SOUTHERN FIRST BANCSHARES INC - Quarter Report: 2006 June (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.

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 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.
                        

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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.

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GREENVILLE FIRST BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
AND COMPREHENSIVE INCOME
FOR THE SIX MONTHS ENDED JUNE 30, 2006  AND 2005
(Unaudited)

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

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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.

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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 and Trust II (collectively the "Trusts").  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 Trusts are special purpose subsidiaries 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 and six month periods ended June 30, 2006 are not necessarily indicative of the results that may be expected for the year ending December 31, 2006.  For further information, refer to the consolidated financial statements and footnotes thereto included in the company's Form 10-K for the year ended December 31, 2005 (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.  The financial statements related to the special purpose subsidiaries, Greenville First Statutory Trust I and Trust II, have not been consolidated in accordance with Financial Accounting Standards Board ("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 - Stock Dividend

             On June 20, 2006, the company's Board of Directors approved a 10 percent stock dividend to the company's shareholders.  The record date was July 24, 2006 and the distribution date was August 14, 2006.  Earnings per share and average shares outstanding have been adjusted to reflect the stock dividend in our Consolidated Statements of Income and in Note 4.

Note 3 - Note Payable

The company has an unused $4.5 million revolving line of credit with another bank that matures on March 20, 2007.  The line of credit bears interest at a rate of three-month libor plus 2.00%, which at June 30, 2006 was 7.48%.  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 June 30, 2006, the company believes it is in compliance with all covenants.

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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 six months ended June 30, 2006 and 2005.  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.  On January 1, 2006, the company adopted the fair value recognition provisions of the FASB's Statement of Financial Accounting Standards ("SFAS") No. 123(R), Accounting for Stock-Based Compensation, to account for compensation costs under its stock option plan.  The company previously utilized the intrinsic value method under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (as amended) ("APB 25").  Under the intrinsic value method prescribed by APB 25, no compensation costs were recognized for the company's stock options because the option exercise price in its plans equals the market price on the date of grant.  Prior to January 1, 2006, the company only disclosed the pro forma effects on net income and earnings per share as if the fair value recognition provisions of SFAS No. 123(R) had been utilized. On December 20, 2005, the Board of Directors approved accelerating the vesting of 45,813 unvested stock options effective December 28, 2005.  The decision to accelerate vesting of these options was made so as to reduce compensation expense upon the adoption of SFAS No. 123(R) by approximately $68,000 and $52,000 in the years ended December 31, 2006 and 2007, respectively, and $4,000 in each of the years ended December 31, 2008 and 2009.

            In adopting SFAS No. 123, the company elected to use the modified prospective method to account for the transition from the intrinsic value method to the fair value recognition method.  Under the modified prospective method, compensation cost is recognized from the adoption date forward for all new stock options granted and for any outstanding unvested awards as if the fair value method had been applied to those awards as of the date of grant. The following table illustrates the effect on net income and earnings per share as if the fair value based method had been applied to all outstanding and unvested awards in each period.  All stock options were fully vested at June 30, 2006.

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             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 6.76% for 2005, risk-free interest rate of 4.02% for 2005, expected lives of the options 10 years, and the assumed dividend rate was zero.  No options were granted during the three and six month periods ended June 30, 2006.

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

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  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 six months of 2006.  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, 2005, as filed in our annual report on Form 10-K.

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                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 judgments 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

 Beginning in July of 2004 and through the second quarter of 2006, our short-term or variable rate interest-earning assets and interest-bearing liabilities increased as the Federal Reserve began to increase short-term rates as the economy showed signs of strengthening following an economic decline and historically low interest rates.  During this period, the Federal Reserve increased rates 16 times for a total of 400 basis points.  Three of these rate increases occurred during the first six months of 2006 for a total of 75 basis points.  Many economists believe that the Federal Reserve is nearing the end of the rate increases.  The following discussion includes our analysis of the effect we anticipate these rising interest rates will have on our financial condition.  However, no assurance can be given that the Federal Reserve will actually end the interest rate hikes or that the results we anticipate will actually occur.

Results of Operations

Income Statement Review

Summary

Three months ended June 30, 2006 and 2005

Our net income was $969,955 and $821,658 for the three months ended June 30, 2006 and 2005, respectively, an increase of $148,297, or 18.1%.  The increase in net income resulted primarily from an increase of $641,547 in net interest income which was partially offset by an increase of $135,000 in the provision for loan losses, a decrease of $83,496 in noninterest income, $220,821 of additional noninterest expense and a $53,933 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 47.9% and 49.3% for the three months ended June 30, 2006 and 2005, respectively. 

Six months ended June 30, 2006 and 2005

                Our net income was $1,811,859 and $1,481,807 for the six months ended June 30, 2006 and 2005, respectively, an increase of $330,052, or 22.3%.  The increase in net income resulted primarily from an increase of $1,320,760 in net interest income, partly offset by an increase of $190,000 in the provision for loan losses, a decrease of $141,297 in noninterest income, $526,154 of additional noninterest expense and a $133,257 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 49.3% and 50.3% for the six months ended June 30, 2006 and 2005, respectively. 

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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 six months ended June 30, 2006, our average loan portfolio was $64.9 million higher compared to the average for the six months ended June 30, 2005.  The growth in the first six months of 2006 was $39.1 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 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 June 30, 2006, net loans represented 82.0% of total assets, while investments and federal funds sold represented 13.3% of total assets.  While we plan to continue our focus on increasing the loan portfolio, as rates on investment securities continue to rise and additional deposits are obtained, we also anticipate increasing the size of the investment portfolio. 

The historically low interest rate environment in the last four years allowed us to obtain short-term borrowings and wholesale certificates of deposit generally 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 until 2005, 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 June 30, 2006, retail deposits represented $218.2 million, or 47.9% of total assets, borrowings represented $124.6 million, or 27.4% of total assets, and wholesale out-of-market deposits represented $76.8 million, or 16.9% of total assets.

In anticipation of rising interest rates, we opened one retail deposit office in March of 2005 and a second in November of 2005.  We plan to focus our efforts in these two locations to obtain low cost transaction accounts that we believe will not be affected as much by changing rates.  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.  We anticipate that the two additional retail deposit offices will assist us in meeting these objectives, although no assurance can be given that these objectives will be achieved.  We also anticipate that deposit promotions and the opening of the two new offices will continue to have a negative impact on earnings in the year 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.

As more fully discussed in the - "Market Risk" and - "Liquidity and Interest Rate Sensitivity" sections below, at June 30, 2006, 54.6% of our loans had variable rates.  Given our percentage of rate-sensitive loans, our primary focus during the past three years has been to obtain short-term liabilities to fund our asset growth.  This strategy improves our ability to manage the impact on our earnings resulting from anticipated changes in market interest rates.

At June 30, 2006, 76.5% of our interest-bearing liabilities had a maturity of less than one year.   Therefore, we believe that we are positioned to benefit from future decreases in short-term rates.  Conversely, future increases in short-term rates would likely have a negative effect on our earnings.  At June 30, 2006, we had $58.0 million more liabilities than assets that reprice within the next twelve months. 

We intend to maintain a capital level for the bank that exceeds the OCC requirements to be classified as a "well capitalized" bank.  To provide the additional capital needed to support our bank's growth in assets, in 2003 we issued $6.2 million in junior subordinated debentures in connection with our trust preferred securities offering.  During 2004, we issued 920,000 additional shares of common stock that resulted in $14.9 million of additional capital.  In 2005, we issued an additional $7.2 million in junior subordinated debentures in a second trust preferred securities offering.  We also have a $4.5 million unused short-term holding company line of credit that could be utilized to provide additional capital for the bank if deemed necessary. As of June 30, 2006, the company's regulatory capital levels were over $13.7 million in excess of the various well capitalized requirements.

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 and the changes in interest rates earned on our assets and interest rates paid on our liabilities.

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Our net interest income margin was 3.33% and 3.40% for the three months and six months ended June 30, 2006, while our net interest spread was 2.90% and 2.96% for the same periods, respectively.  During these periods, our net interest margin exceeded our net interest spread because we had more interest-earning assets than interest-bearing liabilities.  Average interest-earning assets exceeded average interest-bearing liabilities by $45.4 million, and $45.8 million for the three and six months ended June 30, 2006 and 2005, respectively. 

During the three and six months ended June 30, 2006, our rates on both short-term or variable rate earning-assets and short-term or variable rate interest-bearing liabilities continued 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 declined since more of our rate sensitive liabilities repriced than our rate sensitive assets during the 12 month period ending June 30, 2006.  Given the fact that the Federal Reserve has increased short-term rates by 400 basis points since July 2004, we believe that short-term interest rates are currently at or near their peak.  Therefore, we have chosen to increase the amount of fixed rate loans in our loan portfolio and targeted to have a significant portion of our liabilities to reprice within a twelve month period. 

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 the three and six months ended June 30, 2006 and 2005.  A review of these tables show 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 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 that the significant portion of the increases in net interest income in both the 2006 and 2005 periods have resulted from the increased levels of assets and liabilities in each period.  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 table sets 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 three-month and six-month periods ended June 30, 2006 and 2005, 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.

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Our net interest spread was 2.90% for the three months ended June 30, 2006, compared to 2.97% for the three months ended June 30, 2005.  The net interest spread is the difference between the yield we earn on our interest-earning assets and the rate we pay on our interest-bearing liabilities.  Because we had more interest-bearing liabilities than interest-earning assets that repriced, our net interest spread decreased 7 basis points in the three months ended June 30, 2006, compared to the same period in 2005.

Our net interest margin is calculated as net interest income divided by average interest-earning assets.  Our net interest margin for the three months ended June 30, 2006 was 3.33%, compared to 3.36% for the three months ended June 30, 2005.  During the three months ended June 30, 2006, interest-earning assets averaged $429.2 million, compared to $348.5 million in the three months ended June 30, 2005.  Interest earning assets exceeded interest bearing liabilities by $45.4 million and $44.9 million for the three month periods ended June 30, 2006 and 2005, respectively. 

Our loan yield increased 107 basis points for the three months ended June 30, 2006 compared to the three months ended June 30, 2005 as a result of approximately 55% of the loan portfolio having variable rates, combined with the increase in rates over the twelve months ended June 30, 2006.  Offsetting the increase in our loan yield is a 98 basis point increase in the cost of our interest-bearing deposits for the second quarter of 2006 compared to the same period in 2005.  The increase in the rate on our time deposits is due to the renewal rates on time deposits being much higher than the original rates as a result of the number of increases in the market rate in the past twenty-four months.  In addition, the cost of our savings and money market accounts has increased by 185 basis points as we have increased the rates we offer on these products to stay competitive in response to the increase in short-term market rates.  The 96 basis point increase in FHLB advances and the 215 basis point increase in other borrowed funds in the second quarter of 2006 compared to the same period in 2005 resulted primarily from the impact of the 175 basis point increase in short-term market rates over the past twelve months.  As of June 30, 2006, approximately 41% of our FHLB advances had variable rates, while all of our other borrowings had variable rates.

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Net interest income, the largest component of our income, was $3.6 million and $2.9 million for the three months ended June 30, 2006 and 2005, respectively.  Of the $641,547 increase in net interest income in the second quarter of 2006, approximately $579,000 related to the impact of higher average earning assets and interest-bearing liabilities in the three months ended June 30, 2006 compared to the same period in 2005.  Average earning assets were $80.7 million higher during the three months ended June 30, 2006 compared to the same period in 2005 and average interest-bearing liabilities increased by $80.3 million during the same period.  The remaining increase in net interest income is largely a result of the net impact of higher interest rates on both interest-earning assets and interest-bearing liabilities.

Interest income for the three months ended June 30, 2006 was $7.5 million, consisting of $6.8 million on loans, $657,156 on investments, and $43,405 on federal funds sold.  Interest income for the three months ended June 30, 2005 was $5.2 million, consisting of $4.8 million on loans, $429,775 on investments, and $27,509 on federal funds sold.  Interest on loans for the three months ended June 30, 2006 and 2005 represented 90.7% and 91.3%, respectively, of total interest income, while income from investments and federal funds sold represented only 9.3% and 8.7% 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 86.8% and 88.0% of average interest-earning assets for the three months ended June 30, 2006 and 2005, respectively.  Included in interest income on loans for the three months ended June 30, 2006 and 2005 was $137,239 and $158,042, respectively, related to the net amortization of loan fees and capitalized loan origination costs.

Interest expense for the three months ended June 30, 2006 was $3.9 million, consisting of $2.5 million related to deposits and $1.4 million related to borrowings.  Interest expense for the three months ended June 30, 2005 was $2.3 million, consisting of $1.5 million related to deposits and $853,709 related to borrowings.  Interest expense on deposits for the three months ended June 30, 2006 and 2005 represented 63.9% and 63.0%, respectively, of total interest expense, while interest expense on borrowings represented 36.1% and 37.0%, respectively, of total interest expense for the same three month periods.  During the three months ended June 30, 2006, average interest-bearing deposits increased by $58.7 million over the same period in 2005, while FHLB and other borrowings during the three months ended June 30, 2006 increased $21.6 million over the same period in 2005.  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. 

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Our net interest spread was 2.96% for the six months ended June 30, 2006, compared to 2.98% for the six months ended June 30, 2005.  The net interest spread is the difference between the yield we earn on our interest-earning assets and the rate we pay on our interest-bearing liabilities.  Because we had more interest-bearing liabilities than interest-earning assets that repriced, our net interest spread decreased 2 basis points in the six months ended June 30, 2006, compared to the same period in 2005.

Our net interest margin is calculated as net interest income divided by average interest-earning assets.  Our net interest margin for the six months ended June 30, 2006 was 3.40%, compared to 3.35% for the six months ended June 30, 2005.  During the six months ended June 30, 2006, interest-earning assets averaged $410.4 million, compared to $337.2 million in the six months ended June 30, 2005.  Interest earning assets exceeded interest bearing liabilities by $45.8 million and $43.2 million for the six month periods ended June 30, 2006 and 2005, respectively. 

Our loan yield increased 114 basis points for the six months ended June 30, 2006 compared to the six months ended June 30, 2005 as a result of approximately 55% of the loan portfolio having variable rates, combined with the increase in rates over the twelve months ended June 30, 2006.  Offsetting the increase in our loan yield is a 101 basis point increase in the cost of our interest-bearing deposits for the first six months of 2006 compared to the same period in 2005.  The increase in the rate on our time deposits is due to the renewal rates on time deposits being much higher than the original rates due to the number of increases in the market rate in the past twenty-four months.  In addition, the cost of our savings and money market accounts has increased by 162 basis points as we have increased the rates we offer on these products to stay competitive in response to the increase in short-term market rates.  The 101 basis point increase in FHLB advances and the 220 basis point increase in other borrowed funds in the first six months of 2006 compared to the same period in 2005 resulted primarily from the impact of the 175 basis point increase in short-term market rates over the past twelve months.  As of June 30, 2006, approximately 41% of our FHLB advances had variable rates, while all of our other borrowings had variable rates.

Net interest income, the largest component of our income, was $6.9 million and $5.6 million for the six months ended June 30, 2006 and 2005, respectively.  Of the $1.3 million increase in net interest income, approximately $1.1 million related to the impact of higher average earning assets and interest-bearing liabilities in the six months ended June 30, 2006 compared to the same period in 2005.  Average earning assets were $73.3 million higher during the six months ended June 30, 2006 compared to the same period in 2005, and average interest-bearing liabilities increased by $70.6 million during the same period.  The remaining increase in net interest income is largely a result of the net impact of higher interest rates on both interest-earning assets and interest-bearing liabilities.

Interest income for the six months ended June 30, 2006 was $14.1 million, consisting of $12.9 million on loans, $1.1 million on investments, and $91,796 on federal funds sold.  Interest income for the six months ended June 30, 2005 was $9.8 million, consisting of $8.9 million on loans, $834,865 on investments, and $33,320 on federal funds sold.  Interest on loans for the six months ended June 30, 2006 and 2005 represented 91.6% and 91.1%, respectively, of total interest income, while income from investments and federal funds sold represented only 8.4% and 8.9% 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 88.3% and 88.2% of average interest-earning assets for the six months ended June 30, 2006 and 2005, respectively.  Included in interest income on loans for the six months ended June 30, 2006 and 2005, was $277,436 and $276,839, respectively, related to the net amortization of loan fees and capitalized loan origination costs.

Interest expense for the six months ended June 30, 2006 was $7.2 million, consisting of $4.6 million related to deposits and $2.6 million related to borrowings.  Interest expense for the six months ended June 30, 2005 was $4.2 million, consisting of $2.6 million related to deposits and $1.6 million related to borrowings.  Interest expense on deposits for the six months ended June 30, 2006 and 2005 represented 64.3% and 62.0%, respectively, of total interest expense, while interest expense on borrowings represented 35.7% and 38.0%, respectively, of total interest expense for the same periods.  During the six months ended June 30, 2006, average interest-bearing deposits increased by $56.1 million over the same period in 2005, while FHLB and other borrowings during the six months ended June 30, 2006 increased $14.5 million over the same period in 2005.  During the six months ended June 30, 2006, we pledged additional collateral to the FHLB, allowing us 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.

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Rate/Volume Analysis

Net interest income can be analyzed in terms of the impact of changing interest rates and changing volume.  The following table sets 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.