Item 1: Business
General. - Carrollton Bancorp, a Maryland corporation (the “Company”), a bank holding company registered under the Bank Holding Company Act of 1956, as amended, was organized on January 11, 1990, and is headquartered in Baltimore, Maryland. Carrollton Bank (the “Bank”) is a commercial bank and the principal subsidiary of the Company. The Bank was chartered by an act of the General Assembly of Maryland (Chapter 727) approved April 10, 1900. The Bank is engaged in a general commercial and retail banking business and, as of December 31, 2008, had a total of ten branch locations in Maryland with two branch locations in Baltimore City; three branch locations in Anne Arundel County; four branches in Baltimore County and one branch in Harford County. The Bank’s wholly owned subsidiaries are Carrollton Mortgage Services, Inc. (“CMSI”), which is used primarily to originate and sell residential mortgage loans, Carrollton Financial Services, Inc. (“CFS”), which provides brokerage services, and Mulberry Street LLC (“MSLLC”) which is used to dispose of other real estate owned. Carrollton Community Development Corporation (“CCDC”) is a 96.4% owned subsidiary of the Bank which promotes, develops and improves the housing and economic conditions of people in Maryland, particularly the Metropolitan Baltimore area.
The Bank is an independent, community bank that seeks to provide personal attention and professional financial services to its customers while offering virtually all of the banking services of larger competitors. Our customers are primarily individuals and small and medium-sized businesses. The Bank’s business philosophy includes offering informed and courteous service, local and timely decision-making, flexible and reasonable operating procedures and consistently applied credit policies.
On or around March 23, 2009, the executive offices of the Company and the principal office of the Bank will be relocated to 7151 Columbia Gateway Drive, Suite A, Columbia, Maryland 21046, telephone number (410) 312-5400. The Company files quarterly and annual reports with the Securities and Exchange Commission (“SEC”) on forms 10-Q and 10-K, respectively, proxy materials on Schedule 14A and current reports on Form 8-K. The Company makes available, free of charge, all of these reports, as well as any amendments, through the Company’s Internet site as soon as is reasonably practicable after they are filed electronically with the SEC. The address of that site is http://www.carrolltonbank.com. To access the SEC reports, click on “About Us” -“SEC Filings”. The SEC also maintains an internet site that contains reports, proxy materials and information statements at http://sec.gov. In addition, the Company will provide paper copies of filings free of charge upon written request.
Recent Market Developments. - In response to the financial crises affecting the banking system and financial markets and going concern threats to investment banks and other financial institutions, on October 3, 2008, the Emergency Economic Stabilization Act of 2008 (the “EESA”) was signed into law. Pursuant to the EESA, the U.S. Treasury was given the authority to, among other things, purchase up to $700 billion of mortgages, mortgage-backed securities and certain other financial instruments from financial institutions for the purpose of stabilizing and providing liquidity to the U.S. financial markets.
On October 14, 2008, the Secretary of the Department of the Treasury announced that the Department of the Treasury will purchase equity stakes in a wide variety of banks and thrifts. Under the program, known as the Troubled Asset Relief Program Capital Purchase Program (the “TARP Capital Purchase Program”), from the $700 billion authorized by the EESA, the Treasury made $250 billion of capital available to U.S. financial institutions in the form of preferred stock. In conjunction with the purchase of preferred stock, the Treasury received, from participating financial institutions, warrants to purchase common stock with an aggregate market price equal to 15% of the preferred investment. Participating financial institutions were required to adopt the Treasury’s standards for executive compensation and corporate governance for the period during which the Treasury holds equity issued under the TARP Capital Purchase Program. On February 13, 2009, the Company raised $9,201,000 through participation in the TARP Capital Purchase Program.
The Company issued 9,201 shares of Fixed Rate Cumulative Perpetual Preferred Stock, Series A, liquidation preference $1,000 per share (the “Series A Preferred Stock”), and a warrant to purchase 205,379 shares of the Company’s common stock, par value $1.00 per share. The warrant is exercisable at $6.72 per share at any time on or before February 13, 2019. Treasury has agreed not to exercise voting power with respect to any shares of common stock issued upon exercise of the warrant.
On November 21, 2008, the Board of Directors of the Federal Deposit Insurance Corporation (“FDIC”) adopted a final rule relating to the Temporary Liquidity Guarantee Program (“TLG Program”). The TLG Program was announced by the FDIC on October 14, 2008, preceded by the determination of systemic risk by the Secretary of the Department of Treasury (after consultation with the President), as an initiative to counter the system-wide crisis in the nation’s financial sector. Under the TLG Program the FDIC will (i) guarantee, through the earlier of maturity or June 30, 2012, certain newly issued senior unsecured debt issued by participating institutions on or after October 14, 2008, and before June 30, 2009 and (ii) provide full FDIC deposit insurance coverage for non-interest bearing transaction deposit accounts, Negotiable Order of Withdrawal (“NOW”) accounts paying less than 0.5% interest per annum and Interest on Lawyers Trust Accounts (“IOLTA”) accounts held at participating FDIC insured institutions through December 31, 2009. Coverage under the TLG Program was available for the first 30 days without charge. The fee assessment for coverage of senior unsecured debt ranges from 50 basis points to 100 basis points per annum, depending on the initial maturity of the debt. The fee assessment for deposit insurance coverage is 10 basis
points per quarter on amounts in covered accounts exceeding $250,000. On November 25, 2008, the Company elected to participate in the deposit insurance coverage for non-interest bearing transaction deposit accounts. On December 10, 2008, the Company declined to participate in the senior unsecured debt program.
Description of Services. - The Bank provides a broad range of consumer and commercial banking products and services to individuals, businesses, professionals and governments. The services and products have been designed in such a manner as to appeal to consumers and business principals.
The following is a partial listing of the types of services and products that the Bank offers:
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Commercial loans for businesses, including those for working capital purposes, equipment purchases and accounts receivable and inventory financing.
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Commercial and residential real estate loans for acquisition, refinancing and construction.
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Consumer loans including automobile loans, home equity loans and lines of credit.
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Loans guaranteed by the United States Small Business Administration.
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Money market deposits, demand deposits, NOW accounts, savings accounts and certificates of deposit.
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Internet banking, including electronic bill payment.
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Letters of credit and remittance services.
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Credit and debit card services.
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Merchant credit card deposit servicing.
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Brokerage services for stocks, bonds, mutual funds and annuities.
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A 24-hour ATM network.
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After-hours depository services.
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Safe deposit boxes.
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Other services, such as direct deposit, traveler’s checks and IRAs.
Customer service hours for the Bank are competitive with other institutions in the market area. The Bank also acts as a reseller of services purchased from third party vendors for customers requiring services not offered directly by the Bank.
Lending Activities. - The Bank makes various types of loans to borrowers based on, among other things, an evaluation of the borrowers’ net asset value, cash flow, security and ability to repay. Loans to consumers include home mortgage loans, home equity lines of credit, home improvement loans, overdraft lines of credit, and installment loans for automobiles, boats and recreational vehicles. The Bank also makes loans secured by deposit accounts and common stocks. The Bank’s commercial loan product line includes commercial mortgage loans, time and demand loans, lines and letters of credit, and acquisition, development and construction financing. The Notes to the Consolidated Financial Statements contained in Part II, Item 8 report the classification by type of loan for the whole portfolio.
First and second residential mortgage loans, made principally through the Bank’s subsidiary, CMSI, enable customers to purchase or refinance residential properties. These loans are secured by liens on the residential property. All first mortgage loans with a loan to value ratio greater than 80% have private mortgage insurance coverage equal to or greater than the amount required under the Federal National Mortgage Association guidelines. Residential loans are considered comparatively low risk based on the type of collateral (residential property) and the underwriting standards used. The Bank experienced $423,687 of losses and $4,358 in recoveries on residential mortgage loans in 2008. The Bank experienced $76,426 of losses and no recoveries on residential mortgage loans in 2007. The Bank experienced no losses and no recoveries in 2006. There were approximately $877,000 of residential mortgage loans delinquent more than 90 days at December 31, 2008.
Home equity lines of credit are typically second mortgage loans (sometimes first mortgages) secured by the borrower’s primary residence structured as a revolving borrowing line with a maximum loan amount. Customers write checks to access the line. Generally, the Bank has a second lien on the property behind the first mortgage lien holder. The Bank has a number of different equity loan products that it offers. Borrowers can choose between fixed rate loans or loans tied to the prime rate with margins ranging from 0% to 1.5%. The Bank will finance up to 90% of the value of the home in combination with the first mortgage loan balance, depending on the rate and program. Home equity loans carry a higher level of risk than first mortgage residential loans because of the second lien position on the property, and because a higher loan to value ratio is used in the underwriting of the loan. However, the overall risk of loss on home equity loans is also considered comparatively low due to the underlying values of the collateral. The Bank experienced losses on home equity loans of $75,000 during 2008, $100,455 during 2007 and none during 2006. The Bank experienced no recoveries on home equity loans during 2008, 2007 and 2006. There were approximately $199,000 of home equity loans delinquent more than 90 days at December 31, 2008.
Commercial and investment mortgage loans are first mortgage loans made to individuals or to businesses to finance acquisitions of plant or earning assets, such as rental property. These loans are secured by a first mortgage lien on the commercial property, and may be further secured by other property or other assets depending on the value of the mortgaged property. In most instances, these loans are guaranteed personally by the principals. The Bank typically looks for cash flow from the business at least equal to 115% coverage of the business debt service, and for income-producing property to be self-supporting, generally, with a minimum debt service coverage ratio of 120% to 125%. Commercial mortgage loans carry more risk than residential real estate loans. Commercial mortgage loans tend to be larger in size, and the properties tend to exhibit more fluctuation in value. The repayment of the loan is primarily dependent on the success of the business itself, or the tenants in the case of income producing property. Economic cycles can affect the success of a business. The Bank experienced losses on commercial mortgage loans of $518,755 during 2008, $220,640 during 2007, and $59,120 during 2006. The Bank experienced recoveries on commercial and investment mortgages of $9,643 in 2008, $187 in 2007 and $6,290 in 2006. There were approximately $2.0 million commercial mortgage loans past due more than 90 days at December 31, 2008.
Construction and land development loans are loans to finance the acquisition and development of parcels of land and to construct residential housing or commercial property. The Bank typically will finance 70% to 80% of the discounted future value of these projects, or 80% of value or 90% of cost, whichever is less, on a single-family detached home. The loan is collateralized by the project or real estate itself, and other assets or guarantees of the principals in most cases. Repayment to the Bank is anticipated from the proceeds of sale of the final units, or permanent mortgage financing on a residential construction loan for a single borrower. These types of loans carry a higher degree of risk than a commercial mortgage loan. Interest rates, buyer preferences, and desired locations are all subject to change during the period from the time of the loan commitment to final delivery of the final unit, all of which can change the economics of the project. In addition, real estate developers to whom these loans are typically made are subject to the business risk of operating a business in a competitive environment. The Bank experienced $1.2 million of losses and $32,648 in recoveries on construction and land development loans during 2008. The Bank did not experience any losses or recoveries on construction and land development loans during 2007, and 2006. There were approximately $3.6 million in construction and land development loans past due more than 90 days at December 31, 2008.
Demand and time loans and lines of credit are loans to businesses for relatively short periods of time, usually not more than one year. These loans are made for any valid business purpose. These loans may be secured by assets of the borrower or guarantor, but may be unsecured based on the personal guarantee of the principal. If secured, loans may be made for up to 100% of the value of the collateral. The businesses to which these loans are made are subject to normal business risk, and cash flows of the business may be subject to economic cycles. In addition, the value of the collateral may fluctuate. If guaranteed by the principal, the net worth and assets of the principal may be dissipated by demands of the business, or due to other factors. The Bank had no losses or recoveries on demand and time loans in 2008, 2007 and 2006. There were $583,000 of demand and time and line of credit loans delinquent more than 90 days at December 31, 2008.
Home improvement loans are loans made to borrowers to complete improvements to their homes including such projects as room additions, swimming pool installations or new roofs. The Bank makes unsecured home improvement loans to a maximum amount of $15,000. Any loan above that limit is secured by a deed of trust. Borrowers are required to own their home, and to meet certain income and debt ratio requirements. The Bank also reviews the credit history of all applicants. Because they are unsecured or secured by a deed of trust, these loans are more risky than first mortgage residential lending. This risk is mitigated somewhat based on the fact that the loans are used to improve the borrower’s home, typically a borrower’s most significant asset. In addition, the debt-to-income ratio requirement helps determine the borrower’s current ability to repay the loan. The Bank had charge-offs of home improvement loans of $0, $249, and $11,515 in 2008, 2007 and 2006, respectively. There were recoveries of $320, $608 and $0 in 2008, 2007, and 2006, respectively. There were approximately $3,000 of home improvement loans delinquent more than 90 days at December 31, 2008.
The remainder of the consumer loan portfolio is comprised of installment loans for automobiles, boats and recreational vehicles (“RV”), overdraft protection lines, and loans secured by deposit accounts or stocks. The largest portion of this group is installment loans for automobiles and other vehicles. The Bank will finance up to 90% of the cost of a new car purchase, or the maximum loan amount as determined by the National Automobile Dealers Association (“NADA”) publication for used cars. The Bank will finance up to 85% of the cost of a new boat or RV, or the maximum loan amount determined by the NADA Boat/RV Guide for used Boats and RVs. These loans are secured by the vehicle purchased. Borrowers must meet certain income and debt ratio requirements, and a credit review is performed on each applicant. These types of loans are subject to the risk that the value of the vehicle will decline faster than the amount due on the loan. However, the income-to-debt ratio requirement helps determine the borrower’s current ability to repay. The Bank had no losses on automobile loans in 2007 and $6,849 in 2006 and recoveries of $0, $5,598, and $1,251 in 2008, 2007 and 2006, respectively. There were no automobile or other vehicle loans past due more than 90 days at December 31, 2008.
Overdraft lines and other personal loans are unsecured lending arrangements. These loans or lines of credit are made to allow customers to easily make purchases of consumer goods. If the lines are handled as agreed, they will typically be automatically renewed each year. Because they are unsecured, these loans carry a higher level of risk than secured lending transactions. The Bank attempts to mitigate significant risk by establishing fairly low credit limits. Net charge-offs in 2008, 2007, and 2006 were $24,501, $2,916, and $11,662, respectively. There were $11,000 overdraft loans and other personal loans past due more than 90 days at December 31, 2008.
Loans secured by savings accounts and stock and bond certificates are secured lending arrangements. The Bank will advance funds for up to 95% of balances in savings or certificate of deposit accounts. The Bank will advance funds up to 60% of the market value of actively
traded stock certificates and bonds or 50% of the market value of listed but not actively traded stocks and bonds. Loans secured by stocks and bonds are subject to margin calls to maintain the loan to value ratio. Collateral is not released until the loan is repaid, and the borrower is generally required to pay interest monthly. There were no losses on loans secured by savings accounts or stock and bond certificates during 2008, 2007, or 2006. Recoveries on loans secured by stocks and bonds were $0, $437, and $0 in 2008, 2007, and 2006 respectively. There were no loans secured by savings accounts or stock and bond certificates past due more than 90 days at December 31, 2008.
The Bank is the principal originator of the loans it makes, at this time. In prior periods, residential mortgage loans and home equity loans and lines of credit were predominantly purchased from a network of brokers or other types of originators with whom the Bank did business. The Bank has sold some loans in the secondary market and therefore derives a small amount of noninterest income from serviced loans. These income amounts are not significant to the amounts of noninterest income derived from other sources.
CMSI originates adjustable and fixed-rate residential mortgage loans at terms and conditions and with documentation that permit their sale in the secondary mortgage market. CMSI’s practice is to immediately sell substantially all residential mortgage loans in the secondary market with servicing released.
CCDC was established in 1995 for the purpose of promoting, developing, and improving the housing and economic conditions of people in Maryland with particular emphasis in the Metropolitan Baltimore area. CCDC promotes through loans, investments, and other transactions, efforts to increase housing for low and moderate-income individuals.
MSLLC was established in 2004 for the purpose of disposing of real estate owned. At December 31, 2008, there were six properties with a fair market value of $1.7 million. There was no activity in MSLLC in 2007 and 2006.
Investment Activities. - The Company maintains a portfolio of investment securities to provide liquidity and income. The current portfolio amounts to about 17% of total assets, and is invested primarily in U.S. government agency securities, state and municipal bonds, corporate bonds, and mortgage-backed securities with maturities varying from 2009 to 2038, as well as equity securities.
Deposit Services. - The Bank offers a wide range of both personal and commercial types of deposit accounts and services as a means of gathering funds. Deposit accounts available include noninterest-bearing demand checking, interest-bearing checking (NOW accounts), savings, money market, certificates of deposit, and individual retirement accounts. Deposit accounts carry varying fee structures depending on the level of services desired by the customer. Interest rates vary depending on the balance in the account maintained by the customer. Commercial deposit customers may also choose an overnight investment account which automatically invests excess balances available in demand accounts on a daily basis in repurchase agreements. The Bank’s customer base for deposits is primarily retail in nature. The Bank also offers certificates of deposit over $100,000 to its retail and commercial customers. The Bank has used deposit brokers in the past and may do so in the future to meet liquidity needs.
The Company offers Certificate of Deposit Registry Service (“CDARS”) deposits to its customers. This is a program which allows customers to deposit more than would normally be covered by FDIC insurance. CDARS is a nationwide program that allows participating banks to “swap” customer deposits so that no customer has greater than the insurable maximum in one bank, but the customer only deals with his/her own bank.
In addition to traditional deposit services, the Bank offers telephone banking services, internet banking services and internet bill paying services to its customers. Also, the Bank offers remote deposit capture to its commercial customers.
Brokerage Activities. - CFS provides full service brokerage services for stocks, bonds, mutual funds and annuities. For 2008, commission income totaled $682,000 and net income was $158,000.
Market. - The Company considers its core markets to be the communities within the Baltimore Metropolitan Statistical Area (“Baltimore MSA”), particularly Baltimore City and the counties of Baltimore, Anne Arundel and Harford. Lending activities are broader and include areas outside of the Baltimore MSA. CMSI operates in Delaware, Pennsylvania, Virginia and West Virginia in addition to its core Maryland operations. All of the Company’s revenue is generated within the United States.
Competition. - The Bank faces strong competition in all areas of its operations. This competition comes from entities operating in Baltimore City, Baltimore County, Anne Arundel County, Harford County, and Carroll County, and includes branches of some of the largest banks in Maryland. Its most direct competition for deposits historically has come from other commercial banks, savings banks, savings and loan associations and credit unions. The Bank also competes for deposits with money market funds, mutual funds and corporate and government securities. The Bank competes with the same banking entities for loans, as well as mortgage banking companies and other institutional lenders. The competition for loans varies from time to time depending on certain factors, including, among others, the general availability of lendable funds and credit, general and local economic conditions, current interest rate levels, conditions in the mortgage market and other factors which are not readily predictable. Some of the Bank’s competitors have greater assets and operating capacity than the Bank.
Current federal law allows the acquisition of banks by bank holding companies nationwide. Further, federal and Maryland law permit interstate banking. Recent legislation has broadened the extent to which financial services companies, such as investment banks and insurance companies, may control commercial banks. As a consequence of these developments, competition in the Bank’s principal market may increase, and a further consolidation of financial institutions in Maryland may occur.
Asset Management. - The Bank makes available several types of loan services to its customers as described above, depending on customer needs. Recent emphasis has been made on originating short-term (one year or less), variable rate commercial loans and variable rate home equity lines of credit, with the balance of its funds invested in consumer/installment loans and real estate loans, both commercial and residential. In addition, a portion of the Bank’s assets is invested in high-grade securities and other investments in order to provide income, liquidity and safety. Such investments include U.S. government agency securities, corporate bonds, mortgage-backed securities and collateralized mortgage obligations, as well as advances of federal funds to other member banks of the Federal Reserve System. Subject to the effects of taxes, the Bank also invests in tax-exempt state and municipal securities with a minimum rating of “A” by a recognized ratings agency. The Bank’s primary source of funds is customer deposits. The risk of non-repayment (or deferred payment) of loans is inherent in the business of commercial banking, regardless of the type of loan or borrower. The Bank’s efforts to expand its loan portfolio to small and medium-sized businesses may result in the Bank undertaking certain lending risks which are somewhat different from those involved in loans made to larger businesses. The Bank’s management evaluates all loan applications and seeks to minimize the exposure to credit risks through the use of thorough loan application, approval and monitoring procedures. However, there can be no assurance that such procedures significantly reduce all risks.
Employees. - As of December 31, 2008, the Bank and its subsidiaries had 137 full time equivalent employees, 28 of whom were officers. Each officer generally has responsibility for one or more loan, banking, customer contact, operations, or subsidiary functions. Non-officer employees are employed in a variety of administrative capacities. Management believes that it has a favorable relationship with its employees.
Critical accounting policies
The Company’s financial condition and results of operations are sensitive to accounting measurements and estimates of matters that are inherently uncertain. When applying accounting policies in areas that are subjective in nature, management must use its best judgment to arrive at the carrying value of certain assets. One of the most critical accounting policies applied is related to the valuation of the loan portfolio.
A variety of estimates impact the carrying value of the loan portfolio including the calculation of the allowance for loan losses, valuation of underlying collateral and the timing of loan charge-offs.
The allowance for loan losses is one of the most difficult and subjective judgments. The allowance is established and maintained at a level that management believes is adequate to cover losses resulting from the inability of borrowers to make required payments on loans. Estimates for loan losses are arrived at by analyzing risks associated with specific loans and the loan portfolio. Current trends in delinquencies and charge-offs, the views of Bank regulators, changes in the size and composition of the loan portfolio and peer comparisons are also factors. The analysis also requires consideration of the economic climate and direction and change in the interest rate environment, which may impact a borrower’s ability to pay, legislation impacting the banking industry and economic conditions specific to the Bank’s service area. Because the calculation of the allowance for loan losses relies on estimates and judgments relating to inherently uncertain events, results may differ from our estimates.
Another critical accounting policy is related to securities. Securities are evaluated periodically to determine whether a decline in their value is other than temporary. The term “other than temporary” is not intended to indicate a permanent decline in value. Rather, it means that the prospects for near term recovery of value are not necessarily favorable, or that there is a lack of evidence to support fair values equal to, or greater than, the carrying value of the investment. Management reviews criteria such as the magnitude and duration of the decline, as well as the reasons for the decline, to predict whether the loss in value is other than temporary. Once a decline in value is determined to be other than temporary, the value of the security is reduced and a corresponding charge to earnings is recognized.
Supervision and Regulation
General. - The Company and Bank are extensively regulated under federal and state law. Generally, these laws and regulations are intended to protect depositors, not stockholders. The following is a summary description of certain provisions of certain laws, which affect the regulation of banks and holding companies. The discussion is qualified in its entirety by reference to applicable laws and regulations. Changes in these laws and regulations may have a material effect on the business and prospects of the Company and the Bank.
As a bank holding company, the Company is subject to the Bank Holding Company Act of 1956, as amended (the “BHCA”). The BHCA is administered by the Board of Governors of the Federal Reserve System (the “Board of Governors”), and the Company is required to file with the Board of Governors such reports and information as may be required pursuant to the BHCA. The Board of Governors also may examine the Company and any of its nonbank subsidiaries. The BCHA requires every bank holding company to obtain the prior approval of the Board of Governors before: (i) it or any of its subsidiaries (other than a bank) acquires substantially all of the assets of any bank; (ii) it acquires ownership or control of any voting shares of any bank if after such acquisition it would own or control, directly or indirectly, more than five percent of the voting shares of such bank; or (iii) it merges or consolidates with any other bank holding company.
Under the BHCA, a bank holding company is generally prohibited from engaging in, or acquiring direct or indirect control of more than five percent (5%) of the voting shares of any company engaged in non-banking activities. A major exception to this prohibition is for activities the Board of Governors finds, by order or regulation, to be so closely related to banking or managing or controlling banks. Some of the activities that the Board of Governors has determined by regulation to be properly incident to the business of a bank holding
company are: making or servicing loans and certain types of leases; engaging in certain investment advisory and discount brokerage activities; performing certain data processing services; acting in certain circumstances as a fiduciary or as an investment or financial advisor; ownership of certain types of savings associations; engaging in certain insurance activities; and making investments in certain corporations or projects designed primarily to promote community welfare.
Federal and State Bank Regulation. The Bank is a Maryland state-chartered bank, with all the powers of a commercial bank, regulated and examined by the Office of the Maryland Commissioner of Financial Regulation (the “Commissioner’) and the FDIC. The Commissioner and the FDIC have extensive enforcement authority over the institutions they regulate to prohibit or correct activities which violate law, regulations or written agreements with the regulator, or which are deemed to constitute unsafe or unsound practices. Enforcement actions may include the appointment of a conservator or receiver, the issuance of a cease and desist order, the termination of deposit insurance, the imposition of civil money penalties on the institution, its directors, officers, employees and institution-affiliated parties, and the enforcement of any such mechanisms through restraining orders or other court actions.
In its lending activities, the maximum legal rate of interest, fees and charges which a financial institution may charge on a particular loan depends on a variety of factors such as the type of borrower, the purpose of the loan, the amount of the loan and the date the loan is made. Other laws tie the maximum amount, which may be loaned to any one customer and its related interests to capital levels. The Bank is also subject to certain restrictions on extensions of credit to executive officers, directors, principal stockholders or any related interest of such persons which generally require that such credit extensions be made on substantially the same terms as are available to third persons dealing with the Bank and not involve more than the normal risk of repayment.
The Community Reinvestment Act (“CRA”) requires that in connection with the examination of financial institutions within their jurisdictions, the FDIC evaluate the record of the financial institutions in meeting the credit needs of their local communities, including low and moderate-income neighborhoods, consistent with the safe and sound operation of these banks. The factors are also considered by all regulatory agencies in evaluating mergers, acquisitions and applications to open a branch or facility. As of the date of its most recent examination report, the Bank has a CRA rating of “Satisfactory.”
Under the Federal Deposit Insurance Corporation Improvement Act of 1991(“FDICIA”), each federal banking agency is required to prescribe, by regulation, non-capital safety and soundness standards for institutions under its authority. The federal banking agencies, including the FDIC, have adopted standards covering internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, and compensation, fees and benefits. An institution that fails to meet those standards may be required by the agency to develop a plan acceptable to the agency, which specifies the steps that the institution will take to meet the standards. Failure to submit or implement such a plan may subject the institution to regulatory sanctions. The Bank believes that it meets substantially all standards which have been adopted. FDICIA also imposed new capital standards on insured depository institutions described under the caption, “Capital Requirements.”
Before establishing new branch offices, the Bank must meet certain minimum capital stock and surplus requirements. Prior to establishment of the branch, the Bank must obtain Commissioner and FDIC approval.
Deposit Insurance. Congress has temporarily increased FDIC deposit insurance from $100,000 to $250,000 per depositor through December 31, 2009. On January 1, 2010, the standard coverage limit will return to $100,000 for all deposit categories except IRAs and Certain Retirement Accounts, which will be insured up to $250,000 per owner. The Company is participating in the FDIC’s Temporary Liquidity Guarantee Program. Consequently, unlimited deposit insurance coverage is available through December 31, 2009 for non-interest bearing transaction accounts. As an FDIC insured institution, deposits of the Bank are currently insured through the Bank Insurance Fund (“BIF”). For traditional and ROTH IRA’s, the federal deposit insurance limit is $250,000. The FDIC is required to establish the semi-annual assessments for BIF-insured depository institutions at a rate determined to be appropriate to maintain or increase the reserve ratio of the respective deposit insurance funds at or above 1.25 percent of estimated insured deposits or at such higher percentage that the FDIC determines to be justified for that year by circumstances raising significant risk of substantial future losses to the fund. The Bank paid a de minimus semi-annual assessment in 2008.
In an effort to restore capitalization levels and to ensure the BIF will adequately cover projected losses from future bank failures, the FDIC, in October 2008, proposed a rule to alter the way in which it differentiates for risk in the risk-based assessment system and to revise deposit insurance assessment rates, including base assessment rates. The FDIC proposed raising the current rates uniformly by 7 basis points for the assessment for the first quarter of 2009 resulting in annualized assessment rates for Risk Category 1 institutions ranging from 12 to 14 basis points. The proposal for first quarter 2009 assessment rates was adopted as a final rule in December 2008. The FDIC also proposed, effective April 1, 2009, initial base assessment rates for Risk Category 1 institutions of 10 to 14 basis points. After the effect of potential base-rate adjustments, the annualized assessment rate for Risk Category 1 institutions would range from 8 to 21 basis points. A final rule related to this proposal is expected to be issued during the first quarter of 2009. The Company cannot provide any assurance as to the amount of any proposed increase in its deposit insurance premium rate, should such an increase occur, as such changes are dependent upon a variety of factors, some of which are beyond the Company’s control.
Limits on Dividends and Other Payment. Both federal and state laws impose restrictions on the ability of the Bank to pay dividends. The Federal Reserve Board (“FRB”) has issued a policy statement, which provides that, as a general matter, insured banks may pay dividends only out of prior operating earnings. For a Maryland state-chartered bank, dividends may be paid out of undivided profits or,
with the prior approval of the Commissioner, from surplus in excess of 100% of required capital stock. If, however, the surplus of a Maryland bank is less than 100% of its required capital stock, cash dividends may not be paid in excess of 90% of the net earnings. In addition to these specific restrictions, bank regulatory agencies, in general, also have the ability to prohibit proposed dividends by a financial institution, which would otherwise be permitted under applicable regulations if the regulatory body determines that such distribution would constitute an unsafe or unsound practice.
On February 13, 2009, the Company raised $9,201,000 through the sale of the Series A Preferred Stock which will qualify as Tier 1 capital. The Series A Preferred Stock will pay cumulative dividends at a rate of 5% per annum until February 15, 2014. Beginning February 16, 2014, the dividend rate will increase to 9% per annum. Dividends are payable quarterly. The Treasury’s current consent shall be required for any increase in the common dividends per share until February 13, 2012 unless prior to such date, the Series A Preferred Stock is redeemed in whole or the Treasury has transferred all of the Series A Preferred Stock to third parties. For as long as the Series A Preferred Stock is outstanding, no dividend can be paid on the common stock unless all dividends on the Series A Preferred Stock have been paid.
On and after February 15, 2012, the Company may, at its option, redeem shares of Series A Preferred Stock, in whole or in part, at any time and from time to time, for cash at a per share amount equal to the sum of the liquidation preference per share plus any accrued and unpaid dividends to but excluding the redemption date. Prior to February 15, 2012, the Company may redeem shares of Series A Preferred Stock only if it has received aggregate gross proceeds of not less than $ 9,201,000 from one or more qualified equity offerings, and the aggregate redemption price may not exceed the net proceeds received by the Company from such offerings. The redemption of the Series A Preferred Stock requires prior regulatory approval.
The warrant is exercisable at $6.72 per share at any time on or before February 13, 2019. Treasury has agreed not to exercise voting power with respect to any shares of common stock issued upon exercise of the warrant.
The Series A Preferred Stock and the warrant were issued in a transaction exempt from registration pursuant to Section 4(2) of the Securities Act of 1933, as amended. The Company has agreed to register the Series A Preferred Stock, the warrant, and the shares of common stock underlying the warrant (the “warrant shares”) as soon as practicable after the date of the issuance of the Series A Preferred Stock and the warrant. Neither the Series A Preferred Stock nor the warrant will be subject to any contractual restrictions on transfer, except that Treasury may not transfer a portion of the warrant with respect to, or exercise the warrant for, more than one-half of the warrant shares prior to the earlier of (a) the date on which the Company has received aggregate gross proceeds of not less than $9,201,000 from one or more qualified equity offerings and (b) December 31, 2009.
The Purchase Agreement also subjects the Company to certain of the executive compensation limitations included in the EESA. As a condition to the closing of the transaction, Robert A. Altieri, James M. Uveges, Gary M. Jewell, William D. Sherman, and Lola B. Stokes (the Company’s Senior Executive Officers, as defined in the Purchase Agreement) each: (i) voluntarily waived any claim against the Treasury or the Company for any changes to such Senior Executive Officer’s compensation or benefits that are required to comply with the regulation issued by the Treasury under the TARP Capital Purchase Program as published in the Federal Register on October 20, 2008 and acknowledging that the regulation may require modification of the compensation, bonus, incentive and other benefit plans, arrangements and policies and agreements (including so-called “golden parachute” agreements) as they relate to the period the Treasury holds any equity or debt securities of the Company acquired through the TARP Capital Purchase Program; and (ii) entered into an amendment to Messer’s Altieri, Uveges, Jewell and Mrs. Stokes employment agreements that provide that any severance payments made to such officers will be reduced, as necessary, so as to comply with the requirements of the TARP Capital Purchase Program.
Capital Requirements. The FDIC adopted certain risk-based capital guidelines to assist in the assessment of the capital adequacy of a banking organization’s operations for both transactions reported as assets on the balance sheet and transactions, such as letters of credit and recourse arrangements, which are recorded as off balance sheet items. Under these guidelines, nominal dollar amounts of assets and credit equivalent amounts of off balance sheet items are multiplied by one of several risk adjustment percentages, which range from 0% for assets with low credit risk, such as certain U.S. Treasury securities, to 100% for assets with relatively high credit risk, such as business loans.
A banking organization’s risk-based capital ratios are obtained by dividing its qualifying capital by its total risk adjusted assets. The regulators measure risk-adjusted assets, which include off balance sheet items, against both total qualifying capital (the sum of Tier 1 capital and limited amounts of Tier 2 capital) and Tier 1 capital. “Tier 1,” or core capital, includes common equity, perpetual preferred stock (excluding auction rate issues) and minority interest in equity accounts of consolidated subsidiaries, less goodwill and other intangibles, subject to certain exceptions. “Tier 2,” or supplementary capital, includes, among other things, limited-life preferred stock, hybrid capital instruments, mandatory convertible securities, qualifying subordinated debt, and the allowance for loan losses, subject to certain limitations and less required deductions. The inclusion of elements of Tier 2 capital is subject to certain other requirements and limitations of the federal banking agencies. Banks subject to the risk-based capital guidelines are required to maintain a ratio of Tier 1 capital to risk-weighted assets of at least 4% and a ratio to total capital to risk-weighted assets of at least 8%. The appropriate regulatory authority may set higher capital requirements when particular circumstances warrant.
In August 1995 and May 1996, the federal banking agencies adopted final regulations specifying that the agencies will include, in their evaluations of a bank’s capital adequacy, an assessment of the bank’s interest rate risk (“IRR”) exposure. The standards for measuring the adequacy and effectiveness of a banking organization’s interest rate risk management include a measurement of board of director and
senior management oversight, and a determination of whether a banking organization’s procedures for comprehensive risk management are appropriate to the circumstances of the specific banking organization. The Bank has internal IRR models that are used to measure and monitor IRR. Additionally, the regulatory agencies have been assessing IRR on an informal basis for several years. For these reasons the addition of IRR evaluation to the agencies’ capital guidelines has not resulted in significant changes in capital requirements for the Bank.
Failure to meet applicable capital guidelines could subject a banking organization to a variety of enforcement actions, including limitations on its ability to pay dividends, the issuance by the applicable regulatory authority of a capital directive to increase capital and, in the case of depository institutions, the termination of deposit insurance by the FDIC, as well as to the measures described under the caption, “Federal Deposit Insurance Corporation Improvement Act of 1991” below, as applicable to undercapitalized institutions. In addition, future changes in regulations or practices could further reduce the amount of capital recognized for purposes of capital adequacy. Such a change could affect the ability of the Bank to grow and could restrict the amount of profits, if any, available for the payment of dividends to the stockholders.
Federal Deposit Insurance Corporation Improvement Act of 1991. In December 1991, Congress enacted FDICIA, which substantially revised the bank regulatory and funding provisions of the Federal Deposit Insurance Act and made significant revisions to several other federal banking statutes. FDICIA provides for, among other things, (i) publicly available annual financial condition and management reports for financial institutions, including audits by independent accountants, (ii) the establishment of uniform accounting standards by federal banking agencies, (iii) the establishment of a “prompt corrective action” system of regulatory supervision and intervention, based on capitalization levels, with more scrutiny and restrictions placed on depository institutions with lower levels of capital, (iv) additional grounds for the appointment of a conservator or receiver, and (v) restrictions or prohibitions on accepting brokered deposits, except for institutions which significantly exceed minimum capital requirements. FDICIA also provides for increased funding of the FDIC insurance funds and the implementation of risk-based premiums, described further under the caption “Deposit Insurance.”
A central feature of FDICIA is the requirement that the federal banking agencies take “prompt corrective action” with respect to depository institutions that do not meet minimum capital requirements. Pursuant to FDICIA, the federal bank regulatory authorities have adopted regulations setting forth a five-tiered system for measuring the capital adequacy of the depository institutions that they supervise. Under these regulations, a depository institution is classified in one of the following capital categories: “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” and “critically undercapitalized.” An institution may be deemed by the regulators to be in a capitalization category that is lower than is indicated by its actual capital position if, among other things, it receives an unsatisfactory examination rating with respect to asset quality, management, earnings or liquidity. The Bank is currently “well capitalized.”
FDICIA generally prohibits a depository institution from making any capital distribution (including payment of a cash dividend) if the depository institution would thereafter be undercapitalized. Undercapitalized depository institutions are subject to growth limitations and are required to submit capital restoration plans. If a depository institution fails to submit an acceptable plan, it is treated as if it is significantly undercapitalized. Significantly undercapitalized depository institutions may be subject to a number of other requirements and restrictions, including orders to sell sufficient voting stock to become adequately capitalized, requirements to reduce total assets and stop accepting deposits from correspondent banks. Critically undercapitalized institutions are subject to the appointment of a receiver or conservator; generally within 90 days of the date such institution is determined to be critically undercapitalized.
FDICIA provides the federal banking agencies with significantly expanded powers to take enforcement action against institutions, which fail to comply with capital or other standards. Such action may include the termination of deposit insurance by the FDIC or the appointment of a receiver or conservator for the institution. FDICIA also limits the circumstances under which the FDIC is permitted to provide financial assistance to an insured institution before appointment of a conservator or receiver.
Financial Modernization. In November 1999, the Gramm-Leach-Bliley Act (“GLBA”) was signed into law. Effective in part on March 11, 2000, GLBA revised the BHCA and repealed the affiliation provisions for the Glass-Steagall Act of 1933, which, taken together, limited the securities, insurance and other non-banking activities of any company that controls a FDIC insured institution. Under GLBA, bank holding companies can elect, subject to certain qualifications, to become a “financial holding company.” GLBA provides that a financial holding company may engage in a full range of financial activities, including insurance and securities sales and underwriting activities, and real estate development, with the expedited notice procedures.
Maryland law generally permits Maryland state-chartered banks, including the Bank, to engage in the same activities, directly or through an affiliate, as national banks. GLBA permits certain qualified national banks to form financial subsidiaries, which have broad authority to engage in all financial activities except insurance underwriting, insurance investments, real estate investment or development, or merchant banking. Thus, GLBA has the effect of broadening the permitted activities of Maryland state-chartered banks.
The PATRIOT Act
The Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the “PATRIOT Act”) requires financial institutions to develop a customer identification plan that includes procedures to:
·
Collect identifying information about customers opening a deposit or loan account.
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Verify customer identity.
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Maintain records of the information used to verify the customer’s identity.
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Determine whether the customer appears on any list of suspected terrorists or terrorist organizations.
Under the provisions of the PATRIOT Act, the Bank is also required from time to time to search its customer data base for the names of known or suspected terrorists as provided by the government.
Due to the extensive regulation of the commercial banking business in the United States, the Company is particularly susceptible to changes in federal and state legislation and regulations.
Governmental Monetary Policies and Economic Controls
The Company is affected by monetary policies of regulatory agencies, including the FRB, which regulates the national money supply in order to mitigate recessionary and inflationary pressures. Among the techniques available to the FRB are: engaging in open market transactions in U.S. Government securities, changing the discount rate on bank borrowings, changing reserve requirements against bank deposits, prohibiting the payment of interest on demand deposits, and imposing conditions on time and savings deposits. These techniques are used in varying combinations to influence the overall growth of bank loans, investments and deposits. Their use may also affect interest rates charged on loans or paid on deposits. The effect of governmental policies on the earnings of the Company cannot be predicted. However, the Company’s earnings will be impacted by movement in interest rates, as discussed in Part II Item 7a., “Quantitative and Qualitative Disclosure About Market Risk.”
Item 1A:
Item 1A: Risk Factors
The risks and uncertainties described below are not the only ones that we face. Additional risks and uncertainties that we are unaware of, or that we currently deem immaterial, also may become important factors that affect us and our business. If any of these risks were to occur, our business, financial condition or results of operations could be materially and adversely affected. Also, consider the other information in this Annual Report on Form 10-K, as well as the documents incorporated by reference.
The Company’s Business May Be Adversely Affected by Conditions in the Financial Markets and Economic Conditions Generally
Since December 2007, the United States has been in a recession. Business activity across a wide range of industries and regions is greatly reduced and local governments and many businesses are facing extremely difficult operating conditions due to the lack of consumer spending and the lack of liquidity in the credit markets. Unemployment has increased significantly.
Since mid-2007, and particularly during the second half of 2008, the financial services industry and the securities markets generally were materially and adversely affected by significant declines in the values of nearly all asset classes and by a serious lack of liquidity. This was initially triggered by declines in home prices and the values of subprime mortgages, but spread to all mortgage and real estate asset classes, to leveraged bank loans and to nearly all asset classes, including equities. The global markets have been characterized by substantially increased volatility and short-selling and an overall loss of investor confidence, initially in financial institutions, but more recently in companies in a number of other industries and in the broader markets.
Market conditions have also led to the failure or merger of a number of prominent financial institutions. Financial institution failures or near-failures have resulted in further losses as a consequence of defaults on securities issued by them and defaults under contracts entered into with such entities as counterparties. Furthermore, declining asset values, defaults on mortgages and consumer loans, and the lack of market and investor confidence, as well as other factors, have all combined to increase credit default swap spreads, to cause rating agencies to lower credit ratings, and to otherwise increase the cost and decrease the availability of liquidity, despite very significant declines in Federal Reserve borrowing rates and other government actions. Some banks and other lenders have suffered significant losses and have become reluctant to lend, even on a secured basis, due to the increased risk of default and the impact of declining asset values on the value of collateral. The foregoing has significantly weakened the strength and liquidity of some financial institutions worldwide. In 2008, the U.S. government, the Federal Reserve and other regulators have taken numerous steps to increase liquidity and to restore investor confidence, including investing approximately $200 billion in the equity of other banking organizations, but asset values have continued to decline and access to liquidity continues to be very limited.
The Company’s financial performance generally, and in particular the ability of borrowers to pay interest on and repay principal of outstanding loans and the value of collateral securing those loans, is highly dependent upon the business environment in the markets where the Company operates, in the State of Maryland and, in particular, the Baltimore, Washington metropolitan region. A favorable business environment is generally characterized by, among other factors, economic growth, declining unemployment, efficient capital markets, low inflation, high business and investor confidence, and strong business earnings. Unfavorable or uncertain economic and market conditions can be caused by: declines in economic growth, business activity or investor or business confidence; rising unemployment, limitations on the availability or increases in the cost of credit and capital; increases in inflation or interest rates; natural disasters; or a combination of these or other factors.
Overall, during 2008, the business environment has been adverse for many households and businesses in the United States and worldwide. The business environment in Maryland and the markets in which the Company operates has been less adverse than in the
United States generally but continues to deteriorate. It is expected that the business environment in the State of Maryland, the United States and worldwide will continue to deteriorate for the foreseeable future. There can be no assurance that these conditions will improve in the near term. Such conditions could adversely affect the credit quality of the Company’s loans, results of operations and financial condition.
The Company’s Profitability Depends Significantly On Economic Conditions In The State Of Maryland
The Company’s success depends primarily on the general economic conditions of the State of Maryland and the specific local markets in which the Company operates. Unlike larger national or other regional banks that are more geographically diversified, the Company provides banking and financial services to customers in the Baltimore, Washington metropolitan area. The local economic conditions in these areas have a significant impact on the demand for the Company’s products and services as well as the ability of the Company’s customers to repay loans, the value of the collateral securing loans and the stability of the Company’s deposit funding sources. Although economic conditions in the State of Maryland have experienced less decline than in the United States generally, these conditions are declining and are expected to continue to decline in the future. A significant decline in general economic conditions, whether caused by recession, inflation, unemployment, changes in securities markets, acts of terrorism, outbreak of hostilities or other international or domestic occurrences or other factors could impact these local economic conditions and, in turn, have a material adverse effect on the Company’s financial condition and results of operations.
Competition may decrease our growth or profits.
We face significant competition for banking services in our primary market in which we operate. Competition in the local banking industries may limit our ability to attract and retain customers. We may face competition now and in the future from the following: other local and regional banking institutions, including larger commercial banking organizations; savings banks; credit unions; other financial institutions; and non-bank financial services companies serving the area.
In particular, our competitors may possess greater resources that may afford them a marketplace advantage by enabling them to maintain numerous banking locations and mount extensive promotional and advertising campaigns. Additionally, banks and other financial institutions with larger capitalization and financial intermediaries not subject to bank regulatory restrictions have larger lending limits, which enable them to serve the credit needs of larger customers. We also face competition from out-of-state financial intermediaries that have opened low-end production offices or that solicit deposits in their respective market areas. If we are unable to attract and retain banking customers we may be unable to continue our loan growth and level of deposits and our results of operations and financial condition may otherwise be negatively affected.
In the past, we have expanded our operations into non-banking activities such as insurance-related products and brokerage services. We may have difficulty competing with more established providers of these products and services due to the intense competition in many of these industries. In addition, we may be unable to attract and retain non-banking customers due to a lack of market and product knowledge or other industry specific matters or an inability to attract and retain qualified, experienced employees. Our failure to attract and retain customers with respect to these non-banking activities could negatively impact our future earnings.
Changes in interest rates and other factors beyond our control may adversely affect our earnings and financial condition.
Our main source of income from operations is net interest income, which is equal to the difference between the interest income received on loans, investment securities and other interest-earning assets and the interest expense incurred in connection with deposits, borrowings and other interest-bearing liabilities. As a result, our net interest income can be affected by changes in market interest rates. These rates are highly sensitive to many factors beyond our control, including general economic conditions, both domestic and foreign, and the monetary and fiscal policies of various governmental and regulatory authorities. We have adopted asset and liability management policies to try to minimize the potential adverse effects of changes in interest rates on our net interest income, primarily by altering the mix and maturity of loans, investments and funding sources. However, even with these policies in place, we cannot provide assurance that changes in interest rates will not negatively impact our operating results.
An increase in interest rates also could have a negative impact on our business by reducing the ability of borrowers to repay their current loan obligations, which could not only result in increased loan defaults, foreclosures and write-offs, but also necessitate further increases to our allowance for loan losses. Increases in interest rates also may reduce the demand for loans and, as a result, the amount of loan and commitment fees. In addition, fluctuations in interest rates may result in disintermediation, which is the flow of funds away from depository institutions into direct investments that pay higher rates of return, and may affect the value of our investment securities and other interest-earning assets.
We originate and sell mortgage loans. Changes in interest rates affect demand for our loan products and the revenue realized on the sale of loans. A decrease in the volume of loans sold and lower gains on sales of mortgages can decrease our revenues and net income.
Our allowance for loan losses may not be adequate to cover our actual loan losses, which could adversely affect our earnings.
If our customers default on the repayment of their loans, our profitability could be adversely affected. A borrower’s default on its obligations under one or more of our loans may result in lost principal and interest income and increased operating expenses as a result of the allocation of management time and resources to the collection and work-out of the loans. If collection efforts are unsuccessful or
acceptable workout arrangements cannot be reached, we may have to write-off the loans in whole or in part. Although we may acquire any real estate or other assets that secure the defaulted loans through foreclosure or other similar remedies, the amount owed under the defaulted loans may exceed the value of the assets acquired.
Our management periodically makes a determination of our allowance for loan losses based on available information, including the quality of our loan portfolio, economic conditions, and the value of the underlying collateral and the level of our non-accruing loans. If our assumptions prove to be incorrect, our allowance may not be sufficient and future additions to the allowance may be necessary which will result in an expense for the period. If, as a result of general economic conditions or an increase in nonperforming loans, management determines that an increase in our allowance for loan losses is necessary, we may incur additional expenses.
In addition, as an integral part of their examination process, bank regulatory agencies periodically review our allowance for loan losses and the value we attribute to real estate acquired through foreclosure or other similar remedies. These regulatory agencies may require us to adjust our determination of the value for these items based on their judgment. These adjustments could negatively impact our results of operations or financial condition.
In the course of our business, we may acquire, through foreclosure, properties securing loans that are in default. Particularly in commercial real estate lending, there is a risk that hazardous substances could be discovered on these properties. In this event, we might be required to remove these substances from the affected properties at our sole cost and expense. The cost of this removal could substantially exceed the value of the affected properties. We may not have adequate remedies against the prior owners or other responsible parties and could find it difficult or impossible to sell the affected properties. The occurrence of one or more of these events could adversely affect our financial condition or operating results.
Changes in local economic conditions could adversely affect our business.
Because we serve primarily individuals and smaller businesses, the ability of our customers to repay their loans is impacted by the economic conditions in these areas. As of December 31, 2008, approximately 72% of our loan portfolio consisted of commercial loans, defined as commercial and industrial, municipal, multi-family, commercial real estate and construction loans. Thus, our results of operations, both in terms of the origination of new loans and the potential default of existing loans, is heavily dependent upon the strength of local businesses.
We have traditionally obtained funds principally through deposits and borrowings. As a general matter, deposits are a cheaper source of funds than borrowings, because interest rates paid for deposits are typically less than interest rates charged for borrowings. If, as a result of competitive pressures, market interest rates, general economic conditions or other events, the balance of our deposits decrease relative to our overall banking operations, we may have to rely more heavily on borrowings as a source of funds in the future. Such an increased reliance on borrowings could have a negative impact on our results of operations or financial condition.
Government regulation significantly affects our business.
Bank holding companies and state and federally chartered banks operate in a highly regulated environment and are subject to supervision and examination by federal and state regulatory agencies. We are subject to the BHCA, as amended, and to regulation and supervision by the Federal Deposit Insurance Corporation, or FDIC, and the Office of the Maryland Commissioner. The cost of compliance with regulatory requirements may adversely affect our results of operations or financial condition. Federal and state laws and regulations govern numerous matters including: changes in the ownership or control of banks and bank holding companies; maintenance of adequate capital and the financial condition of a financial institution; permissible types, amounts and terms of extensions of credit and investments; permissible non-banking activities; the level of reserves against deposits; and restrictions on dividend payments. Regulations affecting banks and financial services companies undergo continuous change, and we cannot predict the ultimate effect of these changes, which could have a material adverse effect on our profitability or financial condition. Federal economic and monetary policy may also affect our ability to attract deposits and other funding sources, make loans and investments, and achieve satisfactory interest spreads.
The FDIC, and state banking authorities possess cease and desist powers to prevent or remedy unsafe or unsound practices or violations of law by banks subject to their regulation, and the FRB possesses similar powers with respect to bank holding companies. These and other restrictions limit the manner in which we may conduct our business and obtain financing.
Furthermore, our banking business is affected not only by general economic conditions, but also by the monetary policies of the FRB. Changes in monetary or legislative policies may affect the interest rates we must offer to attract deposits and the interest rates we can charge on our loans, as well as the manner in which we offer deposits and make loans. These monetary policies have had, and are expected to continue to have, significant effects on the operating results of depository institutions, including our Bank.
Under regulatory capital adequacy guidelines and other regulatory requirements, we must meet guidelines that include quantitative measures of assets, liabilities, and certain off-balance sheet items, subject to qualitative judgments by regulators about components, risk weightings and other factors. If we fail to meet these minimum capital guidelines and other regulatory requirements, our financial condition would be materially and adversely affected. Our failure to maintain the status of “well capitalized” under our regulatory framework could affect the confidence of our customers in us, thus compromising our competitive position. In addition, failure to maintain the status of “well capitalized” under our regulatory framework or “well managed” under regulatory examination procedures could compromise our status as a bank holding company and related eligibility for a streamlined review process for acquisition proposals.
Changes in the Federal and State tax laws may negatively impact the financial performance of the Company.
The Company is subject to changes in tax law that could increase the effective tax rate payable to the state or federal government. These law changes may be retroactive to previous periods and as a result, could negatively affect the current and future performance of the Company.
Technology failure could adversely affect our operations and profits.
We rely heavily on communications and information systems to conduct our business. Any failure or interruptions or breach in security of these systems could result in failures or disruptions in our customer relationship management, general ledger, deposits, and servicing or loan origination systems. The occurrence of any failures or interruptions could result in a loss of customer business and have a material adverse effect on our results of operations and financial condition.
The Company is subject to litigation risk.
In the normal course of business, the Corporation may become involved in litigation, the outcome of which may have a direct material impact on our financial position and daily operations. Please see Note 16, “Contingencies” for the current status of existing and threatened litigation.
Changes in accounting standards or interpretation in new or existing standards could materially affect the results of the Company.
From time to time the Financial Accounting Standards Board (“FASB”) and the SEC change accounting regulations and reporting standards that govern the preparation of the Company’s financial statements. In addition, the FASB, SEC, bank regulators and the outside independent auditors may revise their previous interpretations regarding existing accounting and regulations and the application of these accounting standards. These revisions in their interpretations are out of the Company’s control and may have a material impact on the Company’s financial results of operations.
Our ability to pay dividends is limited by law and contract.
Our ability to pay dividends to our shareholders largely depends on the Company’s receipt of dividends from the Bank. The amount of dividends that the Bank may pay to the Company is limited by federal laws and regulations. We also may decide to limit the payment of dividends even when we have the legal ability to pay them in order to maintain earnings for use in our business.
The market price for our common stock may be volatile.
The market price for our common stock has fluctuated, ranging between $5.50 and $15.08 per share during the 12 months ended December 31, 2008. The overall market and the price of our common stock may continue to be volatile. There may be a significant impact on the market share of our common stock due to, among other things:
Variations in our anticipated or actual operating results or the results of our competitors;
Changes in investors’ or analysts’ perceptions of the risks and conditions of business;
The size of the public float of our common stock;
Regulatory developments;
The announcement of acquisitions or new branch locations by us or our competitors;
Market conditions; and
General economic conditions.
Additionally, the average daily trading volume for our common stock is low and on various days throughout the year, there is no activity on the stock. There can be no assurance that a more active or consistent trading market will develop. As a result, relatively small trades could have a significant impact on the price of our stock.
Item 2:
Item 2: Properties
The Company owned the following properties, which had a book value of $2.3 million at December 31, 2008:
The Company leased the following facilities at an aggregate annual rental of approximately $1.2 million as of December 31, 2008:
* Expiration date, assuming the Company exercises all extension options.
(1) On or around March 23, 2009, the Executive, Lending and Finance offices at 344 N. Charles Street and the administrative and operational offices at 1589 Sulphur Spring Road will move to 7151 Columbia Gateway Drive, Suite A, Columbia, Maryland 21046.
Item 3:
Item 3: Legal Proceedings
The Company is involved in various routine legal actions arising from normal business activities. In management’s opinion, the outcome of these matters, individually or in the aggregate, will not have a material adverse impact on the results of operation or financial position of the Company.
Item 4:
Item 4: Submission of Matters to a Vote of Security-Holders
There were no matters submitted to a vote of the shareholders during the quarter ended December 31, 2008.
Part II
Item 5:
Item 5: Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Trading and Dividends
As of December 31, 2008, there were 372 shareholders of record of the Company. The Company’s Common Stock has traded on the National Association of Security Dealers’ Automated Quotation System (“NASDAQ”) National Market Tier of The NASDAQ Stock Market under the symbol “CRRB”. Currently, there are two broker-dealers who make a market in the Common Stock.
As a depository institution whose deposits 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 to the FDIC. The Bank currently is not in default under any of its obligations to the FDIC. As a commercial bank under the Maryland Financial Institution Law, the Bank may declare cash dividends from undivided profits or, with the prior approval of the Commissioner of Financial Regulation, out of surplus in excess of 100% of its required capital stock, and after providing for due or accrued expenses, losses, interest and taxes.
The Company and the Bank, in declaring and paying dividends, are also limited insofar as minimum capital requirements of regulatory authorities must be maintained. The Company and the Bank currently comply with such capital requirements.
Dividends declared per share on the Company’s common stock were $0.48 in 2008 and 2007, and $0.45 in 2006, representing a payout ratio of 137.23% in 2008, 63.88% in 2007, and 48.98% in 2006. The dividend payout ratio is the result of dividing the amount of dividends paid by net income.
The Company implemented a Dividend Reinvestment Plan that provides automatic reinvestment of dividends in additional shares of Company common stock.
During 2008, the Company repurchased and retired 276,137 shares of common stock at an average price of $14.07. During 2007, the Company repurchased and retired 16,015 shares of common stock at a price of $16.50 per share. In 2006, the Company repurchased and retired 7,518 shares of common stock at a price of $17.14 per share.
The following table sets forth the high and low sales price and dividends per share of the Company’s common stock for the periods indicated.
As of December 31, 2008, there were 372 common shareholders of record holding an aggregate of 2,564,988 shares. The Company believes there to be in excess of 540 beneficial owners of the Company’s Common Stock.
The ability of the Company to pay dividends in the future will be dependent on the earnings, if any, financial condition and business of the Company, as well as other relevant factors, such as regulatory requirements. No assurance can be given either that the Company’s future earnings, if any, will be sufficient to enable it to pay dividends, or that if such earnings are sufficient, that the Company will not decide to retain such earnings for general working capital and other funding needs. In addition, the Company is highly dependent on dividends received from the Bank to enable it to pay dividends to shareholders. No assurance can be given that the Bank will continue to generate sufficient earnings to enable it to pay dividends to the Company, or that it will continue to meet regulatory capital requirements which, if not met, could prohibit payment of dividends to the Company.
On February 13, 2009, as part of the TARP Capital Purchase Program, the Company entered into a Letter Agreement, and the related Securities Purchase Agreement - Standard Terms (collectively, the “Purchase Agreement”), with the United States Department of the Treasury (“Treasury”), pursuant to which the Company issued (i) 9,201 shares of Fixed Rate Cumulative Perpetual Preferred Stock, Series
A, liquidation preference $1,000 per share (the “Series A Preferred Stock”), and (ii) a warrant to purchase 205,379 shares of the Company’s common stock, par value $1.00 per share, for an aggregate purchase price of $1,380,147 in cash (the “Warrant”).
The Series A Preferred Stock will qualify as Tier 1 capital and will pay cumulative dividends at a rate of 5% per annum until February 15, 2014. Beginning February 16, 2014, the dividend rate will increase to 9% per annum. On and after February 15, 2012, the Company may, at its option, redeem shares of Series A Preferred Stock, in whole or in part, at any time and from time to time, for cash at a per share amount equal to the sum of the liquidation preference per share plus any accrued and unpaid dividends to but excluding the redemption date. Prior to February 15, 2012, the Company may redeem shares of Series A Preferred Stock only if it has received aggregate gross proceeds of not less than $9,201,000 from one or more qualified equity offerings, and the aggregate redemption price may not exceed the net proceeds received by the Company from such offerings. The redemption of the Series A Preferred Stock requires prior regulatory approval.
The Warrant is exercisable in whole or in part, from time to time, at $6.72 per share at any time on or before February 13, 2019. The number of shares of common stock issuable upon exercise of the Warrant and the exercise price per share will be adjusted if specific events occur. Treasury has agreed not to exercise voting power with respect to any shares of common stock issued upon exercise of the Warrant.
Pursuant to the terms of the Purchase Agreement, prior to the earlier of (i) February 13, 2012 or (ii) the date on which the Series A Preferred Stock has been redeemed in full or Treasury has transferred all of the Series A Preferred Stock to non-affiliates, the Company cannot increase its quarterly cash dividend above $0.08 or repurchase any shares of its common stock or other capital stock or equity securities or trust preferred securities without the consent of Treasury.
In addition, pursuant to the Articles Supplementary relating to the Series A Preferred Stock, so long as any shares of Series A Preferred Stock remain outstanding, the Company may not declare or pay any dividends or distributions on the Company’s common stock or any class or series of the Company’s equity securities ranking junior, as to dividends and upon liquidation, to the Series A Preferred Stock (“Junior Stock”) (other than dividends payable solely in shares of common stock) or on any other class or series of the Company’s equity securities ranking, as to dividends and upon liquidation, on a parity with the Series A Preferred Stock (“Parity Stock”), and may not repurchase or redeem any common stock, Junior Stock or Parity Stock, unless all accrued and unpaid dividends for past dividend periods, including the latest completed dividend period, have been paid or have been declared and a sufficient sum has been set aside for the benefit of the holders of the Series A Preferred Stock.
The repurchase restrictions described above do not apply in certain limited circumstances, including the repurchase of common stock in connection with the administration of any employee benefit plan in the ordinary course of business and consistent with past practice, but only to offset the increase in the number of diluted shares outstanding resulting from the grant, vesting or exercise of equity-based compensation.
Stock Performance Table
The Company is required by the SEC to provide a five-year comparison of the cumulative total shareholder return on our common stock compared with that of a broad equity market index, and either a published industry index or a constructed peer group index of the Company.
The following chart compares the cumulative shareholder return on the Company’s common stock from December 31, 2003, to December 31, 2008, with the cumulative total of the NASDAQ Composite (U.S.), the NASDAQ Bank and SNL Mid-Atlantic Indices. The comparison assumes $100 was invested on December 31, 2003, in the Company’s common stock and in each of the foregoing indices. It also assumes reinvestment of any dividends.
The Company does not make, nor does it endorse, any predictions as to future stock performance.
The following table provides information about the Company’s equity securities that may be issued under all of the Company’s equity compensation plans as of the end of the most recently completed fiscal year:
Equity Compensation Plan
Item 6:
Item 6: Selected Financial Data
(a)
Net interest margin is the ratio of net interest income, determined on a fully taxable equivalent basis (a non-GAAP financial measure), to total average interest earning assets.
Item 7:
Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations
Forward-Looking Statements
This Annual Report on Form 10-K and certain information incorporated herein by reference contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All statements included or incorporated by reference in this Annual Report on Form 10-K, other than statements that are purely historical, are forward-looking statements. Statements that include the use of terminology such as “anticipates,” “expects,” “intends,” “plans,” “believes,” “estimates” and similar expressions also identify forward-looking statements. The forward-looking statements are based on the Company’s current intent, belief and expectations. Forward-looking statements in this Annual Report on Form 10-K include, but are not limited to statements of the Company’s plans, strategies, objectives, intentions, including, among other statements, statements involving the Company’s projected loan and deposit growth, loan collateral values, collectibility of loans, anticipated changes in other operating income, payroll and branching expenses, branch, office and product expansion of the Company and its subsidiary, and liquidity and capital levels.
These statements are not guarantees of future performance and are subject to certain risks and uncertainties that are difficult to predict. Actual results may differ materially from these forward-looking statements because of interest rate fluctuations, a deterioration of economic conditions in the Baltimore-Washington metropolitan area, a downturn in the real estate market, losses from impaired loans, an increase in nonperforming assets, potential exposure to environmental laws, changes in federal and state bank laws and regulations, the highly competitive nature of the banking industry, a loss of key personnel, changes in accounting standards and other risks described in the Company’s filings with the SEC. Existing and prospective investors are cautioned not to place undue reliance on these forward-looking statements, which speak only as of today’s date. The Company undertakes no obligation to update or revise the information contained in this Annual Report whether as a result of new information, future events or circumstances or otherwise. Past results of operations may not be indicative of future results. Readers should carefully review the risk factors described in other documents the Company files from time to time with the SEC, including the Quarterly Reports on Form 10-Q to be filed by the Company in 2009.
Business and Overview
The Company is a bank holding company headquartered in Baltimore, Maryland with one wholly-owned subsidiary, the Bank. The Bank has four subsidiaries, CMSI, CFS, and MSLLC which are wholly owned, and CCDC, which is 96.4% owned.
The Bank is engaged in a general commercial and retail banking business with ten branch locations. CMSI is in the business of originating residential mortgage loans and has two branch locations. CFS provides brokerage services to customers and MSLLC manages and disposes of real estate acquired through foreclosures. CCDC promotes, develops and improves the housing and economic conditions of people in Maryland.
Total assets for the year ended December 31, 2008 compared to December 31, 2007 reflect a 15% increase to $404.2 million. Gross loans, including loans held for sale, increased 13% or $36.2 million from $269.2 million at December 31, 2007, to $305.4 million at December 31, 2008. Investments increased 26% or $14.0 million to $66.8 million at December 31, 2008. Total deposits increased 2% or $6.7 million to $292.4 million while borrowings increased 168% or $49.9 million. During the same period, stockholders’ equity decreased $8.5 million or 24% to $27.4 million or 6.78% of total assets compared to 10.2% at December 31, 2007. The decrease was due primarily to the repurchase of 276,137 shares for $3.9 million, dividends paid of $1.2 million, and a decrease in accumulated other comprehensive income of $4.3 million, all of which was partially offset by net income of $847,000.
Net income for the year ended December 31, 2008, totaled $847,000 compared to $2.1 million for the prior year, a $1.3 million or 60% decrease. The decrease was due to the $1.6 million increase in the provision for loan losses and the $538,000 pretax charge to close the Wilkens Plaza drive thru branch. The increase in the provision for loan losses was due to an increase in the level of nonperforming assets, which required additional allocations to the allowance for credit losses.
Net income for the year ended December 31, 2007, totaled $2.1 million compared to $2.6 million for the prior year, an 18% decrease. The Company’s earnings performance for the year ended December 31, 2007, was impacted by the decision to stop servicing money service businesses (MSB) as of September 2006, hiring consultants to assist in documenting internal controls for compliance with Sarbanes-Oxley Act of 2002 (“SOX”), the increase in the provision for loan losses, and legal fees and related expenses for non-accrual loans.
The earnings for the year ended December 31, 2006, included a before tax charge of approximately $1.8 million ($1.2 million after tax) representing the loss from a check kiting scheme by one of the Bank’s commercial customers. The earnings also included a charge of approximately $2.3 million representing a prepayment penalty for restructuring a $35 million FHLBA advance at a fixed rate of 6.84% maturing February 2, 2010. This charge was substantially offset by a gain of approximately $2.3 million from the sale of equity securities.
Comparing the year ended December 31, 2008, and 2007, net interest income remained relatively flat at $13.0 million. The reduction in rates by the Federal Reserve during the year contributed to the reduction in the Company’s net interest margin from 4.34% for the year ended December 31, 2007 to 3.93% for the year ended December 31, 2008. The 41 basis points decrease in the net interest margin was substantially offset by the $34.2 million increase in average earning assets.
The Company recorded a provision for loan losses of $2.1 million for the year ended December 31, 2008, compared to $536,000 in 2007. The increase in the provision for loan losses was due to the increase in nonperforming loans and other loan risk factors. Nonperforming assets increased from $5.9 million at December 31, 2007 to $9.8 million at December 31, 2009. The allowance for loan losses represented 1.12% of outstanding loans at December 31, 2008.
For the year ended December 31, 2008, noninterest income was $6.6 million compared to $6.3 million for the year ended December 31, 2007, an increase of $312,000 or 5%. The increase was due to the $244,000 gain on the sale and call of securities purchased at a discount partially offset by the write down of equity securities, and a $263,000 or 12% increase in the fees and commissions earned by CMSI. These increases were partially offset by a $126,000 or 13% decrease in service charges, a $53,000 or 3% decrease in Point of Sale revenue and ATM fees and a $21,000 or 4% decrease in other fees and commissions.
Noninterest expenses were $17.5 million for the year ended December 31, 2008, compared to $16.5 million for the year ended December 31, 2007, a $993,000 or 6% increase. The increase resulted from a one-time pre-tax charge of $538,000 to close the Wilkens Plaza drive thru branch, a $238,000 increase in OREO expenses, a $257,000 increase in occupancy expense caused by opening of our new Cockeysville branch and relocating our White Marsh branch to Perry Hall and normal lease escalation charges, and a $506,000 or 37% increase in employee benefits, in particular medical expenses. These increases in expenses were offset by a $281,000 reduction in salary expenses due to fewer employees and a $159,000 or 15% decrease in professional services related to consulting fees for compliance with SOX in 2007.
The Company paid dividends of $0.48 per share to shareholders during 2008.
Results of Operations
Summary
The Company reported net income for 2008 of $847,000 or $0.32 per diluted share, representing a 60.2% decrease from 2007 net income of $2.1 million or $0.75 per share.
Loans held for sale increased $14.1 million or 186.3% due to the increase in refinancings of residential mortgages due to the reduction in rates by the Federal Reserve during the year.
The loan portfolio net of the Allowance for Loan Losses increased 8.6% to $280.5 million as a result of the Company’s continuing efforts to align the loan portfolio to be in line with typical commercial banks. Interest income on loans, including loans held for sale, decreased 9.8% due to the reduction in the yield on average loans, including loans held for sale, from 7.66% for the year ended December 31, 2007 to 6.64% for the year ended December 31, 2008. The 102 basis points decrease in the yield was partially offset by the $11.3 million increase in average gross loans and loans held for sale.
The deposit portfolio increased 2.4% to $292.4 million, with the majority of the growth derived from certificates of deposit. Partially affecting these increases were decreases in noninterest bearing deposits, money market accounts and savings accounts. Borrowings from the Federal Home Loan Bank of Atlanta (“FHLBA”) increased $50.2 million to fund the growth in loans and investments. Total interest expense decreased during 2008 due to the reduction in the yield on total interest bearing liabilities from 3.73% for the year ended December 31, 2007, to 2.86% for the year ended December 31, 2008. The 87 basis point decrease in the yield was partially offset by the $33.4 million increase in average total interest bearing liabilities. Noninterest income increased 5.0% or $312,000 in 2008 compared to 2007. The increase was due to the $224,000 gain in the sale and call of securities purchased at a discount partially offset by the write down of equity securities, and a $263,000 or 11.5% increase in the fees and commissions earned by CMSI. These increases were partially offset by a $126,000 or 13.3% decrease in service charges, a $53,000 or 2.8% decrease in Point of Sale revenue and ATM fees and a $21,000 or 4.3% decrease in other fees and commissions.
Noninterest expense increased 6.0% or $993,000 in 2008 compared to 2007. The increase resulted from a one-time pre-tax charge of $538,000 to close the Wilkens Plaza drive thru branch, a $238,000 increase in OREO expenses, a $257,000 increase in occupancy expense caused by opening of our new Cockeysville branch and relocating of our White Marsh branch to Perry Hall and normal lease escalation charges, and a $506,000 or 37.1% increase in employee benefits, in particular medical expenses. These increases in expenses were offset by a $281,000 or 3.9% reduction in salary expenses due to fewer employees and a $159,000 or 14.8% decrease in professional services related to consulting fees for compliance with SOX in 2007.
The Company reported net income for 2007 of $2.1 million or $0.75 per diluted share, representing an 18% decrease from 2006 net income of $2.6 million or $0.90 per share.
The loan portfolio net of the Allowance for Loan Losses and including loans held for sale increased 0.6% to $265.9 million as a result of the Company’s continuing efforts to align the loan portfolio to be in line with typical commercial banks. Loans held for sale were substantially the same at $7.5 million due to the slow down in the residential housing market. Interest income on loans, including loans held for sale, increased 3.2% due to average loans, including loans held for sale, increasing $10.6 million and partially offset by loans repricing to lower rates in the fourth quarter of 2007.
The deposit portfolio increased 2.8% to $285.6 million, with the majority of the growth derived from money market accounts and certificates of deposit. Partially affecting these increases were decreases in noninterest bearing deposits and savings accounts. Interest expense increased during 2007, due to an $8.3 million increase in average interest-bearing deposits and the yield on interest-bearing deposits increasing 44 basis points.
Noninterest income decreased 29.5% or $2.6 million in 2007 compared to 2006, due primarily to a $2.2 million gain on the sale of securities in 2006, a 15.3% or $171,000 decrease in service charges, a 7.3% or $181,000 decrease in the fees and commissions earned by CMSI and an 8.1% or $166,000 decrease on Point of Sale revenue and ATM fees.
Noninterest expense decreased 15.0% or $2.9 million in 2007 compared to 2006. The decrease was due to the $1.8 million charge from the check kiting scheme by one of the Bank’s commercial customers and the $2.3 million prepayment penalty for restructuring a FHLBA advance in 2006 partially offset by the $225,000 or 3% increase in salaries, the $269,000 or 15% increase in occupancy costs and the $855,000 or 20% increase in other operating expenses. The $225,000 increase in salaries was due to additional personnel for the new branch opened in May 2007 and normal salary increases partially offset by the elimination of personnel. The $269,000 increase in occupancy costs was due to normal lease escalation charges, the new branch rent started in March 2007, and a significant increase in a 30-year branch lease that renewed in April 2006. The $855,000 increase was due to $202,000 in consulting fees for compliance with SOX, increased legal fees and related costs due to a significant commercial loan to one borrower and increased nonaccrual loans and a $155,000 write down and cost to dispose of a real estate owned property in 2007 compared to a recovery of legal fees and related expenses on the payoff of a delinquent loan in 2006.
Net Interest Income
Net interest income, the amount by which interest income on interest-earning assets exceeds interest expense on interest-bearing liabilities, is the most significant component of the Company’s earnings. Net interest income is a function of several factors, including changes in the volume and mix of interest-earning assets and funding sources, and market interest rates. While management policies influence these factors, external forces, including customer needs and demands, competition, the economic policies of the federal government and the monetary policies of the FRB, are also important.
The following table sets forth, for the periods indicated, information regarding the average balances of interest-earning assets and interest-bearing liabilities, the amount of interest income and interest expense and the resulting yields on average interest-earning assets and rates paid on average interest-bearing liabilities. Average balances are also provided for noninterest-earning assets and noninterest-bearing liabilities.
Average Balances, Interest, and Yields
(a)
Interest on investments and loans is presented on a fully taxable equivalent basis (a non-GAAP financial measure), using the federal income tax rates of 34% and, where applicable, the state rate of 8.25% for 2008 and 7% for 2007 and 2006 (or a combined federal and state rate of 39.445% for 2008 and 38.62% for 2007 and 2006) to increase tax exempt interest income to a taxable equivalent basis. This is a non-GAAP measure that management believes is useful when comparing annual results,
(b)
Loans held for sale are included in residential mortgage loans.
(c)
Net interest margin is the ratio of net interest income, determined on a fully taxable-equivalent basis, to total average interest earning assets.
Net interest income on a tax-equivalent basis was substantially the same at $14.2 million for the years ended December 31, 2008, and 2007. The decrease in the net interest margin of 41 basis points from 4.34% for the year ended December 31, 2007, to 3.93% for the year ended December 31, 2008, was partially offset by a $34.2 million increase in average interest-earning assets during 2008 compared to 2007.
The $11.3 million or 4.2% increase in average loans outstanding is attributed to the Company’s active business development efforts in its residential, commercial real estate, and construction and land development loan portfolio and general economic conditions of the Company’s primary service market. The yield on loans decreased to 6.64% in 2008 compared to 7.66% for 2007 as the Federal Open Market Committee (“FOMC”) lowered rates in 2008. The yield on investment securities decreased to 5.51% in 2008 from 5.75% in 2007. Total interest-earning assets increased $34.2 million or 10.4% while the yield decreased 105 basis points. Total interest-bearing liabilities increased $33.4 million or 12.7% while the yield decreased 87 basis points. Interest-bearing deposits were substantially the same at $229.6 million while borrowings increased $33.6 million or 104.2% to fund loan and investment growth. The net impact was a slight increase in tax-equivalent net interest income for the year ended December 31, 2008, compared to 2007.
Net interest income on a tax-equivalent basis decreased to $14.2 million for the year ended December 31, 2007, compared to $14.6 million for 2006. The decrease in tax-equivalent net interest income during 2007 was due to the decrease in the net interest margin of 23 basis points partially offset by a $10.6 million increase in average interest-earning assets during 2007 compared to 2006.
The $10.6 million or 4.1% increase in average loans outstanding is attributed to the Company’s active business development efforts in its residential and construction and land development loan portfolio and general economic conditions of the Company’s primary service market. The yield on loans decreased to 7.66% in 2007 compared to 7.73% for 2006 as the FOMC began lowering rates in September 2007. The yield on investment securities increased to 5.75% in 2007 from 5.55% in 2006. The net impact was a $430,000 or 2.9% decrease in tax-equivalent interest income for the year ended December 31, 2007, compared to 2006.
Interest expense increased $1.0 million to $9.8 million in 2007 from $8.7 million in 2006. Interest expense on deposits increased primarily due to a change in the deposit mix, with an increase in the amount of interest-bearing deposits and the cost of interest-bearing deposits increased from 3.08% in 2006 to 3.52% in 2007. Interest expense on borrowed funds decreased due to a $6.7 million decrease in average borrowed funds and the cost of average borrowed funds decreasing to 5.22% for the year ended December 31, 2007, compared to 5.48% for the same period in 2006.
The following table and the related discussions of interest income and interest expense provide further analysis of the changes in net interest income during 2008 and 2007:
(a)
Interest on investments and loans is presented on a fully taxable equivalent basis (a non-GAAP financial measure), using regular income tax rates.
(b)
The change in interest income and expense due to variance in both rate and volume has been allocated to the change due to variance in rate.
Provision for Loan Losses
On a monthly basis, management of the Company reviews all loan portfolios to determine trends and monitor asset quality. For consumer loan portfolios, this review generally consists of reviewing delinquency levels on an aggregate basis with timely follow-up on accounts that become delinquent. In commercial loan portfolios, delinquency information is monitored and periodic reviews of business and property leasing operations are performed on an individual loan basis to determine potential collection and repayment problems.
Due to the slow down in the housing and real estate market and the unprecedented state of the economy, the Company has experienced an increase in its delinquency rate and charge off rate. The Company recorded a provision for loan losses of $2.1 million in 2008, $536,000 in 2007, and none for the year ended December 31, 2006. Nonaccrual, restructured and delinquent loans over 90 days to total loans increased to 3.42% at the end of 2008 compared to 2.26% in 2007. The ratio of net loan losses to average loans increased in 2008 to 0.74% compared to 0.15% for 2007. Nonaccrual, restructured, and delinquent loans over 90 days to total loans increased to 2.26% at the end of 2007 compared to 2.19% in 2006. The ratio of net loan losses to average loans increased in 2007 to 0.15% compared to 0.08% for 2006.
Noninterest Income
Noninterest income increased from $6.3 million during 2007 to $6.6 million in 2008, an increase of $312,000 or 5.0%. The increase was due to the $244,000 gain on the sale and call of securities purchased at a discount partially offset by the write down of equity securities, and a $263,000 or 11.5% increase in the fees and commissions earned by CMSI. These increases were partially offset by a $126,000 or 13.3% decrease in service charges, a $53,000 or 2.8% decrease in Point of Sale revenue and ATM fees and a $21,000 or 4.3% decrease in other fees and commissions.
Noninterest income decreased from $8.9 million during 2006 to $6.3 million in 2007 due primarily to the $2.2 million gain on the sale of securities in 2006. The $181,000 decrease in net gains and fees on sales of mortgage loans corresponded to a decrease in the fees received on mortgage loans sold during the year due to a slow down in the residential housing market. The $166,000 decrease in electronic banking was due to a reduction in the number of Point of Sale transactions in 2007 compared to 2006. The $171,000 decrease in service charges was due to the decision to stop servicing money service businesses (MSB) as of September 2006, and was partially offset by fee increases effective January 2007. In 2006, sales of available-for-sale securities generated $2.2 million in gains compared to $840,000 in 2005.
Electronic banking income is comprised of three sources: national point of sale (“POS”) sponsorships, ATM fees, and check card fees. The fees from the ATMs represent approximately 4% of total electronic banking revenue in 2007. The Company sponsors merchants who accept ATM cards for purchases within various networks (i.e. STAR, PULSE, and NYCE). This national POS sponsorship income represents approximately 82% of total electronic banking revenue. Fees from check cards comprise the remaining 14% of electronic banking revenue.
The Company offers a variety of financial planning and investment options to customers, through its subsidiary, CFS, and recognizes commission income as these services are provided.
Noninterest Expenses
Noninterest expense consists primarily of costs associated with personnel, occupancy and equipment, data processing, marketing and professional fees. Noninterest expenses were $17.5 million for the year ended December 31, 2008 compared to $16.5 million for the year ended December 31, 2007, a $993,000 or 6.0% increase. The increase resulted from a one-time pre-tax charge of $538,000 to close the Wilkens Plaza drive thru branch, a $238,000 increase in OREO expenses, a $257,000 or 12.4% increase in occupancy expense resulting from the opening of our new Cockeysville branch and relocating of our White Marsh branch to Perry Hall and normal lease escalation charges, and a $506,000 or 37.1% increase in employee benefits, in particular medical expenses. These increases in expenses were offset by a $281,000 or 3.9% reduction in salary expenses due to fewer employees and a $159,000 or 14.8% decrease in professional services related to consulting fees for compliance with SOX in 2007.
Noninterest expenses were $16.5 million for the year ended December 31, 2007 compared to $19.4 million for the year ended December 31, 2006, a $2.9 million or 15% decrease. The decrease was due to the $1.8 million charge from the check kiting scheme in 2006, the $2.3 million prepayment penalty for restructuring the FHLB advance in 2006. These decreases were partially offset by the $225,000 or 3% increase in salaries, the $269,000 or 15% increase in occupancy costs, the $671,000 or 129% increase in professional fees, and the $183,000 or 5% increase in other operating expenses. The $225,000 increase in salaries was due to additional personnel for the new branch opened in May 2007 and normal salary increases partially offset by the elimination of personnel. The $269,000 increase in occupancy costs was due to normal lease escalation charges, the new branch rent started in March 2007, and a significant increase in a 30-year branch lease that expired April 2006. The $671,000 increase in professional fees was due to $202,000 in consulting fees for compliance with SOX, increased legal fees and related costs due to a significant commercial loan to one borrower and increased nonaccrual loans. The $183,000 increase in other operating expenses was due primarily to a $155,000 write down and cost to dispose of a real estate owned property in 2007 compared to a recovery of legal fess and related expenses on the payoff of a delinquent loan in 2006.
Income Tax Provision
Income tax expense was $124,000 in 2008, $1.1 million in 2007 and $1.3 million in 2006. The effective tax rate was 12.8% in 2008, 33.1% in 2007, and 33.9% in 2006. The effective tax rates fluctuate from year to year due to changes in the mix of tax-exempt loans, investments and life insurance policies as a percentage of total loans and investments. In 2008, tax exempt interest was a substantial percentage of income before income taxes which resulted in a significantly lower effective tax rate. During 2007 and 2006, the Company purchased additional tax exempt securities, which reduced the effective tax rates.
Financial Condition
Summary
Total assets of the Company increased by 14.6% to $404.2 million at December 31, 2008 from $352.8 million at December 31, 2007. Investment securities increased 26.5% to $66.8 million at December 31, 2008. Gross loans, excluding loans held for sale, increased by 8.4% to $283.7 million at December 31, 2008 compared to $261.6 million at the end of 2007. Interest-earning assets increased $53.3 million to $383.2 million and were 94.8% of total assets at December 31, 2008.
Investment Securities
The investment portfolio consists of investment securities held to maturity and securities available for sale. Investment securities held to maturity are those securities that the Company has the positive intent and ability to hold to maturity and are carried at amortized cost. Securities available for sale are those securities that the Company intends to hold for an indefinite period of time but not necessarily until maturity. These securities are carried at fair value and may be sold as part of an asset/liability management strategy, liquidity management, interest rate risk management, regulatory capital management or other similar factors.
The components of the investment portfolio were as follows at December 31:
Note: Investments classified as available for sale are carried at fair value whereas investments classified as held to maturity are carried at amortized cost.
The following table shows the maturity of the investment portfolio at December 31, 2008:
The investment portfolio consists primarily of U. S. Government agency securities, mortgage-backed securities, corporate bonds, state and municipal obligations, and equity securities. The income from state and municipal obligations is exempt from federal income tax. Certain agency securities are exempt from state income taxes. The Company uses its investment portfolio as a source of both liquidity and earnings.
Investment securities increased $14.0 million to $66.8 million at December 31, 2008 compared to $52.8 million at December 31, 2007.
Loans
The following table represents a breakdown of loan balances at December 31:
Gross loans, excluding loans held for sale, increased $22.1 million or 8.4% from $261.6 million at December 31, 2007 to $283.7 million at December 31, 2008. The increase was in residential lending and commercial real estate lending while construction and land development and demand and time loans decreased. Commercial loans amounted to $204.7 million at December 31, 2008 and were 72% of total loans. Consumer loans amounted to $79.0 million and were 28% of total loans.
The following table shows the contractual maturities and interest rate sensitivities of the Company’s loans at December 31, 2008. Some loans may include contractual installment payments that are not reflected in the table until final maturity. In addition, the Company’s experience indicates that a significant number of loans will be extended or repaid prior to contractual maturity. Consequently, the table is not intended to be a forecast of future cash repayments.
The following table provides information concerning nonperforming assets and past due loans at December 31, 2008:
(a) Loans are placed in nonaccrual status when they are past-due 90 days as to either principal or interest or when, in the opinion of management, the collection of all interest and/or principal is in doubt. A loan remains in nonaccrual status until the loan is current as to payment of both principal and interest and the borrower demonstrated the ability to pay and remain current. Management may grant a waiver from nonaccrual status for a 90-day past-due loan that is both well secured and in the process of collection.
Allowance for Loan Losses
An allowance for loan losses is maintained to absorb losses in the existing loan portfolio. The allowance is a function of specific loan allowances, general loan allowances based on historical loan loss experience and current trends, and allowances based on general economic conditions that affect the collectibility of the loan portfolio. These can include, but are not limited to exposure to an industry experiencing problems, changes in the nature or volume of the portfolio and delinquency and nonaccrual trends. The portfolio review and calculation of the allowance is performed by management on a continuing basis.
The specific allowance is based on regular analysis of the loan portfolio and is determined by analysis of collateral value, cash flow and guarantor capacity, as applicable. The specific allowance was $290,127, $901,582, and $534,639 as of December 31, 2008, 2007 and 2006, respectively.
The general allowance is calculated using internal loan grading results and appropriate allowance factors on approximately ten classes of loans. This process is reviewed on a regular basis. The allowance factors may be revised whenever necessary to address current credit quality trends or risks associated with particular loan types. Historic trend analysis is utilized to obtain the factors to be applied. The general allowance was $1.6 million, $1.4 million, and $2.0 million as of December 31, 2008, 2007 and 2006, respectively.
Allocation of a portion of the allowance does not preclude its availability to absorb losses in other categories. An unallocated reserve is maintained to recognize the imprecision in estimating and measuring loss when evaluating the allowance for individual loans or pools of loans.
During the years ended December 31, 2004 through 2008, the unallocated portion of the allowance for loan losses has fluctuated with the specific and general allowances so that the total allowance for loan losses would be at a level that management believes is the best estimate of probable future loan losses at the balance sheet date. The specific allowance may fluctuate from period to period if the balance of what management considers problem loans changes. The general allowance will fluctuate with changes in the mix of the Company’s loan portfolio, economic conditions, or specific industry conditions. The requirements of the Company’s federal regulators are a consideration in determining the required total allowance. Due to the level of the unallocated allowance, management did not make any provision for loan losses in 2006 and 2005.
Management believes that it has adequately assessed the risk of loss in the loan portfolios based on a subjective evaluation and has provided an allowance which is appropriate based on that assessment. Because the allowance is an estimate based on current conditions, any change in the economic conditions of the Company’s market area or change within a borrower’s business could result in a revised evaluation, which could alter the Company’s earnings.
The following charts show the level of loan losses recorded by the Company for the past five years, management’s allocation of the allowance for loan losses by type of loan as of the end of each year, and other statistical information. The allocation of the allowance reflects management’s analysis of economic risk potential by type of loan, and is not intended as a forecast of loan losses.
A breakdown of the allowance for loan losses is provided in the table below; however, management does not believe that the allowance can be segregated by category with precision. The breakdown of the allowance is based primarily on those factors discussed previously in evaluating the allowance as a whole. Since all of those factors are subject to change, the breakdown is not necessarily indicative of the category of actual or realized credit losses.
The table below provides a percentage breakdown of the loan portfolio by category to total loans at December 31:
All loan allowances are subject to regulatory examinations and determinations as to the appropriateness of the methodology and adequacy on an annual basis.
At December 31, 2008 the allowance for loan losses was $3.2 million, a 2.8% decrease from the end of 2007. The ratio of the allowance to total loans was 1.12% at December 31, 2008 and 1.25% at December 31, 2007. The ratio of net loan losses to average loans outstanding for 2008 was 0.82% compared to 0.15% for 2007. The ratio of nonaccrual loans, restructured loans and loans delinquent more than 90 days to total loans and foreclosed real estate increased to 3.42% at December 31, 2008 from 2.26% at the end of 2007. The ratio of real estate loans to total loans increased to 86.1% at the end of 2008 from 81.4% at the end of 2007.
Funding Sources
Deposits
The following table sets forth the average deposit balances and average rates paid on deposits during the years ended December 31:
The following table provides the maturities of certificates of deposit of the Company in amounts of $100,000 or more at December 31, 2008:
Total deposits at December 31, 2008 increased by $6.7 million to $292.4 million from the end of 2007. Interest bearing accounts increased by $11 million and noninterest-bearing deposits decreased by $4.3 million.
The Company began offering CDARS deposits to its customers during 2004. This program allows for customers who wish to invest more than the amounts that would normally be covered by FDIC insurance with the Bank. The program is nationwide and allows participating banks to “swap” customer deposits so that no customer has greater than the insurable maximum in one bank, but the customer only deals with his/her own bank. As of December 31, 2008, the Bank had approximately $21.5 million in CDARS deposits, an increase of $7.9 million from December 31, 2007.
Borrowed Funds
Borrowed funds consist of securities sold under repurchase agreements, federal funds purchased and borrowings from the FHLB. Securities sold under repurchase agreements are securities sold to the Bank’s customers under a continuing “roll-over” contract and mature in one business day. The underlying securities sold are federal agency securities that are segregated from the Company’s other investment securities. Federal funds purchased are unsecured, overnight borrowings from other financial institutions.
Information with respect to borrowings is as follows at and for the years ended December 31:
Debt retirement expense of $2.3 million was incurred in 2006 due to the restructuring of a $35.0 million FHLBA advance that had a maturity date of February 2, 2010 and an interest rate of 6.84%.
The Company may borrow under available unsecured federal funds line of credit of $5 million and a secured federal funds line of credit of $10 million with other institutions. There was no balance outstanding under these lines at December 31, 2008 and 2007. These lines bear interest at the current federal funds rate of the correspondent bank.
Capital
Bank holding companies and banks are required by the FRB and FDIC to maintain minimum levels of Tier 1 (or Core) and Tier 2 capital measured as a percentage of assets on a risk-weighted basis. Capital is primarily represented by shareholders’ equity, adjusted for the allowance for loan losses and certain issues of preferred stock, convertible securities, and subordinated debt, depending on the capital level being measured. Assets and certain off-balance sheet transactions are assigned to one of five different risk-weighting factors for purposes of determining the risk-adjusted asset base. The minimum levels of Tier 1 and Tier 2 capital to risk-adjusted assets are 4% and 8%, respectively, under the regulations.
In addition, the FRB and the FDIC require that bank holding companies and banks maintain a minimum level of Tier 1 (or Core) capital to average total assets excluding intangibles for the current quarter. This measure is known as the leverage ratio. The current regulatory minimum for the leverage ratio for institutions to be considered adequately capitalized is 4%, but could be required to be maintained at a higher level based on the regulator’s assessment of an institution’s risk profile. The following chart shows the regulatory capital levels for the Company and Bank at December 31, 2008 and 2007. The Company’s subsidiary bank also exceeded the FDIC required minimum capital levels at those dates by a substantial margin. Based on the levels of capital, the Company and the Bank are well capitalized.
The following table shows the Company’s and the Bank’s capital ratios as of December 31:
Total shareholders’ equity decreased 23.8% or $8.5 million to $27.4 million at December 31, 2008. The decrease was due primarily to the repurchase of 276,137 shares for $3.9 million, dividends paid of $1.2 million, and a decrease in accumulated other comprehensive income of $4.3 million, all of which was partially offset by net income of $847,000. The decrease in accumulated other comprehensive income was due to the decrease in the fair market value of the available for sale securities, the loss on the frozen defined benefit pension plan partially offset by the increase in the fair market value of the effective cash flow hedge. Under regulatory requirements, amounts reported as accumulated other comprehensive income/loss related to these items do not increase or reduce regulatory capital and are not included in the calculation of risk-based capital and leverage ratios.
Liquidity and Capital Expenditures
Liquidity
Liquidity describes the ability of the Company to meet financial obligations, including lending commitments and contingencies that arise during the normal course of business. Liquidity is primarily needed to meet the borrowing and deposit withdrawal requirements of the customers of the Company, as well as to meet current and planned expenditures.
The Company’s liquidity is derived primarily from its deposit base and equity capital. Liquidity is provided through the Company’s portfolios of cash and interest-bearing deposits in other banks, federal funds sold, loans held for sale, unpledged investment securities held to maturity due within one year, and unpledged securities available for sale. Such assets totaled $37.3 million or 9.2% of total assets at December 31, 2008.
The borrowing requirements of customers include commitments to extend credit and the unused portion of lines of credit, which totaled $111.0 million at December 31, 2008. Of this total, management places a high probability of required funding within one year on approximately $60.5 million. The amount remaining is unused home equity lines and other consumer lines on which management places low probability of funding.
The Company also has external sources of funds through the Federal Reserve Bank (“FRB”) and FHLB, which can be drawn upon when required. There is a line of credit totaling approximately $64 million with the Federal Home Loan Bank of Atlanta (the “FHLB”) based on qualifying loans pledged as collateral. Also the Company can pledge securities at the FRB and FHLB and borrow approximately 97% of the fair market value of the securities. In addition, the Company had $33.7 million of securities pledged at the FHLB under which the Company’s subsidiary, Carrollton Bank, could have borrowed approximately $32.7 million. Also, Carrollton Bank has $8.2 million of securities pledged at FRB under which it could have borrowed approximately $8.0 million. Approximately $2.6 million of securities have not been pledged against any borrowings. Outstanding borrowings at the FHLB were $65.2 million at December 31, 2008. Additionally, the Company has an unsecured federal funds line of credit of $5.0 million and a $10.0 secured federal funds line of credit with other institutions. The secured federal funds line of credit with another institution would require Carrollton Bank to transfer securities pledged at the FHLB or FRB to this institution before Carrollton Bank could borrow against this line. There was no balance outstanding under these lines at December 31, 2008. These lines bear interest at the current federal funds rate of the correspondent bank.
Capital Expenditures
Capital expenditures were approximately $489,000 in 2008, $2.3 million in 2007 and $801,000 in 2006. The capital expenditures in 2008 related to renovations at a couple of branches and purchases of equipment, including computer equipment. The capital expenditures in 2007 were principally due to completing the construction of the Cockeysville branch and construction of a new branch in Perry Hall which opened in January 2008. Capital expenditures in 2006 were due to renovations at a couple of branches and partial construction of a new branch in Cockeysville expected to open in the second quarter of 2007.
Capital expenditures are projected to be approximately $1.2 million for fiscal year 2009 for renovations at one of the Company’s branch locations, purchases of several ATM’s, purchase of hardware, software, cubicles, filing cabinets and storage for the new corporate headquarters.
Market Risk and Interest Rate Sensitivity
The Company’s interest rate risk represents the level of exposure it has to fluctuations in interest rates and is primarily measured as the change in earnings and the theoretical market value of equity that results from changes in interest rates. The Asset/Liability Management Committee of the Board of Directors (the “ALCO”) oversees the Company’s management of interest rate risk. The objective of the management of interest rate risk is to optimize net interest income during volatile as well as stable interest rate environments while maintaining a balance between the maturity and repricing characteristics of assets and liabilities that is consistent with the Company’s liquidity, asset and earnings growth, and capital adequacy goals.
Due to changes in interest rates, the level of income for a financial institution can be affected by the repricing characteristics of its assets and liabilities. At December 31, 2008, the Company is in an asset sensitive position. Management continuously takes steps to reduce higher costing fixed rate funding instruments, while increasing assets that are more fluid in their repricing. An asset sensitive position, theoretically, is favorable in a rising rate environment since more assets than liabilities will reprice in a given time frame as interest rates rise. Management works to maintain a consistent spread between yields on assets and costs of deposits and borrowings, regardless of the direction of interest rates.
In order to partially offset a reduction in interest income in a declining interest rate environment, on December 14, 2005, the Bank purchased a $10.0 million notional amount interest rate Floor with a minimum interest rate (strike rate) of 7.0% based on the U.S. prime rate. The term of the Floor is five years. The Floor will reduce the variability of cash flow from a pool of variable rate loans should the rate index of the loans fall below the predetermined strike rate of the hedge (7%).
The following chart shows the static gap position for interest sensitive assets and liabilities of the Company as of December 31, 2008. The chart is as of a point in time, and reflects only the contractual terms of the loan or deposit accounts in assigning assets and liabilities to the various repricing periods except that deposit accounts with no contractual maturity, such as money market, NOW and savings accounts, have been allocated evenly over a five-year period. In addition, the maturities of investments shown in the gap table will differ from contractual maturities due to anticipated calls of certain securities based on current interest rates. While this chart indicates the opportunity to reprice assets and liabilities within certain time frames, it does not reflect the fact that interest rate changes occur in disproportionate increments for various assets and liabilities.
Period from December 31, 2008 in which assets and liabilities reprice:
Inflation
Inflation may be expected to have an impact on the Company’s operating costs and thus on net income. A prolonged period of inflation could cause interest rates, wages, and other costs to increase and could adversely affect the Company’s results of operations unless the fees charged by the Company could be increased correspondingly. However, the Company believes that the impact of inflation was not material for 2008, 2007, and 2006.
Off-Balance Sheet Arrangements
The Company enters into off-balance sheet arrangements in the normal course of business. These arrangements consist primarily of commitments to extend credit, lines of credit and letters of credit. In addition, the Company has certain operating lease obligations.
Credit commitments are agreements to lend to a customer as long as there is no violation of any condition to the contract. Loan commitments generally have interest rates fixed at current market amounts, fixed expiration dates, and may require payment of a fee. Lines of credit generally have variable interest rates. Such lines do not represent future cash requirements because it is unlikely that all customers will draw upon their lines in full at any time. Letters of credit are commitments issued to guarantee the performance of a customer to a third party.
The Company’s exposure to credit loss in the event of nonperformance by the borrower is the contract amount of the commitment. Loan commitments, lines of credit, and letters of credit are made on the same terms, including collateral, as outstanding loans. The Company is not aware of any accounting loss it would incur by funding its commitments.
Outstanding loan commitments, unused lines of credit and letters of credit were as follows at December 31, 2008:
Contractual Obligations
The Company enters into contractual obligations in the normal course of business. Among these obligations are short and long-term FHLBA advances, operating leases related to branch and administrative facilities, a long term contract with a data processing provider and purchase contracts related to construction of a new branch office. Payments required under these obligations are set forth in the table below as of December 31, 2008.
(1)
Represents payments required under contract, based on average monthly charges for 2008 and assuming a growth rate of 3%, with the Company’s current data processing service provider that expires in October 2016.
New Accounting Pronouncements
In May 2008, the Financial Accounting Standards Board, or FASB, issued FSP APB14-1, Accounting for Convertible Debt Instruments That May Be Settled In Cash upon Conversion (Including Partial Cash Settlement), which applies to all convertible debt instruments that have a “net settlement feature”, which means instruments that by their terms may be settled either wholly or partially in cash upon conversion. Under FSP APB 14-1, the liability and equity components of convertible debt instruments that may be settled wholly or partially in cash upon conversion must be accounted for separately in a manner reflective of their issuer’s nonconvertible debt borrowing rate. Previous guidance provided for accounting of this type of convertible debt instruments entirely as debt. FSP APB 14-1 is effective for financial statements issued for fiscal years beginning after December 15, 2008 and interim periods within those fiscal years. The adoption of this statement will have no affect on the Company’s financial statements.
SFAS No. 160, Noncontrolling Interest in Consolidated Financial Statements, an amendment of ARB Statement No. 51. SFAS 160 amends Accounting Research Bulletin (“ARB”) No. 51, Consolidated Financial Statements, to establish accounting and reporting standards for the non-controlling interest in a subsidiary and for the deconsolidation of a subsidiary. SFAS 160 clarifies that a non-controlling interest in a subsidiary, which is sometimes referred to as minority interest, is an ownership interest in the consolidated entity that should be reported as a component of equity in the consolidated financial statements. Among other requirements, SFAS 160 requires consolidated net income to be reported at amounts that include the amounts attributable to both the parent and the non-controlling interest. It also requires disclosure, on the face of the consolidated income statement, of the amounts of consolidated net income attributable to the parent and to the non-controlling interest. SFAS 160 is effective for the Company on January 1, 2009 and is not expected to have a significant impact on the Company’s financial statements.
In March 2008, the FASB issued SFAS 161, Disclosures about Derivative Instruments and Hedging Activities, an amendment of FASB Statement No. 133, which enhances the disclosure requirements related to derivative instruments and hedging activity to provide greater transparency about (i) how and why an entity uses derivative instruments, (ii) how derivative instruments and related hedge items are accounted for under SFAS 133 and its related interpretations, and (iii) how derivative instruments and related hedged items affect an entity’s financial position, results of operations and cash flows. To meet those objectives, SFAS 161 requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of gains and losses on derivative instruments and disclosures about credit-risk-related contingent features in derivative agreements. SFAS 161 is effective for the Company on January 1, 2009 and is not expected to have a significant impact on the Company’s financial statements.
SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles.” SFAS 162 identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles (“GAAP”) in the United States (the GAAP hierarchy). The hierarchical guidance provided by SFAS 162 did not have a significant impact on the Company’s financial statements.
FSP No. 132(R)-1 “Employers’ Disclosures about Postretirement Benefit Plan Assets.” FSP 132(R)-1 provides guidance related to an employer’s disclosures about plan assets of defined benefit pension or other post- retirement benefit plans. Under FSP 132(R)-1, disclosures should provide users of financial statements with an understanding of how investment allocation decisions are made, the factors that are pertinent to an understanding of investment policies and strategies, the major categories of plan assets, the inputs and valuation techniques used to measure the fair value of plan assets, the effect of fair value measurements using significant unobservable inputs on changes in plan assets for the period and significant concentrations of risk within plan assets. The disclosures required by FSP 132(R)-1 will be included in the Company’s financial statements beginning with the financial statements for the year-ending December 31, 2009.
Item 7A:
Item 7A: Quantitative and Qualitative Disclosures About Market Risk
For information regarding the market risk of the Company’s financial instruments, see “Market Risk and Interest Rate Sensitivity” in Management’s Discussion and Analysis of Financial Condition and Results of Operations in Item 7.
Item 8:
Item 8: Financial Statements and Supplementary Data
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Shareholders
Carrollton Bancorp
Baltimore, Maryland
We have audited the accompanying consolidated balance sheets of Carrollton Bancorp and Subsidiary as of December 31, 2008 and 2007, and the related consolidated statements of income, changes in shareholders’ equity, and cash flows for each of the three years in the three year period ended December 31, 2008. These consolidated 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 standards of the Public Company Accounting Oversight Board in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform an audit of the Company’s internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our 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 Carrollton Bancorp and Subsidiary as of December 31, 2008 and 2007, and the results of their operations and their cash flows for each of the three years ended December 31, 2008, in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 1 to the financial statements, effective January 1, 2006, the Bank adopted the provisions of Statement of Financial Accounting Standard No. 123R, Share Based Payment, and effective December 31, 2006, Statement of Financial Accounting Standards, No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans - an amendment of FASB Statement No. 87, 88, 106, and 132(R).
Rowles & Company, LLP, Certified Public Accountants
Baltimore, Maryland
March 3,
Consolidated Balance Sheets
The accompanying notes are an integral part of these consolidated financial statements.
Consolidated Statements of Income
The accompanying notes are an integral part of these consolidated financial statements.
Consolidated Statements of Changes in Shareholders’ Equityyears ended December 31, 2008, 2007 and 2006
The accompanying notes are an integral part of these consolidated financial statements.
Consolidated Statements of Cash Flows
The accompanying notes are an integral part of these consolidated financial statements.
Notes to Consolidated Financial Statements
1. Summary of Significant Accounting Policies
The accounting and reporting policies of Carrollton Bancorp and subsidiary (the “Company”) conform to U.S. generally accepted accounting principles. The following is a description of the more significant of these policies.
Organization
The Company was formed January 11, 1990 and is a Maryland corporation chartered as a bank holding company. The Company holds all the issued and outstanding shares of common stock of Carrollton Bank (the “Bank”). The Bank is a Maryland company that engages in general commercial banking operations. Deposits in the Bank are insured, subject to regulatory limitations, by the Federal Deposit Insurance Corporation (the “FDIC”).
The Bank provides commercial and brokerage services to individuals and small and medium-sized businesses. Services offered by the Bank include a variety of loans and a broad spectrum of commercial and consumer financial services.
Basis of Presentation
The consolidated financial statements are prepared in conformity with U.S. generally accepted accounting principles and include all accounts of the Company and its wholly-owned subsidiary, Carrollton Bank. All significant intercompany accounts and transactions have been eliminated in the consolidated financial statements. Certain amounts for prior years have been reclassified to conform to the presentation for 2008. These reclassifications have no effect on stockholders’ equity or net income as previously reported.
Use of Estimates
The preparation of the financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and judgments 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 (the “Allowance”), and other than temporary impairment of investment securities. In connection with the determination of the Allowance, management prepares fair value analyses and obtains independent appraisals as necessary. Management believes that the Allowance is sufficient to address the losses inherent in the current loan portfolio. While management uses available information to recognize losses on loans, future additions to the Allowance may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination processes, periodically review the Bank’s Allowance. Such agencies may require the Bank to recognize additions to the Allowance based on their judgments about information available to them at the time of their examinations.
Securities are evaluated periodically to determine whether a decline in their value is other than temporary. The term “other than temporary” is not intended to indicate a permanent decline in value. Rather, it means that the prospects for near term recovery of value are not necessarily favorable, or that there is a lack of evidence to support fair values equal to, or greater than, the carrying value of the investment. Management reviews criteria such as the magnitude and duration of the decline, as well as the reasons for the decline, to predict whether the loss in value is other than temporary. Once a decline in value is determined to be other than temporary, the value of the security is reduced and a corresponding charge to earnings is recognized.
Fair Value
Effective January 1, 2008, the Company adopted Statement of Financial Accounting Standard No. 157, Fair Value Measurements, or SFAS 157, which establishes a framework for measuring fair value and requires enhanced disclosures about fair value measurements. In accordance with Financial Accounting Standards Board Staff Position (“FSP”) No. SFAS 157-2, “Effective Date of FASB Statement No. 157,” the Company will delay application of SFAS 157 for non-financial assets and non-financial liabilities, until January 1, 2009. SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. The application of SFAS 157 in situations where the market for a financial asset is not active was clarified by the issuance of FSP No. SFAS 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active,” in October 2008. FSP No. SFAS 157-3 became effective immediately and required the use of level 3 inputs for the five TRUP CDOs securities.
SFAS 157 clarifies that fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. SFAS 157 also requires disclosure about how fair value is determined for assets and liabilities and establishes a hierarchy for which these assets and liabilities must be grouped,
1. Summary of Significant Accounting Policies (Continued)
based on significant levels of inputs. See Note 20 for more information, including a listing of our assets and liabilities required to be measured at fair value on a recurring basis and where they are classified within the hierarchy as of December 31, 2008.
In February 2007, the FASB issued Statement No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities.” The standard provides companies with an option to report selected financial assets and liabilities at fair value and establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities. The new standard was effective for the Company on January 1, 2008. The Company did not elect the fair value option for any financial assets or financial liabilities as of January 1, 2008.
Cash and Cash Equivalents
For purposes of the Consolidated Statements of Cash Flows, cash and cash equivalents include cash and due from banks, federal funds sold and interest-bearing deposits with banks.
Federal funds sold are carried at cost, which approximates fair value, and are generally sold for one-day periods.
Federal Home Loan Bank Stock
Federal Home Loan Bank stock is carried at cost, which approximates fair value.
Investment Securities Available for Sale
Securities available for sale are acquired as part of the Company’s asset/liability management strategy and may be sold in response to changes in interest rates, loan demand, changes in prepayment risk and other factors. Securities available for sale are recorded at their fair value. Unrealized holding gains or losses, net of the related tax effect, are excluded from earnings and reported as an item of other comprehensive income until realized. The carrying values of securities available for sale are adjusted for premium amortization to the earlier of the maturity or expected call date and discount accretion to the maturity date. Realized gains and losses, using the specific identification method, are included as a separate component of noninterest income. Related interest and dividends are included in interest income. Declines in the fair value of individual available for sale securities below their cost that are other than temporary result in write-downs of the individual securities to their fair value. Factors affecting the determination of whether an other-than-temporary impairment has occurred include a downgrading of the security by a rating agency, a significant deterioration in the financial condition of the issuer, or that management would not have the intent and ability to hold a security for a period of time sufficient to allow for any anticipated recovery in fair value.
Equity securities represent the stock of various financial institutions.
Investment Securities Held to Maturity
Investment securities held to maturity are those securities which the Company has the ability and positive intent to hold until maturity. Securities so classified at the time of purchase are recorded at cost. Carrying values of securities held to maturity are adjusted for premium amortization to the earlier of the maturity or expected call date and discount accretion to the maturity date. Declines in the fair value of individual held to maturity securities below their cost, that are other than temporary, result in write-downs of the individual securities to their fair value. Factors affecting the determination of whether an other-than-temporary impairment has occurred include a downgrading of the security by the rating agency, a significant deterioration in the financial condition of the issuer, or that management would not have the ability to hold a security for a period of time sufficient to allow for any anticipated recovery in fair value.
Loans Held for Sale
Residential mortgage loans originated for sale are carried at the lower of cost or market, which may be indicated by the committed sale price, determined on an individual basis.
Loans Receivable
Loans are stated at the amount of unpaid principal adjusted for deferred origination fees and costs and the allowance for loan losses. Deferred origination fees and costs are recognized as an adjustment of the related loan yield using the interest method. The Company determines the delinquency status of loans based on contractual loan terms. Loans are generally placed in nonaccrual status when they are past-due 90 days as to either principal or interest or when, in the opinion of management, the collection of all interest and/or principal is in doubt. A loan remains in nonaccrual status until the loan is current as to payment of both principal and interest and the borrower demonstrates the ability to pay and remain current. Management may grant a waiver from nonaccrual status for a 90-day past-due loan that is both well secured and in the process of collection.
1. Summary of Significant Accounting Policies (Continued)
A loan is considered to be impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. A loan is not considered impaired during a period of delay in payment if the Company expects to collect all amounts due, including interest past-due. The Company generally considers a period of delay in payment to include delinquency up to 90 days.
In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 114, Accounting by Creditors for Impairment of a Loan, the Company measures impaired loans: (i) at the present value of expected cash flows discounted at the loan’s effective interest rate; (ii) at the observable market price; or (iii) at the fair value of the collateral if the loan is collateral dependent. If the measure of the impaired loan is less than the recorded investment in the loan, an impairment is recognized through a valuation allowance and corresponding provision for loan losses.
SFAS 114 does not apply to larger groups of smaller-balance homogeneous loans such as consumer installment loans. These loans are collectively evaluated for impairment. The Company’s impaired loans are, therefore, comprised primarily of commercial loans, including commercial mortgage loans, and real estate development and construction loans. In addition, impaired loans are generally loans which management has placed in nonaccrual status. The Company recognizes interest income for impaired loans consistent with its method for nonaccrual loans. Specifically, interest payments received are normally applied to principal. An impaired loan is charged off when the loan, or a portion thereof, is considered uncollectible.
The Company provides for loan losses through the establishment of the Allowance by provisions charged against earnings. The Company’s objective is to ensure that the Allowance is adequate to cover probable loan losses inherent in the loan portfolio at the date of each balance sheet. Management considers a number of factors in estimating the required level of the Allowance. These factors include: historical loss experience in the loan portfolios; the levels and trends in past-due and nonaccrual loans; the status of nonaccrual loans and other loans identified as having the potential for further deterioration; credit risk and industry concentrations; trends in loan volume; the effects of any changes in lending policies and procedures or underwriting standards; and, a continuing evaluation of the economic environment. The Company’s estimate of the required allowance is subject to revision as these factors change and is sensitive to the effects of the economic and market conditions on borrowers. Loan losses are charged against the Allowance when management believes the uncollectibility of the loan is confirmed. Subsequent recoveries, if any, are credited to the Allowance.
Other Real Estate Owned (OREO)
OREO is comprised of properties acquired in partial or total satisfaction of problem loans. The properties are recorded at the lower of cost or estimated fair value less selling costs. Losses incurred at the time of acquisition of the property are charged to the allowance for loan losses. Subsequent write-downs are included in noninterest expense along with operating income and expenses of such properties and gains or losses realized upon disposition.
Premises and Equipment
Premises and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization are charged to noninterest expenses. Depreciation generally is computed on the straight-line basis over the estimated useful lives of the assets, which generally range from three to ten years for furniture and equipment, three to five years for computer software and hardware, and ten to forty years for buildings and leasehold improvements. Leasehold improvements are generally amortized over the terms of the related leases or the lives of the assets, whichever is shorter. The costs of significant purchases, renewals and betterments are capitalized, while the costs of ordinary maintenance and repairs are expensed as incurred and included in noninterest expense.
Bank Owned Life Insurance
The Company purchased insurance on the lives of certain groups of employees. The policies accumulate asset values to meet future liabilities. Increases in the cash surrender value are recorded in noninterest income in the Consolidated Statements of Income.
Income Taxes
The Company and its subsidiary file a consolidated federal income tax return. Deferred income taxes are recognized for the tax consequences of temporary differences between financial statement carrying amounts and the tax basis of assets and liabilities based on enacted tax rates expected to be in effect when such amounts are realized or settled.
Intangible Assets
A deposit intangible asset of $1,847,700, relating to a branch acquisition, is being amortized using the straight-line method over 15 years. The remaining unamortized balance at December 31, 2008 and 2007 was $184,761 and $307,936, respectively. Amortization expense was $123,170 for 2008, 2007, and 2006, respectively.
1. Summary of Significant Accounting Policies (Continued)
The Company capitalizes the value of loan servicing retained on loan sales, and amortizes the value over the estimated life of the portfolio of loans serviced.
Intangible assets are included in “Other assets” on the Consolidated Balance Sheets. Management evaluates intangible assets for impairment quarterly.
Derivative Instruments and Hedging Activities
The Company accounts for derivative instruments and hedging activities utilizing guidelines established in the Financial Accounting Standards Board (“FASB”) Statement No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended. The Company recognizes all derivatives as either assets or liabilities on the balance sheet and measures those instruments at fair value. Changes in fair value of derivatives designated and accounted for as cash flow hedges, to the extent they are effective as hedges, are recorded in “Other Comprehensive Income,” net of deferred taxes. Any hedge ineffectiveness would be recognized in the income statement line item pertaining to the hedged item.
Management periodically reviews contracts from various functional areas of the Company to identify potential derivatives embedded within selected contracts. Management has identified potential embedded derivatives in certain loan commitments for residential mortgages where the Company has intent to sell to an outside investor. Due to the short-term nature of these loan commitments and the minimal historical dollar amount of commitments outstanding, the corresponding impact on the Company’s financial condition and results of operation has not been material.
The Company entered into an interest rate Floor transaction on December 14, 2005. The Floor has a notional amount of $10.0 million with a minimum interest rate of 7.00% based on U.S. prime rate and was initiated to hedge exposure to the variability in the future cash flows derived from adjustable rate home equity loans in a declining interest rate environment. The Floor has a term of five years. This interest rate Floor is designated a cash flow hedge, as it is designed to reduce variation in overall changes in cash flow below the above designated strike level associated with the first Prime based interest payments received each period on its then existing loans. The interest rate of these loans will change whenever the repricing index changes, plus or minus a credit spread (based on each loan’s underlying credit characteristics), until the maturity of the interest rate Floor. Should the Prime rate index fall below the strike level of the Floor prior to maturity, the Floor’s counterparty will pay the Bank the difference between the strike rate and the rate index multiplied by the notional value of the Floor multiplied by the number of days in the period divided by 360 days. The fair value of the Floor will be recorded as “Other Assets” and changes in the fair value will be recorded as “Other Comprehensive Income” a component of shareholders’ equity.
Per Share Data
Basic net income per share is determined by dividing net income by the weighted average number of common shares outstanding giving retroactive effect to any stock dividends and splits declared. Diluted earnings per share is determined by adjusting average shares of common stock outstanding by the potentially dilutive effects of stock options outstanding. The dilutive effects of stock options are computed using the treasury stock method.
Comprehensive Income
Comprehensive income includes all changes in shareholders’ equity during a period, except those relating to investments by and distributions to shareholders. The Company’s comprehensive income consists of net earnings, unrealized gains and losses on securities available for sale, changes in the fair value of the Floor and the adjustment from the adoption of SFAS No. 158, Employees Accounting for Defined Benefit Pension and Other Post Retirement Plans as of December 31, 2006, and is presented in the statements of shareholders’ equity. Accumulated other comprehensive income is displayed as a separate component of shareholders’ equity.
Stock-based Compensation
At the Company’s annual shareholders meeting on May 15, 2007, the 2007 Equity Plan was approved. This Plan provides for the issuance of stock options, stock appreciation rights (SARs), restricted stock, restricted performance stock, unrestricted Company stock and performance unit awards to directors, officers and other eligible employees and makes available 500,000 shares for issuance. The Plan provides for automatic annual grants of 300 shares of unrestricted stock of the Company to each non-employee director. Also, in accordance with the 2007 Equity Plan, 300 shares of unrestricted Common Stock were issued to each non-employee director in May 2008 and 2007. No new grants will be made under the 1998 Long Term Incentive Plan. However, incentive stock options issued under the 1998 plan will remain outstanding until exercised or until the tenth anniversary of the grant date of such options.
On January 1, 2006, the Company adopted the provisions of FASB Statement No. 123 (R), Share-Based Payment, which requires companies to recognize expense related to the fair value of stock-based compensation. Prior to January 1, 2006, the Company accounted for stock-based compensation under the recognition and measurement provisions of Accounting
1. Summary of Significant Accounting Policies (Continued)
Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations, as permitted by FASB Statement No. 123, Accounting for Stock-Based Compensation. In accordance with APB No. 25, no compensation cost was required to be recognized for options granted that had an exercise price equal to the market value of the underlying common stock on the date of the grant.
The Company adopted SFAS 123 (R) using the modified prospective transition method. Under this transition method, compensation cost recognized for the year ended December 31, 2006 includes: a) compensation cost for all share-based compensation granted prior to, but not vested as of January 1, 2006, based on the grant-date fair value estimated in accordance with the original provisions of SFAS 123, and b) compensation cost for all share-based compensation granted subsequent to January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS 123 (R). Prior to January 1, 2006, no compensation expense was recognized for stock option grants, as all such grants had an exercise price equal to the fair market value on the date of the grant.
In December 2005, the Company authorized the grant of 42,000 options to officers and the immediate vesting of such options. All outstanding options to officers where the exercise price of the option exceeded the fair market value of the Company’s stock were also approved for accelerated vesting. This resulted in 75,500 options becoming vested in 2005 that would have otherwise vested in future years.
As a result of adopting SFAS 123R on January 1, 2006, incremental stock-based compensation expense recognized was $7,315 and $17,841 during 2008 and 2007. As of December 31, 2008, there was $2,123 of unrecognized compensation expense related to nonvested stock options, which will be recognized over the remaining vesting period.
2. Cash and Due from Banks
The Bank is required by the Federal Reserve System to maintain certain reserve balances based principally on deposit liabilities. At December 31, 2008 and 2007, the required reserve balances were $1.6 million and $1.2 million, respectively. The Company sells federal funds on an unsecured basis to its correspondent banks. Average balances sold were $2.5 million in 2008 and $3.5 million in 2007.
3. Investment Securities
Investment securities are summarized as follows:
3. Investment Securities (Continued)
Information related to unrealized losses in the portfolio as of December 31, 2008 follows:
Contractual maturities of debt securities at December 31, 2008 and 2007 are shown below. Actual maturities may differ from contractual maturities because borrowers have the right to call or prepay obligations with or without call or prepayment penalties.
3. Investment Securities (Continued)
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.
At December 31, 2008, the Company owned five collateralized debt obligation securities that are backed by trust preferred securities issued by banks, thrifts, and insurance companies (“TRUP CDOs”). The market for these securities at December 31, 2008 was not active and markets for similar securities were also not active. The inactivity was evidenced first by a significant widening of the bid-ask spread in the brokered markets in which TRUP CDOs trade and then by a significant decrease in the volume of trades relative to historical levels. The new issue market is also inactive as no new TRUP CDOs have been issued since 2007. There are currently very few market participants who are willing or able to transact for these securities.
The market values for these securities (and any securities other than those issued or guaranteed by the U.S. Treasury) are very depressed relative to historical levels. For example, the yield on spreads for the broad market of investment grade and high yield corporate bonds reached all time wide levels versus U.S. Treasuries at the end of November 2008 and remain near those levels today. Thus, in today’s market, a low market price for a particular bond may only provide evidence of stress in the credit markets in general versus being an indicator of credit problems with a particular issuer.
Given conditions in the debt markets today and the absence of observable transactions in the secondary and new issue markets, we determined:
·
The few observable transactions and market quotations that are available are not reliable for purposes of determining fair value at December, 31, 2008;
·
An income valuation approach technique (present value technique) that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs will be equally or more representative of fair value than the market approach valuation technique used at prior measurement dates; and
·
Our TRUP CDOs will be classified within Level 3 of the fair value hierarchy because we determined that significant adjustments are required to determine fair value at the measurement date.
Our TRUP CDO valuations were prepared by an independent third party. Their approach to determining fair value involved these steps:
1.
The credit quality of the collateral is estimated using average probability of default values for each issuer (adjusted for rating levels).
2.
The default probabilities also considered the potential for correlation among issuers within the same industry (e.g. banks with other banks).
3.
The loss given default was assumed to be 95% (i.e. a 5% recovery).
4.
The cash flows were forecast for the underlying collateral and applied to each CDO tranche to determine the resulting distribution among the securities.
5.
The expected cash flows were discounted to calculate the present value of the security.
6.
The calculations were modeled in several thousand scenarios using a Monte Carlo engine and the average price was used for valuation purposes.
3. Investment Securities (Continued)
7.
The effective discount rates on an overall basis range from 7% to 31% and are highly dependent upon the credit quality of the collateral, the relative position of the tranche in the capital structure of the TRUP CDO and the prepayment assumptions.
During 2008, the Company wrote down two equity securities for $104,282. At December 31, 2008, seven marketable equity securities had unrealized losses of approximately $83,000 from the Company’s cost basis. At December 31, 2007, five marketable equity securities had unrealized losses of approximately $40,000 from the Company’s cost basis. No credit issues in the remaining equity securities have been identified that cause management to believe the decline in market value is other than temporary. In analyzing the issuer’s financial condition, management considers industry analysis reports, financial performance and projected target prices of investment analysts within a one-year time frame. Unrealized losses on marketable equity securities that are in excess of 50% of cost, and that have been sustained for more than 24 months, are generally recognized by management as being other than temporary and charged to earnings, unless evidence exists to support a realizable value equal to or greater than the Company’s carrying value of the investment.
All unrealized losses on U.S. government agency, mortgage-backed securities, state and municipal securities and corporate bonds as of December 31, 2008 are considered to be temporary losses, because each security will be redeemed at face value at, or prior to maturity. In most cases, the temporary impairment in value is caused by market interest rate fluctuations.
At December 31, 2008 and 2007, securities with an amortized cost of $64.5 million (fair value of $59.7 million) and $16.6 million (fair value of $16.5 million), respectively, were pledged as collateral for government deposits, securities sold under repurchase agreements, advances from the Federal Home Loan Bank, and borrowings from the FRB. At December 31, 2008, there were no borrowings against the securities pledged at the FRB.
In 2008, the Company realized gross gains on sales of or call of securities purchased at a discount of $347,510. These gains were partially offset by the $104,282 write down of equity securities. There were no sales of securities in 2007. In 2006 the Company realized gross gains on sales of securities of $2.2 million. There were no realized losses in 2006. Income taxes on net security gains in 2008 and 2006 were $31,000 and $730,000, respectively.
4. Loans
Major classifications of loans at December 31 are as follows:
The Bank makes loans to customers located in Maryland, Virginia, Pennsylvania and Delaware. Although the loan portfolio is diversified, its performance will be influenced by the regional economy.
The maturity and rate repricing distribution of the loan portfolio at December 31 is as follows:
4. Loans (Continued)
Loan balances have been adjusted by the following deferred amounts as of December 31:
Transactions in the allowance for loan losses for the years ended December 31 were as follows:
Nonperforming assets and loans past-due 90 days or more but accruing interest were as follows at December 31:
At December 31, 2008, the Company had eleven impaired loans totaling approximately $1,554,000, all of which had been classified as non-accrual. The valuation allowance for impaired loans was $290,127 at December 31, 2008.
The average balance of impaired loans amounted to approximately $3.6 million in 2008. During 2008, the Company received total payments on impaired loans of $1.9 million. Of this amount, $133,000 was recorded as interest income for 2008. The remainder was applied to reduce principal.
At December 31, 2007, the Company had nine impaired loans totaling approximately $3,640,000, all of which had been classified as non-accrual. The valuation allowance for impaired loans was $901,652 at December 31, 2007.
The average balance of impaired loans amounted to approximately $3.9 million in 2007. During 2007, the Company received total payments on impaired loans of $669,083. Of this amount, $52,454 was recorded as interest income for 2007. The remainder was applied to reduce principal.
At December 31, 2006 there were no impaired loans.
Loans with a balance of approximately $109.9 million and $97.3 million were pledged as collateral to the Federal Home Loan Bank of Atlanta as of December 31, 2008 and 2007, respectively. At December 31, 2008 and 2007, the Company serviced loans for others totaling $498,000 and $727,000, respectively.
5. Credit Commitments
Outstanding loan commitments, unused lines of credit, and letters of credit were as follows as of December 31:
Loan commitments and lines of credit are agreements to lend to a customer as long as there is no violation of any condition to the contract. Loan commitments generally have interest rates fixed at current market amounts, fixed expiration dates, and may require payment of a fee. Lines of credit generally have variable interest rates. Such lines do not represent future cash requirements because it is unlikely that all customers will draw upon their lines in full at any time. Letters of credit are commitments issued to guarantee the performance of a customer to a third party.
The Company’s exposure to credit loss in the event of nonperformance by the borrower is the contract amount of the commitment. Loan commitments, lines of credit, and letters of credit are made on the same terms, including collateral, as outstanding loans. The Company is not aware of any accounting loss it would incur by funding the above commitments.
6. Related Party Transactions
The Company’s executive officers and directors, or other entities, to which they are related, enter into loan transactions with the Bank in the ordinary course of business. The terms of these transactions are similar to the terms provided to other borrowers entering into similar loan transactions and do not involve more than normal risk of collectibility. During the years ended December 31, 2008, 2007 and 2006, transactions in related party loans were as follows:
A director of the Company is a partner in a law firm that provides legal services to the Company and the Bank. During the years ended December 31, 2008, 2007, and 2006, amounts paid to the law firm in connection with those services were approximately $381,000, $358,000, and $195,000, respectively.
A director of the Company is President of an insurance brokerage through which the Company and the Bank place various insurance policies. During the years ended December 31, 2008, 2007, and 2006, amounts paid to the insurance brokerage for insurance premiums were approximately $214,000, $112,000, and $282,000, respectively.
A director of the Company is President of an electrical company through which the Company and the Bank may contract for electrical services. No such services were performed in 2008, 2007 or 2006.
A director of the Company is the Executive Vice President for a commercial real estate services company, through which the Company and the Bank contracted for appraisal and management services. In late 2006 and 2007, contracts for the construction of two branches were awarded on a competitive bid basis to a related party. Contract payments totaling approximately $126,562 in 2008, $1.5 million in 2007, and $356,000 in 2006 were paid to the related party.
The Bank routinely enters into deposit relationships with its directors, officers and employees in the normal course of business. These deposits bear the same terms and conditions of those prevailing at the time for comparable transactions with
6. Related Party Transactions (Continued)
unrelated parties. Balances of executive officers and directors on deposits as of December 31, 2008 and 2007 were $2.7 million and $2.0 million, respectively.
7. Premises and Equipment
A summary of premises and equipment is as follows as of December 31:
Depreciation and amortization of premises and equipment was $675,409, $663,135, and $611,658, for 2008, 2007, and 2006, respectively. Amortization of software was $60,507, $61,616, and $108,364 for 2008, 2007, and 2006, respectively.
8. Deposits
Major classifications of interest-bearing deposits are as follows as of December 31:
Time deposits mature as follows:
9. Borrowed Funds
Borrowed funds consist of securities sold under repurchase agreements, federal funds purchased, and borrowings from the FHLB. Securities sold under repurchase agreements are securities sold to the Bank’s customers under a continuing “roll-over” contract and mature in one business day. The underlying securities sold are federal agency securities that are segregated from the Company’s other investment securities. Federal funds purchased are unsecured, overnight borrowings from other financial institutions.
9. Borrowed Funds (Continued)
Information with respect to borrowings is as follows at and for the years ended December 31:
Debt retirement expense of $2.3 million was incurred in 2006 due to the restructuring of a $35.0 million FHLB advance that had a maturity date of February 2, 2010 and an interest rate of 6.84%.
The Company also has external sources of funds through the Federal Reserve Bank (“FRB”) and FHLB, which can be drawn upon when required. There is a line of credit totaling approximately $64 million with the Federal Home Loan Bank of Atlanta (the “FHLB”) based on qualifying loans pledged as collateral. Also the Company can pledge securities at the FRB and FHLB and borrow approximately 97% of the fair market value of the securities. In addition, the Company had $33.7 million of securities pledged at the FHLB under which the Company’s subsidiary, Carrollton Bank, could have borrowed approximately $32.7 million. Also, Carrollton Bank has $8.2 million of securities pledged at FRB under which it could have borrowed approximately $8.0 million. Approximately $2.6 million of securities have not been pledged against any borrowings. Outstanding borrowings at the FHLB were $65.2 million at December 31, 2008. Additionally, the Company has an unsecured federal funds line of credit of $5.0 million and a $10.0 secured federal funds line of credit with other institutions. The secured federal funds line of credit with the another institution would require Carrollton Bank to transfer securities pledged at the FHLB or FRB to this institution before Carrollton Bank could borrow against the line. There was no balance outstanding under these lines at December 31, 2008. These lines bear interest at the current federal funds rate of the correspondent bank.
10. Other Noninterest Expenses
Other noninterest expenses include the following for the years ended December 31:
11. Stock Options
At the Company’s annual shareholders meeting on May 15, 2007, the 2007 Equity Plan was approved. Under this plan, 500,000 shares of the Common Stock of the Company were reserved for issuance. Also, in accordance with the 2007 Equity Plan, 300 shares of unrestricted Common Stock were issued to each non-employee director in May 2008 and 2007. No new grants will be made under the 1998 Long Term Incentive Plan. However, incentive stock options issued under this plan will remain outstanding until exercised or until the tenth anniversary of the grant date of such options.
The 1998 Long Term Incentive Plan provided for the granting of common stock options to directors and key employees. In 2004, the shareholders approved increasing the number of shares available for grant under the Plan from 210,000 shares to 300,000 shares. These stock option awards contained a serial feature whereby one third of the options granted vest and can be exercised after each year. Option prices were equal to the estimated fair market value of the common stock at the date of the grant. Options expire ten years after the date of grant or upon employee termination if not exercised.
11. Stock Options (Continued)
Information with respect to options outstanding is as follows for the years ended December 31:
On December 15, 2005, the Board of Directors authorized the grant of 42,000 options to officers and the immediate vesting of such options. All outstanding options to officers where the exercise price of the option exceeded the fair market value of the Company’s stock were also approved for accelerated vesting. This resulted in 75,500 options becoming vested in 2005 that would have otherwise vested in future years.
As a result of adopting SFAS 123R on January 1, 2006, incremental stock-based compensation expense recognized was $7,315 and $17,841 during 2008 and 2007. As of December 31, 2008, there was $9,437 of unrecognized compensation expense related to nonvested stock options, which will be recognized over the remaining vesting period. The total intrinsic value of options excised during the year ended December 31, 2008 and 2007 was approximately $5,000 and $86,000, respectively.
A summary of information about stock options outstanding is as follows at December 31, 2008:
11. Stock Options (Continued)
As of December 31, 2008, the weighted average exercise price of shares underlying options currently exercisable was $14.15 per share.
No options were granted in 2008. The value of each option is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions used for grants during the years ended December 31, 2007 and 2006:
The dividend yield is based on estimated future dividend yields. The risk-free rate for periods within the contractual term of the share option is based on the U.S. Treasury yield curve in effect at the time of the grant. Expected volatilities are generally based on historical volatilities.
12. Net Income Per Share
The calculation of net income per common share as restated giving retroactive effect to any stock dividends and splits is as follows for the years ended December 31:
13. Comprehensive Income
Comprehensive income is defined as net income plus transactions and other occurrences which are the result of nonowner changes in equity. For the Company, nonowner equity changes are comprised of unrealized gains or losses on available for sale securities, changes in the fair value of the derivative interest rate floor transaction and changes in the net actuarial gain/loss of the Company’s frozen Defined Benefit Pension Plan. These items, net of taxes, will be accumulated with net income in determining comprehensive income. Presented below is a reconcilement of net income to comprehensive income for the years ended December 31:
13. Comprehensive Income (Continued)
The components of accumulated other comprehensive income, net of tax, as of year-end were as follows:
14. Capital Standards
The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary action taken by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting procedures. The Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier 1 capital (as defined) to risk-weighted assets (as defined), and of Tier 1 capital to average assets (as defined). Management believes, as of December 31, 2008, that the Bank meets all capital adequacy requirements to which it is subject. As of December 31, 2008, the most recent notification from the Federal Reserve Bank and the FDIC categorized the Company and the Bank as “well capitalized” under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes would change the Company’s or the Bank’s category.
15. Retirement Plans
In the year ended December 31, 2006, the Company adopted SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, which requires the recognition of the funded status of defined benefit postretirement plans and related disclosures. While it does not impact net income, this resulted in a one-time adjustment to accumulated other comprehensive income in shareholders’ equity of $484 (net of tax) for the Pension Plan.
Effective December 31, 2004, the Company froze the Defined Benefit Pension Plan. Participant benefits stopped accruing as of the date of the freeze. No new participants entered the Plan after December 31, 2004.
15. Retirement Plans (Continued)
The following table sets forth the financial status of the Plan as of and for the years ended December 31:
15. Retirement Plans (Continued)
Allocation of Assets
There are no net transaction obligation (asset), prior service cost (credit) and estimated net loss (gain) for the Plan that are expected to be amortized from accumulated other comprehensive income into net periodic benefit cost over the next fiscal year.
Benefits expected to be paid from the Plan are as follows:
The Plan’s investment strategy is predicated on its investment objectives and the risk and return expectations of asset classes appropriate for the Plan. Investment objectives have been established by considering the Plan’s liquidity needs and time horizon and the fiduciary standards under ERISA. The asset allocation strategy is developed to meet the Plan’s long term needs in a manner designed to control volatility and to reflect the Company’s risk tolerance.
In determining the long-term rate of return on pension plan assets assumption, the target asset allocation is first reviewed. An expected long-term rate of return is assumed for each asset class, and an underlying inflation rate assumption is also made. The effects of asset diversification and periodic fund rebalancing are also considered.
The Company has a contributory thrift plan qualifying under Section 401(K) of the Internal Revenue Code. Employees with one year of service are eligible for participation in the Plan. In conjunction with the curtailment of the pension plan, the Company expanded the thrift plan to make it a Safe Harbor Plan. Once an employee has been at the Company for one year, the Company then contributes 3% of the employee’s salary to the Plan for the employee’s benefit. The Company also matches 50% of the employee 401(K) contribution up to 6% of employee compensation. Contributions to this Plan, included in employee benefit expenses, were $336,882, $319,236 and $319,453, for 2008, 2007, and 2006, respectively.
16. Contingencies
The Company is involved in various legal actions arising from normal business activities. Management believes that the ultimate liability or risk of loss resulting from these actions will not materially affect the Company’s financial position or results of operations.
17. Income Taxes
On January 1, 2007, the Company adopted the Financial Accounting Standards Board (“FASB”) Final Interpretation Number 48, Accounting for Uncertainty in Income Taxes. The Company has no adjustments to report with respect to the effect of adoption of FIN 48.
The components of income tax expense are as follows for the years ended December 31:
The components of the deferred tax benefits were as follows for the years ended December 31:
The components of the net deferred tax liability were as follows for the years ended December 31:
17. Income Taxes (Continued)
The differences between the federal income tax rate of 34 percent and the effective tax rate for the Company are reconciled as follows:
18. Lease Commitments
The Company leases various branch and general office facilities to conduct its operations. The leases have remaining terms which range from a period of 1 year to 20 years. Most leases contain renewal options which are generally exercisable at increased rates. Some of the leases provide for increases in the rental rates at specified times during the lease terms, prior to the expiration dates.
The leases generally provide for payment of property taxes, insurance, and maintenance costs by the Company. The total rental expense for all real property leases amounted to $1,249,543, $1,129,007, and $937,160, for 2008, 2007, and 2006, respectively.
Lease obligations will require minimum rental payments as follows:
19. Parent Company Financial Information
The balance sheets as of December 31, 2008 and 2007 and statements of income and cash flows for Carrollton Bancorp (Parent Only) for 2008, 2007 and 2006, are presented below:
Statements of Income
19. Parent Company Financial Information (Continued)
Statements of Cash Flows
20. Fair Value and Financial Instruments
SFAS 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. A fair value measurement assumes that the transaction to sell the asset or transfer the liability occurs in the principal market for the asset or liability or, in the absence of a principal market, the most advantageous market for the asset or liability. The price in the principal (or most advantageous) market used to measure the fair value of the asset or liability shall not be adjusted for transaction costs. An orderly transaction is a transaction that assumes exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets and liabilities; it is not a forced transaction. Market participants are buyers and sellers in the principal market that are (i) independent, (ii) knowledgeable, (iii) able to transact and (iv) willing to transact.
SFAS 157 requires the use of valuation techniques that are consistent with the market approach, the income approach and/or the cost approach. The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets and liabilities. The income approach uses valuation techniques to convert future amounts, such as cash flows or earnings, to a single present amount on a discounted basis. The cost approach is based on the amount that currently would be required to replace the service capacity of an asset (replacement cost). Valuation techniques should be consistently applied. Inputs to valuation techniques refer to the assumptions that market participants would use in pricing the asset or liability. Inputs may be observable, meaning those that reflect the assumptions market participants would use in pricing the asset or liability developed based on market data obtained from independent sources, or unobservable, meaning those that reflect the reporting entity’s own assumptions about the assumptions market participants would use in pricing the asset or liability developed based on the best information available in the circumstances. In that regard, SFAS 157 establishes a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The fair value hierarchy is as follows:
Level 1: Quoted prices (unadjusted) or identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.
Level 2: Significant other observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, and other inputs that are observable or can be corroborated by observable market data.
Level 3: Significant unobservable inputs that reflect a company’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.
The Company uses the following methods and significant assumptions to estimate fair value for financial assets and financial liabilities:
Securities available for sale: The fair value of securities available for sale are determined by obtaining quoted prices on nationally recognized securities exchanges. If quoted market prices are not available, fair value is determined using quoted market prices for similar securities. Equity securities are reported at fair value using Level 1 inputs.
Derivatives: Derivatives are reported at fair value utilizing Level 2 inputs. The Company obtains dealer quotations to value its interest rate floor. For purposes of potential valuation adjustments to its derivative position, the Company evaluates the credit risk of its counterparty. Accordingly, the Company has considered factors such as the likelihood of default by the counterparty and the remaining contractual life, among other things, in determining if any fair value adjustment related to credit risk is required.
Loans held for sale: The fair value of loans held for sale is determined, when possible, using quoted secondary-market prices. If no such quoted pricing exists, the fair value of a loan is determined using quoted prices for a similar asset or assets, adjusted for the specific attributes of that loan.
Impaired loans and other real estate owned: Nonrecurring fair value adjustments to loans and other real estate owned (“OREO”) reflect full or partial write-downs that are based on the loans or OREO’s observable market price or current appraised value of the collateral in accordance with SFAS 114, Accounting by Creditors for Impairment of a Loan. Since the market for impaired loans and OREO is not active, loans or OREO subjected to nonrecurring fair value adjustments based on the current appraised value of the collateral may be classified as Level 2 or Level 3 depending on the type of asset and the inputs to the valuation. When appraisals are used to determine impairment and these appraisals are based on a market approach incorporating a dollar-per-square-foot multiple, the related loans or OREO are classified as Level 2. If the appraisals require significant adjustments to market-based valuation inputs or apply an income approach based on unobservable cash flows to measure fair value, the related loans or OREO subjected to nonrecurring fair value adjustments are typically classified as Level 3 due to the fact that Level 3 inputs are significant to the fair value measurement.
20. Fair Value and Financial Instruments (Continued)
Approximately $104,000 write down of equity securities was recognized as a reduction of gain on sales.
Certain other assets are measured at fair value on a nonrecurring basis. These adjustments to fair value usually result from application of lower of cost or fair value accounting or write-downs of individual assets due to impairment. For assets measured at fair value on a nonrecurring basis during 2008 that were still held in the balance sheet at year end, the following table provides the level of valuation assumptions used to determine each adjustment and the carrying value of the related individual assets at year end.
During 2008, the Company recognized losses related to certain assets that are measured at fair value on a nonrecurring basis (i.e. loans and loans held for sale). Approximately $2.3 million of losses related to loans were recognized as chargeoffs for loan losses and $167,000 write downs of OREO properties were recognized as other operating expenses. During 2008, there were no losses related to loans held for sale accounted for at the lower of cost or fair value.
The following methods and assumptions were used to estimate the fair value of each class of financial instrument.
Cash and cash equivalents
The carrying amount of cash and due from banks is a reasonable estimate of fair value.
Federal funds sold and Federal Home Loan Bank deposit
The carrying amount of federal funds sold and Federal Home Loan Bank deposit is a reasonable estimate of fair value.
Investment Securities
The fair values of securities held to maturity and securities available for sale are based upon quoted market prices or dealer quotes. Level 3 of the fair value hierarchy was used to determine fair value of Trust Preferred securities because the market for these securities at December 31, 2008 was not active.
Loans held for sale
The fair value of residential mortgage loans originated for sale is estimated by discounting future cash flows using current rates for which similar loans would be made to borrowers with similar credit histories.
20. Fair Value and Financial Instruments (Continued)
Loans, net
The fair value of loans receivable is estimated by discounting future cash flows using current rates for which similar loans would be made to borrowers with similar credit histories.
Deposit liabilities
The fair value of demand deposits and savings accounts is the amount payable on demand. The fair value of fixed maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities. The estimated fair value of deposits does not take into account the value of the Company’s long-term relationships with depositors, commonly known as core deposit intangibles, which are separate intangible assets, and not considered financial instruments. Nonetheless, the Company would likely realize a core deposit premium if its deposit portfolio were sold in the principal market for such deposits.
Federal funds purchased and securities sold under agreements to repurchase
The carrying amount of federal funds purchased and securities sold under agreements to repurchase is a reasonable estimate of fair value.
Advances from the FHLB
The fair value of long-term FHLB advances is estimated by discounting the value of contractual cash flows using rates currently offered for advances with similar terms and remaining maturities.
Commitments to extend credit, standby letters of credit and financial guarantees written
The Company charges fees for commitments to extend credit. Interest rates on loans for which these commitments are extended are normally committed for periods of less than one month. Fees charged on standby letters of credit and other financial guarantees are deemed to be immaterial and these guarantees are expected to be settled at face amount or expire unused. It is impractical to assign any fair value to these commitments.
21. Consolidated Quarterly Results of Operations (Unaudited)
21. Consolidated Quarterly Results of Operations (Unaudited) (Continued)
22. Subsequent Event
On February 13, 2009, as part of the TARP Capital Purchase Program, the Company entered into a Letter Agreement, and the related Securities Purchase Agreement - Standard Terms (collectively, the “Purchase Agreement”), with the United States Department of the Treasury (“Treasury”), pursuant to which the Company issued (i) 9,201 shares of Fixed Rate Cumulative Perpetual Preferred Stock, Series A, liquidation preference $1,000 per share (“Series A Preferred Stock”), and (ii) a warrant to purchase 205,379 shares of the Company’s common stock, par value $1.00 per share.
The Company raised $9,201,000 through the sale of the Series A Preferred Stock which will qualify as Tier 1 capital. With the full amount of the Treasury’s investment, on a pro-forma basis, at December 31, 2008, the Company’s Tier I capital ratio would increase to approximately 12.78% and total risk-based capital ratio would increase to approximately 13.84%. The Series A Preferred Stock will pay cumulative dividends at a rate of 5% per annum until February 15, 2014. Beginning February 16, 2014, the dividend rate will increase to 9% per annum. Dividends are payable quarterly.
On and after February 15, 2012, the Company may, at its option, redeem shares of Series A Preferred Stock, in whole or in part, at any time and from time to time, for cash at a per share amount equal to the sum of the liquidation preference per share plus any accrued and unpaid dividends to but excluding the redemption date. Prior to February 15, 2012, the Company may redeem shares of Series A Preferred Stock only if it has received aggregate gross proceeds of not less than $ 9,201,000 from one or more qualified equity offerings, and the aggregate redemption price may not exceed the net proceeds received by the Company from such offerings. The redemption of the Series A Preferred Stock requires prior regulatory approval.
The warrant is exercisable in whole or in part at $6.72 per share at any time on or before February 13, 2019. Treasury has agreed not to exercise voting power with respect to any shares of common stock issued upon exercise of the warrant.
The Series A Preferred Stock and the warrant were issued in a transaction exempt from registration pursuant to Section 4(2) of the Securities Act of 1933, as amended. The Company has agreed to register the Series A Preferred Stock, the warrant, and the shares of common stock underlying the warrant (the “warrant shares”) as soon as practicable after the date of the issuance of the Series A Preferred Stock and the warrant. Neither the Series A Preferred Stock nor the warrant will be subject to any contractual restrictions on transfer, except that Treasury may not transfer a portion of the warrant with respect to, or exercise the warrant for, more than one-half of the warrant shares prior to the earlier of (a) the date on which the Company has received aggregate gross proceeds of not less than $9,201,000 from one or more qualified equity offerings and (b) December 31, 2009.
The Purchase Agreement also subjects the Company to certain of the executive compensation limitations included in the Emergency Economic Stabilization Act of 2008 (the “EESA”). As a condition to the closing of the transaction, Robert A. Altieri, James M. Uveges, Gary M. Jewell, William D. Sherman, and Lola B. Stokes (the Company’s Senior Executive Officers, as defined in the Purchase Agreement) each: (i) voluntarily waived any claim against the Treasury or the Company for any changes to such Senior Executive Officer’s compensation or benefits that are required to comply with the regulation issued by the Treasury under the TARP Capital Purchase Program as published in the Federal Register on October 20, 2008 and acknowledging that the regulation may require modification of the compensation, bonus, incentive and other benefit plans, arrangements and policies and agreements (including so-called “golden parachute” agreements) as they relate to the period the Treasury holds any equity or debt securities of the Company acquired through the TARP Capital Purchase Program; and (ii) entered into an amendment to Messer’s Altieri, Uveges, Jewell and Mrs. Stokes employment agreements that provide that any severance payments made to such officers will be reduced, as necessary, so as to comply with the requirements of the TARP Capital Purchase Program.
The Treasury’s current consent shall be required for any increase in the common dividends per share until February 13, 2012 unless prior to such date, the Series A preferred stock is redeemed in whole or the Treasury has transferred all of the Series A Preferred Stock to third parties.
Item 9:
Item 9: Changes in and Disagreements With Accountants On Accounting and Financial Disclosure
There have been no changes in or disagreements with accountants, on accounting and financial disclosure during 2008.
Item 9A(T):
Item 9A(T): Controls and Procedures
Evaluation of Disclosure Controls and Procedures. We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission, and that such information is accumulated and communicated to our management, including the Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. Management necessarily applied its judgment in assessing the costs and benefits of such controls and procedures which, by their nature, can provide only reasonable assurance regarding management’s control objective.
We carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-15, as of the end of the fiscal period covered by this report on Form 10-K. Based upon that evaluation, each of our Chief Executive Officer and our Chief Financial Officer concluded that our disclosure controls and procedures are effective in timely alerting them to material information relating to us required to be disclosed in our Exchange Act reports.
Management’s Report on Internal Control over Financial Reporting. Management is responsible for establishing and maintaining adequate internal control over financial reporting as such term is defined in Exchange Act Rules 13a-15(f). The Company’s internal controls over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Because of its inherent limitations, internal controls over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may be inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate.
Under the supervision and with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, management conducted an evaluation of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2008 based on the framework in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, management concluded that the Company’s internal control over financial reporting was effective as of December 31, 2008 under this framework.
This annual report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit the Company to provide only management’s report in this annual report.
Changes in Internal Control over Financial Reporting. In connection with our evaluation, no change was identified in our internal controls over financial reporting that occurred during the fourth quarter of 2008 that has materially affected, or is reasonably likely to materially affect, our internal controls over financial reporting.
Item 9B:
Item 9B: Other Information
None.
PART III
Item 10:
Item 10: Directors, Executive Officers and Corporate Governance
The information required by this Item is incorporated by reference to the information appearing under the captions “Election of Directors,” “Executive Officers” and “Section 16(a) Beneficial Ownership Reporting Compliance” in the Company’s definitive Proxy Statement for the Annual Meeting of Shareholders to be held on May 12, 2009.
Item 11:
Item 11: Executive Compensation
The information required by this Item is incorporated by reference to the information appearing under the captions “Executive Compensation,” “Outstanding Equity Awards at 2008 Fiscal Year End,” “Grants of Plan-Based Awards,” “Option Exercises and Stocks Vested” and “Pension Benefits and Perquisites” in the Company’s definitive Proxy Statement for the Annual Meeting of Shareholders to be held on May 12, 2009.
Item 12:
Item 12: Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The information required by this Item is incorporated by reference to the information appearing under the caption “Security Ownership of Directors and Executive Officers” and “Certain Beneficial Owners” in the Company’s definitive Proxy Statement for the Annual Meeting of Shareholders to be held on May 12, 2009.
Item 13:
Item 13: Certain Relationships and Related Transactions, and Director Independence
The information required by this Item is hereby incorporated by reference to the information appearing under the caption “Certain Transactions and Relationships” in the Company’s definitive Proxy Statement for the Annual Meeting of Shareholders to be held on May 12, 2009.
Item 14:
Item 14: Principal Accounting Fees and Services
The information required by this Item is hereby incorporated by reference to the information appearing under the caption “Audit Fees and Services” in the Company’s definitive Proxy Statement for the Annual Meeting of Shareholders to be held on May 12, 2009.
PART IV
Item 15:
Item 15: Exhibits, Financial Statement Schedules
1.
Financial Statements
Carrollton Bancorp and Subsidiaries:
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets as of December 31, 2008, and 2007
Consolidated Statements of Income for the years ended December 31, 2008, 2007, and
Consolidated Statements of Changes in Shareholders’ Equity for the years ended December 31, 2008, 2007, and 2006
Consolidated Statements of Cash Flows for the years ended December 31, 2008, 2007, and
Notes to Consolidated Financial Statements
2.
Financial Statement Schedules
None
3.
Exhibits
(2)
Incorporated by reference from Registration Statement dated January 12, 1990, on SEC Form S-4 (1933 Act File No.: 33-33027).
(4)
Incorporated by reference to the Registrant’s Form 8-K filed 6/19/2007 (File No.: 000-23090).
(6)
Incorporated by reference to the Registrant’s Form 8-K filed 10/24/2007 (File No.: 000-23090).
(8)
Incorporated by reference to the Registrant’s Form 8-K filed 9/30/2008 (File No.: 000-23090)
Signatures
Pursuant to the requirement of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
CARROLLTON BANCORP
(Registrant)
Pursuant to the requirements of 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.
Principal Financial and Accounting Officer
Exhibit Index
(1)
Incorporated by reference to the Registrant’s Form 8-K filed February 17, 2009 (File No.: 000-23090).
(2)
Incorporated by reference from Registration Statement dated January 12, 1990 on SEC Form S-4 (1933 Act File No.: 33-33027).
(3)
Incorporated by reference from Annual Report on Form 10-KSB for the fiscal year ended December 31, 1994 (1934 Act File No.: 0-23090).
(4)
Incorporated by reference to the Registrant’s Form 8-K filed June19, 2007 (File No.: 000-23090)
(5)
Incorporated by reference to the Registrant’s Form 8-K filed September 25, 2007 (File No. : 000-23090)
(6)
Incorporated by reference to the Registrant’s Form 8-K filed October 24, 2007 (File No. : 000-23090)
(7)
Incorporated by reference to the Registrant’s Form 8-K filed November 8, 2007 (File No. : 000-23090)
(8)
Incorporated by reference to the Registrant’s Form 8-K filed September 30, 2008 (File No.: 000-23090)