SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2002
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 For the transaction period
from ___________________ to ______________________
Commission File Number: 0-23971
CITIZENS SOUTH BANKING CORPORATION
(Exact name of Registrant as specified in its Charter)
DELAWARE 54-2069979
(State or Other Jurisdiction of (I.R.S. Employer Identification Number)
Incorporation or Organization)
245 WEST MAIN AVENUE, GASTONIA, NORTH CAROLINA 28052-4140
(Address of Principal Executive Office) (Zip Code)
(704) 868-5200
(Registrant's Telephone Number, Including Area Code)
Securities Registered Pursuant to Section 12(b) of the Act:
NONE
Securities Registered Pursuant to Section 12(g) of the Act:
COMMON STOCK, PAR VALUE $0.01 PER SHARE
(Title of Class)
Indicate by check mark whether the issuer (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 twelve months (or for such shorter period that the
Registrant was required to file reports) and (2) has been subject to such
requirements for the past 90 days.
YES |X| NO |_|
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendments to this Form 10-K. |_|
Indicate by check mark whether the Registrant is an accelerated filer
as defined in Rule 126-2 of the Act YES |X| NO |_|
As of March 12, 2003, 9,076,552 shares of common stock, $0.01 par
value, were outstanding and the aggregate market value of the voting stock held
by non-affiliates was $90.6 million.
DOCUMENTS INCORPORATED BY REFERENCE
PART III: Sections of the Preliminary Proxy Statement dated April 3, 2003 as
filed pursuant to Section 14 of the Securities and Exchange Act of
1934 in connection with the 2003 Annual Meeting of Stockholders.
CITIZENS SOUTH BANKING CORPORATION
AND SUBSIDIARIES
FORM 10-K FOR THE FISCAL YEAR ENDED DECEMBER 31, 2002
TABLE OF CONTENTS
PART I
ITEM 1. BUSINESS........................................................................... 1
ITEM 2. PROPERTIES......................................................................... 36
ITEM 3. LEGAL PROCEEDINGS.................................................................. 37
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS................................ 37
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND
RELATED STOCKHOLDER MATTERS.................................................... 38
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA............................................... 39
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS......................................................... 41
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK......................... 49
ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA........................... 50
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS
ON ACCOUNTING AND FINANCIAL DISCLOSURE......................................... 86
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT................................. 87
ITEM 11. EXECUTIVE COMPENSATION............................................................. 87
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
AND RELATED STOCKHOLDER MATTERS............................................... 87
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS..................................... 87
ITEM 14. CONTROLS AND PROCEDURES ........................................................... 87
PART IV
ITEM 15. EXHIBITS, LISTS, AND REPORTS ON FORMS 8-K.......................................... 88
SIGNATURES ................................................................................... 95
0
PART I
ITEM 1. BUSINESS
CITIZENS SOUTH BANKING CORPORATION
Citizens South Banking Corporation (which changed its name from Gaston
Federal Bancorp, Inc. on May 22, 2002) is a Delaware corporation that owns all
of the outstanding common stock of Citizens South Bank (formerly known as Gaston
Federal Bank). Citizens South Banking Corporation (also referred to as the
"Company", the "Registrant", "we", "us", or "our") was organized on September
30, 2002, for the purpose of acting as the holding company for Citizens South
Bank (the "Bank"). The Company's principal business activities are overseeing
and directing the business of the Bank and investing the net stock offering
proceeds retained by the Company. The Company's assets consist primarily of the
outstanding capital stock of the Bank, deposits held at the Bank, and investment
securities. At December 31, 2002, the Company had consolidated assets of $492.6
million, deposits of $340.9 million, and stockholders' equity of $96.4 million.
Also, as of December 31, 2002, there were 9,062,727 shares of the Company's
common stock issued and outstanding. The common stock of the Company currently
trades on the Nasdaq National Market under the ticker symbol CSBC. The Company's
executive office is located at 245 West Main Avenue, P.O. Box 2249, Gastonia,
North Carolina 28053-2249. Its telephone number at this address is (704)
868-5200.
CITIZENS SOUTH BANK
Citizens South Bank (which changed its name from Gaston Federal Bank on
March 11, 2002) is a federally chartered savings bank headquartered in Gastonia,
North Carolina. The Bank's principal business activity is offering FDIC-insured
deposit accounts to local customers through its nine branch offices and
investing those deposits, together with funds generated from operations and
borrowings, in nonresidential mortgage loans, construction loans, commercial
business loans, consumer loans, investment securities, and mortgage-backed
securities. The Bank also acts as a broker in both the origination of loans
secured by one-to-four family dwellings and in the sale of uninsured financial
products. The Bank's results of operations are heavily dependent on net interest
income, which is the difference between the income earned on loans and
securities and the interest paid on deposits and borrowings. Results of
operations are also materially affected by the Bank's provision for loan losses,
gains or losses from the sales of assets, fee income generated from deposit and
loan accounts, commissions earned from the sale of uninsured investment
products, and noninterest expenses. The Bank's noninterest expense primarily
consists of compensation and employee benefits, occupancy expense, professional
services, advertising, and other noninterest expenses. Results of operations are
also significantly affected by general economic and competitive conditions,
changes in interest rates, and actions of regulatory and governmental
authorities.
Citizens South Bank is the successor entity to Gaston Federal Bank, which
was established on December 31, 1904, as Gastonia Mutual Building and Loan
Association under a charter from the State of North Carolina. Gastonia Mutual
Building and Loan Association became Gastonia Mutual Savings and Loan
Association on January 20, 1959. Gastonia Mutual converted to a Federal charter
and became Gaston Federal Savings and Loan Association on June 10, 1981. On
April 30, 1982, Mount Holly Federal Savings and Loan Association (formerly
Mutual Building and Savings Association, which was established in 1937 in Mount
Holly, North Carolina) merged into Gaston Federal. On April 9, 1998, Gaston
Federal Savings and Loan Association reorganized into the mutual holding company
structure and Gaston Federal Bancorp, Inc., its holding company, sold stock to
the public. Gaston Federal became Gaston Federal Bank, a wholly-owned subsidiary
of Gaston Federal Bancorp, Inc., which traded under the ticker symbol GBNK. On
December 31, 2001, Gaston Federal Bancorp, Inc. acquired Innes Street Financial
Corporation ("Innes Street"), of Salisbury, North Carolina, which merged into
Gaston Federal
1
Bank. Innes Street was the holding company of Citizens Bank, Inc., which
operated three full service branch offices as a North Carolina chartered savings
bank established in 1907 in Salisbury, North Carolina. Gaston Federal Bank
changed its name to Citizens South Bank on March 11, 2002. Gaston Federal
Bancorp, Inc. changed its name to Citizens South Banking Corporation on May 22,
2002.
On December 31, 2001, the Company acquired 100% of the outstanding shares
of common stock of Innes Street and its wholly-owned subsidiary, Citizens Bank.
Accordingly, the results of operations of Innes Street have been included in the
consolidated financial statements of the Company since the acquisition effective
at the close of business, December 31, 2001. The aggregate purchase price for
the transaction was approximately $38 million. Innes Street and its subsidiary
served the Salisbury, North Carolina, area for over ninety years by providing
that community and the surrounding counties with general banking services.
Citizens Bank operated three full-service branch offices in the North Carolina
cities of Salisbury, Statesville, and Rockwell, North Carolina. At the time of
the acquisition, Innes Street had total assets of $221.8 million, net loans of
$170.5 million, total deposits of $175.4 million, and total liabilities of
$183.9 million. The transaction was accounted for using the purchase method of
accounting. The Company filed a Current Report on Form 8-K with the Securities
and Exchange Commission on December 31, 2001, which provides additional
information about the acquisition and is incorporated herein by reference.
Citizens South Bank has nine full-service branch offices in the North
Carolina Counties of Gaston, Rowan, and Iredell. The Bank's executive office is
located at 245 West Main Avenue, P.O. Box 2249, Gastonia, North Carolina
28053-2249. Its telephone number at this address is (704) 868-5200.
MARKET AREA AND COMPETITION
We consider our primary market area to be the North Carolina Counties of
Gaston, Rowan, Iredell, Mecklenburg, Cabarrus, Lincoln, and Cleveland, and the
South Carolina County of York. Our market area predominately centers in the
suburbs surrounding the Metro region of Charlotte, which is the twenty-fifth
largest city in the United States. Charlotte has a diverse economic base.
Primary business sectors in the Metro Charlotte region include banking and
finance, insurance, manufacturing, textiles, apparel, fabricated metals,
construction, health care, transportation, retail trade, telecommunications,
government services, and education. The Bank's corporate headquarters is located
in Gastonia, North Carolina, which is located in the I-85 corridor,
approximately 20 miles west of Charlotte, North Carolina.
The Bank's corporate headquarters and five branch offices are located in
Gaston County, North Carolina. These offices are located in the cities of
Gastonia (three offices), Dallas, Mount Holly, and Stanley. According to data
provided by the FDIC as of June 30, 2002, there were 12 banks and thrifts
operating in Gaston County with $1.7 billion in deposits. As of June 30, 2002,
the Bank had $163.9 million in deposits in Gaston County, or 10.6% of the total
deposits in the county. This represents the third highest market share in the
County.
We also operate two branch offices in Rowan County, North Carolina, which
is approximately 60 miles northeast of the corporate headquarters. These offices
are located in the cities of Salisbury and Rockwell. According to data provided
by the FDIC as of June 30, 2002, there were 11 banks and thrifts operating in
Rowan County with $1.2 billion in deposits. As of June 30, 2002, the Bank had
$115.5 million in deposits in Rowan County, or 9.8% of the total deposits in the
county. This represents the fourth highest market share in the County.
We have one branch office in Iredell County, North Carolina, in the city of
Statesville, which is approximately 60 miles north of the corporate
headquarters. According to data provided by the FDIC as of June 30, 2002, there
were 11 banks and thrifts operating in Iredell County with $1.4 billion in
deposits. As of June 30, 2002, the Bank had $48.4 million in deposits in Iredell
County, or 3.35% of the total deposits in the county. This represents the ninth
highest
2
market share in the County. The Bank also has begun construction on another
office in Iredell County in the city of Mooresville, North Carolina.
Construction is expected to be completed in the second quarter of 2003.
EMPLOYEES
As of December 31, 2002, the Company had 104 full-time and 10 part-time
employees, none of whom is represented by a collective bargaining unit.
Management believes its relationship with its employees is good.
LENDING ACTIVITIES
GENERAL. At December 31, 2002, our net loans receivable totaled $299.9
million, or 60.9% of total assets at that date. In the past, we concentrated our
lending activities on conventional first mortgage loans secured by one-to-four
family properties. Currently, the Bank concentrates its lending activities on
construction loans, nonresidential real estate loans, commercial business loans
and consumer loans. A substantial portion of our loan portfolio is secured by
real estate, either as primary or secondary collateral, located in our primary
market area.
3
LOAN PORTFOLIO ANALYSIS. The following table sets forth the composition of our
loan portfolio at the dates indicated. We had no concentration of loans
exceeding 10% of total gross loans other than as disclosed below.
December 31, 2002 December 31, 2001 December 31, 2000
-------------------- ------------------ ------------------
Amount Percent Amount Percent Amount Percent
-------------------- ------------------ ------------------
(Dollars in Thousands)
Real estate loans:
One- to four family residential $148,843 48.26% $196,572 57.33% $109,907 66.43%
Multifamily residential ....... 8,962 2.91 8,696 2.54 2,003 1.21
Construction .................. 15,321 4.97 16,525 4.82 9,597 5.80
Nonresidential ................ 61,984 20.10 49,235 14.36 12,925 7.81
-------- ----- -------- ----- -------- -----
Total real estate loans ....... 235,111 76.23 271,028 79.05 134,432 81.25
Commercial business loans ..... 12,084 3.92 6,930 2.03 12,834 7.76
Consumer loans ................ 61,213 19.85 64,883 18.92 18,183 10.99
-------- ----- -------- ----- -------- -----
Total gross loans ............. 308,408 100.00% 342,841 100.00% 165,449 100.00%
===== ===== =====
Less:
Loans in process .............. 5,418 5,306 4,758
Deferred loan fees, net ....... 89 78 305
Allowance for loan losses...... 2,995 3,136 1,566
-------- -------- --------
Total loans, net .............. $299,906 $334,321 $158,820
======== ======== ========
September 30, 2000 September 30, 1999 September 30, 1998
-------------------- ------------------ ------------------
Amount Percent Amount Percent Amount Percent
-------------------- ------------------ ------------------
(Dollars in Thousands)
Real estate loans:
One- to four family residential $129,031 70.36% $129,332 73.42% $105,526 73.50%
Multifamily residential ....... 2,046 1.12 2,414 1.37 3,771 2.63
Construction .................. 6,939 3.78 8,513 4.83 10,573 7.36
Nonresidential ................ 12,633 6.90 7,266 4.13 8,076 5.63
-------- ----- -------- ----- -------- -----
Total real estate loans ....... 150,649 82.16 147,525 83.75 127,946 89.12
Commercial business loans ..... 15,552 8.48 17,019 9.67 6,629 4.62
Consumer loans ................ 17,168 9.36 11,599 6.58 8,989 6.26
-------- ----- -------- ----- -------- -----
Total gross loans.............. 183,369 100.00% 176,143 100.00% 143,564 100.00%
===== ===== =====
Less:
Loans in process .............. 4,544 6,205 5,152
Deferred loan fees, net ....... 325 385 501
Allowance for loan losses...... 1,537 1,509 1,411
-------- -------- --------
Total loans, net .............. $176,963 $168,044 $136,500
======== ======== ========
4
ONE-TO-FOUR FAMILY REAL ESTATE LENDING. At December 31, 2002, our
one-to-four family residential loan portfolio totaled $148.8 million, or 48.26%
of our total loan portfolio. These loans are typically originated under terms,
conditions and documentation that permit them to be sold to U.S.
Government-sponsored agencies such as FNMA ("Fannie Mae") or FHLMC ("Freddie
Mac"). These loans customarily include "due on sale" clauses, which give us the
right to declare a loan immediately due and payable in the event the borrower
sells or otherwise disposes of the real property subject to the mortgage and the
loan is not paid. Our one-to-four family mortgage loans generally have
maturities ranging from ten to thirty years and are fully amortizing with
monthly or bi-weekly payments sufficient to repay the total amount of the loan
with interest by the end of the loan term. We require title insurance insuring
the status of its lien or an acceptable attorney's opinion on all first mortgage
loans where real estate is the primary source of security. We also require that
fire and casualty insurance (and, if appropriate, flood insurance) be maintained
in an amount at least equal to the outstanding loan balance. Pursuant to
underwriting guidelines adopted by our Board of Directors, we can lend up to 95%
of the appraised value of the property securing a one-to-four family residential
loan. For loans that have a loan-to-value ("LTV") ratio of more than 80%, we
require private mortgage insurance for between 20% and 30% of the amount of the
loan. We do not require private mortgage insurance for loans that have a LTV
ratio of 80% or less.
We offer both fixed- and adjustable-rate mortgage loans at competitive
rates and terms. Our adjustable-rate mortgage ("ARM") loans typically provide
for an interest rate which adjusts every year after an initial term of one,
three, five, seven or ten years based on the one-year Treasury constant maturity
index and are typically based on a 30-year amortization schedule. Our current
ARM loans do not provide for negative amortization. Our ARM loans generally
provide for annual and lifetime interest rate adjustment limits of 2% and 5%,
respectively. The retention of ARM loans in our loan portfolio helps to reduce
our exposure to changes in interest rates. There are, however, unquantifiable
credit risks resulting from the potential of increased payments due to changed
rates to be paid by the customer. It is possible that during periods of rising
interest rates the risk of default on ARM loans may increase as a result of
repricing and the increased payments required by the borrower. In addition,
although ARM loans allow us to increase the sensitivity of our asset base to
changes in the interest rates, the extent of this interest sensitivity is
limited by the annual and lifetime interest rate adjustment limits. Because of
these considerations, we have no assurance that yields on ARM loans will be
sufficient to offset increases in our cost of funds. We believe these risks,
which have not had a material adverse effect on us to date, generally are less
than the risks associated with holding fixed-rate loans in portfolio during a
rising interest rate environment.
In 1999, we began originating and closing substantially all fixed-rate
mortgages as a broker for independent third parties on a servicing released
basis. All loan documents are in the names of the third parties and borrowers
have no recourse against us in connection with these loans. This process allows
us to provide more competitive mortgage products in our market area including
15- and 30-year fixed-rate loans and long-term fixed-rate Federal Housing
Administration and Veterans Administration products. We also benefit by being
able to immediately record fee income we earn on these loans during the period
in which the loan is closed and we can better manage our interest rate risk
since long-term fixed-rate loans are not being retained in our loan portfolio.
MULTIFAMILY RESIDENTIAL REAL ESTATE LENDING. At December 31, 2002, our
multifamily residential real estate (more than four units) loan portfolio
totaled $9.0 million, or 2.91% of our total loan portfolio. The majority of our
multifamily residential real estate loans are secured by apartment buildings
located in our primary market area. The interest rates on our multifamily
residential real estate loans generally adjust at either one-, three-, or
five-year intervals, based on the constant maturity Treasury index, with annual
and lifetime
5
interest rate adjustment limits of 2% and 5%, respectively, or adjust based on
our prime rate. These loans are originated to amortize in a maximum of 20 years.
We require appraisals of all properties securing multifamily residential real
estate loans. Appraisals are performed by an independent appraiser designated by
management. We consider the quality and location of the real estate, the credit
of the borrower, the cash flow of the project, and the quality of management
involved with the property. LTV ratios on our multifamily residential real
estate loans are generally limited to 80%. As part of the criteria for
underwriting multifamily residential real estate loans, we generally impose a
debt coverage ratio (the ratio of net cash from operations before payment of
debt service to debt service) of not less than 1.25. It is also our policy to
obtain personal guarantees from the principals of corporate borrowers on
multifamily residential real estate loans.
Multifamily residential real estate lending affords us an opportunity
to receive interest at rates higher than those generally available from
one-to-four family residential lending. However, loans secured by such
properties usually have higher balances and are more difficult to evaluate and
monitor and, therefore, involve a greater degree of risk than one-to-four family
residential mortgage loans. If the estimate of value proves to be inaccurate, in
the event of default and foreclosure we may be in possession of a property that
has insufficient value to assure full repayment. Because payments on such loans
are often dependent on the successful operation and management of the
properties, repayment of such loans may be affected by adverse conditions in the
real estate market or the economy. We seek to minimize these risks by limiting
the maximum LTV ratio, strictly scrutinizing the financial condition and
management capacity of the borrower, and the quality of the collateral securing
the loan.
CONSTRUCTION LENDING. At December 31, 2002, total construction loans
amounted to $15.3 million, or 4.97% of the total loan portfolio. We generally
originate residential construction-permanent loans to individuals who have a
contract with a builder for the construction of their residence and speculative
construction loans to local builders for purposes of building one-to-four family
residential properties. Prior to making a commitment to fund a construction
loan, we require an appraisal of the property by an independent state-licensed
and qualified appraiser approved by the Board of Directors. Our staff, or an
independent appraiser retained by us, reviews and inspects each project prior to
disbursement of funds during the term of the construction loan. Loan proceeds
are disbursed after inspection of the project based on a percentage of
completion. Monthly payment of accrued interest is required during the
construction period.
Our construction-permanent loans are typically made in connection with
the granting of the permanent financing on the property. These loans convert to
a fully amortizing three- or five-year adjustable- or fixed-rate loan at the end
of the 12-month construction term. If the construction is not complete after 12
months, we will generally modify the loan so that the term is for a period
necessary to complete construction. These loans are generally originated
pursuant to the same policies regarding loan-to-value ratios and credit quality
as are used in connection with loans secured by existing one-to-four family
residential real estate.
Our speculative construction loans are typically granted to local
builders with an established relationship with us. These loans are typically for
a term of 12 months at an interest rate tied to our prime lending rate. If the
property is not sold at the end of the 12-month term, we will generally extend
the loan for a period necessary to sell the property. These loans are
underwritten based on the financial strength of the builder. In order to reduce
our exposure, builders are typically limited in the number of outstanding unsold
properties they may have with us at any one time.
Construction lending affords us the opportunity to charge higher
interest rates relative to permanent residential lending. However, construction
lending is generally considered to involve a higher degree of risk than
permanent residential lending because of the inherent difficulty in estimating a
property's value at the
6
completion of the construction. The nature of these loans is such that they are
generally more difficult to evaluate and monitor. If the estimate of
construction cost proves to be inaccurate, we may be required to advance funds
beyond the amount originally committed to permit completion of the project. If
the estimate of value upon completion proves to be inaccurate, we may be
confronted at or prior to the maturity of the loan with a project the value of
which is insufficient to collateralize the loan. Projects may also be
jeopardized by disagreements between borrowers and builders and by the failure
of builders to pay subcontractors. We have attempted to minimize the foregoing
risks by, among other things, limiting our construction lending primarily to
residential properties located within our market area, requiring lien waivers
from contractors prior to making disbursements, and holding back a portion of
the loan proceeds until construction is complete.
NONRESIDENTIAL REAL ESTATE LENDING. At December 31, 2002, our
nonresidential real estate loans totaled $61.9 million, or 20.10% of the total
loan portfolio. We originate mortgage loans for the acquisition and refinancing
of nonresidential real estate properties and land. The majority of our
nonresidential real estate properties are secured by office buildings, churches,
retail shops, and land which are generally located in our primary market area.
These loans generally have interest rates that are either fixed for a period of
five to seven years, or adjust at either one-, three-, or five-year intervals,
based on the constant maturity Treasury index, with annual and lifetime interest
rate adjustment limits of 2% and 5%, respectively, or adjust based on our prime
rate. These loans typically are originated to amortize in a maximum of 20 years.
We require appraisals of all properties securing nonresidential real estate
loans. Appraisals are performed by an independent appraiser designated by
management. We consider the quality and location of the real estate, the credit
of the borrower, the cash flow of the project, and the quality of management
involved with the property. Loan-to-value ratios on our nonresidential real
estate loans are generally limited to 80% of the appraised value of the secured
property. As part of the criteria for underwriting nonresidential real estate
loans, we generally impose a debt coverage ratio (the ratio of net cash from
operations before payment of debt service to debt service) of not less than 1.25
times. It is also our policy to obtain personal guarantees from the principals
of corporate borrowers on nonresidential real estate loans.
This type of lending affords us an opportunity to receive interest at
rates higher than those generally available from one-to-four family residential
lending. However, loans secured by such properties usually have higher balances
and are more difficult to evaluate and monitor and, therefore, involve a greater
degree of risk than residential mortgage loans. If the estimate of value proves
to be inaccurate, in the event of default and foreclosure we may be in
possession of a property that has insufficient value to assure full repayment.
Because payments on such loans are often dependent on the successful
development, operation, and management of the properties, repayment of such
loans may be affected by adverse conditions in the real estate market or the
economy. We seek to minimize these risks by limiting the maximum LTV ratio,
strictly scrutinizing the financial condition and management capacity of the
borrower, and the quality of the collateral securing the loan. We also obtain
loan guarantees from financially capable parties based on a review of personal
financial statements.
COMMERCIAL BUSINESS LOANS. At December 31, 2002, we had $12.1 million
of commercial business loans that represented 3.92% of the total loan portfolio.
We originate commercial business loans to customers who are generally well known
by us and are located in our primary market area. Commercial business loans may
be either unsecured or secured by collateral other than real estate, such as
vehicles, equipment, or stock. The decision to grant a commercial business loan
depends primarily on the creditworthiness and cash flow of the borrower and any
guarantors. The interest rates for our commercial business loans generally
adjust based on our prime rate, or are fixed at the time of closing for a term
of generally five to seven years. We generally require annual financial
statements from our corporate borrowers and personal guarantees from the
corporate
7
principals. We also generally require an estimate of value for any collateral
that secures the loan. Unsecured commercial business loans totaled $4.2 million
as of December 31, 2002.
Commercial business lending generally involves greater risk than
residential mortgage lending and involves risks that are different from those
associated with residential and nonresidential real estate lending. Commercial
business loans are often unsecured or secured by equipment or other business
assets. The liquidation of collateral in the event of a borrower default is
often an insufficient source of repayment because equipment and other business
assets may be obsolete or of limited use. Accordingly, the repayment of a
commercial business loan depends primarily on the creditworthiness of the
borrower and any guarantors, while liquidation of collateral is a secondary and
often insufficient source of repayment
CONSUMER LOANS. At December 31, 2002, our consumer loan portfolio
totaled $61.2 million, or 19.85% of the total loan portfolio. We originate a
variety of consumer loans including home equity lines of credit ("HELOCs"),
second mortgage loans, loans secured by savings accounts, automobiles,
recreational vehicles, and unsecured personal loans.
The largest component of our consumer loan portfolio is home equity
lines of credit, which totaled $49.2 million. Our HELOCs have variable interest
rates that are tied to The Wall Street Journal prime lending rate (the "prime
rate") and may adjust monthly, and generally mature in 15 years. The maximum LTV
ratio on these loans is typically 90%, including the outstanding balance of any
superior liens. Unused commitments to extend credit under these HELOCs totaled
$43.3 million. HELOCs originated by us are typically secured by properties
located in our normal lending area or to customers who have a relationship with
us. These loans are generally underwritten to the same credit standards used
when underwriting first mortgage loans. We also generally require title
insurance and an independent estimate of value. HELOCs obtained from the
acquisition of Innes Street were generally originated using a third party
internet loan provider. These loans, which are secured by properties located in
North Carolina, Georgia, and Virginia, were underwritten based on the
applicant's credit history and the value of the collateral. Our lien position on
these loans is covered by a either a title insurance policy or signed affidavit
from the borrower verifying our lien position.
Most of the other consumer loans are second mortgage loans obtained in
the acquisition of Innes Street. These loans were generally originated using a
third party internet loan provider and are secured by properties located in
North Carolina, Georgia, and Virginia. The loans were underwritten based on the
applicant's credit history and the value of the collateral. These loans
typically have a fixed rate of interest and generally mature in 15 years. The
maximum LTV ratio is 90%, including the outstanding balance of any superior
liens. Our lien position on these loans is covered by either a title insurance
policy or a signed affidavit from the borrower verifying our lien position.
Other consumer loans are typically made to existing customers, although
we actively solicit consumer loans by promotions and advertising directed at new
prospective customers. We view consumer lending as an important part of our
business because consumer loans generally have shorter terms and higher yields,
thus reducing exposure to changes in interest rates. In addition, we believe
that offering consumer loans helps to expand and create stronger ties to our
customer base. Subject to market conditions, we intend to continue emphasizing
consumer lending. Consumer loans not secured by real estate are made with fixed
interest rates and have terms that generally do not exceed five years.
Consumer loans entail greater risk than do residential mortgage loans,
particularly in the case of consumer loans that are unsecured or secured by
rapidly depreciating assets. In such cases, any repossessed collateral for a
defaulted consumer loan may not provide an adequate source of repayment of the
8
outstanding loan balance as a result of the greater likelihood of damage, loss
or depreciation. The remaining deficiency often does not warrant further
substantial collection efforts against the borrower beyond obtaining a
deficiency judgment. In addition, consumer loan collections are dependent on the
borrower's continuing financial stability, and are more likely to be adversely
affected by job loss, divorce, illness or personal bankruptcy. Furthermore, the
application of various federal and state laws, including federal and state
bankruptcy and insolvency laws, may limit the amount that can be recovered on
such loans. We employ strict underwriting procedures for consumer loans. These
procedures include an assessment of the applicant's credit history and the
ability to meet existing and proposed debt obligations. Although the applicant's
creditworthiness is the primary consideration, the underwriting process also
includes an evaluation of the proposed collateral for the loan. We underwrite
and originate our consumer loans internally, which we believe limits our
exposure to credit risks associated with loans underwritten or purchased from
brokers and other external sources.
9
MATURITY OF LOAN PORTFOLIO. The following table sets forth certain
information at December 31, 2002 regarding the dollar amount of loans maturing
in our portfolio based on their contractual terms to maturity, but does not
include scheduled payments or potential prepayments. Demand loans, loans having
no stated schedule of repayments and no stated maturity, and overdrafts are
reported as becoming due within one year. Loan balances do not include
undisbursed loan proceeds, unearned discounts, unearned income and allowance for
loan losses.
Real Estate Loans
----------------------------------------------------
One-to-Four Multi-
Family Family Non- Commercial
Residential Residential Construction Residential Business Consumer Total
------------------------ ------------------------- ---------- -------- --------
(In Thousands)
Amounts Due:
Within 1 year ...... $ 3,266 $ 0 $13,103 $10,910 $ 4,774 $ 721 $ 32,774
Over 1 to 2 years .. 927 281 132 4,005 1,142 577 7,264
Over 2 to 3 years .. 1,147 300 0 3,022 943 715 6,127
Over 3 to 5 years .. 6,525 25 0 18,695 2,672 2,595 30,512
Over 5 to 10 years.. 25,543 3,980 0 12,244 1,188 7,189 50,144
Over 10 to 20 years. 63,100 4,376 428 13,108 1,165 49,416 131,593
Over 20 years ...... 48,335 0 1,659 0 0 0 49,994
-------- ------ ------- ------- ------- ------- --------
Total amount due ... $148,843 $8,962 $15,321 $61,984 $12,084 $61,213 $308,408
======== ====== ======= ======= ======= ======= ========
The following table sets forth the dollar amount of all loans for which
final payment is not due until after December 31, 2003. The table also shows the
amount of loans which have fixed rates of interest and those which have
adjustable rates of interest.
Fixed Rates Adjustable Rates Total
----------- ---------------- --------
(In Thousands)
Real Estate Loans:
One-to-four family residential . $ 73,826 $ 71,751 $145,577
Multifamily residential ........ 5,259 3,703 8,962
Construction ................... 959 1,260 2,219
Nonresidential ................. 15,073 36,001 51,074
------ ------- -------
Total real estate loans ........... 95,117 112,715 207,832
Commercial business ............... 4,213 3,097 7,310
Consumer loans .................... 10,516 49,976 60,492
------ ------- -------
Total loans .................... $109,846 $165,788 $275,634
======== ======== ========
Scheduled contractual principal repayments of loans do not reflect the
actual life of such assets. The average life of a loan is substantially less
than its contractual terms because of prepayments. In addition, due-on-sale
clauses on loans generally give us the right to declare loans 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, however, when current mortgage loan market
rates are substantially higher than rates on existing mortgage loans and,
conversely, decrease when rates on existing mortgage loans are substantially
higher than current mortgage loan market rates.
LOAN SOLICITATION AND PROCESSING. Our lending activities are subject to
the written, non-discriminatory, underwriting standards and loan origination
procedures established by management and approved by our Board of Directors.
Loan originations come from a number of sources. The customary sources of loan
originations are real estate agents, home builders, walk-in customers, referrals
and existing customers. Loan officers also call on local businesses soliciting
commercial products. We advertise our loan products in various print media
including the local newspaper. In our marketing, we emphasize our community
ties,
10
personalized customer service, and an efficient underwriting and approval
process. We use professional fee appraisers for most residential real estate
loans and construction loans and all commercial real estate and land loans. On
new loan originations, we require hazard, title and, to the extent applicable,
flood insurance on all security property.
All loans (i) of $2.0 million or more, (ii) in any amount to borrowers
with existing exposure to us of $2.0 million or more, or (iii) in any amount
that when added to the borrower's existing exposure to us causes such total
exposure to be $2.0 million or more, must be approved by our Board of Directors.
All single loans in excess of $.5 million, regardless of the borrower's exposure
to the Bank, must be approved by the Board of Directors. In addition, all
unsecured loans of $400,000 or more must be approved by our Board of Directors.
Loans of less than $2.0 million, or customers with exposure (including the
proposed loan) of less than $2.0 million, or unsecured loans of less than
$400,000, as applicable, may be approved individually or jointly by our lending
officers within loan approval limits delegated by our Board of Directors. In
addition, the Board of Directors has delegated "incremental" loan approval
limits to certain lending officers which allows them to approve a new loan to an
existing customer in an amount equal to, or less than, their incremental loan
limit that would otherwise require approval by the Board of Directors or the
additional approval of another lending officer. Any loan approved by a lending
officer using their incremental loan limit must be ratified by the Board of
Directors or approved by another lending officer, as applicable, after the loan
has been made.
LOAN ORIGINATIONS, SALES AND PURCHASES. The following table sets forth
total loans originated and repaid during the periods indicated.
At and For the Twelve Months Ended
-------------------------------------------------------
December 31, September 30,
------------------------------------- -------------
2002 2001 2000 2000
(In Thousands)
Total loans receivable at beginning of period.... $ 334,321 $ 158,820 $ 169,931 $ 176,143
Total loan originations:
One-to-four family residential................ 14,594 1,419 3,700 4,951
Multifamily residential....................... 1,365 0 0 0
Construction.................................. 8,843 8,849 3,800 2,716
Nonresidential real estate.................... 47,540 12,881 6,734 6,164
Commercial business........................... 20,509 23,203 19,554 20,104
Consumer...................................... 42,060 22,119 19,485 18,083
----------- ----------- ----------- -----------
Total loans originated........................... 134,911 68,471 53,274 52,018
Loans purchased.................................. 125 170,527 0 20
Loans sold....................................... (1,419) 0 (18,169) (215)
Principal repayments............................. (168,032) (63,497) (46,216) (44,597)
----------- ----------- ----------- -----------
Net loan activity................................ (34,415) 175,501 (11,111) 7,226
----------- ----------- ----------- -----------
Total loans receivable at end of period.......... $ 299,906 $ 334,321 $ 158,820 $ 183,369
=========== =========== ============ ===========
LOAN COMMITMENTS. We issue commitments for various types of loans
conditioned upon the occurrence of certain events. Such commitments are made in
writing on specified terms and conditions and are honored for up to 60 days from
approval, depending on the type of transaction. At December 31, 2002, we had
loan commitments (excluding undisbursed portions of interim construction loans
of $5.4 million) of $8.8 million and unused commercial lines of credit of $12.5
million and unused consumer lines of credit of $44.3 million.
LOAN FEES. In addition to interest earned on loans, we receive income
from fees in connection with loan originations, loan modifications, late
payments and for miscellaneous services related to its loans. Income from these
activities varies from period to period depending upon the volume and type of
loans made and
11
competitive conditions. We charge loan origination fees that are generally
calculated as a percentage of the amount borrowed. In accordance with applicable
accounting standards, loan origination fees and discount points in excess of
loan origination costs are deferred and recognized over the contractual
remaining lives of the related loans on a level yield basis. Discounts and
premiums on loans purchased are accreted and amortized in the same manner. Fees
collected on loans originated as a broker for independent third party investors
are recognized in the period in which the loan is sold. We recognized $224,000,
$106,000, $101,000, and $108,000 of deferred loan fees during the fiscal years
ended December 31, 2002, December 31, 2001, December 31, 2000, and September 30,
2000, respectively, in connection with loan originations, refinancings, payoffs,
sales and ongoing amortization of outstanding loans held in our loan portfolio.
NONPERFORMING ASSETS AND DELINQUENCIES. When a borrower fails to make a
required payment on a loan, we attempt to cure the deficiency by contacting the
borrower and collecting the payment. Computer generated late notices are mailed
15 days after a payment is due. In most cases, deficiencies are cured promptly.
If a delinquency continues, additional contact is made either through a notice
or other means and we will attempt to work out a payment schedule and actively
encourage delinquent borrowers to seek home ownership counseling. While we
generally prefer to work with borrowers to resolve such problems, we will
institute foreclosure or other proceedings, as necessary, to minimize any
potential loss. Loans are placed on nonaccrual status generally if, in the
opinion of management, principal or interest payments are not likely in
accordance with the terms of the loan agreement, or when principal or interest
is past due 90 days or more. Interest accrued but not collected at the date the
loan is placed on nonaccrual status is reversed against income in the current
period. Loans may be reinstated to accrual status when payments are under 90
days past due and, in the opinion of management, collection of the remaining
past due balances can be reasonably expected. Our Board of Directors is informed
monthly of the total amount of loans which are more than 30 days delinquent.
Loans that are more than 90 days delinquent or in foreclosure are reviewed by
the Board on an individual basis each month.
12
The following table sets forth information with respect to our
nonperforming assets at the dates indicated. As of such dates, we had no
restructured loans within the meaning of SFAS No. 15.
December 31, September 30,
----------------------- ---------------------
2002 2001 2000 2000 1999 1998
---- ---- ---- ---- ---- ----
(Dollars in Thousands)
Loans accounted for on a nonaccrual basis:
Real estate loans:
One-to-four family residential ............. $ 329 $ 756 $ 236 $ 211 $ 94 $ 970
Multifamily residential .................... 0 70 71 0 0 177
Construction ............................... 90 0 0 0 0 0
Nonresidential real estate ................. 0 0 0 0 0 91
Commercial business ............................ 21 150 75 0 0 0
Consumer ....................................... 76 196 97 46 0 0
------ ------ ------ ------ ------ -------
Total nonaccrual loans ......................... 516 1,172 479 257 94 1,238
Accruing loans which were contractually
past due 90 days or more ................. 0 0 0 0 0 0
------ ------ ------ ------ ------ -------
Total nonperforming loans ...................... 516 1,172 479 257 94 1,238
Real estate owned .............................. 1,307 1,470 0 0 259 247
------ ------ ------ ------ ------ -------
Total nonperforming assets ..................... $1,823 $2,642 $ 479 $ 257 $ 353 1,485
====== ====== ====== ====== ====== =======
Nonaccrual loans and loans 90 days past due as a
percentage of net loans .................... 0.17% 0.35% 0.30% 0.15% 0.06% 0.91%
Nonaccrual loans and loans 90 days past due as a
percentage of total assets ................. 0.11% 0.26% 0.19% 0.11% 0.04% 0.60%
Total nonperforming assets
as a percentage of total assets .......... 0.37% 0.59% 0.19% 0.11% 0.15% 0.71%
13
Interest income that would have been recorded for the fiscal years
ended December 31, 2002, December 31, 2001, December 31, 2000, September 30,
2000, and September 30, 1999, had nonaccruing loans been current in accordance
with their original terms amounted to $27,000, $26,000, $25,000, $13,000, and
$10,000, respectively. We did not include any interest income on such loans for
such periods.
REAL ESTATE ACQUIRED IN SETTLEMENT OF LOANS. Real estate acquired by us
as a result of foreclosure or by deed-in-lieu of foreclosure is classified as
real estate acquired in settlement of loans until sold. Generally, foreclosed
assets are held for sale and such assets are carried at fair value minus
estimated cost to sell the property. After the date of acquisition, all costs
incurred in maintaining the property are expensed and costs incurred for the
improvement or development of such property are capitalized up to the extent of
their net realizable value. At December 31, 2002, we had $1.3 million in real
estate acquired in settlement of loans. The majority of this balance is
comprised of one commercial office building with a net book value of $1.1
million. This property was under contract to sell for $1.1 million to an
independent third party without financing assistance from us. This sale was
completed in February 2003.
RESTRUCTURED LOANS. Under U.S. Generally Accepted Accounting Principals
("GAAP"), we are required to account for certain loan modifications or
restructuring as a "troubled debt restructuring." In general, the modification
or restructuring of a debt constitutes a troubled debt restructuring if we, for
economic or legal reasons related to the borrower's financial difficulties,
grant a concession to the borrowers that we would not otherwise consider. Debt
restructurings or loan modifications for a borrower do not necessarily always
constitute troubled debt restructurings, however, and troubled debt
restructurings do not necessarily result in nonaccrual loans. We had no
restructured loans as of December 31, 2002.
ASSET CLASSIFICATION. The OTS has adopted various regulations regarding
problem assets of financial institutions. The regulations require that each
insured institution review and classify its assets on a regular basis. In
addition, in connection with examinations of insured institutions, OTS examiners
have the authority to identify problem assets and, if appropriate, require them
to be classified. There are three classifications for problem assets:
substandard, doubtful and loss. Substandard assets have one or more 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 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, we establish specific allowances for loan losses for the full amount of
the portion of the asset classified as loss. All or a portion of general loan
loss allowances established to cover possible losses related to assets
classified substandard or doubtful can be included in determining an
institution's regulatory capital, while specific valuation allowances for loan
losses generally do not qualify as regulatory capital. Assets that do not
currently expose the insured institution to sufficient risk to warrant
classification in one of the aforementioned categories but possess weaknesses
are designated "special mention" and monitored by us.
As of December 31, 2002, the aggregate amount of our assets classified
as substandard was $5.5 million and $47,000 was classified as doubtful. There
were no assets classified as loss. Included in the substandard classification
was $1.8 million in one-to-four family dwelling loans, $25,000 in multifamily
dwelling loans, $153,000 in nonresidential real estate loans, $2.0 million in
commercial business loans, $223,000 in consumer loans, and $1.3 million in real
estate owned. These loans were classified due to payment problems, bankruptcy,
cash flow weakness, possible collateral deficiencies, or other weaknesses
considered by management to warrant a substandard classification. The $47,000
classified doubtful represented
14
five consumer and commercial loans granted to the same principal and secured by
various vehicles. These loans were classified due to the payment history and
problems with the principal's business. These loans are in various stages of
collection. The aggregate amount designated special mention was $2.6 million.
Assets designated special mention generally represent loans that are performing,
but may have a slow payment history or other weakness considered by management
to warrant a special mention designation. Pursuant to SFAS 114, management
determined that impaired loans were not material as of December 31, 2002.
As of December 31, 2001, the aggregate amount of our assets classified
as substandard was $4.5 million and $150,000 was classified as doubtful. There
were no assets classified as loss. Included in the substandard classification
was $1.9 million in mortgage loans secured by one-to-four family dwellings,
$102,000 in multifamily dwelling loans, $459,000 in nonresidential mortgage
loans, $262,000 in commercial business loans, $294,000 in consumer loans, and
$1.5 million in real estate owned. These loans were classified due to payment
problems, bankruptcy, cash flow weakness, possible collateral deficiencies, or
other weaknesses considered by management to warrant a substandard
classification. The $150,000 doubtful classification represents a commercial
business loan to a commercial borrower that has experienced cash flow problems.
The aggregate amount designated special mention was $2.9 million. Assets
designated special mention generally represent loans that are performing, but
may have a slow payment history or other weakness considered by management to
warrant a special mention designation. Pursuant to SFAS 114, management
determined that impaired loans were not material as of December 31, 2001.
ALLOWANCE FOR LOAN LOSSES. We have established a systematic methodology
for the determination of provisions for loan losses. The methodology is set
forth in a formal policy and considers all loans in the portfolio. Specific
allowances are established for certain individual loans that management
considers to be impaired. The remainder of the portfolio is segmented into
groups of loans with similar risk characteristics for evaluation and analysis.
In originating loans, we recognize that losses will be experienced and that the
risk of loss will vary with, among other things, the type of loan being made,
the creditworthiness of the borrower over the term of the loan, general economic
conditions, and in the case of a secured loan, the quality of the security of
the loan. We increase our allowance for loan losses by charging provisions for
loan losses against our income. Management's periodic evaluation of the adequacy
of the allowance is consistently applied and is based on our past loan loss
experience, particular risks inherent in the different kinds of lending that we
engage in, adverse situations that may affect the borrower's ability to repay,
the estimated value of any underlying collateral, current economic conditions,
and other relevant internal and external factors that affect loan
collectibility. Generally, a provision for loan losses is charged against income
monthly to maintain the allowance for loan losses.
At December 31, 2002, we had an allowance for loan losses of $3.0
million. Management believes that this amount meets the requirement for losses
on loans that management considers to be impaired, for known losses and for
risks inherent in the remaining loan portfolios. Although management believes
that it uses the best information available to make such determinations, future
adjustments to the allowance for loan losses may be necessary and results of
operations could be significantly adversely affected if circumstances differ
substantially from the assumptions used in making the determinations.
15
The following table sets forth an analysis of our allowance for loan
losses.
At and For the Twelve Months Ended
-------------------------------------------------------------------------------
December 31, September 30,
------------------------------------- -------------------------------------
2002 2001 2000 2000 1999 1998
--------- --------- --------- --------- --------- ---------
(Dollars in Thousands)
Gross loans outstanding ...................... $ 308,408 $ 342,841 $ 165,449 $ 183,369 $ 176,143 $ 143,564
========= ========= ========= ========= ========= =========
Average loans outstanding .................... $ 320,505 $ 166,574 $ 174,610 $ 174,176 $ 158,534 $ 141,322
========= ========= ========= ========= ========= =========
Allowance at beginning of period ............. $ 3,136 $ 1,566 $ 1,517 $ 1,509 $ 1,411 $ 1,110
Allowance acquired in acquisition ............ 0 1,553 0 0 0 0
Provision .................................... 225 120 52 30 105 300
Recoveries ................................... 17 1 1 1 1 5
Charge-offs:
One-to-four family residential ............. (16) 0 0 0 0 0
Nonresidential mortgage loans .............. (175) 0 0 0 0 0
Commercial business loans .................. (150) 0 0 0 0 0
Consumer loans ............................. (42) (104) (4) (3) (8) (5)
--------- --------- --------- --------- --------- ---------
Allowance at end of period ................... $ 2,995 $ 3,136 $ 1,566 $ 1,537 $ 1,509 $ 1,411
========= ========= ========= ========= ========= =========
Allowance for loan losses as a percentage
of gross loans outstanding ................. 0.97% 0.91% 0.95% 0.84% 0.86% 0.98%
========= ========= ========= ========= ========= =========
Net loans charged off as a percentage of gross
loans outstanding .......................... 0.12% 0.03% --- % --- % ---% ---%
========= ========= ========= ========= ========= =========
Ratio of allowance to nonperforming loans .... 580.43% 267.58% 326.93% 598.05% 1,605.32% 113.97%
========= ========= ========= ========= ========= =========
16
The following table sets forth the breakdown of the allowance for loan
losses by loan category at the dates indicated. Management believes that the
allowance can be allocated by category only on an approximate basis. The
allocation of the allowance to each category is not necessarily indicative of
future losses and does not restrict the use of the allowance to absorb losses in
any other category.
December 31, 2002 December 31, 2001 December 31, 2000 September 30, 2000
------------------- ------------------- --------------------- --------------------
Percent of Percent of Percent of Percent of
Loans in Each Loans in Each Loans in Each Loans in Each
Category to Category to Category to Category to
Amount Total Loans Amount Total Loans Amount Total Loans Amount Total Loans
------ ----------- ------ ---------- ------ ----------- ------ -----------
(Dollars in Thousands)
Real estate loans:
One-to-four family residential $ 475 48.26% $ 800 57.33% $ 400 66.43% $ 400 70.36%
Multifamily residential ...... 100 2.91 100 2.54 50 1.21 50 1.12
Construction ................. 150 4.97 150 4.82 55 5.80 50 3.78
Nonresidential ............... 500 20.10 225 14.36 70 7.81 50 6.90
----- ----- ----- ----- --- ----- --- -----
Total real estate loans ........ 1,225 76.23 1,275 79.05 575 81.25 550 82.16
Commercial business ............ 600 3.92 744 2.03 500 7.76 500 8.48
Consumer loans ................. 1,170 19.85 1,117 18.92 491 10.99 487 9.36
----- ----- ----- ----- --- ----- --- -----
Total allowance for loan losses $2,995 100.00% $3,136 100.00% $1,566 100.00% $1,537 100.00%
====== ====== ====== ====== ====== ====== ====== ======
September 30, 1999 September 30, 1998
------------------- -------------------
Percent of Percent of
Loans in Each Loans in Each
Category to Category to
Amount Total Loans Amount Total Loans
------ ----------- ------ ----------
(Dollars in Thousands)
Real estate loans:
One-to-four family residential $ 700 73.42% $ 699 73.50%
Multifamily residential ...... 75 1.37 75 2.63
Construction ................. 100 4.83 125 7.36
Nonresidential ............... 225 4.13 200 5.63
----- ----- ----- -----
Total real estate loans ........ 1,110 83.75 1.099 89.12
Commercial business ............ 273 9.67 104 4.62
Consumer loans ................. 136 6.58 208 6.26
----- ----- ----- -----
Total allowance for loan losses $1,509 100.00% $1,411 100.00%
====== ====== ====== ======
17
INVESTMENT ACTIVITIES
We purchase investment securities with excess liquidity arising when
investable funds exceed loan demand. Our investment policies generally limit
investments to U.S. Government and agency securities, municipal bonds,
certificates of deposit, investment grade corporate debt obligations,
mortgage-backed securities and certain types of equity securities. Our
investment policy does not permit engaging directly in hedging activities or
purchasing high risk mortgage derivative products or non-investment grade
corporate bonds. Investments are made based on certain considerations, which
include the interest rate, yield, settlement date and maturity of the
investment, our liquidity position, and anticipated cash needs and sources
(which in turn include outstanding commitments, upcoming maturities, estimated
deposits and anticipated loan amortization and repayments). The effect that the
proposed investment would have on our credit and interest rate risk and
risk-based capital is also considered.
18
The following table sets forth the amortized cost and fair value of our
investment and mortgage-backed securities, at the dates indicated.
December 31, 2002 December 31, 2001
------------------------------- --------------------------------
Net Net
Amortized Unrealized Fair Amortized Unrealized Fair
Cost Gain(Loss) Value Cost Gain(Loss) Value
------- --------- ------- ------- --------- -------
(Dollars in Thousands)
Investment SecuritiesAvailable for Sale:
U.S. Government and agency securities ...... 25,053 568 25,621 11,902 202 12,104
Municipal bonds ............................ 7,413 276 7,689 6,205 (93) 6,112
Trust preferred securities ................. 2,000 0 2,000 0 0 0
Corporate bonds ............................ 0 0 0 4,020 141 4,161
------- ------- ------- ------- ------- -------
Total investment securities ................... $34,466 $ 844 $35,310 $22,127 $ 250 $22,377
======= ======= ======= ======= ======= =======
Mortgage-backed Securities Available for Sale:
FHLMC ...................................... 24,667 280 24,947 8,736 36 8,772
FNMA ....................................... 33,951 276 34,227 3,368 42 3,410
GNMA ....................................... 9,408 126 9,534 11,042 97 11,139
SBA ........................................ 1,720 (19) 1701 2,103 (19) 2,084
------- ------- ------- ------- ------- -------
Total mortgage-backed securities .............. $69,746 $ 662 70,409 $25,249 $ 156 $25,405
======= ======= ======= ======= ======= =======
Other Investments Available for Sale:
FHLMC common stock ......................... 19 1,115 1,134 19 1,259 1,278
Other equity securities .................... 3,244 (94) 3,150 2,248 43 2,291
------- ------- ------- ------- ------- -------
Total other investments ....................... $ 3,263 $ 1,021 $ 4,284 $ 2,267 $ 1,302 $ 3,569
======= ======= ======= ======= ======= =======
December 31, 2000
--------------------------------
Net
Amortized Unrealized Fair
Cost Gain(Loss) Value
------- --------- -------
(Dollars in Thousands)
Investment SecuritiesAvailable for Sale:
U.S. Government and agency securities ...... 22,204 (92) 22,112
Municipal bonds ............................ 6,216 (179) 6,037
Trust preferred securities ................. 0 0 0
Corporate bonds ............................ 3,002 37 3,039
------- ------- -------
Total investment securities ................... $31,422 $ (234) $31,188
======= ======= =======
Mortgage-backed Securities Available for Sale:
FHLMC ...................................... 5,241 (44) 5,197
FNMA ....................................... 2,829 (37) 2,792
GNMA ....................................... 11,230 (67) 11,163
SBA ........................................ 3,905 (102) 3,803
------- ------- -------
Total mortgage-backed securities .............. $23,205 $ (250) $22,955
======= ======= =======
Other Investments Available for Sale:
FHLMC common stock ......................... 19 1,303 1,322
Other equity securities .................... 243 69 312
------- ------- -------
Total other investments ....................... $ 262 $ 1,372 $ 1,634
======= ======= =======
19
The following table sets forth information regarding the scheduled
maturities, carrying values, approximate fair values, and weighted average
yields for our investment securities portfolio at December 31, 2002, by
contractual maturity. The following table does not take into consideration the
effects of scheduled repayments or the effects of possible prepayments.
At December 31, 2002
---------------------------------------------------------------------------------------
Less than 1 year 1 to 5 years Over 5 to 10 years Over 10 years
------------------ --------------------- ------------------- ------------------
Weighed Weighted Weighted Weighted
Book Average Book Average Book Average Book Average
Value Yield (1) Value Yield (1) Value Yield (1) Value Yield (1)
------ --------- ------- --------- ------ --------- ------ --------
(Dollars in Thousands)
U.S. Govt. and agency securities $ 998 6.22% $18,093 3.51% $5,962 6.34% $ 0 0.00%
Municipal bonds ................ 516 6.01 2,215 5.02 2,706 5.72 1,976 6.70
Trust preferred securities ..... 0 0.00 0 0.00 0 0.00 2,000 3.62
------ ------ ------- ------ ------ ------ ------ ------
Total .......................... $1,514 6.15% $20,308 3.68% $8,668 6.15% $3,976 5.15%
====== ====== ======= ====== ======= ====== ====== ======
At December 31, 2002
-----------------------------
Total Securities
-----------------------------
Weighted
Book Average Market
Value Yield (1) Value
------- --------- -------
(Dollars in Thousands)
U.S. Govt. and agency securities $25,053 4.29% $25,621
Municipal bonds ................ 7,413 5.79 7,689
Trust preferred securities ..... 2,000 3.62 2,000
------- ------ -------
Total .......................... $34,466 4.58% $35,310
======= ====== =======
- --------------------
(1) Yields on tax exempt obligations have been computed on a tax equivalent
basis.
20
BORROWINGS. We have the ability to use advances from the Federal Home
Loan Bank of Atlanta ("FHLB") to supplement our supply of lendable funds and to
meet deposit withdrawal requirements. The FHLB functions as a central reserve
bank providing credit for member financial institutions. As a member of the
FHLB, we are required to own capital stock in the FHLB and we are authorized to
apply for advances on the security of such stock and certain of our mortgage
loans and other assets (principally securities that are obligations of, or
guaranteed by, the U.S. Government) provided certain creditworthiness standards
have been met. Advances are made pursuant to several different credit programs.
Each credit program has its own interest rate and range of maturities. Depending
on the program, limitations on the amount of advances are based on the financial
condition of the member institution and the adequacy of collateral pledged to
secure the credit.
The following table summarizes our borrowings from the Federal Home
Loan Bank of Atlanta.
For the Twelve Months Ended
----------------------------------------------------------
December 31, December 31, December 31, September 30,
2002 2001 2000 2000
---------- ----------- ----------- -------------
(Dollars in Thousands)
Advances from FHLB:
Average balance outstanding ........ $39,759 $41,253 $40,931 $39,400
Maximum amount outstanding at any
month during the year ............. 46,500 42,500 42,500 43,500
Balance outstanding at end of year . 46,500 40,500 42,500 40,000
Weighted average interest rate
during year ....................... 5.50% 5.69% 5.83% 5.87%
23
NET INTEREST INCOME
Net interest income represents the difference between income on
interest-earning assets and expense on interest-bearing liabilities. Net
interest income also depends on the relative amounts of interest-earning assets
and interest-bearing liabilities and the interest rate earned or paid on them,
respectively. The following table sets forth certain information relating to the
Company for the years ended December 31, 2002, 2001 and 2000. For the years
indicated, the total dollar amount of interest income from average
interest-earning assets and the resultant yields, as well as the interest
expense on average interest-bearing liabilities, is expressed both in dollars
and rates. No tax equivalent adjustments were made.
At and For the Twelve Months Ended
DECEMBER 31, 2002 December 31, 2001 December 31, 2000
AVERAGE INTEREST Average Interest Average Interest
OUTSTANDING EARNED/ YIELD/ Outstanding Earned/ Yield/ Outstanding Earned/ Yield/
BALANCE PAID RATE Balance Paid Rate Balance Paid Rate
------- ------ ---- ------- ------ ---- ------- ------ ----
(DOLLARS IN THOUSANDS)
Interest-earning assets:
Investment securities ........ $ 29,515 $ 1,482 5.02% $ 29,150 $ 1,704 5.85% $ 31,484 $ 1,890 6.00%
Mortgage-backed securities ... 28,765 1,402 4.87 25,221 1,434 5.69 21,641 1,455 6.72
Interest-bearing bank deposits 37,963 600 1.58 24,707 993 4.02 2,925 168 5.74
Loans receivable (1) ......... 320,505 21,232 6.62 166,574 12,252 7.36 174,610 13,320 7.63
------- ------ ---- ------- ------ ---- ------- ------ ----
Total interest-earning assets .. 416,748 24,716 5.93 245,652 16,383 6.67 230,660 16,833 7.29
Noninterest-earning assets...... 41,568 17,148 14,083
-------- ------- -------
Total assets.................... 458,316 262,800 244,743
======== ======= =======
Interest-bearing liabilities,:
Demand deposit accounts....... 23,485 93 0.40 15,285 186 1.22 13,685 230 1.68
Money market deposit accounts. 32,285 498 1.54 16,862 460 2.73 14,096 489 3.47
Savings accounts.............. 45,292 638 1.41 18,677 398 2.13 21,270 636 2.99
Certificates of deposit....... 236,360 6,733 2.85 117,993 6,329 5.36 105,734 5,941 5.62
Borrowed funds................ 44,242 2,233 5.05 42,803 2,398 5.60 40,931 2,388 5.83
------- ------ ---- ------- ------ ---- ------- ------ ----
Total interest-bearing
liabilities................... 381,664 10,195 2.67 211,620 9,771 4.62 195,716 9,684 4.95
------ ----- -----
Noninterest-bearing liabilities. 17,409 10,304 9,813
------- ------- -------
Total liabilities............... 399,073 221,924 205,529
======= ======= =======
Total equity.................... 59,243 40,876 39,214
-------- -------- --------
Total liabilities and equity.... $458,316 $262,800 $244,743
======== ======== ========
Net interest income............. $14,521 $ 6,612 $ 7,149
======= ======= =======
Interest rate spread (2)........ 3.26% 2.05% 2.34%
====== ====== ======
Net interest margin (3)......... 3.17% 2.52% 2.92%
====== ====== ======
Net yield on interest-earning
assets (4).................... 3.48% 2.69% 3.10%
====== ====== ======
Ratio of average interest-earning
assets to avg. interest-bearing
liabilities................... 109.19% 116.08% 117.85%
====== ====== ======
- --------------------------
(1) Average loan balances include nonaccrual loans.
(2) Interest rate spread represents the difference between the average yield on
interest-earning assets and the average cost of interest-earning
liabilities.
(3) Net interest margin is calculated by dividing net interest income by average
assets for the period.
(4) Net yield on interest-earning assets represents net interest income as a
percentage of average interest-earning assets.
24
The table below sets forth information regarding changes in our
interest income and interest expense for the periods indicated. For each
category of our interest-earning assets and interest-bearing liabilities,
information is provided on changes attributable to (i) changes in volume
(changes in volume multiplied by old rate); (ii) changes in rate (changes in
rate multiplied by old volume); (iii) the net change. The changes attributable
to the combined impact of volume and rate have been allocated proportionately to
the changes due to volume and the changes due to rate.
FOR THE YEAR ENDED For the Year Ended
DECEMBER 31, 2002 VS DECEMBER 31, 2001 December 31, 2001 vs December 31, 2000
INCREASE (DECREASE) Increase (Decrease)
DUE TO Due to
-------------------------------------- --------------------------------------
VOLUME RATE NET Volume Rate Net
------ ------ ----- ------ ---- ----
(IN THOUSANDS)
Interest income:
Investment securities ......... $ 21 $ (243) $ (222) $(137) $ (49) $ (186)
Mortgage-backed securities .... 2,155 (2,187) (32) (316) 295 (21)
Interest--bearing bank deposits 2,992 (3,385) (393) 859 (34) 825
Loans receivable .............. 10,062 (1,082) 8,980 (601) (467) (1,068)
------ ------ ----- ---- ---- ------
Total interest income ..... 15,230 (6,897) 8,333 (195) (255) (450)
------ ------ ----- ---- ---- ------
Interest expense:
Deposits ...................... 1,093 (504) 589 496 (419) 77
Borrowed funds ................ 85 (250) (165) 75 (65) 10
------ ------ ----- ---- ---- ------
Total interest expense .... 1,178 (754) 424 571 (484) 87
------ ------ ----- ---- ---- ------
Net interest income ........... $14,052 $(6,143) $ 7,909 $(766) $ 229 $ (537)
======= ======= ======= ===== ===== =======
25
GENERAL. Our most significant form of market risk is interest rate
risk, as the majority of our assets and liabilities are sensitive to changes in
interest rates. The principal objective of our interest rate risk management is
to evaluate the interest rate risk inherent in our assets and liabilities,
determine the level of risk appropriate given our business strategy, operating
environment, capital and liquidity requirements, and performance objectives, and
manage the risk consistent with the guidelines approved by the Board of
Directors. Through such management, we seek to reduce the vulnerability of our
operations to changes in interest rates. Our Asset/Liability Committee ("ALCO")
is comprised of various members of our senior management team and various
outside Directors. The ALCO is responsible for reviewing with the Board of
Directors our activities and strategies, the effect of those strategies on our
net interest margin, the fair value of the portfolio, and the effect that
changes in interest rates will have on our portfolio and our exposure limits.
Management recognizes that the long-term effect of interest rate
changes on our income can be substantial. Accordingly, during the past year,
management utilized the following strategies to manage interest rate risk: (1)
emphasizing the origination and retention of shorter-term commercial business
loans and nonresidential mortgage loans, (2) emphasizing the origination of
adjustable-rate home equity lines of credit, (3) emphasizing the origination and
retention of one-to-four family residential adjustable-rate mortgage loans, (4)
originating all new fixed-rate mortgage loans as a broker for various third
party investors, and (5) investing in shorter term investment securities.
NET PORTFOLIO VALUE. The Office of Thrift Supervision ("OTS"), our
primary regulator, requires the computation of amounts by which the net present
value of an institution's cash flow from assets, liabilities and off- balance
sheet items ("net portfolio value" or "NPV") would change in the event of a
range of assumed changes in market interest rates. These computations estimate
the effect on an institution's NPV from instantaneous and permanent 1% to 3%
(100 to 300 basis points) increases and decreases in market interest rates.
The following table presents our NPV at December 31, 2002, as
calculated by an independent third party, based upon information provided by us.
Percentage Change in Net Portfolio Value
Changes Board
in Market Projected Policy
Interest Rates Change (1) Limit
(basis points)
+300 -6.3% -45.0%
+200 -2.3% -30.0%
+100 0.1% -15.0%
0 0.0% 0.0%
-100 -3.0% -15.0%
-200 -6.5% -30.0%
-300 -7.6% -45.0%
- -------------------------
(1) Calculated as the amount of change in the estimated NPV divided by the
estimated NPV assuming no change in interest rates.
Certain shortcomings are inherent in the methodology used in the above
interest rate risk measurement. Modeling changes in NPV requires the making of
certain assumptions which may or may not reflect the manner in which actual
yields and costs respond to changes in market interest rates. In this regard,
the NPV table presented assumes that the composition of our interest sensitive
assets and liabilities existing at the beginning of a period remains constant
over the period being measured and also assumes that a particular change in
interest rates is reflected uniformly across the yield curve regardless of the
duration to maturity or repricing of specific assets and liabilities.
Accordingly, although the NPV table provides an indication of our interest rate
risk exposure at a particular point in time, such measurements are not intended
26
to and do not provide a precise forecast of the effect of changes in market
interest rates on our net interest income and will differ from actual results.
SUPERVISION AND REGULATION
GENERAL. Citizens South Banking Corporation is a unitary savings and
loan holding company, subject to regulation and supervision by the Office of
Thrift Supervision. Citizens South Bank is a federally chartered SAIF-insured
stock savings bank, subject to examination, supervision, and regulation by the
OTS, as its primary federal regulator, and the Federal Deposit Insurance
Corporation ("FDIC"), as the deposit insurer. Citizens South Bank is also a
member of and owns stock in the Federal Home Loan Bank of Atlanta, which is a
part of the Federal Home Loan Bank System. The Bank must file reports with the
OTS and the FDIC concerning its activities and financial condition in addition
to obtaining regulatory approvals prior to entering into certain transactions
such as mergers or acquisitions. This regulation and supervision establishes a
comprehensive framework of activities in which an institution may engage and is
intended primarily for the protection of the insurance fund and depositors.
Under this system of federal regulation, financial institutions are periodically
examined to ensure that they satisfy applicable standards with respect to their
capital adequacy, assets, management, earnings, liquidity and sensitivity to
market interest rates. Citizens South Bank also is regulated to a lesser extent
by the Board of Governors of the Federal Reserve System, governing reserves to
be maintained against deposits and other matters. Citizens South Bank's
relationship with its depositors and borrowers also is regulated to a great
extent by both federal and state laws, especially in matters concerning the
ownership of deposit accounts and the form and content of Citizens South Bank's
loan documents. Any change in these laws or regulations, whether by the FDIC,
the OTS, Congress, or the state legislature could have a material adverse impact
on Citizens South Banking Corporation and Citizens South Bank and their
operations.
THE USA PATRIOT ACT. In response to the events of September 11, 2001,
the Uniting and Strengthening America by Providing Appropriate Tools Required to
Intercept and Obstruct Terrorism Act of 2001, or the USA PATRIOT Act, was signed
into law on October 26, 2001. The USA PATRIOT Act gives the federal government
new powers to address terrorist threats through enhanced domestic security
measures, expanded surveillance powers, increased information sharing and
broadened anti-money laundering requirements. By way of amendments to the Bank
Secrecy Act, Title III of the USA PATRIOT Act takes measures intended to
encourage information sharing among bank regulatory agencies and law enforcement
bodies. Further, certain provisions of Title III impose affirmative obligations
on a broad range of financial institutions, including banks, thrifts, brokers,
dealers, credit unions, money transfer agents and parties registered under the
Commodity Exchange Act.
Among other requirements, Title III of the USA PATRIOT Act imposes the following
requirements with respect to financial institutions:
- Pursuant to Section 352, all financial institutions must
establish anti-money laundering programs that include, at
minimum: (i) internal policies, procedures, and controls; (ii)
specific designation of an anti-money laundering compliance
officer; (iii) ongoing employee training programs; and (iv) an
independent audit function to test the anti-money laundering
program.
- Section 326 authorizes the Secretary of the Department of
Treasury, in conjunction with other bank regulators, to issue
regulations by October 26, 2002 that provide for minimum
27
standards with respect to customer identification at the time
new accounts are opened.
- Section 312 requires financial institutions that establish,
maintain, administer, or manage private banking accounts or
correspondence accounts in the United States for non-United
States persons or their representatives (including foreign
individuals visiting the United States) to establish
appropriate, specific, and, where necessary, enhanced due
diligence policies, procedures, and controls designed to
detect and report money laundering.
- Financial institutions are prohibited from establishing,
maintaining, administering or managing correspondent accounts
for foreign shell banks (foreign banks that do not have a
physical presence in any country), and will be subject to
certain record keeping obligations with respect to
correspondent accounts of foreign banks.
- Bank regulators are directed to consider a holding company's
effectiveness in combating money laundering when ruling on
Federal Reserve Act and Bank Merger Act applications.
The federal banking agencies have begun to propose and implement
regulations pursuant to the USA PATRIOT Act. These proposed and interim
regulations would require financial institutions to adopt the policies and
procedures contemplated by the USA PATRIOT Act.
SARBANES-OXLEY ACT OF 2002. On July 30, 2002, the President signed into
law the Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley"), which implemented
legislative reforms intended to address corporate and accounting fraud. In
addition to the establishment of a new accounting oversight board that will
enforce auditing, quality control and independence standards and will be funded
by fees from all publicly traded companies, Sarbanes-Oxley places certain
restrictions on the scope of services that may be provided by accounting firms
to their public company audit clients. Any non-audit services being provided to
a public company audit client will require preapproval by the company's audit
committee. In addition, Sarbanes-Oxley makes certain changes to the requirements
for audit partner rotation after a period of time. Sarbanes-Oxley requires chief
executive officers and chief financial officers, or their equivalent, to certify
to the accuracy of periodic reports filed with the Securities and Exchange
Commission, subject to civil and criminal penalties if they knowingly or
willingly violate this certification requirement. The Company's Chief Executive
Officer and Chief Financial Officer have signed certifications to this Form 10-K
as required by Sarbanes-Oxley. In addition, under Sarbanes-Oxley, counsel will
be required to report evidence of a material violation of the securities laws or
a breach of fiduciary duty by a company to its chief executive officer or its
chief legal officer, and, if such officer does not appropriately respond, to
report such evidence to the audit committee or other similar committee of the
board of directors or the board itself.
Under Sarbanes-Oxley, longer prison terms will apply to corporate
executives who violate federal securities laws; the period during which certain
types of suits can be brought against a company or its officers is extended; and
bonuses issued to top executives prior to restatement of a company's financial
statements are now subject to disgorgement if such restatement was due to
corporate misconduct. Executives are also prohibited from trading the company's
securities during retirement plan "blackout" periods, and loans to company
executives (other than loans by financial institutions permitted by federal
rules and regulations) are restricted. In addition, a provision directs that
civil penalties levied by the Securities and Exchange Commission as a result of
any judicial or administrative action under Sarbanes-Oxley be deposited to a
fund for the benefit of harmed investors. The Federal Accounts for Investor
Restitution provision also requires the
28
Securities and Exchange Commission to develop methods of improving collection
rates. The legislation accelerates the time frame for disclosures by public
companies, as they must immediately disclose any material changes in their
financial condition or operations. Directors and executive officers must also
provide information for most changes in ownership in a company's securities
within two business days of the change.
Sarbanes-Oxley also increases the oversight of, and codifies certain
requirements relating to audit committees of public companies and how they
interact with the company's "registered public accounting firm." Audit committee
members must be independent and are absolutely barred from accepting consulting,
advisory or other compensatory fees from the issuer. In addition, companies must
disclose whether at least one member of the committee is a "financial expert"
(as such term is defined by the Securities and Exchange Commission) and if not,
why not. Under Sarbanes-Oxley, a company's registered public accounting firm is
prohibited from performing statutorily mandated audit services for a company if
such company's chief executive officer, chief financial officer, comptroller,
chief accounting officer or any person serving in equivalent positions had been
employed by such firm and participated in the audit of such company during the
one-year period preceding the audit initiation date. Sarbanes-Oxley also
prohibits any officer or director of a company or any other person acting under
their direction from taking any action to fraudulently influence, coerce,
manipulate or mislead any independent accountant engaged in the audit of the
company's financial statements for the purpose of rendering the financial
statements materially misleading. Sarbanes-Oxley also requires the Securities
and Exchange Commission to prescribe rules requiring inclusion of any internal
control report and assessment by management in the annual report to
shareholders. Sarbanes-Oxley requires the company's registered public accounting
firm that issues the audit report to attest to and report on management's
assessment of the company's internal controls.
Although we anticipate that we will incur additional expense in
complying with the provisions of the Sarbanes-Oxley Act and the resulting
regulations, management does not expect that such compliance will have a
material impact on our results of operations or financial condition.
FEDERAL BANKING REGULATION
BUSINESS ACTIVITIES. A federal savings bank derives its lending and
investment powers from the Home Owners' Loan Act, as amended, and the
regulations of the OTS. Under these laws and regulations, Citizens South Bank
may invest in mortgage loans secured by residential and commercial real estate,
commercial business and consumer loans, certain types of debt securities and
certain other assets. Citizens South Bank also may establish subsidiaries that
may engage in activities not otherwise permissible for Citizens South Bank,
including real estate investment and securities and insurance brokerage.
CAPITAL REQUIREMENTS. Office of Thrift Supervision regulations require
savings banks to meet three minimum capital standards: a 1.5% tangible capital
ratio, a 4% leverage ratio (3% for banks receiving the highest rating on the
CAMELS rating system) and an 8% risk-based capital ratio. The prompt corrective
action standards discussed below, in effect, establish a minimum 2% tangible
capital standard.
The risk-based capital standard for savings banks requires the
maintenance of Tier 1 (core) and total capital (which is defined as core capital
and supplementary capital) to risk-weighted assets of at least 4% and 8%,
respectively. In determining the amount of risk-weighted assets, all assets,
including certain off-balance sheet assets, are multiplied by a risk-weight
factor of 0% to 100%, assigned by the OTS capital regulation based on the risks
believed inherent in the type of asset. Core capital is defined as common
stockholders' equity (including retained earnings), certain noncumulative
perpetual preferred stock and related surplus and minority interests in equity
accounts of consolidated subsidiaries, less intangibles other than certain
mortgage servicing rights and credit card relationships. The components of
supplementary capital currently include
29
cumulative preferred stock, long-term perpetual preferred stock, mandatory
convertible securities, subordinated debt and intermediate preferred stock, the
allowance for loan and lease losses limited to a maximum of 1.25% of
risk-weighted assets and up to 45% of net unrealized gains on available-for-sale
equity securities with readily determinable fair market values. Overall, the
amount of supplementary capital included as part of total capital cannot exceed
100% of core capital. At December 31, 2002, Citizens South Bank's capital
exceeded all applicable requirements.
LOANS-TO-ONE BORROWER. A federal savings bank generally may not make a
loan or extend credit to a single or related group of borrowers in excess of 15%
of unimpaired capital and surplus on an unsecured basis. An additional amount
may be loaned, equal to 10% of unimpaired capital and surplus, if the loan is
secured by readily marketable collateral, but generally does not include real
estate. As of December 31, 2002, Citizens South Bank was in compliance with the
loans-to-one borrower limitations.
QUALIFIED THRIFT LENDER TEST. As a federal savings bank, Citizens South
Bank is subject to a qualified thrift lender, or "QTL," test. Under the QTL
test, Citizens South Bank must maintain at least 65% of its "portfolio assets"
in "qualified thrift investments" in at least nine months of the most recent 12
month period. "Portfolio assets" generally means total assets of a savings
institution, less the sum of specified liquid assets up to 20% of total assets,
goodwill and other intangible assets, and the value of property used in the
conduct of the savings bank's business. "Qualified thrift investments" includes
various types of loans made for residential and housing purposes, investments
related to such purposes, including certain mortgage-backed and related
securities, and loans for personal, family, household and certain other purposes
up to a limit of 20% of portfolio assets. "Qualified thrift investments" also
include 100% of an institution's credit card loans, education loans and small
business loans. Citizens South Bank also may satisfy the QTL test by qualifying
as a "domestic building and loan association" as defined in the Internal Revenue
Code of 1986. A savings bank that fails the qualified thrift lender test must
either convert to a bank charter or operate under specified restrictions. At
December 31, 2002, Citizens South Bank maintained approximately 74% of its
portfolio assets in qualified thrift investments.
LIMITATIONS ON CAPITAL DISTRIBUTIONS. OTS regulations govern capital
distributions by a federal savings bank, which include cash dividends, stock
repurchases and other transactions charged to the capital account. A savings
bank must file an application for approval of a capital distribution if: (1) the
total capital distributions for the applicable calendar year exceed the sum of
the savings bank's net income for that year to date plus the savings bank's
retained net income for the preceding two years; (2) the bank would not be at
least adequately capitalized following the distribution; (3) the distribution
would violate any applicable statute, regulation, agreement or OTS-imposed
condition; or (4) the savings bank is not eligible for expedited treatment of
its filings. Even if an application is not otherwise required, every savings
bank that is a subsidiary of a holding company must still file a notice with the
OTS at least 30 days before the board of directors declares a dividend or
approves a capital distribution. The OTS may disapprove a notice or application
if: (1) the savings bank would be undercapitalized following the distribution;
(2) the proposed capital distribution raises safety and soundness concerns; or
(3) the capital distribution would violate a prohibition contained in any
statute, regulation or agreement.
COMMUNITY REINVESTMENT ACT AND FAIR LENDING LAWS. All savings banks
have a responsibility under the Community Reinvestment Act and related
regulations of the OTS to help meet the credit needs of their communities,
including low- and moderate-income neighborhoods. In connection with its
examination of a federal savings bank, the OTS is required to assess the savings
bank's record of compliance with the Community Reinvestment Act. In addition,
the Equal Credit Opportunity Act and the Fair Housing Act prohibit lenders from
discriminating in their lending practices on the basis of characteristics
specified in those statutes. A bank's failure to comply with the provisions of
the Community Reinvestment Act could, at a minimum, result in regulatory
restrictions on its activities. The failure to comply with the Equal Credit
30
Opportunity Act and the Fair Housing Act could result in enforcement actions by
the OTS, as well as other federal regulatory agencies and the Department of
Justice. Citizens South Bank received a "Satisfactory" Community Reinvestment
Act rating in its most recent federal examination.
TRANSACTIONS WITH RELATED PARTIES. A federal savings bank's authority
to engage in transactions with its "affiliates" is limited by OTS regulations
and by Sections 23A and 23B of the Federal Reserve Act (the "FRA"). The term
"affiliates" for these purposes generally means any company that controls or is
under common control with an institution. Citizens South Banking Corporation and
its non-savings institution subsidiaries are affiliates of Citizens South Bank.
In general, transactions with affiliates must be on terms that are as favorable
to the savings bank as comparable transactions with non-affiliates. In addition,
certain types of these transactions are restricted to an aggregate percentage of
the savings bank's capital. Collateral in specified amounts must usually be
provided by affiliates in order to receive loans from the savings bank. In
addition, OTS regulations prohibit a savings bank from lending to any of its
affiliates that are engaged in activities that are not permissible for bank
holding companies and from purchasing the securities of any affiliate, other
than a subsidiary.
Citizens South Bank's authority to extend credit to its directors,
executive officers and 10% shareholders, as well as to entities controlled by
such persons, is currently governed by the requirements of Sections 22(g) and
22(h) of the FRA and Regulation O of the Federal Reserve Board. Among other
things, these provisions require that extensions of credit to insiders (i) be
made on terms that are substantially the same as, and follow credit underwriting
procedures that are not less stringent than, those prevailing for comparable
transactions with unaffiliated persons and that do not involve more than the
normal risk of repayment or present other unfavorable features, and (ii) not
exceed certain limitations on the amount of credit extended to such persons,
individually and in the aggregate, which limits are based, in part, on the
amount of Citizens South Bank's capital. In addition, extensions of credit in
excess of certain limits must be approved by Citizens South Bank's Board of
Directors.
ENFORCEMENT. The Office of Thrift Supervision has primary enforcement
responsibility over federal savings institutions and has the authority to bring
enforcement action against all "institution-affiliated parties," including
stockholders, and attorneys, appraisers and accountants who knowingly or
recklessly participate in wrongful action likely to have an adverse effect on an
insured institution. Formal enforcement action may range from the issuance of a
capital directive or cease and desist order to removal of officers and/or
directors of the institution, receivership, conservatorship or the termination
of deposit insurance. Civil penalties cover a wide range of violations and
actions, and range up to $25,000 per day, unless a finding of reckless disregard
is made, in which case penalties may be as high as $1 million per day. The FDIC
also has the authority to recommend to the Director of the OTS that enforcement
action be taken with respect to a particular savings institution. If action is
not taken by the Director, the FDIC has authority to take action under specified
circumstances.
STANDARDS FOR SAFETY AND SOUNDNESS. Federal law requires each federal
banking agency to prescribe certain standards for all insured depository
institutions. These standards relate to, among other things, internal controls,
information systems and audit systems, loan documentation, credit underwriting,
interest rate risk exposure, asset growth, compensation, and other operational
and managerial standards as the agency deems appropriate. The federal banking
agencies adopted Interagency Guidelines Prescribing Standards for Safety and
Soundness to implement the safety and soundness standards required under federal
law. The guidelines set forth the safety and soundness standards that the
federal banking agencies use to identify and address problems at insured
depository institutions before capital becomes impaired. The guidelines address
internal controls and information systems, internal audit systems, credit
underwriting, loan documentation, interest rate risk exposure, asset growth,
compensation, fees and benefits. If the appropriate federal banking agency
determines that an institution fails to meet any standard prescribed by the
guidelines, the agency may require
31
the institution to submit to the agency an acceptable plan to achieve compliance
with the standard. If an institution fails to meet these standards, the
appropriate federal banking agency may require the institution to submit a
compliance plan.
PROMPT CORRECTIVE ACTION REGULATIONS. Under the prompt corrective
action regulations, the OTS is required and authorized to take supervisory
actions against undercapitalized savings banks. For this purpose, a savings bank
is placed in one of the following five categories based on the bank's capital:
1) well-capitalized (at least 5% leverage capital, 6% tier 1 risk-based capital
and 10% total risk-based capital); 2) adequately capitalized (at least 4%
leverage capital, 4% tier 1 risk-based capital and 8% total risk-based capital);
3) undercapitalized (less than 8% total risk-based capital, 4% tier 1 risk-based
capital or 3% leverage capital); 4) significantly undercapitalized (less than 6%
total risk-based capital, 3% tier 1 risk-based capital or 3% leverage capital);
and 5) critically undercapitalized (less than 2% tangible capital). Generally,
the banking regulator is required to appoint a receiver or conservator for a
bank that is "critically undercapitalized." The regulation also provides that a
capital restoration plan must be filed with the OTS within 45 days of the date a
bank receives notice that it is "undercapitalized," "significantly
undercapitalized" or "critically undercapitalized." In addition, numerous
mandatory supervisory actions become immediately applicable to the bank,
including, but not limited to, restrictions on growth, investment activities,
capital distributions and affiliate transactions. The OTS may also take any one
of a number of discretionary supervisory actions against undercapitalized banks,
including the issuance of a capital directive and the replacement of senior
executive officers and directors. At December 31, 2002, Citizens South Bank met
the criteria for being considered "well-capitalized."
INSURANCE OF DEPOSIT ACCOUNTS. Deposit accounts in Citizens South Bank
are insured by the Savings Association Insurance Fund of the Federal Deposit
Insurance Corporation, generally up to a maximum of $100,000 per separately
insured depositor. Citizens South Bank's deposits therefore are subject to FDIC
deposit insurance assessments. The FDIC has adopted a risk-based system for
determining deposit insurance assessments. The FDIC is authorized to raise the
assessment rates as necessary to maintain the required ratio of reserves to
insured deposits of 1.25%. In addition, all FDIC-insured institutions must pay
assessments to the FDIC at an annual rate of approximately .0212% of insured
deposits to fund interest payments on bonds maturing in 2017 issued by a federal
agency to recapitalize the predecessor to the Savings Association Insurance
Fund.
PROHIBITIONS AGAINST TYING ARRANGEMENTS. Federal savings banks are
prohibited, subject to some exceptions, from extending credit to or offering any
other service, or fixing or varying the consideration for such extension of
credit or service, on the condition that the customer obtain some additional
service from the institution or its affiliates or not obtain services of a
competitor of the institution.
FEDERAL HOME LOAN BANK SYSTEM. Citizens South Bank is a member of the
Federal Home Loan Bank System, which consists of 12 regional Federal Home Loan
Banks. The Federal Home Loan Bank System provides a central credit facility
primarily for member institutions. As a member of the Federal Home Loan Bank of
Atlanta, Citizens South Bank is required to acquire and hold shares of capital
stock in the Federal Home Loan Bank in an amount at least equal to 1% of the
aggregate principal amount of its unpaid residential mortgage loans and similar
obligations at the beginning of each year, or 1/20 of its borrowings from the
Federal Home Loan Bank, whichever is greater. As of December 31, 2002, Citizens
South Bank was in compliance with this requirement.
FEDERAL RESERVE SYSTEM. The Federal Reserve Board regulations require
savings banks to maintain non-interest-earning reserves against their
transaction accounts, such as negotiable order of withdrawal and regular
checking accounts. At December 31, 2002, Citizens South Bank was in compliance
with these reserve
32
requirements. The balances maintained to meet the reserve requirements imposed
by the Federal Reserve Board may be used to satisfy liquidity requirements
imposed by the Office of Thrift Supervision.
HOLDING COMPANY REGULATION. Citizens South Banking Corporation is a
unitary savings and loan holding company, subject to regulation and supervision
by the Office of Thrift Supervision. The OTS has enforcement authority over
Citizens South Banking Corporation and its non-savings institution subsidiaries.
Among other things, this authority permits the OTS to restrict or prohibit
activities that are determined to be a risk to Citizens South Bank. Under prior
law, a unitary savings and loan holding company generally had no regulatory
restrictions on the types of business activities in which it may engage,
provided that its subsidiary savings bank was a qualified thrift lender. The
Gramm-Leach-Bliley Act of 1999, however, restricts unitary savings and loan
holding companies not existing or applied for before May 4, 1999 to those
activities permissible for financial holding companies or for multiple savings
and loan holding companies. Citizens South Banking Corporation is not a
grandfathered unitary savings and loan holding company and, therefore, will be
limited to the activities permissible for financial holding companies or for
multiple savings and loan holding companies. A financial holding company may
engage in activities that are financial in nature, including underwriting equity
securities and insurance, incidental to financial activities or complementary to
a financial activity. A multiple savings and loan holding company is generally
limited to activities permissible for bank holding companies under Section
4(c)(8) of the Bank Holding Company Act, subject to the prior approval of the
OTS, and certain additional activities authorized by OTS regulations. Federal
law prohibits a savings and loan holding company, directly or indirectly, or
through one or more subsidiaries, from acquiring control of another savings
institution or holding company thereof, without prior written approval of the
OTS. It also prohibits the acquisition or retention of, with specified
exceptions, more than 5% of the equity securities of a company engaged in
activities that are not closely related to banking or financial in nature or
acquiring or retaining control of an institution that is not federally insured.
In evaluating applications by holding companies to acquire savings institutions,
the OTS must consider the financial and managerial resources, future prospects
of the savings institution involved, the effect of the acquisition on the risk
to the insurance fund, the convenience and needs of the community and
competitive factors.
FEDERAL SECURITIES LAWS. Citizens South Banking Corporation filed with
the Securities and Exchange Commission a registration statement under the
Securities Act of 1933 for the registration of the common stock issued pursuant
to the 2002 stock offering. Citizens South Banking Corporation's common stock
continues to be registered with the Securities and Exchange Commission under the
Securities Exchange Act of 1934. Citizens South Banking Corporation continues to
be subject to the information, proxy solicitation, insider trading restrictions
and other requirements under the Securities Exchange Act of 1934.
FEDERAL AND STATE TAXATION
FEDERAL TAXATION
GENERAL. The Company and the Bank are subject to federal income
taxation in the same general manner as other corporations, with some exceptions
discussed below. The following discussion of federal taxation is intended only
to summarize certain pertinent federal income tax matters and is not a
comprehensive description of the tax rules applicable to the Bank. The Bank's
federal income tax returns were most recently audited by the Internal Revenue
Service for the fiscal year ended September 30, 1994. For additional information
regarding taxation, see note 10 of the consolidated financial statements.
33
METHOD OF ACCOUNTING. For federal income tax purposes, the Bank
currently reports its income and expenses on the accrual method of accounting
and uses a tax year ending December 31 for filing its consolidated federal
income tax returns. The Small Business Protection Act of 1996 (the "1996 Act")
eliminated the use of the reserve method of accounting for bad debt reserves by
savings institutions, effective for taxable years beginning after 1995.
BAD DEBT RESERVES. Prior to the 1996 Act, the Bank was permitted to
establish a reserve for bad debts and to make annual additions to the reserve.
These additions could, within specified formula limits, be deducted in arriving
at the Bank's taxable income. As a result of the 1996 Act, the Bank must use the
specific charge off method in computing its bad debt deduction beginning with
its 1996 federal tax return. In addition, the federal legislation requires the
recapture (over a six year period) of the excess of tax bad debt reserves at
September 30, 1996 over those established as of September 30, 1988. The reserve
subject to recapture was completely amortized as of December 31, 2002, and had a
balance of $0.
TAXABLE DISTRIBUTIONS AND RECAPTURE. Prior to the 1996 Act, bad debt
reserves created prior to January 1, 1988 were subject to recapture into taxable
income should the Bank fail to meet certain thrift asset and definitional tests.
New federal legislation eliminated these thrift-related recapture rules.
However, under current law, pre-1988 reserves remain subject to recapture should
the Bank make certain nondividend distributions or cease to maintain a bank
charter. At December 31, 2002, the Bank's total federal pre-1988 reserve was
approximately $8.0 million. This reserve reflects the cumulative effects of
federal tax deductions by the Bank for which no federal income tax provision has
been made.
MINIMUM TAX. The Code imposes an alternative minimum tax ("AMT") at a
rate of 20% on a base of regular taxable income plus certain tax preferences
("alternative minimum taxable income" or "AMTI"). The AMT is payable to the
extent such AMTI is in excess of an exemption amount. Net operating losses can
offset no more than 90% of AMTI. Certain payments of alternative minimum tax may
be used as credits against regular tax liabilities in future years. The Bank has
not been subject to the alternative minimum tax and has no such amounts
available as credits for carryover.
NET OPERATING LOSS CARRYOVERS. A financial institution may carry back
net operating losses to the preceding five taxable years (for losses incurred in
2001 and 2002) and forward to the succeeding 20 taxable years. This provision
applies to losses incurred in taxable years beginning after 1986. At December
31, 2002, the Bank had no net operating loss carryforwards for federal income
tax purposes.
CORPORATE DIVIDENDS-RECEIVED DEDUCTION. The Company may exclude from
its income 100% of dividends received from the Bank as a member of the same
affiliated group of corporations. The corporate dividends-received deduction is
80% in the case of dividends received from corporations with which a corporate
recipient does not file a consolidated return, and corporations which own less
than 20% of the stock of a corporation distributing a dividend may deduct only
70% of dividends received or accrued on their behalf.
STATE TAXATION
STATE OF NORTH CAROLINA. Under North Carolina law, the corporate income
tax is 7.0% of federal taxable income as computed under the Code, subject to
certain prescribed adjustments. In addition, for tax years beginning in 1991,
1992, 1993 and 1994, corporate taxpayers were required to pay a surtax equal to
4%, 3%, 2% and 1%, respectively, of the state income tax otherwise payable by
it. An annual state franchise tax is imposed at a rate of 0.15% applied to the
greatest of the institution's (i) capital stock, surplus and undivided profits,
(ii) investment in tangible property in North Carolina or (iii) 55% of the
appraised valuation of property in North Carolina.
34
STATE OF DELAWARE. Delaware franchise taxes are imposed on the
Registrant. Two methods are provided for calculating the tax and the lesser tax
is payable. The first method is based on the authorized number of shares. The
tax under this method is $90.00 for the first 10,000 authorized number of shares
plus $50.00 for each additional 10,000 shares or part thereof. The second method
is based on a assumed par value capital. The tax rate under this method is $200
per $1,000,000 or portion thereof of assumed pas value capital. "Assumed par" is
computed by dividing total assets by total issued shares (including treasury
shares). "Assumed par value capital" is calculated by multiplying the lesser of
"assumed par" or stated par value by total authorized shares. For fiscal 2002
the Registrant recorded Delaware franchise tax expense of $0 and submitted
payments that totaled $0.
35
ITEM 2. PROPERTIES
The following table sets forth certain information regarding our
offices at December 31, 2002. Management considers the facilities to be well
maintained and sufficiently suitable for present operations. The net book value
of premises and equipment was $8.8 million at December 31, 2002.
Approximate Owned
Location Principal Use Facility Size or Leased
- -------- ------------- ------------- ---------
(square feet)
245 West Main Avenue Headquarters and 12,400 Owned
Gastonia, North Carolina 28052-4140 Banking Office
251 West Main Avenue, Suite 201 Office Support 2,380 Leased
Gastonia, North Carolina 28052-4140
1535 Burtonwood Drive Banking Office 4,740 Owned
Gastonia, North Carolina 28054-4011
233 South Main Street Banking Office 2,370 Owned
Mount Holly, North Carolina 28120-1620
1670 Neal Hawkins Road Banking Office and 5,320 Owned
Gastonia, North Carolina 28056-6429 Mortgage Center
3135 Dallas High Shoals Highway Banking Office 3,225 Owned
Dallas, North Carolina 28034-1307
412 South Highway 27 Banking Office 3,225 Owned
Stanley, North Carolina 28164-2055
401 West Innes Street Banking Office 5,560 Owned
Salisbury, North Carolina 28144-4232
427 West Innes Street Office Support 4,535 Owned
Salisbury, North Carolina 28144-4232
106 West Main Street Banking Office 1,500 Owned
Rockwell, North Carolina 28138-8859
307 North Center Street Banking Office 8,260 Owned
Statesville, North Carolina 28677-4063
36
ITEM 3. LEGAL PROCEEDINGS
Periodically, there have been various claims and lawsuits involving the
Company or the Bank, such as claims to enforce liens, condemnation proceedings
on properties in which we hold security interests, claims involving the making
and servicing of real property loans and other issues incident to our business.
We are not a party to any pending legal proceedings that it believes would have
a material adverse effect on the financial condition or operations of the
Company or the Bank.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of the security holders during the
fourth quarter of 2002.
37
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS
The Company's common stock, $0.01 par value, trades on the Nasdaq
National Market under the symbol CSBC. Price and volume information is contained
in the Wall Street Journal and other daily newspapers in the Nasdaq section
under the National Market System listings. As of February 1, 2003, the Company
had 1,396 stockholders of record (excluding the number of persons or entities
holding stock in street name through various brokerage firms), and 9,069,628
shares outstanding. The following brokers made a market in the Company's stock
during 2002:
AnPac Securities, Group, Inc. 1-800-897-0384
Friedman, Billings, Ramsey & Co. 1-800-688-3272
Goldman, Sachs & Co. 1-800-221-8320
Herzog, Heine, Geduld, Inc. 1-800-221-3600
Keefe, Bruyette & Woods, Inc. 1-800-342-5529
Knight Securities L.P. 1-800-222-4910
McDonald Investments (Trident) 1-800-340-6355
Moors & Cabot, Inc. 1-800-426-0501
Ryan Beck & Co., Inc. 1-800-395-7926
Sandler O'Neill & Partners 1-212-466-8020
The following table sets forth quarterly closing market price ranges
for the Common Stock over the past two years, as adjusted to reflect the
conversion and stock offering completed September 30, 2002.
FISCAL YEAR 2002 HIGH LOW
First quarter $ 7.73 $ 6.65
Second quarter $10.70 $ 7.52
Third quarter $10.42 $ 8.64
Fourth quarter $10.24 $ 9.30
FISCAL YEAR 2001 HIGH LOW
First quarter $ 5.69 $ 5.11
Second quarter $ 5.96 $ 5.47
Third quarter $ 7.62 $ 5.71
Fourth quarter $ 7.53 $ 6.77
38
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The following table sets forth certain information concerning the
financial position of the Company and its subsidiaries as of and for the dates
indicated. The consolidated data is derived from, and should be read in
conjunction with the Consolidated Financial Statements of the Company and its
subsidiaries and related notes presented in Item 8.
At and for the twelve months ended
--------------------------------------------------------
December 31, September 30,
-------------------------------- --------------------
2002 2001 2000 2000 1999
-------- -------- -------- -------- --------
(Dollars in thousands, except per share data) (unaudited)
INCOME STATEMENT DATA:
Interest income ............................................. $ 24,716 $ 16,382 $ 16,833 $ 16,414 $ 15,238
Interest expense ............................................ 10,195 9,770 9,684 9,219 7,888
------ ----- ----- ----- -----
Net interest income ......................................... 14,521 6,612 7,149 7,195 7,350
Provision for loan losses ................................... 225 120 53 30 105
------ ----- ----- ----- -----
Net interest income after provision for loan losses ......... 14,296 6,492 7,096 7,165 7,245
Noninterest income .......................................... 4,121 3,006 2,473 2,068 2,374
Noninterest expense ......................................... 11,381 7,092 6,975 5,961 6,260
------ ----- ----- ----- -----
Income before income taxes .................................. 7,036 2,406 2,594 3,272 3,359
Income tax expense .......................................... 2,528 702 846 1,068 1,198
------ ----- ----- ----- -----
Net income .................................................. $ 4,508 $ 1,704 $ 1,748 $ 2,185 $ 2,262
======== ======== ======== ======== ========
PER SHARE DATA (1):
Basic net income ............................................ $ 0.51 $ 0.20 $ 0.20 $ 0.25 $ 0.23
Diluted net income .......................................... 0.51 0.20 0.20 0.25 0.23
Cash dividends declared ..................................... 0.16 0.14 0.11 0.11 0.10
Period-end book value ....................................... 10.64 4.62 4.40 4.35 4.25
BALANCE SHEET DATA:
Total assets ................................................ $492,567 $447,581 $252,750 $244,651 $237,453
Loans receivable, net ....................................... 299,906 334,321 158,820 176,963 168,044
Mortgage-backed and related securities ...................... 70,409 25,405 22,955 19,722 19,992
Investment securities ....................................... 39,594 25,946 32,822 32,930 28,642
Deposits .................................................... 340,862 353,692 167,931 161,352 159,425
Borrowings .................................................. 47,575 42,057 42,737 40,606 35,500
Stockholders' equity ........................................ 96,383 41,630 39,763 39,287 39,709
PERFORMANCE RATIOS:
Return on average assets .................................... 0.98% 0.65% 0.71% 0.90% 0.96%
Return on average equity .................................... 7.61 4.17 4.46 5.53 5.19
Avg. interest-earning assets to avg. interest-bearing
liabilities ................................................. 109.19 116.08 117.85 114.97 120.44
Noninterest expense to average total assets ................. 2.48 2.70 2.85 2.45 2.78
Interest rate spread ........................................ 3.26 2.05 2.34 2.53 2.65
Net interest margin (2) ..................................... 3.17 2.52 2.92 2.96 3.27
ASSET QUALITY RATIOS:
Allowance for loan losses to total loans at the end of period 0.97% 0.91% 0.95% 0.84% 0.86%
Nonperforming loans to total loans .......................... 0.17 0.35 0.30 0.15 0.06
Nonperforming assets to total assets ........................ 0.37 0.59 0.19 0.11 0.04
CAPITAL RATIOS:
Average equity to average total assets ...................... 12.93% 15.55% 16.02% 16.26% 18.51%
Equity to assets at period end .............................. 19.57 9.30 15.73 16.06 16.72
Dividend payout ratio (1) (3) .............................. 31.37 70.00 55.00 44.00 43.48
OTHER DATA:
Number of outstanding loans ................................. 6,188 7,534 3,801 3,760 4,368
Number of deposit accounts .................................. 24,140 25,366 15,620 16,218 14,419
Number of full service offices .............................. 9 9 5 5 4
(footnotes on following page)
39
(1) Income per share and the dividend payout ratio are not presented for the
twelve months ended December 31, 1998, since no stock was outstanding prior
to the initial public offering of Citizens South Banking Corporation in
April 1998. All per share data for periods prior to September 30, 2002, has
been adjusted to reflect the exchange ratio of 2.1408-to-1 in conjunction
with the Company's stock offering.
(2) Net interest margin is calculated by dividing net interest income by
average assets for the period.
(3) Dividend payout ratio is calculated by dividing cash dividends per share
declared for the period by net income per share for the period. Citizens
South Holdings, MHC, the mutual holding company for Citizens South Banking
Corporation, began waiving dividends in August 2000 and as of September 30,
2002, had waived dividends totaling approximately $1.8 million. Citizens
South Holdings, MHC owned between 53% and 58% of the outstanding common
stock of the Company during the period in which the dividends were waived.
40
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
FORWARD-LOOKING STATEMENTS
This report may contain certain "forward-looking statements" that
represent the Company's expectations or beliefs concerning future events. Such
forward-looking statements are about matters that are inherently subject to
certain risks and uncertainties that could cause actual results to differ
materially from those projected in the forward-looking statements. Factors that
could cause such a difference include, but are not limited to, the timing and
amount of revenues that may be recognized by the Company, continuation of
current revenue and expense trends (including trends affecting chargeoffs and
provisions for loan losses), unforeseen changes in the Company's markets, legal
and regulatory changes, and general changes in the economy. Because of the risks
and uncertainties inherent in forward-looking statements, readers are cautioned
not to place undue reliance on these statements. The Company assumes no
obligation to update or revise these forward-looking statements to reflect
events or circumstances that occur after the date of this report. Readers should
carefully review the risk factors described in other documents the Company files
from time to time with the SEC, including annual reports on Form 10-K, quarterly
reports on Form 10-Q, and current reports on Form 8-K.
CRITICAL ACCOUNTING POLICIES
The Company's critical accounting policy relates to the evaluation of
the allowance for loan losses which is based on management's opinion of an
amount that is adequate to absorb losses in the Company's existing loan
portfolio. The allowance for loan losses is established through a provision for
loan losses based on available information including the composition of the loan
portfolio, historical loan losses, specific impaired loans, availability and
quality of collateral, age of the various portfolios, changes in local economic
conditions, and loan performance and quality of the portfolio. Different
assumptions used in evaluating the adequacy of the Company's allowance for loan
losses could result in material changes in the Company's consolidated financial
condition or consolidated financial results of operations. The Company's
policies with respect to the methodology for determining the allowance for loan
losses involve a higher degree of complexity and require management to make
subjective judgments that often require assumptions or estimates about uncertain
matters. These critical policies and their assumptions are periodically reviewed
with the Board of Directors.
COMPARISON OF FINANCIAL CONDITION
Comparison of the Years Ended December 31, 2002 and 2001
ASSETS
Total assets at December 31, 2002, increased by $45.0 million, or
10.1%, from $447.6 million at December 31, 2001 to $492.6 million. The increase
in assets was primarily due to the receipt of $45.5 million in net proceeds from
the stock offering which was completed on September 30, 2002. Cash and cash
equivalents increased by $26.1 million, or 124.5%, investment securities
increased by $13.6 million, or 52.6%, and mortgage-backed securities increased
by $45.0 million, or 177.1%. These balances increased primarily due to the
receipt of funds from the stock offering and an increased level of prepayments
on one-to-four family residential real estate loans resulting from historically
low interest rates. One-to-four family residential real estate loans decreased
by $47.8 million, or 24.3%, while other loans increased by $13.3 million, or
9.1%. This change in the composition of the loan portfolio represents
management's efforts to originate shorter-term nonresidential commercial and
consumer loans in order to reduce the Company's vulnerability to rising interest
rates. Substantially all new fixed-rate one-to-four family residential loans are
originated and closed as a broker
41
for an independent third party on a servicing-released basis.
LIABILITIES
Total liabilities at December 31, 2002, decreased by $9.8 million, or
2.4%, from $406.0 million at December 31, 2001 to $396.2 million. This decrease
was primarily due to a $22.5 million, or 9.1%, decrease in certificates of
deposit to $224.4 million. A portion of the decrease in certificates of deposit
was due to the $4.7 million in Citizens South Bank deposits that were used to
purchase stock in the Company during the stock offering that closed September
30, 2002. The decrease in certificates of deposit was offset, in part, by a $9.7
million, or 9.1%, increase in core deposits (checking, savings, and money market
deposit accounts) to $116.5 million at December 31, 2001. This change in the
deposit portfolio composition reflects management's commitment to building new
and enhancing existing customer relationships by focusing on a customer's
primary financial needs such as checking accounts, savings accounts, and money
market deposit accounts. Management plans to continue to aggressively market its
retail and commercial deposit products to the local community and to increase
the Bank's core deposit market share through an expanding branch network.
Borrowed money also increased by $5.5 million, or 13.1%, to $47.6 million. These
additional funds were primarily used to purchase mortgage-backed securities.
EQUITY
Total equity at December 31, 2002, increased by $54.8 million, or
131.5%, from $41.6 million at December 31, 2001 to $96.4 million. This increase
was due to the $51.1 million received from the stock offering, the $4.5 million
in net income for the year, a $422,000 increase in the accumulated unrealized
gains on available-for-sale securities, and $289,000 of paid in capital from the
exercise of stock options. These increases were offset, in part, by a $922,000
increase in the allocation of common stock purchased with the loan to the ESOP
and by cash dividend payments of $874,000.
RESULTS OF OPERATIONS
Comparison of the Years Ended December 31, 2002 and 2001
GENERAL
Net income was $4.5 million, or $0.51 per share, for the year ended
December 31, 2002, compared to $1.7 million, or $0.20 per share, for the year
ended December 31, 2001. Net interest income increased by $7.9 million, or
119.6%, due primarily to an increase in interest-earning assets in excess of the
increase in interest-costing liabilities, each of which resulted from the
acquisition of Innes Street. Noninterest income increased $1.1 million, or
37.1%, as a result of increased fees generated from deposit accounts and loans.
Noninterest expense increased by $4.3 million, or 60.5%, due, in part, to
expenses associated with the operation of three additional full-service branch
offices resulting from the Innes Street acquisition as well as expenses
associated with changing the name of the Company and Bank.
INTEREST INCOME
Interest income for the year ended December 31, 2002 increased by $8.3
million, or 50.9%, to $24.7 million. This increase was primarily due to the
$171.1 million, or 69.6%, increase in average interest-earning assets to $416.7
million due to the acquisition. Interest earned on loans increased by $9.0
million, or 73.3%, to $21.2 million. During the year, average outstanding loans
increased by $153.9 million, or 92.4%, from $166.6 million to $320.5 million,
while the average yield on loans decreased from 7.4% to 6.6%. Interest earned on
investment securities decreased by $222,000, or 13.0%. The average balance of
investment securities increased by $365,000, to $29.5 million; however, the
yield on investment securities decreased from
42
5.9% to 5.0%. Average interest-earning bank deposits increased by $13.3 million,
or 53.7%, from $24.7 million to $38.0 million, while the average yield decreased
from 4.0% to 1.6%. These changes resulted in a reduction in interest earned on
interest-bearing balances of $393,000, or 39.6%, to $600,000. Interest earned on
mortgage-backed securities decreased $32,000, or 2.2%. Average outstanding
mortgage-backed securities increased by $3.5 million, or 14.1%, to $28.8
million, while the yield decreased from 5.7% to 4.9%.
During the year ended December 31, 2002, interest rates continued to
decrease, resulting in increased prepayments on fixed-rate loans, lower interest
rates on adjustable rate loans, increased calls on investment securities,
prepayments on mortgage-backed securities, and lower investment yields.
INTEREST EXPENSE
Interest expense for the year ended December 31, 2002, increased
$425,000, or 4.3%, to $10.2 million. This increase was due to a $589,000, or
8.0%, increase in interest paid on deposits. Average interest-bearing deposits
increased $168.6 million, or 99.9%, to $337.4 million. The average interest rate
paid on deposits decreased from 4.2% to 2.3% due to lower market rates. Average
borrowings increased by $1.4 million, or 3.4%, to $44.2 million, while the rate
paid on borrowings decreased from 5.6% to 5.1% due to lower market interest
rates. These changes resulted in a $165,000, or 6.9%, reduction of interest paid
on borrowings to $2.2 million.
NET INTEREST INCOME
Net interest income increased by $7.9 million, or 119.6%, from $6.6
million for 2001 to $14.5 million for 2002. Net interest margin increased from
2.5% for 2001 to 3.2% for 2002. Average interest-earning assets increased $171.1
million to $416.7 million, while average interest-bearing liabilities increased
$170.0 million to $381.7 million. The percentage of interest-earning assets to
interest-bearing liabilities decreased from 116.1% to 109.2%. The primary reason
for the changes was the acquisition.
PROVISION FOR LOAN LOSSES
The Company provided $225,000 and $120,000 in loan loss provisions for
the years ended December 31, 2002 and 2001, respectively. The allowance for loan
losses as a percentage of loans was 0.97% at December 31, 2002, compared to
0.91% at December 31, 2001. The increase in the ratio of allowances to total
loans was primarily due to the continued slowdown in the local economy resulting
from layoffs and business closings. Due in part to the slowdown in the local
economy, the amount of loans charged-off increased from $104,000 in 2001 to
$384,000 in 2002. Also see "Nonperforming Assets" and "Allowance for Loan
Losses" for further discussion.
NONINTEREST INCOME
For the year ended December 31, 2002, noninterest income increased by
$1.1 million, or 37.1%, from $3.0 million to $4.1 million. The primary reasons
for the change were a $475,000 increase in fees on deposit accounts and a
$310,000 increase in loan fee income. The increase in fees on deposit accounts
resulted from a continued emphasis on building our portfolio of fee-generating
demand deposit accounts, the additional deposit accounts acquired from Innes
Street, and a competitive fee structure on deposit products. Loan fee income
increased due to a higher number of loan originations resulting, in part, from
lower interest rates. Commissions on sales of financial products decreased by
$51,000 due to reduced sales resulting from a declining stock market. Dividends
on FHLB stock increased due to additional shares held as a result of the
acquisition. Other income increased by $107,000 due, in part, to income
generated by additional purchases of bank-owned life insurance during 2001.
During the year ended December 31, 2002, the Company sold $4.0
43
million in investment securities, $5.0 million in mortgage-backed securities,
and $1.4 million of residential loans at a gain of $243,000. During the fiscal
year ended December 31, 2001, the Company did not recognize any gains on the
sale of assets.
NONINTEREST EXPENSES
Noninterest expense increased by $4.3 million, or 60.5%, from $7.1
million in 2001 to $11.4 million in 2002. The primary reason for the increase
was the acquisition and the resulting staffing and operating expenses related to
the addition of three full-service branch offices. Compensation and benefits
increased $1.7 million, or 44.3%, to $5.6 million due to the increased personnel
needed to operate three additional offices and the additional personnel needed
to complete the acquisition. All of the back office functions of the two
organizations were consolidated during the first quarter of 2002. The additional
offices also caused office occupancy to increase by $697,000, or 95.0%, to $1.4
million. Advertising expense increased by $203,000, or 111.2%, to $385,000 as a
result of the Company and Bank changing their names in 2002 to reflect the
Company's expansion outside of Gaston County. Professional services increased by
$104,000, or 46.9%, to $327,000 due to increased expenses associated with
operating a larger fully-public organization. During 2002, the Company amortized
$963,000 of the $2.4 million core deposit premium booked in conjunction with the
acquisition. The core deposit premium is being amortized over a seven-year
period on an accelerated basis. Other expenses increased by $531,000, or 45.6%,
to $1.7 million as a result of the name change, the increased number of offices,
and the valuation allowance recognized on real estate owned. During 2002,
management accepted a written contract to sell a parcel of commercial real
estate acquired by foreclosure for $1.1 million. This resulted in the
recognition of a $169,000 valuation allowance during 2002 to adjust the book
value of the property to reflect the fair value of the property. The sale was
consummated in February 2003.
PROVISION FOR INCOME TAXES
The Company's provision for income taxes was $2.5 million and $702,000
for the years ended December 31, 2002 and 2001, respectively. The change was
primarily due to a $4.6 million increase in pretax income. The effective tax
rate increased from 29.2% to 35.9% due to a smaller percentage of income being
derived from tax-advantaged assets such as municipal securities, U.S. Government
Agency securities, and bank-owned life insurance that generate tax-exempt
income.
RESULTS OF OPERATIONS
Comparison of the Years Ended December 31, 2001 and 2000
GENERAL
Net income was $1,704,000, or $0.20 per share, for the year ended
December 31, 2001, compared to $1,748,000, or $0.20 per share, for the year
ended December 31, 2000. Net interest income decreased by $537,000, or 7.5%, due
to significant decreases in short-term interest rates during 2001, coupled with
abnormally high levels of low-yielding liquid assets being held in anticipation
of the $37.9 million cash acquisition of Innes Street. This decrease was offset
by a $533,000, or 21.6%, increase in noninterest income, resulting from
increased fees generated from deposit accounts and loans. Noninterest expense
increased by $117,000, or 1.7%, due to expenses associated with the opening of a
new branch office in 2001 and increased expenses associated with servicing
additional deposit accounts.
INTEREST INCOME
Interest income for the year ended December 31, 2001, decreased by
$451,000, or 2.7%, to $16.4 million. This change was primarily due to
significant decreases in short-term interest rates during 2001,
44
coupled with abnormally high levels of low-yielding liquid assets held by the
Bank in anticipation of the $37.9 million cash acquisition of Innes Street.
These liquid assets would normally have been used to purchase higher-yielding
investment or mortgage-backed securities. Interest earned on loans decreased by
$1.1 million, or 8.0%, to $12.3 million due to the prepayment of higher-yielding
mortgage loans and the decreased yield on adjustable-rate loans resulting from a
425 basis point decrease in the prime lending rate during 2001. Also during
2001, average outstanding loans decreased by $8.0 million, or 4.6%, from $174.6
million to $166.6 million, while the yield on loans decreased from 7.6% to 7.4%.
Interest earned on investment securities decreased by $186,000, or
9.9%. The average balance of investment securities decreased by $2.3 million to
$29.1 million and the yield decreased from 6.0% to 5.1%. Interest earned on
mortgage-backed securities decreased $21,000, or 1.5%. Average outstanding
mortgage-backed securities increased by $3.6 million to $25.2 million, while the
yield decreased from 6.7% to 5.7%. During the year ended December 31, 2001,
interest rates decreased significantly resulting in increased calls on
investment securities, prepayments on mortgage-backed securities, and lower
investment yields. The prepayments in mortgage-backed securities were offset by
additional purchases of $9.0 million in 2001. Interest earned on
interest-bearing deposits increased by $825,000, or 491.4%. Average
interest-earning bank deposits increased by $21.8 million from $2.9 million to
$24.7 million, the effects of which were offset by a decrease in the average
yield from 5.7% to 4.0%. The increase in average balances was due to liquid
assets held in anticipation of the acquisition, while the change in average
yield was due to a significant decline in short-term interest rates during 2001.
INTEREST EXPENSE
Interest expense for the year ended December 31, 2001, increased
$86,000, or 0.9%, to $9.8 million. This increase was due to a $77,000, or 1.1%,
increase in interest paid on deposits and a $9,000, or 0.4%, increase in
interest paid on borrowings. Average interest-bearing deposits increased $14.0
million, or 9.0%, to $168.8 million. The average interest rate paid on deposits
decreased from 4.7% to 4.2% from 2000 to 2001 due to lower market rates. In
2001, the Company increased its market share in Gaston County from fourth place
to second place in a field of 13 banks. Average borrowings increased by $1.9
million, or 4.6%, to $42.8 million, while the rate paid on borrowings decreased
from 5.8% to 5.6% due to lower market interest rates.
NET INTEREST INCOME
Net interest income decreased by $537,000, or 7.5%, from $7.1 million
for 2000 to $6.6 million for 2001. Net interest margin decreased from 2.9% for
2000 to 2.5% for 2001. Average interest-earning assets increased $15.0 million
to $245.7 million, while average interest-bearing liabilities increased $15.9
million to $211.6 million. The percentage of interest-earning assets to
interest-bearing liabilities decreased from 117.9% to 116.1%. The primary
reasons for this change were the purchase of $2.6 million in bank-owned life
insurance and the addition of one full-service branch office.
PROVISION FOR LOAN LOSSES
The Company provided $120,000 and $53,000 in loan loss provisions for
the years ended December 31, 2001 and 2000, respectively. The allowance for loan
losses as a percentage of loans was 0.91% at December 31, 2001, compared to
0.95% at December 31, 2000. The decrease was primarily due to a material change
in the composition of the Company's loan portfolio as a result of the
acquisition of Innes Street. The acquisition increased the Company's loan
portfolio by $170.5 million and resulted in a larger percentage of loans secured
by one-to-four family dwellings. Management generally considers these types of
loans to have a lower degree of loss based on historical information. As a
result, the overall loan portfolio, in management's
45
opinion, had a lower rate of losses inherent in the portfolio as of December 31,
2001, compared to December 31, 2000. The ratio of nonperforming loans to total
loans increased slightly from 0.30% to 0.35% during the period. Also see
"Nonperforming Assets" and "Allowance for Loan Losses" for further discussion.
NONINTEREST INCOME
For the year ended December 31, 2001, noninterest income increased by
$533,000, or 21.6%, from $2.5 million to $3.0 million. The primary reasons for
the change were a $1.0 million increase in fees on deposit accounts and a
$119,000 increase in loan fee income. The increase in fees on deposit accounts
resulted from an aggressive marketing program to increase fee generating demand
deposit accounts, the opening of a new branch office, and a competitive fee
structure on deposit products. Loan fee income increased due to a higher number
of loan originations resulting, in part, from lower interest rates. Other income
increased by $202,000 due, in part, to income generated by from additional
purchases of bank-owned life insurance. These increases were offset by a
$550,000 reduction in commissions earned on the sale of investment products
resulting from a slowdown in the economy.
During the year ended December 31, 2001, the Company did not recognize
any gains on the sale of assets. During the fiscal year ended December 31, 2000,
the Company sold $5.3 million in investment securities, $595,000 in
mortgage-backed securities, and mortgage loan servicing of a $17.2 million
portfolio of residential loans at a gain of $271,000.
NONINTEREST EXPENSE
Noninterest expense increased by $117,000, or 1.7%, from $7.0 million
in 2000 to $7.1 million in 2001. The primary reasons for the change were a
$125,000, or 3.4%, increase in compensation and benefits, a $121,000, or 19.8%,
increase in office occupancy, and a $576,000, or 52.8%, increase in other
recurring noninterest expenses. The increases were the result of adding a
full-service branch office in February 2001 and additional expenses associated
with the servicing of a larger number of fee-generating transaction deposit
accounts. The Company also recognized expenses of $259,000 associated with the
integration of the data processing and other operations associated with the
Innes Street acquisition and $129,000 related to the release of additional ESOP
shares and the write-off of an equity investment. The Company recognized modest
decreases in professional services, deposit insurance, and advertising. During
the year ended December 31, 2001, the Company sold $1.3 million in
mortgage-backed securities at a loss of $10,000. During the year ended December
31, 2000, the Company sold $18.2 million in loans at a loss of $873,000. These
loans were primarily long-term fixed-rate mortgage loans that were sold in order
to reduce the Company's exposure to rising interest rates. The proceeds were
used to fund the origination of shorter-term nonresidential loans and
adjustable-rate home equity lines of credit.
PROVISION FOR INCOME TAXES
The provision for income taxes was $702,000 and $846,000 for the years
ended December 31, 2001, and 2000, respectively. The change was primarily due to
a $188,000 reduction in pretax income and an increase in tax-advantaged assets
such as municipal securities, U.S. Government Agency securities, and bank-owned
life insurance that generate tax-exempt income. The purchase of these
tax-advantaged assets resulted in a decrease in the effective tax rate from
32.6% to 29.2%.
NONPERFORMING ASSETS
Nonperforming assets totaled $1.8 million at December 31, 2002, and
$2.6 million at December 31, 2001. Loans 90 days or more past due decreased by
$656,000 to $516,000 as of December 31, 2002, due in
46
part to $367,000 in net loan charge-offs during 2002. Loans are reviewed on a
regular basis and an allowance for uncollectable interest is established on
loans where collection is questionable, generally when loans become 90 days or
more delinquent. Loans that are considered to be uncollectable or that have
become 90 days or more delinquent are placed on nonaccrual status. Also, during
the period, real estate acquired through foreclosure decreased $163,000, or
11.1%, to $1.3 million at the end of 2002.
ALLOWANCE FOR LOAN LOSSES
Management has established a systematic methodology for evaluating the
adequacy of the Company's allowance for loan losses. This determination is
conducted on a quarterly basis using available information including, in part,
the composition of the loan portfolio, historical loan losses, availability and
quality of collateral, age of various loan portfolios, changes in local economic
conditions, and loan performance and quality of the portfolio. Specific
allowances are established for certain loans that management considers impaired.
The amount of loans individually evaluated and considered impaired under SFAS
114 at December 31, 2002, and 2001, were not considered to be material.
The Company increases the allowance for loan losses by charging
provisions for loan losses against income. For the fiscal years ended December
31, 2002, 2001, and 2000, the provision for loan losses was $225,000, $120,000,
and $52,000, respectively. During the same periods, net loan chargeoffs amounted
to $367,000, $104,000, and $4,000, respectively. The allowance for loan losses
as a percentage of total loans for the fiscal years 2002, 2001, and 2000, were
0.97%, 0.91%, and 0.95%, respectively.
Management believes that the current level of the allowance for loan
losses meets the requirement for losses on loans that management considers to be
impaired, for known losses, and for risks inherent in the remaining portfolios.
Although management believes that it uses the best information available to make
evaluations, future adjustments to the allowance may be necessary if any of the
factors used in determining the adequacy of the allowance differ substantially
from the assumptions used in making the evaluation. The allowance for loan
losses is subject to periodic evaluation by various regulatory authorities and
may be subject to adjustment upon their examination.
MANAGEMENT OF MARKET RISK
The Company's most significant form of market risk is interest rate
risk, as the majority of the Company's assets and liabilities are sensitive to
changes in interest rates. The Company's Asset/Liability Committee (the "ALCO")
is responsible for monitoring and managing exposure to interest rate risk and
ensuring that the level of sensitivity of the Company's net portfolio value is
maintained within limits established by the Board of Directors. Through such
management, the ALCO seeks to reduce the vulnerability of the Company's
operations to changes in interest rates. During the past year, the ALCO utilized
the following strategies to manage interest rate risk: (1) emphasizing the
origination and retention of short-term commercial business loans and
nonresidential mortgage loans, (2) emphasizing the origination of
adjustable-rate home equity lines of credit; (3) emphasizing the origination and
retention of one- to four- family residential adjustable-rate mortgage loans;
(4) originating all new fixed-rate mortgage loans as a broker for a third party;
and (5) investing in shorter-term investment securities.
The Office of Thrift Supervision, the Bank's primary regulator,
requires the computation of amounts by which the net present value of the Bank's
cash flow from assets, liabilities, and off balance sheet items (the Bank's net
portfolio value or "NPV") would change in the event of a range of assumed
changes in market interest rates. These computations estimate the effect on a
bank's NPV from instantaneous and permanent one hundred- to three hundred-basis
point increases and decreases in market interest rates. The following table
presents the Bank's projected change in NPV at December 31, 2002, as calculated
by an independent third
47
party, based upon information provided by the Bank.
Changes in Interest Rates Projected NPV Change Board Limit
300 basis point rise -6.3% -45.0%
200 basis point rise -2.3% -30.0%
100 basis point rise 0.1% -15.0%
No change 0.0% 0.0%
100 basis point decline -3.0% -15.0%
200 basis point decline -6.5% -30.0%
300 basis point decline -7.6% -45.0%
Certain shortcomings are inherent in the methodology used in the above
interest rate risk measurement. Modeling changes in NPV require the making of
certain assumptions, which may or may not reflect the manner in which actual
yields and costs respond to changes in market interest rates. In this regard,
the NPV table presented assumes that the composition of the interest sensitive
assets and liabilities existing at the beginning of a period remains constant
over the period being measured and also assumes that a particular change in
interest rates is reflected uniformly across the yield curve regardless of the
duration to maturity or repricing of specific assets and liabilities.
Accordingly, although the NPV table provides an indication of the Bank's
interest rate risk exposure at a particular point in time, such measurements are
not intended to and do not provide a precise forecast of the effect of changes
in market interest rates on the Bank's net interest income and will differ from
actual results.
IMPACT OF INFLATION AND CHANGING PRICES
The consolidated financial statements and related notes have been
prepared in accordance with U.S. generally accepted accounting principles which
require the measurement of financial position and operating results in terms of
historical dollars, without considering the change in the relative purchasing
power of money over time due to inflation. Unlike most industrial companies,
nearly all the assets and liabilities of the Company are financial in nature. As
a result, interest rates have a more significant impact on the Company's
performance than the effect of inflation. Interest rates do not necessarily
change in the same magnitude as the price of goods and services.
LIQUIDITY AND CAPITAL RESOURCES
The Company's liquidity management objective is to ensure the
availability of sufficient cash flows to meet all financial commitments and to
capitalize on opportunities for expansion. Liquidity management addresses the
ability to meet deposit withdrawals on demand or at contractual maturity, to
repay borrowings as they mature, and to fund new loans and investments as
opportunities arise. The primary sources of internally generated funds are
principal and interest payments on loans receivable, cash flows generated from
operations, and cash flows generated by investments. External sources of funds
include increases in deposits and Federal Home Loan Bank ("FHLB") advances.
At December 31, 2002, the Company had loan commitments (excluding
undisbursed portions of construction loans of $5.4 million) of $8.9 million and
unused lines of credit of $56.8 million. The Company believes that it has
adequate resources to fund loan commitments as they arise. If the Company
requires funds beyond its internal funding capabilities, the Company has $76.4
million in additional advances available from its line of credit from the FHLB.
At December 31, 2002, approximately $169.3 million of time deposits were
scheduled to mature within a year, and the Company expects that a portion of
these time deposits will not be renewed upon maturity. If there is a higher than
normal level of time deposits that are not renewed at maturity,
48
then the Company may experience a decrease in liquidity. This may result in the
Company offering higher than market interest rates to maintain deposits, which
would increase interest expense.
The Company's cash and cash equivalents increased $26.1 million for the
twelve months ended December 31, 2002, compared to a $5.8 million decrease for
the twelve month period ended December 31, 2001. Net cash provided by operating
activities was $6.5 million for the twelve months ended December 31, 2002,
compared to $1.6 million for the twelve months ended December 31, 2001. During
the 2002 fiscal year, the Company recognized net income of $4.5 million that
increased the cash provided by operating activities. Net cash used for investing
activities was $22.6 million for the 2002 fiscal year, compared to a $17.6
million for the 2001 fiscal year. During 2002 net outstanding loans decreased by
$33.1 million, maturities and prepayments of investment and mortgage-backed
securities amounted to $18.2 million, sales of investment and mortgage-backed
securities amounted to $9.0 million, and purchases of investment and
mortgage-backed securities amounted to $85.0 million. During the 2001 period,
net loans increased by $4.9 million, maturities and prepayments of investment
and mortgage-backed securities totaled $20.7 million, sales of investment and
mortgage-backed securities amounted to $1.3 million, and purchases of investment
and mortgage-backed securities amounted to $14.4 million. During 2002, the
Company experienced increased loan prepayments due to the historically low level
of interest rates. Net cash provided by financing activities was $42.2 million
for the twelve months ended December 31, 2002, compared to $10.2 million for the
twelve months ended December 31, 2001. This change was primarily due to the
$45.5 million issuance of common stock in 2002. Also, deposits for the 2002
fiscal year decreased by $8.1 million compared to a $10.4 million increase
during the comparable period of 2001. This change in deposits was partly due to
some deposit runoff experienced in the first quarter of 2002 as a result of the
acquisition.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Information responsive to this item in contained in Item 7. above under
the captions "Management of Market Risk" and "Liquidity and Capital Resources".
49
ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
REPORT OF INDEPENDENT AUDITORS
The Board of Directors
Citizens South Banking Corporation
We have audited the accompanying consolidated statements of condition of
Citizens South Banking Corporation as of December 31, 2002 and 2001 and the
related consolidated statements of operations, comprehensive income, changes in
stockholders' equity and cash flows for the years ended December 31, 2002 and
December 31, 2001, for the three month period ended December 31, 2000 and for
the year ended September 30, 2000. These financial statements are the
responsibility of management. Our responsibility is to express an opinion on
these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Citizens South
Banking Corporation as of December 31, 2002 and 2001 and the results of their
operations and their cash flows for the years ended December 31, 2002 and
December 31, 2001, for the three month period ended December 31, 2000 and for
the year ended September 30, 2000, in conformity with accounting principles
generally accepted in the United States of America.
/s/ Cherry Bekaert & Holland, L.L.P.
- ------------------------------------
Gastonia, North Carolina
February 5, 2003
50
CITIZENS SOUTH BANKING CORPORATION
CONSOLIDATED STATEMENTS OF CONDITION
DECEMBER 31, DECEMBER 31,
2002 2001
------------- -------------
ASSETS
Cash and due from banks ........................................................$ 7,606,918 $ 6,047,576
Interest-earning bank balances ................................................. 39,391,870 14,891,738
------------- -------------
Cash and cash equivalents .................................................... 46,998,788 20,939,314
Investment securities available-for-sale ....................................... 39,593,947 25,945,953
Mortgage-backed and related securities available-for-sale ...................... 70,408,888 25,405,468
Loans, net ..................................................................... 299,905,719 334,321,357
Premises and equipment, net .................................................... 8,806,912 8,640,146
Accrued interest receivable .................................................... 1,912,610 1,726,614
Federal Home Loan Bank stock ................................................... 2,639,500 3,892,700
Intangible assets .............................................................. 8,658,504 9,671,855
Other assets ................................................................... 13,642,418 17,037,721
------------- -------------
Total assets ..............................................................$ 492,567,286 $ 447,581,128
============= =============
LIABILITIES AND EQUITY
Deposits .......................................................................$ 340,861,932 $ 353,692,314
Advances from Federal Home Loan Bank ........................................... 46,500,000 40,500,000
Repurchase agreements .......................................................... 1,075,182 1,556,693
Deferred compensation .......................................................... 6,097,029 5,609,925
Other liabilities .............................................................. 1,650,463 4,591,849
------------- -------------
Total liabilities ......................................................... 396,184,606 405,950,781
Commitments and contingencies
Stockholders' Equity
Preferred stock, 10,000,000 shares authorized, none issued ................... -- --
Common stock, $0.01 par value, 20,000,000 shares authorized in 2002,
$1.00 par value, 20,000,000 shares authorized in 2001,
issued and outstanding 9,062,727 in 2002
issued and outstanding 4,581,034 in 2001 .................................. 90,628 4,581,034
Additional paid-in-capital ................................................... 68,175,723 16,843,428
Unallocated common stock held by Employee Stock Ownership Plan ............... (2,161,566) (1,239,831)
Retained earnings, substantially restricted .................................. 28,739,476 25,105,261
Accumulated unrealized gain on securities available-for-sale, net of tax ..... 1,538,419 1,116,458
Treasury stock of 371,600 shares at cost ..................................... -- (4,776,003)
------------- -------------
------------- -------------
Total stockholders' equity ................................................ 96,382,680 41,630,347
------------- -------------
Total liabilities and stockholders' equity ................................$ 492,567,286 $ 447,581,128
============= =============
See notes to consolidated financial statements.
51
CITIZENS SOUTH BANKING CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
THREE MONTH
YEAR ENDED YEAR ENDED YEAR ENDED YEAR ENDED PERIOD ENDED
DECEMBER 31, DECEMBER 31, DECEMBER 31, SEPTEMBER 30, DECEMBER 31,
2002 2001 2000 2000 2000
----------- ----------- ----------- ---------- -----------
(UNAUDITED)
INTEREST INCOME
Loans ................................. $21,232,156 $12,251,432 $13,319,877 $12,985,629 $3,436,162
Investment securities ................. 2,082,359 2,696,812 2,058,080 2,126,673 560,681
Mortgage-backed and related securities 1,401,924 1,434,278 1,455,478 1,302,079 373,169
----------- ----------- ----------- ---------- -----------
Total interest income ............... 24,716,439 16,382,522 16,833,435 16,414,381 4,370,012
INTEREST EXPENSE
Deposits .............................. 7,961,809 7,372,689 7,296,265 6,968,270 1,997,336
Borrowed funds ........................ 2,233,383 2,397,790 2,388,506 2,250,728 600,346
----------- ----------- ----------- ---------- -----------
Total interest expense .............. 10,195,192 9,770,479 9,684,771 9,218,998 2,597,682
----------- ----------- ----------- ---------- -----------
Net interest income ................. 14,521,247 6,612,043 7,148,664 7,195,383 1,772,330
----------- ----------- ----------- ---------- -----------
PROVISION FOR LOAN LOSSES ............... 225,000 120,000 52,500 30,000 30,000
----------- ----------- ----------- ---------- -----------
Net interest income after provision for . 14,296,247 6,492,043 7,096,164 7,165,383 1,742,330
loan losses
NONINTEREST INCOME
Fee income on deposit accounts ........ 2,287,598 1,812,370 762,255 588,562 302,407
Fee income on loan accounts ........... 769,337 459,348 340,663 315,760 95,589
Gain on sale of securities ............ 243,233 -- 228,764 224,884 3,880
Gain on sale of other assets .......... -- -- 41,925 31,925 10,000
Commissions on sales of financial ..... 161,951 213,261 763,225 602,877 221,578
products
Dividends on FHLB stock ............... 177,119 146,908 163,933 156,288 42,416
Other income .......................... 481,275 374,111 171,814 147,507 48,877
----------- ----------- ----------- ---------- -----------
Total noninterest income ............ 4,120,513 3,005,998 2,472,579 2,067,803 724,747
NONINTEREST EXPENSE
Compensation and benefits ............. 5,555,507 3,849,821 3,724,531 3,642,979 886,173
Occupancy ............................. 1,430,026 733,389 612,110 623,893 142,122
Office supplies expense ............... 377,080 199,301 183,993 157,557 58,425
NOW account expense ................... 251,300 367,008 54,225 55,558 11,842
Loss on sale of assets ................ 137,647 9,537 872,745 -- 872,745
Advertising ........................... 384,620 182,093 189,326 197,012 48,210
Professional services ................. 326,596 222,374 242,789 220,664 82,469
Data processing ....................... 197,764 331,197 207,939 215,845 48,210
Deposit insurance ..................... 61,475 32,972 34,004 49,453 8,302
Amortization of core deposit intangible 963,000 -- -- -- --
Other ................................. 1,695,759 1,164,494 853,666 797,927 240,437
----------- ----------- ----------- ---------- -----------
Total noninterest expense ........... 11,380,774 7,092,186 6,975,328 5,960,888 2,398,935
----------- ----------- ----------- ---------- -----------
INCOME BEFORE INCOME TAXES .............. 7,035,986 2,405,855 2,593,415 3,272,298 68,142
PROVISION FOR INCOME TAXES .............. 2,528,052 701,730 845,780 1,087,430 5,300
----------- ----------- ----------- ---------- -----------
NET INCOME .............................. $ 4,507,934 1,704,125 $ 1,747,635 2,184,868 $ 62,842
=========== =========== =========== ========== ===========
EARNINGS PER SHARE
Basic earnings per share .............. $ 0.51 0.20 $ 0.20 0.25 $ 0.01
Diluted earnings per share ............ $ 0.51 0.20 $ 0.20 0.25 $ 0.01
See notes to consolidated financial statements.
52
CITIZENS SOUTH BANKING CORPORATION
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
THREE MONTH
YEAR ENDED YEAR ENDED YEAR ENDED YEAR ENDED PERIOD ENDED
DECEMBER 31, DECEMBER 31, DECEMBER 31, SEPTEMBER 30, DECEMBER 31,
2002 2001 2000 2000 2000
---------- ---------- ---------- --------- ----------
(UNAUDITED)
Net income $4,507,934 $1,704,125 $1,747,635 2,184,868 $ 62,842
---------- ---------- ---------- --------- ----------
Other comprehensive income, net of tax:
Unrealized gains (losses) on securities
Cumulative effect of a change in
accounting principle for the
adoption of the provisions of SFAS
No. 133 - - (367,372) - (367,372)
Unrealized holding gains (losses)
arising during period, net of tax effect
of $(324,917), $(292,053), $(607,157),
$(50,223), and $(479,743), respectively 577,630 519,206 1,131,008 76,096 852,877
Reclassification adjustment for
losses (gains) included in net income,
net of tax effect of $87,564, $(3,281),
$82,355, $80,958, and $1,397, respectively (155,669) 5,834 (146,409) (143,926) (2,483)
---------- ---------- ---------- --------- ----------
Other comprehensive income 421,961 525,040 617,227 (67,830) 483,022
Comprehensive income $4,929,895 $2,229,165 $2,364,862 2,117,038 $ 545,864
========== ========== ========== ========= ==========
See notes to consolidated financial statements.
53
CITIZENS SOUTH BANKING CORPORATION
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
Retained
Additional Unallocated Earnings
Preferred Common Paid-In Common Stock Substantially
Stock Stock Capital Held by ESOP Restricted
--------- ----------- ----------- ----------- ------------
BALANCE, SEPTEMBER 30, 1999 ...................... $ -- $ 4,581,034 $16,650,944 $(1,493,434) $ 22,653,309
Comprehensive results:
Net income ..................................... -- -- -- -- 2,184,868
Other comprehensive results, net of tax ........ -- -- -- -- --
Allocation from shares purchased with loan to ESOP -- -- 11,271 112,713 --
Cash dividends declared on common stock .......... -- -- -- -- (861,809)
Repurchase of common stock ....................... -- -- -- -- --
--------- ----------- ----------- ----------- ------------
BALANCE, SEPTEMBER 30, 2000 ...................... -- (1,380,721) 23,976,368 108,396
Comprehensive results:
Net income ..................................... -- -- -- -- 62,842
Other comprehensive results, net of tax ........ -- -- -- -- --
Allocation from shares purchased with loan to ESOP -- -- 11,271 28,178 --
Cash dividends declared on common stock .......... -- -- -- -- (108,677)
--------- ----------- ----------- ----------- ------------
BALANCE, DECEMBER 31, 2000 ....................... -- (1,352,543) 23,930,533 591,418 (4,660,517)
Comprehensive results:
Net income ..................................... -- -- -- -- 1,704,125
Other comprehensive results, net of tax ........ -- -- -- -- --
Allocation from shares purchased with loan to ESOP -- -- 169,942 112,712 --
Cash dividends declared on common stock .......... -- -- -- -- (529,397)
Repurchase of common stock ....................... -- -- -- -- --
--------- ----------- ----------- ----------- ------------
BALANCE, DECEMBER 31, 2000 ....................... -- (1,239,831) 25,105,261 1,116,458 (4,776,003)
Comprehensive results:
Net income ..................................... -- -- -- -- 4,507,934
Other comprehensive results, net of tax ........ -- -- -- -- --
Allocation from shares purchased with loan to ESOP -- -- -- (1,051,980) --
Cash dividends declared on common stock .......... -- -- 143,733 130,245 --
Repurchase of common stock ....................... -- 24,052 264,572 -- --
Issuance of common stock ......................... 50,923,990 -- --
(4,514,458)
Cash dividends declared on common stock .......... -- -- -- -- (873,719)
--------- ----------- ----------- ----------- ------------
BALANCE, DECEMBER 31, 2002 ....................... $ -- 90,628 $68,175,723 $(2,161,566) 28,739,476
Accumulated
Unrealized Total
Gains(Losses), Treasury Stockholders'
net of tax Stock Equity
------------ ---------- ------------
BALANCE, SEPTEMBER 30, 1999 ...................... $ 176,226 (2,859,489) $ 39,708,590
Comprehensive results:
Net income ..................................... -- -- 2,184,868
Other comprehensive results, net of tax ........ (67,830) -- (67,830)
Allocation from shares purchased with loan to ESOP -- -- 123,984
Cash dividends declared on common stock .......... -- -- (861,809)
Repurchase of common stock ....................... -- (1,801,028) (1,801,028)
------------ ---------- ------------
BALANCE, SEPTEMBER 30, 2000 ...................... (4,660,517) 39,2 4,581,034 16,662,215
Comprehensive results:
Net income ..................................... -- -- 62,842
Other comprehensive results, net of tax ........ 483,022 -- 483,022
Allocation from shares purchased with loan to ESOP -- -- 39,449
Cash dividends declared on common stock .......... -- -- (108,677)
------------ ---------- ------------
BALANCE, DECEMBER 31, 2000 ....................... 39,763,411 4,581,034 16,673,486
Comprehensive results:
Net income ..................................... -- -- 1,704,125
Other comprehensive results, net of tax ........ 525,040 -- 525,040
Allocation from shares purchased with loan to ESOP -- -- 282,654
Cash dividends declared on common stock .......... -- -- (529,397)
Repurchase of common stock ....................... -- (115,486) (115,486)
------------ ---------- ------------
BALANCE, DECEMBER 31, 2000 ....................... 41,630,347 4,581,034 16,843,428
Comprehensive results:
Net income ..................................... -- -- 4,507,934
Other comprehensive results, net of tax ........ 421,961 -- 421,961
Allocation from shares purchased with loan to ESOP -- -- (1,051,980)
Cash dividends declared on common stock .......... -- -- 273,978
Repurchase of common stock ....................... -- -- 288,624
Issuance of common stock ......................... -- 4,776,003 51,185,535
Cash dividends declared on common stock .......... -- -- (873,719)
------------ ---------- ------------
BALANCE, DECEMBER 31, 2002 ....................... $ 1,538,419 -- $ 96,382,680
See notes to consolidated financial statements.
54
CITIZENS SOUTH BANKING CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
THREE MONTH
YEAR ENDED YEAR ENDED YEAR ENDED YEAR ENDED PERIOD ENDED
DECEMBER 31, DECEMBER 31, DECEMBER 31, SEPTEMBER 30, DECEMBER 31,
2002 2001 2000 2000 2000
---------- ---------- ---------- ---------- ----------
(UNAUDITED)
OPERATING ACTIVITIES
Net Income ....................................... $4,507,934 $1,704,125 $1,747,635 $2,184,868 $ 62,842
Adjustments to reconcile net income to net cash
provided by operating activities
Provision for loan losses ........................ 225,000 120,000 52,500 30,000 30,000
Depreciation ..................................... 744,650 359,971 385,965 400,037 81,466
Deferred income tax (benefit) .................... 198,052 (46,000) (112,100) (117,000) (21,700)
(Gain) loss on sale of investments ............... (243,233) 9,115 (228,764) (224,884) (3,880)
available-for-sale
(Gain) loss on sale of other assets .............. (31,756) 422 (41,925) (31,925) (10,000)
Loss on sale of loans ............................ -- -- 872,745 -- 872,745
Deferred loan origination fees ................... 12,191 (228,188) 2,733 (60,258) (11,872)
Amortization of intangible assets ................ 963,000 -- -- -- --
Allocation of shares to the ESOP ................. 273,978 282,654 124,011 123,984 39,449
(Increase) decrease in interest receivable ....... (185,996) 394,864 (327,332) (137,224) 30,073
Net (increase) decrease in other operating
assets............................................ 72,988 (1,041,213) (1,448,300) (954,027) (189,488)
---------- ---------- ---------- ---------- ----------
Net cash provided by operating activities ........ 6,536,808 1,555,750 1,027,168 1,213,571 879,635
INVESTING ACTIVITIES
Net decrease(increase) in loans made to .......... 33,094,308 (4,865,741) (7,949,710) (8,898,383) (906,289)
customers
Proceeds from the sale of loans .................. 1,418,648 -- 18,168,538 10,000 18,158,538
Proceeds from the sale of premises
and equipment .................................... 26,281 196,131 10,000 -- 10,000
Proceeds from the sale of investment securities .. 4,000,000 -- 5,256,594 2,256,594 3,000,000
Proceeds from the sale of mortgage-backed
and related securities ........................... 5,043,176 1,256,834 594,581 594,581 --
Proceeds from sale of REO ........................ 300,357 -- -- -- --
Maturities and prepayments of investment
securities ....................................... 6,856,814 12,821,204 2,341,686 2,963,600 1,234,315
Maturities and prepayments of mortgage-backed
and related securities .......................... 11,257,899 7,899,220 3,403,113 3,774,271 755,421
Purchases of investment securities ............... (24,200,000) (5,420,000) (8,100,000) (9,350,000) (3,500,000)
Purchases of mortgage-backed and related
securities ....................................... (60,754,560) (9,041,182) (8,087,856) (4,149,204) (3,938,652)
Purchases of FHLB stock .......................... -- -- (402,300) (402,300) --
Proceeds from sale of FHLB stock ................. 1,253,200 -- -- -- --
Acquisition of Innes Street Financial, net of
cash acquired..................................... -- (19,174,273) -- -- --
Purchases of premises and equipment .............. (934,824) (1,244,290) (1,628,035) (1,720,029) (421,207)
---------- ---------- ---------- ---------- ----------
Net cash provided by (used for)
investing activities ............................. (22,638,701) (17,572,097) 3,606,611 (14,920,870) 14,392,126
FINANCING ACTIVITIES
Net increase (decrease) in deposits .............. (8,143,224) 10,411,725 9,328,038 1,926,736 6,579,331
Issuance of additional common stock .............. 45,446,376 -- -- -- --
Dividends to stockholders ........................ (873,719) (529,397) (729,507) (861,809) (108,677)
Exercise of options .............................. 288,624 -- -- -- --
Repurchase of common stock ....................... -- (115,486) (897,250) (1,801,028) --
Advances from FHLB .............................. 7,500,000 5,000,000 10,000,000 15,000,000 5,000,000
Repayments of advances from FHLB ................. (1,500,000) (5,679,941) (3,000,000) (10,500,000) (2,500,000)
Increase (decrease) in repurchase agreements ..... (481,510) 1,320,063 236,630 605,500 (368,870)
Increase (decrease) in advances from
borrowers for insurance and taxes ................ (75,180) (160,165) (60,161) 310,099 (719,499)
---------- ---------- ---------- ---------- ----------
Net cash provided by(used for) financing
activities........................................ 42,161,367 10,246,799 14,877,750 4,679,498 7,882,285
Net increase (decrease) in cash and cash ......... 26,059,474 (5,769,548) 19,511,529 (9,027,801) 23,154,046
equivalents
Cash and cash equivalents at the beginning of
the year.......................................... 20,939,314 26,708,862 7,197,333 12,582,617 3,554,816
---------- ---------- ---------- ---------- ----------
Cash and cash equivalents at the end of the year
the year.......................................... $46,998,788 $20,939,314 $ 26,708,862 $ 3,554,816 $ 26,708,862
55
See notes to consolidated financial statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Citizens South Banking Corporation (the "Company"), formerly Gaston Federal
Bancorp, Inc., is a stock holding company whose activities are primarily limited
to holding the stock of Citizens South Bank, formerly Gaston Federal Bank (the
"Bank"). The Bank is a community-oriented federal stock savings bank engaged
primarily in the business of offering deposits to customers through its branch
offices and investing those deposits, together with funds generated from
operations and borrowings, in residential, commercial and consumer loans and in
mortgage-backed securities. The Bank's wholly owned subsidiary, Citizens South
Financial Services, Inc. (doing business as Citizens South Investment Services)
acts as an independent agent selling various uninsured financial products.
The Board of Directors of the Citizens South Holdings, MHC (the "MHC") a federal
mutual holding company which owned a majority of the Company's outstanding
shares of common stock, the Company and the Bank approved the Plan of Conversion
and Reorganization (the "Plan") on May 23, 2002. Pursuant to the Plan, the MHC
converted from the mutual holding company form of organization to the fully
public form and merged into the Bank. Pursuant to the plan, the Company, which
owns 100% of the Bank, was succeeded by a new Delaware corporation with the same
name, Citizens South Banking Corporation. As part of the conversion, shares of
common stock of Citizens South Banking Corporation representing the ownership
interest of the MHC were offered for sale in the offering. The existing publicly
held shares of the Company, which represented the remaining ownership interest
in the Company, were exchanged for new shares of common stock of Citizens South
Banking Corporation, the new Delaware corporation. The exchange ratio of 2.1408
shares of $0.01 par value common stock for each share of par value causing stock
held by the public ensured that immediately after the reorganization and the
share exchange, the public stockholders of the Company owned the same aggregate
percentage of Citizens South Banking Corporation common stock that they owned
immediately prior to the reorganization.
On September 30, 2002, the mutual-to-stock conversion of Citizens South
Holdings, MHC, and the related stock offering of the Mutual Holding Company's
ownership in Citizens South Banking Corporation were completed. In conjunction
with the stock offering, the Company sold 5,259,945 shares of common stock at
$10.00 per share, which represented the "super maximum" range of the stock
offering. Gross proceeds from the stock offering amounted to $52.6 million. Net
proceeds amounted to $45.5 million and reflect the following reductions from
gross proceeds: 1) $1.4 million in costs incurred related to the stock offering;
2) $1.0 million used to purchase stock for the ESOP; and 3) $4.7 million in
withdrawals from Citizens South Bank deposit accounts (the stock purchased by
the ESOP via loan and the application of deposits for shares are non-cash
financing activities).
As a result of the conversion, all historical financial information that is
based on or derived from the actual or average number of outstanding shares of
common stock during any period prior to September 30, 2002, has been
appropriately adjusted to reflect the exchange ratio of 2.1408-to-1. The
conversion was accounted for as a change in corporate form with no subsequent
change in historical basis for the Company's assets, liabilities and equity.
On December 31, 2001, Citizens South Banking Corporation completed its
acquisition of Innes Street Financial Corporation and its wholly-owned
subsidiary, Citizens Bank, Inc. As part of the acquisition, Innes Street's
stockholders received $18.50 per share for each of Innes Street's common stock
issued and outstanding. The aggregate purchase price for the transaction was
approximately $38 million. The transaction was accounted for using the purchase
method. See Note 2 for additional information.
57
During the three-month period ended December 31, 2000, the Company's Board of
Directors adopted a resolution to change the Company's fiscal year-end from
September 30th to December 31st effective October 1, 2000. The accounting and
reporting policies of Citizens South Banking Corporation follow accounting
principles generally accepted in the United States of America and policies
within the financial services industry. The following is a summary of the more
significant policies.
Principles of Consolidation - The consolidated financial statements include the
accounts of Citizens South Banking Corporation, its wholly-owned subsidiary,
Citizens South Bank, and the Bank's wholly-owned subsidiary, Citizens South
Financial Services, Inc. All significant intercompany accounts and transactions
have been eliminated.
Use of Estimates - The financial statements are prepared in accordance with
accounting principles generally accepted in the United States of America which
require management to make estimates and assumptions that affect the amounts
reported in the financial statements and accompanying notes. Actual results
could differ from those estimates.
Cash and Cash Equivalents - The Company considers cash on hand, cash due from
banks, which are maintained in financial institutions, and interest-earning
deposits, which are maintained with the Federal Home Loan Bank (FHLB), as cash
and cash equivalents.
Securities - Management determines the appropriate classification of securities
at the time of purchase.
Securities classified as available-for-sale are carried at fair value. Such
securities are used to execute asset/liability management strategies and to
manage liquidity. Adjustments for unrealized gains or losses, net of related
income tax effect, are recorded as an addition or deduction from equity in the
form of other comprehensive results.
The Company has no securities classified as held-to-maturity.
Amortization of premiums and accretion of discounts are included in interest
income over the life of the related security, or in the case of mortgage-backed
and related securities, the estimated life of the security. Gains or losses on
the sale of securities are recognized on a specific identification, trade date
basis.
Loans and Allowance for Loan Losses - Loans are carried at their principal
amount outstanding. Income on loans is accrued based upon the outstanding
principal balance. Generally, loans are classified as nonaccrual, and the
accrual of interest is discontinued, when the contractual payment of principal
and interest has become 90 days past due or when, in management's judgment,
principal or interest is not collectible in accordance with the terms of the
obligation. Cash receipts on nonaccrual loans are applied to principal. The
accrual of interest resumes when the loan returns to performing status.
The Company evaluates impairment of its residential mortgage and consumer loans
on a collective basis. For commercial loans, a loan is considered to be impaired
when based on current information, it is probable that the Company will not
collect all amounts due in accordance with contractual terms. Management
monitors several internally generated reports, including past due reports,
payment histories, criticized asset reports, which include loans with historical
payment problems or borrowers in troubled industries as well as other sources of
information such as borrower financial statements, the value collateral, etc. to
identify impaired loans. Discounted cash flow analyses or the estimated fair
value of collateral are used in determining the fair value of impaired loans.
When the ultimate collectibility of the principal balance of an
58
impaired loan is in doubt, cash receipts are applied to principal.
The allowance for loan losses is determined by management and maintained at a
level based on losses inherent in the portfolio that are probable and reasonably
estimated at the balance sheet date. Management's determination of the adequacy
of the allowance is based on an evaluation of the portfolio, historical loan
loss experience, availability and quality of collateral, changes in economic
conditions, and the quality of the loan portfolio. Loans are charged to the
allowance at the time they are determined to be losses. Subsequent recoveries
are credited to the allowance.
Mortgage Servicing Rights - Statement of Financial Accounting Standards ("SFAS")
No. 140 requires the recognition of originated mortgage servicing rights
("mortgage servicing rights" or "MSRs") as assets by allocating total costs
incurred between the originated loan sold and the servicing rights retained
based on their relative fair values. MSRs are amortized in proportion to the
servicing income over the estimated life of the related mortgage loan using the
interest method.
Concentrations of Credit Risk - The Company makes loans to individuals and small
businesses primarily in Gaston, Rowan, and Iredell Counties, North Carolina and
surrounding counties. The Company has a diversified loan portfolio, and the
borrowers' ability to repay their loans is not dependent upon any specific
economic segment.
Premises and Equipment - Premises and equipment are stated at cost less
accumulated depreciation and amortization. Depreciation and amortization are
computed over the estimated useful lives of the assets (from 3 to 30 years)
primarily by the straight-line method. Leasehold improvements are amortized on a
straight-line basis over the shorter of the estimated useful life of the
improvement or the lease term.
Intangible Assets - Intangible assets with finite lives, primarily core deposit
intangibles, are amortized over their estimated useful life. Goodwill is not
amortized, but is evaluated for impairment on an annual basis.
Other Real Estate Owned - Other real estate owned is comprised of real estate
properties acquired in partial or total satisfaction of problem loans. The
properties are recorded at the lower of cost or fair value less estimated costs
to sell at the date acquired. Losses arising at the time of acquisition of such
properties are charged against the allowance for loan losses. Subsequent
write-downs that may be required to the carrying value of these properties are
charged to noninterest expenses. Gains and losses realized from the sale of
other real estate owned are included in noninterest income.
Loan Origination Fees - Origination fees received and direct costs incurred are
deferred and amortized to interest income over the contractual lives of the
loans, using the level yield method.
Income Taxes - Deferred income taxes reflect the net tax effects of temporary
differences between the carrying amounts of assets and liabilities for financial
reporting purposes and the amounts used for income tax purposes. Amounts
provided for deferred income taxes relate primarily to differences between tax
and financial reporting for unrealized gains and losses on securities
available-for-sale, allowances for loan losses, depreciation, and deferred
compensation.
Advertising - Advertising costs are expensed as incurred.
Reclassifications - Certain of the prior year amounts have been reclassified to
conform to current year presentation; such reclassifications are immaterial to
the financial statements.
59
Comprehensive Income - SFAS No. 130, Reporting Comprehensive Income, establishes
standards for the reporting and display of comprehensive income and its
components in financial statements. SFAS No. 130 defines comprehensive income as
net income, as currently reported, as well as unrealized gains and losses on
assets available for sale and certain other items not currently included in the
income statement. The disclosure requirements of SFAS No. 130 have been included
in the Consolidated Statements of Comprehensive Income.
Operating Segments - SFAS No. 131, Disclosures about Segments of an Enterprise
and Related Information, establishes standards for the way public business
enterprises report information about operating segments. This statement also
establishes standards for related disclosures about products, services,
geographic areas and major customers. In adopting SFAS No. 131, the Company has
determined that, using the definitions contained in the statement, all of its
activities constitute only one reportable operating segment.
Accounting for Derivatives - SFAS No. 133, Accounting for Derivative Instruments
and Hedging Activities, as amended by SFAS No. 137 and SFAS No. 138, establishes
accounting and reporting requirements for derivative instruments, including
derivative instruments embedded in other contracts. The Company adopted the
provisions of this statement effective October 1, 2000. In connection with the
adoption of the provisions of SFAS No. 133, the Company transferred all
securities previously designated as held-to-maturity at September 30, 2000, into
the available-for-sale category. The transfer was accounted for at the fair
values of the securities at September 30, 2000. The effect of the transfer was
to decrease carrying values of these securities by approximately $603,000 and
increase the deferred tax assets by approximately $236,000. The unrealized
holding loss on the transferred securities, net of tax, of approximately
$367,000 is reported in accumulated other comprehensive income as the cumulative
effect of an accounting change.
Business Combinations - SFAS No. 141, Business Combinations, establishes
standards for the financial accounting and reporting for business combinations
and supersedes APB Opinion No. 16, Business Combinations, and FASB Statement No.
38, Accounting for Preacquisition Contingencies of Purchased Enterprises. The
provisions of this statement apply to business combinations initiated after June
30, 2001. All business combinations are to be accounted for using the purchase
method. The reporting and disclosure requirements of SFAS No. 141 have been
included in the financial statements.
Impact of Recently Adopted Accounting standards - Effective January 1, 2002, the
Company adopted the provisions of SFAS No. 142, Goodwill and Other Intangible
Assets. SFAS No. 142 requires that goodwill and intangible assets with
indefinite useful lives no longer be amortized, but instead tested for
impairment at least annually in accordance with its provisions. SFAS 142 also
requires that intangible assets with definite useful lives be amortized over
their respective estimated useful lives to their estimated residual values. In
connection with adoption of SFAS 142, the Company is required to perform an
initial assessment of whether there is an indication that goodwill is impaired.
During the second quarter of 2002, the Company completed its initial analysis of
potential impairment under the provisions of SFAS No. 142, and determined based
on that analysis that goodwill was not impaired. The Company also completed its
annual impairment test at December 31, 2002 and determined based on that
analysis that goodwill was not impaired. Goodwill will be tested for impairment
annually, or between annual tests if an event occurs or circumstances change
that would more likely than not reduce the fair value of a reporting unit below
its carrying amount. The Company had no goodwill related to acquisitions
initiated prior to July 1, 2001, or other intangible assets recorded prior to
the adoption of the provisions of SFAS No. 142 whose carrying amounts or
amortization were changed by the adoptions of the provisions of SFAS No. 142.
SFAS 144, Accounting for the Impairment or Disposal of Long-lived Assets, was
issued in August 2001 and supersedes SFAS No. 121. SFAS No. 144 establishes
standards for the financial accounting and reporting
60
requirements for the impairment or disposal of long-lived assets. The provisions
of SFAS No. 144 were adopted effective January 1, 2002. The adoption of the
provisions of SFAS No. 144 did not have a material impact on the consolidated
financial statements of the Company.
SFAS No. 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB
Statement No. 13, and Technical Corrections, was issued in April 2002. The
adoption of the provisions of this statement did not have a significant effect
on financial position or results of operation of the Company.
SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities,
was issued in June 2002 and addresses financial accounting and reporting for
costs associated with exit or disposal activities. This statement is effective
for exit or disposal activities initiated after December 31, 2002 and is not
expected to have a material impact on the financial statements of the Company.
SFAS No. 147, Acquisitions of Certain Financial Institutions an amendment of
FASB Statements No. 72 and 144 and FASB Interpretation No. 9, was issued in
October 2002 and provides guidance on the application of the purchase method to
acquisitions of financial institutions. This statement is effective for
acquisitions on or after October 1, 2002 and is not expected to have a material
impact on the financial statements of the Company.
SFAS No. 148, Accounting for Stock-Based Compensation - Transition and
Disclosure - An Amendment of FASB Statement No. 123, was issued in December 2002
and provides alternative methods of transition for a voluntary change to the
fair value based method of accounting for stock-based employee compensation. In
addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to
require prominent disclosures in both annual and interim financial statements
about the method of accounting for stock-based employee compensation and the
effect of the method used on reported results. This statement is effective for
fiscal years ending after December 15, 2002 and is not expected to have a
material impact on the financial statements of the Company.
Unaudited Financial Information - In management's opinion, the consolidated
results of operations and cash flows for the year ended December 31, 2000, which
are unaudited, reflects all adjustments (consisting solely of normal recurring
adjustments) necessary for a fair presentation of the financial information for
the year ended December 31, 2000, in conformity with accounting principles
generally accepted in the United States of America.
NOTE 2 - BUSINESS COMBINATION
On December 31, 2001, the Company acquired 100% of the outstanding shares of
common stock of Innes Street Financial Corporation and its wholly owned
subsidiary, Citizens Bank. Accordingly, the results of operations of Innes
Street Financial Corporation have been included in the consolidated financial
statements of the Company since the acquisition effective at the close of
business, December 31, 2001.
As part of the acquisition, Innes Street's stockholders received $18.50 per
share for each share of Innes Street's common stock issued and outstanding. The
aggregate purchase price for the transaction was approximately $38 million.
Innes Street Financial Corporation and its subsidiary have served the Salisbury,
North Carolina area for over ninety years by providing this community and
surrounding counties with general banking services. As a result of the
acquisition, the Company will expand its market reach and provide its banking
products in new
61
markets in North Carolina that it had previously not been servicing. The Company
also expects to reduce costs through economies of scale.
The following table summarizes the estimated fair values of the assets acquired
and liabilities assumed at the date of acquisition.
DECEMBER 31, 2001
------------------------
Cash and cash equivalents $ 6,793,000
Investment securities 2,600,000
Loans, net 170,527,000
Premises and equipment 3,801,000
Intangible assets 2,872,000
Goodwill 6,581,000
Other assets 28,616,000
------------
Total assets acquired 221,790,000
Deposits 175,350,000
Other liabilities 8,503,000
------------
Total liabilities assumed 183,853,000
------------
Net assets acquired $ 37,937,000
============
Of the $2,872,000 of intangible assets, $2,447,000 was assigned to core deposit
premium, which is being amortized over a 7-year life on an accelerated basis.
The remaining intangibles relate to mortgage servicing rights. Goodwill of
$6,581,000 represents the excess of the purchase price over the fair value of
assets acquired and liabilities assumed, none of which is deductible for income
tax purposes
62
The following summarizes the results of operations as though the acquisition of
Innes Street Financial Corporation had occurred at the beginning of each period.
Year Ended December 31,
2001 2000
---- ----
Interest income $ 29,872,000 $ 29,287,000
Interest expense (18,106,000) (16,948,000)
---------------- ----------------
Net interest income 11,766,000 12,339,000
Provision for loan losses (146,000) (53,000)
---------------- ----------------
Net interest income after provision 11,620,000 12,286,000
Noninterest income 3,143,000 2,832,000
Noninterest expense (10,531,000) (10,760,000)
---------------- ----------------
Income before income taxes 4,232,000 4,358,000
Provision for income taxes 1,431,000 1,511,000
---------------- ----------------
Net income $ 2,801,000 $ 2,847,000
================ ================
Basic earnings per share $ 0.69 $ 0.70
Diluted earnings per share $ 0.68 $ 0.70
63
NOTE 3 - INVESTMENT SECURITIES
The aggregate book and fair values, as well as gross unrealized gains and
losses, of investment securities as of December 31 were as follows:
December 31, 2002
----------------------------------------------------------------------
Book Unrealized Unrealized Fair
Value Gains Losses Value
----------------------------------------------------------------------
Investment securities Available for Sale
- ----------------------------------------
U.S. Treasury and other agencies $ 25,052,753 $ 567,878 $ - $ 25,620,631
Municipals 7,413,046 283,925 (8,013) 7,688,958
FHLMC stock 19,200 1,114,560 - 1,133,760
Trust preferred securities 2,000,000 - - 2,000,000
Other equity securities 3,244,208 13,637 (107,247) 3,150,598
----------------- ---------------- --------------- ----------------
Total available-for-sale $ 37,729,207 $ 1,980,000 $ (115,260) $ 39,593,947
================= ================ =============== ================
December 31, 2002
----------------------------------------------------------------------
Book Unrealized Unrealized Fair
Value Gains Losses Value
----------------------------------------------------------------------
Mortgage-backed and related securities Available-for-Sale
- ---------------------------------------------------------
FNMA $ 33,951,075 289,856 (13,752) 34,227,179
GNMA 9,408,318 126,846 (1,506) 9,533,658
SBA's 1,719,851 - (18,704) 1,701,147
FHLMC 24,667,415 281,796 (2,307) 24,946,904
----------------- ---------------- --------------- ----------------
Total mortgage-backed and
Related securities $ 69,746,659 698,498 (36,269) 70,408,888
================= ================ =============== ================
64
December 31, 2001
----------------------------------------------------------------------
Book Unrealized Unrealized Fair
Value Gains Losses Value
----------------------------------------------------------------------
Investment securities Available for Sale
- ----------------------------------------
U.S. Treasury and other agencies $ 11,901,559 $ 202,013 $ - $ 12,103,572
Municipals 6,205,365 44,441 (137,541) 6,112,265
FHLMC stock 19,200 1,258,752 - 1,277,952
Corporate Bonds 4,020,137 141,198 - 4,161,335
Other equity securities 2,247,838 108,010 (65,019) 2,290,829
---------------- --------------- ---------------- ----------------
Total available-for-sale $ 24,394,099 $ 1,754,414 $ (202,560) $ 25,945,953
================ =============== ============== ===============
December 31, 2001
----------------------------------------------------------------------
Book Unrealized Unrealized Fair
Value Gains Losses Value
----------------------------------------------------------------------
Mortgage-backed and related securities Available-for-Sale
- ---------------------------------------------------------
FNMA $ 3,367,936 $ 42,568 $ - $ 3,410,504
GNMA 11,041,992 101,284 (4,430) 11,138,846
SBA's 2,102,705 - (18,296) 2,084,409
FHLMC 8,735,995 52,810 (17,096) 8,771,709
----------------- ---------------- --------------- ----------------
Total mortgage-backed and
Related securities $ 25,248,628 $ 196,662 $ (39,822) $ 25,405,468
================= ================ =============== ================
65
The book value and estimated fair value of debt securities at December 31, 2002,
by contractual maturity, are shown below. Expected maturities will differ from
contractual maturities because borrowers may have the right to call or prepay
obligations with or without call or prepayment penalties.
December 31, 2002 December 31, 2001
------------------------------------ ---------------------------------
Book Fair Book Fair
Value Value Value Value
------------------------------------ ---------------------------------
Available-for-Sale
- ------------------
Due in one year or less $ 1,514,357 $ 1,535,934 $ 2,048,994 $ 2,050,841
Due after one year through five years 20,307,737 20,652,265 9,341,118 9,633,130
Due after five years through ten years 8,667,384 9,069,786 8,281,037 8,348,041
Due after ten years 3,976,322 4,051,605 2,455,912 2,345,160
Equities 3,263,407 4,284,357 2,267,038 3,568,781
----------------- --------------- --------------- ---------------
$ 37,729,207 $ 39,593,947 $ 24,394,099 $ 25,945,953
================= =============== =============== ===============
Mortgage-backed and related securities $ 69,746,659 $ 70,408,888 $ 25,248,628 $ 25,405,468
================= =============== =============== ===============
Gross realized gains on the sale of securities available for sale were $256,661,
$0, $228,764, $256,331, and $3,880 for the years ended December 31, 2002,
December 31, 2001, December 31, 2000, September 30, 2000 and the three month
period ended December 31, 2000, respectively. Gross realized losses on the sale
of securities available for sale were $13,428, $9,115, $0, $31,447 and $0 for
the years ended December 31, 2002, December 31, 2001, December 31, 2000,
September 30, 2000, the three month period ended December 31, 2000,
respectively. After-tax net gains (losses) on the sale of securities were
$155,669, $(5,834), $146,409, $143,926, and $2,483 for the years ended December
31, 2002, December 31, 2001, December 31, 2000, September 30, 2000, and the
three month period ended December 31, 2000, respectively.
Investment securities having a carrying amount of approximately $15,065,00 have
been pledged as collateral to secure public deposits at December 31, 2002.
Investment securities having a carrying amount of $2,000,000 have been pledged
as collateral for repurchase agreements at December 31, 2002.
66
NOTE 4 - LOANS AND ALLOWANCE FOR LOAN LOSSES
The following is a summary of loans outstanding by category at December 31:
2002 2001
----------------- ------------------
Real estate:
One-to-four family residential $148,843,298 $196,571,503
Multi-family residential 8,961,744 8,696,209
Commercial mortgage 52,053,943 42,436,769
Construction 15,321,560 16,525,140
Land 9,930,316 6,798,302
Commercial 12,084,201 6,930,477
Consumer 61,213,368 64,882,124
----------------- ------------------
Gross loans 308,408,430 342,840,524
Less:
Loans in process 5,418,729 5,305,894
Deferred loan fees, net 89,406 77,215
Allowance for loan losses 2,994,576 3,136,058
----------------- ------------------
Net loans $299,905,719 $334,321,357
================= ==================
The Company evaluates impairment of its residential mortgage and consumer loans
on a collective basis. Commercial loans individually evaluated and considered
impaired under SFAS No. 114 at December 31, 2002 and 2001 were immaterial.
Changes in the allowance for loan losses for the years ended December 31, 2002,
December 31, 2001, December 31, 2000, September 30, 2000, and the three month
period ended December 31, 2000, were as follows:
Year Ended Year Ended Year Ended Year Ended Three Month
December December December September Period Ended
2002 2001 2000 2000 December 2000
-------------- ------------- ------------ ------------ -------------
Balance at beginning of year $ 3,136,058 $ 1,566,298 $ 1,516,905 $1,509,465 $ 1,536,505
Reserve acquired in acquisition - 1,553,099 - - -
Provision for loan losses 225,000 120,000 52,500 30,000 30,000
Recoveries on loans previously
charged off 17,033 943 732 394 244
Loans charged off (383,515) (104,282) (3,839) (3,354) (451)
-------------- ------------- ------------ ------------ -------------
Balance at end of year $ 2,994,576 $ 3,136,058 $ 1,566,298 $1,536,505 $ 1,566,298
============== ============= ============ ============ =============
67
Directors, executive officers, and associates of such persons were customers of
and had transactions with the Bank in the ordinary course of business. Included
in such transactions are outstanding loans and commitments, all of which were
made under normal credit terms and did not involve more than normal risk of
collection. The aggregate amounts of these loans were $3,604,217 and $2,541,737
at December 31, 2002 and 2001, respectively. During the year ended December 31,
2002, new loans of $1,694,356 were made and payments totaled $631,876. During
the year ended December 31, 2001, new loans of $982,000 were made and payments
totaled $1,271,000. During the three month period ended December 31, 2000, new
loans of $429,000 were made and payments totaled $115,000. During the year ended
September 30, 2000, new loans of $853,313 were made and payments totaled
$409,041.
As part of the Bank's interest rate risk management, in November 2000, the Bank
sold 157 fixed-rate mortgage loans with a book value of $18,202,227 with
servicing released. These fixed-rate mortgage loans had a weighted average
coupon of 6.3% and a weighted average maturity of 153 months. The Company
recognized a pre-tax loss of $872,745 on this sale.
During the year ended September 30, 2000, the Bank sold one loan with a book
value of $9,457 at a gain of $543. The Bank held no loans for sale at December
31, 2002 and 2001.
NOTE 5 - PREMISES AND EQUIPMENT
Premises and equipment at December 31 are summarized as follows:
2002 2001
--------------- ---------------
Land $ 2,846,805 $ 2,851,955
Buildings 6,186,770 5,637,149
Land Improvements 110,715 110,715
Furniture and equipment 2,754,801 2,911,165
--------------- ---------------
11,899,091 11,510,984
Less: accumulated depreciation 3,092,179 2,870,838
--------------- ---------------
$ 8,806,912 $ 8,640,146
=============== ===============
NOTE 6 - BANK OWNED LIFE INSURANCE
The Company owns bank-owned life insurance to fund certain employee benefit
plans. The Company purchased $2,600,000 in bank-owned life insurance during the
year ended December 31, 2001 and acquired approximately $800,000 in bank-owned
life insurance in the acquisition of Innes Street Financial Corporation
effective December 31, 2001. The bank-owned life insurance policies are recorded
in other assets at their cash surrender values of $6,833,628 and $6,492,853 at
December 31, 2002 and 2001, respectively.
68
NOTE 7 - INTANGIBLE ASSETS
Amortized intangible assets at December 31, 2002 and 2001 are summarized as
follows:
December 31, 2002 December 31, 2001
-------------- -----------------
Core deposit intangible $ 2,447,000 $ 2,447,000
Mortgage servicing rights 673,896 673,896
-------------- -----------------
3,120,896 3,120,896
Less: accumulated amortization 1,132,914 30,041
-------------- -----------------
$ 1,987,982 $ 3,090,855
============== =================
Amortization expense for intangible assets subject to amortization was
$1,102,873 during the year ended December 31, 2002 and $30,041 during the year
ended December 31, 2001 since these intangibles were recognized on December 31,
2001 in connection with the acquisition of Innes Street Financial Corporation as
described in Note 2. The fair value of MSRs at December 31, 2002 and 2001
approximated carrying value. The total amount of loans serviced for others at
December 31, 2002 and December 31, 2001 were $33,503,785 and $43,297,000,
respectively.
Estimated amortization expense for the next five succeeding fiscal years ending
December 31 are as follows:
2003 $ 522,000
2004 $ 359,000
2005 $ 268,000
2006 $ 184,000
2007 $ 139,000
The balance of goodwill was $6,670,522 and $6,581,000 at December 31, 2002 and
2001. The increase in goodwill is due to costs of the acquisition that exceeded
the initial estimates made during the purchase price allocation.
NOTE 8 - DEPOSITS
Deposit balances and interest expense and average rates paid for the years ended
December 31, 2002, December 31, 2001, and the three month period ended December
31, 2000 and the year ended September 30 are summarized as follows:
December 31, December 31,
2002 2001
--------------------------------------------------------------------------------------------
Actual Interest Average Actual Interest Average
Balance Expense Rate Balance Expense Rate
------- ------- ---- ------- ------- ----
Noninterest bearing $ 11,203,428 $ - - $ 7,952,755 $ - -
Interest bearing checking 25,772,621 93,452 0.4% 25,329,824 186,098 1.2%
Money market deposit 35,810,998 497,398 1.5% 29,489,123 459,947 2.7%
Savings 43,670,086 637,769 1.4% 44,011,250 398,268 2.1%
Certificates of deposit 224,404,799 6,733,190 2.9% 246,909,362 6,328,376 5.4%
------------------ -------------- ---------- --------------- ------------- -----------
69
$ 340,861,932 $ 7,961,809 2.3% $ 353,692,314 $ 7,372,689 4.2%
================== ============== ========== =============== ============= ===========
December 31, September 30,
2000 2000
------------------------------------------------------------------------------------------
Actual Interest Average Actual Interest Average
Balance Expense Rate Balance Expense Rate
------- ------- ---- ------- ------- ----
Noninterest bearing $ 7,096,258 $ - - $ 5,272,347 $ - -
Interest bearing checking 14,562,151 58,383 1.1% 14,008,668 225,549 1.1%
Money market deposit 14,689,852 135,164 3.6% 14,908,946 452,410 3.2%
Savings 17,922,242 133,064 2.9% 19,188,828 692,521 3.1%
Certificates of deposit 113,660,342 1,670,725 6.1% 107,972,725 5,597,790 5.4%
------------------ -------------- ---------- ---------------- ------------- -----------
$ 167,930,845 $ 1,997,336 4.7% $161,351,514 $6,968,270 4.3%
================== ============== ========== ================ ============= ===========
Contractual maturities of certificates of deposit as of December 31, 2002 and
2001 are as follows:
2002 2001
---- ----
Under 1 year $ 169,266,978 $ 221,439,430
1 to 2 years 36,368,520 20,096,176
2 to 3 years 12,739,157 5,194,589
3 to 4 years 6,030,144 179,167
------------------- -------------------
$ 224,404,799 $ 246,909,362
=================== ===================
Certificates of deposit in excess of $100,000 totaled $49,140,313 and
$51,043,952 at December 31, 2002 and 2001, respectively, and may not be fully
insured by the FDIC. Interest paid on deposits and other borrowings was
$10,382,999 for the year ended December 31, 2002, $10,167,219 for the year ended
December 31, 2001, $2,690,090 for the three-month period ended December 31, 2000
and $8,921,888 for the year ended September 30, 2000, respectively.
Directors, executive officers, and associates of such persons were customers of
and had transactions with the Bank in the ordinary course of business. Included
in such transactions are deposit accounts, all of which were made under normal
terms. The aggregate amount of these deposit accounts was $3,333,855 and
$1,693,000 at December 31, 2002, 2001, respectively. The significant increase in
these deposits during the year ended December 31, 2002 primarily was due to the
inclusion of the Bank's advisory directors, who were directors of Innes Street
Financial Corporation, pursuant to the acquisition of Citizens Bank, Inc. on
December 31, 2001. In addition, four individuals were added to the complement of
executive officers during 2002.
The deposits of the Bank are insured by the Savings Association Insurance Fund
(SAIF), one of two funds administered by the FDIC. The Bank's annual SAIF
premium rates were $.0204 per $100 of deposits for the years ended December 31,
2002 and December 31, 2001, the three-month period ended December 31, 2000 and
the year ended September 30, 2000.
70
NOTE 9 - ADVANCES FROM THE FEDERAL HOME LOAN BANK
Advances from the Federal Home Loan Bank of Atlanta are pursuant to lines of
credit and are collateralized by a lien on qualifying first mortgage loans in an
amount necessary to satisfy outstanding indebtedness plus accrued interest.
Advances had interest rates ranging from 1.95% to 6.60% at December 31, 2002 and
3.59% to 6.60% at December 31, 2001. The total amount available on the line of
credit is 25% of total assets of the Bank. The unused portion of the line of
credit available to the Company at December 31, 2002 was approximately
$76,381,000.
Maturities of advances at December 31 are as follows:
2002 2001
--------------- ---------------
Advances from FHLB due:
Less than 1 year $ 6,000,000 $ -
1 to 2 years 6,500,000 6,500,000
2 to 3 years 7,000,000 5,000,000
3 to 4 years - 7,000,000
4 to 5 years - -
5 to 10 years 27,000,000 22,000,000
After 10 years - -
--------------- ---------------
$ 46,500,000 $ 40,500,000
=============== ===============
Interest rates on certain convertible advances may be reset on certain dates at
the option of the Federal Home Loan Bank in accordance with the terms of the
note. The Bank has the option of repaying the outstanding advance or converting
the interest rate from a fixed rate to a floating rate at the time the advance
is called by the Federal Home Loan Bank. The Bank currently has one $5.0 million
advance that will be callable quarterly until it matures in January 2005. The
Bank has one $5.0 million advance that will be callable quarterly beginning
November 2005 until it matures in November 2012. The Bank also has five other
advances that have a one-time call option. Interest rates on $8.0 million may
reset in 2003, $8.0 million may reset in 2004, and $5.0 million may reset in
2005.
The Company also has a $2,000,000 line of credit with First Charter Bank with no
outstanding balance at December 31, 2002.
71
NOTE 10 - INCOME TAXES
The provision for income taxes is summarized below:
Three Month
Year Ended Year Ended Year Ended Year Ended Period Ended
December December December September December
2002 2001 2000 2000 2000
--------------- -------------- ---------------- ---------------- -----------------
Currently payable
Federal $ 1,978,000 $ 734,730 869,480 $ 1,100,430 $ 19,000
State 352,000 13,000 88,400 104,000 8,000
--------------- -------------- ---------------- ---------------- -----------------
2,330,000 747,730 957,880
1,204,430 27,000
Three Month
Year Ended Year Ended Year Ended Year Ended Period Ended
December December 2001 December September December
2002 2000 2000 2000
--------------- --------------- --------------- ----------------- ----------------
Deferred
Federal 207,052 (37,000) (71,400) (76,000) (12,700)
State (9,000) (9,000) (40,700) (41,000) (9,000)
--------------- -------------- ----------------- ----------------- ----------------
198,052 (46,000) (112,100) (117,000) (21,700)
--------------- -------------- ----------------- ----------------- ----------------
Total income
taxes $ 2,528,052 $ 701,730 $ 845,780 $ 1,087,430 $ 5,300
=============== ============== ================= ================= ================
72
The reasons for the difference between consolidated income tax expense and the
amount computed by applying the statutory federal income tax rate of 34% to
income before income taxes were as follows:
Three Month
Year Ended Year Ended Year Ended Year Ended Period Ended
December December December September December
2002 2001 2000 2000 2000
-------------- ------------- ----------- -------------- --------------
Federal income taxes at statutory
rate $ 2,392,000 $ 818,000 $ 882,000 $ 1,113,000 $ 23,000
State income taxes, net of federal
benefit 226,000 (2,000) 32,000 42,000 (1,000)
Effect of federal tax exempt
interest (92,000) (91,000) (97,000) (92,000) (23,000)
Other 2,052 (23,270) 28,780 24,430 6,300
------------- ------------- ----------- -------------- --------------
$2,528,052 $ 701,730 $ 845,780 $ 1,087,430 5,300
============= ============= =========== ============== ==============
Effective tax rate 35.9% 29.2% 32.6% 33.2% 7.8%
============= ============= =========== ============== ==============
Income taxes receivable are included in other assets and were $253,786 and
$551,338 at December 31, 2002 and 2001, respectively. Income taxes paid for the
years ended December 31, 2002 and 2001, the three-month period ended December
31, 2000 and the year ended September 30, 2000 were $2,530,000, $936,000,
$97,000, and $1,176,000, respectively.
73
The tax effects of temporary differences that give rise to significant portions
of deferred tax assets and liabilities at December 31 are as follows:
2002 2001
-----------------------------------
Deferred tax assets
Deferred compensation $ 1,036,156 $ 1,436,944
Allowance for loan losses 1,171,478 1,261,435
Excess carrying value of liabilities
assumed for financial reporting
purposes over tax basis 49,663 513,000
Other 210,090 95,455
----------------- -----------------
Gross deferred tax assets 2,467,387 3,306,834
Deferred tax liabilities
Excess carrying value of assets acquired
for financial reporting purposes over
tax basis 1,477,478 2,011,294
Deferred loan fees 195,050 299,001
Unrealized gain on securities
Available-for-sale 988,550 683,202
Other - 239,895
---------------- -----------------
Gross deferred tax liabilities 2,661,078 3,233,392
---------------- -----------------
Net deferred tax asset (liability) $ (193,691) $ 73,442
================= =================
The Company, in accordance with SFAS No. 109, did not record a deferred tax
liability of approximately $3,140,000 as of December 31, 2002 related to the
cumulative special bad debt deduction for savings and loan associations
recognized for income tax reporting prior to September 30, 1988, Citizen South
Bank's base year.
Management believes that the Company will fully realize deferred tax assets
based on future taxable temporary differences, refundable income taxes from
carryback years, and current levels of operating income.
74
NOTE 11 - COMMITMENTS TO EXTEND CREDIT
Commitments to extend credit are agreements to lend as long as there is no
violation of any condition established in the contract. Commitments generally
have fixed expiration dates or other termination clauses and may require payment
of a fee. Since commitments may expire without being drawn upon, the total
commitment amounts do not necessarily represent future cash requirements.
Commitments to extend credit as of December 31 are as follows:
2002 2001
---------------- --------------
Residential mortgage loan commitments $ 3,674,100 $ 2,198,430
Non-residential mortgage loan commitments 2,450,000 5,073,573
Commercial loan commitments 1,780,000 1,241,200
Consumer loan commitments 920,686 251,000
Unused lines of credit
Commercial 12,492,446 12,275,000
Consumer 44,332,632 41,211,000
Residential mortgage loan commitments at December 31, 2002 either have fixed
rates ranging from 5.25% to 6.0% or variable rates ranging from 4.25% to 4.625%.
Non-residential mortgage loan commitments have variable rates ranging from the
Bank's prime rate (4.25% at December 31, 2002) to the Bank's prime rate minus
0.25%. Commercial loan commitments either have fixed rates at 7.00% or variable
rates at the Bank's prime rate minus 0.50%. Consumer loan commitments either
have fixed rates ranging from 5.625% to 8.25% or variable rates ranging from the
Bank's prime rate plus 0% to 1%. Commitment periods are typically 60 days.
NOTE 12 - REGULATORY CAPITAL REQUIREMENTS
The Bank is subject to various regulatory capital requirements administered by
the federal banking agencies. Under the capital adequacy guidelines and the
regulatory framework for prompt corrective action, the Bank must meet specific
capital guidelines that involve quantitative measures of assets, liabilities,
and certain commitments as calculated under regulatory accounting practices. The
capital amounts and classification are also subject to qualitative judgments by
the regulators about components, risk weightings and other factors. Failure to
meet minimum capital requirements can initiate certain mandatory, and possibly
discretionary, actions by regulators that, if undertaken, could have a direct
material effect on the Bank's financial statements.
The Bank is required to maintain: tangible capital of at least 1.5% of adjusted
total assets; core capital of at least 4.0% of adjusted total assets; and total
capital of at least 8.0% of risk weighted assets. At December 31, 2002, the
Bank's tangible capital and core capital were both $57,304,000 or 11.92% of
tangible assets, and total capital was $60,801,000 or 19.69% of risk-weighted
assets. The Company's primary regulator, the Office of Thrift Supervision,
informed the Bank that it was in the well-capitalized category as of the most
recent regulatory examination, and management is not aware of any events that
have occurred since that would have changed its classification.
75
To Be Well
Capitalized Under
For Capital Prompt Corrective
Actual Adequacy Purposes Action Provisions
---------------------- ----------------------- -----------------------
Amount Ratio Amount Ratio Amount Ratio
--------- --------- --------- --------- ---------- ---------
(dollars in (dollars in thousands) (dollars in thousands)
thousands)
As of December 31, 2002
Total Risk-Based Capital
(to Risk-Weighted Assets) $ 60,801 19.69% 24,702 8.00% 30,877 10.00%
Tier 1 Capital
(to Risk-Weighted Assets) 57,304 18.56% 12,351 4.00% 18,526 6.00%
Tier 1 Capital
(to Adjusted Total Assets) 57,304 11.92% 19,232 4.00% 24,040 5.00%
Tangible Capital
(to Adjusted Total Assets) 57,304 11.92% 7,212 1.50% 14,424 3.00%
As of December 31, 2001
Total Risk-Based Capital
(to Risk-Weighted Assets) $ 30,616 10.25% $ 23,892 8.00% $ 29,865 10.00%
Tier 1 Capital
(to Risk-Weighted Assets) 26,922 9.01% 11,946 4.00% 17,919 6.00%
Tier 1 Capital
(to Adjusted Total Assets) 26,922 6.17% 17,440 4.00% 21,800 5.00%
Tangible Capital
(to Adjusted Total Assets) 26,922 6.17% 6,540 1.50% 13,080 3.00%
As of December 31, 2000
Total Risk-Based Capital
(to Risk-Weighted Assets) $ 38,069 25.48% $ 11,952 8.00% $ 14,940 10.00%
Tier 1 Capital
(to Risk-Weighted Assets) 35,917 24.04% 5,976 4.00% 8,964 6.00%
Tier 1 Capital
(to Adjusted Total Assets) 35,917 14.29% 10,078 4.00% 12,598 5.00%
Tangible Capital
(to Adjusted Total Assets) 35,917 14.29% 3,779 1.50% 7,559 3.00%
76
NOTE 13 - EMPLOYEE BENEFIT PLANS
The Bank provides supplemental benefits to substantially all employees through a
401(k) savings plan. Effective January 1, 2002, eligible participants may
contribute up to 75% of eligible compensation, with the Bank providing matching
contributions of 50% of employee contributions up to 6% of eligible
compensation. Prior to January 1, 2002, eligible participants were allowed
contribute up to 15% of eligible compensation, with the Bank providing matching
contributions of 50% of employee contributions up to 6% of compensation. The
plan also provides for discretionary employer contributions. Total expense
relating to this plan was $93,032 for the year ended December 31, 2002, $62,314
for the year ended December 31, 2001, $141,357 for the year ended December 31,
2000, $58,678 for the year ended September 30, 2000 and $15,565 for the three
month period ended December 31, 2000.
The Bank also maintains nonqualified deferred compensation and/or supplemental
retirement plans for certain of its directors. During 2001, the Bank added a
similar plan for certain executive officers. Total expense for the plans was
$312,182 for the year ended December 31, 2002, $300,199 for the year ended
December 31, 2001, $86,470 for the year ended December 31, 2000, $175,288 for
the year ended September 30, 2000 and $28,662 for the three month period ended
December 31, 2000.
Prior to the acquisition at December 31, 2001, Citizens Bank maintained
non-qualified deferred compensation plans for key employees and directors: a
diversified and a non-diversified plan. These plans have been adopted by
Citizens South Bank. The eligible employees may defer a portion of their
compensation and the directors may defer a portion of their directors' fees. The
deferred assets are maintained in rabbi trusts, which are included in Other
Assets of the Company. The assets are accounted for at market value in
accordance with FASB Statement No. 115, Accounting for Certain Investments in
Debt and Equity Securities, with the resulting gains or losses in value recorded
as an adjustment to the fair value of the deferred compensation obligation.
On July 1, 2000, the Company terminated its participation in the Financial
Institutions Retirement Fund, a multiemployer, qualified, noncontributory
defined benefit pension plan that covered substantially all employees of the
Bank meeting certain age and service requirements. As a result of the
termination, plan participants who had accumulated a balance in the plan of less
than $3,500 or who were 55 years of age or greater on the termination date
received a lump sum payment equal to their balance accumulated in the plan. The
balances of those plan participants who had accumulated an amount of $3,500 or
greater in the plan and who were less than 55 years of age on the termination
date remain in the plan until those participants reach the age of 55 years.
The plan requires employers to fund amounts necessary to meet ERISA minimum
funding requirements. Total expense relating to this plan was $85,419 in the
year ended September 30, 2000 recognized prior to the termination of the plan on
July 1, 2000. Separate company information relating to the Bank is not
available.
1999 Stock Option Plan - On April 12, 1999, the Company's shareholders also
approved the Citizens South Bank 1999 Stock Option Plan that provided the
issuance of 211,335 options for directors and officers to purchase the Company's
common stock. Pursuant to the mutual holding company conversion and
reorganization completed on September 30, 2002, each share of the $1.00 par
value common stock of Citizens South Banking Corporation (the former Federal
corporation) was exchanged for 2.1408 shares of $0.01 par value common stock of
the Citizens South Banking Corporation (the new Delaware Corporation), which
preserved the previous shareholders' interest in Citizens South Banking
Corporation. Thus, the 211,335 shares of common stock in the 1999 Stock Option
Plan were exchanged for 452,425 shares, with
77
the exercise prices previously granted options adjusted according to the same
ratio. The Company applies the provisions of Accounting Principles Board Opinion
No. 25 in accounting for the plan and accordingly, no compensation expense has
been recognized in connection with the granting of the stock options. In
accordance with SFAS No. 123, Accounting for Stock-Based Compensation, the
Company adopted the disclosure-only option and elected to apply the provisions
of APB No. 25 for financial statement purposes.
Had the compensation cost for the Company's stock option plan been determined in
accordance with the fair-value accounting provisions of SFAS No. 123, net
income, basic earnings per share, and diluted earnings per share would have been
as follows (note that all earnings per share numbers have been adjusted to the
reflect the exchange ratio of 2.1408-to-1):
Year Ended Year Ended Year Ended
December 31 2002 December 31 2001 December 31 2000
------------------ ------------------ -----------------
Net income:
As reported $ 4,507,934 $ 1,704,125 $ 1,747,635
Pro forma $ 4,398,801 $ 1,600,118 $ 1,554,948
Basic earnings per share:
As reported $ 0.51 $ 0.20 $ 0.20
Pro forma $ 0.50 $ 0.18 $ 0.18
Diluted earnings per share:
As reported $ 0.51 $ 0.20 $ 0.20
Pro forma $ 0.50 $ 0.18 $ 0.18
Three Month
Year Ended Period Ended
September 30 2000 December 31 2000
------------------ ------------------
Net income:
As reported $ 2,184,868 $ 62,842
Pro forma $ 1,934,841 $ 36,840
Basic earnings per share:
As reported $ 0.25 $ 0.01
Pro forma $ 0.22 $ 0.01
Diluted earnings per share:
As reported $ 0.25 $ 0.01
Pro forma $ 0.22 $ 0.01
78
The following is a summary of stock option activity and related information for
the years ended December 31, 2002 and December 31, 2001, the three-month period
ended December 31, 2000 and the year ended September 30, 2000.
Year Ended December 31, 2002 Year Ended December 31, 2001
---------------------------- -----------------------------
Weighted Avg. Weighted Avg.
Options Exercise Price Options Exercise Price
---------- -------------- --------- ----------------
Outstanding-
Beginning of period $ 410,494 $ 5.63 $ 410,494 $ 5.63
Granted 21,407 7.26 -- --
Exercised (51,500) 5.61 -- --
Forfeited -- -- -- --
--------- -------- --------- --------
Outstanding-end of period 380,401 $ 5.73 410,494 $ 5.63
========= =========
Exercisable-end of period 294,451 $ 5.63 287,826 $ 5.62
========= =========
Weighted average fair value
of options granted during
the period $ 1.60 $ --
========= =========
Year Ended December 31, 2000 Year Ended September 30, 2000
---------------------------- -----------------------------
Weighted Avg. Weighted Avg.
Options Exercise Price Options Exercise Price
---------- -------------- --------- --------------
Outstanding-
Beginning of period $ 426,394 $ 5.63 $ 428,308 $ 5.63
Granted -- -- 5,352 5.61
Exercised -- -- -- --
Forfeited (15,900) 5.63 (7,266) 5.61
--------- -------- --------- --------
Outstanding-end of period 410,494 $ 5.63 426,394 $ 5.63
========= =========
Exercisable-end of period 229,706 $ 5.62 236,066 $ 5.61
========= =========
Weighted average fair value
of options granted during
the period $ -- $ 1.20
========= =========
Exercise prices for options outstanding as of December 31, 2002 ranged from
$5.61 to $7.27. Exercise prices for option outstanding as of December 31, 2001,
December 31, 2000 and September 30, 2000, ranged from $5.605 to $7.264. The
weighted average remaining contractual life of those options is approximately
three years at December 31, 2002 and 2001 and approximately four years at
December 31, 2000 and September 30, 2000.
The fair value of each option grant is estimated on the date of grant using the
Black-Scholes option-pricing model with the following weighted average
assumptions used for the year ended December 31, 2002: dividend yield of 3.27%,
expected volatility of 34%, a risk-free interest rate of 5.00%, and expected
lives of 7 years. The following weighted average assumptions were used for the
year ended December 31, 2001, the three month period ended December 31, 2000 and
the year ended September 30, 2000; dividend yield of 2.08%, expected volatility
of 22%, a risk-free interest rate of 6.00%, and expected lives of 7 years for
79
the options.
Employee Stock Ownership Plan - The Bank established an Employee Stock Ownership
Plan (ESOP). The ESOP is a tax-qualified retirement plan designed to invest
primarily in the Company's common stock. All full-time employees of the Bank who
have completed one year of service with the Bank will be eligible to participate
in the ESOP. The ESOP utilized funds borrowed from the Company totaling
$1,690,680, to purchase approximately 8%, or 169,068 shares of the Company's
common stock issued in the 1998 Conversion. The ESOP utilized funds borrowed
from the Company totaling $1,051,980 to purchase 105,198 additional shares of
the Company's common stock issued in the 2002 Conversion. The loans to the ESOP
will be primarily repaid with contributions from the Bank to the ESOP over a
period not to exceed 15 years for each loan. Under the terms of the ESOP, the
Bank makes contributions to the ESOP sufficient to cover all payments of
principal and interest as they become due. The 1998 loan had an outstanding
balance of $1,127,119 with an interest rate of 4.25% and $1,239,831 with an
interest rate of 4.75% at December 31, 2002 and 2001, respectively. The interest
rate on the loan is based on the Bank's prime rate. The 2002 loan had an
outstanding balance of $981,848 with an interest rate of 4.25% at December 31,
2002.
Shares purchased with the loan proceeds are held in a suspense account by the
trustee of the plan for future allocation among participants as the loan is
repaid. Contributions to the ESOP and shares released from the suspense account
are allocated among participants on the basis of compensation as described in
the plan. The number of shares released to participants will be determined based
upon the percentage of principal and interest payments made during the year
divided by the total remaining principal and interest payments including the
current year's payment. Participants will vest in the shares allocated to their
respective accounts over a period not to exceed 5 years. Any forfeited shares
are allocated to the then remaining participants in the same proportion as
contributions. As of December 31, 2002, 89,225 shares have been allocated to
participants and 185,041 shares remain unallocated. The fair value of the
unallocated shares was $1,887,418 at December 31, 2002. The Company recognizes
compensation expense attributable to the ESOP ratably over the fiscal year based
upon the estimated number of ESOP shares to be allocated each December 31st. The
Company recognized $145,305, $315,000, $21,000 and $124,000 as compensation
expense in the year ended December 31, 2002, the year ended December 31, 2001,
the three-month period ended December 31, 2000 and the year ended September 30,
2000, respectively.
The trustee for the ESOP must vote all allocated shares held in the ESOP trust
in accordance with the instructions of the participants. Unallocated shares held
by the ESOP trust are voted by the trustee in a manner calculated to most
accurately reflect the results of the allocated ESOP shares voted, subject to
the requirements of the Employee Retirement Income Security Act of 1974, as
amended (ERISA).
NOTE 14 - FAIR VALUE OF FINANCIAL INSTRUMENTS
The following methods and assumptions were used by the Company in estimating its
fair value disclosures for financial instruments. In cases where quoted market
prices are not available, fair values are based on estimates using present value
or other valuation techniques. The estimates are significantly affected by the
assumptions used, including discount rates and estimates of future cash flows.
These estimates may differ substantially from amounts that could be realized in
an immediate sale or settlement of the instrument.
Fair value approximates book value for the following financial instruments due
to their short-term nature: cash and due from banks, interest-earning bank
balances, and advances from customers for taxes and insurance.
80
Fair value for investment securities and mortgage-backed and related securities
are based on quoted market prices. If a quoted market price is not available,
fair value is estimated using market prices for similar securities.
Fair value for variable rate loans that reprice frequently is based on the
carrying value reduced by an estimate of credit losses inherent in the
portfolio. Fair value for all other loans is estimated by discounting their
future cash flows using interest rates currently being offered for loans of
comparable terms and credit quality.
Fair value for demand deposit accounts and interest-bearing accounts with no
fixed maturity is equal to the carrying value. Certificate of deposit fair
values are estimated by discounting cash flows from expected maturities using
interest rates currently being offered for similar instruments.
The carrying amount of repurchase agreements approximates fair value due to the
short-term nature of the agreements.
Fair value for the advances from the Federal Home Loan Bank Board is based on
discounted cash flows using current interest rates.
At December 31, 2002 and 2001, The Company had outstanding unfunded commitments
to extend credit offered in the normal course of business. Fair values of these
commitments are based on fees currently charged for similar instruments. At
December 31, 2002 and 2001, the carrying amounts and fair values of these
off-balance sheet financial instruments were immaterial.
The Company has used management's best estimates of fair values of financial
instruments based on the above assumptions. This presentation does not include
certain financial instruments, nonfinancial instruments or certain intangible
assets such as customer relationships, deposit base intangibles, or goodwill.
Accordingly, the aggregate fair value amounts presented do not represent the
underlying value of the Company. The estimated fair values of financial
instruments as of December 31 were as follows:
2002 2001
---------------------------------------------------------------------------
Carrying Amount Estimated Fair Carrying Amount Estimated Fair
Value Value
---------------------------------------------------------------------------
Financial assets
Cash and due from banks $ 7,606,918 $ 7,606,918 $ 6,047,576 $ 6,047,576
Interest-earning bank balances 39,391,870 39,391,870 14,891,738 14,891,738
Investment and mortgage-
backed securities 110,002,835 110,002,835 51,351,421 51,351,421
Loans 299,905,719 308,059,946 334,321,357 335,561,635
Financial liabilities
Deposits 340,861,932 362,762,003 353,692,314 355,528,258
Repurchase agreements 1,075,182 1,075,182 1,556,693 1,556,693
Advances from FHLB 46,500,000 50,182,876 40,500,000 41,796,771
NOTE 15 - EARNINGS PER SHARE
81
Earnings per share has been determined under the provisions of SFAS No. 128,
Earnings Per Share. Basic earnings per share is computed by dividing net income
applicable to common stock by the weighted average number of common shares
outstanding during the period, without considering any dilutive items. Diluted
earnings per share is computed by dividing net income applicable to common stock
by the weighted average number of common shares and common stock equivalents for
items that are dilutive, net of shares assumed to be repurchased using the
treasury stock method. Common stock equivalents arise from the assumed
conversion of outstanding stock options.
The only potential stock of the Company as defined in SFAS No. 128, is stock
options granted to various directors and officers of the Bank. The following is
a summary of the computation of basic and diluted earnings per share (note all
earnings per share amounts have been adjusted to reflect the 2.1408-to1
conversion which occurred in the current year):
82
Year Ended Year Ended Year Ended
December 31, December 31, December 31,
2002 2001 2000
---------------- ----------------- -----------------
Net income $ 4,507,934 $ 1,704,125 $ 1,747,635
Weighted average outstanding shares 8,767,982 8,745,626 8,753,609
Basic earnings per share $ 0.51 $ 0.20 $ 0.20
Weighted average outstanding shares 8,767,982 8,745,626 8,753,609
Dilutive effect of stock options 102,072 40,637 -
---------------- ----------------- -----------------
Weighted average diluted shares 8,870,054 8,786,263 8,753,609
Diluted earnings per share $ 0.51 $ 0.20 $ 0.20
Three Month
Year Ended Period Ended
September 30, December 31,
2000 2000
---------------- ------------------
Net income $ 2,184,868 $ 62,842
Weighted average outstanding shares 8,815,673 8,739,324
Basic earnings per share $ 0.25 $ 0.01
Weighted average outstanding shares 8,815,673 8,739,324
Dilutive effect of stock options 2,368 -
---------------- ------------------
Weighted average diluted shares 8,818,041 8,739,324
Diluted earnings per share $ 0.25 $ 0.01
On October 9, 1998, the Company's Board of Directors announced the authorization
to repurchase up to 105,668 shares of outstanding common stock under the 1998
Stock Repurchase Plan. On April 19, 1999, the Company's Board of Directors
announced the authorization to repurchase 295,869 shares of outstanding common
stock for the 1999 Stock Option Plan and the 1999 Recognition and Retention
Plan. On May 23, 2000, the Company's Board of Directors announced the
authorization to repurchase up to 92,539 shares of outstanding common stock.
As of December 31, 2002, 371,600 shares have been repurchased under these plans
at an average price of $12.85 per share.
83
NOTE 16 - PARENT-ONLY FINANCIAL INFORMATION
The earnings of the Bank are recognized by Citizens South Banking Corporation
using the equity method of accounting. Accordingly, undistributed earnings of
the Bank are recorded as increases in the Company's investment in the Bank. The
following are the condensed financial statements of the Company as of December
31, 2002 and 2001 and for the years ended December 31, 2002 and 2001, the three
month period ended December 31, 2000, and the year ended September 30, 2000.
CONDENSED STATEMENTS OF FINANCIAL CONDITION
December 31, December 31,
2002 2001
---------------- ----------------
Assets
Cash and cash equivalents $ 28,332,114 $ 1,929,167
Investment in securities available-for-sale 961,644 867,527
Investment in subsidiary 67,034,481 38,742,791
Other assets 185,735 137,184
---------------- ----------------
Total assets $ 96,513,974 $ 41,676,669
================ ================
Liabilities and Stockholders' Equity
Liabilities $ 131,294 $ 46,322
Stockholders' Equity 96,382,680 41,630,347
---------------- ----------------
Total liabilities and stockholders' equity $ 96,513,974 $ 41,676,669
================ ================
CONDENSED STATEMENTS OF OPERATIONS
Three Month
Year Ended Year Ended Period Ended Year Ended
December 31, December 31, December 31, September 30,
2002 2001 2000 2000
----------------- ----------------- ----------------- ------------------
Interest income $ 255,815 $ 75,772 $ 23,006 $ 125,441
Interest expense (26,865) - - -
Other operating income 81,592 - - -
Other operating expenses (94,346) (74,481) (2,393) (74,952)
----------------- ----------------- ----------------- ------------------
Income before income taxes and
undistributed earnings from
subsidiaries 216,196 1,291 20,613 50,489
Income taxes (83,162) (200) (8,000) (19,000)
----------------- ----------------- ----------------- ------------------
Income before undistributed
earnings from subsidiaries 133,034 1,091 12,613 31,489
Equity in undistributed earnings of
Subsidiaries 4,374,900 1,703,034 50,229 2,153,379
----------------- ----------------- ----------------- ------------------
Net income $ 4,507,934 $ 1,704,125 $ 62,842 $ 2,184,868
================= ================= ================= ==================
84
CONDENSED STATEMENTS OF CASH FLOWS
Three Month
Year Ended Year Ended Period Ended Year Ended
December 31, December 31, December 31, September 30,
2002 2001 2000 2000
----------------- ---------------- ---------------- -----------------
Operating activities
Net income $ 4,507,934 $1,704,125 $ 62,842 $ 2,184,868
Adjustments to reconcile net income to net
Cash provided by operating activities
(Gain) on sale of investments (81,592) - - -
Equity in undistributed (earnings) loss of
subsidiaries (4,374,900) (1,703,034) (50,229) (2,153,379)
Allocation of shares to ESOP 273,998 282,654 39,449 123,984
Decrease (increase) in other operating
assets (48,551) (62,391) 129,373 (215,155)
(Decrease) increase in other operating
liabilities 84,972 9,336 29,437 17,464
----------------- ---------------- ---------------- -----------------
Net cash provided by (used in)
operating activities 361,861 230,690 210,872 (42,218)
Investing activities
Purchase of investments available-for-sale (94,117) - (51,000) (150,007)
Acquisition of Innes Street Financial Corp.,
net of cash acquired - (22,607,382) - -
----------------- ---------------- ---------------- -----------------
Net cash used in investing activities (94,117) (22,607,382) (51,000) (150,007)
Financing activities
Issuance of additional common stock 50,133,534 - - -
Repurchase of common stock - (115,486) - (1,801,028)
Contributed capital to bank subsidiary (23,124,612) - - -
Dividends received from bank subsidiary - 22,555,137 - -
Dividends to stockholders (873,719) (529,397) (108,677) (861,808)
----------------- ---------------- ---------------- -----------------
Net cash (used in) provided by
financing activities 26,135,203 21,910,254 (108,677) (2,662,836)
Net increase (decrease) in cash and cash
equivalents 26,402,947 (466,438) 51,195 (2,855,061)
Cash and cash equivalents, beginning of
period 1,929,167 2,395,605 2,344,410 5,199,471
----------------- ---------------- ---------------- -----------------
Cash and cash equivalents, end of period $ 28,332,114 $ 1,929,167 $ 2,395,605 $ 2,344,410
================= ================ ================ =================
85
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
86
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The "Proposal I - Election of Directors" section of the Registrant's
preliminary proxy statement for its 2002 annual meeting of stockholders (the
"Preliminary Proxy Statement") is incorporated herein by reference.
ITEM 11. EXECUTIVE COMPENSATION
The "Proposal I - Election of Directors" section of the Registrant's
Preliminary Proxy Statement is incorporated herein by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS
The "Proposal I - Election of Directors" section of the Registrant's
Preliminary Proxy Statement is incorporated herein by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The "Proposal I - Election of Directors" section of the Registrant's
Preliminary Proxy Statement is incorporated herein by reference.
ITEM 14. CONTROLS AND PROCEDURES
(a) Evaluation of disclosure controls and procedures.
Under the supervision and with the participation of the
Company's management, including the Company's Chief Executive Officer
and Chief Financial Officer, the Company evaluated the effectiveness of
the design and operation of the Company's disclosure controls and
procedures (as defined in Rule 13a-14(c) under the Exchange Act) within
90 days prior to the filing date of this report. Based upon that
evaluation, the Chief Executive Officer and Chief Financial Officer
concluded that the Company's disclosure controls and procedures were
effective in timely alerting them to the material information relating
to the Company and its subsidiaries required to be included in the
Company's periodic SEC filings.
(b) Changes in internal controls.
There were no significant changes made in the Company's
internal controls during the period covered by this report or, to the
Company's knowledge, any other factors that could significantly affect
these controls subsequent to the date of their evaluation.
87
PART IV
ITEM 15. EXHIBITS, LISTS, AND REPORTS ON FORM 8-K
A. EXHIBITS
3.1 Certificate of Incorporation of Citizens South Banking Corporation
(incorporated herein by reference to the Registration Statement on Form
S-1 (File No. 333-91498), originally filed with the Commission on June
28, 2002
3.2 Bylaws of Citizens South Banking Corporation (incorporated herein by
reference to the Registration Statement on Form S-1 (File No.
333-91498), originally filed with the Commission on June 28, 2002
4 Form of Common Stock Certificate of Citizens South Banking Corporation
(incorporated herein by reference to the Registration Statement on Form
S-1 (File No. 333-91498), originally filed with the Commission on June
28, 2002
10.1 Employment Agreement with Kim S. Price (incorporated by reference to
the Registration Statement on Form SB-2 (File No. 333-42951),
originally filed with the Commission on December 22, 1997
10.2 Deferred Compensation and Income Continuation Agreement (incorporated
by reference to the Registration Statement on Form SB-2 (File No.
333-42951), originally filed with the Commission on December 22, 1997
10.3 Employee Stock Option Plan (incorporated by reference to the
Registration Statement on Form SB-2 (File No. 333-42951), originally
filed with the Commission on December 22, 1997
10.4 Supplemental Executive Retirement Plan (incorporated by reference to
the Registration Statement on Form SB-2 (File No. 333-42951),
originally filed with the Commission on December 22, 1997
10.5 Form of Merger/Protection Agreement with Gary F. Hoskins (incorporated
herein by reference to the Registration Statement on Form S-1 (File No.
333-91498), originally filed with the Commission on June 28, 2002
10.6 Form of Merger/Protection Agreement with Paul L. Teem, Jr.
(incorporated herein by reference to the Registration Statement on Form
S-1 (File No. 333-91498), originally filed with the Commission on June
28, 2002
10.7 Form of Merger/Protection Agreement with Michael R. Maguire
(incorporated herein by reference to the Registration Statement on Form
S-1 (File No. 333-91498), originally filed with the Commission on June
28, 2002
88
21 Subsidiaries of Registrant(incorporated herein by reference to the
Registration Statement on Form S-1 (File No. 333-91498), originally
filed with the Commission on June 28, 2002
23 Consent of Cherry, Bekaert & Holland, L.L.P.
24 Power of Attorney (set forth on signature page)
99.1 Certification of Chief Executive Officer and Chief Financial Officer
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
99.2 Certification of Chief Executive Officer and Chief Financial Officer
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
89
SIGNATURES
Pursuant to the requirements of Section 13 of the Securities Exchange
Act of 1934, the Company has duly caused this report to be signed on its behalf
by the undersigned, thereunto duly authorized.
CITIZENS SOUTH BANKING CORPORATION
Date: March 26, 2003 By: /s/ Kim S. Price
-------------- ----------------------------
Kim S. Price
President and Chief
Executive Officer
Pursuant to the requirements of the Securities Exchange of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
By: /s/ Kim S. Price By: /s/ Gary F. Hoskins
----------------------- -----------------------------
Kim S. Price Gary F. Hoskins
President, Chief Executive Officer and Executive Vice President,
Director (Principal Executive Officer) Treasurer and Chief
Financial Officer(Principal
Financial and Accounting
Officer)
Date: March 26, 2003 Date: March 26, 2003
----------------------- --------------------------------
By: /s/ David W. Hoyle By: /s/ Ben R. Rudisill, II
----------------------- -----------------------------
David W. Hoyle Ben R. Rudisill, II
Chairman Vice Chairman
Date: March 26, 2003 Date: March 26, 2003
----------------------- --------------------------------
By: /s/ Martha B. Beal By: /s/ Charles D. Massey
----------------------- -----------------------------
Martha B. Beal Charles D. Massey
Director Director
Date: March 26, 2003 Date: March 26, 2003
----------------------- --------------------------------
By: /s/ James J. Fuller By: /s/ Eugene R. Matthews, II
----------------------- -----------------------------
James J. Fuller Eugene R. Matthews, II
Director Director
Date: March 26, 2003 Date: March 26, 2003
----------------------- --------------------------------