Item 1.
Business
Forward Looking
Statements.
The Private Securities Litigation Reform Act of 1995 states that disclosure of forward looking information is desirable
for investors and encourages such disclosure by providing a safe harbor for forward looking statements by corporate management.
This Annual Report on Form 10-K contains forward looking statements that involve risk and uncertainty. The words “anticipates”,
“believes”, “can”, “continue”, “could”, “estimates”, “expects”,
“intends”, “seeks”, “may”, “might”, “plans”, “projects”,
“should”, “would”, “targets”, “will”, and the negative thereof and similar words
and expressions are intended to identify forward looking statements. In order to comply with the terms of the safe harbor, the
Company notes that a variety of risks and uncertainties could cause its actual results and experience to differ materially from
the anticipated results or other expectations expressed in the Company's forward looking statements. There are risks and uncertainties
that may affect the operations, performance, development, growth projections and results of the Company's business. They include,
but are not limited to, economic growth, interest rate movements, timely development of technology enhancements for products, services
and operating systems, the impact of competitive products, services and pricing, customer requirements, regulatory changes and
similar matters. Readers of this report are cautioned not to place undue reliance on forward looking statements that are subject
to influence by these risk factors and unanticipated events, as actual results may differ materially from management's expectations.
General
First South Bancorp, Inc.
First South
Bancorp, Inc. (the “Company”) is a Virginia corporation that serves as the holding company for First South Bank (the
“Bank”), a North Carolina chartered commercial bank. The Company’s principal business is overseeing the business
of the Bank and operating through the Bank a commercial banking business. The Bank has one significant operating segment, the providing
of general commercial banking services to its markets located in the state of North Carolina. The Company’s common stock
is traded on the NASDAQ Global Select Market under the symbol “FSBK”.
First South Bank.
The Bank is a North
Carolina chartered commercial bank headquartered in Washington, North Carolina. The Bank received Federal Deposit Insurance Corporation
(“FDIC”) insurance of its deposits in 1959. The Bank’s principal business consists of attracting deposits from
the general public and investing these funds in commercial real estate loans, commercial and industrial business loans, consumer
loans and loans secured by first and second mortgages on owner-occupied, single-family residences in the Bank’s market area.
The Bank’s income consists of interest
and fees earned on loans and investments, loan servicing and other fees, gains on the sale of loans and investments, and service
charges and fees collected on deposit accounts. The Bank’s expenses consist of interest expense on deposits and borrowings
and noninterest expense such as compensation and employee benefits, occupancy expenses, FDIC insurance, and other miscellaneous
expenses. Funds for these activities are provided by deposits, borrowings, repayments of outstanding loans and investments and
other operating revenues.
Market Area.
The Bank makes loans and
obtains deposits throughout eastern and central North Carolina, where the Bank’s offices are located. As of December 31,
2015, management believes that a majority of all deposits and loans come from its primary market area. The economy of the Bank’s
primary market area is diversified, with employment distributed among manufacturing, agriculture and non-manufacturing activities.
There are a significant number of major employers, colleges and universities, hospitals and military bases located throughout the
Bank’s primary market area.
The average unemployment rate in the nineteen
county market area served by the Bank was 6.6% at December 31, 2015, compared to 5.6% for the State of North Carolina, 5.2% for
the Federal Reserve Fifth District and a 5.0% National average at the same date.
Critical
Accounting Policies.
The Bank has identified the policies below as critical to its business operations and the understanding
of its results of operations. The impact and any associated risks related to these policies on the Bank’s business operations
is discussed throughout
Notes to Consolidated Financial Statements and
Management’s
Discussion and Analysis of Financial Condition and Results of Operations
in this Annual Report on Form 10-K,
where such policies affect reported and expected financial results.
Use of Estimates.
The preparation of
financial statements in conformity with accounting principles generally accepted in the United States of America requires management
to make estimates and assumptions. Estimates affect the reported amounts of assets and liabilities and disclosure of contingent
assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting
period. Actual results could differ from those estimates.
Loan Impairment and Allowance for Credit
Losses.
A loan or lease is considered impaired, based on current information and events, if it is probable that the Bank will
be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan or
lease agreement. All collateral-dependent loans are measured for impairment based on the fair value of the collateral, while uncollateralized
loans and other loans determined not to be collateral dependent are measured for impairment based on the present value of expected
future cash flows discounted at the historical effective interest rate. The Bank uses several factors in determining if a loan
or lease is impaired. The Bank’s internal asset classification procedures include a thorough review of significant loans,
leases and lending relationships and include the accumulation of related data. This data includes loan and lease payment status,
borrowers’ financial data and borrowers’ operating factors such as cash flows, operating income or loss, etc.
The allowance for credit losses is increased
by charges to income and decreased by charge-offs (net of recoveries). Management’s periodic evaluation of the adequacy
of the allowance for credit losses is based on the Bank’s past loan and lease loss experience, known and inherent risks
in loans and leases held for investment and in unfunded loan commitments, adverse situations that may affect the borrowers’
ability to repay, the estimated value of any underlying collateral, certain qualitative factors and current economic conditions.
While management believes that it has established the allowance for credit losses in accordance with accounting principles generally
accepted in the United States of America and has taken into account the views of its regulators and the current economic environment,
there can be no assurance in the future that regulators or risks in loans and leases held for investment and in unfunded loan
commitments will not require adjustments to the allowance for credit losses.
Income Taxes.
Deferred tax asset
and liability balances are determined by application of temporary differences of the tax rate expected to be in effect when taxes
will become payable or receivable. Temporary differences are differences between the tax basis of assets and liabilities and their
reported amounts in the financial statements that will result in taxable or deductible amounts in future years. The effect on deferred
taxes of a change in tax rates is recognized in income in the period that includes the enactment date.
Off-Balance
Sheet Risk.
The Bank is a party to financial instruments with off-balance sheet risk in the normal course of business
to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial
instruments include commitments to extend credit and involve, to varying degrees, elements of credit and interest rate risk in
excess of the amount recognized in the balance sheet.
The Bank’s exposure to credit loss in the event of nonperformance
by the other party to the financial instrument for commitments to extend credit is represented by the contractual amount of those
instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance
sheet instruments. See
Unfunded Commitments Composition
below for additional information.
Lending Activities.
General.
The Bank’s loan portfolio consists of loans held for sale as well as loans and leases held for investment. Gross loans held
for sale totaled $3.9 million at December 31, 2015, or 0.4% of total assets. Loans and leases held for investment, net of fees
and associated allowance for loan and lease losses, totaled $599.1 million at December 31, 2015, or 63.3% of total assets. The
Bank’s policy is to concentrate its lending activities within its market area.
Loans Held
for Sale
. The Bank originates single family residential first mortgage loans. A certain portion of these originations are classified
as loans held for sale. Pursuant to Accounting Standards Codification (“ASC”) 825,
Financial Instruments
, the
Bank marked these mortgage loans to market
at December 31, 2015. The Bank had $3.9 million of mortgage loans held for sale
at December 31, 2015. See Notes 1 and 3 of Notes to Consolidated Financial Statements for additional information
.
Loans and Leases Held for Investment.
The Bank originates a significant amount of loans and leases (“loans”) held for investment. At December 31, 2015, commercial
real estate, construction, and lot/land loans amounted to $410.0 million, or 67.5% of gross loans held for investment. The Bank
strives to originate commercial and industrial business loans and consumer loans. At December 31, 2015, commercial and industrial
business loans totaled $45.5 million, or 7.5% of gross loans held for investment. Consumer loans, including real estate, construction,
lots and raw land, and home equity lines of credit, totaled $62.9 million, or 10.3% of gross loans held for investment. At December
31, 2015, $72.3 million, or 11.9% of gross loans held for investment, consisted of single-family, residential mortgage loans. At
December 31, 2015, the Bank had $17.2 million of lease receivables, or 2.8% of gross loans held for investment. The Bank relies
on ASC 310,
Receivables
, for general guidance regarding accounting disclosures for loans receivable.
Portfolio Composition of Loans Held for
Investment.
The following table contains a summary of the composition of loans held for investment by classification of loan
category, at December 31, 2015 and 2014, respectively. At December 31, 2015, the Bank had no concentrations of loans exceeding
10% of gross loans, other than as disclosed below.
|
|
At December 31,
|
|
|
|
2015
|
|
|
2014
|
|
|
2013
|
|
|
2012
|
|
|
2011
|
|
Loans Held for Investment
|
|
Amount
|
|
|
% of
Gross
Loans
|
|
|
Amount
|
|
|
% of
Gross
Loans
|
|
|
Amount
|
|
|
% of
Gross
Loans
|
|
|
Amount
|
|
|
% of
Gross
Loans
|
|
|
Amount
|
|
|
% of
Gross
Loans
|
|
|
|
(Dollars in thousands)
|
|
Mortgage Loans:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Residential real
estate
|
|
$
|
68,229
|
|
|
|
11.2
|
%
|
|
$
|
64,647
|
|
|
|
13.4
|
%
|
|
$
|
67,426
|
|
|
|
14.9
|
%
|
|
$
|
72,505
|
|
|
|
16.4
|
%
|
|
$
|
58,499
|
|
|
|
10.9
|
%
|
Residential construction
|
|
|
3,934
|
|
|
|
0.6
|
|
|
|
1,382
|
|
|
|
0.3
|
|
|
|
1,201
|
|
|
|
0.3
|
|
|
|
2,834
|
|
|
|
0.6
|
|
|
|
2,483
|
|
|
|
0.5
|
|
Residential
lots and raw land
|
|
|
157
|
|
|
|
0.1
|
|
|
|
828
|
|
|
|
0.2
|
|
|
|
904
|
|
|
|
0.2
|
|
|
|
885
|
|
|
|
0.2
|
|
|
|
822
|
|
|
|
0.2
|
|
Total mortgage loans
|
|
|
72,320
|
|
|
|
11.9
|
|
|
|
66,857
|
|
|
|
13.9
|
|
|
|
69,531
|
|
|
|
15.4
|
|
|
|
76,224
|
|
|
|
17.2
|
|
|
|
61,804
|
|
|
|
11.6
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Commercial
loans and leases:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Commercial real estate
|
|
|
338,714
|
|
|
|
55.7
|
|
|
|
255,800
|
|
|
|
53.2
|
|
|
|
227,280
|
|
|
|
50.3
|
|
|
|
216,618
|
|
|
|
48.9
|
|
|
|
273,703
|
|
|
|
51.2
|
|
Commercial construction
|
|
|
42,987
|
|
|
|
7.1
|
|
|
|
27,646
|
|
|
|
5.7
|
|
|
|
24,597
|
|
|
|
5.4
|
|
|
|
20,495
|
|
|
|
4.6
|
|
|
|
25,441
|
|
|
|
4.8
|
|
Commercial
lots and raw land
|
|
|
28,271
|
|
|
|
4.7
|
|
|
|
27,502
|
|
|
|
5.7
|
|
|
|
27,681
|
|
|
|
6.1
|
|
|
|
34,785
|
|
|
|
7.9
|
|
|
|
72,385
|
|
|
|
13.5
|
|
Commercial
and industrial
|
|
|
45,481
|
|
|
|
7.5
|
|
|
|
28,379
|
|
|
|
5.9
|
|
|
|
26,108
|
|
|
|
5.8
|
|
|
|
20,768
|
|
|
|
4.7
|
|
|
|
17,683
|
|
|
|
3.3
|
|
Lease receivables
|
|
|
17,235
|
|
|
|
2.8
|
|
|
|
12,392
|
|
|
|
2.6
|
|
|
|
8,179
|
|
|
|
1.8
|
|
|
|
5,712
|
|
|
|
1.3
|
|
|
|
7,578
|
|
|
|
1.4
|
|
Total
commercial loans and leases
|
|
|
472,688
|
|
|
|
77.8
|
|
|
|
351,719
|
|
|
|
73.1
|
|
|
|
313,845
|
|
|
|
69.4
|
|
|
|
298,378
|
|
|
|
67.4
|
|
|
|
396,790
|
|
|
|
74.2
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Consumer loans:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Consumer real estate
|
|
|
17,239
|
|
|
|
2.8
|
|
|
|
18,863
|
|
|
|
3.9
|
|
|
|
21,221
|
|
|
|
4.7
|
|
|
|
19,350
|
|
|
|
4.4
|
|
|
|
19,366
|
|
|
|
3.6
|
|
Consumer construction
|
|
|
196
|
|
|
|
0.1
|
|
|
|
1,412
|
|
|
|
0.3
|
|
|
|
1,549
|
|
|
|
0.3
|
|
|
|
681
|
|
|
|
0.1
|
|
|
|
746
|
|
|
|
0.1
|
|
Consumer
lots and raw land
|
|
|
9,643
|
|
|
|
1.6
|
|
|
|
10,430
|
|
|
|
2.2
|
|
|
|
14,726
|
|
|
|
3.3
|
|
|
|
17,249
|
|
|
|
3.9
|
|
|
|
20,934
|
|
|
|
3.9
|
|
Home equity lines of credit
|
|
|
29,709
|
|
|
|
4.8
|
|
|
|
28,059
|
|
|
|
5.8
|
|
|
|
27,546
|
|
|
|
6.1
|
|
|
|
26,654
|
|
|
|
6.0
|
|
|
|
30,479
|
|
|
|
5.7
|
|
Consumer
other
|
|
|
6,070
|
|
|
|
1.0
|
|
|
|
3,932
|
|
|
|
0.8
|
|
|
|
3,547
|
|
|
|
0.8
|
|
|
|
4,347
|
|
|
|
1.0
|
|
|
|
4,903
|
|
|
|
0.9
|
|
Total consumer loans
|
|
|
62,857
|
|
|
|
10.3
|
|
|
|
62,696
|
|
|
|
13.0
|
|
|
|
68,589
|
|
|
|
15.2
|
|
|
|
68,281
|
|
|
|
15.4
|
|
|
|
76,428
|
|
|
|
14.2
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Gross
loans held for investment
|
|
|
607,865
|
|
|
|
100.0
|
%
|
|
|
481,272
|
|
|
|
100.0
|
%
|
|
|
451,965
|
|
|
|
100.0
|
%
|
|
|
442,883
|
|
|
|
100.0
|
%
|
|
|
535,022
|
|
|
|
100.0
|
%
|
Less
deferred loan origination fees, net
|
|
|
850
|
|
|
|
|
|
|
|
836
|
|
|
|
|
|
|
|
1,005
|
|
|
|
|
|
|
|
1,036
|
|
|
|
|
|
|
|
1,062
|
|
|
|
|
|
Less
allowance for loan and lease losses
|
|
|
7,867
|
|
|
|
|
|
|
|
7,520
|
|
|
|
|
|
|
|
7,609
|
|
|
|
|
|
|
|
7,860
|
|
|
|
|
|
|
|
15,194
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
loans held for investment, net
|
|
$
|
599,148
|
|
|
|
|
|
|
$
|
472,916
|
|
|
|
|
|
|
$
|
443,351
|
|
|
|
|
|
|
$
|
433,987
|
|
|
|
|
|
|
$
|
518,766
|
|
|
|
|
|
Unfunded Commitments Composition.
The
Bank is a party to financial instruments with off-balance-sheet risk in the normal course of business, primarily to meet the financing
needs of its customers. These financial instruments include commitments to extend credit, as listed in the table below. Those instruments
involve varying degrees and elements of credit and interest rate risk in excess of the amount recognized in the balance sheet.
The Bank’s exposure to credit risk in the event of nonperformance by the other party to the commitments to extend credit
and standby letters of credit is represented by the contractual amount of those instruments. The Bank uses the same credit underwriting
policies and procedures in making commitments and conditional obligations as it does for on-balance-sheet instruments.
The Bank estimates probable
losses related to unfunded lending commitments and records a reserve for unfunded commitments in other liabilities on the consolidated
balance sheet. At December 31, 2015 and 2014, the balance of the reserve for unfunded commitments was $336,000 and $290,000, respectively.
See
Historical Loss and Qualitative Analysis
below for additional information regarding the reserve for unfunded commitments. In developing this analysis, the Bank relies on
actual historical loss experience for the most recent twelve quarters and exercises management’s best judgment in assessing
qualitative risk. There were no changes in the Bank’s accounting policy and methodology used to estimate the reserve for
unfunded commitments at December 31, 2015. See Note 18 of the Notes to Consolidated Financial Statements for additional information
regarding unfunded commitments and off-balance sheet risk.
The following table sets forth selected data
relating to the composition of the Bank’s unfunded commitments by type of loan at the dates indicated.
|
|
At December 31,
|
|
|
|
2015
|
|
|
2014
|
|
Unfunded Commitments
|
|
Amount
|
|
|
%
|
|
|
Amount
|
|
|
%
|
|
|
|
(Dollars in thousands)
|
|
Residential mortgage loans
|
|
|
|
|
|
|
|
|
|
Construction
|
|
$
|
4,831
|
|
|
|
4.0
|
%
|
|
$
|
2,588
|
|
|
|
3.0
|
%
|
Total residential mortgage loans
|
|
|
4,831
|
|
|
|
4.0
|
|
|
|
2,588
|
|
|
|
3.0
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Commercial loans and leases:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Real estate secured
|
|
|
22,113
|
|
|
|
18.3
|
|
|
|
13,937
|
|
|
|
15.9
|
|
Non-Real Estate
|
|
|
18,620
|
|
|
|
15.4
|
|
|
|
13,185
|
|
|
|
15.0
|
|
Construction
|
|
|
23,772
|
|
|
|
19.7
|
|
|
|
11,070
|
|
|
|
12.6
|
|
Total commercial loans and leases
|
|
|
64,505
|
|
|
|
53.4
|
|
|
|
38,192
|
|
|
|
43.5
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Consumer loans:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Home equity loans
|
|
|
45,886
|
|
|
|
38.0
|
|
|
|
41,215
|
|
|
|
47.0
|
|
Real Estate Secured
|
|
|
224
|
|
|
|
0.2
|
|
|
|
291
|
|
|
|
0.3
|
|
Non-Real Estate
|
|
|
4,911
|
|
|
|
4.1
|
|
|
|
5,143
|
|
|
|
5.9
|
|
Construction
|
|
|
406
|
|
|
|
0.3
|
|
|
|
263
|
|
|
|
0.3
|
|
Total consumer loans
|
|
|
51,427
|
|
|
|
42.6
|
|
|
|
46,912
|
|
|
|
53.5
|
|
Total Unfunded Commitments
|
|
$
|
120,763
|
|
|
|
100.0
|
%
|
|
$
|
87,692
|
|
|
|
100.0
|
%
|
Maturities of Loans Held for Investment.
The following table sets forth certain information at December 31, 2015, regarding the dollar amount of maturing loans held for
investment, based on their scheduled maturities. Demand loans, loans having no stated maturity, and overdrafts are reported as
due in one year or less.
The table does not include any estimate of
prepayments which significantly shortens the average life of mortgage loans and may cause the Bank’s repayment experience
to differ from that shown below. Loan balances are net of undisbursed construction loans-in-process. Lease receivable balances
are included in other loans.
Gross Loans Held for Investment
|
|
Due in One
Year or Less
|
|
|
Due After 1
Through 5 Years
|
|
|
Due After 5 or
More Years
|
|
|
Total
|
|
|
|
(In thousands)
|
|
|
|
|
Residential real estate loans
|
|
$
|
2,914
|
|
|
$
|
2,278
|
|
|
$
|
67,128
|
|
|
$
|
72,320
|
|
Commercial real estate, business and other loans
|
|
|
62,666
|
|
|
|
291,768
|
|
|
|
181,111
|
|
|
|
535,545
|
|
Total
|
|
$
|
65,580
|
|
|
$
|
294,046
|
|
|
$
|
248,239
|
|
|
$
|
607,865
|
|
The following table sets forth the dollar amount
of loans held for investment due one year or more after December 31, 2015, with fixed interest rates and with floating or adjustable
interest rates.
Gross Loans Held for Investment
|
|
Fixed Rates
|
|
|
Floating or
Adjustable Rates
|
|
|
|
(In thousands)
|
|
Residential real estate loans
|
|
$
|
40,231
|
|
|
$
|
29,175
|
|
Commercial real estate, business and other loans
|
|
|
374,443
|
|
|
|
98,436
|
|
Total
|
|
$
|
414,674
|
|
|
$
|
127,611
|
|
Scheduled contractual principal repayments
of loans do not reflect their actual life. The average life of loans can be substantially less than their contractual terms because
of prepayments. In addition, due-on-sale clauses on loans generally give the Bank the right to declare a loan immediately due and
payable in the event, among other things, that the borrower sells the real property subject to the mortgage and the loan is not
repaid. The average life of mortgage loans tends to increase when current mortgage loan market rates are substantially higher than
rates on existing mortgage loans and, conversely, decrease when current mortgage loan market rates are substantially lower than
rates on existing mortgage loans.
Originations, Purchases and Sales of Loans
.
The Bank has authority to originate and purchase loans secured by real estate located throughout the state of North Carolina and
the United States. Consistent with its emphasis on being a community-oriented financial institution, the Bank concentrates its
lending activities in its primary market area.
The Bank’s loan originations
are derived from a number of sources, including calling officers, referrals from depositors and borrowers, repeat customers, advertising,
as well as walk-in customers. The Bank’s solicitation programs consist of advertisements in local media, in addition to participation
in various community organizations and events. Real estate loans are originated by the Bank’s loan personnel. The Bank’s
loan personnel consists of both salaried employees with an annual incentive and commission paid mortgage loan officers. Loan applications
are accepted at the Bank’s offices, by mail, through the Bank’s website, by phone and loan officers originating loans
at off-site locations, such as a realtor office. The Bank did not purchase any loans for the year ended December 31, 2015, compared
to $3.9 million for the year ended December 31, 2014. During the years ended 2015 and 2014, the Bank purchased participations in
loans totaling $4.9 million and $10.2 million, respectively, from other financial institutions. During 2015, the Bank sold $3.3
million of participations in loans to other financial institutions, compared to none during 2014.
The Bank sells single-family mortgage loans
that it originates to the Federal Home Loan Mortgage Corporation (“FHLMC”, also known as “Freddie Mac”).
The Bank also exchanges single-family mortgage loans for mortgage-backed securities with FHLMC. During 2015
,
the Bank sold $34.6 million of loans to FHLMC, compared to $21.3 million of sales executed during 2014. The Bank generally
retains servicing on loans sold to or exchanged with FHLMC. In 2016, the Bank anticipates selling mortgage loans, servicing retained,
to the Federal National Mortgage Association (“FNMA”, also known as “Fannie Mae”).
The Bank also sells single-family mortgage
loans servicing released to the Federal Housing Administration (FHA), the United States Department of Veterans Affairs (VA), the
United States Department of Agriculture (USDA), and NC Housing Finance Agency (NCHFA).
Loan Underwriting Policies
. The Bank’s
lending activities are subject to the Bank’s written, non-discriminatory underwriting standards, its outside investors and
to loan origination procedures prescribed by the Bank’s Board of Directors (the “Board”) and its management.
Detailed loan applications are obtained to determine the borrower’s willingness and ability to repay, and the more significant
items on these applications are verified through the use of credit reports, financial information and confirmations. All mortgage
loans and any single commercial or consumer loan over $3.0 million or any borrower with aggregate credit of greater than $4.0 million
must be approved by the Directors’ Loan Committee. The Directors’ Loan Committee is comprised of three outside directors
who serve on a rotating basis. Such loans are presented weekly by the Management Loan Committee. The President does not serve on
the Directors’ Loan Committee. Individual officers of the Bank have been granted authority by the Board to approve consumer
and commercial loans up to varying specified dollar amounts depending upon the type of loan and the lender’s level of expertise.
In addition, committees of credit administrators and loan officers have loan authorities greater than individual authorities. These
authorities are based on aggregate borrowings of an individual or entity. On a monthly basis, the full Board reviews the actions
taken by the Directors’ Loan Committee.
Generally, after receipt of a loan application
from a prospective borrower, in compliance with federal and state laws and regulations, a credit report and verifications are ordered,
or obtained, to verify specific information relating to the loan applicant’s employment, income and credit standing. If a
proposed loan is to be secured by real estate, an appraisal of the real estate is usually undertaken either by an appraiser approved
by the Bank and licensed by the State of North Carolina or an evaluation by qualified Bank personnel. The type of valuation is
dependent upon factors such as the real estate property type and the amount of the loan request. Applications for single-family
residential mortgage loans are underwritten and closed in accordance with the standards of FHLMC, FNMA, investor guidelines or
the Bank’s internal guidelines. The Bank uses an automated underwriting software program owned by FHLMC named Loan Prospector
on the majority of mortgage loans underwritten for sale to FHLMC. In addition, mortgage loans sold to other investors may be manually
underwritten by the Bank, or through FHLMC’s Loan Prospector, FNMA Desktop Underwriter, or the respective investor, or the
respective investor’s representatives, or through an investor’s automated underwriting system, if applicable. In the
case of single-family residential mortgage loans, except when the Bank becomes aware of a particular risk of environmental contamination,
the Bank generally does not obtain a formal environmental report on the real estate at the time a loan is made. A formal environmental
report may be required in connection with nonresidential real estate loans.
It is the Bank’s policy to record a lien
on the real estate securing a loan and to obtain title insurance which insures that the property is free of prior encumbrances
and other possible title defects. Borrowers must also obtain hazard insurance prior to closing and, when the property is in a flood
plain as designated by the Federal Emergency Management Agency (“FEMA”), obtain flood insurance.
If the amount of a residential mortgage loan
originated or refinanced exceeds 80% of the lesser of the appraised value or contract price, the Bank’s practice generally
is to obtain private mortgage insurance at the borrower’s expense on that portion of the principal amount of the loan that
exceeds 80%. Certain government insured or guaranteed mortgage loans have loan-to-values higher than 95%, which are generally sold
to outside investors, servicing released. The Bank generally makes single-family residential mortgage loans with up to a 95% loan-to-value
ratio if the required private mortgage insurance is obtained. The Bank generally limits the loan-to-value ratio on commercial real
estate mortgage loans to 85%, although the loan-to-value ratio on residential and commercial real estate loans in limited circumstances
has been as high as 100%. The Bank generally limits the loan-to-value ratio on multi-family residential real estate loans to 85%,
although in limited circumstances the loan-to-value ratio has been higher. The Bank is subject to regulations that limit the amount
the Bank can lend to one borrower. See “Depository Institution Regulation — Limits on Loans to One Borrower.”
Under these limits, the Bank’s loans-to-one-borrower were limited to $13.2 million at December 31, 2015. The Bank had no
lending relationships in excess of the loans-to-one-borrower limit at December 31, 2015.
Interest rates
charged by the Bank on loans are affected by inherent risk, competitive factors, the demand for such loans and the supply of funds
available for lending purposes. These factors are, in turn, affected by general economic conditions, monetary policies of the federal
government, including the Federal Reserve Board, legislative tax policies and government budgetary matters
.
Single-Family Residential Real Estate Lending.
The Bank is an originator of single-family, residential real estate loans in its market area. At December 31, 2015, single-family,
residential mortgage loans, excluding home improvement loans, totaled $72.3 million, or 11.9% of gross loans held for investment.
The Bank originates fixed-rate and adjustable-rate mortgage loans at competitive interest rates. At December 31, 2015, $39.2 million,
or 54.2%, of the gross residential mortgage loan portfolio was comprised of fixed-rate residential mortgage loans. Generally, the
Bank retains fixed-rate mortgages with maturities of less than 10 years, while fixed-rate loans with longer maturities may be retained
in the portfolio or sold in the secondary market. The Bank also originates conventional mortgage loans in its market area, which
are underwritten, closed and sold servicing-retained in the secondary market. The Bank also originates government mortgage loans
which are underwritten, closed and sold servicing-released to an outside investor.
The Bank also offers adjustable-rate residential
mortgage loans. The adjustable-rate loans currently offered by the Bank have interest rates which adjust every one, three, five,
seven, or ten years from the closing date of the loan or on an annual basis commencing after an initial fixed-rate period of one,
three, five, seven or ten years in accordance with a designated index plus a stipulated margin. The primary index utilized by the
Bank is the weekly average yield on U.S. Treasury securities adjusted to a constant comparable maturity equal to the loan adjustment
period, as made available by the Federal Reserve Board (the “Treasury Rate”). The Bank offers adjustable-rate loans
that meet FHLMC underwriting standards, as well as loans that do not meet such standards. The Bank’s adjustable-rate single-family
residential real estate loans that do not meet FHLMC standards have a cap of generally 2.0% on any increase in the interest rate
at any adjustment date, and include a cap on the maximum interest rate over the life of the loan, which cap is generally up to
6.0% above the initial rate. The Bank’s adjustable-rate loans provide for a floor on the minimum interest rate over the life
of the loan, most recently the floor is generally the initial loan rate. Further, the Bank generally does not offer “teaser”
rates,
i.e.
, initial rates below the fully indexed rate, on such loans. The adjustable-rate mortgage loans offered by the
Bank that do conform to FHLMC standards have a cap of up to 6.0% above the initial rate over the life of a loan and include a floor.
All of the Bank’s adjustable-rate loans require that any payment adjustment resulting from a change in the interest rate
of an adjustable-rate loan be sufficient to result in full amortization of the loan by the end of the loan term and, thus, do not
permit any of the increased payment to be added to the principal amount of the loan, or so-called negative amortization. At December
31, 2015, $33.1 million, or 45.2% of the gross residential mortgage loans were adjustable-rate loans.
The retention
of adjustable-rate loans in the loan portfolio helps reduce exposure to increases in prevailing market interest rates. However,
there are unquantifiable credit risks resulting from potential increases in costs to borrowers in the event of upward repricing
of adjustable-rate loans. It is possible that during periods of rising interest rates, the risk of default on adjustable-rate loans
may increase due to increases in interest costs to borrowers. Further, although adjustable-rate loans allow the Bank to manage
the sensitivity of its interest-earning assets to changes in interest rates, the extent of this interest sensitivity is limited
by the initial fixed-rate period before the first adjustment and the lifetime interest rate adjustment limitations. Accordingly,
there can be no assurance that yields on the adjustable-rate loans will fully adjust to compensate for increases in the cost of
funds
.
The Bank makes loan commitments on single-family
residential mortgage loans between 15 and 90 days for each loan approved. If the borrower desires a longer commitment, the commitment
may be extended for good cause and upon written approval. Fees between $175 and $1,200 are charged in connection with the issuance
of a commitment letter. The interest rate may be guaranteed for the commitment period.
Construction Lending.
The Bank also
offers residential and commercial construction loans, with a substantial portion of such loans originated to date being for the
construction of single-family dwellings in the Bank’s primary market area. Residential construction loans are offered primarily
to individuals building their primary, investment or secondary residence, as well as to selected local builders to build single-family
dwellings. Generally, loans to owner/occupants for the construction of their own single-family residential properties are originated
in connection with the permanent loan on the property and have a construction term of 6 to 18 months. Such loans are offered on
a fixed-rate or adjustable-rate basis. Generally, interest rates on residential construction loans made to the owner/occupant have
interest rates during the construction period above the rate offered by the Bank on the permanent loan product selected by the
borrower. Upon completion of construction, the permanent loan rate will be set at the rate then offered by the Bank on that permanent
loan product, not to exceed the predetermined permanent rate cap. Interest rates on residential construction loans to builders
are generally set at the prime rate plus a margin of between 0.0% and 2.0% and adjust either monthly or daily. Interest rates on
commercial construction loans are generally based on the prime rate plus a negotiated margin of between 0.0% and 2.0% and adjust
either monthly or daily, with construction terms generally not exceeding 18 months. Advances are made on a percentage of completion
basis. The Bank originates speculative and pre-sold construction loans on 1-to-4 family residential properties in select markets
within its primary market area. At December 31, 2015, our commercial construction portfolio, totaling $43.0 million or 7.1% of
gross loans held for investment, comprised the bulk of our construction lending.
Prior to making a commitment to fund a loan,
the Bank requires an appraisal of the property by appraisers approved by the Board for loans in excess of $250,000. For loans up
to $250,000, and certain qualified owner occupied commercial loans up to $1.0 million, the Bank requires an evaluation of the property
by qualified Bank personnel, or an outside appraisal by an approved appraiser. The Bank also reviews and inspects each project
at the commencement of construction and periodically during the term of the construction loan. The Bank generally charges a 0.25%
to 1.0% construction loan fee for speculative builder loans and for construction loans to owner-occupants. For residential construction
loans, the Bank generally charges an origination fee, construction fee, and/or a commitment fee up to 1.0% of the commitment amount.
Construction financing is generally considered
to involve a higher degree of risk of loss than long-term financing on improved, occupied real estate. Risk of loss on a construction
loan is dependent largely upon the accuracy of the initial estimate of the property’s value at completion of construction
and the estimated cost (including interest) of construction. During the construction phase, a number of factors could result in
delays and cost overruns. If the estimate of construction costs proves to be inaccurate and the borrower is unable to meet the
Bank’s requirements of putting up additional funds to cover extra costs or change orders, then the Bank will demand that
the loan be paid off and, if necessary, institute foreclosure proceedings, or refinance the loan. If the estimate of value proves
to be inaccurate, the Bank may be confronted, at or prior to the maturity of the loan, with collateral having a value which is
insufficient to assure full repayment. The Bank has sought to minimize this risk by limiting construction lending to qualified
borrowers (
i.e.
, borrowers who satisfy all credit requirements and whose loans satisfy all other underwriting standards
which would apply to the Bank’s permanent mortgage loan financing for the subject property). On loans to builders, the Bank
works only with selected builders with whom it has experience and carefully monitors their creditworthiness. Builder relationships
are analyzed and underwritten annually by the Bank’s credit administration department.
Commercial
Real Estate Lending.
The Bank originates commercial real estate loans, generally limiting them to loans secured by properties
in its primary market area and to borrowers with whom it has other loan relationships. The Bank’s commercial real estate
loan portfolio includes loans to finance the acquisition of small office buildings and commercial and industrial buildings with
a preference to owner occupied properties. Such loans generally range in size from $100,000 to $4.5 million. At December 31, 2015,
commercial real estate loans totaled $338.7 million, or 55.7% of gross loans held for investment. This portfolio is comprised of
$50.1 million of 1-4 family commercial real estate loans, as well as $145.4 million and $143.2 million of owner and non-owner occupied
commercial loans, respectively. Commercial real estate loans are originated for three to ten year terms with interest rates that
adjust based on either the prime rate as quoted in
The Wall Street Journal
,
plus a negotiated margin of between 0.0%
and 2.0% for shorter term loans, or on a fixed-rate basis with interest calculated on a 15 to 20 year amortization schedule, generally
with a balloon payment due after three to ten years
.
Commercial real estate (“CRE”)
lending entails additional risks, as compared with single-family residential property lending. CRE loans typically involve larger
loan balances to single borrowers or groups of related borrowers. The payment experience on CRE loans typically is dependent on
the successful operation of the real estate project, retail establishment or business. These risks can be significantly affected
by supply and demand conditions in the market for office, retail and residential space, and, as such, may be subject to a greater
extent to adverse conditions in the economy generally. To minimize these risks, the Bank generally limits itself to its market
area or to borrowers with which it has prior experience or who are otherwise known to the Bank. It has been the Bank’s policy
to obtain annual financial statements of the business of the borrower or the project for which CRE loans are made for loans over
$900,000. In addition, in the case of CRE loans made to a partnership or a corporation, the Bank obtains personal guarantees from
an owner with 20% or more interest in the company and for loans over $900,000 annual financial statements of the principals of
the partnership or corporation.
The Bank has
a policy that it will not extend, directly or indirectly, any additional credit to or for the benefit of any borrower who is obligated
in any manner to the Bank on any extension of credit or portion thereof that has been charged-off or is adversely classified as
doubtful or loss, so long as such credit remains uncollected, without prior approval of a majority of the Board of Directors
.
When appropriate to mitigate risks, the Bank
makes commercial loans guaranteed by the US Small Business Administration (SBA) and the USDA. The Bank maintains a Certified Lender
and Preferred Lender status with the SBA and is eligible to participate in all SBA loan programs available. The Bank may sell the
guaranteed portion of SBA and USDA loans and retain the servicing rights. During 2015, the Bank sold $1.5 million of SBA loans,
compared to none during 2014.
Commercial and Industrial Business Lending.
The Bank originates commercial and industrial business loans to small and medium sized businesses in its market area. The Bank’s
commercial borrowers are generally small businesses engaged in manufacturing, distribution, retailing, service companies, or professionals
in healthcare, engineering, architecture, accounting and law. Commercial and industrial business loans are generally made to finance
the purchase of inventory, new or used equipment or commercial vehicles, to support trading assets and for short-term working capital.
Such loans generally are secured by equipment and inventory, and when appropriate, cross-collateralized by a real estate mortgage,
although commercial and industrial business loans are sometimes granted on an unsecured basis. Such loans generally are made for
terms of five years or less, depending on the purpose of the loan and the collateral, with loans to finance operating expenses
made for one year or less, with interest rates that typically either adjust daily at a rate equal to the prime rate as stated in
The Wall Street Journal
, plus a margin of between 0.0% and 2.5% or at a negotiated fixed rate. Generally, commercial loans
are made in amounts ranging between $5,000 and $4.0 million. At December 31, 2015, commercial and industrial business loans totaled
$45.5 million, or 7.5% of gross loans held for investment.
The Bank underwrites
commercial and industrial business loans on the basis of the borrower’s cash flow and ability to service the debt from earnings
rather than relying solely on the basis of underlying collateral value, and the Bank seeks to structure such loans to have more
than one source of repayment. The borrower is required to provide the Bank with sufficient information to allow the Bank to make
its lending determination. In most instances, this information consists of three years of financial statements, a statement of
projected cash flows, current financial information on any guarantor and any additional information on the collateral. For unsecured
loans over $50,000 with maturities exceeding one year, the Bank requires that borrowers and guarantors provide updated financial
information at least annually throughout the term of the loan
.
The Bank’s commercial and industrial
business loans may be structured as short-term loans, term loans or as lines of credit. Short-term commercial and industrial business
loans are generally for periods of 36 months or less and are generally self-liquidating from asset conversion cycles. Commercial
and industrial business term loans are generally made to finance the purchase of assets and have maturities of seven years or less.
Commercial and industrial business lines of credit are typically made for the purpose of supporting trading assets and providing
working capital. Such loans are usually approved with a term of 12 months and are reviewed annually. The Bank also offers both
secured and unsecured standby letters of credit for its commercial borrowers. The terms of standby letters of credit generally
do not exceed one year, and they are underwritten as stringently as any commercial loan and generally are of a performance nature.
Commercial and industrial business loans may
involve greater risk than other types of lending. Because payments on such loans are often dependent on successful operation of
the business involved, repayment of such loans may be subject to a greater risk to adverse conditions in the economy. The Bank
seeks to minimize these risks through its underwriting guidelines, which requires the loan to be supported by adequate cash flow
of the borrower, profitability of the business, collateral and personal guarantees of the individuals in the business. The Bank
limits this type of lending to its market area and to borrowers who are well known to the Bank, or the Bank is able to adequately
confirm the background and stability of the borrower.
Lease Receivables.
Lease receivables
are originated by the Bank’s wholly-owned subsidiary, First South Leasing, LLC (“FSL”). FSL primarily offers
leases on equipment utilized for business purposes. Lease terms generally range from 12 to 60 months and include options
to purchase the leased equipment at the end of the lease. Most leases provide 100% of the cost of the equipment and are secured
by the leased equipment. FSL requires the leased equipment to be insured and that FSL be listed as a loss payee and named
as an additional insured on the insurance policy. At December 31, 2015, lease receivables totaled $17.2 million, or 2.8% of gross
loans held for investment.
Consumer Lending.
The Bank also originates
consumer loans. The consumer loans originated by the Bank include automobile loans, cash secured loans, home equity loans and other
miscellaneous consumer loans, both secured and unsecured loans. At December 31, 2015, consumer loans totaled $62.9 million, or
10.3% of gross loans held for investment.
At December 31, 2015, home equity line of credit
loans totaled $29.7 million, or 4.9% of gross loans held for investment. Home equity lines of credit have adjustable interest rates
tied to the prime interest rate plus or minus a margin, and require monthly payments based on the outstanding balance. Home equity
lines of credit are generally secured by subordinate liens against residential real property. The Bank requires fire and extended
coverage casualty insurance (and if appropriate, flood insurance) to be maintained in amount sufficient to cover its loan. Home
equity loans are generally limited so that the amount of such loans, along with any senior indebtedness, does not exceed 80% of
the value of the real estate security.
Consumer lending allows the Bank to earn yields
higher than those on single-family residential lending. However, consumer loans have greater risks than residential mortgage loans,
particularly in the case of unsecured loans or loans secured by rapidly depreciable assets such as automobiles. Repossessed collateral
for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the
greater likelihood of damage, loss or depreciation. The remaining deficiency oftentimes does not warrant further collection efforts
against the borrower. In addition, consumer loan collections are dependent on the borrower’s continuing financial stability,
and are more likely to be adversely affected by events such as job loss, divorce, illness or personal bankruptcy. Further, the
application of various state and federal laws, including federal and state bankruptcy and insolvency law, may limit the amount
which may be recovered. In underwriting consumer loans, the Bank considers the borrower’s credit history, an analysis of
their income and ability to repay the loan, and the value of the collateral.
Loan Fees and Servicing
. The Bank receives
fees in connection with late payments and for miscellaneous services related to its loans. The Bank also charges fees in connection
with loan originations. These fees can consist of origination, discount, construction and/or commitment fees, depending on the
type of loan. The Bank services loans sold to FHLMC with servicing retained, generally for an annual servicing fee of 0.25% of
the loan amount.
The Bank has developed a program to originate
residential mortgage loans as an agent for a credit union. The Bank receives a 1.0% origination fee for each loan as well as an
annual 0.375% servicing fee of the loan amount. All of these loans are funded and closed in the name of the credit union.
In addition, the Bank may sell the guaranteed
portion of SBA loans originated and receives an annual servicing fee of 1.0% on the outstanding balance.
Nonperforming
Loans and Other Problem Assets
. It is management’s policy to continually monitor its loan portfolio to anticipate and
address potential and actual delinquencies. When a borrower fails to make a payment on a loan, the Bank takes immediate steps to
have the delinquency cured and the loan restored to current status. Loans which are delinquent more than 15 days incur a late fee
of 4.0% on mortgage and consumer loans and up to 6.0% on commercial loans, of the monthly payment of principal and interest due.
As a matter of policy, the Bank will contact the borrower after the loan has been delinquent 15 days. If payment is not promptly
received, the borrower is contacted again, and efforts are made to formulate an affirmative plan to cure the delinquency. Generally,
after any loan is delinquent 30 days or more, a default letter is sent to the borrower. If the default is not cured after 45 days
from the default letter, formal legal proceedings may commence to collect amounts owed
.
Loans generally are placed on nonaccrual status,
and accrued but unpaid interest is reversed, when, in management’s judgment, it is determined that the collectability of
interest, but not necessarily principal, is doubtful. This occurs when payment is delinquent in excess of 90 days, if not so prior
classified. Consumer loans that have become more than 180 days past due are generally charged off, or a specific allowance may
be provided for any expected loss. All other loans are charged off when management concludes that they are uncollectible. See Notes
1 and 4 of the Notes to Consolidated Financial Statements and Management’s Discussion and Analysis of Financial Condition
and Results of Operation for additional information.
Payments on nonaccrual
loans are posted as principal receipts unless a payment arrangement has been established and is being paid on a timely basis. As
payments are received on loans with an established payment arrangement, the funds are applied to principal and interest as scheduled.
Mortgage and consumer loans are generally removed from nonaccrual status and interest resumes accruing once a loan has had a period
of sustained payments, generally six months. Commercial loans are generally removed from nonaccrual status and interest resumes
accruing when none of the principal and interest is due and unpaid or when the loan becomes otherwise well secured and in the process
of collection and has had a period of sustained payments, generally six months
.
In a troubled
debt restructuring (“TDR”), the Bank’s primary objective is to make the best of a difficult situation. Concessions
are granted to protect as much of the loan amount as possible. Additionally, the Bank expects to obtain more cash or other value
from the borrower, or increase the probability of collection, by granting a concession than by not granting one. The Bank faces
significant challenges when working with borrowers who are experiencing diminished operating cash flows, depreciated collateral
values, or prolonged sales and rental absorption periods. While borrowers may experience deterioration in their financial condition,
many continue to be creditworthy customers who have the willingness and capacity to repay their debts. In such cases, the Bank
finds it mutually beneficial to work constructively together with its borrowers, and that prudent restructurings are often in the
best interest of the Bank and the borrower
.
The Bank offers
a variety of restructuring concessions for economic or legal reasons related to a borrower’s financial condition that would
not otherwise be considered. TDR concessions may include, but are not limited to, any one or a combination of the following: a
modification of the loan terms such as a reduction of the contractual interest rate, principal, payment amount or accrued interest;
an extension of the maturity date at a stated interest rate lower than the current market rate for a new debt with similar risks;
a change in payment type, i.e. from principal and interest, to interest only with all principal due at maturity; a substitution
or acceptance of additional collateral; and a substitution or addition of new debtors for the original borrower
.
The
Bank’s restructuring success includes but is not limited to any one or combination of the following: improves the prospects
for repayment of principal and interest; reduces the prospects of further write downs and charge-offs; reduces the prospects of
potential additional foreclosures; helps borrowers to maintain a creditworthy status; and ultimately will reduce the volume of
classified, criticized and/or nonaccrual loans
.
The Bank relies
on ASC 310-40-50 for guidance regarding disclosure of TDRs. Under ASC 310-40-50-2, information about an impaired loan that has
been restructured in a TDR involving a modification of terms need not be included in disclosures required by paragraphs 310-10-50-15(a)
and 310-10-50-15(c) in years after the restructuring if both of the following conditions exist
: (1) t
he
restructuring agreement specifies an interest rate equal to or greater than the rate that the creditor was willing to accept at
the time of the restructuring for a new loan with comparable risk; and (2) the loan is not impaired based on the terms specified
by the restructuring agreement
.
When a restructuring agreement with a particular
borrower specifies a rate that is less than a market rate the Bank would be willing to accept at the time of the restructuring
for a new loan with comparable risk, that loan will not qualify or be considered for redesignating in a subsequent period. Information
about any such loans that do not qualify for redesignating will continue to be disclosed as required.
When a restructuring
agreement with a particular borrower specifies a rate that is equal to or greater than a market rate the Bank would be willing
to accept at the time of the restructuring for a new loan with comparable risk, that loan may qualify and will be considered for
redesignating in a subsequent period if the loan is not impaired based on the terms specified by the restructuring agreement and
is in compliance with its modified terms. Since these loans meet the conditions of ASC 310-40-50-2, information regarding these
loans may be omitted from disclosures required by paragraphs 310-10-50-15(a) and 310-10-50-15(c) in years after the restructuring
.
Generally, loans
whose terms are modified in troubled debt restructurings are evaluated for impairment. However, if the Bank has written down a
loan and the measure of the restructured loan is equal to or greater than the recorded investment, no impairment would be recognized.
The Bank is required to disclose the amount of the write-down and the recorded investment in the year of the write-down, but is
not required to disclose the recorded investment in that loan in later years if the two criteria in ASC 310-40-50-2 are met. The
Bank continues to measure loan impairment on the contractual terms specified by the original loan agreement in accordance with
ASC 310-10-35-20 through 35-26 and 310-10-35-37 for those certain loans that may meet the criteria to be redesignated and are no
longer called TDRs
.
On a loan-by-loan
basis, the Bank restructures loans that were either on nonaccrual or accrual basis prior to restructuring. If a loan was on nonaccrual
basis prior to restructuring, it remains on nonaccrual basis until the borrower has demonstrated a willingness and ability to meet
the terms and conditions of the restructuring and to make the restructured loan payments, generally for a period of at least six
months. If a restructured loan was on accrual basis prior to restructuring and the Bank expects the borrower to perform to the
terms and conditions of the loan after restructuring (i.e. the loan was current, on accrual basis, the monthly payment is not significantly
larger than the contractual payment before restructuring, and the borrower has the ability to make the restructured loan payments),
the loan remains on an accrual basis and placement on nonaccrual is not required
.
The Bank also performs restructurings on certain
troubled loan workouts whereby existing loans are restructured into a multiple note structure (“A Note and B Note”
structure). The Bank separates a portion of the current outstanding debt into a new legally enforceable note (Note A) that is reasonably
assured of repayment and performance according to prudently modified terms. The portion of the debt that is not reasonably assured
of repayment (Note B) is adversely classified and charged-off upon restructuring
.
The benefit of this workout strategy is for
the Note A to remain a performing asset, for which the borrower has the willingness and ability to meet the restructured payment
terms and conditions. In addition, this workout strategy reduces the prospects of further write downs and charge offs, and also
reduces the prospects of a potential foreclosure. Following restructuring, Note A credit classifications generally improve from
“substandard” to “pass”, if supported by the borrower’s ability to repay the loan. The general terms
of the new loans restructured under the Note A and Note B structure differ as follows:
Note A
: First lien position; fixed or
adjustable current market interest rate; fixed month term to maturity; payments – interest only to maturity, or full principal
and interest to maturity. Note A is underwritten in accordance with the Company’s customary underwriting standards and is
generally on an accrual basis.
Note B
: Second lien position; fixed
or adjustable below current market interest rate; fixed month term to maturity; payments – due in full at maturity. Note
B is underwritten in accordance with the Company’s customary underwriting standards, except for the below market interest
rate and payment terms, and is on a nonaccrual basis and charged-off.
Information concerning multiple note restructures
for certain commercial real estate loan workouts originated for 2015 and 2014 is as follows
:
|
|
Year Ended
12/31/15
|
|
|
Year Ended
12/31/14
|
|
|
|
(In thousands)
|
|
Note A Structure
|
|
|
|
|
|
|
|
|
Commercial real estate (1)
|
|
$
|
268
|
|
|
$
|
275
|
|
|
|
|
|
|
|
|
|
|
Note B Structure
|
|
|
|
|
|
|
|
|
Commercial real estate (2)
|
|
$
|
174
|
|
|
$
|
174
|
|
|
|
|
|
|
|
|
|
|
Reduction of interest income
|
|
$
|
11
|
|
|
$
|
5
|
|
|
(1)
|
If Note A was on nonaccrual status, it may be placed back on accrual status based on sustained
historical payment performance of generally six months.
|
|
(2)
|
Note B is immediately charged-off upon restructuring; however, payment in full is due at maturity
of the note.
|
Aside from the
loans defined as nonaccrual, over 90 days past due, classified, or restructured, there were no loans at December 31, 2015, where
known information about possible credit problems of borrowers caused management to have serious concerns as to the ability of the
borrowers to comply with present loan repayment terms and may result in disclosure as nonaccrual, over 90 days past due or restructured.
Management has evaluated its non-performing loans and believes they are either well collateralized or adequately reserved. However,
there can be no assurance in the future that regulators, increased risks in the loan portfolio, adverse changes in economic conditions
or other factors will not require further adjustments to the allowance for credit losses
.
See Note 6 of the Notes to Consolidated Financial Statements for additional information
.
Based on an impairment analysis of loans held
for investment, at December 31, 2015 there were $15.8 million of loans classified as impaired, net of $297,000 in write-downs and
payments applied to principal; compared to $20.3 million of loans classified as impaired, net of $375,000 in write-downs and payments
applied to principal at December 31, 2014. The allowance for loan losses included $618,000 and $792,000 specifically provided for
these impaired loans at December 31, 2015 and 2014, respectively.
A loan is considered
impaired, based on current information and events, if it is probable that the Bank will be unable to collect the scheduled payments
of principal and interest when due according to the contractual terms of the loan arrangement. All collateral-dependent loans are
measured for impairment based on the fair value of the collateral, while uncollateralized loans and other loans determined not
to be collateral dependent are measured for impairment based on the present value of expected future cash flows discounted at the
historical effective interest rate. The Bank uses several factors in determining if a loan is impaired. The internal asset classification
procedures include a thorough review of significant loans and lending relationships and include the accumulation of related data.
This data includes loan payments status, borrowers’ financial data and borrowers’ operating factors such as cash flows,
operating income or loss, and various other matters. See Notes 1, 4 and 5 of the Notes to Consolidated Financial Statements
for additional information
.
At December 31,
2015, the Bank had $3.2 million of loans held for investment on nonaccrual status, segregated by the following classes of financing
receivables: residential real estate - $1.4 million; commercial real estate - $1.1 million; lease receivables - $95,000; home equity
lines-of-credit - $81,000; consumer real estate - $307,000; consumer lots and raw land - $140,000; and consumer other - $2,000.
See Notes 1 and 4 of the Notes to Consolidated Financial Statements for additional information
.
Other real estate
owned (“OREO”) acquired in settlement of loans is classified as real estate acquired through foreclosure. It is recorded
at the lower of the estimated fair value (less estimated selling costs) of the underlying real estate or the carrying amount of
the loan. Any required write-down of a loan to its fair value (less estimated selling costs) is charged against the allowance for
credit losses. In most cases, the estimated fair values are derived from an initial appraisal, an updated appraisal or a broker’s
price opinion (“BPO”) with appropriate comparables. In certain instances when a listing agreement is renewed for a
lesser amount, management will adjust the recorded estimated fair value of the subject property accordingly. In certain instances
when the Bank receives an offer to purchase near the end of a quarterly accounting period for less than the current carrying value
and the sale does not consummate until the next accounting period, management will adjust the recorded estimated fair value of
the subject property accordingly. OREO is reviewed annually to determine the property is appropriately valued and any subsequent
valuation adjustments are charged against current income. Costs related to holding such real estate is charged against income in
the current period. See Notes 1, 7 and 20 of the Notes to Consolidated Financial Statements and Management’s Discussion
and Analysis of Financial Condition and Results of Operation for additional information
.
Classified Assets and Credit Quality.
Federal
regulations require banks to review their classification of assets on a regular basis. In addition, in connection with regulatory
examinations, examiners have authority to identify problem assets and if appropriate, classify them in their reports of examination.
There are four classifications for problem assets: “special mention,” “substandard,” “doubtful”
and “loss.” Special mention assets contain a potential weakness that deserves management’s close attention and
which could cause a more serious problem if not corrected. Substandard assets have one or more well-defined weaknesses and are
characterized by the distinct possibility that the insured institution will sustain some loss if the deficiencies are not corrected.
Doubtful assets have the weaknesses of substandard assets with the additional characteristic that the weaknesses make collection
or liquidation in full, on the basis of currently existing facts, conditions and values, questionable, and there is a high possibility
of loss. An asset classified as a loss is considered uncollectible and of such little value that continuance as an asset of the
institution is not warranted. If an asset or portion thereof is classified as loss or is impaired, a bank must either establish
a specific allowance for loss in the amount of the portion of the asset classified as loss, or charge off such amount. Work-in-process
loans are loans that have been approved and sent to the attorney for closing, but have not yet been returned for processing. These
loans are not given a risk grade until they have been processed and are therefore excluded from the credit quality reporting.
The Bank assigns
a risk grade to each commercial, consumer, and in-house mortgage loan. The grading system established by the Bank includes grades
1 through 9. These grades are defined as follows: “1” is Excellent and considered to be of the highest quality with
significant financial strength, stability, and liquidity; “2” is Above Average and supported by above average financial
strength and stability; “3” is Average and supported by upper tier industry-average financial strength and stability;
“4” is Acceptable and supported by lower end industry-average financial strength and stability; “5” is
Watch and has been identified by the lender as a loan that has shown some degree of deterioration from its original status; “6”
is Special Mention; “7” is Substandard; “8” is Doubtful; and “9” is Loss. Risk grades 1 through
5 are collectively labeled “Pass” by regulators, and have minimal risk and minimal loss history. See Note 4 of
the Notes to Consolidated Financial Statements for additional information
.
Loans held for
investment that are graded as watch, criticized or classified are reviewed not less than quarterly, to determine whether any loans
require classification or re-classification. At December 31, 2015 and 2014, the Bank had $27.1 million and $33.1 million, respectively,
of watch loans. At December 31, 2015, the Bank had $27.5 million of criticized and classified loans, including $13.3 million of
special mention, $14.2 million of substandard, none classified as of doubtful, and none classified as loss; compared to $30.4 million
of criticized and classified loans at December 31, 2014, including $14.6 million of special mention, $15.7 million of substandard,
$89,000 of doubtful and none as loss
.
Allowance
for Credit Losses.
The Bank maintains general and specific allowances for loan and lease losses (“ALLL”) and an
allowance for unfunded loan commitments (“AULC”), collectively, the allowance for credit losses (“ACL”)
at levels the Bank believes are appropriate in light of the risk inherent in loans and leases held for investment and in unfunded
loan commitments. The Bank has developed policies and procedures for assessing the adequacy of the ACL that reflect the assessment
of credit risk and impairment analysis. This assessment includes an analysis of qualitative and quantitative trends in the levels
of classified loans. Future assessments of credit risk may yield different results, depending on changes in the qualitative and
quantitative trends, which may require increases or decreases in the ACL
.
The Bank uses
various modeling, calculation methods and estimation tools for measuring its credit risk and performing impairment analysis, which
is the basis used in developing the ACL. The factors supporting the allowance do not diminish the fact that the entire ACL is available
to absorb probable losses in both the loan and leases portfolio and in unfunded loan commitments. Based on the overall credit quality
of the loan and leases portfolio, the Bank believes it has established the ACL pursuant to generally accepted accounting principles
(“GAAP”), and has taken into account the views of its regulators and the current economic environment. Management evaluates
the information upon which it bases the ACL quarterly and believes its accounting decisions remain accurate. However, there can
be no assurance in the future that regulators, increased risks in its loan and leases portfolio, changes in economic conditions
and other factors will not require additional adjustments to the ACL
.
The ACL calculation
methodology takes into account GAAP and regulatory guidance. The calculation methodology is focused on current borrower analysis
and loss factors that are indicative of actual historical loss experience over the most recent eight quarters. The ACL contains
both general and specific reserves. The Bank may establish a specific reserve for certain loans calculated using an estimate of
the expected cash flows from the borrower discounted at the loan’s effective interest rate and for collateral dependent loans
for which an impairment analysis has not yet been completed. For collateral dependent loans when impairment can be reasonably calculated,
the Bank will write down the affected loan by the level of that impairment. See Notes 1, 4, 5 and 6 of the Notes to Consolidated
Financial Statements and Management’s Discussion and Analysis of Financial Condition and Results of Operation for additional
information
.
Historical Loss and Qualitative Analysis.
The assessment of the adequacy of the ACL includes an analysis of actual historical loss percentages of both classified and
pass loans, as well as qualitative risk factors allocated among specific categories of loans. In developing this analysis, the
Bank relies on actual loss history for the most recent twelve quarters and exercises management’s best judgment in assessing
credit risk. The assessment of qualitative factors includes various subjective component areas assessed in terms of basis points
used in determining the overall adequacy of the ACL. The evaluation of qualitative risk factors will result in a positive or negative
adjustment to the ACL validation. Adjustments for each qualitative risk component may range from +25 basis points to -10 basis
points. A component score of 0 basis points indicates no effect on the ACL. A component rating of +25 basis points indicates the
assessed maximum potential of increased risk to the adequacy of the ACL. A -10 basis point component rating indicates the most
positive effect on the ACL.
On a quarterly basis the Board reviews the
ACL methodology. During 2015 and 2014, the look back period the Bank utilizes for prior credit losses to be included in the allowance
modeling was expanded from eight quarters to twelve quarters, in order to incorporate more loss history of the recent current economic
downturn.
Following is
a summary of activity in the ACL, which includes the allowance for loan and lease losses and unfunded loan commitments, for the
periods indicated
:
|
|
Allowance for Loan and
Lease Losses
|
|
|
Allowance for Unfunded
Loan Commitments
|
|
|
Allowance for Credit
Losses
|
|
|
|
(In thousands)
|
|
Balance at December 31, 2010
|
|
|
18,830
|
|
|
|
237
|
|
|
|
19,067
|
|
Provisions for credit losses
|
|
|
10,813
|
|
|
|
17
|
|
|
|
10,830
|
|
Loans and leases charged-off
|
|
|
(15,106
|
)
|
|
|
-
|
|
|
|
(15,106
|
)
|
Loans and leases recovered
|
|
|
657
|
|
|
|
-
|
|
|
|
657
|
|
Net (charge-offs)/recoveries
|
|
|
(14,449
|
)
|
|
|
-
|
|
|
|
(14,449
|
)
|
Balance December 31, 2011
|
|
|
15,194
|
|
|
|
254
|
|
|
|
15,448
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Balance at December 31, 2011
|
|
|
15,194
|
|
|
|
254
|
|
|
|
15,448
|
|
Provisions for credit losses
|
|
|
23,252
|
|
|
|
(26
|
)
|
|
|
23,226
|
|
Loans and leases charged-off
|
|
|
(32,201
|
)
|
|
|
-
|
|
|
|
(32,201
|
)
|
Loans and leases recovered
|
|
|
1,615
|
|
|
|
-
|
|
|
|
1,615
|
|
Net (charge-offs)/recoveries
|
|
|
(30,586
|
)
|
|
|
-
|
|
|
|
(30,586
|
)
|
Balance December 31, 2012
|
|
|
7,860
|
|
|
|
228
|
|
|
|
8,088
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Balance at December 31, 2012
|
|
|
7,860
|
|
|
|
228
|
|
|
|
8,088
|
|
Provisions for credit losses
|
|
|
1,085
|
|
|
|
36
|
|
|
|
1,121
|
|
Loans and leases charged-off
|
|
|
(1,945
|
)
|
|
|
-
|
|
|
|
(1,945
|
)
|
Loans and leases recovered
|
|
|
609
|
|
|
|
-
|
|
|
|
609
|
|
Net (charge-offs)/recoveries
|
|
|
(1,336
|
)
|
|
|
-
|
|
|
|
(1,336
|
)
|
Balance December 31, 2013
|
|
|
7,609
|
|
|
|
264
|
|
|
|
7,873
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Balance at December 31, 2013
|
|
|
7,609
|
|
|
|
264
|
|
|
|
7,873
|
|
Provisions for credit losses
|
|
|
1,100
|
|
|
|
26
|
|
|
|
1,126
|
|
Loans and leases charged-off
|
|
|
(1,316
|
)
|
|
|
-
|
|
|
|
(1,316
|
)
|
Loans and leases recovered
|
|
|
127
|
|
|
|
-
|
|
|
|
127
|
|
Net (charge-offs)/recoveries
|
|
|
(1,189
|
)
|
|
|
-
|
|
|
|
(1,189
|
)
|
Balance December 31, 2014
|
|
|
7,520
|
|
|
|
290
|
|
|
|
7,810
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Balance at December 31, 2014
|
|
|
7,520
|
|
|
|
290
|
|
|
|
7,810
|
|
Provisions for credit losses
|
|
|
800
|
|
|
|
46
|
|
|
|
846
|
|
Loans and leases charged-off
|
|
|
(702
|
)
|
|
|
-
|
|
|
|
(702
|
)
|
Loans and leases recovered
|
|
|
249
|
|
|
|
-
|
|
|
|
249
|
|
Net (charge-offs)/recoveries
|
|
|
(453
|
)
|
|
|
-
|
|
|
|
(453
|
)
|
Balance at December 31, 2015
|
|
$
|
7,867
|
|
|
$
|
336
|
|
|
$
|
8,203
|
|
The following
table is an allocation of the ACL by loan portfolio segment at the dates indicated. The allocation of the ACL to each loan portfolio
segment is not necessarily indicative of future losses and does not restrict the use of the ACL to absorb losses in any category
.
|
|
At
December 31,
|
|
|
|
2015
|
|
|
2014
|
|
|
2013
|
|
|
2012
|
|
|
2010
|
|
|
|
Amount
|
|
|
Percent
of
Total
Loans
|
|
|
Amount
|
|
|
Percent
of
Total
Loans
|
|
|
Amount
|
|
|
Percent
of
Total
Loans
|
|
|
Amount
|
|
|
Percent
of
Total
Loans
|
|
|
Amount
|
|
|
Percent
of
Total
Loans
|
|
|
|
(Dollars
in thousands)
|
|
Allowance for Loan and
Lease Losses:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Residential
mortgage
|
|
$
|
779
|
|
|
|
9.9
|
%
|
|
$
|
1,195
|
|
|
|
15.9
|
%
|
|
$
|
933
|
|
|
|
12.3
|
%
|
|
$
|
1,237
|
|
|
|
15.7
|
%
|
|
$
|
1,375
|
|
|
|
9.1
|
%
|
Commercial (1)
|
|
|
6,102
|
(2)
|
|
|
77.6
|
|
|
|
5,258
|
|
|
|
69.9
|
|
|
|
5,481
|
|
|
|
72.0
|
|
|
|
5,023
|
|
|
|
63.9
|
|
|
|
10,213
|
|
|
|
67.2
|
|
Consumer
|
|
|
986
|
(3)
|
|
|
12.5
|
|
|
|
1,067
|
|
|
|
14.2
|
|
|
|
1,195
|
|
|
|
15.7
|
|
|
|
1,600
|
|
|
|
20.4
|
|
|
|
3,606
|
|
|
|
23.7
|
|
Total
allowance for loan and lease losses
|
|
$
|
7,867
|
|
|
|
100.0
|
%
|
|
$
|
7,520
|
|
|
|
100.0
|
%
|
|
$
|
7,609
|
|
|
|
100.0
|
%
|
|
$
|
7,860
|
|
|
|
100.0
|
%
|
|
$
|
15,194
|
|
|
|
100.0
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Allowance for Unfunded
Loan Commitments:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Mortgage
|
|
$
|
-
|
|
|
|
-
|
%
|
|
$
|
-
|
|
|
|
-
|
%
|
|
$
|
-
|
|
|
|
-
|
%
|
|
$
|
-
|
|
|
|
-
|
%
|
|
$
|
-
|
|
|
|
-
|
%
|
Commercial
|
|
|
119
|
|
|
|
35.4
|
|
|
|
84
|
|
|
|
29.0
|
|
|
|
60
|
|
|
|
22.7
|
|
|
|
42
|
|
|
|
18.4
|
|
|
|
52
|
|
|
|
20.5
|
|
Consumer
|
|
|
217
|
|
|
|
64.6
|
|
|
|
206
|
|
|
|
71.0
|
|
|
|
204
|
|
|
|
77.3
|
|
|
|
186
|
|
|
|
81.6
|
|
|
|
202
|
|
|
|
79.5
|
|
Total
allowance for unfunded loan commitments (4)
|
|
$
|
336
|
|
|
|
100.0
|
%
|
|
$
|
290
|
|
|
|
100.0
|
%
|
|
$
|
264
|
|
|
|
100.0
|
%
|
|
$
|
228
|
|
|
|
100.0
|
%
|
|
$
|
254
|
|
|
|
100.0
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Combined
total allowance for credit losses
|
|
$
|
8,203
|
|
|
|
|
|
|
$
|
7,810
|
|
|
|
|
|
|
$
|
7,873
|
|
|
|
|
|
|
$
|
8,088
|
|
|
|
|
|
|
$
|
15,448
|
|
|
|
|
|
|
(1)
|
Includes commercial real estate, commercial and industrial business loans and lease receivables.
|
|
(2)
|
Includes $379,000 of specific allowance for loan losses on commercial real estate loans.
|
|
(3)
|
Includes $239,000 of specific allowance for loan losses on consumer loans.
|
|
(4)
|
Recorded as other liabilities in the consolidated statements of financial condition.
|
Investment Securities Activities
General
. Interest income from investment
securities generally provides the second largest source of income to the Bank, after interest and fees on loans. The Board has
authorized investment in U.S. Government and agency securities, state government obligations, municipal securities, obligations
of the Federal Home Loan Bank (“FHLB”), mortgage-backed securities, commercial paper and corporate bonds. The Bank’s
objective is to use investment securities to enhance earnings and provide liquidity. At December 31, 2015, the Bank’s investment
securities available for sale and held to maturity totaled $248.3 million and $508,000, respectively, with unrealized securities
gains of $4.3 million, net of deferred taxes. Investment and aggregate investment limitations and credit quality parameters of
each class of investment are prescribed in the Bank’s investment policy. The Bank performs an analysis on the investment
securities portfolio on a quarterly basis to determine the impact on earnings and market value under various interest rate scenarios
and prepayment conditions. Securities purchases are subject to the oversight of the Bank’s Asset/Liability Management Committee
(“ALCO”) consisting of four directors, and are reviewed by the Board on a monthly basis. The Bank’s President
and Chief Financial Officer have authority to make specific investment decisions within the parameters determined by the Board.
Mortgage-Backed Securities
. At December
31, 2015, mortgage-backed securities with an amortized cost of $128.8 million and a carrying value of $131.7 million, or 13.9%
of total assets, were held as available for sale. Mortgage-backed securities are carried at fair value, and unrealized gains and
losses are recognized as direct increases or decreases in equity, net of applicable income taxes. Mortgage-backed securities represent
participation interests in pools of single-family or multi-family mortgages, and their principal and interest payments are passed
from the mortgage originators through intermediaries that pool and repackage the participation interest in the form of securities
to investors. The intermediaries include government sponsored entities such as FHLMC, the Federal National Mortgage Association
(“FNMA”, also known as “Fannie Mae”) and the Government National Mortgage Association (“GNMA”,
also known as “Ginnie Mae”), which guarantee the payment of principal and interest to investors. Mortgage-backed securities
generally increase the quality of the Bank’s assets by virtue of the guarantees that back them, are more liquid than individual
mortgage loans and may be used to collateralize borrowings or other obligations of the Bank.
At December 31, 2015, the
mortgage-backed securities portfolio had a weighted average yield of 2.65%. The yield is based on the interest income and the amortization
of the premium or accretion of the discount related to the mortgage-backed security. Premiums and discounts on mortgage-backed
securities are amortized or accreted over the estimated term of the securities using a level yield method. At December 31, 2015,
the average life of the mortgage-backed securities portfolio was approximately 6.0 years. The actual life of a mortgage-backed
security varies depending on mortgagors prepaying/repaying the underlying mortgages.
Municipal
Securities.
At December 31, 2015, municipal securities with an amortized cost of $55.5 million and a carrying value of $56.8
million, or 6.0% of total assets, were held as available for sale. Municipal securities are carried at fair value, and unrealized
gains and losses are recognized as direct increases or decreases in equity, net of applicable income taxes
.
Municipal
securities represent debt securities issued by a state, municipality or county to finance capital expenditures, such as the construction
of highways, bridges or schools. Municipal securities purchased by the Bank are generally exempt from federal taxes, and from state
and local taxes where the security is issued by a municipality located within the state of North Carolina. At December 31, 2015,
the municipal securities portfolio had a weighted average yield of 2.87%, and an average life of approximately 6.6 years
.
Corporate
Bonds
. At December 31, 2015, corporate bonds with an amortized cost of $28.7 million and a carrying value of $28.4 million,
or 3.0% of total assets, were held as available for sale. Corporate bonds are carried at fair value, and unrealized gains and losses
are recognized as direct increases or decreases in equity, net of applicable income taxes. Corporate bonds represent investment
grade debt instruments issued by companies for the purpose of raising capital. At December 31, 2015, the corporate bonds portfolio
had a weighted average yield of 1.79%, and an average life of approximately 4.4 years
.
Government Agencies
. At December 31,
2015, government agencies with an amortized cost of $30.9 million and a carrying value of $31.4 million, or 3.3% of total assets,
were held as available for sale. Government agencies are carried at fair value, and unrealized gains and losses are recognized
as direct increases or decreases in equity, net of applicable income taxes. At December 31, 2015, the government agencies portfolio
has a weighted average yield of 2.28%, and an average life of approximately 5.0 years. At December 31, 2015, the Company had $508,000
of government agencies classified as held to maturity.
Investment
Securities
. Investments in certain securities are classified into three categories and accounted for as follows: (1) debt and
equity securities bought with the intent to hold to maturity are classified as held for investment and reported at amortized cost;
(2) debt and equity securities bought and held principally for the purpose of selling them in the near term are classified as trading
securities and reported at fair value, with unrealized gains and losses included in earnings; (3) debt and equity securities not
classified as either held for investment securities or trading securities are classified as available for sale securities and reported
at fair value, with unrealized gains and losses excluded from earnings and reported as accumulated other comprehensive income,
a separate component of equity
.
As a member of the FHLB of Atlanta, the Bank
is required to maintain an investment in FHLB stock. The Bank had $2.4 million of FHLB stock at December 31, 2015.
See Notes 1 and
2 of the Notes to Consolidated Financial Statements and Management’s Discussion and Analysis of Financial Condition and Results
of Operation for additional information
.
The following table sets forth the carrying
value of the Bank’s investment securities portfolio, categorized as available for sale and held to maturity at December 31,
2015 and 2014, respectively. The Bank had no securities categorized as trading securities at December 31, 2015 and 2014, respectively.
|
|
At December 31,
|
|
|
|
2015
|
|
|
2014
|
|
Securities available for sale:
|
|
(In thousands)
|
|
Government agencies
|
|
$
|
31,385
|
|
|
$
|
31,232
|
|
Mortgage-backed securities
|
|
|
131,684
|
|
|
|
174,280
|
|
Municipal securities
|
|
|
56,831
|
|
|
|
55,702
|
|
Corporate bonds
|
|
|
28,395
|
|
|
|
31,085
|
|
Total
|
|
$
|
248,295
|
|
|
$
|
292,299
|
|
|
|
|
|
|
|
|
|
|
Securities held to maturity:
|
|
|
|
|
|
|
|
|
Government agencies
|
|
$
|
508
|
|
|
$
|
507
|
|
Total
|
|
$
|
508
|
|
|
$
|
507
|
|
The following table sets
forth the scheduled maturities, carrying values, amortized cost and average yields for the Bank’s investment securities portfolio
at December 31, 2015.
|
|
Five
Years or Less
|
|
|
Five
to Ten Years
|
|
|
More
than Ten Years
|
|
|
Total
Investment Portfolio
|
|
|
|
Carrying
Value
|
|
|
Average
Yield
|
|
|
Carrying
Value
|
|
|
Average
Yield
|
|
|
Carrying
Value
|
|
|
Average
Yield
|
|
|
Carrying
Value
|
|
|
Amortized
Cost
|
|
|
Average
Yield
|
|
|
|
(Dollars in thousands)
|
|
Securities
available for sale:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Government
agencies
|
|
$
|
15,576
|
|
|
|
1.97
|
%
|
|
$
|
15,809
|
|
|
|
2.60
|
%
|
|
$
|
-
|
|
|
|
-
|
%
|
|
$
|
31,385
|
|
|
$
|
30,850
|
|
|
|
2.28
|
%
|
Mortgage-backed
securities
|
|
|
63,739
|
|
|
|
2.16
|
|
|
|
42,956
|
|
|
|
2.48
|
|
|
|
24,989
|
|
|
|
4.20
|
|
|
|
131,684
|
|
|
|
128,820
|
|
|
|
2.65
|
|
Municipal
securities (2)
|
|
|
24,899
|
|
|
|
2.64
|
|
|
|
26,853
|
|
|
|
2.97
|
|
|
|
5,079
|
|
|
|
3.42
|
|
|
|
56,831
|
|
|
|
55,534
|
|
|
|
2.87
|
|
Corporate
bonds
|
|
|
18,624
|
|
|
|
1.88
|
|
|
|
9,771
|
|
|
|
1.63
|
|
|
|
-
|
|
|
|
-
|
|
|
|
28,395
|
|
|
|
28,744
|
|
|
|
1.79
|
|
Total available
for sale
|
|
$
|
122,838
|
|
|
|
2.19
|
%
|
|
$
|
95,389
|
|
|
|
2.55
|
%
|
|
$
|
30,068
|
|
|
|
4.07
|
%
|
|
$
|
248,295
|
|
|
$
|
243,948
|
|
|
|
2.56
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Securities
held to maturity:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Government
agencies
|
|
$
|
508
|
|
|
|
1.36
|
%
|
|
$
|
-
|
|
|
|
-
|
%
|
|
$
|
-
|
|
|
|
-
|
%
|
|
$
|
508
|
|
|
$
|
508
|
|
|
|
1.36
|
%
|
FHLB stock
(1)
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
|
|
2,369
|
|
|
|
5.36
|
|
|
|
2,369
|
|
|
|
2,369
|
|
|
|
5.36
|
|
Total held
to maturity
|
|
$
|
508
|
|
|
|
1.36
|
%
|
|
$
|
-
|
|
|
|
-
|
%
|
|
$
|
2,369
|
|
|
|
5.36
|
%
|
|
$
|
2,877
|
|
|
$
|
2,877
|
|
|
|
4.65
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total Portfolio
|
|
$
|
123,346
|
|
|
|
2.19
|
%
|
|
$
|
95,389
|
|
|
|
2.55
|
%
|
|
$
|
32,437
|
|
|
|
4.16
|
%
|
|
$
|
251,172
|
|
|
$
|
246,825
|
|
|
|
2.58
|
%
|
|
(1)
|
As a member of the FHLB of Atlanta, the Bank is required to maintain an investment in FHLB stock,
which has no stated maturity. FHLB stock is recorded at cost, which approximates market value.
|
|
(2)
|
The tax equivalent yield on municipal securities at December 31, 2015 was 4.17%.
|
Deposit Activity
and Other Sources of Funds.
Deposits are the Bank’s primary source of funds for lending, investment activities and general
operational purposes. Other sources of funds include loan principal and interest repayments, maturities and paydowns on investment
securities, and interest payments thereon. Although loan repayments are a relatively stable source of funds, deposit inflows and
outflows are significantly influenced by general interest rates and money market conditions. Borrowings may be used on a short-term
basis to compensate for reductions in the availability of funds, or on a longer term basis for general operational purposes. The
Bank has access to borrowings from the FHLB of Atlanta, the Federal Reserve Bank of Richmond, as well as from other correspondent
banks and other financial institutions
.
Deposits.
The Bank attracts deposits
principally from within its market area by offering a variety of deposit instruments, including checking accounts, money market
accounts, statement savings accounts, Individual Retirement Accounts, and certificates of deposit which range in maturity from
seven days to five years. Deposit terms vary according to the length of time the funds must remain on deposit and the interest
rate. Maturities, terms, service fees and withdrawal penalties for its deposit accounts are established by the Bank on a periodic
basis. The Bank reviews its deposit pricing on a weekly basis or more frequently based on market conditions. In determining the
characteristics of its deposit accounts, the Bank considers the rates offered by competing institutions, lending and liquidity
requirements, growth goals and federal regulations. Management believes it prices its deposits comparably to rates offered by its
competitors.
The
Bank attempts to compete for deposits with other institutions in its market area by offering competitively priced deposit instruments
that are crafted to meet the needs of its customers. Additionally, the Bank seeks to meet customers’ needs by providing digital
technology, convenient customer service, efficient staff and convenient hours of service. Substantially all of the Bank’s
depositors are North Carolina residents. To provide additional convenience, the Bank participates in the Cirrus and STAR Automated
Teller Machine (ATM) networks at locations throughout the United States, through which customers can gain access to their accounts
at any time. To better serve its customers, the Bank has installed forty-one ATMs at locations throughout its market area, including
seventeen that are Intelligent Deposit ATMs. Intelligent Deposit ATMs , also known as deposit automation, employs smart technology
to read currency notes and checks for automated processing to the customer’s account. The Bank provides both personal and
business on-line banking services. These services include mobile banking, mobile deposits, eStatements, bill paying, access to
check images, funds transfers between accounts, ACH originations, wire transfers and stop payment orders for checks, as applicable
by personal or business account type. The Bank also provides imaged check statements, which reduces the cost of returning paper
items. Additionally, the Bank offers Remote Deposit Capture for business customers
.
The following table sets forth the distribution
of the Bank’s deposit accounts based on their original contractual maturities, and corresponding weighted average interest
rates based on year-end balances for the periods indicated.
|
|
At December 31,
|
|
|
|
2015
|
|
|
2014
|
|
|
2013
|
|
|
|
Amount
|
|
|
Weighted
Average Rate
|
|
|
Amount
|
|
|
Weighted
Average Rate
|
|
|
Amount
|
|
|
Weighted
Average Rate
|
|
|
|
(Dollars in thousands)
|
|
Non-maturity accounts:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Non-interest bearing checking
|
|
$
|
169,546
|
|
|
|
-
|
|
|
$
|
147,544
|
|
|
|
-
|
|
|
$
|
96,445
|
|
|
|
-
|
|
Interest-bearing accounts:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest bearing checking
|
|
|
173,934
|
|
|
|
0.07
|
%
|
|
|
180,558
|
|
|
|
0.07
|
%
|
|
|
128,161
|
|
|
|
0.06
|
%
|
Money market
|
|
|
72,442
|
|
|
|
0.15
|
|
|
|
87,914
|
|
|
|
0.15
|
|
|
|
43,388
|
|
|
|
0.16
|
|
Savings accounts
|
|
|
135,370
|
|
|
|
0.17
|
|
|
|
117,933
|
|
|
|
0.17
|
|
|
|
69,543
|
|
|
|
0.19
|
|
Total interest bearing accounts
|
|
|
381,746
|
|
|
|
0.12
|
|
|
|
386,405
|
|
|
|
0.12
|
|
|
|
241,092
|
|
|
|
0.12
|
|
Total non-maturity accounts
|
|
|
551,292
|
|
|
|
0.08
|
|
|
|
533,949
|
|
|
|
0.08
|
|
|
|
337,537
|
|
|
|
0.09
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Certificate accounts:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
3 months or less
|
|
|
4,540
|
|
|
|
0.14
|
|
|
|
3,574
|
|
|
|
0.00
|
|
|
|
2,522
|
|
|
|
0.00
|
|
Over 3 months through 1 year
|
|
|
49,718
|
|
|
|
0.35
|
|
|
|
54,825
|
|
|
|
0.23
|
|
|
|
37,401
|
|
|
|
0.23
|
|
Over 1 year through 3 years
|
|
|
118,738
|
|
|
|
0.64
|
|
|
|
126,148
|
|
|
|
0.63
|
|
|
|
187,183
|
|
|
|
0.89
|
|
Over 3 years
|
|
|
87,034
|
|
|
|
1.36
|
|
|
|
69,784
|
|
|
|
1.31
|
|
|
|
21,061
|
|
|
|
1.31
|
|
Total
|
|
|
260,030
|
|
|
|
0.82
|
|
|
|
254,331
|
|
|
|
0.72
|
|
|
|
248,167
|
|
|
|
0.82
|
|
Total deposits
|
|
$
|
811,322
|
|
|
|
0.32
|
%
|
|
$
|
788,280
|
|
|
|
0.29
|
%
|
|
$
|
585,704
|
|
|
|
0.40
|
%
|
The Bank also holds brokered
deposits as part of its funding. Under the Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”),
only well-capitalized and adequately capitalized institutions may accept brokered deposits. The Bank accepts brokered deposits
through the use of third-party intermediaries. As of December 31, 2015, brokered deposits represented approximately 3.1% of the
Bank’s total deposits.
The following table indicates
the amount of the Bank’s certificates of deposit of $100,000 or more by time remaining until maturity as of December 31,
2015. At that date, such deposits represented 14.3% of total deposits and had a weighted average rate of 0.90%.
Maturity Period
|
|
(In thousands)
|
|
3 months or less
|
|
$
|
22,085
|
|
Over 3 months through 1 year
|
|
|
41,597
|
|
Over 1 year through 3 years
|
|
|
46,634
|
|
Over 3 years
|
|
|
5,983
|
|
Total
|
|
$
|
116,299
|
|
At
December 31, 2015, FHLMC mortgage-backed securities with an amortized cost of $11.8 million were pledged as collateral for deposits
from public entities. See Notes 2 and 10 of the Notes to Consolidated Financial Statements and Management’s Discussion and
Analysis of Financial Condition and Results of Operation for additional information
.
Borrowings.
During
2015 and 2014, in addition to the Company’s subordinated debentures, the Bank’s borrowings consisted primarily of FHLB
advances.
The
Bank is authorized to access advances from the FHLB of Atlanta to supplement its liquidity needs for funds to meet loan origination
and deposit withdrawal requirements. The FHLB of Atlanta functions as a central correspondent bank providing credit for its member
financial institutions. As a member of the FHLB System, the Bank is required to own stock in the FHLB of Atlanta. FHLB advances
are available under several different programs, each of which has its own interest rate and range of maturities. The FHLB capital
stock requirement is based on the sum of a membership stock component currently totaling 0.09% of the Bank’s total assets
with a cap of $15.0 million, and an activity-based stock component of 4.25% of outstanding FHLB advances. Advances from the FHLB
of Atlanta are secured by certain loans that are pledged as collateral
.
See Notes 13 and 23
of the Notes to Consolidated Financial Statements and Management’s Discussion and Analysis of Financial Condition and Results
of Operation for additional information.
The following
table sets forth certain information regarding short-term borrowings by the Bank at the dates and for the periods indicated
:
|
|
At or for the Year Ended December 31,
|
|
|
|
2015
|
|
|
2014
|
|
|
2013
|
|
|
|
(Dollars in thousands)
|
|
Amounts outstanding at end of periods:
|
|
|
|
|
|
|
|
|
|
FHLB advances
|
|
$
|
37,000
|
|
|
$
|
-
|
|
|
$
|
-
|
|
Rate paid on:
|
|
|
|
|
|
|
|
|
|
|
|
|
FHLB advances
|
|
|
0.81
|
%
|
|
|
-
|
%
|
|
|
-
|
%
|
Maximum amount of borrowings outstanding at any month end:
|
|
|
|
|
|
|
|
|
|
|
|
|
FHLB advances
|
|
$
|
39,500
|
|
|
$
|
124,500
|
|
|
$
|
19,500
|
|
Approximate average short-term borrowings outstanding:
|
|
|
|
|
|
|
|
|
|
|
|
|
FHLB advances
|
|
$
|
15,761
|
|
|
$
|
14,952
|
|
|
$
|
-
|
|
Approximate weighted average rate paid:
|
|
|
|
|
|
|
|
|
|
|
|
|
FHLB advances
|
|
|
0.79
|
%
|
|
|
1.01
|
%
|
|
|
0.26
|
%
|
Competition.
The Bank faces competition in originating loans and attracting deposits. The Bank competes for real estate and other loans
principally on the basis of interest rates, the types of loans it originates, the deposit products it offers and the quality of
services it provides to borrowers. The Bank also competes by offering products which are tailored to the local community, including
lease financing. Its competition in originating real estate loans comes primarily from other commercial banks, savings institutions,
mortgage bankers and mortgage brokers. Commercial banks, credit unions and finance companies provide vigorous competition in consumer
lending. Competition may increase as a result of the reduction of restrictions on the interstate operations of financial institutions
.
The Bank attracts
deposits through its branch offices primarily from local communities. Consequently, competition for deposits is principally from
other commercial banks, savings institutions, credit unions and brokers in the Bank’s primary market area. The Bank competes
for deposits and loans by offering a variety of deposit accounts at competitive rates, convenient business hours, a commitment
to outstanding customer service and a well-trained staff. The Bank’s primary market area for gathering deposits and/or originating
loans is eastern and central North Carolina, where the Bank’s offices are located
.
The
Bank also makes securities brokerage services available through an affiliation with an independent broker-dealer
.
Employees.
As of December 31, 2015,
the Bank had 298 full-time and 15 part-time employees, none of whom were represented by a collective bargaining agreement. Management
considers the Bank’s relationships with its employees to be good.
Depository Institution Regulation
General.
The Bank is a North Carolina chartered commercial bank and its deposit accounts are insured by the Deposit Insurance Fund (“DIF”)
administered by the FDIC. The Bank is subject to supervision, examination and regulation by the North Carolina Office of the Commissioner
of Banks (“Commissioner”) and the FDIC and to North Carolina and federal statutory and regulatory provisions governing
such matters as capital standards, mergers, subsidiary investments and establishment of branch offices. The FDIC also has the authority
to conduct special examinations. The Bank is required to file reports with the Commissioner and the FDIC concerning its activities
and financial condition and is required to obtain regulatory approval prior to entering into certain transactions, including mergers
with, or acquisitions of, other depository institutions
.
The system of
supervision and regulation applicable to the Bank establishes a comprehensive framework for the operations of the Bank, and is
intended primarily for the protection of the FDIC and the depositors of the Bank, rather than stockholders. Changes in the regulatory
framework could have a material effect on the Bank that in turn, could have a material effect on the Company. Certain legal and
regulatory requirements are applicable to the Bank and the Company. This discussion does not purport to be a complete explanation
of all such laws and regulations and is qualified in its entirety by reference to the statutes and regulations involved
.
North Carolina Banking Law.
The Bank
is incorporated under and subject to the provisions of Chapter 53C of the General Statutes of North Carolina, which provides for
the supervision and regulation of the Bank by the State of North Carolina through the State Banking Commission, the Commissioner
of Banks, and the Office of the Commissioner of Banks. It contains provisions regarding the following topics: formation and organization
of banks; corporate governance of banks; activities and powers of banks; bank operations; mergers and other change-in-control or
business combination transactions; charter conversions; and bank holding companies.
The statute also grants the Commissioner the
authority to issue administrative rules with respect to the establishment, operation, conduct, and termination of any and all activities
and businesses that are subject to regulation by the Commissioner. Rules issued by the Commissioner are subject to review and approval
of the State Banking Commission. The Bank is subject to these rules, which are set forth in Chapter 3 of Title 4 of the North Carolina
Administrative Code. The Office of the Commissioner of Banks conducts regular supervisory examinations of the Bank in coordination
with the FDIC. The FDIC serves as the Bank’s primary federal regulator.
Dodd-Frank Wall Street Reform and Consumer
Protection Act.
In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) was
signed into law. This law significantly changed the structure of bank regulation, affecting the lending, deposit, investment, trading,
and operating activities of financial institutions and their holding companies. The Dodd-Frank Act required various federal agencies
to adopt a broad range of new rules and regulations, and to prepare numerous studies and reports for Congress. The federal agencies
were granted broad discretion in drafting rules and regulations. The Dodd-Frank Act included, among other things:
|
·
|
Creation of a Financial Stability Oversight Council to identify emerging systemic risks posed by
financial firms, activities and practices, and to improve cooperation between federal agencies.
|
|
·
|
Creation of a Bureau of Consumer Financial Protection authorized to promulgate and enforce consumer
protection regulations relating to financial products, which affects both banks and non-bank financial companies.
|
|
·
|
Establishment of strengthened capital and prudential standards for banks and bank holding companies.
|
|
·
|
Enhanced regulation of financial markets, including derivatives and securitization markets.
|
|
·
|
Elimination of certain trading activities by banks.
|
|
·
|
A permanent increase of FDIC deposit insurance to $250,000 per depository category and an increase
in the minimum deposit insurance fund reserve requirement from 1.15% to 1.35%, with assessments to be based on assets as opposed
to deposits.
|
|
·
|
Amendments to the Truth in Lending Act aimed at improving consumer protections with respect to
mortgage originations, including originator compensation, minimum repayment standards, and prepayment considerations.
|
|
·
|
Enhanced disclosure and other requirements relating to executive compensation and corporate governance.
|
Not all the rules required or expected to be
implemented under the Dodd-Frank Act have been adopted or proposed, certain of the rules that have been adopted or proposed are
subject to phase-in or transitional periods, and many of the rules that have been adopted are subject to interpretation or clarification.
The implications of the Dodd-Frank Act continue to depend to a large extent on the implementation of the legislation by the federal
banking regulators as well as how market practices and structures change in response to the requirements of the Dodd-Frank Act.
The Volcker Rule
. The Dodd-Frank Act
prohibits insured depository institutions and their holding companies from engaging in proprietary trading except in limited circumstances,
and prohibits them from owning equity interests in excess of 3% of Tier 1 capital in private equity and hedge funds (known as the
“Volcker Rule”). On December 10, 2013, five U.S. financial regulators adopted final rules (the “Final Rules”)
implementing the Volcker Rule. The Final Rules prohibit banking entities from (1) engaging in short-term proprietary trading for
their own accounts, and (2) having certain ownership interests in and relationships with hedge funds or private equity funds, which
are referred to as “covered funds.” The Final Rules are intended to provide greater clarity with respect to both the
extent of those primary prohibitions and of the related exemptions and exclusions. The Final Rules also require each regulated
entity to establish an internal compliance program that is consistent with the extent to which it engages in activities covered
by the Volcker Rule. Although the Final Rules provide some tiering of compliance and reporting obligations based on size, the fundamental
prohibitions of the Volcker Rule apply to banking entities of any size, including the Company and the Bank. The Final Rules were
effective on April 1, 2014, but the conformance period was extended from its statutory end date of July 21, 2014 until July 21,
2015. In addition, the Federal Reserve granted an extension until July 21, 2016 of the conformance period for banking entities
to conform investments in and relationships with covered funds that were in place prior to December 31, 2013, and announced its
intention to further extend this aspect of the conformance period until July 21, 2017. The Volcker Rule is not expected to have
a material impact on the Bank or the Company.
Safety and
Soundness Guidelines.
Under the Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”), as amended
by the Riegle Community Development and Regulatory Improvement Act of 1994, each federal banking agency was required to establish
safety and soundness standards for institutions under its authority. The interagency guidelines require depository institutions
to maintain internal controls and information systems and internal audit systems that are appropriate for the size, nature and
scope of the institution’s business. The guidelines also establish certain basic standards for loan documentation, credit
underwriting, interest rate risk exposure, asset growth and information security. The guidelines further provide that depository
institutions should maintain safeguards to prevent the payment of compensation, fees and benefits that are excessive or that could
lead to material financial loss, and should take into account factors such as comparable compensation practices at comparable institutions.
If the appropriate federal banking agency determines that a depository institution is not in compliance with the safety and soundness
guidelines, it may require the institution to submit an acceptable plan to achieve compliance with the guidelines. A depository
institution must submit an acceptable compliance plan to its primary federal regulator within 30 days of receipt of a request for
such a plan. Failure to submit or implement a compliance plan may subject the institution to regulatory sanctions. Management believes
that the Bank meets the standards adopted in the interagency guidelines
.
Capital Requirements
. The Company and
the Bank are subject to various regulatory capital requirements administered by federal and state regulators. Failure to meet minimum
capital requirements could result in certain mandatory and possible additional discretionary actions by regulators that, if undertaken,
could have a material adverse effect on the financial condition of the Company and the Bank. Under capital adequacy guidelines
and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that
involve quantitative measures of their assets, liabilities, and certain off-balance sheet items as calculated under regulatory
accounting policies. Capital amounts and classifications are also subject to judgments by the regulators regarding qualitative
components, risk weightings, and other factors.
In 2013, the Federal Reserve Board approved
and published the final Basel III Capital Rules establishing a new comprehensive capital framework for U.S. banking organizations.
The rules implemented the Basel Committee’s December 2010 framework (“Basel III”) for strengthening international
capital standards as well as certain provisions of the Dodd-Frank Act. The Basel III Capital Rules, among other things, (i) introduced
a new capital measure called “Common Equity Tier 1” (“CET1”), (ii) specified that Tier 1 capital consists
of CET1 and “Additional Tier 1 capital” instruments meeting specified requirements, (iii) defined CET1 narrowly by
requiring that most deductions/adjustments to regulatory capital measures be made to CET1 and not to the other components of capital
and (iv) expanded the scope of the deductions from and adjustments to capital as compared to existing regulations. The Basel III
Capital Rules were effective for the Bank on January 1, 2015 (subject to a phase-in period for certain components). CET1 capital
for the Bank consists of common stock, related paid-in capital, and retained earnings. In connection with the adoption of the Basel
III Capital Rules, we elected to opt-out of the requirement to include most components of accumulated other comprehensive income
in CET1. CET1 for the Bank is reduced by goodwill and other intangible assets, net of associated deferred tax liabilities and subject
to transition provisions.
Basel III limits
capital distributions and certain discretionary bonus payments if the banking organization does not hold a “capital conservation
buffer” consisting of 2.50% of CET1 capital, Tier 1 capital and total capital to risk-weighted assets in addition to the
amount necessary to meet minimum risk-based capital requirements. The capital conservation buffer will be phased in beginning January
1, 2016, at 0.625% of risk-weighted assets, increasing each year until fully implemented at 2.50% on January 1, 2019. When fully
phased in on January 1, 2019, Basel III will require (i) a minimum ratio of CET1 capital to risk-weighted assets of at least 4.50%,
plus a 2.50% capital conservation buffer, (ii) a minimum ratio of Tier 1 capital to risk-weighted assets of at least 6.00%, plus
the capital conservation buffer, (iii) a minimum ratio of total capital to risk-weighted assets of at least 8.00%, plus the 2.50%
capital conservation buffer and (iv) a minimum leverage ratio of 4.00%. The Bank continues to be well-capitalized under the Basel
III rules as of the date of this report. See Note 15 of Notes to Consolidated Financial Statements for additional information.
The FDIC joined in the Basel III standards
and issued an “interim final rule” applicable to the Bank that is identical in substance to the final rules issued
by the Federal Reserve. The Bank was required to comply with the interim final rule beginning on January 1, 2015, subject to a
transition period for several aspects of the interim final rule, including the capital conservation buffer and the regulatory capital
adjustments and deductions.
Compliance by the Company and the Bank with
the new Basel III capital standards has not materially affected their respective operations. Based on modeling of the Basel III
requirements, the Bank does not anticipate the implementation of the new Basel III standards to have a significant impact on the
level of its regulatory capital ratios.
Prompt Corrective
Regulatory Action.
Under FDICIA, federal banking regulators are required to take prompt corrective action if an insured depository
institution fails to satisfy the minimum capital requirements discussed above, including a leverage limit, a risk-based capital
requirement, a common equity Tier 1 capital requirement, and any other measure deemed appropriate by the federal banking regulators
for measuring capital adequacy of an insured depository institution. All institutions, regardless of their capital levels, are
restricted from making any capital distribution or paying any management fees if the institution would thereafter fail to satisfy
the minimum levels for any of its capital requirements. An institution that fails to meet the minimum level for any relevant capital
measure (an “undercapitalized institution”) may be: (i) subject to increased monitoring by the appropriate federal
banking regulator; (ii) required to submit an acceptable capital restoration plan within 45 days; (iii) subject to asset growth
limits; and (iv) required to obtain prior regulatory approval for acquisitions, branching and new lines of businesses. The capital
restoration plan must include a guarantee by the institution’s holding company that the institution will comply with the
plan until it has been adequately capitalized on average for four consecutive quarters, under which the holding company would be
liable up to the lesser of 5% of the institution’s total assets or the amount necessary to bring the institution into capital
compliance as of the date it failed to comply with its capital restoration plan. A “significantly undercapitalized”
institution, or an undercapitalized institution that does not submit an acceptable capital restoration plan, may be subject to
regulatory demands for recapitalization, broader application of restrictions on transactions with affiliates, limitations on interest
rates paid on deposits, asset growth and other activities, possible replacement of directors and officers, and restrictions on
capital distributions by any bank holding company controlling the institution. Any company controlling the institution may also
be required to divest the institution or the institution could be required to divest subsidiaries. The senior executive officers
of a significantly undercapitalized institution may not receive bonuses or increases in compensation without prior approval and
the institution is prohibited from making payments of principal or interest on its subordinated debt. In their discretion, the
federal banking regulators may also impose the foregoing sanctions on an undercapitalized institution if the regulators determine
that such actions are necessary to carry out the purposes of the prompt corrective action provisions. If an institution’s
ratio of tangible capital to total assets falls below the “critical capital level” established by the appropriate federal
banking regulator, the institution will be subject to conservatorship or receivership within specified time periods
.
Under the implementing
regulations, federal banking regulators including the FDIC, generally measure an institution’s capital adequacy on the basis
of its total risk-based capital ratio (the ratio of its total capital to risk-weighted assets), Tier 1 risk-based capital ratio
(the ratio of its core capital to risk-weighted assets) and leverage ratio (the ratio of its core capital to adjusted total assets).
See Note 15 of the Notes to Consolidated Financial Statements and Management’s Discussion and Analysis of Financial Condition
and Results of Operation for additional information
.
The following
table shows the Bank’s actual capital ratios and the required capital ratios for the various prompt corrective action categories
as of December 31, 2015:
Capital Requirements as of December 31, 2015
|
|
Actual
|
|
|
Well
Capitalized
|
|
Adequately
Capitalized
|
|
Undercapitalized
|
|
Significantly
Undercapitalized
|
Total risk-based capital ratio
|
|
|
13.3
|
%
|
|
10.0% or more
|
|
8.0% or more
|
|
Less than 8.0%
|
|
Less than 6.0%
|
Tier 1 risk-based capital ratio
|
|
|
12.1
|
%
|
|
8.0% or more
|
|
6.0% or more
|
|
Less than 6.0%
|
|
Less than 4.0%
|
Leverage ratio
|
|
|
8.7
|
%
|
|
5.0% or more
|
|
4.0% or more
|
|
Less than 4.0%
|
|
Less than 3.0%
|
Common equity Tier 1 risk-based capital ratio
|
|
|
12.1
|
%
|
|
6.5% or more
|
|
4.5% or more
|
|
Less than 4.5%
|
|
Less than 4.0%
|
A “critically undercapitalized”
institution is defined as one that has a ratio of “tangible equity” to total assets of less than 2.0%. Tangible equity
is defined as Tier 1 capital plus non-Tier 1 perpetual preferred stock. The FDIC may reclassify a well-capitalized institution
as adequately capitalized and may require an adequately capitalized or undercapitalized institution to comply with supervisory
actions applicable to institutions in the next lower capital category (but may not reclassify a significantly undercapitalized
institution as critically undercapitalized) if the FDIC determines, after notice and an opportunity for a hearing, that the institution
is in an unsafe or unsound condition or that the institution has received and not corrected a less-than-satisfactory rating for
any regulatory rating category.
North Carolina Capital Requirements and
Regulatory Action.
Under North Carolina banking law, a bank’s “required capital” is equal to at least the
amount required for the bank to be considered “adequately capitalized” under the federal regulatory capital standards
described above. “Inadequate capital” is defined as an amount of capital equal to at least 75% but less than 100% of
required capital. “Insufficient capital” is defined as an amount of capital less than 75% of required capital.
The Commissioner is empowered to take regulatory
action if a bank’s capital falls below the required capital level. If the Commissioner determines that a bank has “inadequate
capital” or “insufficient capital,” the Commissioner may order the bank to take corrective action. If the Commissioner
determines that that a bank has insufficient capital and is conducting business in an unsafe or unsound manner or in a fashion
that threatens the financial integrity of the bank, the Commissioner may serve a notice of charges and show-cause order on the
bank and, if after a hearing, he determines that supervisory control of the bank is necessary to protect the bank’s customers,
creditors, or the general public, the Commissioner may take supervisory control of the bank. The Commissioner may also take custody
of the books and records of a bank and appoint a receiver if the bank’s capital is impaired such that the likely realizable
value of the bank’s assets is insufficient to pay and satisfy the claims of its depositors and creditors.
Community
Reinvestment Act.
The Bank, like other financial institutions, is subject to the Community Reinvestment Act (“CRA”).
The purpose of the CRA is to encourage financial institutions to help meet the credit needs of their entire communities, including
the needs of low-and moderate-income neighborhoods. The federal banking agencies have implemented an evaluation system that rates
an institution based on its actual performance in meeting community credit needs. Under these regulations, an institution is first
evaluated and rated under three categories: a lending test, an investment test and a service test. For each of these three tests,
the institution is given a rating of either “outstanding,” “high satisfactory,” “low satisfactory,”
“needs to improve,” or “substantial non-compliance.” A set of criteria for each rating has been developed
and is included in the regulation. If an institution disagrees with a particular rating, the institution has the burden of rebutting
the presumption by clearly establishing that the quantitative measures do not accurately present its actual performance, or that
demographics, competitive conditions or economic or legal limitations peculiar to its service area should be considered. The ratings
received under the three tests will be used to determine the overall composite CRA rating. The composite ratings currently given
are: “outstanding,” “satisfactory,” “needs to improve” or “substantial non-compliance.
”
The Bank’s CRA rating would be a factor to be considered by the FRB and the FDIC in considering
applications submitted by the Bank to acquire branches or to acquire or combine with other financial institutions and take other
actions and, if such rating was less than “satisfactory,” could result in the denial of such applications. During the
Bank’s last compliance examination dated June 22, 2015, the Bank received a “satisfactory” rating with respect
to CRA compliance
.
Federal Home Loan Bank System.
The FHLB
System consists of 12 district FHLBs subject to supervision and regulation by the Federal Housing Finance Agency (“FHFA”).
The FHLBs provide a central credit facility primarily for member institutions. As a member of the FHLB of Atlanta, the Bank is
required to acquire and hold shares of capital stock in the FHLB of Atlanta. The Bank was in compliance with this requirement with
investment in FHLB of Atlanta stock of $2,369,300 at December 31, 2015. The FHLB of Atlanta serves as a reserve or central bank
for its member institutions within its assigned district. It is funded primarily from proceeds derived from the sale of consolidated
obligations of the FHLB System. It offers advances to members in accordance with policies and procedures established by the FHFA
and the Board of Directors of the FHLB of Atlanta. Common uses for long-term advances are to fund fixed-rate loans and securities,
to manage interest-rate risk and supplement retail deposits.
Reserves
. Pursuant to FRB regulations,
during 2015 the Bank maintained average daily reserves on net transaction accounts equal to 3% of the amount over $14.5 million
up to and including $103.6 million, plus 10% on amounts over $103.6 million. For 2016, the Bank must maintain average daily reserves
on net transaction accounts equal to 3% of the amount over $15.2 million up to and including $110.2 million, plus 10% on amounts
over $110.2 million. This percentage is subject to adjustment by the FRB. Because required reserves must be maintained in the form
of vault cash or in a Federal Reserve Bank account, the effect of the reserve requirement reduces the amount of the Bank’s
interest-earning assets. The Bank is also subject to the reserve requirements of North Carolina commercial banks. North Carolina
law requires state nonmember banks to maintain a reserve fund in an amount equal to the amount or ratio fixed by the Commissioner.
As of December 31, 2015, the Bank met all of its reserve requirements.
Insurance of Deposit Accounts.
The Bank’s
deposits are insured up to limits set by the Deposit Insurance Fund (the “DIF”) of the FDIC. The DIF was formed on
March 31, 2006 by the merger of the Bank Insurance Fund and the Savings Insurance Fund, in accordance with the Federal Deposit
Insurance Reform Act of 2005 (the “Reform Act”). The Reform Act established a range of 1.15% to 1.50% within which
the FDIC may set the Designated Reserve Ratio (the “reserve ratio”). The Dodd-Frank Act gave the FDIC greater discretion
to manage the DIF, raised the minimum DIF reserve ratio to 1.35%, and removed the upper limit of 1.50%.The FDIC’s current
DIF restoration plan is designed to ensure that the fund reaches 1.35% by September 30, 2020, as required by the Dodd-Frank Act.
The FDIC also proposed a long-range plan for management of the DIF. As part of this plan, the FDIC adopted a final rule to set
the reserve ratio at 2.0%. In 2010, the Dodd-Frank Act permanently increased FDIC insurance coverage to $250,000 per depositor.
The FDIC imposes
a risk-based deposit insurance premium assessment on member institutions in order to maintain the DIF. This assessment system was
amended by the Reform Act and further amended by the Dodd-Frank Act. Under this system, as amended, the assessment rates for an
insured depository institution vary according to the level of risk incurred in its activities. To arrive at an assessment rate
for a banking institution, the FDIC places it in one of four risk categories determined by reference to its capital levels and
supervisory ratings. In addition, in the case of those institutions in the lowest risk category, the FDIC further determines its
assessment rate based on certain specified financial ratios or, if applicable, its long-term debt ratings. The assessment rate
schedule can change from time to time, at the discretion of the FDIC, subject to certain limits. The Dodd-Frank Act changed the
methodology for calculating deposit insurance assessments from the amount of an insured institution’s domestic deposits to
its total assets minus tangible capital. In 2011, the FDIC issued a new regulation implementing these revisions to the assessment
system
.
In addition to the assessment for deposit insurance,
insured institutions are required to make payments on bonds issued by the Financing Corporation (“FICO”), established
by the Competitive Equality Banking Act of 1987 to recapitalize the former Federal Savings & Loan Insurance Corporation (“FSLIC”)
deposit insurance fund. The Bank’s quarterly FICO payments during the year ended December 31, 2015 was 0.60 cents annually
per $100 of assessable deposits.
The FDIC has
authority to increase insurance assessments. A significant increase in insurance premiums would also increase the operating expenses
of the Bank. Management cannot predict what deposit insurance assessment rates will be in the future
.
Insurance
of deposits may be terminated by the FDIC upon a finding that an insured institution has engaged in unsafe or unsound practices,
is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition
imposed by the FDIC. As of the date of this report, management of the Bank is not aware of any practice, condition or violation
that might lead to termination of its FDIC deposit insurance
.
Liquidity
Requirements
. FDIC policy requires that banks maintain an average daily balance of liquid assets (cash, certain time deposits,
mortgage-backed securities, loans held for sale and specified United States government, state, or federal agency obligations) in
an amount which it deems adequate to protect the safety and soundness of the bank. The FDIC currently has no specific level which
it requires. The Bank maintains its liquidity position under policy guidelines based on liquid assets in relationship to deposits
and short-term borrowings. Based on its policy calculation guidelines, the Bank’s calculated liquidity ratio was 33.8% of
total deposits and short-term borrowings at December 31, 2015, which management believes is more than adequate to meet the Bank’s
current funding needs
.
Dividend Restrictions.
FDIC regulations
and North Carolina banking laws restrict the Bank from making any capital distributions if after making the distribution, the Bank’s
capital ratios would be below the level necessary to categorize the Bank as “adequately capitalized” under the FDIC’s
prompt corrective action regulations.
Limits on Loans to One Borrower.
The
Bank generally is subject to both federal banking regulations and North Carolina law regarding loans to any one borrower, including
related entities. Under applicable law, with certain limited exceptions, loans and extensions of credit to a single borrower outstanding
at one time shall not exceed 15% of the Bank’s unimpaired capital and surplus. An additional amount may be lent, equal to
10% of the Bank’s unimpaired capital and surplus, if such loans are secured by readily marketable collateral. Under these
limits, the Bank’s loans to one borrower were limited to $13.2 million at December 31, 2015. At that date, the Bank had no
lending relationships in excess of the loans-to-one-borrower limit. Notwithstanding the statutory loans-to-one-borrower limitations,
the Bank has a self-imposed loans-to-one-borrower limit, which currently is $9.0 million, and it has been exceeded from time to
time subject to advance approval by the Director’s Loan Committee; there were no borrowing relationships over that limit
during 2015. At December 31, 2015, the Bank’s largest lending relationship was $8.1 million, consisting of five commercial
construction loans, one residential real estate loan, and one home equity line of credit. All loans within this relationship were
current and performing in accordance with their contractual terms at December 31, 2015.
Transactions
with Related Parties.
Transactions between a state nonmember bank and any affiliate are subject to Sections 23A and 23B of
the Federal Reserve Act and FRB Regulation W. An affiliate of a state nonmember bank is any company or entity which controls, is
controlled by or is under common control with the state nonmember bank. In a holding company context, the parent holding company
of a state nonmember bank (such as the Company) and any companies which are controlled by such parent holding company are affiliates
of the state nonmember bank. Generally, Sections 23A and 23B (i) limit the extent to which an institution or its subsidiaries may
engage in “covered transactions” with any one affiliate to an amount equal to 10% of such institution’s capital
stock and surplus, and contain an aggregate limit on all such transactions with all affiliates to an amount equal to 20% of such
capital stock and surplus and (ii) require that all such transactions be on terms substantially the same, or at least as favorable,
to the institution or subsidiary as those provided to a non-affiliate. The term “covered transaction” includes the
making of loans, purchase of assets, issuance of a guarantee and similar other types of transactions
.
See
Note 24 of the Notes to Consolidated Financial Statements for additional information
.
Loans to Directors,
Executive Officers and Principal Stockholders.
State nonmember banks are subject to the restrictions contained in Section 22(h)
of the Federal Reserve Act and FRB Regulation O on loans to executive officers, directors and principal stockholders. Under Section
22(h), loans to a director, executive officer and to a greater than 10% stockholder of a state nonmember bank and certain affiliated
interests of such persons, may not exceed, together with all other outstanding loans to such person and affiliated interests, the
institution’s loans-to-one-borrower limit and all loans to such persons may not exceed the institution’s unimpaired
capital and unimpaired surplus. Section 22(h) also prohibits loans above amounts prescribed by the appropriate federal banking
agency to directors, executive officers and greater than 10% stockholders of a depository institution, and their respective affiliates,
unless such loan is approved in advance by a majority of the board of directors of the institution with any “interested”
director not participating in the voting. Regulation O prescribes the loan amount (which includes all other outstanding loans to
such person) as to which such prior board of directors approval is required as being the greater of $25,000 or 5% of capital and
surplus (or any loans aggregating $500,000 or more). Further, Section 22(h) requires that loans to directors, executive officers
and principal stockholders generally be made on terms substantially the same as offered in comparable transactions to other persons.
Section 22(h) also generally prohibits a depository institution from paying the overdrafts of any of its executive officers or
directors
.
State nonmember
banks are subject to the requirements and restrictions of Section 22(g) of the Federal Reserve Act on loans to executive officers.
Section 22(g) of the Federal Reserve Act requires approval by a depository institution’s board of directors for such extensions
of credit, and imposes reporting requirements and additional restrictions on the type, amount and terms of credits to such officers.
Section 106 of the Bank Holding Company Act of 1956, as amended (“BHCA”) prohibits extensions of credit to executive
officers, directors, and greater than 10% stockholders of a depository institution by any other institution which has a correspondent
banking relationship with the institution, unless such extension of credit is on substantially the same terms as those prevailing
at the time for comparable transactions with other persons and does not involve more than the normal risk of repayment or present
other unfavorable features
.
Restrictions
on Certain Activities
. State chartered nonmember banks with deposits insured by the FDIC are generally prohibited from engaging
in equity investments that are not permissible for a national bank. The foregoing limitation, however, does not prohibit FDIC-insured
state banks from acquiring or retaining an equity investment in a subsidiary in which the bank is a majority owner. State chartered
banks are also prohibited from engaging as a principal in any type of activity that is not permissible for a national bank and,
subject to certain exceptions, subsidiaries of state chartered FDIC-insured banks may not engage as a principal in any type of
activity that is not permissible for a subsidiary of a national bank, unless in either case, the FDIC determines that the activity
would pose no significant risk to the DIF and the bank is, and continues to be, in compliance with applicable capital standards
.
USA Patriot
Act.
The USA Patriot Act (“Patriot Act”) is intended to strengthen the ability of U.S. law enforcement and the
intelligence community to work cohesively to combat terrorism on a variety of fronts. The impact of the Patriot Act on financial
institutions of all kinds is significant and wide ranging. The Patriot Act contains sweeping anti-money laundering and financial
transparency laws and imposes various regulations including standards for verifying client identification at account opening, and
rules to promote cooperation among financial institutions, regulators and law enforcement entities in identifying parties that
may be involved in terrorism or money laundering. Failure of a financial institution to maintain and implement adequate programs
to combat money laundering and terrorist financing, or to comply with all of the relevant laws or regulations, could result in
legal consequences for the institution
.
Office of Foreign Assets Control Regulation
.
The United States has imposed economic sanctions affecting transactions with designated foreign countries, nationals and others.
These are typically known as “OFAC” rules based on their administration by the U.S. Treasury’s Office of Foreign
Assets Control (OFAC). OFAC administered sanctions targeting countries take many different forms. Generally, they contain one or
more of the following elements: (i) restrictions on trade with or investment in a sanctioned country, including prohibitions against
direct or indirect imports from and exports to a sanctioned country and prohibitions on “U.S. persons” engaging in
financial transactions relating to making investments in, or providing investment-related advice or assistance to a sanctioned
country; and (ii) blocking of assets in which the government or specially designated nationals of the sanctioned country have an
interest, by prohibiting transfers of property subject to U.S. jurisdiction (including property in the possession or control of
U.S. persons). Blocked assets (e.g., property and bank deposits) cannot be paid out, withdrawn, set off or transferred in any manner
without a license from OFAC. Failure of a financial institution to comply with these sanctions could result in legal consequences
for the institution.
Gramm-Leach-Bliley
Act.
The Gramm-Leach-Bliley Act (“GLBA”) (the Financial Services Modernization Act of 1999) expanded certain activities
in which banks and bank holding companies may engage. The GLBA made three fundamental changes: repealed key provisions of the Glass-Steagall
Act to permit commercial banks to affiliate with investment banks; modified the BHCA to permit companies that own commercial banks
to engage in a broader range of financial activities; and allowed subsidiaries of banks to engage in a broad range of financial
activities that are not permitted for banks themselves. The GLBA also contains a range of supervisory requirements and activities,
including requirements for safeguarding the privacy of customer information
.
Privacy
. In addition to expanding the
activities in which banks and bank holding companies may engage, the GLBA imposes requirements on financial institutions with respect
to customer privacy. The GLBA generally prohibits disclosure of customer information to non-affiliated third parties unless the
customer has been given the opportunity to object and has not objected to such disclosure. Financial institutions are further required
to disclose their privacy policies to customers annually. Financial institutions are required to comply with state law if it is
more protective of customer privacy than the GLBA. The GLBA contains other provisions, including a prohibition against ATM surcharges
unless the customer has first been provided notice of the imposition and amount of the fee.
Ability-to-Repay and Qualified Mortgage
Rule.
Pursuant to the Dodd-Frank Act, the Consumer Financial Protection Bureau (“CFPB”) issued a final rule
effective on January 10, 2014, amending Regulation Z under the Truth in Lending Act, requiring mortgage lenders to make a reasonable
and good faith determination based on verified and documented information that a consumer applying for a mortgage loan has a reasonable
ability to repay the loan according to its terms. Mortgage lenders are required to determine consumers’ ability to repay
in one of two ways. The first alternative requires the mortgage lender to consider the following eight underwriting factors when
making the credit decision: (1) current or reasonably expected income or assets; (2) current employment status; (3) the monthly
payment on the covered transaction; (4) the monthly payment on any simultaneous loan; (5) the monthly payment for mortgage-related
obligations; (6) current debt obligations, alimony and child support; (7) the monthly debt-to-income ratio or residual income;
and (8) credit history. Alternatively, the mortgage lender can originate “qualified mortgages,” which are entitled
to a presumption that the creditor making the loan satisfied the ability-to-repay requirements. In general, a qualified mortgage
is a mortgage loan without negative amortization, interest-only payments, balloon payments, or terms exceeding 30 years. In addition,
to be a qualified mortgage, the points and fees paid by a consumer cannot exceed 3% of the total loan amount.
Consumer Laws and Regulations.
The
Bank is also subject to other federal and state consumer laws and regulations that are designed to protect consumers in transactions
with banks. While the list set forth below is not exhaustive, these laws and regulations include the Truth in Lending Act, the
Truth in Savings Act, the Electronic Funds Transfer Act, the Expedited Funds Availability Act, the Check Clearing for the 21
st
Century Act, the Fair Credit Reporting Act, the Equal Credit Opportunity Act, the Fair Housing Act, the Home Mortgage Disclosure
Act, the Fair and Accurate Transactions Act, the Mortgage Disclosure Improvement Act and the Real Estate Settlement Procedures
Act, among others. These laws and regulations mandate certain disclosure requirements and regulate the manner in which financial
institutions must deal with customers when taking deposits or making loans to customers. The Bank must comply with the applicable
provisions of these consumer protection laws and regulations as part of its ongoing customer relations.
We cannot predict whether or not there will
be additional proposed laws or reforms that would affect the U.S. financial system or financial institutions, whether or when
such changes may be adopted, how such changes may be interpreted and enforced, or how such changes may affect us.
Government Monetary Policies and Economic
Controls.
The Bank’s earnings and growth, as well as the earnings and growth of the banking industry, are affected by
the credit policies of monetary authorities, including the Federal Reserve. An important function of the Federal Reserve is to
regulate the national supply of bank credit in order to combat recession and curb inflationary pressures. Among the instruments
of monetary policy used by the Federal Reserve to implement these objectives are open market operations in U.S. government securities,
changes in reserve requirements against bank deposits, and changes in the Federal Reserve discount rate. These tools are used
in varying combinations to influence the overall growth of bank loans, investments, and deposits, and may also affect interest
rates charged on loans or paid for deposits. The monetary policies of the Federal Reserve have had a significant effect on the
operating results of commercial banks in the past and are expected to continue to have such an effect in the future.
In light of changing conditions in the national
economy and in money markets, as well as the effect of credit policies by monetary and fiscal authorities, including the Federal
Reserve, it is difficult to predict the impact of possible future changes in interest rates, deposit levels, and loan demand, or
their effect on the Bank’s business and earnings or on the financial condition of the Bank’s customers.
Regulation of the Company
General
. The Company, as the sole shareholder
of the Bank, is a bank holding company registered with the FRB. Bank holding companies are subject to comprehensive regulation
by the FRB under the BHCA, and the regulations of the FRB. As a bank holding company, the Company is required to file annual reports
and such additional information with the FRB as it may require, and is subject to regular examinations by the FRB. The FRB also
has extensive enforcement authority over bank holding companies, including, among other things, the ability to assess civil money
penalties, to issue cease
-
and
-
desist or removal orders and to
require that a holding company divest subsidiaries, including its bank subsidiaries. In general, enforcement actions may be initiated
for violations of law and regulations and unsafe or unsound practices.
Under the BHCA, a bank holding company must
obtain FRB approval before: (i) acquiring, directly or indirectly, ownership or control of any voting shares of another bank or
bank holding company if, after such acquisition, it would own or control more than 5% of such shares (unless it already owns or
controls the majority of such shares); (ii) acquiring all or substantially all of the assets of another bank or bank holding company;
or (iii) merging or consolidating with another bank holding company. In evaluating applications for acquisitions, the FRB considers
such things as the financial condition and management of the target and the acquirer, the convenience and needs of the communities
involved, CRA ratings and competitive factors.
The BHCA also
prohibits a bank holding company, with certain exceptions, from acquiring direct or indirect ownership or control of more than
5% of the voting shares of any company which is not a bank or bank holding company, or from engaging directly or indirectly in
activities other than those of banking, managing or controlling banks, or providing services for its subsidiaries. The principal
exceptions to these prohibitions involve certain nonbank activities which, by statute or by FRB regulation or order, have been
identified as activities closely related to the business of banking or managing or controlling banks. The list of activities permitted
by the FRB includes, among other things, operating a savings institution, mortgage company, finance company, credit card company
or factoring company; performing certain data processing operations; providing certain investment and financial advice; underwriting
and acting as an insurance agent for certain types of credit-related insurance; leasing property on a full-payout, non-operating
basis; selling money orders, travelers’ checks and United States Savings Bonds; real estate and personal property appraising;
providing tax planning and preparation services; and, subject to certain limitations, providing securities brokerage services for
customers. The Company currently engages in some of these permitted activities through the Bank, but has no present plans to operate
a credit card company or factoring company, perform data processing operations, real estate and personal property appraising or
provide tax planning and tax preparation services
.
The GLBA authorized bank holding companies
that meet specified qualitative standards to opt to become a “financial holding company.” A financial holding company
may engage in activities that are permissible for bank holding companies in addition to activities deemed to be financial in nature
or incidental to financial activities. These include insurance underwriting and investment banking. As of December 31, 2015, the
Company has not opted to become a financial holding company.
The FRB has adopted
guidelines regarding the capital adequacy of bank holding companies, which require bank holding companies to maintain specified
minimum ratios of capital to total assets and capital to risk-weighted assets. See “Depository Institution Regulation - Capital
Requirements
.”
Acquisition
of Bank Holding Companies and Banks.
Under the BHCA, any company must obtain FRB approval prior to acquiring control of the
Company or the Bank. Pursuant to the BHCA, “control” is defined as ownership of more than 25% of any class of voting
securities of the Company or the Bank, the ability to control the election of a majority of directors, or the exercise of a controlling
influence over management or policies of the Company or the Bank. The Change in Bank Control Act (“CBCA”) and the related
FRB regulations require any person or persons acting in concert to file a written notice with the FRB before such person or persons
may acquire control of the Company or the Bank. The CBCA defines “control” as the power, directly or indirectly, to
vote 25% or more of any voting securities or to direct the management or policies of a bank holding company or an insured bank;
however, a rebuttable presumption of control exists upon the acquisition of power to vote 10% or more of a class of voting securities
for a company whose securities are registered under the Securities Exchange Act of 1934
.
Interstate Banking.
Federal law allows
the FRB to approve an application of an adequately capitalized and adequately managed bank holding company to acquire control of,
or acquire all or substantially all of the assets of, a bank located in a state other than the holding company’s home state,
without regard to whether the transaction is prohibited by the laws of any state. The FRB may not approve the acquisition of a
bank that has not been in existence for a minimum of five years without regard for a longer minimum period specified by the law
of the host state. The FRB is prohibited from approving an application if the applicant (and its depository institution affiliates)
controls or would control (i) more than 10% of the insured deposits in the United States, or (ii) 30% or more of the deposits in
the target bank’s home state or in any state in which the target bank maintains a branch. Federal law does not limit a state’s
authority to restrict the percentage of total insured deposits in the state which may be held or controlled by a bank or bank holding
company to the extent such limitation does not discriminate against out-of-state banks or bank holding companies. Individual states
may also waive the 30% state-wide concentration limit.
The federal banking agencies are authorized
to approve interstate merger transactions without regard to whether such transaction is prohibited by the laws of any state, unless
the home state of one of the banks has adopted a law opting out of the interstate mergers. Interstate acquisitions of branches
are permitted only if laws of the state in which the branch is located permits such acquisitions. Interstate mergers and branch
acquisitions are subject to the nationwide and statewide insured deposit concentration amounts described above. North Carolina
has enacted legislation permitting interstate banking acquisitions.
The Dodd-Frank Act allows national and state
banks to establish branches in any state if that state would permit the establishment of the branch by a state bank chartered in
that state.
Dividends.
The FRB has issued a joint interagency statement on the payment of cash dividends by banking organizations, which expresses the
FRB’s view that in setting dividend levels, a banking organization should consider its ongoing earnings capacity, the adequacy
of its loan loss allowance, and the overall effect that a dividend payout would have on its cost of funding, its capital position,
and, consequently, its ability to serve the expected needs of creditworthy borrowers. Banking organizations should not maintain
a level of cash dividends that is inconsistent with the organization's capital position, that could weaken the organization's overall
financial health, or that could impair its ability to meet the needs of creditworthy borrowers. Federal and state banking regulators
will continue to review the dividend policies of individual banking organizations and will take action when dividend policies are
found to be inconsistent with sound capital and lending policies
.
The FRB has issued
a supervisory letter (SR 09-4) to provide greater clarity regarding payment of dividends. The letter largely reiterates FRB supervisory
policies and guidance, and heightens expectations that a bank holding company will inform and consult with the FRB supervisory
staff sufficiently in advance of (i) declaring and paying a dividend that could raise safety and soundness concerns (i.e. declaring
and paying a dividend that exceeds earnings for the period which the dividend is being paid); (ii) redeeming or repurchasing regulatory
capital instruments when the bank holding company is experiencing financial weakness; or (iii) redeeming or repurchasing common
stock or perpetual preferred stock that could result in a net reduction as of the end of a quarter in the amount of such equity
instruments outstanding compared with the beginning of the quarter in which the redemption or repurchase occurred
.
Furthermore,
under the prompt corrective action regulations adopted by the FRB, the FRB may prohibit a bank holding company from paying any
dividends if the holding company’s bank subsidiary is classified as “undercapitalized”. See “Depository
Institution Regulation - Prompt Corrective Regulatory Action
.”
Bank holding
companies are required to give the FRB prior written notice of any purchase or redemption of their outstanding equity securities
if the gross consideration for the purchase or redemption, when combined with the net consideration paid for all such purchases
or redemptions during the preceding 12 months, is equal to 10% or more of the their consolidated net worth. The FRB may disapprove
such a purchase or redemption if it determines that the proposal would constitute an unsafe or unsound practice or would violate
any law, regulation, FRB order, directive, or any condition imposed by, or written agreement with the FRB. Bank holding companies
whose capital ratios exceeded the thresholds for well capitalized banks on a consolidated basis are exempt from the foregoing requirement
if they were given satisfactory ratings in their most recent regulatory examination and are not the subject of any unresolved supervisory
issues
.
Incentive
Compensation Policies and Restrictions.
In 2010, the federal banking agencies issued guidance which applies to all banking
organizations supervised by the agencies. Pursuant to the guidance, to be consistent with safety and soundness principles, a banking
organization’s incentive compensation arrangements should: (1) provide employees with incentives that appropriately balance
risk and reward; (2) be compatible with effective controls and risk management; and (3) be supported by strong corporate governance
including active and effective oversight by the banking organization’s board of directors. Monitoring methods and processes
used by a banking organization should be commensurate with the size and complexity of the organization and its use of incentive
compensation
.
In addition,
in 2011, the federal banking agencies, along with the Federal Housing Finance Agency, and the Securities and Exchange Commission,
released a proposed rule intended to ensure that regulated financial institutions design their incentive compensation arrangements
to account for risk. Specifically, the proposed rule would require compensation practices of the Company to be consistent with
the following principles: (1) compensation arrangements appropriately balance risk and financial reward; (2) such arrangements
are compatible with effective controls and risk management; and (3) such arrangements are supported by strong corporate governance.
In addition, financial institutions with $1 billion or more in assets would be required to have policies and procedures to ensure
compliance with the rule and would be required to submit annual reports to their primary federal regulator. The comment period
has closed and a final rule has not yet been published
.
Taxation –
General.
The Company files its federal and state income tax returns based on a fiscal year ending December 31
.
Federal Income
Taxation.
The Company reports income taxes in accordance with financial accounting standards which require the recognition
of deferred tax assets and liabilities for the temporary difference between financial statement and tax basis of the Company's
assets and liabilities using the enacted tax rates in effect in the years in which the differences are expected to reverse. Valuation
allowances are provided if based upon the weight of available evidence, it is more likely than not that some or all of the deferred
tax assets will not be realized. The Company has assessed if it had any significant uncertain tax positions as of December 31,
2015 and determined there were none. Accordingly, no reserve for uncertain tax positions was recorded. The Company and the Bank
file a consolidated federal income tax return. The Company’s federal income tax returns are open for audit for the years
ended after December 31, 2012
.
State Income Taxation.
Under North Carolina
law, the corporate income tax rate for the years ended December 31, 2015 and 2014 was 5.00% and 6.00%, respectively, of federal
taxable income as computed under the Internal Revenue Code, subject to certain state adjustments. North Carolina enacted tax reform
in 2013 for lowering the state’s corporate income tax rates. The state corporate income tax rate for 2014 was reduced from
6.9% to 6.0%; was reduced to 5.0% for 2015; is scheduled to be reduced to 4.0% for 2016; and may be reduced to 3.0% for 2017 if
certain revenue goals set by the Legislature are met.
An annual state franchise tax is imposed at
a rate of 0.15% applied to the greater of the institution’s (i) capital stock, surplus and undivided profits, (ii) investment
in tangible property in North Carolina or (iii) appraised valuation of tangible property in North Carolina. The Company and the
Bank file separate state income tax returns.
See Notes 1 and
14 of the Notes to Consolidated Financial Statements for additional information regarding taxation
.