ITEM 1. BUSINESS
FORWARD-LOOKING STATEMENTS
The Private Securities Litigation Reform Act of 1995 states that the disclosure of forward looking information is desirable for investors and encourages such disclosure by providing a safe harbor for forward looking statements by corporate management. This Annual Report on Form 10-K, contains forward looking statements that involve risk and uncertainty. In order to comply with the terms of the safe harbor, the Company notes that a variety of risks and uncertainties could cause its actual results and experience to differ materially from the anticipated results or other expectations expressed in the Company's forward looking statements. There are risks and uncertainties that may affect the operations, performance, development, growth projections and results of the Company's business. They include, but are not limited to, economic growth, interest rate movements, timely development of technology enhancements for products, services and operating systems, the impact of competitive products, services and pricing, customer requirements, regulatory changes and similar matters. Readers of this report are cautioned not to place undue reliance on forward looking statements that are subject to influence by these risk factors and unanticipated events. Accordingly, actual results may differ materially from management's expectations.
GENERAL
First South Bancorp, Inc. First South Bancorp, Inc. (the "Company") is a Virginia corporation that serves as the holding company for First South Bank, a North Carolina chartered commercial bank (the "Bank"). The Company's principal business is overseeing the business of the Bank and operating through the Bank a commercial banking business. The Bank has one significant operating segment, the providing of general commercial banking services to its markets located in the state of North Carolina. The Company's common stock is traded on the Nasdaq National Market under the symbol "FSBK".
First South Bank. The Bank is a North Carolina chartered commercial bank headquartered in Washington, North Carolina and serves eastern North Carolina. The Bank received federal insurance of its deposits in 1959.
The Bank's principal business consists of attracting deposits from the general public and investing these funds in commercial real estate loans, commercial business loans, consumer loans and loans secured by first mortgages on owner-occupied, single-family residences in the Bank's market area.
The Bank derives its income principally from interest earned on loans and investments and, to a lesser extent, loan servicing and other fees and gains on the sale of loans and investments. The Bank's principal expenses are interest expense on deposits and borrowings and noninterest expense such as compensation and employee benefits, office occupancy expenses and other miscellaneous expenses. Funds for these activities are provided principally by deposits, repayments of outstanding loans and investments and operating revenues.
MARKET AREA
Although the Company makes loans and obtains deposits throughout central, eastern, northeastern and southeastern North Carolina, where the Bank's offices are located. As of December 31, 2005, management estimates that more than 95% of deposits and 90% of loans came from its primary market area.
The economy of the Company's primary market area is diversified, with employment distributed among manufacturing, agriculture and non-manufacturing activities. There are a significant number of major employers in the Company's primary market area. The unemployment rate in the Company's market area is equivalent to the national average and the unemployment rate for the State of North Carolina.
CRITICAL ACCOUNTING POLICIES
The Company has identified the policies below as critical to its business operations and the understanding of its results of operations. The impact and any associated risks related to these policies on the Company's business operations is discussed throughout Management's Discussion and Analysis of Financial Condition and Results of Operations where such policies affect reported and expected financial results.
Use of Estimates. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions. Estimates affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Loan Impairment and Allowance for Loan Losses. A loan is considered impaired, based on current information and events, if it is probable that the Bank will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Uncollateralized loans are measured for impairment based on the present value of expected future cash flows discounted at the historical effective interest rate, while all collateral-dependent loans are measured for impairment based on the fair value of the collateral.
The Bank uses several factors in determining if a loan is impaired. The internal asset classification procedures include a thorough review of significant loans and lending relationships and include the accumulation of related data. This data includes loan payment status, borrowers' financial data and borrowers' operating factors such as cash flows, operating income or loss, etc.
The allowance for loan losses is increased by charges to income and decreased by charge-offs (net of recoveries). Management's periodic evaluation of the adequacy of the allowance is based on the Bank's past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower's ability to repay, the estimated value of any underlying collateral, and current economic conditions. While management believes that it has established the allowance in accordance with accounting principles generally accepted in the United States of America and has taken into account the views of its regulators and the current economic environment, there can be no assurance that in the future the Bank's regulators or risks in its portfolio will not require further increases in the allowance.
Income Taxes. Deferred tax asset and liability balances are determined by application to temporary differences of the tax rate expected to be in effect when taxes will become payable or receivable. Temporary differences are differences between the tax basis of assets and liabilities and their reported amounts in the financial statements that will result in taxable or deductible amounts in future years. The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date.
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 and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit and involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheet.
The Company's exposure to credit loss in the event of non-performance by the other party to the financial instrument for commitments to extend credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.
LENDING ACTIVITIES
General. The Company's gross loan portfolio, including real estate construction loans in process, totaled $799.0 million at December 31, 2005, representing 95.9% of total assets at that date. It is the Company's policy to concentrate its lending within its market area. The Company originates a significant amount of commercial real estate loans. At December 31, 2005, commercial real estate loans amounted to $570.5 million, or 71.4% of the Company's gross loan portfolio. In recent years, the Company has sought to increase originations of commercial business loans and consumer loans. At December 31, 2005, commercial business loans totaled $38.5 million, or 4.8% of the Company's gross loan portfolio, and consumer loans totaled $100.5 million, or 12.6% of the Company's gross loan portfolio. To a lesser extent, the Company also originates multi-family residential real estate loans. At December 31, 2005, $49.4 million, or 6.2% of the Company's gross loan portfolio, consisted of single-family, residential mortgage loans. The Company's residential mortgage construction loans totaled $25.3 million, or 3.1% of the Company's gross loan portfolio, at December 31, 2005.
Loan Portfolio Composition. The following table sets forth selected data relating to the composition of the Company's loan portfolio by type of loan at the dates indicated. At December 31, 2005, the Company had no concentrations of loans exceeding 10% of gross loans other than as disclosed below.
Loan Maturities. The following table sets forth certain information at December 31, 2005 regarding the dollar amount of loans maturing in the Company's portfolio based on their maturity and repricing terms, including scheduled repayments of principal. Demand loans, loans having no stated schedule of repayments and no stated maturity, and overdrafts are reported as due in one year or less. The table does not include any estimate of prepayments which significantly shorten the average life of mortgage loans and may cause the Company's repayment experience to differ from that shown below. Loan balances are net of construction loans in process. Lease balances are included in other loans.
The following table sets forth at December 31, 2005 the dollar amount of all loans due one year or more after December 31, 2005 which have predetermined interest rates and have floating or adjustable interest rates.
Predetermined Floating or Rates Adjustable Rates ---------------- ---------------- (In thousands)
Residential real estate loans ...... $ 68,419 $ 10,600 Commercial real estate, business and other loans ..................... 194,355 832 ---------------- ---------------- Total ......................... $ 262,774 $ 11,432 ================ ================
Scheduled contractual principal repayments of loans do not reflect the actual life of such assets. The average life of loans can be substantially less than their contractual terms because of prepayments. In addition, due-on-sale clauses on loans generally give the Bank the right to declare a loan immediately due and payable in the event, among other things, that the borrower sells the real property subject to the mortgage and the loan is not repaid. The average life of mortgage loans tends to increase when current mortgage loan market rates are substantially higher than rates on existing mortgage loans and, conversely, decrease when current mortgage loan market rates are substantially lower than rates on existing mortgage loans.
Originations, Purchases and Sales of Loans. The Bank generally has authority to originate and purchase loans secured by real estate located throughout the state of North Carolina and the United States. Consistent with its emphasis on being a community-oriented financial institution, the Bank concentrates its lending activities in its market area.
The Bank's loan originations are derived from a number of sources, including referrals from depositors and borrowers, repeat customers, advertising, calling officers as well as walk-in customers. The Bank's solicitation programs consist of advertisements in local media, in addition to participation in various community organizations and events. Real estate loans are originated by the Bank's loan personnel. A majority of the Bank's loan personnel are salaried, and certain mortgage loan officers are paid on a commission basis based on a percentage of closed mortgage loan volume. With the exception of applications for boat or recreational vehicle loans, which may be originated on an indirect basis through an arrangement with dealers, loan applications are accepted at the Bank's offices. In all cases, the Bank has final approval of the application. Historically, the Bank generally has not purchased loans. However, the Bank may in the future consider making limited loan purchases, including purchases of commercial loans.
In recent years, the Bank has sold or exchanged for mortgage-backed securities a significant amount of fixed-rate, single-family mortgage loans that it originated. During the years ended December 31, 2005, 2004 and 2003, these transactions totaled $29.0 million, $40.5 million and $145.8 million, respectively. Such loans are sold to or exchanged with the Federal Home Loan Mortgage Corporation ("FHLMC"). The Bank generally retains servicing on loans sold or exchanged.
Loan Underwriting Policies. The Bank's lending activities are subject to the Bank's written, non-discriminatory underwriting standards and to loan origination procedures prescribed by the Bank's Board of Directors and its management. Detailed loan applications are obtained to determine the borrower's ability to repay, and the more significant items on these applications are verified through the use of credit reports, financial information and confirmations. The Bank uses an automated underwriting software program owned by FHLMC named Loan Prospector on the majority of loans underwritten for sale to FHLMC. In addition, loans sold to other investors may be manually underwritten by the Bank or the respective investor, or the respective investor's representatives, or through an investor's automated underwriting system, if applicable. All large loans are presented weekly by the management loan committee to a loan committee of the Board of Directors of the Bank, made up of three outside directors who serve on a rotating basis. The President does not serve on the loan committee of the Board of Directors. Individual officers of the Bank have been granted authority by the Board of Directors to approve consumer and commercial loans up to varying specified dollar amounts, depending upon the type of loan. In addition, committees of loan officers have loan authorities greater than individual authorities. These authorities are based on aggregate borrowings of an individual or entity. All loans to a single borrower aggregating in excess of $1,500,000 must be approved by the Loan Committee. On a monthly basis, the full Board of Directors reviews the actions taken by the loan committee.
Applications for single-family real estate loans are underwritten and closed in accordance with the standards of FHLMC or the investor's guidelines. Generally, upon receipt of a loan application from a prospective borrower, a credit report and verifications are ordered, or obtained, to verify specific information relating to the loan applicant's employment, income and credit standing. If a proposed loan is to be secured by a mortgage on real estate, an appraisal of the real estate is usually undertaken either by an appraiser approved by the Bank and licensed by the State of North Carolina or by qualified Bank personnel. In the case of single-family residential mortgage loans, except when the Bank becomes aware of a particular risk of environmental contamination, the Bank generally does not obtain a formal environmental report on the real estate at the time a loan is made. A formal environmental report may be required in connection with nonresidential real estate loans.
It is the Bank's policy to record a lien on the real estate securing a loan and to obtain title insurance which insures that the property is free of prior encumbrances and other possible title defects. Borrowers must also obtain hazard insurance policies prior to closing and, when the property is in a flood plain as designated by the Department of Housing and Urban Development, pay flood insurance policy premiums.
With respect to single-family residential mortgage loans, the Bank makes a loan commitment of between 15 and 60 days for each loan approved. If the borrower desires a longer commitment, the commitment may be extended for good cause and upon written approval. Fees of between $175 and $500 are charged in connection with the issuance of a commitment letter. The interest rate is guaranteed for the commitment period.
If the amount of a residential loan originated or refinanced exceeds 80% of the lesser of the appraised value or contract price, the Bank's policy generally is to obtain private mortgage insurance at the borrower's expense on that portion of the principal amount of the loan that exceeds 80%. The Bank will make a single-family residential mortgage loan with up to a 100% loan-to-value ratio if the required private mortgage insurance is obtained. The Bank generally limits the loan-to-value ratio on commercial real estate mortgage loans to 85%, although the loan-to-value ratio on commercial real estate loans in limited circumstances has been as high as 100%. The Bank limits the loan-to-value ratio on multi-family residential real estate loans to 85%.
The Bank is subject to regulations that limit the amount the Bank can lend to one borrower. See "-- Depository Institution Regulation -- Limits on Loans to One Borrower." Under these limits, the Bank's loans-to-one-borrower were limited to $11.3 million at December 31, 2005. At that date, the Bank had no lending relationships in excess of the loans-to-one-borrower limit.
Interest rates charged by the Bank on loans are affected principally by competitive factors, the demand for such loans and the supply of funds available for lending purposes. These factors are, in turn, affected by general economic conditions, monetary policies of the federal government, including the Federal Reserve Board, legislative tax policies and government budgetary matters.
Single-Family Residential Real Estate Lending. The Bank historically has been and continues to be an originator of single-family, residential real estate loans in its market area. At December 31, 2005, single-family, residential mortgage loans, excluding home improvement loans, totaled $49.4 million, or 6.2% of the Company's gross loan portfolio.
The Bank originates fixed-rate mortgage loans at competitive interest rates. At December 31, 2005, $24.8 million, or 32.0%, of the Company's residential mortgage loan portfolio was comprised of fixed-rate residential mortgage loans. Generally, the Company retains fixed-rate mortgages with maturities of 15 years or less while fixed-rate loans with longer maturities may be retained in portfolio or sold in the secondary market. The Bank also offers FHA and VA mortgage loans in its market area, which are underwritten, closed and sold to a correspondent investor.
The Bank also offers adjustable-rate residential mortgage loans. The adjustable-rate loans currently offered by the Bank have interest rates which adjust every one, three or five years from the closing date of the loan or on an annual basis commencing after an initial fixed-rate period of one, three or five years in accordance with a designated index (the primary index utilized by the Bank is the weekly average yield on U.S. Treasury securities adjusted to a constant comparable maturity equal to the loan adjustment period, as made available by the Federal Reserve Board (the "Treasury Rate")), plus a stipulated margin. The Bank offers adjustable-rate loans that meet FHLMC standards, as well as loans that do not meet such standards. The Bank's adjustable-rate single-family residential real estate loans that do not meet FHLMC standards have a cap of generally 2% on any increase in the interest rate at any adjustment date, and include a cap on the maximum interest rate over the life of the loan, which cap generally is 3% to 4.5% above the initial rate. In return for providing a relatively low cap on interest rate increases over the life of the loan, the Bank's adjustable-rate loans provide for a floor on the minimum interest rate over the life of the loan, which floor generally is the initial rate. Further, the Bank generally does not offer "teaser" rates, i.e., initial rates below the fully indexed rate, on such loans. The adjustable-rate mortgage loans offered by the Bank that do conform to FHLMC standards have a cap of 6% above the initial rate over the life of a loan but do not include a floor, may be offered with a teaser rate and have a 25 basis point lower margin above the index on which the interest rate is based. All of the Bank's adjustable-rate loans require that any payment adjustment resulting from a change in the interest rate of an adjustable-rate loan be sufficient to result in full amortization of the loan by the end of the loan term and, thus, do not permit any of the increased payment to be added to the principal amount of the loan, or so-called negative amortization. At December 31, 2005, $52.8 million, or 68.0%, of the Company's residential mortgage loans were adjustable-rate loans.
The retention of adjustable-rate loans in the Company's portfolio helps reduce the Company's exposure to increases or decreases in prevailing market interest rates. However, there are unquantifiable credit risks resulting from potential increases in costs to borrowers in the event of upward repricing of adjustable-rate loans. It is possible that during periods of rising interest rates, the risk of default on adjustable-rate loans may increase due to increases in interest costs to borrowers. Further, although adjustable-rate loans allow the Company to increase the sensitivity of its interest-earning assets to changes in interest rates, the extent of this interest sensitivity is limited by the initial fixed-rate period before the first adjustment and the lifetime interest rate adjustment limitations. Accordingly, there can be no assurance that yields on the Company's adjustable-rate loans will fully adjust to compensate for increases in the Company's cost of funds.
Construction Lending. The Bank also offers residential and commercial construction loans, with a substantial portion of such loans originated to date being for the construction of owner-occupied, single-family dwellings in the Bank's primary market area. Residential construction loans are offered primarily to individuals building their primary, investment or secondary residence, as well as to selected local developers to build single-family dwellings. Generally, loans to owner/occupants for the construction of owner-occupied, single-family residential properties are originated in connection with the permanent loan on the property and have a construction term of six to 18 months. Such loans are offered on a fixed-rate or adjustable-rate basis. Interest rates on residential construction loans made to the owner/occupant have interest rates during the construction period of 0.5% or more above the rate offered by the Bank on the permanent loan product selected by the borrower. Upon completion of construction, the permanent loan rate will be set at the rate then offered by the Bank on that permanent loan product, not to exceed the predetermined permanent rate cap. Interest rates on residential construction loans to builders are set at the prime rate plus a margin of between 0% and 1% and adjust annually. Interest rates on commercial construction loans are based on the prime rate plus a negotiated margin of between 0% and 1% and adjust daily, with construction terms generally not exceeding 18 months. Advances are made on a percentage of completed basis. At December 31, 2005, $25.3 million, or 3.1%, of the Company's gross loan portfolio consisted of construction loans, virtually all of which was secured by single-family residences.
Prior to making a commitment to fund a loan, the Bank requires both an appraisal of the property by appraisers approved by the Board of Directors and a study of the feasibility of the proposed project. The Bank also reviews and inspects each project at the commencement of construction and periodically during the term of the construction loan. The Bank generally charges a 0.50% to 1.25% construction loan fee for speculative builder loans. For construction loans to owner-occupants, the Bank generally charges a 1% construction loan fee and a commitment fee ranging from $275 to $425.
Construction financing generally is considered to involve a higher degree of risk of loss than long-term financing on improved, occupied real estate. Risk of loss on a construction loan is dependent largely upon the accuracy of the initial estimate of the property's value at completion of construction or development and the estimated cost (including interest) of construction. During the construction phase, a number of factors could result in delays and cost overruns. If the estimate of construction costs proves to be inaccurate and the borrower is unable to meet the Bank's requirements of putting up additional funds to cover extra costs or change orders, then the Bank will demand that the loan be paid off and, if necessary, institute foreclosure proceedings, or refinance the loan. If the estimate of value proves to be inaccurate, the Bank may be confronted, at or prior to the maturity of the loan, with collateral having a value which is insufficient to assure full repayment. The Bank has sought to minimize this risk by limiting construction lending to qualified borrowers (i.e., borrowers who satisfy all credit requirements and whose loans satisfy all other underwriting standards which would apply to the Bank's permanent mortgage loan financing for the subject property) in the Bank's market area. On loans to builders, the Bank works only with selected builders with whom it has experience and carefully monitors the creditworthiness of the builders. Builder relationships are analyzed and underwritten annually by the Bank's credit administration department.
Multi-Family Residential and Commercial Real Estate Lending. The Bank originates commercial real estate loans, as well as a limited amount of multi-family residential real estate loans, generally limiting such originations to loans secured by properties in its primary market area and to borrowers with whom it has other loan relationships. The Company's multi-family residential loan portfolio consists primarily of loans secured by small apartment buildings, and the commercial real estate loan portfolio includes loans to finance the acquisition of small office buildings and commercial and industrial buildings with a preference to owner occupied. Such loans generally range in size from $100,000 to $2.0 million. At December 31, 2005, multi-family residential and commercial real estate loans totaled $2.9 million and $570.5 million, respectively, which amounted to 0.4% and 71.4%, respectively, of the Company's gross loan portfolio. Multi-family and commercial real estate loans are originated either for three to seven year terms with interest rates that adjust based on either the prime rate as quoted in The Wall Street Journal plus a negotiated margin of between 0% and 1% for shorter term loans, or on a fixed-rate basis with interest calculated on a 15 to 25 year amortization schedule generally with a balloon payment due after three to seven years.
Multi-family residential and commercial real estate lending entails significant additional risks as compared with single-family residential property lending. Multi-family residential and commercial real estate loans typically involve larger loan balances to single borrowers or groups of related borrowers. The payment experience on such loans typically is dependent on the successful operation of the real estate project, retail establishment or business. These risks can be significantly affected by supply and demand conditions in the market for office, retail and residential space, and, as such, may be subject to a greater extent to adverse conditions in the economy generally. To minimize these risks, the Bank generally limits itself to its market area or to borrowers with which it has prior experience or who are otherwise known to the Bank. It has been the Bank's policy to obtain annual financial statements of the business of the borrower or the project for which commercial or multi-family residential real estate loans are made. In addition, in the case of commercial mortgage loans made to a partnership or a corporation, the Bank obtains personal guarantees and annual financial statements of the principals of the partnership or corporation.
Commercial Lending. The Company's commercial loans consist of loans secured by commercial real estate and commercial business loans, which are not secured by real estate. For a discussion of the Company's commercial real estate lending see "-- Multi-Family and Commercial Real Estate Lending."
In recent years, the Bank has emphasized commercial business lending. The Bank originates commercial business loans to small and medium sized businesses in its market area. The Bank's commercial borrowers are generally small businesses engaged in manufacturing, distribution or retailing, or service professionals in healthcare, accounting and law. Commercial business loans are generally made to finance the purchase of inventory, new or used equipment or commercial vehicles, to support trading assets and for short-term working capital. Such loans generally are secured by equipment and inventory, and, if possible, cross-collateralized by a real estate mortgage, although commercial business loans are sometimes granted on an unsecured basis. Such loans generally are made for terms of five years or less, depending on the purpose of the loan and the collateral, with loans to finance operating expenses made for one year or less, with interest rates that typically either adjust daily at a rate equal to the prime rate as stated in The Wall Street Journal plus a margin of between 0% and 2% or at a negotiated fixed rate. Generally, commercial loans are made in amounts ranging between $5,000 and $2,000,000. At December 31, 2005, commercial business loans totaled $38.5 million, or 4.8% of the Company's gross loan portfolio.
The Bank underwrites its commercial business loans on the basis of the borrower's cash flow and ability to service the debt from earnings rather than on the basis of underlying collateral value, and the Bank seeks to structure such loans to have more than one source of repayment. The borrower is required to provide the Bank with sufficient information to allow the Bank to make its lending determination. In most instances, this information consists of at least two years of financial statements, a statement of projected cash flows, current financial information on any guarantor and any additional information on the collateral. For loans over $20,000 with maturities exceeding one year, the Bank requires that borrowers and guarantors provide updated financial information at least annually throughout the term of the loan.
The Bank's commercial business loans may be structured as short-term loans, term loans or as lines of credit. Short-term commercial business loans are for periods of 12 months or less and are generally self-liquidating from asset conversion cycles. Commercial business term loans are generally made to finance the purchase of assets and have maturities of five years or less. Commercial business lines of credit are typically made for the purpose of supporting trading assets and providing working capital. Such loans are usually approved with a term of 12 months and are reviewed annually. The Bank also offers secured standby letters of credit for its commercial borrowers. The terms of standby letters of credit generally do not exceed one year, and they are underwritten as stringently as any commercial loan and generally are of a performance nature.
Commercial business loans are often larger and may involve greater risk than other types of lending. Because payments on such loans are often dependent on successful operation of the business involved, repayment of such loans may be subject to a greater extent to adverse conditions in the economy. The Bank seeks to minimize these risks through its underwriting guidelines, which require that the loan be supported by adequate cash flow of the borrower, profitability of the business, collateral and personal guarantees of the individuals in the business. In addition, the Bank limits this type of lending to its market area and to borrowers with which it has prior experience or who are otherwise well known to the Bank.
Consumer Lending. In recent years, the Bank has been successful in its strategy of increasing its portfolio of consumer loans. The consumer loans originated by the Bank include automobile loans, certificate of deposit loans, home equity loans and miscellaneous other consumer loans, including unsecured loans. At December 31, 2005, consumer loans totaled $100.5 million, or 12.6% of the Company's gross loan portfolio.
The Bank's automobile loans are generally underwritten in amounts up to 90% of the lesser of the purchase price of the automobile or, with respect to used automobiles, the loan value as published by the National Automobile Dealers Association. The terms of most such loans do not exceed 60 months. The Bank requires that the vehicles be insured and the Bank be listed as loss payee on the insurance policy.
The Bank makes certificate of deposit loans for up to 95% of the depositor's account balance. The interest rate is normally 2% above the annual percentage yield paid on the account and the account must be pledged as collateral to secure the loan. Interest generally is billed on a quarterly basis. At December 31, 2005, loans on certificates of deposit totaled $1.8 million, or 0.2% of the Company's gross loan portfolio.
At December 31, 2005, the Company had approximately $42.1 million in home equity line of credit loans, representing approximately 5.3% of its gross loan portfolio. The Company's home equity lines of credit have adjustable interest rates tied to the prime interest rate plus a margin. The home equity lines of credit require monthly payments until the loan is paid in full. Home equity lines of credit are generally secured by subordinate liens against residential real property. The Bank requires that fire and extended coverage casualty insurance (and, if appropriate, flood insurance) be maintained in an amount at least sufficient to cover its loan. Home equity loans are generally limited so that the amount of such loans, along with any senior indebtedness, does not exceed 85% of the value of the real estate security.
Consumer lending affords the Company the opportunity to earn yields higher than those obtainable on single-family residential lending. However, consumer loans entail greater risk than do residential mortgage loans, particularly in the case of loans which are unsecured (as is the case with credit card loans) or secured by rapidly depreciable assets such as automobiles. 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 and credit card loan collections are dependent on the borrower's continuing financial stability, and thus are more likely to be adversely affected by events such as job loss, divorce, illness or personal bankruptcy. Further, the application of various state and federal laws, including federal and state bankruptcy and insolvency law, may limit the amount which may be recovered. In underwriting consumer loans, the Bank considers the borrower's credit history, an analysis of the borrower's income and ability to repay the loan, and the value of the collateral.
Loan Fees and Servicing. The Bank receives fees in connection with late payments and for miscellaneous services related to its loans. The Bank also charges fees in connection with loan originations. These fees can consist of origination, discount, construction and/or commitment fees, depending on the type of loan. The Bank generally does not service loans for others except as set forth below and except for mortgage loans originated and sold by the Bank with servicing retained.
In addition, the Bank has developed a program to originate loans for a local credit union. The Bank receives a $600 origination fee for each loan as well as an annual servicing fee of 0.375% of the loan amount. All of these loans are funded and closed in the name of the credit union. The Bank has explored the possibility of developing similar arrangements with other institutions, although none are currently planned.
Nonperforming Loans and Other Problem Assets. It is management's policy to continually monitor its loan portfolio to anticipate and address potential and actual delinquencies. When a borrower fails to make a payment on a loan, the Bank takes immediate steps to have the delinquency cured and the loan restored to current status. Loans which are delinquent more than 15 days incur a late fee of 4% of the monthly payment of principal and interest due. As a matter of policy, the Bank will contact the borrower after the loan has been delinquent 15 days. If payment is not promptly received, the borrower is contacted again, and efforts are made to formulate an affirmative plan to cure the delinquency. Generally, after any loan is delinquent 45 days or more, a default letter is sent to the borrower. If the default is not cured after 30 days, formal legal proceedings are commenced to collect amounts owed.
Loans generally are placed on nonaccrual status, and accrued but unpaid interest is reversed, when, in management's judgment, it is determined that the collectibility of interest, but not necessarily principal, is doubtful. Generally, this occurs when payment is delinquent in excess of 90 days. Consumer loans are generally charged off, or any expected loss is reserved for, after they become more than 120 days past due. All other loans are charged off when management concludes that they are uncollectible. See Note 4 of Notes to Consolidated Financial Statements for the Year Ended December 31, 2005.
Real estate acquired by the Bank as a result of foreclosure is classified as real estate acquired through foreclosure until such time as it is sold and is recorded at the lower of the estimated fair value (less estimated costs to sell) of the underlying real estate or the carrying amount of the loan. Costs relating to holding or improving such real estate are charged against income in the current period. Any required write-down of the loan to its fair value less estimated selling costs upon foreclosure is charged against the allowance for loan losses. See Note 4 of Notes to Consolidated Financial Statements for the Year Ended December 31, 2005.
The following table sets forth information with respect to the Bank's nonperforming assets at the dates indicated. At the dates shown, the Bank had no restructured loans within the meaning of Statement of Financial Accounting Standards No. 15.
During the year ended December 31, 2005, additional gross interest income of approximately $143,189 would have been recorded on loans accounted for on a nonaccrual basis if the loans had been current throughout this period.
At December 31, 2005, the Bank had no loans not classified as nonaccrual, 90 days past due or restructured loans where known information about possible credit problems of borrowers caused management to have serious concerns as to the ability of the borrowers to comply with present loan repayment terms and may result in disclosure as nonaccrual, 90 days past due or restructured.
There were no loans accruing interest which were contractually past due 90 days or more at the end of any reported period.
At December 31, 2005, an analysis of the Bank's portfolio did not reveal any impaired loans that needed to be classified under SFAS No. 114 or 118. A loan is considered impaired, based on current information and events, if it is probable that the Bank will be unable to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan arrangement. Uncollateralized loans are measured for impairment based on the present value of expected future cash flows discounted at the historical effective interest rate, while all collateral dependent loans are measured for impairment based on the fair value of the collateral. The Bank uses several factors in determining if a loan is impaired. The internal asset classification procedures include a thorough review of significant loans and lending relationships and include the accumulation of related data. This data includes loan payments status, borrowers' financial data and borrowers' operating factors such as cash flows, operating income or loss, and various other matters.
At December 31, 2005, the Company had $2.3 million of nonaccrual loans, which consisted of twenty-seven single-family residential real estate loans totaling $1.4 million, six commercial real estate loans totaling $555,000, five commercial business loans totaling $220,000 and ten consumer loans totaling $122,000.
At December 31, 2005, the Bank had $14,000 of real estate owned, which consisted of one single-family residential lot.
Classified Assets. Federal regulations require that the Bank classify its assets on a regular basis. In addition, in connection with examinations of insured institutions, examiners have authority to identify problem assets and if appropriate, classify them in their reports of examination. There are four classifications for problem assets: "special mention," "substandard," "doubtful" and "loss." Special mention assets contain some weakness as defined under the substandard category, but do not contain the risk level associated with an adverse classification. Special mention assets are noted for a watch list to indicate that a potential weakness or risk exists, which could cause a more serious problem if not corrected. Substandard assets have one or more defined weaknesses and are characterized by the distinct possibility that the insured institution will sustain some loss if the deficiencies are not corrected. Doubtful assets have the weaknesses of substandard assets with the additional characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions and values, questionable, and there is a high possibility of loss. An asset classified loss is considered uncollectible and of such little value that continuance as an asset of the institution is not warranted. Assets classified as substandard or doubtful require a bank to establish general allowances for loan losses. If an asset or portion thereof is classified loss, a bank must either establish a specific allowance for loss in the amount of the portion of the asset classified loss, or charge off such amount. The Bank regularly reviews its assets to determine whether any assets require classification or re-classification. At December 31, 2005, the Company had $19.2 million in classified assets, including $11.0 million in assets classified as special mention, $8.2 million in assets classified as substandard and no assets classified as doubtful or loss, compared to $19.1 million in classified assets, including $10.8 million in assets classified as special mention, $7.9 million in assets classified as substandard, $62,000 in assets classified as doubtful and $251,000 in assets classified as loss at December 31, 2004.
Allowance for Loan Losses. The Company's policy is to establish reserves for estimated probable losses on delinquent loans when it determines that losses are expected to be incurred on such loans. The allowance for losses on loans is maintained at a level believed adequate by management to absorb probable losses in the portfolio. Management's determination of the adequacy of the allowance is based on an evaluation of the portfolio, past loss experience, current economic conditions, volume, growth and composition of the portfolio, and other relevant factors. The allowance is increased by provisions for loan losses which are charged against income.
Although management believes it uses the best information available to make determinations with respect to the allowances for losses and believes such allowances are adequate, future adjustments may be necessary if economic conditions differ substantially from the economic conditions in the assumptions used in making the initial determinations. Management anticipates that the Company's allowance for loan losses will increase in the future as it implements the Board of Directors' strategy of continuing existing lines of business while gradually expanding commercial business and consumer lending, which loans generally entail greater risks than single-family residential mortgage loans.
The following table sets forth an analysis of the Company's allowance for loan losses for the periods indicated.
The following table allocates the allowance for loan losses by loan category at the dates indicated. The allocation of the allowance to each category is not necessarily indicative of future losses and does not restrict the use of the allowance to absorb losses in any category.
- --------------- (1) Includes commercial real estate, commercial business loans and lease receivables. (2) Includes $82,000 of specific allowance for loan losses on two commercial business loans.
INVESTMENT ACTIVITIES
General. Interest income from mortgage-backed securities and investment securities generally provides the second largest source of income to the Company after interest on loans. The Bank's Board of Directors has authorized investment in U.S. Government and agency securities, state government obligations, municipal securities, obligations of the Federal Home Loan Bank ("FHLB") and mortgage-backed securities. The Bank's objective is to use such investments to reduce interest rate risk, enhance yields on assets and provide liquidity. At December 31, 2005, the Company's mortgage-backed securities and investment securities portfolio amounted to $22.7 million and $41.8 million, respectively. At such date, the Company had an unrealized loss of $371,000, net of deferred taxes, with respect to its securities.
Investment and aggregate investment limitations and credit quality parameters of each class of investment are prescribed in the Bank's investment policy. The Bank performs analyses on mortgage-backed securities and investment securities prior to forming mortgage pools and on an ongoing basis to determine the impact on earnings and market value under various interest rate and prepayment conditions. Securities purchases are subject to the oversight of the Bank's Investment Committee consisting of four directors and are reviewed by the Board of Directors on a monthly basis. The Bank's President has authority to make specific investment decisions within the parameters determined by the Board of Directors.
Mortgage-Backed Securities. At December 31, 2005, the Company's mortgage-backed securities amounted to $22.7 million, or 2.72% of total assets. Mortgage-backed securities represent a participation interest in a pool of single-family or multi-family mortgages, the principal and interest payments on which are passed from the mortgage originators through intermediaries that pool and repackage the participation interest in the form of securities to investors such as the Bank. Such intermediaries may include quasi-governmental agencies such as FHLMC, FNMA and GNMA which guarantee the payment of principal and interest to investors. Mortgage-backed securities generally increase the quality of the Bank's assets by virtue of the guarantees that back them, are more liquid than individual mortgage loans and may be used to collateralize borrowings or other obligations of the Bank. At December 31, 2005, all of the Company's mortgage-backed securities were backed by loans originated by the Bank and swapped with the FHLMC in exchange for such mortgage-backed securities.
The FHLMC is a public corporation chartered by the U.S. Government. The FHLMC issues participation certificates backed principally by conventional mortgage loans. The FHLMC guarantees the timely payment of interest and the ultimate return of principal on participation certificates. FHLMC securities are not backed by the full faith and credit of the United States, however, these securities are considered to be among the highest quality investments with minimal credit risks. The maximum loan limit for FNMA and FHLMC currently is $359,650.
Mortgage-backed securities typically are issued with stated principal amounts, and the securities are backed by pools of mortgages that have loans with interest rates that are within a range and having varying maturities. The underlying pool of mortgages can be composed of either fixed-rate or adjustable-rate loans. As a result, the risk characteristics of the underlying pool of mortgages, (i.e., fixed-rate or adjustable-rate) as well as prepayment risk, are passed on to the certificate holder. The life of a mortgage-backed pass-through security thus approximates the life of the underlying mortgages.
Mortgage-backed securities generally yield less than the loans which underlie such securities because of their payment guarantees or credit enhancements which offer nominal credit risk. In addition, mortgage-backed securities are more liquid than individual mortgage loans and may be used to collateralize borrowings of the Bank in the event that the Bank determined to utilize borrowings as a source of funds. Mortgage-backed securities issued or guaranteed by the FHLMC (except interest-only securities or the residual interests in CMOs) are weighted at no more than 20% for risk-based capital purposes, compared to a weight of 50% to 100% for residential loans. See "Depository Institution Regulation -- Capital Requirements."
At December 31, 2005, mortgage-backed securities with an amortized cost of $21.0 million and a carrying value of $20.6 million were held as available for sale, and mortgage-backed securities with an amortized cost of $2.1 million and a carrying value of $2.1 million were held for investment. Mortgage-backed securities which are held to maturity are carried at cost, adjusted for the amortization of premiums and the accretion of discounts using a method which approximates a level yield. Mortgage-backed securities classified as available for sale are carried at fair value. Unrealized gains and losses on available for sale mortgage-backed securities are recognized as direct increases or decreases in equity, net of applicable income taxes. See Notes 1, 2 and 3 of the Notes to Consolidated Financial Statements in the Annual Report filed as Exhibit 13 hereto. At December 31, 2005, the Bank's mortgage-backed securities had a weighted average yield of 5.26%.
At December 31, 2005, the average contractual maturity of the Company's fixed-rate mortgage-backed securities available-for-sale was approximately 17.7 years, while the average contractual maturity of mortgage-backed securities held for investment was approximately 7.8 years. The actual maturity of a mortgage-backed security varies, depending on when the mortgagors prepay or repay the underlying mortgages. Prepayments of the underlying mortgages may shorten the life of the investment, thereby adversely affecting its yield to maturity and the related market value of the mortgage-backed security. The yield is based upon the interest income and the amortization of the premium or accretion of the discount related to the mortgage-backed security. Premiums and discounts on mortgage-backed securities are amortized or accreted over the estimated term of the securities using a level yield method. The prepayment assumptions used to determine the amortization period for premiums and discounts can significantly affect the yield of the mortgage-backed security, and these assumptions are reviewed periodically to reflect the actual prepayment. The actual prepayments of the underlying mortgages depend on many factors, including the type of mortgage, the coupon rate, the age of the mortgages, the geographical location of the underlying real estate collateralizing the mortgages and general levels of market interest rates. The difference between the interest rates on the underlying mortgages and the prevailing mortgage interest rates is an important determinant in the rate of prepayments. During periods of falling mortgage interest rates, prepayments generally increase, and, conversely, during periods of rising mortgage interest rates, prepayments generally decrease. If the coupon rate of the underlying mortgage significantly exceeds the prevailing market interest rates offered for mortgage loans, refinancing generally increases and accelerates the prepayment of the underlying mortgages. Prepayment experience is more difficult to estimate for adjustable-rate mortgage-backed securities.
Investment Securities. The Company's investment securities consist primarily of securities issued by the U.S. government and government agencies. At December 31, 2005, the Company's entire portfolio of investment securities was classified available for sale and amounted to $41.8 million. The Company attempts to maintain a high degree of liquidity in its investment securities portfolio by choosing those that are readily marketable. As of December 31, 2005, the estimated average life of the Company's investment securities portfolio was approximately 2.3 years. In addition, at December 31, 2005, the Company had $1.7 million of FHLB stock.
The following table sets forth the scheduled maturities, carrying values, amortized cost and average yields for the Company's investment securities and mortgage-backed securities portfolio at December 31, 2005.
- --------------- (1) As a member of the FHLB of Atlanta, the Bank is required to maintain an investment in FHLB stock, which has no stated maturity.
The following table sets forth the carrying value of the Company's investment securities and mortgage-backed securities portfolio at the dates indicated.
At December 31, ------------------------- 2005 2004 2003 ------- ------- ------- (In thousands) Securities available for sale: U.S. government and agency securities ............ $41,827 $32,058 $50,072 Mortgage-backed securities ....................... 20,639 6,639 11,715 ------- ------- ------- Total ......................................... $62,466 $38,697 $61,787 ======= ======= =======
Securities held to maturity: FHLB stock ....................................... $ 1,689 $ 1,825 $ 2,127 Mortgage-backed securities ....................... 2,063 2,569 -- ------- ------- ------- Total ......................................... $ 3,752 $ 4,394 $63,914 ======= ======= =======
DEPOSIT ACTIVITY AND OTHER SOURCES OF FUNDS
General. Deposits are the primary source of the Bank's funds for lending, investment activities and general operational purposes. In addition to deposits, the Bank derives funds from loan principal and interest repayments, maturities of investment securities and mortgage-backed securities and interest payments thereon. Although loan repayments are a relatively stable source of funds, deposit inflows and outflows are significantly influenced by general interest rates and money market conditions. Borrowings may be used on a short-term basis to compensate for reductions in the availability of funds, or on a longer term basis for general operational purposes. The Bank has access to borrowings from the FHLB of Atlanta.
Deposits. The Bank attracts deposits principally from within its market area by offering a variety of deposit instruments, including checking accounts, money market accounts, statement and passbook savings accounts, Individual Retirement Accounts, and certificates of deposit which range in maturity from seven days to five years. Deposit terms vary according to the minimum balance required, the length of time the funds must remain on deposit and the interest rate. Maturities, terms, service fees and withdrawal penalties for its deposit accounts are established by the Bank on a periodic basis. The Bank reviews its deposit pricing on a weekly basis. In determining the characteristics of its deposit accounts, the Bank considers the rates offered by competing institutions, lending and liquidity requirements, growth goals and federal regulations. Management believes it prices its deposits comparably to rates offered by its competitors. The Bank does not accept brokered deposits.
The Bank attempts to compete for deposits with other institutions in its market area by offering competitively priced deposit instruments that are tailored to the needs of its customers. Additionally, the Bank seeks to meet customers' needs by providing convenient customer service to the community, efficient staff and convenient hours of service. Substantially, all of the Bank's depositors are North Carolina residents. To provide additional convenience, the Bank participates in the Cirrus and STAR Automatic Teller Machine networks at locations throughout the United States, through which customers can gain access to their accounts at any time. To better serve its customers, the Bank has installed automatic teller machines at twenty-three office locations.
The following tables set forth the distribution of the Bank's deposit accounts and corresponding weighted average interest rates. Management does not believe that the use of year-end balances instead of average balances resulted in any material difference in the information presented.
- -------------- (1) Original term.
The following table indicates the amount (in thousands) of the Company's certificates of deposit of $100,000 or more by time remaining until maturity as of December 31, 2005. At such date, such deposits represented 21.0% of total deposits and had a weighted average rate of 3.75%.
Maturity Period --------------- (In thousands)
Three months or less ........... $ 3,821 Over three through six months .. 5,029 Over six through 12 months ..... 65,156 Over 12 months ................. 79,948 -------- Total .................... $153,954 ========
At December 31, 2005, U.S. Agency Bonds with an amortized cost of $17.0 million were pledged as collateral for deposits from public entities.
Borrowings. Savings deposits historically have been the primary source of funds for the Bank's lending, investment and general operating activities. The Bank is authorized, however, to use advances from the FHLB of Atlanta to supplement its supply of lendable funds and to meet deposit withdrawal requirements. The FHLB of Atlanta functions as a central reserve bank providing credit for savings institutions and certain other member financial institutions. As a member of the FHLB System, the Bank is required to own stock in the FHLB of Atlanta and is authorized to apply for advances. Advances are pursuant to several different programs, each of which has its own interest rate and range of maturities. The FHLB capital stock requirement is based on the sum of a membership stock component totaling 0.20% of the Bank's total assets plus an activity-based stock component of 4.5% of outstanding FHLB advances. Advances from the FHLB of Atlanta are secured by the Bank's stock in the FHLB of Atlanta and other eligible assets. During the years ended December 31, 2005, 2004 and 2003, the Bank's borrowings consisted of FHLB advances and retail repurchase agreements. Retail repurchase agreements represent agreements to sell securities under terms which require the Bank to repurchase the same or substantially similar securities by a specified date.
The following table sets forth certain information regarding short-term borrowings by the Company at the dates and for the periods indicated:
(1) Based on month-end balances.
COMPETITION
The Company faces strong competition in originating real estate, commercial business and consumer loans and in attracting deposits. The Bank competes for real estate and other loans principally on the basis of interest rates, the types of loans it originates, the deposit products it offers and the quality of services it provides to borrowers. The Bank also competes by offering products which are tailored to the local community. Its competition in originating real estate loans comes primarily from other commercial banks, savings institutions, mortgage bankers and mortgage brokers. Commercial banks, credit unions and finance companies provide vigorous competition in consumer lending. Competition may increase as a result of the recent reduction of restrictions on the interstate operations of financial institutions.
The Bank attracts its deposits through its branch offices primarily from the local communities. Consequently, competition for deposits is principally from other commercial banks, savings institutions, credit unions and brokers in the Bank's primary market area. The Bank competes for deposits and loans by offering what it believes to be a variety of deposit accounts at competitive rates, convenient business hours, a commitment to outstanding customer service and a well-trained staff. The Bank believes it has developed strong relationships with local realtors and the community in general.
Management considers its primary market area for gathering deposits and/or originating loans to be central, eastern, northeastern and southeastern North Carolina, where the Bank's offices are located. The Bank originates loans throughout eastern North Carolina.
EMPLOYEES
As of December 31, 2005, the Bank had 252 full-time and 37 part-time employees, none of whom were represented by a collective bargaining agreement. Management considers the Bank's relationships with its employees to be good.
DEPOSITORY INSTITUTION REGULATION
General. The Bank is a North Carolina chartered commercial bank and its deposit accounts are insured by the Savings Association Insurance Fund ("SAIF") administered by the Federal Deposit Insurance Corporation ("FDIC"). The Bank is subject to supervision, examination and regulation by the Commissioner and the FDIC and to North Carolina and federal statutory and regulatory provisions governing such matters as capital standards, mergers, subsidiary investments and establishment of branch offices. The FDIC also has the authority to conduct special examinations. The Bank is required to file reports with the Commissioner and the FDIC concerning its activities and financial condition and will be required to obtain regulatory approval prior to entering into certain transactions, including mergers with, or acquisitions of, other depository institutions.
As a federally insured depository institution, the Bank is subject to various regulations promulgated by the Board of Governors of the Federal Reserve System ("Federal Reserve Board"), including Regulation B (Equal Credit Opportunity), Regulation D (Reserve Requirements), Regulations E (Electronic Fund Transfers), Regulation Z (Truth in Lending), Regulation CC (Availability of Funds and Collection of Checks) and Regulation DD (Truth in Savings).
The system of regulation and supervision applicable to the Bank establishes a comprehensive framework for the operations of the Bank, and is intended primarily for the protection of the FDIC and the depositors of the Bank. Changes in the regulatory framework could have a material effect on the Bank that in turn, could have a material effect on the Company.
Capital Requirements. The Federal Reserve Board and the FDIC have established guidelines with respect to the maintenance of appropriate levels of capital by bank holding companies with consolidated assets of $150 million or more and state nonmember banks, respectively. The regulations impose two sets of capital adequacy requirements: minimum leverage rules, which require bank holding companies and state nonmember banks to maintain a specified minimum ratio of capital to total assets, and risk-based capital rules, which require the maintenance of specified minimum ratios of capital to "risk-weighted" assets. The regulations of the FDIC and the Federal Reserve Board require bank holding companies and state nonmember banks, respectively, to maintain a minimum leverage ratio of "Tier 1 capital" to total assets of 3.0%. Although setting a minimum 3.0% leverage ratio, the capital regulations state that only the strongest bank holding companies and banks, with composite examination ratings of 1 CAMELS under the rating system used by the federal bank regulators, are permitted to operate at or near such minimum level of capital. All other bank holding companies and banks must maintain a leverage ratio of at least 4%. Tier 1 capital is the sum of common stockholders' equity, noncumulative perpetual preferred stock (including any related surplus), and minority interests in consolidated subsidiaries; minus all intangible assets (other than certain purchased mortgage servicing rights and purchased credit card receivables), identified losses and investments in certain subsidiaries. As a SAIF-insured, state-chartered bank, the Bank must also deduct from Tier 1 capital an amount equal to its investments in, and extensions of credit to, subsidiaries engaged in activities that are not permissible for national banks, other than debt and equity investments in subsidiaries engaged in activities undertaken as agent for customers or in mortgage banking activities or in subsidiary depository institutions or their holding companies. Any bank or bank holding company experiencing or anticipating significant growth is expected to maintain capital well above the minimum levels. In addition, the Federal Reserve Board has indicated that whenever appropriate, and in particular when a bank holding company is undertaking expansion, seeking to engage in new activities or otherwise facing unusual or abnormal risks, it will consider, on a case-by-case basis, the level of an organization's ratio of tangible Tier 1 capital to total assets in making an overall assessment of capital.
In addition to the leverage ratio, the regulations of the Federal Reserve Board and the FDIC require bank holding companies and state chartered nonmember banks to maintain a minimum ratio of qualifying total capital to risk-weighted assets of at least 8.0% of which at least 4.0% must be Tier 1 capital. Qualifying total capital consists of Tier 1 capital plus Tier 2 or "supplementary capital" items which include allowances for loan losses in an amount of up to 1.25% of risk-weighted assets, cumulative preferred stock and preferred stock with a maturity of 20 years or more, certain other capital instruments and up to 45% of unrealized gains on equity securities. The includible amount of Tier 2 capital cannot exceed the institution's Tier 1 capital. Qualifying total capital is further reduced by the amount of the bank's investments in banking and finance subsidiaries that are not consolidated for regulatory capital purposes, reciprocal cross-holdings of capital securities issued by other banks and certain other deductions. The risk-based capital regulations assign balance sheet assets and the credit equivalent amounts of certain off-balance sheet items to one of four broad risk weight categories ranging from 0% to 100%. The aggregate dollar amount of each category is multiplied by the risk weight assigned to that category based principally on the degree of credit risk associated with the obligor. The sum of these weighted values equals the bank holding company or the bank's risk-weighted assets.
In addition to FDIC regulatory capital requirements, the North Carolina Bank Commissioner requires that the Bank have adequate capitalization which is determined based upon each Bank's particular set of circumstances. The Bank is subject to the Commissioner's capital surplus regulation which requires commercial banks to maintain a capital surplus of at least 50% of common capital. Common capital is defined as the total of the par value of shares times the number of shares outstanding.
Prompt Corrective Regulatory Action. Under FDICIA, the federal banking regulators are required to take prompt corrective action if an insured depository institution fails to satisfy certain minimum capital requirements, including a leverage limit, a risk-based capital requirement, and any other measure deemed appropriate by the federal banking regulators for measuring the capital adequacy of an insured depository institution. All institutions, regardless of their capital levels, are restricted from making any capital distribution or paying any management fees if the institution would thereafter fail to satisfy the minimum levels for any of its capital requirements. An institution that fails to meet the minimum level for any relevant capital measure (an "undercapitalized institution") may be: (i) subject to increased monitoring by the appropriate federal banking regulator; (ii) required to submit an acceptable capital restoration plan within 45 days; (iii) subject to asset growth limits; and (iv) required to obtain prior regulatory approval for acquisitions, branching and new lines of businesses. The capital restoration plan must include a guarantee by the institution's holding company that the institution will comply with the plan until it has been adequately capitalized on average for four consecutive quarters, under which the holding company would be liable up to the lesser of 5% of the institution's total assets or the amount necessary to bring the institution into capital compliance as of the date it failed to comply with its capital restoration plan. A "significantly undercapitalized" institution, as well as any undercapitalized institution that does not submit an acceptable capital restoration plan, may be subject to regulatory demands for recapitalization, broader application of restrictions on transactions with affiliates, limitations on interest rates paid on deposits, asset growth and other activities, possible replacement of directors and officers, and restrictions on capital distributions by any bank holding company controlling the institution. Any company controlling the institution may also be required to divest the institution or the institution could be required to divest subsidiaries. The senior executive officers of a significantly undercapitalized institution may not receive bonuses or increases in compensation without prior approval and the institution is prohibited from making payments of principal or interest on its subordinated debt. In their discretion, the federal banking regulators may also impose the foregoing sanctions on an undercapitalized institution if the regulators determine that such actions are necessary to carry out the purposes of the prompt corrective provisions. If an institution's ratio of tangible capital to total assets falls below the "critical capital level" established by the appropriate federal banking regulator, the institution will be subject to conservatorship or receivership within specified time periods.
Under the implementing regulations, the federal banking regulators, including the FDIC, generally measure an institution's capital adequacy on the basis of its total risk-based capital ratio (the ratio of its total capital to risk-weighted assets), Tier 1 risk-based capital ratio (the ratio of its core capital to risk-weighted assets) and leverage ratio (the ratio of its core capital to adjusted total assets). The following table shows the capital ratios required for the various prompt corrective action categories.
- ---------------- * 3.0% if institution has a composite 1 CAMELS rating.
A "critically undercapitalized" institution is defined as an institution that has a ratio of "tangible equity" to total assets of less than 2.0%. Tangible equity is defined as core capital plus cumulative perpetual preferred stock (and related surplus) less all intangibles other than qualifying supervisory goodwill and certain purchased mortgage servicing rights. The FDIC may reclassify a well capitalized institution as adequately capitalized and may require an adequately capitalized or undercapitalized institution to comply with the supervisory actions applicable to institutions in the next lower capital category (but may not reclassify a significantly undercapitalized institution as critically undercapitalized) if the FDIC determines, after notice and an opportunity for a hearing, that the institution is in an unsafe or unsound condition or that the institution has received and not corrected a less-than-satisfactory rating for any CAMELS rating category.
Safety and Soundness Guidelines. Under FDICIA, as amended by the Riegle Community Development and Regulatory Improvement Act of 1994 (the "CDRI Act"), each federal banking agency was required to establish safety and soundness standards for institutions under its authority. The interagency guidelines require depository institutions to maintain internal controls and information systems and internal audit systems that are appropriate for the size, nature and scope of the institution's business. The guidelines also establish certain basic standards for loan documentation, credit underwriting, interest rate risk exposure, asset growth and information security. The guidelines further provide that depository institutions should maintain safeguards to prevent the payment of compensation, fees and benefits that are excessive or that could lead to material financial loss, and should take into account factors such as comparable compensation practices at comparable institutions. If the appropriate federal banking agency determines that a depository institution is not in compliance with the safety and soundness guidelines, it may require the institution to submit an acceptable plan to achieve compliance with the guidelines. A depository institution must submit an acceptable compliance plan to its primary federal regulator within 30 days of receipt of a request for such a plan. Failure to submit or implement a compliance plan may subject the institution to regulatory sanctions. Management believes that the Bank substantially meets all the standards adopted in the interagency guidelines.
Community Reinvestment Act. The Bank, like other financial institutions, is subject to the Community Reinvestment Act ("CRA"). The purpose of the CRA is to encourage financial institutions to help meet the credit needs of their entire communities, including the needs of low-and moderate-income neighborhoods. During the Bank's last compliance examination, the Bank received a satisfactory rating with respect to CRA compliance.
The federal banking agencies have implemented an evaluation system that rates an institution based on its actual performance in meeting community credit needs. Under these regulations, an institution is first evaluated and rated under three categories: a lending test, an investment test and a service test. For each of these three tests, the institution is given a rating of either "outstanding," "high satisfactory," "low satisfactory," "needs to improve," or "substantial non-compliance." A set of criteria for each rating has been developed and is included in the regulation. If an institution disagrees with a particular rating, the institution has the burden of rebutting the presumption by clearly establishing that the quantitative measures do not accurately present its actual performance, or that demographics, competitive conditions or economic or legal limitations peculiar to its service area should be considered. The ratings received under the three tests will be used to determine the overall composite CRA rating. The composite ratings currently given are: "outstanding," "satisfactory," "needs to improve" or "substantial non-compliance."
The Bank's CRA rating would be a factor to be considered by the Federal Reserve Board and the FDIC in considering applications submitted by the Bank to acquire branches or to acquire or combine with other financial institutions and take other actions and, if such rating was less than "satisfactory," could result in the denial of such applications.
Federal Home Loan Bank System. The FHLB System consists of 12 district FHLBs subject to supervision and regulation by the Federal Housing Finance Board ("FHFB"). The FHLBs provide a central credit facility primarily for member institutions. As a member of the FHLB of Atlanta, the Bank is required to acquire and hold shares of capital stock in the FHLB of Atlanta. The Bank was in compliance with this requirement with investment in FHLB of Atlanta stock at December 31, 2005, of $1.7 million. The FHLB of Atlanta serves as a reserve or central bank for its member institutions within its assigned district. It is funded primarily from proceeds derived from the sale of consolidated obligations of the FHLB System. It offers advances to members in accordance with policies and procedures established by the FHFB and the Board of Directors of the FHLB of Atlanta. Long-term advances may only be made for the purpose of providing funds for residential housing finance, small businesses, small farms and small agribusinesses.
Reserves. Pursuant to regulations of the Federal Reserve Board, the Bank must maintain average daily reserves equal to 3% on transaction accounts of $7.8 million up to $40.5 million, plus 10% on the remainder. This percentage is subject to adjustment by the Federal Reserve Board. Because required reserves must be maintained in the form of vault cash or in a noninterest bearing account at a Federal Reserve Bank, the effect of the reserve requirement is to reduce the amount of the institution's interest-earning assets. As of December 31, 2005, the Bank met its reserve requirements.
The Bank is also subject to the reserve requirements of North Carolina commercial banks. North Carolina law requires state nonmember banks to maintain, at all times, a reserve fund in an amount set by the State Banking Commission.
Deposit Insurance. The Bank is required to pay assessments based on a percentage of its insured deposits to the FDIC for insurance of its deposits by the SAIF. Under the FDIC's risk-based deposit insurance assessment system, the assessment rate for an insured depository institution depends on the assessment risk classification assigned to the institution by the FDIC, which is determined by the institution's capital level and supervisory evaluations. Based on the data reported to regulators for the date closest to the last day of the seventh month preceding the semi-annual assessment period, institutions are assigned to one of three capital groups -- well capitalized, adequately capitalized or undercapitalized -- using the same percentage criteria as in the prompt corrective action regulations. See "-- Prompt Corrective Regulatory Action." Within each capital group, institutions are assigned to one of three subgroups on the basis of supervisory evaluations by the institution's primary supervisory authority and such other information as the FDIC determines to be relevant to the institution's financial condition and the risk posed to the deposit insurance fund. Subgroup A consists of financially sound institutions with only a few minor weaknesses. Subgroup B consists of institutions that demonstrate weaknesses which, if not corrected, could result in significant deterioration of the institution and increased risk of loss to the deposit insurance fund. Subgroup C consists of institutions that pose a substantial probability of loss to the deposit insurance fund unless effective corrective action is taken.
The assessment rate for SAIF members currently ranges from zero for well capitalized institutions in Subgroup A to 0.27% of deposits for undercapitalized institutions in Subgroup C. SAIF members are also assessed an amount for Financing Corporation bond payments, which for fiscal 2005, averaged 1.39 basis points.
Liquidity Requirements. FDIC policy requires that banks maintain an average daily balance of liquid assets (cash, certain time deposits, mortgage-backed securities, loans available for sale and specified United States government, state, or federal agency obligations) in an amount which it deems adequate to protect safety and soundness of the bank. The FDIC currently has no specific level which it requires. Under the FDIC's calculation method, management calculated the Bank's liquidity ratio as 13.0% of total deposits at December 31, 2005, which management believes is adequate.
Dividend Restrictions. Under FDIC regulations, the Bank is prohibited from making any capital distributions if after making the distribution, the Bank would have: (i) a total risk-based capital ratio of less than 8.0%; (ii) a Tier 1 risk-based capital ratio of less than 4.0%; or (iii) a leverage ratio of less than 4.0%.
Earnings of the Bank appropriated to bad debt reserves and deducted for federal income tax purposes are not available for payment of cash dividends or other distributions to stockholders without payment of taxes at the then current tax rate by the Bank on the amount of earnings removed from the pre-1988 reserves for such distributions. The Bank intends to make full use of this favorable tax treatment and does not contemplate use of any earnings in a manner which would create federal tax liabilities.
Limits on Loans to One Borrower. The Bank generally is subject to both FDIC regulations and North Carolina law regarding loans to any one borrower, including related entities. Under applicable law, with certain limited exceptions, loans and extensions of credit by a state chartered nonmember bank to a person outstanding at one time and not fully secured by collateral having a market value at least equal to the amount of the loan or extension of credit shall not exceed 15% of the unimpaired capital of the Bank. Loans and extensions of credit fully secured by readily marketable collateral having a market value shall not exceed 10% of the unimpaired capital fund of the Bank. Under these limits, the Bank's loans to one borrower were limited to $12.8 million at December 31, 2005. At that date, the Bank had no lending relationships in excess of the loans-to-one-borrower limit. Notwithstanding the statutory loans-to-one-borrower limitations, the Bank has a self imposed loans-to-one-borrower limit, which currently is $5.5 million, which it has exceeded from time to time as approved in advance by the Board of Directors. At December 31, 2005, the Bank's largest lending relationship was a $6.1 million relationship consisting of twelve commercial real estate loans. All loans within this relationship were current and performing in accordance with their terms at December 31, 2005.
Transactions with Related Parties. Transactions between a state nonmember bank and any affiliate are governed by Sections 23A and 23B of the Federal Reserve Act. An affiliate of a state nonmember bank is any company or entity which controls, is controlled by or is under common control with the state nonmember bank. In a holding company context, the parent holding company of a state nonmember bank (such as the Company) and any companies which are controlled by such parent holding company are affiliates of the savings institution or state nonmember bank. Generally, Sections 23A and 23B (i) limit the extent to which an institution or its subsidiaries may engage in "covered transactions" with any one affiliate to an amount equal to 10% of such institution's capital stock and surplus, and contain an aggregate limit on all such transactions with all affiliates to an amount equal to 20% of such capital stock and surplus and (ii) require that all such transactions be on terms substantially the same, or at least as favorable, to the institution or subsidiary as those provided to a non-affiliate. The term "covered transaction" includes the making of loans, purchase of assets, issuance of a guarantee and similar other types of transactions.
Loans to Directors, Executive Officers and Principal Stockholders. State nonmember banks also are subject to the restrictions contained in Section 22(h) of the Federal Reserve Act and the applicable regulations thereunder on loans to executive officers, directors and principal stockholders. Under Section 22(h), loans to a director, executive officer and to a greater than 10% stockholder of a state nonmember bank and certain affiliated interests of such persons, may not exceed, together with all other outstanding loans to such person and affiliated interests, the institution's loans-to-one-borrower limit and all loans to such persons may not exceed the institution's unimpaired capital and unimpaired surplus. Section 22(h) also prohibits loans, above amounts prescribed by the appropriate federal banking agency, to directors, executive officers and greater than 10% stockholders of a depository institution, and their respective affiliates, unless such loan is approved in advance by a majority of the board of directors of the institution with any "interested" director not participating in the voting. Regulation O prescribes the loan amount (which includes all other outstanding loans to such person) as to which such prior board of director approval is required as being the greater of $25,000 or 5% of capital and surplus (or any loans aggregating $500,000 or more). Further, Section 22(h) requires that loans to directors, executive officers and principal stockholders be made on terms substantially the same as offered in comparable transactions to other persons. Section 22(h) also generally prohibits a depository institution from paying the overdrafts of any of its executive officers or directors.
State nonmember banks also are subject to the requirements and restrictions of Section 22(g) of the Federal Reserve Act on loans to executive officers. Section 22(g) of the Federal Reserve Act requires approval by the board of directors of a depository institution for such extensions of credit and imposes reporting requirements for and additional restrictions on the type, amount and terms of credits to such officers. In addition, Section 106 of the BHCA prohibits extensions of credit to executive officers, directors, and greater than 10% stockholders of a depository institution by any other institution which has a correspondent banking relationship with the institution, unless such extension of credit is on substantially the same terms as those prevailing at the time for comparable transactions with other persons and does not involve more than the normal risk of repayment or present other unfavorable features.
Additionally, North Carolina statutes set forth restrictions on loans to executive officers of state-chartered banks, which provide that no bank may extend credit to any of its executive officers nor a firm or partnership of which such executive officers is a member, nor a company in which such executive officer owns a controlling interest, unless the extension of credit is made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions by the bank with persons who are not employed by the bank, and provided further that the extension of credit does not involve more than the normal risk of repayment.
Restrictions on Certain Activities. State chartered nonmember banks with deposits insured by the FDIC are generally prohibited from engaging in equity investments that are not permissible for a national bank. The foregoing limitation, however, does not prohibit FDIC-insured state banks from acquiring or retaining an equity investment in a subsidiary in which the bank is a majority owner. State chartered banks are also prohibited from engaging as a principal in any type of activity that is not permissible for a national bank and, subject to certain exceptions, subsidiaries of state chartered FDIC-insured state banks may not engage as a principal in any type of activity that is not permissible for a subsidiary of a national bank, unless in either case, the FDIC determines that the activity would pose no significant risk to the appropriate deposit insurance fund and the bank is, and continues to be, in compliance with applicable capital standards.
Patriot Act. The Patriot Act is intended to strengthen U.S. law enforcement's and the intelligence communities' abilities to work cohesively to combat terrorism on a variety of fronts. The potential impact of the Patriot Act on financial institutions of all kinds is significant and wide ranging. The Patriot Act contained sweeping anti-money laundering and financial transparency laws and imposes various regulations including standards for verifying client identification at account opening, and rules to promote cooperation among financial institutions, regulators and law enforcement entities in identifying parties that may be involved in terrorism or money laundering.
REGULATION OF THE COMPANY
General. The Company, as the sole shareholder of the Bank, is a bank holding company and is registered with the Federal Reserve Board. Bank holding companies are subject to comprehensive regulation by the Federal Reserve Board under the Bank Holding Company Act of 1956, as amended (the "BHCA"), and the regulations of the Federal Reserve Board. As a bank holding company, the Company is required to file with the Federal Reserve Board annual reports and such additional information as the Federal Reserve Board may require, and is subject to regular examinations by the Federal Reserve Board. The Federal Reserve Board also has extensive enforcement authority over bank holding companies, including, among other things, the ability to assess civil money penalties, to issue cease and desist or removal orders and to require that a holding company divest subsidiaries (including its bank subsidiaries). In general, enforcement actions may be initiated for violations of law and regulations and unsafe or unsound practices.
Under the BHCA, a bank holding company must obtain Federal Reserve Board approval before: (i) acquiring, directly or indirectly, ownership or control of any voting shares of another bank or bank holding company if, after such acquisition, it would own or control more than 5% of such shares (unless it already owns or controls the majority of such shares); (ii) acquiring all or substantially all of the assets of another bank or bank holding company; or (iii) merging or consolidating with another bank holding company. In evaluating applications for acquisitions, the Federal Reserve Board considers such things as the financial condition and management of the target and the acquirer, the convenience and needs of the communities involved (including CRA ratings) and competitive factors.
The BHCA also prohibits a bank holding company, with certain exceptions, from acquiring direct or indirect ownership or control of more than 5% of the voting shares of any company which is not a bank or bank holding company, or from engaging directly or indirectly in activities other than those of banking, managing or controlling banks, or providing services for its subsidiaries. The principal exceptions to these prohibitions involve certain nonbank activities which, by statute or by Federal Reserve Board regulation or order, have been identified as activities closely related to the business of banking or managing or controlling banks. The list of activities permitted by the Federal Reserve Board includes, among other things, operating a savings institution, mortgage company, finance company, credit card company or factoring company; performing certain data processing operations; providing certain investment and financial advice; underwriting and acting as an insurance agent for certain types of credit-related insurance; leasing property on a full-payout, non-operating basis; selling money orders, travelers' checks and United States Savings Bonds; real estate and personal property appraising; providing tax planning and preparation services; and, subject to certain limitations, providing securities brokerage services for customers. The Company has no present plans to engage in any of these activities.
The Gramm-Leach-Bliley Act of 1999 authorized bank holding companies that meet specified qualitative standards to opt to become a "financial holding company." A financial holding company may engage in activities that are permissible for bank holding companies in addition to activities deemed to be financial in nature or incidental to financial activities. These include insurance underwriting and investment banking. The Company has not up to now opted to become a financial holding company.
The Federal Reserve Board has adopted guidelines regarding the capital adequacy of bank holding companies, which require bank holding companies to maintain specified minimum ratios of capital to total assets and capital to risk-weighted assets. See "-- Depository Institution Regulation -- Capital Requirements."
Acquisition of Bank Holding Companies and Banks. Under the BHCA, any company must obtain approval of the Federal Reserve Board prior to acquiring control of the Company or the Bank. For purposes of the BHCA, "control" is defined as ownership of more than 25% of any class of voting securities of the Company or the Bank, the ability to control the election of a majority of the directors, or the exercise of a controlling influence over management or policies of the Company or the Bank. In addition, the Change in Bank Control Act and the related regulations of the Federal Reserve Board require any person or persons acting in concert, to file a written notice with the Federal Reserve Board before such person or persons may acquire control of the Company or the Bank. The Change in Bank Control Act defines "control" as the power, directly or indirectly, to vote 25% or more of any voting securities or to direct the management or policies of a bank holding company or an insured bank; however, a rebuttable presumption of control exists upon the acquisition of power to vote 10% or more of a class of voting securities for a company, such as the Company, whose securities are registered under the Securities Exchange Act of 1934.
Interstate Banking. Federal law allows the Federal Reserve Board to approve an application of an adequately capitalized and adequately managed bank holding company to acquire control of, or acquire all or substantially all of the assets of, a bank located in a state other than the holding company's home state, without regard to whether the transaction is prohibited by the laws of any state. The Federal Reserve Board may not approve the acquisition of a bank that has not been in existence for a minimum of five years without regard for a longer minimum period specified by the law of the host state. The Federal Reserve Board is prohibited from approving an application if the applicant (and its depository institution affiliates) controls or would control (i) more than 10% of the insured deposits in the United States, or (ii) 30% or more of the deposits in the target bank's home state or in any state in which the target bank maintains a branch. Federal law does not limit a state's authority to restrict the percentage of total insured deposits in the state which may be held or controlled by a bank or bank holding company to the extent such limitation does not discriminate against out-of-state banks or bank holding companies. Individual states may also waive the 30% state-wide concentration limit.
Additionally, the federal banking agencies are authorized to approve interstate merger transactions without regard to whether such transaction is prohibited by the law of any state, unless the home state of one of the banks has adopted a law opting out of the interstate mergers. Interstate acquisitions of branches are permitted only if the law of the state in which the branch is located permits such acquisitions. Interstate mergers and branch acquisitions are subject to the nationwide and statewide insured deposit concentration amounts described above. North Carolina has enacted legislation permitting interstate banking acquisitions.
Federal law authorizes the FDIC to approve interstate branching de novo by state banks only in states which specifically allow for such branching. The appropriate federal banking agencies adopted regulations which prohibit any out-of-state bank from using the interstate branching authority primarily for the purpose of deposit production. These regulations include guidelines to ensure that interstate branches operated by an out-of-state bank in a host state are reasonably helping to meet the credit needs of the communities which they serve.
Dividends. The Federal Reserve Board has issued a policy statement on the payment of cash dividends by bank holding companies, which expresses the Federal Reserve Board's view that a bank holding company should pay cash dividends only to the extent that the company's net income for the past year is sufficient to cover both the cash dividends and a rate of earnings retention that is consistent with the company's capital needs, asset quality and overall financial condition. The Federal Reserve Board also indicated that it would be inappropriate for a company experiencing serious financial problems to borrow funds to pay dividends. Furthermore, under the prompt corrective action regulations adopted by the Federal Reserve Board, the Federal Reserve Board may prohibit a bank holding company from paying any dividends if the holding company's bank subsidiary is classified as "undercapitalized". See "-- Depository Institution Regulation -- Prompt Corrective Regulatory Action."
Bank holding companies are required to give the Federal Reserve Board prior written notice of any purchase or redemption of its outstanding equity securities if the gross consideration for the purchase or redemption, when combined with the net consideration paid for all such purchases or redemptions during the preceding 12 months, is equal to 10% or more of the their consolidated net worth. The Federal Reserve Board may disapprove such a purchase or redemption if it determines that the proposal would constitute an unsafe or unsound practice or would violate any law, regulation, Federal Reserve Board order, directive, or any condition imposed by, or written agreement with, the Federal Reserve Board. Bank holding companies whose capital ratios exceeded the thresholds for well capitalized banks on a consolidated basis are exempt from the foregoing requirement if they were rated CAMELS 1 or 2 in their most recent regulatory inspection and are not the subject of any unresolved supervisory issues.
TAXATION - GENERAL
The Company files its federal income tax return based on a fiscal year ending December 31.
FEDERAL INCOME TAXATION
Legislation that became effective for tax years beginning after December 31, 1995 requiring the Bank to recapture into taxable income over a six taxable year period the portion of the tax loan reserve that exceeds the pre-1988 tax loan loss reserve. The Bank will no longer be allowed to use the reserve method for tax loan loss provisions, but would be allowed to use the experience method of accounting for bad debts. There will be no future effect on net income from the recapture because the taxes on these bad debts reserves has already been accrued as a deferred tax liability.
The Bank's federal income tax returns have been audited through the year ended September 30, 1992.
STATE INCOME TAXATION
Under North Carolina law, the corporate income tax currently is 6.90% of federal taxable income as computed under the Internal Revenue Code, subject to certain prescribed adjustments. An annual state franchise tax is imposed at a rate of .15% applied to the greatest of the institutions (i) capital stock, surplus and undivided profits, (ii) investment in tangible property in North Carolina or (iii) appraised valuation of property in North Carolina.
For additional information regarding taxation, see Notes 1 and 10 of Notes to Consolidated Financial Statements in the Annual Report.
ITEM 1A.
ITEM 1A. RISK FACTORS
CERTAIN INTEREST RATE MOVEMENTS MAY IMPACT EARNINGS AND ASSET VALUE.
Prior to 2005, interest rates have recently been at historically low levels. However, since December 31, 2004, the prime lending rate has increased from 5.25% to 7.25% at December 31, 2005. Short-term and intermediate-term market interest rates are used as a guide to price the Bank's loans and deposits. The recent increase in such interest rates has had a positive impact on the Bank's interest rate spread and net interest margin to date, as a result of the asset sensitive nature of the Bank's balance sheet. Should short-term interest rates decline dramatically in the near future, and if rates on the Bank's loans and investments reprice downwards faster than the rates on the Bank's deposits and borrowings, the Bank could experience compression of its interest rate spread and net interest margin, which could have a negative effect on the Bank's profitability.
Changes in interest rates also affect the value of the Bank's interest-earning assets, and in particular the Bank's securities portfolio. Generally, the value of fixed-rate securities fluctuates inversely with changes in interest rates. Unrealized gains and losses on securities available for sale are reported as a separate component of equity, net of tax. Decreases in the fair value of securities available for sale resulting from increases in interest rates could have an adverse effect on stockholders' equity.
STRONG COMPETITION WITHIN THE BANK'S MARKET AREA COULD HURT PROFITS AND SLOW GROWTH.
The Bank faces intense competition both in making loans and attracting deposits. This competition makes it more difficult for the Bank to make new loans and at times has required the Bank to offer higher deposit rates. Price competition for loans and deposits could result in the Bank earning less on loans and paying more on deposits, which could reduce net interest income. Competition also makes it more difficult to grow loans and deposits, and to hire and retain experienced employees. Some of the institutions with which the Bank competes have substantially greater resources and lending limits than the Bank has and may offer services that the Bank does not provide. Management expects competition to continue in the future as a result of legislative, regulatory and technological changes and the continuing trend of consolidation in the financial services industry. The Bank's profitability depends upon its continued ability to compete successfully in its market area.
THE COMPANY AND THE BANK OPERATE IN A HIGHLY REGULATED ENVIRONMENT AND MAY BE ADVERSELY AFFECTED BY CHANGES IN LAWS AND REGULATIONS.
The Bank is subject to extensive regulation, supervision and examination by the North Carolina Commissioner of Banks and the FDIC, as its primary federal regulator. The Company also is subject to regulation and supervision by the Board of Governors of the Federal Reserve System and by the Commissioner. Such regulation and supervision govern the activities in which an institution and its holding company may engage, and are intended primarily for the protection of the insurance fund and the depositors and borrowers of the Bank rather than for holders of the Company's common stock. Regulatory authorities have extensive discretion in their supervisory and enforcement activities, including the imposition of restrictions on operations, the classification of the Bank's assets and determination of the level of allowance for loan losses. Any change in such regulation and oversight, whether in the form of regulatory policy, regulations, legislation or supervisory action, may have a material impact on operations.
THE BANK EMPHASIZES COMMERCIAL REAL ESTATE, COMMERCIAL BUSINESS AND CONSUMER LENDING, WHICH GENERALLY ARE RISKIER THAN RESIDENTIAL MORTGAGE LENDING.
The Bank currently operates as a North Carolina chartered commercial bank. Prior to its conversion to a commercial bank in 1997, the Bank operated as a traditional savings and loan association, primarily emphasizing the origination of loans secured by single-family residences. Upon converting to a commercial bank, the Board of Directors determined there was a local demand for commercial real estate, commercial business and consumer loans. As a result, the Board of Directors determined to refocus the Bank's strategy. Pursuant to this strategy, while continuing to pursue its existing business of originating single-family residential mortgage loans, the Bank took advantage of the business opportunities identified by the Board of Directors by gradually expanding into commercial real estate, commercial business and consumer lending. In furtherance of this strategy, the Bank recruited experienced commercial real estate and consumer loan and consumer lending officers and developed commercial real estate, commercial business and consumer loan products. As a result of these efforts over the years, at December 31, 2005, the Company had commercial real estate, commercial business and consumer loans totaling $570.5 million, $38.5 million and $100.5 million, respectively, which represented 71.4%, 4.8% and 12.6%, respectively, of total loans. As December 31, 2005, $77.6 million, or 9.7% of total loans, consisted of residential real estate mortgage loans.
While commercial real estate, commercial business and consumer loans are generally more interest rate sensitive and carry higher yields than do residential mortgage loans, they generally carry a higher degree of credit risk than residential mortgage loans.
Commercial real estate lending entails significant additional risks as compared with single-family residential property lending. Commercial real estate loans typically involve larger loan balances to single borrowers or groups of related borrowers. The payment experience on such loans typically is dependent on the successful operation of the real estate project, retail establishment or business. These risks can be significantly affected by supply and demand conditions in the market for office, retail and residential space, and, as such, may be subject to a greater extent to adverse conditions in the economy generally. To minimize these risks, the Bank generally limits itself to its market area or to borrowers with which it has prior experience or who are otherwise known to the Bank. It has been the Bank's policy to obtain annual financial statements of the business of the borrower or the project for which commercial real estate loans are made. In addition, in the case of commercial mortgage loans made to a partnership of a corporation, the Bank seeks, whenever possible, to obtain personal guarantees and annual financial statements of the principals of the partnership or corporation.
Commercial business loans are often larger and may involve greater risk than other types of lending. Because payments on such loans are often dependant on successful operation of the business involved, repayment of such loans may be subject to a greater extent to adverse conditions in the economy. The Bank will seek to minimize these risks through its underwriting guidelines, which may require certain safeguards, such as the loan be supported by adequate cash flow of the borrower, profitability of the business, collateral and personal guarantees of the individual in the business. In addition, the Bank generally limits this type of lending to its market area and to borrowers with whim it has prior experience or who are otherwise well known to the Bank.
Consumer loans entail greater risk than do residential mortgage loans, particularly in the case of loans which are unsecured or secured by rapidly depreciable assets. 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 this are more likely to be adversely affected by events such as job loss, divorce, illness or personal bankruptcy. See "Business of the Bank - Lending Activities - Consumer and Other Lending."
THE COMPANY'S FINANCIAL CONDITION AND RESULTS OF OPERATIONS ARE DEPENDANT ON THE ECONOMY IN THE BANK'S MARKET AREA.
The Bank's market area consists of central, eastern, northeastern and southeastern North Carolina, where the Bank's offices are located. As of December 31, 2005, management estimates that more than 95% of deposits and 90% of loans came from its primary market area. Because of the Bank's concentration of business activities in its primary market area, the Company's financial condition and results of operations depend upon economic conditions in its market area.
PROVISIONS IN THE COMPANY'S CERTIFICATE OF INCORPORATION AND BYLAWS AND STATUTORY PROVISIONS COULD DISCOURAGE A HOSTILE ACQUISITION OF CONTROL.
The Company's Certificate of Incorporation and Bylaws contain certain provisions that could discourage nonnegotiated takeover attempts that certain stockholders might deem to be in their interests or through which stockholders might otherwise receive a premium for their shares over the then current market price and that may tend to perpetuate existing management. These provisions include: the classification of the terms of the members of the Board of Directors; supermajority provisions for the approval of certain business combinations; elimination of cumulative voting by stockholders in the election of directors; certain provisions relating to meetings of stockholders; restrictions on the acquisition of the Company's equity securities; and provisions allowing the Board of Directors to consider nonmonetary factors in evaluating a business combination or a tender or exchange offer. The provisions in the Company's Certificate of Incorporation requiring a supermajority vote for the approval of certain business combinations and containing restrictions on acquisitions of the Company's equity securities provide that the supermajority voting requirements or acquisition restrictions do not apply to business combinations or acquisitions meeting specified Board of Directors approval requirements. The Certificate of Incorporation also authorizes the issuance of 1,000,000 shares of preferred stock as well as additional shares of Common Stock up to a total of 25,000,000 outstanding shares. These shares could be issued without stockholder approval on terms or in circumstances that could deter a future takeover attempt.
In addition, Virginia law provides for certain restrictions an acquisition of the Company, and federal and North Carolina laws contain various restrictions on acquisitions of control of banks and their holding companies.
The Certificate of Incorporation, Bylaw and statutory provisions, as well as certain other provisions of state and federal law and certain provisions in the Company's and the Bank's employee benefit plans are employment agreements and change in control severance agreements, may have the effect of discouraging or preventing a future takeover attempt in which stockholders of the Company otherwise might receive a substantial premium for their shares over then current market prices.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
Not Applicable.
ITEM 2.
ITEM 2. PROPERTIES
The following table sets forth the location and certain additional information regarding the Bank's offices at December 31, 2005.
----------- ** Lease land, own building.
The book value of the Bank's investment in premises and equipment was $8.8 million at December 31, 2005. See Note 5 to Consolidated Financial Statements.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
From time to time, the Company and/or the Bank is a party to various legal proceedings incident to their business. At December 31, 2005, there were no legal proceedings to which either the Company or the Bank was a party, or to which any of their property was subject, which were expected by management to result in a material loss to the Company or the Bank. There are no pending regulatory proceedings to which the Company or the Bank is a party or to which either of their properties is subject which are currently expected to result in a material loss.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDERS MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
(a) The information contained in the section captioned "Market Information" in the Company's Annual Report to Stockholders for the Fiscal Year Ended December 31, 2005 (the "Annual Report") filed as Exhibit 13 hereto is incorporated herein by reference.
(b) Not applicable.
(c) The following table sets forth information regarding the Company's repurchases of its common stock during the fourth quarter of the fiscal year covered by this Annual Report.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The information contained in the table captioned "Selected Consolidated Financial and Other Data" on page 3 in the Annual Report is incorporated herein by reference.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The information contained in the section captioned "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 4 through 14 in the Annual Report is incorporated herein by reference.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The information contained in the section captioned "Market Risk" on page 6 in the Annual Report is incorporated herein by reference.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Report of Independent Auditors, Consolidated Financial Statements, Notes to Consolidated Financial Statements and Selected Financial Data contained on pages 15 through 40 in the Annual Report, which are listed under Item 15 herein, are incorporated herein by reference.
The report of PricewaterhouseCoopers LLP with respect to the consolidated statements of operations, changes in stockholders' equity and cash flows of the Company for the year ended December 31, 2003 follows.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
[Letterhead of PricewaterhouseCoopers LLP]
To the Board of Directors and Shareholders of First South Bancorp, Inc.:
In our opinion, the accompanying consolidated statements of operations, of changes in stockholders' equity, and of cash flows present fairly, in all material respects, the results of operations and cash flows of First South Bancorp, Inc. and its subsidiaries for the year ended December 31, 2003 (appearing on pages 15 through 40 of the First South Bancorp, Inc. 2005 Annual Report to Shareholders which has been incorporated by reference in this Form 10-K) in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit of these statements in accordance with auditing standards generally accepted in the United States of America, which 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, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
/s/ PricewaterhouseCoopers LLP
Raleigh, North Carolina March 4, 2004
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRMS ON ACCOUNTING AND FINANCIAL DISCLOSURE
The information contained under the section captioned "Relationship with Independent Registered Public Accounting Firm" in the Company's definitive proxy statement for the Company's 2006 Annual Meeting of Stockholders (the "Proxy Statement") is incorporated herein by reference.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
As of the end of the period covered by this report, management of the Company carried out an evaluation, under the supervision and with the participation of the Company's principal executive officer and principal financial officer, of the effectiveness of the Company's disclosure controls and procedures. Based on this evaluation, the Company's principal executive officer and principal financial officer concluded that the Company's disclosure controls and procedures are effective in ensuring that information required to be disclosed by the Company in reports that it files or submits under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission's rules and forms. It should be noted that the design of the Company's disclosure controls and procedures is based in part upon certain reasonable assumptions about the likelihood of future events, and there can be no reasonable assurance that any design of disclosure controls and procedures will succeed in achieving its stated goals under all potential future conditions, regardless of how remote, but the Company's principal executive and financial officers have concluded that the Company's disclosure controls and procedures are, in fact, effective at a reasonable assurance level.
The annual report of management on the effectiveness of internal control over financial and the attestation report thereon issued by the Company's independent registered public accounting firm are set forth below under "Management's Report on Internal Control Over Financial Reporting" and "Report of Independent Registered Public Accounting Firm".
MANAGEMENT'S ANNUAL REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
[Letterhead of First South Bancorp, Inc.]
Management of First South Bancorp, Inc. and subsidiary (the "Company") is responsible for establishing and maintaining effective internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. 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 U.S. generally accepted accounting principles.
Under the supervision and with the participation of management, including the principal executive officer and principal financial officer, the Company conducted an evaluation of the effectiveness of internal control over financial reporting based on the framework in INTERNAL CONTROL--INTEGRATED FRAMEWORK issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation under the framework in INTERNAL CONTROL--INTEGRATED FRAMEWORK, management of the Company has concluded the Company maintained effective internal control over financial reporting as of December 31, 2005.
Internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting can also be circumvented by collusion or improper management override. Because of such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting.
Management is also responsible for compliance with laws and regulations relating to safety and soundness which are designated by the FDIC and the appropriate federal banking agency. Management assessed its compliance with these designated laws and regulations relating to safety and soundness and believes that the Company complied, in all significant respects, with such laws and during the year ended December 31, 2005.
Dixon Hughes PLLC, an independent, registered public accounting firm, has audited the Company's consolidated financial statements as of and for the year ended December 31, 2005, and has issued an attestation report on the Company's assessment of the effectiveness of the Company's internal control over financial reporting as of December 31, 2005, which is included herein.
First South Bancorp, Inc. March 7, 2006
/s/ Thomas A. Vann /s/ William L. Wall - ------------------------------------ ---------------------------- Thomas A. Vann William L. Wall President and Chief Executive Officer Executive Vice President and Chief Financial Officer
ATTESTATION REPORT OF REGISTERED PUBLIC ACCOUNTING FIRM
[Letterhead of Dixon Hughes PLLC]
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders First South Bancorp, Inc. Washington, North Carolina
We have audited management's assessment, included in the accompanying Management's Annual Report on Internal Control Over Financial Reporting, that First South Bancorp, Inc. (the "Company") maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in INTERNAL CONTROL--INTEGRATED FRAMEWORK issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management's assessment and an opinion on the effectiveness of 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, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company's internal control over financial reporting is a process designed 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. Because management's assessment and our audit were conducted to also meet the reporting requirements of Section 112 of the Federal Deposit Insurance Company Improvement Act (FDICIA), management's assessment and our audit of the Company's internal control over financial reporting included controls over the preparation of financial statements in accordance with the instructions to the Consolidated Financial Statements for Bank Holding Companies (form FR Y-9 C). A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management's assessment that First South Bancorp, Inc. maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on criteria established in INTERNAL CONTROL--INTEGRATED FRAMEWORK issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on criteria established in INTERNAL CONTROL--INTEGRATED FRAMEWORK issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated statement of financial condition of the Company as of December 31, 2005 and the related consolidated statements of operations, changes in stockholders' equity and cash flows for the year then ended December 31, 2005, and our report dated March 7, 2006, expressed an unqualified opinion on those consolidated financial statements.
We do not express an opinion or any other form of assurance on management's statement referring to compliance with designated laws and regulations related to safety and soundness.
/s/ Dixon Hughes PLLC - --------------------- Sanford, North Carolina March 7, 2006
CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING
There have been no changes in the Company's internal control over financial reporting identified in connection with the evaluation required under paragraph (d) of Securities and Exchange Commission Rule 13a-15 that occurred during the Company's last fiscal quarter, 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
Not applicable.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information contained under the sections captioned "Proposal I -- Election of Directors" and "Section 16(a) Beneficial Ownership Reporting Compliance" in the Proxy Statement is incorporated herein by reference.
The Company has adopted a Code of Ethics that applies to the Company's principal executive officer, principal financial officer and principal accounting officer. The Company has posted such Code of Ethics on its Internet Web site and intends to satisfy the disclosure requirement under Item 10 of Form 8-K regarding an amendment to, or waiver from, the Code of Ethics by posting such information on its Internet website. The Company's Internet website may be accessed as follows: http://www.firstsouthnc.com.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information contained under the sections captioned "Proposal I -- Election of Directors," "-- Compensation Committee Report on Executive Compensation," "-- Comparative Stock Performance Graph," "-- Executive Compensation" and "-- Director Compensation" in the Proxy Statement is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
(a) SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS. Information required by this item is incorporated herein by reference to the section captioned "Voting Securities and Security Ownership" in the Proxy Statement.
(b) SECURITY OWNERSHIP OF MANAGEMENT. Information required by this item is incorporated herein by reference to the sections captioned "Voting Securities and Security Ownership" and "Proposal I -- Election of Directors" in the Proxy Statement.
(c) CHANGES IN CONTROL. Management of the Company knows of no arrangements, including any pledge by any person of securities of the Company, the operation of which may at a subsequent date result in a change in control of the registrant.
(d) EQUITY COMPENSATION PLANS. The following table sets forth certain information with respect to the Company's equity compensation plans as of December 31, 2005.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this item is incorporated herein by reference to the section captioned "Proposal I -- Election of Directors -- Transactions with Management" in the Proxy Statement.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
Information required by this item is incorporated herein by reference to the section captioned "Audit and Other Fees Paid to Independent Accountant" in the Proxy Statement.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) LIST OF DOCUMENTS FILED AS PART OF THIS REPORT
(1) Financial Statements. The following consolidated financial statements are incorporated by reference from Item 8 hereof:
Report of Independent Registered Public Accounting Firm Consolidated Statements of Financial Condition as of December 31, 2005 and 2004 Consolidated Statements of Operations for the Years Ended December 31, 2005, 2004 and 2003 Consolidated Statements of Changes in Stockholders Equity for the Years Ended December 31, 2005 and 2004
Consolidated Statements of Cash Flows for the Years Ended December 31, 2005 and 2004 and 2003 Notes to Consolidated Financial Statements
(2) Financial Statement Schedules. All schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are omitted because of the absence of conditions under which they are required or because the required information is included in the consolidated financial statements and related notes thereto.
(3) Exhibits. The following is a list of exhibits filed as part of this Annual Report on Form 10-K and is also the Exhibit Index.
NO. DESCRIPTION
3.1 Certificate of Incorporation of First South Bancorp, Inc. (Incorporated herein by reference from Exhibit 3.1 to the Company's Registration Statement on Form S-1 (File No. 333-16335))
3.2 Bylaws of First South Bancorp, Inc., as amended (Incorporated herein by reference from the Company's Annual Report on Form 10-K for the Year Ended December 31, 2004 (File No. 0-22219))
4.1 Form of Common Stock Certificate of First South Bancorp, Inc. (Incorporated herein by reference from Exhibit 1 to the Company's Registration Statement on Form 8-A)
4.2 Junior Subordinated Indenture between First South Bancorp, Inc. and The Bank of New York dated September 26, 2004 (Incorporated herein by reference from the Company's Annual Report on Form 10-K for the Year Ended December 31, 2003 (File No. 0-22219))
10.1(a) Employment Agreement between First South Bancorp, Inc. and Thomas A. Vann, as amended (Incorporated herein by reference from the Company's Annual Report on Form 10-K for the Year Ended December 31, 2003 (File No. 0-22219))*
10.1(b) Employment Agreement between First South Bank and Thomas A. Vann, as amended (Incorporated herein by reference from the Company's Annual Report on Form 10-K for the Year Ended December 31, 2003 (File No. 0-22219))*
10.2 Change in Control Protective Agreements between Home Savings Bank, SSB, First South Bancorp, Inc. and Mary R. Boyd, Sherry L. Correll and Kristie W. Hawkins (Incorporated herein by reference from Exhibit 10.4 to the Company's Registration Statement on Form S-1 (File No. 333-16335))*
10.3 Supplemental Income Agreements as Amended and Restated December 14, 1995 between Home Savings Bank, SSB and Sherry L. Correll and Thomas A. Vann and the 1996 Amendment Thereto (Incorporated herein by reference from Exhibit 10.5 to the Company's Registration Statement on Form S-1 (File No. 333-16335))*
10.4 Supplemental Income Plan Agreements as Amended and Restated December 14, 1995 between Home Savings Bank, SSB and James F. Buckman, Thomas A. Vann and William L. Wall and the 1996 Amendment Thereto (Incorporated herein by reference from Exhibit 10.6 to the Company's Registration Statement on Form S-1 (File No. 333-16335))*
10.5 Home Savings Bank, SSB Director's Deferred Compensation Plan Agreements as Amended and Restated December 14, 1995 with Edmund T. Buckman, Jr., Linley H. Gibbs, Jr., Frederick N. Holscher, Frederick H. Howdy, Charles E. Parker, Jr., Marshall T. Singleton and Thomas A. Vann and the 1996 Amendment Thereto (Incorporated herein by reference from Exhibit 10.7 to the Company's Registration Statement on Form S-1 (File No. 333-16335))*
10.6 First South Bank Director's Retirement Plan Agreements as Amended and Restated December 14, 1995 with Edmund T. Buckman, Jr., Linley H. Gibbs, Jr., Frederick N. Holscher, Frederick H. Howdy, Charles E. Parker, Jr. and Thomas A. Vann, the 1996 Amendment thereto and the 2004 Amendment thereto (Incorporated herein by reference from the Company's Annual Report on Form 10-K for the Year Ended December 31, 2003 (File No. 0-22219))*
10.7 Home Savings Bank, SSB Director's Retirement Payment Agreements as Amended and Restated December 14, 1995 with Edmund T. Buckman, Jr., Linley H. Gibbs, Jr., Frederick N. Holscher, Frederick H. Howdy, Charles E. Parker, Jr., and Thomas A. Vann and the 1996 Amendment Thereto (Incorporated herein by reference from Exhibit 10.9 to the Company's Registration Statement on Form S-1 (File No. 333-16335))*
10.8 Home Savings Bank, SSB Directors Retirement Plan Agreement with Marshall Singleton and the 2004 Amendment thereto (Incorporated herein by reference from the Company's Annual Report on Form 10-K for the Year Ended December 31, 2003 (File No. 0-22219))*
10.9 First South Bancorp, Inc. 1997 Stock Option Plan, as amended (Incorporated herein by reference from Exhibit 10.10 to the Company's Annual Report on Form 10-K for the Year Ended September 30, 1999 (File No. 0-22219))*
10.10 Supplemental Income Plan Agreement between First South Bank and Robert E. Branch dated September 21, 2004
10.11 Change-in-Control Protective Agreement between First South Bank, First South Bancorp, Inc. and Robert E. Branch dated January 27,
10.12 Change-in-Control Protective Agreement between First South Bank, First South Bancorp, Inc. and William L. Wall dated January 1, 2001 (Incorporated herein by reference from Exhibit 10.12 to the Company's Annual Report on Form 10-K for the Year Ended September 30, 2001 (File No. 0-22219))*
10.13 Trust Preferred Securities Guarantee Agreement between First South Bancorp, Inc., and The Bank of New York dated September 26, 2003 (Incorporated herein by reference from the Company's Annual Report on Form 10-K for the Year Ended December 31, 2003 (File No. 0-22219))
13 Annual Report to Stockholders for the Fiscal Year Ended December 31,
21 Subsidiaries of the Registrant
23.1 Consent of PricewaterhouseCoopers LLP
23.2 Consent of Dixon Hughes PLLC
31.1 Rule 13a-14(a) Certification of Chief Executive Officer
31.2 Rule 13a-14(a) Certification of Chief Financial Officer
32 Certification pursuant to 18 U.S.C. Section 1350
- --------------------------- * Compensatory plan or arrangement
(b) EXHIBITS. The exhibits required by Item 601 of Regulation S-K are either filed as part of this Annual Report on Form 10-K or incorporated by reference herein.
(c) FINANCIAL STATEMENTS AND SCHEDULES EXCLUDED FROM ANNUAL REPORT. There are no other financial statements and financial statement schedules which were excluded from the Annual Report to Stockholders pursuant to Rule 14a-3(b) which are required to be included herein.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
FIRST SOUTH BANCORP, INC.
March 15, 2006 By: /s/Thomas A. Vann --------------------- Thomas A. Vann President
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
/s/Thomas A. Vann March 15, 2006 - -------------------------------------------- Thomas A. Vann President and Director (Principal Executive Officer)
/s/William L. Wall March 15, 2006 - -------------------------------------------- William L. Wall Executive Vice President, Chief Financial Officer and Secretary (Principal Financial and Accounting Officer)
/s/Edmund T. Buckman, Jr. March 15, 2006 - -------------------------------------------- Edmund T. Buckman, Jr. Director
/s/Linley H. Gibbs, Jr. March 15, 2006 - -------------------------------------------- Linley H. Gibbs, Jr. Director
/s/Frederick N. Holscher March 15, 2006 - -------------------------------------------- Frederick N. Holscher Director
/s/Frederick H. Howdy March 15, 2006 - -------------------------------------------- Frederick H. Howdy Director
/s/Charles E. Parker, Jr. March 15, 2006 - -------------------------------------------- Charles E. Parker, Jr. Director
/s/Marshall T. Singleton March 15, 2006 - -------------------------------------------- Marshall T. Singleton Director
/s/H.D. Reaves, Jr. March 15, 2006 - -------------------------------------------- H. D. Reaves, Jr. Director
2005 Annual Report
First South Bancorp
Letter to Stockholders 1
Mission Statement 2
Selected Consolidated Financial Information and Other Data 3
Management's Discussion and Analysis of Financial Condition and Results of Operations 4
Report of Independent Registered Public Accounting Firm 15
Consolidated Statements of Financial Condition 16
Consolidated Statements of Operations 17
Consolidated Statements of Changes in Stockholders' Equity 18
Consolidated Statements of Cash Flows 19
Notes to Consolidated Financial Statements 20
Board of Directors 41
Executive Officers 41
Area Executives & Subsidiary Executives 41
City & Branch Executives 41
First South Bank Office Locations 42
Stockholder Information 43
LETTER TO STOCKHOLDERS
To Our Stockholders:
The financial results achieved by First South Bancorp ("First South") and its wholly owned subsidiary, First South Bank ("Bank") during the year ended December 31, 2005 were extremely positive for our stockholders. We accomplished both our financial and strategic objectives, set a new earnings record and continued to enhance shareholder value.
For 2005, we are pleased to report record earnings of $14.1 million representing a 20.6% increase over the $11.7 million earned in 2004. The significance of these earnings is reflected in the Bank's ability to reprice its assets quickly and manage its operating cost. Diluted earnings per share increased 18.4% to $2.12 per share for 2005 from $1.79 per share for 2004.
The assets of First South grew by 15.4% to $833.1 million at year end 2005, from $722.1 million at year end 2004. In addition, total loans and leases were $707.8 million and deposits were $733.8 million, respectively, at year end 2005. Internal growth was strong in a very competitive environment and the Bank's reliance on borrowings was minimal.
The total return to our stockholders increased dramatically in 2005. We increased the quarterly cash dividend payment rate by 17.7%, and combined with the market appreciation of our common stock, resulted in a 40.9% total return to our stockholders.
We enjoyed many positive events during 2005. U.S. Banker recognized First South as 3rd among the top 200 publicly traded community banks in the United States with assets of $1 billion or less, ranked by 3-year average return on equity. The American Banker ranked First South as the 54th most efficient bank holding company among the largest 500 in the United States and as having the 77th largest net interest margin among all banking companies in the United States. Business North Carolina ranked the top 75 public companies in North Carolina by twelve measures, and First South was ranked 2nd in net interest margin, 5th in return on average equity, 8th in total one-year return and 9th in return on capital. We are pleased with these recognitions, as they further exemplify the visibility of First South and the Bank among both the business and investment communities.
During 2005, the Bank opened three new full service banking offices in Avon, Durham, and Greenville, North Carolina allowing us to better serve the banking needs in our growing market area and allowing us to expand our customer base in existing markets. Many of our future strategies will focus on enhancing the franchise value of First South. Our goal is to be a high performance bank, both in profitability and growth without compromising service. We are committed to our shareholders, our customers and our employees.
We will continue to review the structure of the assets and liabilities of the Bank in order to meet the challenges of a changing world. We will use internal and external growth to meet our strategic plan. The consolidation of our industry will continue and this should create significant opportunities for First South. We will continue to look for acquisition opportunities and will expand our operations into new markets.
The outstanding financial results achieved this year would not have been possible without the hard work and dedication of our employees. We are appreciative and proud of their accomplishments. They are committed to First South, its principles and to providing their customers the highest possible level of service. We will continue to invest in our employees, which will ultimately result in improved service to our customers and enhanced shareholder value.
I want to thank Mr. Edmund "Eddie Buck" Buckman for his thirty years of service on the Bank's Board of Directors. Eddie Buck joined the Bank in 1975 and was its Chairman from 1991 to 1996 and served on numerous committees. His wisdom, insight and warm smile will be missed. We thank him for all he has done to make First South so successful and we wish him the best in his retirement.
Each member of your Board of Directors along with our officers and employees join me in thanking you for supporting First South Bancorp. As always, your comments or suggestions are welcomed and we look forward to your continued support.
Sincerely,
/s/ Tom Vann Tom Vann President and Chief Executive Officer
MISSION STATEMENT
"Our mission is to become the premier community bank in eastern North Carolina. We will enhance shareholder value by serving the personal and business needs of our markets, providing superior customer service, investing in the communities that we serve, and enriching the lives of our employees."
SELECTED CONSOLIDATED FINANCIAL INFORMATION AND OTHER DATA
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
General. First South Bancorp, Inc. (the "Company") was formed for the purpose of issuing common stock, owning 100% of First South Bank (the "Bank") and operating through the Bank a commercial banking business, therefore, this discussion of consolidated financial condition and results of operations relates principally to the Bank. The business of the Bank consists principally of attracting deposits from the general public and using them to originate secured and unsecured commercial and consumer loans, permanent mortgage and construction loans secured by single-family residences and other loans. The Bank's earnings depend primarily on its net interest income, the difference between interest earned on interest earning assets and interest paid on interest-bearing liabilities. The level of noninterest income and expenses also affects the Bank's earnings.
Prevailing economic conditions, as well as federal and state regulations, affect the operations of the Bank. The Bank's cost of funds is influenced by interest rates paid on competing investments, rates offered on deposits by other financial institutions in the Bank's market area and by general market interest rates. Lending activities are affected by the demand for financing of real estate and various types of commercial and consumer loans, and by interest rates at which such financing may be offered. The Bank's business emphasis is to operate as a well-capitalized, profitable and independent community oriented financial institution dedicated to providing quality customer service and meeting the financial needs of the communities it serves. Management believes the Bank can be more effective in serving its customers than many larger competitors because of its ability to respond quickly and effectively to customer needs and inquiries. The Bank's ability to provide these services is enhanced by the stability of the Bank's senior management team.
The Company's common stock is listed and trades on the Nasdaq Stock Market under the symbol FSBK.
Stock Split. On April 23, 2004 the Company paid a three-for-two stock split, in the form of a 50% stock dividend, to stockholders of record as of April 2, 2004. Stockholders received one additional share of common stock for every two shares held on the record date. All prior period share and per share data have been adjusted for the split.
Liquidity and Capital Resources. The Bank's primary sources of funds are deposits, principal and interest payments on loans, proceeds from loan and securities sales, and advances from the Federal Home Loan Bank of Atlanta (the "FHLB"). While maturities and scheduled amortization of loans are predictable sources of funds, deposit flows and loan prepayments are influenced by interest rates, economic conditions and local competition. The Bank's primary investing activity is the origination of commercial, consumer and mortgage loans and lease financing receivables. During fiscal 2005 and 2004, originations of loans held for sale and investment, net of principal repayments, were $107.3 million and $117.5 million, respectively. The Bank's primary financing activities are the attraction of checking, certificate and savings deposits, and obtaining FHLB advances.
The levels of cash and cash equivalents depend on the Bank's operating, financing, lending and investing activities during any given period. At December 31, 2005 and 2004, cash and cash equivalents totaled $32.9 million and $20.9 million, respectively. The Bank has other sources of liquidity if a need for additional funds arises. Investment and mortgage-backed securities available for sale totaled $62.5 million at December 31, 2005 and $38.7 million at December 31, 2004. During the years ended December 31, 2005 and 2004, the Bank sold or exchanged real estate loans of $29.0 million and $40.5 million, respectively. Borrowings consisting of FHLB advances, junior subordinated debentures and retail repurchase agreements were $22.1 million at December 31, 2005 compared to $25.1 million at December 31, 2004. The Bank has pledged its FHLB Atlanta stock and certain loans as collateral for actual or potential FHLB advances. The Bank has a minimum credit availability with the FHLB of 40% of the Bank's total assets. At December 31, 2005 the Bank had unused credit availability with the FHLB of $327.1 million.
In 2003, the Company completed the private placement in a pooled offering of $10.3 million of trust preferred securities, issued by First South Preferred Trust I, a Delaware statutory trust. The trust preferred securities bear interest at a rate of 2.95% over three-month LIBOR payable quarterly, have a 30-year maturity and are first redeemable, in whole or in part, on or after September 30, 2008, with certain exceptions. For regulatory purposes, the $10.3 million total of trust preferred securities qualifies as Tier 1 capital for the Company and the Bank, to the extent such proceeds have been invested in the Bank and the Company. Proceeds from the trust preferred securities were used by the statutory trust to purchase junior subordinated debentures issued by the Company. For additional information, see Note 19 of Notes to Consolidated Financial Statements.
As a North Carolina chartered commercial bank and a Federal Deposit Insurance Corporation (the "FDIC") insured institution, the Bank is required to meet various state and federal regulatory capital standards. The Bank's stand-alone equity was $75.5 million at December 31, 2005, compared to $68.1 million at December 31, 2004. The Commissioner requires the Bank to maintain a capital surplus of not less than 50% of common capital stock. The FDIC requires the Bank to meet a minimum leverage capital requirement of Tier I capital (consisting of retained earnings and common stockholders' equity, less any intangible assets) to assets ratio of at least 4%, and a total capital to risk-weighted assets ratio of 8%, of which 4% must be in the form of Tier I capital. The Bank was in compliance with all regulatory capital requirements at December 31, 2005 and 2004.
At December 31, 2005, stockholders' equity was $68.2 million, compared to $59.7 million at December 31, 2004. Net income for fiscal 2005 was $14.1 million, compared to $11.7 million for fiscal 2004. At December 31, 2005 there were 6,339,548 shares of common stock outstanding, net of 1,660,452 treasury shares.
Contractual Obligations and Commitments. In the normal course of business there are various outstanding contractual obligations of the Company that will require future cash outflows. In addition, there are commitments and contingent liabilities, such as commitments to extend credit, which may or may not require future cash outflows. Table 1 below reflects contractual obligations of the Company outstanding as of December 31, 2005.
Table 1 - Contractual Obligations and Commitments
In the normal course of business, the Company may enter into purchase agreements for goods or services. In management's opinion, the dollar amount of such agreements at December 31, 2005 is not material and has not been included in Table 1 above.
Asset/Liability Management. The Bank strives to maintain consistent net interest income and reduce its exposure to adverse changes in interest rates by matching the terms to repricing of its interest-sensitive assets and liabilities. Factors beyond the Bank's control, such as market interest rates and competition, may also impact interest income and interest expense. The Bank's net interest income will generally increase when interest rates rise over an extended period of time, and conversely, will decrease when interest rates decline. The Bank can significantly influence its net interest income by controlling the increases and decreases in its interest income and interest expense, which are caused by changes in market interest rates. See Table 2 below for additional information on the effects of net interest income caused by changes in interest rates.
The President of the Bank reports interest rate risk and trends, liquidity and capital ratio requirements to the Board on a regular basis. The Board reviews the maturities of the Bank's assets and liabilities and establishes policies and strategies designed to regulate the flow of funds and to coordinate the sources, uses and pricing of such funds. The first priority in structuring and pricing assets and liabilities is to maintain an acceptable interest rate spread while reducing the net effects of changes in interest rates. The Bank's management is responsible for administering the policies and determinations of the Board with respect to the Bank's asset and liability goals and strategies.
A principal strategy in managing the Bank's interest rate risk has been to increase interest sensitive assets such as commercial loans, lease financing receivables and consumer loans. At December 31, 2005, the Bank had $548.6 million of commercial loans and lease receivables and $101.8 million of consumer loans, compared to $475.4 million and $98.4 million, respectively, at December 31, 2004. The Bank had $10.8 million of loans held for sale at December 31, 2005, compared to $6.0 million at December 31, 2004. Depending on conditions existing at a given time, the Bank may sell fixed-rate residential mortgage loans in the secondary market. In managing its portfolio of investment securities, a majority of investment and mortgage-backed securities are held as available for sale, allowing the Bank to sell a security in a timely manner should an immediate liquidity need arise. The Bank had $62.5 million of investment and mortgage-backed securities classified as available for sale at December 31, 2005, compared to $38.7 million at December 31, 2004.
Market Risk. Market risk reflects the risk of economic loss resulting from changes in market prices and interest rates. The risk of loss can be reflected in diminished current market values and/or reduced potential net interest income in future periods. Market risk arises primarily from interest rate risk inherent in lending and deposit taking activities. The Bank does not maintain a trading account for any class of financial instruments, nor does it engage in hedging activities or purchase high-risk derivative instruments. Furthermore, the Bank is not subject to foreign currency exchange risk or commodity price risk.
The Bank measures interest rate risk by computing estimated changes in net interest income and the net portfolio value ("NPV") of its cash flows from assets, liabilities and off-balance sheet items in the event of a range of assumed changes in market interest rates. The Bank's exposure to interest rates is reviewed on a quarterly basis by management and the Board. Exposure to interest rate risk is measured with the use of interest rate sensitivity analysis to determine the change in NPV in the event of hypothetical changes in interest rates, while interest rate sensitivity gap analysis is used to determine the repricing characteristics of assets and liabilities. If estimated changes to NPV and net interest income are not within the limits established by the Board, it may direct management to adjust the Bank's asset and liability mix to bring interest rate risk within Board approved limits.
NPV represents the market value of portfolio equity and is equal to the market value of assets minus the market value of liabilities, with adjustments made for off-balance sheet items. This analysis assesses the potential loss in risk sensitive instruments in the event of sudden and sustained 1% to 3% increases and decreases in market interest rates. The Board has adopted an interest rate risk policy that establishes maximum increases in NPV of 17%, 36% and 56% and decreases in NPV of 15%, 36% and 61% in the event of sudden and sustained 1% to 3% increases or decreases in market interest rates. Table 2 below presents the Bank's projected changes in NPV and net interest income in the event of sudden and sustained increases or decreases in market interest rates for the various rate shock levels at December 31, 2005. At December 31, 2005, the Bank's estimated changes in NPV and net interest income were within the targets established by the Board.
Table 2 - Projected Change in NPV and Net Interest Income
The NPV calculation is based on the net present value of discounted cash flows utilizing market prepayment assumptions. Computations of prospective effects of hypothetical interest rate changes are based on numerous assumptions, including relative levels of market interest rates, loan prepayments and deposit decay rates, and should not be relied upon as indicative of actual results. Further, the computations do not contemplate any actions the Bank may undertake in response to changes in interest rates.
Certain shortcomings are inherent in the method of analysis presented in Table 2. For example, although certain assets and liabilities may have similar maturities to repricing, they may react in differing degrees to changes in market interest rates. The interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market rates. Certain assets, such as adjustable-rate loans, have features that restrict changes in interest rates on a short-term basis and over the life of the asset. In addition, the proportion of adjustable-rate loans in the Bank's portfolio could decrease in future periods if market interest rates remain at or decrease below current levels due to refinance activity. Further, in the event of a change in interest rates, prepayment and early withdrawal levels would likely deviate from those assumed in the table. Also, the ability of many borrowers to repay their adjustable-rate debt may decrease in the event of an increase in interest rates.
In addition, the Bank uses interest sensitivity gap analysis to monitor the relationship between the maturity and repricing of its interest-earning assets and interest-bearing liabilities, while maintaining an acceptable interest rate spread. Interest sensitivity gap is defined as the difference between the amount of interest-earning assets maturing or repricing within a specific time period and the amount of interest-bearing liabilities maturing or repricing within that time period. A gap is considered positive when the amount of interest-sensitive assets exceeds the amount of interest-sensitive liabilities, and is considered negative when the amount of interest-rate-sensitive liabilities exceeds the amount of interest-rate-sensitive assets. Generally, during a period of rising interest rates, a negative gap would adversely affect net interest income, while a positive gap would result in an increase in net interest income. Conversely, during a period of falling interest rates, a negative gap would result in an increase in net interest income, while a positive gap would negatively affect net interest income. The Bank's goal is to maintain a reasonable balance between exposure to interest rate fluctuations and earnings.
Rate/Volume Analysis. Net interest income can also be analyzed in terms of the impact of changing interest rates on average interest-earning assets and average interest-bearing liabilities, and the changing volume or amount of these assets and liabilities.
Table 3 below represents the extent to which changes in interest rates and changes in the volume of average interest-earning assets and average interest-bearing liabilities have affected the Company's interest income and interest expense during the periods indicated. For each category of average interest-earning asset and average interest-bearing liability, information is provided on changes attributable to: (i) changes in volume (changes in volume multiplied by old rate); (ii) changes in rate (change in rate multiplied by old volume); (iii) changes in rate-volume (changes in rate multiplied by the changes in volume); and (iv) net change (total of the previous columns).
Analysis of Net Interest Income. Net interest income primarily represents the difference between income derived from interest-earning assets and interest expense on interest-bearing liabilities. Net interest income is affected by both the difference between the yield on earning assets and the average cost of funds ("interest rate spread"), and the relative volume of interest-earning assets, interest-bearing liabilities and noninterest-bearing deposits.
Table 4 below sets forth certain information relating to the Company's Statements of Financial Condition and Statements of Operations for the three years ended December 31, 2005, 2004, and 2003, reflecting the yield on average earning assets and the average cost of funds for the periods indicated. Average balances are derived from month end balances. The Company does not believe that using month end balances rather than average daily balances has caused any material difference in the information presented.
Table 3 - Rate/Volume Analysis
Table 4 - Yield/Cost Analysis
- --------------------------------- (1) Includes classified loans. (2) Represents the difference between the yield on earning assets and the average cost of funds. (3) Represents the net interest income divided by average earning assets.
Results of Operations
Comparison of Financial Condition at December 31, 2005 and 2004
Total assets increased 15.4% to $833.1 million at December 31, 2005 from $722.1 million at December 31, 2004. Earning assets increased 14.6% to $774.5 million at December 31, 2005 from $676.0 million at December 31, 2004, reflecting continued net growth in the loan and leases receivable portfolio and opening three new full service banking offices. Earning assets were 93.0% of total assets at December 31, 2005, compared to 93.7 % at December 31, 2004.
Loans and lease receivables, net of allowance for loan losses and deferred loan fees, increased 12.0% to $707.8 million at December 31, 2005 from $631.8 million at December 31, 2004. The Bank continues to emphasize the origination of both secured and unsecured commercial and consumer loans, in order to take advantage of shorter terms to maturity in managing its exposure to market and interest rate risk due to changes in interest rates. The Bank also sells selected mortgage loans in the secondary mortgage market in order to reduce its exposure to interest rate and credit risk, while retaining servicing to generate additional fee income. Loans serviced for others totaled $260.6 million at December 31, 2005 compared to $277.3 million serviced at December 31, 2004.
Commercial loans and lease receivables increased 15.4% to $548.6 million at December 31, 2005 from $475.4 million at December 31, 2004. Consumer loans increased 3.4% to $101.8 million at December 31, 2005 from $98.4 million at December 31, 2004. This growth reflects the Bank's increased focus of the growth and development of its commercial and consumer loan and lease receivables portfolio. Commercial and consumer loans and lease receivables originations increased to $474.1 million during fiscal 2005, from $394.1 million during fiscal 2004.
Residential real estate mortgage loans increased to $68.0 million at December 31, 2005 from $67.5 million at December 31, 2004, reflecting the loan origination volume, net of loan sales and exchanges. During fiscal 2005, the Bank originated $119.3 million of residential mortgage loans, compared to $115.8 million during fiscal 2004. The Bank sold $12.7 million of mortgage loans during fiscal 2005, compared to $37.6 million during fiscal 2004, reflecting the slow down in origination and refinancing volumes due to the rise in interest rates. In addition, during fiscal 2005 the Bank implemented a strategy to securitize current held for sale mortgage loan originations into mortgage-backed securities in order to support future liquidity management needs.
Investment and mortgage-backed securities increased 66.8% to $64.5 million at December 31, 2005, from $38.7 million at December 31, 2004. During 2005, $16.0 million of investment maturities were reinvested in a total of $27.0 million of investment securities available for sale, compared to $16.0 million of investment maturities used to fund loan originations and banking operations in 2004. The Bank exchanged $16.4 million of mortgage loans for mortgage-backed securities during fiscal 2005, compared to $2.8 million during fiscal 2004. The Bank sold no investment or mortgage-backed securities available for sale during the 2005, compared to $2.3 million sold during fiscal 2004.
Pursuant to adopting the provisions of financial accounting standards, goodwill related to prior period acquisitions is not amortized. The unamortized balance of the Company's goodwill is tested for impairment at least annually. The Company has performed its annual impairment test and has determined that there has been no impairment of goodwill as of December 31, 2005 and 2004. Goodwill related to prior period acquisitions was $4.2 million at December 31, 2005 and 2004.
Deposits increased 16.7% to $733.8 million at December 31, 2005 from $628.5 million at December 31, 2004. Certificates of deposit increased 26.2% to $467.4 million at December 31, 2005 from $370.2 million at December 31, 2004. The Bank continued to market lower cost core deposits during 2005, resulting in net checking account growth of 3.6% to $244.9 million at December 31, 2005 from $236.3 million at December 31, 2004. The Bank manages its cost of deposits by constantly monitoring the volume and rates being paid on maturing certificates of deposits in relationship to current funding needs and competitive market interest rates. During fiscal 2005 and 2004, the Bank repricing maturing certificates of deposits at competitive market rates, and combined with the growth of lower costing checking accounts, has provided an effective means of managing its deposit cost.
Total borrowings were $22.1 million at December 31, 2005 compared to $25.1 million at December 31, 2004. FHLB advances and junior subordinated debentures were $15.8 million at December 31, 2005, compared to $20.8 million at December 31, 2004. Borrowings in the form of repurchase agreements were $6.3 million at December 31, 2005, compared to $4.3 million at December 31, 2004, representing funds held in cash management accounts for commercial banking customers.
Stockholders' equity was $68.2 million at December 31, 2005, compared to $59.7 million at December 31, 2004. The consolidated equity to assets ratio was 8.2% and 8.3% at December 31, 2005 and December 31, 2004, respectively. Accumulated other comprehensive loss was $371,000 at December 31, 2005 compared to accumulated other comprehensive income of $873,000 at December 31, 2004, reflecting a decrease in unrealized gains on available for sale securities resulting from an increase in interest rates during the respective periods.
During the years ended December 31, 2005 and 2004, the Company declared four quarterly cash dividends each, totaling $0.80 and $0.68 per share respectively. These cash dividend payments reflect dividend payout ratios on basic earnings of 35.9% for fiscal 2004 and 36.4% for fiscal 2004. Future quarterly dividends will be determined at the discretion of the Board of Directors based upon earnings, the capital and financial condition of the Company, and general economic conditions.
Pursuant to stock repurchase programs adopted by the Company during fiscal years 2005 and 2004, the Company acquired 9,303 and 78,400 shares of its common stock, respectively, through both open market and private purchases. Shares acquired under the repurchase program are being held as treasury stock, at cost. At December 31, 2005, treasury shares were 1,660,452 totaling $28.8 million, compared to 1,735,324 shares totaling $29.7 million at December 31, 2004. The Company will use the repurchased shares of its outstanding common stock for general corporate purposes including the future exercise of stock options and funding shares issued pursuant to potential future stock splits.
During fiscal 2005 and 2004, 101,652 and 84,983 shares, respectively, were issued on the exercise of stock options. In addition, during fiscal 2005 and 2004, 17,477 and 14,569 shares were tendered to pay for the exercise price of stock options being exercised. During fiscal 2004, the Company used 628,610 treasury shares to issue common stock for a three-for-two stock split.
Comparison of Operating Results for the Years Ended December 31, 2005 and 2004
Net Income. Net income increased 20.6% to $14.1 million for the year ended December 31, 2005 from $11.7 million for the year ended December 31, 2004. Basic earnings per share increased 19.3% to $2.23 per share for the year ended December 31, 2005 from $1.87 per share for the year ended December 31, 2004. Diluted earnings per share increased 18.4% to $2.12 per share for the year ended December 31, 2005 from $1.79 per share for the year ended December 31, 2004. The average numbers of basic shares were 6,325,382 and 6,251,866 and the average numbers of diluted shares were 6,653,481 and 6,557,149, respectively, for the years ended December 31, 2005 and 2004. Return on average assets and return on average equity were 1.8% and 21.9% respectively for fiscal 2005, compared to 1.6% and 20.5% for fiscal 2004.
Interest Income. Interest income increased 32.3% to $53.2 million for fiscal 2005 from $40.2 million for fiscal 2004. During 2005 the increase in interest income resulted from a combination of an increase in interest rates and the increase in the volume of interest-earning assets, enabling the Bank to earn an increased level of interest income. The average balance of interest-earning assets increased 12.9% to $738.1 million for fiscal 2005, from $653.7 million for fiscal 2004. The yield on average interest-earning assets was 7.2% and 6.2% for 2005 and 2004, respectively.
Interest Expense. Interest expense increased 59.5% to $15.5 million for fiscal 2005 from $9.7 million for fiscal 2004. The increase in interest expense also reflects the increase in interest rates and the increase in the volume average interest-bearing liabilities, offset by an increase in noninterest-bearing checking accounts. The average balance of interest-bearing liabilities increased 10.9% to $622.0 million for fiscal 2005 from $560.8 million for fiscal 2004. The average balance of noninterest-bearing deposits increased 19.9% to $94.7 million for fiscal 2005 from $79.0 million for fiscal 2004. The average cost of funds (including noninterest-bearing deposits) was 2.2% for 2005, compared to 1.5% for 2004, reflecting a rising interest rate environment during 2005.
Net Interest Income. Net interest income increased 23.7% to $37.7 million for fiscal 2005 from $30.5 million for fiscal 2004. The increase in net interest income during 2005 is attributable to a 37.9% greater increase in the volume of average interest-earning assets as compared to the increase in the volume of interest-bearing liabilities, and the increase in noninterest-bearing deposits. The net yield on interest-earning assets (net interest income divided by average interest-earning assets) was 5.1% for fiscal 2005, compared to 4.7% fiscal 2004. The Bank's interest rate spread (the difference between the effective yield on average interest-earning assets and the effective average cost of funds) was 5.0% for fiscal 2005, compared to 4.4% for fiscal 2004.
See Table 3 - Rate/Volume Analysis and Table 4 - Yield/Cost Analysis above for additional information on interest income, interest expense, net interest income, average balances and yield/cost ratios.
Provision for Loan Losses. The Bank maintains both general and specific allowances for losses on loans based upon management's evaluation of risk in the loan portfolio and past loan loss experience. The Bank's methodology for evaluating its general and specific allowance for loan losses includes amounts specifically allocated to loans that are individually determined to be impaired, as well as general reserve amounts allocated to groups of loans that have not been individually assessed for impairment. The Bank provided $1.7 million for general and specific loan losses during fiscal 2005, compared to $968,000 for fiscal 2004. These provisions were necessary to absorb losses in the loan portfolio and to support the inherent risks associated with the growth in commercial and consumer loans discussed above. The general and specific allowance for loan losses was $9.2 million at December 31, 2005 and $8.3 million at December 31, 2004, which the Bank believes is adequate. The ratio of the general and specific allowance for loan losses to total loans was 1.3% at December 31, 2005 and 2004, respectively.
The Bank uses an analytical approach through a classification of assets program to determine the adequacy of its loan loss allowances and the necessary provision for loan losses. The loan portfolio is reviewed on a quarterly basis and delinquent loans are individually analyzed. Consideration is given to the loan status, payment history, repayment ability, probability of repayment, and loan-to-value percentages. Loans are classified in appropriate categories applicable to their circumstances as a result of this review and analysis. After reviewing current economic conditions, changes in delinquency status, and actual loan losses incurred by the Bank, management establishes an appropriate reserve percentage applicable to each category of assets, and provision for loan losses is recorded when necessary to bring the allowances to a level consistent with this analysis. The ratio of non-performing loans to total loans was .3% at December 31, 2005 and .4% at December 31, 2004.
Noninterest Income. Noninterest income declined 6.2% to $8.2 million for fiscal 2005 from $8.8 million for fiscal 2004. Other income consists of fees, service charges and servicing fees earned on loans, service charges and insufficient funds fees collected on deposit accounts, gains from sales of loans and mortgage-backed securities and other miscellaneous income. Fees and service charges declined 5.6% to $6.1 million for fiscal 2005 from $6.5 million for fiscal 2004. Fees, service charges earned and insufficient funds fees collected during the respective periods is attributable to the volume of loan, deposit account, and insufficient funds transactions processed during each period, and the collection of related fees and service charges. Servicing fee income on loans serviced for others declined 5.6% to $684,000 for fiscal 2005 from $724,000 for fiscal 2004, as loans serviced for others declined to $260.6 million at year end 2005 from $277.3 million at year end 2004.
Gains from sales of loans, investments and mortgage-backed securities declined to $199,000 for fiscal 2005 from $597,000 for fiscal 2004. The volume of loans and mortgage-backed securities sold during fiscal 2005 was $29.1 million, compared to $39.9 million sold during fiscal 2004, reflecting the strategy previously discussed to retain current held for sale mortgage loan originations for securitization into available for sale mortgage-backed securities. In addition, these sales provide liquidity necessary to support the Bank's operating, financing and lending activities.
Noninterest Expenses. Noninterest expenses increased 7.7% to $21.1 million for fiscal 2005 from $19.6 million in fiscal 2004. The Company's efficiency ratio (noninterest expenses as a percentage of net interest income plus noninterest income) improved to 46.0% for fiscal 2005 compared to 49.9% for fiscal 2004. The efficiency ratio measures the proportion of net operating revenues that are absorbed by overhead expenses.
The largest single component of these expenses is compensation and fringe benefits, which increased 5.7% to $12.7 million for fiscal 2005 from $12.0 million for fiscal 2004. Full-time equivalent employees increased to 270 at December 31, 2005 from 250 at December 31, 2004. This growth is due to additional personnel resulting from opening three full-service banking offices and administrative staff required to support the $111.1 million net growth in assets during fiscal 2005.
Data processing expense has grown proportionately with the growth in customer accounts and transaction activity primarily attributable to the growth in earning assets and deposits. Other noninterest expenses including advertising, deposit insurance, premises and equipment, payroll and other taxes, repairs and maintenance, and office expenses have also grown from period to period in conjunction with the growth in earning assets and deposit accounts.
Income Taxes. The provision for income taxes increased 28.4% to $8.9 million for fiscal 2005 from $7.0 million for fiscal 2004. The increase in provision for income taxes is primarily the result of the 23.5% increase of pretax earnings to $23.1 million for fiscal 2005 from $18.7 million for fiscal 2004, and an increase in the federal tax rate from 34% to 35% during 2005 based on an increased volume of federal taxable income. Changes in the amount of income tax provisions reflect changes in pretax income and expenses, the application of permanent and temporary differences, and the income tax rates in effect during each period. The effective income tax rates for fiscal 2005 and 2004 were 38.8% and 37.3%, respectively.
Comparison of Operating Results for the Years Ended December 31, 2004 and 2003
Net Income. Net income increased 2.6% to $11.7 million for the year ended December 30, 2004 from $11.4 million for the year ended December 31, 2003. Diluted earnings per share increased 3.5% to $1.79 per share for the year ended December 31, 2004 from $1.73 per share for the year ended December 31, 2003. The average number diluted shares were 6,557,149 and 6,604,392, respectively, for the years ended December 31, 2004 and 2003. Return on average assets and return on average equity were 1.6% and 20.5% respectively for fiscal 2004, compared to 1.8% and 22.1% for fiscal 2003.
Interest Income. Interest income increased 8.9% to $40.2 million for fiscal 2004 from $36.9 million for fiscal 2003. During 2004 the increase in interest income resulted primarily from the increase in the volume of interest-earning assets, enabling the Bank to maintain a more consistent level of interest income. The average balance of interest-earning assets increased 9.7% to $653.7 million for fiscal 2004, from $595.7 million for fiscal 2003. The yield on average interest-earning assets was 6.2% for 2004 and 2003, respectively.
Interest Expense. Interest expense declined 4.9% to $9.7 million for fiscal 2004 from $10.2 million for fiscal 2003. The decline in interest expense reflects a lower cost of average interest-bearing liabilities due to the general decline in interest rates, offset by a $4.4 million growth in noninterest-bearing checking accounts. The average balance of interest-bearing liabilities increased 7.4% to $560.4 million for fiscal 2004 from $521.8 million for fiscal 2003. The average balance of noninterest-bearing deposits increased 21.9% to $79.0 million for fiscal 2004 from $64.8 million for fiscal 2003. The average cost of funds was 1.5% for 2004, compared to 1.7% for 2003, reflecting a lower interest rate environment during 2004.
Net Interest Income. Net interest income increased 14.2% to $30.5 million for fiscal 2004 from $26.7 million for fiscal 2003. The increase in net interest income during 2004 is attributable to an increase in the volume of average interest-earning assets, lower interest rates on interest-bearing liabilities, and the increase in noninterest-bearing deposits. The net yield on interest-earning assets was 4.7% for fiscal 2004, compared to 4.5% fiscal 2003. The Bank's interest rate spread was 4.6% for fiscal 2004, compared to 4.5% for fiscal 2003.
Provision for Loan Losses. The Bank maintains an allowance for losses on loans based upon management's evaluation of risk in the loan portfolio and past loan loss experience. The Bank provided $968,000 for loan losses during fiscal 2004, compared to $988,000 for fiscal 2003. These provisions were necessary to absorb losses in the loan portfolio and to support the inherent risks associated with the growth in commercial and consumer loans discussed above. The allowance for loan losses was $8.3 million at December 31, 2004 and $7.6 million at December 31, 2003, which the Bank believes is adequate. The ratio of the allowance for loan losses to total loans was 1.3% at December 31, 2004, compared to 1.4% at December 31, 2003. The ratio of non-performing loans to total loans was .4% at December 31, 2004 and .5% at December 31, 2003.
Noninterest Income. Noninterest income declined 16.7% to $8.8 million for fiscal 2004 from $10.5 million for fiscal 2003. Fees and service charges increased 11.2% to $6.5 million for fiscal 2004 from $5.8 million for fiscal 2003, reflecting the growth of the commercial and consumer loan portfolios and the growth in checking accounts during fiscal 2003. Servicing fee income on loans serviced for others increased 10.5% to $724,000 for fiscal 2004 from $656,000 for fiscal 2003.
Gains from sales of loans, investments and mortgage-backed securities declined 80.2% to $597,000 for fiscal 2003 from $3.0 million for fiscal 2003. During 2004 the Bank experienced much less dependence on gains from mortgage loan sales, unlike 2003, due to decreased origination and refinance volumes caused primarily by rising interest rates during the current year. The volume of loans and mortgage-backed securities sold during fiscal 2004 was $39.9 million, compared to $147.0 million sold during fiscal 2003.
Noninterest Expenses. Noninterest expenses increased 8.9% to $19.6 million for fiscal 2004 from $18.0 million in fiscal 2003. The Company's efficiency ratio (noninterest expenses divided by net interest income plus noninterest income) was 49.9% compared to fiscal 2004 from 48.3% for fiscal 2003.
The largest single component of these expenses is compensation and fringe benefits, which increased 13.2% to $12.0 million for fiscal 2004 from $10.6 million for fiscal 2003. Full-time equivalent employees increased to 250 at December 31, 2004 from 236 at December 31, 2003. This growth is due to additional personnel resulting from purchasing two full-service banking offices and administrative staff required to support the $45.4 million net growth in assets during fiscal 2004.
Data processing expense has grown proportionately with the growth in customer accounts and transaction activity primarily attributable to the growth in earning assets and deposits. Other noninterest expenses including advertising, deposit insurance, premises and equipment, payroll and other taxes, repairs and maintenance, and office expenses have also grown from period to period in conjunction with the growth in earning assets and deposit accounts.
Income Taxes. The provision for income taxes increased 1.8% to $7.0 million for fiscal 2004 from $6.8 million for fiscal 2003. The increase in provision for income taxes is primarily the result of the 2.3% increase of pretax earnings to $18.7 million for fiscal 2004 from $18.3 million for fiscal 2003. The change in the amount of income tax provisions also reflects changes in other pretax income and expenses, the application of permanent and temporary differences, and the income tax rates in effect during each period. The effective income tax rates for fiscal 2004 and 2003 were 37.3% and 37.5%, respectively.
Impact of Inflation and Changing Prices. The financial statements of the Bank and accompanying footnotes have been prepared in accordance with generally accepted accounting principles. They require the measurement of financial position and operating results in terms of historical dollars without considering the change in the relative purchasing power of money over time and due to inflation. The impact of inflation is reflected in the increased cost of the Bank's operations. Unlike most industrial companies, nearly all the assets and liabilities of the Bank are monetary. As a result, interest rates have a greater impact on the Bank's performance than do the effects of general levels of inflation. Interest rates do not necessarily move in the same direction or to the same extent as the price of goods and services.
Forward Looking Statements. The Private Securities Litigation Reform Act of 1995 states that the disclosure of forward looking information is desirable for investors and encourages such disclosure by providing a safe harbor for forward looking statements by corporate management. This Annual Report, including the Letter to Stockholders and Management's Discussion and Analysis of Financial Condition and Results of Operations, contains forward looking statements that involve risk and uncertainty. In order to comply with the terms of the safe harbor, the Company notes that a variety of risks and uncertainties could cause its actual results and experience to differ materially from the anticipated results or other expectations expressed in the Company's forward looking statements. There are risks and uncertainties that may affect the operations, performance, development, growth projections and results of the Company's business. They include, but are not limited to, economic growth, interest rate movements, timely development of technology enhancements for products, services and operating systems, the impact of competitive products, services and pricing, customer requirements, regulatory changes and similar matters. Readers of this report are cautioned not to place undue reliance on forward looking statements that are subject to influence by these risk factors and unanticipated events. Accordingly, actual results may differ materially from management's expectations.
Off-Balance Sheet Arrangements. See Note 14 of the "Notes to Consolidated Financial Statements" for a full description of financial instruments with off-balance sheet risk to which the Bank is a party in the normal course of business to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit and involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheet.
Recent Accounting Pronouncements. See Note 1 of the "Notes to Consolidated Financial Statements" for a full description of recent accounting pronouncements including the respective effective dates of adoption and effects on results of operations and financial condition.
DIXON HUGHES PLLC
Certified Public Accountants and Advisors
Report of Independent Registered Public Accounting Firm
To the Stockholders and the Board of Directors First South Bancorp, Inc. Washington, North Carolina
We have audited the accompanying consolidated statements of financial condition of First South Bancorp, Inc. and Subsidiary as of December 31, 2005 and 2004, and the related consolidated statements of operations, changes in stockholders' equity and cash flows for each of the years in the two-year period ended December 31, 2005. 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. The consolidated financial statements of First South Bancorp, Inc and Subsidiary for the year then ended December 31, 2003 were audited by other auditors whose report dated March 4, 2004 expressed an unqualified opinion on those statements.
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 First South Bancorp, Inc. and Subsidiary at December 31, 2005 and 2004 and the results of their operations and their cash flows for each of the years in the two-year period ended December 31, 2005 in conformity with accounting principles generally accepted in the United States of America.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of First South Bancorp, Inc.'s internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated March 7, 2006 expressed unqualified opinions on both management's assessment of the Company's internal control over financial reporting and the effectiveness of the Company's internal control over financial reporting.
/s/ Dixon Hughes PLLC Sanford, North Carolina March 7, 2006
FIRST SOUTH BANCORP, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION December 31, 2005 and 2004
The accompanying notes are an integral part of these consolidated financial statements.
FIRST SOUTH BANCORP, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF OPERATIONS December 31, 2005, 2004 and 2003
The accompanying notes are an integral part of these consolidated financial statements.
FIRST SOUTH BANCORP, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY December 31, 2005, 2004 and 2003
The accompanying notes are an integral part of these consolidated financial statements.
FIRST SOUTH BANCORP, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOWS December 31, 2005, 2004 and 2003
The accompanying notes are an integral part of these consolidated financial statements.
FIRST SOUTH BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2005, 2004 and 2003 - -------------------------------------------------------------------------------- 1. BASIS OF PRESENTATION AND ACCOUNTING POLICIES
ORGANIZATION AND NATURE OF OPERATIONS
First South Bancorp, Inc. (the "Company") is a bank holding company incorporated under the laws of the State of Virginia. First South Bank (the "Bank"), the wholly owned subsidiary of the Company, is organized and incorporated under the laws of the state of North Carolina. The Federal Reserve Board regulates the Company and the Federal Deposit Insurance Corporation and the North Carolina Office of the Commissioner of Banks regulate the Bank.
The consolidated financial statements include the accounts of the Company, the Bank, and the Bank's wholly owned subsidiary, First South Leasing, LLC. All significant intercompany balances and transactions have been eliminated in consolidation.
The Company follows accounting principles generally accepted in the United States of America and general practices within the financial services industry as summarized below:
USE OF ESTIMATES
The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents include demand and time deposits (with remaining maturities of ninety days or less at time of purchase) at other financial institutions.
INVESTMENTS AND MORTGAGE-BACKED SECURITIES
Investments in certain securities are classified into three categories and accounted for as follows: (1) debt securities that the entity has the positive intent and the ability to hold to maturity are classified as held-to-maturity and reported at amortized cost; (2) debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and reported at fair value, with unrealized gains and losses included in earnings; (3) debt and equity securities not classified as either held-to-maturity securities or trading securities are classified as available for sale securities and reported at fair value, with unrealized gains and losses excluded from earnings and reported as accumulated other comprehensive income, a separate component of equity.
A decline in the market value of any AFS or HTM security below cost that is deemed to be other-than-temporary results in a reduction in carrying amount to fair value. The impairment is charged to earnings and a new cost basis for the security is established. To determine whether an impairment is other-than-temporary, the Company considers whether it has the ability and intent to hold the investment until a market price recovery and considers whether evidence indicating the cost of the investment is recoverable outweighs evidence to the contrary. Evidence considered in this assessment includes the reasons for the impairment, the severity and duration of the impairment, changes in value subsequent to year-end, and forecasted performance of the investee.
Premiums and discounts on debt securities are recognized as adjustments to interest income using the interest method over the period to maturity. Gains and losses on the sale of securities are determined using the specific identification method.
Mortgage-backed securities represent participating interests in pools of long-term first mortgage loans. Premiums and discounts are amortized using the interest method over the remaining period to contractual maturity, adjusted for anticipated prepayments.
FIRST SOUTH BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2005, 2004 and 2003 - --------------------------------------------------------------------------------
1. BASIS OF PRESENTATION AND ACCOUNTING POLICIES (Continued)
LOANS RECEIVABLE AND ALLOWANCE FOR LOAN LOSSES
Loans receivable held for investment are stated at the amount of unpaid principal, reduced by an allowance for probable loan losses and net of deferred origination fees. Interest on loans is accrued based on the principal amount outstanding and is recognized using the interest method.
Loan origination fees, as well as certain direct loan origination costs, are deferred. Such costs and fees are recognized as an adjustment to yield over the contractual lives of the related loans.
Commitment fees to originate or purchase loans are deferred, and if the commitment is exercised, recognized over the life of the loan as an adjustment of yield. If the commitment expires unexercised, commitment fees are recognized in income upon expiration of the commitment. Fees for originating loans for other financial institutions are recognized as loan fee income.
A loan is considered impaired, based on current information and events, if it is probable that the Bank will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Uncollateralized loans are measured for impairment based on the present value of expected future cash flows discounted at the historical effective interest rate, while all collateral-dependent loans are measured for impairment based on the fair value of the collateral. The Bank uses several factors in determining if a loan is impaired. Internal asset classification procedures include a thorough review of significant loans and lending relationships and include the accumulation of related data. This data includes loan payment status, borrowers' financial data and borrowers' operating factors such as cash flows, operating income or loss, etc. At December 31, 2005 and 2004, there were no loans, individually or in the aggregate, that are material to the consolidated financial statements which were defined as impaired.
The allowance for loan losses is increased by charges to income and decreased by charge-offs (net of recoveries). Management's periodic evaluation of the adequacy of the allowance is based on the Bank's past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower's ability to repay, the estimated value of any underlying collateral, and current economic conditions. While management believes that it has established the allowance in accordance with accounting principles generally accepted in the United States of America and has taken into account the views of its regulators and the current economic environment, there can be no assurance that in the future the Bank's regulators or risks in its portfolio will not require further increases in the allowance.
LOANS HELD FOR SALE
Loans originated and intended for sale are carried at the lower of cost or aggregate estimated market value. Net unrealized losses are recognized as charges to income. Gains and losses on sales of whole or participating interests in real estate loans are recognized at the time of sale and are determined by the difference between net sales proceeds and the Bank's carrying value of the loans sold, adjusted for the recognition of any servicing assets retained.
As a part of its normal business operations, the Bank originates mortgage loans that have been approved by secondary investors. The Bank issues a rate lock commitment to a borrower and concurrently "locks-in" with a secondary market investor, under a best efforts delivery mechanism. The terms of the loan are set by the secondary investors and are transferred within a short time period of the Bank initially funding the loan. The Bank receives origination fees from borrowers and servicing release premiums from investors that are recognized when the loan is sold on the Statement of Operations in the line item "Gain on sale of mortgage loans and mortgage-backed securities". Between the initial funding of the loans by the Bank and subsequent purchase by the investor, the Bank carries the loans on its Statement of Financial Condition at the lower of cost or fair market value.
FIRST SOUTH BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2005, 2004 and 2003 - --------------------------------------------------------------------------------
1. BASIS OF PRESENTATION AND ACCOUNTING POLICIES (Continued)
INCOME RECOGNITION ON IMPAIRED AND NONACCRUAL LOANS
Loans, including impaired loans, are generally classified as nonaccrual if they are past due as to maturity or payment of principal or interest for a period of more than 90 days, unless such loans are well-secured and in the process of collection. If a loan or a portion of a loan is classified as doubtful or is partially charged off, the loan is generally classified as nonaccrual. Loans that are on a current payment status or past due less than 90 days may also be classified as nonaccrual if repayment in full of principal and/or interest is in doubt.
Loans may be returned to accrual status when all principal and interest amounts contractually due (including arrearages) are reasonably assured of repayment within an acceptable period of time, and there is a sustained period of repayment performance (generally a minimum of six months) by the borrower, in accordance with the contractual terms of interest and principal.
While a loan is classified as nonaccrual and the future collectibility of the recorded loan balance is doubtful, collections of interest and principal are generally applied as a reduction to principal outstanding, except in the case of loans with scheduled amortization where the payment is generally applied to the oldest payment due. When the future collectibility of the recorded loan balance is expected, interest income may be recognized on a cash basis limited to that which would have been recognized on the recorded loan balance at the contractual interest rate. Receipts in excess of that amount are recorded as recoveries to the allowance for loan losses until prior charge-offs have been fully recovered.
MORTGAGE SERVICING RIGHTS
When mortgage loans, or mortgage-backed securities, are sold, the proceeds are allocated between the related loans and the retained mortgage servicing rights based on their relative fair values.
Servicing assets and liabilities are amortized on a straight line basis over the average period of estimated net servicing income (if servicing revenue exceed servicing costs) or net servicing loss (if servicing costs exceed servicing revenues). All servicing assets or liabilities are assessed for impairment or increased obligation based on their fair value.
The Company recorded amortization of mortgage servicing rights of $372,559, $277,078 and $242,012 for prepayments during the years ended December 31, 2005, 2004 and 2003, respectively. There were no impairments recognized during the years ended December 31, 2005 and 2004. Servicing asset impairments totaling $680,622 were recorded during the year ended December 31, 2003.
PREMISES AND EQUIPMENT
Premises and equipment are stated at cost less accumulated depreciation or amortization, if a capital lease. Depreciation and amortization are computed using the straight-line method based on the estimated service lives of the assets. Useful lives range from 10 to 40 years for substantially all premises and from 3 to 20 years for equipment and fixtures.
REAL ESTATE OWNED
Assets acquired through loan foreclosure are recorded as real estate owned at the estimated fair value of the property less estimated costs to sell at the date of foreclosure. The carrying amount is subsequently reduced by additional allowances which are charged to earnings if the estimated fair value declines below its initial value plus any capitalized costs. Costs related to the improvement of the property are capitalized, whereas costs related to holding the property are expensed. There were no valuation adjustments recognized during the year ended December 31, 2005. The Company recognized valuation adjustments of approximately $19,178 and $125,000 during the years ended December 31, 2004 and 2003, respectively.
FIRST SOUTH BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2005, 2004 and 2003 - --------------------------------------------------------------------------------
1. BASIS OF PRESENTATION AND ACCOUNTING POLICIES (Continued)
INVESTMENT IN FEDERAL HOME LOAN BANK STOCK
The Bank is required to invest in Class B capital stock, par value $100, of the Federal Home Loan Bank of Atlanta ("FHLB"). The FHLB capital stock requirement is based on the sum of a membership stock component totaling 20% of the Bank's total assets plus an activity based stock component of 4.5% of outstanding FHLB advances. At December 31, 2005 and 2004, the Bank owned 16,892 and 18,252 shares of the FHLB's capital stock, respectively.
The Bank carries this investment at cost. Due to the redemption provisions of the FHLB, the Company estimated that fair value equals cost and that this investment was not impaired at December 31, 2005.
GOODWILL AND INTANGIBLE ASSETS
Net assets of companies acquired in purchase transactions are recorded at fair value at the date of acquisition, as such, the historical cost basis of individual assets and liabilities are adjusted to reflect their fair value. Identified intangible assets resulting from the branch acquisitions described in Note 20 are amortized on a straight-line basis over 10 years, resulting in amortization expense of approximately $31,000 per year. Goodwill is not amortized, but is reviewed for potential impairment on an annual basis at the reporting unit level. The impairment test is performed in two phases. The first step of the goodwill impairment test, used to identify potential impairment, compares the fair value of the reporting unit with its carrying amount, including goodwill. If the fair value of the reporting unit exceeds its carrying amount, goodwill of the reporting unit is considered not impaired; however, if the carrying amount of the reporting unit exceeds its fair value an additional procedure must be performed. That additional procedure compares the implied fair value of the reporting unit's goodwill (as defined in SFAS No. 142) with the carrying amount of that goodwill. An impairment loss is recorded to the extent that the carrying amount of goodwill exceeds its implied fair value. Other intangible assets are evaluated for impairment if events and circumstances indicate a possible impairment. Such evaluation of other intangible assets is based on undiscounted cash flow projections.
INCOME TAXES
The Company reports income taxes in accordance with Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes, ("SFAS No. 109") which requires the recognition of deferred tax assets and liabilities for the temporary difference between financial statement and tax basis of the Company's assets and liabilities using the enacted tax rates in effect in the years in which the differences are expected to reverse. Valuation allowances are provided if, based upon the weight of available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized.
ADVERTISING
Advertising costs are expensed as incurred. For the years ended December 31, 2005, 2004 and 2003, the Company incurred advertising expense totaling $187,536, $185,468 and $204,614, respectively.
FIRST SOUTH BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2005, 2004 and 2003 - --------------------------------------------------------------------------------
1. BASIS OF PRESENTATION AND ACCOUNTING POLICIES (Continued)
COMPREHENSIVE INCOME
The Company's other comprehensive income relates to unrealized gains (losses) on available for sale securities. Information concerning the Company's other comprehensive income (loss) for the years ended December 31, 2005, 2004 and 2003 is as follows:
STOCK COMPENSATION PLANS
The Company has adopted SFAS No. 123, Accounting for Stock Based Compensation. As permitted by SFAS No. 123, the Company has chosen to apply APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. Accordingly, no compensation cost has been recognized for options granted under the Plan. Had compensation cost for the Company's Plan been determined based on the fair value at the grant dates for awards under the Plan consistent with the methods of SFAS No. 123, the Company's net income and net income per share would have been reduced to the pro forma amounts indicated below, reflecting additional compensation expense, net of applicable income taxes, of $121,291, $84,675 and $123,152 for the years ended December 31, 2005, 2004 and 2003, respectively.
SEGMENT INFORMATION
The Company follows the provisions of SFAS No. 131, Disclosure About Segments of an Enterprise and Related Information, which specifies guidelines for determining an entity's operating segments and the type and level of financial information to be disclosed. Based on these guidelines management has determined that the Bank operates in one business segment, the providing of general commercial financial services to customers located in its market areas. The various products are those generally offered by community banks. The allocation of Bank resources is based on overall performance of the Bank, rather than individual branches or products.
RECLASSIFICATION
Certain amounts in the 2004 and 2003 consolidated financial statements have been reclassified to conform with the 2005 presentation. These reclassifications had no effect on the net income or stockholders' equity as previously reported.
FIRST SOUTH BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2005, 2004 and 2003 - --------------------------------------------------------------------------------
1. BASIS OF PRESENTATION AND ACCOUNTING POLICIES (Continued)
NEW ACCOUNTING PRONOUNCEMENTS
In November 2003, the Emerging Issues Task Force ("EITF") issued EITF Issue No. 03-01, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments ("EITF 03- 01"). EITF 03-01 provided guidance for evaluating whether an investment is other-than-temporarily impaired and requires certain disclosures with respect to these investments. In September 2004, the Financial Accounting Standards Board ("FASB") issued a FASB Staff Position ("FSP EITF 03-1-b") to delay the requirement to record impairment losses in accordance with EITF 03-01. The guidance also included accounting considerations subsequent to the recognition of an other-than-temporary impairment and requirements for disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. In November 2005, the FASB issued FSP FAS 115-1 and FAS 124-1, which addresses the determination as to when an investment is considered impaired. This FSP nullifies certain requirements of EITF 03-01 and supersedes EITF Topic No. D-44, "Recognition of Other-Than-Temporary Impairment upon the Planned Sale of a Security Whose Cost Exceeds Fair Value." This FSP is to be applied to reporting periods beginning after December 15. 2005. The Company is in process of evaluating the impact of this FSP.
In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123(r) ("SFAS No. 123(r)"), "Share-Based Payment", which is a revision of FASB Statement No. 123 "Accounting for Stock-Based Compensation" and supersedes APB Opinion No. 25 "Accounting for Stock Issued to Employees". SFAS No. 123(r) requires companies to recognize in the income statement the grant-date fair value of stock options and other equity-based compensation issued to employees over the period during which an employee is required to provide service in exchange for the award, which will often be the shorter of the vesting period of the period the employee will be retirement eligible. SFAS No. 123(r) sets accounting requirements for "share-based" compensation to employees, including employee-stock purchase plans ("ESPPs"). Awards to most nonemployee directors will be accounted for as employee awards. This Statement was to be effective for public companies that do not file as small business issuers as of the beginning of interim or annual reporting periods beginning after June 15, 2005. In April 2005, the Securities and Exchange Commission ("SEC") issued Release No. 2005-57, which defers the effective date of SFAS No. 123(r) for many registrants. Registrants that do not file as small business users must adopt SFAS No. 123(r) as of the beginning of their first annual period beginning after June 15, 2005. Accordingly, the Company will adopt SFAS No. 123(r) on January 1, 2006, and is currently evaluating the effect on its consolidated financial statements.
In March 2005, the SEC issued Staff Accounting Bulletin No. 107 ("SAB 107"), which contains guidance on applying the requirements in SFAS No. 123(r). SAB 107 provides guidance on valuation techniques, development of assumptions used in valuing employee share options and related MD&A disclosures. SAB 107 is effective for the period in which SFAS No. 123(r) is adopted. The Company will adopt SAB 107 on January 1, 2006, and is currently evaluating the effect on its consolidated financial statements.
In May 2005, the FASB issued Statement of Financial Accounting Standards No. 154 ("SFAS No. 154"), "Accounting Changes and Error Corrections", which replaces APB Opinion No. 20 "Accounting Changes" and FASB Statement No. 3 "Reporting Accounting Changes in Interim Financial Statements". SFAS No. 154 changes the requirements for the accounting for and reporting of a change in an accounting principle. SFAS No. 154 requires retrospective application for voluntary changes in an accounting principle unless it is impracticable to do so. SFAS No. 154 is effective for accounting changes made in fiscal years beginning after December 15, 2005. The Company will adopt SFAS No. 154 on January 1, 2006 with no expected material effect on its consolidated financial statements.
From time to time, the FASB issues exposure drafts for proposed statements of financial accounting standards. Such exposure drafts are subject to comment from the public, to revisions by the FASB and to final issuance by the FASB as statements of financial accounting standards. Management considers the effect of the proposed statements on the consolidated financial statements of the Company and monitors the status of changes to and proposed effective dates of exposure drafts.
FIRST SOUTH BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2005, 2004 and 2003 - --------------------------------------------------------------------------------
2. INVESTMENT SECURITIES
Investment securities at December 31, 2005 and 2004 are classified as available for sale according to management's intent and summarized as follows:
The following table shows U.S. Treasury and Agency Notes unrealized losses and fair value, aggregated by length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2005. The current year unrealized losses on these investment securities are a result of volatility in the market during 2005 and relate to eight U.S. Treasury and Agency Notes. All unrealized losses on U.S. Treasury and Agency Notes are considered by management to be temporary given the credit ratings on these investment securities and the short duration of the unrealized loss.
U.S. Treasury and Agency notes at December 31, 2005 are contractually scheduled to mature as follows:
Estimated Amortized market cost value --------------- ----------------
Due within one year $ 10,012,354 $ 10,092,354 Due after one year through five years 32,028,708 31,735,336 --------------- ----------------
Total $ 42,041,062 $ 41,827,690 =============== ================
There were no sales of U.S. Treasury and Agency Notes during the years ended December 31, 2005, 2004 and 2003.
U.S. Treasury and Agency Notes with an amortized cost of approximately $17.0 million and $13.0 million were pledged to secure deposits from public entities and repurchase agreements at December 31, 2005 and 2004, respectively.
3. MORTGAGE-BACKED SECURITIES
Mortgage-backed securities at December 31, 2005 and 2004 are classified as available for sale according to management's intent and summarized as follows:
FIRST SOUTH BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2005, 2004 and 2003 - --------------------------------------------------------------------------------
3. MORTGAGE-BACKED SECURITIES (Continued)
The following tables present mortgage-backed securities unrealized losses and fair values, aggregated by length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2005 and 2004. The current year unrealized losses on these investment securities are a result of volatility in the market during 2005 and relate to eight FHLMC participation certificates. All unrealized losses on FHLMC participation certificates are considered by management to be temporary given the credit ratings on these investment securities and the short duration of the unrealized loss.
FIRST SOUTH BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2005, 2004 and 2003 - --------------------------------------------------------------------------------
3. MORTGAGE-BACKED SECURITIES (Continued)
Mortgage-backed securities, classified as available for sale or held for investment, at December 31, 2005 are contractually scheduled to mature as follows:
Estimated Amortized market cost value --------------- ----------------
Due after one year through five years $ 252,988 $ 259,782 Due after five years through ten years 6,312,372 6,408,715 Due after ten years 16,509,294 16,033,880 --------------- ---------------- $ 23,074,654 $ 22,702,377 =============== ================
Expected maturities may differ from contractual maturities because borrowers have the right to call or prepay obligations with or without call or prepayment penalties.
No mortgage-backed securities were sold in 2005. Mortgage-backed securities with a carrying value of approximately $2.5 million, and $10.2 million were sold during the years ended December 31, 2004 and 2003, respectively. Gross realized gains on the sale of mortgage-backed securities were $88,844 during the year ended December 31, 2004. Net realized gains on the sales of mortgage-backed securities were $291,738 and $302,315 during the years ended December 31, 2003 and 2002, respectively.
Mortgage-backed securities with an amortized cost of approximately $476,566 and $378,284 were pledged as collateral for treasury, tax, and loan deposits at December 31, 2005 and 2004, respectively.
4. LOANS RECEIVABLE
Loans receivable at December 31, 2005 and 2004 are summarized as follows:
2005 2004 --------------- ----------------
Mortgage loan $ 68,022,652 $ 67,518,036 Consumer loans 101,833,555 98,441,200 Commercial loans 536,638,140 463,779,519 Leasing 11,981,099 11,622,296 --------------- ----------------
Total 718,475,446 641,361,051 --------------- ---------------- Less: Allowance for loan losses (9,222,305) (8,343,382) Deferred loan fees, net (1,433,223) (1,201,634) ---------------- ----------------
Loans receivable, net $ 707,819,918 $ 631,816,035 =============== ================
The Bank has pledged its eligible real estate loans to collateralize actual or potential borrowings from the Federal Home Loan Bank of Atlanta (See Note 9).
During the years ended December 31, 2005, 2004, and 2003 the Bank exchanged loans with outstanding principal balances of $16,354,875, $2,841,484 and $8,952,095, respectively, with the Federal Home Loan Mortgage Corporation ("FHLMC") for mortgage-backed securities of equal value.
The Bank originates mortgage loans for portfolio investment or sale in the secondary market. During the period of origination, mortgage loans are designated as either held for sale or for investment purposes. Transfers of loans held for sale to the investment portfolio are recorded at the lower of cost or market value on the transfer date. Loans receivable held for sale at December 31, 2005 and 2004 are fixed rate mortgage loans with an estimated market value of approximately $11,029,237 and $6,298,000, respectively.
FIRST SOUTH BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2005, 2004 and 2003 - --------------------------------------------------------------------------------
4. LOANS RECEIVABLE (Continued)
Net gains on sales of loans receivable held for sale amounted to $199,414, $508,218 and $2,717,078 for the years ended December 31, 2005, 2004 and 2003, respectively.
The changes in the allowance for loan losses for the years ended December 31, 2005, 2004 and 2003 are as follows:
FIRST SOUTH BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2005, 2004 and 2003 - --------------------------------------------------------------------------------
5. PREMISES AND EQUIPMENT (Continued)
The Company leases certain branch facilities and equipment under separate agreements that expire at various dates through September 30, 2010. Future rentals under these leases are as follows:
2006 $ 378,711 2007 344,864 2008 305,113 2009 67,634 2010 24,615 Thereafter - --------------
$ 1,120,937
Rental expense amounting to approximately $395,919, $389,000 and $305,000 during the years ended December 31, 2005, 2004 and 2003, respectively, is included in premises and equipment expense on the accompanying consolidated statements of operations.
6. DEPOSITS
At December 31, 2005, the scheduled maturities of time deposits were as follows (in thousands):
2006 $ 373,651,511 2007 56,594,338 2008 29,934,718 2009 4,945,618 2010 2,237,637 Thereafter - -------------
Total time deposits $ 467,363,822 =============
7. EMPLOYEE BENEFIT PLANS
The Company participated in a multi-employer defined benefit pension plan which covered substantially all employees; however, effective January 31, 2002 the Company's Board of Directors approved a plan to freeze the accrual of future benefits under the plan. Consequently, no new employees became eligible to participate in the plan after January 31, 2002. Effective October 1, 2004 the Company withdrew from the plan. Active employees who were participating in the plan became 100% vested on that date could select from a variety of benefit payment options based on their age and benefit payment amount. Expenses of the plan for unfunded liability, withdrawal fees, administrative fees and PBGC premiums the years ended December 31, 2005, 2004 and 2003 were $0, $624,968 and $0, respectively.
The Company also participates in a multi-employer defined contribution plan which covers substantially all employees. Under the plan, employees may contribute from 1% to 15% of compensation, subject to an annual maximum as determined by the Internal Revenue Code. The Company makes matching contributions of 100% of employees' contributions up to 5% of the employees' salaries. The plan provides that employees' contributions are 100% vested at all times and the Bank's contributions vest 25% for each year of service. The expenses related to the Company's contributions to this plan for the years ended December 31, 2005, 2004 and 2003 were $326,549, $283,966 and $244,474, respectively.
FIRST SOUTH BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2005, 2004 and 2003 - --------------------------------------------------------------------------------
7. EMPLOYEE BENEFIT PLANS (Continued)
Directors and certain officers participate in deferred compensation plans. These plans generally provide for fixed payments beginning at retirement. These payments are earned over service periods of up to ten years, and can include provisions for deferral of current payments. The expense related to these plans during the years ended December 31, 2005, 2004 and 2003 aggregated $486,662, $500,089 and $579,730, respectively. The plans generally include provisions for forfeitures of unvested portions of payments, and vesting in the event of death or disability. The total liability under this plan was approximately $3,398,402 at December 31, 2005 and is included in other liabilities in the accompanying consolidated statements of financial condition.
8. STOCK OPTION PLAN
On April 8, 1998, the Shareholders of the Company approved the First South Bancorp, Inc. 1997 Stock Option Plan (the "Plan"). The purpose of this Plan is to advance the interests of the Company through providing selected key employees and Directors of the Bank and the Company with the opportunity to purchase shares. The Plan reserves 1,474,742 shares for grant within ten years of the effective date. The option price is required to be 100% of the stock's fair market value as defined, with an exception for any shareholder with more than a 10% ownership interest in the Company. The exercise price is required to be 110% of the stock's fair market value for these options holders. Vesting is determined on the date of the grant. Options have a 10-year life; however, there are additional limitations for shareholders with more than a 10% ownership interest in the Company. The Plan also has a change of control provision under which all options immediately vest if a change of control, as defined, occurs.
A summary of the status of the Plan as of December 31, 2005, 2004 and 2003, and changes during the years then ended, including weighted-average exercise price ("Price"), is presented below:
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants for the years ended December 31, 2005, 2004 and 2003, respectively: dividend growth rate of 17% for each period; expected volatility of 21.4%, 21.7% and 21.2% ; risk-free interest rates ranging from 4.03% to 4.47% during the year ended December 31, 2005; 3.59% to 4.11% during the year ended December 31, 2004; and 3.65% to 4.49% during the year ended December 31, 2003; and expected lives of 6 years.
FIRST SOUTH BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2005, 2004 and 2003 - --------------------------------------------------------------------------------
8. STOCK OPTION PLAN (Continued)
The following table summarizes additional information about the Plan at December 31, 2005, including weighted-average remaining contractual life ("Life") and Price:
9. BORROWED MONEY
Borrowed money represents advances from the FHLB and repurchase agreements. Advances outstanding from the FHLB at December 31, 2005 and 2004 had a weighted average rate of 4.40% and 2.44%, respectively, and totaled $5,500,000 and $10,500,000, respectively. These advances have a scheduled maturity date of January 3, 2007.
At December 31, 2005 and December 31, 2004, repurchase agreements outstanding had average rates of 3.59% and 1.62%, and totaled $6,287,500 and $4,291,900, respectively.
At December 31, 2005 and 2004, repurchase agreements were collateralized by U.S. government agency obligations with a principal balance of $7,000,000 and $5,000,000, respectively. The Company has pledged all of its stock in the FHLB and certain loans secured by one to four family residential mortgages as collateral for actual or potential borrowings from the FHLB. At December 31, 2005 and 2004, the Company had approximately $160.8 million and $133.7 million, respectively, of additional credit available with the FHLB.
10. INCOME TAXES
The components of income tax expense for the years ended December 31, 2005, 2004 and 2003 are as follows:
Years Ended December 31, ------------------------------------------------------- 2005 2004 2003 ---------------- ---------------- ---------------- Current Federal $ 7,925,068 $ 4,817,313 $ 4,507,141 State 1,568,269 1,007,039 746,935 ---------------- ---------------- ----------------
9,493,337 5,824,352 5,254,076 ---------------- ---------------- ---------------- Deferred Federal (496,214) 1,004,496 1,448,063 State (49,927) 137,192 138,568 ----------------- ---------------- ----------------
(546,141) 1,141,688 1,586,631 ----------------- ---------------- ----------------
Total $ 8,947,196 $ 6,966,040 $ 6,840,707 ================ ================ ================
FIRST SOUTH BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2005, 2004 and 2003 - --------------------------------------------------------------------------------
10. INCOME TAXES (Continued)
Reconciliations of the expected income tax expense at statutory tax rates with income tax expense reported in the statements of operations for the years ended December 31, 2005, 2004 and 2003 are as follows:
11. REGULATORY CAPITAL REQUIREMENTS
Dividend payments made by the Company are subject to regulatory restrictions under Federal Reserve Board policy as well as to limitations under applicable provisions of Virginia corporate law. The Federal Reserve Board may prohibit a bank holding company from paying any dividends if the holding company's bank subsidiary is classified as "undercapitalized." Under Virginia law, dividends may be paid out of surplus or, if there is no surplus, out of net profits for the fiscal year in which the dividend is declared and for the preceding fiscal year. Furthermore, under FDIC regulations, the Bank is prohibited from making any capital distributions if, after making the distribution, the Bank would have: (i) a total risk-based capital ratio of less than 8.0%; (ii) a Tier 1 risk-based capital ratio of less than 4.0%; or (iii) a leverage ratio of less than 4.0%.
FIRST SOUTH BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2005, 2004 and 2003 - --------------------------------------------------------------------------------
11. REGULATORY CAPITAL REQUIREMENTS (Continued)
The Bank is subject to various regulatory capital requirements administered by the federal and state banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Bank's financial statements. Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios, as set forth in the table below. Management believes, as of December 31, 2004, that the Bank meets all capital adequacy requirements to which it is subject. The Company's most significant asset is its investment in First South Bank. Consequently, the information concerning capital ratios is essentially the same for the Company and the Bank.
As of December 31, 2005, the most recent notification from the FDIC categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized the Bank must maintain minimum amounts and ratios, as set forth in the table below. There are no conditions or events since that notification that management believes have changed the Bank's category.
The Bank's actual regulatory capital amounts and ratios as of December 31, 2005 and 2004 are presented in the table below (dollars in thousands):
12. EARNINGS PER SHARE
The following table provides a reconciliation of income available to common stockholders and the average number of shares outstanding (less unearned deferred stock awards and treasury shares) for the years ended December 31, 2005, 2004 and 2003. Options to purchase 703,772, 773,974 and 852,708 shares of common stock were outstanding at December 31, 2005, 2004, and 2003, respectively.
FIRST SOUTH BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2005, 2004 and 2003 - --------------------------------------------------------------------------------
12. EARNINGS PER SHARE (Continued)
For the year ended December 31, 2005, there were 7,200 options that were antidilutive since the exercise price exceeded the average market price of the Company's common stock for the year. These options have been omitted from the calculation of diluted earnings per share for 2005.
13. MORTGAGE BANKING ACTIVITIES
Mortgage loans serviced for others are not included in the accompanying consolidated statements of financial condition. The unpaid principal balances of mortgage loans serviced for others were $260,632,000, $277,252,000 and $288,917,000 at December 31, 2005, 2004, and 2003 respectively. Servicing loans for others generally consists of collecting mortgage payments, maintaining escrow accounts, disbursing payment to investors and foreclosure processing. Loan servicing income is recorded on the accrual basis and includes servicing fees from investors and certain charges collected from borrowers, such as late payment fees.
At December 31, 2005 and 2004, mortgage servicing rights reported in the consolidated statements of financial condition, net of amortization, were $1,402,085 and $1,698,778 respectively.
During the years ended December 31, 2005 and 2004 respectively, the Company recorded additional servicing assets of $75,866 and $240,305 as a result of sales of loans or mortgage-backed securities. Amortization of servicing assets during the years ended December 31, 2005, 2004, and 2003 aggregated $372,559 $277,077, and $242,012, respectively. The fair value of recognized servicing assets amounted to approximately $1,843,000 and $2,036,000 as of December 31, 2005 and 2004, respectively. The Company's significant assumptions used to estimate their fair value include weighted average life, prepayment speeds, and expected costs to transfer servicing to a third party.
14. FINANCIAL INSTRUMENT WITH OFF-BALANCE SHEET RISK AND SIGNIFICANT GROUP CONCENTRATION OF CREDIT 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 and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit and involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheet.
The Company's exposure to credit loss in the event of non-performance by the other party to the financial instrument for commitments to extend credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. The Company evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management's credit evaluation of the borrower.
FIRST SOUTH BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2005, 2004 and 2003 - --------------------------------------------------------------------------------
14. FINANCIAL INSTRUMENT WITH OFF-BALANCE SHEET RISK AND SIGNIFICANT GROUP CONCENTRATION OF CREDIT RISK: (Continued)
A summary of the contractual amounts of the Company's exposure to off-balance sheet risk as of December 31, 2005 and 2004 is as follows:
Included in the commitments to originate loans as of December 31, 2005 and December 31, 2004, are fixed interest rate loan commitments of approximately $23.8 million and $18.4 million, respectively. The shorter duration of interest-sensitive liabilities, to the extent they are used to fund these fixed-rate loans, indicates that the Company is exposed to interest rate risk because, in a rising rate environment, liabilities will be repricing faster at higher interest rates, thereby reducing the market value of fixed-rate long-term assets and net interest income.
The Company's lending is concentrated primarily in Beaufort, Craven, Cumberland, Dare, Edgecombe, Lenoir, Durham, Nash, Pasquotank, Pitt, Robeson, Wake, and surrounding counties in North Carolina. Credit has been extended to certain of the Company's customers through multiple lending transactions.
Since many of the commitments are expected to expire without being drawn upon, amounts reported do not necessarily represent future cash requirements.
15. PARENT COMPANY FINANCIAL INFORMATION
The Company's principal asset is its investment in the Bank. Condensed financial statements of the parent company as of December 31, 2005, 2004 and 2003 are as follows:
FIRST SOUTH BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2005, 2004 and 2003 - --------------------------------------------------------------------------------
15. PARENT COMPANY FINANCIAL INFORMATION (Continued)
FIRST SOUTH BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2005, 2004 and 2003 - --------------------------------------------------------------------------------
16. QUARTERLY FINANCIAL DATA (UNAUDITED) (Continued)
17. FAIR VALUES OF FINANCIAL INSTRUMENTS
Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments" ("SFAS No. 107"), requires the disclosure of estimated fair values for financial instruments. Quoted market prices, if available, are utilized as an estimate of the fair value of financial instruments. Because no quoted market prices exist for a significant part of the Company's financial instruments, the fair value of such instruments has been derived based on management's assumptions with respect to future economic conditions, the amount and timing of future cash flows and estimated discount rates with respect to future economic conditions, the amount and timing of future cash flows and estimated discount rates. Different assumptions could significantly affect these estimates. Accordingly, the net realizable value could be materially different from the estimates presented below. In addition, the estimates are only indicative of individual financial instruments' values and should not be considered an indication of the fair value of the Company taken as a whole.
Fair values have been estimated using data which management considers as the best available, and estimation methodologies deemed suitable for the pertinent category of financial instrument.
The estimation methodologies, resulting fair values, and recorded carrying amounts at December 31, 2005 and 2004 were as follows:
Cash and cash equivalents are by definition short-term and do not present any unanticipated credit issues. Therefore, the carrying amount is a reasonable estimate of fair value. The estimated fair values of investment securities and mortgage backed securities are provided in Notes 2 and 3 to the financial statements. These are based on quoted market prices, when available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities.
The fair value of the net loan portfolio has been estimated using the present value of expected cash flows, discounted at an interest rate adjusted for servicing costs and giving consideration to estimated prepayment risk and credit loss factors, as follows:
FIRST SOUTH BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2005, 2004 and 2003 - --------------------------------------------------------------------------------
17. FAIR VALUES OF FINANCIAL INSTRUMENTS (Continued)
The fair value of deposit liabilities with no stated maturities has been estimated to equal the carrying amount (the amount payable on demand), totaling $266,389,243 and $258,338,325 at December 31, 2005 and 2004, respectively. The fair value estimates for these products do not reflect the benefits that the Bank receives from the low-cost, long-term funding they provide. These benefits are considered significant.
The fair value of certificates of deposits and advances from the FHLB is estimated by discounting the future cash flows using the current rates offered for similar deposits and advances with the same remaining maturities. The carrying value and estimated fair values of certificates of deposit and FHLB advances at December 31, 2005 and 2004 are as follows:
2005 2004 --------------- --------------- Certificates of deposits Carrying amount $ 467,363,822 $ 370,198,380 Estimated fair value 466,326,243 371,886,000
Advances for Federal Home Loan Bank: Carrying amount $ 5,500,000 $ 10,500,000 Estimated fair value 5,500,000 10,500,000
The carrying amount of accrued interest receivable, FHLB stock, note receivable, junior subordinated debentures, accrued interest payable, and repurchase agreements approximates their fair value.
There is no material difference between the carrying amount and estimated fair value of off-balance sheet items totaling $212,520,000 and $228,272,000 at December 31, 2005 and 2004, respectively, which are primarily comprised of unfunded loan commitments.
The Company's remaining assets and liabilities are not considered financial instruments.
18. SUPPLEMENTAL CASH FLOW INFORMATION
Supplemental cash flow information for the years ended December 31, 2005, 2004 and 2003 is as follows:
Noncash assets acquired in branch acquisitions are presented in Note 20.
19. JUNIOR SUBORDINATED DEBENTURES OWED TO UNCONSOLIDATED SUBSIDIARY TRUST AND CORPORATION-OBLIGATED MANDATORILY REDEEMABLE PREFERRED TRUST SECURITIES OF SUBSIDIARY TRUST HOLDING SOLELY DEBENTURES OF THE COMPANY
The Company has sponsored a trust, First South Preferred Trust I (the Trust), of which 100% of the common equity is owned by the Company. The Trust was formed for the purpose of issuing company-obligated preferred trust securities (the Preferred Trust Securities) to third-party investors and investing the proceeds from the sale of such Preferred Trust Securities solely in junior subordinated debt securities of the Company (the Debentures).
FIRST SOUTH BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2005, 2004 and 2003 - --------------------------------------------------------------------------------
19. JUNIOR SUBORDINATED DEBENTURES OWED TO UNCONSOLIDATED SUBSIDIARY TRUST AND CORPORATION-OBLIGATED MANDATORILY REDEEMABLE PREFERRED TRUST SECURITIES OF SUBSIDIARY TRUST HOLDING SOLELY DEBENTURES OF THE COMPANY (Continued)
The Debentures held by the Trust are the sole assets of the Trust. Distributions on the Preferred Trust Securities issued by the Trust are payable quarterly at a rate equal to the interest rate being earned by the Trust on the Debentures held by that Trust. The Preferred Trust Securities are subject to mandatory redemption, in whole or in part, upon repayment of the Debentures. The Company has entered into an agreement, which fully and unconditionally guarantees the Preferred Trust Securities subject to the terms of the guarantee. The Debentures held by the Trust are first redeemable, in whole or in part, by the Company on after September 30, 2008.
In the fourth quarter of 2003, as a result of applying the provisions of FIN 46R, governing when an equity interest should be consolidated, the Company was required to deconsolidate the subsidiary Trust from its financial statements. The deconsolidation of the net assets and results of operations of the Trust had virtually no impact on the Company's financial statements or liquidity position since the Company continues to be obligated to repay the Debentures held by the Trust and guarantees repayment of the Preferred Trust Securities issued by the Trust. The consolidated debt obligation related to the Trust increased from $10 million to $10.3 million upon deconsolidation with the difference representing the Company's common ownership interest in the Trust.
Subject to certain limitations, the Junior Subordinated Debentures qualify as Tier I capital for the Company under Federal Reserve Board guidelines.
Consolidated debt obligations as of December 31, 2005 related to a subsidiary Trust holding solely Debentures of the Company follows:
The Company recorded $31,440 and $23,668 in core deposit intangible amortization expense during the years ended December 31, 2005 and 2004, respectively. Amortization expense related to this intangible is anticipated to be approximately $31,000 per year over the next 5 years, with the remaining balance totaling approximately $104,000 to be amortized thereafter. These estimates are subject to change in future periods to the extent management determines it is necessary to make adjustments to the carrying value or estimated useful life of this amortizing intangible asset.
STOCKHOLDER INFORMATION
Corporate Headquarters First South Bancorp, Inc. Telephone: 252-946-4178 1311 Carolina Avenue Fax: 252-946-3873 Washington, NC 27889 E-mail: info@firstsouthnc.com Website: www.firstsouthnc.com
Stock Listing Information The Company's common stock is listed and trades on the Nasdaq Stock Market under the symbol FSBK. As of March 1, 2006, there were 888 registered stockholders of record.
Stock Price Information The following is the high and low trading price information and dividends declared per share for the periods indicated.
Quarter Ended High Low Dividends ------------- ------ ------ ---------- March 31, 2005 $ 28.50 $ 23.43 $ .20 June 30, 2005 36.25 27.31 .20 September 30, 2005 36.19 31.19 .20 December 31, 2005 38.00 29.47 .20
March 31, 2004 (1) 25.87 21.00 .17 June 30, 2004 26.96 21.25 .17 September 30, 2004 25.09 22.41 .17 December 31, 2004 25.94 24.50 .17 ---------------- (1) Adjusted for three-for-two stock split on April 23, 2004.
Registrar and Transfer Agent Inquiries regarding stock transfer, registration, lost certificates or changes in name and address should be directed to the Company's stock registrar and transfer agent: Registrar and Transfer Company, 10 Commerce Drive, Cranford, New Jersey 07016; via the Internet at www.rtco.com; or toll-free at (800) 866-1340.
Form 10-K The Annual Report on Form 10-K of the Company as filed with the Securities and Exchange Commission is available via the Internet on the Company's website at www.firstsouthnc.com under the headings "About Us - Newsroom - SEC Filings: EDGAR-Online". Shareholders will be provided a copy without charge by writing to the Corporate Secretary, William L. Wall, First South Bancorp, Inc., P. O. Box 2047, Washington, NC 27889.
Investor Information
Shareholders, investors, and analysts interested in additional information may contact William L. Wall, Chief Financial Officer, First South Bancorp, Inc., P.O. Box 2047, Washington, NC 27889; or via email to bwall@firstsouthnc.com.
Annual Meeting The Annual Meeting of Stockholders of First South Bancorp, Inc. will be held Thursday, May 25, 2006 at 11:00 a.m., at the main office of First South Bank, 1311 Carolina Avenue, Washington, North Carolina.