ITEM 1. BUSINESS.
GENERAL
James Monroe Bancorp (the "Company") was incorporated under the laws of the Commonwealth of Virginia on April 9, 1999 to be the holding company for James Monroe Bank (the "Bank"). The Company acquired all of the shares of the Bank on July 1, 1999 in a mandatory share exchange under which each outstanding share of common stock of the Bank was exchanged for one share of the Company common stock. The Bank, a Virginia chartered commercial bank, which is a member of the Federal Reserve System, is the Company's sole operating subsidiary. The Bank commenced banking operations on June 8, 1998, and currently operates out of its main office and five full service branch offices and one drive-up/walk through limited service branch. The Bank seeks to provide a high level of personal service and a sophisticated menu of products to individuals and small to medium sized businesses. While the Bank offers a full range of services to a wide array of depositors and borrowers, it has chosen small to medium sized businesses, professionals and the individual retail customer as its primary target market. The Bank believes that as financial institutions grow and are merged with or acquired by larger institutions with headquarters that are far away from the local customer base, the local business and individual is further removed from the point of decision-making. The Bank attempts to place the customer contact and the ultimate decision on products and credits as close together as possible.
LENDING ACTIVITIES
The Bank offers a wide array of lending services to its customers, including commercial loans, lines of credit, personal loans, auto loans and financing arrangements for personal equipment and business equipment. Loan terms, including interest rates, loan to value ratios, and maturities, are tailored as much as possible to meet the needs of the borrower. A special effort is made to keep loan products as flexible as possible within the guidelines of prudent banking practices in terms of interest rate risk and credit risk.
When considering loan requests, the primary factors taken into consideration are the cash flow and financial condition of the borrower, the value of the underlying collateral, if applicable, and the character and integrity of the borrower. These factors are evaluated in a number of ways including an analysis of financial statements, credit reviews, trade reviews, and visits to the borrower's place of business. We have implemented a comprehensive loan policy and procedures manual to provide our loan officers with term, collateral, loan-to-value and pricing guidelines. The policy manual and sound credit analysis, together with thorough review by the Asset-Liability Committee, have resulted in a profitable loan portfolio with minimal delinquencies or problem loans.
Our aim is to build and maintain a commercial loan portfolio consisting of term loans, demand loans, lines of credit and commercial real estate loans provided to primarily locally-based borrowers. These types of loans are generally considered to have a higher degree of risk of default or loss than other types of loans, such as residential real estate loans, because repayment may be affected by general economic conditions, interest rates, the quality of management of the business, and other factors which may cause a borrower to be unable to repay its obligations. Traditional installment loans and personal lines of credit will be available on a selective basis. General economic conditions can directly affect the quality of a small and mid-sized business loan portfolio. We attempt to manage the loan portfolio to avoid high concentrations of similar industry and/or collateral pools, although this cannot be assured.
Loan business is generated primarily through referrals and direct-calling efforts. Referrals of loan business come from directors, shareholders, current customers and professionals such as lawyers, accountants and financial intermediaries.
At December 31, 2004, the Bank's statutory lending limit to any single borrower was $5.22 million, subject to certain exceptions provided under applicable law. As of December 31, 2004, the Bank's credit exposure to its largest borrower was $4,181,000.
Commercial Loans. Commercial loans are written for any prudent business purpose, including the financing of plant and equipment, the carrying of accounts receivable, contract administration, and the acquisition and construction of real estate projects. Special attention is paid to the commercial real estate market, which is particularly active in the Northern Virginia market area. The Bank's commercial loan portfolio reflects a diverse group of borrowers with no concentration in any borrower, or group of borrowers.
The lending activities in which we engage carry the risk that the borrowers will be unable to perform on their obligations. As such, interest rate policies of the Federal Reserve Board and general economic conditions, nationally and in our primary market area will have a significant impact on our results of operations. To the extent that economic conditions deteriorate, business and individual borrowers may be less able to meet their obligations to the Bank in full, in a timely manner, resulting in decreased earnings or losses to the Bank. To the extent that loans are secured by real estate, adverse conditions in the real estate market may reduce the ability of the borrower to generate the necessary cash flow for repayment of the loan, and reduce our ability to collect the full amount of the loan upon a default. To the extent that the Bank makes fixed rate loans, general increases in interest rates will tend to reduce our spread as the interest rates we must pay for deposits increase while interest income is flat. Economic conditions and interest rates may also adversely affect the value of property pledged as security for loans.
We constantly strive to mitigate risks in the event of unforeseen threats to the loan portfolio as a result of an economic downturn or other negative influences. Plans for mitigating inherent risks in managing loan assets include carefully enforcing loan policies and procedures, evaluating each borrower's industry and business plan during the underwriting process, identifying and monitoring primary and alternative sources for repayment and obtaining collateral that is margined to minimize loss in the event of liquidation.
Commercial real estate loans will generally be owner occupied or managed transactions with a principal reliance on the borrower's ability to repay, as well as prudent guidelines for assessing real estate values. Risks inherent in managing a commercial real estate portfolio relate to either sudden or gradual drops in property values as a result of a general or local economic downturn. A decline in real estate values can cause loan to value margins to increase and diminish the bank's equity cushion on both an individual and portfolio basis. The Bank attempts to mitigate commercial real estate lending risks by carefully underwriting each loan of this type to address the perceived risks in the individual transaction. Generally, the Bank requires a loan to value ratio of 75% of the lower of an appraisal or cost. A borrower's ability to repay is carefully analyzed and policy calls for an ongoing cash flow to debt service requirement of 1.1:1.0. An approved list of commercial real estate appraisers selected on the basis of rigorous standards has been established. Each appraisal is scrutinized in an effort to insure current comparable market values.
As noted above, commercial real estates loans are generally made on owner occupied or managed properties where there is both a reliance on the borrower's financial health and the ability of the borrower and the business to repay. Whenever appropriate and available, the Bank seeks Federal and State loan guarantees, such as the Small Business Administration's "7A" and "504" loan programs, to reduce risks. The Bank generally requires personal guarantees on all loans as a matter of policy; exceptions to policy are documented. All borrowers will be required to forward annual corporate, partnership and personal financial statements to comply with bank policy and enforced through the loan covenants documentation for each transaction. Interest rate risks to the Bank are mitigated by using either floating interest rates or by fixing rates for a short period of time, generally less than five years. While loan amortizations may be approved for up to 360 months, loans generally have a call provision (maturity date) of 5-10 years or less. Specific and non-specific provisions for loan loss reserves are generally set based upon a methodology developed by management and approved by the board of directors and described more fully in the Company's Critical Accounting Policies included herein.
Commercial term loans are used to provide funds for equipment and general corporate needs. This loan category is designed to support borrowers who have a proven ability to service debt over a term generally not to exceed 60 months. The Bank generally requires a first lien position on all collateral and guarantees from owners having at least a 20% interest in the involved business. Interest rates on commercial term loans are generally floating, adjust within 3 to 5 years, or are fixed for a term not to exceed five years. Management carefully monitors industry and collateral concentrations to avoid loan exposures to a large group of similar industries and/or similar collateral. Commercial loans are evaluated for historical and projected cash flow attributes, balance sheet strength, and primary and alternate resources of personal guarantors. Commercial term loan documents require borrowers to forward regular financial information on both the business and on personal guarantors. Loan covenants require at least annual submission of complete financial information and in certain cases this information is required more frequently, depending on the degree to which lenders desire information resources for monitoring a borrower's financial condition and compliance with loan covenants. Examples of properly margined collateral for loans, as required by bank policy, would be a 75% advance on the lesser of appraisal or recent sales price on commercial property, 80% or less advance on eligible receivables, 50% or less advance on eligible inventory and an 80% advance on appraised residential property. Collateral borrowing certificates may be required to monitor certain collateral categories on a monthly or quarterly basis. Key person life insurance is required as appropriate and as necessary to mitigate the risk loss of a primary owner or manager.
The Bank attempts to further mitigate commercial term loan loss by using Federal and State loan guarantee programs such as offered by the United States Small Business Administration. The loan loss reserve of approximately 1.12% of the entire portfolio in this group, exclusive of the government guaranteed portion, has been established. Specific loan reserves will be used to increase overall reserves based on increased credit and/or collateral risks on an individual loan basis. At December 31, 2004, specific reserves have been assigned or made for specific credits. A risk rating system is used to proactively determine loss exposure and provide a measurement system for setting general and specific reserve allocations.
Commercial lines of credit are used to finance a business borrower's short-term credit needs and/or to finance a percentage of eligible receivables and inventory. In addition to the risks inherent in term loan facilities, line of credit borrowers typically require additional monitoring to protect the lender against increasing loan volumes and diminishing collateral values. Commercial lines of credit are generally revolving in nature and require close scrutiny. The Bank generally requires at least an annual out of debt period (for seasonal borrowers) or regular financial information (monthly or quarterly financial statements, borrowing base certificates, etc.) for borrowers with more growth and greater permanent working capital financing needs. Advances against collateral are generally in the same percentages as in term loan lending. Lines of credit and term loans to the same borrowers are generally cross-defaulted and cross-collateralized. Industry and collateral concentration, general and specific reserve allocation and risk rating disciplines are the same as those used in managing the commercial term loan portfolio. Interest rate charges on this group of loans generally float at a factor at or above the prime lending rate. Generally, personal guarantees are required on these loans.
As part of its internal loan review process management reviews all loans 30-days delinquent, loans on the Watch List, loans rated special mention, substandard, or doubtful, and other loans of concern at least quarterly. Loan reviews are reported to the board of directors with any adversely rated changes specifically mentioned. All other loans with their respective risk ratings are reported monthly to the Bank's Board of Directors. The Audit Committee coordinates periodic documentation and internal control reviews by outside vendors to complement loan reviews.
Mortgage Lending. In the first quarter of 2003, the Company established a mortgage lending operation as a division of the Bank, which originates conforming, 1-4 family residential mortgage loans, on a pre-sold basis, for sale to secondary market purchasers, servicing released. Under the program, loans are originated and funded by the Bank in conformity to the standards of the secondary market purchasers, and which the secondary market purchasers will agree to purchase prior to funding by the bank. While the Bank is subject to repurchasing certain loans which are ultimately determined not to meet the purchaser's standards, including as a result of inaccuracies or fraud in borrower's documentation, the Company's risk related to the borrower's credit in respect of these loans is minimal. Activity in the residential mortgage loan market is highly sensitive to changes in interest rates. There is no assurance that the Company will be able to successfully maintain the mortgage loan operation, that it will continue to be profitable, or that the Company will not be subject to borrower credit risks in respect of these loans.
Other Loans. Loans are considered for any worthwhile personal or business purpose on a case-by-case basis, such as the financing of equipment, receivables, contract administration expenses, land acquisition and development, and automobile financing. Consumer credit facilities are underwritten to focus on the borrower's credit record, length of employment and cash flow to debt service. Car, residential real estate and similar loans require advances of the lesser of 80% loan to collateral value or cost. Loan loss reserves for this group of loans are generally set at approximately 1.12% subject to adjustments as required by national or local economic conditions.
INVESTMENT ACTIVITIES
The investment policy of the Bank is an integral part of its overall asset/liability management program. The investment policy is to establish a portfolio which will provide liquidity necessary to facilitate funding of loans and to cover deposit fluctuations while at the same time achieving a satisfactory return on the funds invested. The Bank seeks to maximize earnings from its investment portfolio consistent with the safety and liquidity of those investment assets.
The securities in which the Bank may invest are subject to regulation and are limited to securities which are considered investment grade securities. In addition, the Bank's internal investment policy restricts investments to the following categories: U.S. Treasury securities; obligations of U.S. government agencies; investment grade obligations of U.S. private corporations; mortgage-backed securities, including securities issued by Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation; or securities of states and political subdivisions.
SOURCES OF FUNDS
Deposits. Deposits obtained through bank offices have traditionally been the principal source of the Bank's funds for use in lending and for other general business purposes. In order to better serve the needs of its customers, the Bank offers several types of deposit accounts in addition to standard savings, checking, and NOW accounts. Special deposit accounts include the Clarendon, Loudoun and Fairfax Money Market Accounts which pay a higher rate of interest but require a larger minimum deposit. Personal checking requires a $300 minimum balance and may have no monthly fee, per check charge, or activity limit. Small Business Checking allows a small business to pay no monthly service charge with a minimum balance of $1,000 but limits the number of checks and deposits per month. If the minimums are exceeded in this account, the small business may move to another account with a minimum balance of $2,500 and would be entitled to a higher minimum number of checks and deposits without incurring a monthly fee. If the small business grows and exceeds these minimums, the regular commercial analysis account is available where adequate balance can offset the cost of activity. Therefore, the bank offers a range of accounts to meet the needs of the customer without the customer incurring charges or fees.
Bills have been introduced in each of the last several Congresses which would permit banks to pay interest on checking and demand deposit accounts established by businesses, a practice which is currently prohibited by regulation. If the legislation effectively permitting the payment of interest on business demand deposits is enacted, of which there can be no assurance, it is likely that we may be required to pay interest on some portion of our noninterest bearing deposits in order to compete against other banks. As a significant portion of our deposits are non-interest bearing demand deposits established by businesses, payment of interest on these deposits could have a significant negative impact on our net income, net interest income, interest margin, return on assets and equity, and other indices of financial performance. We expect that other banks would be faced with similar negative impacts. We also expect that the primary focus of competition would continue to be based on other factors, such as quality of service.
Borrowing. While the Company has not placed significant reliance on borrowings as a source of liquidity, we have established various borrowing arrangements in order to provide management with additional sources of liquidity and funding, thereby increasing flexibility. Management believes that the Company currently has adequate liquidity available to respond to current liquidity demands.
COMMUNITY REINVESTMENT ACT
The Bank is committed to serving the banking needs of the entire community, including low and moderate income areas, and is a supporter of the Community Reinvestment Act ("CRA"). There are several ways in which the Bank attempts to fulfill this commitment, including working with economic development agencies, undertaking special projects, and becoming involved with neighborhood outreach programs.
The Bank has contacts with state and city agencies that assist in the financing of affordable housing developments as well as with groups which promote the economic development of low and moderate income individuals. The Bank has computer software to geographically code all types of accounts to track business development and performance by census tract and to assess market penetration in low and moderate income neighborhoods within the primary service area. The Bank is a registered Small Business Administration lender.
The Company encourages its directors and officers to participate in community, civic and charitable organizations. Management and members of the Board of Directors periodically review the various CRA activities of the Bank, including the advertising program and geo-coding of real estate loans by census tract data which specifically focuses on low income neighborhoods, its credit granting process with respect to business prospects generated in these areas, and its involvement with community leaders on a personal level.
COMPETITION
In attracting deposits and making loans, we encounter competition from other institutions, including larger commercial banking organizations, savings banks, credit unions, other financial institutions and non-bank financial service companies serving our market area. Financial and non-financial institutions not located in the market are also able to reach persons and entities based in the market through mass marketing, the internet, telemarketing, and other means. The principal methods of competition include the level of loan interest rates, interest rates paid on deposits, efforts to obtain deposits, range of services provided and the quality of these services. Our competitors include a number of major financial companies whose substantially greater resources may afford them a marketplace advantage by enabling them to maintain numerous banking locations and mount extensive promotional and advertising campaigns. In light of the deregulation of the financial service industry and the absence of interest rate controls on deposits, we anticipate continuing competition from all of these institutions in the future. Additionally, as a result of legislation which reduced restrictions on interstate banking and widened the array of companies that may own banks, we may face additional competition from institutions outside our market and outside the traditional range of bank holding companies which may take advantage of such legislation to acquire or establish banks or branches in our market. There can be no assurance that we will be able to successfully meet these competitive challenges.
In addition to offering competitive rates for its banking products and services, our strategy for meeting competition has been to concentrate on specific segments of the market for financial services, particularly small business and individuals, by offering such customers customized and personalized banking services.
We believe that active participation in civic and community affairs is an important factor in building our reputation and, thereby, attracting customers.
EMPLOYEES
As of December 31, 2004, the Bank had 84 full time equivalent employees. The Company has no employees who are not also employees of the Bank. Our employees are not represented by any collective bargaining unit, and we believe our employee relations are good. The Bank maintains a benefit program, which includes health and dental insurance, life, short-term and long-term disability insurance, and a 401(k) plan for substantially all employees.
SUPERVISION AND REGULATION
JAMES MONROE BANCORP
Bancorp is a bank holding company registered under the Bank Holding Company Act of 1956, as amended, (the "Act") and is subject to supervision by the Federal Reserve Board. As a bank holding company, Bancorp is required to file with the Federal Reserve Board an annual report and such other additional information as the Federal Reserve Board may require pursuant to the Act. The Federal Reserve Board may also make examinations of Bancorp and each of its subsidiaries.
The Act requires approval of the Federal Reserve Board for, among other things, the acquisition by a proposed bank holding company of control of more than five percent (5%) of the voting shares, or substantially all the assets, of any bank or the merger or consolidation by a bank holding company with another bank holding company. The Act also generally permits the acquisition by a bank holding company of control, or substantially all the assets, of any bank located in a state other than the home state of the bank holding company, except where the bank has not been in existence for the minimum period of time required by state law, but if the bank is at least 5 years old, the Federal Reserve Board may approve the acquisition.
Under current law, with certain limited exceptions, a bank holding company is prohibited from acquiring control of any voting shares of any company which is not a bank or bank holding company and from engaging directly or indirectly in any activity other than banking or managing or controlling banks or furnishing services to or performing service for its authorized subsidiaries. A bank holding company may, however, engage in or acquire an interest in, a company that engages in activities which the Federal Reserve Board has determined by order or regulation to be so closely related to banking or managing or controlling banks as to be properly incident thereto. In making such a determination, the Federal Reserve Board is required to consider whether the performance of such activities can reasonably be expected to produce benefits to the public, such as convenience, increased competition or gains in efficiency, which outweigh possible adverse effects, such as undue concentration of resources, decreased or unfair competition, conflicts of interest or unsound banking practices. The Federal Reserve Board is also empowered to differentiate between activities commenced de novo and activities commenced by the acquisition, in whole or in part, of a going concern. Some of the activities that the Federal Reserve Board has determined by regulation to be closely related to banking include making or servicing loans, performing certain data processing services, acting as a fiduciary or investment or financial advisor, and making investments in corporations or projects designed primarily to promote community welfare.
Effective on March 11, 2001, the Gramm Leach Bliley Act (the "GLB Act") allows a bank holding company or other company to certify status as a financial holding company, which will allow such company to engage in activities that are financial in nature, that are incidental to such activities, or are complementary to such activities. The GLB Act enumerates certain activities that are deemed financial in nature, such as underwriting insurance or acting as an insurance principal, agent or broker, underwriting, dealing in or making markets in securities, and engaging in merchant banking under certain restrictions. It also authorizes the Federal Reserve Board to determine by regulation what other activities are financial in nature, or incidental or complementary thereto.
Subsidiary banks of a bank holding company are subject to certain restrictions imposed by the Federal Reserve Act on any extensions of credit to the bank company or any of its subsidiaries, or investments in the stock or other securities thereof, and on the taking of such stock or securities as collateral for loans to any borrower. Further, a holding company and any subsidiary bank are prohibited from engaging in certain tie-in arrangements in connection with the extension of credit. A subsidiary bank may not extend credit, lease or sell property, or furnish any services, or fix or vary the consideration for any of the foregoing, on the condition that: (i) the customer obtain or provide some additional credit, property or services from or to such bank other than a loan, discount, deposit or trust service; (ii) the customer obtain or provide some additional credit, property or service from or to Bancorp or any other subsidiary of Bancorp; or (iii) the customer not obtain some other credit, property or service from competitors, except for reasonable requirements to assure the soundness of credit extended.
The Federal Reserve has also adopted capital guidelines for bank holding companies that are substantially the same as those applying to state member banks, although these requirements are not currently applicable to Bancorp.
JAMES MONROE BANK
The Bank is a Virginia chartered commercial bank and a member of the Federal Reserve System. Its deposit accounts are insured by the Bank Insurance Fund of the FDIC up to the maximum legal limits of the FDIC and it is subject to regulation, supervision and regular examination by the Virginia Bureau of Financial Institutions and the Federal Reserve. The regulations of these various agencies govern most aspects of James Monroe Bank's business, including required reserves against deposits, loans, investments, mergers and acquisitions, borrowings, dividends and location and number of branch offices. The laws and regulations governing the Bank generally have been promulgated to protect depositors and the deposit insurance funds, and not for the purpose of protecting stockholders.
Banking is a business which depends on interest rate differentials. In general, the differences between the interest paid by a bank on its deposits and its other borrowings and the interest received by a bank on loans extended to its customers and securities held in its investment portfolio constitute the major portion of the Bank's earnings. Thus, the earnings and growth 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 Board, which regulates the supply of money through various means including open market dealings in United States government securities. The nature and timing of changes in such policies and their impact on the Bank cannot be predicted.
Branching and Interstate Banking. The federal banking agencies are authorized to approve interstate bank merger transactions without regard to whether such transaction is prohibited by the law of any state, unless the home state of one of the banks has opted out of the interstate bank merger provisions of the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the "Riegle-Neal Act") by adopting a law after the date of enactment of the Riegle-Neal Act and prior to June 1, 1997, which applies equally to all out-of-state banks and expressly prohibits merger transactions involving out-of-state banks. Interstate acquisitions of branches are permitted only if the law of the state in which the branch is located permits such acquisitions. Such interstate bank mergers and branch acquisitions are also subject to the nationwide and statewide insured deposit concentration limitations described in the Riegle-Neal Act.
The Riegle-Neal Act authorizes the federal banking agencies to approve interstate branching de novo by national and state banks in states which specifically allow for such branching. Virginia has enacted laws which permit interstate acquisitions of banks and bank branches and permit out-of-state banks to establish de novo branches.
USA Patriot Act. Under the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act, commonly referred to as the "USA Patriot Act" or the "Patriot Act", financial institutions are subject to prohibitions against specified financial transactions and account relationships, as well as enhanced due diligence standards intended to detect, and prevent, the use of the United States financial system for money laundering and terrorist financing activities. The Patriot Act requires financial institutions, including banks, to establish anti-money laundering programs, including employee training and independent audit requirements, meet minimum standards specified by the act, follow minimum standards for customer identification and maintenance of customer identification records, and regularly compare customer lists against lists of suspected terrorists, terrorist organizations and money launderers. The costs or other effects of the compliance burdens imposed by the Patriot Act or future anti-terrorist, homeland security or anti-money laundering legislation or regulations cannot be predicted with certainty.
Capital Adequacy Guidelines. The Federal Reserve Board has adopted risk-based capital adequacy guidelines pursuant to which they assess the adequacy of capital in examining and supervising banks and bank holding companies and in analyzing bank regulatory applications. Risk-based capital requirements determine the adequacy of capital based on the risk inherent in various classes of assets and off-balance sheet items.
State member banks are expected to meet a minimum ratio of total qualifying capital (the sum of core capital (Tier 1) and supplementary capital (Tier 2)) to risk weighted assets of 8%. At least half of this amount (4%) should be in the form of core capital.
Tier 1 Capital generally consists of the sum of common stockholders' equity and perpetual preferred stock (subject in the case of the latter to limitations on the kind and amount of such stock which may be included as Tier 1 Capital), less goodwill, without adjustment for changes in the market value of securities classified as "available for sale" in accordance with FAS 115. Tier 2 Capital consists of the following: hybrid capital instruments; perpetual preferred stock which is not otherwise eligible to be included as Tier 1 Capital; term subordinated debt and intermediate-term preferred stock; and, subject to limitations, general allowances for loan losses. Assets are adjusted under the risk-based guidelines to take into account different risk characteristics, with the categories ranging from 0% (requiring no risk-based capital) for assets such as cash and certain U.S. government and agency securities, to 100% for the bulk of assets which are typically held by a bank holding company, including certain multi-family residential and commercial real estate loans, commercial business loans and consumer loans. Residential first mortgage loans on one to four family residential real estate and certain seasoned multi-family residential real estate loans, which are not 90 days or more past-due or non-performing and which have been made in accordance with prudent underwriting standards are assigned a 50% level in the risk-weighing system, as are certain privately-issued mortgage-backed securities representing indirect ownership of such loans. Off-balance sheet items also are adjusted to take into account certain risk characteristics.
In addition to the risk-based capital requirements, the Federal Reserve Board has established a minimum 4.0% Leverage Capital Ratio (Tier 1 Capital to total adjusted assets) requirement for the most highly-rated banks, with an additional cushion of at least 100 to 200 basis points for all other banks, which effectively increases the minimum Leverage Capital Ratio for such other banks to 4.0% - 6.0% or more. The highest-rated banks are those that are not anticipating or experiencing significant growth and have well diversified risk, including no undue interest rate risk exposure, excellent asset quality, high liquidity, good earnings and, in general, those which are considered a strong banking organization. A bank having less than the minimum Leverage Capital Ratio requirement shall, within 60 days of the date as of which it fails to comply with such requirement, submit a reasonable plan describing the means and timing by which a bank shall achieve its minimum Leverage Capital Ratio requirement. A bank that fails to file such plan is deemed to be operating in an unsafe and unsound manner, and could subject that bank to a cease-and-desist order. Any insured depository institution with a Leverage Capital Ratio that is less than 2.0% is deemed to be operating in an unsafe or unsound condition pursuant to Section 8(a) of the Federal Deposit Insurance Act (the "FDIA") and is subject to potential termination of deposit insurance. However, such an institution will not be subject to an enforcement proceeding solely on account of its capital ratios, if it has entered into and is in compliance with a written agreement to increase its Leverage Capital Ratio and to take such other action as may be necessary for the institution to be operated in a safe and sound manner. The capital regulations also provide, among other things, for the issuance of a capital directive, which is a final order issued to a bank that fails to maintain minimum capital or to restore its capital to the minimum capital requirement within a specified time period. Such directive is enforceable in the same manner as a final cease-and-desist order.
Prompt Corrective Action. Under Section 38 of the FDIA, each federal banking agency is required to implement a system of prompt corrective action for institutions which it regulates. The federal banking agencies have promulgated substantially similar regulations to implement the system of prompt corrective action established by Section 38 of the FDIA. Under the regulations, a bank shall be deemed to be: (i) "well capitalized" if it has a Total Risk Based Capital Ratio of 10.0% or more, a Tier 1 Risk Based Capital Ratio of 6.0% or more, a Leverage Capital Ratio of 5.0% or more and is not subject to any written capital order or directive; (ii) "adequately capitalized" if it has a Total Risk Based Capital Ratio of 8.0% or more, a Tier 1 Risk Based Capital Ratio of 4.0% or more and a Tier 1 Leverage Capital Ratio of 4.0% or more (3.0% under certain circumstances) and does not meet the definition of "well capitalized;" (iii) "undercapitalized" if it has a Total Risk Based Capital Ratio that is less than 8.0%, a Tier 1 Risk based Capital Ratio that is less than 4.0% or a Leverage Capital Ratio that is less than 4.0% (3.0% under certain circumstances); (iv) "significantly undercapitalized" if it has a Total Risk Based Capital Ratio that is less than 6.0%, a Tier 1 Risk Based Capital Ratio that is less than 3.0% or a Leverage Capital Ratio that is less than 3.0%; and (v) "critically undercapitalized" if it has a ratio of tangible equity to total assets that is equal to or less than 2.0%.
An institution generally must file a written capital restoration plan which meets specified requirements with an appropriate federal banking agency within 45 days of the date the institution receives notice or is deemed to have notice that it is undercapitalized, significantly undercapitalized or critically undercapitalized. A federal banking agency must provide the institution with written notice of approval or disapproval within 60 days after receiving a capital restoration plan, subject to extensions by the applicable agency.
An institution which is required to submit a capital restoration plan must concurrently submit a performance guaranty by each company that controls the institution. Such guaranty shall be limited to the lesser of (i) an amount equal to 5.0% of the institution's total assets at the time the institution was notified or deemed to have notice that it was undercapitalized or (ii) the amount necessary at such time to restore the relevant capital measures of the institution to the levels required for the institution to be classified as adequately capitalized. Such a guaranty shall expire after the federal banking agency notifies the institution that it has remained adequately capitalized for each of four consecutive calendar quarters. An institution which fails to submit a written capital restoration plan within the requisite period, including any required performance guaranty, or fails in any material respect to implement a capital restoration plan, shall be subject to the restrictions in Section 38 of the FDIA which are applicable to significantly undercapitalized institutions.
A "critically undercapitalized institution" is to be placed in conservatorship or receivership within 90 days unless the FDIC formally determines that forbearance from such action would better protect the deposit insurance fund. Unless the FDIC or other appropriate federal banking regulatory agency makes specific further findings and certifies that the institution is viable and is not expected to fail, an institution that remains critically undercapitalized on average during the fourth calendar quarter after the date it becomes critically undercapitalized must be placed in receivership. The general rule is that the FDIC will be appointed as receiver within 90 days after a bank becomes critically undercapitalized unless extremely good cause is shown and an extension is agreed-to by the federal regulators. In general, good cause is defined as capital, which has been raised and is imminently available for infusion into a bank except for certain technical requirements which may delay the infusion for a period of time beyond the 90 day time period.
Immediately upon becoming undercapitalized, an institution shall become subject to the provisions of Section 38 of the FDIA, which (i) restrict payment of capital distributions and management fees; (ii) require that the appropriate federal banking agency monitor the condition of the institution and its efforts to restore its capital; (iii) require submission of a capital restoration plan; (iv) restrict the growth of the institution's assets; and (v) require prior approval of certain expansion proposals. The appropriate federal banking agency for an undercapitalized institution also may take any number of discretionary supervisory actions if the agency determines that any of these actions is necessary to resolve the problems of the institution at the least possible long-term cost to the deposit insurance fund, subject in certain cases to specified procedures. These discretionary supervisory actions include: requiring the institution to raise additional capital; restricting transactions with affiliates; requiring divestiture of the institution or the sale of the institution to a willing purchaser; and any other supervisory action that the agency deems appropriate. These and additional mandatory and permissive supervisory actions may be taken with respect to significantly undercapitalized and critically undercapitalized institutions.
Additionally, under Section 11(c)(5) of the FDIA, a conservator or receiver may be appointed for an institution where: (i) an institution's obligations exceed its assets; (ii) there is substantial dissipation of the institution's assets or earnings as a result of any violation of law or any unsafe or unsound practice; (iii) the institution is in an unsafe or unsound condition; (iv) there is a willful violation of a cease-and-desist order; (v) the institution is unable to pay its obligations in the ordinary course of business; (vi) losses or threatened losses deplete all or substantially all of an institution's capital, and there is no reasonable prospect of becoming "adequately capitalized" without assistance; (vii) there is any violation of law or unsafe or unsound practice or condition that is likely to cause insolvency or substantial dissipation of assets or earnings, weaken the institution's condition, or otherwise seriously prejudice the interests of depositors or the insurance fund; (viii) an institution ceases to be insured; (ix) the institution is undercapitalized and has no reasonable prospect that it will become adequately capitalized, fails to become adequately capitalized when required to do so, or fails to submit or materially implement a capital restoration plan; or (x) the institution is critically undercapitalized or otherwise has substantially insufficient capital.
Regulatory Enforcement Authority. Federal banking law grants substantial enforcement powers to federal banking regulators. This enforcement authority includes, among other things, the ability to assess civil money penalties, to issue cease-and-desist or removal orders and to initiate injunctive actions against banking organizations and institution-affiliated parties. In general, these enforcement actions may be initiated for violations of laws and regulations and unsafe or unsound practices. Other actions or inactions may provide the basis for enforcement action, including misleading or untimely reports filed with regulatory authorities.
Deposit Insurance Premiums. The FDIA establishes a risk based deposit insurance assessment system. Under applicable regulations, deposit premium assessments are determined based upon a matrix formed utilizing capital categories - well capitalized, adequately capitalized and undercapitalized - defined in the same manner as those categories are defined for purposes of Section 38 of the FDIA. Each of these groups is then divided into three subgroups which reflect varying levels of supervisory concern, from those which are considered healthy to those which are considered to be of substantial supervisory concern. The matrix so created results in nine assessment risk classifications, with rates ranging from 0.00% of insured deposits for well capitalized institutions having the lowest level of supervisory concern, to 0.27% of insured deposits for undercapitalized institutions having the highest level of supervisory concern. In general, while the Bank Insurance Fund of the FDIC ("BIF") maintains a reserve ratio of 1.25% or greater, no deposit insurance premiums are required. When the BIF reserve ratio falls below that level, all insured banks would be required to pay premiums. Payment of deposit premiums, either under current law or as the deposit insurance system may be reformed, will have an adverse impact on earnings.
ITEM 2.
ITEM 2. PROPERTIES.
We currently maintain seven banking offices in the Northern Virginia market. All of our properties are occupied under leases which have terms extending until at least 2006 and with the exception of our Manassas office have one or more renewal options. We have also leased 14,107 square feet in a new building in Chantilly, Virginia which houses our Chantilly branch and certain administrative and operations functions.
ADDRESS TYPE OF FACILITY ------- ---------------- 3033 Wilson Boulevard Main banking office, executive office Arlington, Virginia 3914 Centreville Road Full service branch, administrative Chantilly, Virginia offices, back office operations 7023 Little River Turnpike Full service branch, Mortgage division Annandale, Virginia 10509 Judicial Drive Full service branch Fairfax, Virginia 606 South King Street Full service branch Leesburg, Virginia 10 W. Market Street Drive through/walk through limited Leesburg, Virginia service branch 7900 Sudley Road Full service branch Manassas, Virginia
Management believes the existing facilities are adequate to conduct the Company's business.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS.
The Company may be involved in routine legal proceedings in the ordinary course of its business. At December 31, 2004, there were no pending or, to the knowledge of the Company, threatened legal proceedings.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
No matters were submitted for the vote of shareholders during the quarter ended December 31, 2004.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS.
Market for Common Stock and Dividends. Since August 27, 2002, our common stock has been trading on the Nasdaq SmallCap Market under the symbol "JMBI." Prior to that date and since January 19, 2001, the common stock was traded on the OTC Bulletin Board. As of December 31, 2004, there were 4,445,224 shares of common stock outstanding, held by approximately 1,900 shareholders of record. At that date, there were also outstanding options to purchase 532,713 shares of common stock, 443,487 of which were exercisable.
Set forth below is our share price history for the each quarter since January 1, 2002 through December 31, 2004. Information provided represents high and low bid prices, which reflect inter-dealer prices without retail mark-up, mark-down or commission, and may not represent actual trades. To date, trading in the common stock has been relatively light. No assurance can be given that an active trading market will develop, or if one develops, can be maintained. Information has been adjusted to reflect the three-for-two stock split in the form of a 50% stock dividend paid on July 25, 2002, the five-for-four stock split in the form of a 25% stock dividend paid on May 16, 2003, and the three-for-two stock split in the form of a 50% stock dividend paid on June 1,
2004 2003 2002 ------------------ -------------------- ----------------- Period Ended High Low High Low High Low -------- -------- --------- -------- ------- -------- March 31, $19.13 $16.43 $11.87 $ 8.72 $6.76 $6.05 June 30, $19.35 $17.51 $15.87 $11.20 $8.54 $6.27 September 30, $19.25 $18.00 $17.60 $14.50 $8.27 $5.92 December 31, $19.90 $17.65 $17.80 $14.80 $9.07 $6.96
Dividends. Holders of the common stock are entitled to receive dividends as and when declared by the Board of Directors. On July 25, 2002, the Company effected a three-for-two stock split in the form of a 50% stock dividend. On May 16, 2003, we paid a five-for-four stock split in the form of a 25% stock dividend. On June 1, 2004 the Company effected a three-for-two stock split in the form of a 50% stock dividend. The Company has not paid cash dividends since it became the holding company for the Bank, and prior to that time the Bank did not pay any cash dividends, each electing to retain earnings to support growth. We currently intend to continue the policy of retaining earnings to support growth for the immediate future. Future dividends will depend primarily upon the Bank's earnings, financial condition, and need for funds and capital, as well as applicable governmental policies and regulations. There can be no assurance that we will have earnings at a level sufficient to support the payment of dividends, or that we will in the future elect to pay dividends.
Regulations of the Federal Reserve and Virginia law place a limit on the amount of dividends the Bank may pay without prior approval. Prior regulatory approval is required to pay dividends which exceed the Bank's net profits for the current year plus its retained net profits for the preceding two calendar years, less required transfers to surplus. At December 31, 2004, $7,218,000 was available for the payment of dividends by the Bank without prior regulatory approval. State and federal regulatory authorities also have authority to prohibit a bank from paying dividends if they deem payment to be an unsafe or unsound practice.
The Federal Reserve has established guidelines with respect to the maintenance of appropriate levels of capital by registered bank holding companies. Compliance with such standards, as presently in effect, or as they may be amended from time to time, could possibly limit the amount of dividends that the Company may pay in the future. In 1985, the Federal Reserve issued a policy statement on the payment of cash dividends by bank holding companies. In the statement, the Federal Reserve expressed its view that a holding company experiencing earnings weaknesses should not pay cash dividends exceeding its net income, or which could only be funded in ways that weakened the holding company's financial health, such as by borrowing.
As a depository institution, the deposits of which are insured by the FDIC, the Bank may not pay dividends or distribute any of its capital assets while it remains in default on any assessment due the FDIC. The Bank is not currently in default under any of its obligations to the FDIC.
Recent Sales of Unregistered Shares. None.
Use of Proceeds: Not Applicable.
Securities Authorized for Issuance Under Equity Compensation Plans. The following table sets forth information regarding options issuable and issued under our plans under which stock options or other equity based compensation may be granted.
Equity Compensation Plan Information
(1) Consists of the 1998 Management Incentive Stock Option Plan, 1999 Director's Stock Option Plan and 2003 Equity Compensation Plan described further in Note 8 to the consolidated financial statements, and in response to Item 10 hereof. Certain employment arrangements of the Company, which have not individually been approved by shareholders, and which are described in response to Item 11 hereof, call for the issuance of options to purchase common stock under the stock option plan which have been approved by shareholders.
Issuer Repurchases of Common Stock. No shares of the Company's common stock were repurchased by or on behalf of the Company during the fourth quarter of 2004.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA.
(1) Information has been adjusted to reflect the 3-for-2 stock split paid on June 1, 2004, the 5-for-4 stock split paid on May 16, 2003 and the 3-for-2 stock split paid on July 25, 2002.
(2) Computed by dividing noninterest expense by the sum of net interest income on a tax equivalent basis and noninterest income, including securities gains or losses and gains or losses on the sale of loans. This is a non-GAAP financial measure, which we believe provides investors with important information regarding our operational efficiency. Comparison of our efficiency ratio with those of other companies may not be possible, because other companies may calculate the efficiency ratio differently.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
FORWARD LOOKING STATEMENTS
This Management's Discussion and Analysis and other portions of this report contain forward looking statements within the meaning of the Securities Exchange Act of 1934, as amended, including statements of goals, intentions, and expectations as to future trends, plans, events or results of Company operations and policies and regarding general economic conditions. In some cases, forward looking statements can be identified by use of such words as "may," "will," "anticipate," "believes," "expects," "plans," "estimates," "potential," "continue," "should," and similar words or phases. These statements are based upon current and anticipated economic conditions, nationally and in the Company's market, interest rates and interest rate policies, competitive factors, government agencies and other third parties, which by their nature are not susceptible to accurate forecast, and are subject to significant uncertainty. Because of these uncertainties and the assumptions on which this discussion and the forward looking statements are based, actual future operations and results in the future may differ materially from those indicated herein. Readers are cautioned against placing undue reliance on any such forward looking statement.
INTRODUCTION
This Management's Discussion and Analysis reviews the financial condition and results of operations of the Company and its subsidiaries as of and for the years ended December 31, 2004, 2003 and 2002. Some tables cover more than these periods to comply with Securities and Exchange Commission disclosure requirements or to illustrate trends over a period of time. When reading this discussion, reference should be made to the consolidated financial statements and related notes that appear herein and to our consolidated financial statements and footnotes thereto for the year ended December 31, 2004.
CRITICAL ACCOUNTING POLICIES
There were no changes to the Company's critical accounting policies in the fourth quarter of 2004. Critical accounting policies are those applications of accounting principles or practices that require considerable judgment, estimation, or sensitivity analysis by management. In the financial service industry, examples, albeit not an all inclusive list, of disclosures that may fall within this definition are the determination of the adequacy of the allowance for loan losses, valuation of mortgage servicing rights, valuation of derivatives or securities without a readily determinable market value, and the valuation of the fair value of intangibles and goodwill. Except for the determination of the adequacy of the allowance for loan losses, the Company does not believe there are other practices or policies that require significant sensitivity analysis, judgments, or estimations.
Allowance for Loan Losses. The Company has developed a methodology to determine, on a quarterly basis, an allowance to absorb probable loan losses inherent in the portfolio based on evaluations of the collectibility of loans, historical loss experience, peer bank loss experience, delinquency trends, economic conditions, portfolio composition, and specific loss estimates for loans considered substandard or doubtful. All commercial and commercial real estate loans that exhibit probable or observed credit weaknesses are subject to individual review. If necessary, reserves would be allocated to individual loans based on management's estimate of the borrower's ability to repay the loan given the availability of collateral and other sources of cash flow. Any reserves for impaired loans are measured based on the present rate or fair value of the underlying collateral. The Company evaluates the collectibility of both principal and interest when assessing the need for a loss accrual. A composite allowance factor that considers the Company's and other peer bank loss experience ratios, delinquency trends, economic conditions, and portfolio composition are applied to the total of commercial and commercial real estate loans not specifically evaluated. A percentage of this composite allowance factor is also applied to the aggregate of unused commercial lines of credit which the Company has an obligation to honor but where the borrower has not elected to draw on their lines of credit.
Homogeneous loans, such as consumer installment, residential mortgage loans, home equity loans, and smaller consumer loans are not individually risk graded. Reserves are established for each homogeneous pool of loans based on the expected net charge offs from a current trend in delinquencies, losses or historical experience and general economic conditions. The Company has no material delinquencies in these types of loans, and has not, since inception, had a trend or an indication of a trend that would guide the Company in expected material losses in these types of homogeneous pools of loans.
The Company's allowance for loan losses is determined based upon a methodology developed by management as described above and is approved by the board of directors each quarter.
COMPANY HIGHLIGHTS SINCE DECEMBER 31, 2003 ARE:
o Average assets grew $91.5 million (34%).
o Average loans grew $63.3 million (44%).
o Average deposits grew $72.4 million (30%).
o Net interest margin was 3.72% for the full year 2004 compared to 3.73% for the full year 2003.
o Asset quality remained strong as nonperforming assets decreased $161 thousand to $349 thousand. The allowance for loan losses totaled 1.12% of total loans outstanding at December 31, 2004.
o The Company ended the year with excellent liquidity and adequate capital to support further growth.
o The Company opened a sixth banking office in Chantilly, Virginia on July 26, 2004. In addition to the branch site, the Company leased 7,000 square feet of space on the second floor of the branch building to accommodate expanding administrative, operational support and mortgage services departments. The move into the new operations space was accomplished on July 10, enabling the Bank to maintain its focus on excellent customer service while continuing to grow at a rapid rate.
o The Company opened a seventh banking office in Manassas, Virginia on September 27, 2004. The Bank has hired three lenders who have spent a significant part of their banking careers working in the Manassas market.
o The Company's expansion into the Chantilly and Manassas markets, along with the opening of the new operations center, are growth oriented initiatives taken after additional capital was raised in the fourth quarter of 2003. While these pro-active initiatives have increased operating expenses, as evidenced by the rise in the Bank's efficiency ratio to 60% for the full year 2004, the Company's focus remains on a long term strategy of expanding our franchise throughout the Northern Virginia market.
o The Company effected a three-for-two stock split for shareholders of record on May 14, 2004, paid on June 1, 2004.
BALANCE SHEET
Year Ended December 31, 2004 vs. Year Ended December 31, 2003. Total assets increased by $144.8 million from December 31, 2003 to December 31, 2004, ending the period at $450.8 million. During this period, the Company emphasized the importance of becoming the primary banker for our customers with the goal of providing both lending and deposit services. These efforts resulted in deposit growth of $148.9 million and loan growth of $80.9 million. The securities portfolio grew during the year by $24.5 million, ending the period at $146.8 million. The Company's liquidity position improved by $42.6 million as overnight investments totaled $35.8 million at year end. Stockholders' equity increased $3.0 million as a result of the $2.967 million of earnings retention for the year 2004, and $401,000 in proceeds from the issuance of shares upon the exercise of options and the sale of shares in the Company's KSOP plan, offset by a $358,000 decrease in the unrealized gains on securities available for sale.
Year Ended December 31, 2003 vs. Year Ended December 31, 2002. Total assets increased by $66.9 million from December 31, 2002 to December 31, 2003, ending the period at $305.7 million. The increase in assets was funded by deposit growth of $41.2 million, issuance of common stock of $12.8 million, $5 million in proceeds from the issuance of trust preferred capital notes and $6.9 million in short term borrowings. These funding mechanisms enabled the Company to fund an increase in loans of $47.4 million and the addition of $46.3 million to the securities portfolio. To minimize exposure to historically low short-term interest rates the Company became a net purchaser of overnight funds during the fourth quarter of 2003. Stockholders' equity increased $14.7 million as a result of the $2.601 million of earnings retention for the year 2003, the $12.8 million, net of commissions and expenses, from the sale of common stock in the public offering, and $370,000 from the exercise of options and sale of shares in the Company's KSOP plan, offset by a $1.0 million decrease in the unrealized gains on securities available for sale.
RESULTS OF OPERATIONS
For the year ended December 31, 2004, the Company earned $2.970 million, or $.67 per basic share and $.64 per diluted share, compared with $2.601 million, or $.73 per basic share and $.68 per diluted share, for the year ended December 31, 2003 and $1.553 million, or $.50 per basic share and $.48 per diluted share, for the year ended December 31, 2002. The comparable earnings per share are impacted by the 600,000 shares issued in November 2003, coupled with the 3-for-2 stock split this year, resulting in approximately 850,000 more shares outstanding in computing 2004 earnings per share. Return on average assets was .83% and return on average equity was 8.35% for the year ended December 31, 2004 compared to a .97% return on average assets and 11.94% return on average equity for the year ended December 31, 2003 and a .88% return on average assets and a 10.15% return on average equity for the year ended December 31, 2002.
During 2004, the Company continued to focus on managing its net interest margin, especially in light of the low interest rate environment. Beginning in 2001 through June 2003, the Federal Reserve reduced the federal funds target rate an aggregate of 550 basis points. These dramatic reductions over a relatively short period continued to impact the loan and investment portfolios in 2003 and 2004, as loans repriced on a delayed basis or renewed at lower interest rates, and as investment securities matured or were called, and were reinvested at lower rates. This was partially offset by continued repricing upon renewal of certificates of deposit. While the Federal Reserve began to reverse the rate reductions, through a series of five increases aggregating 125 basis points, beginning on June 30, 2004, and continuing in August, September, November and December 2004, the rate reductions and continuing low rate environment has resulted in a reduction in the net interest margin throughout the period, from 5.09% in 2000 to 4.56% in 2001 to 3.90% in 2002 to 3.73% in 2003 to 3.72 in 2004. Despite these reductions, the Company's practice of managing its interest rate risk process has mitigated the negative effect of such a severely declining and low rate environment. The Company expects that continued increases in the federal funds target rate will contribute to an increased margin as earning assets reprice, while repricing of deposits lags. However, as discussed further under "Liquidity and Interest Rate Sensitivity Management," as a result of competitive factors, market conditions, customer preferences and other factors, the Company may not be able to benefit from further increases in market interest rates.
Although the Company has continued to grow in asset size since its inception in 1998 it has been able to control its operating efficiency. During the third and fourth quarters of 2004 the Company expanded into the Chantilly and Manassas markets and opened a new operations center. These are growth oriented initiatives taken after additional capital was raised in the fourth quarter of 2003. While these pro-active initiatives have increased operating expenses, as evidenced by the rise in the efficiency ratio to 60.0% for the year as compared to 56.5% in 2003, the Company's focus remains on a long term strategy of expanding our franchise throughout the Northern Virginia market. The efficiency ratio is a non-GAAP financial measure, which we believe provides investors with important information regarding our operational efficiency. We compute our efficiency ratio by dividing noninterest expense by the sum of net interest income on a tax equivalent basis and noninterest income, which includes securities gains or losses and gains or losses on the sale of mortgage loans. Comparison of our efficiency ratio with those of other companies may not be possible, because other companies may calculate the efficiency ratio differently.
NET INTEREST INCOME, AVERAGE BALANCES AND YIELDS
Net interest income is the difference between interest and fees earned on assets and the interest paid on deposits and borrowings. Net interest income is one of the major determining factors in the Bank's performance as it is the principal source of revenue and earnings. Unlike the larger regional or mega-banks that have significant sources of fee income, community banks, such as James Monroe Bank, rely on net interest income from traditional banking activities as the primary revenue source.
Table 1 provides certain information relating to the Company's average consolidated statements of financial condition and reflects the interest income on interest earning assets and interest expense of interest bearing liabilities for the years ended December 31, 2004, 2003 and 2002 and the average yields earned and rates paid during those periods. These yields and costs are derived by dividing income or expense by the average daily balance of the related asset or liability for the periods presented. The Company did not have any tax exempt income during any of the periods presented in Table 1. Nonaccrual loans have been included in the average balances of loans receivable.
2004 vs. 2003. For the year ended December 31, 2004, net interest income increased $3.2 million, or 34.2%, to $12.6 million from the $9.4 million for the year ended December 31, 2003. This was primarily a result of the increase in the volume of interest earning assets, and partially offset by the effect of loan repricings. Total average earning assets increased by $87.2 million, or 34.5%, from 2003 to 2004. The yield on earning assets decreased by only 2 basis points from 2003, reflecting the benefit of faster growth in higher yielding loans rather than lower yielding securities and overnight investments. Average loans outstanding grew by $63.3 million, or 43.6%, during 2004. The yield on such loans decreased by 48 basis points. Average federal funds increased $2.4 million, or 12.0%, while the yield increased 53 basis points. The average balance of the security portfolio grew $21.8 million, or 25.3%, and the yield on the portfolio improved 27 basis points. Although many agency bonds were called throughout 2004 they were reinvested at favorable rates in similar instruments.
For the year ended December 31, 2004, average interest bearing liabilities increased $64.8 million or 36.8% from the prior year. Interest bearing deposits grew $59.6 million and borrowings, which includes federal funds purchased and trust preferred capital notes, increased $5.2 million. Interest expense paid on these liabilities for 2004 was $4.8 million compared with $3.6 million for 2003. The cost of funds declined 4 basis points from 2.05% during 2003 to 2.01% during 2004.
The resulting effect of the changes in interest rates between 2004 and 2003, offset by changes in the volume and mix of earning assets and interest bearing liabilities resulted in a virtually stable net interest margin of 3.72% in 2004 versus 3.73% in 2003. Management believes this stability is indicative of the Company's interest rate risk management process.
2003 vs. 2002. For the year ended December 31, 2003, net interest income increased $2.9 million, or 45.1%, to $9.4 million from the $6.5 million for the year ended December 31, 2002. This was primarily a result of the increase in the volume of interest earning assets, and partially offset by the effect of declining interest rates, loan repricing, the investment of the liquidity generated into lower yielding securities, and short-term investments. Total average earning assets increased by $86.4 million, or 52.0%, from 2002 to 2003. The yield on earning assets decreased by 92 basis points from 2002, reflecting the continued impact of reductions in interest rates over the past three years. Yields on federal funds and the securities portfolio decreased by 56 and 130 basis points, respectively. Average loans outstanding grew by $39.0 million, or 36.8%, during 2003. The yield on such loans decreased by 65 basis points. The securities yield reflected the most sensitivity to declining rates, while loan yields and the federal funds rate, which is the short-term liquidity yield declined, but not as significantly. In the case of the securities portfolio, many agency bonds were called in 2003 and 2002 and reinvested at the current lower market rates.
For the year ended December 31, 2003, average interest bearing liabilities increased $54.9 million or 45.3% from the prior year. Interest bearing deposits grew $51.8 million and borrowings, which includes federal funds purchased and trust preferred capital notes, increased $3.1 million. Interest expense paid on these liabilities for 2003 was $3.6 million, the same level as 2002. The cost of funds declined 93 basis points from 2.98% during 2002 to 2.05% during 2003.
The resulting effect of the changes in interest rates between 2003 and 2002, offset by changes in the volume and mix of earning assets and interest bearing liabilities resulted in a slight decline in the interest margin of 3.73% in 2003 versus 3.90% in 2002.
TABLE 1: AVERAGE BALANCE SHEETS, NET INTEREST INCOME AND YIELDS/RATES
Table 2 shows the composition of the net change in net interest income for the periods indicated, as allocated between the change in net interest income due to changes in the volume of average earning assets and interest bearing liabilities, and the changes in net interest income due to changes in interest rates. As the table shows, the increase in net interest income of $3.2 million for the year ended December 31, 2004, as compared to the twelve months ended December 31, 2003, is due to the growth in the volume of earning assets and interest bearing liabilities. While the decrease in interest rates has, to date, affected total interest income, and to a lesser extent, total interest expense, management has controlled its exposure to changes in interest rates such that the negative effect of the decline in interest rates and the decline in loan yields, as adjustable rate loans have repriced downward over the past several years, resulted in a modest $501,000 reduction of net interest income, whereas the growth in earning assets and deposits resulted in an increase of $3.7 million to net interest income. Interest income over the past year increased $4.4 million. As shown in the table, $5.0 million of this increase is the result of the Company's strong growth in earning assets, particularly in loans, while changes in rates resulted in a $572,000 reduction in interest income. Interest expense during this comparable period increased $1.2 million or 33.6%, from $3.6 million in interest expense in 2003 to $4.8 million in interest expense in 2004. Of this increase, $1.3 million is due to growth in interest bearing liabilities, and $71,000 is attributable to declining rates.
Similar to changes in 2004, the increase in net interest income of $2.9 million for the year ended December 31, 2003 as compared to the twelve months ended December 31, 2002 is due to the growth in the volume of earning assets and interest bearing liabilities. Of this increase, $3.7 million is attributable to strong growth in earning assets and interest bearing liabilities, whereas, declining rates resulted in a $774,000 reduction in net interest income. Interest income increased $2.9 million from $10.1 million in 2002 to $13.0 million in 2003. Of this increase, $5.1 million is the result of growth in earning assets whereas $2.2 million is attributable to declining interest rates. Interest expense was virtually the same in 2003 as in 2002 at $3.6 million; however, increased balances of $55.0 million resulted in an increase in interest expense of $1.4 million while at the same time management of interest rates paid on these liabilities reduced interest expense by a similar amount.
TABLE 2
PROVISION AND ALLOWANCE FOR LOAN LOSSES
The provision for loan losses is based upon a methodology that includes among other factors, a specific evaluation of commercial and commercial real estate loans that are considered special mention, substandard or doubtful. All other loans are then categorized in pools of loans with common characteristics. A potential loss factor is applied to these loans which considers the historical charge off history of the Company and its peer group, trends in delinquencies and loan grading, current economic conditions, and factors that include the composition of the Company's loan portfolio. At December 31, 2004, the Company had impaired loans on nonaccrual status totaling $349,000. The Company had no other loans over 90 days past due and had no other loans on nonaccrual status as of December 31, 2004. The provision for loan losses increased primarily due to reserves required on new loans. See Note 3 to the audited consolidated financial statements for additional information regarding the Company's asset quality and allowance for loan losses.
A methodology established in 2003 determining an appropriate allowance for loan losses was approved by the Audit Committee and the Board of Directors. The quarterly provision is approved by the Board. The methodology is reevaluated on a quarterly basis. Pending the development of a negative trend with respect to past due loans or charge offs or significant changes in economic conditions, the Company continues to maintain an allowance it believes is adequate.
As reflected in Table 4 below, the allowance is allocated among the various categories of loans based upon the methodology described herein.
TABLE 3
The following table presents the activity in the allowance for loan losses for the years ended December 31, 2000 through 2004.
TABLE 4
The following table shows the allocation of the allowance for loan losses at the dates indicated. The allocation of portions of the allowance to specific categories of loans is not intended to be indicative of future losses, and does not restrict the use of the allowance to absorb losses in any category of loans. See Note 3 to the audited consolidated financial statements included in this report for additional information regarding the allowance for loan losses and nonperforming assets.
TABLE 5
The following table shows the amounts of non-performing assets at the dates indicated.
At December 31, 2004, there were no performing loans considered potential problem loans, defined as loans which are not included in the past due, nonaccrual or restructured categories, but for which known information about possible credit problems causes management to have serious doubts as to the ability of the borrowers to comply with the present loan repayment terms. It is the Company's policy to apply all payments received on nonaccrual loans to principal until the balance has been satisfied or the loan returns to accrual status. During 2003, approximately $23,000 in gross interest income would have been recorded on nonaccrual and impaired loans had the loans been accruing interest throughout the period.
LOANS
The loan portfolio is the largest component of earning assets and accounts for the greatest portion of total interest income. At December 31, 2004, total loans were $250.0 million, a 47.9% increase from the $169.0 million in loans outstanding at December 31, 2003. Total loans at December 31, 2003 represented a 39.7% increase from the $121.0 million of loans at December 31, 2002. In general, loans are internally generated with the exception of a small percentage of participation loans purchased from other local community banks. Lending activity is largely confined to our market of Northern Virginia. We do not engage in highly leveraged transactions or foreign lending activities. Loans in the commercial category, as well as commercial real estate mortgages, consist primarily of short-term (five year or less final maturity) and/or floating or adjustable rate commercial loans made to small to medium-sized companies. We do not have any agricultural loans in the portfolio. There are no substantial loan concentrations to any one industry or to any one borrower.
Virtually all of the Company's commercial real estate mortgage and development loans, which account for approximately 67% of our total loans at December 31, 2004, relate to property in the Northern Virginia market. As such, they are subject to risks relating to the general economic conditions in that market, and the market for real estate in particular. While the region has experienced some decline in economic activity during 2002 and 2003, the local real estate market remains generally strong, and the Company attempts to mitigate risk though careful underwriting, including primary reliance on the borrower's financial capacity and ability to repay without resort to the property, and lends primarily with respect to properties occupied or managed by the owner.
The Company's 1-4 family residential real estate loans are generally not the typical purchase money first mortgage loan or refinancing, but are loans made for other purposes and the collateral obtained is a first deed of trust on the residential property of the borrower. The underlying loan would have a final maturity much shorter than the typical first mortgage and may be a variable or fixed rate loan. As reflected in Table 6, 34% of the Company's loans are fixed rate loans and 84% of the Company's loans reprice or have a maturity date that falls within five-years.
Consumer loans consist primarily of secured installment credits to individuals, residential construction loans secured by a first deed of trust, home equity loans, or home improvement loans. The consumer portfolio, which includes consumer loans, home equity loans, and 1-4 family residential loans, represents 5.8% of the loan portfolio at December 31, 2004, as compared to 7.5% at December 31, 2003 and 8.9% at December 31, 2002.
TABLE 6
Table 6 shows the maturities of the loan portfolio and the sensitivity of loans to interest rate fluctuations at December 31, 2004. Maturities are based on the earlier of contractual maturity or repricing date. Demand loans, loans with no contractual maturity and overdrafts are represented in one year or less.
At December 31, 2004, the aggregate amount of loans due after one year which have fixed rates was approximately $52.5 million, and the amount with variable or adjustable rates was approximately $79.2 million.
TABLE 7
The following table presents the composition of the loan portfolio by type of loan at the dates indicated.
INVESTMENT SECURITIES
The carrying value (fair value) of the Company's securities portfolio increased $24.5 million to $146.8 million at December 31, 2004 from $122.3 million at December 31, 2003. The carrying value (fair value) of the Company's securities portfolio increased $46.3 million to $122.3 million at December 31, 2003 from $76.1 million at December 31, 2002.
The Company currently, and for all periods shown, classifies its entire securities portfolio as available for sale. Increases in the portfolio have occurred whenever deposit growth has outpaced loan demand and the forecast for loan growth is such that the investment of excess liquidity in investment securities (as opposed to short term investments such as federal funds) is warranted. In general, our investment philosophy is to acquire high quality government agency securities or high grade corporate bonds, with a maturity of five to six years or less in the case of fixed rate securities. In the case of mortgage backed securities, the policy is to invest only in those securities whose average expected life is projected to be approximately five to six years or less. Mortgage backed securities with a maturity of ten years or more are either adjustable rate securities or the expected life of the mortgage pool is generally no more than five or six years. To the extent possible, we attempt to "ladder" the one time call dates for all our securities. The Company's investment policy is driven by its interest rate risk process and the need to minimize the effect of changing interest rates to the entire balance sheet.
TABLE 8
The following table presents detail of investment securities in our portfolio at the dates indicated.
TABLE 9
The following table provides information regarding the maturity composition of our investment portfolio, at fair value, at December 31, 2004.
For additional information regarding the investment portfolio, see Note 2 to the consolidated financial statements for the year ended December 31, 2004.
At December 31, 2004, there were no issuers, other than issuers who are U.S. government agencies, whose securities owned by the Company had an aggregate book value of more than 10% of total stockholders' equity of the Company.
OFF BALANCE SHEET ARRANGEMENTS
Credit-Related Financial Instruments. The Company is a party to credit related financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, standby letters of credit and commercial letters of credit. Such commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in consolidated balance sheets.
The Company's exposure to credit loss is represented by the contractual amount of these commitments. The Company follows the same credit policies in making commitments as it does for on-balance sheet instruments. At December 31, 2004 and 2003, the following financial instruments were outstanding whose contract amounts represent credit risk:
2004 2003 ---------------- --------------- (Dollars in thousands)
Commitments to extend credit $ 52,461 $ 25,863 Stand-by letters-of-credit $ 2,591 $ 1,371
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. The commitments for equity lines of credit may expire without being drawn upon. Therefore, the total commitments amounts do not necessarily represent future cash requirements. The amount of collateral obtained, if it is deemed necessary by the Company, is based on management's credit evaluation of the customer.
Unfunded commitments under commercial lines-of-credit, revolving credit lines and overdraft protection agreements are commitments for possible future extensions of credit to existing customers. These lines-of-credit are uncollateralized and usually do not contain a specified maturity date and may not be drawn upon to the total extent to which the Company is committed.
Commercial and standby letters-of-credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Those letters-of-credit are primarily issued to support public and private borrowing arrangements. Essentially all letters-of-credit issued have expiration dates within one year. The credit risk involved in issuing letters-of-credit is essentially the same as that involved in extending loan facilities to customers. The Company generally holds collateral supporting those commitments if deemed necessary.
With the exception of these off-balance sheet arrangements, and the Company's obligations in connection with its trust preferred securities, the Company has no off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on the Company's financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures, or capital resources, that is material to investors. For further information, see Notes 11 and 17 to the consolidated financial statements.
CONTRACTUAL OBLIGATIONS
TABLE 10
The Company has entered into certain contractual obligations including long term debt, operating leases and obligations under service contracts. The following table summarizes the Company's contractual cash obligations as of December 31, 2004.
The table does not reflect deposit liabilities entered into in the ordinary course of the Company's banking business. At December 31, 2004, the Company had $239.1 million of demand and savings deposits, exclusive of interest, which have no stated maturity or payment date. The Company also had $73.1 million of time deposits, exclusive of interest, the maturity distribution of which is set forth in Note 5 to the Consolidated Financial Statements. For additional information about the Company's deposit obligations, see "Net Interest Income" and "Deposits" above. See Note 17 to the Consolidated Financial Statements for additional information regarding the trust preferred securities and related capital notes.
LIQUIDITY AND INTEREST RATE SENSITIVITY MANAGEMENT
The primary objectives of asset and liability management are to provide for the safety of depositor and investor funds, assure adequate liquidity, and maintain an appropriate balance between interest sensitive earning assets and interest bearing liabilities. Liquidity management involves the ability to meet the cash flow requirements of customers, who may be depositors wanting to withdraw funds or borrowers needing assurance that sufficient funds will be available to meet their credit needs.
We define liquidity for these purposes as the ability to raise cash quickly at a reasonable cost without principal loss. The primary liquidity measurement we utilize is called the Basic Surplus, which captures the adequacy of our access to reliable sources of cash relative to the stability of our funding mix of deposits. Accordingly, we have established borrowing facilities with other banks (Federal funds) and the Federal Home Loan Bank as sources of liquidity in addition to the deposits.
The Basic Surplus approach enables us to adequately manage liquidity from both tactical and contingency perspectives. At December 31, 2004, our Basic Surplus ratio (net access to cash and secured borrowings as a percentage of total assets) was approximately 17.2% compared to the present internal minimum guideline range of 5% to 10%.
Financial institutions utilize a number of methods to evaluate interest rate risk. Methods range from the original static gap analysis (the difference between interest sensitive assets and interest sensitive liabilities repricing during the same period, measured at a specific point in time), to running multiple simulations of potential interest rate scenarios, to rate shock analysis, to highly complicated duration analysis.
One tool that we utilize in managing our interest rate risk is the matched funding matrix. The matrix arrays repricing opportunities along a time line for both assets and liabilities. The longer term, more fixed rate sources are presented in the upper left hand corner while the shorter term, more variable rate items, are at the lower left. Similarly, uses of funds, such as assets, are arranged across the top moving from left to right.
The body of the matrix is derived by allocating the longest fixed rate funding sources to the longest fixed rate assets and shorter term variable sources to shorter term variable uses. The result is a graphical depiction of the time periods over which we expect to experience exposure to rising or falling rates. Since the scales of the liability and assets sides are identical, all numbers in the matrix would fall within the diagonal lines if we were perfectly matched across all repricing time frames. Numbers outside the diagonal lines represent two general types of mismatches: liability sensitive in time frames when numbers are to the left of the diagonal line and asset sensitive in time frames when numbers are to the right of the diagonal line.
At December 31, 2004, we were modestly liability sensitive in the short term and then we become asset sensitive out beyond two years. This is primarily caused by the assumptions used in allocating a repricing term to nonmaturity deposits--demand deposits, savings accounts, and money market deposit accounts. The actual impact due to changes in interest rates is difficult to quantify in that the administrative ability to change rates on these products is influenced by competitive market conditions in changing rate environments, prepayments of loans, customer demands, and many other factors. These products may not reprice consistently with assets such as variable rate commercial loans or other loans that immediately reprice as the prime rate changes. While the traditional gap analysis and the matched funding matrix show a general picture of our potential sensitivity to changes in interest rates, it cannot quantify the actual impact of interest rate changes.
Thus, the Company manages its exposure to possible changes in interest rates by simulation modeling or "what if" scenarios to quantify the potential financial implications of changes in interest rates. In practice, each quarter approximately 14 different "what if" scenarios are evaluated which include the following scenarios: Static Rates, Most Likely Rate Projection, Rising Rate Environment, Declining Rate Environment, Ramp Up 100bp and 200bp over 12-months, and Ramp Down 100bp and 200bp over 12-months scenarios. In addition, 8 rate shock scenarios are modeled at 50bp up and 50bp down increments but not below zero. At December 31, 2004, the following 12-month impact on net interest income is estimated to range from a positive impact of 3.8% in a rising rate scenario, to a negative impact of (0.8)% if rates decline 100 basis points from current levels. The Company believes these ranges of exposure to changes in interest rates to be well within acceptable range given a wide variety of potential rate change scenarios. This process is performed each quarter to ensure the Company is not materially at risk to possible changes in interest rates.
The following are the projected potential percentage impact on the Company's net interest income over the next 12 months for the most likely to occur scenarios, but measured against a static interest rate environment as of December 31, 2004. The Company is positioned to improve earnings if rates continue to rise. With respect to further reductions in rates, the Company would experience further negative implications on margins and earnings; however, the Company does not believe that a 100 basis point decline is realistic given that interest rates remain near historically low levels, and in light of the Federal Reserve's indications with respect to the interest rate environment. Thus management believes the exposure to further changes in interest rates would not have a material negative effect on the results of operations.
Static Rates -0- % Most Likely Rates 1.9 % Ramp Up 100bp- 12 months 1.2 % Ramp Up 200bp- 12 months 2.3 % Ramp Down 100bp- 12 months (0.8)% Rising Rate Scenario 3.8 % Low Rate Environment 0.9 %
TABLE 11 (Dollars in thousands)
NONINTEREST INCOME AND EXPENSE
Noninterest income consists primarily of service charges on deposit accounts and fees and other charges for banking services. Noninterest expense consists primarily of salary and benefit costs and occupancy and equipment expense. To date, the Company has not been required to pay any premiums for deposit insurance. To the extent that deposit premiums may become required, the Company's results of operations will be adversely affected.
TABLE 12
The categories of noninterest income that exceed 1% of operating revenue are as follows:
The increases in noninterest income for the each period shown are the result of the continued growth of the Company and the expansion of products resulting in fee income. During the second quarter of 2003, we began originating conforming residential mortgage loans on a pre-sold basis, for sale to secondary market investors, servicing released. In addition, the Company earned cash management fees relating to off-balance sheet customer sweep accounts which had average balances of between $16 and $24 million during 2004. During 2004 and 2003, cash management fees declined primarily due to lower balances resulting from commercial customers not utilizing the product during this sustained extremely low interest rate environment.
TABLE 13
The categories of noninterest expense that exceed 1% of operating revenues are as follows:
Non-interest expense increased $2.3 million or 39.0% from $6.0 million for the year ended December 31, 2003, to $8.3 million for 2004. Approximately 63% of this increase is in salary and benefit costs. In 2004 the Company added a number of commercial loan officers, processing staff, and administrative support staff to support the growth in customers and transactions being processed. The increase in occupancy cost is due to the opening of our two new branches in Chantilly and Manassas and our new operations center in Chantilly. The rise in equipment expense is attributable to
additional investments in technology. Growth in other expenses is due in part to costs related to new products such as lockbox services and loans originated through the mortgage division.
DEPOSITS AND OTHER BORROWINGS
The principal sources of funds for the Bank are core deposits (demand deposits, NOW accounts, money market accounts, savings accounts and certificates of deposit less than $100,000) from the local market areas surrounding the Bank's offices. The Bank's deposit base includes transaction accounts, time and savings accounts and accounts which customers use for cash management and which provide the Bank with a source of fee income and cross-marketing opportunities as well as a low-cost source of funds. Time and savings accounts, including money market deposit accounts, also provide a relatively stable and low-cost source of funding.
TABLE 14
The following table reflects average deposits and average rates paid by category for the periods indicated.
TABLE 15
The following table indicates the amount of certificates of deposit of $100,000 or more and less than $100,000, and their remaining maturities.
CAPITAL MANAGEMENT
Management monitors historical and projected earnings, asset growth, as well as its liquidity and various balance sheet risks in order to determine appropriate capital levels. At December 31, 2004, stockholders' equity increased $3.0 million from the $33.9 million of equity at December 31, 2003 primarily as a result of the $2.967 million in retained earnings for 2004.
The Company has reported a steady improvement in earnings since the Bank opened on June 8, 1998. Positive earnings were reported in the ninth month of operations and have continued with $810 thousand of earnings in 2000, $1.1 million of earnings for 2001, $1.6 million of earnings for 2002, $2.6 million of earnings for 2003, and $3.0 million of
earnings for 2004. One of the Company's first strategies was to restore the lost capital from the initial organization costs of $254 thousand and the accumulated earnings loss of $452 thousand for 1998. As of December 31, 2001, the earnings for 2000 and 2001 had recouped the losses and at December 31, 2002 the Company had retained earnings of approximately $2.9 million. In addition, the Company has fully utilized its net operating losses for tax purposes beginning in September 2001 and has been at a 34% effective tax rate since that date.
For information regarding our regulatory capital ratios, please refer to note 10 to the consolidated financial statements.
The ability of the Company to continue to grow is dependent on its earnings and the ability to obtain additional funds for contribution to the Bank's capital, through borrowing, the sale of additional common stock, or through the issuance of additional trust preferred securities. In the event that the Company is unable to obtain additional capital for the Bank on a timely basis, the growth of the Company and the Bank may be curtailed, and the Company and the Bank may be required to reduce their level of assets in order to maintain compliance with regulatory capital requirements. Under those circumstances net income and the rate of growth of net income may be adversely affected. The Company believes that its current capital is sufficient to meet anticipated growth, although there can be no assurance.
The Federal Reserve has revised the capital treatment of trust preferred securities, in light of recent accounting pronouncements and interpretations regarding variable interest entities, which have been read to encompass the subsidiary trusts established to issue trust preferred securities, and to which the Company issued subordinated debentures. As a result, the capital treatment of trust preferred securities has been revised to provide that in the future, such securities can be counted as Tier 1 capital at the holding company level, together with certain other restricted core capital elements, up to 25% of total capital (net of goodwill), and any excess as Tier 2 capital up to 50% of Tier 1 capital. At December 31, trust preferred securities represented 21.0% of the Company's tier 1 capital and 18.9% of its total capital. Future trust preferred issuances to increase holding company capital levels may not be available to the same extent as currently. The Company may be required to raise additional equity capital, through the sale of common stock or otherwise, sooner than it would otherwise do so.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Stockholders and Directors James Monroe Bancorp, Inc. and Subsidiaries Arlington, Virginia
We have audited the accompanying consolidated balance sheets of James Monroe Bancorp, Inc. and Subsidiaries as of December 31, 2004 and 2003, and the related consolidated statements of income, changes in stockholders' equity and cash flows for the years ended December 31, 2004, 2003 and 2002. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of James Monroe Bancorp, Inc. and Subsidiaries as of December 31, 2004 and 2003, and the results of their operations and their cash flows for the years ended December 31, 2004, 2003 and 2002, in conformity with U.S. generally accepted accounting principles.
/s/ Yount, Hyde & Barbour, P.C.
Winchester, Virginia January 7, 2005
JAMES MONROE BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS December 31, 2004 and 2003 (Dollars in thousands, except share data)
The accompanying notes are an integral part of these consolidated financial statements.
JAMES MONROE BANCORP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME For the Years Ended December 31, 2004, 2003 and 2002 (Dollars in thousands, except per share data)
The accompanying notes are an integral part of these consolidated financial statements.
JAMES MONROE BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY For the Years Ended December 31, 2004, 2003 and 2002 (Dollars in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
JAMES MONROE BANCORP, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows For the Years Ended December 31, 2004, 2003 and 2002 (Dollars in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
Notes to Audited Consolidated Financial Statements
JAMES MONROE BANCORP, INC. AND SUBSIDIARIES NOTES TO AUDITED CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. NATURE OF BANKING ACTIVITIES AND SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION AND CONSOLIDATION
The consolidated financial statements include the accounts of James Monroe Bancorp, Inc. (the "Company") and its wholly owned subsidiaries, James Monroe Bank (the "Bank"), James Monroe Statutory Trust I ("Trust I") and James Monroe Statutory Trust II ("Trust II"). In consolidation, significant inter-company accounts and transactions have been eliminated. FASB Interpretation No. 46(R) requires that the Company no longer consolidate James Monroe Statutory Trust I and II. The subordinated debt of the trusts is reflected as a liability of the Company and the common securities of the trusts as another asset.
BUSINESS
The Company, through its banking subsidiary, offers various loan, deposit and other financial service products to its customers, principally located throughout Northern Virginia. Additionally, the Company maintains correspondent banking relationships and transacts daily federal funds transactions on an unsecured basis, with regional correspondent banks.
The accounting and reporting policies and practices of the Company conform with U.S. generally accepted accounting principals. The following is a summary of the most significant of such policies and procedures.
USE OF ESTIMATES
The preparation of consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses and the valuation of deferred tax assets.
CASH AND CASH EQUIVALENTS
For purposes of reporting cash flows, cash and due from banks include cash on hand and amounts due from banks, including cash items in process of clearing.
INTEREST BEARING DEPOSITS IN BANKS
Interest bearing deposits in banks mature within one month and are carried at cost.
SECURITIES AVAILABLE FOR SALE
Securities classified as available for sale are equity securities with readily determinable fair values and those debt securities that the Company intends to hold for an indefinite period of time but not necessarily to maturity. Any decision to sell a security classified as available for sale would be based on various factors, including significant movements in interest rates, changes in the maturity mix of the Company's assets and liabilities, liquidity needs, regulatory capital considerations, and other similar factors. These securities are carried at fair value, with any unrealized gains or losses reported as a separate component of other comprehensive income net of the related deferred tax effect. Purchase premiums and discounts are recognized in interest income using the interest method over the terms of the securities. Declines in the fair value of available for sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses. In estimating other than temporary impairment losses, management considers (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. Gains and losses on the sale of securities are recorded on the trade date and are determined using the specific identification method. Gains and losses on the sale of securities are recorded on the trade date and are determined using the specific identification method.
Notes to Audited Consolidated Financial Statements
LOANS
The Company, through its banking subsidiary, grants mortgage, commercial and consumer loans to customers. A substantial portion of the loan portfolio is represented by commercial real estate loans throughout Northern Virginia. The ability of the Company's debtors to honor their contracts is dependent upon the real estate and general economic conditions in this area.
Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off generally are reported at their outstanding unpaid principal balances adjusted for charge offs, the allowance for loan losses, and any deferred fees or costs on originated loans. Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and recognized as an adjustment of the related loan yield using the interest method.
The accrual of interest on mortgage and commercial loans is discontinued at the time the loan is 90 days delinquent unless the credit is well-secured and in process of collection. Other personal loans are typically charged off no later than 180 days past due. In all cases, loans are placed on nonaccrual or charged off at an earlier date if collection of principal or interest is considered doubtful.
All interest accrued but not collected for loans that are placed on nonaccrual or charged off is reversed against interest income. The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.
LOANS HELD FOR SALE
Loans originated and intended for sale in the secondary market are carried at the lower of cost or estimated fair value in the aggregate. Net unrealized losses, if any, are recognized through a valuation allowance by charges to income. The Company generally does not retain the mortgage servicing.
ALLOWANCE FOR LOAN LOSSES
The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.
The allowance consists of specific, general and unallocated components. The specific component relates to loans that are classified as either special mention, substandard or doubtful. For such loans that are also classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers non-classified loans and is based on historical loss experience adjusted for qualitative factors. An unallocated component is maintained to cover uncertainties that could affect management's estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.
A loan is considered impaired when, based on current information and events, it is probable that a creditor will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower's prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial and construction loans by either the present value of expected future cash flows discounted at the loan's effective interest rate, the loan's obtainable market price, or the fair value of the collateral if the loan is collateral dependent.
Notes to Audited Consolidated Financial Statements
Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual consumer and residential loans for impairment disclosures.
BANK PREMISES AND EQUIPMENT
Premises and equipment are stated at cost less accumulated depreciation and amortization that is computed using the straight-line method over the following estimated useful lives:
YEARS Leasehold improvements 10 Furniture and equipment 3-10
Costs incurred for maintenance and repairs are expensed currently.
INCOME TAXES
Deferred income tax assets and liabilities are determined using the liability (or balance sheet) method. Under this method, the net deferred tax asset or liability is determined based on the tax effects of the temporary differences between the book and tax bases of the various balance sheet assets and liabilities and gives current recognition to changes in tax rates and laws. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized.
FAIR VALUE OF FINANCIAL INSTRUMENTS
Statement of Financial Accounting Standards (SFAS) No. 107, Disclosures About Fair Value of Financial Instruments, requires disclosure of fair value information about financial instruments, whether or not recognized in the balance sheet, for which it is practicable to estimate that value. In cases where quoted market prices are not available, fair values are based on estimates using present value techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instrument. SFAS No. 107 excludes certain financial instruments and all nonfinancial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented should not be considered an indication of the fair value of the Company taken as a whole.
RATE LOCK COMMITMENTS
The Company enters into commitments to originate loans whereby the interest rate on the loan is determined prior to funding (rate lock commitments). Rate lock commitments on mortgage loans that are intended to be sold are considered to be derivatives. Accordingly, such commitments, along with any related fees received from potential borrowers, are to be recorded at fair value in derivative assets or liabilities, with changes in fair value recorded in the net gain or loss on sale of loans. Fair value is based on fees currently charged to enter into similar agreements, and for fixed-rate commitments also considers the difference between current levels of interest rates and the committed rates. Prior to July 1, 2002 such commitments were recorded to the extent of fees received. Fees received were subsequently included in the net gain or loss on sale of loans. Any differences between recorded and calculated amounts were not material.
Notes to Audited Consolidated Financial Statements
STOCK COMPENSATION PLANS
At December 31, 2004, the Company has three stock-based compensation plans which are described more fully in Note 8. The Company accounts for these plans under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. No stock-based employee compensation cost is reflected in net income, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of the grant. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation.
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions:
2004 2003 2002 -------- -------- -------
Dividend yield 0.00% 0.00% 0.00% Expected life 7.7 years 8.3 years 10 years Expected volatility 37.23% 32.07% 0.50% Risk-free interest rate 3.80% 4.07% 5.05%
EARNINGS PER SHARE
Basic earnings per share represents income available to common stockholders divided by the weighted-average number of common shares outstanding during the period. Diluted earnings per share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed issuance. Potential common shares that may be issued by the Company relate solely to outstanding stock options, and are determined using the treasury stock method.
Notes to Audited Consolidated Financial Statements
Earnings per common share have been computed based on the information in the following table. Shares have been restated to reflect the stock splits as discussed in Note 18. Options totaling 5,000 and 4,313 for the years ended December 31, 2004 and 2003, respectively were excluded from the computation of diluted earnings per share as their effect would have been anti-dilutive. No options were excluded from the computation of diluted earnings per share for the year ended December 31, 2002. For the years presented, there was no adjustment to income from potential common shares.
RECENT ACCOUNTING PRONOUNCEMENTS
In January 2003, the Financial Accounting Standards Board ("FASB") issued FASB Interpretation No. 46, "Consolidation of Variable Interest Entities" ("FIN 46"). This Interpretation provides guidance with respect to the identification of variable interest entities when the assets, liabilities, non-controlling interests, and results of operations of a variable interest entity need to be included in a Company's consolidated financial statements. An entity is deemed a variable interest entity, subject to the interpretation, if the equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support from other parties, or in cases in which the equity investors lack one or more of the essential characteristics of a controlling financial interest, which include the ability to make decisions about the entity's activities through voting rights, the obligations to absorb the expected losses of the entity if they occur, or the right to receive the expected residual returns of the entity if they occur. Due to significant implementation issues, the FASB modified the wording of FIN 46 and issued FIN 46R in December of 2003. FIN 46R deferred the effective date for the provisions of FIN 46 to entities other than Special Purpose Entities ("SPEs") until financial statements issued for periods ending after March 15, 2004. SPEs were subject to the provisions of either FIN 46 or FIN 46R as of December 15, 2003. Management has evaluated the Company's investments in variable interest entities and potential variable interest entities or transactions, particularly in trust preferred securities structures because these entities or transactions constitute the Company's primary FIN 46 and FIN 46R exposure. The adoption of FIN 46 and FIN 46R did not have a material effect on the Company's consolidated financial position or consolidated results of operations.
On March 9, 2004, the SEC Staff issued Staff Accounting Bulletin No. 105, "Application of Accounting Principles to Loan Commitments" ("SAB 105"). SAB 105 clarifies existing accounting practices relating to the valuation of issued loan commitments, including interest rate lock commitments ("IRLC"), subject to SFAS No. 149 and Derivative Implementation Group Issue C13, "Scope Exceptions: When a Loan Commitment is included in the Scope of Statement 133." Furthermore, SAB 105 disallows the inclusion of the values of a servicing component and other internally developed intangible assets in the initial and subsequent IRLC valuation. The provisions of SAB 105 were effective for loan commitments entered into after March 31, 2004. The Company has adopted the provisions of SAB 105. Since the provisions of SAB 105 affect only the timing of the recognition of mortgage banking income, management does not anticipate that this guidance will have a material adverse effect on either the Company's consolidated financial position or consolidated results of operations.
Notes to Audited Consolidated Financial Statements
Emerging Issues Task Force Issue No. (EITF) 03-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments," was issued and is effective March 31, 2004. The EITF 03-1 provides guidance for determining the meaning of "other than temporarily impaired" and its application to certain debt and equity securities within the scope of Statement of Financial Accounting Standards No. 115 "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS No. 115") and investments accounted for under the cost method. The guidance requires that investments which have declined in value due to credit concerns or solely due to changes in interest rates must be recorded as other-than-temporarily impaired unless the Company can assert and demonstrate its intention to hold the security for a period of time sufficient to allow for a recovery of fair value up to or beyond the cost of the investment which might mean maturity. This issue also requires disclosures assessing the ability and intent to hold investments in instances in which an investor determines that an investment with a fair value less than cost is not other-than-temporarily impaired. On September 30, 2004, the Financial Accounting Standards Board decided to delay the effective date for the measurement and recognition guidance contained in Issue 03-1. This delay does not suspend the requirement to recognize other-than-temporary impairments as required by existing authoritative literature. The disclosure guidance in Issue 03-1 was not delayed.
EITF No. 03-16, "Accounting for Investments in Limited Liability Companies was ratified by the Board and is effective for reporting periods beginning after June 15, 2004." APB Opinion No. 18, "The Equity Method of Accounting Investments in Common Stock," prescribes the accounting for investments in common stock of corporations that are not consolidated. AICPA Accounting Interpretation 2, "Investments in Partnerships Ventures," of Opinion 18, indicates that "many of the provisions of the Opinion would be appropriate in accounting" for partnerships. In EITF Abstracts, Topic No. D-46, "Accounting for Limited Partnership Investments," the SEC staff clarified its view that investments of more than 3 to 5 percent are considered to be more than minor and, therefore, should be accounted for using the equity method. Limited liability companies (LLCs) have characteristics of both corporations and partnerships, but are dissimilar from both in certain respects. Due to those similarities and differences, diversity in practice exists with respect to accounting for non-controlling investments in LLCs. The consensus reached was that an LLC should be viewed as similar to a corporation or similar to a partnership for purposes of determining whether a non-controlling investment should be accounted for using the cost method or the equity method of accounting. The Company had no such investments as of December 31, 2004.
In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123 (revised 2004), "Share-Based Payment." This Statement establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services. It also addresses transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entity's equity instruments or that may be settled by the issuance of those equity instruments. The Statement focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. The Statement requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award (with limited exceptions). That cost will be recognized over the period during which an employee is required to provide service in exchange for the award - the requisite service period (usually the vesting period). The entity will initially measure the cost of employee services received in exchange for an award of liability instruments based on its current fair value; the fair value of that award will be remeasured subsequently at each reporting date through the settlement date. Changes in fair value during the requisite service period will be recognized as compensation cost over that period. The grant-date fair value of employee share options and similar instruments will be estimated using option-pricing models adjusted for the unique characteristics of those instruments (unless observable market prices for the same or similar instruments are available). If an equity award is modified after the grant date, incremental compensation cost will be recognized in an amount equal to the excess of the fair value of the modified award over the fair value of the original award immediately before the modification. This Statement is effective for public entities that do not file as small business issuers--as of the beginning of the first interim or annual reporting period that begins after June 15, 2005. Under the transition method, compensation cost is recognized on or after the required effective date for the portion of outstanding awards for which the requisite service has not yet been rendered, based on the grant-date fair value of those awards calculated under Statement 123 for either recognition or pro forma disclosures. For periods before the required effective date, entities may elect to apply a modified version of retrospective application under which financial statements for prior periods are adjusted on a basis consistent with the pro forma disclosures required for those periods by Statement 123.
Notes to Audited Consolidated Financial Statements
NOTE 2. SECURITIES AVAILABLE FOR SALE
The amortized cost and estimated fair value of securities available for sale, with gross unrealized gains and losses, follows:
Notes to Audited Consolidated Financial Statements
Information pertaining to securities with gross unrealized losses at December 31, 2004 and December 31, 2003, aggregated by investment category and length of time that the individual securities have been in a continuous loss position, follows:
Management evaluates securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation. Consideration is given to (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.
The bonds in an unrealized loss position at December 31, 2004 were temporarily impaired due to the current interest rate environment and not increased credit risk. All securities owned by the Company are payable at par at maturity. Of the temporarily impaired securities, 17 are U.S. Government agency issued bonds (Government National Mortgage Association and the Federal Home Loan Bank) rated AAA by Standard and Poor's, 25 are government sponsored enterprise issued bonds (Federal National Mortgage Association and Federal Home Loan Mortgage Corporation) rated AAA by Standard and Poor's, and one is a corporate bond rated BBB by Standard and Poor's. As management has the ability to hold debt securities until maturity, or for the foreseeable future, no declines are deemed to be other than temporary.
The amortized cost and fair value of securities by contractual maturity at December 31, 2004 follows:
Notes to Audited Consolidated Financial Statements
Securities carried at $43,510,000 and $37,482,000 at December 31, 2004 and 2003, respectively, were pledged to secure public deposits and for other purposes required or permitted by law.
For the years ended December 31, 2004, 2003 and 2002, proceeds from sales of securities available for sale amounted to $41,174,000, $72,397,000 and $6,359,000, respectively. Gross realized gains amounted to $59,000, $299,000 and $244,000, respectively. The tax provision applicable to these realized gains amounted to $20,000, $102,000, and $83,000 respectively.
NOTE 3. LOANS AND ALLOWANCE FOR LOAN LOSSES
Major classifications of loans are as follows:
Changes in the allowance for loan losses are as follows:
Notes to Audited Consolidated Financial Statements
The following is a summary of information pertaining to impaired loans:
No additional funds are committed to be advanced in connection with impaired loans.
All nonaccrual loans were included in the impaired loan disclosure under SFAS No. 114 as of December 31, 2004. Nonaccrual loans excluded from impaired loan disclosure under SFAS No. 114 amounted to $186,000 and $56,000 at December 31, 2003 and 2002 respectively. If interest on these loans had been accrued, such income would have approximated $12,000 for 2003 and $10,000 for 2002.
There were no loans 90 days past due and still accruing interest at December 31, 2004 or 2002. Loans totaling $34,000 were 90 days past due and still accruing interest at December 31, 2003.
NOTE 4. BANK PREMISES AND EQUIPMENT
Bank premises and equipment consist of the following:
DECEMBER 31, ------------------- (Dollars in thousands) 2004 2003 ------- ------- Leasehold improvements $ 1,243 $ 749 Furniture and equipment 1,370 763 Computers 813 455 Software 399 278 Premises and equipment in process 22 118 ------- ------- 3,847 2,363 Less accumulated depreciation 1,409 975 ------- ------- $ 2,438 $ 1,388 ======= =======
Depreciation and amortization charged to operations totaled $436,000, $323,000 and $257,000 for the years ended December 31, 2004, 2003 and 2002, respectively.
Notes to Audited Consolidated Financial Statements
NOTE 5. DEPOSITS
Interest bearing deposits consist of the following:
At December 31, 2004, the scheduled maturities of time deposits are as follows:
(Dollars in thousands)
2005 $ 62,088 2006 2,608 2007 5,675 2008 358 2009 2,403 -------- $ 73,132 ========
Notes to Audited Consolidated Financial Statements
NOTE 6. INCOME TAXES
Significant components of the Company's net deferred tax assets consist of the following:
Allocation of federal income taxes between current and deferred portions for the years ended December 31, 2004, 2003 and 2002 is as follows:
DECEMBER 31, --------------------------------- 2004 2003 2002 -------- -------- ------ (Dollars in thousands)
Current tax provision $ 1,848 $ 1,548 $ 921 Deferred tax (benefit) (291) (220) (109) -------- -------- ------ $ 1,557 $ 1,328 $ 812 ======== ======== ======
The income tax provision differs from the amount of income tax determined by applying the U.S. federal income tax rate to pretax income for the years ended December 31, 2004, 2003 and 2002, due to the following:
Notes to Audited Consolidated Financial Statements
NOTE 7. LEASE COMMITMENTS AND TOTAL RENTAL EXPENSE
The Company leases its facilities under operating leases expiring at various dates through 2011. The leases provide that the Company pay as additional rent, its proportionate share of real estate taxes, insurance, and other operating expenses. The leases contain a provision for annual increases of 3%. Total rental expense for the years ended December 31, 2004, 2003 and 2002 was $662,000, $450,000 and $398,000, respectively.
The minimum lease commitments for the next five years and thereafter are:
(Dollars in thousands)
2005 $ 890 2006 853 2007 844 2008 545 2009 563 Thereafter 2,450 -------- $ 6,145 ========
NOTE 8. STOCK OPTION PLANS
The Company's 1998 Stock Option Plan (1998 Plan) for key employees is accounted for in accordance with Accounting Principles Board (APB) Opinion 25, Accounting for Stock Issued to Employees, and related interpretations. The 1998 Plan provides that 258,412 shares of the Company's common stock will be reserved for both incentive stock options and non-qualified stock options to purchase common stock of the Company. The exercise price per share for incentive stock options and non-qualified stock options shall not be less than the fair market value of a share of common stock on the date of grant, and may be exercised in increments, commencing after the date of grant. One-third of the options granted become vested and exercisable in each of the three years following the grant date. Each incentive and non-qualified stock option granted under this plan shall expire not more than ten years from the date the option is granted.
In 1999, the Company adopted a stock option plan in which options for 188,100 shares of common stock were reserved for issuance to directors of the Company. The Company applies APB Opinion 25 and related interpretations in accounting for the stock option plan. Accordingly, no compensation has been recognized for grants under this plan. The stock option plan requires that options be granted at an exercise price equal to at least 100% of the fair market value of the common stock on the date of grant. All options granted under this plan have vested and expire not more than ten years from the date the options were granted.
In 2003, the Company adopted the 2003 Executive Compensation plan that reserves 375,000 shares of the Company's common stock for both incentive and non-qualified stock options, restricted stock, and stock appreciation rights, for issuance to employees and directors. The Company applies APB Opinion 25 and related interpretations in accounting for the plan. Accordingly, no compensation has been recognized for grants under this plan. The stock option plan required that options be granted at an exercise price equal to at least 100% of the fair market value of the common stock on the date of grant. Options granted under this plan become vested and exercisable within three to five years following the grant date with the exception of options granted to directors which vest immediately. Options granted under this plan shall expire not more than ten years from the date the option is granted.
Notes to Audited Consolidated Financial Statements
A summary of the status of the Company's employee stock options is presented in the table below. Information has been restated to reflect the stock splits as discussed in Note 18.
A summary of the status of the Company's director stock options is presented in the table below. Information has been restated to reflect the stock splits as discussed in Note 18.
Information pertaining to options outstanding for all plans at December 31, 2004 is as follows:
NOTE 9. 401(K) PLAN
Effective January 1, 1999, the Company adopted a Section 401(k) plan covering employees meeting certain eligibility requirements as to minimum age and years of service. Employees may make voluntary contributions to the 401(k) plan through payroll deductions on a pre-tax basis. The Company may make discretionary contributions to the 401(k) plan based on its earnings. The plan has a KSOP component whereby employees may elect to allocate a portion of funds to an Employee Stock Ownership Plan. The employer's contributions are subject to a vesting schedule requiring the completion of five years of service before these benefits become vested. A participant's 401(k) plan account, together with investment earnings thereon, is distributable following retirement, death, disability or other termination of employment under various payout options. For the years ended December 31, 2004, 2003 and 2002, expense attributable to the plan amounted to $80,000, $43,000 and $29,000 respectively.
NOTE 10. MINIMUM REGULATORY CAPITAL REQUIREMENTS
The Company (on a consolidated basis) and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company's and Bank's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Prompt corrective action provisions are not applicable to bank holding companies.
Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the following table) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined) and of Tier 1 capital (as defined) to average assets (as defined). Management believes, as of December 31, 2004 and 2003, that the Company and the Bank exceeded all capital adequacy requirements to which they are subject.
As of December 31, 2004, the most recent notification from the Federal Deposit Insurance Corporation categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, an institution must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the following tables. There are no conditions or events since the notification that management believes have changed the Bank's category. The Company's and the Bank's actual capital amounts and ratios as of December 31, 2004 and 2003 are also presented in the table.
Notes to Audited Consolidated Financial Statements
RESTRICTION ON DIVIDENDS
Prior approval of the Bank's regulatory agencies is required to pay dividends which exceed the Bank's net profits for the current year, plus its retained net profits for the preceding two years. At December 31, 2004, the Bank could pay $7,218,000 in dividends without prior regulatory approval. The Bank did not pay any cash dividends during the years ended December 31, 2004, 2003 or 2002.
NOTE 11. OFF-BALANCE SHEET ACTIVITIES
Credit-Related Financial Instruments. The Company is a party to credit related financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, standby letters of credit and commercial letters of credit. Such commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in consolidated balance sheets.
The Company's exposure to credit loss is represented by the contractual amount of these commitments. The Company follows the same credit policies in making commitments as it does for on-balance sheet instruments. At December 31, 2004 and 2003, the following financial instruments were outstanding whose contract amounts represent credit risk:
(Dollars in thousands) 2004 2003 ------------- -----------
Commitments to extend credit $ 52,461 $ 25,863 Standby letters of credit $ 2,591 $ 1,371
Notes to Audited Consolidated Financial Statements
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. The commitments for equity lines of credit may expire without being drawn upon. Therefore, the total commitments amounts do not necessarily represent future cash requirements. The amount of collateral obtained, if it is deemed necessary by the Company, is based on management's credit evaluation of the customer.
Unfunded commitments under commercial lines-of-credit, revolving credit lines and overdraft protection agreements are commitments for possible future extensions of credit to existing customers. These lines-of-credit are uncollateralized and usually do not contain a specified maturity date and may not be drawn upon to the total extent to which the Company is committed.
Commercial and standby letters-of-credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Those letters-of-credit are primarily issued to support public and private borrowing arrangements. Essentially all letters-of-credit issued have expiration dates within one year. The credit risk involved in issuing letters-of-credit is essentially the same as that involved in extending loan facilities to customers. The Company generally holds collateral supporting those commitments if deemed necessary.
The Company maintains a portion of its cash balances with several financial institutions. Accounts at each institution are secured by the Federal Deposit Insurance Corporation up to $100,000. Unsecured balances were approximately $691,000 at December 31, 2004.
NOTE 12. TRANSACTIONS WITH DIRECTORS AND OFFICERS
The Company has had, and may be expected to have in the future, banking transactions in the ordinary course of business with directors and principal officers, their immediate families and affiliated companies in which they are principal stockholders (commonly referred to as related parties). In the opinion of management, such loans are made on the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with others. They do not involve more than normal credit risk or present other unfavorable features.
Aggregate loan balances with related parties totaled $4,030,000 and $4,319,000 at December 31, 2004 and 2003, respectively. During the year ended December 31, 2004, total principal additions were $300,000 and total principal payments were $589,000.
NOTE 13. FAIR VALUE OF FINANCIAL INSTRUMENTS AND INTEREST RATE RISK
The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:
CASH AND CASH EQUIVALENTS - For these instruments, the carrying amount is a reasonable estimate of fair value.
INTEREST BEARING DEPOSITS IN BANKS - The carrying amounts of interest bearing deposits maturing within ninety days approximate their fair value.
AVAILABLE FOR SALE SECURITIES - Fair values for securities, excluding restricted stock, are based on quoted market prices. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. The carrying value of restricted stock approximates fair value based on the redemption provisions of the respective entity.
LOANS RECEIVABLE - Fair value for performing loans is calculated by discounting estimated cash flows using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality.
Notes to Audited Consolidated Financial Statements
Fair value for non-performing loans is based on the lesser of estimated cash flows which are discounted using a rate commensurate with the risk associated with the estimated cash flows, or values of underlying collateral.
MORTGAGE LOANS HELD FOR SALE - Fair values of mortgage loans held for sale are based on commitments on hand from investors or prevailing market prices.
DEPOSIT LIABILITIES - The fair value of demand deposits, savings accounts and certain money market deposits is the amount payable on demand at the reporting date. The fair value of certificates of deposit is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for deposits of similar remaining maturities.
LONG-TERM BORROWINGS - The fair values of the Company's long-term borrowings are estimated using discounted cash flow analysis based on the Company's current incremental borrowing rates for similar types of borrowing arrangements.
ACCRUED INTEREST - The carrying amounts of accrued interest approximate fair value.
OFF BALANCE SHEET INSTRUMENTS - Fair values for off-balance sheet credit-related instruments are based on fees currently charged to enter similar arrangements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair value of standby letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counterparties at the reporting date. At December 31, 2004 and 2003, the fair values of loan commitments and standby letters of credit were deemed immaterial.
Notes to Audited Consolidated Financial Statements
The estimated fair values of the Company's financial instruments at December 31, 2004 and 2003 are as follows:
The Company assumes interest rate risk (the risk that general interest rate levels will change) as a result of its normal operations. As a result, the fair values of the Company's financial instruments will change when interest rate levels change and that change may be either favorable or unfavorable to the Company. Management attempts to match maturities of assets and liabilities to the extent believed necessary to minimize interest rate risk. However, borrowers with fixed rate obligations are less likely to prepay in a rising rate environment and more likely to prepay in a falling rate environment. Conversely, depositors who are receiving fixed rates are more likely to withdraw funds before maturity in a rising rate environment and less likely to do so in a falling rate environment. Management monitors rates and maturities of assets and liabilities and attempts to minimize interest rate risk by adjusting terms of new loans and deposits and by investing in securities with terms that mitigate the Company's overall interest rate risk.
NOTE 14. COMMITMENTS AND CONTINGENT LIABILITIES
The Bank has unsecured lines of credit with correspondent banks totaling $26,500,000 available for overnight borrowing. There were no amounts drawn on these lines at December 31, 2004. The Company had outstanding balances on these lines of $6,886,000 at December 31, 2003.
As a member of the Federal Reserve System, the Bank is required to maintain certain average reserve balances. For the final reporting period in the year ended December 31, 2004, the aggregate amount of daily average balances was approximately $7,269,000.
NOTE 15. OTHER NONINTEREST INCOME AND EXPENSES
The principal components of other noninterest income in the consolidated statements of income are:
Notes to Audited Consolidated Financial Statements
The principal components of other operating expenses in the consolidated statements of income are:
NOTE 16. CONDENSED FINANCIAL STATEMENTS OF PARENT COMPANY
Financial information pertaining only to James Monroe Bancorp, Inc. is as follows:
CONDENSED BALANCE SHEETS December 31, 2004 and 2003
Notes to Audited Consolidated Financial Statements
CONDENSED INCOME STATEMENTS For the Years Ended December 31, 2004, 2003 and 2002
CONDENSED STATEMENTS OF CASH FLOW For the Years Ended December 31, 2004, 2003 and 2002
Notes to Audited Consolidated Financial Statements
NOTE 17. TRUST PREFERRED CAPITAL SECURITIES
On March 25, 2002, James Monroe Statutory Trust I, a subsidiary of the Company, was formed for the purpose of issuing redeemable trust preferred securities and purchasing the Company's junior subordinated debentures, which are its sole assets. The Company owns all of Trust I's outstanding common securities. On March 26, 2002, $5 million of the trust preferred securities were issued in a pooled underwriting totaling approximately $500 million. The securities bear interest at a rate equal to the three-month LIBOR plus 360 basis points, subject to a cap of 11% which is set and payable on a quarterly basis. During 2004, the interest rates ranged from 4.71% to 5.55%. The rate for the quarterly period beginning December 26, 2004, was 6.15%. The securities have a maturity date of March 25, 2032, and are subject to varying call provisions beginning March 26, 2007.
On July 16, 2003, James Monroe Statutory Trust II, a newly formed subsidiary of the Company, was formed for the purpose of issuing redeemable trust preferred securities and purchasing the Company's junior subordinated debentures, which are its sole assets. The Company owns all of Trust II's outstanding common securities. On July 31, 2003, $4 million of the trust preferred securities were issued in a private placement transaction. The securities bear interest at a rate equal to the three-month LIBOR plus 310 basis points, subject to a cap of 12% which is set and payable on a quarterly basis. During 2004, the interest rates ranged from 4.20% to 5.08%. The rate for the quarterly period beginning December 31, 2004, was 5.66%. The securities have a maturity date of July 31, 2033, and are subject to ranging call provisions beginning July 31, 2008.
The trust preferred securities may be included in Tier 1 capital for regulatory capital adequacy determination purposes up to 25% of Tier 1 capital. The portion of the securities not considered as Tier 1 capital will be included in Tier 2 capital. At December 31, 2004, all of the trust preferred securities qualified as Tier 1 capital.
The Company and the Trusts believe that, taken together, the Company's obligations under the junior subordinated debentures, the Indentures, the Trust Declarations and the Guarantees entered into in connection with the issuance of the trust preferred securities constitute a full and unconditional guarantee by the Company of the Trusts' respective obligations with respect to the trust preferred securities.
Subject to certain exceptions and limitations, the Company may elect from time to time to defer interest payments on the junior subordinated debt securities, which would result in a deferral of distribution payments on the related trust preferred securities.
NOTE 18. COMMON STOCK SPLITS
On July 25, 2002, the Company issued 613,195 additional shares necessary to effect a 3-for-2 common stock split in the form of a 50% stock dividend to shareholders of record July 11, 2002. The earnings per common share for all periods prior to July 2002 have been restated to reflect the stock split.
On May 16, 2003, the Company issued 459,968 additional shares necessary to effect a 5-for-4 common stock split in the form of a 25% stock dividend to shareholders of record April 25, 2003. The earnings per common share for all periods prior to May 2003 have been restated to reflect the stock split.
On June 1, 2004, the Company issued 1,478,317 additional shares necessary to effect a 3-for-2 common stock split in the form of a 50% stock dividend to shareholders of record on May 14, 2004. The earnings per common share for all periods prior to June 2004 have been restated to reflect the stock split.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES.
The Company's management, under the supervision and with the participation of the Chief Executive Officer and Chief Financial Officer, evaluated, as of the last day of the period covered by this report, the effectiveness of the design and operation of the Company's disclosure controls and procedures, as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures were adequate. There were no changes in the Bank's internal control over financial reporting (as defined in Rule 13a-15 under the Securities Act of 1934) during the quarter ended December 31, 2004 that has materially affected, or is reasonably likely to materially affect, the Bank's internal control over financial reporting.
ITEM 9B.
ITEM 9B. OTHER INFORMATION.
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
Code of Ethics. The Company has adopted a Code of Ethics that applies to the President and Executive Vice President/Chief Financial Officer. The Company will provide a copy of the Code of Ethics without charge upon written request directed to Richard I. Linhart, Secretary, James Monroe Bancorp, Inc., 3033 Wilson Boulevard 22201.
The other information required by Item 10 is incorporated by reference from the material under the caption "Election of Directors" contained at pages 4 through 7, and under the caption "Compliance with Section 16(a) of the Securities Exchange Act of 1934" at page 12, of the Company's definitive proxy statement for the annual meeting of shareholders to be held on April 28, 2005 (the "Proxy Statement").
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION.
The information required by Item 11 is incorporated by reference from the material under the caption "Executive Compensation," contained at pages 7 through 12 of the Proxy Statement.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS.
The information required by Item 12 is incorporated by reference from the material under the captions "Securities Ownership of Directors, Executive Officers and Five Percent Beneficial Owners" contained at Page 3 of the Proxy Statement, and included under the caption "Securities Authorized for Issuance Under Equity Compensation Plans" under Item 5 hereof.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
The information required by Item 13 is incorporated by reference from the material under the caption "Certain Relationships and Related Transactions" contained at page 10 of the Proxy Statement.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES.
The information required by Item 14 is incorporated by reference from the material under the caption "Independent Registered Public Accounting Firm" contained at page 13 of the Proxy Statement.
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES.
(A) THE FOLLOWING FINANCIAL STATEMENTS ARE INCLUDED IN THIS REPORT:
Report of Independent Auditors
Consolidated Balance Sheets at December 31, 2003 and 2004
Consolidated Statements of Income for the years ended December 31, 2002, 2003 and 2004
Consolidated Statements of Cash Flows for the years ended December 31, 2002, 2003 and 2004
Consolidated Statements of Changes in Stockholders' Equity for the years ended December 31, 2002, 2003 and 2004
Notes to the Consolidated Financial Statements
(B) EXHIBITS
Exhibit No. Description of Exhibits
3(a) Articles of Incorporation of James Monroe Bancorp, as amended (1) 3(b) Bylaws of James Monroe Bancorp (2) 4(a) Indenture, dated as of March 26, 2002 between James Monroe Bancorp, Inc. and State Street Bank and Trust Company of Connecticut, National Association, as trustee (3) 4(b) Amended and Restated Declaration of Trust, dated as of March 26, 2002 among James Monroe Bancorp, Inc., State Street Bank and Trust Company of Connecticut, National Association, as Institutional Trustee, and John R. Maxwell, David W. Pijor and Richard I. Linhart as Administrators (3) 4(c) Guarantee Agreement dated as of March 26, 2002, between James Monroe Bancorp, Inc. and State Street Bank and Trust Company of Connecticut, National Association, as trustee (3) 4(d) Indenture, dated as of July 31, 2003 between James Monroe Bancorp, Inc. and U.S. Bank, National Association, as trustee (3) 4(e) Amended and Restated Declaration of Trust, dated as of July 31, 2003 among James Monroe Bancorp, Inc., U.S. Bank, National Association, as Institutional Trustee, and John R. Maxwell, David W. Pijor and Richard I. Linhart as Administrators (3) 4(f) Guarantee Agreement dated as of July 31, 2003, between James Monroe Bancorp, Inc. and U.S. Bank, National Association, as trustee (3) 10(a) Employment contract between James Monroe Bancorp and John R. Maxwell(4) 10(b) Employment contract between James Monroe Bancorp and Richard I. Linhart (5) 10(c) James Monroe Bancorp 1998 Management Incentive Stock Option Plan (6) 10(d) James Monroe Bancorp 2000 Director's Stock Option Plan (7) 10(e) James Monroe Bancorp, Inc. 2003 Equity Compensation Plan (8) 11 Statement re: Computation of Per Share Earnings
Please refer to Note 1 to the financial statements included in this report.
21 Subsidiaries of the Registrant 23 Independent Auditor's Consent 31(a) Certification of Chief Executive Officer 31(b) Certification of Chief Financial Officer 32(a) Certification of Chief Executive Officer 32(b) Certification of Chief Financial Officer - -------------------------- (1) Incorporated by reference to exhibit 3(a) to the Company's Annual Report on Form 10-KSB for the year ended December 31, 2002.
(2) Incorporated by reference to exhibit 3(b) to the Company's registration statement on Form SB-2 (No. 333-38098).
(3) Not filed in accordance with the provisions of Item 601(b)(4)(iii) of Regulation SK. The Company agrees to provide a copy of these documents to the Commission upon request.
(4) Incorporated by reference to exhibit of same number to the Company's Annual Report on Form 10-KSB for the year ended December 31, 2002.
(5) Incorporated by reference to exhibit of same number to the Company's Annual Report on Form 10-KSB for the year ended December 31, 2003.
(6) Incorporated by reference to exhibit 10(b) to the Company's registration statement on Form SB-2 (No. 333-38098).
(7) Incorporated by reference to exhibit 10(c) to the Company's registration statement on Form SB-2 (No. 333-38098).
(8) Incorporated by reference to exhibit 10(e) to the Company's Quarterly Report on Form 10-QSB for the quarter ended March 31, 2003
SIGNATURES
In accordance with Section 13 of the Securities Exchange Act of 1934, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
JAMES MONROE BANCORP, INC.
March 9, 2005 By: /s/ John R. Maxwell -------------------------- John R. Maxwell, President
In accordance with the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.