity investment securities portfolio and loans receivable-evaluated for impairment.
At December 31, 2015
(In thousands)
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(24) Fair Value Measurements (Continued)
At December 31, 2014
(In thousands)
The Company's held-to-maturity portfolio includes investments in two pooled trust preferred securities, totaling $3.8 million of par value at December 31, 2015. The collateral underlying these structured securities are instruments issued by financial institutions. The Company owns the A-3 tranches in each issuance. Observable trading activity remains limited for these types of securities. The Company has estimated the fair value of the securities through the use of internal calculations and through information provided by external pricing services. Given the level of subordination below the A-3 tranches, and the actual and expected performance of the underlying collateral, the Company expects to receive all contractual interest and principal payments recovering the amortized cost basis of each of the two securities, and concluded that these securities are not other-than-temporarily impaired. The Company also utilizes a multi-scenario model which assumes varying levels of additional defaults and deferrals and the effects of such adverse developments on the contractual cash flows for the A-3 tranches. In each of the adverse scenarios, there was no indication of a break to the A-3 contractual cash flows.
The Company's loans receivable-evaluated for impairment are measured at the present value of its expected future cash flows discounted at the loan's coupon rate, or at the loan's observable market price or fair value of the collateral if the loan is collateral dependent. The Company measures the collateral value on loans receivable-evaluated for impairment by obtaining an updated appraisal of the underlying collateral and may discount further the appraised value, if necessary, to an amount equal to the expected cash proceeds in the event the loan is foreclosed upon and the collateral is sold. This third party appraisal data is based on market comparisons and may be subject to further adjustment for certain non-observable criteria. In addition, an estimate of costs to sell the collateral is assumed.
Loans receivable-evaluated for impairment that are designated at fair value using Level 3 inputs on a nonrecurring basis total $1.3 million at December 31, 2015. The total amount for each period presented represents the entire population of loans receivable-evaluated for impairment, and of this amount, $1.3 million was determined to be impaired and recorded at fair value. Collateral is in the form of real estate or business assets including equipment, inventory, and accounts receivable. The vast majority of the Company's collateral is real estate. The value of real estate collateral is determined utilizing an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser using observable market data (Level 2). However, in certain instances, the Company applies a discount to the valuation of the collateral if the collateral being evaluated is in process of construction or a residence. In addition, the Company considers past experience of actual sales of collateral and may further discount the appraisal of the collateral being evaluated. This is considered a Level 3 valuation. The value of business equipment is based upon the net book value on the applicable business's financial statements if not considered significant using observable market data. Likewise,
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(24) Fair Value Measurements (Continued)
values for inventory and accounts receivable collateral are based on financial statement balances or aging reports (Level 3). Fair value adjustments are recorded in the period incurred as provision for loan losses on the consolidated statements of income. At December 31, 2015, the Company's Level 3 loans consisted of five relationships which were secured primarily by business assets, residential real estate and listed securities.
Although management uses its best judgment in estimating the fair value of financial instruments, there are inherent limitations in any estimation technique. Because of the wide range of valuation techniques and the numerous estimates and assumptions which must be made, it may be difficult to make reasonable comparisons between the Company's fair value information and that of other banking institutions. It is important that the many uncertainties be considered when using the estimated fair value disclosures and that, because of these uncertainties, the aggregate fair value amount should not be construed as representative of the underlying value of the Company.
Fair Value of Financial Instruments
The assumptions used and the estimates disclosed represent management's best judgment of appropriate valuation methods for estimating the fair value of financial instruments. These estimates are based on pertinent information available to management at the valuation date. In certain cases, fair values are not subject to precise quantification or verification and may change as economic and market factors and management's evaluation of those factors change.
The following summarizes the significant methodologies and assumptions used in estimating the fair values presented in the following table, and not disclosed elsewhere in this footnote.
Cash and Cash Equivalents
The carrying amount of cash and cash equivalents is used as a reasonable estimate of fair value.
Investment Securities Held-to-Maturity and Other Investments
Fair values for investment securities held-to-maturity are based on quoted market prices or prices quoted for similar financial instruments.
Loans Held for Sale
Loans held for sale are carried at the lower of cost or estimated fair value. The estimated fair value is based upon the related purchase price commitments from secondary market investors.
Loans Receivable, Net
In order to determine the fair market value for loans receivable, the loan portfolio was segmented based on loan type, credit quality and maturities. For certain variable rate loans with no significant credit concerns and frequent repricings, estimated fair values are based on current carrying amounts. The fair values of other loans are estimated using discounted cash flow analyses, at interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. The fair value analysis also included other assumptions to estimate fair value, intended to approximate those a market participant would use in an orderly transaction, with adjustments for discount rates, interest rates, and
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(24) Fair Value Measurements (Continued)
liquidity, as appropriate. This method of estimating fair value does not incorporate the exit-price concept of fair value which is appropriate for this disclosure.
Deposits
The fair values for demand deposits are equal to the carrying amount since they are payable on demand at the reporting date. The carrying amounts of variable rate, fixed-term money market accounts and certificates of deposit (CDs) approximate their fair value at the reporting date. Fair values for fixed-rate CDs are estimated using a discounted cash flow calculation that applies interest rates currently being offered on CDs to a schedule of aggregated expected monthly maturities on time deposits.
Other Borrowed Funds
The fair value of other borrowed funds is estimated using a discounted cash flow calculation that applies interest rates currently available for loans with similar terms.
Accrued Interest Receivable
The carrying amount of accrued interest receivable approximates its fair value.
The following summarizes the carrying amount of these financial assets and liabilities that the Company has not recorded at fair value on a recurring basis at December 31, 2015 and 2014:
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(24) Fair Value Measurements (Continued)
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(25) Parent Company Only Financial Statements
The Cardinal Financial Corporation (Parent Company only) condensed financial statements are as follows:
PARENT COMPANY ONLY CONDENSED STATEMENTS OF CONDITION
December 31, 2015 and 2014
(In thousands)
PARENT COMPANY ONLY CONDENSED STATEMENTS OF OPERATIONS
Years Ended December 31, 2015, 2014, and 2013
(In thousands)
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(25) Parent Company Only Financial Statements (Continued)
PARENT COMPANY ONLY CONDENSED STATEMENTS OF CASH FLOWS
Years ended December 31, 2015, 2014, and 2013
(In thousands)
CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements (Continued)
(26) Other Operating Expenses
The following shows the composition of other operating expenses for the years ended December 31, 2015, 2014, and 2013:
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
No changes in the Company's independent accountants or disagreements on accounting and financial disclosure required to be reported hereunder have taken place.
Item 9A.
Item 9A. Controls and Procedures
Disclosure Controls and Procedures
The Company maintains disclosure controls and procedures that are designed to provide assurance that information required to be disclosed by the Company in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods required by the Securities and Exchange Commission and that such information is accumulated and communicated to the Company's management including the Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. An evaluation of the effectiveness of the design and operation of the Company's disclosure controls and procedures as of the end of the period covered by this report was carried out under the supervision and with the participation of management, including the Company's Chief Executive Officer and Chief Financial Officer. Based on the evaluation, because of the material weakness in internal control over financial reporting described below, the aforementioned officers concluded that, as of December 31, 2015, the Company's disclosure controls and procedures were not effective.
Management's Report on Internal Control over Financial Reporting
Management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934. The Company's internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of the Company's financial reporting and the preparation of published financial statements in accordance with generally accepted accounting principles.
A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the Company's annual or interim financial statements will not be prevented or detected on a timely basis.
Management assessed the effectiveness of the Company's internal control over financial reporting as of December 31, 2015. In making this assessment, management used the 2013 criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework. During the fourth quarter of 2015, management identified the following deficiencies in the operating effectiveness of certain controls relating to the process of estimating the allowance for loan losses that in aggregate were determined to be a material weakness: i) controls over recording specific reserves on impaired loans in the general ledger; ii) controls over the accuracy of data used to develop historical loss factors; and iii) controls over the support to develop loss factors and the use of loss factors that are in accordance with the approved allowance for loan losses policy. This material weakness did not result in any material misstatement of the Company's consolidated financial statements for any period presented.
Based on management's assessment, and as a result of the material weakness discussed above, management concluded that, as of December 31, 2015, the Company's internal control over financial reporting was not effective based on criteria set forth by COSO in its 2013 Internal Control-Integrated Framework.
Our independent registered public accounting firm, KPMG LLP, has issued an attestation report which expressed an adverse opinion on the effectiveness of our internal control over financial reporting which appears in Item 8.
Remediation Plan for Material Weakness in Internal Control Over Financial Reporting
In response to the material weakness identified above, the Company is in the process of implementing changes to its internal control over financial reporting, including changes to the allowance for loan losses process owners and control operators.
Changes in Internal Control Over Financial Reporting
During the fourth quarter of 2014, management identified a material weakness in internal control over the Company's process to record new or modified loans into the loan sub-ledger system. This material weakness did not result in any material misstatement of the Company's consolidated financial statements for any period presented. In response to the material weakness identified above, the Company implemented changes to its internal control over financial reporting, including hiring a qualified and highly experienced Credit Administrator and a Quality Control Supervisor, and creating a step-by-step checklist of the key elements related to the recording of new or modified loans into the loan sub-ledger system to ensure completeness and accuracy of all inputs. As of December 31, 2015, the Company concluded that the material weakness has been fully remediated.
Except for the foregoing, there was no change in the Company's internal control over financial reporting in the quarter ended December 31, 2015 that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting.
Item 9B.
Item 9B. Other Information
None.
PART III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance
Pursuant to General Instruction G(3) of Form 10-K, the information contained in the "Election of Directors" section and under the headings "Executive Officers," "The Committees of the Board of Directors," "Code of Ethics" and "Section 16(a) Beneficial Ownership Reporting Compliance" in the Company's Proxy Statement for the 2016 Annual Meeting of Shareholders is incorporated herein by reference.
Item 11.
Item 11. Executive Compensation
Pursuant to General Instruction G(3) of Form 10-K, the information contained in the "Executive Compensation" section and under the heading "Director Compensation" in the Company's Proxy Statement for the 2016 Annual Meeting of Shareholders is incorporated herein by reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Security Ownership of Certain Beneficial Owners and Management. Pursuant to General Instruction G(3) of Form 10-K, the information contained under the headings "Security Ownership of Directors and Executive Officers" and "Security Ownership of Certain Beneficial Owners" in the Company's Proxy Statement for the 2016 Annual Meeting of Shareholders is incorporated herein by reference.
Equity Compensation Plan Information. The following table sets forth information as of December 31, 2015, with respect to compensation plans under which shares of our Common Stock are authorized for issuance.
(1)Amounts exclude any securities to be issued upon exercise of outstanding options, warrants and rights.
(2)The Company does not have any equity compensation plans that have not been approved by shareholders.
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence
Pursuant to General Instruction G(3) of Form 10-K, the information contained under the heading "Certain Relationships and Related Transactions" and "Independence of the Directors" in the Company's Proxy Statement for the 2016 Annual Meeting of Shareholders is incorporated herein by reference.
Item 14.
Item 14. Principal Accounting Fees and Services
Pursuant to General Instruction G(3) of Form 10-K, the information contained under the headings "Fees of Independent Public Accountants" and "Audit Committee Pre-Approval Policies and Procedures," in the Company's Proxy Statement for the 2016 Annual Meeting of Shareholders is incorporated herein by reference.
Part IV
Item 15.
Item 15. Exhibits, Financial Statement Schedules
(a)(1) and (2) The response to this portion of Item 15 is included in Item 8 above.
(3)Exhibits
2.1
Agreement and Plan of Reorganization, dated as of September 9, 2013, between Cardinal Financial Corporation and United Financial Banking Companies, Inc. (incorporated by reference to Exhibit 2.1 to the Current Report on Form 8-K filed September 10, 2013).
3.1
Articles of Incorporation of Cardinal Financial Corporation (incorporated by reference to Exhibit 3.1 to the Registration Statement on Form SB-2, Registration No. 333-82946 (the "Form SB-2")).
3.2
Articles of Amendment to the Articles of Incorporation of Cardinal Financial Corporation, setting forth the designation for the Series A Preferred Stock (incorporated by reference to Exhibit 3.2 to the Form SB-2).
3.3
Articles of Amendment to the Articles of Incorporation of Cardinal Financial Corporation, setting forth the designation for the Series B Preferred Stock (incorporated by reference to Exhibit 3.1 to the Current Report on Form 8-K filed January 22, 2009).
3.4
Bylaws of Cardinal Financial Corporation (restated in electronic format as of February 10, 2016) (incorporated by reference to Exhibit 3.1 to the Current Report on Form 8-K for filed February 11, 2016).
4.1
Form of Common Stock Certificate (incorporated by reference to Exhibit 4.1 to the Form SB-2).
10.1
Employment Agreement, dated as of November 1, 2010, between Cardinal Financial Corporation and Bernard H. Clineburg (incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K filed November 1, 2010).*
10.2
Amendment to the Employment Agreement by and between Cardinal Financial Corporation and Bernard H. Clineburg, dated November 13, 2012 (incorporated by reference to Exhibit 10.2 to the Annual Report on Form 10-K for the year ended December 31, 2012).*
10.3
Amendment Two of the Employment Agreement by and between Cardinal Financial Corporation and Bernard H. Clineburg, dated February 10, 2016 (incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K filed February 11, 2016).*
10.4
Executive Employment Agreement, dated as of February 12, 2002, between Cardinal Financial Corporation and Christopher W. Bergstrom (incorporated by reference to Exhibit 10.5 to the Form SB-2).*
10.5
Addendum to Executive Employment Agreement for Christopher W. Bergstrom, dated August 17, 2011 (incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K filed August 23, 2011).*
10.6
Cardinal Financial Corporation 1999 Stock Option Plan, as amended (incorporated by reference to Exhibit 10.7 to the Form SB-2).*
10.7
Cardinal Financial Corporation 2002 Equity Compensation Plan, as amended and restated April 21, 2006 (incorporated by reference to Exhibit 4.4 to the Registration Statement on Form S-8, Registration No. 333-134923).*
10.8
Cardinal Financial Corporation Executive Deferred Income Plan, as amended and restated February 25, 2009 (incorporated by reference to Exhibit 10.1 to the Quarterly Report on Form 10-Q for the period ended March 31, 2009).*
10.9
Cardinal Financial Corporation Directors Deferred Income Plan, as amended and restated February 25, 2009 (incorporated by reference to Exhibit 10.2 to the Quarterly Report on Form 10-Q for the period ended March 31, 2009).*
10.10
George Mason Mortgage, LLC Executive Deferred Income Plan, as amended and restated February 25, 2009 (incorporated by reference to Exhibit 10.3 to the Quarterly Report on Form 10-Q for the period ended March 31, 2009).*
10.11
Executive Employment Agreement, dated November 7, 2007, between Cardinal Financial Corporation and Kendal E. Carson (incorporated by reference to Exhibit 10.1 to the Quarterly Report on Form 10-Q for the period ended September 30, 2007).*
10.12
Amendment to Executive Employment Agreement of Kendal E. Carson (incorporated by reference to Exhibit 10.4 to the Quarterly Report on Form 10-Q for the period ended March 31, 2009).*
10.13
Supplemental Executive Retirement Plan, dated November 7, 2007, between Cardinal Financial Corporation and Kendal E. Carson (incorporated by reference to Exhibit 10.2 to the Quarterly Report on Form 10-Q for the period ended September 30, 2007).*
10.14
Executive Employment Agreement, dated March 17, 2010, between Cardinal Financial Corporation and Alice P. Frazier (incorporated by reference to exhibit 10.11 to the Annual Report on Form 10-K for the period ended December 31, 2010).*
10.15
Amendment of Executive Employment Agreement of Alice P. Frazier (incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K filed July 17, 2014).
10.16
Form of Incentive Stock Option Agreement (incorporated by reference to Exhibit 10.11 to the Annual Report on Form 10-K for the period ended December 31, 2007).*
10.17
Form of Restricted Stock Award Agreement (incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K filed March 22, 2015).*
Subsidiaries of Cardinal Financial Corporation.
Consent of KPMG LLP.
31.1
Rule 13a-14(a) Certification of Principal Executive Officer.
31.2
Rule 13a-14(a) Certification of Chief Executive Officer.
31.3
Rule 13a-14(a) Certification of Chief Financial Officer.
32.1
Statement of Principal Executive Officer Pursuant to 18 U.S.C. § 1350.
32.2
Statement of Chief Executive Officer Pursuant to 18 U.S.C. § 1350.
32.3
Statement of Chief Financial Officer Pursuant to 18 U.S.C. § 1350.
The following materials from the Registrant's Annual Report on Form 10-K for the year ended December 31, 2015, formatted in Extensible Business Reporting Language (XBRL), include: (i) the Condensed Consolidated Statements of Income, (ii) the Condensed Consolidated Balance Sheets, (iii) the Condensed Consolidated Statements of Cash Flows, and (iv) related notes (furnished herewith).
*Management contracts and compensatory plans and arrangements.
(b)Exhibits See Item 15(a)(3) above.
(c)Financial Statement Schedules See Item 15(a)(2) above.
SIGNATURES
Pursuant to the requirements of Section 13 and 15 (d) of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on March 15, 2016.
Signatures
Titles
/s/ BERNARD H. CLINEBURG
Name: Bernard H. Clineburg
Executive Chairman
(Co-Principal Executive Officer)
/s/ CHRISTOPHER W. BERGSTROM
Name: Christopher W. Bergstrom
President and Chief Executive Officer
(Co-Principal Executive Officer)
/s/ MARK A. WENDEL
Name: Mark A. Wendel
Executive Vice President and Chief Financial Officer (Principal Financial Officer)
/s/ JENNIFER L. DEACON
Name: Jennifer L. Deacon
Executive Vice President and Chief Accounting Officer (Principal Accounting Officer)
/s/ B.G. BECK
Name: B. G. Beck
Director
/s/ WILLIAM G. BUCK
Name: William G. Buck
Director
Signatures
Titles
/s/ SIDNEY O. DEWBERRY
Name: Sidney O. Dewberry
Director
/s/ MICHAEL A. GARCIA
Name: Michael A. Garcia
Director
/s/ J. HAMILTON LAMBERT
Name: J. Hamilton Lambert
Director
/s/ BARBARA B. LANG
Name: Barbara B. Lang
Director
/s/ WILLIAM J. NASSETTA
Name: William J. Nassetta
Director
/s/ WILLIAM E. PETERSON
Name: William E. Peterson
Director
/s/ ALICE M. STARR
Name: Alice M. Starr
Director
/s/ STEVEN M . WILTSE
Name: Steven M. Wiltse
Director
EXHIBIT INDEX
*Management contracts and compensatory plans and arrangements.