SOUTHERN FIRST BANCSHARES INC - Quarter Report: 2005 September (Form 10-Q)

GREENVILLE FIRST BANCSHARES, INC.
PART I.  FINANCIAL INFORMATION

Item 1.  Financial Statements

       The financial statements of Greenville First Bancshares, Inc. and Subsidiary are set forth in the following pages.

   GREENVILLE FIRST BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS

See notes to consolidated financial statements that are an integral part of these consolidated statements.

 GREENVILLE FIRST BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF INCOME

 See notes to consolidated financial statements that are an integral part of these consolidated statements.     

GREENVILLE FIRST BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF INCOME

See notes to consolidated financial statements that are an integral part of these consolidated statements.

GREENVILLE FIRST BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
AND COMPREHENSIVE INCOME
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2005 AND 2004
(Unaudited)

 See notes to consolidated financial statements that are an integral part of these consolidated statements.

GREENVILLE FIRST BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS

See notes to consolidated financial statements that are an integral part of these consolidated statements.

GREENVILLE FIRST BANCSHARES, INC.  AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1 - Nature of Business and Basis of Presentation

Business activity

           Greenville First Bancshares, Inc. is a South Carolina corporation that owns all of the capital stock of Greenville First Bank, N.A. and all of the stock of Greenville First Statutory Trust I (the "Trust").  The bank is a national bank organized under the laws of the United States located in Greenville County, South Carolina.  The bank is primarily engaged in the business of accepting demand deposits and savings deposits insured by the Federal Deposit Insurance Corporation, and providing commercial, consumer and mortgage loans to the general public.  The Trust is a special purpose subsidiary for the sole purpose of issuing trust preferred securities.

Basis of Presentation

          The accompanying financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q.  Accordingly, they do not include all the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements.  In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included.  Operating results for the three-month and nine-month periods ended September 30, 2005 are not necessarily indicative of the results that may be expected for the year ending December 31, 2005.  For further information, refer to the consolidated financial statements and footnotes thereto included in the company's Form 10-KSB for the year ended December 31, 2004 (Registration Number 000-27719) as filed with the Securities and Exchange Commission.  The consolidated financial statements include the accounts of Greenville First Bancshares, Inc., and its wholly owned subsidiary Greenville First Bank, N.A.  As discussed in Note 2, the financial statements related to the special purpose subsidiary, Greenville First Statutory Trust I, have not been consolidated in accordance with FASB Interpretation No. 46.

 Cash and Cash Equivalents

          For purposes of the Consolidated Statements of Cash Flows, cash and federal funds sold are included in "cash and cash equivalents."  These assets have contractual maturities of less than three months.

Note 2 - Accounting for Variable Interest Entities

          Effective January 1, 2004, the company adopted FASB Interpretation No. 46, ("FIN 46"), "Consolidation of Variable Interest Entities." In accordance with FIN 46, the $186,000 investment by the parent company, Greenville First Bancshares, Inc,  in the special purpose subsidiary, Greenville First Statutory Trust I,  results in the special purpose subsidiary being treated as a "variable interest entity" as defined in FIN 46.  Therefore, in accordance with the revised rules, the company did not consolidate its special purpose trust subsidiary.  Prior to January 1, 2004, the effective date of the adoption of FIN 46, the company had consolidated the special purpose subsidiary.  The 2003 consolidated financial statements have been restated, resulting in the "deconsolidation" of this wholly-owned subsidiary.  The deconsolidation of this wholly-owned subsidiary increased both the company's other assets by $186,000 and the debt associated with the junior subordinated debentures.  The company's maximum exposure to loss on this debt is the $186,000 invested in the special purpose subsidiary.  However, in addition to the loss exposure related to the investment in the special purpose subsidiary, the company has a full and unconditional guarantee for the $6,000,000 junior subordinated debentures that were issued.  The special purpose subsidiary was formed for the sole purpose of issuing the junior subordinated debentures.

         The company has an unused $4.5 million revolving line of credit with another bank that matures on March 20, 2006.  The line of credit bears interest at a rate of three-month libor plus 2.00%, which at September 30, 2005 was 6.07%.  The company has pledged the stock of the bank as collateral for this line of credit.  The line of credit agreement contains various covenants related to net income and asset quality.  As of September 30, 2005, the company believes it is in compliance with all covenants.

Note 4 - Earnings per Share

          The following schedule reconciles the numerators and denominators of the basic and diluted earnings per share computations for the three months and nine months ended September 30, 2005 and 2004.  Dilutive common shares arise from the potentially dilutive effect of the company's stock options and warrants that are outstanding.  The assumed conversion of stock options and warrants can create a difference between basic and dilutive net income per common share.  The average dilutive shares have been computed utilizing the "treasury stock" method.

Note 5 - Stock Based Compensation

             The company has a stock-based employee compensation plan.  The company accounts for the plan under the recognition and measurement principles of Accounting Principles Board ("APB") Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations.  No stock-based employee compensation cost is reflected in net income, as all stock options granted under these plans had an exercise price equal to the market value of the underlying common stock on the date of grant.  The following table illustrates the effect on net income and earnings per share if the company had applied the fair value recognition provisions of Financial Accounting Standards Board ("FASB"), Statement of Financial Accounting Standards ("SFAS") No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation.

                The fair value of the option grant is estimated on the date of grant using the Black-Scholes option-pricing model.  The following assumptions were used for grants: expected volatility of 10% for 2004, risk-free interest rate of 3.00% for 2004, expected lives of the options 10 years, and the assumed dividend rate was zero.  No options were granted during the nine months ended September 30, 2005.

Item 2.  Management's Discussion and Analysis of Financial Condition and Results of Operations.

The following discussion reviews our results of operations and assesses our financial condition.  You should read the following discussion and analysis in conjunction with the accompanying consolidated financial statements.  The commentary should be read in conjunction with the discussion of forward-looking statements, the financial statements and the related notes and the other statistical information included in this report.

DISCUSSION OF FORWARD-LOOKING STATEMENTS

          This report contains "forward-looking statements" relating to, without limitation, future economic performance, plans and objectives of management for future operations, and projections of revenues and other financial items that are based on the beliefs of management, as well as assumptions made by and information currently available to management.  The words "may," "will," "anticipate," "should," "would," "believe," "contemplate," "expect," "estimate," "continue," and "intend," as well as other similar words and expressions of the future, are intended to identify forward-looking statements.  Our actual results may differ materially from the results discussed in the forward-looking statements, and our operating performance each quarter is subject to various risks and uncertainties that are discussed in detail in our filings with the Securities and Exchange Commission, including, without limitation:

•         significant increases in competitive pressure in the banking and financial services industries;

•         changes in the interest rate environment which could reduce anticipated or actual margins;

•         changes in political conditions or the legislative or regulatory environment;

•         general economic conditions, either nationally or regionally and especially in our primary service area, becoming less favorable than expected resulting in, among other things, a deterioration in credit quality;

•         changes occurring in business conditions and inflation;

•         changes in technology;

•         changes in monetary and tax policies;

•         the level of allowance for loan loss;

•         the rate of delinquencies and amounts of charge-offs;

•         the rates of loan growth and the lack of seasoning of our loan portfolio;

•         adverse changes in asset quality and resulting credit risk-related losses and expenses;

•         loss of consumer confidence and economic disruptions resulting from terrorist activities;

•         changes in the securities markets; and

•         other risks and uncertainties detailed from time to time in our filings with the Securities and Exchange Commission

Overview

  We were incorporated in March 1999 to organize and serve as the holding company for Greenville First Bank, N.A.  Since we opened our bank in January 2000, we have experienced consistent growth in total assets, loans, deposits, and shareholders' equity, which has continued during the first nine months of 2005.  To support this growth, we conducted an underwritten public offering of our common stock in September and October 2004.  On September 24, 2004 and October 15, 2004, we sold 800,000 and 120,000 shares, respectively, of common stock.  The net proceeds from this offering were approximately $15.0 million.

Like most community banks, we derive the majority of our income from interest received on our loans and investments.  Our primary source of funds for making these loans and investments is our deposits, on which we pay interest.  Consequently, one of the key measures of our success is our amount of net interest income, or the difference between the income on our interest-earning assets, such as loans and investments, and the expense on our interest-bearing liabilities, such as deposits and borrowings.  Another key measure is the spread between the yield we earn on these interest-earning assets and the rate we pay on our interest-bearing liabilities, which is called our net interest spread. 

There are risks inherent in all loans, so we maintain an allowance for loan losses to absorb probable losses on existing loans that may become uncollectible.  We maintain this allowance by charging a provision for loan losses against our operating earnings for each period.  We have included a detailed discussion of this process, as well as several tables describing our allowance for loan losses.

In addition to earning interest on our loans and investments, we earn income through fees and other charges to our customers.  We have also included a discussion of the various components of this noninterest income, as well as of our noninterest expense.

               The following discussion and analysis also identifies significant factors that have affected our financial position and operating results during the periods included in the accompanying financial statements.  We encourage you to read this discussion and analysis in conjunction with our financial statements and the other statistical information included in our filings with the Securities and Exchange Commission.

Critical Accounting Policies

          We have adopted various accounting policies that govern the application of accounting principles generally accepted in the United States and with general practices within the banking industry in the preparation of our financial statements.  Our significant accounting policies are described in the footnotes to our audited consolidated financial statements as of December 31, 2004, as filed in our annual report on Form 10-KSB.

            Certain accounting policies involve significant judgments and assumptions by us that have a material impact on the carrying value of certain assets and liabilities.  We consider these accounting policies to be critical accounting policies.  The judgment and assumptions we use are based on historical experience and other factors, which we believe to be reasonable under the circumstances.  Because of the nature of the judgment and assumptions we make, actual results could differ from these judgments and estimates that could have a material impact on the carrying values of our assets and liabilities and our results of operations.

            We believe the allowance for loan losses is the critical accounting policy that requires the most significant judgment and estimates used in preparation of our consolidated financial statements.  Some of the more critical judgments supporting the amount of our allowance for loan losses include judgments about the credit worthiness of borrowers, the estimated value of the underlying collateral, the assumptions about cash flow, determination of loss factors for estimating credit losses, the impact of current events, and conditions, and other factors impacting the level of probable inherent losses.  Under different conditions, the actual amount of credit losses incurred by us may be different from management's estimates provided in our consolidated financial statements.  Refer to the portion of this discussion that addresses our allowance for loan losses for a more complete discussion of our processes and methodology for determining our allowance for loan losses.

Effect of Economic Trends

             During the year ended December 31, 2004, our rates on both short-term or variable rate earning assets and short-term or variable rate interest-bearing liabilities declined primarily as a result of the previous actions taken by the Federal Reserve to lower short-term rates.  Our rates on both short-term or variable earning assets and short-term or variable rate interest-bearing liabilities began to increase in the third quarter of 2004 as a result of actions taken by the Federal Reserve to increase short-term rates.

              During the first six months of 2004, many economists believed the economy began to show signs of strengthening.  After operating under historically low interest rates during the first half of 2004, the Federal Reserve increased the short-term interest rate five times for a total of 125 basis points in the second half of 2004. During the first nine months of 2005, the Federal Reserve continued to increase rates an additional 150 basis points.  Many economists believe that the Federal Reserve will continue to increase rates during the remainder of 2005. However, no assurance can be given that the Federal Reserve will take such action.

Results of Operations

Income Statement Review

Summary

 Three months ended September 30, 2005 and 2004

            Our net income was $927,321 and $506,906 for the three months ended September 30, 2005 and 2004, respectively, an increase of $420,415, or 82.9%.  The $420,415 increase in net income resulted primarily from an increase of $913,738 in net interest income and a decrease of $150,000 in the provision for loan losses which was partially offset by $403,272 of additional noninterest expense and a $257,481 increase in income tax expense.  Our efficiency ratio has continued to improve because our net interest income and other income continue to increase at a higher rate than the increases in our overhead expenses.  Our efficiency ratio was 48.0% and 49.8% for the three months ended September 30, 2005 and 2004, respectively. 

 Nine months ended September 30, 2005 and 2004

            Our net income was $2,409,127 and $1,308,707 for the nine months ended September 30, 2005 and 2004, respectively, an increase of $1,100,420, or 84.1%.  The $1,100,420 increase in net income resulted primarily from an increase of $2,622,237 in net interest income and a decrease of $190,000 in the provision for loan losses which was partially offset by $1,122,964 of additional noninterest expense and a $674,252 increase in income tax expense.  Our efficiency ratio has continued to improve because our net interest income and other income continue to increase at a higher rate than the increases in our overhead expenses.  Our efficiency ratio was 49.5% and 52.7% for the nine months ended September 30, 2005 and 2004, respectively. 

Net Interest Income

             Our level of net interest income is determined by the level of earning assets and the management of our net interest margin.  The continuous growth in our loan portfolio is the primary driver of the increase in net interest income.  During the nine months ended September 30, 2005, our average loan portfolio increased $69.2 million compared to the average for the nine months ended September 30, 2004.  The growth in the first nine months of 2005 was $69.6 million.  We anticipate the growth in loans will continue to drive the growth in assets and the growth in net interest income.  However, no assurance can be given that we will be able to continue to increase loans at the same levels we have experienced in the past. 

               Our decision to grow the loan portfolio at the current pace created the need for a higher level of capital and the need to increase deposits and borrowings.  This loan growth strategy also resulted in a significant portion of our assets being in higher earning loans than in lower yielding investments.  At September 30, 2005, loans represented 85.2% of total assets, while investments and federal funds sold represented 11.6% of total assets.  While we plan to continue our focus on increasing the loan portfolio, as rates on investment securities begin to rise and additional deposits are obtained, we also anticipate increasing the size of the investment portfolio.  We also intend to maintain a capital level for the bank that exceeds the Office of the Comptroller of the Currency (OCC) requirements to be classified as a "well capitalized" bank.

                The historically low interest rate environment in the last three years allowed us to obtain short-term borrowings and wholesale certificates of deposit at rates that were lower than certificate of deposit rates being offered in our local market.  Therefore, we decided not to begin our retail deposit office expansion program until the beginning of 2005.  This funding strategy allowed us to continue to operate in one location, maintain a smaller staff, and not incur marketing costs to advertise deposit rates, which in turn allowed us to focus on the fast growing loan portfolio.  At September 30, 2005, retail deposits represented $153.7 million, or 41.0% of total assets, borrowings represented $103.9 million, or 27.7% of total assets, and wholesale out-of-market deposits represented $83.2 million, or 22.2% of total assets.

In anticipation of rising interest rates, we opened one retail deposit office in March of 2005 and a second retail deposit office in the beginning of November 2005.  We plan to focus our efforts in these two locations to obtain low cost transaction accounts that are less affected by rising rates.  Also, in anticipation of rising rates, during the first three months of 2005 we offered aggressive rates on retail certificates of deposits.  In conjunction with the new retail office, we anticipate offering aggressive rates to obtain checking accounts and new money market accounts.  We anticipate that the higher rates being offered may increase our overall cost of funds.  Our goal is to increase both the percentage of assets being funded by "in market" retail deposits and to increase the percentage of low-cost transaction accounts to total deposits.  No assurance can be given that these objectives will be achieved; however, we anticipate that the two additional retail deposit offices will assist us in meeting these objectives.  We also anticipate the current deposit promotion and the opening of the two new offices will have a negative impact on earnings in the years ending 2005 and 2006.  However, we believe that these two strategies will provide additional clients in our local market and will provide a lower alternative cost of funding in a higher or rising interest rate environment, which we believe will increase earnings in future periods.

As more fully discussed in the - "Market Risk" and - "Liquidity and Interest Rate Sensitivity" sections below, at September 30, 2005, 65.7% of our loans had variable rates.  In anticipation of rising rates, during the first six months in 2005, we extended the maturities on various FHLB advances and wholesale certificates of deposit.  This strategy improves our ability to manage the impact on our earnings resulting from anticipated increases in market interest rates.  At September 30, 2005, 70.0% of interest-bearing liabilities had a maturity of less than one year.   Therefore, we believe that we are positioned to benefit from future increases in short-term rates.  At September 30, 2005, we had $79.3 million more assets than liabilities that reprice within the next three months.  Accordingly, we believe that our net interest spread may continue to increase if further action is taken by the Federal Reserve to continue to increase short-term rates.

During the three months and nine months ended September 30, 2005, our rates on both short-term or variable rate earning-assets and short-term or variable rate interest-bearing liabilities began to increase primarily as a result of the actions taken by the Federal Reserve over the last twelve months to raise short-term rates.   The impact of the Federal Reserve's actions resulted in an increase in both the yields on our variable rate assets and the rates that we paid for our short-term deposits and borrowings.  Our net interest spread increased slightly since more of our rate sensitive assets repriced sooner than our rate sensitive liabilities during the 12 month period ending September 30, 2005.  We have chosen to limit the exposure to changes in short-term rates by targeting to have the majority of our assets reprice within one year.  We are also targeting to have approximately the same level of liabilities to reprice within the same twelve month period.  Our net interest spread for the three month and nine month periods ended September 30, 2005 was 3.02% and 2.99%, respectively.  Because we had more interest-earning assets than interest-bearing liabilities that repriced, our net interest spread increased 5 basis points in the three months ended September 30, 2005 and by 2 basis points in the nine months ended September 30, 2005, compared to the same respective periods in 2004.

In addition to the growth in both assets and liabilities, and the timing of repricing of our assets and liabilities, net interest income is also affected by the ratio of interest-earning assets to interest-bearing liabilities.                                                         

For the three months and nine months ended September 30, 2005, our net interest margin was 3.45% and 3.39%, respectively.  The change in our net interest margin was 25 basis points higher than the change in net interest spread for the three month period ended September 30, 2005 and 22 basis points higher for the nine month period ended September 30, 2005 when compared to the same periods in 2004.  The additional 25 and 22 basis points resulted primarily because our interest-earning assets exceeded interest-bearing liabilities by $47.1 million and $44.6 million for the three and nine month periods ended September 30, 2005, respectively, compared to $22.7 million and $22.4 million for the same periods in 2004.  These changes are primarily a result from the impact of the secondary offering that was completed in the last half of 2004.

We have included a number of tables to assist in our description of various measures of our financial performance.  For example, the "Average Balances" tables show the average balance of each category of our assets and liabilities as well as the yield we earned or the rate we paid with respect to each category during both the three months ended September 30, 2005 and 2004 and the first nine months of 2005 and 2004.  A review of these tables shows that our loans typically provide higher interest yields than do other types of interest-earning assets, which is why we direct a substantial percentage of our earning assets into our loan portfolio.  Similarly, the "Rate/Volume Analysis" tables help demonstrate the effect of changing interest rates and changing volume of assets and liabilities on our financial condition during the periods shown.  A review of these tables shows the significant poriton of the increase in net interest income results from the changes in volume.  We also track the sensitivity of our various categories of assets and liabilities to changes in interest rates, and we have included tables to illustrate our interest rate sensitivity with respect to interest-earning accounts and interest-bearing accounts.  Finally, we have included various tables that provide detail about our investment securities, our loans, our deposits, and other borrowings.

The following tables set forth information related to our average balance sheets, average yields on assets, and average costs of liabilities.  We derived these yields by dividing income or expense by the average balance of the corresponding assets or liabilities.  We derived average balances from the daily balances throughout the periods indicated.  During the nine months ended September 30, 2005 and 2004, all investments were taxable.  During the same periods, we had no interest-bearing deposits in other banks or any securities purchased with agreements to resell.  All investments were owned at an original maturity of over one year.  Nonaccrual loans are included in the following tables.  Loan yields have been reduced to reflect the negative impact on our earnings of loans on nonaccrual status.  The net of capitalized loan costs and fees are amortized into interest income on loans.

Our net interest spread was 3.02% for the three months ended September 30, 2005, compared to 2.97% for the three months ended September 30, 2004.

Our net interest margin for the three months ended September 30, 2005 was 3.45%, compared to 3.15% for the three months ended September 30, 2004.  During the three months ended September 30, 2005, earning assets averaged $357.1 million, compared to $276.5 million in the three months ended September 30, 2004.  Interest earning assets exceeded interest bearing liabilities by $47.1 million and $22.7 million for the three month periods ended September 30, 2005 and 2004, respectively.  Our higher level of interest-earning assets compared to interest-bearing liabilities in the 2005 period resulted from the proceeds from the secondary offering that was completed in the third and fourth quarters of 2004.  Our net interest spread increased 5 basis points in the third quarter of 2005 while the net interest margin increased 30 basis points.  Our net margin increased more than the net interest spread primarily as a result of additional capital raised during the second half of 2004.

Our loan yield increased 120 basis points for the three months ended September 30, 2005 compared to the three months ended September 30, 2004 as a result of approximately two thirds of the loan portfolio having variable rates, combined with the increase in prime rates over the twelve months ended September 30, 2005.  Our deposit cost also increased as a result of our decision to aggressively market interest-bearing transaction accounts by paying an above market rate.  Also, we extended the maturity dates on various jumbo time deposits.  These decisions along with the higher overall market rates resulted in the deposit costs in the third quarter of 2005 being 82 basis points higher than in the third quarter of 2004.  In addition to the impact of the increase in short-term borrowing rates on variable FHLB advances, we also extended the maturities of various FHLB advances resulting in higher borrowing costs in the third quarter of 2005 compared to 2004.  The 169 basis point increase in other borrowed funds in the third quarter of 2005 compared to the same period in 2004 resulted from the impact of the 200 basis point increase in short-term market rates.  All the other borrowings rates are tied to short-term market interest rates. 

Net interest income, the largest component of our income, was $3.1 million and $2.2 million for the three months ended September 30, 2005 and 2004, respectively.  The significant increase in the third quarter of 2005 related to higher levels of both average earning assets and interest-bearing liabilities.  Average earning assets were $80.7 million higher during the three months ended September 30, 2005 compared to the same period in 2004. 

The $913,738 increase in net interest income for the three months ended September 30, 2005 compared to the same period in 2004 resulted primarily from a $717,000 increase in net interest income related to the impact of higher average earning assets and interest-bearing liabilities in the three months ended September 30, 2005 compared to the same period in 2004.  The remaining increase is largely a result of the impact of higher interest rates on both interest-earning assets and interest-bearing liabilities.

Interest income for the three months ended September 30, 2005 was $5.7 million, consisting of $5.2 million on loans, $416,249 on investments, and $18,436 on federal funds sold.  Interest income for the three months ended September 30, 2004 was $3.6 million, consisting of $3.4 million on loans, $224,993 on investments, and $6,184 on federal funds sold.  Interest on loans for the three months ended September 30, 2005 and 2004 represented 92.3% and 93.6%, respectively, of total interest income, while income from investments and federal funds sold represented only 7.7% and 6.4% of total interest income.  The high percentage of interest income from loans relates to our strategy to maintain a significant portion of our assets in higher earning loans compared to lower yielding investments.  Average loans represented 89.0% and 91.8% of average interest-earning assets for the three months ended September 30, 2005 and 2004, respectively.  Included in interest income on loans for the three months ended September 30, 2005 and 2004, was $164,185 and $115,641, respectively, related to the net amortization of loan fees and capitalized loan origination costs.

Interest expense for the three months ended September 30, 2005 was $2.6 million, consisting of $1.6 million related to deposits and $935,121 related to borrowings.  Interest expense for the three months ended September 30, 2004 was $1.4 million, consisting of $943,048 related to deposits and $501,075 related to borrowings.  Interest expense on deposits for the three months ended September 30, 2005 and 2004 represented 63.5% and 65.3%, respectively, of total interest expense, while interest expense on borrowings represented 36.5% and 34.7%, respectively, of total interest expense for the same three month periods.  The lower percentage of interest expense on deposits and the higher percentage of interest on borrowings for the three months ended September 30, 2005 compared to the three months ended September 30, 2004 resulted from our decisions to delay our retail deposit office expansion program and instead utilize additional borrowings from the FHLB and from the sale of securities under agreements to repurchase with brokers.   During the three months ended September 30, 2005, average interest-bearing deposits increased by $43.5 million over the same period in 2004, while FHLB and other borrowing during the three months ended September 30, 2005 increased $12.8 million over the same period in 2004.  During the three months ended September 30, 2005, we were able to pledge additional collateral to the FHLB, allowing us the ability to increase our FHLB borrowings.  Both the short-term borrowings from the FHLB and the sale of securities under agreements to repurchase provide us with the opportunity to obtain low cost funding with various maturities similar to the maturities on our loans and investments. 

Our net interest spread was 2.99% for the nine months ended September 30, 2005, compared to 2.97% for the nine months ended September 30, 2004.

Our net interest margin for the nine months ended September 30, 2005 was 3.39%, compared to 3.15% for the nine months ended September 30, 2004.  During the nine months ended September 30, 2005, earning assets averaged $343.9 million, compared to $257.6 million in the nine months ended September 30, 2004.  Interest earning assets exceeded interest bearing liabilities by $44.5 million and $22.4 million for the nine month periods ended September 30, 2005 and 2004, respectively.  Our higher level of interest-earning assets compared to interest-bearing liabilities in the 2005 period resulted from the proceeds from the secondary offering that was completed in the third and fourth quarters of 2004.  Our net interest spread increased 2 basis points in the first nine months of 2005 while the net interest margin increased 24 basis points.  Our net margin increased more than the net interest spread primarily as a result of additional capital raised during the second half of 2004. 

Our loan yield increased 106 basis points for the nine months ended September 30, 2005 compared to the nine months ended September 30, 2004 as a result of approximately two thirds of the loan portfolio having variable rates, combined with the increase in prime rates over the twelve months ended September 30, 2005.  Our deposit cost increased as a result of our decision to aggressively market interest-bearing transaction accounts by paying an above market rate.  Also, we extended the maturity dates on various jumbo time deposits.  These decisions along with the higher overall market rates resulted in the deposit costs in the first nine months of 2005 being 73 basis points higher than in the first nine months of 2004.  In addition to the impact of the increase in short-term borrowing rates on variable FHLB advances, we also extended the maturities of various FHLB advances resulting in higher borrowing costs in the first nine months of 2005 compared to 2004.  The 152 basis point increase in other borrowed funds in the first nine months of 2005 compared to the same period in 2004 resulted from the impact of the 200 basis point increase in short-term market rates.  All the other borrowings rates are tied to short-term market interest rates. 

The $2.6 million increase in net interest income for the nine months ended September 30, 2005 compared to the same period in 2004 resulted primarily from a $2.2 million increase in net interest income related to the impact of higher average earning assets and interest-bearing liabilities in the nine months ended September 30, 2005 compared to the same period in 2004.  The remaining increase is largely a result of the impact of higher interest rates on both interest-earning and interest-bearing liabilities.

Interest income for the nine months ended September 30, 2005 was $15.5 million, consisting of $14.2 million on loans, $1.3 million on investments, and $51,756 on federal funds sold.  Interest income for the nine months ended September 30, 2004 was $9.8 million, consisting of $9.1 million on loans, $670,171 on investments, and $15,477 on federal funds sold.  Interest on loans for the nine months ended September 30, 2005 and 2004 represented 91.6% and 93.0%, respectively, of total interest income, while income from investments and federal funds sold represented only 8.4% and 7.0% of total interest income.  The high percentage of interest income from loans relates to our strategy to maintain a significant portion of our assets in higher earning loans compared to lower yielding investments.  Average loans represented 88.5% and 91.2% of average interest-earning assets for the nine months ended September 30, 2005 and 2004, respectively.  Included in interest income on loans for the nine months ended September 30, 2005 and 2004, was $441,024 and $347,960, respectively, related to the net amortization of loan fees and capitalized loan origination costs.

Interest expense for the nine months ended September 30, 2005 was $6.8 million, consisting of $4.2 million related to deposits and $2.6 million related to borrowings.  Interest expense for the nine months ended September 30, 2004 was $3.7 million, consisting of $2.5 million related to deposits and $1.2 million related to borrowings.  Interest expense on deposits for the nine months ended September 30, 2005 and 2004 represented 62.6% and 68.0%, respectively, of total interest expense, while interest expense on borrowings represented 37.4% and 32.0%, respectively, of total interest expense for the same periods.  The lower percentage of interest expense on deposits and the higher percentage of interest on borrowings for the nine months ended September 30, 2005 compared to the nine months ended September 30, 2004 resulted from our decisions to delay our retail deposit office expansion program and instead utilize additional borrowings from the FHLB and from the sale of securities under agreements to repurchase with brokers.   During the nine months ended September 30, 2005, average interest-bearing deposits increased by $40.5 million over the same period in 2004, while FHLB and other borrowings during the nine months ended September 30, 2005 increased $23.7 million over the same period in 2004.  During the nine months ended September 30, 2005, we were able to pledge additional collateral to the FHLB, allowing us the ability to increase our FHLB borrowings.  Both the short-term borrowings from the FHLB and the sale of securities under agreements to repurchase provide us with the opportunity to obtain low cost funding with various maturities similar to the maturities on our loans and investments. 

             Net interest income can be analyzed in terms of the impact of changing interest rates and changing volume.  The following tables set forth the effect which the varying levels of interest-earning assets and interest-bearing liabilities and the applicable rates have had on changes in net interest income for the periods presented.

Provision for Loan Losses

          We have established an allowance for loan losses through a provision for loan losses charged as an expense on our statement of income.  We review our loan portfolio periodically to evaluate our outstanding loans and to measure both the performance of the portfolio and the adequacy of the allowance for loan losses.  Please see the discussion below under "Balance Sheet Review - Provision and Allowance for Loan Losses" for a description of the factors we consider in determining the amount of the provision we expense each period to maintain this allowance.

           Nine months ended September 30, 2005 and 2004

            For the nine months ended September 30, 2005 and 2004, there was a noncash expense related to the provision for loan losses of $835,000 and $1,025,000, respectively.  The additional provisions and net recoveries on charged-off loans added to our allowance for loan losses in the nine months ended September 30, 2005 and 2004.  The net increase in the allowance for loan losses was $867,625 and $867,943 for the nine months ended September 30, 2005 and 2004, respectively.  The allowance for loan losses increased $32,625 more than the provision for loan losses in the nine months ended September 30, 2005 as a result of $62,286 in recoveries combined with charge-offs of $29,661 in the nine month period.  The allowance for loan losses at September 30, 2004 did not increase by the entire amount of the provision for loan losses because we reported net charge-offs of $157,057 for the nine months ended September 30, 2004.  The $157,057 net charge-offs during the first nine months of 2004 represented 0.07% of the average outstanding loan portfolio for the nine months ended September 30, 2004.  The $867,625 and the $867,943 increases in the allowance for the nine months ended September 30, 2005 and 2004, respectively, related to our decision to increase the allowance in response to the $44.0 million and the $59.0 million growth in loans for the nine months ended September 30, 2005 and 2004, respectively.  The loan loss reserve was $4.6 million and $3.6 million as of September 30, 2005 and 2004, respectively.  The allowance for loan losses as a percentage of gross loans was 1.41% at September 30, 2005 and 1.33% at September 30, 2004, while the percentage of nonperforming loans to gross loans was 0.38% and 0.07% at September 30, 2005 and 2004, respectively.

Noninterest Income

          The following tables set forth information related to our noninterest income.