Item 1 BUSINESS
General
Overview. We are a Georgia corporation and a multi-bank holding company headquartered in Macon, Georgia. Since our formation on February 10, 1994, we have made several strategic acquisitions and have expanded our market presence throughout Middle Georgia, as well as to the northern metropolitan area of Atlanta, Georgia, and to the southeastern coastal region of Georgia. In June 2003, we changed our name from SNB Bancshares, Inc. to Security Bank Corporation and changed our stock symbol on the Nasdaq Global Select Market to “SBKC.” We changed our name to Security Bank Corporation to leverage our “Security Bank” branding, which is well recognized in our core markets.
We provide a wide variety of community banking services through our six banking subsidiaries and 18 mortgage production offices, with a substantial portion of our business being drawn from Bibb, Houston and Jones Counties and in the north metropolitan area of Atlanta in the State of Georgia. At December 31, 2006, we had total assets of approximately $2.50 billion, total deposits of approximately $1.97 billion and total shareholders’ equity of approximately $306.4 million.
Our Subsidiary Banks. Substantially all of our business is conducted through our six state-chartered subsidiary banks. The names and total assets at December 31, 2006 of the Banks are as follows:
Our subsidiary Banks each operate autonomously under the corporate umbrella of Security Bank Corporation. As a result, each bank has its own board of directors and management comprised of persons known in the local community in which each bank operates. We provide significant assistance and oversight to our subsidiary Banks in areas such as budgeting, marketing, human resource management, credit administration, operations and funding. This allows us to maintain efficient centralized reporting and policies while maintaining local decision-making capabilities.
Fairfield Financial Services, Inc. In addition to our traditional banking services, we also operate Fairfield Financial Services, Inc. (“Fairfield Financial”), a subsidiary of Security Bank of Bibb County. Fairfield Financial is an interim real estate development lender and a traditional residential mortgage originator with a number of production locations throughout Georgia. During 2006, Fairfield Financial closed over $189.0 million in residential mortgages, making it one of the largest residential mortgage originators in Middle Georgia. For the year ended December 31, 2006, Fairfield Financial posted approximately $2.4 million in net income. Approximately 17% of Fairfield Financial’s 2006 gross revenue was a product of its traditional residential mortgage origination business, with the remaining 83% derived from its interim real estate and real estate development lending activities.
Our Market Area
We provide a wide variety of community banking services through 46 full service banking and loan production offices. A substantial portion of our business is drawn from the Middle Georgia counties of Bibb, Houston and Jones. We believe we are the market leader among community banks based in Middle Georgia and we expect to gain market share at the expense of our super-regional and national competitors in these core markets.
We believe the continued growth of Atlanta is beneficial to the Middle Georgia market. Specifically, the increasing congestion of the Atlanta metropolitan area is a factor that we believe will provide new customers for the Middle Georgia market. Because we are approximately one hour’s drive south from Atlanta, the metropolitan area of Macon, Georgia is beginning to become attractive to people working in Atlanta who do not want to live in Atlanta’s “big city” atmosphere. We expect this dynamic to continue as Atlanta’s urban sprawl increases.
We made a strategic decision to expand into other markets in the State of Georgia. In January 2003, we expanded our market presence by opening a de novo banking office in the city of Brunswick, which is located on the southeastern coast of Georgia in Glynn County. This banking office provides diversification outside of our Middle Georgia market and allows us to take advantage of opportunities presented by the Glynn County area, which is situated midway between Savannah, Georgia and Jacksonville, Florida. In addition, we opened a de novo branch on St. Simons Island in 2005.
In May 2005, we made our initial entry into the metro Atlanta market by acquiring SouthBank (now Security Bank of North Metro), a community bank located in Woodstock, Georgia. Then, in March and July 2006, we made additional entries into the metro Atlanta market with the acquisitions of Neighbors Bancshares, Inc. (now Security Bank of North Fulton) and Homestead Bank (now Security Bank of Gwinnett County), community banks located in Alpharetta and Suwanee, Georgia, respectively. The Atlanta metropolitan area continues to experience significant growth and economic prosperity, and the acquisition of these banks should help us take advantage of the opportunities resulting from the tremendous growth and allow us to reach into new areas with a large retail and commercial customer base. In addition, due primarily to the operations of Fairfield Financial, we service communities throughout Georgia and in northeastern Florida.
Competition
There is significant competition within the financial services industry in general as well as with respect to the particular financial services provided by the Company and the Banks. Within our markets, the Banks compete directly with major banking institutions of comparable or larger size and resources, as well as with various other smaller banking organizations. The Banks also have numerous local and national nonbank competitors, including savings and loan associations, credit unions, mortgage companies, personal and commercial finance companies, investment brokerage and financial advisory firms, and mutual fund companies. Entities that deliver financial services and access to financial products and transactions exclusively through the Internet are another source of competition. Technological advances have also allowed the Banks and other financial institutions to provide electronic and Internet-based services that enhance the value of traditional financial products. Continued consolidation within the financial services industry will most likely change the nature and intensity of competition that we face, but can also create opportunities for us to demonstrate and exploit competitive advantages.
According to FDIC deposit data as of June 30, 2006, in the combined markets of Bibb, Jones and Houston Counties, our three core counties of operation, bank and thrift deposits totaled approximately $4.33 billion. Approximately 51% of this deposit base was controlled by super-regional and national institutions, including BB&T, Bank of America, SunTrust Bank, Wachovia Bank, Colonial Bank and CB&T Bank of Middle Georgia (Synovus). Despite the considerable resources that these competitors possess, we have achieved a significant market share in each of these counties. As of June 30, 2006, our deposits accounted for 29% of the combined deposit base for these three counties, which ranked us first in overall market share and first in market share and asset base of any community bank based in these counties. Our expanded banking presence in Glynn County is still developing; however, our market share at June 2006 increased approximately 66% compared to June 2005. Our presence in metropolitan Atlanta is still in early stages of development. We anticipate that similar competitive advantages enjoyed by us in our core markets, namely our ability to attract customers away from small community banks and super-regional and national competitors due to our overall borrowing capacity and level of customer service, will allow us to make substantial headway in gaining market share in Glynn County and in metropolitan Atlanta.
Lending Services
Through the Banks, we offer a range of lending services, including real estate-construction, real estate-mortgage, commercial, financial and agricultural and loans to individuals. Our total loans, net of unearned interest at December 31, 2006, were approximately $1.90 billion, or approximately 85.0% of total earning assets. The interest rates charged on loans vary with the degree of risk, maturity and amount of the loan and are further subject to competitive pressures, money market rates, availability of funds and government regulations.
Types of Loans. We offer the following types of loans (which are based on Call Report classifications):
•
Real Estate-Construction. Our construction loan portfolio consists of loans for non-agricultural, residential and commercial construction and land development projects. The majority of loans made to residential builders are made against presales wherein the purchaser has already been pre-qualified for a permanent loan. Commercial construction loans for residential or retail properties are typically backed by pre-lease and/or pre-sale requirements prior to loan funding. Also, all contractor customers (residential or commercial) are required to meet stringent underwriting standards that focus on: experience, years of successful operation, high personal credit scores and significant unencumbered personal and corporate liquidity. Loans are made within regulatory loan-to-value guidelines with additional collateral occasionally required as necessary to protect our interests. Progress reports are maintained on each loan and appropriate progress is required prior to funding. As of December 31, 2006, these loans represented approximately 51.4% of our portfolio.
•
Real Estate-Mortgage. Our residential mortgage loans consist of residential loans to individuals intended for resale and residential loans to individuals intended to be held in our loan portfolio. These loans are generally made on the basis of the borrower’s ability to repay the loan from his or her employment and other income and are secured by residential real estate, the value of which is reasonably ascertainable. Other real estate mortgage loans may include loans where the primary reasons for the loans are for commercial, financial or agricultural purposes or loans made to individuals for personal, family or household purposes but are secured by real estate. As of December 31, 2006, these loans represented approximately 38.5% of our portfolio.
•
Commercial, Financial and Agricultural. We make commercial loans to qualified businesses in our market area. This portion of our portfolio consists primarily of commercial and industrial loans for the financing of accounts receivable, inventory, property, plant and equipment. Because we make these loans based on the borrower’s demonstrated ability to repay out of cash flow from his or her business, and because we know the customers to whom these loans are made, we consider these loans to be of very high quality. Although large loans of this nature might otherwise be assumed to carry additional risk, our loans are typically well-collateralized and our exposure to any one borrower is limited because we focus on overall relationships. Under our risk rating system, credit grades with higher intrinsic risk profiles limit the amount that can be loaned into any one borrowing relationship, thereby limiting our exposure to riskier credits and applying larger loan loss allocations to the credit. As of December 31, 2006, these loans represented approximately 7.5% of our portfolio.
•
Loans to Individuals. This portfolio consists principally of installment loans to individuals for personal, family and household purposes. These loans entail a high degree of risk due to the typically highly depreciable nature of any underlying collateral and collectibility risks resulting from the borrower’s insolvency or bankruptcy. To mitigate this risk, we perform a thorough credit and financial analysis of the borrower and seek adequate collateral for the loan. As of December 31, 2006, these loans represented approximately 2.6% of our portfolio.
We originate loans with a variety of terms, including fixed and floating or variable rates, and a variety of maturities. Although we offer a variety of loans, we emphasize the use of real estate as collateral. As of December 31, 2006, approximately 90% of our loan portfolio, regardless of type, was secured by real estate. Although the Banks generally lend to clients located in their market areas, our Fairfield Financial subsidiary is more geographically diversified, with approximately 97.7% of its interim real estate development portfolio
(excluding participated loans) consisting of loans in areas of Georgia outside the Middle Georgia market, as illustrated in the following table:
Other Products and Services
We provide a full range of additional retail and commercial banking products and services, including checking, savings and money market accounts; certificates of deposit; credit cards; individual retirement accounts; safe-deposit boxes; money orders; electronic funds transfer services; travelers’ checks and automatic teller machine access. On February 21, 2007, the Company completed the acquisition of CFS Wealth Management, LLC, an independent investment management and financial planning firm in Macon, Georgia. The Company will begin to introduce the firm and its investment advisory services to its customers in the months following the acquisition. We do not currently offer trust or fiduciary services.
Financial Information about Segments
Financial information regarding segments is contained in a separate section of this Annual Report on Form 10-K. See Note 1 of Notes to Consolidated Financial Statements beginning on page of Exhibit 13 of this Annual Report on Form 10-K.
Employees
As of December 31, 2006, the Company had 501 employees on a full-time equivalent basis. The Company considers its relationship with its employees to be excellent.
Seasonality
We do not consider our business to be cyclical or seasonal in nature.
Supervision and Regulation
Bank Holding Company Regulation
General
We are a bank holding company within the meaning of the Bank Holding Company Act of 1956, as amended (“BHCA”). As a bank holding company registered with the Federal Reserve under the BHCA and the Georgia Department of Banking and Finance (the “Georgia Department”) under the Financial Institutions Code of Georgia, we are subject to supervision, examination and reporting by the Federal Reserve and the Georgia Department.
Our activities are limited to banking, managing or controlling banks, furnishing services to or performing services for its subsidiaries, or engaging in any other activity that the Federal Reserve determines to be so closely related to banking, or managing or controlling banks, as to be a proper incident to these activities.
We are required to file with the Federal Reserve and the Georgia Department periodic reports and any additional information as they may require. The Federal Reserve and Georgia Department will also regularly examine us and may examine our bank or other subsidiaries.
Activity Limitations
The BHCA requires prior Federal Reserve approval for, among other things:
•
the acquisition by a bank holding company of direct or indirect ownership or control of more than 5% of the voting shares or substantially all of the assets of any bank, or
•
a merger or consolidation of a bank holding company with another bank holding company.
Similar requirements are imposed by the Georgia Department.
A bank holding company may acquire direct or indirect ownership or control of voting shares of any company that is engaged directly or indirectly in banking or managing or controlling banks or performing services for its authorized subsidiaries. A bank holding company may also engage in or acquire an interest in a company that engages in activities that the Federal Reserve has determined by regulation or order to be so closely related to banking as to be a proper incident to these activities. The Federal Reserve normally requires some form of notice or application to engage in or acquire companies engaged in such activities. Under the BHCA, we will generally be prohibited from engaging in or acquiring direct or indirect control of more than 5% of the voting shares of any company engaged in activities other than those referred to above.
The BHCA permits a bank holding company located in one state to lawfully acquire a bank located in any other state, subject to deposit-percentage, aging requirements and other restrictions. The Riegle-Neal Interstate Banking and Branching Efficiency Act also generally provides that national and state-chartered banks may, subject to applicable state law, branch interstate through acquisitions of banks in other states.
In November 1999, Congress enacted the Gramm-Leach-Bliley Act, which made substantial revisions to the statutory restrictions separating banking activities from other financial activities. Under the Gramm-Leach-Bliley Act, bank holding companies that are well-capitalized and well-managed and meet other conditions can elect to become “financial holding companies.” As financial holding companies, they and their subsidiaries are permitted to acquire or engage in activities that were not previously allowed by bank holding companies such as insurance underwriting, securities underwriting and distribution, travel agency activities, broad insurance agency activities, merchant banking and other activities that the Federal Reserve determines to be financial in nature or complementary to these activities. Financial holding companies continue to be subject to the overall oversight and supervision of the Federal Reserve, but the Gramm-Leach-Bliley Act applies the concept of functional regulation to the activities conducted by subsidiaries. For example, insurance activities would be subject to supervision and regulation by state insurance authorities. While we have not elected to become a financial holding company in order to exercise the broader activity powers provided by the Gramm-Leach-Bliley Act, we may elect to do so in the future.
Limitations on Acquisitions of Bank Holding Companies
As a general proposition, other companies seeking to acquire control of a bank holding company would require the approval of the Federal Reserve under the BHCA. In addition, individuals or groups of individuals seeking to acquire control of a bank holding company would need to file a prior notice with the Federal Reserve (which the Federal Reserve may disapprove under certain circumstances) under the Change in Bank Control Act. Control is conclusively presumed to exist if an individual or company acquires 25% or more of any class of voting securities of the bank holding company. Control may exist under the Change in Bank Control Act if the individual or company acquires 10% or more of any class of voting securities of the bank holding company. A company may be presumed to have control under the BHCA if it acquires 5% or more of any class of voting securities of the bank holding company.
Source of Financial Strength
Federal Reserve policy requires a bank holding company to act as a source of financial strength and to take measures to preserve and protect bank subsidiaries in situations where additional investments in a troubled bank
may not otherwise be warranted. In addition, if a bank holding company has more than one bank or thrift subsidiary, each of the bank holding company’s subsidiary depository institutions are responsible for any losses to the FDIC as a result of an affiliated depository institution’s failure.
As a result, a bank holding company may be required to loan money to its subsidiaries in the form of capital notes or other instruments that qualify as capital of the subsidiary bank under regulatory rules. However, any loans from the bank holding company to those subsidiary banks will likely be unsecured and subordinated to that bank’s depositors and perhaps to other creditors of that bank. In the event of the Company’s bankruptcy, any commitment by the Company to a bank regulatory agency to maintain the capital of a subsidiary bank at a certain level would be assumed by the bankruptcy trustee and entitled to priority of payment.
Bank Regulation
General
The Banks are commercial banks chartered under the laws of the State of Georgia, and as such are subject to supervision, regulation and examination by the Georgia Department. The Banks are members of the FDIC, and their deposits are insured by the FDIC’s Deposit Insurance Fund up to the amount permitted by law. The FDIC and the Georgia Department routinely examine the Banks and monitor and regulate all of the Banks’ operations, including such things as the adequacy of reserves, the quality and documentation of loans, the payments of dividends, the capital adequacy, the adequacy of systems and controls, credit underwriting and asset liability management, compliance with laws and the establishment of branches. Interest and other charges collected or contracted for by the Banks are subject to state usury laws and certain federal laws concerning interest rates. The Banks file periodic reports with the FDIC and Georgia Department.
Transactions with Affiliates and Insiders
The Company is a legal entity separate and distinct from the Banks. Various legal limitations restrict the Banks from lending or otherwise supplying funds to the Company and other non-bank subsidiaries of the Company, all of which are deemed to be “affiliates” of the Banks for the purposes of these restrictions. The Company and the Banks are subject to Section 23A of the Federal Reserve Act. Section 23A defines “covered transactions,” which include extensions of credit, and limits a bank’s covered transactions with any affiliate to 10% of such bank’s capital and surplus and with all affiliates to 20% of such bank’s capital and surplus. All covered and exempt transactions between a bank and its affiliates must be on terms and conditions consistent with safe and sound banking practices, and banks and their subsidiaries are prohibited from purchasing low-quality assets from the bank’s affiliates. Finally, Section 23A requires that all of a bank’s extensions of credit to an affiliate be secured by collateral in amounts ranging from 100% to 130% of the loan amount, depending on the nature of the collateral. , The Company and the Banks are also subject to Section 23B of the Federal Reserve Act, which generally limits covered and other transactions between a bank and its affiliates to terms and under circumstances, including credit standards, that are substantially the same or at least as favorable to the bank as prevailing at the time for transactions with unaffiliated companies.
The Banks are also restricted in the loans that they may make to our executive officers, directors, or any owner of 10% or more of its stock or the stock of the Company, and certain entities affiliated with any such person. Amounts of such loans are subject to various limits, depending on the purpose of the loan, and certain Bank board approvals may be necessary.
Dividends
The Company is a legal entity separate and distinct from the Banks. The principal source of the Company’s cash flow, including cash flow to pay dividends to its shareholders, is dividends that the Banks pay to it. Statutory and regulatory limitations apply to the Banks’ payment of dividends to the Company as well as to the Company’s payment of dividends to its shareholders.
A variety of federal and state laws and regulations affect the ability of the Bank and the Company to pay dividends. A depository institution may not pay any dividend if payment would cause it to become undercapitalized or if it already is undercapitalized. The federal bank regulatory authorities may prevent the payment of a dividend if they determine that the payment would be an unsafe and unsound banking practice. As a rule, the amount of a dividend may not exceed the sum of year-to-date net income and of retained net income in the immediately previous two years. Additionally, the federal agencies have issued policy statements to the effect that bank holding companies and insured banks should generally only pay dividends out of current operating earnings. In addition, regulations promulgated by the Georgia Department limit the Bank’s payment of dividends.
Enforcement Policies and Actions
Federal law gives the Federal Reserve and FDIC substantial powers to enforce compliance with laws, rules and regulations. Banks or individuals may be ordered to cease and desist from violations of law or other unsafe or unsound practices. The agencies have the power to impose civil money penalties against individuals or institutions of up to $1 million per day for certain egregious violations. Persons who are affiliated with depository institutions can be removed from any office held in that institution and banned from participating in the affairs of any financial institution. The banking regulators have not hesitated to use the enforcement authorities provided in federal law.
Capital Regulations
The federal bank regulatory authorities have adopted capital guidelines for banks and bank holding companies. In general, the authorities measure the amount of capital an institution holds against its assets. There are three major capital tests: (1) the Total Capital ratio (the total of Tier 1 Capital and Tier 2 Capital measured against risk-adjusted assets), (2) the Tier 1 Capital ratio (Tier 1 Capital measured against risk-adjusted assets) and (3) the leverage ratio (Tier One Capital measured against total (i.e., non-risk-weighted) assets).
Tier 1 Capital consists of common equity, retained earnings and a limited amount of qualifying preferred stock, less goodwill and certain core deposit intangibles. Tier 2 Capital consists of non-qualifying preferred stock, qualifying subordinated, perpetual, and/or mandatory convertible debt, term subordinated debt and intermediate term preferred stock and up to 45% of the pretax unrealized holding gains on available-for-sale equity securities with readily determinable market values that are prudently valued, and a limited amount of any loan loss allowance.
In measuring the adequacy of capital, assets are generally weighted for risk. Certain assets, such as cash and U.S. government securities, have a zero risk weighting. Others, such as commercial and consumer loans, have a 100% risk weighting. Risk weightings are also assigned for off-balance sheet items such as loan commitments. The various items are multiplied by the appropriate risk-weighting to determine risk-adjusted assets for the capital calculations. For the leverage ratio mentioned above, assets are not risk-weighted.
The federal bank regulatory authorities recently proposed two new risk-based capital rules. The first, popularly known as “Basel II,” would impose complex new requirements on the largest U.S. banking organizations, those with assets in excess of $250 billion or foreign exposures in excess of $10 billion. The other, known as “Basel IA,” would revise the current risk-based capital rules to which the Company and the Banks are subject in a way intended to provide a measure of equivalence to the Basel II rules. The proposals currently are subject to public comment. The proposed rules are written so as to take effect in 2009, but we cannot predict whether the final rules in fact will do so. The proposed rules address only risk-based capital requirements. Public statements from the federal bank regulatory authorities indicate that the current leverage ratio requirement will remain in place, as will the prompt corrective action regime discussed immediately below.
FDICIA & Prompt Corrective Action
The Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”) established a “prompt corrective action” program in which every bank is placed in one of five regulatory categories, depending
primarily on its regulatory capital levels. The federal bank regulatory authorities must take “prompt corrective action” in respect of depository institutions that do not meet minimum capital requirements. There are five capital tiers for financial institutions: “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” and “critically undercapitalized.” Under these regulations, a bank will be:
•
“well capitalized” if it has a Total Capital ratio of 10% or greater, a Tier 1 Capital ratio of 6% or greater, a leverage ratio of 5% or better - or 4% in certain circumstances - and is not subject to any written agreement, order, capital directive, or prompt corrective action directive by a federal bank regulatory agency to meet and maintain a specific capital level for any capital measure;
•
“adequately capitalized” if it has a Total Capital ratio of 8% or greater, a Tier 1 Capital ratio of 4% or greater, and a leverage ratio of 4% or greater - or 3% in certain circumstances - and is not well capitalized;
•
“undercapitalized” if it has a Total Capital ratio of less than 8%, a Tier 1 Capital ratio of less than 4% - or 3% in certain circumstances;
•
“significantly undercapitalized” if it has a Total Capital ratio of less than 6% or a Tier 1 Capital ratio of less than 3%, or a leverage ratio of less than 3%; or
•
“critically undercapitalized” if its tangible equity is equal to or less than 2% of average quarterly tangible assets.
The regulations also establish procedures for “downgrading” an institution to a lower capital category based on supervisory factors other than capital. Specifically, a federal bank regulatory agency may, after notice and an opportunity for a hearing, reclassify a well-capitalized institution as adequately capitalized and may require an adequately capitalized institution or an undercapitalized institution to comply with supervisory actions as if it were in the next lower category if the institution is operating in an unsafe or unsound condition or engaging in an unsafe or unsound practice. The FDIC may not, however, reclassify a significantly undercapitalized institution as critically undercapitalized.
Federal law generally prohibits a depository institution from making any capital distribution, including the payment of a dividend or paying any management fee to its holding company if the depository institution would be undercapitalized as a result. Undercapitalized depository institutions may not accept brokered deposits absent a waiver from the FDIC, are subject to growth limitations and are required to submit a capital restoration plan for approval. For a capital restoration plan to be acceptable, the depository institution’s parent holding company must guarantee that the institution will comply with such capital restoration plan. The aggregate liability of the parent holding company is limited to the lesser of 5% of the depository institution’s total assets at the time it became undercapitalized, and the amount necessary to bring the institution into compliance with applicable capital standards. If a depository institution fails to submit an acceptable plan, it is treated as if it is significantly undercapitalized. If the controlling holding company fails to fulfill its obligations under this law and files, or has filed against it, a petition under the federal Bankruptcy Code, the FDIC claim related to the holding company’s obligations would be entitled to a priority in such bankruptcy proceeding over third party creditors of the bank holding company.
Significantly undercapitalized depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become adequately capitalized, requirements to reduce total assets, and cessation of receipt of deposits from correspondent banks. Critically undercapitalized institutions are subject to the appointment of a receiver or conservator.
At December 31, 2006, the Company exceeded the minimum Tier 1, risk-based and leverage ratios and qualified as “well-capitalized” under current Federal Reserve Board criteria. As of December 31, 2006, we had Tier 1 Capital and Total Capital of approximately 10.51% and 11.59%, respectively, of risk-weighted assets. As of December 31, 2006, we had a leverage ratio of Tier 1 Capital to total average assets of approximately 9.70%.
The guidelines also provide that institutions experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels without significant reliance on intangible assets. Higher capital may be required in individual cases, depending upon a bank or bank holding company’s risk profile. All bank holding companies and banks are expected to hold capital commensurate with the level and nature of their risks, including the volume and severity of their problem loans. Lastly, the Federal Reserve’s guidelines indicate that the Federal Reserve will continue to consider a “Tangible Tier 1 Leverage Ratio,” calculated by deducting all intangibles, in evaluating proposals for expansion or new activity.
Cross-Default Liability
Under the Federal Deposit Insurance Act (the “FDIA”), an insured depository institution that is under common control with another insured depository institution is generally liable for (1) any loss incurred, or reasonably anticipated to be incurred, by the FDIC in connection with the default of the commonly controlled institution or (2) any assistance provided by the FDIC to any commonly controlled institution that is in danger of default. The term “default” is defined to mean the appointment of a conservator or receiver for such institution and “in danger of default” is defined generally as the existence of certain conditions indicating that a “default” is likely to occur in the absence of regulatory assistance. Thus, if applicable, one of our Banks could incur liability to the FDIC pursuant to this statutory provision in the event of the default of another bank or insured depository institution that we own or control. Such liability is subordinated in right of payment to deposit liabilities, secured obligations, any other general or senior liability, and any obligation subordinated to depositors or other general creditors, other than obligations owed to any affiliate of the depository institution (with certain exceptions) and any obligations to shareholders in such capacity. The Company currently controls six banks.
Standards for Safety and Soundness
The FDIA requires the federal bank regulatory agencies to prescribe, by regulation or guideline, operational and managerial standards for all insured depository institutions relating to: (1) internal controls, information systems and internal audit systems; (2) loan documentation; (3) credit underwriting; (4) interest rate risk exposure; and (5) asset growth. The agencies also must prescribe standards for asset quality, earnings and stock valuation, as well as standards for compensation, fees and benefits. The federal bank regulatory authorities have adopted regulations and Interagency Guidelines Prescribing Standards for Safety and Soundness (“Safety and Soundness Guidelines”) to implement these required standards. The Safety and Soundness Guidelines set forth the safety and soundness standards that the federal bank regulatory authorities use to identify and address problems at insured depository institutions before capital becomes impaired. Under the regulations, if the FDIC determines that the bank fails to meet any standards prescribed by the Safety and Soundness Guidelines, the agency may require the bank to submit to the agency an acceptable plan to achieve compliance with the standard, as required by the FDIC. The final regulations establish deadlines for the submission and review of such safety and soundness compliance plans.
Deposit Insurance Assessments
The Banks’ deposits are insured by the FDIC and thus the Banks are subject to FDIC deposit insurance assessments. The FDIC utilizes a risk-based deposit insurance premium scheme to determine the assessment rates for insured depository institutions. Each financial institution is assigned to one of three capital groups, well capitalized, adequately capitalized, or undercapitalized.
In November 2006, the FDIC adopted final regulations that set the deposit insurance assessment rates that took effect in 2007. The FDIC uses a risk-based assessment system that assigns insured depository institutions to one of four risk categories based on three primary sources of information: (1) supervisory risk ratings for all institutions, (3) capital ratios for most institutions, and (3) long-term debt issuer ratings for large institutions that have such ratings. The new premium rate structure imposes a minimum assessment of from five to seven cents
for every $100 of domestic deposits on institutions that are assigned to the lowest risk category. This category is expected to encompass substantially all insured institutions, including the Banks. A one time assessment credit is available to offset up to 100% of the 2007 assessment. Any remaining credit can be used to offset up to 90% of subsequent annual assessments through 2010. For institutions assigned to higher risk categories, the premium that took effect in 2007 ranges from ten cents to 43 cents per $100 of deposits.
The FDIC also collects a deposit-based assessment from insured financial institutions on behalf of The Financing Corporation (“FICO”). The funds from these assessments are used to service debt issued by FICO in its capacity as a financial vehicle for the Federal Savings & Loan Insurance Corporation. The FICO assessment rate is set quarterly and in 2006 ranged from 1.32 cents to 1.24 cents per $100 of assessable deposits. For the first quarter of 2007, the FICO assessment rate is 1.22 cents per $100 of assessable deposits.
Mortgage Banking Regulation
Fairfield Financial is regulated as a “notificant” by the Georgia Department as it is a wholly owned subsidiary of a federally insured bank. It is also qualified as a Fannie Mae and Freddie Mac seller/servicer and must meet the requirements of such corporations and of the various private parties with which it conducts business, including warehouse lenders and those private entities to which it sells mortgage loans.
Anti-Tying Restrictions
Under amendments to BHCA and Federal Reserve regulations, a bank is prohibited from engaging in certain tying or reciprocity arrangements with its customers. In general, a bank may not extend credit, lease, sell property, or furnish any services or fix or vary the consideration for these on the condition that (1) the customer obtain or provide some additional credit, property, or services from or to the bank, the bank holding company or subsidiaries thereof or (2) the customer may not obtain some other credit, property, or services from a competitor, except to the extent reasonable conditions are imposed to assure the soundness of the credit extended. Certain arrangements are permissible: a bank may offer combined-balance products and may otherwise offer more favorable terms if a customer obtains two or more traditional bank products; and certain foreign transactions are exempt from the general rule. A bank holding company or any bank affiliate also is subject to anti-tying requirements in connection with electronic benefit transfer services.
Community Reinvestment Act
The Banks are subject to the provisions of the Community Reinvestment Act of 1977, as amended (the “CRA”), and the federal bank regulatory agencies’ related regulations. Under the CRA, all banks and thrifts have a continuing and affirmative obligation, consistent with safe and sound operation, to help meet the credit needs for their entire communities, including low - and moderate-income neighborhoods. The CRA requires a depository institution’s primary federal regulator, in connection with its examination of the institution or its evaluation of certain regulatory applications, to assess the institution’s record in assessing and meeting the credit needs of the community served by that institution, including low- and moderate-income neighborhoods. The regulatory agency’s assessment of the institution’s record is made available to the public.
Current CRA regulations rate institutions based on their actual performance in meeting community credit needs. Following the most recent CRA examination which occurred in either 2004 or 2005, the Banks received a “satisfactory” rating.
Privacy and Data Security
The Gramm-Leach-Bliley Act imposed new requirements on financial institutions with respect to consumer privacy. The statute generally prohibits disclosure of consumer information to non-affiliated third parties unless the consumer has been given the opportunity to object and has not objected to such disclosure. Financial
institutions are further required to disclose their privacy policies to consumers annually. Financial institutions, however, will be required to comply with state law if it is more protective of consumer privacy than the Gramm-Leach-Bliley Act. The statute also directed federal regulators, including the Federal Reserve and the FDIC, to prescribe standards for the security of consumer information. The Company and our Banks are subject to such standards, as well as standards for notifying consumers in the event of a security breach.
Consumer Regulations
Activities of the Banks are subject to a variety of statutes and regulations designed to protect consumers, such as including the Fair Credit Reporting Act (“FCRA”), Equal Credit Opportunity Act (“ECOA”), and Truth-in-Lending Act (“TILA”). Interest and other charges collected or contracted for by the Banks are also subject to state usury laws and certain other federal laws concerning interest rates. The Banks’ loan operations are also subject to federal laws and regulations applicable to credit transactions. Together, these laws and regulations include provisions that:
•
governing disclosures of credit terms to consumer borrowers;
•
requiring financial institutions to provide information to enable the public and public officials to determine whether a financial institution is fulfilling its obligation to help meet the housing needs of the community it serves;
•
prohibiting discrimination on the basis of race, creed, or other prohibited factors in extending credit;
•
governing the use and provision of information to credit reporting agencies; and
•
governing the manner in which consumer debts may be collected by collection agencies.
The deposit operations of the Banks are also subject to laws and regulations that:
•
impose a duty to maintain the confidentiality of consumer financial records and prescribe procedures for complying with administrative subpoenas of financial records; and
•
governs automatic deposits to and withdrawals from deposit accounts and customers’ rights and liabilities arising from the use of automated teller machines and other electronic banking services.
Anti-Money Laundering and Anti-Terrorism Legislation
In the wake of the tragic events of September 11th, on October 26, 2001, the President signed the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism (USA PATRIOT) Act of 2001. Under the USA PATRIOT Act, financial institutions are subject to prohibitions against specified financial transactions and account relationships as well as enhanced due diligence and “know your customer” standards in their dealings with foreign financial institutions and foreign customers. For example, the enhanced due diligence policies, procedures, and controls generally require financial institutions to take reasonable steps:
•
to conduct enhanced scrutiny of account relationships to guard against money laundering and report any suspicious transaction;
•
to ascertain the identity of the nominal and beneficial owners of, and the source of funds deposited into, each account as needed to guard against money laundering and report any suspicious transactions;
•
to ascertain for any foreign bank, the shares of which are not publicly traded, the identity of the owners of the foreign bank, and the nature and extent of the ownership interest of each such owner; and
•
to ascertain whether any foreign bank provides correspondent accounts to other foreign banks and, if so, the identity of those foreign banks and related due diligence information.
The USA PATRIOT Act requires financial institutions to establish anti-money laundering programs. The USA PATRIOT Act sets forth minimum standards for these programs, including:
•
the development of internal policies, procedures and controls;
•
the designation of a compliance officer;
•
an ongoing employee training program; and
•
an independent audit function to test the programs.
In addition, the USA PATRIOT Act authorizes the Secretary of the Treasury to adopt rules increasing the cooperation and information sharing between financial institutions, regulators and law enforcement authorities regarding individuals, entities and organizations engaged in, or reasonably suspected based on credible evidence of engaging in, terrorist acts or money laundering activities. Any financial institution complying with these rules will not be deemed to have violated the privacy provisions of the Gramm-Leach-Bliley Act, as discussed above.
Commercial Real Estate Lending and Concentrations
On December 12, 2006, the federal bank regulatory agencies released Guidance on Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices (the “Guidance”). The Guidance, which was issued in response to the agencies’ concern that rising CRE concentrations might expose institutions to unanticipated earnings and capital volatility in the event of adverse changes in the commercial real estate market, reinforces existing regulations and guidelines for real estate lending and loan portfolio management.
Highlights of the Guidance include the following:
•
The agencies have observed that CRE concentrations have been rising over the past several years with small to mid-size institutions showing the most significant increase in CRE concentrations over the last decade. However, some institutions’ risk management practices are not evolving with their increasing CRE concentrations, and therefore, the Guidance reminds institutions that strong risk management practices and appropriate levels of capital are important elements of a sound CRE lending program.
•
The Guidance applies to national banks and state chartered banks and is also broadly applicable to bank holding companies. For purposes of the Guidance, CRE loans include loans for land development and construction, other land loans and loans secured by multifamily and nonfarm residential properties. The definition also extends to loans to REITS and unsecured loans to developers if their performance is closely linked to the performance of the general CRE market.
•
The agencies recognize that banks serve a vital role in their communities by supplying credit for business and real estate development. Therefore, the Guidance is NOT intended to limit banks’ CRE lending. Instead, the Guidance encourages institutions to identify and monitor credit concentrations, establish internal concentration limits, and report all concentrations to management and the board of directors on a periodic basis.
•
The agencies recognized that different types of CRE lending present different levels of risk, and therefore, institutions are encouraged to segment their CRE portfolios to acknowledge these distinctions. However, the CRE portfolio should not be divided into multiple sections simply to avoid the appearance of risk concentration.
•
Institutions should address the following key elements in establishing a risk management framework for identifying, monitoring, and controlling CRE risk: (1) board and management oversight; (2) portfolio management; (3) management information systems; (4) market analysis; (5) credit underwriting standards; (6) portfolio stress testing and sensitivity analysis; and (7) credit review function.
•
As part of the ongoing supervisory monitoring processes, the agencies will use certain criteria to identify institutions that are potentially exposed to significant CRE concentration risk. An institution that has experienced rapid growth in CRE lending, has notable exposure to a specific type of CRE, or is approaching or exceeds specified supervisory criteria may be identified for further supervisory analysis.
The Company believes that the Guidance is applicable to it, as it has a concentration in CRE loans. The Company and its Board of Directors have discussed the Guidance and believe that that the Company’s underwriting policy, management information systems, independent credit administration process and monthly monitoring of real estate loan concentrations will be sufficient to address the Guidance.
Allowance for Loan and Lease Losses (“ALLL”)
On December 13, 2006, the federal bank regulatory agencies released Interagency Policy Statement on the Allowance for Loan and Lease Losses (ALLL), which revises and replaces the banking agencies’ 1993 policy statement on the ALLL. The revised statement was issued to ensure consistency with generally accepted accounting principles (“GAAP”) and more recent supervisory guidance. The revised statement extends the applicability of the policy to credit unions. Additionally, the agencies issued 16 FAQs to assist institutions in complying with both GAAP and ALLL supervisory guidance.
Highlights of the revised statement include the following:
•
The revised statement emphasizes that the ALLL represents one of the most significant estimates in an institution’s financial statements and regulatory reports and that an assessment of the appropriateness of the ALLL is critical to an institution’s safety and soundness.
•
Each institution has a responsibility to develop, maintain, and document a comprehensive, systematic, and consistently applied process for determining the amounts of the ALLL. An institution must maintain an ALLL that is sufficient to cover estimated credit losses on individual impaired loans as well as estimated credit losses inherent in the remainder of the portfolio.
•
The revised statement updates the previous guidance on the following issues regarding ALLL: (1) responsibilities of the board of directors, management, and bank examiners; (2) factors to be considered in the estimation of ALLL; and (3) objectives and elements of an effective loan review system.
•
The agencies recognize that institutions may not have sufficient time to bring their ALLL processes and documentation into full compliance with the revised guidance for 2006 year end reporting purposes. However, these changes and enhancements should be completed near term.
The Company and its Board of Directors have discussed the revised statement and believe that the Company’s ALLL methodology is comprehensive, systematic, and that it is consistently applied across the Company. The Company believes its management information systems, independent credit administration process, policies and procedures are sufficient to address the guidance.
Fiscal and Monetary Policy
Banking is a business that depends on interest rate differentials. In general, the difference between the interest paid by a bank on its deposits and its other borrowings, and the interest received by a bank on its loans and securities holdings, constitutes the major portion of a bank’s earnings. Thus, our earnings and growth and that of the Bank will be subject to the influence of economic conditions generally, both domestic and foreign, and also to the monetary and fiscal policies of the United States and its agencies, particularly the Federal Reserve. The Federal Reserve regulates the supply of money through various means, including open market dealings in United States government securities, the discount rate at which banks may borrow from the Federal Reserve, and the reserve requirements on deposits.
These policies have a direct effect on the amount of the Bank’s loans and deposits and on the interest rates charged on loans and paid on deposits, with the result that federal policies may have a material effect on earnings of the Bank. Policies that are directed toward changing the supply of money and credit and raising or lowering interest rates may have an effect on the Bank’s earnings. We cannot predict the conditions in the national and international economies and money markets, the actions and changes in policy by monetary and fiscal authorities, or their effect on the Company or the Banks.
Sarbanes-Oxley Act of 2002
We are required to comply with various corporate governance and financial reporting requirements under the Sarbanes-Oxley Act of 2002, as well as rules and regulations adopted by the SEC, the Public Company Accounting Oversight Board and Nasdaq. In particular, we are required to include management and independent auditor reports on internal controls as part this Annual Report on Form 10-K pursuant to Section 404 of the Sarbanes-Oxley Act. We have evaluated our controls, including compliance with the SEC rules on internal controls, and have and expect to continue to spend significant amounts of time and money on compliance with these rules. Our failure to comply with these internal control rules may materially adversely affect our reputation, ability to obtain the necessary certifications to financial statements, and the values of our securities. The assessments of financial reporting controls as of December 31, 2006 are included elsewhere in Annual Report on Form 10-K with no material weaknesses reported.
Available Information
Our filings with the SEC, including our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to these reports, are accessible free of charge at our website at www.securitybank.net as soon as reasonably practicable after filing with the SEC. By making this reference to our website, we do not intend to incorporate into this report any information contained in the website. The website should not be considered part of this report.
The SEC maintains a website at www.sec.gov that contains reports, proxy and information statements, and other information regarding issuers including the Company that file electronically with the SEC.
Item 1A
Item 1A RISK FACTORS
In addition to the other information contained in or incorporated by reference into this Form 10-K and the exhibits hereto, the following risk factors should be considered carefully in evaluating our business. The risks disclosed below, either alone or in combination, could materially adversely affect the business, financial condition or results of operations of the Company. Additional risks not presently known to us, or that we currently deem immaterial, may also adversely affect our business, financial condition or results of operations. Further to the extent that any of the information contained in the Annual Report on Form 10-K constitutes forward-looking statements, the risk factors set forth below also are cautionary statement identifying important factors that could cause our actual results to differ materially from those expressed in any forward-looking statements made by or on behalf of us.
Our business is subject to the success of the local economies where we operate.
Our success significantly depends upon the growth in population, income levels, deposits and housing starts in our primary and secondary markets. If the communities in which we operate do not grow or if prevailing economic conditions locally or nationally are unfavorable, our business may not succeed. Adverse economic conditions in our specific market area affect the ability of our customers to repay their loans to us and generally affect our financial condition and results of operations. We are less able than a larger institution to spread the risks of unfavorable local economic conditions across a large number of diversified economies. Moreover, we cannot give any assurance that we will benefit from any market growth or favorable economic conditions in our primary market areas if they do occur.
Any adverse market or economic conditions in the State of Georgia may disproportionately increase the risk that our borrowers are unable to make their loan payments. In addition, the market value of the real estate securing loans as collateral could be adversely affected by unfavorable changes in market and economic conditions. As of December 31, 2006, approximately 90% of our loans held for investment were secured by real estate. Approximately 35% of our commercial real estate portfolio represents loans for which the related property is neither presold not preleased, and are therefore speculative in nature. These loans are based on the perceived
present and future demand for commercial real estate in a particular market served by the Company. These loans are monitored by on-site inspections and are considered to have higher risks than other real estate loans due to their ultimate repayment being sensitive to interest rate changes, general economic conditions and trends, the demand for and value of the properties, and the availability of long-term financing. Any sustained period of increased payment delinquencies, foreclosures or losses caused by adverse market or economic conditions, including a downturn in the real estate market, in the State of Georgia could adversely affect the value of our assets, our revenues, results of operations and financial condition.
Commercial banks and other financial institutions are affected by economic and political conditions, both domestic and international, and by governmental monetary policies. Conditions such as inflation, recession, unemployment, high interest rates, short money supply, scarce natural resources, international disorders, terrorism and other factors beyond the Company’s control may adversely affect profitability. In addition, a significant portion of the Company’s primary business area is located near Robins Air Force Base, one of the largest employers in Georgia, and many of the Company’s customers are financially dependent, directly and indirectly, on the continued operation of Robins Air Force Base. Military installations, such as Robins Air Force Base, are subject to annual review and potential closing by the United States Congress. The closing of Robins Air Force Base, or a significant reduction in the operations conducted there may result in, among other things, deterioration in the Company’s credit quality or a reduced demand for credit and may harm the financial stability of the Company’s customers. Due to the Company’s limited market area, these negative conditions may have a more noticeable effect on the Company than would be experienced by an institution with a larger, more diverse market area.
We may face risks with respect to future expansion and acquisitions or mergers.
We continuously seek to acquire other financial institutions or parts of those institutions and may engage in de novo branch expansion in the future. We may also consider and enter into new lines of business or offer new products or services. We also may receive future inquiries and have discussions with potential acquirers of us. Acquisitions and mergers involve a number of risks, including:
•
the time and costs associated with identifying and evaluating potential acquisitions and merger partners;
•
the estimates and judgments used to evaluate credit, operations, management and market risks with respect to the target institution may not be accurate;
•
the time and costs of evaluating new markets, hiring experienced local management and opening new offices, and the time lags between these activities and the generation of sufficient assets and deposits to support the costs of the expansion;
•
our ability to finance an acquisition and possible dilution to our existing shareholders;
•
the diversion of our management’s attention to the negotiation of a transaction, and the integration of the operations and personnel of the combining businesses;
•
entry into new markets where we lack experience;
•
the introduction of new products and services into our business;
•
the incurrence and possible impairment of goodwill associated with an acquisition and possible adverse short-term effects on our results of operations; and
•
the risk of loss of key employees and customers.
We may incur substantial costs to expand, and we can give no assurance that such expansion will result in the levels of profits we seek. There can be no assurance that, integration efforts for any future mergers or acquisitions will be successful. Also, we may issue equity securities, including common stock and securities convertible into shares of our common stock in connection with future acquisitions, which could cause ownership and economic dilution to our current shareholders. There is no assurance that, following any future merger or acquisition, our integration efforts will be successful or that our company, after giving effect to the acquisition, will achieve profits comparable to or better than our historical experience.
Combining acquired companies may be more difficult, costly, or time-consuming than we expect.
It is possible that the integration process for our acquisitions could result in the loss of key employees or disruption of each institution’s ongoing business or inconsistencies in standards, procedures and policies that would adversely affect the Company’s ability to maintain relationships with clients and employees or to achieve the anticipated benefits of the merger. If the Company has difficulties with the integration process, it might not achieve the economic benefits expected to result from the acquisition. As with any merger of banking institutions, there also may be business disruptions that cause the Company to lose customers or cause customers to remove their deposits or loans from the Banks and move their business to competing financial institutions.
Our continued pace of growth may require us to raise additional capital in the future, but that capital may not be available when it is needed.
We are required by federal and state regulatory authorities to maintain adequate levels of capital to support our operations. We anticipate that our capital resources will satisfy our capital requirements for the foreseeable future. We may at some point, however, need to raise additional capital to support our continued growth.
Our ability to raise additional capital, if needed, will depend on conditions in the capital markets at that time, which are outside our control, and on our financial performance. Accordingly, we cannot assure you of our ability to raise additional capital if needed on terms acceptable to us. If we cannot raise additional capital when needed, our ability to further expand our operations through internal growth and acquisitions could be materially impaired.
Changes in interest rates may negatively affect our earnings and the value of our assets.
Changes in interest rates may affect our level of interest income, the primary component of our gross revenue, as well as the level of our interest expense, our largest recurring expenditure. In a period of rising interest rates, our interest expense could increase in different amounts and at different rates while the interest that we earn on our assets may not change in the same amounts or at the same rates. Accordingly, increases in interest rates could decrease our net interest income.
Residential mortgage originations generated $5.4 million, or 17%, of our gross revenue in 2006. A period of rising interest rates would negatively affect our residential mortgage origination business.
Changes in the level of interest rates also may negatively affect our ability to originate real estate loans, the value of our assets and our ability to realize gains from the sale of our assets, all of which ultimately affect our earnings. A decline in the market value of our assets may limit our ability to borrow additional funds or result in our lenders requiring additional collateral from us under our loan agreements. As a result, we could be required to sell some of our loans and investments under adverse market conditions, upon terms that are not favorable to us, in order to maintain our liquidity. If those sales are made at prices lower than the amortized costs of the investments, we will incur losses.
Our loan portfolio includes a substantial amount of commercial and industrial loans which include risks that may be greater than the risks related to residential loans.
Our commercial and industrial loan portfolio was $142.5 million at December 31, 2006, comprising 7.5% of loans receivable. Commercial and industrial loans generally carry larger loan balances and involve a greater degree of financial and credit risks than home equity loans or residential mortgage loans. Any significant failure to pay on time by our customers would hurt our earnings. The increased financial and credit risk associated with these types of loans is a result of several factors, including the concentration of principal in a limited number of loans and borrowers, the size of loan balances, the effects of general economic conditions on income-producing properties and the increased difficulty of evaluating and monitoring these types of loans. In addition, when
underwriting a commercial or industrial loan, we may take a security interest in commercial real estate and, in some instances upon a default by the borrower, we may foreclose on and take title to the property, which may lead to potential financial risk for us under applicable environmental laws. If hazardous substances were discovered on any of these properties, we may be liable to governmental entities or third parties for the costs of remediation of the hazard, as well as for personal injury and property damage. Many environmental laws can impose liability regardless of whether we knew of, or were responsible for, the contamination. Furthermore, the repayment of loans secured by commercial real estate is typically dependent upon the successful operation of the related real estate or commercial project. If the cash flow from the project is reduced, the borrower’s ability to repay the loan may be impaired. This cash flow shortage may result in the failure to make loan payments. In such cases, we may be compelled to modify the terms of the loan. In addition, the nature of these loans is such that they are generally less predictable and more difficult to evaluate and monitor. As a result, repayment of these loans may, to a greater extent than residential loans, be subject to adverse conditions in the real estate market or economy.
We face regulatory risks related to our commercial real estate loan concentrations.
Commercial real estate or “CRE” is cyclical and poses risks of possible loss due to concentration levels and similar risks of the asset class, especially since approximately 77% of our loan portfolio consisted of CRE loans at December 31, 2006. The banking regulators have begun giving CRE lending greater scrutiny, and may require banks with higher levels of CRE loans to implement improved underwriting, internal controls, risk management policies and portfolio stress testing, as well as possibly requiring higher levels of allowances for possible loan losses and capital levels as a result of CRE lending growth and exposures. See “Supervision and Regulation - Commercial Real Estate Lending and Concentrations.”
If our allowance for loan losses is not sufficient to cover actual loan losses, our earnings could decrease.
Our loan customers may not repay their loans according to the terms of these loans, and the collateral securing the payment of these loans may be insufficient to assure repayment. We may experience significant loan losses, which could have a material adverse effect on our operating results. Management makes various assumptions and judgments about the collectibility of our loan portfolio, including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral for the repayment of many of our loans. We maintain an allowance for loan losses in an attempt to cover any loan losses, which may occur. In determining the size of the allowance, we rely on an analysis of our loan portfolio based on historical loss experience, volume and types of loans, trends in classification, volume and trends in delinquencies and non-accruals, national and local economic conditions and other pertinent information. As we expand into new markets, our determination of the size of the allowance could be understated due to our lack of familiarity with market-specific factors.
If our assumptions are wrong, our current allowance may not be sufficient to cover future loan losses, and adjustments may be necessary to allow for different economic conditions or adverse developments in our loan portfolio. Material additions to our allowance would materially decrease our net income. Our allowance for loan losses was $22.3 million, $16.1 million and $10.9 million as of December 31, 2006, 2005 and 2004, respectively.
In addition, federal and state regulators periodically review our allowance for loan losses and may require us to increase our provision for loan losses or recognize further loan charge-offs, based on judgments different than those of our management. Any increase in our allowance for loan losses or loan charge-offs as required by these regulatory agencies could have a negative effect on our operating results.
If we are unable to increase our share of deposits in our market, we may accept out of market and brokered deposits, the costs of which may be higher than expected.
We can offer no assurance that we will be able to maintain or increase our market share of deposits in our highly competitive service area. If we are unable to do so, we may be forced to accept increased amounts of out
of market or brokered deposits. As of December 31, 2006, we had approximately $480.7 million in out of market deposits, including brokered deposits, which represented approximately 24% of our total deposits. At times, the cost of out of market and brokered deposits exceeds the cost of deposits in our local market. In addition, the cost of out of market and brokered deposits can be volatile, and if we are unable to access these markets or if our costs related to out of market and brokered deposits increases, our liquidity and ability to support demand for loans could be adversely affected.
Competition from financial institutions and other financial service providers may adversely affect our profitability.
The banking business is highly competitive and we experience competition in each of our markets from many other financial institutions. We compete with commercial banks, credit unions, savings and loan associations, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market funds and other mutual funds, as well as other super-regional, national and international financial institutions that operate offices in our primary market areas and elsewhere.
We compete with these institutions both in attracting deposits and in making loans. In addition, we have to attract our customer base from other existing financial institutions and from new residents. Many of our competitors are well-established, larger financial institutions. While we believe we can and do successfully compete with these other financial institutions in our primary markets, we may face a competitive disadvantage as a result of our smaller size, lack of geographic diversification and inability to spread our marketing costs across a broader market. Although we compete by concentrating our marketing efforts in our primary markets with local advertisements, personal contacts, and greater flexibility and responsiveness in working with local customers, we can give no assurance that this strategy will be successful.
We are subject to extensive regulation that could limit or restrict our activities.
We operate in a highly regulated industry and are subject to examination, supervision and comprehensive regulation by various federal and state agencies. Our compliance with these regulations is costly and restricts certain of our activities, including payment of dividends, mergers and acquisitions, investments, loans and interest rates charged, interest rates paid on deposits and locations of offices. We are also subject to capitalization guidelines established by our regulators, which require us to maintain adequate capital to support our growth.
The laws and regulations applicable to the banking industry could change at any time, and we cannot predict the effects of these changes on our business and profitability. Because government regulation greatly affects the business and financial results of all commercial banks and bank holding companies, our cost of compliance could adversely affect our ability to operate profitably.
The Sarbanes-Oxley Act of 2002, and the related rules and regulations promulgated by the Securities and Exchange Commission and Nasdaq that are now applicable to us, have increased the scope, complexity and cost of corporate governance, reporting and disclosure practices. In order to comply with the Sarbanes-Oxley Act, we no longer use our independent auditors for internal audit and internal controls functions. As a result, we have experienced greater compliance costs and we can give no assurances that the effectiveness of our internal audit and internal controls functions will remain the same as when those functions were performed by our independent auditors.
Our directors and executive officers own a significant portion of our common stock.
Our directors and executive officers, as a group, beneficially owned approximately 14.71% of our outstanding common stock as of February 27, 2007. As a result of their ownership, the directors and executive officers will have the ability, by voting their shares in concert, to significantly influence the outcome of all matters submitted to our shareholders for approval, including the election of directors.
Additionally, the directors of Security Bank of Jones County have agreed that as long as they serve as directors on our board or one of the boards of our subsidiaries that they will vote all of the shares of our common stock owned by them in accordance with the recommendation of our board of directors through our annual meeting in 2007. As of December 31, 2006, the total number of shares of our common stock that were subject to voting agreements was 779,652 shares or 4.1% of our outstanding stock at that time.
Our ability to pay dividends is limited and we may be unable to pay future dividends.
Our ability to pay dividends is limited by regulatory restrictions and the need to maintain sufficient consolidated capital. The ability of our six bank subsidiaries to pay dividends to us is limited by their obligations to maintain sufficient capital and by other general restrictions on their dividends that are applicable to Georgia banks and banks that are regulated by the FDIC. If we do not satisfy these regulatory requirements, we will be unable to pay dividends on our common stock.
We may issue additional shares of our common stock in the future, which would dilute your ownership if you did not, or were not permitted to, invest in the additional issuances.
Our articles of incorporation authorize our board of directors, without shareholder approval, to, among other things, issue additional common stock or issue preferred stock in connection with future equity offerings and acquisitions of securities or assets of other companies. From time to time, we expect to issue additional equity securities to raise additional equity to support our portfolio. The issuance of any additional shares of common stock could be substantially dilutive to our common shareholders if they elect not to invest in future offerings. Moreover, to the extent that we issue restricted stock units, stock appreciation rights, options or warrants to purchase our common stock in the future and those stock appreciation rights, options or warrants are exercised or as the restricted stock units vest, our shareholders may experience further dilution. Holders of our shares of common stock have no preemptive rights that entitle holders to purchase their pro rata share of any offering of shares of any class or series and, therefore, our shareholders may not be permitted to invest in future issuances of our common stock.
We may issue debt and equity securities, which are senior to our common stock as to distributions and in liquidation, which could negatively affect the value of our common stock.
In the future, we may attempt to increase our capital resources by entering into debt or debt-like financing that is unsecured or secured by all or up to all of our assets, or issuing debt or equity securities, which could include issuances of secured or unsecured commercial paper, medium-term notes, senior notes, subordinated notes, preferred stock or common stock. In the event of our liquidation, our lenders and holders of our debt securities would receive a distribution of our available assets before distributions to the holders of our common stock. Because our decision to incur debt and issue securities in our future offerings will depend on market conditions and other factors beyond our control, we cannot predict or estimate the amount, timing or nature of our future offerings and debt financings. Further, market conditions could require us to accept less favorable terms for the issuance of our securities in the future. Thus, you will bear the risk of our future offerings reducing the value of your shares of common stock and diluting your interest in us.
Item 1B
Item 1B UNRESOLVED STAFF COMMENTS
None.
Item 2
Item 2 PROPERTIES
The Company, through the Banks, owned 19 full-service banking locations as of December 31, 2006. In addition, the Banks lease one limited-service banking location and operations centers in Macon and Perry. Fairfield Financial leases a number of mortgage production offices throughout Georgia and the Southeast, each of which management believes to be reasonable and appropriate for the market area. The net book value of all facilities including furniture, fixtures and equipment totaled $39.8 million as of December 31, 2006. Management considers that its properties are well maintained. For additional information regarding our premises and equipment, see Note 8 of Notes to Consolidated Financial Statements beginning on page of Exhibit 13 of this Annual Report on Form 10-K.
Item 3
Item 3 LEGAL PROCEEDINGS
The Company and its subsidiaries may become parties to various legal proceedings arising from the normal course of business. As of December 31, 2006, there are no material pending legal proceedings to which the Company or its subsidiaries are a party or of which any of its property is the subject.
Item 4
Item 4 SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
Part II
Item 5
Item 5 MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
As of February 13, 2007, we had approximately 1,768 shareholders of record plus approximately 2,177 shareholders listed in “street name.” Our common stock is quoted on the Nasdaq Global Select Market under the symbol “SBKC.”
The following table sets forth the high and low sale prices and closing prices per share of common stock as reported on the Nasdaq Global Select Market, and the dividends declared per share for the periods indicated.
For a discussion on dividend restrictions, see Item 1, “Business-Supervision and Bank Regulation.”
The Company did not purchase any shares of its common stock during the quarter ended December 31, 2006.
Stock Performance Graph
Set forth below is a line graph comparing the percentage change in the cumulative shareholder return on the Company’s common stock with the cumulative Nasdaq Total Return Index and the SNL Southeast Bank Index. The graph assumes $100 invested on December 31, 2001 in the common stock of the Company and the reinvestment of dividends compared to $100 invested in each of the two indexes.
The following performance graph and related information shall not be deemed “soliciting material” or to be “filed” with the SEC, nor shall such information be incorporated by reference into any future filings under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, except to the extent we specifically incorporate it by reference into such filing.
Item 6
Item 6 SELECTED FINANCIAL DATA
Our selected consolidated financial data presented below as of and for the years ended December 31, 2002 through December 31, 2006 is derived from our audited consolidated financial statements, which are included elsewhere in this Annual Report on Form 10-K. In the opinion of management, all adjustments (consisting only of normal recurring accruals) that are necessary for a fair presentation for such periods or dates have been made. See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for a full discussion of comparability between periods.
(1) Net interest income divided by average interest-earning assets.
(2) Yield on interest-earning assets less cost of interest-bearing liabilities.
(3) Other expenses divided by net interest income and other income.
(4) Nonperforming loans include nonaccrual loans and loans past due 90 days or more and still accruing interest.
(5) Nonperforming assets are nonperforming loans plus other real estate owned.
(6) Calculated on a fully tax-equivalent basis.
Item 7
Item 7 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion reviews our financial condition and results of operations and contains forward-looking statements that are subject to known and unknown risks, uncertainties and other factors that may cause the Company’s actual results to differ materially from those expressed or implied by such forward-looking statements. Factors that could cause or contribute to such differences include those discussed in Item 1A, “Risk Factors” and elsewhere in this Annual Report on Form 10-K. You should read the following discussion and analysis of our financial condition and results of operations in conjunction with “Selected Financial Data” and our Consolidated Financial Statements and the related notes included elsewhere in this Annual Report on Form 10-K.
Overview
Security Bank Corporation was incorporated on February 10, 1994 for the purpose of becoming a bank holding company. We are subject to extensive federal and state banking laws and regulations, including the Bank Holding Company Act of 1956 and the bank holding company laws of Georgia. We own six subsidiary banks-Security Bank of Bibb County, Security Bank of Houston County, Security Bank of Jones County, Security Bank of North Metro, Security Bank of North Fulton and Security Bank of Gwinnett County. We also own Fairfield Financial, an operating subsidiary of Security Bank of Bibb County. Our subsidiaries are also subject to various federal and state banking laws and regulations.
Like most financial institutions, our profitability depends largely upon net interest income, which is the difference between the interest received on earning assets, such as loans and investment securities, and the interest paid on interest-bearing liabilities, principally deposits and borrowings. Our results of operations are also affected by our provision for loan losses; non-interest expenses, such as salaries, employee benefits, and occupancy expenses; and non-interest income, such as mortgage loan fees and service charges on deposit accounts.
Economic conditions, competition and federal monetary and fiscal policies also affect financial institutions. For example, 2006 was characterized by continuing increases in the Federal Reserve’s target federal funds rate to reduce inflationary pressures and, therefore, sustain the pace of economic growth. Lending activities are also influenced by regional and local economic factors, such as housing supply and demand, competition among lenders, customer preferences and levels of personal income and savings in our primary market area.
Our balanced growth continued during 2006, with increases in assets, loans, deposits, shareholders’ equity and earnings per share. The following chart shows our growth in these areas from December 31, 2005 to December 31, 2006:
A total increase in loan volume of $632.3 million, $280.6 million excluding our acquisitions, resulted from continued strong loan demand in our core markets and was the primary contributor to an increase in net income to $23.4 million for 2006.
Approximately $356.3 million of the total increase in deposits of $679.6 million resulted from our acquisitions. The remaining $323.3 million increase in deposits in 2006 is the result of our success in attracting new customers to our Premium Select Checking product, which offers a money market interest rate and checking account convenience. During 2006, approximately 2,570 new Premium Select Checking accounts were opened. The increase in total deposits is also related to the increased use of out of market deposits, which we can often acquire at targeted maturities to mitigate interest rate risk.
Our investment portfolio increased $78.9 million during 2006. Excluding our acquisitions, investment securities increased $44.9 million or 31%, primarily in order to provide on-balance sheet liquidity in support of strong loan demand. The overall level of investment securities increased slightly to 9.2% of assets at the end of 2006, as compared to 9.1% of assets at the end of 2005.
Fairfield Financial closed over $467.9 million in loans during 2006 and posted approximately $2.4 million in net income. Approximately 17% of its 2006 gross revenue was a product of its traditional residential mortgage origination business, with the remaining 83% being derived from its interim real estate and real estate development lending activities.
The following table illustrates our selected key financial data for each of the past five years.
SELECTED FIVE YEAR FINANCIAL DATA
(Dollars in thousands, except per share data and number of shares)
(1) Investment Securities include Restricted Stock (in thousands): 2006 - $7,521; 2005 - $6,974; 2004 - $4,918; 2003 - $3,935 and 2002 - $3,614.
Critical Accounting Policies
The accounting principles we follow and our methods of applying these principles conform with accounting principles generally accepted in the United States and general practices within the banking industry. In connection with the application of those principles, we have made judgments and estimates which, in the case of the determination of our allowance for loan and lease losses (ALLL), goodwill and stock-based compensation have been critical to the determination of our financial position and results of operations.
Allowance for Loan and Lease Losses (ALLL)
Our management assesses the adequacy of the ALLL prior to the end of each calendar quarter. This assessment includes procedures to estimate the allowance and test the adequacy and appropriateness of the resulting balance. The ALLL consists of two components: (1) an allocated amount representative of specifically identified credit exposure and exposures that are readily predictable by historical or comparative experience; and (2) an amount due to stress factors that are representative of inherent loss related to various economic factors and characteristics of our company’s loan portfolio that is not as readily identifiable. Even though the ALLL is composed of two components, the entire ALLL is available to absorb any credit losses.
We establish the allocated amount separately for three tiers:
•
substandard loans with specific allocations based on collateral exposure;
•
loans based on five different credit ratings (watch list, other assets specifically mentioned, substandard, doubtful and loss) with allocations based on historical losses per rating category; and
•
the rest of the loan portfolio with allocations based on historical losses in the total portfolio.
We base the allocation for unique loans primarily on risk rating grades assigned to each of these loans as a result of our loan management and internal loan review processes. We then assign each risk-rating grade a loss ratio, which is determined based on the experience of management, discussions with banking regulators and our internal loan review process (which is maintained at the holding company level).
The amount due to stress factors is particularly subjective and does not lend itself to exact mathematical calculation. The amount due to stress represents estimated inherent credit losses, which may exist, but have not yet been identified, as of the balance sheet date. In estimating the unallocated amount, we apply three stress factors. The first stress factor consists of economic factors including such matters as changes in the local or national economy, the depth or experience in the lending staff, any concentrations of credit (such as commercial real estate) in any particular industry group, and new banking laws or regulations. The second stress factor is based on the credit grade of the loans in our unsecured consumer loan portfolio. The third stress factor represents potential exposure as a result of the aggregate speculative real estate loans in the company. After we assess applicable factors, we evaluate the remaining amount based on our management’s experience.
We then test the resulting ALLL balance by comparing the balance in the ALLL with historical trends and peer information. Our management then evaluates the result of the procedures performed, including the result of our testing, and makes a conclusion regarding the appropriateness of the balance of the ALLL in its entirety. The directors’ loan committee reviews the assessments prior to the filing of quarterly and annual financial information.
In assessing the adequacy of the ALLL, we also rely on an ongoing independent credit administration review process. We undertake this process both to ascertain whether there are loans in the portfolio whose credit quality has weakened over time and to assist in our overall evaluation of the risk characteristics of the entire loan portfolio. Our credit administration review process includes the judgment of management, the input of our internal loan review function, and reviews that may have been conducted by bank regulatory agencies as part of their usual examination process.
Stock-Based Compensation
In accordance with Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation, management has elected to expense the fair value of stock options. We utilize the Black-Scholes model in determining the fair value of the stock options. The model takes into account certain estimated factors such as the expected life of the stock option and the volatility of the stock.
The expected life of the stock option is a function of the vesting period of the grant, the average length of time similar grants have remained outstanding, and the expected volatility of the underlying stock. Volatility is a measure of the amount by which a price has fluctuated or is expected to fluctuate during a period.
Goodwill
Effective January 1, 2002, SFAS No. 142, Goodwill and Other Intangible Assets was adopted. In accordance with this statement, goodwill and intangible assets deemed to have indefinite lives no longer are being amortized but will be subject to impairment tests in accordance with the pronouncement. Other intangible assets, primarily core deposits, will continue to be amortized over their estimated useful lives. In 2002, the required impairment testing of goodwill was performed and no impairment existed as of the valuation date, as the fair value of our net assets exceeded their carrying value. If for any future period we determine that there has been impairment in the carrying value of our goodwill balances, we will record a charge to our earnings, which could have a material adverse effect on our net income.
Results of Operations for the Years Ended December 31, 2006, 2005 and 2004
Our net income was $23.4 million, $16.2 million, and $12.3 million, for the years ended December 31, 2006, 2005, and 2004, respectively. Our 2006 earnings were up by 44% over 2005, and the 2005 earnings showed a 31% increase over 2004. Diluted earnings per share (“EPS”) amounted to $1.33 in 2006, $1.27 in 2005 and $1.07 in 2004. The $1.33 EPS in 2006 was up $0.06 per share over 2005 results for an increase of 4.7%. The $1.27 EPS in 2005 was up $0.20 per share over 2004 results for an increase of 18.7%. Our return on average equity (“ROE”) of 9.28% in 2006 is a 352 basis-point decline from our 2005 ROE of 12.80%. The decline in the ROE in 2006 was primarily attributable to the losses on the sale of securities of $1.6 million, common equity offerings of approximately $67.2 million in connection with our two acquisitions and the public offering of 1,725,000 shares of the Company’s common stock. The ROE for 2005 of 12.80% was a 24 basis-point decline from the ROE of 13.04% for 2004. This decline was caused primarily attributable to common equity offerings of approximately $58.4 million in connection with the acquisitions of SouthBank and Rivoli BanCorp.
The following table provides an analysis of the dollar and percentage changes we have experienced in our income statements, balances sheets and key ratios in recent years.
ANALYSIS OF CHANGES IN INCOME STATEMENT & KEY RATIOS
(Dollars in thousands, except per share data and number of shares)
(1) See “Reconciliation of Non-GAAP Financial Measures.”
Net Interest Income
Net interest income (the difference between the interest earned on assets and the interest paid on deposits and liabilities) is the principal source of our earnings. Our average net interest rate margin, on a tax-equivalent basis, was 4.40% in 2006, 4.46% in 2005 and 4.45% in 2004. Net interest income before tax equivalency adjustments in 2006 amounted to $79.4 million, up 58% from $50.4 million in 2005. The 2005 net interest income was up 27% from $39.6 million in 2004. The increases in 2005 and 2006 are the result of continued strong loan demand in our core markets.
The following table presents a summary of interest income, adjusted to a tax-equivalent basis, interest expense and the resulting average net interest rate margins for the past three years.
NET INTEREST INCOME
(Dollars in thousands)
(1) Reflects taxable equivalent adjustments using the statutory federal income tax rate of 35% in adjusting interest on tax-exempt securities to a fully taxable basis.
(2) Average Earning Assets used in ratios as follows (in thousands): 2006 - $1,815,505; 2005 - $1,137,202 and 2004 - $896,582.
2006 compared to 2005:
Net Interest Income. Net interest income on a tax-equivalent basis for the year ended December 31, 2006 increased $29.1 million to $79.8 million from $50.7 million for the year ended December 31, 2005. The increase in net interest income was attributable to an increase of $70.0 million, or 89%, in interest income while interest expense only increased $40.8 million during 2006. The net interest rate spread (the yield on earning assets minus the cost of interest-bearing liabilities) decreased 20 basis points from 4.07% for the year ended December 31, 2005 to 3.87% for the year ended December 31, 2006, while the net interest margin (net interest income on a tax-equivalent basis divided by average earning assets) decreased from 4.46% to 4.40% during the same period.
The decrease in the net interest rate spread in 2006 was primarily reflective of a 148 basis-point increase in the average cost of interest-bearing liabilities, while the yield on earning assets increased only 128 basis points. We experienced significant increases in the costs of all deposits except for savings accounts as our average cost of interest-bearing deposits increased to 4.18% in 2006 from 2.69% in 2005. Meanwhile, the loan portfolio yield increased 135 basis points as higher-yielding fixed rate loans repriced at higher rates and variable rate loans with interest rate floors began to participate fully in rate increases during 2006.
Interest Income. Interest income on a tax-equivalent basis was $148.5 million for the year ended December 31, 2006, an increase of $70 million from $78.5 million for the year ended December 31, 2005. Interest income on loans and investment securities increased $65.5 million and $3.3 million, respectively, for the year ended December 31, 2006 compared to the year ended December 31, 2005.
The increase in interest income on loans for the year ended December 31, 2006 compared to the year ended December 31, 2005 was primarily attributable to an increase in average balance of $602.0 million, of which
$189.9 million was attributable to the inclusion of loan balances acquired from Neighbors Bancshares, Inc. and Homestead Bank. Excluding the acquired loan balances, the $412.1 million increase in average loans is attributable to the continued strong loan growth in our core markets.
Interest income on investment securities increased $3.3 million as a result of an increase of $58.2 million in average balance for the year ended December 31, 2006 compared to the year ended December 31, 2005, and an increase of 49 basis points in the average yield on these securities during the same period. Excluding investment securities acquired from Neighbors Bancshares, Inc. and Homestead Bank, the average balance of investment securities increased $39.1 million.
The primary reason for the increase in the average balance of investment securities of $39.1 million was to maintain the level of investment securities as a percent of total assets, so that on-balance sheet liquidity would keep pace with loan growth. At December 31, 2006, investment securities equaled 9.2% of assets, as compared to 9.1% at December 31, 2005.
Overall, the yield on interest-earning assets increased 128 basis points from 6.90% during the year ended December 31, 2005 to 8.18% for the year ended December 31, 2006.
Interest Expense. Interest expense increased $40.8 million, to $68.6 million, for the year ended December 31, 2006, from $27.8 million for the year ended December 31, 2005. The increase in interest expense resulted primarily from an increase of $37.1 million in interest expense on deposits. Excluding the expense resulting from our acquisitions, interest expense increased $31.0 million and interest expense on deposits increased $27.7 million. The average cost of interest-bearing deposits, the largest component of interest expense, increased by 149 basis points and the average balance increased by $571.4 million. Of the $571.4 million increase in average balances, interest-bearing NOW accounts increased $152.4 million, money market accounts increased $46.8 million and savings accounts decreased $0.7 million. The increase in the average balance for interest-bearing NOW accounts is primarily due to the increase in the number of customers with the Premium Select Checking account, which offers a competitive interest rate and the benefits of a traditional checking account. Given the advantages and attractive interest rate offered with the Premium Select Checking account, some of our customers transferred their deposits from our traditional money market account to the Premium Select Checking account. Time deposits, the largest category of deposits, increased $372.9 million; primarily due to the increase in brokered and internet-based CD’s to fund loan growth in the Fairfield Interim Lending (Acquisition and Development) division.
The interest expense on borrowed funds in 2006 increased by $3.8 million or 92% when compared to 2005. This increase is related to an increase of $38.8 million or 39% in the average balance of borrowed funds combined with an increase of 158 basis points to 5.69% in the average costs of borrowings. The increase in the average balance is related to an increase in advances with the Federal Home Loan Bank (“FHLB”) to meet the Company’s funding needs.
compared to 2004:
Net Interest Income. Net interest income on a tax-equivalent basis for the year ended December 31, 2005 increased $10.8 million to $50.7 million from $39.9 million for the year ended December 31, 2004. The increase in net interest income was attributable to an increase of $24.2 million, or 45%, in interest income while interest expense only increased $13.4 million during 2005. The net interest rate spread (the yield on earning assets minus the cost of interest-bearing liabilities) decreased 11 basis points from 4.18% for the year ended December 31, 2004 to 4.07% for the year ended December 31, 2005, while the net interest margin (net interest income on a tax-equivalent basis divided by average earning assets) increased one basis point from 4.45% to 4.46% during the same period.
The decrease in the net interest rate spread in 2005 was primarily reflective of a 95 basis-point increase in the average cost of interest-bearing liabilities, while the yield on earning assets increased 84 basis points. We
experienced significant increases in the costs of all deposits except for savings accounts as our average cost of interest-bearing deposits increased to 2.69% in 2005 from 1.73% in 2004. Meanwhile, the loan portfolio yield increased 91 basis points as higher-yielding fixed rate loans repriced at higher rates and variable rate loans with interest rate floors began to participate fully in rate increases during 2005.
Interest Income. Interest income on a tax-equivalent basis was $78.5 million for the year ended December 31, 2005, an increase of $24.2 million from $54.3 million for the year ended December 31, 2004. Interest income on loans and investment securities increased $23.3 million and $0.5 million, respectively, for the year ended December 31, 2005 compared to the year ended December 31, 2004.
The increase in interest income on loans for the year ended December 31, 2005 compared to the year ended December 31, 2004 was primarily attributable to an increase in average balance of $222.0 million, of which $72.8 million was attributable to the inclusion of seven months of loan balances acquired from SouthBank in May 2005. Excluding the loan balances acquired from SouthBank, the $149.2 million increase in average loans is attributable to continued strong loan growth in our core markets.
Interest income on investment securities increased $0.5 million as a result of an increase of $12.2 million in average balance for the year ended December 31, 2005 compared to the year ended December 31, 2004, and an increase of one basis point in the average yield on these securities during the same period. Excluding investment securities acquired from SouthBank, the average balance of investment securities increased $2.1 million.
The primary reason for the increase in the average balance of investment securities of $2.1 million was to maintain the level of investment securities as a percent of total assets, so that on-balance sheet liquidity would keep pace with loan growth. At December 31, 2005, investment securities equaled 9.1% of assets, as compared to 10.5% at December 31, 2004.
Overall, the yield on interest-earning assets increased 84 basis points from 6.06% during the year ended December 31, 2004 to 6.90% for the year ended December 31, 2005.
Interest Expense. Interest expense increased $13.4 million, to $27.8 million, for the year ended December 31, 2005, from $14.4 million for the year ended December 31, 2004. The increase in interest expense resulted primarily from an increase of $12.0 million in interest expense on deposits. Excluding seven months of expense resulting from our acquisition of SouthBank, interest expense increased $10.5 million and interest expense on deposits increased $9.3 million. The average cost of interest-bearing deposits, the largest component of interest expense, increased by 96 basis points and the average balance increased by $206.7 million. Of the $206.7 million increase in average balances, interest-bearing NOW accounts increased $76.9 million, money market accounts decreased $5.2 million and savings accounts increased $0.7 million. The increase in the average balance for interest-bearing NOW accounts is primarily due to the introduction of the Premium Select Checking account, which offers a competitive interest rate and the benefits of a traditional checking account. Given the advantages and attractive interest rate offered with the Premium Select Checking account, some of our customers transferred their deposits from our traditional money market account to the Premium Select Checking account. Time deposits, the largest category of deposits, increased $134.3 million; primarily due to the increase in brokered and internet-based CD’s to fund loan growth in the Fairfield Interim Lending (Acquisition and Development) division.
The interest expense on borrowed funds in 2005 increased by $1.4 million or 54% when compared to 2004. This increase was caused by an increase of $9.2 million or 10.1% in the average balance of borrowed funds combined with an increase of 117 basis points to 4.11% in the average costs of borrowings.
Interest Rates and Interest Differential
The following tables set forth our average balance sheets, interest and yield information on a tax-equivalent basis for the years ended December 31, 2006, 2005, and 2004.
AVERAGE BALANCE SHEETS, INTEREST AND YIELDS
(Tax-equivalent basis, dollars in thousands)
Notes to Table of Average Balance Sheets, Interest and Yields:
(1) Interest income includes loan fees as follows (in thousands): 2006 - $7,442; 2005 - $4,367 and 2004 - $3,287.
(2) Average loans are shown net of unearned income. Nonaccrual loans are included.
(3) Reflects taxable equivalent adjustments using the statutory income tax rate of 35% in adjusting interest on tax exempt investment securities to a fully taxable basis. The taxable equivalent adjustment included above amounts to (in thousands) $413 for 2006; $324 for 2005; and $365 for 2004.
(4) Investment securities are stated at amortized or accreted cost.
The following table provides a detailed analysis of the changes in interest income and interest expense due to changes in rate and volume for the year 2006 compared to the year 2005 and for the year 2005 compared to the year 2004.
RATE / VOLUME ANALYSIS
(In thousands)
(1) The change in interest due to both rate and volume has been allocated to the rate component.
(2) Reflects taxable equivalent adjustments using the statutory federal income tax rate of 35% in adjusting interest on tax exempt investment securities to a fully taxable basis.
Provision for Loan Losses
The provision for loan losses is a charge to current earnings taken to increase the allowance for loan losses. The general nature of lending results in periodic charge-offs of non-performing loans, in spite of our continuous loan review process, credit standards and internal controls. During 2006 and 2005, we considered the effects of various economic factors on the cash flow of some of our borrowers. We expensed $4.47 million in 2006, $2.83 million in 2005, and $2.82 million in 2004 for loan loss provisions. The increase in the provision for loan losses in 2006 was primarily due to growth in the Company’s loan portfolio and the addition of $4.1 million of loss reserves in connection with the acquisitions of Neighbors Bancshares, Inc. and Homestead Bank during the period. Our net charge-offs as a percentage of average loans outstanding were 0.15% in 2006, 0.12% in 2005, and 0.17% in 2004. The 2006 level of net charge-offs to average loans of 0.15% was low compared to the five-year average of 0.21%. Amounts of net loans charged-off during recent years are reasonable by industry standards. We incurred net charge-offs of $2.36 million in 2006, compared to $1.22 million during 2005 and $1.32 million during 2004. The increase in net charge-offs in 2006 is primarily attributable to the identification of a specifically identified loss related to one acquisition and development (A&D) relationship in Fairfield Financial’s interim lending portfolio. The allowance for loan losses on December 31, 2006 was 1.18% of outstanding net loans receivable, down from 1.27% at December 31, 2005 and 1.29% at December 31, 2004. The decrease in the percentage in 2006 is a result of the charge-offs incurred by Fairfield Financial. See “Nonperforming Assets” section on page 45 for further discussion.
Non-interest Income
2006 compared to 2005:
Non-interest income of $17.9 million in 2006 represented an increase of 8.5% or $1.4 million from $16.5 million recorded in 2005. Service charges on deposit accounts, which constitute 51% of non-interest income, are the largest component of non-interest income, generating $9.2 million for 2006, up from $7.4 million in 2005. Fees generated from our courtesy overdraft protection product accounted for $6.8 million, or 74% of service charges on deposits. The increase in fees from our courtesy overdraft product is also attributable to the significant growth in deposits during the year of $323.3 million or 25%, excluding the impact of 2006 acquisitions. The second largest component of non-interest income is mortgage banking income, which constituted 28% of non-interest income during 2006. Mortgage banking income increased $0.4 million, from $4.5 million in 2005 to $4.9 million in 2006. The increases in service charges and mortgage banking income are offset by losses of $1.6 million incurred in connection with the restructuring of the Company’s bond portfolio in December 2006.
2005 compared to 2004:
Non-interest income of $16.5 million in 2005 represented an increase of 12.2% or $1.8 million from $14.7 million recorded in 2004. Service charges on deposit accounts, which constitute 44.3% of non-interest income, are the largest component of non-interest income, generating $7.4 million for 2005, up from $6.5 million in 2004. Fees from our courtesy overdraft protection product, accounted for $5.3 million, or 72.4% of service charges on deposits. The courtesy overdraft product completed its fourth full year in 2005, but its growth was enhanced by the success of the high-performance checking program. The increase in fees from our courtesy overdraft product is also attributable to the significant growth in deposits during the year of $182.1 million or 22%, excluding the impact of the SouthBank and Rivoli BanCorp acquisitions. The second largest component of non-interest income is mortgage banking income, which constituted 27.5% of non-interest income during 2005. Mortgage banking income decreased $0.4 million from $4.9 million in 2004 to $4.5 million in 2005. The decrease in mortgage banking income is attributable to the slow down in the refinance market resulting from increasing interest rates. This decline was offset by commissions and fees generated by Fairfield Financial’s interim lending division. Commissions and fees increased 5.4% to $2.5 million over amounts reported in 2004.
Non-interest Expense
2006 compared to 2005:
Non-interest expense was $55.6 million for the year ended 2006, up 44.3% or $17.0 million, from $38.6 million in 2005. Salaries and benefits, the largest component of non-interest expense, constituting 58% of non-interest expense, increased $9.6 million to $32.4 million in 2006 from $22.8 million in 2005. Approximately $2.4 million of the increase in salaries and benefits is related to the hiring of employees in connection with the acquisitions of Neighbors Bancshares, Inc. and Homestead Bank. Also contributing to the increase is the hiring of employees in connection with the acquisition of Rivoli BanCorp on December 31, 2005. The remainder of the increase is due to normal salary and benefit increases from merit increases and the hiring of new employees.
All other operating overhead increased by $7.4 million, or 48%, during 2006. Excluding the expenses incurred by the banks acquired during the year, other operating overhead increased approximately $5.8 million or 37%. Approximately $1.4 million is attributable to increased occupancy and equipment expenses resulting from the continued growth of the bank in our core markets. The increase is also attributable to a $795,000 increase in the amortization of intangibles resulting from the 2005 acquisitions of SouthBank and Rivoli BanCorp. Furthermore, approximately $590,000 of the increase is the result of increased audit and other professional fees. The remaining increase of $3.0 million is related to increases in various service-related expenses including appraisal fees and directors’ fees.
2005 compared to 2004:
Non-interest expense was $38.5 million for the year ended 2005, up 19.9% or $6.4 million, from $32.1 million in 2004. Salaries and benefits, the largest component of non-interest expense, constituting 59.2% of non-interest expense, increased $4.2 million to $22.8 million in 2005 from $18.6 million in 2004. Approximately $1.1 million of the increase in salaries and benefits is related to the hiring of approximately twenty employees in connection with the acquisition of SouthBank. The remainder of the increase is due to normal salary and benefit increases from merit increases and the hiring of new employees.
All other operating overhead increased by $2.2 million or 16.6% during 2005. Excluding SouthBank’s operating results for the seven months ended December 31, 2005, other operating overhead increased approximately $1,402,000 or 10.3%. The primary increases were due to the fees associated with and expenses incurred by the Company in connection with the acquisitions of SouthBank and Rivoli BanCorp as well as increases in directors’ fees and audit and accounting fees primarily attributable to compliance with Section 404 of the Sarbanes-Oxley Act of 2002.
Income Tax Expense
Our consolidated federal and state income tax expense increased to $13.9 million in 2006, up from $9.3 million in 2005 and $6.9 million in 2004. The effective tax rate was 37.2%, 36.5% and 36.0% in 2006, 2005 and 2004, respectively. Our effective tax rate has historically been at or just below the maximum corporate federal and state income tax rates due to the relatively small percentage of tax-free investments carried on the balance sheet. See Note 9 to our Consolidated Financial Statements for a detailed analysis of income taxes.
Quarterly Results of Operations
The following table provides income statement recaps and earnings per share data for each of the four quarters for the years ended December 31, 2006 and 2005.
QUARTERLY RESULTS OF OPERATIONS
(Dollars in thousands, except per share data)
Distribution of Assets, Liabilities & Shareholders’ Equity
The following table presents condensed average balance sheets for the periods indicated, and the percentages of each of these categories to total average assets for each period.
AVERAGE BALANCE SHEETS
(Dollars in thousands)
As of December 31, 2006, total assets were $2.50 billion, an increase of $831.7 million, or 50% over 2005. Total loans and loans held for sale increased by $632.3 million, or 50%, in 2006. The increase in loans was the primary driver of asset growth during 2006. Excluding the acquisitions of Neighbors Bancshares, Inc. and Homestead Bank, total assets increased $364.9 million or 22% and loans increased $280.3 million or 22%. Excluding our acquisitions, to fund our loan and asset growth, we increased deposits by $323.3 million and shareholders’ equity by $47.5 million.
As of December 31, 2005, total assets were $1.66 billion, an increase of $598.9 million, or 56% over 2004. Total loans and loans held for sale increased by $424.4 million, or 50%, in 2005. The increase in loans was the
primary driver of asset growth during 2005. Excluding the acquisitions of SouthBank and Rivoli BanCorp, total assets increased $205.1 million or 19.3% and loans increased $151.2 million or 17.7%. Excluding our acquisitions, to fund our loan and asset growth, we increased deposits by $182.1 million and shareholders’ equity by $14.2 million.
Loan Portfolio
Our loan portfolio constitutes our largest interest-earning asset. To analyze prospective loans, management reviews our credit quality and interest rate pricing guidelines to determine whether to extend a loan and the appropriate rate of interest for each loan. At December 31, 2006 and 2005, loans receivable, net of unearned income, of $1.90 billion and $1.27 billion, respectively, amounted to 76.2% and 76.5% of total assets, and 96.5% and 98.5% of deposits. Loans, including loans held for sale amounted to 89.0% of all funding sources from interest-bearing liabilities at December 31, 2006 and 87.4% at December 31, 2005. Our loan portfolio grew by 49% from December 31, 2005 to December 31, 2006. Excluding the acquisitions of Neighbors Bancshares, Inc. and Homestead Bank, our loan portfolio grew organically by 22% during 2006. Loan yields were 8.62% for 2006, compared to 7.27% for 2005 and 6.36% for 2004. Our allowance for loan losses as a percentage of loans receivable amounted to 1.18% at December 31, 2006, compared to 1.27% and 1.29% at December 31, 2005 and 2004, respectively.
The largest components of our loan portfolio are the real estate construction loans and the other mortgages secured by nonfarm, nonresidential properties. Real estate construction and land development loans, which constituted 51.4% of the loans outstanding at December 31, 2006, are loans secured by real estate made to finance land development and residential and commercial construction.
The following table presents the amount of loans outstanding by category, both in dollars and in percentages of the total portfolio, at the end of each of the past five years.
LOANS BY TYPE
(In Thousands)
Lending Limits
When the amount of a loan or loans to a single borrower or relationship exceeds an individual officer’s lending authority, the lending decision must be approved by a more senior officer with the requisite loan authority, or the lending decision will be made by either the officers’ or directors’ loan committee.
Lending limits vary based on the type of loan and nature of the borrower. In general, however, we are able to loan to any one borrower a maximum amount equal to either 15% of total risk-based capital, or 25% of total risk-based capital if the amount that exceeds 15% is fully secured. As of December 31, 2006, our legal lending limit was approximately $32.2 million (unsecured) plus an additional $21.5 million (secured) for a total of approximately $53.7 million, for loans that meet federal and/or state collateral guidelines. Regardless of the legal lending limit, our internal guidelines limit the amount available to be loaned to any one borrowing relationship. We adjust the maximum amount available to any one borrower or relationship in accordance with an assigned
credit grade. Every loan of material size is assigned a credit grade either by our credit administration department or by the appropriate approval committee, with grades denoting more credit risk receiving a lower in-house maximum. As a result, our exposure to loans with more risk should be limited by the credit grades assigned to those loans. These credit grades are reviewed regularly by bank management, regulatory authorities and our external loan review vendor for appropriateness and applicability.
Underwriting
Collectively, our chief operating officer and our subsidiary bank presidents, who also act as our primary local lending officers, have over 150 years of lending experience. This experienced loan team has developed stringent credit underwriting and monitoring guidelines/policies while simultaneously delivering strong growth in our loan portfolio. We stress individual accountability to our loan officers, basing a portion of their compensation on the performance of the loans they approve. We employ a prudent credit approval process and have developed a comprehensive risk-management system for monitoring and measuring the adequacy of our allowance for loan losses and anticipating net charge-offs.
Nonperforming Assets
Nonperforming assets consist of nonaccrual loans, loans restructured due to debtors’ financial difficulties, loans past due 90 days or more as to interest or principal and still accruing, and other real estate owned, which is real estate acquired through foreclosure and repossession. Nonaccrual loans are those loans on which recognition of interest income has been discontinued. Restructured loans generally allow for an extension of the original repayment period or a reduction or deferral of interest or principal because of deterioration in the financial position of the borrower. When management believes there is sufficient doubt as to the collectibility of principal or interest on any loan, or generally when loans are 60 days or more past due, the accrual of the applicable interest is discontinued and the loan is designated as nonaccrual, unless the loan is well secured and in the process of collection. Interest payments received on nonaccrual loans are either applied against principal or reported as income, according to management’s judgment as to the collectibility of principal. Loans are returned to an accrual status when factors indicated doubtful collectibility on a timely basis no longer exist. Other real estate owned is initially recorded at the lower of cost or estimated market value at the date of acquisition. A provision for estimated losses is recorded when a subsequent decline in value occurs.
Nonperforming assets at December 31, 2006 amounted to approximately $37.2 million, or 1.94% of total loans and other real estate. This compares to approximately $9.4 million in nonperforming assets or 0.74% of total loans and other real estate at December 31, 2005.
The increase in nonperforming assets is primarily attributable to three A&D credit relationships totaling approximately $20 million that were placed on nonaccrual status during the fourth quarter of 2006. The change in status of these loans is primarily related to the borrowers’ illiquidity, not from problems or issues with the specific real estate projects involved. Management believes that the increase in nonperforming assets during 2006 is not indicative of a trend. Presently, the vast majority of the Company’s credits in this category continue to perform; however, management cannot predict the impact of future economic changes on our nonperforming assets. Further, the nonperforming assets represent less than 4% of the Company’s overall A&D portfolio and less than 2% of the Company’s total loan portfolio.
The following table sets forth our nonaccrual and past-due loans, along with other real estate owned at the end of the past five years, and the amount of interest foregone in 2006 on our nonperforming assets. There were no restructured loans during the periods presented.
NONPERFORMING ASSETS
(Dollars in thousands)
At December 31, 2006 and December 31, 2005 there were no other loans classified for regulatory purposes as loss or doubtful that are not included in the table above, but there were other loans classified for regulatory purposes as substandard or special mention that are not included in the table above. However, management is aware of no such substandard or special mention loans not included above, which (1) represent or result from trends or uncertainties that management reasonably expects will materially impact future operating results, liquidity, or capital resources, or (2) represent material credits about which any information causes management to have serious doubts as to the ability of the borrowers to comply with the loan repayment terms. We have no loans in our portfolio to borrowers in foreign countries.
Loan concentrations exist when large amounts of money are loaned to multiple borrowers who would be similarly impacted by economic or other conditions. The loan portfolio is concentrated in various commercial, real estate and consumer loans to individuals and entities located in Middle Georgia, and to a lesser extent northern metropolitan Atlanta and Glynn County and in other Georgia markets where Fairfield Financial operates loan offices. As of December 31, 2006 and 2005, approximately 89.8% and 87.7%, respectively, of our loan portfolio was secured by real estate. These loans are well collateralized and, in management’s opinion, do not pose an unacceptable level of credit risk. The Company does make speculative loans to borrowers in that the collateral property has not been pre-sold or pre-leased. While these loans are inherently riskier due to the fact that the borrower may not be able to sell or lease the property as intended, the Company only makes these loans to established customers with a good history of prior developments. At December 31, 2006, the Company had outstanding speculative loans of approximately $510.5 million.
The largest components of our loan portfolio are the construction and land development loans and mortgage loans secured by nonfarm, nonresidential properties. Real estate construction and land development loans, which are 51.4% of the loan portfolio, are made to finance land development and residential and commercial construction. Mortgage loans secured by nonfarm, nonresidential properties, which are 24.1% of the portfolio, are loans made to finance the purchase or development of commercial properties such as hotels, motels, shopping centers, timber holdings, office buildings and convenience stores. Of the total, the largest collateral types are retail facilities (29.5%) and office facilities (20.8%).
We have no other interest-bearing assets that would be required to be disclosed as nonperforming assets if they were loans.
Summary of Loan Loss Experience
The following table summarizes loans charged-off, recoveries of loans previously charged-off and additions to the allowance for loan losses that have been charged to operating expense (i.e., provisions for loan losses) for the periods indicated. We have no lease financing or foreign loans.
ANALYSIS OF THE ALLOWANCE FOR LOAN LOSSES
(Dollars in thousands)
The allowance for loan losses as a percentage of net loans, excluding loans held for sale, decreased to 1.18% at December 31, 2006 from 1.27% at December 31, 2005. The decrease in the percentage is primarily attributable to the substantial loan growth during 2006 and increased charge-offs discussed in the preceding “Nonperforming Assets” section. Excluding our acquisitions, loans increased $280.6 million or 22% in 2006 from the prior year.
The provision for loan losses represents management’s determination of the amount necessary to be transferred to the allowance for loan losses to maintain a level that it considers adequate in relation to the risk of future losses inherent in the loan portfolio. It is the policy of our subsidiary Banks to provide for exposure to losses principally through an ongoing loan review process. This review process is undertaken to ascertain any probable losses that must be charged-off and to assess the risk characteristics of individually significant loans and of the portfolio in the aggregate. This review takes into consideration the judgments of the responsible lending
officers and the loan committees of our subsidiary Banks’ boards of directors, and also those of the regulatory agencies that review the loans as part of their regular examination process. During routine examinations of the Banks, the primary banking regulators may, from time to time, require additions to the Banks’ provisions for loan losses and allowances for loan losses if the regulators’ credit evaluations differ from those of management.
In addition to ongoing internal loan reviews and risk assessment, management uses other factors to judge the adequacy of the allowance, including current economic conditions, loan loss experience, regulatory guidelines and current levels of non-performing loans. Management believes that the balances of $22.3 million and $16.1 million in the allowance for loan losses at December 31, 2006 and 2005, respectively, were adequate to absorb known risks in the loan portfolio at those dates. No assurance can be given, however, that adverse economic conditions or other circumstances will not result in increased losses in our loan portfolio or that our allowance for loan losses will be sufficient to absorb such unexpected losses.
In accordance with SFAS No. 114, Accounting by Creditors for Impairment of a Loan and SFAS No. 118, Accounting by Creditors for Impairment of a Loan-Income Recognition and Disclosures, management, considering current information and events regarding the borrowers’ ability to repay their obligations, considers a loan to be impaired when the ultimate collectibility of all amounts due, according to the contractual terms of the loan agreement, is in doubt. When a loan becomes impaired, management calculates the impairment based on the present value of expected future cash flows discounted at the loan’s effective interest rate. If the loan is collateral dependent, the fair value of the collateral is used to measure the amount of impairment. The amount of impairment and any subsequent changes are recorded, through a charge to earnings, as an adjustment to the allowance for loan losses. When management considers a loan, or a portion thereof, as uncollectible, it is charged against the allowance for loan losses.
An allocation of the allowance for loan losses has been made to provide for the possibility of incurred losses within the various loan categories. The allocation is based primarily on previous charge-off experience adjusted for risk characteristic changes among each category. Additional allowance amounts are allocated by evaluating the loss potential of individual loans that management has considered impaired. The allowance for loan loss allocation is based on subjective judgment and estimates, and therefore is not necessarily indicative of the specific amounts or loan categories in which charge-offs may ultimately occur.
The following table shows a five-year comparison of the allocation of the allowance for loan losses based on loan categories. The loan balance in each category is expressed as a percentage of the total loans at the end of the respective periods.
ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES
(Dollars in thousands)
Investment Portfolio
The investment securities portfolio is another major interest-earning asset and consists of debt and equity securities categorized as either “Available for Sale” or “Held to Maturity.” Given our strong loan demand, the investment portfolio is viewed primarily as a source of liquidity, with yield as a secondary consideration. Because the investment portfolio is primarily for liquidity purposes, the investment portfolio has a relatively short effective duration of 2.55 years. The investment portfolio also serves to balance interest rate risk and credit risk related to the loan portfolio.
As of December 31, 2006, our portfolio of bonds and equity investments amounted to $229.9 million, or 9.2% of total assets, compared to $151.0 million, or 9.1% of total assets at December 31, 2005. Excluding securities acquired from Neighbors Bancshares, Inc. and Homestead Bank, the Company’s total investment portfolio was $189.0 million at December 31, 2006.
The average tax-equivalent yield on the portfolio was 4.74% for the year 2006 versus 4.25% in 2005 and 4.24% in 2004. During 2006, net (losses) gains on the sale of securities were $(1.6 million), compared to losses and gains of less than $0.1 million in 2005 and 2004, respectively. In December 2006, the Company restructured its bond portfolio and sold a total of approximately $54 million in bonds with lower yielding rates at a loss of approximately $1.3 million to reinvest in higher-yielding bonds.
At December 31, 2006, the major portfolio components, based on amortized or accreted cost, included 57.7% in mortgage-backed securities issued by U.S. government agencies; 29.0% in other bonds of U.S. government agencies; 9.2% in state, county and municipal bonds; 3.3% in restricted stocks; and 0.8% in other securities. As of December 31, 2006, the investment portfolio had gross unrealized gains of $0.4 million and gross unrealized losses of $1.4 million for a net unrealized loss of $1.0 million. As of December 31, 2005, the portfolio had a net unrealized loss of $2.4 million. In accordance with SFAS No. 115, shareholders’ equity included net unrealized losses of $0.6 million for December 31, 2006 and net unrealized losses of $1.6 million for December 31, 2005 recorded on the Available for Sale portfolio, net of deferred tax effects. No trading account has been established by us and none is anticipated.
The following table summarizes the Available for Sale and Held to Maturity investment securities portfolios as of December 31, 2006, 2005 and 2004. Available for Sale securities are shown at fair value, while Held to Maturity securities are shown at amortized or accreted cost. Unrealized gains and losses on securities Available for Sale are excluded from earnings and are reported, net of deferred taxes, in accumulated other comprehensive income, a component of shareholders’ equity.
INVESTMENT SECURITIES
(Dollars in thousands)
The following table illustrates the contractual maturities and weighted average yields of investment securities Available for Sale held at December 31, 2006. Expected maturities will differ from contractual maturities because certain issuers have the right to call or prepay obligations with or without call or prepayment penalties. No prepayment assumptions have been estimated in the table. The weighted average yields are calculated on the basis of the amortized cost and effective yields of each security weighted for the scheduled maturity of each security. The yield on state, county and municipal securities is computed on a tax-equivalent basis using a statutory federal income tax rate of 35%. At December 31, 2006, the Company had $1.24 million carrying value ($1.21 million of fair value) of State, County and Municipal investment securities classified as held to maturity, with an average yield of 5.47% with all securities maturing in either the within one year or the one to five year time periods.
MATURITIES OF INVESTMENT SECURITIES AND AVERAGE YIELDS
(Dollars in thousands)
As of December 31, 2006 and 2005, we had no holdings of securities of a single issuer in which the aggregate book value and aggregate market value of the securities exceeded 10% of shareholders’ equity, excluding U.S. Government and agency issues.
Deposits
Deposits are our primary liability and funding source. Total deposits as of December 31, 2006 were $2.0 billion, an increase of 53% from $1.3 billion at December 31, 2005. Average deposits in 2006 were $1.6 billion, an increase of 62% from $1.0 billion during 2005. Excluding the deposits acquired in our acquisitions of Neighbors Bancshares, Inc. and Homestead Bank, deposits at December 31, 2006 increased $323.3 million or 25% over the balances at December 31, 2005. The average cost of deposits, considering non-interest checking accounts, was 3.75% during 2006, up from 2.37% during 2005 and 1.50% for 2004. We seek to set competitive deposit rates in our local markets to retain and grow our market share of deposits in our market area as our principal funding source. On an average basis for the year 2006, 10.3% of our deposits were held in non-interest-bearing checking accounts, 28.2% were in lower yielding interest-bearing transaction, money market and savings accounts, and 61.5% were in time certificates with higher yields. Comparable average deposit mix percentages during 2005 were 12.0%, 25.8% and 62.2%, respectively. We hold no deposit funds from foreign depositors.
To help generate additional local, low-cost consumer core deposits, we continued a comprehensive marketing program during 2006. The program has been, in our view, extremely successful. For the year ended December 31, 2006, we opened 3,062 new transaction accounts primarily through the efforts of our High Performance Checking campaign.
The following table reflects average balances of deposit categories for the years 2006, 2005 and 2004.
AVERAGE DEPOSITS
(Dollars in thousands)
The following table outlines the maturities of certificates of deposit of $100,000 or more as of December 31, 2006, 2005 and 2004. All of our time deposits as of December 31, 2006 are certificates of deposit.
MATURITY DISTRIBUTION OF CERTIFICATES OF DEPOSIT OF $100,000 OR MORE
(In Thousands)
Borrowed Funds
Our interest-bearing sources of borrowed funds at December 31, 2006 totaled $175.6 million. The major component was $83.5 million in various advances from the FHLB. We have borrowed from the FHLB under two separate programs. The first program is a Blanket Agreement for Advances and Security Agreement with the FHLB, under which our Banks have pledged residential first-mortgage loans, commercial real estate loans and investment securities of $401.1 million as collateral to secure available lines of credit. At December 31, 2006, our lendable collateral value, which represents approximately 34.2% of eligible collateral, was $137.1 million, $53.7 million of which was available. These advances have maturities in varying amounts through March 2011 and interest rates ranging from 3.19% to 5.92%. The second FHLB program allowed for advances to our Banks under a warehouse line secured by our loans held for sale. This warehouse line matured on January 24, 2005. Total outstanding advances from the FHLB averaged $67.1 million during 2006, with an average interest cost of 4.84%. Of the $83.5 million in FHLB advances outstanding at December 31, 2006, $13.5 million, or 16.0%, mature during 2007. Another $60.0 million, or 72%, mature in 2008, and another $5.0 million or 6.0% mature in 2010. The remaining $5.0 million, or 6.0%, mature after four years. In connection with our acquisitions of Neighbors Bancshares, Inc. and Homestead Bank, we assumed $25.0 million in FHLB advances that mature in 2007. In 2005, FHLB advances averaged $58.6 million with an average interest cost of 3.37%.
We have a revolving line of credit with The Bankers Bank in Atlanta, Georgia totaling $17 million. The line is secured with the common stock of Security Bank of Bibb County (and indirectly the stock of Fairfield Financial as its subsidiary), Security Bank of Houston County and Security Bank of Jones County as collateral, and carries a floating interest rate of prime minus 100 basis points on $14 million and prime minus 50 basis points on $3 million. We use the revolving line of credit primarily to provide capital injections as necessary to our subsidiary Banks. At December 31, 2006 and 2005 the outstanding balance on the revolving line of credit was zero. The Company did not borrow under the line of credit during 2006. Per an agreement with the Federal Reserve Bank of Atlanta, we may not draw more than $4 million on the line of credit without prior approval. For 2005, the average balance was $5.4 million at a cost of 6.80%.
As a result of our acquisition of Rivoli BanCorp in December 2005, we assumed a line of credit for $2 million with a correspondent bank. The line of credit matures on March 6, 2007 and interest is payable quarterly based on the prime rate. There was no outstanding balance at December 31, 2006.
During the fourth quarter of 2002, we issued $18.0 million in trust preferred securities. To support the trust preferred securities issued by the trust, we issued a like amount of junior subordinated debentures to the trust, which the trust purchased from us using proceeds from its sale of the trust preferred securities. The trust preferred securities and related junior subordinated debentures pay interest at a floating annual rate, reset quarterly, equal to the three-month LIBOR rate plus 3.25%, which rate equaled 8.62% at December 31, 2006. We used the proceeds from the offering to retire holding company debt and to fund our acquisition of Security Bank of Jones County.
In December 2005, we issued an additional $19.0 million in trust preferred securities. To support the trust preferred securities issued by the trust, we issued a like amount of junior subordinated debentures to the trust, which the trust purchased from us using proceeds from its sale of the trust preferred securities. We used the proceeds from the offering to pay off our line of credit with The Bankers Bank and to fund the acquisition of the Rivoli BanCorp. The trust preferred securities issued by the trust in 2005, and the junior subordinated debentures we issued to the trust in connection with that offering, bear a fixed rate of interest equal to 6.46% annually for the first five years and a floating rate of interest, reset quarterly, equal to the three-month LIBOR rate plus 1.40% annually thereafter. In each case, the trust preferred securities and related junior subordinated debentures issued by us have a maturity of 30 years and are redeemable after five years, subject to certain conditions and limitations.
In connection with our acquisition of Rivoli BanCorp, we assumed $3.0 million in junior subordinated debentures it had issued to a trust subsidiary in connection with an issuance of trust preferred securities. Rivoli
BanCorp’s trust subsidiary issued trust preferred securities in 2002 through a pool sponsored by Wells Fargo Bank. The Rivoli BanCorp trust preferred securities and related junior subordinated debentures have a 30-year maturity and are redeemable after five years, subject to certain conditions and limitations. The Rivoli BanCorp trust preferred securities and related junior subordinated debentures pay interest at a floating annual rate, reset quarterly, equal to the three-month LIBOR rate plus 3.45%, which rate equaled 8.82% at December 31, 2006.
The following table outlines our various sources of borrowed funds during the years 2006, 2005 and 2004, the amounts outstanding at year end, at the maximum point for each component during the three years and on average for each year, and the average interest rate that we paid for each borrowing source. The maximum month-end balance represents the high indebtedness for each component of borrowed funds at any time during each of the calendar years shown.
BORROWED FUNDS
(Dollars in thousands)
Capital Resources and Dividends
We place an emphasis on maintaining an adequate capital base to support our activities in a safe manner while at the same time maximizing shareholder returns. We continue to exceed all minimum regulatory capital requirements as shown in the table below. Our equity capital of $306.4 million at December 31, 2006 amounts to 12.3% of total assets, compared to 10.8% at December 31, 2005, and 10.0% at December 31, 2004. On average, our equity capital was 12.4% of assets during 2006, compared to 10.2% for 2005 and 9.7% for 2004. The increase in the capital ratios in 2006 was primarily due to our issuance of approximately $67.2 million in new
equity capital in connection with the acquisitions of Neighbors Bancshares, Inc. and Homestead Bank. In addition, in May 2006, the Company sold 1,725,000 shares of its common stock in a public offering that generated $35.9 million in additional capital.
Our market capitalization increased from $335.1 million at the end of 2005 to $437.4 million at the end of 2006, an increase of 31%. The increase in market capitalization was primarily due to the issuance of common stock discussed above.
Principal uses of our capital base in recent years have been:
•
sustaining the capital adequacy of our subsidiaries as they continue to grow at a steady pace;
•
expanding our presence in Middle Georgia with more physical locations and improved delivery systems;
•
expanding into contiguous Houston County through our 1998 acquisition of Crossroads Bank of Georgia (Security Bank of Houston County) and developing a mortgage loan division;
•
acquiring Fairfield Financial to broaden and expand our mortgage services markets with new management talent and more physical locations throughout Georgia;
•
expanding into Jones County through our 2003 acquisition of the Bank of Gray (Security Bank of Jones County);
•
enhancing corporate infrastructure systems to support our multi-bank environment;
•
opening de novo branches in Glynn County in 2003 and 2005;
•
expanding our presence in Middle Georgia through our 2005 acquisition of Rivoli BanCorp.
•
expanding into northern metropolitan Atlanta through our 2005 and 2006 acquisitions of SouthBank (Security Bank of North Metro), Neighbors Bancshares, Inc. (Security Bank of North Fulton) and Homestead Bank (Security Bank of Gwinnett County);
Potential uses of our capital base could include future acquisitions and de novo branches.
Current regulatory standards require bank holding companies to maintain a minimum risk-based capital ratio of qualifying total capital to risk weighted assets of 8.0%, with at least 4.0% of the capital consisting of Tier 1 capital, and a Tier 1 leverage ratio of at least 4.0%. Additionally, the regulatory agencies define a well-capitalized bank as one that has a Tier 1 leverage ratio of at least 5.0%, a Tier 1 capital ratio of at least 6.0%, and a total risk-based capital ratio of at least 10%. As of December 31, 2006, we had a Tier 1 leverage ratio of 9.70%, a Tier 1 capital ratio of 10.51%, and a total risk-based capital ratio of 11.59%, and were therefore “well-capitalized” according to all regulatory guidelines. Maintaining these capital levels is crucial to our growth strategy, because the Federal Reserve Bank of Atlanta has indicated that it will not approve any future acquisition whereby the resulting combined company is not “well-capitalized” at the holding company level.
The following table demonstrates our capital ratio calculations as of December 31, 2006 and 2005.
CAPITAL RATIOS
(Dollars in thousands)
We declared and paid cash dividends of $5,264,962, or $0.30 per share of common stock, during 2006, up from $3,271,320, or $0.26 per share, during 2005 and $2,483,659, or $0.22 per share, in 2004. The ratios of cash dividends paid to net income for these years were 22.1%, 19.9% and 20.0%, respectively. Since the commencement of cash dividend payments in 1992, our board of directors has consistently declared and paid dividends on a quarterly basis.
As of December 31, 2006, $40 million of junior subordinated debentures related to trust preferred securities was classified as Tier 1 capital under Federal Reserve Board guidelines. For regulatory purposes, the trust preferred securities represent a minority investment in a consolidated subsidiary, which is currently included in Tier 1 capital, so long as it does not exceed 25% of total Tier 1 capital. Under Financial Accounting Standards Board (FASB) Interpretation No. 46 (FIN 46) and Revised Amendment to FIN 46, Consolidation of Variable Interest Entities, however, the trust subsidiary must be deconsolidated for accounting purposes. The Federal Reserve recently adopted amendments to its capital adequacy rules that explicitly deduct goodwill and intangibles from equity in determining the amount of trust preferred securities and other “restricted core capital elements” that can be included in Tier 1 Capital.
Liquidity
Primarily through the actions of our subsidiary Banks, we engage in liquidity management to ensure adequate cash flow for deposit withdrawals, credit commitments and repayments of borrowed funds. Liquidity needs are met through loan repayments, net interest and fee income and the sale or maturity of existing assets. In addition, liquidity is continuously provided through the acquisition of new deposits, the renewal of maturing deposits and external borrowings. Management monitors deposit flow and evaluates alternate pricing structures to retain and grow deposits as needed. To the extent needed to fund loan demand, traditional local deposit
funding sources are supplemented by the use of FHLB borrowings, brokered deposits and other wholesale deposit sources outside our immediate market area, including an Internet-based national CD service. Management has found that most non-relationship oriented retail CDs are interchangeable with wholesale funding sources such as brokered deposits and national market CDs and alternates between these sources depending on the relative cost.
Our Asset/Liability Management Committee meets weekly to discuss liquidity-related issues such as loan pipelines, deposit pricing and upcoming deposit maturities, among others. Through various asset/liability management strategies, we maintain a balance among goals of liquidity, safety and earnings potential. Our subsidiary Banks monitor internal policies that are consistent with regulatory liquidity guidelines.
The investment portfolio provides a ready means to raise cash if liquidity needs arise. As of December 31, 2006, we held $221.2 million in bonds (excluding restricted stock) at current market value in our Available for Sale portfolio. We purchase only marketable investment grade bonds. Although a portion of our bond portfolio is encumbered as pledges to secure various public funds deposits, repurchase agreements and for other purposes, management can restructure and free up investment securities for sale if required to meet liquidity needs. At December 31, 2006, approximately $115.5 million, or 52%, of our Available for Sale investment portfolio was pledged to secure deposits, repurchase agreements and for other related purposes.
Management continues to emphasize programs to generate local core deposits as our primary funding source. The stability of our core deposit base is an important factor in our liquidity position. A heavy percentage of the deposit base is comprised of accounts of individuals and small businesses with comprehensive banking relationships and limited volatility.
At December 31, 2006 and 2005, our subsidiary Banks had $748.2 million and $393.9 million, respectively, in certificates of deposit of $100,000 or more. These larger deposits represented 42% and 35% of respective total interest-bearing deposits. Management seeks to monitor and control the use of these larger certificates, which tend to be more volatile in nature, to ensure an adequate supply of funds as needed. Relative interest costs to attract local core relationships are compared to market rates of interest on various external deposit sources to help minimize our overall cost of funds.
Our local market deposit sources have not been sufficient to fund the Company’s strong loan growth trends over the past five years. As a result, our Banks supplemented deposit sources with brokered deposits and Internet-based certificates of deposit. As of December 31, 2006 the Banks reported $410.1 million, or 21% of total deposits, in brokered certificates of deposit attracted by external third parties with a weighted average rate of 5.29%. Additionally, the Banks use external wholesale or Internet services to obtain out of market certificates of deposits at competitive interest rates as needed. As of December 31, 2006, the Banks reported $70.6 million in wholesale CDs, representing 3.6% of total deposits and carrying a weighted average rate of 5.14% at year end.
To plan for contingent sources of funding not satisfied by both local and out of market deposit balances, we have established multiple borrowing sources to augment our funds management. At the holding company level, we have an unsecured line of credit, and borrowing capacity also exists through the membership of our subsidiary Banks in the FHLB program. At December 31, 2006 we had, at the holding company level, a $17.0 million revolving line of credit with The Bankers Bank, with zero outstanding at year end. Per an agreement with the Federal Reserve Bank of Atlanta, the Company will not borrow more than $4.0 million under the line of credit with the Bankers Bank without prior approval. This line of credit is secured by the common stock of three of our subsidiary Banks and indirectly, the stock of Fairfield Financial. Based on the collateral value of assets pledged to the FHLB at December 31, 2006 under our two programs for advances, our subsidiary Banks had total borrowing capacity of up to $137.1 million, of which $83.5 million was drawn and outstanding at year end. Our subsidiary Banks have also established overnight borrowing lines for federal funds purchased through various correspondent banks that collectively amounted to $155 million in capacity at December 31, 2006. Approximately $25.0 million of our federal funds lines were in use at year end. Management believes that the various funding sources discussed above are adequate to meet our liquidity needs in the future without any material adverse impact on operating results.
Interest Rate Risk Management
We have successfully managed the level of our net interest margin since 2001, despite the pressure on our net interest margin from a low interest rate environment that has evolved into a moderate rate environment with an inverted yield curve. Our net interest margin was 4.40% in 2006, 4.46% in 2005 and 4.45% in 2004. As noted above, we have been successful in generating low cost transaction accounts, as well as selectively alternating between retail CDs, borrowed funds and Internet/brokered CDs to generate the lowest cost funding sources available.
To help us manage fluctuations in our net interest income, we use simulation modeling to estimate the impact on net interest income of both the current level of market interest rates and for changes to the current level of market interest rates. We measure the projected changes in market interest rates in terms of rate “shifts” of plus or minus 100, 200 and 300 basis points over the current levels of market interest rates. We assume rate shifts occur ratably over a 12-month measurement horizon. We then use a new set of market interest rates to derive pricing for maturing or repricing assets and liabilities. We base projected pricing for maturing and repricing assets and liabilities upon market interest rates and actual pricing experience over the period immediately preceding the projection period.
Using the outlook for market interest rates at December 31, 2006 and using actual pricing experience immediately preceding the projection, our simulation model projects a net interest margin of 4.3% for the twelve-month period ending December 31, 2007. This compares to a net interest margin of 4.4% for the year ended December 31, 2006. The net interest margin is projected to be 4.3%, 4.2% and 4.2% for a 100, 200 and 300 basis-point fall in rates, respectively. Assuming a 100 basis-point rise in rates over year end market levels, the net interest margin is projected to be 4.4% for the 12-month horizon. The net interest margin is projected to be 4.5% and 4.6% for a 200 and 300 basis-point rise in rates, respectively, over the same measurement period. Our interest rate risk profile shows a fairly balanced position for both rising and falling rates, with our balance sheet as of December 31, 2006 being slightly asset-sensitive. The consensus Blue Chip Economic Forecast at December 31, 2006 predicts the yield curve will no longer be inverted in the second half of 2007, and will remain flat through the first half of 2008. Accordingly, we are closely monitoring the estimated effects of these forecasted rates.
We also use a cumulative gap analysis model that seeks to measure the repricing differentials, or gap, between rate-sensitive assets and liabilities over various time horizons. The following table reflects the gap positions of our consolidated balance sheets as of December 31, 2006 and 2005 at various repricing intervals. This gap analysis indicates that we had a slightly asset-sensitive balance sheet over a one-year time horizon at December 31, 2006, with cumulative rate-sensitive assets amounting to 105% of cumulative rate-sensitive liabilities. At December 31, 2005, our balance sheet was slightly asset-sensitive over a one-year time horizon, with rate-sensitive assets amounting to 103% of rate-sensitive liabilities. The projected deposit repricing volumes reflect adjustments based on management’s assumptions of the expected rate sensitivity to current market rates for core deposits without contractual maturity (i.e., interest-bearing checking, savings and money market accounts). Adjustments are also made for callable investment securities in the bond portfolio to place these bonds in call date categories. Management believes that our current degree of interest rate risk is acceptable in the current interest rate environment.
The following table sets forth information regarding interest rate sensitivity.
INTEREST RATE SENSITIVITY
(Dollars in thousands)
(1) Excludes the effect of SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, consisting of a net unrealized loss of $1,027 in 2006 and a net unrealized loss of $2,445 in 2005. Includes FHLB stock & other equity securities.
(2) Includes loans held for sale, net of allowance.
The following table provides information on the maturity distribution of selected categories of the loan portfolio and certain interest sensitivity data as of December 31, 2006.
MATURITIES AND SENSITIVITIES OF LOANS TO CHANGES IN INTEREST RATES
(Dollars in thousands)
Contractual Obligations
As of December 31, 2006, we are contractually obligated under long-term agreements as follows:
CONTRACTUAL OBLIGATIONS
(Dollars in thousands)
The FHLB bank advances program is a Blanket Agreement for Advances and Security Agreement with the FHLB, under which our subsidiaries have pledged residential first-mortgage loans, commercial real estate loans and investments securities as collateral to secure available lines of credit.
Our correspondent bank line of credit is with the Thomasville National Bank in Thomasville, Georgia. The line is secured with the common stock of the Company and a pledged investment security. The line of credit was assumed in connection with the acquisition of Rivoli BanCorp.
The $41.2 million of subordinated debentures above relate to our trust preferred securities, which were issued or assumed in 2002 and 2005. The proceeds of the trust preferred securities were used to pay down holding company debt, and to fund the acquisitions of Security Bank of Jones County and Rivoli BanCorp.
Other bank facilities are leased under operating leases included in the table above.
Deferred compensation plans are maintained by four of our subsidiary Banks. These plans are for specific officers to defer current compensation until termination, retirement, death or an unforeseeable emergency. The contracts were initially funded through the purchase of life insurance policies.
Off-Balance Sheet Arrangements
We are a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments consist of commitments to extend credit and standby letters of credit. 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.
Standby letters of credit are written conditional commitments issued by a bank to guarantee the performance of a customer to a third party. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. A commitment involves, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheets. Our exposure to credit loss in the event of non-performance by the other party to the instrument is represented by the contractual notional amount of the instrument.
Because certain commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. We use the same credit policies in making commitments to extend credit as we do for on-balance sheet instruments. Collateral held for commitments to extend credit varies but may include accounts receivable, inventory, property, plant, equipment and income-producing commercial properties.
The following table summarizes our off-balance sheet financial instruments whose contract amounts represented credit risk as of December 31, 2006:
No losses are anticipated as a result of the commitments and we do not feel that they are reasonably likely to have a material effect on our consolidated financial condition.
After the initial commitment to extend credit has been made, we may receive a letter of credit fee or loan origination fee, but do not typically receive any further revenues or incur any additional expenses on the unfulfilled commitments.
Inflation
Inflation impacts our financial condition and operating results. However, because most of the assets of the Banks are monetary in nature, the effect is less significant compared to other commercial or industrial companies with heavy investments in inventories and fixed assets. Inflation influences the growth of total banking assets, which in turn produces a need for an increased equity capital base to support growing banks. Inflation also influences interest rates and tends to raise the general level of salaries, operating costs and purchased services. Our mortgage division is particularly impacted by swings in the interest rate cycle. We have not attempted to measure the effect of inflation on various types of income and expense due to difficulties in quantifying the impact. Management’s awareness of inflationary effects has led to various operational strategies to cope with its impact. We engage in various asset/liability management strategies to control interest rate sensitivity and minimize exposure to interest rate risk. Prices for banking products and services are continually reviewed in relation to current costs, and overhead cost cutting is an ongoing task.
Reconciliation of Non-GAAP Financial Measures
This Annual Report on Form 10-K contains financial information determined by methods other than in accordance with generally accepted accounting principles (“GAAP”). These non-GAAP measures typically adjust GAAP performance measures to exclude the effects of significant gains, losses or expenses that are
unusual in nature and not expected to recur. The non-GAAP financial measures included in this Annual Report on Form 10-K are referred to as “net operating income,” “basic operating earnings per share” and “diluted operating earnings per share,” which exclude losses on the sale of investment securities and gains on the early prepayment of advances with the Federal Home Loan Bank. Please note that the calculation of earnings per share and operating earnings per share is based on the Company’s net income and weighted average shares outstanding during the fourth quarter of 2006, 2005 and 2004 and the fiscal years ended December 31, 2006, 2005 and 2004. Since these items and their impact on the Company’s performance are difficult to predict, management believes presentations of financial measures excluding the impact of these items provide useful supplemental information that is important for a proper understanding of the operating results of the Company’s core business. These disclosures should not be viewed as a substitute for operating results determined in accordance with GAAP, nor are they necessarily comparable to non-GAAP performance measures that may be presented by other companies. A reconciliation of GAAP to non-GAAP measures is included in the table below.
GAAP TO NON-GAAP RECONCILIATION TABLE
(Dollars in thousands, except per share data)
Item 7A
Item 7A QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The information required by this Item 7A is set forth under the heading “Interest Rate Risk Management” in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” beginning on Page 28.
Item 8
Item 8 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The following consolidated financial statements of the Registrant and its subsidiaries are included on Exhibit 13 of this Annual Report on Form 10-K:
Item 9
Item 9 CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
Item 9A
Item 9A CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
As of the end of the period covered by this Annual Report on Form 10-K, the Company’s Chief Executive Officer and the Chief Financial Officer evaluated the effectiveness of the Company’s disclosure controls and procedures in accordance with Rule 13a-15 under the Securities Exchange Act of 1934, as amended. Based on their evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective.
Management’s Annual Report on Internal Control over Financial Reporting
The management of Security Bank Corporation (SBKC) is responsible for establishing and maintaining adequate internal control over financial reporting. SBKC’s internal control system was designed to provide reasonable assurance to the Company’s management and board of directors regarding the preparation and fair presentation of published financial statements.
All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.
Our management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006. In making this assessment, it used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework. The scope of our assessment with respect to the year ended December 31, 2006 included all of our operations other than those that we acquired in the March 31 and July 31 acquisitions of substantially all of the assets and liabilities of Neighbors Bancshares, Inc. and Homestead Bank (which we refer to as the “the acquisitions”), respectively. Because we acquired these operations during the fiscal year, we excluded these operations from our assessment with respect to the year ended December 31, 2006. The following consolidated totals include these entities whose internal controls have not been assessed: total assets as of December 31, 2006 and total revenues for the year ended December 31, 2006 were $532.1 million and $19.8 million, respectively. SEC rules require that we include in our assessment of the internal control over financial reporting of the acquired entities’ operations within one year after the date of the acquisitions. Based on our assessment, excluding the operations discussed above, management believes that the Company maintained effective internal control over financial reporting as of December 31, 2006.
Attestation Report of the Registered Public Accounting Firm
SBKC’s independent auditors have issued an attestation report on our assessment of the company’s internal control over financial reporting. This report appears in Item 8.
Changes in Internal Control over Financial Reporting
There were no changes in the Company’s internal control over financial reporting during the last fiscal quarter in the period covered by this Annual Report on 10-K that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
Item 9B
Item 9B OTHER INFORMATION
None.
Part III
Item 10
Item 10 DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
Information required by this item will be set forth below and under the headings “Proposal I-Elections of Directors,” “Corporate Governance” and “Section 16(a) Beneficial Ownership Reporting Compliance” of the Proxy Statement, and possibly elsewhere therein, and is incorporated herein by reference.
Directors
Name
Principal Occupation
Edward M. Beckham, II
Mr. Beckham is a partner in Beckham Bros. Distribution.
Alford C. Bridges
Mr. Bridges is President and Vice President of Whiteway Development Corporation d/b/a Appling Brothers.
Frank H. Childs, Jr.
Mr. Frank Childs is a partner in the Groover & Childs law firm. Mr. Childs is also the County Attorney for Jones County.
Thad G. Childs, Jr.
Mr. Thad Childs is the Senior Community Banker of Security Bank of Jones County.
Benjamin W. Griffith, III
Mr. Griffith is President and owner of Southern Pine Plantations, Inc.
Ruthie G. McMichael
Ms. McMichael has been a teacher in Jones County Public Schools for 27 years and is the Media Specialist at Clifton Ridge Middle School.
Robert T. Mullis
Mr. Mullis holds ownership interests in various businesses and in real estate holdings.
Ben G. Porter
Mr. Porter is Chairman of Filmworks USA.
John W. Ramsey
Mr. Ramsey retired as the Chairman and Chief Executive Officer of Fairfield Financial Services, Inc., a wholly owned subsidiary of Security Bank of Bibb County on December 31, 2006. Mr. Ramsey is President and owner of Rams Four Ltd. Mr. Ramsey owns Rams Head Ltd., a Subchapter S corporation that owns Group Financial Southeast (“GFSE”) and various other real estate holdings. He also owns Laurel Island Country Club Ltd.
T. Kevin Reece
Mr. Reece is the Chief Executive Officer of Sivica Investments.
Robert M. Stalnaker
Mr. Stalnaker is a managing partner in HealthQuest Technologies, LLC.
H. Cullen Talton, Jr.
Mr. Talton is the sheriff of Houston County, Georgia and a real estate developer.
Joe E. Timberlake, III
Mr. Timberlake is the treasurer of Flintlake, Inc., and a managing partner in Timberlands Partnership and Timberlake LLP.
H. Averett Walker
Mr. Rett Walker is the President and Chief Executive Officer of the Company.
Larry C. Walker
Mr. Larry Walker is an attorney with the firm of Walker, Hulbert, Gray & Byrd.
Richard W. White, Jr.
Mr. White is President and part owner of White Brothers Warehouse, Inc.
James R. Williams
Mr. Williams is Chairman and Chief Executive Officer of Parkway Office Suites, Ltd., President of Willford Corporation, LLC and a Partner in Flyboy Aviation Properties, LLC and Mathis Field, LLC.
Executive Officers
Name
Principal Occupation
Richard A. Collinsworth
Mr. Collinsworth is the Executive Vice President and Executive Credit Officer of the Company and also serves as President of Security Bank of Bibb County. He is also the Company’s Chief Operating Officer, and the Regional Executive for the Company’s Middle Georgia division.
James R. McLemore
Mr. McLemore is the Executive Vice President and Chief Financial Officer of the Company and Security Bank of Bibb County.
H. Averett Walker
See information under the heading “Directors” above.
Item 11
Item 11 EXECUTIVE COMPENSATION
Information required by this item will be set forth under the headings “Executive Compensation,” “Additional Information Regarding Executive Compensation,” “Compensation Committee Report,” “Compensation Committee Interlocks and Insider Participation,” and “Audit Committee Report” of the Proxy Statement, and possibly elsewhere therein. All such information in the Proxy Statement is incorporated herein by reference, except that the information contained in the Proxy Statement under the headings “Compensation Committee Report” and “Audit Committee Report” is deemed furnished with this Annual Report on Form 10-K, and shall not be deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, nor shall it be deemed incorporated by reference in any filing under the Securities Act of 1933 or the Securities Exchange Act of 1934.
Item 12
Item 12 SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
Information required by this item will be set forth under the headings “Security Ownership of Certain Beneficial Owners and Management” and “Equity Compensation Plan Information” of the Proxy Statement, and possibly elsewhere therein, and is incorporated herein by reference.
Item 13
Item 13 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
Information required by this item will be set forth under the headings “Corporate Governance” and “Transactions with Related Persons” of the Proxy Statement, and possibly elsewhere therein, and is incorporated herein by reference.
Item 14
Item 14 PRINCIPAL ACCOUNTANT FEES AND SERVICES
Information required by this item will be set forth under the heading “Proposal IV-Ratification of Selection of the Independent Auditors” of the Proxy Statement, and possibly elsewhere therein, and is incorporated herein by reference.
Part IV
Item 15
Item 15 EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) The following documents are filed as part of this Annual Report on Form 10-K:
(1) Financial Statements
(2) Financial Statement Schedules:
All schedules are omitted as the required information is inapplicable or the information is presented in the financial statements or the related notes.
(3) A list of the exhibits required by Item 601 of Regulation S-K to be filed as a part of this Annual Report on Form 10-K is shown on the “Exhibit Index” filed herewith.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
SECURITY BANK CORPORATION
/s/ H. AVERETT WALKER
H. AVERETT WALKER
President/Director/Chief Executive Officer
Date: March 15, 2007
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this Annual Report on Form 10-K has been signed by the following persons on behalf of the registrant and in the capacities on March 15, 2007:
EXHIBIT INDEX
* Indicates a management contract or compensatory plan or arrangement.