SOUTHERN FIRST BANCSHARES INC - Quarter Report: 2008 September (Form 10-Q)

 

 

 

 

 

SOUTHERN FIRST BANCSHARES, INC.
PART I.  FINANCIAL INFORMATION

            

Item 1.  Financial Statements

 

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

 

SOUTHERN FIRST BANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

(Dollars in thousands)

                                                                                        

 

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

 

---

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

(Dollars in thousands, except share data)

 

 

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

 

---

 

 

 

SOUTHERN  FIRST BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
AND COMPREHENSIVE INCOME
FOR THE NINE MONTHS ENDED SEPTEMBER  30, 2008  AND 2007

(Dollars in thousands, except share data)

 (Unaudited)

                                                                                                                                                        

 

 

---

 

 

 

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

(Dollars in thousands)

 

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

 

---

 

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

Note 1 – Nature of Business and Basis of Presentation

Business activity

 

    Southern First Bancshares, Inc., (the “Company”) is a South Carolina corporation that owns all of the capital stock of Southern First Bank, N.A. (the “Bank”) and all of the stock of Greenville First Statutory Trust I and II (collectively (the “Trusts”)).  On July 2, 2007, the Company and Bank changed their names to Southern First Bancshares, Inc. and Southern First Bank, N.A., respectively.  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 organized 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, 2008 are not necessarily indicative of the results that may be expected for the year ending December 31, 2008.  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, 2007 (Registration Number 000-27719) as filed with the Securities and Exchange Commission.  The consolidated financial statements include the accounts of Southern First Bancshares, Inc., and its wholly owned subsidiary Southern First Bank, N.A.  In accordance with Financial Accounting Standards Board (“FASB”) Interpretation No. 46, the financial statements related to the special purpose subsidiaries, Greenville First Statutory Trust I and Trust II, have not been consolidated.

 

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 – Other than Temporary Impairment on Investment Securities

            

    During the three months ended September 30, 2008, we recorded an impairment charge of $1.8 million, pre-tax, on our Federal National Mortgage Association (“FNMA”) preferred stock, which was determined to have suffered an other-than-temporary impairment as a result of the Government’s decision on September 7, 2008 to place the FNMA and Federal Home Loan Mortgage Corporation (“FHLMC”) under conservatorship.

 

    As a result of the passage of the Emergency Economic Stabilization Act of 2008, the Bank’s ability to utilize the loss on the FNMA preferred stock against ordinary income was considered in determining that the company did not need to establish a valuation for the the deferred tax asset that was recorded related to the $1.8 million impairment charge.

 

Note 3 – Property Held for Sale

           

    In February 2007, we decided to actively market the sale of our former main office and corporate headquarters building.  Accordingly, we reclassified the building from property and equipment to property held for sale, in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144 “Accounting for the Impairment and Disposal of Long-Lived Assets,” and ceased depreciation of the building.  In March 2007 we received a sales contract on the building.   Based on the sales contract, adjusted for estimated commissions and other selling costs, we recorded a $375,000 gain in the carrying value of the building at the end of the first quarter of 2007.  The $375,000 gain was partially offset by other unrelated real estate operating expenses of $46,407.  The net gain on real estate operations recorded in the three months ended March 31, 2007 was $328,593.

 

---

 

 

     On April 13, 2007, we completed the sale of the former main office building.  Based on the higher carrying value established at March 31, 2007, we incurred a loss of approximately $55,000 on the sale which was recorded in the second quarter of 2007.   

 

 

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 and nine months ended September 30, 2008 and 2007.  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. 

 

 

    At September 30, 2008 and 2007, 59,750 and 13,000 options, respectively, were anti-dilutive in the calculation of earnings per share as their exercise price exceeded the fair market value (dollars in thousands, except share data).

 

 

 

 

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 SFAS No. 123(R), “Accounting for Stock-Based Compensation,” to account for compensation costs under its stock option plan. 

 

  In adopting SFAS No. 123(R), 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 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 10.00% for 2008 and 2007, risk-free interest rate of 4.60% for 2008 and 2007, expected lives of the options 10 years, and the assumed dividend rate was zero. 

 

7

 

 

Note 6 – Fair Value Measurement

 

   Effective January 1, 2008, the Company adopted SFAS No. 157, “Fair Value Measurements” which provides a framework for measuring and disclosing fair value under generally accepted accounting principles. SFAS No. 157 requires disclosures about the fair value of assets and liabilities recognized in the balance sheet in periods subsequent to initial recognition, whether the measurements are made on a recurring or on a nonrecurring basis.

 

   SFAS No. 157 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. SFAS No. 157 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:

 

Level 1

Quoted prices in active markets for identical assets or liabilities. Level 1 assets and liabilities include certain debt and equity securities and derivative contracts that are traded in an active exchange market.

 

Level 2

Observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Level 2 assets and liabilities include fixed income securities and mortgage-backed securities that are held in the Company’s available-for-sale portfolio, certain derivative contracts and impaired loans.

 

Level 3

Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation.  These methodologies may result in a significant portion of the fair value being derived from unobservable data.  

 

Assets measured at fair value on a recurring basis as of September 30, 2008 are as follows:

 

 

   The Company has no liabilities carried at fair value or measured at fair value on a recurring or nonrecurring basis.

 

   The Company is predominantly an asset based lender with real estate serving as collateral on approximately 79% of loans. Loans which are deemed to be impaired are valued on a nonrecurring basis at the lower of cost or market value of the underlying real estate collateral. Such market values are generally obtained using independent appraisals, which the Company considers to be level 2 inputs. The aggregate carrying amount, net of specific reserves, of impaired loans at September 30, 2008 was $3.4 million.

 

   FASB Staff Position No. 157-2 delays the implementation of SFAS No. 157 until the first quarter of 2009 with respect to goodwill, other intangible assets, real estate and other assets acquired through foreclosure and other non-financial assets measured at fair value on a nonrecurring basis.

 

---

 

 

The table below presents a reconciliation for the period of January 1, 2008 to September 30, 2008, for all Level 3 assets that are measured at fair value on a recurring basis.

 

 

 

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 statements which constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These statements are based on many assumptions and estimates and are not guarantees of future performance.  Our actual results may differ materially from those anticipated in any forward-looking statements, as they will depend on many factors about which we are unsure, including many factors which are beyond our control.  The words “may,”  “would,” “could,” “will,” “expect,” “anticipate,” “believe,” “intend,” “plan,” and “estimate,” as well as similar expressions, are meant to identify such forward-looking statements.  Potential risks and uncertainties that could cause our actual results to differ from those anticipated in any forward-looking statements include, but are not limited to, those described in our Form 10-K for the year ended December 31, 2007 under Item 1A- Risk Factors and the following:

 

•         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 deposit flows,

•         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.

 

---

 

 

 

            These risks are exacerbated by the recent developments in national and international financial markets, and we are unable to predict what effect these uncertain market conditions will have on our company.  During 2008, the capital and credit markets have experienced extended volatility and disruption. In the last 90 days, the volatility and disruption have reached unprecedented levels.  There can be no assurance that these unprecedented recent developments will not materially and adversely affect our business, financial condition and results of operations.

 

            We undertake no obligation to publicly update or otherwise revise any forward-looking statements, whether as a result of new information, future events, or otherwise.

 

Overview

 

We were incorporated in March 1999 to organize and serve as the holding company for Greenville First Bank, N.A.  On July 2, 2007, we changed our name to Southern First Bancshares, Inc. and the bank’s name to Southern First Bank, N.A., although we will continue to operate as Greenville First Bank in Greenville County.  Our primary reason for the name change was related to our expansion into the Columbia, South Carolina market.  Since we opened our bank in January 2000, we have experienced consistent growth in total assets, loans and deposits which has continued during the first nine months of 2008. 

 

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.

 

In response to financial conditions affecting the banking system and financial markets and the potential threats to the solvency of investment banks and other financial institutions, the United States government has taken unprecedented actions. On October 3, 2008, President Bush signed into law the Emergency Economic Stabilization Act of 2008 (the “EESA”).  Pursuant to the EESA, the U.S. Treasury will have the authority to, among other things, purchase mortgages, mortgage-backed securities, and other financial instruments from financial institutions for the purpose of stabilizing and providing liquidity to the U.S. financial markets. On October 14, 2008, the U.S. Department of Treasury announced the Capital Purchase Program under the EESA, pursuant to which the Treasury intends to make senior preferred stock investments in participating financial institutions.  We are evaluating whether to participate in the Capital Purchase Program.  Regardless of our participation, governmental intervention and new regulations under these programs could materially and adversely affect our business, financial condition and results of operations.

 

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, 2007, as filed in our annual report on Form 10-K.

 

---

 

 

 

             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

 

             Following an economic decline and historically low interest rates that ended in the first six months of 2004, the Federal Reserve began increasing short-term rates as the economy showed signs of strengthening.  Between July 2004 and July 2006, the Federal Reserve increased rates at 17 of their meetings for a total of 425 basis points. Between July 2006 and September 18, 2007, the Federal Reserve allowed short-term rates to remain unchanged.  Beginning in July 2004 and continuing until September 18, 2007, our rates on both short-term or variable rate interest-earning assets and interest-bearing liabilities increased.  The momentum of the 17 rate increases resulted in higher rates on interest-earning assets and higher interest-bearing liabilities during the first nine months of 2007; subsequently, as fixed rate loans, deposits, and borrowings matured during this period they repriced at higher interest rates.  In late September 2007, the Federal Reserve reversed their position and lowered the short-term rates initially by 50 basis points and by an additional 50 basis points in the fourth quarter of 2007.  The Federal Reserve has continued to aggressively decrease rates by lowering the short-term rate 225 basis points in the first nine months of 2008 which has caused the rates on our short-term or variable rate assets and liabilities to decline in 2008.  In addition, the Federal Reserve has decreased rates an additional 100 basis points in October 2008.  The following discussion includes our analysis of the effect that we anticipate changes in interest rates will have on our financial condition.  However, we can give no assurances as to the future actions of the Federal Reserve or to the anticipated results that will actually occur.

 

 

Results of Operations

Income Statement Review

Summary

 

Three months ended September30, 2008 and 2007

 

For the three months ended September 30, 2008, we incurred a net loss of $126,000 compared to net income of $957,000 for the three months ended September 30, 2007, a decrease of $1.1million, or 113.3%.  The $1.1 million decrease in net income resulted primarily from an impairment charge of $1.2 million, net of taxes, related to our FNMA preferred stock, as well as increases of $255,000 in noninterest expenses and $200,000 in the provision for loan losses, partially offset by increases of $420,000 in net interest income and $166,000 in noninterest income, excluding the impairment charge.

 

Excluding the impairment charge, our earnings were $1.1 million for the third quarter 2008, a $115,000, or 12.0% increase from the same period in 2007.  Our efficiency ratio improved to 57.8% for the three months ended September 30, 2008 from 58.8% for the same period in 2007.  The lower efficiency ratio is due primarily to our having established a presence in the Columbia market and expansion costs related to the Columbia office that are being absorbed as the office increases loan and deposit production.  Our efficiency ratio is computed by dividing noninterst expense by the sum of net interest income, excluding the gain on sale and impairment charge on securities and real estate activity, and noninterest income.

 

---

 

 

                Nine months ended September 30, 2008 and 2007

 

                Our net income was $1.5 million and $2.7 million for the nine months ended September 30, 2008 and 2007, respectively, a decrease of $1.2 million, or 44.4%.  The decrease in net income resulted primarily from an impairment charge of $1.2 million, net of taxes, related to our FNMA preferred stock, as well as increases of $1.1 million in noninterest expenses and $660,000 in the provision for loan losses, partially offset by increases of $1.7 million in net interest income and $110,000 in noninterest income, excluding the impairment charge. 

 

                Excluding the impairment charge, our earnings for the nine month period ended September 30, 2008 were virtually unchanged from the same period in 2007 at $2.7 million.  Our efficiency ratio improved to 60.8% for the nine months ended September 30, 2008 from 61.3% for the same period in 2007.  The lower efficiency ratio is due primarily to our having established a presence in the Columbia market and expansion costs related to the Columbia office that are being absorbed as the office increases loan and deposit production.  Our efficiency ratio is computed by dividing noninterest expense by the sum of net interest income, excluding the gain on sale and impairment charge on securities and real estate activity, and noninterest income.

 

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, 2008, our average loan portfolio increased $96.8 million compared to the average for the nine months ended September 30, 2007.  The actual growth in the first nine months of 2008 was $52.4 million.  We anticipate that growth in loans will continue to drive growth in assets and subsequently, growth in net interest income.  However, we expect to incur lower levels of growth during the remainder of 2008.  In an effort to maximize our utilization of capital, we anticipate managing the level of loan growth to ensure the bank remains well-capitalized. 

 

    Our past decision to grow the loan portfolio 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 rather than in lower yielding investments.  At September 30, 2008, net loans represented 79.6% of total assets while investments and federal funds sold represented 14.6% of total assets.  However, as described below, we have also increased our level of deposits significantly. 

 

    The historically low interest rate environment that was experienced between January of 2000 and July of 2004 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 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. 

 

    We opened two retail deposit offices in 2005 and two additional offices in July of 2008.  We also converted our Columbia loan production office into a full service branch facility during the third quarter of 2007.  We now have four retail offices in the Greenville market and two retail offices in the Columbia market.  Our focus for these locations is to obtain low cost transaction accounts, resulting in an increase in both the percentage of assets being funded by “in market” retail deposits as well as  the percentage of low-cost transaction accounts to total deposits.  We believe that this growth strategy will provide additional clients in our two market areas and will eventually provide a lower alternative cost of funding.   At September 30, 2008, retail deposits represented $285.2 million, or 40.9% of total assets, borrowings represented $175.1 million, or 25.1% of total assets, and wholesale out-of-market deposits represented $192.6 million, or 27.7% of total assets.

 

    Our net interest income margin for the nine months ended September 30, 2008 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 $51.2 million and $48.7 million for the nine months ended September 30, 2008 and 2007, respectively.

 

---

 

 

 

In addition to the growth in both assets and liabilities, and the ratio of interest-earning assets to interest-bearing liabilities, net interest income is also affected by the timing of the repricing of our assets and liabilities and the changes in interest rates earned on our assets and interest rates paid on our liabilities.  Until September 18, 2007, our yields on interest earning assets and the rates that we paid for our deposits and borrowings continued to increase primarily as a result of the actions taken by the Federal Reserve to raise short-term rates prior to July 30, 2006.  Our fixed rate loans were being originated or renewed at higher rates, while the rates on new or maturing interest-bearing liabilities were also higher than in the past.  Given the fact that the Federal Reserve increased short-term rates by 425 basis points between July 2004 and July 2006 and allowed rates to remain unchanged until September 18, 2007, we believed during most of 2006 and the first nine months of 2007 that short-term interest rates were at or near their peak.  Therefore, we chose to increase the amount of fixed rate loans in our loan portfolio, and we targeted to have a significant portion of our liabilities to reprice within a twelve month period.  On September 18, 2007, the Federal Reserve began to decrease short-term rates with an initial 50 basis point reduction and continued the decrease with an additional 275 basis points through the end of 2007 and the first nine months of 2008.  While the bank had more liabilities than assets that repriced down during the nine months ended September 30, 2008 due to the competition for deposits and the overall low market rates, we were not able to lower the rates on our liabilities in proportion to the reduction in rates experienced on our assets.  With the recent 100 basis point reduction in short-term rates in October 2008, we anticipate that our net interest margin will decline during the next three months as many of our interest-earning assets and interest-bearing liabilities reprice to lower rates. 

 

As more fully discussed in the – “Market Risk” and – “Liquidity and Interest Rate Sensitivity” sections below, at September 30, 2008, approximately 58% of our loans had fixed rates.  For the past two years, we have placed more emphasis on fixed rate loans; however, we have recently changed our focus to increasing the amount of variable rate loans in our portfolio.  Our fixed rate loans as a percentage of total loans decreased from 60% at September 30, 2007 to 58% at September 30, 2008.  While increasing our percentage of fixed rate loans during the past three years, our focus has been to obtain short-term liabilities to fund our asset growth.  This strategy has resulted in our ability to move from being asset sensitive to being liability sensitive for the next twelve months. 

 

At September 30, 2008, 76.0% of our interest-bearing liabilities were either variable rate or had a maturity of less than one year.   Of the $286.8 million of interest-bearing liabilities set to reprice within three months, 44.3% or $127.1 million are transaction, money market or savings accounts which are already at or near their lowest rates and provide little opportunity for benefit should market rates continue to decline or stay constant.  However, certificates of deposit that are currently maturing or renewing are repricing at low rates.  We expect to benefit, even if market rates increase slightly as these deposits reprice.   At September 30, 2008, we had $148.8 million more liabilities than assets that reprice within the next twelve months.  Included in our FHLB advances and related debt, are a number of borrowings with callable features as of September 30, 2008.  We believe that the optionality on many of these borrowings will not be exercised until interest rates increase significantly.  In addition, we believe that the interest rates that we pay on the majority of our interest-bearing transaction accounts would only be impacted by a portion of any change in market rates.  This key assumption is utilized in our overall evaluation of our level of interest sensitivity.

 

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 shows 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 nine month periods ended September 30, 2008 and 2007.  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” table demonstrates 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 as short-term rates continued to rise, the increase in net interest income is more effected by the changes in rates than in prior years.  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 three and nine month periods ended September 30, 2008 and 2007, we had less than $100,000 in interest-bearing deposits in other banks and no securities purchased with agreements to resell.  All investments owned have 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, on a tax-equivalent basis, was 2.69% for the three months ended September 30, 2008 compared to 2.74% for the three months ended September 30, 2007.  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.

 

The 5 basis point reduction in our net interest spread resulted primarily from the lower spread on the $99.0 million growth in average earning assets in the third quarter of 2008 compared to the same period in 2007.  Of the $99.0 million in growth, $19.5 million, or 19.7%, occurred in investments and federal funds, while the remaining growth of $79.4 million, or 80.3%, occurred in loans.  During the third quarter of 2008, our investments and federal funds yielded a combined weighted rated of 5.12%, while our loans yielded a weighted rate of 6.28%. 

 

The growth of $99.0 million in earning assets was funded primarily with $68.5 million in certificates of deposit and $23.2 million in borrowings.  For the three months ended September 30, 2008, our certificates of deposit had a weighted rate of 3.98%, while our borrowings had a weighted rate of 3.88% for a combined weighted rate of 3.94%.

 

---

 

 

 

Since we funded 90.4% of the growth in earning assets with higher costing borrowings and certificates of deposit at a combined rate of 3.94% rather than with lower costing transaction accounts at a rate of 1.49%, the additional earning assets and liabilities yielded a lower than historical net spread of 2.35%, causing the overall net interest spread to decline by 6 basis points.  Offsetting the decrease in net interest spread due to growth was a 1 basis point increase due to the repricing of short-term liabilities such as one year certificates of deposit which continue to reprice downward to current market rates as they mature.  During 2007 and the first nine months of 2008, management determined that the bank had capital to support additional asset growth.  Consequently, given the flat interest rate environment, both earnings and return on equity could be increased with additional assets and liabilities even if the net interest spreads were at less than historical levels.

 

Our net interest margin is calculated as net interest income divided by average interest-earning assets.  Our net interest margin, on a tax-equivalent basis, for the three months ended September 30, 2008 was 2.94% compared to 3.15% for the three months ended September 30, 2007  During the three months ended September 30, 2008, interest-earning assets exceeded interest-bearing liabilities by $48.7 million compared to $51.1 million for the three month period ended September 30, 2007.  During the third quarter of 2008, interest-earning assets averaged $658.2 million compared to $559.3 million in the third quarter of 2007. 

 

Our loan yield decreased 135 basis points for the three months ended September 30, 2008 compared to the three months ended September 30, 2007 as a result of the 325 basis point reduction in short-term rates in the past twelve months which had an immediate impact on our variable rate loans, which represented 42% of our total loans at September 30, 2008.  Offsetting the decrease in our loan yield was a 123 basis point decrease in the cost of our interest-bearing deposits for the third quarter of 2008 compared to the same period in 2007.  The decrease in the rate on interest-bearing deposits is due primarily to the 119 basis point decrease on the cost of time deposits as their renewal rates have been lower than their original rates as a result of the decreases in market rates over the past twelve months.  In addition, the cost of our transaction, savings and money market accounts has decreased as we have lowered the rates we offer on these products.  The cost of our savings and money market accounts has decreased by 186 basis points from September 30, 2007, while the rate on our transaction accounts has decreased 74 basis points in the same period.  The 85 basis point decrease in FHLB advances and related debt and the 200 basis point decrease in other borrowed funds in the third quarter of 2008 compared to the same period in 2007 resulted primarily from the impact of the 325 basis point decrease in short-term market rates over the past twelve months.  As of September 30, 2008, approximately 12% 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 $4.8 million and $4.4 million for the three months ended September 30, 2008 and 2007, respectively.  The increase in the third quarter of 2008 related primarily to the net effect of higher levels of both average interest-earning assets and interest-bearing liabilities.  Average interest-earning assets were $99.0 million higher during the three months ended September 30, 2008 compared to the same period in 2007.  During the same period, average interest-bearing liabilities increased $101.4 million.  The higher average balances resulted in $326,000 of additional net interest income for the three months ended September 30, 2008, while lower spreads on the average balances reduced net interest income by $40,000.

 

Interest income for the three months ended September 30, 2008 was $10.1 million, consisting of $8.7 million on loans, $1.3 million on investments, and $57,000 on federal funds sold.  Interest income for the three months ended September 30, 2007 was $10.3 million, consisting of $9.1 million on loans, $1.1 million on investments, and $77,000 on federal funds sold.  Interest on loans for the three months ended September 30, 2008 and 2007 represented 86.7% and 88.5%, respectively, of total interest income, while income from investments and federal funds sold represented only 13.9% and 11.5%, respectively, 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 83.9% and 84.6% of average interest-earning assets for the three months ended September 30, 2008 and 2007, respectively.  Included in interest income on loans for the three months ended September 30, 2008 and 2007 was $148,000 and $179,000, respectively, which related to the net amortization of loan fees and capitalized loan origination costs.

 

Interest expense for the three months ended September 30, 2008 was $5.2 million, consisting of $3.5 million related to deposits and $1.7 million related to FHLB advances and other borrowings.  Interest expense for the three months ended September 30, 2007 was $5.9 million, consisting of $4.0 million related to deposits and $1.8 million related to FHLB advances and other borrowings.  Interest expense on deposits for the three months ended September 30, 2008 and 2007 represented 67.7% and 68.5%, respectively, of total interest expense, while interest expense on FHLB advances and other borrowings represented 32.3% and 31.5%, respectively, of total interest expense for the same three month periods.  For the three months ended September 30, 2008, average interest-bearing deposits increased by $78.2 million over the same period in 2007, while FHLB advances increased $25.0 million and other borrowings decreased $1.8 million during the three months ended September 30, 2008 over the same period in 2007.  Both the short-term borrowings from the FHLB advances 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 2.59% for the nine months ended September 30, 2008, compared to 2.67% for the nine months ended September 30, 2007.  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. 

 

The 8 basis point reduction in our net interest spread resulted primarily from a lower spread on the $114.8 million growth in average earning assets in the first nine months of 2008 compared to the same period in 2007.  Of the $114.8 million in growth, $18.0 million, or 15.7%, occurred in investments and federal funds, while the remaining growth of $96.8 million, or 84.3%, occurred in loans.  During the first nine months of 2008, our investments and federal funds yielded a combined weighted rated of 5.05%, while our loans yielded a weighted rate of 6.55%. 

 

The growth of $114.8 million in earning assets was funded primarily with $73.1 million in certificates of deposit and $30.9 million in borrowings.  For the nine months ended September 30, 2008, our certificates of deposit had a weighted rate of 4.38%, while our borrowings had a weighted rate of 4.05% for a combined weighted rate of 4.26%.

 

---

 

 

 

Since we funded 92.6% of the growth in earning assets with higher costing borrowings and certificates of deposit at a combined rate of 4.26% rather than with lower costing transaction accounts at a rate of 1.70%, the additional earning assets and liabilities yielded a lower than historical net spread of 2.24%, causing the overall net interest spread to decline by 7 basis points.  The remaining 1 basis point reduction in the overall net interest spread resulted from the immediate impact of loans repricing in 2008.  During 2007 and the first nine months of 2008, management determined that the bank had capital to support additional asset growth.  Consequently, given the flat interest rate environment, both earnings and return on equity could be increased with additional assets and liabilities even if the net interest spreads were at less than historical levels.

 

Our net interest margin is calculated as net interest income divided by average interest-earning assets.  Our net interest margin, on a tax-equivalent basis, for the nine months ended September 30, 2008 was 2.88%, compared to 3.09% for the nine months ended September 30, 2007.  During the nine months ended September 30, 2008, interest-earning assets averaged $652.2 million, compared to $537.4 million in the nine months ended September 30, 2007.  Interest earning assets exceeded interest bearing liabilities by $51.2 million and $48.7 million for the nine month periods ended September 30, 2008 and 2007, respectively. 

 

Our loan yield decreased 104 basis points for the nine months ended September 30, 2008, compared to the nine months ended September 30, 2007, as a result of the 325 basis point reduction in short-term rates in the past twelve months which had an immediate impact on our variable rate loans, which represented 42% of our total loans at September 30, 2008.  Offsetting the decrease in our loan yield was an 86 basis point decrease in the cost of our interest-bearing deposits for the first nine months of 2008 compared to the same period in 2007.  The decrease in the rate on interest-bearing deposits is due primarily to the 79 basis point decrease on the cost of time deposits as their renewal rates have been lower than their original rates as a result of the decreases in market rates over the past nine months.  In addition, the cost of our transaction, savings and money market accounts has decreased as we have lowered the rates we offer on these products.  The cost of our savings and money market accounts has decreased by 159 basis points from September 30, 2007 while the rate on our transaction accounts has decreased 59 basis points in the same period.  The 67 basis point decrease in FHLB advances and related debt and the 152 basis point decrease in other borrowed funds in the first nine months of 2008 compared to the same period in 2007 resulted primarily from the impact of the 325 basis point decrease in short-term market rates over the past twelve months.  As of September 30, 2008, approximately 12% 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 $14.0 million and $12.4 million for the nine months ended September 30, 2008 and 2007, respectively.  Of the $1.7 million increase in net interest income, approximately $2.4 million related to the impact of higher average earning assets and interest-bearing liabilities in the nine months ended September 30, 2008 compared to the same period in 2007, while lower spreads on the average balances reduced net interest income by $633,000.

 

Interest income for the nine months ended September 30, 2008 was $30.7 million, consisting of $26.6 million on loans, $3.8 million on investments, and $238,000 on federal funds sold.  Interest income for the nine months ended September 30, 2007 was $29.0 million, consisting of $25.3 million on loans, $3.2 million on investments, and $441,000 on federal funds sold.  Interest on loans for the nine months ended September 30, 2008 and 2007 represented 86.7% and 87.3%, respectively, of total interest income, while income from investments and federal funds sold represented only 13.3% and 12.7%, respectively, 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 83.2% and 83.0% of average interest-earning assets for the nine months ended September 30, 2008 and 2007, respectively.  Included in interest income on loans for the nine months ended September 30, 2008 and 2007, was $583,000 and $525,000, respectively, related to the net amortization of loan fees and capitalized loan origination costs.

 

Interest expense for both nine month periods ended September 30, 2008 and 2007 was $16.7 million, consisting of $11.5 million related to deposits and $5.2 million and $5.1 million, respectively, related to borrowings.  Interest expense on deposits for the nine months ended September 30, 2008 and 2007 represented 68.9% and 69.4%, respectively, of total interest expense, while interest expense on borrowings represented 31.1% and 30.6%, respectively, of total interest expense for the same periods.  During the nine months ended September 30, 2008, average interest-bearing deposits increased by $81.4 million, while FHLB and other borrowings increased $30.9 million compared to the same period in 2007.  During the nine months ended September 30, 2008, 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.

 

---

 

Rate/Volume Analysis

 

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.

 

---

 

 

Three and nine months ended September 30, 2008 and 2007

 

For the three months ended September 30, 2008 and 2007, we incurred a noncash expense related to the provision for loan losses of $650,000 and $450,000, respectively, bringing the allowance for loan losses to $6.5 million and $5.4 million, respectively.  The allowance represented 1.16% of gross loans at September 30, 2008 and 1.13% of gross loans at September 30, 2007.  During the three months ended September 30, 2008, we charged-off $621,000 of loans and recorded virtually no recoveries on loans previously charged-off.  During the three months ended September 30, 2007, we charged off $297,000 of loans and recorded $1,000 of recoveries on loans previously charged-off.  The $621,000 and $296,000 net charge-offs during the third quarters of 2008 and 2007, respectively, represented an annualized rate of 0.45% and 0.25% of the average outstanding loan portfolio for the three months ended September 30, 2008 and 2007, respectively.

 

For the nine months ended September 30, 2008, we incurred a noncash expense related to the provision for loan losses of $2.0 million, bringing the allowance for loan losses to $6.5 million, or 1.16% of gross loans, as of September 30, 2008.  The $2.0 million provision for the nine months ended September 30, 2008 related primarily to the level of charge-offs that occurred during this period.   During the nine month period ended September 30, 2008, we charged-off $1.2 million in loans and recorded $10,000 of recoveries on loans previously charged-off.  In comparison, for the nine months ended September 30, 2007, we added $1.3 million to the provision for loan losses, resulting in an allowance of $5.4 million at September 30, 2007. During the nine months ended September 30, 2007, we charged-off $823,000 of loans and recorded $31,000 of recoveries on loans previously charged-off.

 

At September 30, 2008, the allowance for loan losses represented 1.9 times the amount of non-performing loans.  As a result of this level of coverage on non-performing loans and our internal loan calculation, we determined that the provisions of $650,000 and $2.0 million for the three and nine months ended September 30, 2008 were adequate.

 

Noninterest Income

 

             The following table sets forth information related to our noninterest income. 

 

Three months ended September 30, 2008 and 2007

 

Noninterest income for the three months ended September 30, 2008 was a loss of $1.4 million, a decrease of 677.7% over noninterest income of $247,000 for the same period of 2007.  The $1.7 million decrease in noninterest income is primarily related to a pre-tax impairment charge of $1.8 million on our FNMA preferred stock and a $7,000 decrease in loan fee income.  Partially offsetting these decreases were increases of $66,000 in service fees on deposit accounts, $18,000 in income from bank owned life insurance, a $7,000 gain on sale of securities, $63,000 in real estate owned activity and $20,000 in other income.  Excluding the impairment charge, noninterest income for the third quarter 2008 was $414,000, a $167,000 increase, or 67.6%, compared to the same period in 2007.

 

Loan fee income consists primarily of late charge fees, fees from issuance of letters of credit, and mortgage origination fees we receive on residential loans funded and closed by a third party.  Loan fees were $38,000 and $45,000 for the three months ended September 30, 2008 and 2007, respectively.  The $7,000 decrease for the three months ended September 30, 2008 compared to the same period in 2007 related primarily to a $4,000 decrease in late charge fees, a $2,000 decrease in fees received from the issuance of letters of credit, and a $2,000 decrease in mortgage origination fees.  Late charge fees were $26,000 and $30,000 for the third quarter of 2008 and 2007, respectively, while income related to amortization of fees on letters of credit was $11,000 and $13,000 for the three months ended September 30, 2008 and 2007, respectively.  Mortgage origination fees were $0 and $2,000 for the three months ended September 30, 2008 and 2007, respectively.

 

---

 

 

 

Service fees on deposit accounts consist primarily of service charges on our checking, money market, and savings accounts and the fee income received from client non-sufficient funds (“NSF”) transactions.   Deposit fees were $177,000 and $111,000 for the three months ended September 30, 2008 and 2007, respectively.  The $66,000 increase is primarily related to a $42,000 increase in NSF fees and a $24,000 increase in other deposit related fees.  NSF fee income was $122,000 and $80,000 for the three months ended September 30, 2008 and 2007, respectively, representing 68.5% of total service fees on deposits in the 2008 period compared to 71.5% of total service fees on deposits in the 2007 period.  The significant increase in NSF fee income is due primarily to an increased effort to collect rather than waive NSF fees from our clients.  Service charges on deposit accounts were $43,000 and $19,000 for the three month periods ended September 30, 2008 and 2007, respectively.  The $24,000 increase is due to the service charges on deposit accounts exceeding the interest earned credit on those same accounts as the rate earned on deposit balances has decreased with the decrease in short-term market rates.

 

We held $11.7 million of bank owned life insurance at the end of the third quarter of 2008.  Income derived from this life insurance was $114,000 for the three months ended September 30, 2008 compared to $96,000 for the three months ended September 30, 2007. 

 

         During the three months ended September 30, 2008, we recorded a $7,000 gain on a Government sponsored security that was called.  In addition, we recorded an impairment charge of $1.8 million, pre-tax, on our FNMA preferred stock, which was determined to have suffered an other-than-temporary impairment as a result of the Government’s decision on September 7, 2008 to place the FNMA under conservatorship.

 

             Real estate owned activity includes income and expenses from property held for sale and other real estate we own.  For the three months ended September 30, 2008, we had a loss on real estate owned activity of $7,000, a $63,000 increase from the same period in 2007. 

 

Other income consisted primarily of fees received on debit card transactions, sale of customer checks, wire transfers and courier fee income.  Other income was $85,000 and $65,000 for the three months ended September 30, 2008 and 2007, respectively.  The $20,000 increase relates primarily to a $13,000 increase in debit card transaction fees.  Debit card transaction fees were $61,000 and $48,000 for the three months ended September 30, 2008 and 2007, respectively, and represented 71.9% and 73.4% of total other income for the third quarters of 2008 and 2007, respectively.  The corresponding transaction costs associated with debit card transactions are included in noninterest data processing and related costs.  The debit card transaction costs were $25,000 and $20,000 for the three months ended September 30, 2008 and 2007, respectively.  The net impact of the fees received and the related cost of the debit card transactions on earnings for the three months ended September 30, 2008 and 2007 was $36,000 and $28,000, respectively. 

 

Nine months ended September 30, 2008 and 2007

 

Noninterest income in the nine month period ended September 30, 2008 was a loss of $741,000, a decrease of 175.0% over noninterest income of $989,000 in the same period of 2007.  The $1.7 million decrease in noninterest income is primarily related to a pre-tax $1.8 million impairment charge on FNMA preferred stock and $167,000 in other real estate owned activity.  Partially offsetting these decreases were increases of $5,000 in loan fee income, $175,000 in service fees on deposit accounts, $34,000 in income from bank owned life insurance, $7,000 gain on sale of securities, and $57,000 in other income.  Excluding the impairment charge, noninterest income for the nine months ended September 30, 2008 was $1.1 million, an $111,000, or 11.2%, increase compared to the same period in 2007.

 

Loan fee income consists primarily of late charge fees, fees from issuance of letters of credit and mortgage origination fees we receive on residential loans funded and closed by a third party.  Loan fees were $126,000 and $121,000 for the nine months ended September 30, 2008 and 2007, respectively.  The $5,000 increase for the nine months ended September 30, 2008 compared to the same period in 2007 related primarily to increases of $2,000 in late charge fees and $13,000 in fees received from the issuance of letters of credit, partially offset by a decrease of $11,000 in mortgage origination fees.  Late charge fees were $78,000 and $76,000 for the nine months ended September 30, 2008 and 2007, respectively, while income related to amortization of fees on letters of credit was $40,000 and $27,000 for the first nine months of 2008 and 2007, respectively.    Mortgage origination fees were $7,000 and $18,000 for the nine months ended September 30, 2008 and 2007, respectively,

 

---

 

 

 

Service fees on deposits were $468,000 and $293,000 for the nine months ended September 30, 2008 and 2007, respectively.  While the number of client accounts continues to grow, the $175,000 increase is primarily related to the amount of NSF fees collected in the first nine months of 2008 compared to the same period in 2007.  NSF income increased $116,000 to $319,000 for the nine months ended September 30, 2008 from $203,000 for the same period in 2007, representing 68.1% of total service fees on deposits in the 2008 period compared to 69.2% of total service fees on deposits in the 2007 period.  The increase in NSF fee income is due primarily to an increased effort to collect rather than waive NSF fees from our clients.  In addition, service charges on deposit accounts increased $69,000 during the nine months ended September 30, 2008 to $127,000 from $58,000 for the same period in 2007 due to the service charges on deposit accounts exceeding the interest earned credit.  The interest rate earned on deposit accounts has decreased in relation to short-term market rates.  Partially offsetting the increase in NSF fees collected and service charges was an $8,000 decrease in overdraft fees which were $13,000 for the nine months ended September 30, 2008 compared to $22,000 for the same period in 2007. 

 

We held $11.7 million of bank owned life insurance at the end of the third quarter of 2008.  Income derived from this life insurance was $312,000 for the nine months ended September 30, 2008 compared to $278,000 in the nine months ended September 30, 2007. 

 

During the three months ended September 30, 2008, we recorded a $7,000 gain on a Government sponsored security that was called.  In addition, we recorded an impairment charge of $1.8 million, pre-tax, on our FNMA preferred stock, which was determined to have suffered an other-than-temporary impairment as a result of the Government’s decision on September 7, 2008 to place the FNMA under conservatorship.

 

            Real estate owned activity includes income and expenses from property held for sale and other real estate we own.  For the nine months ended September 30, 2008, we had a loss on real estate owned activity of $58,000, a $167,000 decrease from the same period in 2007.  For the nine months ended September 30, 2007, we had income from real estate activity of $109,000 which included a pre-tax gain of $319,000 on property held for sale.  In addition, we leased a portion of the property held for sale and collected monthly rent of approximately $19,000 in March 2007.  We also had income and expenses related to loans that were transferred into other real estate owned.  Expenses on these properties exceeded income derived from the real estate by $247,000 for the nine months ended September 30, 2007.

 

Other income consisted primarily of fees received on debit card transactions, sale of customer checks, and wire transfers.  Other income was $245,000 and $188,000 for the nine months ended September 30, 2008 and 2007, respectively.  The $57,000 increase relates primarily to a $40,000 increase in debit card transaction fees and an $11,000 increase in other fee income.  Debit card transaction fees were $170,000 and $130,000 for the nine months ended September 30, 2008 and 2007, respectively and represented 69.4% of total other income for the first nine months of 2008 and 2007.  The corresponding transaction costs associated with debit card transactions are included in noninterest data processing and related costs.  The debit card transaction costs were $69,000 and $55,000 for the nine months ended September 30, 2008 and 2007, respectively.  The net impact of the fees received and the related cost of the debit card transactions on earnings for the nine months ended September 30, 2008 and 2007 was $101,000 and $75,000, respectively.  Other fee income, which includes ACH processing fees, was $25,000 and $14,000 for the nine months ended September 30, 2008 and 2007, respectively.

 

Noninterest expenses

 

            The following table sets forth information related to our noninterest expenses. 

 

---

 

 

Three months ended September30, 2008 and 2007

 

We incurred noninterest expenses of $3.0 million for the three months ended September 30, 2008 compared to $2.8 million for the three months ended September 30, 2007.  Average interest-earning assets increased 17.7% during this period, while noninterest expenses increased 9.2%.

 

For the three months ended September 30, 2008, compensation and benefits, occupancy, and data processing and related costs represented 79.2% of the total noninterest expense compared to 78.8% for the same period in 2007. 

 

Nine months ended September 30, 2008 and 2007

 

We incurred noninterest expenses of $9.2 million for the nine months ended September 30, 2008 compared to $8.1 million for the nine months ended September 30, 2007.  Average interest-earning assets increased 21.4% during this period, while noninterest expenses increased 13.6%.

 

For the nine months ended September 30, 2008 and 2007 compensation and benefits, occupancy, and data processing and related costs represented 79.2% of the total noninterest expense. 

 

The following table sets forth information related to our compensation and benefits. 

 

 

Three months ended September 30, 2008 and 2007

 

Compensation and benefits expense was $1.6 million and $1.5 million for the three months ended September 30, 2008 and 2007, respectively.   Compensation and benefits represented 53.5% and 55.5% of our total noninterest expense for the three months ended September 30, 2008 and 2007, respectively.  The $78,000 increase in compensation and benefits in the third quarter of 2008 compared to the same period in 2007 resulted from increases of $238,000 in base compensation and $45,000 in benefits expense, partially offset by a $203,000 decrease in incentive compensation and a $2,000 increase in loan origination compensation expense, which is required to be capitalized and amortized over the life of the loan as a reduction of loan interest income. 

 

The $238,000 increase in base compensation expense related to the cost of 13 additional employees as well as annual salary increases.  Ten of the new employees were hired to staff and support our two additional branch office locations while the remaining three employees were hired to further enhance our credit review, finance and information technology departments.  Incentive compensation represented 4.5% and 17.8 % of total compensation and benefits for the three months ended September 30, 2008 and 2007, respectively.  The incentive compensation expense recorded for the third quarters of 2008 and 2007 represented an accrual of the estimated incentive compensation earned during the third quarter of the respective year.  The incentive compensation accrual was reduced in the third quarter of 2008 when management determined that certain corporate objectives affecting incentive compensation would not be achieved.  Benefits expense increased $45,000 in the third quarter of 2008 compared to the same period in 2007.  Benefits expense represented 21.9% and 19.1% of the total compensation for the three months ended September 30, 2008 and 2007, respectively.

 

---

 

 

Nine months ended September 30, 2008 and 2007

 

Compensation and benefits expense was $5.1 million and $4.5 million for the nine months ended September 30, 2008 and 2007, respectively.   Compensation and benefits represented 55.9% and 55.2% of our total noninterest expense for the nine months ended September 30, 2008 and 2007, respectively.  The $670,000 increase in compensation and benefits in the first nine months of 2008 compared to the same period in 2007 resulted from increases of $672,000 in base compensation and $127,000 in benefits expense, partially offset by a $121,000 decrease in incentive compensation and an $8,000 increase in loan origination compensation expense, which is required to be capitalized and amortized over the life of the loan as a reduction of loan interest income. 

 

The $672,000 increase in base compensation expense related to the cost of 13 additional employees as well as annual salary increases.  Ten of the new employees were hired to staff and support our two additional branch office locations while the remaining three employees were hired to further enhance our credit review, finance and information technology departments.  Incentive compensation represented 12.4% and 16.9 % of total compensation and benefits for the nine months ended September 30, 2008 and 2007, respectively.  The incentive compensation expense recorded for the first nine months of 2008 and 2007 represented an accrual of the estimated incentive compensation earned during the first nine months of the respective year.  Benefits expense increased $127,000 in the first nine months of 2008 compared to the same period in 2007.  Benefits expense represented 21.7% and 21.5% of the total compensation for the nine months ended September 30, 2008 and 2007, respectively.

 

The following tables set forth information related to our data processing and related costs. 

 

Data processing and related costs were $347,000 and $310,000, an increase of $37,000, for the three months ended September 30, 2008 and 2007, respectively.   During the first nine months of 2008 and the same period of 2007, our data processing and related costs were $1.0 million and $865,000, respectively, an increase of $147,000.

 

During the three months ended September 30, 2008, our data processing costs for our core processing system were $266,000 compared to $227,000 for the three months ended September 30, 2007.  We have contracted with an outside computer service company to provide our core data processing services.  Costs for our core data processing services increased $39,000, or 17.2%, from $266,000 to $227,000 for the three months ended September 30, 2008 compared to the same period in 2007.  The increases in costs were caused by a higher number of loan and deposit accounts.  A significant portion of the fee charged by the third party processor is directly related to the number of loan and deposit accounts and the related number of transactions.  During the nine months ended September 30, 2008 and 2007, data processing costs for our core processing system were $776,000 and $623,000, respectively, an increase of $153,000, or 24.6%.

 

We receive income from debit card transactions performed by our clients.  Since we outsource this service, we are charged related transaction expenses from our merchant service provider.  Debit card transaction expense was $25,000 and $20,000 for the three months ended September 30, 2008 and 2007, respectively.  During the first nine months of 2008 and 2007, debit card transaction expense was $69,000 and $55,000, respectively.

 

Occupancy expense represented 14.4% and 12.1% of total noninterest expense for the three months ended September 30, 2008 and 2007, respectively.  Occupancy expense for the three months ended September 30, 2008 and 2007 was $437,000 and $337,000, respectively, an increase of $100,000.  The increase is primarily due to the increased costs of depreciation and rent expense associated with our two new retail offices which opened in July 2008.  For the nine months ended September 30, 2008, occupancy expense increased $53,000 to $1.1 million from the same period ended September 30, 2007.  Occupancy expense represented 12.3% and 13.3% of total noninterest expense for the first nine months of 2008 and 2007, respectively.

 

---

 

 

The remaining $40,000 increase in noninterest expense for the three month period ended September 30, 2008 compared to the same period in 2007 resulted primarily from increases of $15,000 in marketing expenses, $25,000 in insurance, and $21,000 in telephone expenses, partially offset by decreases of $4,000 in professional fees and $17,000 in other noninterest expenses.  The increase in marketing expenses relates primarily to our new Greenville and Columbia offices, as well as expanding our market awareness in those areas while the $25,000 increase in insurance costs is related to the growth in deposits and the FDIC deposit insurance assessment based on our deposit balances.  In addition, telephone expenses have increased with the addition of our two new offices and the additional number of employees.  The decrease in professional fees is due primarily to the additional costs incurred during 2007 related to the name change of our company while the decrease in other noninterest expenses relates primarily to a reduction in collection expenses compared to the same period in 2007.

 

For the nine month period ended September 30, 2008, remaining noninterest expenses increased $230,000 from the same period in 2007.  Of this amount, marketing expenses represented $63,000 of the increase, $85,000 was related to insurance, $29,000 related to telephone expenses and other expenses represented $101,000 of the increase.  Partially offsetting these increases was a $48,000 decrease in professional fees due to the additional costs incurred during 2007 related to the name change of our company.  The increase in marketing expenses relates primarily to our new Greenville and Columbia offices, as well as expanding our market awareness in those areas while the $85,000 increase in insurance costs is related to the growth in deposits and the FDIC deposit insurance assessment based on our deposit balances.  In addition, telephone expenses have increased with the addition of our two new offices and the additional number of employees.  A significant portion of the increase in other expenses is due to increased costs of postage and office supplies, business meals, education expenses and deposit account losses.

 

We recorded an income tax benefit of $148,000 for the three months ended September 30, 2008 compared to an expense of $478,000 during the same period in 2007.   For the nine months ended September 30, 2008, income tax expense was $630,000 compared to $1.3 million for the same period in 2007.  Our effective tax rate was (54.0)% and 33.3%, respectively, for the three month periods ended September 30, 2008 and 2007, respectively, and 29.8% and 32.4% for the nine month periods ended September 30, 2008and 2007, respectively. 

 

The impact of the loss on the other than temporary impairment and income from tax-exempt municipal securities and bank owned life insurance resulted in the negative tax rate for the three months ended September 30, 2008.  Below is a table reflecting the actual income tax expense (benefit) compared to the income (loss) before taxes and the proforma income, excluding the impairment charge, for the three and nine month periods ended September 30, 2008.  The decrease in the effective tax rate, based on operating earnings, for the 2008 periods compared to 2007 results primarily from the tax exempt income on additional bank owned life insurance which we purchased in the third quarter of 2008.

 

 

                As a result of the passage of the EESA, the bank’s ability to utilize the loss on the FNMA preferred stock against ordinary income was considered in determining that the company did not need to establish a valuation allowance for the deferred tax asset that was recorded in relation to the $1.8 million impairment charge.

 

 

Balance Sheet Review

 

General

 

            At September 30, 2008, we had total assets of $696.6 million, consisting principally of $554.8 million in loans, $90.0 million in investments, $12.0 million in federal funds sold, and $9.2 million in cash and due from banks, and $11.7 in bank owned life insurance.  Our liabilities at September 30, 2008 totaled $658.9 million, which consisted principally of $477.8 million in deposits, $161.7 million in FHLB advances and related debt, and $13.4 million in junior subordinated debentures.  At September 30, 2008, our shareholders’ equity was $37.7 million.

 

---

 

 

 

 

At December 31, 2007, we had total assets of $628.1 million, consisting principally of $503.1 million in loans, $87.5 million in investments, $9.3 million in federal funds sold, $7.7 million in cash and due from banks and $8.9 million in bank owned life insurance.  Our liabilities at December 31, 2007 totaled $589.9 million, consisting principally of $412.8 million in deposits, $158.5 million in FHLB advances, and $13.4 million of junior subordinated debentures.  At December 31, 2007, our shareholders’ equity was $38.3 million.

 

Federal Funds Sold

 

At September 30, 2008, our federal funds sold were $12.0 million, or 1.7% of total assets.  At December 31, 2007, our $9.3 million in federal funds sold on an overnight basis comprised 1.5% of total assets. 

 

Investments

Contractual maturities and yields on our investments that are available for sale and are held to maturity at September 30, 2008 are shown in the following table.  Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.  We had no securities with maturities less than one year at September 30, 2008.

 

 

 

            At September 30, 2008, our investments included securities issued by the Federal Home Loan Mortgage Corporation and Federal National Mortgage Association with carrying values of $16.3 million, and $37.8 million, respectively.

 

The amortized costs and the fair value of our investments at September 30, 2008 and December 31, 2007 are shown in the following table.

 

 

              Other investments totaled $8.5 million at September 30, 2008 and consisted primarily of Federal Home Loan Bank stock with a cost of $6.7 million, Federal Reserve Bank stock with a cost of $1.3 million, and investments in Greenville First Statutory Trust I and Trust II of $186,000 and $217,000, respectively.

 

---

 

At September 30, 2008, we had $90.0 million in our investment securities portfolio which represented approximately 12.9% of our total assets.  We held U.S. Government sponsored enterprise securities, municipal securities, and mortgage-backed securities with a fair value of $81.2 million and an amortized cost of $85.2 million for an unrealized loss of $4.0 million.  We believe, based on industry analyst reports and credit ratings that the deterioration in value of these securities, except for our FNMA preferred stock for which we recorded an impairment charge of $1.8 million in the third quarter 2008, is attributed to changes in market interest rates and not in the credit quality of the issuer and therefore, these losses are not considered other-than-temporary.  We have the ability and intent to hold these securities until such time as the value recovers or the securities mature.

 

At December 31, 2007, the $87.5 million in our investment securities portfolio represented approximately 13.9% of our total assets.  We held government sponsored enterprise securities, municipal securities, and mortgage-backed securities with a fair value of $78.6 million and an amortized cost of $78.7 million for an unrealized loss of $101,000. 

 

Contractual maturities and yields on our available for sale and held to maturity investments at December 31, 2007 are shown in the following table.  Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.  At December 31, 2007, we had no securities with a maturity of less than one year.

 

 

At December 31, 2007, our investments included securities issued by the Federal National Mortgage Association and Federal Home Loan Mortgage Corporation with carrying values of $37.6 million and $16.2 million, respectively.

 

Other investments totaled $8.7 million at December 31, 2007 and consisted of Federal Reserve Bank stock with a cost of $1.0 million, investments in Greenville First Statutory Trust I and II of $186,000 and $217,000, respectively, and Federal Home Loan Bank stock with a cost of $7.2 million.

 

Loans

 

            Since loans typically provide higher interest yields than other types of interest earning assets, a substantial percentage of our earning assets are invested in our loan portfolio.  For the nine months ended September 30, 2008 and 2007, average loans were $542.7 million and $445.9 million, respectively.  Before the allowance for loan losses, total loans outstanding at September 30, 2008 were $561.3 million.  Average loans for the year ended December 31, 2007 were $459.2 million.  Before the allowance for loan losses, total loans outstanding at December 31, 2007 were $508.9 million.

 

The principal component of our loan portfolio is loans secured by real estate mortgages.    Most of our real estate loans are secured by residential or commercial property.  We do not generally originate traditional long term residential mortgages, but we do issue traditional second mortgage residential real estate loans and home equity lines of credit.  We obtain a security interest in real estate whenever possible, in addition to any other available collateral.  This collateral is taken to increase the likelihood of the ultimate repayment of the loan.  Generally, we limit the loan-to-value ratio on loans we make to 80%.  Due to the short time our portfolio has existed, the current mix may not be indicative of the ongoing portfolio mix.  We attempt to maintain a relatively diversified real estate loan portfolio to help reduce the risk inherent in concentration in certain types of collateral.

 

---

 

 

The following table summarizes the composition of our loan portfolio at September 30, 2008 and December 31, 2007.

 

 

Maturities and Sensitivity of Loans to Changes in Interest Rates

The information in the following tables is based on the contractual maturities of individual loans, including loans which may be subject to renewal at their contractual maturity.  Renewal of such loans is subject to review and credit approval, as well as modification of terms upon maturity.  Actual repayments of loans may differ from the maturities reflected below because borrowers have the right to prepay obligations with or without prepayment penalties.

 

The following table summarizes the loan maturity distribution by type and related interest rate characteristics at September 30, 2008.

 

 

---

 

 

 

The following table summarizes the loan maturity distribution by type and related interest rate characteristics at December 31, 2007.

 

 

Provision and Allowance for Loan Losses

 

We have established an allowance for loan losses through a provision for loan losses charged to expense on our statement of income.  The allowance for loan losses represents an amount which we believe will be adequate to absorb probable losses on existing loans that may become uncollectible.  Our judgment as to the adequacy of the allowance for loan losses is based on a number of assumptions about future events, which we believe to be reasonable, but which may or may not prove to be accurate.  Our determination of the allowance for loan losses is based on evaluations of the collectability of loans, including consideration of factors such as the balance of impaired loans, the quality, mix, and size of our overall loan portfolio, economic conditions that may affect the borrower’s ability to repay the loan, the amount and quality of collateral securing the loans, our historical loan loss experience, and a review of specific problem loans.  We also consider subjective issues such as changes in the lending policies and procedures, changes in the local/national economy, changes in volume or type of credits, changes in volume/severity of problem loans, quality of loan review and board of director oversight, concentrations of credit, and peer group comparisons.  Due to our limited operating history, the provision for loan losses has been made primarily as a result of our assessment of general loan loss risk compared to banks of similar size and maturity.  Due to the rapid growth of our bank over the past several years and our short operating history, a large portion of the loans in our loan portfolio and of our lending relationships are of relatively recent origin.  In general, loans do not begin to show signs of credit deterioration or default until they have been outstanding for some period of time, a process known as seasoning.  As a result, a portfolio of older loans will usually behave more predictably than a newer portfolio.  Because our loan portfolio is relatively new, the current level of delinquencies and defaults may not be representative of the level that will prevail when the portfolio becomes more seasoned, which may be higher than current levels.  If delinquencies and defaults increase, we may be required to increase our provision for loan losses, which would adversely affect our results of operations and financial condition.  Periodically, we adjust the amount of the allowance based on changing circumstances.  We charge recognized losses to the allowance and add subsequent recoveries back to the allowance for loan losses.  There can be no assurance that charge-offs of loans in future periods will not exceed the allowance for loan losses as estimated at any point in time or that provisions for loan losses will not be significant to a particular accounting period. 

 

---

 

 

 

The following table summarizes the activity related to our allowance for loan losses for the nine months ended September 30, 2008 and 2007:

 

 

We do not allocate the allowance for loan losses to specific categories of loans.  Instead, we evaluate the adequacy of the allowance for loan losses on an overall portfolio basis utilizing our credit grading system which we apply to each loan.  We have retained an independent consultant to review the loan files on a test basis to confirm our internal grading of our loans.