M&F BANCORP INC /NC/ - Quarter Report: 2008 September (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2008

Commission file number 0-27307

M&F BANCORP, INC.

(Exact name of registrant as specified in its charter)

2634 Durham Chapel Hill Blvd., Durham, NC 27707-2800

(Address of Principal Executive Offices)

(919) 683-1521

Indicate by check mark whether the registrant (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the previous 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  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definition of “large accelerated filer”, “accelerated filer”, “smaller reporting company” in rule 12b-2 of the Exchange Act. (Check One)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act)    Yes  ¨    No  x

State the number of shares outstanding of each of the issuer’s class of common equity, as of the latest practicable date:

Common Stock no par value 2,031,337

Outstanding at November 6, 2008

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PART I

FINANCIAL

INFORMATION

Item 1 — Consolidated Financial Statements

CONSOLIDATED BALANCE SHEETS

See notes to consolidated financial statements.

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CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)

See notes to consolidated financial statements.

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CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY (UNAUDITED)

See notes to consolidated financial statements.

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CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

(continued on next page)

See notes to consolidated financial statements.

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See notes to consolidated financial statements.

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Notes to Consolidated Financial Statements

Basis of Presentation

The Consolidated Financial Statements include the accounts and transactions of M&F Bancorp, Inc. (the “Company”) and its wholly-owned bank subsidiary, Mechanics and Farmers Bank (the “Bank”). All significant inter-company accounts and transactions have been eliminated in consolidation. The Consolidated Financial Statements have been prepared in accordance with generally accepted accounting principles in the United States (“U.S. GAAP”) for interim financial statements and in accordance with the instructions to Form 10-Q and Rule 8-03 of Regulation S-X. The accompanying interim Consolidated Financial Statements are unaudited except for the balance sheet as of December 31, 2007, which was derived from the Company’s audited consolidated Annual Report on Form 10-KSB.

The Consolidated Financial Statements included herein do not include all the information and notes required by U.S. GAAP and should be read in conjunction with the Consolidated Financial Statements and the related notes thereto included in the Company’s Annual Report on Form 10-KSB as of and for the year ended December 31, 2007.

In the opinion of management, the interim financial statements include all adjustments, consisting of normal recurring accruals, necessary for a fair presentation of the financial position, results of operations and cash flows in the accompanying unaudited Consolidated Financial Statements. The unaudited operating results for the periods presented may not be indicative of annual results.

New Accounting Pronouncements

In September 2006, the Financial Accounting Standards Board (“FASB”) ratified the Emerging Issues Task Force (“EITF”) conclusion under EITF Issue No. 06-4, Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements (“EITF 06-4”). EITF 06-4 requires that endorsement split-dollar life insurance arrangements which provide a postretirement benefit to an employee be recorded in accordance with FASB Statement No. 106, Employer’s Accounting for Postretirement Benefits Other Than Pensions or APB Opinion No. 12, Omnibus Opinion—1967, based on the substance of the agreement with the employee. Under the provision of these Statements, a liability should be accrued equal to the actuarial present value of the future death benefit over the service period. EITF 06-4 is effective for fiscal years beginning after December 15, 2007. The effects of adopting EITF 06-4 can be recorded either as (i) a change in accounting principle through a cumulative-effect adjustment to retained earnings or to other components of equity as of the beginning of the year of adoption, or (ii) a change in accounting principle through retrospective application to all prior periods. The Company adopted EITF 06-4 as of January 1, 2008; adoption of these provisions resulted in an increase in other liabilities of approximately $0.2 million with the offset reflected as a cumulative-effect adjustment to retained earnings.

In September 2006, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 157, Fair Value Measurements (“SFAS No. 157”), which defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. SFAS No. 157 became effective for the Company beginning January 1, 2008. Certain requirements of SFAS No. 157 are effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The effective date for other requirements of SFAS No. 157, which is elective, has been deferred for one year by the FASB. On January 1, 2008, the Company adopted SFAS No. 157, which has not had a material impact on the Company’s financial condition or results of operations.

In October 2008, the FASB issued a Staff Position No. 157-3, Determining the Fair Value of a Financial Asset When the Market for that Asset is Not Active (“FSP 157-3”), which clarifies the application of SFAS No. 157 in a market that is not active. FSP 157-3 provides an illustrative example to follow in the case of non-forced liquidations or distressed transactions for items requiring significant adjustments using unobservable inputs to determine fair value at the measurement date. FSP 157-3 is effective on issuance, and has not had a material impact on the Company’s financial condition or results of operations.

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities. SFAS No. 159 permits companies to elect to follow fair value accounting for certain financial assets and liabilities in an effort to mitigate volatility in earnings without having to apply complex hedge accounting provisions. The standard also establishes presentation and disclosure requirements designed to facilitate comparison between entities that choose different measurement attributes for similar types of assets and liabilities. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. On January 1, 2008, the Company adopted SFAS No. 159, which has not had a material impact on the Company’s financial condition or results of operations because the Company has not elected to include any items under its provisions.

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In December 2007, the FASB issued Statement of SFAS No. 141 (revised 2007), Business Combinations. SFAS No. 141(R), among other things, establishes principles and requirements for how the acquirer in a business combination (i) recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any non-controlling interest in the acquired business, (ii) recognizes and measures the goodwill acquired in the business combination or a gain from a bargain purchase, and (iii) determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. SFAS No. 141(R) is effective for fiscal years beginning on or after December 15, 2008, with early adoption prohibited. The Company is required to adopt SFAS No. 141(R) for all business combinations for which the acquisition date is on or after January 1, 2009. This standard will change our accounting treatment for business combinations on a prospective basis.

In December 2007, the FASB issued SFAS No. 160, Non-controlling Interests in Consolidated Financial Statements, an Amendment of ARB No. 51. SFAS No. 160 establishes accounting and reporting standards for non-controlling interests in a subsidiary and for the deconsolidation of a subsidiary. Minority interests will be re-characterized as non-controlling interests and classified as a component of equity. It also establishes a single method of accounting for changes in a parent’s ownership interest in a subsidiary and requires expanded disclosures. This statement is effective for fiscal years beginning on or after December 15, 2008, with early adoption prohibited. The Company does not expect adoption of SFAS No. 160 to have any impact on its financial position, results of operation, or cash flows.

In May 2008, the FASB issued SFAS No. 162, The Hierarchy of Generally Accepted Accounting Principles (“SFAS No. 162”). This statement identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of financial statements of nongovernmental entities that are presented in conformity with U.S. GAAP. This Statement shall be effective sixty days following the Securities and Exchange Commission’s approval of the Public Company Accounting Oversight Board amendments to Auditing (United States) Section 411, The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles. The Company does not believe the adoption of SFAS No. 162 will have a material impact on its financial condition, results of operations or cash flows.

On March 28, 2008 the Company completed the acquisition of 100% of the outstanding stock of MCSB. The consolidated statements of income do not include the operations for MCSB prior to the acquisition on March 28, 2008.

The acquisition was accounted for as a purchase by the Company of MCSB using the purchase method of accounting; accordingly, the assets and liabilities of MCSB have been recorded at their respective fair values on the date the acquisition was completed. The acquisition was effected by the issuance of shares of the Company’s common stock to MCSB shareholders, subject to the assertion of dissenters’ rights. Except where dissenters’ rights were asserted, each share of MCSB common stock was exchanged for one share of the Company’s common stock. The shares of the Company’s common stock issued were recorded at $8.73 per share. This represented the average of the closing share prices of the Company’s common stock on the day of, and for the period two days prior and two days after August 10, 2007, the day of the announcement of the acquisition.

In the acquisition, shareholders of MCSB received 345,691 shares of the Company’s stock valued at $3.0 million, a liability was established for dissenters’ rights payments totaling $0.2 million, and purchase price consideration was reduced by registration costs of $0.2 million. In addition, the Company incurred $0.8 million in direct acquisition costs. Included in this amount is a severance benefit for Mutual employees terminated within 60 days after the acquisition, equal to two weeks salary plus a further one week’s salary for each year of credited service with MCSB in excess of two years, with the minimum severance of four weeks’ salary. The purchase price allocation is as follows:

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The aggregate value of the Company common stock exchanged and cash consideration paid was less than the fair value of the net assets of MCSB, resulting in a “credit excess” which was allocated on a pro rata basis against amounts assigned to the acquired assets except (i) financial assets other than investments accounted for by the equity method, (ii) assets to be disposed of by sale, (iii) deferred tax assets, (iv) prepaid assets relating to pension or other postretirement benefits, and (v) any other current assets. The credit excess remaining after reducing to zero the amounts that otherwise would have been assigned to those assets has been recognized as an extraordinary gain in the Company’s statement of operations. In accordance with the purchase method of accounting, the Company’s financial statements for periods before consummation of the acquisition were not restated to reflect MCSB’s historical financial position or results of operations.

The results of the fair market valuation indicated that there were no core deposit intangibles, and in accordance with SFAS No. 141 the fair value of premises and equipment of $1.0 million was eliminated against the initial calculation of the credit excess. Any remaining credit was recorded as extraordinary gain. The allocations made are preliminary and such amounts are subject to adjustments as additional analysis is performed or obtained from other third party sources. Any such adjustments would impact the extraordinary gain recognized herein.

On April 10, 2008, a dissenting MCSB shareholder requested a payout of his 18,028 shares under dissenters’ rights. This shareholder requested a payment per share that was greater than the Company’s estimate of the fair value of its shares, as previously offered and paid by the Company. The dissenting shareholder corresponded with the Company regarding the fair value of MCSB’s shares. The Company believes that the dissenting shareholder did not timely commence court proceedings and has forfeited the right to judicial appraisal to determine the fair value of the shares and accrued interest.

The following pro-forma information, for the three and nine-month periods ended September 30, 2008 and 2007, reflects the Company’s estimated consolidated results of operations as if the acquisition occurred at January 1 of the respective periods, unadjusted for any anticipated cost savings resulting from the acquisition. Unaudited pro forma data is not necessarily indicative of the results that would have occurred had the acquisition taken place at the beginning of the periods presented, nor of future results.

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Basic earnings per share (“EPS”) computations are based upon the weighted average number of shares outstanding during the periods. Diluted earnings per share computations are based upon the weighted average number of shares outstanding during each period plus the dilutive effect of outstanding stock options. The weighted average shares and effect of dilutive stock options are included in the following table, which provides a reconciliation of the number of shares between the computation of basic EPS and diluted EPS:

The Company had 25,200 options outstanding as of September 30, 2008 and 2007. Options outstanding were anti-dilutive for the three and nine-month periods ended September 30, 2008.

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Loans are made primarily to customers in the Company’s market areas within North Carolina. The Company’s loans, classified by type were as follows:

Nonperforming assets were as follows:

The Company’s total allowance for loan losses to nonperforming assets decreased from 100.85% to 49.55%, while nonaccrual loans increased from $1.5 million to $4.1 million between December 31, 2007 and September 30, 2008. The real estate construction and commercial loan portfolios are predominately owner-occupied in a unique market in which the Company has specialized lending expertise. This real estate construction portion of the loan portfolio has decreased from 6.3% of the total loans outstanding as of December 31, 2007 to 1.1% of total loans outstanding as of September 30, 2008, principally because upon completion of the construction, loans are converted to real estate secured loans. The Company’s loan portfolio has no acquisition and development loans.

The Company acquired $1.6 million in nonaccrual loans in the acquisition of MCSB, and evaluated the risk of loss and the underlying collateral for each loan to ensure adequacy of allowance coverage. It is the opinion of management that the allowance adequately addresses the risk of loss for nonaccrual and impaired loans in the Company’s portfolio.

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Allowances for loan losses consisted of the following:

Dividends have been declared and paid quarterly as follows:

The Company sponsors a non-contributory qualified defined benefit retirement (pension) plan for substantially all full-time employees. The Company also sponsors a non-qualified, unfunded supplemental executive retirement plan that provides benefits to certain current and former executives.

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The components of the net periodic benefit cost are reflected in salaries and benefits expense for the nine months ended September 30, 2008 and 2007 were as follows:

The Company provides post-retirement benefits to certain former executive officers. In 2008, a liability was established to record certain split-dollar insurance contract benefits to specified current and former executive officers. As of September 30, 2008, the amount of this liability was $0.2 million and is reflected in other liabilities.

Comprehensive loss includes net income (loss) and all other changes to the Company’s equity, with the exception of transactions with shareholders. The Company’s other comprehensive (loss) income and accumulated other comprehensive (loss) income are comprised of unrealized gains and losses on certain investments in debt securities.

During the second quarter of 2008, management conducted an in-depth review of the Company’s fixed assets and identified an error in its disclosure of the Company’s estimate of the useful lives for premises, erroneously stating that the estimated useful lives for premises, “range from 15 to 30 years”, whereas in practice the estimated useful lives for premises has ranged from 40 to 50 years. As such, this error had no impact on the Company’s financial position or results of operation. The Board of the Company’s subsidiary has approved an updated policy with estimated useful lives for premises ranging from 30 to 50 years.

In addition, the review of the Company’s fixed assets identified that estimated useful lives of some assets should be revised. This resulted in computer hardware and software being expensed in the quarter ended June 30, 2008 in the aggregate amount of $0.3 million, and other assets expensed in the aggregate amount of $0.03 million, which expenses are reflected in the results of operations in occupancy and equipment for the nine months ended September 30, 2008. These changes in estimate have been applied prospectively, and have reduced net fixed assets by $0.3 million. The adjustment reduced net income by $0.2 million after tax, or $0.11 per share for the nine months ended September 30, 2008.

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On January 1, 2008, the Company adopted SFAS No. 157, “Fair Value Measurements,” which defines fair value, establishes a framework for measuring fair value under U.S. GAAP, and enhances disclosures about fair value measurements. The Company elected not to delay the application of SFAS No. 157 to non-financial assets and non-financial liabilities, as allowed by FASB Staff Position SFAS 157-2. SFAS No. 157 applies whenever other standards require (or permit) assets or liabilities to be measured at fair value and, therefore, does not expand the use of fair value in any new circumstances. Fair value is defined as the exchange price that would be received to sell an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. SFAS No. 157 clarifies that fair value should be based on the assumptions market participants would use when pricing an asset or liability and establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. The fair value hierarchy gives the highest priority to quoted prices in active markets and the lowest priority to unobservable data. SFAS No. 157 requires fair value measurements to be separately disclosed by level within the fair value hierarchy. Under SFAS No. 157, the Company bases fair values on the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. For assets and liabilities recorded at fair value, it is the Company’s policy to maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements, in accordance with the fair value hierarchy in SFAS No. 157.

Fair value measurements for assets and liabilities where there exists limited or no observable market data and, therefore, are based primarily upon estimates, are often calculated based on the economic and competitive environment, the characteristics of the asset or liability and other factors. Therefore, the results cannot be determined with precision and may not be realized in an actual sale or immediate settlement of the asset or liability. Additionally, there may be inherent weaknesses in any calculation technique, and changes in the underlying assumptions used, including discount rates and estimates of future cash flows, could significantly affect the results of current or future values.

The Company utilizes fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. Securities available-for-sale and derivatives are recorded at fair value on a recurring basis. Additionally, from time to time, the Company may be required to record at fair value other assets on a nonrecurring basis, such as loans held for sale, loans held for investment and certain other assets. These nonrecurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets.

Under SFAS No. 157, the Company groups assets and liabilities at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:

Level 1 — Valuations for assets and liabilities traded in active exchange markets, such as the New York Stock Exchange. The Company has none of these instruments at September 30, 2008.

Level 2 — Valuations are obtained from readily available pricing sources via independent providers for market transactions involving similar assets or liabilities. The Company’s principal market for these securities is the secondary institutional markets and valuations are based on observable market data in those markets. Level 2 securities include U. S. Government agency obligations, state and municipal bonds and mortgage-backed securities. The Company has Level 2 securities at September 30, 2008.

Level 3 — Valuations for assets and liabilities that are derived from other valuation methodologies, including option pricing models, discounted cash flow models and similar techniques, and not based on market exchange, dealer, or broker traded transactions. Level 3 valuations incorporate certain assumptions and projections in determining the fair value assigned to such assets or liabilities. The Company has Level 3 assets and liabilities at September 30, 2008.

Impaired loans: Impaired loans are evaluated and valued at the time the loan is identified as impaired, and are carried at the lower of cost or market value. Market value is measured based on the value of the collateral securing these loans or net present value of expected future cash flows discounted at the loan’s effective interest rate. Impaired loans are classified at a Level 3 in the fair value hierarchy. Collateral may be real estate and/or business assets including equipment, inventory, and/or accounts receivable. The value of business equipment, inventory, and accounts receivable collateral is based on net book value on the business’ financial statements and, if necessary, discounted based on management’s review and analysis. Appraised and reported values may be discounted based on management’s historical knowledge, changes in market conditions from the time of valuation, and/or management’s expertise and knowledge of the client and the client’s business. Impaired loans are reviewed and evaluated on at least a quarterly basis for additional impairment and adjusted accordingly, based on the same factors identified above.

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Foreclosed assets: Foreclosed assets are adjusted to fair value, less costs to sell, upon transfer of the loans to foreclosed assets. Subsequently, foreclosed assets are carried at the lower of the carrying value or the fair value, less costs to sell. Fair value is based upon independent market prices, appraised values of the collateral, or management’s estimation of the value of the collateral. The Company records the foreclosed asset as nonrecurring Level 3.

The following table summarizes quantitative disclosures about the fair value measurement for each category of assets carried at fair value as of September 30, 2008.

The following discussion relates to the fair values of the acquisition of MCSB:

Loans: Management, in connection with valuation experts, performed a discounted cash flow analysis to determine the present value of the loans acquired from MCSB. The discount rate utilized was based on the weighted average coupon rate of each loan category in the acquired portfolio compared to current market rates for similar loans as suggested by SFAS No. 107 – “Disclosures about Fair Value of Financial Instruments” as amended by SFAS No. 157. Since market quotes for the valuation date are not readily available for all of the various categories of loans acquired, the valuation was based on MCSB’s posted rates for similar loan categories as of the acquisition date (Level 1 inputs). For commercial loans, the most current interest rate information on the measurement date for commercial and industrial loans made by small domestic banks was from the Federal Reserve’s E. Survey of Terms of Business Lending released on March 14, 2008 which included averages for more than $19 billion dollars of new loans for the measurement period dated February 4-8, 2008. In addition, Freddie Mac’s weekly Primary Mortgage Market Survey for the week ending March 27, 2008 was utilized (Level 2 inputs).

These assumptions resulted in the fair value shown below, equating to a weighted rate reduction of 17 basis points in a replacement scenario. The Loan portfolio has been reflected in the table below as Level 2.

Fixed assets: Real estate appraisers analyzed the value of the buildings acquired utilizing market and cash flow assumptions. All other fixed assets, which were insignificant, were reflected at book value. With the mix of book and appraised values, fixed assets have been reflected as Level 3 assets.

Deposits: The fair value of core deposits as determined by the valuation experts utilized a discounted cash flow analysis of the deposits acquired from MCSB compared to alternative funding sources available to the Company to support the deposits acquired. Paragraph 12 of SFAS No. 107, for deposit liabilities with no defined maturities, defines the fair value of deposits as the amount payable on demand at the reporting date; therefore no mark-to-market adjustment is required. The fair value determination involves a number of underlying inputs and input levels:

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These assumptions did not provide a positive core deposit intangible premium value primarily as a result of the excessive overhead cost burden associated with multiple branch locations with a very small core deposit base. Given the mix of Level 2 and Level 3 inputs, the full fair value for deposits has been reflected in the table below as Level 3.

FHLB of Atlanta Borrowing Valuation: A discounted cash flow analysis was utilized to determine the present value of the borrowings from the FHLB acquired in the transaction pursuant to SFAS No. 107 as amended by SFAS No. 157. The fair value of borrowed funds due within one year is the amount payable at the reporting date. The fair value of long term borrowed funds is estimated by discounting the future cash flows using the current rates at which similar loans could be obtained with similar credit ratings and for the same remaining maturities. FHLB advances are unique in that funds are available to member banks based on established size limitations and are not subject to pricing variations based on traditional credit ratings of the borrower as in a typical borrower/lender relationship. Consequently, the fair value adjustment only needs to take into account interest rate variations from the last date of pricing until the next re-pricing date in the case of adjustable rate credits and the next maturity date in the case of a fixed rate credit. Given the ready market information available to all member banks, this has been reflected in the table below as a Level 2.

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The following table gives the fair values as of the acquisition date of MCSB: