ITEM 5.
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
There is not a large market for the Company’s shares, which are quoted on the OTC Bulletin Board under the symbol “MNBT” and are not traded on any national exchange. Trading is generally limited to private transactions and, therefore, there is limited reliable information available as to the number of trades or the prices at which our stock has traded. Management has reviewed the limited information available regarding the range of prices at which the Company’s common stock has been sold. The following table sets forth, for the calendar periods indicated, the range of high and low reported sales prices. This data is provided for information purposes only and should not be viewed as indicative of the actual or market value of our common stock:
These quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission, and may not represent actual transactions.
As of the date of this filing, the Company has approximately 2,000 holders of record of its common stock. The Company has no other class of securities issued or outstanding.
Dividends from the Bank are the Company’s primary source of funds to pay dividends on its capital stock. Under the National Bank Act, the Bank may, in any calendar year, without the approval of the OCC, pay dividends to the extent of net profits for that year, plus retained net profits for the preceding two years (less any required transfers to surplus). Given the losses incurred by the Bank in 2009 and 2010, the Bank’s ability to pay dividends to the Company beginning on January 1, 2010 was limited. The need to maintain adequate capital in the Bank also limits dividends that may be paid to the Company. The OCC and Federal Reserve have the general authority to limit the dividends paid by insured banks and bank holding companies, respectively, if such payment may be deemed to constitute an unsafe or unsound practice. If, in the particular circumstances, the OCC determines that the payment of dividends would constitute an unsafe or unsound banking practice, the OCC may, among other things, issue a cease and desist order prohibiting the payment of dividends. Additional information regarding restrictions on the ability of the Bank to pay dividends to the Company is contained in this report under “Item 1 - Business- Supervision and Regulation.”
Issuer Purchases of Equity Securities
The Company made no repurchases of its Common Stock during the fourth quarter of 2010.
ITEM 7.
ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
To better understand financial trends and performance, our management analyzes certain key financial data in the following pages. This analysis and discussion reviews our results of operations for the two-year period ended December 31, 2010, and our financial condition at December 31, 2009 and 2010. We have provided comparisons of financial data as of and for the fiscal years ended December 31, 2009 and 2010, to illustrate significant changes in performance and the possible results of trends revealed by that historical financial data. The following discussion should be read in conjunction with our consolidated audited financial statements, including the notes thereto, and the selected consolidated financial data presented elsewhere in this Annual Report on Form 10-K.
Overview
We conduct our business, which consists primarily of traditional commercial banking operations, through our wholly owned subsidiary, Mountain National Bank. Through the Bank we offer a broad range of traditional banking services from our corporate headquarters in Sevierville, Tennessee, our regional headquarters in Maryville, TN, and through ten additional branches in Sevier County and Blount County, Tennessee. Our banking operations primarily target individuals and small businesses in Sevier and Blount Counties and the surrounding area. The retail nature of the Bank’s commercial banking operations allows for diversification of depositors and borrowers, and we believe that the Bank is not dependent upon a single or a few customers. But, due to the predominance of the tourism industry in Sevier County, a significant portion of the Bank’s commercial loan portfolio is concentrated within that industry, including the residential real estate segment of that industry. The predominance of the tourism industry also makes our business more seasonal in nature, particularly with respect to deposit levels, than may be the case with banks in other market areas. The tourism industry in Sevier County has remained relatively stable during the past couple of years, particularly with respect to overnight rentals and hospitality services, and management does not anticipate any significant changes in that trend in the future.
Critical Accounting Policies
Our accounting and reporting policies are in accordance with accounting principles generally accepted in the United States of America and conform to general practices accepted within the banking industry. Our significant accounting policies are described in the notes to our consolidated financial statements. Certain accounting policies require management to make significant estimates and assumptions that have a material impact on the carrying value of certain assets and liabilities, and we consider these to be critical accounting policies. The estimates and assumptions used are based on historical experience and other factors that management believes to be reasonable under the circumstances. Actual results could differ significantly from these estimates and assumptions, which could have a material impact on the carrying value of assets and liabilities at the balance sheet dates and on our results of operations for the reporting periods.
We believe the following are the critical accounting policies that require the most significant estimates and assumptions and that are particularly susceptible to a significant change in the preparation of our financial statements.
Valuation of Investment Securities
Management conducts regular reviews to assess whether the values of our investments are impaired and whether any such impairment is other than temporary. The determination of whether other-than-temporary impairment has occurred involves significant assumptions, estimates and judgments by management. Changing economic conditions - global, regional or related to industries of specific issuers - could adversely affect these values.
On May 1, 2009, Silverton Bank, the bank subsidiary of Silverton Financial Services, Inc. (“Silverton”), was placed into receivership by the OCC after Silverton Bank’s capital deteriorated significantly in the first quarter of 2009, and on June 5, 2009 Silverton filed a petition for bankruptcy. The Company does not anticipate that it will recover any of the Bank’s investment in either the common securities or trust preferred securities issued by Silverton or its affiliated trust. As a result, the Company recorded an impairment charge of $347,368, which represents the Company’s full investment in the securities, during the first quarter of 2009.
We recorded no additional other-than-temporary impairment of our investment securities during 2009 and 2010.
Allowance and Provision for Loan Losses
The allowance and provision for loan losses are based on management’s assessments of amounts that it deems to be adequate to absorb probable incurred losses inherent in our existing loan portfolio. The allowance for loan losses is established through a provision for losses based on management’s evaluation of current economic conditions, volume and composition of the loan portfolio, the fair market value or the estimated net realizable value of underlying collateral, historical charge-off experience, the level of nonperforming and past due loans, and other indicators derived from reviewing the loan portfolio. The evaluation includes a review of all loans on which full collection may not be reasonably assumed. Should the factors that are considered in determining the allowance for loan losses change over time, or should management’s estimates prove incorrect, a different amount may be reported for the allowance and the associated provision for loan losses. For example, because economic conditions in our market area have undergone an unexpected and adverse change in the last two years, we have had to increase our allowance for loan losses by taking a charge against earnings in the form of additional provisions for loan losses.
Valuation of Other Real Estate Owned
Real estate properties acquired through or in lieu of loan foreclosure are initially recorded at the fair value less estimated selling cost at the date of foreclosure. The fair value of other real estate is generally based on current appraisals, comparable sales, and other estimates of value obtained principally from independent sources. Any write-downs based on the asset’s fair value at the date of acquisition are charged to the allowance for loan losses. Valuations are periodically performed by management, and any subsequent write-downs are recorded as a charge to operations, if necessary, to reduce the carrying value of a property to fair value less cost to sell. Other real estate owned also includes excess Bank property not utilized when subdividing land acquired for the construction of Bank branches. Costs of significant property improvements are capitalized. Costs relating to holding property are expensed.
Deferred Tax Asset Valuation
A valuation allowance is recognized for a deferred tax asset if, based on the weight of available evidence, it is more-likely-than-not that some portion or the entire deferred tax asset will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. In making such judgments, significant weight is given to evidence that can be objectively verified. As a result of its increased credit losses, the Company entered into a three-year cumulative pre-tax loss position during 2010. A cumulative loss position is considered significant negative evidence in assessing the realizability of a deferred tax asset which is difficult to overcome. The Company’s estimate of the realization of its deferred tax assets was based on the scheduled reversal of deferred tax liabilities and taxable income available in prior carry back years. We did not consider future taxable income in determining the realizability of our deferred tax assets, and as such, recorded a valuation allowance to reduce our net deferred tax asset to approximately $1.4 million. When the Company’s profitability returns and continues to a point that is considered sustainable, some or all of the valuation allowance may be reversed. The timing of the reversal of the valuation allowance is dependent on an assessment of future events and will be based on the circumstances that exist as of that future date.
Results of Operations for the Years Ended December 31, 2010 and 2009
General Discussion of Our Results
Our principal source of revenue is net interest income at the Bank. Net interest income is the difference between:
•
income received on interest-earning assets, such as loans and investment securities; and
•
payments we make on our interest-bearing sources of funds, such as deposits and borrowings.
The level of net interest income is determined primarily by the average balances, or volume, of interest-earning assets and interest-bearing liabilities and the various rate spreads between the interest-earning assets and the Company’s funding sources. Changes in our net interest income from period to period result from, among other things:
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increases or decreases in the volumes of interest-earning assets and interest-bearing liabilities;
•
increases or decreases in the average rates earned and paid on those assets and liabilities;
•
our ability to manage our interest-earning asset portfolio, which includes loans;
•
the availability and costs of particular sources of funds, such as non-interest bearing deposits; and
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our ability to “match” liabilities to fund assets of similar maturities at a profitable spread of rates earned on assets over rates paid on liabilities.
In 2010 and 2009, our other principal sources of revenue were service charges on deposit accounts and credit/debit card related income.
Net Income (Loss)
The following is a summary of our results of operations (dollars in thousands except per share amounts):
The net loss for 2010 was primarily attributable to the provision for loan losses, the continued compression in the Company’s net interest margin and the disallowance of the deferred tax asset. The provision for loan losses reflects the continued elevated levels of net loans charged-off and increased probable losses as a result of the slowdown in economic conditions, primarily with respect to the real estate construction and development segment of our portfolio and is discussed in more detail under “Provision for Loan Losses.” Total average loans, our largest interest earning-asset, decreased approximately $17,928,000 during 2010. More significantly, the average balance of nonaccrual loans increased approximately $38,311,000 during the year from approximately $21,444,000 at December 31, 2009 to approximately $59,755,000 at December 31, 2010. The interest associated with these loans that was excluded and reversed from income throughout 2010 was a significant factor contributing to the decrease in interest income, the 83 basis point reduction of the yield earned on loans and the continued compression of our net interest margin. Nonaccrual loans and interest income are discussed in more detail under “Allowance for Loan Losses” and “Net Interest Income.” During 2010, we established a valuation allowance against our deferred tax assets in order to adjust the net carrying amount to what we believe is currently realizable. The deferred tax valuation allowance and related tax expense is described in more detail under “Income Taxes.” The net loss during 2010 was lessened by the decrease in noninterest expense which was primarily related to the decrease in salaries and employee benefits from personnel cutbacks, as described in more detail under “Noninterest Expenses.”
Basic and diluted loss per share was ($3.97) and ($3.97), respectively, for 2010, compared to ($1.61) and ($1.61), respectively, for 2009 reflecting the increased net loss from 2009 to 2010. The average number of shares outstanding was unchanged during 2010.
The Bank’s net interest margin, the difference between the yields on earning assets, including loan fees, and the rate paid on funds to support those assets, declined 73 basis points from 3.07% at December 31, 2009, to 2.34% at December 31, 2010. The increasing volume of nonaccrual loans has caused a more prolonged and significant compression in the Bank’s margin than expected. See the section titled “Net Interest Income,” below for a more detailed discussion.
The following chart illustrates our net income (loss) for the periods indicated. The changes below were impacted by changes in rate as well as changes in volume:
The following discussion and analysis describes, in greater detail, the specific changes in each income statement component.
Net Interest Income
Average Balances, Interest Income, and Interest Expense
The following table contains condensed average balance sheets for the years indicated. In addition, the amount of our interest income and interest expense for each category of interest-earning assets and interest-bearing liabilities and the related average interest rates, net interest spread and net yield on average interest earning assets are included.
Average Balance Sheet and Analysis of Net Interest Income
for the Years Ended December 31, 2010 and 2009
(in thousands, except rates)
The large volume of nonaccrual loans as well as a securities portfolio that, at certain times during 2010, contained comparatively low-rate investments resulted in the continued compression of our net interest margin as we experienced reduced yields on a significant portion of our earning asset base. Rate and volume variances during 2010 caused a decrease in interest income and interest expense as well as net interest income which decreased approximately $5,257,000 in 2010 compared to 2009. The Company’s net interest margin decreased by 73 basis points in 2010 compared to 2009. Yields on our loan portfolio decreased by 83 basis points in 2010 compared to 2009, reflecting the approximately $38 million increase in average nonaccrual loans during the year as well as the continuing very low rate environment. As discussed in more detail under “Securities,” we shifted a significant portion of our investment portfolio to shorter-term securities in preparation for their liquidation. This shift caused the yield on our investment securities portfolio to decrease 167 basis points during 2010 when compared to 2009. Partially offsetting the decrease in yields earned on our average earning assets was a corresponding decrease in our funding costs. Rates paid on our interest-bearing deposits decreased by 41 basis points in 2010 compared to 2009, reflecting the continued effects of a decreasing interest rate environment. The average rate paid on time deposits, in particular, takes longer to adjust to current market rates due to the varied and sometimes extended repricing speed of these deposits. Also contributing to our lower funding costs was a 35 basis point decrease in rates paid on subordinated debt in 2010.
Average balances of our earning assets decreased by approximately $43 million in 2010 compared to 2009, primarily due to a reduction in average securities and average loans which decreased approximately $41 million and $18 million, respectively, in 2010. The liquidity created by the reduction in securities and loans was used to fund the withdrawal of certain municipal deposits during the year as discussed in more detail under “Deposits.” The remaining funds were used to pre-pay an FHLB advance and invested in federal funds sold.
Our net interest margin, the difference between the yield on earning assets, including loan fees, and the rate paid on funds to support those assets, averaged 2.34% during 2010 versus 3.07% in 2009, a decrease of 73 basis points. The decrease in our net interest margin reflects a decrease in the average spread in 2010 between the rates we earned on our interest-earning assets, which had a decrease in overall yield of 104 basis points to 4.31% at December 31, 2010, as compared to 5.35% at December 31, 2009, and the rates we paid on interest-bearing liabilities, which had a less substantial decrease of 34 basis points in the overall rate to 2.05% at December 31, 2010, versus 2.39% at December 31, 2009. Our interest-earning assets, including approximately $163,000,000 in loans tied to prime that reprice more quickly than our interest-bearing liabilities, particularly time deposits and borrowings with a fixed rate and term. Therefore, during the declining and low interest rate environments experienced over the last two years, our net interest margin has been compressed as our interest-sensitive assets and liabilities reprice at their expected speeds. Additionally, the approximately $38 million increase in average nonaccrual loans and reduction in the average rate earned on our investment securities portfolio negatively impacted our net interest margin. The negative effect of nonaccrual loans will continue as long as and to the extent that the balance of nonaccrual loans is elevated. The yield earned on investment securities will likely not fully recover for some time as new investments obtained during the current economic environment typically do not carry the same yield as those that we sold during 2010. When market interest rates begin to increase, our net interest margin will likely remain compressed until interest rates exceed the established rate floors.
The interest income we earn on loans is the largest component of net interest income and the Bank’s net interest margin. The average balance of our loan portfolio decreased approximately $17.9 million during 2010 and, as mentioned above, the yield we earned on these loans decreased as well. Both of these factors contributed to the approximately $4.4 million reduction in loan related interest income. While management separately deals with the nonperforming loans that accounted for a considerable portion of the decline in yield and income during 2010, measures to offset the impact of the ongoing depressed rate environment, including certain terms and conditions applicable to performing loans such as repricing frequency, rate floors and fixed interest rates, have been used by the Bank in an attempt to reduce the impact of low interest rates.
Interest income on investment securities decreased approximately $3.6 million from 2009 to 2010 due to the 167 basis point decrease in the yield earned on these securities as well as the approximately $40.8 million decrease in volume of securities owned.
The decrease in interest expense during 2010 as compared to 2009 was primarily due to the general decrease in interest rates paid on deposits, primarily demand deposit accounts and time deposits (including brokered deposits), as well as subordinated debt. The decreases in the average balance of time deposits of approximately $2 million and interest-bearing demand deposits of approximately $31 million also contributed to the decrease in interest expense from 2009 to 2010. As a result of the approximately $3.6 million decrease in average federal funds purchased during 2010, the average rate paid on combined FHLB advances and other borrowings during 2010 was higher than the average rate paid during 2009. The rates paid to borrow federal funds are based on current market rates and are significantly lower than the average rates paid on our FHLB borrowings which are generally fixed rates obtained at various times under different market conditions. FHLB advances are typically subject to prepayment penalties that severely limit any interest rate advantages gained from early payment if current market rates are lower than rates applicable to outstanding advances. In spite of the 2010 average rate increase, interest expense on borrowed funds decreased approximately $130,000, reflecting the approximately $6.8 million decrease in average borrowed funds. In addition to the decrease in average federal funds purchased, we prepaid a $7.5 million FHLB advance during the third quarter of 2010 which is discussed in more detail under “Noninterest Expense” as well as “Note 7. FHLB Advances.” Interest expense on subordinated debt decreased during 2010 due exclusively to the 35 basis point decrease in the average rate paid on this debt which is priced at a spread above 3-month LIBOR.
Even as our cost of interest-bearing deposits has declined due to the actions of the Federal Open Markets Committee (“FOMC”) in recent years, the local competition for deposits, in some instances, has and could continue to cause interest rates paid on deposits to remain above market levels during 2010.
Rate and Volume Analysis
The following table sets forth the extent to which changes in interest rates and changes in volume of interest-earning assets and interest-bearing liabilities have affected our interest income and interest expense during the years indicated. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (1) change in volume (change in volume multiplied by previous year rate); (2) change in rate (change in rate multiplied by current year volume); and (3) a combination of change in rate and change in volume. The changes in interest income and interest expense attributable to both volume and rate have been allocated proportionately to the change due to volume and the change due to rate.
ANALYSIS OF CHANGES IN NET INTEREST INCOME
FOR THE YEARS ENDED DECEMBER 31, 2010 AND 2009
(dollars in thousands)
Provision for Loan Losses
The provision for loan losses represents a charge to earnings necessary to establish an allowance for loan losses and is based on management’s evaluation of economic conditions, volume and composition of the loan portfolio, historical charge-off experience, the level of nonperforming and past due loans, and other indicators derived from reviewing the loan portfolio. Management performs such reviews quarterly and makes appropriate adjustments to the level of the allowance for loan losses as a result of these reviews.
As discussed in more detail under “Discussion of Financial Condition - Allowance for Loan Losses,” management determined it was necessary to increase the allowance for loan loss account through the provision for loan losses. Although total loans decreased approximately $33 million during 2010, the continuing increased level of provision for loan loss expense during 2010, as well as 2009, was due to increased charge-offs and delinquencies, related primarily to deterioration in the real estate segment of the Company’s loan portfolio, particularly construction and land development, as well as increased probable losses as the result of the slowdown in economic conditions. Continuing reductions in property values and the reduced volume of sales of developed and undeveloped land has led to an increase of impaired loans determined to be collateral dependent. As the collateral value for these land loans has declined significantly during 2010 and into 2011, related charge-offs and provision expense have been incurred. Management has continued its ongoing review of the loan portfolio with particular emphasis on construction and land development loans and we believe we have identified and adequately provided for losses present in the loan portfolio; however, due to the necessarily approximate and imprecise nature of the allowance for loan loss estimate, certain projected scenarios may not occur as anticipated. Additionally, further deterioration of factors relating to the loan portfolio, such as conditions in the local and national economy and the local real estate market, could have an added adverse impact and require additional provision expense and higher allowance levels.
Noninterest Income
The following table presents the major components of noninterest income for 2010 and 2009 (dollars in thousands).
The principal components of noninterest income during both 2009 and 2010 were service charges on deposits, fees associated with credit/debit cards included in “other fees and commissions”, and income resulting from the increase in the cash surrender value of bank owned life insurance (“BOLI”). Additionally, during 2009 and 2010, we sold approximately $90 million and $104 million, respectively, of our available-for-sale investment securities in order to reposition our bond portfolio for asset liability management purposes. As a result of the sale of these securities, during 2010 we realized a $1.5 million net gain and during 2009 we realized a $2.6 million net gain, excluding the securities impairment loss described below. Also during 2009, we recorded an approximately $1.5 million net loss on OREO, which includes valuation adjustments as well as gains and losses on disposal. We recorded a small net gain on OREO in 2010. The reduction in service charges on deposit accounts was primarily the result of a decrease in overdraft fees. During January 2009, we implemented an authorized overdraft program that led to increased overdraft fee income when compared to prior years. However, during 2010 these fees decreased as compared to 2009 due, in part, to regulatory changes that became effective during 2010 which are discussed in the following paragraph, as well as general consumer behavior. The increase in other fees and commissions from 2009 to 2010 was the result of increases in credit/debit card fees. The increase in other noninterest income was attributable to increases in the following areas: approximately $208,000 increase in OREO income related to rental of certain of our OREO properties, approximately $158,000 increase in income generated by our investment in the Appalachian Fund for Growth partnership and approximately $130,000 increase in income generated by the increased cash surrender value of BOLI.
In November 2009, the Federal Reserve Board issued a final rule that, effective July 1, 2010, prohibited financial institutions from charging customers fees for paying overdrafts on automated teller machine and debit card transactions, unless a consumer consents, or opts in, to the overdraft service for those types of transactions. Consumers must be provided a notice that explains the financial institution’s overdraft services, including the fees associated with the service, and the consumers’ choices. This rule had a negative impact on insufficient funds income during 2010.
In the first quarter of 2009, the Company experienced losses of $347,368 related to impairment of common stock held by the Bank and issued by Silverton and trust preferred securities held by the Bank and issued by a trust affiliated with Silverton which are guaranteed by Silverton. On May 1, 2009, Silverton’s bank subsidiary, Silverton Bank, was placed into receivership by the OCC after Silverton Bank’s capital deteriorated significantly in the first quarter of 2009. On June 5, 2009, Silverton filed a petition for bankruptcy. The Company does not anticipate that it will recover any of the Bank’s investment in either the common securities or trust preferred securities issued by Silverton or its affiliated trust. As a result, the Company recorded an impairment charge of $347,368 during the first quarter of 2009, which represents the Company’s full investment in the securities.
Noninterest Expenses
The following table presents the major components of noninterest expense for 2010 and 2009 (dollars in thousands).
The largest component of our noninterest expense continues to be the cost of salaries and employee benefits, which decreased by approximately $1,348,000 during 2010, and was the most significant factor contributing to the overall decrease in noninterest expense. Other operating expenses decreased slightly as a whole, however; this decrease was negatively affected by an approximately $350,000 FHLB pre-payment penalty incurred during the third quarter of 2010 as well as the approximately $118,000 increase in OREO expense related to maintenance and upkeep of our foreclosed properties. These increases were offset by the effects of several cost cutting initiatives enacted during the first quarter of 2010 in an effort to improve its profitability during 2010. These measures included, but were not limited to, areas such as employee related expenses, business travel and other discretionary spending, equipment and supply expenses and marketing expenses. In total, these initiatives reduced the Company’s expenses by approximately $1.5 million during 2010. The decrease in noninterest expense was also attributable to the decrease in FDIC assessment expense during 2010 related to the overall decrease in deposits.
Income Taxes
Our provision for income taxes and effective tax rates for 2010 and 2009 were as follows:
Provision for Income Taxes and Effective Tax Rates
(dollars in thousands)
The effective income tax rate for the year ended December 31, 2010 was approximately (55.68%), compared to an income tax benefit rate of 47.26% for the year ended December 31, 2009. Our income tax expense rate for 2010 was principally impacted by the recognition of a valuation allowance during 2010 as more fully discussed in “Note 6. Income Taxes.” Establishing a valuation allowance required us to record a significant tax expense which, when applied to a pretax loss, caused a negative effective tax rate. Additionally, tax exempt income has the effect of increasing a taxable loss, therefore increasing effective tax rates as a percentage of pretax income. This is the opposite effect on tax rates when a company has pretax income.
During 2009 and 2010, the effective tax rate was positively impacted by the continuing tax benefits generated from MNB Real Estate, Inc., which is a real estate investment trust subsidiary formed during the second quarter of 2005. The income generated from tax-exempt municipal bonds and bank owned life insurance also improved our effective tax rate in both years. Additionally, during 2006, the Bank became a partner in Appalachian Fund for Growth II, LLC with three other Tennessee banking institutions. This partnership has invested in a program that generated a federal tax credit in the amount of approximately $200,000 per year during 2009 and 2010. The program is also expected to generate a one-time state tax credit in the amount of $200,000 to be utilized over a maximum of 20 years to offset state tax liabilities.
Discussion of Financial Condition
General Discussion of Our Financial Condition
The following is a summary comparison of selected major components of our financial condition for the periods ended December 31, 2010 and 2009 (dollars in thousands):
Loans
At December 31, 2009 and 2010, loans comprised 74.2% and 77.4% of our total earning assets, respectively. While both loans and securities decreased during 2010, the increase in loans as a percent of total earning assets was caused by the relatively more significant decrease in our investment securities portfolio as discussed under “Securities.” Total earning assets as a percent of total assets, were 86.8% at December 31, 2010, compared to 86.3% at December 31, 2009. This slight increase in total earning assets relative to total assets in 2010 was attributable to decreases in nonearning assets including deferred tax assets, OREO and prepaid expenses associated with the Bank’s FDIC assessment. The increase in total earning assets as a percent of total assets was offset by decreases in loans and securities.
Loan Portfolio. Our loan portfolio consisted of the following loan categories and amounts as of the dates indicated:
Commercial and consumer loans tend to be more risky than loans that are secured by real estate; however, the Bank seeks to control this risk with adherence to quality underwriting standards. Still, as reflected in our 2009 and 2010 results of operations and described in more detail under “Allowance for Loan Losses,” real estate construction and development loans do involve risk and if the underlying collateral, which in the case of acquisition and development loans may involve large parcels of real property, is not equal to the value of the loan, we may suffer losses if the borrower defaults on its obligation to us.
Maturities and Sensitivities of Loan Portfolio to Changes in Interest Rates. Total loans as of December 31, 2010 are classified in the following table according to maturity or scheduled repricing:
Of our loans maturing more than one year after December 31, 2010, approximately $80,696,000 had fixed rates of interest and approximately $83,588,000 had variable rates of interest. At December 31, 2010, loans to sub-dividers/developers were 17.7% of total loans and loans to franchise hotels & motels were 11.2% of total loans. No other concentrations of credit exceeded ten percent of our total loans.
Past Due Loans and Non-Performing Assets
The following table presents performing loans that were past due at least 30 days but less than 90 days as of December 31, 2010 and 2009:
Due to management’s ongoing efforts to identify and enter into workout arrangements with borrowers experiencing financial difficulty, delinquent loans at December 31, 2010 remained stable and were slightly lower than delinquent loans at December 31, 2009. Developers that do not have adequate cash flow or cash reserves to sustain the required interest payments on their loans during this period of economic stress have been unable to continue their developments. As a result, the Bank has classified a significant portion of these loans as non-performing assets.
The Bank’s non-performing assets consist of loans past due 90 days or more and still accruing, nonaccrual loans and OREO. Loans that have been restructured and remain on accruing status are not included in non-performing assets. The following table presents the Bank’s non-performing assets for the periods indicated:
Delinquent and nonaccrual loans at both December 31, 2010 and December 31, 2009 consisted primarily of construction and land development loans and commercial and consumer real estate loans. Approximately $27,929,000 of the nonaccrual loans, or 52.7% of the approximate $53,005,000 total at December 31, 2010, are construction and land development loans while commercial real estate and consumer real estate make up approximately $6,362,000 and $18,647,000, or 12.1% and 35.2%, respectively, of nonaccrual loans at that date.
Notwithstanding the general favorable trends in tourism in Sevier County, residential and commercial real estate sales continued to be weak during 2010, following the same pattern that began during the second half of 2008 and continued throughout 2009. The reduced sales have negatively impacted past due, nonaccrual and charged-off loans. Price declines during 2009 and 2010 have had an adverse impact on overall real estate values. These trends have had the greatest effect on the construction and development and commercial real estate portfolios resulting in the significant increase in nonaccrual loans during 2009 and continuing during 2010. Many of the borrowers in these categories are dependent upon real estate sales to generate the cash flows used to service their debt. Since real estate sales have been depressed, many of these borrowers have experienced greater difficulty meeting their obligations, and to the extent that sales remain depressed, these borrowers may continue to have difficulty meeting their obligations.
The following table sets forth the reduction in interest income we experienced in 2009 and 2010 as a result of non-performance of certain loans during the year:
The purpose of placing a loan on nonaccrual is to prevent the Bank from overstating its income. The decision to place a loan on nonaccrual is made by management based on a monthly review. Management also reviews any loans placed on nonaccrual that are: (1) being maintained on a cash basis because of deterioration in the financial position of the borrower; or (2) for which payment in full of interest or principal is not expected.
Generally, the Bank does not accrue interest on any loan when principal or interest are in default for 90 days or more unless the loan is well secured and in the process of collection. Consumer loans and residential real estate loans secured by 1-4 family dwellings are ordinarily not subject to those guidelines.
Management may restore a non-accruing loan to an accruing status when principal and interest is no longer due and unpaid, or it otherwise becomes both well secured and in the process of collection. All loans on non-accrual are reported on the Bank’s watch loan list.
The Bank’s OREO decreased approximately $1,435,000 during 2010. One property, an operating nightly condo rental operation located in Pigeon Forge, Tennessee, which previously secured a loan for approximately $5,116,000, represents approximately $4,640,000, or 36%, of the OREO balance at December 31, 2010 (included in consumer real estate in the table above). The condos are currently under management contract with an experienced nightly rental management company as we seek to market the sale of the condo units.
Potential problem loans, which are not included in nonperforming loans, amounted to approximately $58.9 million, or 15.72% of total loans outstanding at December 31, 2010, compared to approximately $27.2 million, or 6.66% of total loans outstanding at December 31, 2009. Potential problem loans represent those loans with a well-defined weakness and where information about possible credit problems of borrowers has caused management to have serious doubts about the borrower’s ability to comply with present repayment terms. This definition is believed to be substantially consistent with the standards established by the OCC, the Bank’s primary regulator, for loans classified as substandard or worse, excluding the impact of nonperforming loans. The large increase in potential problem loans was caused primarily by the downgrade of additional residential construction and development loans, commercial and industrial loans, and commercial real estate loans due to the continuing deterioration in the economy. Loans past due 30 days or longer have been excluded from potential problem loans.
During 2009, the Bank formed a Special Assets department. This department was significantly expanded during 2010 and it is dedicated to oversight of non-performing assets. The Special Assets department focuses on relationships that represent current and potential performance problems related to the Bank’s loan portfolio. The department also handles administration of the Bank’s OREO properties including incorporating new information and data as it becomes available and applying that information to the recorded value of assets.
Allowance for Loan Losses
The allowance for loan losses represents management’s assessment and estimates of the risks associated with extending credit and its evaluation of the quality of our loan portfolio. Management analyzes the loan portfolio to determine the adequacy of the allowance for loan losses and the appropriate provision required to maintain the allowance for loan losses at a level believed to be adequate to absorb probable incurred loan losses. In assessing the adequacy of the allowance, management reviews the size, quality and risk of loans in the portfolio. Management also considers such factors as the Bank’s loan loss experience, the amount of past due and nonperforming loans, impairment of loans, specific known risks, the status, amounts and values of nonperforming assets (including loans), underlying collateral values securing loans, current and anticipated economic conditions and other factors which affect the allowance for potential credit losses. Based on an analysis of the credit quality of the loan portfolio prepared by the Bank’s risk officer, the CFO presents a quarterly analysis of the adequacy of the allowance for loan losses for review by our board of directors.
During 2010, management sought to enhance its assessment of the allowance for loan losses by incorporating the results of a comprehensive historic loss rates migration analysis. The study provided more precise historical loss trends and percentages attributable to specific loan grades and types than were previously available. Consideration was given to recent charge off experience which management believes is a more reliable basis due to current economic conditions. The study did not have a material effect on the outcome of the allowance calculation; rather this data was used to narrow and refine management’s calculation and supported management’s previous estimation of the adequacy of the allowance for loan loss balance.
Our allowance for loan losses is also subject to regulatory examinations and determinations as to adequacy, which may take into account such factors as the methodology used to calculate the allowance and the level of risk in the loan portfolio. During their routine examinations of banks, regulatory agencies may advise a bank to make additional provisions to its allowance for loan losses, which would negatively impact a bank’s results of operations, when the opinion of the regulators regarding credit evaluations and allowance for loan loss methodology differ materially from those of the bank’s management. During the regular safety and soundness examination conducted by the Bank’s regulatory agency during the first quarter of 2011, significant increases were incurred due to required provisions to the allowance based on loans determined to be collateral dependent by the OCC. These changes have been recognized and incorporated into the results of operations as of December 31, 2010.
Concentrations of credit risk typically involve loans to one borrower, an affiliated group of borrowers, borrowers engaged in or dependent upon the same industry, or a group of borrowers whose loans are secured by the same type of collateral. Our most significant concentration of credit risks lies in the high proportion of our loans to businesses and individuals dependent on the tourism industry and loans to subdividers and developers of land. The Bank assesses loan risk by primary concentrations of credit by industry and loans directly related to the tourism industry are monitored carefully. At December 31, 2010, approximately $192 million in loans, or 51% of total loans, were to businesses and individuals whose ability to repay depends to a significant extent on the tourism industry in the markets we serve as compared to approximately $200 million in loans, or 49% of total loans, at December 31, 2009. The most significant decreases in this category were display advertising, full service restaurants and overnight rentals by owner which decreased approximately $5 million, $3 million and $1 million, respectively.
While it is the Bank’s policy to charge off in the current period loans for which a loss is considered confirmed, there are additional risks of losses which cannot be quantified precisely or attributed to particular loans or classes of loans. Because the risk of loss includes unpredictable factors, such as the state of the economy and conditions affecting individual borrowers, management’s judgments regarding the appropriate size of the allowance for loan losses is necessarily approximate and imprecise, and involves numerous estimates and judgments that may result in an allowance that is insufficient to absorb all incurred loan losses.
Management is not aware of any loans classified for regulatory purposes as loss, doubtful, substandard, or special mention that have not been identified and sufficiently provided for in the allowance for loan losses which (1) represent or result from trends or uncertainties which management reasonably expects will materially impact future operating results, liquidity, or capital resources, or (2) represent material credits about which management is aware of any information which causes management to have serious doubts as to the ability of such borrowers to comply with the loan repayment terms.
Individually impaired loans are loans that the Bank does not expect to collect all amounts due according to the contractual terms of the loan agreement and include any loans that meet the definition of a troubled debt restructuring (“TDR”), as discussed in more detail below. In some cases, collection of amounts due becomes dependent on liquidating the collateral securing the impaired loan. Collateral dependent loans do not necessarily result in the loss of principal or interest amounts due; rather the cash flow is disrupted until the underlying collateral can be liquidated. As a result, the Bank’s impaired loans may exceed nonaccrual loans which are placed on nonaccrual status when questions arise about the future collectability of interest due on these loans. The status of impaired loans is subject to change based on the borrower’s financial position.
Problem loans are identified and monitored by the Bank’s watch list report which is generated during the loan review process. This process includes review and analysis of the borrower’s financial statements and cash flows, delinquency reports and collateral valuations. The watch list includes all loans determined to be impaired. Management determines the proper course of action relating to these loans and receives monthly updates as to the status of the loans.
The following table presents impaired loans as of December 31, 2010 and December 31, 2009:
The increase in impaired loans during 2010 was primarily related to the continued weakening of the residential and commercial real estate market in the Bank’s market areas. Within this segment of the portfolio, the Bank has traditionally made loans to, among other borrowers, home builders and developers of land. These borrowers have continued to experience stress during the current real estate recession due to a combination of declining demand for residential real estate, excessive volume of properties available and the resulting price and collateral value declines. In addition, housing starts in the Bank’s market areas continue to be at historically low levels. An extended recessionary period in real estate will likely cause the Bank’s real estate mortgage loans, which include construction and land development loans, to continue to underperform and may result in increased levels of impaired loans and non-performing assets, which may negatively impact the Company’s results of operations.
Thirty-six impaired loans with a total balance of approximately $28,804,000 were considered to be collateral dependent at December 31, 2010, and of this amount approximately $22,804,000 are trouble debt restructurings discussed in more detail below. Collateral dependent loans are recorded at the lower of cost or the appraised value net of estimated selling costs. It is generally determined these loans will be repaid by the liquidation of the collateral securing the loans. Management obtains independent appraisals of the collateral securing collateral dependent loans at least annually from independent licensed real estate appraisers and the carrying amount of the loans that exceed the appraised value net of estimated selling costs is taken as a charge against the allowance for loan losses and may result in additional charges to the provision expense. At the date of this filing, seven of the thirty-six collateral dependent loans were pending receipt of a current reviewed appraisal (an appraisal within the past twelve months). It is anticipated these appraisals, when received, will result in additional charge off to be recorded during the first quarter of 2011 totaling approximately $1,400,000. Management believes the anticipated losses on these loans have been adequately provided as of December 31, 2010 and there is a specific reserve relating to these loans equal to the estimated loss to be recorded. All loans considered collateral dependent are nonaccrual loans and included in the nonperforming loan balances. Management has recorded partial charge offs on these collateral dependent loans totaling $5,545,331 as of December 31, 2010.
Due to the weakening credit status of a borrower, we may elect to formally restructure certain loans to facilitate a repayment plan that minimizes the potential losses, if any, that we might incur. All restructured loans are classified as impaired loans and, if on nonaccruing status as of the date of restructuring, the loans are included in the nonperforming loan balances. Not included in nonperforming loans are loans that have been restructured that were performing as of the restructure date. At December 31, 2010 and 2009, there were $36.0 million and $21.8 million, respectively, of accruing restructured loans that remain in a performing status.
TDRs at December 31, 2010 totaled approximately $82,443,000 which is 89.3% of total impaired loans. The TDRs related primarily to construction and development loans totaling approximately $36,661,000, or 39.7% of impaired loans, 1-4 family residential loans totaling approximately $25,630,000, or 27.8% of impaired loans and commercial real estate loans totaling approximately $20,023,000, or 21.7% of impaired loans. The TDRs are due to lack of real estate sales and weak or insufficient cash flows of the guarantors of the loans due to the current economic climate. The majority of the TDRs are for a limited term, in most instances, of one to two years, and include an interest rate reduction during this term.
Our allowance for loan losses at December 31, 2010 was approximately $10,942,000, a net decrease of approximately $411,000 for the year. The allowance for loan losses as a percentage of total loans, non-accrual loans and non-performing assets at December 31, 2010 was 2.92%, 20.64% and 20.48%, respectively, compared to 2.78%, 28.00% and 27.95%, respectively, at December 31, 2009. Net charge-offs during 2010 increased from approximately $5,612,000 in 2009 to approximately $8,138,000 in 2010, representing a net charge-off ratio of 2.05% in 2010 compared to 1.35% in 2009. Management continues to evaluate and adjust our allowance for loan losses, and presently believes the allowance for loan losses is adequate to provide for probable losses inherent in the loan portfolio. Management believes the loans, including those loans that were delinquent at December 31, 2010, that will result in additional charge-offs have been identified and adequate provision has been made in the allowance for loan loss balance. No assurance can be given, however, that adverse economic circumstances, declines in real estate values or other events or changes in borrowers’ financial conditions, particularly borrowers in the real estate construction and development business, will not result in increased losses in the Bank’s loan portfolio or in the need for increases in the allowance for loan losses through additional provision expense in future periods.
The following table summarizes our loan loss experience and related adjustments to the allowance for loan losses as of the dates and for the periods indicated:
The following table presents our allocation of the allowance for loan losses to the categories of loans in our loan portfolio as of the dates indicated:
Securities
Our investment securities portfolio consists primarily of mortgage-backed securities and municipal securities. The investment securities portfolio is the second largest component of our earning assets and represented 18.11% of total earning assets and 15.73% of total assets at year-end 2010. As an integral component of our asset/liability management strategy, we manage our investment securities portfolio to maintain liquidity, balance interest rate risk and augment interest income. We also use our investment securities portfolio to meet pledging requirements for deposits and borrowings. The average yield on our investment securities portfolio during 2010 was 2.31% versus 3.98% for 2009, a decrease of 167 basis points. Net unrealized gains (losses) on securities available for sale, included in accumulated other comprehensive income (loss), decreased from a net unrealized gain of $283,014 for the year ended December 31, 2009 to a net unrealized loss of ($1,064,678) at December 31, 2010.
The approximately $59 million decrease in investment securities during 2010 was primarily liquidated through U.S. Treasury securities that matured during the second and third quarters of 2010 and is primarily attributable to decreased pledging requirements related to the reduction in municipal deposits discussed in more detail below and under “Deposits.” Municipal deposits, which are secured by a portion of the Bank’s investment securities and are currently required to be over-collateralized by such securities, decreased approximately $60 million, or 60%, during 2010 from approximately $100 million at December 31, 2009 to approximately $40 million at December 31, 2010. Pledging requirements for municipal deposits have decreased approximately $67 million from approximately $115 million to approximately $48 million at December 31, 2009 and December 31, 2010, respectively. As an integral component of our asset/liability management strategy, we manage our investment securities portfolio to maintain liquidity, balance interest rate risk and augment interest income. In addition to securing public deposits, we also use our investment securities portfolio to meet pledging requirements for borrowings.
During the third quarter of 2009, in an effort to improve the Bank’s long-term liquidity position, management developed a strategy that would reduce the size of the Bank’s assets between $50 million and $100 million. A central element of this strategy involved not bidding to retain certain public deposits as the contracts came up for renewal. These deposits are collateralized with securities representing up to 126% of the value of the deposits. In preparation to liquidate the securities pledged to secure the public funds as the funds were drawn out of the Bank, management sold substantial portions of its mortgage-backed and municipal securities and re-invested the proceeds from sales and maturities of mortgage-backed and municipal securities in short-term U.S. Treasury and government agency securities. In most cases, the securities were sold at a gain. When comparing the December 31, 2010 and 2009 portfolio balances, the significant changes that occurred in our portfolio during 2010 are not immediately evident, however; the distribution of the portfolio changed considerably throughout 2010 as funds were transferred among categories as described above. These changes caused a decrease in the yield on investment securities during 2010 as the rates earned on short-term U.S. Treasury and government agency securities are significantly lower than the rates earned on mortgage-backed and municipal securities. At December 31, 2010, the Bank’s portfolio was back to a more historically characteristic composition. However, the yield earned on investment securities will likely not fully recover for some time as new investments obtained during the current interest rate environment typically do not carry the same yield as those that we sold during 2010.
Additionally, at December 31, 2010, we had approximately $31 million in mortgage-backed and municipal securities pledged as collateral for certain federal funds lines of credit and FHLB borrowings. The average yields on these investments generally exceeded the cost of the interest-bearing deposits that funded them during 2010. However, the cost of these deposits and the lower yield associated with these securities, when compared to loans, negatively impacted our net interest margin during 2010. Included in our investment securities portfolio as of December 31, 2010, was approximately $5,519,000 in tax-exempt municipal securities.
The carrying amounts of securities at the dates indicated are summarized as follows:
The following table contains the contractual maturity distribution, carrying value, and weighted-average yield to maturity of our investment securities.
We did not hold any securities from a single issuer that exceeded 10% of total shareholders’ equity as of December 31, 2010, except for mortgage-backed securities issued by government sponsored entities that had a carrying value of approximately $81,145,000 and $114,057,000 at December 31, 2010 and 2009, respectively.
Deposits
Total deposits decreased during 2010 and the balances were distributed as follows:
The balance in NOW accounts primarily consists of public funds deposits. As discussed under Investment Securities, management anticipated the significant reduction in NOW accounts during 2010 that was the result of withdrawal of the deposits of a local municipal entity upon contract renewal. Public funds are generally obtained through a bidding process under varying terms.
The increase in money market accounts is related to the seasonality of the tourism industry in the Bank’s market area. The Bank’s customers typically experience their strongest cash inflows during the third and fourth quarter of each year.
The increase in savings deposits is the result of the continued success of our competitive rate savings product.
The increase in certificates of deposit was the result of an increase in customer deposits and acceptance of deposits through a national listing service. We offer certificate of deposit accounts on a wide range of terms in order to achieve sustained growth in a market area where there is strong competition for new deposits.
Brokered deposits are certificates of deposit acquired from approved brokers on terms that are substantially similar to deposits acquired in the local market. Brokered deposits decreased approximately $43 million during 2010, and represented approximately 6.01% and 13.68% of total deposits at December 31, 2010 and 2009, respectively. The Bank significantly reduced its reliance on brokered deposits during 2010 and management intends to seek to further reduce the level of brokered deposits during 2011. The average cost of our brokered deposits at December 31, 2010 was 1.70%. During 2010, the average cost of these deposits was 1.81%. We have not and do not intend to replace any maturing brokered deposits during 2011.
Because we anticipate that we will be required to enter into an OCC Consent Order that will establish specific capital amounts to be maintained by the Bank, the Bank cannot be considered better than “adequately capitalized” under capital adequacy regulations, even if the Bank exceeds the levels of capital set forth in the Consent Order and the normal requirements for “well capitalized” status. As long as it is considered an adequately capitalized institution, the Bank may not accept, renew or roll over brokered deposits without prior approval of the FDIC. As of December 31, 2010, brokered deposits maturing in the next 24 months totaled approximately $18.8 million. Funding sources for the maturing brokered deposits include, among other sources: our cash account at the Federal Reserve Bank of Atlanta; growth, if any, of core deposits from current and new retail and commercial customers; scheduled repayments on existing loans; and the possible pledge or sale of investment securities.
Because the Bank will not be considered “well capitalized” following issuance of the Consent Order, it will also not be permitted to pay interest on deposits at rates that are more than 75 basis points above the national rate as determined by the FDIC. These interest rate limitations may limit the ability of the Bank to increase or maintain core deposits from current and new deposit customers.
The average balances of deposit accounts by category and the average rates paid thereon are presented below for the periods indicated:
The balances in time certificates of deposit issued in amounts of $100,000 or more as of December 31, 2010, are shown below by time remaining until maturity:
The average balance of interest-bearing demand and savings deposits decreased approximately $25,387,000 during 2010. The average rate paid on these interest-bearing demand and savings deposits in 2010 was 1.09%, down from 1.25% in 2009.
Our total average cost of interest-bearing deposits (including demand, savings and certificate of deposit accounts) for 2010 was 1.76%, down from 2.17% in the prior year.
Shareholders’ Equity
The decrease in shareholders’ equity was primarily the result of the 2010 net loss of approximately $10,451,000. Accumulated other comprehensive income (loss) represents the net unrealized gain (losses) on securities available-for-sale. The decrease in accumulated comprehensive income from a net gain of $283,014 at December 31, 2009 to a net loss of $1,064,678 at December 31, 2010 also contributed to the decrease in shareholders’ equity during 2010.
Interest Rate Sensitivity Management
Interest rate risk is the risk to earnings or market value of equity from the potential movement in interest rates. The primary purpose of managing interest rate risk is to reduce the effects of interest rate volatility and achieve reasonable stability of earnings from changes in interest rates and preserve the value of our equity. Changes in interest rates affect, among other things, our net interest income, volume of loan production and the fair value of financial instruments and our loan portfolio. A key component of our interest rate risk management policy is the maintenance of an appropriate mix of assets and liabilities.
Our earnings are affected not only by general economic conditions, but also by the monetary and fiscal policies of the U.S. and its agencies, particularly the Federal Reserve. The monetary policies of the Federal Reserve can influence the overall growth of loans, investment securities, and deposits and the level of interest rates earned on assets and paid for liabilities. The nature and impact of future changes in monetary policies are generally not predictable.
It is our objective to manage assets and liabilities to control the impact of interest rate fluctuations on earnings and to provide a satisfactory, consistent level of profitability within the framework of established cash, loan, investment, borrowing, and capital policies. Certain officers within the Bank are charged with the responsibility for monitoring policies and procedures that are designed to ensure acceptable composition of the asset/liability mix.
The Bank’s asset/liability mix is monitored on a regular basis and a report reflecting the interest rate sensitive assets and interest rate sensitive liabilities is prepared and presented to our Board of Directors and management’s asset/liability committee on a quarterly basis. The key objective of our asset/liability management policy is to monitor and adjust the mix of interest rate sensitive assets and liabilities so as to minimize the impact of substantial movements in interest rates on earnings by matching rates and maturities of our interest-earning assets to those of our interest-bearing liabilities. An asset or liability is considered to be interest rate-sensitive if it will reprice or mature within the time period analyzed, usually one year or less.
We use interest rate sensitivity gap analysis to achieve the appropriate mix of interest rate-sensitive assets and liabilities. The interest rate-sensitivity gap is the difference between the interest-earning assets and interest-bearing liabilities scheduled to mature or reprice within a given time period. A gap is considered positive when the amount of interest rate-sensitive assets exceeds the amount of interest rate-sensitive liabilities. A gap is considered negative when the amount of interest rate-sensitive liabilities exceeds the amount of interest rate-sensitive assets. During a period of rising interest rates, a negative gap would tend to adversely affect net interest income, while a positive gap would tend to result in an increase in net interest income. Conversely, during a period of falling interest rates, a negative gap would tend to result in an increase in net interest income, while a positive gap would tend to adversely affect net interest income. If our assets and liabilities were equally flexible and moved concurrently, the impact of any increase or decrease in interest rates on net interest income would be minimal.
A simple interest rate “gap” analysis by itself may not be an accurate indicator of how net interest income will be affected by changes in interest rates. Accordingly, we also evaluate how the repayment of particular assets and liabilities is impacted by changes in interest rates. Income associated with interest-earning assets and costs associated with interest-bearing liabilities may not be affected uniformly by changes in interest rates. In addition, unpredictable variables such as the magnitude and duration of changes in interest rates may have a significant impact on net interest income. For example, although certain assets and liabilities may have similar maturities or periods of repricing, they may react in different degrees to changes in market interest rates. Interest rates on certain types of assets and liabilities fluctuate in advance of changes in general market rates, while interest rates on other types of assets and liabilities may lag behind changes in general market rates. In addition, certain assets, such as adjustable rate mortgage loans, have features (generally referred to as “interest rate caps”), that limit changes in interest rates. Prepayment and early withdrawal levels also could deviate significantly from those assumed in calculating the interest rate gap.
The following table summarizes our interest-sensitive assets and liabilities as of December 31, 2010. Adjustable rate loans are included in the period in which their interest rates are scheduled to adjust. Fixed rate loans are included in the periods in which they are anticipated to be repaid based on scheduled maturities and anticipated prepayments. Investment securities are included in the period in which they are scheduled to mature while mortgage backed securities are included according to expected repayment. Certificates of deposit are presented according to contractual maturity dates.
Analysis of Interest Sensitivity
As of December 31, 2010
(dollars in thousands)
At December 31, 2010, the Bank’s cumulative one-year interest rate sensitivity gap ratio was (14.19%), which would tend to indicate that our interest-earning assets will re-price during this period at a rate slower than our interest-bearing liabilities. The effects of certain categories of interest-bearing liabilities, primarily interest-bearing demand deposits and overnight federal funds purchased, tend to be overstated in our gap analysis and we believe that the spread between our interest-earning assets and interest-bearing liabilities will not be affected as much by the repricing period for these deposits as they will by the current interest rate environment. Currently, due to the extended period of low interest rates, our short term interest-sensitive assets and liabilities are likely close to their floors. Certain longer term interest-sensitive assets and liabilities, particularly fixed rate loans, time deposits and long-term borrowings, have more potential for repricing adjustments as they mature and are replaced at current rate levels. Additionally, when interest rates increase, our cumulative interest rate sensitivity gap indicates that a larger volume of our interest-bearing liabilities will reprice more quickly than our interest-earning assets. This could cause further compression of our net interest margin until the volume of interest-sensitive assets earning higher rates of interest gets closer to the volume of interest-sensitive liabilities already bearing higher rates of interest.
Return on Assets and Equity
The following table summarizes our return on average assets and return on average equity as well as our dividend payout ratio for the years ended December 31, 2010, 2009 and 2008:
Capital Adequacy and Liquidity
Our funding sources primarily include customer-based core deposits and customer repurchase accounts. The Bank, being situated in a market that relies on tourism as its principal industry, can be subject to periods of reduced deposit funding because tourism in Sevier County is seasonably slow in the winter months. The Bank manages seasonal deposit outflows through its secured Federal Funds lines of credit at various correspondent banks. Available lines totaled $33 million with $10 million secured and accessible as of December 31, 2010, and are available on one day’s notice. The Bank also has a cash management line of credit in the amount of $100 million from the FHLB of Cincinnati as well as a line of credit totaling approximately $24 million at December 31, 2010 from the Federal Reserve Discount Window that the Bank uses to meet short-term liquidity demands, none of which was borrowed as of that date. The borrowing capacity can be increased based on the amount of collateral pledged.
Capital adequacy is important to the continued financial safety and soundness and growth of the Bank and the Company. Our banking regulators have adopted risk-based capital and leverage guidelines to measure the capital adequacy of national banks and bank holding companies. Based on these guidelines, management believes the Bank and the Company met the current regulatory definitions for “well capitalized” at December 31, 2010. However, as noted below, the Bank anticipates that it will be required to enter into a Consent Order which will contain higher capital standards which will result in it being deemed to be “adequately capitalized” for regulatory purposes, including being subject to broker deposit restrictions.
Regulatory Capital Requirements
The Bank and Company are subject to minimum capital standards as set forth by federal bank regulatory agencies.
Capital for regulatory purposes differs from equity as determined under generally accepted accounting principles. Generally, “Tier 1” regulatory capital will equal capital as determined under generally accepted accounting principles together with eligible trust preferred securities and less any unrealized gains or losses on securities available for sale, while “Tier 2” capital includes the allowance for loan losses up to certain limitations. Total risk based capital is the sum of Tier 1 and Tier 2 capital.
Total capital at the Bank also has an important effect on the amount of FDIC insurance premiums paid. Institutions not considered well capitalized are subject to higher rates for FDIC insurance.
The Bank is subject to the supervision, examination and reporting requirements of the National Bank Act and the regulations of the OCC. In the first quarter of 2010, the Bank agreed to an OCC individual minimum capital requirement (“IMCR”) to maintain a minimum Tier 1 capital to average assets ratio of 9% and a minimum total capital to risk-weighted assets ratio of 13%. As of December 31, 2010, the Tier 1 capital to average assets ratio for the Bank was below the agreed upon 9% minimum. As a result, it is subject to further enforcement action.
The table below sets forth the Bank’s capital ratios as of the periods indicated:
The table below sets forth the Company’s capital ratios as of the periods indicated:
In November 2003, the Company formed a wholly owned Delaware statutory trust subsidiary, MNB Capital Trust I. This subsidiary issued approximately $5.5 million in trust preferred securities, guaranteed by the Company on a junior subordinated basis. In June 2006, the Company formed a wholly owned Delaware statutory trust subsidiary, MNB Capital Trust II. This subsidiary issued approximately $7.5 million in trust preferred securities, guaranteed by the Company on a junior subordinated basis. The Company obtained the proceeds from the trusts’ sale of trust preferred securities by issuing junior subordinated debentures to the trusts. Under the Financial Accounting Standards Board’s revised Interpretation No. 46 (“FIN 46R”), the trust subsidiaries must be deconsolidated with the Company for accounting purposes. As a result of this accounting pronouncement, the Federal Reserve adopted changes to its capital rules with respect to the regulatory capital treatment afforded to trust preferred securities. The Federal Reserve’s current rules permit qualified trust preferred securities and other restricted capital elements to be included as Tier 1 capital up to 25% of core capital, net of goodwill and intangibles. Additionally, following passage of the Dodd-Frank Act, trust preferred and cumulative preferred securities will no longer be deemed Tier 1 capital for bank holding companies, but trust preferred securities issued by bank holding companies with under $15 billion in total assets at December 31, 2009 will be grandfathered in and continue to count as Tier 1 capital. The Company believes that its trust preferred securities qualify under both of these revised regulatory capital rules and accordingly, expects that it will continue to treat its $13 million of trust preferred securities as Tier 1 capital subject to the limits listed above.
Liquidity is the ability of a company to convert assets into cash or cash equivalents without significant loss. Our liquidity management involves maintaining our ability to meet the day-to-day cash flow requirements of our customers, whether they are depositors wishing to withdraw funds or borrowers requiring funds to meet their credit needs. Without proper liquidity management, we would not be able to perform the primary function of a financial intermediary and would, therefore, not be able to meet the production and growth needs of the communities we serve.
The primary function of asset and liability management is not only to assure adequate liquidity in order for us to meet the needs of our customer base, but also to maintain an appropriate balance between interest-sensitive assets and interest-sensitive liabilities so that we can also meet the investment objectives of our shareholders. For additional information relating to our interest rate sensitivity management, refer to the discussion above under the heading “Interest Rate Sensitivity Management.” Daily monitoring of the sources and uses of funds is necessary to maintain an acceptable cash position that meets both the needs of our customers and the objectives of our shareholders. In a banking environment, both assets and liabilities are considered sources of liquidity funding and both are therefore monitored on a daily basis.
Off-Balance Sheet Arrangements
Our only material off-balance sheet arrangements consist of commitments to extend credit and standby letters of credit issued in the ordinary course of business to facilitate customers’ funding needs or risk management objectives.
Commitments and Lines of Credit
In the ordinary course of business, the Bank has granted commitments to extend credit and standby letters of credit to approved customers. Generally, these commitments to extend credit have been granted on a temporary basis for seasonal or inventory requirements and have been approved by the Bank’s loan committee. These commitments are recorded in the financial statements as they are funded. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitment amounts expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.
The following is a summary of the Bank’s commitments outstanding at December 31, 2010 and 2009.
Commitments to extend credit include unused commitments for open-end lines secured by 1-4 family residential properties, commitments to fund loans secured by commercial real estate, construction loans, land development loans, and other unused commitments. Commitments to fund commercial real estate, construction, and land development loans decreased approximately $6,369,000 during 2010, reflecting current economic conditions in our market.
Effects of Inflation
Our consolidated financial statements and related data presented herein have been prepared in accordance with generally accepted accounting principles, which require the measurement of financial position and operational results in terms of historic dollars, without considering changes in the relative purchasing power of money over time due to inflation.
Inflation generally increases the costs of funds and operating overhead, and to the extent loans and other assets bear variable rates, the yields on such assets. Unlike most industrial companies, virtually all of the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates generally have a more significant effect on the performance of a financial institution than the effects of general levels of inflation. In addition, inflation affects financial institutions’ cost of goods and services purchased, the cost of salaries and benefits, occupancy expense, and similar items. Inflation and related increases in interest rates generally decrease the market value of investments and loans held and may adversely affect liquidity, earnings, and stockholders’ equity. Mortgage originations and refinancings tend to slow as interest rates increase, and likely will reduce the Bank’s volume of such activities and the income from the sale of residential mortgage loans in the secondary market.
Significant Accounting Changes
The information appearing under “Note 18. Recent Accounting Pronouncements” in the 2010 notes to the financial statements is incorporated herein by reference.
ITEM 8.
ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The consolidated financial statements of the Company, including notes thereto, and the reports of the Company’s independent registered public accounting firm are included in this Annual Report on Form 10-K beginning at page and are incorporated herein by reference.
ITEM 9.
ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A.
CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Company’s reports and other information filed with the Commission, under the Exchange Act, is recorded, processed, summarized and reported within the time periods specified in the Commission’s rules and forms, and that such information is accumulated and communicated to the management, including the Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
The Company carried out an evaluation, under the supervision and with the participation of management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Exchange Act Rule 13a-15. Based upon the foregoing, the Chief Executive Officer along with the Chief Financial Officer concluded that certain deficiencies identified in internal controls and procedures created a material weakness and resulted in the Company’s disclosure controls and procedures not being effective to ensure that information required to be disclosed in the Company’s reports under the Exchange Act was recorded, summarized and reported within the time periods specified in the Commission’s rules and forms as of the end of the period covered by this report. Based on this determination of the existence of a material weakness, which began during the fourth quarter of 2010 and continued into the first quarter of 2011, management identified certain areas requiring internal control and procedure improvements.
Management’s Annual Report on Internal Control over Financial Reporting
Management of the Company is responsible for establishing and maintaining effective internal control over financial reporting. Internal control is designed to provide reasonable assurance to the Company’s management and board of directors regarding the preparation of reliable published financial statements. Internal control over financial reporting includes self-monitoring mechanisms, and actions are taken to correct deficiencies as they are identified.
Because of inherent limitations in any system of internal control, no matter how well designed, misstatements due to error or fraud may occur and not be detected, including the possibility of the circumvention or overriding of controls. Accordingly, even effective internal control over financial reporting can provide only reasonable assurance with respect to financial statement preparation. Further, because of changes in conditions, internal control effectiveness may vary over time.
Management assessed the Company’s internal control over financial reporting as of December 31, 2010. This assessment was based on criteria for effective internal control over financial reporting described in “Internal Control - Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment the Chief Executive Officer and Chief Financial Officer concluded that, as of December 31, 2010, the Company’s system of internal control over financial reporting was not effective as it relates to certain internal controls over the special assets function. See “Changes in Internal Control over Financial Reporting” for further information.
This annual report does not include an attestation report of the Company’s independent registered public accounting firm regarding internal control over financial reporting because that requirement under Section 404 of the Sarbanes Oxley Act of 2002 was permanently removed for non-accelerated filers pursuant to the provisions of Section 989(G) set forth in the Dodd-Frank Act.
Changes in Internal Control over Financial Reporting
During Management’s assessment of the Company’s internal control over financial reporting at December 31, 2010, the following deficiencies were noted: 1) Loans determined to be collateral dependent were not properly identified in a timely manner which created a material internal control deficiency. Procedures have been put in place by the Bank’s Special Assets Department to ensure loans that are dependent upon the sale of the underlying collateral for repayment are properly identified and documented when the determination is made the loan is collateral dependent and this information is incorporated in the allowance for loan loss calculation. 2) Appraisals and appraisal reviews from an independent third-party appraiser or collateral valuations performed internally for loans determined to be collateral dependent were not ordered, received or reviewed prior to the reporting date which could result in overstatement of loans and income and understatement of the provision for loan losses, charge off and the allowance for loan losses. The Special Assets Department has created procedures and updated the Appraisal Policy to address this deficiency. The remediation plan for these internal control deficiencies is noted below. Other than the items noted above, during the fourth quarter of 2010 there were no other changes in the Company’s internal control over financial reporting that have materially affected, or that are reasonably likely to materially affect, the Company’s internal control over financial reporting.
During and subsequent to the fourth quarter of 2010, management took the following remediation actions regarding the above referenced internal control deficiencies:
1)
During the first quarter of 2011, the OCC, during their regular safety and soundness exam, determined several loans were not properly identified by the Bank as collateral dependent as of December 31, 2010. Collateral dependent loans require a charge off of the loan balance if the recorded investment in the loan exceeds the underlying collateral value net of cost to sell. To make the determination the proper recorded investment has been recorded, the current appraised value of the collateral must be obtained. The Special Assets Department, formed during 2009, is in charge of complying with these requirements. During the first quarter of 2011, procedures were put in place in the Special Assets Department to comply with these requirements and the results of their efforts have been incorporated into the financial statements as of December 31, 2010.
2)
As noted in item 1, collateral dependent loans require the Bank to obtain a current appraisal or collateral valuation performed internally to allow for the determination as to whether there is sufficient collateral securing the loan. In addition to the requirement of obtaining the appraisal, the appraisal must be reviewed by an independent third-party appraiser charged with determining the appraisal has been properly performed. After the review, the Bank determines if the appraisal is acceptable, then provides the documentation to the Accounting Department to incorporate the results into the calculation of the allowance for loan losses. Failure to comply with any of these steps could result in the overstatement of both assets and income. The Special Assets Department, as noted in item 1, is in charge of complying with these requirements and during the first quarter of 2011, procedures were put in place to comply with these requirements and the results of their efforts have been incorporated into the financial statements as of December 31, 2010.
3)
During the first quarter of 2011, Management ensured proper controls are in place when evidence of impairment of a loan exists or prior to the annual appraisal date, the Special Assets Department will order appraisals or collateral valuations in a timely manner to allow for proper review and implementation of the results into the allowance for loan loss calculation. Proper controls have also been developed and incorporated into the process to assure a potential impairment is recorded when appraisal or valuation and review process is not complete as of a reporting date.
4)
The Bank has revised its policy and procedures to require independent third-party appraisals or collateral valuations performed internally for all loans considered to be impaired, classified or worse. The Special Assets Department, as noted in item 1, is in charge of complying with these requirements and during the first quarter of 2011, procedures were put in place to comply with these requirements and the results of their efforts have been incorporated into the financial statements as of December 31, 2010.
The identified material weakness in our internal controls over financial reporting will not be considered remediated until the new controls are fully implemented, in operation for a sufficient period of time, tested, and concluded by management to be operating effectively.
None.
PART III
ITEM 10.
ITEM 10.
DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
The information appearing under the headings “Proposal #1 Election of Directors,” “Additional Information Concerning the Company’s Board of Directors and Committees” and “Section 16(a) Beneficial Ownership Reporting Compliance” in the Proxy Statement (the “2011 Proxy Statement”) relating to the annual meeting of shareholders of the Company is incorporated herein by reference.
The information appearing under the heading “Compensation of Named Executive Officers and Directors” in the 2011 Proxy Statement is incorporated herein by reference.
ITEM 12.
ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The information appearing under the heading “Outstanding Voting Securities of the Company and Principal Holders Thereof” in the 2011 Proxy Statement is incorporated herein by reference.
The information appearing under “Note 14. Stock Options and Warrants” in the 2010 notes to the financial statements is incorporated herein by reference.
ITEM 13.
ITEM 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
The information appearing under the headings “Certain Relationships and Transactions” and “Proposal #1 Election of Directors” in the 2011 Proxy Statement is incorporated herein by reference.
ITEM 14.
ITEM 14.
PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information appearing under the caption “Proposal #2 - Ratification of the Appointment of Independent Registered Public Accounting Firm” in the 2011 Proxy Statement is incorporated herein by reference.
PART IV
ITEM 15.
ITEM 15.
EXHIBITS, FINANCIAL STATEMENT SCHEDULES
(a)(2)
Financial statement schedules. Inapplicable.
(a)(3)
The following exhibits are filed as a part of or incorporated by reference in this report:
*
Denotes management contract or compensatory plan or arrangement.
The Company is a party to certain agreements entered into in connection with the offering by MNB Capital Trust I of an aggregate of $5,500,000 in trust preferred securities and the offering by MNB Capital Trust II of an aggregate of $7,500,000 in trust preferred securities, as more fully described in this Annual Report on Form 10-K. In accordance with Item 601(b)(4)(iii) of Regulation S-K, and because the total amount of the trust preferred securities is not in excess of 10% of the Company’s total assets, the Company has not filed the various documents and agreements associated with the trust preferred securities herewith. The Company has, however, agreed to furnish copies of the various documents and agreements associated with the trust preferred securities to the Commission upon request.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
MOUNTAIN NATIONAL BANCSHARES, INC.
(Registrant)
By: /s/ Dwight B. Grizzell
Dwight B. Grizzell
President and Chief Executive Officer
Date: April 13, 2011
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
/s/ Dwight B. Grizzell
Dwight B. Grizzell, President,
Date: April 13, 2011
Chief Executive Officer and Director
/s/ Richard A. Hubbs
Richard A. Hubbs, Senior Vice President and
Date: April 13, 2011
Chief Financial Officer (Principal Financial
and Accounting Officer)
/s/ Gary A. Helton
Gary A. Helton, Director
Date: April 13, 2011
/s/ Charlie R. Johnson
Charlie R. Johnson, Director
Date: April 13, 2011
/s/ Sam L. Large
Sam L. Large, Director
Date: April 13, 2011
/s/ Jeffrey J. Monson
Jeffrey J. Monson, Director
Date: April 13, 2011
/s/ Linda N. Ogle
Linda N. Ogle, Director
Date: April 13, 2011
/s/ Michael C. Ownby
Michael C. Ownby, Director
Date: April 13, 2011
/s/ John M. Parker
John M. Parker, Director
Date: April 13, 2011
/s/ Ruth Reams
Ruth Reams, Director
Date: April 13, 2011
Mountain National Bancshares, Inc. and Subsidiaries
Consolidated Financial Report
December 31, 2010
CONTENTS
Report of Independent Registered Public Accounting Firm
The Board of Directors and Shareholders
Mountain National Bancshares, Inc.
We have audited the accompanying consolidated balance sheets of Mountain National Bancshares, Inc. and subsidiaries (the Company) as of December 31, 2010 and 2009, and the related consolidated statements of operations, changes in shareholders’ equity, and cash flows for the years then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit 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 includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2010 and 2009, and the results of its operations and its cash flows for the years then ended, in conformity with U.S. generally accepted accounting principles.
As discussed in Note 15 of the consolidated financial statements, the Corporation’s bank subsidiary is not in compliance with an existing commitment it made to maintain revised minimum regulatory capital levels in connection with a formal regulatory agreement which has imposed limitations on certain operations. Failure to comply with the regulatory agreement and the commitment may result in additional regulatory enforcement actions.
/s/ Crowe Horwath LLP
Brentwood, Tennessee
April 13, 2011
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
December 31, 2010 and 2009
See accompanying Notes to Consolidated Financial Statements
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
Years Ended December 31, 2010 and 2009
See accompanying Notes to Consolidated Financial Statements
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
Years Ended December 31, 2010 and 2009
See accompanying Notes to Consolidated Financial Statements
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31, 2010 and 2009
See accompanying Notes to Consolidated Financial Statements
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 1 - Summary of Significant Accounting Policies
The accounting and reporting policies of Mountain National Bancshares, Inc. and its subsidiaries (the “Company”) conform to U.S. generally accepted accounting principles and practices within the banking industry. The policies that materially affect financial position and results of operations are summarized as follows:
Nature of operations and geographic concentration:
The Company is a bank-holding company which owns all of the outstanding common stock of Mountain National Bank (the “Bank”). The Bank provides a variety of financial services through its branch offices located in Sevier and Blount Counties, Tennessee. The Bank’s primary deposit products are demand deposits, savings accounts, and certificates of deposit. Its primary lending products are commercial loans, real estate loans, and installment loans.
Principles of consolidation:
The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. The Company’s principal subsidiary is Mountain National Bank. All material inter-company accounts and transactions have been eliminated in consolidation.
Use of estimates:
The preparation of financial statements in conformity with generally accepted accounting principles in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates and such differences could be material to the financial statements. The allowance for loan losses, other real estate owned, deferred tax assets and fair values of financial instruments are particularly subject to change.
The determination of the adequacy of the allowance for loan losses is based on estimates that are particularly susceptible to significant changes in the economic environment and market conditions. In connection with the determination of the estimated losses on loans, management obtains independent appraisals for significant collateral.
The Bank’s loans are generally secured by specific items of collateral including real property, consumer assets, and business assets. Although the Bank has a diversified loan portfolio, a substantial portion of its debtors’ ability to honor their contracts is dependent on local economic conditions.
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 1 - Summary of Significant Accounting Policies (continued)
Due to the predominance of the tourism industry in Sevier County, a significant portion of our commercial loan portfolio is concentrated within that industry. The predominance of the tourism industry also makes our business more seasonal in nature than may be the case with banks and financial institutions in other market areas.
While management uses available information to recognize losses on loans, further reductions in the carrying amounts of loans may be necessary based on changes in local economic conditions. In addition, regulatory agencies, as an integral part of their examination process, periodically review the estimated losses on loans. Such agencies may advise the Bank to recognize additional losses based on their judgments about information available to them at the time of their examination. Because of these factors, it is reasonably possible that the estimated losses on loans may change materially in the near term. However, the amount of the change that is reasonably possible cannot be estimated.
Statements of cash flows:
The Company considers all cash and amounts due from depository institutions with maturities under 90 days and Federal Funds sold to be cash equivalents for purposes of the statements of cash flows. Net cash flows are reported for customer loan and deposit transactions, interest bearing deposits in other financial institutions, federal funds purchased and repurchase agreements.
Investment Securities:
Debt securities are classified as held to maturity when the Bank has the positive intent and ability to hold the securities to maturity. Securities held to maturity are carried at amortized cost.
Debt securities not classified as held to maturity are classified as available for sale. Securities available for sale are carried at fair value with unrealized gains and losses, net of taxes, reported in other comprehensive income (loss). Realized gains (losses) on securities available for sale are included in other income (expense) and, when applicable, are reported as a reclassification adjustment, net of tax, in other comprehensive income (loss). Realized gains and losses on sales of securities are recorded in non-interest income on the trade date and are determined on the specific-identification method.
The amortization of premiums and accretion of discounts are recognized in interest income using methods approximating the level-yield method over the period to maturity, without anticipating prepayments, except for mortgage backed securities where prepayments are anticipated.
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 1 - Summary of Significant Accounting Policies (continued)
Restricted equity securities include common stock of the Federal Home Loan Bank of Cincinnati and Federal Reserve Bank stock. These securities are carried at cost.
Management evaluates securities for other-than-temporary impairment (“OTTI”) at least on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. For securities in an unrealized loss position, management considers the extent and duration of the unrealized loss, and the financial condition and near-term prospects of the issuer. Management also assesses whether it intends to sell, or it is more likely than not that it will be required to sell, a security in an unrealized loss position before recovery of its amortized cost basis. If either of the criteria regarding intent or requirement to sell is met, the entire difference between amortized cost and fair value is recognized as impairment through earnings. For debt securities that do not meet the aforementioned criteria, the amount of impairment is split into two components as follows: 1) OTTI related to credit loss, which must be recognized in the statement of operations and 2) OTTI related to other factors, which is recognized in other comprehensive income (loss). The credit loss is defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis. For equity securities, the entire amount of impairment is recognized through earnings.
Securities sold under agreements to repurchase:
The Bank enters into sales of securities under agreements to repurchase identical securities the next day.
Loans:
Loans are stated at unpaid principal balances, less the allowance for loan losses. The “recorded investment” in loans presented throughout the Notes to the Consolidated Financial Statements is defined as the outstanding principal balance of loans. Interest income is accrued on the unpaid principal balance.
The accrual of interest on real estate and commercial loans is discontinued at the time the loan is 90 days delinquent unless the credit is well-secured and in process of collection. Installment loans and other personal loans are typically charged off no later than 90 days past due. Past due status is based on the contractual terms of the loan. In all cases, loans are placed on nonaccrual or charged off at an earlier date if collection of principal or interest is considered doubtful.
All interest accrued but not collected for loans that are placed on nonaccrual or charged off is reversed against interest income. The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Generally, loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured, which usually requires a minimum of six months sustained repayment performance.
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 1 - Summary of Significant Accounting Policies (continued)
Loans held for sale:
Mortgage loans originated and intended for sale in the secondary market are carried at the lower of aggregate cost or fair value, as determined by outstanding commitments from investors. Net unrealized losses, if any, are recorded as a valuation allowance and charged to earnings. Mortgage servicing rights are sold with the related loan. Loans held for sale totaled $216,500 and $0 at December 31, 2010 and 2009, respectively, and are included with loans on the balance sheet.
Allowance for loan losses:
The allowance for loan losses is maintained at a level which, in management’s judgment, is adequate to absorb probable incurred credit losses inherent in the loan portfolio. The amount of the allowance is based on management’s evaluation of the collectability of the loan portfolio, including the nature of the portfolio, credit concentrations, trends in historical loss experience, specific impaired loans, economic conditions, and other risks inherent in the portfolio. Allowances for impaired loans are generally determined based on collateral values or the present value of estimated cash flows. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged off. The allowance is increased by a provision for loan losses, which is charged to expense and reduced by charge-offs, net of recoveries. Changes in the allowance relating to impaired loans are charged or credited to the provision for loan losses.
During 2010, management sought to enhance its assessment of the allowance for loan losses by incorporating the results of a comprehensive historic loss rates migration analysis. The study provided more precise historical loss trends and percentages attributable to specific loan grades and types than were previously available. Consideration was given to recent charge off experience which management believes is a more reliable basis due to current economic conditions. The study did not have a material effect on the outcome of the allowance calculation; rather this data was used to narrow and refine management’s calculation and supported management’s previous estimation of the adequacy of the allowance for loan loss balance.
The allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired or loans otherwise classified as substandard or doubtful.
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 1 - Summary of Significant Accounting Policies (continued)
A loan is considered 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. Loans, for which the terms have been modified, and for which the borrower is experiencing financial difficulties, are considered troubled debt restructurings and classified as impaired. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record and the amount of the shortfall in relation to the principal and interest owed.
Loans over $100,000 that are graded special mention or worse according to the Company’s internal credit risk rating system, which is described in more detail under “Note 3. Loans and Allowance for Loan Losses,” are individually evaluated for impairment. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment, and accordingly, they are not separately identified for impairment disclosures. Troubled debt restructurings are separately identified for impairment disclosures and are measured at the present value of estimated future cash flows using the loan’s effective rate at inception. If a troubled debt restructuring is considered to be a collateral dependent loan, the loan is reported, net, at the fair value of the collateral. For troubled debt restructurings that subsequently default, the Company determines the amount of reserve in accordance with the accounting policy for the allowance for loan losses.
The general component of the allowance covers non-impaired loans and is based on historical loss experience adjusted for current factors. The historical loss experience is determined by portfolio segment and is based on the actual loss history experienced by the Company over the most recent three years for loans secured by real estate and five years for all other loans. This actual loss experience is supplemented with other economic and qualitative factors based on the risks present for each portfolio segment. These economic and qualitative factors include consideration of the following: levels of and trends in delinquencies and impaired loans; levels of and trends in charge-offs and recoveries; trends in volume and terms of loans; effects of any changes in risk selection and underwriting standards; other changes in lending policies, procedures, and practices; experience, ability, and depth of lending management and other relevant staff; changes in loan review; national and local economic trends and conditions; changes in value of underlying collateral; industry conditions; and effects of changes in credit concentrations.
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 1 - Summary of Significant Accounting Policies (continued)
Portfolio segments are defined as the level at which an entity develops and documents a systematic methodology to determine its allowance. As part of management’s quarterly assessment of the allowance, management divides the loan portfolio into six segments: construction and land development, commercial real estate, commercial, residential real estate, consumer and credit cards. Each segment, described in more detail below, is then analyzed such that an allocation of the allowance is estimated for each loan segment. Both quantitative and qualitative factors are used by management at the portfolio segment level in determining the adequacy of the allowance for the Company. During 2010, we incorporated the results of a historical loan loss migration analysis into our determination of the allowance for loan losses. We believe the increased emphasis on our historical loss experience metrics provides a better estimate of losses inherent in our portfolio. This refinement of our methodology did not result in a material change in our allowance.
Construction and land development loans include loans to finance the process of improving land preparatory to erecting new structures or the on-site construction of industrial, commercial or residential buildings. Construction and land development loans also include loans secured by vacant land, except land known to be used or usable for agricultural purposes. Construction loans generally are made for relatively short terms. They generally are more vulnerable to changes in economic conditions. Further, the nature of these loans is such that they are more difficult to evaluate and monitor. The risk of loss on a construction loan is dependent largely upon the accuracy of the initial estimate of the property’s value upon completion of the project and the estimated cost (including interest) of the project. Periodic site inspections are made on construction loans.
Commercial real estate loans include loans secured by non-residential real estate, including farmland and improvements thereon. Often these loans are made to single borrowers or groups of related borrowers, and the repayment of these loans largely depends on the results of operations and management of these properties. Adverse economic conditions may affect the repayment ability of these loans.
Commercial loans include loans for commercial or industrial purposes to business enterprises that are not secured by real estate. Commercial loans are typically made on the basis of the borrower’s ability to repay from the cash flow of the borrower’s business. Commercial loans are generally secured by accounts receivable, inventory and equipment. The collateral securing loans may depreciate over time, may be difficult to appraise and may fluctuate in value based on the success of the business. The Company seeks to minimize these risks through its underwriting standards.
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 1 - Summary of Significant Accounting Policies (continued)
Residential real estate loans include loans secured by residential real estate, including single-family and multi-family dwellings. Mortgage title insurance and hazard insurance are normally required. Adverse economic conditions in the Company’s market area may reduce borrowers’ ability to repay these loans and may reduce the collateral securing these loans.
Consumer loans include loans to individuals for household, family and other personal expenditures that are not secured by real estate. Consumer loans are generally secured by vehicles and other household goods. The collateral securing consumer loans may depreciate over time. The Company seeks to minimize these risks through its underwriting standards.
Credit Card loans include revolving lines of credit issued for commercial and consumer purposes. These lines are generally unsecured. Several factors including adverse economic conditions and unfavorable circumstances relative to individual customers may affect repayment of these loans.
Classes of loans and leases are a disaggregation of a Company’s portfolio segments. Classes are defined as a group of loans and leases which share similar initial measurement attributes, risk characteristics, and methods for monitoring and assessing credit risk. Management has determined that the Company has eight classes of loans and leases (construction and land development, commercial mortgage, commercial and industrial, residential mortgage, home equity and junior liens, multi-family, other consumer and credit cards). The “other consumer” class of loans is comprised of both revolving credit and installment loans.
The assessment also includes an unallocated component. We believe that the unallocated amount is warranted for inherent factors that cannot be practically assigned to individual loan categories, such as the imprecision in the overall loss allocation measurement process, the volatility of the local economies in the markets we serve and imprecision in our credit risk ratings process.
Reserve for unfunded commitments:
The reserve for unfunded commitments represents the estimate for probable credit losses inherent in these commitments to extend credit. Unfunded commitments to extend credit include standby letters of credit and commitments to fund available lines of credit. The process used to determine the reserve for unfunded commitments is consistent with the process for determining the allowance for loan losses and the reserve, if any, is included in other liabilities.
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 1 - Summary of Significant Accounting Policies (continued)
Investment in Partnership:
The Bank is a partner in Appalachian Fund for Growth II, LLC with three other Tennessee banking institutions. This partnership involves a “new markets tax credit” which is generated from a tax credit allocation from the Community Development Financial Institutions Fund (“CDFI”). The purposes of the partnership are (a) to have the primary mission of providing investment capital, solely in the form of loans, to low-income communities in accordance with the New Markets Tax Credit Program and (b) to make loans that are qualified low-income community investment loans. This partnership is accounted for using the equity method of accounting.
Premises and equipment:
Land is carried at cost. Other premises and equipment are carried at cost net of accumulated depreciation. Depreciation is computed using the straight-line and the declining balance methods based on the estimated useful lives of the assets. Useful lives range from three to forty years for premises and improvements, and from three to ten years for furniture and equipment. Maintenance and repairs are expensed as incurred while major additions and improvements are capitalized. Gains and losses on dispositions are included in current operations.
Other real estate owned:
Real estate properties acquired through or in lieu of loan foreclosure are initially recorded at the fair value less estimated selling cost at the date of foreclosure, establishing a new cost basis. Any write-downs based on the asset’s fair value at the date of acquisition are charged to the allowance for loan losses. Valuations are periodically performed by management, and any subsequent write-downs are recorded as a charge to operations, if necessary, to reduce the carrying value of a property to fair value less cost to sell. Other real estate owned (“ORE”) also includes excess Bank property not utilized when subdividing land acquired for the construction of Bank branches. Costs of significant property improvements are capitalized. Costs relating to holding property are expensed.
Income taxes:
The Company files consolidated federal and state income tax returns with the Bank and its subsidiaries. Income taxes are provided for the tax effects of the transactions reported in the financial statements and consist of taxes currently due plus deferred income taxes related primarily to differences between the basis of the allowance for loan losses and accumulated depreciation. The deferred tax assets and liabilities represent the future tax return consequences of those differences, which will either be taxable or deductible when the assets and liabilities are recovered or settled. Deferred tax assets and liabilities are reflected using enacted income tax rates. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized.
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 1 - Summary of Significant Accounting Policies (continued)
A tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded.
Advertising costs:
The Company expenses all advertising costs as incurred. Advertising expense was $122,670 and $276,129 for the years ended December 31, 2010 and 2009, respectively.
Company owned life insurance:
The Company has purchased life insurance policies on certain key executives. Company owned life insurance is recorded at the amount that can be realized under the insurance contract at the balance sheet date, which is the cash surrender value adjusted for other charges or other amounts due that are probable at settlement.
Long-term assets:
Premises and equipment and other long-term assets are reviewed for impairment when events indicate their carrying amount may not be recoverable from future undiscounted cash flows. If impaired, the assets are recorded at fair value.
Loan commitments and related financial instruments:
Financial instruments include off-balance sheet credit instruments, such as commitments to make loans and commercial letters of credit, issued to meet customer financing needs. The face amount for these items represents the exposure to loss, before considering customer collateral or ability to repay. Such financial instruments are recorded when they are funded.
Retirement plans:
Employee 401(k) and profit sharing plan expense is the amount of matching contributions made by the Company pursuant to the Company’s 401(k) benefit plan. Deferred compensation and supplemental retirement plan expense allocates the benefits over years of service.
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 1 - Summary of Significant Accounting Policies (continued)
Earnings (losses) per common share:
Basic earnings (losses) per common share is net income (loss) divided by the weighted average number of common shares outstanding during the period. Diluted earnings per common share includes the dilutive effect of additional potential common shares issuable under stock options and stock warrants. Any shares having an antidilutive effect are excluded from the calculation. Earnings (loss) and dividends per share are restated for all stock splits and dividends through the date of issue of the financial statements.
Comprehensive income (loss):
Comprehensive income (loss) consists of net income (loss) and other comprehensive income (loss). Other comprehensive income (loss) includes unrealized gains and losses on securities available for sale, which is also recognized as a separate component of equity.
Loss contingencies:
Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. Management does not believe there are now such matters that will have a material effect on the financial statements.
Restrictions on cash:
Cash on hand or on deposit with the Federal Reserve Bank was required to meet regulatory reserve and clearing requirements. Beginning October 1, 2008, the Federal Reserve was authorized to pay interest on these balances based on a spread to the average target federal funds rate. These balances did not earn interest prior to that date.
Equity:
Stock dividends in excess of 20% of the Company’s outstanding shares are reported by transferring the par value of the stock issued from retained earnings to common stock. Stock dividends for 20% or less of the Company’s outstanding shares are reported by transferring the fair value, as of the ex-dividend date, of the stock issued from retained earnings to common stock and additional paid-in capital. Fractional share amounts are paid in cash with a reduction in retained earnings.
Dividend restriction:
Banking regulations require maintaining certain capital levels and may limit the dividends paid by the bank to the holding company or by the holding company to shareholders. Banking regulations also limit the ability of banks that are incurring losses to pay dividends without prior regulatory approval. (See “Note 15 - Regulatory Matters” for more specific disclosure.)
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 1 - Summary of Significant Accounting Policies (continued)
Fair value of financial instruments:
Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed in “Note 13 - Fair Value.” Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect these estimates.
Stock-based compensation:
Compensation cost is recognized for stock options and restricted stock awards issued to employees, based on the fair value of these awards at the date of grant. A Black-Scholes model is utilized to estimate the fair value of stock options, while the market price of the Company’s common stock at the date of grant is used for restricted stock awards. Compensation cost is recognized over the required service period, generally defined as the vesting period. At December 31, 2010, the Company has a stock-based compensation plan, which is described more fully in “Note 14 - Stock Options.”
Segment reporting:
While the chief decision-makers monitor the revenue streams of the various products and services, operations are managed and financial performance is evaluated on a Company-wide basis. In the Company’s operations, each branch is viewed by management as being a separately identifiable business or segment from the perspective of monitoring performance and allocation of financial resources. Although the branches operate independently and are managed and monitored separately, each is substantially similar in terms of business focus, type of customers, products and services. Accordingly, the Company’s consolidated financial statements reflect the presentation of segment information on an aggregated basis in one reportable segment.
Reclassifications:
Some items in the prior year financial statements were reclassified to conform to the current presentation. Reclassifications had no effect on prior year net income or shareholders’ equity.
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 2 - Securities
Securities have been classified in the balance sheet according to management’s intent as securities held to maturity or securities available for sale. The amortized cost and approximate fair value of securities at December 31, 2010 and 2009 are as follows:
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 2 - Securities (continued)
The proceeds from sales of securities and the associated gains and losses are listed below:
During the first quarter of 2010, the Bank sold one security classified as held-to-maturity. The remaining held-to-maturity security in the Bank’s portfolio was reclassified as available for sale. The approximately $1.3 million residual balance in held-to-maturity securities at December 31, 2010 represents securities held in the portfolio of MNB Investments, Inc., a consolidated subsidiary of the Bank. MNB Investments, Inc. does not intend and it is not more likely than not that it would be required to sell these securities prior to maturity.
The amortized cost and fair value of securities at December 31, 2010, by contractual maturity, are shown below. Securities not due at a single maturity date, primarily mortgage-backed securities, are shown separately.
At December 31, 2010 and 2009, securities with a carrying value of approximately $78,019,000 and $131,039,000, respectively, were pledged to secure public deposits and for other purposes required or permitted by law. At December 31, 2010 and 2009, the carrying amount of securities pledged to secure repurchase agreements was approximately $1,064,000 and $2,293,000, respectively.
The Company did not hold any securities from a single issuer that exceeded 10% of total shareholders’ equity as of December 31, 2010, other than securities of the U.S. Government and its agencies and mortgage-backed securities issued by government sponsored entities that had a carrying value of approximately $81,145,000 and $114,057,000 at December 31, 2010 and 2009, respectively.
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 2 - Securities (continued)
The following table summarizes the investment securities with unrealized losses at December 31, 2010 and 2009 aggregated by major security type and length of time in a continuous unrealized loss position:
December 31, 2010:
December 31, 2009:
As of December 31, 2010, the Company’s security portfolio consisted of 76 securities, 56 of which were in an unrealized loss position. The majority of unrealized losses are related to the Company’s obligations of states and political subdivisions and mortgage-backed securities, as discussed below.
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 2 - Securities (continued)
Mortgage-Backed Securities
At December 31, 2010, 100% of the mortgage-backed securities held by the Company were issued by U.S. government-sponsored entities and agencies, primarily Fannie Mae, Freddie Mac and Ginnie Mae, institutions which the government has affirmed its commitment to support. Because the decline in fair value is attributable to changes in interest rates and illiquidity, and not credit quality, and because the Company does not have the intent to sell these mortgage-backed securities and it is likely that it will not be required to sell the securities before their anticipated recovery, the Company does not consider these securities to be other-than-temporarily impaired at December 31, 2010.
Obligations of States and Political Subdivisions
Unrealized losses on obligations of states and political subdivisions have not been recognized in income because the issuer(s)’ bonds are of high credit quality, the decline in fair value is largely due to changes in interest rates and other market conditions, and because the Company does not have the intent to sell these securities and it is likely that it will not be required to sell the securities before their anticipated recovery. The Company does not consider these securities to be other-than-temporarily impaired at December 31, 2010.
Other-Than-Temporary-Impairment
Management evaluates securities for OTTI at least on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. In determining OTTI, management considers many factors, including: (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, (3) whether the market decline was affected by macroeconomic conditions, and (4) whether the entity has the intent to sell the debt security or more likely than not will be required to sell the debt security before its anticipated recovery. The assessment of whether an other-than-temporary decline exists involves a high degree of subjectivity and judgment and is based on the information available to management at a point in time.
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 2 - Securities (continued)
When OTTI occurs, the amount of the OTTI recognized in earnings depends on whether an entity intends to sell the debt security or it is more likely than not it will be required to sell the security before recovery of its amortized cost basis, less any current-period credit loss. If an entity intends to sell or it is more likely than not it will be required to sell the security before recovery of its amortized cost basis, less any current-period credit loss, the OTTI shall be recognized in earnings equal to the entire difference between the investment’s amortized cost basis and its fair value at the balance sheet date. Otherwise, the OTTI shall be separated into the amount representing the credit loss and the amount related to all other factors. The amount of the total OTTI related to the credit loss is determined based on the present value of cash flows expected to be collected and is recognized in earnings. The amount of the total OTTI related to other factors is recognized in other comprehensive income (loss), net of applicable taxes. The previous amortized cost basis less the OTTI recognized in earnings becomes the new amortized cost basis of the investment.
Other Securities
On May 1, 2009, Silverton Bank, the bank subsidiary of Silverton Financial Services, Inc. (“Silverton”), was placed into receivership by the Office of the Comptroller of the Currency after Silverton Bank’s capital deteriorated significantly in the first quarter of 2009, and on June 5, 2009 Silverton filed a petition for bankruptcy. The Company does not anticipate that it will recover any of the Bank’s investment in either the common securities or trust preferred securities issued by Silverton or its affiliated trust. As a result, the Company recorded an impairment charge of $347,368, which represents the Company’s full investment in the securities, during the first quarter of 2009.
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 3 - Loans and Allowance for Loan Losses
At December 31, 2010 and 2009, the Bank’s loans consisted of the following:
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 3 - Loans and Allowance for Loan Losses (continued)
A summary of transactions in the allowance for loan losses for the years ended December 31, 2010 and 2009 is as follows:
The Bank had a concentration of credit at December 31, 2010 in real estate loans, which totaled approximately $344,281,000. Real estate loans accounted for 92% of total loans and were primarily commercial loans secured by commercial properties and residential mortgage loans. Additionally, a large portion of the Bank’s real estate loans were for construction, land acquisition and development. Substantially all real estate loans are secured by properties located in Tennessee.
Loans to executive officers, principal shareholders and directors and their affiliates were approximately $13,448,000 and $17,933,000 at December 31, 2010 and 2009, respectively. For the year ended December 31, 2010, the activity in these loans included new borrowings of approximately $1,352,000 and repayments of approximately $5,837,000. None of these loans to executive officers, principal shareholders and directors and their affiliates, were impaired at December 31, 2010 or 2009.
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 3 - Loans and Allowance for Loan Losses (continued)
The following table presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment and based on impairment method as of December 31, 2010:
Individually impaired loans were as follows:
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 3 - Loans and Allowance for Loan Losses (continued)
The following table presents loans individually evaluated for impairment by class of loans as of December 31, 2010:
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 3 - Loans and Allowance for Loan Losses (continued)
At December 31, 2010 and 2009, the Bank had certain impaired loans on nonaccruing interest status. The principal balance of these nonaccrual loans amounted to approximately $53,005,000 and $39,587,000 at December 31, 2010 and 2009, respectively. In most cases, at the date such loans were placed on nonaccrual status, the Bank reversed all previously accrued interest income against the current year earnings. Had nonaccruing loans been on accruing status, interest income would have been higher by approximately $3,164,000 and $1,358,000 for the years ended December 31, 2010 and 2009, respectively.
Nonperforming loans were as follows:
Nonperforming loans include both smaller balance homogeneous loans that are collectively evaluated for impairment and individually classified as impaired loans.
The following table presents the recorded investment in nonperforming loans by class of loans as of December 31, 2010:
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 3 - Loans and Allowance for Loan Losses (continued)
The following table presents the aging of the recorded investment in past due loans, including the payment status of loans on non-accrual which have been incorporated into the table, as of December 31, 2010 by class of loans:
Troubled Debt Restructurings:
Impaired loans also include loans that the Bank may elect to formally restructure due to the weakening credit status of a borrower such that the restructuring may facilitate a repayment plan that minimizes the potential losses, if any, that the Bank may have to otherwise incur. These loans are classified as impaired loans and, if on nonaccruing status as of the date of restructuring, the loans are included in the nonperforming loan balances noted below. Not included in nonperforming loans are loans that have been restructured that were performing as of the restructure date. The Company has allocated $3,699,700 of specific reserves to customers whose loan terms have been modified in troubled debt restructurings as of December 31, 2010. The Company has $82,442,903 outstanding to customers whose loans are classified as a troubled debt restructuring. The Company has committed to lend additional amounts totaling $1,241,287 related to loans classified as troubled debt restructurings. At December 31, 2010 and 2009, there were $35,751,985 and $21,797,811, respectively, of accruing restructured loans that remain in a performing status.
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 3 - Loans and Allowance for Loan Losses (continued)
Credit Quality Indicators:
The Company uses several credit quality indicators, which are updated at least annually, to manage credit risk in an ongoing manner. The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information and current economic trends, among other factors. The Company uses an internal credit risk rating system that categorizes loans into pass, special mention or classified categories. Credit risk ratings are applied to all loans individually with the exception of credit cards.
The following are the definitions of the Company’s risk ratings:
Pass:
Loans that are not adversely rated, are contractually current as to principal and interest and are otherwise in compliance with the contractual terms of the loan or lease agreement. Management believes that there is a low likelihood of loss related to those loans that are considered pass.
Special Mention:
Loans classified as special mention have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the institution’s credit position at some future date.
Substandard/
Accruing:
Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.
Substandard/
Nonaccrual:
A loan classified as nonaccrual has all the deficiencies of a loan graded substandard but collection of the full amount of principal and interest owed is uncertain or unlikely and collateral support, if any, may be weak.
Doubtful:
Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing estimations, facts, conditions and values, highly questionable and improbable. Doubtful loans include only the portion of each specific loan deemed uncollectible and the classification can change as certain current information and facts are ascertained.
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 3 - Loans and Allowance for Loan Losses (continued)
The following tables presents by class and by risk category, the recorded investment in the Company’s loans as of December 31, 2010.
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 4 - Bank Premises and Equipment
A summary of Bank premises and equipment at December 31, 2010 and 2009, is as follows:
Depreciation expense for the years ended December 31, 2010 and 2009 amounted to $1,433,948 and $1,430,157, respectively.
Note 5 - Deposits
The aggregate amount of time deposits in denominations of $100,000 or more at December 31, 2010 and 2009, was approximately $121,566,000 and $168,252,000, respectively, including brokered deposits of approximately $27,019,000 and $69,955,000, respectively, for each time period.
At December 31, 2010, the scheduled maturities of time deposits for each of the five years subsequent to December 31, 2010 were as follows:
Deposits of employees, officers and directors totaled approximately $6,200,000 at December 31, 2010 and $8,482,000 at December 31, 2009.
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 6 - Income Taxes (Benefits)
Income tax expense (benefit) in the statements of income for the years ended December 31, 2010 and 2009 consists of the following:
Income tax expense (benefit) differs from amounts computed by applying the Federal income tax statutory rate of 34% in 2010 and 2009 to income before income taxes. A reconciliation of the differences for the years ended December 31, 2010 and 2009 is as follows:
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 6 - Income Taxes (Benefits) (continued)
Significant components of the Company’s deferred tax assets and liabilities at December 31, 2010 and 2009 were as follows:
A valuation allowance is recognized for a deferred tax asset if, based on the weight of available evidence, it is more-likely-than-not that some portion of the entire deferred tax or asset will not be realized. In making such judgments, significant weight is given to evidence that can be objectively verified. As a result of increased credit losses, the Company entered into a three-year cumulative pre-tax loss position in 2010. A cumulative loss position is considered significant negative evidence in assessing the reliability deferred tax asset which is difficult to overcome. The Company’s estimate of the realization of its deferred tax assets was based on future reversals of existing taxable temporary differences and taxable income in prior carry back years. The Company did not consider future taxable income in determining the reliability of its deferred assets. During 2010, we recorded a valuation allowance of $7,372,520. The timing of the reversal of the valuation allowance is dependent on our assessment of future events and will be based on the circumstances that exist as of that future date.
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 6 - Income Taxes (Benefits) (continued)
During 2010 and per ASC 740-20-45, the Company had income tax expense related to changes in the unrealized gains and losses on investment securities available for sale totaling approximately $515,000. This expense was recorded through accumulated other comprehensive income and increased our deferred tax valuation allowance.
The Bank has a federal net operating loss carryforward of approximately $1,578,000 which will expire in 2030. The Bank has a Tennessee net operating loss carryforward of which approximately $1,590,000 will expire in 2021, $1,630,000 which will expire in 2022, $1,563,000 which will expire in 2023, $3,748,000 which will expire in 2024 and $5,818,000 which will expire in 2025 if not offset by future taxable income.
The Bank has a minimum tax credit of $130,000 that can be carried forward indefinitely.
The Company currently has no unrecognized tax benefits that, if recognized, would favorably affect the effective income tax rate in future periods. The Company does not expect any unrecognized tax benefits to significantly increase or decrease in the next twelve months. It is the Company’s policy to recognize any interest accrued related to unrecognized tax benefits in interest expense, with any penalties recognized as operating expenses.
The Company and its subsidiaries are subject to U.S. federal income tax as well as income tax of the state of Tennessee. The Company is no longer subject to examination by taxing authorities for tax years before 2007.
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 7 - Federal Home Loan Bank Advances
The Bank has an agreement with the Federal Home Loan Bank of Cincinnati (“FHLB”) that provides short-term and long-term funding to the Bank in an amount up to $100,000,000. The Bank’s portfolio of one to four single-family mortgages, commercial real estate, home equity lines of credit, multi-family mortgages and junior mortgages have been pledged as collateral for any advances under a blanket lien arrangement requiring a collateral-to-loan ratio of 145%, 210%, 200%, 230% and 195%, respectively. At year end, advances from the FHLB were as follows:
Each advance is payable at its maturity date, with prepayment penalties that vary according to the type of advance. Maturities of the notes payable for each of the years subsequent to December 31, 2010 are as follows:
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 7 - Federal Home Loan Bank Advances (continued)
During the third quarter of 2010, the Bank elected to pre-pay a $7,500,000 FHLB advance that was scheduled to mature in November 2011. The pre-payment resulted in a penalty of approximately $350,000 which essentially accelerated payment of the interest that would have been due on the advance through its maturity. Management chose to pay off the advance early due to increasing collateralization requirements associated with the Bank’s outstanding FHLB debt and difficulty finding pledgeable collateral with a yield sufficient to cover or exceed the cost of the debt. Additionally, management chose to pay off the advance in order to reduce a non-core funding source. The pre-payment penalty is included in other non-interest expense in the Company’s 2010 statement of operations.
Note 8 - Subordinated Debentures
On November 7, 2003, we established MNB Capital Trust I and on June 9, 2006, we established MNB Capital Trust II (“Trust I” and “Trust II” or collectively, the “Trusts”). The Company is the sole sponsor of the Trusts and acquired each Trust’s common securities for $171,000 and $232,000, respectively. The Trusts were created for the exclusive purpose of issuing 30-year capital trust preferred securities (“Trust Preferred Securities”) in the aggregate amount of $5,500,000 for Trust I and $7,500,000 for Trust II and using the proceeds to acquire junior subordinated debentures (“Subordinated Debentures”) issued by the Company. The sole assets of the Trusts are the Subordinated Debentures. Both are wholly-owned statutory business trusts, however; the Company is not considered the primary beneficiary of Trust I or Trust II (variable interest entities), therefore the Trusts are not consolidated in the Company’s financial statements. The Company’s aggregate $403,000 investment in the Trusts is included in other assets in the accompanying consolidated balance sheets and the $13,403,000 obligation of the Company is reflected as subordinated debt.
The Trust I Preferred Securities bear a floating interest rate based on a spread over 3-month LIBOR and was 3.340% at December 31, 2010 which is set each quarter and mature on December 31, 2033. The Trust II Preferred Securities bear a floating interest rate based on a spread over 3-month LIBOR and was 1.889% at December 31, 2010 which is set each quarter and mature on July 7, 2036. Distributions are payable quarterly. The Trust Preferred Securities are subject to mandatory redemption upon repayment of the Subordinated Debentures at their stated maturity date or their earlier redemption in an amount equal to their liquidation amount plus accumulated and unpaid distributions to the date of redemption. The Company guarantees the payment of distributions and payments for redemption or liquidation of the Trust Preferred Securities to the extent of funds held by the Trusts. The Company’s obligations under the Subordinated Debentures together with the guarantee and other back-up obligations, in the aggregate, constitute a full and unconditional guarantee by the Company of the obligations of the Trusts under the Trust Preferred Securities.
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 8 - Subordinated Debentures (continued)
The Subordinated Debentures are unsecured, bear interest at a rate equal to the rates paid by the Trusts on the Trust Preferred Securities and mature on the same dates as those noted above for the Trust Preferred Securities. Interest is payable quarterly. The Company may defer the payment of interest at any time for a period not exceeding 20 consecutive quarters without default provided that deferral period does not extend past the stated maturity. During any such deferral period, distributions on the Trust Preferred Securities will also be deferred and the Company’s ability to pay dividends on its common shares will be restricted.
On December 14, 2010, the Company exercised its rights to defer regularly scheduled interest payments of $84,680 on all of its issues of junior subordinated debentures relating to outstanding trust preferred securities. The regular scheduled interest payments will continue to be accrued for payment in the future and reported as an expense for financial statement purposes.
Subject to approval by the Federal Reserve Bank of Atlanta, if then required, the Trust Preferred Securities may be redeemed prior to maturity at the Company’s option on or after December 31, 2008, for Trust I and on or after July 7, 2011, for Trust II. The Trust Preferred Securities may also be redeemed at any time in whole (but not in part) in the event of unfavorable changes in laws or regulations that result in (1) the Trusts becoming subject to federal income tax on income received on the Subordinated Debentures, (2) interest payable by the Company on the Subordinated Debentures becoming non-deductible for federal tax purposes, (3) the requirement for the Trusts to register under the Investment Company Act of 1940, as amended, or (4) loss of the ability to treat the Trust Preferred Securities as “Tier 1 capital” under the Federal Reserve capital adequacy guidelines.
Following passage of the Dodd Frank Wall Street Reform and Consumer Protection Act (the “Reform Act”), bank holding companies like the Company must be subject to capital requirements that are at least as severe as those imposed on banks under current federal regulations. Trust preferred and cumulative preferred securities will no longer be deemed Tier 1 capital for bank holding companies following passage of the Reform Act, but trust preferred securities issued by bank holding companies with under $15 billion in total assets at December 31, 2009 will be grandfathered in and continue to count as Tier 1 capital. Accordingly, the Company’s trust preferred securities will continue to count as Tier 1 capital.
The Company’s investments in Trust I and Trust II are included in other assets. These investments are accounted for under the equity method and consist of 100% of the common stock of Trust I and Trust II.
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 9 - Securities Sold Under Agreements to Repurchase
Securities sold under agreements to repurchase are variable rate financing arrangements with no fixed maturity. Upon cancellation of the agreement, the securities underlying the agreements are returned to the Company. Information concerning securities sold under agreements to repurchase is summarized as follows:
Note 10 - Employee Benefit Plans
The Bank sponsors a 401(k) employee benefit plan covering substantially all employees who have completed at least six months of service and met minimum age requirements. The Bank’s contribution to the plan is discretionary and was $15,181 for 2010 and $111,373 for 2009. During the first quarter of 2010, the Bank elected to suspend its 401(k) matching contributions indefinitely.
The Company also has salary continuation agreements in place with certain key officers. Such agreements are structured with differing benefits based on the participants overall position and responsibility. These agreements provide the participants with a supplemental income upon retirement at age 65, additional incentive to remain with the Company in order to receive these deferred retirement benefits and a compensation package that is competitive in the market. These agreements vest over a ten year period, require a minimum number of years of service and contain change of control provisions. All benefits would cease in the event of termination for cause, and if the participant’s employment were to end due to disability, voluntary termination or termination without cause, the participant would be entitled to receive certain reduced benefits based on vesting and other conditions.
The estimated cost of this obligation is being accrued over the service period for each officer. The Company recognized expense of $374,393 and $301,943 during 2010 and 2009, respectively, related to these agreements. The total amount accrued at December 31, 2010 and 2009 was $1,469,716 and $1,095,323, respectively.
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 11 - Leases
The Bank is leasing the land on which its Gatlinburg branch is located under a non-cancelable lease agreement that expires in 2013. This lease agreement contains renewal options for twelve additional five-year terms.
The Bank is also leasing the land on which its Justice Center branch is located under a non-cancelable lease agreement that expires in 2013. This lease agreement contains renewal options for six additional five-year terms.
In addition, the Bank is leasing the building in which its Gatlinburg walk-up facility is located and the property on which it has placed certain automated teller machines. These leases expire at various dates through 2015 and contain various renewal options. Total rental expense under all operating leases was $189,180 in 2010 and $182,330 in 2009.
The following is a schedule by years of future minimum rental payments required under operating leases that have initial or remaining non-cancelable lease terms in excess of one year as of December 31, 2010:
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 12 - Financial Instruments with Off-Balance Sheet Risk
In the normal course of business, the Bank has outstanding commitments and contingent liabilities, such as commitments to extend credit and standby letters of credit, which are not included in the accompanying financial statements. The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit and standby letters of credit is represented by the contractual or notional amount of those instruments. The Bank uses the same credit policies in making such commitments as it does for instruments that are included in the balance sheet. At December 31, 2010, commitments under standby letters of credit and undisbursed loan commitments, substantially all of which are carried at variable rates, were as follows:
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on management’s credit evaluation. Collateral held varies but may include accounts receivable, inventory, property and equipment, and income-producing commercial properties.
Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Standby letters of credit generally have fixed expiration dates or other termination clauses and may require payment of a fee. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Bank’s policy for obtaining collateral, and the nature of such collateral, is essentially the same as that involved in making commitments to extend credit.
The Bank was not required to perform on any financial guarantees and did not incur any losses on its commitments during 2010 or 2009.
Note 13 - Fair Value
Fair value is the exchange price that would be received for an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. There are three levels of inputs that may be used to measure fair value:
Level 1: Quoted prices (unadjusted) for 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; or 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.
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 13 - Fair Value (continued)
The Company used the following methods and significant assumptions to estimate the fair value of each type of financial instrument:
Investment Securities Available for Sale - Securities classified as available for sale are reported at fair value utilizing Level 2 inputs. For these securities, the Company obtains fair value measurements from an independent service provider. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U. S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayments speeds, credit information and the securities’ terms and conditions, among other things.
Impaired Loans - The fair value of impaired loans with specific allocations of the allowance for loan losses may be based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value. If the recorded investment in an impaired loan exceeds the measure of fair value, a valuation allowance may be established as a component of the allowance for loan losses or the expense is recognized as a charge-off. As a result of partial charge-offs, certain impaired loans are carried at fair value with no allocation. Certain impaired loans are not measured at fair value, which generally includes troubled debt restructurings that are measured for impairment based upon the present value of expected cash flows discounted at the loan’s original effective interest rate, and are excluded from the assets measured on a nonrecurring basis.
Other Real Estate - The fair value of ORE is generally based on current appraisals, comparable sales, and other estimates of value obtained principally from independent sources, adjusted for estimated selling costs. At the time of foreclosure, any excess of the loan balance over the fair value of the real estate held as collateral is treated as a charge against the allowance for loan losses. Gains or losses on sale and any subsequent adjustments to the value are recorded as a gain or loss on ORE. ORE is classified within Level 3 of the hierarchy.
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 13 - Fair Value (continued)
Assets and Liabilities Measured on a Recurring Basis
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 13 - Fair Value (continued)
Assets and Liabilities Measured on a Non-Recurring Basis
Certain assets and liabilities are measured at fair value on a nonrecurring basis, that is, the instruments are not measured at fair value on an ongoing basis but are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment). The following table summarizes assets and liabilities measured at fair value on a non-recurring basis as of December 31, 2010 and December 31, 2009, segregated by the level of the valuation inputs within the fair value hierarchy utilized to measure fair value:
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 13 - Fair Value (continued)
Fair Value of Financial Instruments
Fair value estimates are made at a specific point in time, based on relevant market information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular financial instrument. Because no market exists for a significant portion of the Company’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature; involve uncertainties and matters of judgment; and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect the estimates. Accordingly, the aggregate fair value amounts presented are not intended to represent the underlying value of the Company.
Fair value estimates are based on existing financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. The following methods and assumptions were used to estimate the fair value of each class of financial instruments:
Cash and cash equivalents:
For cash and cash equivalents, the carrying amount is a reasonable estimate of fair value.
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 13 - Fair Value (continued)
Investment Securities:
The fair value of securities is estimated as previously described for securities available for sale, and in a similar manner for securities held to maturity.
Restricted investments:
Restricted investments consist of Federal Home Loan Bank and Federal Reserve Bank stock. It is not practicable to determine the fair value due to restrictions placed on the transferability of the stock.
The fair value of loans is calculated by discounting scheduled cash flows through the estimated maturity using estimated market discount rates, adjusted for credit risk and servicing costs. The estimate of maturity is based on historical experience with repayments for each loan classification, modified, as required, by an estimate of the effect of current economic and lending conditions. The allowance for loan losses is considered a reasonable discount for credit risk.
The fair value of deposits with no stated maturity, such as demand deposits, money market accounts, and savings deposits, is equal to the amount payable on demand. The fair value of time deposits is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for deposits of similar remaining maturities.
Federal funds purchased and securities sold under agreements to repurchase:
The estimated value of these liabilities, which are extremely short term, approximates their carrying value.
Subordinated debentures:
For the subordinated debentures with a floating interest rate tied to LIBOR, the fair value is based on the discounted value of contractual cash flows. The discount rate is estimated using the most recent offering rates available for subordinated debentures of similar amounts and remaining maturities.
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 13 - Fair Value (continued)
Federal Home Loan Bank advances:
For FHLB advances the fair value is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for FHLB advances of similar amounts and remaining maturities.
Accrued interest receivable and payable:
The carrying amounts of accrued interest receivable and payable approximate their fair value.
Commitments to extend credit, letters of credit and lines of credit:
The fair value of commitments is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair values of these commitments are insignificant and are not included in the table below.
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 13 - Fair Value (continued)
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 14 - Stock Options
The Company has a stock option plan that is administered by the Board of Directors and provides for both incentive stock options and nonqualified stock options. The exercise price of each option shall not be less than 100 percent of the fair market value of the common stock on the date of grant. All options have been granted at the fair market value of the shares at the date of grant. The maximum term for each option is ten years. The maximum number of shares that can be issued under the plan is 724,239. The following table provides certain information about the Company’s equity compensation plan as of December 31, 2010:
The Company has granted incentive stock options to certain key officers and employees. The Company has also granted nonqualified stock options to non-employee organizers of the Bank. The stock option agreements state that upon termination of employment, employees have 90 days to exercise any stock options vested as of the termination date.
The Company issues new shares to satisfy option exercises from the authorized shares allocated to the employee stock option plan.
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 14 - Stock Options (continued)
Information related to the stock option plan during each year follows:
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model using the assumptions noted in the following table for years in which options were granted. Expected volatilities are based on historical exercise patterns, employee terminations and historical stock prices. The expected life of options granted represents the period of time that options granted are expected to be outstanding. The U.S. Treasury 10 year constant maturity rate in effect at the date of grant is used to derive the risk-free interest rate for the contractual period of the options.
Note 15 - Regulatory Matters
The Bank and Company are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action applicable to the Bank, the Bank and Company must meet specific capital guidelines that involve quantitative measures of assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 15 - Regulatory Matters (continued)
Quantitative measures established by regulation to ensure capital adequacy require the Bank and Company to maintain minimum amounts and ratios (set forth in the table below) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital (as defined) to average assets (as defined). In addition, the Company’s and the Bank’s regulators may impose additional capital requirements on financial institutions and their bank subsidiaries, like the Company and the Bank, beyond those provided for statutorily, which standards may be in addition to, and require higher levels of capital, than the general capital adequacy guidelines. As discussed below, the Bank has agreed to maintain certain of its capital ratios above statutory levels. As of December 31, 2010 and discussed below, the Bank failed to meet all capital adequacy requirements to which it is subject.
As of December 31, 2010, the most recent notification from the Office of the Comptroller of the Currency (“OCC”) categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. However, as noted below, the Bank anticipates that it will be required to enter into a Consent Order which will contain higher capital standards which will result in it being deemed to be “adequately capitalized” for regulatory purposes.
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 15 - Regulatory Matters (continued)
The actual capital amounts and ratios are presented in the table. Dollar amounts are presented in thousands.
As a result of a regulatory examination conducted during the first quarter of 2009, the Bank has entered into a formal written agreement in which it made certain commitments to the OCC, including commitments to, among other things, implement a written program to reduce the high level of credit risk in the Bank including strengthening credit underwriting and problem loan workouts and collections, reduce its level of criticized assets, implement a concentration risk management program related to commercial real estate lending, improve procedures related to the maintenance of the Bank’s ALLL, strengthen the Bank’s internal loan review program, strengthen the Bank’s loan workout department, and develop a liquidity plan that improves the Bank’s reliance on wholesale funding sources. The Company has taken action to comply with these requirements and does not believe compliance with these commitments will have a materially adverse impact on its operations.
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 15 - Regulatory Matters (continued)
In February 2010, the Bank agreed to an OCC requirement to maintain a minimum Tier 1 capital to average assets ratio of 9% and a minimum total capital to risk-weighted assets ratio of 13%. The OCC imposed this requirement to maintain capital at higher levels than those required by applicable federal regulations because the OCC believed that the Bank’s capital levels were less than satisfactory given the level of credit risk in the Bank, specifically the high level of nonperforming assets and provision for loan losses. As noted above, the Bank had 8.41% of Tier 1 capital to average assets and 13.25% of total capital to risk-weighted assets ratio at December 31, 2010 and thus failed to satisfy its minimum Tier 1 capital to average assets ratio. Failure to satisfy such requirement could result in further enforcement action by the OCC.
In the fourth quarter of 2010, the OCC informed the Bank that, because the OCC does not believe that the Bank has fully satisfied the requirements of the formal written agreement, it will be requested to replace the formal written agreement with a consent order (the “Consent Order”) containing commitments for further improvements in the Bank’s operations. While the requirements of the Consent Order are not currently known to the Bank, the OCC has informed the Bank’s management that the Consent Order will likely contain provisions similar to those currently contained in the existing minimum capital commitment that the Bank made to the OCC in connection with the Bank’s entering into the formal written agreement, requiring the Bank to maintain a minimum Tier 1 leverage capital ratio of 9% and a minimum total risk-based capital ratio of 13%. If the Bank fails to comply with the requirements of the Consent Order, the OCC may impose additional limitations, restraints, commitments or conditions on the Bank. Once the Consent Order is effective, the Bank will be deemed to be “adequately capitalized” even if the Bank’s capital ratios exceed those minimum amounts necessary to be considered “well capitalized” under federal banking regulations as well as the minimum ratios set forth in the Consent Order.
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 15 - Regulatory Matters (continued)
Dividend restrictions:
The Company’s principal source of funds for dividend payments is dividends received from the Bank. The Bank is subject to limitations on the payment of dividends to the Company under federal banking laws and the regulations of the OCC. The Company is also subject to limits on payment of dividends to its shareholders by the rules, regulations and policies of federal banking authorities. Under these regulations, the amount of dividends that may be paid in any calendar year is limited to the current year’s net profits, combined with the retained net profits of the preceding two years, subject to the capital requirements described above.
As of December 31, 2010, pursuant to federal banking regulations and due to losses incurred during 2009 and 2010, the Company and Bank may not, without the prior approval of their respective banking authorities, pay any dividends until such time that current year profits exceed the net losses and dividends of the prior two years. Generally, federal regulatory policy discourages payment of holding company or bank dividends if the holding company or its subsidiaries are experiencing losses.
Supervisory guidance from the Federal Reserve Board indicates that bank holding companies that are experiencing financial difficulties generally should eliminate, reduce or defer dividends on Tier 1 capital instruments including trust preferred securities, preferred stock or common stock, if the holding company needs to conserve capital for safe and sound operation and to serve as a source of strength to its subsidiaries. The Company has informally committed to the Federal Reserve Board that it will not (1) declare or pay dividends on the Company’s common or preferred stock, or (2) incur any additional indebtedness without in each case, the prior written approval of the Federal Reserve Board.
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 16 - Other Comprehensive Income (Loss)
Other comprehensive income (loss) consists of unrealized holding gains and losses on securities available for sale. A summary of other comprehensive income (loss) and the related tax effects for the years ended December 31, 2010 and 2009 is as follows:
Note 17 - Earnings (Loss) Per Common Share
Basic earnings (loss) per share represents income (loss) available to common stockholders divided by the weighted-average number of common shares outstanding during the period. Diluted earnings (loss) per share reflects additional common shares that would have been outstanding if dilutive potential common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income (loss) that would result from the assumed issuance.
Potential common shares that may be issued by the Company relate to outstanding stock options, determined using the treasury stock method.
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 17 - Earnings (Loss) Per Common Share (continued)
Earnings (loss) per common share have been computed based on the following:
Potential common shares that would have the effect of decreasing diluted loss per share are considered to be antidilutive and therefore not included in calculating diluted loss per share. During the year ended December 31, 2009, due to the net loss, there were 19,315 shares excluded from this calculation although the exercise price for such shares’ underlying options was less than the fair value of the Company’s common stock. For the year ended December 31, 2010, the exercise price of all outstanding options was greater than the fair value of the Company’s stock.
Note 18 - Recent Accounting Pronouncements
FASB ASC 810 Consolidation (“ASC 810”) was amended to change how a company determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. The determination of whether a company is required to consolidate an entity is based on, among other things, an entity’s purpose and design and a company’s ability to direct the activities of the entity that most significantly impact the entity’s economic performance. The new authoritative accounting guidance requires additional disclosures about the reporting entity’s involvement with variable-interest entities and any significant changes in risk exposure due to that involvement as well as its affect on the entity’s financial statements. The new authoritative accounting guidance under ASC 810 was effective January 1, 2010 and did not have a significant impact on our financial statements.
FASB ASC 860 Transfers and Servicing (“ASC 860”) was amended to enhance reporting about transfers of financial assets, including securitizations, and where companies have continuing exposure to the risks related to transferred financial assets. The new authoritative accounting guidance eliminates the concept of a “qualifying special-purpose entity” and changes the requirements for derecognizing financial assets. The new authoritative accounting guidance also requires additional disclosures about all continuing involvements with transferred financial assets including information about gains and losses resulting from transfers during the period. The new authoritative accounting guidance under ASC 860 was effective January 1, 2010 and did not have a significant impact on our financial statements.
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 18 - Recent Accounting Pronouncements (continued)
FASB ASC 310 Receivables (“ASC 310”) was amended to enhance disclosures about credit quality of financing receivables and the allowance for credit losses. The amendments require an entity to disclose credit quality information, such as internal risk gradings, more detailed nonaccrual and past due information, and modifications of its financing receivables. The disclosures under ASC 310, as amended, were effective for interim and annual reporting periods ending on or after December 15, 2010. We do not expect this amendment to have a significant impact on our financial results, but it will significantly expand the disclosures that we are required to provide, some of which are included in this annual filing, as required, with additional disclosures included in future filings.
FASB ASU No. 2010-06 Improving Disclosures About Fair Value Measurements (“ASU 2010-06”) amended guidance for fair value measurements and disclosures to clarify and provide additional disclosure requirements related to recurring and non-recurring fair value measurements. The update requires new disclosures for transfers in and out of Levels 1 and 2, and requires a reconciliation to be provided for the activity in Level 3 fair value measurements. A reporting entity should disclose separately the amounts of significant transfers in and out of Levels 1 and 2 and provide an explanation for the transfers. This guidance was effective for interim periods beginning after December 15, 2009, and did not have a material effect on the Company’s results of operations or financial position.
In the reconciliation for fair value measurements using observable inputs (Level 3) a reporting entity should present separately information about purchases, sales, issuances, and settlements on a gross basis rather than a net basis. Disclosures relating to purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurement will become effective beginning after December 15, 2010, and for interim periods within those fiscal years. The adoption of this standard is not expected to have a material effect on the Company’s results of operations or financial position.
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 19 - Condensed Parent Information
BALANCE SHEETS
STATEMENTS OF INCOME (LOSS)
MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 19 - Condensed Parent Information (continued)
STATEMENTS OF CASH FLOWS