CECIL BANCORP INC - Annual Report: 2008 (Form 10-K)

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-K

(Mark One)

For the Fiscal Year Ended December 31, 2008

or

For the transition period from _________________ to __________________

 

Commission File Number: 0-24926

 

 

 

 

Registrant’s telephone number, including area code: (410) 398-1650.

Securities registered pursuant to Section 12(b) of the Act: None.

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, par value $0.01 per share

(Title of Class)

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.         Yes x No o

 

Indicate by check mark if disclosure of delinquent filers in response to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.        o

 

Indicate by a check mark if the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “accelerated filer,” “large accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act:

 

 

 

As of March 27, 2009 the registrant had 3,689,346 shares of Common Stock issued and outstanding. The aggregate market value of shares held by nonaffiliates on such date was approximately $15.3 million based on the closing sale price of $8.22 per share of the Registrant’s Common Stock on June 30, 2008. For purposes of this calculation, it is assumed that the 1,825,837 shares held by directors and officers of the Registrant are shares held by affiliates.

 

Documents Incorporated by Reference: Part III: Portions of the registrant’s definitive proxy statement for the 2009 Annual Meeting.

 

 

CECIL BANCORP, INC.

ANNUAL REPORT ON FORM 10-K

for the fiscal year ended December 31, 2008

 

 

 

CAUTION ABOUT FORWARD-LOOKING STATEMENTS

 

Cecil Bancorp, Inc. (“Cecil Bancorp” or the “Company”) makes forward-looking statements in this Form 10-K that are subject to risks and uncertainties. These forward-looking statements include:

 

 

These forward-looking statements are subject to significant uncertainties because they are based upon or are affected by:

 

 

Because of these uncertainties, the actual future results may be materially different from the results indicated by these forward-looking statements. In addition, Cecil Bancorp’s past results of operations do not necessarily indicate its future results.

 

PART I

 

Item 1. Business

 

General

Cecil Bancorp, Inc. (the “Company”) is the holding company for Cecil Bank (the “Bank”). The Company is a financial holding company subject to regulation by the Board of Governors of the Federal Reserve System (“Federal Reserve”). The Bank is a Maryland chartered commercial bank, is a member of the Federal Reserve System and the Federal Home Loan Bank (“FHLB”) of Atlanta, and is an Equal Housing Lender. Its deposits are insured by the Deposit Insurance Fund (“DIF”) of the Federal Deposit Insurance Corporation (“FDIC”). The Bank commenced operations in 1959 as a Federal savings and loan association. On October 1, 2002, the Bank converted from a stock federal savings bank to a Maryland commercial bank. Its deposits have been federally insured up to applicable limits, and it has been a member of the FHLB system since 1959.

 

 

The Bank conducts it business through its main office in Elkton, Maryland, and branches in Elkton, North East, Fair Hill, Rising Sun, Cecilton, Aberdeen, Conowingo, and Havre de Grace, Maryland.

The Bank’s business strategy is to operate as an independent community-oriented commercial bank dedicated to real estate, commercial, and consumer lending, funded primarily by retail deposits. The Bank has sought to implement this strategy by (1) continuing to emphasize residential mortgage lending through the origination of adjustable-rate mortgage loans while increasing its construction, commercial real estate, other commercial, and consumer lending portfolios; (2) investing in adjustable-rate and short-term liquid investments; (3) controlling interest rate risk exposure; (4) maintaining asset quality; (5) containing operating expenses; and (6) maintaining “well capitalized” status. The Company offers a full range of brokerage and investment services through a relationship with Community Bankers Securities, LLC.

On December 23, 2008, as part of the Troubled Asset Relief Program (“TARP”) Capital Purchase Program, the Company sold 11,560 shares of Fixed Rate Cumulative Perpetual Preferred Stock, Series A (the “Series A Preferred Stock”), and a warrant to purchase 261,538 shares of the Company’s common stock to the United States Department of the Treasury for an aggregate purchase price of $11.560 million in cash, with $37,000 in offering costs, and net proceeds of $11.523 million. The Preferred Stock and the warrant were issued in a private placement exempt from registration pursuant to Section 4(2) of the Securities Act of 1933, as amended.

The Series A Preferred Stock qualifies as Tier 1 capital and will pay cumulative dividends at a rate of 5% per annum for the first five years, and 9% per annum thereafter. The preferred stock may be redeemed by the Company after three years. Prior to the end of the three years, the preferred stock may be redeemed by the Company only with proceeds from the sale of qualifying equity securities of the Company.

The warrant has a 10-year term and is immediately exercisable upon its issuance, with an exercise price, subject to anti-dilution adjustments, equal to $6.63 per share of common stock. The Treasury has agreed not to exercise voting power with respect to any shares of common stock issued upon exercise of the warrant.

In the event of any liquidation, dissolution or winding up of the affairs of the Company, whether voluntary or involuntary, holders of the Series A Preferred Stock shall be entitled to receive for each share of the Series A Preferred Stock, out of the assets of the Company or proceeds thereof (whether capital or surplus) available for distribution to stockholders of the Company, subject to the rights of any creditors of the Company, before any distribution of such assets or proceeds is made to or set aside for the holders of common stock and any other stock of the Company ranking junior to the Series A Preferred Stock as to such distribution, payment in full in an amount equal to the sum of (i) the liquidation amount of $1,000 per share and (ii) the amount of any accrued and unpaid dividends, whether or not declared, to the date of payment.

The Company’s and the Bank’s principal executive office is at 127 North Street, Elkton, Maryland 21921, and its telephone number is (410) 398-1650. The Company maintains a website at www.cecilbank.com.

 

 

REGULATION, SUPERVISION, AND GOVERNMENTAL POLICY

Following is a brief summary of certain statutes and regulations that significantly affect the Company and the Bank. A number of other statutes and regulations affect the Company and the Bank but are not summarized below.

Holding Company Regulation. The Company is registered as a holding company under the Bank Holding Company Act of 1956 and, as such, is subject to supervision and regulation by the Federal Reserve. As a holding company, the Company is required to furnish to the Federal Reserve annual and quarterly reports of its operations and additional information and reports. The Company is also subject to regular examination by the Federal Reserve.

 

The Bank Holding Company Act also limits the investments and activities of bank holding companies. In general, a bank holding company is prohibited from acquiring direct or indirect ownership or control of more than 5% of the voting shares of a company that is not a bank or a bank holding company or from engaging directly or indirectly in activities other than those of banking, managing or controlling banks, providing services for its subsidiaries, non-bank activities that are closely related to banking, and other financially related activities. The activities of the Company are subject to these legal and regulatory limitations under the Bank Holding Company Act and Federal Reserve regulations.

 

The Company has elected to become a financial holding company within the meaning of the Gramm-Leach-Bliley Act. Financial holding companies are authorized by statute to engage in a number of financial activities previously impermissible for bank holding companies, including securities underwriting, dealing and market making; sponsoring mutual funds and investment companies; insurance underwriting and agency; and merchant banking activities. The Federal Reserve and the Treasury Department may authorize additional activities for financial holding companies if they are “financial in nature” or “incidental” to financial activities. A bank holding company may only remain a financial holding company as long as each of its subsidiary banks is well capitalized, well managed, and has at least a “satisfactory” CRA rating. A financial holding company must provide notice to the Federal Reserve within 30 days after commencing activities previously determined by statute or by the Federal Reserve and Department of the Treasury to be permissible.

 

If the Bank ceases to be “well capitalized” or “well managed,” the Company will not be in compliance with the requirements of the Bank Holding Company Act regarding financial holding companies. If a financial holding company is notified by the Federal Reserve of such a change in the ratings of any of its subsidiary banks, it must take certain corrective actions within specified time frames. Furthermore, if the Bank were to receive a CRA rating of less than “satisfactory,” then the Company would be prohibited from engaging in new activities or acquiring companies other than bank holding companies, banks or savings associations until the rating is raised to “satisfactory” or better.

 

The Federal Reserve has the power to order a holding company or its subsidiaries to terminate any activity, or to terminate its ownership or control of any subsidiary, when it has reasonable cause to believe that the continuation of such activity or such ownership or control constitutes a serious risk to the financial safety, soundness, or stability of any bank subsidiary of that holding company.

 

Under the Bank Holding Company Act of 1956, a bank holding company must obtain the prior approval of the Federal Reserve before (i) acquiring direct or indirect ownership or control of any class of voting securities of any bank or bank holding company if, after the acquisition, the bank holding company would directly or indirectly own or control more than 5% of the class; (2) acquiring all or substantially all of the assets of another bank or bank holding company; or (3) merging or consolidating with another bank holding company.

 

 

 

Under the Bank Holding Company Act, any company must obtain approval of the Federal Reserve prior to acquiring control of the Company or the Bank. For purposes of the Bank Holding Company Act, “control” is defined as ownership of 25% or more of any class of voting securities of the Company or the Bank, the ability to control the election of a majority of the directors, or the exercise of a controlling influence over management or policies of the Company or the Bank.

 

The Bank Holding Company Act permits the Federal Reserve to approve an application of bank holding company to acquire control of, or acquire all or substantially all of the assets of, a bank located in a state other than that holding company’s home state. The Federal Reserve may not approve the acquisition of a bank that has not been in existence for the minimum time period (not exceeding five years) specified by the statutory law of the host state. The Bank Holding Company Act also prohibits the Federal Reserve from approving an application if the applicant (and its depository institution affiliates) controls or would control more than 10% of the insured deposits in the United States or 30% or more of the deposits in the target bank’s home state or in any state in which the target bank maintains a branch. The Bank Holding Company Act does not affect the authority of states to limit the percentage of total insured deposits in the state which may be held or controlled by a bank or bank holding company to the extent such limitation does not discriminate against out-of-state banks or bank holding companies. The State of Maryland allows out-of-state financial institutions to establish branches in Maryland, subject to certain limitations.

 

The Change in Bank Control Act and the related regulations of the Federal Reserve require any person or persons acting in concert (except for companies required to make application under the Holding Company Act), to file a written notice with the Federal Reserve before the person or persons acquire control of the Company or the Bank. The Change in Bank Control Act defines “control” as the direct or indirect power to vote 25% or more of any class of voting securities or to direct the management or policies of a bank holding company or an insured bank.

 

The Federal Reserve has adopted guidelines regarding the capital adequacy of bank holding companies, which require bank holding companies to maintain specified minimum ratios of capital to total assets and capital to risk-weighted assets. See “Regulatory Capital Requirements.”

 

The Federal Reserve has the power to prohibit dividends by bank holding companies if their actions constitute unsafe or unsound practices. The Federal Reserve has issued a policy statement on the payment of cash dividends by bank holding companies, which expresses the Federal Reserve’s view that a bank holding company should pay cash dividends only to the extent that the company’s net income for the past year is sufficient to cover both the cash dividends and a rate of earnings retention that is consistent with the company’s capital needs, asset quality, and overall financial condition. In a recent Supervisory Letter, the Federal Reserve staff has stated that, as a general matter, bank holding companies should eliminate cash dividends if net income available to shareholders for the past four quarters, net of dividends previously paid, is not sufficient to fully fund the dividend.

 

Bank Regulation. The Bank became a Maryland chartered bank on October 1, 2002. The Bank is a member of the Federal Reserve System and is subject to supervision by the Federal Reserve and the State of Maryland. Deposits of the Bank are insured by the FDIC to the legal maximum for each insured depositor. Deposits, reserves, investments, loans, consumer law compliance, issuance of securities, payment of dividends, establishment of branches, mergers and acquisitions, corporate activities, changes in control, electronic funds transfers, responsiveness to community needs, management practices, compensation policies, and other aspects of operations are subject to regulation by the appropriate federal and state supervisory authorities. In addition, the Bank is subject to numerous federal, state and local laws and regulations which set forth specific restrictions and procedural requirements with respect to

 

 

extensions of credit (including to insiders), credit practices, disclosure of credit terms and discrimination in credit transactions.

 

The Federal Reserve regularly examines the operations and condition of the Bank, including, but not limited to, its capital adequacy, reserves, loans, investments, and management practices. These examinations are for the protection of the Bank’s depositors and the federal Deposit Insurance Fund. In addition, the Bank is required to furnish quarterly and annual reports to the Federal Reserve. The Federal Reserve’s enforcement authority includes the power to remove officers and directors and the authority to issue cease-and-desist orders to prevent a bank from engaging in unsafe or unsound practices or violating laws or regulations governing its business.

 

The Federal Reserve has adopted regulations regarding the capital adequacy, which require member banks to maintain specified minimum ratios of capital to total assets and capital to risk-weighted assets. See “Regulatory Capital Requirements.” Federal Reserve and State regulations limit the amount of dividends that the Bank may pay to the Company.

 

The Bank is subject to restrictions imposed by federal law on extensions of credit to, and certain other transactions with, the Company and other affiliates, and on investments in their stock or other securities. These restrictions prevent the Company and the Bank’s other affiliates from borrowing from the Bank unless the loans are secured by specified collateral, and require those transactions to have terms comparable to terms of arms-length transactions with third persons. In addition, secured loans and other transactions and investments by the Bank are generally limited in amount as to the Company and as to any other affiliate to 10% of the Bank’s capital and surplus and as to the Company and all other affiliates together to an aggregate of 20% of the Bank’s capital and surplus. Certain exemptions to these limitations apply to extensions of credit and other transactions between the Bank and its subsidiaries. These regulations and restrictions may limit the Company’s ability to obtain funds from the Bank for its cash needs, including funds for acquisitions and for payment of dividends, interest, and operating expenses.

 

Under Federal Reserve regulations, banks must adopt and maintain written policies that establish appropriate limits and standards for extensions of credit secured by liens or interests in real estate or are made for the purpose of financing permanent improvements to real estate. These policies must establish loan portfolio diversification standards; prudent underwriting standards, including loan-to-value limits, that are clear and measurable; loan administration procedures; and documentation, approval, and reporting requirements. A bank’s real estate lending policy must reflect consideration of the Interagency Guidelines for Real Estate Lending Policies (the “Interagency Guidelines”) adopted by the federal bank regulators. The Interagency Guidelines, among other things, call for internal loan-to-value limits for real estate loans that are not in excess of the limits specified in the Guidelines. The Interagency Guidelines state, however, that it may be appropriate in individual cases to originate or purchase loans with loan-to-value ratios in excess of the supervisory loan-to-value limits.

 

Deposit Insurance. The Bank’s deposits are insured to applicable limits by the Federal Deposit Insurance Corporation. Pursuant to the Emergency Economic Stabilization Act of 2008, the maximum deposit insurance amount has been increased from $100,000 to $250,000 until December 31, 2009. On October 13, 2008, the FDIC established a Temporary Liquidity Guarantee Program under which the FDIC will fully guarantee all non-interest-bearing transaction accounts until December 31, 2009 (the “Transaction Account Guarantee Program”) and all senior unsecured debt of insured depository institutions or their qualified holding companies issued between October 14, 2008 and October 31, 2009 that matures prior to December 31, 2012 (the “Debt Guarantee Program”). Senior unsecured debt would include federal funds purchased and certificates of deposit standing to the credit of the bank. After November 12, 2008, institutions that did not opt out of the program by December 5, 2008 are assessed at the rate of ten basis points for transaction account balances in excess of $250,000 and at a rate of between

 

 

50 and 100 basis points of the amount of debt issued. Participating holding companies that have not issued FDIC-guaranteed debt prior to April 1, 2009 must apply to remain in the Debt Guarantee Program. Participating institutions will be subject to surcharges for debt issued after that date. The Bank is currently participating in both the Transaction Account Guarantee Program and the Debt Guarantee Program but Cecil Bancorp, Inc. will not remain in the Debt Guarantee Program.

 

The FDIC has adopted a risk-based premium system that provides for quarterly assessments based on an insured institution’s ranking in one of four risk categories based on their examination ratings and capital ratios. Well-capitalized institutions with the CAMELS ratings of 1 or 2 are grouped in Risk Category I and have been assessed for deposit insurance at an annual rate of between five and seven basis points with the assessment rate for an individual institution determined according to a formula based on a weighted average of the institution’s individual CAMELS component ratings plus either five financial ratios or the average ratings of its long-term debt. Institutions in Risk Categories II, III and IV have been assessed at annual rates of 10, 28 and 43 basis points, respectively.

 

For the quarter beginning January 1, 2009, the FDIC has raised the base annual assessment rate for institutions in Risk Category I to between 12 and 14 basis points while the base annual assessment rates for institutions in Risk Categories II, III and IV have been increased to 17, 35 and 50 basis points, respectively. For the quarter beginning April 1, 2009 the FDIC has set the base annual assessment rate for institutions in Risk Category I at between 12 and 16 basis points and the base annual assessment rates for institutions in Risk Categories II, III and IV at 22, 32 and 45 basis points, respectively. An institution’s assessment rate could be lowered by as much as five basis points based on the ratio of its long-term unsecured debt to deposits or, for smaller institutions, the ratio of certain amounts of Tier 1 capital to deposits. The assessment rate would be adjusted for Risk Category I institutions that have a high level of brokered deposits and have experienced higher levels of asset growth (other than through acquisitions) and could be increased by as much as ten basis points for institutions in Risk Categories II, III and IV whose ratio of brokered deposits to deposits exceeds 10% of assets. Reciprocal deposit arrangements like CDARS would count as brokered deposits for Risk Category II, III and IV institutions but not for institutions in Risk Category I. An institution’s base assessment rate would also be increased if an institution’s ratio of secured liabilities (including FHLB advances and repurchase agreements) to deposits exceeds 25%. The maximum adjustment for secured liabilities for institutions in Risk Categories I, II, III and IV would be 8, 11, 16 and 22.5 basis points, respectively, provided that the adjustment may not increase the base assessment rate by more than 50%. The FDIC has further proposed to collect a special assessment of 20 basis points based on insured deposits as of June 30, 2009. The special assessment would be payable on September 30, 2009. The FDIC, however, has indicated that it will reduce the special assessment to 10 basis points if its line of credit from the U.S. Treasury is increased.

 

Regulatory Capital Requirements. The Federal Reserve has established guidelines for maintenance of appropriate levels of capital by bank holding companies and member banks. The regulations impose two sets of capital adequacy requirements: minimum leverage rules, which require bank holding companies and banks to maintain a specified minimum ratio of capital to total assets, and risk-based capital rules, which require the maintenance of specified minimum ratios of capital to “risk-weighted”

 

The regulations of the Federal Reserve in effect at December 31, 2008, do not impose capital ratio requirements on bank holding companies with assets of less than $500 million that do not engage in a material amount of non-banking activities, conduct significant off-balance sheet activities or have outstanding a material amount of debt or equity securities that are registered with the SEC (other than trust preferred securities). The Company is, therefore, not subject to the Federal Reserves capital ratio requirements. The Bank, however, is fully subject to the Federal Reserve’s capital standards. The regulations of the Federal Reserve in effect at December 31, 2008, required all member banks to maintain a minimum leverage ratio of “Tier 1 capital” (as defined in the risk-based capital guidelines discussed in the

 

 

following paragraphs) to total assets of 3.0%. The capital regulations state, however, that only the strongest bank holding companies and banks, with composite examination ratings of 1 under the rating system used by the federal bank regulators, would be permitted to operate at or near this minimum level of capital. All other banks are expected to maintain a leverage ratio of at least 1% to 2% above the minimum ratio, depending on the assessment of an individual organization’s capital adequacy by its primary regulator. A bank experiencing or anticipating significant growth is expected to maintain capital well above the minimum levels. In addition, the Federal Reserve has indicated that it also may consider the level of an organization’s ratio of tangible Tier 1 capital (after deducting all intangibles) to total assets in making an overall assessment of capital.

 

In general, the risk-based capital rules of the Federal Reserve in effect at December 31, 2008, required member banks to maintain minimum levels based upon a weighting of their assets and off-balance sheet obligations according to risk. The risk-based capital rules have two basic components: a core capital (Tier 1) requirement and a supplementary capital (Tier 2) requirement. Core capital consists primarily of common stockholders’ equity, noncumulative perpetual preferred stock, and minority interests in the equity accounts of consolidated subsidiaries; less all intangible assets, except for certain mortgage servicing rights and purchased credit card relationships. Supplementary capital elements include, subject to certain limitations, the allowance for losses on loans and leases; perpetual preferred stock that does not qualify as Tier 1 capital; long-term preferred stock with an original maturity of at least 20 years from issuance; hybrid capital instruments, including perpetual debt and mandatory convertible securities; subordinated debt, intermediate-term preferred stock, and up to 45% of pre-tax net unrealized gains on available for sale equity securities.

 

The risk-based capital regulations assign balance sheet assets and credit equivalent amounts of off-balance sheet obligations to one of four broad risk categories based principally on the degree of credit risk associated with the obligor. The assets and off-balance sheet items in the four risk categories are weighted at 0%, 20%, 50%, and 100%. These computations result in the total risk-weighted assets.

 

The risk-based capital regulations require all commercial banks to maintain a minimum ratio of total capital to total risk-weighted assets of 8%, with at least 4% as core capital. For the purpose of calculating these ratios: (i) supplementary capital is limited to no more than 100% of core capital; and (ii) the aggregate amount of certain types of supplementary capital is limited. In addition, the risk-based capital regulations limit the allowance for credit losses that may be included in capital to 1.25% of total risk-weighted assets.

 

The federal bank regulatory agencies have established a joint policy regarding the evaluation of commercial banks’ capital adequacy for interest rate risk. Under the policy, the Federal Reserve’s assessment of a bank’s capital adequacy includes an assessment of the bank’s exposure to adverse changes in interest rates. The Federal Reserve has determined to rely on its examination process for such evaluations rather than on standardized measurement systems or formulas. The Federal Reserve may require banks that are found to have a high level of interest rate risk exposure or weak interest rate risk management systems to take corrective actions. Management believes its interest rate risk management systems and its capital relative to its interest rate risk are adequate.

 

Federal banking regulations also require banks with significant trading assets or liabilities to maintain supplemental risk-based capital based upon their levels of market risk. The Bank did not have significant levels of trading assets or liabilities during 2008, and was not required to maintain such supplemental capital.

 

The Federal Reserve has established regulations that classify banks by capital levels and provide for the Federal Reserve to take various “prompt corrective actions” to resolve the problems of any bank that

 

 

fails to satisfy the capital standards. Under these regulations, a well-capitalized bank is one that is not subject to any regulatory order or directive to meet any specific capital level and that has a total risk-based capital ratio of 10% or more, a Tier 1 risk-based capital ratio of 6% or more, and a leverage ratio of 5% or more. An adequately capitalized bank is one that does not qualify as well-capitalized but meets or exceeds the following capital requirements: a total risk-based capital ratio of 8%, a Tier 1 risk-based capital ratio of 4%, and a leverage ratio of either (i) 4% or (ii) 3% if the bank has the highest composite examination rating. A bank that does not meet these standards is categorized as undercapitalized, significantly undercapitalized, or critically undercapitalized, depending on its capital levels. A bank that falls within any of the three undercapitalized categories established by the prompt corrective action regulation is subject to severe regulatory sanctions. As of December 31, 2008, the Bank was well capitalized as defined in the Federal Reserve’s regulations.

 

For additional information regarding the Company’s and the Bank’s compliance with their respective regulatory capital requirements, see Note 13, “Regulatory Matters,” to the consolidated financial statements.

 

Supervision and Regulation of Mortgage Banking Operations. The Company’s mortgage banking business is subject to the rules and regulations of the U.S. Department of Housing and Urban Development (“HUD”), the Federal Housing Administration (“FHA”), the Veterans’ Administration (“VA”), and FNMA with respect to originating, processing, selling, and servicing mortgage loans. Those rules and regulations, among other things, prohibit discrimination and establish underwriting guidelines, which include provisions for inspections and appraisals, require credit reports on prospective borrowers, and fix maximum loan amounts. Lenders such as the Company are required annually to submit to FNMA, FHA and VA audited financial statements, and each regulatory entity has its own financial requirements. The Company’s affairs are also subject to examination by the Federal Reserve, FNMA, FHA and VA at all times to assure compliance with the applicable regulations, policies, and procedures. Mortgage origination activities are subject to, among others, the Equal Credit Opportunity Act, Federal Truth-in-Lending Act, Fair Housing Act, Fair Credit Reporting Act, the National Flood Insurance Act and the Real Estate Settlement Procedures Act and related regulations that prohibit discrimination and require the disclosure of certain basic information to mortgagors concerning credit terms and settlement costs. The Company’s mortgage banking operations also are affected by various state and local laws and regulations and the requirements of various private mortgage investors.

 

Markets

The Company’s primary market area comprises Cecil and Harford Counties in northeastern Maryland.

The Bank’s executive office, two branches, and financial and loan centers are in Elkton, Maryland, and additional Cecil County branches are located in North East, Fair Hill, Rising Sun, Cecilton, and Conowingo, Maryland. Elkton is the county seat, and has a population of approximately 12,000. The population of the Cecil County is approximately 86,000. Cecil County is located in the extreme northeast of the Chesapeake Bay, at the crux of four states - Maryland, Delaware, Pennsylvania, and New Jersey. Elkton is located about 50 miles from Philadelphia and Baltimore. One-fifth of the U.S. population resides within 300 miles of the County. Interstate I-95, the main north-south East Coast artery, bisects the County. In addition, the four lane U.S. 40 parallels the Interstate. Cecil County has over 200 miles of waterfront between five rivers and the Chesapeake Bay. Key employers include companies such as Air Products, ATK, DuPont, General Electric, W.L. Gore & Associates, IKEA and Terumo Medical, as well as State, County and Local Governments.

 

 

The Bank also operates one branch in Aberdeen and two banking offices in Havre de Grace, Maryland, in Harford County. Harford County is twenty-three miles from Baltimore and twenty miles from Wilmington, Delaware. The county is a major transportation link; Interstate 95 and mainlines for CSX Railroad and Conrail run through the County. The County’s major industrial centers along the I-95 Corridor are Aberdeen, Belcamp, Edgewood and Havre de Grace. Major private sector employers in the county include Battelle, CACI, Clorox Products Manufacturing, Custom Direct, Computer Sciences Corporation, Cytec Engineered Materials, EAI (a subsidiary of SAIC), EG&G/Lear Siegler, EPS, Frito-Lay, Independent Can, MITRE Corporation, Northrop Grumman, Nutramax Laboratories, Rite Aid, SafeNet, SAIC, Saks Fifth Avenue, Smiths Detection, SURVICE Engineering, and Upper Chesapeake Health. The U.S. Army Aberdeen Proving Ground is the major government employer in the county.

Loans and Mortgage Backed Securities

One to Four Family Residential Real Estate Lending. The Bank offers conventional mortgage loans on one- to four-family residential dwellings. Most loans are originated in amounts up to $350,000, on single-family properties located in the Bank’s primary market area. The Bank makes conventional mortgage loans, as well as loans guaranteed under the Rural Development Program of the Department of Agriculture (USDA Housing Loans). The Bank’s mortgage loan originations are generally for terms of 15, 20 and 30 years, amortized on a monthly basis with interest and principal due each month. Residential real estate loans often remain outstanding for significantly shorter periods than their contractual terms as borrowers may refinance or prepay loans at their option, without penalty. Conventional residential mortgage loans granted by the Bank customarily contain “due-on-sale” clauses that permit the Bank to accelerate the indebtedness of the loan upon transfer of ownership of the mortgaged property. The Bank uses standard Federal Home Loan Mortgage Corporation (“FHLMC”) documents, to allow for the sale of loans in the secondary mortgage market. The Bank’s lending policies generally limit the maximum loan-to-value ratio on mortgage loans secured by owner-occupied properties to 95% of the lesser of the appraised value or purchase price of the property, with the condition that private mortgage insurance is required on loans with a loan-to-value ratio in excess of 80%. Loans originated under Rural Development programs have loan-to-value ratios of up to 100% due to the guarantees provided by those agencies. The substantial majority of loans in the Bank’s loan portfolio have loan-to-value ratios of 80% or less.

The Bank offers adjustable-rate mortgage loans with terms of up to 40 years. Adjustable-rate loans offered by the Bank include loans which reprice every one, three or five years and provide for an interest rate which is based on the interest rate paid on U.S. Treasury securities of a corresponding term. All newly originated residential adjustable rate mortgage loans have interest rate adjustments limited to three percentage points annually with no interest rate ceiling over the life of the loan. New loans also have an interest rate floor imbedded within the promissory note. Previously originated loans contain a limit of two percentage points annually and six percentage points over the life of the loan.

The Bank retains all adjustable-rate mortgages it originates, which are designed to reduce the Bank’s exposure to changes in interest rates. The retention of adjustable-rate mortgage loans in the Bank’s loan portfolio helps reduce the Bank’s exposure to increases in interest rates. However, there are unquantifiable credit risks resulting from potential increased costs to the borrower as a result of repricing of adjustable-rate mortgage loans. It is possible that during periods of rising interest rates, the risk of default on adjustable-rate mortgage loans may increase due to the upward adjustment of interest cost to the borrower.

The Bank also originates conventional fixed-rate mortgages with terms of 15, 20, 30 or 40 years. The Bank has originated all fixed-rate mortgage loans in recent years for sale in the secondary mortgage market, and a substantial majority of all fixed-rate loans originated since 1990 have been sold, primarily to the FHLMC, with servicing retained by the Bank. Management assesses its fixed rate loan originations

 

 

on an ongoing basis to determine whether the Bank’s portfolio position warrants the loans being sold or held in the Bank’s portfolio.

During the year ended December 31, 2008, the Bank originated $76.0 million in adjustable-rate mortgage loans and $8.1 million in fixed-rate mortgage loans. The Bank also offers second mortgage loans. These loans are secured by a junior lien on residential real estate. The total of first and second liens may not exceed a 90% loan to value ratio. Loans have terms of 5, 10 and 15 years and have fixed rates. The Bank offers home equity lines of credit, which are secured by a junior lien on residential real estate. Customers are approved for a line of credit that provides for an interest rate, which varies monthly, and customers pay 2% of the balance per month.

Construction and Land Loans. The Bank’s construction lending has primarily involved lending for construction of single-family residences, although the Bank does lend funds for the construction of commercial properties and multi-family real estate. All loans for the construction of speculative sale homes have a loan value ratio of not more than 80%. The Bank has financed the construction of non-residential properties on a case by case basis. Loan proceeds are disbursed during the construction phase according to a draw schedule based on the stage of completion. Construction projects are inspected by contracted inspectors or bank personnel. Construction loans are underwritten on the basis of the estimated value of the property as completed.

 

The Bank also, from time to time, originates loans secured by raw land. Land loans granted to individuals have a term of up to 10 years and interest rates adjust every one, three or five years. Land loans granted to developers have terms of up to three years. The substantial majority of land loans have a loan-to-value ratio not exceeding 75%. The Bank may expand its lending on raw land, as market conditions allow, to qualified borrowers experienced in the development and sale of raw land. Loans involving construction financing and loans on raw land have a higher level of risk than loans for the purchase of existing homes since collateral values, land values, development costs and construction costs can only be estimated at the time the loan is approved. The Bank has sought to minimize its risk in construction lending and in lending for the purchase of raw land by offering such financing primarily to builders and developers to whom the Bank has loaned funds in the past and to persons who have previous experience in such projects. The Bank also limits construction lending and loans on raw land to its market area, with which management is familiar, except in conjunction with participated loans.

 

Multi-Family and Commercial Real Estate Lending. The Bank originates loans on multi-family residential and commercial properties in its market area. Loans secured by multi-family and commercial real estate generally are larger and involve greater risks than one- to four-family residential mortgage loans. Because payments on loans secured by such properties are often dependent on successful operation or management of the properties, repayment of such loans may be subject to a greater extent to adverse conditions in the real estate market or the economy. The Bank seeks to minimize these risks in a variety of ways, including limiting the size and loan-to-value ratios of its multi-family and commercial real estate loans. The Bank’s permanent multi-family and commercial real estate loans are typically secured by retail or wholesale establishments, motels/hotels, service industries and industrial or warehouse facilities. The Bank has a concentration in commercial real estate loans secured by retail or wholesale establishments, with $46.3 million, or 11.3%, of the portfolio secured by these properties. Multi-family and commercial real estate loans generally have terms of 20 to 40 years, are either tied to the prime rate or have interest rate adjustments every one, three or five years. These adjustable rate loans have no interest rate change limitations, either annually or over the life of the loan. The loans are also subject to imbedded interest rate floors with no interest rate ceiling over the life of the loan. Multi-family and commercial mortgages are generally made in amounts not exceeding 80% of the lesser of the appraised value or purchase price of the property. Interest rates on commercial real estate loans are negotiated on a loan-by-loan basis.

 

 

Commercial Business Loans. The Bank offers commercial business loans and both secured and unsecured loans and letters of credit, or lines of credit for businesses located in its primary market area. Most business loans have a one year term, while lines of credit can remain open for longer periods. All owners, partners, and officers must sign the loan agreement. The security for a business loan depends on the amount borrowed, the business involved, and the strength of the borrower’s firm. Commercial business lending entails significant risk, as the payments on such loans may depend upon the successful operation or management of the business involved. Although the Bank attempts to limit its risk of loss on such loans by limiting the amount and the term, and by requiring personal guarantees of principals of the business (when additional guarantees are deemed necessary by management), the risk of loss on commercial business loans is substantially greater than the risk of loss from residential real estate lending.

 

Consumer Lending. Consumer loans generally involve more risk than first mortgage loans. Repossessed collateral for a defaulted loan may not provide an adequate source of repayment of the outstanding loan balance as a result of damage, loss, or depreciation, and the remaining deficiency often does not warrant further substantial collection efforts against the borrower. In addition, loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Further, the application of various federal and state laws, including federal and state bankruptcy and insolvency laws, may limit the amount that can be recovered. These loans may also give rise to claims and defenses by a borrower against the Bank, and a borrower may be able to assert against the Bank claims and defenses that it has against the seller of the underlying collateral.

 

The Bank’s consumer loans consist of automobile loans, deposit account loans, home improvement loans, and other consumer loans. Consumer loans are generally offered for terms of up to five years at fixed interest rates. Management expects to continue to promote consumer loans as part of its strategy to provide a wide range of personal financial services to its customers and as a means to increase the yield on the Bank’s loan portfolio. The Bank makes loans for automobiles and recreational vehicles, both new and used, directly to the borrowers. The loans can be for up to the lesser of 100% of the purchase price or the retail value listed by the National Automobile Dealers Association. The terms of the loans are determined by the condition of the collateral. Collision insurance policies are required on all these loans, unless the borrower has substantial other assets and income. The Bank makes deposit account loans for up to 90% of the amount of the depositor’s account balance. The maximum amount of the loan takes into consideration the amount of interest due. The term of the loan is either interest due monthly on demand, or a term loan not to exceed 5 years. The interest rate is 2% higher than the rate being paid on the deposit account. The Bank also makes other consumer loans, which may or may not be secured. The term of the loans usually depends on the collateral. Unsecured loans usually do not exceed $100,000 and have a term of no longer than 12 months. Consumer loans are generally originated at higher interest rates than residential mortgage loans but also tend to have a higher risk than residential loans due to the loan being unsecured or secured by rapidly depreciable assets.

 

Loan Solicitation and Processing. The Bank’s lending activities are subject to written, non-discriminatory underwriting standards and loan origination procedures outlined in loan policies established by its board of directors. Detailed loan applications are obtained to determine the borrower’s ability to repay, and the more significant items on these applications are verified through the use of credit reports, financial statements, and confirmations. Property valuations required by policy are performed by independent outside appraisers approved by the board of directors. With certain limited exceptions, the maximum amount that the Bank may lend to any borrower (including certain related entities of the borrower) at any one time may not exceed 15% of the unimpaired capital and surplus of the institution, plus an additional 10% of unimpaired capital and surplus for loans fully secured by readily marketable collateral. Under these limits, at December 31, 2008, the Bank’s loans to one borrower cannot exceed $8,932,000.

 

 

 

Loan Originations and Sales. Loan originations are derived from a number of sources. Residential mortgage loan originations primarily come from walk-in customers and referrals by realtors, depositors, and borrowers. Applications are taken at all offices, but are processed by the Bank and submitted for approval, as noted above. The Bank has not purchased loans in the secondary mortgage market. All fixed-rate loans are originated according to FHLMC guidelines and, depending on market conditions, may be sold to FHLMC after origination. The Bank retains servicing on all loans sold to FHLMC.

 

Interest Rates and Loan Fees. Interest rates charged by the Bank on mortgage loans are primarily determined by competitive loan rates offered in its market area. Mortgage loan interest rates reflect factors such as general market interest rate levels, the supply of money available to the financial institutions industry and the demand for such loans. These factors are in turn affected by general economic conditions, the monetary policies of the Federal government, including the Board of Governors of the Federal Reserve System (the “Federal Reserve”), and general supply of money in the economy. In addition to interest earned on loans, the Bank receives fees in connection with loan commitments and originations, loan modifications, late payments and for miscellaneous services related to its loans. Income from these activities varies from period to period with the volume and type of loans originated, which in turn is dependent on prevailing mortgage interest rates and their effect on the demand for loans in the markets served by the Bank. The Bank also receives servicing fees on the loan amount of the loans that it services. At December 31, 2008, the Bank was servicing $30.0 million in loans for other financial institutions. For the years ended December 31, 2008 and 2007, the Bank recognized gross servicing income of $100,000 and $96,000, respectively, and total loan fee income of $571,000 and $442,000, respectively.

 

Mortgage-Backed Securities. The Bank maintains a portfolio of mortgage-backed securities in the form of Government National Mortgage Association (“GNMA”) and FHLMC participation certificates. GNMA certificates are guaranteed as to principal and interest by the full faith and credit of the United States, while FHLMC certificates are guaranteed by the agency. Mortgage-backed securities generally entitle the Bank to receive a pro rata portion of the cash flows from an identified pool of mortgages. Although mortgage-backed securities yield from 30 to 100 basis points less than the loans that are exchanged for such securities, they present substantially lower credit risk and are more liquid than individual mortgage loans and may be used to collateralize obligations of the Bank. Because the Bank receives regular payments of principal and interest from its mortgage-backed securities, these investments provide more consistent cash-flows than investments in other debt securities, which generally only pay principal at maturity.

 

Mortgage-backed securities, however, entail certain unique risks. In a declining rate environment, accelerated prepayments of loans underlying these securities expose the Bank to the risk that they will be unable to obtain comparable yields upon reinvestment of the proceeds. In the event the mortgage-backed security has been funded with an interest-bearing liability with a maturity comparable to the original estimated life of the mortgage-backed security, the Bank’s interest rate spread could be adversely affected. Conversely, in a rising interest rate environment, the Bank may experience a lower than estimated rate of repayment on the underlying mortgages, effectively extending the estimated life of the mortgage-backed security and exposing the Bank to the risk that it may be required to fund the asset with a liability bearing a higher rate of interest. The Bank seeks to minimize the effect of extension risk by focusing on investments in adjustable-rate and/or relatively short-term (seven years or shorter maturity) mortgage-backed securities. At December 31, 2008, the Bank had no mortgage derivative products that met the definition of high risk mortgage securities.

 

 

Deposits and Borrowings

 

Deposits. Deposits are attracted principally from the Bank’s market area through the offering of a variety of deposit instruments, including savings accounts and certificates of deposit ranging in term from 91 days to 60 months, as well as regular checking, NOW, passbook and money market deposit accounts. Deposit account terms vary, principally on the basis of the minimum balance required, the time periods the funds must remain on deposit, and the interest rate. The Bank also offers individual retirement accounts (“IRAs”). The Bank’s policies are designed primarily to attract deposits from local residents. To supplement local market deposits, the Bank has access to the national CD market through deposit brokers, including the Certificate of Deposit Account Registry Service (“CDARS”) of Promontory Interfinancial Network and Finance 500, Inc. The Bank may use this market to meet liquidity needs. At December 31, 2008, the Bank had approximately $58.3 million in certificates of deposit that were obtained through the CDARS network, representing 20.0% of total certificates of deposit. Because CDARS deposits are considered brokered deposits, the Bank would not be able to accept or renew CDARS deposits without FDIC permission if the Bank were less than well capitalized. Interest rates, maturity terms, service fees and withdrawal penalties are established by the Bank on a periodic basis. Determination of rates and terms are predicated upon funds acquisition and liquidity requirements, rates paid by competitors, growth goals and federal regulations.

 

Borrowings. Deposits historically have been the primary source of funds for the Bank’s lending and investment activities and for its general business activities. The Bank is authorized, however, to use advances from the FHLB of Atlanta to supplement its supply of lendable funds and to meet deposit withdrawal requirements. Advances from the FHLB typically are secured by the Bank’s stock in the FHLB or pledged assets. The Bank utilized advances from FHLB during the year. The FHLB of Atlanta functions as a central reserve bank providing credit for member financial institutions. As a member, the Bank is required to own capital stock in the FHLB and is authorized to apply for advances on the security of such stock and certain of its loans and other assets (principally, securities which are obligations of, or guaranteed by, the United States) provided certain standards related to creditworthiness have been met.

 

Competition

The Company offers a wide range of lending and deposit services in its market area. In addition, the Company offers a full range of brokerage and investment services through its relationship with Community Bankers Securities, LLC. The Company experiences substantial competition both in attracting and retaining deposits, in making loans, and in providing investment, insurance, and other services. Management believes the Bank is able to compete effectively in its primary market area.

The primary factors in competing for loans are interest rates, loan origination fees, and the range of services offered by lenders. Competitors for loan originations include other commercial banks, savings associations, mortgage bankers, mortgage brokers, and insurance companies. The Bank’s principal competitors for deposits are other financial institutions, including other banks, savings associations, and credit unions located in the Bank’s primary market area of Cecil and Harford Counties in Maryland or doing business in the market area through the internet, by mail, or by telephone. Competition among these institutions is based primarily on interest rates and other terms offered, service charges imposed on deposit accounts, the quality of services rendered, and the convenience of banking facilities. Additional competition for depositors’ funds comes from U.S. Government securities, private issuers of debt obligations and suppliers of other investment alternatives for depositors, such as securities firms. Competition from credit unions has intensified in recent years as historical federal limits on membership have been relaxed. Because federal law subsidizes credit unions by giving them a general exemption from federal income taxes, credit unions have a significant cost advantage over banks and savings associations,

 

 

which are fully subject to federal income taxes. Credit unions may use this advantage to offer rates that are highly competitive with those offered by banks and thrifts.

The banking business in Maryland generally, and the Bank’s primary service area specifically, is highly competitive with respect to both loans and deposits. The Bank competes with many larger banking organizations that have offices over a wide geographic area. These larger institutions have certain inherent advantages, such as the ability to finance wide-ranging advertising campaigns and promotions and to allocate their investment assets to regions offering the highest yield and demand. They also offer services, such as international banking, that are not offered directly by the Bank (but are available indirectly through correspondent institutions), and, by virtue of their larger total capitalization, such banks have substantially higher legal lending limits, which are based on bank capital, than does the Bank. The Bank can arrange loans in excess of its lending limit, or in excess of the level of risk it desires to take, by arranging participations with other banks. Other entities, both governmental and in private industry, raise capital through the issuance and sale of debt and equity securities and indirectly compete with the Bank in the acquisition of deposits.

In addition to competing with other commercial banks, savings associations, and credit unions, commercial banks such as the Bank compete with nonbank institutions for funds. For instance, yields on corporate and government debt and equity securities affect the ability of commercial banks to attract and hold deposits. Commercial banks also compete for available funds with mutual funds. These mutual funds have provided substantial competition to banks for deposits, and it is anticipated they will continue to do so in the future.

Based on data compiled by the FDIC as of June 30, 2008 (the latest date for which such information is available), the Bank had the second largest share of FDIC-insured deposits in Cecil County with approximately 23% and the 14^th largest share of FDIC-insured deposits in Harford County with approximately 2%. This data does not reflect deposits held by credit unions with which the Bank also competes.

Employees

As of January 31, 2009, the Company and the Bank employed 92 persons. None of the Company’s or the Bank’s employees is represented by a union or covered under a collective bargaining agreement. Management of the Company and the Bank consider their employee relations to be excellent.

Item 1A. Risk Factors.  

Not applicable.

Item 1B. Unresolved Staff Comments.  

Not applicable.

 

 

Item 2. Properties

Following are the locations of the Bank at December 31, 2008. The Company has no other locations.

 

 

*Leased.

 

Item 3. Legal Proceedings

 

In the normal course of business, Cecil Bancorp is subject to various pending and threatened legal actions. The relief or damages sought in some of these actions may be substantial. After reviewing pending and threatened actions with counsel, management considers that the outcome of such actions will not have a material adverse effect on Cecil Bancorp’s financial position; however, the Bank is not able to predict whether the outcome of such actions may or may not have a material adverse effect on results of operations in a particular future period as the timing and amount of any resolution of such actions and relationship to the future results of operations are not known.

 

Item 4. Submission of Matters to a Vote of Security Holders

 

No matter was submitted to a vote of security holders during the fourth quarter of 2008, through solicitation of proxies or otherwise.

PART II

 

Item 5. Market for Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

Common shares of Cecil Bancorp are traded over the counter under the symbol CECB, with quotations available on the OTC Bulletin Board. Stockholders received quarterly cash dividends totaling $0.10 per share in both 2008 and 2007. The ratio of dividends per share to diluted net income per share was 20.4% in 2008, compared to 10.9% for 2007. The dividend amount is established by the Board of Directors each quarter. In making its decision on dividends, the Board considers operating results, financial condition, capital adequacy, regulatory requirements, shareholder returns and other factors. Until the third anniversary of the issuance of the Series A Preferred Stock to the Treasury Department or its earlier redemption or transfer by the Treasury Department to an unaffiliated holder, the Company may not increase the dividend on the common stock or repurchase any shares of common stock without the

 

 

consent of the Treasury Department. All per share amounts have been adjusted to give retroactive effect to the 2-for-1 stock split approved by the Board of Directors in March 2007.

 

The number of common shareholders of record was approximately 624 as of March 27, 2009, excluding stockholders who hold in nominee or “street name.”

 

Quarterly Stock Information ⁽¹⁾

 

 

⁽¹⁾ Quotations reflect inter-dealer price, without retail mark-up, mark-down or commissions, and may not represent actual transactions.

 

During the year ended December 31, 2008, 11,589 shares of Cecil Bancorp common stock acquired on the open market by the Cecil Bancorp Employees’ Saving & Profit Sharing Plan (the “401(k) Plan”) were allocated to the accounts of participants in the 401(k) Plan prior to the date of filing of a registration statement for the 401(k) Plan. The Registrant did not receive any proceeds from these sales.

 

 

Item 6. Selected Financial Data

 

Five Year Summary of Selected Financial Data

 

 

(1) All per share amounts have been adjusted to give retroactive effect for the two-for-one stock split approved by the Board of Directors on February 24, 2004, the 1% stock dividends approved by the Board of Directors in December 2005, March 2006, May 2006, and August 2006, and the two-for-one stock split approved by the Board of Directors in March 2007.

(2) Book value is computed using the amount allocated to common stockholders, that is total stockholders’ equity, less the Series A Preferred Stock.

(3) Total stockholders’ equity less the Series A Preferred Stock, net of goodwill and other intangible assets, divided by the number of shares of common stock outstanding at year end.

(4) The Efficiency Ratio equals noninterest expenses as a percentage of net interest income plus noninterest income.

 

 

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

You should read this Management’s Discussion and Analysis of the Company’s consolidated financial condition and results of operations in conjunction with the Company’s consolidated financial statements and the accompanying notes.

 

Summary

 

Cecil Bancorp, Inc. (the “Company”) is the holding company for Cecil Bank (the “Bank”). The Bank is a community-oriented commercial bank chartered under the laws of the State of Maryland and is a member of the Federal Reserve System.

 

The Bank commenced operations in 1959 as a Federal savings and loan association and converted to a Maryland commercial bank in 2002. The Bank conducts its business through its main office in Elkton, Maryland, and branches in Elkton, North East, Fair Hill, Rising Sun, Cecilton, Aberdeen, Conowingo, and Havre de Grace, Maryland. Cecil Service Corporation, a subsidiary of the Bank, acts as leasing agent for the leased branches. The Bank offers a full range of brokerage and investment services through a relationship with Community Bankers Securities, LLC. The Bank’s business strategy is to operate as an independent community-oriented financial institution funded primarily by retail deposits.

 

Consolidated Average Balances, Yields and Rates ⁽¹⁾

 

 

 

 

Comparison of Results of Operations

 

Net income decreased $1.5 million, or 45.6%, to $1.9 million for the year ended December 31, 2008, from $3.4 million for 2007. The decrease in net income is primarily the result of a $2.5 million, or 264.2%, increase in the provision for loan losses, a $1.0 million, or 11.2%, increase in noninterest expense, and a $362,000, or 24.1%, decrease in noninterest income, partially offset by a $1.2 million (8.9%) increase in net interest income and a $1.1 million (51.2%) decrease in income tax expense. Basic and diluted earnings per share for 2008 were $0.50 and $0.49, respectively, down $0.42 and $0.43, or approximately 45.7% and 46.7%, from corresponding 2007 basic and diluted earnings per share amounts of $0.92. Earnings per share calculations have been adjusted to give retroactive effect to the two-for-one stock split approved by the Board of Directors in March 2007. The return on average assets and return on average equity were 0.42% and 6.47%, respectively, for the year ended December 31, 2008. This compares to a return on average assets and the return on average equity of 0.92% and 13.28%, respectively, for 2007.

 

Net interest income, the Company’s primary source of income, increased $1.2 million, or 8.9%, to $15.1 million for the year ended December 31, 2008, from $13.9 million for the year ended December 31, 2007 primarily due to an increase in loan volume. The weighted average yield on interest-earning assets decreased to 7.35% for the year ended December 31, 2008 from 8.22% for the year ended December 31, 2007. The weighted average rate paid on interest bearing liabilities decreased to 3.58% for the year ended December 31, 2008 from 4.22% for the year ended December 31, 2007. The net interest spread decreased to 3.77% for 2008 from 4.00% for 2007 and the net interest margin decreased to 3.78% for 2007 from 4.05% for 2007.

 

Interest and fees on loans receivable increased by $1.3 million, or 4.6%, to $29.0 million for the year ended December 31, 2008 from $27.7 million for the year ended December 31, 2007. The increase is attributable to an increase in the average balance outstanding partially offset by a decline in the average yield earned. The average balance outstanding increased $51.8 million, or 15.6%, to $382.8 million for the year ended December 31, 2008 from $331.0 million for the year ended December 31, 2007. The weighted average yield decreased to 7.56% for the year ended December 31, 2008 from 8.36% for the year ended December 31, 2007.

 

Interest on investment securities decreased by $35,000, or 12.3%, to $249,000 for the year ended December 31, 2008 from $284,000 for the year ended December 31, 2007. The decrease is attributable to a decrease in the weighted average yield, partially offset by an increase in the average balance outstanding. The average balance outstanding increased $23,000 for the year ended December 31, 2008 as compared to the year ended December 31, 2007. The weighted average yield decreased to 4.37% for the year ended December 31, 2008 from 5.01% for the year ended December 31, 2007.

 

Other earning assets consist of Federal Home Loan Bank stock, Federal Reserve Bank stock, and interest bearing deposits with other banks. Dividends on Federal Home Loan and Federal Reserve Bank stock increased $18,000, or 10.4%, to $191,000 for the year ended December 31, 2008 from $173,000 for the year ended December 31, 2007 as a result of an increase in the average balance outstanding partially offset by a decrease in the weighted average yield. The average balance outstanding increased $1.8 million, or 61.8%, to $4.7 million for the year ended December 31, 2008 from $2.9 million for the year ended December 31, 2007. The weighted average yield decreased to 4.09% for the year ended December 31, 2008 from 5.98% for the year ended December 31, 2007. Interest on the interest bearing deposits with other banks decreased $50,000 to $60,000 for the year ended December 31, 2008 from $110,000 for the year ended December 31, 2007 as a result of a decrease in the weighted average yield, partially offset by an increase in the average balance outstanding. The weighted average yield decreased to 0.81% for the year ended December 31, 2008 from 2.77% for the year ended December 31, 2007. The average balance

 

 

outstanding increased $3.5 million, or 87.6%, to $7.4 million for the year ended December 31, 2008 from $4.0 million for the year ended December 31, 2007.

 

Interest expense on deposits decreased $902,000, or 8.0%, to $10.3 million for the year ended December 31, 2008 from $11.2 million for the year ended December 31, 2007. The decrease was the result of a decrease in the average cost of funds partially offset by an increase in the average balance. The weighted average rate decreased to 3.41% for the year ended December 31, 2008 from 3.99% for the year ended December 31, 2007. The average balance outstanding increased $21.1 million, or 7.5%, to $302.0 million for the year ended December 31, 2008 from $280.9 million for the year ended December 31, 2007. Interest expense on fed funds purchased increased 100% to $13,000 for the year ended December 31, 2008. The average balance outstanding during the period was $433,000 and the weighted average rate paid was 3.10%. Interest expense on advances from the Federal Home Loan Bank of Atlanta increased $853,000, or 42.4%, to $2.9 million for the year ended December 31, 2008 from $2.0 million for the year ended December 31, 2007. The average balance outstanding increased $38.6 million, or 91.8%, to $80.6 million for the year ended December 31, 2008 from $42.0 million for the year ended December 31, 2007. The weighted average rate decreased to 3.55% for the year ended December 31, 2008 from 4.79% for the year ended December 31, 2007. Interest expense on junior subordinated debentures was approximately the same at $1.1 million, as the average balance remained the same and the interest rate increased by only 2 basis points.

 

Effect of Volume and Rate Changes on Net Interest Income

 

 

________________

* Variances are computed line-by-line and do not add to the totals shown. Changes in rate-volume (changes in rate multiplied by the changes in volume) are allocated between changes in rate and changes in volume in proportion to the relative contribution of each.

 

The allowance for loan losses is increased by provisions charged to expense. Charge-offs of loan amounts determined by management to be uncollectible decrease the allowance, and recoveries of previous charge-offs are added to the allowance. The Company recognizes provisions for loan losses in amounts necessary to maintain the allowance for loan losses at an appropriate level, based upon management’s reviews of probable losses inherent in the loan portfolio. The provision for loan losses increased $2.5 million to $3.4 million for the year ended December 31, 2008 from $935,000 for the year ended December 31, 2007 as a result of this analysis. (See “Allowance for Loan Losses.”)

 

 

 

Noninterest income decreased $362,000, or 24.1%, to $1.1 million for the year ended December 31, 2008 from $1.5 million for the year ended December 31, 2007. Deposit account fees increased $96,000, or 17.3%, to $650,000 for the year ended December 31, 2008 from $554,000 for the year ended December 31, 2007 due to growth in the portfolio. ATM fees increased $75,000 to $377,000 for the year ended December 31, 2008 from $302,000 for the year ended December 31, 2007. This increase is attributable to increased surcharge fees resulting from increases in cardholder usage. Commission income increased $25,000 to $55,000 for the year ended December 31, 2008 from $30,000 for the year ended December 31, 2007. There was an $11,000 gain on the sale of other real estate owned during the year ended December 31, 2008 as compared to no activity during the same period in 2007. Gain on the sale of loans of $173,000 for the year ended December 31, 2008 was an increase of $59,000, or 51.8%, over the total of $114,000 for the year ended December 31, 2007. The Company recognized a loss of $618,000 on investments, consisting of a $125,000 loss on the sale of the AMF Intermediate Mortgage Fund and an additional $493,000 other than temporary impairment loss on its investments in Triangle Capital Corporation and the AMF Ultra Short Mortgage, Intermediate Mortgage, and Short U.S. Government Funds, for the year ended December 31, 2008, as compared to no such loss over the same period in 2007. Income from bank owned life insurance decreased by $63,000, or 19.8%, to $255,000 for the year ended December 31, 2008 from $318,000 for the year ended December 31, 2007 due to a decrease in crediting rates being paid by the insurance carriers. Other income increased $53,000, or 29.1%, to $235,000 for the year ended December 31, 2008 from $182,000 for the year ended December 31, 2007 primarily due to an increase in income from the Company’s investment in Maryland Title Center LLC, as well as an increase in miscellaneous fees, partially offset by a decrease in income from Triangle Capital Partners, a specialty finance company organized to provide financing solutions to lower middle market companies primarily located in the southeastern United States.

 

Noninterest expense increased $1.0 million, or 11.2%, to $10.0 million for the year ended December 31, 2008 from $9.0 million for the year ended December 31, 2007. The Company experienced an increase in salaries and employee benefits of $429,000, or 7.5%, to $6.1 million for the year ended December 31, 2008 from $5.7 million for the year ended December 31, 2007. This increase is attributable to annual merit increases and an increase in medical insurance benefits provided to employees. Occupancy expense increased $59,000, or 9.4%, to $689,000 for the year ended December 31, 2008 from $630,000 for the year ended December 31, 2007. This increase is due to an increase in utilities and depreciation expense on the new Fair Hill branch, partially offset by a decline in office building repairs and maintenance. Equipment and data processing increased $70,000, or 5.7%, to $1.3 million for the year ended December 31, 2008 from $1.2 million for the year ended December 31, 2007 primarily due to an increase in the fees charged by the Bank’s data service processor, partially offset by declines in small equipment purchases and depreciation expense on furniture and equipment. Professional fees decreased $95,000, or 35.3%, to $174,000 for the year ended December 31, 2008 from $269,000 for the year ended December 31, 2007 primarily due to a decline in Sarbanes-Oxley Section 404 consulting fees, as well as a decrease in non-collection related attorney expenses. Other expenses increased $548,000, or 47.2%, to $1.7 million for the year ended December 31, 2008 from $1.2 million for the year ended December 31, 2007, primarily due to increases in FDIC deposit insurance assessments, loan collection expense, advertising, real estate taxes, and supplies expense, partially offset by a decrease in loan expense. The Company anticipates an increase in deposit insurance expense during 2009 due to planned increases in the FDIC assessment rate and a planned special assessment of 20 basis points.

 

Income tax expense for the years ended December 31, 2008 and 2007 was $1.0 million and $2.1 million, respectively, which equates to effective rates of 35.2% and 37.7%, respectively.

 

 

Comparison of Financial Condition

 

The Company’s assets increased by $91.0 million, or 22.7%, to $492.4 million at December 31, 2008 from $401.4 million at December 31, 2007 primarily due to growth in loans, cash and cash equivalents, and investment securities available-for-sale. The loans receivable portfolio increased by $49.4 million, or 13.8%, to $408.1 million at December 31, 2008 from $358.7 million at December 31, 2007. The increase in loans is due to the Company’s growth strategy and the marketing efforts of the business development and loan departments. During the period, we realized a $24.3 million (30.7%) increase in construction loans, a $16.3 million (12.8%) increase in commercial real estate loans, a $5.8 million (56.7%) increase in commercial business loans, a $3.9 million (3.1%) increase in 1-4 family residential mortgage and home equity loans, and a $1.4 million (43.7%) increase in land loans, partially offset by a $1.9 million (30.6%) decrease in consumer loans. The allowance for loan losses increased by $3.2 million, or 103.1%, to $6.3 million at December 31, 2008 from $3.1 million at December 31, 2007. The allowance for loan losses is increased by provisions charged to expense. Charge-offs of loan amounts determined by management to be uncollectible decrease the allowance, and recoveries of previous charge-offs are added to the allowance. (See “Allowance for Loan Losses” below.) Cash and interest-bearing deposits with banks increased $35.9 million to $41.4 million at December 31, 2008 from $5.5 million at December 31, 2007 primarily due to the excess cash obtained from the increase in the deposit portfolio and the sale of the Series A Preferred Stock, partially offset by increases in the loan and investment portfolios.

 

Investment securities available-for-sale increased by $9.2 million to $11.7 million at December 31, 2008 from $2.5 million at December 31, 2007 due to purchases made with the funds received from the growth in the deposit portfolio, partially offset by other than temporary declines in the market value of the investment in Triangle Capital Corporation and the Shay mutual funds. Investment securities held-to-maturity decreased by $2.4 million, or 89.1%, to $300,000 at December 31, 2008 from $2.7 million at December 31, 2007 due to a security that matured during the year that was not renewed. Restricted investment securities, which consist of Federal Home Loan and Federal Reserve Bank stock, decreased by $832,000, or 17.5%, to $3.9 million at December 31, 2008 from $4.8 million at December 31, 2007 due to the decrease in FHLB advances, which requires a decrease in FHLB stock as mandated by the Federal Home Loan Bank of Atlanta. Other real estate owned increased $2.2 million to $2.8 million at December 31, 2008 from $655,000 at December 31, 2007 due to the acquisition of additional properties in satisfaction of loans receivable. Other intangible assets, consisting entirely of mortgage servicing rights, increased by $89,000, or 37.1%, to $329,000 at December 31, 2008 from $240,000 at December 31, 2007, primarily due to the continued sale of loans with servicing retained during 2008. Bank owned life insurance increased $255,000, or 3.4%, to $7.8 million at December 31, 2008 from $7.5 million at December 31, 2007 due to the increase in the cash surrender value during the year. Other assets increased $232,000, or 4.1%, to $5.9 million at December 31, 2008 from $5.6 million at December 31, 2007, primarily due to an increase of $1.9 million in the Company’s deferred tax asset partially offset by a decline from the $1.7 million receivable at December 31, 2007 from Money Gram Payment Systems, the Company’s third party official check processing agent, that was received in January 2008.

 

The Company’s liabilities increased $77.8 million, or 20.8%, to $452.0 million at December 31, 2008 from $374.2 million at December 31, 2007. Deposits increased $97.5 million, or 36.5%, to $364.5 million at December 31, 2008 from $267.0 million at December 31, 2007. NOW and money market accounts increased by $4.8 million (16.7%), savings accounts decreased by $117,000 (0.6%), national certificates of deposit increased by $93.0 million, local certificates of deposit decreased by $1.9 million (1.3%), and checking accounts increased by $1.7 million (9.6%). Other liabilities increased $1.0 million, or 17.8%, to $6.7 million at December 31, 2008 from $5.7 million at December 31, 2007, primarily due to increases in the liability to fund the supplement executive retirement plan, accrued interest on national certificates of deposit, and accrued FDIC premiums, partially offset by decreases in the liability owed to

 

 

MoneyGram Payment Systems to clear official checks written by the Bank and income taxes payable. Advances from the Federal Home Loan Bank of Atlanta decreased $20.7 million, or 24.5%, to $63.8 million at December 31, 2008 from $84.5 million at December 31, 2007 primarily due to repayments with the excess cash received from the increase in deposits.

 

The Company’s stockholders’ equity increased by $13.2 million, or 48.3%, to $40.4 million at December 31, 2008 from $27.2 million at December 31, 2007. This increase is primarily the result of the Series A Preferred Stock issued to the United States Department of the Treasury for an aggregate purchase price of $11.6 million in cash as part of the Troubled Asset Relief Program Capital Purchase Program, as well as net income of $1.9 million, net of cash dividends of $0.10 per share, or $368,000.

 

Loans Receivable

 

The Bank’s total gross loans grew $49.4 million, or 13.8%, during 2008. During the period, we realized a $24.3 million (30.7%) increase in construction loans, a $16.3 million (12.8%) increase in commercial real estate loans, a $5.8 million (56.7%) increase in commercial business loans, a $3.9 million (3.1%) increase in 1-4 family residential mortgage and home equity loans, and a $1.4 million (43.7%) increase in land loans, partially offset by a $1.9 million (30.6%) decrease in consumer loans. The following table shows the composition of the loan portfolio at December 31.

 

 

Loan classifications beginning with December 31, 2006 in the two preceding tables have been prepared using call report rules, which generally classify loans secured by real estate as real estate loans, regardless of the loans’ primary purpose. Categories for prior years have not been restated, and reflect classification of commercial purpose loans secured by real estate as commercial business loans.

 

 

The following table shows the remaining maturities or next repricing date of outstanding loans at December 31, 2008. Balances are not reduced for loans in process or discounts.

 

 

Allowance for Loan Losses

 

The Bank records provisions for loan losses in amounts necessary to maintain the allowance for loan losses at the level deemed appropriate. The allowance for loan losses is provided through charges to income in an amount that management believes will be adequate to absorb losses on existing loans that may become uncollectible, based upon evaluations of the collectibility of loans and prior loan loss experience. The allowance is based on a careful, continuous review and evaluation of the credit portfolio and ongoing, quarterly assessments of the probable losses inherent in the loan portfolio. The Bank employs a systematic methodology for assessing the appropriateness of the allowance, which includes determination of a specific allowance, a formula allowance, and an unallocated allowance. During the year ended December 31, 2008, there were no changes in the Bank’s methodology for assessing the appropriateness of the allowance.

 

Specific allowances are established in cases where management has identified significant conditions or circumstances related to a credit that management believes indicate the probability that a loss may be incurred in an amount different from the amount determined by application of the formula allowance.

 

The formula allowance is calculated by applying loss factors to corresponding categories of outstanding loans and leases, excluding loans for which specific allocations have been made. Allowances are established for credits that do not have specific allowances according to the application of these credit loss factors to groups of loans based upon (a) their credit risk rating, for loans categorized as substandard or doubtful either by the Bank in its ongoing reviews or by bank examiners in their periodic examinations, or (b) by type of loans, for other credits without specific allowances. These factors are set by management to reflect its assessment of the relative level of risk inherent in each category of loans, based primarily on the credit risk factors employed by bank examiners at their most recent periodic examination of the Bank. Bank regulatory examinations usually occur each year. In these examinations, the examiners review the credit portfolio, establish credit risk ratings for loans, identify charge offs, and perform their own calculation of the allowance for loan losses. Additionally, the Bank engages an independent third party to review a significant portion of our loan portfolio. The use of these credit risk factors based primarily upon periodic examinations is intended to provide a self-correcting mechanism to reduce differences between estimated and actual observed losses.

 

 

The unallocated allowance is based upon management’s evaluation of various conditions that are not directly measured in the determination of the specific and formula allowances. These conditions may include the nature and volume of the loan portfolio, overall portfolio quality, and current economic conditions that may affect the borrowers’ ability to pay. In addition to these conditions, management has identified land acquisition and development loans, as well as construction speculation loans, as higher risk due to current economic factors. Additionally, management has identified commercial business loans as higher risk based on the change in the nature and the volume of the portfolio over the last several periods. Therefore, management has allocated additional reserves to these two pools of loans over and above the specific and formula allowances.

 

Determining the amount of the allowance for loan losses requires the use of estimates and assumptions, which is permitted under accounting principles generally accepted in the United States of America. Actual results could differ significantly from those estimates. While management uses available information to estimate losses on loans, future additions to the allowance may be necessary based on changes in economic conditions. In addition, as noted above, federal and state financial institution examiners, as an integral part of their examination process, periodically review the Bank’s allowance for loan losses, and may require the Bank to recognize additions to the allowance based on their judgments about information available to them at the time of their examination.

 

Management determined that the appropriate allowance for loan losses at December 31, 2008 was $6.3 million, (1.55% of total loans), an increase of $3.2 million, or 103.1%, from the $3.1 million allowance (0.87% of total loans) at December 31, 2007. Net charge-offs were 0.05% of average loans in 2008, while net charge-offs were 0.01% of average loans in 2007. The provision for loan losses required for 2008 was $3.4 million, up $2.5 million (264.2%), from $935,000 in 2007.

 

A summary of activity in the allowance is shown below.

 

 

 

 

 

 

The following table presents a five year history of the allocation of the allowance for loan losses, reflecting the methodology described above, along with the percentage of total loans in each category. The increase in the allowance for 2008 was primarily the result of larger reserves for commercial business loans and non-accrual loans, and to a lesser extent construction loans and commercial real estate loans.

 

 

 

Nonperforming Assets

 

Management reviews and identifies loans and investments that require designation as nonperforming assets. Nonperforming assets are: loans accounted for on a nonaccrual basis; loans past due by 90 days or more but still accruing; restructured loans; and other real estate (assets acquired in settlement of loans). The following tables set forth certain information with respect to nonperforming assets at December 31:

 

 

 

⁽¹⁾ Gross interest income that would have been recorded in 2008 if non-accrual loans and leases had been current and in accordance with their original terms was $1,004,000, while interest actually recorded on such loans was $380,000.

⁽²⁾ Performing loans considered potential problem loans, as defined and identified by management, amounted to $13,142,000 at December 31, 2008.  Although these are loans where known information about the borrowers’ possible credit problems causes management to have doubts as to the borrowers’ ability to comply with the present loan repayment terms, most are well collateralized and are not believed to present significant risk of loss. Loans classified for regulatory purposes not included in nonperforming loans do not, in management’s opinion, represent or result from trends or uncertainties reasonably expected to materially affect future operating results, liquidity or capital resources or represent material credits where known information about the borrowers’ possible credit problems causes management to have doubts as to the borrowers’ ability to comply with the loan repayment terms.

 

 

Loans classified as nonaccrual totaled $10.5 million, or 2.56% of total loans at December 31, 2008, compared with $5.1 million or 1.41% at December 31, 2007. Major factors contributing to the increase were a $2.3 million increase in construction, land development, and other land loans, a $1.9 million increase in loans secured by 1-4 family residential properties and a $1.9 million increase in commercial real estate loans, partially offset by a $500,000 decline in multifamily residential properties.

 

Investment Securities

 

The Bank maintains a portfolio of investment securities to provide liquidity as well as a source of earnings. The Bank’s investment securities portfolio consists primarily of U.S. Government and Agency securities and mortgage-backed and other securities issued by U.S. government-sponsored enterprises (“GSEs”) including Freddie Mac and Fannie Mae. The Bank has also invested in various mutual funds that invest in securities that the Bank is permitted to invest in directly, including the AMF Intermediate Mortgage, Ultra Short Mortgage, and Short U.S. Government Funds, which invest in agency and private label mortgage-backed securities. As a result of the current housing and credit crises, the market values of certain of these Funds’ holdings have declined precipitously over the past year and the Fund manager has prohibited cash redemptions. In light of these circumstances, the Company determined that the decline in the net asset value of these Funds was other-than temporary and wrote down its investment in these funds by $387,000. The Bank has also invested in the equity securities of Triangle Capital Corporation, a publicly traded business development/small business investment company that makes debt and equity investments in middle-market companies in the Southeastern states.Based on the current economic conditions, the duration of time that the security has been in a continuous loss position, and the magnitude of the loss, the Company determined that the decline in value was other than temporary and wrote down its investment in this security by $106,000. As a member of the Federal Reserve and FHLB system, the Bank is also required to invest in the stock of the Federal Reserve Bank of Richmond and FHLB of Atlanta.

 

The composition of investment securities at December 31 is shown below.

 

 

 

(1) At estimated fair value.

(2) Issued by a U. S. Government Agency or secured by U.S. Government Agency collateral.

(3) The outstanding balance of no single issuer, except for U.S. Government, U.S. Government Agency, and FNMA securities, exceeded ten percent of stockholders’ equity at December 31, 2008, 2007 or 2006.

 

 

Contractual maturities and weighted average yields for debt securities available-for-sale and held-to-maturity at December 31, 2008 are presented below. Expected maturities may differ from contractual maturities because borrowers may have the right to prepay obligations with or without prepayment penalties.

 

 

Deposits

 

The following table sets forth the average dollar amount of deposits in the various types of accounts at December 31:

 

 

 

 

 

 

Borrowings

 

Year-end advances from the Federal Home Loan Bank of Atlanta consisted of the following (in thousands):

 

 

 

The following table sets forth information concerning short-term borrowings, which consisted primarily of advances from the Federal Home Loan Bank of Atlanta during the periods indicated.

 

 

Interest Sensitivity

 

The ability to maximize net interest income is largely dependent upon the achievement of a positive interest rate spread (the difference between the weighted average interest yields earned on interest-earning assets and the weighted average interest rates paid on interest-bearing liabilities) that can be sustained during fluctuations in prevailing interest rates. Asset/liability management functions to maximize profitability within established guidelines for interest rate risk, liquidity, and capital adequacy. The Bank’s asset/liability management policies are designed to reduce the impact of changes in interest

 

 

rates on its net interest income by achieving a more favorable match between the maturities or repricing dates of its interest-earning assets and interest-bearing liabilities. Measurement and monitoring of liquidity, interest rate risk, and capital adequacy are performed centrally through the Asset/Liability Management Committee, and reported under guidelines established by management, the Board of Directors and regulators. Oversight of this process is provided by the Board of Directors.

 

The Bank has implemented policies by generally emphasizing the origination of one-year, three-year and five-year adjustable rate mortgage loans, adjustable rate commercial loans and lines of credit, and short-term consumer loans. Since 1995, the Bank has, from time to time, originated fixed rate mortgages for sale in the secondary market. The Bank is currently originating loans for sale in the secondary market through the Federal Home Loan Mortgage Corporation. Management has been monitoring the retention of fixed rate loans through its asset/liability management policy. Management intends to continue to concentrate on maintaining its interest rate spread in a manner consistent with its lending policies, which are principally the origination of adjustable-rate mortgages and commercial loans, and may include an appropriate blend of fixed-rate mortgage loans in its primary market area.

 

The Bank’s net income is largely dependent on its net interest income. The Bank seeks to maximize its net interest margin within an acceptable level of interest rate risk. Interest rate risk can be defined as the amount of forecasted net interest income that may be gained or lost due to favorable or unfavorable movements in interest rates. Interest rate risk, or sensitivity, arises when the maturity or repricing characteristics of assets differ significantly from the maturity or repricing characteristics of liabilities. Net interest income is also affected by changes in the portion of interest-earning assets that are funded by interest-bearing liabilities rather than by other sources of funds, such as noninterest-bearing deposits and stockholders’ equity.

 

The Bank attempts to manage interest rate risk while enhancing net interest margin by adjusting its asset/liability position. At times, depending on the level of general interest rates, the relationship between long- and short-term interest rates, market conditions and competitive factors, the Bank may decide to increase its interest rate risk position somewhat in order to increase its net interest margin. The Bank monitors interest rate risk and adjusts the composition of its interest-related assets and liabilities in order to limit its exposure to changes in interest rates on net interest income over time. The Bank’s asset/liability committee reviews its interest rate risk position and profitability, and recommends adjustments. The asset/liability committee also reviews the securities portfolio, formulates investment strategies, and oversees the timing and implementation of transactions. Notwithstanding the Bank’s interest rate risk management activities, the potential for changing interest rates is an uncertainty that can have an adverse effect on net income.

 

The Bank also analyzes interest rate risk based upon quantitative measures of the percentage changes in fair value of equity capital (or market value of portfolio equity) resulting from a hypothetical immediate change (or shock) of plus or minus 100, 200, and 300 basis points in interest rate levels. Due to the current interest rate environment, the Company did not perform analysis on decreases of 200 and 300 basis points as of December 31, 2008. This analysis is based upon models, which are based upon a number of significant assumptions regarding reactions of interest rates. At December 31, 2008, this analysis indicated that a shock decrease of 100 basis points would decrease the market value of portfolio equity by 13.37%, while interest rate shock increases of 100, 200 and 300 basis points would decrease the market value of portfolio equity by 11.27%, 9.80%, and 9.55%, respectively. These models also provide an analysis of interest rate shock effects on net interest income. At December 31, 2008, this analysis indicated that a shock decrease of 100 basis points would increase net interest income by 2.49%. An interest rate shock increase of 100 basis points would decrease net interest income by 0.28%, while increases of 200 and 300 basis points would increase net interest income by 0.11% and 0.44%, respectively.

 

 

Liquidity

 

Liquidity is measured by a financial institution’s ability to raise funds through deposits, borrowed funds, capital, or the sale of highly marketable assets such as residential mortgage loans and available for sale investments. Additional sources of liquidity, including cash flow from the repayment of loans, are also considered in determining whether liquidity is satisfactory. Liquidity is also achieved through growth of deposits and liquid assets, and accessibility to the capital and money markets. These funds are used to meet deposit withdrawals, maintain reserve requirements, fund loans and operate the organization.

 

Cash and cash equivalents increased $35.9 million during 2008. This increase was the result of $88.0 million in cash provided by financing activities and $6.5 million in cash provided by operating activities, partially offset by $58.6 million in cash used by investing activities.

 

Cash and cash equivalents decreased $1.1 million during 2007. This decrease was the result of $52.9 million in cash used by investing activities, partially offset by $49.9 million in cash provided by financing activities and $1.9 million in cash provided by operating activities.

 

The Bank maintains liquid assets that can be invested in specified short-term securities, and is also permitted to make certain other investments. Liquidity levels may be increased or decreased depending upon the yields on investment alternatives, management’s judgment as to the attractiveness of the yields then available in relation to other opportunities, its expectations of the level of yield that will be available in the future and its projections as to the short term demand for funds to be used in the Bank’s loan origination and other activities. The general objectives of the Bank’s investment policy are to (i) maintain liquidity levels sufficient to meet the operating needs of the Bank (ii) minimize interest rate risk by managing the repricing characteristics of the Bank’s assets and liabilities, (iii) reduce credit risk by investing primarily in U.S. Treasury and agency securities and (iv) absorb excess liquidity when loan demand is low and/or deposit growth is high. The Bank’s investment activities are conducted by senior management (specifically Chief Executive Officer Halsey and Chief Financial Officer Whitehead) and supervised by the Board of Directors. Investments are governed by an investment policy adopted by the Board, which currently provides for maintenance of an investment portfolio for the purposes of providing earnings, ensuring a minimum liquidity reserve and facilitating the Bank’s asset/liability management objectives (e.g., limiting the weighted average terms to maturity or repricing of the Bank’s interest-earning assets). In accordance with the policy, management has primarily invested in U.S. Treasury, government and agency securities and mutual funds.

 

The Bank’s time deposits of $100,000 or more represented 25.60% of total deposits at December 31, 2008, and are shown by maturity in the table below.

 

 

Capital

 

Capital adequacy refers to the level of capital required to sustain asset growth and to absorb losses. The Board of Governors of the Federal Reserve System (“Federal Reserve”), which is the Company’s and the Bank’s principal federal regulator, has established requirements for total and tier 1 (core) risk-based capital and tangible capital. As of December 31, 2008, since the Company had total

 

 

assets less than $500 million, the capital adequacy requirements do not apply on a consolidated basis. At December 31, 2008, the Bank exceeded applicable capital requirements to be well capitalized, having a total risk based capital ratio of 14.64%, a tier 1 risk-based capital ratio of 10.24%, and a tier 1 leverage ratio of 8.64%. See Note 13 “Regulatory Matters” in the notes to the consolidated financial statements.

 

Off-Balance Sheet Arrangements

 

In the normal course of business, Cecil Bancorp makes use of a number of different financial instruments to help meet the financial needs of its customers. In accordance with accounting principles generally accepted in the United States of America, the full notional amount of these transactions is not recorded in the accompanying consolidated financial statements and is referred to as off-balance sheet instruments. These transactions and activities include commitments to extend credit, standby letters of credit, and lease obligations.

 

Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Bank holds collateral supporting those commitments for which collateral is deemed necessary. The issuance of letters of credit is not a significant activity of the Bank.

 

Commitments to extend credit are agreements to lend funds to customers as long as there are no violations of any condition established in the loan contracts. 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 credit worthiness on a case-by-case basis. The amount of collateral obtained, if it is deemed necessary by the Bank upon extension of credit, is based on credit evaluation by management. Collateral held varies but may include accounts receivable, inventory, property, plant and equipment as well as income producing properties. Management believes that the Bank has adequate resources to fund all loan commitments.

 

For additional information regarding off-balance sheet arrangements, please see Note 16 to the Consolidated Financial Statements.

 

 

Critical Accounting Policies

 

Cecil Bancorp’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and follow general practices within the banking industry. Application of these principles requires management to make estimates, assumptions, and judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements may reflect different estimates, assumptions, and judgments. Certain policies inherently rely more on the use of estimates, assumptions, and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. Estimates, assumptions, and judgments are necessary when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset not carried on the financial statements at fair value warrants an impairment write-down or valuation allowance to be established, or when an asset or liability must be recorded contingent upon a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by other third-party sources, when available.

 

Allowance for Loan Losses. The allowance for loan losses is an estimate of the losses that may be sustained in the loan portfolio. The allowance is based on two basic principles of accounting: (1) Statement of Financial Accounting Standards (“SFAS”) No. 5, “Accounting for Contingencies”, which requires that losses be accrued when they are probable of occurring and estimable, and (2) SFAS No. 114, “Accounting by Creditors for Impairment of a Loan”, which requires that losses be accrued when it is probable that Cecil Bancorp will not collect all principal and interest payments according to the loan’s contractual terms.

 

Management believes that the allowance is adequate. However, its determination requires significant judgment, and estimates of probable losses inherent in the credit portfolio can vary significantly from the amounts actually observed. While management uses available information to recognize probable losses, future additions to the allowance may be necessary based on changes in the credits comprising the portfolio and changes in the financial condition of borrowers, such as those that may result from changes in economic conditions. In addition, regulatory agencies, as an integral part of their examination process, periodically review the credit portfolio and the allowance. Such review may result in additional provisions based on their judgments of information available at the time of each examination.

 

Cecil Bancorp’s systematic methodology for assessing the appropriateness of the allowance includes determination of specific, formula, and unallocated components, as described above under “Allowance for Loan Losses” and in Notes 1 and 4 to the Consolidated Financial Statements. At December 31, 2008, a 10% decrease or increase in all categories of risk rated credits for which specific allowances had not been recorded would have resulted in a corresponding decrease or increase of approximately $367,700 in the recommended allowance, assuming no change in other elements considered in the methodology.

 

Other Than Temporary Impairment of Securities. Securities are evaluated periodically to determine whether a decline in their value is other than temporary. The term “other than temporary” is not intended to indicate a permanent decline in value. Rather, it means that the prospects for near term recovery of value are not necessarily favorable, or that there is a lack of evidence to support fair values equal to, or greater than, the carrying value of the investment. Management reviews criteria such as the magnitude and duration of the decline, as well as the reasons for the decline, to predict whether the loss in

 

 

value is other than temporary. Once a decline in value is determined to be other than temporary, the value of the security is reduced and a corresponding charge to earnings is recognized.

 

As of December 31, 2008, with the exception of the Bank’s investments in Triangle Capital Corporation and the AMF Intermediate Mortgage, Ultra Short Mortgage, and Short U.S. Government Funds, as described in the Investment Securities section above, we concluded that any unrealized losses in the available-for-sale portfolios were temporary in nature due to market interest rates and not the underlying credit quality of the issuers of the securities. Additionally, we have the intent and ability to hold these investments for the time necessary to recover the amortized cost. Future events that would materially change this conclusion and require a charge to operations for an impairment loss include a change in the credit quality of the issuers.

 

Income Taxes. The Company accounts for income taxes under the asset/liability method. Deferred tax assets are recognized for the future consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, as well as operating loss and tax credit carry-forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period indicated by the enactment date. A valuation allowance is established for deferred tax assets when, in the judgment of management, it is more likely than not that such deferred tax assets will not become realizable. The judgment about the level of future taxable income is dependent to a great extent on matters that may, at least in part, be beyond the Company’s control. It is at least reasonably possible that management’s judgment about the need for a valuation allowance for deferred tax assets could change in the near term.

 

Goodwill and Other Intangible Assets. The Company accounts for goodwill and other intangible assets under Statement of Financial Accounting Standards (“SFAS”) No. 142, Goodwill and Other Intangible Assets. SFAS No. 142 prescribes a two-phase process for impairment testing of goodwill. The first phase screens for impairment; while the second phase, if necessary, measures the impairment. We consider the Company to be a single reporting unit. Accordingly, all of the goodwill is associated with the entire Company. The Company performs the required impairment analysis of goodwill annually or on an interim basis if circumstances dictate. Any reduction of the enterprise fair value below the recorded amount of equity could require us to write down the value of goodwill or purchased intangibles and record an expense for an impairment loss.

 

Item 7A. Quantitative and Qualitative Disclosures About Market Risk.  

 

Not applicable.

 

 

 

 

 

 

 

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

 

 

 

 

 

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

 

 

Board of Directors and Stockholders

Cecil Bancorp, Inc.

Elkton, Maryland

 

We have audited the accompanying consolidated balance sheets of Cecil Bancorp, Inc. and subsidiaries (the “Company”) as of December 31, 2008 and 2007, and the related consolidated statements of income, changes in stockholders’ 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 consolidated financial statements, 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 Cecil Bancorp, Inc. and subsidiaries as of December 31, 2008 and 2007, and the results of their operations and cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America.

 

 

/s/ Stegman & Company

 

Baltimore, Maryland

March 19, 2009