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[March 04, 2014]
SOUTHERN FIRST BANCSHARES INC - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operation
(Edgar Glimpses Via Acquire Media NewsEdge) 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 the financial statements and the related notes and the other statistical information also included in this report.
OVERVIEW Our business model continues to be client-focused, utilizing relationship teams to provide our clients with a specific banker contact and support team responsible for all of their banking needs. The purpose of this structure is to provide a consistent and superior level of professional service, and we believe it provides us with a distinct competitive advantage. We consider exceptional client service to be a critical part of our culture, which we refer to as "ClientFIRST." At December 31, 2013, we had total assets of $890.8 million, an 11.6% increase from total assets of $798.0 million at December 31, 2012. The largest components of our total assets are loans and securities which were $737.3 million and $73.6 million, respectively, at December 31, 2013. Comparatively, our loans and securities totaled $646.0 million and $86.0 million, respectively, at December 31, 2012. Our liabilities and shareholders' equity at December 31, 2013 totaled $825.2 million and $65.7 million, respectively, compared to liabilities of $733.9 million and shareholders' equity of $64.1 million at December 31, 2012.
The principal component of our liabilities is deposits which were $680.3 million and $576.3 million at December 31, 2013 and 2012, respectively.
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 difference 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. In addition to earning interest on our loans and investments, we earn income through fees and other charges to our clients.
Our net income for the year ended December 31, 2013 was $5.1 million, a 32.6% increase from $3.9 million for the year ended December 31, 2012. After our dividend payment to our preferred stockholders, net income to common shareholders was $4.4 million, or diluted earnings per share ("EPS") of $0.98, for the year ended December 31, 2013 as compared to a net income to common shareholders of $2.8 million, or diluted EPS of $0.64 for the year ended December 31, 2012. The increase in net income resulted primarily from increases in net interest income and noninterest income and a decrease in the provision for loan losses, partially offset by increases in noninterest expense and income tax expense. Net income for the year ended December 31, 2011 was $2.1 million, while net income to common shareholders was $944,000, or diluted EPS of $0.22.
Economic conditions, competition, and the monetary and fiscal policies of the federal government significantly affect most financial institutions, including the Bank. Lending and deposit activities and fee income generation are influenced by levels of business spending and investment, consumer income, consumer spending and savings, capital market activities, and competition among financial institutions, as well as client preferences, interest rate conditions and prevailing market rates on competing products in our market areas.
Effect of Economic Trends Markets in the United States and elsewhere experienced extreme volatility and disruption since the latter half of 2007. While the economy as a whole has steadily improved since 2009, the weak economic conditions are expected to continue into 2014. Financial institutions likely will continue to experience credit losses above historical levels and elevated levels of non-performing assets, charge-offs and foreclosures. In light of these conditions, financial institutions also face heightened levels of scrutiny from federal and state regulators. These factors negatively influenced, and likely will continue to negatively influence, earning asset yields at a time when the market for deposits is intensely competitive. As a result, financial institutions experienced, and are expected to continue to experience, pressure on credit costs, loan yields, deposit and other borrowing costs, liquidity, and capital.
37 --------------------------------------------------------------------------------CRITICAL ACCOUNTING POLICIES We have adopted various accounting policies that govern the application of accounting principles generally accepted in the United States of America and with general practices within the banking industry in the preparation of our financial statements. Our significant accounting policies are described in Note 1 to our Consolidated Financial Statements as of December 31, 2013.
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. Management has reviewed and approved these critical accounting policies and has discussed these policies with the Company's Audit Committee.
Allowance for Loan Losses The allowance for loan loss is management's estimate of credit losses inherent in the loan portfolio. The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. The allowance for loan losses is evaluated on a regular basis by management and is based upon management's periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower's ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.
We have an established process to determine the adequacy of the allowance for loan losses that assesses the losses inherent in our portfolio. While we attribute portions of the allowance to specific portfolio segments, the entire allowance is available to absorb credit losses inherent in the total loan portfolio. Our process involves procedures to appropriately consider the unique risk characteristics of our commercial and consumer loan portfolio segments. For each portfolio segment, impairment is measured individually for each impaired loan. Our allowance levels are influenced by loan volume, loan grade or delinquency status, historic loss experience and other economic conditions.
The allowance consists of general and specific components.
Commercial loans are assessed for estimated losses by grading each loan using various risk factors identified through periodic reviews. We apply historic grade-specific loss factors to each loan class. In the development of our statistically derived loan grade loss factors, we observe historical losses over 12 quarters for each loan grade. These loss estimates are adjusted as appropriate based on additional analysis of external loss data or other risks identified from current economic conditions and credit quality trends. For consumer loans, we determine the allowance on a collective basis utilizing historical losses over 12 quarters to represent our best estimate of inherent loss. We pool loans, generally by loan class with similar risk characteristics.
Included in the general component of the allowance for loan losses for both portfolio segments is a margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating general losses in the portfolio. Uncertainties and 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 or problem loans, quality of loan review and board of director oversight, concentrations of credit, and peer group comparisons are factors considered.
The specific component relates to loans that are classified as impaired. For loans that are classified as impaired, an allowance is established when the value of the impaired loan is lower than the carrying value of that loan. A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Impairment is measured on a loan by loan basis for commercial and consumer loans by either the present value of expected future cash flows discounted at the loan's effective interest rate, the loan's obtainable market price, or the fair value of the collateral if the loan is 38 -------------------------------------------------------------------------------- collateral dependent. The specific component also includes an amount for the estimated impairment on commercial and consumer loans modified in a troubled debt restructuring ("TDR"), whether on accrual or nonaccrual status.
While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in local economic conditions. In addition, regulatory agencies, as an integral part of their examination process, periodically review our allowance for loan losses. Such agencies may require us to recognize additions to the allowances based on their judgments about information available to them at the time of their examination.
Fair Valuation of Financial Instruments We use fair value measurements to record fair value adjustments to certain financial instruments and to determine fair value disclosures. Additionally, we may be required to record other assets at fair value on a nonrecurring basis.
These nonrecurring fair value adjustments typically involve application of lower-of-cost-or-market accounting or write-downs of individual assets. Further, we include in the Notes to the Consolidated Financial Statements information about the extent to which fair value is used to measure assets and liabilities, the valuation methodologies used, and the related impact to income.
Additionally, for financial instruments not recorded at fair value, we disclose the estimate of their fair value.
Fair value is defined as the price that would be received to sell the asset or paid to transfer the liability in an orderly transaction between market participants at the measurement date. Accounting standards establish a three-level hierarchy for disclosure of assets and liabilities recorded at fair value. The classification of assets and liabilities within the hierarchy is based on whether the inputs to the valuation methodology used for measurement are observable or unobservable. Observable inputs reflect market-derived or market-based information obtained from independent sources, while unobservable inputs reflect our estimates about market data. The three levels of inputs that are used to classify fair value measurements are as follows: · Level 1 - Valuation is based upon quoted prices for identical instruments traded in active markets. Level 1 instruments generally include securities traded on active exchange markets, such as the New York Stock Exchange, as well as securities that are traded by dealers or brokers in active over-the-counter markets. Instruments we classify as Level 1 are instruments that have been priced directly from dealer trading desks and represent actual prices at which such securities have traded within active markets.
· Level 2 - Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques, such as matrix pricing, for which all significant assumptions are observable in the market.
Instruments we classify as Level 2 include securities that are valued based on pricing models that use relevant observable information generated by transactions that have occurred in the market place that involve similar securities.
· Level 3 - Valuation is generated from model-based techniques that use significant assumptions not observable in the market. These unobservable assumptions reflect the Company's estimates of assumptions market participants would use in pricing the asset or liability. Valuation techniques include use of option pricing models, discounted cash flow models, and similar techniques.
We attempt to maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements. When available, we use quoted market prices to measure fair value. Specifically, we use independent pricing services to obtain fair values based on quoted prices. Quoted prices are subject to our internal price verification procedures. If market prices are not available, fair value measurement is based upon models that use primarily market-based or independently-sourced market parameters. Most of our financial instruments use either of the foregoing methodologies, collectively Level 1 and Level 2 measurements, to determine fair value adjustments recorded to our financial statements. However, in certain cases, when market observable inputs for model-based valuation techniques may not be readily available, we are required to make judgments about assumptions market participants would use in estimating the fair value of the financial instrument.
The degree of management judgment involved in determining the fair value of an instrument is dependent upon the availability of quoted market prices or observable market parameters. For instruments that trade actively and have quoted market prices or observable market parameters, there is minimal subjectivity involved in measuring fair value. When observable market prices and parameters are not fully available, management's judgment is necessary to estimate fair value. In addition, changes in market conditions may reduce the availability of quoted prices or observable data. For example, reduced liquidity in the capital markets or changes in secondary market activities could result in observable market inputs becoming unavailable. When significant adjustments are required to available observable 39 -------------------------------------------------------------------------------- inputs, it may be appropriate to utilize an estimate based primarily on unobservable inputs. When an active market for a security does not exist, the use of management estimates that incorporate current market participant expectations of future cash flows, and include appropriate risk premiums, is acceptable.
Significant judgment may be required to determine whether certain assets measured at fair value are included in Level 2 or Level 3. If fair value measurement is based upon recent observable market activity of such assets or comparable assets (other than forced or distressed transactions) that occur in sufficient volume and do not require significant adjustment using unobservable inputs, those assets are classified as Level 2. If not, they are classified as Level 3. Making this assessment requires significant judgment.
Other-Than-Temporary Impairment Analysis Our debt securities are classified as securities available for sale and reported at fair value. Unrealized gains and losses, after applicable taxes, are reported in shareholders' equity. We conduct other-than-temporary impairment ("OTTI") analysis on a quarterly basis or more often if a potential loss-triggering event occurs. The initial indicator of OTTI for debt securities is a decline in market value below the amount recorded for an investment and the severity and duration of the decline. For a debt security for which there has been a decline in the fair value below amortized cost basis, we recognize OTTI if we (1) have the intent to sell the security, (2) it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis, or (3) we do not expect to recover the entire amortized cost basis of the security.
Other Real Estate Owned Real estate acquired through foreclosure is initially recorded at the lower of cost or estimated fair value. Subsequent to the date of acquisition, it is carried at the lower of cost or fair value, adjusted for net selling costs. Fair values of real estate owned are reviewed regularly and writedowns are recorded when it is determined that the carrying value of real estate exceeds the fair value less estimated costs to sell. Costs relating to the development and improvement of such property are capitalized, whereas those costs relating to holding the property are expensed.
Income Taxes The financial statements have been prepared on the accrual basis. When income and expenses are recognized in different periods for financial reporting purposes versus for the purposes of computing income taxes currently payable, deferred taxes are provided on such temporary differences. Deferred tax assets and liabilities are recognized for the expected future tax consequences of events that have been recognized in the consolidated financial statements or tax returns. Deferred tax assets and liabilities are measured using the enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be realized or settled. The Company believes that its income tax filing positions taken or expected to be taken on its tax returns will more likely than not be sustained upon audit by the taxing authorities and does not anticipate any adjustments that will result in a material adverse impact on the Company's financial condition, results of operations, or cash flow. Therefore, no reserves for uncertain income tax positions have been recorded.
RESULTS OF OPERATIONS Net Interest Income and Margin Our level of net interest income is determined by the level of earning assets and the management of our net interest margin. For the years ended December 31, 2013, 2012, and 2011, our net interest income was $29.0 million, $26.0 million, and $23.3 million, respectively. The $3.0 million, or 11.6%, increase in net interest income during 2013 was driven by a $63.8 million increase in average earning assets, combined with a $58.2 million increase in our average interest-bearing liabilities. The increase in average earning assets is primarily related to an increase in average loans, while the increase in average interest-bearing liabilities is driven by an increase in interest-bearing deposits. During 2012, our net interest income increased $2.7 million, or 11.6%, while average interest-earning assets increased $14.3 million and average interest-bearing liabilities decreased by $15.0 million.
Interest income for the years ended December 31, 2013, 2012, and 2011 was $36.1 million, $34.7 million, and $35.1 million, respectively. A significant portion of our interest income relates to our strategy to maintain a significant portion of our assets in higher earning loans compared to lower yielding investments and federal funds sold. As such, 94.8% of our interest income related to interest on loans during 2013, 94.1% during 2012 and 93.6% during 2011. Also, included 40 --------------------------------------------------------------------------------in interest income on loans was $692,000, $472,000 and $458,000, for the years ended December 31, 2013, 2012 and 2011, respectively, related to the net amortization of loan fees and capitalized loan origination costs.
Interest expense was $7.1 million, $8.7 million, and $11.9 million for the years ended December 31, 2013, 2012, and 2011, respectively. Interest expense on deposits for the years ended December 31, 2013, 2012 and 2011 represented 40.3%, 48.0%, and 59.0%, respectively, of total interest expense, while interest expense on borrowings represented 59.7%, 52.0%, and 41.0%, respectively, of total interest expense.
We have included a number of tables to assist in our description of various measures of our financial performance. For example, the "Average Balances, Income and Expenses, Yields and Rates" table 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 2013, 2012, and 2011.
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. 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 and interest-bearing accounts.
The following table sets forth information related to our average balance sheet, average yields on assets, and average costs of liabilities at December 31, 2013, 2012 and 2011. We derived these yields or costs 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 same periods, we had no securities purchased with agreements to resell. All investments were owned at an original maturity of over one year.
Nonaccrual loans are included in earning assets 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.
Average Balances, Income and Expenses, Yields and Rates For the Year Ended December 31, 2013 2012 2011 Average Income/ Yield/ Average Income/ Yield/ Average Income/ Yield/ (dollars in thousands) Balance Expense Rate Balance Expense Rate Balance Expense Rate Interest-earning assets Federal funds sold $24,977 $63 0.25% $26,085 $67 0.26% $45,498 $106 0.23% Investment securities, taxable 55,269 1,190 2.15% 63,169 1,419 2.25% 70,832 1,718 2.43% Investment securities, nontaxable (1) 24,219 1,005 4.15% 19,066 877 4.60% 13,593 687 5.05% Loans 688,169 34,242 4.98% 620,514 32,668 5.26% 584,633 32,892 5.63% Total earning assets 792,634 36,500 4.60% 728,834 35,031 4.81% 714,556 35,403 4.95% Nonearning assets 46,986 42,900 41,931 Total assets $839,620 $771,734 $756,487 Interest-bearing liabilities NOW accounts $152,238 383 0.25% $152,433 881 0.58% $140,139 1,437 1.03% Savings & money market 146,185 457 0.31% 112,323 444 0.40% 111,813 840 0.75% Time deposits 230,054 2,022 0.88% 214,743 2,852 1.33% 243,618 4,716 1.94% Total interest-bearing deposits 528,477 2,862 0.54% 479,499 4,177 0.87% 495,570 6,993 1.41% FHLB advances and other borrowings 132,955 3,899 2.93% 123,756 4,154 3.36% 122,704 4,512 3.68% Junior subordinated debt 13,403 336 2.51% 13,403 371 2.77% 13,403 349 2.60% Total interest-bearing liabilities 674,835 7,097 1.05% 616,658 8,702 1.41% 631,677 11,854 1.88% Noninterest-bearing liabilities 99,774 91,022 63,384 Shareholders' equity 65,011 64,054 61,426 Total liabilities and shareholders' equity $839,620 $771,734 $756,487 Net interest spread 3.55% 3.40% 3.07% Net interest income( tax equivalent)/margin $29,403 3.71% $26,329 3.61% $23,549 3.30% Less: tax-equivalent adjustment (1) (382) (333) (261) Net interest income $29,021 $25,996 $23,288 (1) The tax-equivalent adjustment to net interest income adjusts the yield for assets earning tax-exempt income to a comparable yield on a taxable basis.
Our net interest margin, on a tax-equivalent basis, was 3.71% for the twelve months ended December 31, 2013 compared to 3.61% for 2012, and 3.30% for 2011.
The 10 basis point increase in net interest margin during 2013 as compared to the prior year, was driven primarily by a 36 basis point reduction in the cost of our interest bearing liabilities, offset in part by a 21 basis point reduction in the yield on our interest earning assets. During 2012, our net interest margin increased 31 basis points compared to the year ended 2011 due primarily to 47 basis point reduction in the cost of our interest-bearing liabilities.
41 -------------------------------------------------------------------------------- Our average interest-earning assets increased by $63.8 million compared to the 12 months ended December 31, 2013, while the yield on our interest-earning assets decreased by 21 basis points. Our average loan balances increased by $67.7 million during 2013 compared to 2012, while our loan yield decreased by 28 basis points during the same period. The decline in the yield on our interest-earning assets was driven primarily by reduced yields on our loan portfolio due to loans being originated or renewed at market rates which are lower than those in the past.
In addition, our average interest-bearing liabilities increased by $58.2 million during 2013 as compared to 2012, while the cost of our interest-bearing liabilities declined by 36 basis points. During the past 12 months, we have continued to reduce rates on all of our deposit products in line with the historically low Federal funds target rate. Also, the cost of our FHLB advances and other borrowings, including junior subordinated debt, declined by 41 basis points during 2013 as compared to 2012 due primarily to lower rates on our variable rate borrowings, combined with the restructure of $35.0 million of FHLB advances to lower rates during the past 15 months. We do not anticipate a significant reduction in the rates on our deposits or FHLB advances and other borrowings in the future, as these rates are currently at historically low rates.
Our net interest spread was 3.55% for the year ended December 31, 2013 compared to 3.40% for the same period in 2012 and 3.07% for 2011. 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 36 basis point reduction in rate on our interest-bearing liabilities, partially offset by a 21 basis point decline in yield on our earning assets, resulted in a 15 basis point increase in our net interest spread for the 2013 period.
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.
Years Ended December 31, 2013 vs. 2012 December 31, 2012 vs. 2011 Increase (Decrease) Due to Change in Increase (Decrease) Due to Change in Rate/ Rate/(dollars in thousands) Volume Rate Volume Total Volume Rate Volume Total Interest income Loans $3,430 (1,674) (182) 1,574 $1,644 (1,760) (108) (224) Investment securities (65) (88) 3 (150) (56) (128) 3 (181) Federal funds sold (2) (2) - (4) (48) 15 (6) (39) Total interest income 3,363 (1,764) (179) 1,420 1,540 (1,873) (111) (444) Interest expense Deposits 414 (1,572) (157) (1,315) 145 (2,901) (60) (2,816) FHLB advances and other borrowings 300 (516) (39) (255) 39 (394) (3) (358) Junior subordinated debt - (35) - (35) - 22 - 22 Total interest expense 714 (2,123) (196) (1,605) 184 (3,273) (63) (3,152) Net interest income $2,649 359 17 3,025 $1,356 1,400 (48) 2,708 Net interest income, the largest component of our income, was $29.0 million for the year ended December 31, 2013, a $3.0 million increase from net interest income of $26.0 million for the year ended December 31, 2012. The increase in net interest income is due to a $1.4 million increase in interest income combined with a $1.6 million decrease in interest expense. During 2013, our average interest-earning assets increased $63.8 million as compared to 2012, resulting in $3.4 million of additional interest income; however, lower rates on our interest-earning assets reduced interest income by $1.8 million from the prior year. In addition, interest-bearing liabilities increased by $58.2 million during 2013, resulting in $714,000 of additional interest expense; however, lower rates on our interest-bearing liabilities reduced interest expense by $2.1 million from the prior year.
During the year ended December 31, 2012, our net interest income increased $2.7 million from net interest income of $23.3 million for the year ended December 31, 2011. While our average interest-earning assets increased by $14.3 million more than our average interest-bearing liabilities during 2012 as compared to the 2011 period, $3.0 million of the increase in net interest income is due to lower rates on our assets and liabilities, rather than increased balances of our interest-earning assets.
42 --------------------------------------------------------------------------------Provision for Loan Losses We have established an allowance for loan losses through a provision for loan losses charged as an expense on our statements 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 "Results of Operations - 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.
Following is a summary of the activity in the allowance for loan losses.
December 31, (dollars in thousands) 2013 2012 2011 Balance, beginning of period $9,091 8,925 8,386 Provision 3,475 4,550 5,270 Loan charge-offs (2,478) (4,505) (4,938) Loan recoveries 125 121 207 Net loan charge-offs (2,353) (4,384) (4,731) Balance, end of period $10,213 9,091 8,925 For the year ended December 31, 2013, we incurred a noncash expense related to the provision for loan losses of $3.5 million, bringing the allowance for loan losses to $10.2 million, or 1.39% of gross loans, as of December 31, 2013. In comparison, we added $4.6 million and $5.3 million to the provision for loan losses during the years ended December 31, 2012 and 2011, respectively, resulting in an allowance of $9.1 million and $8.9 million at December 31, 2012 and 2011, respectively, which represented 1.41% and 1.49% of gross loans at December 31, 2012 and 2011, respectively. The lower provision expense of $3.5 million during the 2013 period relates primarily to the overall improvement in the credit quality of our loan portfolio during 2013.
During the twelve months ended December 31, 2013, our net charge-offs were $2.4 million, representing 0.34% of average loans, and consisted of $2.5 million in loans charged-off and of $125,000 of recoveries on loans previously charged-off.
In addition, our loan balances increased by $91.3 million while the amount of our nonperforming and classified assets declined. Factors such as these are also considered in determining the amount of loan loss provision necessary to maintain our allowance for loan losses at an adequate level.
We reported net charge-offs of $4.4 million and $4.7 million for the years ended December 31, 2012 and 2011, respectively, including recoveries of $121,000 and $207,000 for the same periods in 2012 and 2011. The net charge-offs of $4.4 million and $4.7 million during 2012 and 2011, respectively, represented 0.71% and 0.81% of the average outstanding loan portfolios for the respective years.
Noninterest Income The following tables set forth information related to our noninterest income.
Year ended December 31, (dollars in thousands) 2013 2012 2011 Loan fee income $1,235 1,044 877 Service fees on deposit accounts 879 767 638 Income from bank owned life insurance 658 632 565 Gain on sale of investment securities - 363 23 Other than temporary impairment on investment securities - - (25) Other income 1,030 956 692 Total noninterest income $3,802 3,762 2,770 Noninterest income was $3.8 million for the year ended December 31, 2013, a $40,000 increase over noninterest income of for the year ended December 31, 2012. The increase in total noninterest income during 2013 resulted primarily from the following: · Loan fee income increased $191,000 or 18.3%, driven by a $177,000 increase in mortgage origination fee income which totaled $1.1 million for the year. In 2013, we expanded our mortgage operations to include full 43 -------------------------------------------------------------------------------- service mortgage capabilities such as on-site underwriting, closing and funding.
We expect to continue to expand in this area in order to enhance our noninterest income.
· Service fees on deposit accounts increased 14.6%, or $112,000, primarily related to increased service charge fee income on our transaction accounts. During 2013, our transaction accounts, which include checking, money market, and savings accounts, grew by $67.2 million, or 19.4%.
· Income from bank owned life insurance increased $26,000 due primarily to income earned on an additional $2.0 million of life insurance policies purchased during the second quarter of 2013.
· Other income increased by $74,000, or 7.7%, due primarily to increased fee income on our ATM and debit cards which is driven by an increase in transaction volume.
Partially offsetting the increases in noninterest income was the fact that we had no gains or losses on sale of investment securities during the current year, while during 2012 we recorded a gain on sale of investment securities of $363,000.
Noninterest income was $3.8 million for the year ended December 31, 2012, a $992,000 increase over noninterest income of $2.8 million for the year ended December 31, 2011. The largest driver of the increase in noninterest income during 2012 was a $363,000 gain on sale of investment securities. In addition, noninterest income increased during 2012 as a result of the following: · Loan fee income increased $167,000 or 19.0%, driven primarily from increased mortgage origination fee income.
· Service fees on deposit accounts increased 20.2%, or $129,000, primarily related to increased non-sufficient funds ("NSF") fee income and additional income from service charges on our checking, money market, and savings accounts.
· Other income increased by $264,000, or 38.2%, due primarily to rental income received from tenants at our Columbia, South Carolina headquarters building and additional fee income on our ATM and debit card transactions.
In accordance with the requirement set forth under the Dodd-Frank Act, in June 2011, the Federal Reserve approved a final rule which caps an issuer's base interchange fee at 21 cents per transaction and allows an additional 5 basis point charge per transaction to help cover fraud losses. Although the rule does not apply to institutions with less than $10 billion in assets, such as our Bank, there is concern that the price controls may harm community banks, which could be pressured by the marketplace to lower their own interchange rates. Our ATM/Debit card fee income is included in other noninterest income and was $560,000, $451,000, and $389,000 for the years ended December 31, 2013, 2012, and 2011, respectively, the majority of which related to interchange fee income.
Noninterest Expenses The following tables set forth information related to our noninterest expenses.
Years ended December 31, (dollars in thousands) 2013 2012 2011 Compensation and benefits $12,302 10,073 8,933 Occupancy 3,056 2,468 2,282 Real estate owned activity 179 939 940 Data processing and related costs 2,406 2,070 1,869 Insurance 818 1,367 1,437 Marketing 731 637 686 Professional fees 858 841 658 Other 1,462 1,118 1,062 Total noninterest expenses $21,812 19,513 17,867 Noninterest expense was $21.8 million for the year ended December 31, 2013, a $2.3 million, or 11.8%, increase from noninterest expense of $19.5 million for 2012.
The increase in total noninterest expenses resulted primarily from the following: · Compensation and benefits expense increased $2.2 million, or 22.1%, during 2013 relating primarily to increases in base and incentive compensation and benefits expenses. Base compensation expense increased by $1.4 million driven by the cost of 13 additional employees five of whom were hired to assist with our expanded mortgage capabilities with the remainder being hired to support our growth in loans and deposits, combined with annual salary increases. Incentive compensation, which is based on certain targeted financial 44 --------------------------------------------------------------------------------performance goals met by management, increased by $260,000, while benefits expenses increased $614,000 during the 2013 period and represented 21.6% of total compensation and benefits during 2013.
· Occupancy expenses increased 23.8%, or $588,000, driven primarily by increased depreciation, utilities, rent, and property tax expenses related primarily to our two new offices in Charleston and Columbia, South Carolina.
· Data processing and related costs increased 16.2%, or $336,000, primarily related to the increased number of clients and accounts we service.
· Marketing expenses increased $94,000, or 14.8%, driven by increased advertising, community sponsorships and business development costs, including additional costs associated with our entry into the Charleston, South Carolina market.
· Other noninterest expenses increased by 30.8%, or $344,000, primarily related to additional costs associated with our mortgage and office expansions, as well as increased travel and collection expenses.
Partially, offsetting the increases in noninterest expenses was a $760,000, or 80.9%, decrease in real estate owned activity which includes expenses related to the management of properties we hold for sale. In addition, insurance expense decreased by $549,000, or 40.2%, due to a reduction in FDIC insurance premiums and a reduction in regulator fees resulting from the Bank's change from a national charter to a South Carolina charter.
Noninterest expense for the years ended December 31, 2012 and 2011 was $19.5 million and $17.9 million, respectively.
The $1.6 million increase during 2012 related primarily to the following: · Compensation and benefits expense increased $1.1 million, or 12.8%, during 2012 relating primarily to increases in base and incentive compensation expenses and benefits expense. Base compensation expense increased by $664,000 driven by the cost of 12 additional employees most of whom were hired to support our new Charleston and Forest Drive offices, combined with annual salary increases.
Incentive compensation increased by $220,000, while benefits expenses increased $276,000 during the 2012 period and represented 20.3% of total compensation and benefits during 2012.
· Occupancy expenses increased 8.2%, or $186,000, driven primarily by increased depreciation, utilities, and repairs and maintenance expenses.
· Data processing and related costs increased 10.8%, or $201,000, primarily related to the increased number of clients and accounts we service.
· Professional fees increased $183,000, or 27.8%, driven by increased legal and accounting expenses and loan appraisal fees during the 2012 period. Of the $841,000 in professional fees during 2012, approximately $130,000 was related to expenses associated with the sale of our Series T Preferred stock by the Treasury in the TARP auction in June 2012 and repurchase of the CPP Warrant in July 2012.
· Other noninterest expenses increased by 5.3%, or $56,000, driven by increased travel and other costs associated with opening our two new retail offices.
Partially offsetting the increases in noninterest expenses was a $70,000, or 4.9%, decrease in insurance expense due to the change in the assessment base calculation for FDIC insurance which took place in the second quarter of 2011.
Our efficiency ratio, excluding gains on sale of investment securities and real estate owned activity, was 65.9% for 2013 compared to 63.2% for 2012. The efficiency ratio represents the percentage of one dollar of expense required to be incurred to earn a full dollar of revenue and is computed by dividing noninterest expense by the sum of net interest income and noninterest income.
The higher efficiency ratio during 2013 relates primarily to the increase in noninterest expense due to the additional costs associated with opening our two new retail locations and expanding our mortgage operations capabilities.
Income tax expense was $2.4 million, $1.8 million and $833,000 for the years ended December 31, 2013, 2012 and 2011, respectively. The increase in income tax expense in 2013 was primarily a result of the increase in our net income. Our effective tax rate was 32.1% for the year ended December 31, 2013, and 32.2% and 28.5% for the years ended December 31, 2012 and 2011, respectively. The lower net income during 2011, combined with additional tax-exempt income from bank owned life insurance and state and municipal investment securities, increased the impact that our tax-exempt income had in lowering our effective tax rate.
Investment Securities At December 31, 2013, the $73.6 million in our investment securities portfolio represented approximately 8.3% of our total assets. Our investment portfolio included U.S. agency securities, SBA securities, state and political subdivisions, 45 --------------------------------------------------------------------------------and mortgage-backed securities with a fair value of $67.4 million and an amortized cost of $69.5 million for an unrealized loss of $2.0 million.
The amortized costs and the fair value of our investments are as follows.
December 31, 2013 2012 2011 Amortized Fair Amortized Fair Amortized Fair (dollars in thousands) Cost Value Cost Value Cost Value Available for Sale US government agencies $8,756 7,755 7,781 7,785 - - SBA securities 5,758 5,271 6,060 6,072 - - State and political subdivisions 23,622 23,370 24,167 25,249 17,390 18,248 Mortgage-backed securities 31,347 31,044 38,428 39,116 81,694 82,412 Total $69,483 67,440 76,436 78,222 99,084 100,660 Contractual maturities and yields on our investments 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.
December 31, 2013 Less Than One Year One to Five Years Five to Ten Years Over Ten Years Total(dollars in thousands) Amount Yield Amount Yield Amount Yield Amount Yield Amount Yield Available for Sale US government agencies $- - $- - $956 2.13% $6,799 2.43% $7,755 2.40% SBA securities - - - - - - 5,271 1.88% 5,271 1.88% State and political subdivisions 1,507 0.51% 2,114 0.67% 7,398 3.22% 12,351 2.88% 23,370 2.63% Mortgage-backed securities - - - - 2,072 1.77% 28,972 2.69% 31,044 2.62% Total $1,507 0.51% $2,114 0.67% $10,426 2.82% $53,393 2.61% $67,440 2.54% At December 31, 2013, the Company had 35 individual investments with a fair market value of $32.4 million that were in an unrealized loss position for less than 12 months and 11 individual investments with a fair market value of $9.0 million that were in an unrealized loss position for 12 months or longer. The unrealized losses were primarily attributable to changes in interest rates, rather than deterioration in credit quality. The individual securities are each investment grade securities. The Company considers the length of time and extent to which the fair value of available-for-sale debt securities have been less than cost to conclude that such securities were not other-than-temporarily impaired. We also consider other factors such as the financial condition of the issuer including credit ratings and specific events affecting the operations of the issuer, volatility of the security, underlying assets that collateralize the debt security, and other industry and macroeconomic conditions. As the Company has no intent to sell securities with unrealized losses and it is not more-likely-than-not that the Company will be required to sell these securities before recovery of amortized cost, we have concluded that the securities are not impaired on an other-than-temporary basis.
Other investments are comprised of the following and are recorded at cost which approximates fair value.
December 31, (dollars in thousands) 2013 2012 Federal Reserve Bank stock $- 1,485 Federal Home Loan Bank stock 5,614 5,807 Certificates of deposit 99 99 Investment in Trust Preferred subsidiaries 403 403 Total $6,116 7,794 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. Average loans for the years ended December 31, 2013 and 2012 were $688.2 million and $620.5 million, respectively. Before allowance for loan losses, total loans outstanding at December 31, 2013 and 2012 were $737.3 million and $646.0 million, respectively.
46 -------------------------------------------------------------------------------- The principal component of our loan portfolio is loans secured by real estate mortgages. As of December 31, 2013, our loan portfolio included $594.6 million, or 80.6%, of real estate loans. As of December 31, 2012, loans secured by real estate made up 80.9% of our loan portfolio and totaled $522.5 million. Most of our real estate loans are secured by residential or commercial property. In addition, included in our consumer real estate loan portfolio are $3.6 million and $2.1 million as of December 31, 2013 and 2012, respectively, of mortgage loans held for sale. We obtain a security interest in real estate, 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 to coincide with the appropriate regulatory guidelines. We attempt to maintain a relatively diversified loan portfolio to help reduce the risk inherent in concentration in certain types of collateral and business types. We do not generally originate traditional long term residential mortgages to hold in our loan portfolio, but we do issue traditional second mortgage residential real estate loans and home equity lines of credit.
Home equity lines of credit totaled $78.5 million as of December 31, 2013, of which approximately 37% were in a first lien position, while the remaining balance was second liens, compared to $77.9 million as of December 31, 2012, with approximately 38% in first lien positions. The average loan had a balance of approximately $105,000 and a loan to value of approximately 67% as of December 31, 2013, compared to an average loan balance of $106,000 and a loan to value of approximately 75% as of December 31, 2012. Further, 0.1% and 0.6% of our total home equity lines of credit were over 30 days past due as of December 31, 2013 and 2012, respectively.
Following is a summary of our loan composition for each of the five years ended December 31, 2013. Of the $91.3 million in loan growth, $59.4 million is related to our new office in the Charleston, South Carolina market with growth of $16.6 million in non-owner occupied real estate, $17.4 million in owner occupied real estate, $6.9 million in commercial construction and $14.1 million in commercial business loans. In addition, the $27.6 million increase in consumer real estate loans is related to our focus to continue to originate high quality 1-4 family consumer real estate loans. Our average consumer real estate loan currently has a principal balance of $304,000, a term of eight years, and an average rate of 4.56%.
December 31, 2013 2012 2011 2010 2009 %of %of %of %of %of (dollars in thousands) Amount Total Amount Total Amount Total Amount Total Amount Total Commercial Owner occupied RE $185,129 25.1% $158,790 24.6% $149,254 24.9% $137,696 24.0% $132,328 23.0% Non-owner occupied RE 166,016 22.5% 165,163 25.6% 164,623 27.5% 163,795 28.6% 160,229 27.9% Construction 30,906 4.2% 20,347 3.1% 17,841 3.0% 11,319 2.0% 22,718 4.0% Business 129,687 17.6% 114,169 17.7% 111,831 18.7% 109,351 19.1% 110,438 19.2% Total commercial loans 511,738 69.4% 458,469 71.0% 443,549 74.1% 422,161 73.7% 425,713 74.1% Consumer Real estate 114,201 15.5% 86,559 13.4% 57,798 9.7% 54,076 9.5% 55,277 9.6% Home equity 78,479 10.6% 77,895 12.1% 82,664 13.8% 79,528 13.9% 74,348 13.0% Construction 19,888 2.7% 13,749 2.1% 5,546 0.9% 8,550 1.5% 7,914 1.4% Other 12,961 1.8% 9,277 1.4% 9,077 1.5% 8,077 1.4% 11,018 1.9% Total consumer loans 225,529 30.6% 187,480 29.0% 155,085 25.9% 150,231 26.3% 148,557 25.9% Total gross loans, net of deferred fees 737,267 100.0% 645,949 100.0% 598,634 100.0% 572,392 100.0% 574,270 100.0% Less - allowance for loan losses (10,213) (9,091) (8,925) (8,386) (7,760) Total loans, net $727,054 $636,858 $589,709 $564,006 $566,510 Maturities and Sensitivity of Loans to Changes in Interest Rates The information in the following table 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.
47 --------------------------------------------------------------------------------The following table summarizes the loan maturity distribution by type and related interest rate characteristics.
December 31, 2013 After one One year but within After five (dollars in thousands) or less five years years Total Commercial Owner occupied RE $26,959 93,377 64,793 185,129 Non-owner occupied RE 45,937 96,891 23,188 166,016 Construction 11,619 13,844 5,443 30,906 Business 63,720 58,780 7,187 129,687 Total commercial loans 148,235 262,892 100,611 511,738 Consumer Real estate 18,397 34,068 61,736 114,201 Home equity 4,988 26,319 47,172 78,479 Construction 11,749 1,709 6,430 19,888 Other 6,451 5,334 1,176 12,961 Total consumer loans 41,585 67,430 116,514 225,529 Total gross loan, net of deferred fees $189,820 330,322 217,125 737,267 Loans maturing - after one year with Fixed interest rates 380,476 Floating interest rates 166,971 Nonperforming Assets Nonperforming assets include real estate acquired through foreclosure or deed taken in lieu of foreclosure and loans on nonaccrual status. The following table shows the nonperforming assets and the related percentage of nonperforming assets to total assets and gross loans for the five years ended December 31, 2013. Generally, a loan is placed on nonaccrual status when it becomes 90 days past due as to principal or interest, or when we believe, after considering economic and business conditions and collection efforts, that the borrower's financial condition is such that collection of the loan is doubtful. A payment of interest on a loan that is classified as nonaccrual is recognized as a reduction in principal when received. Our policy with respect to nonperforming loans requires the borrower to make a minimum of six consecutive payments in accordance with the loan terms before that loan can be placed back on accrual status. Further, the borrower must show capacity to continue performing into the future prior to restoration of accrual status. As of December 31, 2013 and 2012, we had no loans 90 days past due and still accruing.
December 31, (dollars in thousands) 2013 2012 2011 2010 2009 Commercial Owner occupied RE $1,199 155 1,061 1,183 736 Non-owner occupied RE 373 1,255 1,745 3,311 2,560 Construction 914 1,006 1,314 1,377 1,483 Business 712 202 503 1,781 3,351 Consumer Real estate 76 119 476 928 2,551 Home equity 77 577 386 251 503 Construction - - - - - Other 3 44 - 7 75 Nonaccruing troubled debt restructurings 4,983 4,809 4,779 488 482 Total nonaccrual loans, including nonaccruing TDRs 8,337 8,167 10,264 9,326 11,741 Other real estate owned 1,198 1,719 3,686 5,629 3,704 Total nonperforming assets $9,535 $9,886 13,950 14,955 15,445 Nonperforming assets as a percentage of: Total assets 1.07% 1.24% 1.82% 2.03% 2.15% Gross loans 1.29% 1.53% 2.33% 2.61% 2.69% Total loans over 90 days past due (1) $6,493 5,027 8,854 6,439 4,686 Loans over 90 days past due and still accruing - - - - - Accruing troubled debt restructurings 8,045 9,421 7,429 - - (1) Loans over 90 days are included in nonaccrual loans 48 -------------------------------------------------------------------------------- At December 31, 2013, nonperforming assets were $9.5 million, or 1.07% of total assets and 1.29% of gross loans. Comparatively, nonperforming assets were $9.9 million, or 1.24% of total assets and 1.53% of gross loans, at December 31, 2012. Nonaccrual loans increased $170,000 to $8.3 million at December 31, 2013 from $8.2 million at December 31, 2012. During 2013, we added $5.2 million or nine new loans to nonaccrual while removing or charging off $801,000 or seven nonaccrual loans from 2012 and transferring two properties totaling $1.3 million to real estate acquired in settlement of loans. In addition, 14 loans, or $2.1 million, were either paid off or returned to accrual status during 2013. The amount of foregone interest income on the nonaccrual loans for the years ended December 31, 2013 and 2012 was approximately $543,000 and $402,000, respectively.
Nonperforming assets include other real estate owned. These assets decreased $521,000 to $1.2 million at December 31, 2013 from $1.7 million at December 31, 2012. During 2013, we sold six properties for approximately $1.7 million and recognized a $5,000 loss on the sales. In addition, we added three properties to other real estate owned during 2013 for $1.4 million, and recorded write-downs on three properties of $130,000. The balance at December 31, 2013 includes three commercial properties for $1.1 million and three residential real estate properties totaling $105,000. We believe that these properties are appropriately valued at the lower of cost or market as of December 31, 2013.
At December 31, 2013, 2012 and 2011, the allowance for loan losses represented 122.5%, 111.3%, and 87.0% of the amount of non-performing loans. A significant portion, or 92.8%, of nonperforming loans at December 31, 2013 are secured by real estate. Our nonperforming loans have been written down to approximately 68% of their original nonperforming balance. We have evaluated the underlying collateral on these loans and believe that the collateral on these loans combined with our write-downs on these loans is sufficient to minimize future losses. As a result of this level of coverage on non-performing loans, we believe the provision of $3.5 million for the year ended December 31, 2013 to be adequate.
As a general practice, most of our loans are originated with relatively short maturities of less than 10 years. As a result, when a loan reaches its maturity we frequently renew the loan and thus extend its maturity using similar credit standards as those used when the loan was first originated. Due to these loan practices, we may, at times, renew loans which are classified as nonperforming after evaluating the loan's collateral value and financial strength of its guarantors. Nonperforming loans are renewed at terms generally consistent with the ultimate source of repayment and rarely at reduced rates. In these cases the Bank will seek additional credit enhancements, such as additional collateral or additional guarantees to further protect the loan. When a loan is no longer performing in accordance with its stated terms, the Bank will typically seek performance under the guarantee.
In addition, approximately 81% of our loans are collateralized by real estate and over 88% of our impaired loans are secured by real estate. The Bank utilizes third party appraisers to determine the fair value of collateral dependent loans. Our current loan and appraisal policies require the Bank to obtain updated appraisals on an annual basis, either through a new external appraisal or an internal appraisal evaluation. Impaired loans are individually reviewed on a quarterly basis to determine the level of impairment. As of December 31, 2013, we do not have any impaired loans carried at a value in excess of the appraised value. We typically charge-off a portion or create a specific reserve for impaired loans when we do not expect repayment to occur as agreed upon under the original terms of the loan agreement.
At December 31, 2013, impaired loans totaled approximately $16.6 million for which $14.1 million of these loans have a reserve of approximately $4.7 million allocated in the allowance. During 2013, the average recorded investment in impaired loans was approximately $16.1 million. At December 31, 2012, impaired loans totaled approximately $17.6 million for which $9.5 million of these loans had a reserve of approximately $3.7 million allocated in the allowance. During 2012, the average recorded investment in impaired loans was approximately $17.9 million.
The Company considers a loan to be a troubled debt restructuring ("TDR") when the debtor experiences financial difficulties and the Company provides concessions such that we will not collect all principal and interest in accordance with the original terms of the loan agreement. Concessions can relate to the contractual interest rate, maturity date, or payment structure of the note. As part of our workout plan for individual loan relationships, we may restructure loan terms to assist borrowers facing challenges in the current economic environment. As of December 31, 2013, we determined that we had loans totaling $13.0 million, which we considered TDRs. As of December 31, 2012, we had loans totaling $14.2 million, which we considered TDRs. See Notes 1 and 4 to the Consolidated Financial Statements for additional information on TDRs.
49 --------------------------------------------------------------------------------Allowance for Loan Losses At December 31, 2013 and December 31, 2012, the allowance for loan losses was $10.2 million and $9.1 million, respectively, or 1.39% and 1.41% of outstanding loans, respectively. The allowance for loan losses as a percentage of our outstanding loan portfolio decreased primarily as a result of the overall improvement in the credit quality of our loan portfolio during 2013. During the year ended December 31, 2013, our net charged-off loans decreased by $2.0 million and our total nonaccrual loans increased by $170,000, as compared to the year ended December 31, 2012. See Note 3 to the Consolidated Financial Statements for more information on our allowance for loan losses.
The following table summarizes the activity related to our allowance for loan losses for the five years ended December 31, 2013.
Year ended December 31, (dollars in thousands) 2013 2012 2011 2010 2009 Balance, beginning of period $9,091 8,925 8,386 7,760 7,005 Provision for loan losses 3,475 4,550 5,270 5,610 4,310 Loan charge-offs: Commercial Owner occupied RE (390) (1,857) (72) (143) - Non-owner occupied RE (249) (513) (1,052) (1,343) (482) Construction - - (67) - (1,096) Business (1,664) (1,230) (3,243) (2,982) (1,741) Total commercial (2,303) (3,600) (4,434) (4,468) (3,319) Consumer Real estate (22) (214) (129) (235) (117) Home equity (106) (691) (175) (286) (94) Construction - - - - - Other (47) - (200) (171) (134) Total consumer (175) (905) (504) (692) (345) Total loan charge-offs (2,478) (4,505) (4,938) (5,160) (3,664) Loan recoveries: Commercial Owner occupied RE 1 4 14 1 - Non-owner occupied RE 1 42 42 - 14 Construction - - - - - Business 115 27 149 167 92 Total commercial 117 73 205 168 106 Consumer Real estate - 2 - 4 - Home equity 8 32 2 3 - Construction - - - - - Other - 14 - 1 3 Total consumer 8 48 2 8 3 Total recoveries 125 121 207 176 109 Net loan charge-offs (2,353) (4,384) (4,731) (4,984) (3,555) Balance, end of period $10,213 9,091 8,925 8,386 7,760Allowance for loan losses to gross loans 1.39% 1.41% 1.49% 1.47% 1.35% Net charge-offs to average loans 0.34% 0.71% 0.81% 0.86% 0.63% Deposits and Other Interest-Bearing Liabilities Our primary source of funds for loans and investments is our deposits, advances from the FHLB, and structured repurchase agreements. In the past, we have chosen to obtain a portion of our certificates of deposits from areas outside of our market in order to obtain longer term deposits than are readily available in our local market. We have adopted guidelines regarding our use of brokered CDs that limit our brokered CDs to 25% of total deposits and dictate that our current interest rate risk profile determines the terms. In addition, we do not obtain time deposits of $100,000 or more through the Internet. These guidelines allow us to take advantage of the attractive terms that wholesale funding can offer while mitigating the related inherent risk.
50 -------------------------------------------------------------------------------- Our retail deposits represented $617.0 million, or 90.7% of total deposits at December 31, 2013, while our out-of-market, or brokered, deposits represented $63.3 million, or 9.3% of our total deposits at December 31, 2013. At December 31, 2012, retail deposits represented $563.3 million, or 97.7% of our total deposits, and brokered CDs were $13.0 million, representing 2.3% of our total deposits, at December 31, 2013. While our total retail deposits increased by $53.7 million during the 2013 period, the retail deposit balances for our two new retail offices, which were opened in December 2012, increased by $51.9 million. In addition, we secured an additional $50.3 million of brokered deposits during the year ended December 31, 2013 in order to fund the $90.2 million of net loan growth. Our loan-to-deposit ratio was 108%, 112%, and 106% at December 31, 2013, 2012, and 2011, respectively.
The following table shows the average balance amounts and the average rates paid on deposits held by us.
December 31, 2013 2012 2011 (dollars in thousands) Amount Rate Amount Rate Amount Rate Noninterest bearing demand deposits $93,378 -% $86,080 -% $58,573 -% Interest bearing demand deposits 152,238 0.25% 152,433 0.58% 140,139 1.03% Money market accounts 139,877 0.32% 107,052 0.41% 107,960 0.77% Savings accounts 6,308 0.09% 5,271 0.13% 3,853 0.18% Time deposits less than $100,000 70,144 0.81% 75,148 1.10% 75,912 1.57% Time deposits greater than $100,000 159,910 0.73% 139,595 1.45% 167,706 2.10% Total deposits $621,855 0.41% $565,579 0.74% $554,143 1.27% During the 12 months ended December 31, 2013, our average transaction account balances increased by $41.0 million, or 11.7%, while our average time deposit balances increased by $15.3 million, or 7.1%, due primarily to a $9.3 million increase in average brokered deposits from the previous 12 month period. In addition, during 2013, as our interest-bearing deposits repriced, we were able to reduce the rates we paid on these deposits; however, we do not anticipate a significant reduction in our deposit costs in the future.
During the past 12 months, we continued our focus on increasing core deposits, which exclude out-of-market deposits and time deposits of $100,000 or more, in order to provide a relatively stable funding source for our loan portfolio and other earning assets. Our core deposits were $481.8 million, $427.9 million, and $413.1 million at December 31, 2013, 2012 and 2011, respectively. Included in time deposits of $100,000 or more at December 31, 2013 is $39.1 million of wholesale CDs scheduled to mature within the next 12 months at a weighted average rate of 0.76%.
All of our time deposits are certificates of deposits. The maturity distribution of our time deposits of $100,000 or more is as follows: December 31, (dollars in thousands) 2013 2012 Three months or less $25,892 47,713 Over three through six months 28,157 32,056 Over six through twelve months 63,659 36,396 Over twelve months 80,644 32,198 Total $198,352 148,363 Liquidity and Capital Resources Liquidity represents the ability of a company to convert assets into cash or cash equivalents without significant loss, and the ability to raise additional funds by increasing liabilities. Liquidity management involves monitoring our sources and uses of funds in order to meet our day-to-day cash flow requirements while maximizing profits. Liquidity management is made more complicated because different balance sheet components are subject to varying degrees of management control. For example, the timing of maturities of our investment portfolio is fairly predictable and subject to a high degree of control at the time investment decisions are made. However, net deposit inflows and outflows are far less predictable and are not subject to the same degree of control.
At December 31, 2013 and 2012, our liquid assets amounted to $39.2 million and $29.4 million, or 4.4% and 3.7% of total assets, respectively. Our investment securities at December 31, 2013 and 2012 amounted to $73.6 million and $86.0 million, or 8.3% and 10.8% of total assets, respectively. Investment securities traditionally provide a secondary 51 -------------------------------------------------------------------------------- source of liquidity since they can be converted into cash in a timely manner.
However, approximately 33% of these securities are pledged against outstanding debt. Therefore, the related debt would need to be repaid prior to the securities being sold in order for these securities to be converted to cash. In addition, approximately 37% of our investment securities are pledged to secure client deposits.
Our ability to maintain and expand our deposit base and borrowing capabilities serves as our primary source of liquidity. We plan to meet our future cash needs through the liquidation of temporary investments, the generation of deposits, and from additional borrowings. In addition, we will receive cash upon the maturity and sale of loans and the maturity of investment securities. We maintain three federal funds purchased lines of credit with correspondent banks totaling $45.0 million for which there were no borrowings against the lines at December 31, 2013.
We are also a member of the FHLB of Atlanta, from which applications for borrowings can be made. The FHLB requires that securities, qualifying mortgage loans, and stock of the FHLB owned by the Bank be pledged to secure any advances from the FHLB. The unused borrowing capacity currently available from the FHLB at December 31, 2013 was $69.8 million, based on the Bank's $5.6 million investment in FHLB stock, as well as qualifying mortgages available to secure any future borrowings. However, we are able to pledge additional securities to the FHLB in order to increase our available borrowing capacity.
We believe that our existing stable base of core deposits, federal funds purchased lines of credit with correspondent banks, and borrowings from the FHLB will enable us to successfully meet our long-term liquidity needs. However, as short-term liquidity needs arise, we have the ability to sell a portion of our investment securities portfolio to meet those needs.
Total shareholders' equity was $65.7 million at December 31, 2013 and $64.1 million at December 31, 2012. The $1.5 million increase during 2013 is primarily related to net income of $5.1 million for 2013, offset partially by the $1.0 million repurchase of 1,000 shares of our Series T Preferred stock and $2.5 million decline in accumulated other comprehensive income.
The following table shows the return on average assets (net income divided by average total assets), return on average equity (net income divided by average equity), and equity to assets ratio (average equity divided by average total assets) for the three years ended December 31, 2013. Since our inception, we have not paid cash dividends.
December 31, (dollars in thousands) 2013 2012 2011 Return on average assets 0.61% 0.50% 0.28% Return on average equity 7.88% 6.03% 3.40% Return on average common equity 8.81% 5.79% 2.10% Average equity to average assets ratio 7.74% 8.30% 8.12% Common equity to assets ratio 5.65% 5.99% 5.98% Under the capital adequacy guidelines, regulatory capital is classified into two tiers. These guidelines require an institution to maintain a certain level of Tier 1 and Tier 2 capital to risk-weighted assets. Tier 1 capital consists of common shareholders' equity, excluding the unrealized gain or loss on securities available for sale, minus certain intangible assets. In determining the amount of risk-weighted assets, all assets, including certain off-balance sheet assets, are multiplied by a risk-weight factor of 0% to 100% based on the risks believed to be inherent in the type of asset. Tier 2 capital consists of Tier 1 capital plus the general reserve for loan losses, subject to certain limitations. We are also required to maintain capital at a minimum level based on total average assets, which is known as the Tier 1 leverage ratio.
At both the holding company and Bank level, we are subject to various regulatory capital requirements administered by the federal banking agencies. To be considered "well-capitalized," we must maintain total risk-based capital of at least 10%, Tier 1 capital of at least 6%, and a leverage ratio of at least 5%.
To be considered "adequately capitalized" under these capital guidelines, we must maintain a minimum total risk-based capital of 8%, with at least 4% being Tier 1 capital. In addition, we must maintain a minimum Tier 1 leverage ratio of at least 4%. As of December 31, 2013, our capital ratios exceed these ratios and we remain "well capitalized." In July 2013, the FDIC approval of a final rule to implement the Basel III regulatory capital reforms among other changes required by the Dodd-Frank Act.
The framework requires banking organizations to hold more and higher quality capital, which acts as a financial cushion to absorb losses, taking into account the impact of risk. The approved 52 -------------------------------------------------------------------------------- rule includes a new minimum ratio of common equity Tier 1 capital to risk-weighted assets of 4.5% as well as a common equity Tier 1 capital conservation buffer of 2.5% of risk-weighted assets. The rule also raises the minimum ratio of Tier 1 capital to risk-weighted assets from 4% to 6% and includes a minimum leverage ratio of 4% for all banking institutions. For the largest, most internationally active banking organizations, the rule includes a new minimum supplementary leverage ratio that takes into account off-balance sheet exposures. In terms of quality of capital, the final rule emphasizes common equity Tier 1 capital and implements strict eligibility criteria for regulatory capital instruments. It also changes the methodology for calculating risk-weighted assets to enhance risk sensitivity. The changes begin to take effect for the Bank in January 2015. The ultimate impact of the new capital standards on the Company and the Bank is currently being reviewed.
The following table summarizes the capital amounts and ratios of the Bank and the regulatory minimum requirements. See Note 21 to the Consolidated Financial Statements for ratios of the Holding Company.
To be well capitalized For capital under prompt adequacy corrective purposes action provisions Actual minimum minimum (dollars in thousands) Amount Ratio Amount Ratio Amount Ratio As of December 31, 2013 Total Capital (to risk $88,674 12.2% $58,381 8.0% $72,976 10.0% weighted assets) Tier 1 Capital (to risk 79,538 10.9% 29,191 4.0% 43,786 6.0% weighted assets) Tier 1 Capital (to average 79,538 9.1% 34,989 4.0% 43,737 5.0% assets) As of December 31, 2012 Total Capital (to risk $83,763 13.0% $51,498 8.0% $64,372 10.0% weighted assets) Tier 1 Capital (to risk 75,704 11.8% 25,749 4.0% 38,623 6.0% weighted assets) Tier 1 Capital (to average 75,704 9.6% 31,492 4.0% 39,366 5.0% assets) As of December 31, 2011 Total Capital (to risk $80,885 13.1% $49,397 8.0% $61,746 10.0% weighted assets) Tier 1 Capital (to risk 73,152 11.9% 24,698 4.0% 37,047 6.0% weighted assets) Tier 1 Capital (to average 73,152 9.5% 30,920 4.0% 38,651 5.0% assets) The ability of the Company to pay cash dividends is dependent upon receiving cash in the form of dividends from the Bank. The dividends that may be paid by the Bank to the Company are subject to legal limitations and regulatory capital requirements. Further, the Company cannot pay cash dividends on its common stock during any calendar quarter unless full dividends on the Series T preferred stock for the dividend period ending during the calendar quarter have been declared and the Company has not failed to pay a dividend in the full amount of the Series T preferred stock with respect to the period in which such dividend payment in respect of its common stock would occur.
Effect of Inflation and Changing Prices The effect of relative purchasing power over time due to inflation has not been taken into account in our consolidated financial statements. Rather, our financial statements have been prepared on an historical cost basis in accordance with generally accepted accounting principles.
Unlike most industrial companies, our assets and liabilities are primarily monetary in nature. Therefore, the effect of changes in interest rates will have a more significant impact on our performance than will the effect of changing prices and inflation in general. In addition, interest rates may generally increase as the rate of inflation increases, although not necessarily in the same magnitude. As discussed previously, we seek to manage the relationships between interest sensitive assets and liabilities in order to protect against wide rate fluctuations, including those resulting from inflation.
Off-Balance Sheet Risk Commitments to extend credit are agreements to lend to a client as long as the client has not violated any material condition established in the contract.
Commitments generally have fixed expiration dates or other termination clauses and may require the payment of a fee. At December 31, 2013, unfunded commitments to extend credit were approximately $138.7 million, of which $32.6 million is at fixed rates and $106.1 million is at variable rates. At December 31, 2012, unfunded commitments to extend credit were $115.6 million, of which approximately $22.1 million 53 -------------------------------------------------------------------------------- was at fixed rates and $93.5 million was at variable rates. A significant portion of the unfunded commitments related to consumer equity lines of credit.
Based on historical experience, we anticipate that a significant portion of these lines of credit will not be funded. We evaluate each client's credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by us upon extension of credit, is based on our credit evaluation of the borrower. The type of collateral varies but may include accounts receivable, inventory, property, plant and equipment, and commercial and residential real estate.
At December 31, 2013 and 2012, there was a $3.0 million and $2.3 million commitment under letters of credit, respectively. The credit risk and collateral involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to clients. Since most of the letters of credit are expected to expire without being drawn upon, they do not necessarily represent future cash requirements.
A portion of our business is to originate mortgage loans that will be sold in the secondary market to investors. Loan types that we originate include conventional loans, jumbo loans and other governmental agency loan products. We adhere to the legal lending limits and guidelines as set forth by the various governmental agencies and investors to whom we sell loans. Under a "best efforts" selling procedure, we make our best effort to process, fund, and deliver the loan to a particular investor. If the loan fails to fund, there is no immediate cost to us, as the market risk has been transferred to the investor. In the event of a customer loan default, we may be required to reimburse the investor.
Except as disclosed in this document, we are not involved in off-balance sheet contractual relationships, unconsolidated related entities that have off-balance sheet arrangements or transactions that could result in liquidity needs or other commitments that significantly impact earnings.
Market Risk and Interest Rate Sensitivity Market risk is the risk of loss from adverse changes in market prices and rates, which principally arises from interest rate risk inherent in our lending, investing, deposit gathering, and borrowing activities. Other types of market risks, such as foreign currency exchange rate risk and commodity price risk, do not generally arise in the normal course of our business.
We actively monitor and manage our interest rate risk exposure in order to control the mix and maturities of our assets and liabilities utilizing a process we call asset/liability management. The essential purposes of asset/liability management are to ensure adequate liquidity and to maintain an appropriate balance between interest sensitive assets and liabilities in order to minimize potentially adverse impacts on earnings from changes in market interest rates.
Our asset/liability management committee ("ALCO") monitors and considers methods of managing exposure to interest rate risk. We have both an internal ALCO consisting of senior management that meets at various times during each month and a board ALCO that meets monthly. The ALCOs are responsible for maintaining the level of interest rate sensitivity of our interest sensitive assets and liabilities within board-approved limits.
As of December 31, 2013, the following table summarizes the forecasted impact on net interest income using a base case scenario given upward and downward movements in interest rates of 100, 200, and 300 basis points based on forecasted assumptions of prepayment speeds, nominal interest rates and loan and deposit repricing rates. Estimates are based on current economic conditions, historical interest rate cycles and other factors deemed to be relevant.
However, underlying assumptions may be impacted in future periods which were not known to management at the time of the issuance of the Consolidated Financial Statements. Therefore, management's assumptions may or may not prove valid. No assurance can be given that changing economic conditions and other relevant factors impacting our net interest income will not cause actual occurrences to differ from underlying assumptions. In addition, this analysis does not consider any strategic changes to our balance sheet which management may consider as a result of changes in market conditions.
Change in net interest Interest rate scenario income from base Up 300 basis points 9.96% Up 200 basis points 5.93% Up 100 basis points 2.64% Base - Down 100 basis points (4.25)% Down 200 basis points (8.22)% Down 300 basis points (10.36)% 54 --------------------------------------------------------------------------------Contractual Obligations We utilize a variety of short-term and long-term borrowings to supplement our supply of lendable funds, to assist in meeting deposit withdrawal requirements, and to fund growth of interest-earning assets in excess of traditional deposit growth. Certificates of deposit, structured repurchase agreements, FHLB advances, and junior subordinate debentures serve as our primary sources of such funds.
Obligations under noncancelable operating lease agreements are payable over several years with the longest obligation expiring in 2025. We do not feel that any existing noncancelable operating lease agreements are likely to materially impact the Company's financial condition or results of operations in an adverse way. Contractual obligations relative to these agreements are noted in the table below. Option periods that we have not yet exercised are not included in this analysis as they do not represent contractual obligations until exercised.
The following table provides payments due by period for obligations under long-term borrowings and operating lease obligations as of December 31, 2013. In addition, the Company has a contract with a construction company for $1.3 million to construct a new office building in Mt. Pleasant, South Carolina.
December 31, 2013 Payments Due by Period Over One Over Two Over Three After Within to Two to Three to Five Five (dollars in thousands) One Year Years Years Years Years Total Certificates of deposit $165,405 68,309 18,808 13,925 95 266,542 FHLB advances and other 8,900 - 44,500 45,700 25,000 124,100 borrowings Junior subordinated - - - - 13,403 13,403 debentures Operating lease 776 795 794 269 1,129 3,763 obligations Total $175,081 69,104 64,102 59,894 39,627 407,808 Accounting, Reporting, and Regulatory Matters The following is a summary of recent authoritative pronouncements that could impact the accounting, reporting, and/or disclosure of financial information by the Company.
The Balance Sheet topic of the Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") was amended in December 2011 for companies with financial instruments and derivative instruments that offset or are subject to a master netting agreement. The amendments require disclosure of both gross information and net information about instruments and transactions eligible for offset or subject to an agreement similar to a master netting agreement. The amendments were effective for reporting periods beginning on or after January 1, 2013 and required retrospective presentation for all comparative periods presented. Additionally, in January 2013 the FASB clarified that the amendments apply only to derivatives, repurchase agreements and reverse purchase agreements, and securities borrowing and securities lending transactions that are either offset in accordance with specific criteria contained in U.S. GAAP or subject to a master netting arrangement or similar agreement. These amendments did not have a material effect on the Company's financial statements.
The Comprehensive Income topic of the ASC was amended in June 2011. The amendment eliminated the option to present other comprehensive income as a part of the statement of changes in stockholders' equity and required consecutive presentation of the statement of net income and other comprehensive income. The amendments were applicable to the Company January 1, 2012 and have been applied retrospectively. In December 2011, the topic was further amended to defer the effective date of presenting reclassification adjustments from other comprehensive income to net income on the face of the financial statements while the FASB redeliberated the presentation requirements for the reclassification adjustments. In February 2013, the FASB further amended the Comprehensive Income topic clarifying the conclusions from such redeliberations. Specifically, the amendments do not change the current requirements for reporting net income or other comprehensive income in financial statements. However, the amendments do require an entity to provide information about the amounts reclassified out of accumulated other comprehensive income by component. In addition, in certain circumstances an entity is required to present, either on the face of the statement where net income is presented or in the notes, significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income. The amendments were effective for the Company on a prospective basis for reporting periods beginning after December 15, 2012. These amendments did not have a material effect on the Company's financial statements.
55 -------------------------------------------------------------------------------- In April 2013, the FASB issued guidance addressing application of the liquidation basis of accounting. The guidance is intended to clarify when an entity should apply the liquidation basis of accounting. In addition, the guidance provides principles for the recognition and measurement of assets and liabilities and requirements for financial statements prepared using the liquidation basis of accounting. The amendments will be effective for entities that determine liquidation is imminent during annual reporting periods beginning after December 15, 2013, and interim reporting periods therein and those requirements should be applied prospectively from the day that liquidation becomes imminent. Early adoption is permitted. The Company does not expect these amendments to have any effect on its financial statements.
In December 2013, the FASB amended the Master Glossary of the FASB Codification to define "Public Business Entity" to minimize the inconsistency and complexity of having multiple definitions of, or a diversity in practice as to what constitutes, a nonpublic entity and public entity within U.S. GAAP. The amendment does not affect existing requirements, however will be used by the FASB, the Private Company Council ("PCC"), and the Emerging Issues Task Force ("EITF") in specifying the scope of future financial accounting and reporting guidance. The Company does not expect this amendment to have any effect on its financial statements.
Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected to have a significant impact on the Company's financial position, results of operations and cash flows.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk See Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Market Risk and Interest Rate Sensitivity and - Liquidity and Capital Resources.
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