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Table of Contents
 
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
 
FORM 10-Q
 
Quarterly Report Pursuant to Section 13 or 15(D) of the
Securities Exchange Act of 1934
 
For the Quarterly Period Ended June 30, 2002 Commission file number 333-49459
 
 
New South Bancshares, Inc.
(Exact name of registrant as specified in its charter)
 
 
Delaware
(State or other jurisdiction of
incorporation or organization)
  
63-1132716
(I.R.S. Employer Identification No.)
1900 Crestwood Boulevard
Birmingham, Alabama
(Address of Principal Executive Offices)
  
35210
(Zip Code)
 
(205) 951-4000
(Registrant’s telephone number, including area code)
 
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes  x  No  ¨.
 

Table of Contents
 
NEW SOUTH BANCSHARES, INC.
 
FORM 10-Q
INDEX
 
         
Page
Part I.    Financial Information
     
Item 1.
   
Financial Statements (Unaudited)
     
       
2
       
3
       
4
       
5
       
6
Item 2.
      
13
Part II.    Other Information
     
Item 1.
      
25
Item 4.
      
25
Item 5.
      
25
Item 6.
      
25
  
26
  
27
 

Table of Contents
 
NEW SOUTH BANCSHARES, INC.
 
CONSOLIDATED BALANCE SHEETS
 
    
June 30,
2002
     
December 31,
2001
  
    
(Unaudited)
     
(Audited)
  
    
(In thousands)
  
ASSETS
                  
Cash and due from banks
   
$
23,004
 
   
$
9,499
 
Federal funds sold and securities purchased under agreements to resell
   
 
20,000
 
   
 
—  
 
Interest-bearing deposits in other banks
   
 
2,673
 
   
 
16,138
 
Investment securities available for sale
   
 
275,112
 
   
 
302,608
 
Residual interest in loan securitizations
   
 
5,920
 
   
 
8,594
 
Loans available for sale
   
 
84,538
 
   
 
118,267
 
Loans, net of unearned income
   
 
922,824
 
   
 
789,238
 
Allowance for loan losses
   
 
(13,094
)
   
 
(12,613
)
    
  
Net Loans
   
 
909,730
 
   
 
776,625
 
Premises and equipment, net
   
 
7,794
 
   
 
7,959
 
Mortgage servicing rights, net
   
 
16,764
 
   
 
19,777
 
Servicing advances
   
 
11,962
 
   
 
17,160
 
Other assets
   
 
25,044
 
   
 
28,694
 
    
  
Total Assets
   
$
1,382,541
 
   
$
1,305,321
 
    
  
LIABILITIES AND SHAREHOLDERS’ EQUITY
                  
Deposits:
                  
Noninterest-bearing
   
$
67,841
 
   
$
65,057
 
Interest-bearing
   
 
883,336
 
   
 
808,000
 
    
  
Total Deposits
   
 
951,177
 
   
 
873,057
 
Federal funds purchased and securities sold under agreements to repurchase
   
 
183,055
 
   
 
196,749
 
Federal Home Loan Bank advances
   
 
125,025
 
   
 
120,025
 
Notes payable
   
 
5,339
 
   
 
10,295
 
Guaranteed preferred beneficial interests in the Company’s subordinated debentures
   
 
50,500
 
   
 
34,500
 
Accrued expenses, deferred revenue, and other liabilities
   
 
17,560
 
   
 
20,095
 
    
  
Total Liabilities
   
 
1,332,656
 
   
 
1,254,721
 
Shareholders’ Equity:
                  
Common stock of $1.00 par value (authorized: 1.5 million shares; issued and outstanding: 1,255,537.1 at June 30, 2002 and December 31, 2001)
   
 
1,256
 
   
 
1,256
 
Surplus
   
 
29,475
 
   
 
29,475
 
Retained earnings
   
 
31,535
 
   
 
30,962
 
Accumulated other comprehensive loss
   
 
(12,381
)
   
 
(11,093
)
    
  
Total Shareholders’ Equity
   
 
49,885
 
   
 
50,600
 
    
  
Total Liabilities and Shareholders’ Equity
   
$
1,382,541
 
   
$
1,305,321
 
    
  
 
See accompanying notes to consolidated financial statements

2

Table of Contents
 
NEW SOUTH BANCSHARES, INC.
 
CONSOLIDATED INCOME STATEMENTS
(Unaudited)
    
For the three months ended June 30,
    
2002
   
2001
    
(In thousands, except
per share data)
Interest Income:
              
Interest on securities available for sale
   
$
4,690
   
$
3,708
Interest on loans
   
 
19,177
   
 
16,765
Interest on other short-term investments
   
 
45
   
 
265
    
  
Total Interest Income
   
 
23,912
   
 
20,738
Interest Expense:
              
Interest on deposits
   
 
9,761
   
 
12,222
Interest on federal funds purchased and securities sold under agreements to repurchase
   
 
2,118
   
 
473
Interest on Federal Home Loan Bank advances
   
 
1,350
   
 
1,323
Interest on notes payable
   
 
147
   
 
229
Interest expense on guaranteed preferred beneficial interests in the Company's subordinated debentures
   
 
959
   
 
733
    
  
Total Interest Expense
   
 
14,335
   
 
14,980
Net Interest Income
   
 
9,577
   
 
5,758
Provision for loan losses
   
 
1,475
   
 
1,010
    
  
Net Interest Income After Provision for Loan Losses
   
 
8,102
   
 
4,748
Noninterest Income:
              
Loan administration income
   
 
2,074
   
 
3,362
Origination fees
   
 
3,159
   
 
3,197
Gain on sale of investment securities available for sale
   
 
77
   
 
—  
Gain on sale of loans and mortgage servicing rights
   
 
3,837
   
 
4,049
Other income
   
 
1,168
   
 
1,750
    
  
Total Noninterest Income
   
 
10,315
   
 
12,358
Noninterest Expense:
              
Salaries and benefits
   
 
9,303
   
 
8,639
Net occupancy and equipment expense
   
 
1,055
   
 
1,214
Other expense
   
 
4,939
   
 
4,605
    
  
Total Noninterest Expense
   
 
15,297
   
 
14,458
    
  
Income Before Income Taxes
   
 
3,120
   
 
2,648
Provision for income taxes
   
 
161
   
 
138
    
  
Net Income
   
$
2,959
   
$
2,510
    
  
Weighted average shares outstanding
   
 
1,256
   
 
1,256
Earnings per share
   
$
2.36
   
$
2.00
 
See accompanying notes to consolidated financial statements

3

Table of Contents
 
NEW SOUTH BANCSHARES, INC.
 
CONSOLIDATED INCOME STATEMENTS
(Unaudited)
 
    
For the six months ended
June 30,
    
2002
   
2001
    
(In thousands)
Interest Income:
              
Interest on securities available for sale
   
$
9,768
   
$
8,133
Interest on loans
   
 
37,197
   
 
37,790
Interest on other short-term investments
   
 
90
   
 
491
    
  
Total Interest Income
   
 
47,055
   
 
46,414
Interest Expense:
              
Interest on deposits
   
 
19,953
   
 
25,754
Interest on federal funds purchased and securities sold under agreements to repurchase
   
 
4,275
   
 
936
Interest on Federal Home Loan Bank advances
   
 
2,638
   
 
4,035
Interest on notes payable
   
 
339
   
 
477
Interest expense on guaranteed preferred beneficial interests in the Company’s subordinated debentures
   
 
1,707
   
 
1,466
    
  
Total Interest Expense
   
 
28,912
   
 
32,668
Net Interest Income
   
 
18,143
   
 
13,746
Provision for Loan Losses
   
 
3,086
   
 
2,813
    
  
Net Interest Income After Provision for Loan Losses
   
 
15,057
   
 
10,933
Noninterest Income:
              
Loan administration income
   
 
4,489
   
 
5,902
Origination fees
   
 
5,913
   
 
5,653
Gain on sale of investment securities available for sale
   
 
784
   
 
—  
Gain on sale of loans and mortgage servicing rights
   
 
7,955
   
 
9,930
Other income
   
 
2,290
   
 
2,773
    
  
Total Noninterest Income
   
 
21,431
   
 
24,258
Noninterest Expense:
              
Salaries and benefits
   
 
18,579
   
 
16,997
Net occupancy and equipment expense
   
 
2,025
   
 
2,333
Other expense
   
 
9,725
   
 
8,812
    
  
Total Noninterest Expense
   
 
30,329
   
 
28,142
    
  
Income Before Provision for Income Taxes and Cumulative Effect of a Change in Accounting Principle
   
 
6,159
   
 
7,049
Provision for Income Taxes
   
 
313
   
 
359
    
  
Income Before Cumulative Effect of a Change in Accounting Principle
   
 
5,846
   
 
6,690
Cumulative Effect of a Change in Accounting for Derivative Instruments and Hedging Activities, Net of Tax Benefit of $72
   
 
—  
   
 
1,124
    
  
Net Income
   
$
5,846
   
$
5,566
    
  
Weighted average shares outstanding
   
 
1,256
   
 
1,256
Earnings per share
              
Before Cumulative Effect of a Change in Accounting for Derivative Instruments and Hedging Activities
   
$
4.65
   
$
5.32
    
  
Cumulative Effect of a Change in Accounting for Derivative Instruments and Hedging Activities
   
$
—  
   
$
0.89
    
  
Net Income
   
$
4.65
   
$
4.43
    
  
 
See accompanying notes to consolidated financial statements

4

Table of Contents
 
NEW SOUTH BANCSHARES, INC.
 
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
 
    
For the six months ended June 30,
  
    
2002
     
2001
  
    
(In thousands)
  
Operating Activities:
                  
Net income
   
$
5,846
 
   
$
5,566
 
Adjustments to reconcile net income to net cash used in operating activities:
                  
Accretion of discounts and fees
   
 
(366
)
   
 
(968
)
Provision for loan losses
   
 
3,086
 
   
 
2,813
 
Depreciation and amortization
   
 
765
 
   
 
984
 
Amortization and impairment of mortgage servicing rights
   
 
2,664
 
   
 
1,814
 
Origination of loans available for sale
   
 
(365,467
)
   
 
(702,446
)
Proceeds from the sale of loans available for sale and servicing rights
   
 
442,085
 
   
 
714,209
 
Gain on sale of investment securities available for sale
   
 
(784
)
   
 
—  
 
Gain on sale of premises and equipment
   
 
—  
 
   
 
(18
)
Gain on sale of loans available for sale and mortgage servicing rights
   
 
(7,955
)
   
 
(9,930
)
(Increase) decrease in other assets
   
 
6,724
 
   
 
(9,507
)
Decrease in accrued expenses, deferred revenue, and other liabilities
   
 
(2,324
)
   
 
(4,142
)
    
  
Net Cash Provided by (Used in) Operating Activities
   
 
84,274
 
   
 
(1,625
)
Investing Activities:
                  
Net (increase) decrease in interest-bearing deposits in other banks
   
 
13,465
 
   
 
(36,200
)
Net increase in federal funds sold and securities purchased under agreements to resell
   
 
(20,000
)
   
 
(4,150
)
Proceeds from sales of investment securities available for sale
   
 
41,291
 
   
 
—  
 
Proceeds from maturities and calls of investment securities available for sale
   
 
28,137
 
   
 
15,515
 
Purchases of investment securities available for sale
   
 
(63,235
)
   
 
(88,473
)
Net (increase) decrease in loan portfolio
   
 
(145,406
)
   
 
185,471
 
Purchases of premises and equipment
   
 
(641
)
   
 
(562
)
Proceeds from sale of premises and equipment
   
 
41
 
   
 
60
 
Net (investment in) proceeds from sale of real estate owned
   
 
2,473
 
   
 
(51
)
    
  
Net Cash Provided by (Used in) Investing Activities
   
 
(143,875
)
   
 
71,610
 
Financing Activities:
                  
Net increase (decrease) in noninterest-bearing deposits
   
 
2,784
 
   
 
(4,943
)
Net increase (decrease) in interest-bearing deposits
   
 
76,094
 
   
 
(44,309
)
Net increase (decrease) in federal funds purchased and securities
                  
sold under agreements to repurchase
   
 
(16,543
)
   
 
30,010
 
Net decrease in notes payable
   
 
(4,956
)
   
 
(1,271
)
Net increase (decrease) of Federal Home Loan Bank Advances
   
 
5,000
 
   
 
(38,389
)
Proceeds from the issuance of guaranteed preferred beneficial interests in the Company's subordinated debentures
   
 
16,000
 
   
 
—  
 
Dividends paid
   
 
(5,273
)
   
 
(8,600
)
    
  
Net Cash Provided by (Used in) Financing Activities
   
 
73,106
 
   
 
(67,502
)
    
  
Net increase in cash and cash equivalents
   
 
13,505
 
   
 
2,483
 
Cash and cash equivalents at beginning of period
   
 
9,499
 
   
 
14,286
 
    
  
Cash and cash equivalents at end of period
   
$
23,004
 
   
$
16,769
 
    
  
 
See accompanying notes to consolidated financial statements.

5

Table of Contents
 
NEW SOUTH BANCSHARES, INC.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Six Months Ended June 30, 2002
 
1.    General
 
The consolidated financial statements have been prepared using generally accepted accounting principles. The accompanying interim financial statements are unaudited; however, in the opinion of management, all adjustments necessary for the fair presentation of the consolidated financial statements have been included, and are of a normal recurring nature. Certain amounts in the prior year financial statements have been reclassified to conform with the 2002 presentation. These reclassifications had no effect on net income and were not material to the financial statements. These financial statements should be read in conjunction with the consolidated financial statements and notes thereto contained in the Annual Report on Form 10-K for the year ended December 31, 2001.
 
New South Bancshares, Inc. (“Bancshares” or the “Company”) is a unitary thrift holding company formed in 1994. The Company has three wholly owned subsidiaries, New South Federal Savings Bank (“New South” or the “Bank”), Collateral Agency of Texas, Inc., and New South Management Services, LLC. New South has three subsidiaries, Avondale Funding.com, inc. (“Avondale”), New South Agency, Inc., and New South Real Estate, LLC and significant interest in four joint ventures (the “New South Joint Ventures”). The consolidated financial statements presented primarily represent the accounts of Bancshares and New South. Two of the New South Joint Ventures are consolidated with their minority interests included in other accrued expenses, deferred revenues, and other liabilities. Two New South Joint Ventures are accounted for under the equity method. All significant intercompany accounts or transactions have been eliminated upon consolidation.
 
2.    Derivative Instruments and Hedging Activities
 
In June 1998, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 133, Accounting for Derivative Instruments and Hedging Activities (“SFAS No. 133”). In September 2000, the FASB issued SFAS No. 138, Accounting for Certain Derivative Instruments and Hedging Activities—an Amendment of SFAS No. 133. SFAS No. 133, as amended, replaces existing pronouncements and practices with a single, integrated accounting framework for derivatives and hedging activities requiring companies to formally record at fair value all derivatives and to document, designate, and assess the effectiveness of transactions that receive hedge accounting. See “Interest Sensitivity and Market Risk” section for a more detailed discussion of the Company’s utilization of derivative instruments and hedging activities.
 
The Company adopted SFAS No. 133 effective January 1, 2001 and recognized a cumulative-effect transition adjustment of approximately $1.1 million to decrease net income for the effect of the change in the accounting principle relating to derivatives that did not receive hedge accounting treatment. Additionally, the Company recognized a cumulative effect transition adjustment to reduce accumulated other comprehensive income (“OCI”) by $3.2 million on a pre-tax basis. The transition adjustment to OCI represented net unrealized losses on derivative instruments that qualified as cash flow hedges.
 
The Company utilizes certain derivatives in its operations that do not qualify as hedges for accounting purposes, as described above, under SFAS No. 133. The following summarizes the impact on earnings, in thousands, from valuation adjustments relating to these derivatives for the periods indicated:

6

Table of Contents
 
    
Three Months Ended
June 30,
  
    
2002
     
2001
  
Gains (losses) from interest rate caps
   
$
(100
)
   
$
192
 
Gains (losses) from interest rate lock contracts
   
 
322
 
   
 
(122
)
Losses from mandatory forward delivery contracts
   
 
(526
)
   
 
(134
)
    
  
    
$
(304
)
   
$
(64
)
    
  
    
Six Months Ended
June 30,
  
    
2002
     
2001
  
Losses from interest rate caps
   
$
(200
)
   
$
(101
)
Gains (losses) from interest rate lock contracts
   
 
104
 
   
 
(133
)
Gains (losses) from mandatory forward delivery contracts
   
 
(751
)
   
 
3
 
    
  
    
$
(847
)
   
$
(231
)
    
  
 
OCI was decreased by $.1 million and increased by $.2 million during the six months ended 2002 and 2001, respectively from reclassification into earnings resulting from hedge ineffectiveness. Hedge ineffectiveness decreased OCI by $.05 million during the quarter ended June 30, 2002 and increased OCI by $.1 million during the quarter ended June 30, 2001. The extent of hedge ineffectiveness is influenced by a number of factors including future interest rate volatility, hedge performance and correlation.
 
3.    S Corporation Election
 
The Company is an S Corporation, and as such generally is not subject to Federal corporate taxation. Certain states, however, do not recognize S Corporation status; therefore, the Company incurs state income taxes for those jurisdictions. Profits and losses flow through to the S Corporation shareholders directly in proportion to their per share ownership in the entity. Accordingly, shareholders are required to include profits and losses from the Company on their individual income tax returns for federal, and state and local, if applicable, income tax purposes.
 
Typically, S Corporations declare dividends to shareholders in an amount sufficient to enable shareholders to pay the tax on any S Corporation income included in the shareholder’s individual income. The Company paid dividends totaling $5.3 million during the six months ended June 30, 2002. Generally, such dividends are not subject to tax since they result from S Corporation income on which shareholders have previously been taxed.

7

Table of Contents
 
4.    Comprehensive Income
 
Comprehensive income is the change in equity during a period from transactions and other events and circumstances from nonowner sources. For New South and the Company, nonowner transactions consist of changes in unrealized gains and losses on securities available for sale and changes relating to cash flow hedges under SFAS No. 133. The following table represents, in thousands, comprehensive income for the periods indicated.
 
    
Three Months Ended
June 30,
  
    
2002
     
2001
  
Net income
   
$
2,959
 
   
$
2,510
 
Other comprehensive income (loss), net of tax:
                  
Net gains (losses) on current period cash flow hedges
   
 
(6,276
)
   
 
1,159
 
Reclassification adjustment for amount included in net income
   
 
—  
 
   
 
75
 
Unrealized gain on investment securities available for sale
   
 
3,480
 
   
 
428
 
Reclassification adjustments for net gains included in net income
   
 
(77
)
   
 
—  
 
    
  
Other comprehensive income (loss)
   
 
(2,873
)
   
 
1,662
 
    
  
Comprehensive income
   
$
86
 
   
$
4,172
 
    
  
    
Six Months Ended
June 30,
  
    
2002
     
2001
  
Net income
   
$
5,846
 
   
$
5,566
 
Other comprehensive loss, net of tax:
                  
Cumulative effect of a change in accounting for derivative instruments and hedging activities
   
 
—  
 
   
 
(3,222
)
Net losses on current period cash flow hedges
   
 
(1,799
)
   
 
(1,540
)
Reclassification adjustment for amount included in net income
   
 
(52
)
   
 
(199
)
Unrealized gain on investment securities available for sale
   
 
1,347
 
   
 
1,778
 
Reclassification adjustments for net gains included in net income
   
 
(784
)
   
 
—  
 
    
  
Other comprehensive loss
   
 
(1,288
)
   
 
(3,183
)
    
  
Comprehensive income
   
$
4,558
 
   
$
2,383
 
    
  

8

Table of Contents
 
5.    Segment Reporting
 
Reportable segments consist of Residential Mortgage Banking, Commercial Real Estate Lending, Automobile Lending, and Portfolio Management.
 
Residential Mortgage Banking originates and services single-family mortgage loans. These loans are originated through the Company’s network of retail loan origination offices and through brokers and correspondents. Commercial Real Estate Lending consists of loans secured primarily by multi-family housing. Automobile Lending consists of the origination and servicing of loans secured by automobiles, light trucks, and vans. These loans are primarily acquired on an indirect basis through automobile dealers. Portfolio Management oversees the Company’s overall portfolio of marketable assets as well as the New South’s funding needs. Residential Mortgage Banking, Commercial Real Estate Lending, and Automobile Lending retain the assets generated by each unit, and are credited with the interest income generated by those assets unless they are actually sold in the secondary market with the results of such sales being attributed to each unit. Each unit pays a market-based funds-use charge to Portfolio Management. The segment results include certain other overhead allocations. The results for the reportable segments of the Company for the three and six months ended June 30, 2002 and 2001, in thousands, are included in the following tables.

9

Table of Contents
 
    
For the three months ended June 30, 2002
    
Residential
Mortgage
Banking
     
Commercial
Real Estate
Lending
     
Automobile
Lending
     
Portfolio
Management
     
Other
     
Consolidated
Interest income
   
$
11,429
 
   
$
3,404
 
   
$
4,130
 
   
$
4,576
 
   
$
373
 
   
$
23,912
Interest expense
   
 
—  
 
   
 
131
 
   
 
—  
 
   
 
13,250
 
   
 
954
 
   
 
14,335
Intra-company funds (used) / provided
   
 
(7,119
)
   
 
(1,486
)
   
 
(1,273
)
   
 
9,625
 
   
 
253
 
   
 
—  
Provision for loan losses
   
 
455
 
   
 
10
 
   
 
1,085
 
   
 
—  
 
   
 
(75
)
   
 
1,475
Noninterest income
   
 
9,222
 
   
 
102
 
   
 
287
 
   
 
518
 
   
 
186
 
   
 
10,315
Noninterest expense
   
 
10,513
 
   
 
64
 
   
 
1,279
 
   
 
851
 
   
 
2,590
 
   
 
15,297
    
  
  
  
  
  
Net income (loss) before income taxes
   
 
2,564
 
   
 
1,815
 
   
 
780
 
   
 
618
 
   
 
(2,657
)
   
 
3,120
Provision for (benefit of) income taxes
   
 
133
 
   
 
92
 
   
 
40
 
   
 
30
 
   
 
(134
)
   
 
161
    
  
  
  
  
  
Net income (loss)
   
$
2,431
 
   
$
1,723
 
   
$
740
 
   
$
588
 
   
$
(2,523
)
   
$
2,959
    
  
  
  
  
  
Depreciation and amortization, net
   
$
116
 
   
$
—  
 
   
$
25
 
   
$
10
 
   
$
231
 
   
$
382
Total assets
   
 
673,128
 
   
 
180,301
 
   
 
159,683
 
   
 
319,216
 
   
 
50,213
 
   
 
1,382,541
Capital expenditures
   
 
157
 
   
 
—  
 
   
 
5
 
   
 
71
 
   
 
73
 
   
 
306
    
For the three months ended June 30, 2001
    
Residential
Mortgage
Banking
     
Commercial
Real Estate
Lending
     
Automobile
Lending
     
Portfolio
Management
     
Other
     
Consolidated
Interest income
   
$
9,577
 
   
$
3,465
 
   
$
3,610
 
   
$
3,875
 
   
$
211
 
   
$
20,738
Interest expense
   
 
—  
 
   
 
114
 
   
 
—  
 
   
 
14,018
 
   
 
848
 
   
 
14,980
Intra-company funds (used) / provided
   
 
(4,746
)
   
 
(1,591
)
   
 
(1,204
)
   
 
7,560
 
   
 
(19
)
   
 
—  
Provision for loan losses
   
 
(10
)
   
 
50
 
   
 
200
 
   
 
—  
 
   
 
770
 
   
 
1,010
Noninterest income
   
 
11,797
 
   
 
105
 
   
 
281
 
   
 
(1,386
)
   
 
1,561
 
   
 
12,358
Noninterest expense
   
 
8,915
 
   
 
66
 
   
 
1,420
 
   
 
961
 
   
 
3,096
 
   
 
14,458
    
  
  
  
  
  
Net income (loss) before income taxes
   
 
7,723
 
   
 
1,749
 
   
 
1,067
 
   
 
(4,930
)
   
 
(2,961
)
   
 
2,648
Provision for (benefit of) income taxes
   
 
386
 
   
 
92
 
   
 
54
 
   
 
(240
)
   
 
(154
)
   
 
138
    
  
  
  
  
  
Net income (loss)
   
$
7,337
 
   
$
1,657
 
   
$
1,013
 
   
$
(4,690
)
   
$
(2,807
)
   
$
2,510
    
  
  
  
  
  
Depreciation and amortization, net
   
$
208
 
   
$
—  
 
   
$
31
 
   
$
9
 
   
$
245
 
   
$
493
Total assets
   
 
558,787
 
   
 
151,871
 
   
 
125,220
 
   
 
229,111
 
   
 
93,602
 
   
 
1,158,591
Capital expenditures
   
 
103
 
   
 
—  
 
   
 
75
 
   
 
1
 
   
 
84
 
   
 
263

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Table of Contents
    
For the six months ended June 30, 2002
    
Residential
Mortgage
Banking
     
Commercial
Real Estate
Lending
     
Automobile
Lending
     
Portfolio
Management
     
Other
     
Consolidated
Interest income
   
$
22,291
 
   
$
6,540
 
   
$
7,938
 
   
$
9,462
 
   
$
824
 
   
$
47,055
Interest expense
   
 
—  
 
   
 
265
 
   
 
—  
 
   
 
26,888
 
   
 
1,759
 
   
 
28,912
Intra-company funds (used) / provided
   
 
(13,350
)
   
 
(2,765
)
   
 
(2,444
)
   
 
18,003
 
   
 
556
 
   
 
—  
Provision for loan losses
   
 
686
 
   
 
10
 
   
 
2,205
 
   
 
—  
 
   
 
185
 
   
 
3,086
Noninterest income
   
 
17,821
 
   
 
257
 
   
 
829
 
   
 
2,167
 
   
 
357
 
   
 
21,431
Noninterest expense
   
 
20,325
 
   
 
121
 
   
 
2,718
 
   
 
1,709
 
   
 
5,456
 
   
 
30,329
    
  
  
  
  
  
Net income (loss) before income taxes
   
 
5,751
 
   
 
3,636
 
   
 
1,400
 
   
 
1,035
 
   
 
(5,663
)
   
 
6,159
Provision for (benefit of) income taxes
   
 
294
 
   
 
185
 
   
 
71
 
   
 
52
 
   
 
(289
)
   
 
313
    
  
  
  
  
  
Net income (loss)
   
$
5,457
 
   
$
3,451
 
   
$
1,329
 
   
$
983
 
   
$
(5,374
)
   
$
5,846
    
  
  
  
  
  
Depreciation and amortization, net
   
$
237
 
   
$
—  
 
   
$
47
 
   
$
19
 
   
$
462
 
   
$
765
Capital expenditures
   
 
267
 
   
 
—  
 
   
 
108
 
   
 
103
 
   
 
163
 
   
 
641
    
For the six months ended June 30, 2001
    
Residential
Mortgage
Banking
     
Commercial
Real Estate
Lending
     
Automobile
Lending
     
Portfolio
Management
     
Other
     
Consolidated
Interest income
   
$
22,877
 
   
$
6,815
 
   
$
7,082
 
   
$
8,884
 
   
$
756
 
   
$
46,414
Interest expense
   
 
2
 
   
 
226
 
   
 
—  
 
   
 
30,723
 
   
 
1,717
 
   
 
32,668
Intra-company funds (used) / provided
   
 
(12,578
)
   
 
(3,622
)
   
 
(2,583
)
   
 
18,863
 
   
 
(80
)
   
 
—  
Provision for loan losses
   
 
143
 
   
 
50
 
   
 
1,275
 
   
 
—  
 
   
 
1,345
 
   
 
2,813
Noninterest income
   
 
21,744
 
   
 
207
 
   
 
831
 
   
 
(924
)
   
 
2,400
 
   
 
24,258
Noninterest expense
   
 
17,273
 
   
 
147
 
   
 
2,594
 
   
 
2,153
 
   
 
5,975
 
   
 
28,142
    
  
  
  
  
  
Net income (loss) before income taxes and cumulative effect of a change in accounting principle
   
 
14,625
 
   
 
2,977
 
   
 
1,461
 
   
 
(6,053
)
   
 
(5,961
)
   
 
7,049
Provision for (benefit of) income taxes
   
 
741
 
   
 
153
 
   
 
74
 
   
 
(305
)
   
 
(304
)
   
 
359
    
  
  
  
  
  
Net income before cumulative effect of a change in accounting principle
   
 
13,884
 
   
 
2,824
 
   
 
1,387
 
   
 
(5,748
)
   
 
(5,657
)
   
 
6,690
Cumulative effect of change in accounting principle
   
 
—  
 
   
 
—  
 
   
 
—  
 
   
 
1,124
 
   
 
—  
 
   
 
1,124
    
  
  
  
  
  
Net income (loss)
   
$
13,884
 
   
$
2,824
 
   
$
1,387
 
   
$
(6,872
)
   
$
(5,657
)
   
$
5,566
    
  
  
  
  
  
Depreciation and amortization, net
   
$
422
 
   
$
—  
 
   
$
61
 
   
$
19
 
   
$
482
 
   
$
984
Capital expenditures
   
 
287
 
   
 
—  
 
   
 
78
 
   
 
2
 
   
 
195
 
   
 
562

11

Table of Contents
 
6.    Recent Accounting Pronouncements
 
In June 2001, the FASB issued SFAS No. 141, Business Combinations (“SFAS No. 141”) and SFAS No. 142, Goodwill and Other Intangible Assets (“SFAS No. 142”). These statements revise the standards of accounting for business combinations and related goodwill and other intangible assets. SFAS No. 141 was generally effective for business combinations after July 1, 2001 and SFAS No. 142 was effective for fiscal years beginning after December 15, 2001 with certain provisions effective earlier. The adoption of SFAS No. 142 on January 1, 2002 did not have a significant impact on the financial statements.
 
In August 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS No. 144”). This statement revises the standards of accounting for the accounting and reporting for the impairment or disposal of long-lived assets. SFAS No. 144 was effective for fiscal years beginning after December 15, 2001. The adoption of SFAS No. 144 on January 1, 2002 did not have a significant impact on the financial statements.
 
In April 2002, the FASB issued SFAS No. 145, Rescission of SFAS No. 4, 44, and 64, Amendment of SFAS No. 13, and Technical Corrections (“SFAS No. 145”). This statement rescinded SFAS No. 4, 44, and 64, the provisions of which are either addressed in other pronouncements or no longer applicable. SFAS No. 13 was amended to address the accounting for certain lease modifications. Adoption of SFAS No. 145 on January 1, 2002 did not have a significant impact on the financial statements.
 
In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities (“SFAS No. 146”). This statement addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring). SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. The provisions of this statement are effective for exit or disposal activities that are initiated after December 31, 2002, with early application encouraged. The impact of the statement on the Company’s consolidated financial position and results of operations is not expected to be material.

12

Table of Contents
 
Item 2.     Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
Basis of Presentation
 
The following discussion should be read in conjunction with the Company’s Consolidated Financial Statements and Notes thereto and the other financial data included elsewhere in this document. The Company’s accounting policies are integral to the financial results discussed herein. The significant accounting policies of the Company are contained in Footnote 1 to the Consolidated Financial Statements filed in the Company’s Form 10-K for the year ended December 31, 2001. The financial information provided below has been rounded in order to simplify its presentation. However, the ratios and percentages provided below are calculated using the detailed financial information contained in the Consolidated Financial Statements, the Notes thereto, and the other financial data included elsewhere in this document. All tables and financial statements included in this report should be considered an integral part of this analysis.
 
The purpose of this Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is to provide an analysis of significant changes in the Company’s assets, liabilities, and capital at June 30, 2002 as compared to December 31, 2001, in addition to including an analysis of income for the quarter ended June 30, 2002 (“Second Quarter 2002”) and six months ended June 30, 2002 (“YTD 2002”) as compared to the quarter ended June 30, 2001 (“Second Quarter 2001”) and six months ended June 30, 2001 (“YTD 2001”).
 
Forward Looking Statements
 
This management discussion and analysis contains certain forward looking information with respect to the financial condition, results of operations, and business of the Company, including the Notes to Consolidated Financial Statements and statements contained in this discussion with respect to security maturities, loan maturities, loan growth, expectations for and the impact of interest rate changes, the adequacy of the allowance for loan losses, expected loan losses, and the impact of inflation, unknown trends, or regulatory action. The Company cautions readers that forward looking statements, including without limitation those noted above, are subject to risks and uncertainties that could cause actual results to differ materially from those indicated in the forward looking statements. Factors that may cause actual results to differ materially from those contemplated include, among others, the stability of interest rates, the rate of growth of the economy in the Company’s market area, the success of the Company’s marketing efforts, the ability to expand into new segments of the market area, competition, changes in technology, the strength of the consumer and commercial credit sectors, levels of consumer confidence, the impact of regulation applicable to the Company, and the performance of stock and bond markets.
 
Net Income and Key Performance Ratios
 
The Company reported net income of $3.0 million for Second Quarter 2002, a 17.9% increase from net income of $2.5 million for Second Quarter 2001. On a per share basis, net earnings were $2.36 and $2.00, respectively, for the same periods. During Second Quarter 2002 the annualized return on average assets was 0.86% and the annualized return on average equity was 18.84% compared to 0.90% and 17.71%, respectively, for Second Quarter 2001.
 
Net income totaled $5.8 million for YTD 2002, a 5.0% increase from net income of $5.6 million for same period in 2001. On a per share basis, net earnings were $4.65 and $4.43, respectively, for the same periods. YTD 2001 results of operations included a transition adjustment relating to the cumulative effect of a change in accounting principle for derivative instruments and hedging activities of $1.1 million, or $.89 per share and the securitization gain discussed following. During YTD 2002 the annualized return on average assets was 0.87% and the annualized return on average equity was 18.85% compared to 0.94% and 19.22%, respectively, for YTD 2001.

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Table of Contents
 
During 2001, the Company completed the securitization of approximately $254 million of primarily residential nonconforming mortgage loans, $229 million in the first quarter and $25 million in the Second Quarter 2001 (the “Securitization”), recording a gain of $3.7 million. The nature and timing of the Securitization had a significant impact on the Second Quarter 2001 results of operations as well as Second Quarter 2001 averages. The residual interest in the amount of $7.9 million associated with the Securitization was sold to an affiliated company at fair value.
 
Net Interest Income, Earning Assets and Interest-bearing Liabilities
 
Net interest income for Second Quarter 2002 was $9.6 million, a $3.8 million, or 66.3%, increase from $5.8 million for Second Quarter 2001. This increase was primarily attributable to an increase in average earning assets of $274.0 million, to $1,265.7 million during Second Quarter 2002, compared with $991.7 million during Second Quarter 2001, reflecting the Securitization. Net interest income was also affected by a decline in the cost of interest-bearing liabilities of 148 basis points compared with a smaller decrease in the yield on interest earning assets of 81 basis points. The larger decline in the cost of interest-bearing liabilities compared with yield on earning assets reflects the repricing characteristics of certain time deposits and the impact of short-term interest rates as more fully discussed below. The impact of the increase in average earning assets was offset with comparable increases in the level of average interest-bearing liabilities of $256.4 million to $1,236.6 million during Second Quarter 2002, compared with $980.2 million during Second Quarter 2001. Overall, this movement in volumes and rates resulted in an increase in the net interest rate margin of 70 basis points during the Second Quarter 2002 compared with the same period in 2001. Net interest income increased despite the impact of the Company’s interest rate swap contracts (“Swaps”), which decreased net interest income by $3.1 million during Second Quarter 2002, compared with a decrease of $.8 million during Second Quarter 2001. See “Interest Sensitivity and Market Risk” section for a more detailed discussion of Swaps.
 
As discussed further in MD&A, a significant portion of the Company’s securities sold under agreements to repurchase (“Security Repo Agreements”) have been converted from short term to longer term liabilities through the use of Swaps. The impact of the Swaps on Security Repo Agreement increased interest expense for Second Quarter 2002 by 227 basis points verses 39 basis points for Second Quarter 2001. Swaps increased Security Repo Agreement interest expense for YTD 2002 by 224 basis points compared with 24 basis points for YTD 2001.
 
Net interest income for YTD 2002 was $18.1 million, a $4.4 million or 32.0% increase from $13.7 million for YTD 2001. This increase was attributable to an increase in average earning assets of $164.3 million, to $1,238.5 million during YTD 2002, compared with $1,074.2 million during YTD 2001. The impact of the increase in average earning assets was offset with comparable increases in the level of average interest-bearing liabilities of $153.0 million to $1,207.3 million during YTD 2002, compared with $1,054.3 million during YTD 2001. The timing of the Securitization had less impact on the year to date periods than on the quarterly periods discussed above. During YTD 2002, the cost of interest-bearing liabilities declined by 142 basis points compared with a 105 basis point decrease in the yield on interest earning assets. The combined movement in volumes and rates resulted in an increase in the net interest rate margin of 37 basis points during YTD 2002 compared with YTD 2001. The Company’s Swaps decreased net interest income by $6.5 million during YTD 2002, compared with a decrease of $1.0 million during YTD 2001. See “Interest Sensitivity and Market Risk” section for a more detailed discussion of Swaps.
 
The significant change in the impact of the Swaps on the margin is due to the significant decline in short-term interest rates over the last 18 months. The Federal Reserve Bank has lowered short-term interest rates 11 times since January 1, 2001, resulting in a 475 basis point decrease in the federal funds rate. These decreases have resulted in declining yields or costs on all classes of interest-bearing assets and liabilities. Due to a steepening of the yield curve, the short-term interest-bearing assets and liabilities were significantly impacted as can be seen in the yield on federal funds sold and the cost of other interest-bearing deposits.
 
The following tables set forth, for the periods indicated, certain information related to the Company’s average balance sheet and its average yields on assets and average costs of liabilities. Such yields or costs are

14

Table of Contents
derived by dividing income or expense by the average balance of the corresponding assets or liabilities. Average balances have been derived from the daily balances throughout the periods indicated.
 
Average Balances, Income, Expense, and Rates
 
    
For the three months ended June 30,
  
    
2002
     
2001
  
    
Average
Balance
     
Income/
Expense
   
Yield/
Rate
     
Average
Balance
     
Income/
Expense
   
Yield/
Rate
  
    
(In thousands, except percentages)
  
Assets
                                              
Loans, net of unearned income(1)
   
$
951,517
 
   
$
19,177
   
8.08
%
   
$
748,286
 
   
$
16,765
   
8.99
%
Federal funds sold
   
 
7,960
 
   
 
45
   
2.27
 
   
 
23,243
 
   
 
265
   
4.57
 
Investment securities available for sale
   
 
240,420
 
   
 
3,652
   
6.09
 
   
 
147,749
 
   
 
2,340
   
6.35
 
Other investments
   
 
65,845
 
   
 
1,038
   
6.32
 
   
 
72,420
 
   
 
1,368
   
7.58
 
    
  
         
  
      
Total earning assets
   
 
1,265,742
 
   
 
23,912
   
7.58
 
   
 
991,698
 
   
 
20,738
   
8.39
 
Allowance for loan losses
   
 
(12,553
)
                 
 
(13,402
)
              
Other assets
   
 
132,130
 
                 
 
137,112
 
              
    
                
             
Total Assets
   
$
1,385,319
 
                 
$
1,115,408
 
              
    
                
             
Liabilities And Shareholders’ Equity
                                              
Other interest bearing deposits
   
$
8,845
 
   
 
41
   
1.86
 
   
$
4,860
 
   
 
71
   
5.86
 
Savings deposits
   
 
106,126
 
   
 
571
   
2.16
 
   
 
75,765
 
   
 
753
   
3.99
 
Time deposits
   
 
758,304
 
   
 
9,149
   
4.84
 
   
 
710,682
 
   
 
11,398
   
6.43
 
Federal funds purchased and securities sold under agreements to repurchase
   
 
181,714
 
   
 
2,119
   
4.68
 
   
 
43,551
 
   
 
477
   
4.39
 
Other borrowings
   
 
11,389
 
   
 
146
   
5.14
 
   
 
10,277
 
   
 
225
   
8.78
 
Federal Home Loan Bank advances
   
 
119,694
 
   
 
1,350
   
4.52
 
   
 
100,549
 
   
 
1,323
   
5.28
 
Guaranteed preferred beneficial interests in the Company’s subordinated debt
   
 
50,500
 
   
 
959
   
7.62
 
   
 
34,500
 
   
 
733
   
8.55
 
    
  
         
  
      
Total interest bearing liabilities
   
 
1,236,572
 
   
 
14,335
   
4.65
 
   
 
980,184
 
   
 
14,980
   
6.13
 
Noninterest bearing deposits
   
 
77,736
 
                 
 
66,831
 
              
Accrued expenses and other liabilities
   
 
16,174
 
                 
 
16,217
 
              
Shareholders’ equity
   
 
54,837
 
                 
 
52,176
 
              
    
                
             
Total Liabilities and Shareholders’ Equity
   
$
1,385,319
 
                 
$
1,115,408
 
              
    
                
             
                    
                  
Net interest rate spread
                   
2.93
%
                   
2.26
%
             
  
           
  
Net interest income
            
$
9,577
                   
$
5,758
       
             
                  
      
                    
                  
Net interest rate margin
                   
3.03
%
                   
2.33
%
                    
                  
(1)
 
Loans classified as nonaccrual are included in the volume classification. Loan fees for all periods presented are included in the interest amounts for loans.

15

Table of Contents
Average Balances, Income, Expense, and Rates
 
    
For the six months ended June 30,
  
    
2002
     
2001
  
    
Average
Balance
     
Income/
Expense
   
Yield/
Rate
     
Average
Balance
     
Income/
Expense
   
Yield/
Rate
  
    
(In thousands, except percentages)
  
Assets
                                              
Loans, net of unearned income(1)
   
$
910,151
 
   
$
37,197
   
8.24
%
   
$
817,795
 
   
$
37,790
   
9.32
%
Federal funds sold
   
 
11,249
 
   
 
90
   
1.61
 
   
 
20,432
 
   
 
491
   
4.85
 
Investment securities available for sale
   
 
248,589
 
   
 
7,576
   
6.15
 
   
 
163,331
 
   
 
5,413
   
6.68
 
Other investments
   
 
68,490
 
   
 
2,192
   
6.45
 
   
 
72,663
 
   
 
2,720
   
7.55
 
    
  
         
  
      
Total earning assets
   
 
1,238,479
 
   
 
47,055
   
7.66
 
   
 
1,074,221
 
   
 
46,414
   
8.71
 
Allowance for loan losses
   
 
(12,423
)
                 
 
(13,268
)
              
Other assets
   
 
122,654
 
                 
 
127,219
 
              
    
                
             
Total Assets
   
$
1,348,710
 
                 
$
1,188,172
 
              
    
                
             
Liabilities and Shareholders’ Equity
                                              
Other interest bearing deposits
   
$
7,724
 
   
 
80
   
2.09
 
   
$
4,365
 
   
 
135
   
6.24
 
Savings deposits
   
 
100,844
 
   
 
1,094
   
2.19
 
   
 
72,560
 
   
 
1,553
   
4.32
 
Time deposits
   
 
752,346
 
   
 
18,779
   
5.03
 
   
 
747,985
 
   
 
24,066
   
6.49
 
Federal funds purchased and securities sold under agreements to repurchase
   
 
177,066
 
   
 
4,275
   
4.87
 
   
 
36,613
 
   
 
936
   
5.16
 
Other borrowings
   
 
10,119
 
   
 
339
   
6.76
 
   
 
10,957
 
   
 
477
   
8.78
 
Federal Home Loan Bank advances
   
 
116,157
 
   
 
2,638
   
4.58
 
   
 
147,278
 
   
 
4,035
   
5.52
 
Guaranteed preferred beneficial interests in the Company’s subordinated debt
   
 
43,077
 
   
 
1,707
   
7.99
 
   
 
34,500
 
   
 
1,466
   
8.55
 
    
  
         
  
      
Total interest bearing liabilities
   
 
1,207,333
 
   
 
28,912
   
4.83
 
   
 
1,054,258
 
   
 
32,668
   
6.25
 
Noninterest bearing deposits
   
 
67,953
 
                 
 
62,954
 
              
Accrued expenses and other liabilities
   
 
16,654
 
                 
 
15,334
 
              
Shareholders’ equity
   
 
56,770
 
                 
 
55,626
 
              
    
                
             
Total Liabilities and Shareholders’ Equity
   
$
1,348,710
 
                 
$
1,188,172
 
              
    
         
  
         
Net interest rate spread
                   
2.83
%
                   
2.46
%
                    
                  
             
                  
      
Net interest income
            
$
18,143
                   
$
13,746
       
             
                  
      
Net interest rate margin
                   
2.95
%
                   
2.58
%
                    
                  
(1)
 
Loans classified as nonaccrual are included in the average volume classification. Loan fees for all periods presented are included in the interest amounts for loans.
 
The Securitization had a significant impact on loan levels during 2001. Loans averaged $951.5 million during Second Quarter 2002, compared with $748.3 million during Second Quarter 2001, an increase of 27.2% and $910.2 million during YTD 2002, compared with $817.8 million during YTD 2001, an increase of 11.3%.
 
Investment securities available for sale (“Investments AFS”) increased 62.7% when comparing the Second Quarter 2002 average of $240.4 million to the Second Quarter 2001 average of $147.7 million. Investments AFS

16

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averaged $248.6 million during YTD 2002 compared with $163.3 million during YTD 2001, an increase of 52.2%. The increase in Investments AFS reflects the Company’s strategy to more fully leverage its core capital. The Company purchased a portfolio of Ginnie Mae (“GNMA”) securities beginning in the second quarter of 2001 and has increased this portfolio from inception of the strategy. The GNMA securities averaged $195.4 million during Second Quarter 2002 and $46.3 million during Second Quarter 2001. The GNMA securities averaged $194.4 million during YTD 2002 and $15.6 million during YTD 2001. The GNMA securities were primarily funded with certain Security Repo Agreements, which averaged $170.9 million during Second Quarter 2002 compared with $45.4 million during Second Quarter 2001. The Security Repo Agreements averaged $163.1 million during YTD 2002 and $15.3 million during YTD 2001.
 
Excluding the average balance change in Investments AFS and related funding, interest-bearing liabilities increased $130.9 million, or 14.0%, to $1,065.7 million in Second Quarter 2002 from $934.8 million during Second Quarter 2001. Federal Home Loan Bank (“FHLB”) advances averaged $119.7 million and $100.5 million during Second Quarter 2002 and Second Quarter 2001, respectively, an increase of $19.2 million or 19.0%. FHLB advances averaged $116.2 million during YTD 2002 and $147.3 million during YTD 2001, a decrease of $31.1 million, or 21.1%. Interest-bearing deposits averaged $873.3 million during Second Quarter 2002 and $791.3 million during Second Quarter 2001, an increase of $82.0 million, or 10.4%. Interest-bearing deposits averaged $860.9 million during YTD 2002 and $824.9 million during YTD 2001, an increase of $36.0 million, or 4.4%. During both Second Quarter 2002 and YTD 2002, there has been a shift to more liquid savings deposits from typically longer maturity time deposits from the same periods in 2001.
 
Noninterest Income and Noninterest Expenses
 
Noninterest income totaled $10.3 million during Second Quarter 2002 compared to $12.4 million for the same period in the prior year, a decrease of $2.0 million, or 16.5%. Loan administration income totaled $2.1 million during Second Quarter 2002, compared with $3.4 million during Second Quarter 2001, a decrease of $1.3 million, or 38.3%, reflecting lower levels of loans serviced for others and a different delivery method for sales of originated conforming mortgage loan servicing rights. Origination fees totaled $3.2 million during both the Second Quarter 2002 and Second Quarter 2001, despite a 36.7% decline in the origination of residential mortgage loans, due to increases in origination fees relating to construction lending, automobile floorplan lending, and application fees charged in certain residential mortgage lending markets. Gain on sale of Investments AFS, represents the sale of specific securities during Second Quarter 2002. The Company sold higher coupon GNMA securities and bought lower coupon GNMA securities to reduce the Company’s prepayment risk on the GNMA securities purchased at prices above par value. Gain on the sales of loans and mortgage servicing rights during Second Quarter 2002 totaled $3.8 million compared with $4.0 million during Second Quarter 2001, which included $.3 million related to the Securitization, a decrease of $.2 million. Other income was $1.2 million during Second Quarter 2002 and $1.8 million during Second Quarter 2001, a decline of $.6 million, or 33.3% as a result of lower residential mortgage loan originations.
 
Noninterest income totaled $21.4 million during YTD 2002 compared to $24.3 million for the same period in the prior year, a decrease of $2.8 million, or 11.7%. Loan administration income was $4.5 million during YTD 2002, compared with $5.9 million during YTD 2001, a decrease of $1.4 million, or 23.9%, again reflecting lower levels of serviced loans and a different loan servicing sales delivery method. Origination fees were $5.9 million and $5.7 million for YTD 2002 and YTD 2001, respectively, an increase of $.2 million, despite a 19.8% decline in the origination of residential mortgage loans, due to increases in origination fees relating to construction lending, automobile floorplan lending, and application fees charged in certain residential mortgage lending markets. As noted above, gain on sale of Investments AFS, represents the sale of specific securities during YTD 2002. Gain on the sales of loans and mortgage servicing rights during YTD 2002 totaled $8.0 million compared with $9.9 million during YTD 2001, which included $3.4 million related to the Securitization credited to the residential mortgage banking segment, a decrease of $1.9 million, or 19.9%. Excluding the gain from the Securitization, gains increased by $1.5 million as a result of the final quarterly sale of servicing rights to a large mortgage company under a contract which expired during January 2002. Other income, reflecting the lower residential mortgage origination volume noted above, declined by $.5 million to $2.3 million during YTD 2002 from $2.8 during YTD 2001.
 

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Noninterest expenses were $15.3 million during Second Quarter 2002 and $14.5 million during Second Quarter 2001, an increase of $.8 million, or 5.8%. Noninterest expenses were $30.3 million during YTD 2002 and $28.1 million during YTD 2001, an increase of $2.2 million, or 7.8%. Salaries and benefits were $9.3 million for Second Quarter 2002, a $.7 million, or 7.7%, increase compared to $8.6 million for Second Quarter 2001. Salaries and benefits were $18.6 million for YTD 2002, a $1.6 million or 9.3%, increase compared to $17.0 million for YTD 2001. The changes in salaries and benefits were attributable to increased staffing, bonus accruals, increased 401K Company matching contributions resulting from plan modifications, and increased health care costs. Other noninterest expenses totaled $4.9 million in Second Quarter 2002 and $4.6 million in Second Quarter 2001, an increase of $.3 million, or 7.3%, including a $.5 million impairment provision for the writedown of various servicing related assets. Other noninterest expenses totaled $9.7 million during YTD 2002 and $8.8 million during YTD 2001, an increase of $.9 million, or 10.4%, reflecting the writedown of servicing related assets and losses and expenses associated with foreclosed properties and repossessed assets which have been significantly impacted by the recent economic slowdown.
 
Interest Sensitivity and Market Risk
 
Interest Sensitivity
 
Through policies established by the Asset/Liability Management Committee (“ALCO”) formed by New South’s Board of Directors, the Company monitors and manages the repricing and maturity of its assets and liabilities in order to diminish the potential adverse impact that changes in interest rates could have on its net interest income. ALCO uses a combination of traditional gap analysis, which compares the repricings, maturities, and prepayments, as applicable, of New South’s interest-earning assets, interest-bearing liabilities and derivative instruments, and interest rate sensitivity analysis to manage interest rate risk.
 
The Company’s interest rate sensitivity analysis evaluates interest rate risk based on the impact on the net interest income and market value of portfolio equity (“MVPE”) of various interest rate scenarios. The MVPE analysis is required quarterly by the Office of Thrift Supervision (“OTS”) by virtue of the Company’s asset size. The Company also uses an earnings simulation model to determine the effect of several interest rate scenarios on the Company’s net interest income. ALCO meets semi-monthly to monitor and evaluate the interest rate risk position of New South and to formulate and implement strategies for increasing and protecting the net interest rate margin and net income.
 
Brokered deposits are considered to be highly interest-sensitive and are reflected in interest rate risk analyses reviewed by ALCO. Additionally, both ALCO and New South’s Board of Directors are apprised of the level of brokered deposits on an ongoing basis.
 
The Company uses interest rate contracts, primarily Swaps and interest rate caps (“Caps”), to reduce or modify interest rate risk. The impact of these instruments is incorporated into the interest rate risk management model. The Company manages the credit risk of its Swaps, Caps, and forward contracts through a review of creditworthiness of the counterparties to such contracts, Board established credit limits for each counterparty, and monitoring by ALCO.
 
At June 30, 2002, New South had Swaps with notional amounts totaling $405 million. $380 million of the Swaps were receive variable/pay fixed swap contracts designed to convert variable rate funding to a fixed rate, thus reducing the impact of an upward movement in interest rates on the net interest rate margin. At June 30, 2002, $140 million and $240 million of these Swaps were designated as cash flow hedges under SFAS No. 133 of Security Repo Agreements and certain time deposits, respectively. Additionally, the Company has entered into $25 million of receive fixed/pay variable Swaps utilized as cash flow hedges under SFAS No. 133 for certain brokered certificates of deposit included in the Company’s overall funding. These Swaps have decreased $20 million, net, from December 31, 2001 resulting from termination of three Swaps totaling $30 million by the counterparties and the execution of one new Swap of $10 million. These Swaps reduce the current cost of these liabilities and convert them to an adjustable rate. These Swaps are callable at the option of the counterparty, and if called, the Company has the right to call the certificates of deposit.
 

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New South also had $245 million in Caps outstanding at June 30, 2002. The Company is exposed to rising liability costs due to the short-term nature of its liability portfolio. The Caps generally serve to mitigate the Company’s risk against increases in the costs of liabilities. The weighted average LIBOR based strike rate for the Caps is 7.56%, therefore short-term interest rates levels would have to increase significantly before the Caps would provide the Company with a material benefit. At June 30, 2002, 90 day LIBOR was 1.86%. Under SFAS No. 133, the Caps do not qualify for hedge accounting. Accordingly, changes in the market value of the Caps are recorded through the income statement versus OCI. During Second Quarter 2002 and Second Quarter 2001, the Company’s other income was reduced by $.1 million and increased by $.2 million, respectively, for changes in the market value of the Caps. During YTD 2002 and YTD 2001, other income was reduced by $.2 million and $.1 million, respectively. During YTD 2002, the Company did not purchase any additional Caps.

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Asset Quality
 
The following table summarizes nonperforming assets as of the dates indicated.
 
Nonperforming Assets
 
    
June 30,
2002
     
December 31,
2001
  
    
(In thousands, except percentages)
  
Nonaccrual loans
   
$
17,376
 
   
$
15,291
 
Restructured loans
   
 
1,448
 
   
 
5,786
 
    
  
Total nonperforming loans
   
 
18,824
 
   
 
21,077
 
Foreclosed properties and repossessed assets
   
 
5,651
 
   
 
5,748
 
    
  
Total nonperforming assets
   
$
24,475
 
   
$
26,825
 
    
  
Allowance for loan losses to period-end nonperforming loans
   
 
69.56
%
   
 
59.84
%
Allowance for loan losses to period-end nonperforming assets
   
 
53.50
%
   
 
47.02
%
Nonperforming assets to period-end loans and foreclosed properties and repossessed assets
   
 
2.64
%
   
 
3.37
%
Nonperforming loans to period-end loans
   
 
2.04
%
   
 
2.67
%
 
 
Nonperforming assets totaled $20.2 million at June 30, 2002, a decrease of $6.6 million, or 24.8%, from $26.8 million at December 31, 2001 as a result of a decrease in the number and volume of restructured loans. These previously classified restructured loans were removed from the nonperforming assets due to the financial performance of the borrower and improvements in the collateral value of the assets securing the loans. Foreclosed properties decreased by $2.5 million, or 43.0%, to $3.3 million at June 30, 2002 from $5.7 million at December 31, 2001 as a result of property sales.
 
As of June 30, 2002, a servicing termination trigger was exceeded in one of the securitizations for which the Company has retained the servicing. At June 30, 2002, the Company’s servicing asset was $.9 million for this securitization. The Company has advised the bond insurance company of the matter and the bond insurance company has not expressed any intent to exercise their contractual right to replace New South as their servicer. There can be no assurances that the bond insurance company will not exercise their contractual right in the future, which would require New South to write-off any remaining servicing asset for which it no longer performed the servicing function.
 
Provision and Allowance for Loan Losses
 
Management establishes allowances for the purpose of absorbing losses that are inherent within the loan portfolio and that are expected to occur based on management’s review of historical losses, underwriting standards, changes in the composition of the loan portfolio, changes in the economy, and other factors. The allowance for loan losses is maintained at a level considered adequate to provide for losses as determined by management’s continuing review and evaluation of the loans and its judgment as to the impact of economic conditions on the portfolio. Charges are made to the allowance for loans that are charged off during the year while recoveries of these amounts are credited to the account. The Company follows a policy of charging off loans determined to be uncollectible by management.

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Additions to the allowance for loan losses, which are expensed as the provision for loan losses on the Company’s income statement, are made periodically to maintain the allowance at an appropriate level based on management’s analysis of the inherent risk in the loan portfolio. The amount of the provision is a function of the level of loans outstanding, the mix of the outstanding loan portfolio, the levels of classified assets and nonperforming loans, and current and anticipated economic conditions.
 
The Company’s allowance for loan losses is based upon management’s judgment and assumptions regarding risk elements in the portfolio, future economic conditions, and other factors affecting borrowers. The evaluation of the allowance for loan losses includes management’s identification and analysis of loss inherent in various portfolio segments using a credit grading process and specific reviews and evaluations of certain significant problem credits. In addition, management monitors the overall portfolio quality through observable trends in delinquencies, charge-offs, and general economic conditions in the service area with residential mortgage and automobile installment loan portfolios each being evaluated collectively for impairment. The adequacy of the allowance for loan losses and the effectiveness of the Company’s monitoring and analysis system are also reviewed periodically by the OTS.
 
Based on present information and an ongoing evaluation, management considers the allowance for loan losses to be adequate to meet presently known and inherent risks in the loan portfolio. Management’s judgment as to the adequacy of the allowance is based upon a number of assumptions about future events which it believes to be reasonable but which may or may not be valid. Thus, there can be no assurance that charge-offs in future periods will not exceed the allowance for loan losses or that additional increases in the allowance for loan losses will not be required.
 
The following table analyzes activity in the allowance for loan losses for the periods indicated.

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Analysis of the Allowance for Loan Losses
For the six months ended June 30,
(In thousands, except percentages)
 
    
2002
     
2001
  
Average loans, net of unearned income
   
$
910,151
 
   
$
817,795
 
    
  
Balance of allowance for loan losses at beginning of period
   
$
12,613
 
   
$
13,513
 
Loans charged off:
                  
Residential mortgage
   
 
673
 
   
 
3,009
 
Installment
   
 
3,148
 
   
 
2,657
 
Commercial real estate
   
 
6
 
   
 
—  
 
    
  
Total charge-offs
   
 
3,827
 
   
 
5,666
 
    
  
Recoveries of loans previously charged off:
                  
Residential mortgage
   
 
417
 
   
 
162
 
Installment
   
 
805
 
   
 
895
 
Commercial real estate
   
 
—  
 
   
 
—  
 
    
  
Total recoveries
   
 
1,222
 
   
 
1,057
 
    
  
Net charge-offs
   
 
2,605
 
   
 
4,609
 
Addition to allowance charged to expense
   
 
3,086
 
   
 
2,813
 
    
  
Balance of allowance for loan losses at end of period
   
$
13,094
 
   
$
11,717
 
    
  
Net charge-offs to average loans, net of unearned income, annualized
   
 
0.58
%
   
 
1.14
%
 
The provision for loan losses was $3.1 million for YTD 2002 compared with $2.8 million for YTD 2001, an increase of $.3 million. The increase in the provision for loan losses reflects higher average loans during YTD 2002, compared with YTD 2001, which included the impact of the Securitization. At June 30, 2002 and December 31, 2001, the allowance for loan losses was $13.1 million and $12.6 million, respectively. As a percentage of loans, net of unearned income, the allowance for loan losses decreased to 1.42% at June 30, 2002 from 1.60% at December 31, 2001. The decrease resulted from increases in the balance of the Company’s loans.
 
Net charge-offs of residential mortgage loans were $.3 million during YTD 2002 and $2.8 million during YTD 2001, with the YTD 2001 being impacted by higher losses of Avondale’s portfolio. Net charge-offs of installment loans were $2.3 million during YTD 2002 and $1.8 million during YTD 2001 resulting from sensitivity of these assets and borrowers to depressed economic conditions beginning during the second half of 2001.

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Capital
 
At June 30, 2002 shareholders’ equity of the Company totaled $49.9 million, or 3.6% of total assets, compared to $50.6 million, or 3.9% of total assets at December 31, 2001. The decrease is attributable to net income of $5.8 million earned during YTD 2002 offset by a $1.2 million decrease in accumulated other comprehensive loss, and by dividends paid of $5.3 million.
 
The OTS requires thrift financial institutions to maintain capital at adequate levels based on a percentage of assets and off-balance sheet exposures, adjusted for risk weights ranging from zero to 100%. Under the risk-based standard, capital is classified into two tiers. Tier 1 capital of the Bank consists of common shareholder’s equity, excluding accumulated other comprehensive loss, plus minority interest in consolidated subsidiaries, and minus certain intangible assets. The Bank’s Tier 2 capital consists of the general reserve for loan losses subject to certain limitations. Consolidated regulatory capital requirements do not apply to thrift holding companies. The following table sets forth the specific capital amounts and ratios of New South for the indicated periods.
 
Analysis of Capital
 
    
As of
June 30, 2002
     
As of December 31,
2001
  
    
(In thousands, except for percentages)
  
        
Shareholder's equity
   
$
85,317
 
   
$
87,808
 
Minority interest in consolidated subsidiaries
   
 
282
 
   
 
276
 
Accumulated other comprehensive loss
   
 
12,381
 
   
 
11,093
 
Servicing rights capital haircut
   
 
(1,648
)
   
 
—  
 
    
  
Tier 1 capital
   
 
96,332
 
   
 
99,177
 
Allowance for loan losses
   
 
10,760
 
   
 
9,910
 
    
  
Tier 2 capital
   
 
10,760
 
   
 
9,910
 
Low level recourse deduction
   
 
184
 
   
 
213
 
Other
   
 
—  
 
   
 
8,594
 
    
  
Total deductions
   
 
184
 
   
 
8,807
 
    
  
Total risk-based capital
   
$
106,908
 
   
$
100,280
 
    
  
Risk-weighted assets (including off-balance sheet exposure)
   
$
966,899
 
   
$
851,056
 
Tier 1 leverage ratio
   
 
7.03
%
   
 
7.66
%
Total risk-based capital ratio
   
 
11.06
 
   
 
10.64
 
Tier 1 risk-based capital ratio(1)
   
 
9.96
 
   
 
11.78
 
(1)
 
Tier 1 capital utilized in the tier 1 capital ratio is reduced by the low level recourse deduction.
 
New South has consistently exceeded regulatory minimum guidelines and it is the intention of management to continue to monitor these ratios to ensure regulatory compliance and maintain adequate capital for New South. New South’s current capital ratios place the Bank in the well capitalized regulatory category.

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The Company completed the issuance of $16 million of Trust Preferred Securities (“TPS”) through a private placement with an investment bank which closed on March 26, 2002. Part of the proceeds from the sale of TPS were used to repay the Company’s working capital loans and purchase a residual interest in a loan securitization owned by the Bank totaling $5.7 million, its fair value and other corporate purposes, including a possible additional capital investment in the Bank. The TPS will bear an interest rate of 90-day LIBOR plus 360 basis points and will not exceed 11% for the initial five years they are outstanding. The effective interest rate at June 30, 2002 was 5.47%. The TPS are callable at the Company’s option, at par, beginning March 26, 2007 and mature March 26, 2032.
 
Liquidity
 
The Company operated with sufficient liquidity during Second Quarter 2002 and expects liquidity levels to remain sufficient throughout 2002. In particular, at June 30, 2002, the Company had $105.0 million in unused FHLB borrowing capacity. In addition, the Company has available other borrowing sources such as federal funds lines and securities which could be pledged as collateral for Security Repo Agreements.

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PART II
 
OTHER INFORMATION
 
Item 1.     Legal Proceedings
 
The Company, from time to time, has been named in ordinary, routine litigation. Certain of these lawsuits are class actions requesting unspecified or substantial damages. In each case, a class has not yet been certified. These matters have arisen in the normal course of business and are related to lending, collections, servicing and other activities. The Company believes that it has meritorious defenses to these lawsuits. Management is of the opinion that the ultimate resolution of these lawsuits will not have a material adverse effect on the Company’s financial condition or results of operations.
 
Item 4.     Submission of Matters to a Vote of Security Holders
 
The Annual meeting of shareholders of the Company was held on May 28, 2002. The following matter was submitted to a vote of the Company’s shareholders:
 
Election of Three Director Nominees was approved:
 
Name
   
Total Votes
For
     
Total Votes Against
     
Total Votes Withheld
W.T. Ratliff, Jr. (Term Expires 2005)
   
1,110,045.10
     
0
     
0
Robert M. Couch (Term Expires 2005)
   
1,110,045.10
     
0
     
0
David A. Roberts (Term Expires 2005)
   
1,110,045.10
     
0
     
0
 
Remaining Directors not elected at this meeting whose terms continue:
 
William T. Ratliff, III (Term Expires 2003)
Lizabeth R. Nichols (Term Expires 2004)
 
Item 5.     Other Information
 
None.
 
Item 6.     Exhibits and Reports on Form 8-K
 
ITEM 6(A)—EXHIBITS
 
The exhibits listed in the Exhibit Index at page 27 of this Form 10-Q are filed herewith or are incorporated by reference herein.
 
ITEM 6(B)—REPORTS on Form 8-K
 
A report on Form 8-K was filed by the Company during the period April 1, 2002 to June 30, 2002. The report was filed on July 31, 2002 regarding the Company’s change in accountants. No financial statements were filed with this report.

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SIGNATURES
 
Pursuant to the requirements of the Securities Exchange Act of 1934, New South Bancshares, Inc. has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
By:
  
/s/    ROBERT M. COUCH       
   
Robert M. Couch
Executive Vice President
 
August 14, 2002
By:
  
/s/    ROGER D. MURPHREE         
   
Roger D. Murphree
Chief Financial Officer
 
August 14, 2002

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EXHIBIT INDEX
 
The following is a list of exhibits including items incorporated by reference:
 
  *3.1
   
Certificate of Incorporation of New South Bancshares, Inc.
  *3.2
   
By-Laws of New South Bancshares, Inc.
  *4.1
   
Certificate of Trust of New South Capital Trust I
  *4.2
   
Initial Trust Agreement of New South Capital Trust I
**4.3
   
Form of Junior Subordinated Indenture between the Company and Bankers Trust Company, as Debenture Trustee
*
 
Filed with Registration Statement on Form S-1, filed April 6, 1999, registration No.333-49459
**
 
Filed with Amendment No. 1 to the Registration Statement on Form S-1, filed May 13, 1999

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