Back to GetFilings.com

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2004

Commission file no: 0-22955

BAY BANKS OF VIRGINIA, INC.

(Exact name of registrant as specified in its charter)

100 SOUTH MAIN STREET, KILMARNOCK, VIRGINIA 22482

(Address of principal executive offices) (Zip Code)

Registrant’s telephone number, including area code: 804.435.1171

Securities registered under Section 12(b) of the Exchange Act: None

Securities registered under Section 12(g) of the Exchange Act:

Common Stock ($5.00 Par Value)

(Title of Class)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    YES  x    NO  ¨

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 the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).    YES  ¨    NO  x

The aggregate market value of voting stock held by non-affiliates of the registrant at June 30, 2004, based on the closing sale price of the registrant’s common stock on June 14, 2004, was $35,124,180.

The number of shares outstanding of the registrant’s common stock as of March 7, 2005 was 2,353,987.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant’s definitive Proxy Statement for its Annual Meeting of Shareholders to be held on May 16, 2005 are incorporated by reference into Part III of this Form 10-K.

Table of Contents

BAY BANKS OF VIRGINIA

INDEX

2

Table of Contents

PART I

ITEM 1: BUSINESS

GENERAL

Bay Banks of Virginia, Inc. “the Company” is a bank holding company that conducts substantially all of its operations through its subsidiaries, Bank of Lancaster (the “Bank”), and Bay Trust Company (the “Trust Company”). Bay Banks of Virginia, Inc., was incorporated under the laws of the Commonwealth of Virginia on June 30, 1997, in connection with the holding company reorganization of the Bank of Lancaster.

The Bank is a state-chartered bank and a member of the Federal Reserve System. The Bank services individual and commercial customers, the majority of which are in the Northern Neck of Virginia, by providing a full range of banking and related financial services, including checking, savings, other depository services, commercial and industrial loans, residential and commercial mortgages, home equity loans, and consumer installment loans.

The Bank has two offices located in Kilmarnock, Virginia, and one office each in White Stone, Warsaw, Montross, Heathsville, and Callao, Virginia. A substantial amount of the Bank’s deposits are interest bearing, and the majority of the Bank’s loan portfolio is secured by real estate. Deposits of the Bank are insured by the Bank Insurance Fund of the Federal Deposit Insurance Corporation (the “FDIC”). The Bank opened for business in 1930 and has partnered with the community to ensure responsible growth and development since that time.

In August of 1999, Bay Banks of Virginia formed Bay Trust Company. This subsidiary of the Company was created to purchase and manage the assets of the trust department of the Bank of Lancaster. The sale and transfer of assets from the Bank to the Trust Company was completed as of the close of business on December 31, 1999. As of January 1, 2000, the Bank of Lancaster no longer owned or managed the trust function, and thereby no longer receives an income stream from the trust department. Income generated by the Trust Company is consolidated with the Bank’s income and the Company’s income for the purposes of the Company’s consolidated financial statements. The Trust Company opened for business on January 1, 2000, in its permanent location on Main Street in Kilmarnock, Virginia.

The Company’s marketplace is situated on the “Northern Neck” peninsula of Virginia, plus Middlesex County. The “Northern Neck” includes the counties of Lancaster, Northumberland, Richmond, and Westmoreland. The Company’s primary trading area is dominated by smaller, retired households with relatively high per capita incomes. Growth in households, employment, and retail sales is moderate but the local economic conditions are stable as growth has been positive for several years. Health care, tourism, and related services are the major employment sectors in the “Northern Neck.”

The Company had total assets of $303.5 million, deposits of $261.9 million, and shareholders equity of $25.8 million as of December 31, 2004.

Through the Bank of Lancaster and Bay Trust Company, Bay Banks of Virginia provides a wide range of services to its customers in its market area. These services are summarized as follows.

Real Estate Lending. The Bank’s real estate loan portfolio is the largest segment of the loan portfolio. The Bank offers fixed and adjustable rate mortgages on one-to-four family residential properties. These mortgages are underwritten and documented within the guidelines of the regulations of the Board of Governors of the Federal Reserve System (the “Federal Reserve”). The Bank underwrites mainly adjustable rate mortgages as the marketplace allows. Construction loans with a twelve-month term are also a significant component of the Bank’s portfolio. Underwritten at 80% loan to value, and to qualified builders and individuals, these loans are disbursed as construction progresses and verified by Bank inspection. The Bank also offers commercial loans that are secured by real estate. These loans are typically written at 80% loan to value and are either variable with the prime rate of interest, or adjustable in one, three, or five year terms.

The Company also offers secondary market loan origination. Through the Bank, customers may apply for a home mortgage that will be underwritten in accordance with the guidelines of the Federal Home Loan Mortgage Corporation. These loans are then sold into the secondary market on a loan by loan basis. The Bank earns origination fees through offering this service. Customers, upon approval, receive a fixed or adjustable rate of interest with amortization terms up to 30 years. Since these loans are sold into the secondary market, the Company earns no future interest income, nor does it incur any interest rate or re-pricing risk.

3

Table of Contents

Consumer Lending. In an effort to offer a full range of services, the Bank’s consumer lending includes automobile and boat financing, home improvement loans, and unsecured personal loans. These loans historically entail greater risk than loans secured by real estate, but also offer a higher return.

Commercial Lending. Commercial lending activities include small business loans, asset based loans, and other secured and unsecured loans and lines of credit. Commercial lending may entail greater risk than residential mortgage lending, and is therefore underwritten with strict risk management standards. Among the criteria for determining the borrower’s ability to repay is a cash flow analysis of the business and business collateral.

Business Development. The Bank offers several services to commercial customers. These services include Analysis Checking, Cash Management Deposit Accounts, Wire Services, Direct Deposit Payroll Service, Internet Banking, Telephone Banking, and a full line of Commercial Lending options. The Bank also offers Small Business Administration loan products to include the 504 Program which provides long term funding for commercial real estate and long lived equipment. This allows commercial customers to apply for favorable rate loans for the development of business opportunities, while providing the Bank with a partial guarantee of the outstanding loan balance.

Bay Services Company, Inc. The Bank has one wholly owned subsidiary, Bay Services Company, Inc., a Virginia corporation organized in 1994 (“Bay Services”). Bay Services owns an interest in a land title insurance agency, Bankers Title of Fredericksburg, and an investment and insurance services company, Bankers Investment Group. Bankers Title of Fredericksburg sells title insurance to mortgage loan customers, including customers of the Bank of Lancaster and the other financial institutions that have an ownership interest in the agency. Bankers Investment Group provides the Bank’s non-deposit products department with insurance and investment products for marketing within the Bank’s primary marketing area.

Bay Trust Company. The Trust Company offers a broad range of trust and related fiduciary services. Among these are estate settlement and testamentary trusts, revocable and irrevocable personal trusts, managed agency, custodial accounts, and rollover Individual Retirement Accounts, both self-directed and managed.

COMPETITION

The Company’s marketplace is highly competitive. The Company is subject to competition from a variety of commercial banks and financial service companies, large national and regional financial institutions, large regional credit unions, mortgage companies, consumer finance companies, mutual funds and insurance companies. Competition for loans and deposits is affected by numerous factors, but mainly by interest rates and institutional reputation.

SUPERVISION AND REGULATION

Bank holding companies and banks are regulated under both federal and state law. The Company is subject to regulation by the Federal Reserve. Under the Bank Holding Company Act of 1956, the Federal Reserve exercises supervisory responsibility for any non-bank acquisition, merger or consolidation. In addition, the Bank Holding Company Act limits the activities of a bank holding company and its subsidiaries to that of banking, managing or controlling banks, or any other activity that is closely related to banking. In addition, the Company is registered under the bank holding company laws of Virginia, and as such is subject to regulation and supervision by the Virginia State Corporation Commission’s Bureau of Financial Institutions.

The following description summarizes the significant state and Federal laws to which the Company and the Bank are subject. To the extent statutory or regulatory provisions or proposals are set forth the description is qualified in its entirety by reference to the particular statutory or regulatory provisions or proposals.

The Bank is supervised and regularly examined by the Federal Reserve and the Virginia State Corporation Commission’s Bureau of Financial Institutions. These on-site examinations verify compliance with regulations governing corporate practices, capitalization, and safety and soundness. Further, the Bank is subject to the requirements of the Community Reinvestment Act (the “CRA”). The CRA requires financial institutions to meet the credit needs of the local community, including low to moderate-income needs. Compliance with the CRA is monitored through regular examination by the Federal Reserve.

Federal Reserve regulations permit bank holding companies to engage in non-banking activities closely related to banking or to managing or controlling banks. These activities include the making or servicing of loans, performing certain data processing services, and certain leasing and insurance agency activities.

4

Table of Contents

The Company owns 100% of the stock of the Bank of Lancaster. The Bank is prohibited by the Federal Reserve from holding or purchasing its own shares except in limited circumstances. Further, the Bank is subject to certain requirements as imposed by state banking statutes and regulations. The Bank is limited by the Federal Reserve regarding what dividends it can pay the Company. Any dividend in excess of the total of the Bank’s net profit for that year plus retained earnings from the prior two years must be approved by the proper regulatory agencies. Further, under the Federal Deposit Insurance Corporation Improvement Act of 1991 (the “FDICIA”), insured depository institutions are prohibited from making capital distributions, if, after making such distributions, the institution would become “undercapitalized” as defined by regulation. Based upon the Bank’s current financial position, it is not anticipated that this statute will impact the continued operation of the Bank.

As a bank holding company, Bay Banks of Virginia is required to file with the Federal Reserve an annual report and such additional information as it may require pursuant to the Bank Holding Company Act. The Federal Reserve may also conduct examinations of the Company and any or all of its subsidiaries.

CAPITAL REQUIREMENTS

The Federal Reserve, the Office of the Comptroller of the Currency and the FDIC have issued substantially similar risk-based and leverage capital guidelines applicable to banking organizations. In addition, those regulatory agencies may from time to time require that a banking organization maintain capital above the minimum levels because of its financial condition or actual or anticipated growth. Under the risk-based capital requirements of these federal bank regulatory agencies, the Company and the Bank are required to maintain a minimum ratio of total capital to risk-weighted assets of 8%. At least half of the total capital is required to be “Tier 1 capital”, which consists principally of common and certain qualifying preferred shareholders’ equity, less certain intangibles and other adjustments. The remainder (“Tier 2 capital”) consists of a limited amount of subordinated and other qualifying debt (including certain hybrid capital instruments) and a limited amount of the general loan loss allowance. The Tier 1 and total capital to risk-weighted asset ratios of the Company as of December 31, 2004 were 10.3% and 11.2%, respectively.

In addition, each of the federal regulatory agencies has established a minimum leverage capital ratio (Tier 1 capital to average risk-weighted assets) (“Tier 1 leverage ratio”). These guidelines provide for a minimum Tier 1 leverage ratio of 4% for banks and bank holding companies that meet certain specified criteria, including that they have the highest regulatory examination rating and are not contemplating significant growth or expansion. The Tier 1 leverage ratio of the Company as of December 31, 2004, was 7.4%, which is well above the minimum requirement. The guidelines also provide that banking organizations that are experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels, without significant reliance on intangible assets.

DEPOSIT INSURANCE

Pursuant to FDICIA, the FDIC adopted a risk-based assessment system for insured depository institutions that takes into account the risks attributable to different categories and concentrations of assets and liabilities. The risk-based system assigns an institution to one of three capital categories: (i) well-capitalized, (ii) adequately capitalized, or (iii) undercapitalized. The FDIC also assigns an institution to one of three supervisory subgroups within each capital group. The supervisory subgroup to which an institution is assigned is based on an evaluation provided to the FDIC by the institution’s primary federal regulator and information which the FDIC determines to be relevant to the institution’s financial condition and the risk posed to the deposit insurance funds (which may include, if applicable, information provided by the institution’s state supervisor). An institution’s insurance assessment rate is then determined based on the capital category and supervisory category to which it is assigned.

Under the final risk-based assessment system there are nine assessment risk classifications (i.e., combinations of capital groups and supervisory subgroups) to which different assessment rates are applied. Assessment rates for deposit insurance currently range from zero basis points ($2,000 minimum) to .27%. The capital and supervisory subgroup to which an institution is assigned by the FDIC is confidential and may not be disclosed. A bank’s rate of deposit insurance assessments will depend upon the category and subcategory to which the bank is assigned by the FDIC. Any increase in insurance assessments could have an adverse effect on the earnings of insured institutions, including the Bank.

5

Table of Contents

SAFETY AND SOUNDNESS REGULATIONS

The FDIC has adopted guidelines that establish standards for safety and soundness of banks. They are designed to identify potential safety and soundness problems and ensure that banks address those concerns before they pose a risk to the deposit insurance fund. If the FDIC determines that an institution fails to meet any of these standards, the agency can require the institution to prepare and submit a plan to come into compliance. If the agency determines that the plan is unacceptable or is not implemented, the agency must, by order, require the institution to correct the deficiency. The federal banking agencies have broad powers under current federal law to make prompt corrective action to resolve problems of insured depository institutions. The extent of these powers depends upon whether the institution in question is considered “well capitalized,” “adequately capitalized,” “under capitalized,” “significantly under capitalized,” or “critically undercapitalized.” All such terms are defined under uniform regulation defining such capital levels issued by each of the federal banking agencies. The Bank is considered well capitalized.

The FDIC also has safety and soundness regulations and accompanying guidelines on asset quality and earnings standards. The guidelines provide six standards for establishing and maintaining a system to identify problem assets and prevent those assets from deteriorating. The guidelines also provide standards for evaluating and monitoring earnings and for ensuring that earnings are sufficient to maintain adequate capital and reserves. If an institution fails to comply with a safety and soundness standard, the agency may require the institution to submit and implement an acceptable compliance plan, or face enforcement action.

THE GRAMM-LEACH BLILEY ACT OF 1999

The Gramm-Leach-Bliley Act of 1999 (“GLBA”) was signed into law on November 12, 1999. The main purpose of GLBA is to permit greater affiliations within the financial services industry, primarily banking, securities and insurance. The provisions of GLBA that are believed to be of most significance to the Company are discussed below.

GLBA repealed sections 20 and 32 of the Glass-Steagall Act, which sections separated commercial banking from investment banking, and substantially amends the Bank Holding Company Act, which prior to GLBA limited the ability of bank holding companies to engage in the securities and insurance businesses. To achieve this purpose, GLBA created a new type of company, the “financial holding company.” A financial holding company may engage in or acquire companies that engage in a broad range of financial services, including

A bank holding company may elect to become a financial holding company only if all of its depository institution subsidiaries are well-capitalized, well-managed and have at least a satisfactory CRA rating. While the Bank meets these criteria, the Company has not elected to be treated as a financial holding company.

GLBA established a system of functional regulation under which the federal banking agencies regulate the banking activities of financial holding companies and banks’ financial subsidiaries, the Securities and Exchange Commission regulates their securities activities, and state insurance regulators will regulate their insurance activities.

GLBA and certain regulations issued by federal banking agencies also provide protection against the transfer and use by financial institutions of consumers’ nonpublic personal information. A financial institution must provide to its customers, at the beginning of the customer relationship and annually thereafter, the institution’s policies and procedures regarding the handling of customers’ nonpublic personal financial information. The privacy provisions generally prohibit a financial institution from providing a customer’s personal financial information to unaffiliated third parties unless the institution discloses to the customer that the information may be so provided and the customer is given the opportunity to opt out of such disclosure.

Neither the provisions of GLBA nor the Act’s implementing regulations have had a material impact on the Company’s or the Bank’s regulatory capital ratios (as discussed above) or ability to continue to operate in a safe and sound manner.

USA PATRIOT ACT OF 2001

In October, 2001, the USA Patriot Act of 2001 was enacted in response to the terrorist attacks in New York, Pennsylvania and Northern Virginia, which occurred on September 11, 2001. The Patriot Act is intended is to

6

Table of Contents

strengthen U.S. law enforcements’ and the intelligence communities’ abilities to work cohesively to combat terrorism on a variety of fronts. The continuing and potential impact of the Patriot Act and related regulations and policies on financial institutions of all kinds is significant and wide ranging. The Patriot Act contains sweeping anti-money laundering and financial transparency laws, and imposes various regulations, including standards for verifying client identification at account opening, and rules to promote cooperation among financial institutions, regulators and law enforcement entities in identifying parties that may be involved in terrorism or money laundering.

REPORTING OBLIGATIONS UNDER SECURITIES LAWS

The Company is subject to the periodic reporting requirements of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), including the filing of annual, quarterly and other reports with the Securities and Exchange Commission (“SEC”). As an Exchange Act reporting company, the Company is directly affected by the Sarbanes-Oxley Act of 2002 and regulations promulgated thereunder by the SEC, which are aimed at improving corporate governance and reporting procedures. The Company is complying with the new rules and regulations implemented pursuant to the Sarbanes-Oxley Act and intends to comply with any applicable rules and regulations implemented in the future.

ITEM 2: PROPERTIES

The Company, through its subsidiaries, owns or leases buildings that are used in the normal course of business. The main office is located at 100 South Main Street, Kilmarnock, Virginia, in a building owned by the Company. The Company’s subsidiaries own or lease various other offices in the counties or towns in which they operate.

Unless otherwise noted, the properties listed below are owned by the Company and its subsidiaries as of December 31, 2004.

Corporate Headquarters

100 South Main Street, Kilmarnock, Virginia

Bank of Lancaster

100 South Main Street, Kilmarnock, Virginia

708 Rappahannock Drive, White Stone, Virginia

432 North Main Street, Kilmarnock, Virginia

4935 Richmond Road, Warsaw, Virginia

15648 Kings Highway, Montross, Virginia

6941 Northumberland Highway, Heathsville, Virginia

18 Sandy Street, Callao, Virginia

23 West Church Street, Kilmarnock, Virginia

672 North Main Street, Kilmarnock, Virginia (leased)

Bay Trust Company

1 North Main Street, Kilmarnock, Virginia

15648 Kings Highway, Montross, Virginia

ITEM 3: LEGAL PROCEEDINGS

The Company currently is not involved in any material legal proceeding other than the ordinary and routine litigation incidental to its business.

ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

There were no matters submitted to a vote of security holders during the fourth quarter of the year ended December 31, 2004.

7

Table of Contents

PART II

ITEM 5: MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Bay Banks of Virginia common stock trades on the over-the-counter (“OTC”) Bulletin Board under the symbol “BAYK” and transactions generally involve a small number of shares. There were 2,354,187 shares of the Company’s stock outstanding at the close of business on December 31, 2004, which were held by 762 shareholders of record.

The following table summarizes the high and low closing sales prices and dividends declared for the two years ended December 31, 2004.

A discussion of certain restrictions and limitations on the ability of the Bank to pay dividends to the Company and the ability of the Company to pay dividends on its common stock, is set forth in Part I, Business, of this Form 10-K under the heading “Supervision and Regulation.”

The dividend amount on the Company’s common stock is established by the Board of Directors on a quarterly basis with dividends paid on a quarterly basis. In making its decision on the payment of dividends on the Company’s common stock, the Board considers operating results, financial condition, capital adequacy, regulatory requirements, shareholder return, and other factors.

The Company began a share repurchase program in August of 1999 and has continued the program into 2004. The combined plans authorize the repurchase of 180,000 shares.

8

Table of Contents

ITEM 6: SELECTED FINANCIAL DATA

Note: All per-share data is adjusted to reflect a 2-for-1 split on June 7, 2002.

9

Table of Contents

ITEM 7: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion provides information about the major components of the results of operations and financial condition, liquidity and capital resources of Bay Banks of Virginia and its subsidiaries. This discussion and analysis should be read in conjunction with the Consolidated Financial Statements and Notes to Consolidated Financial Statements presented in Item 8, Financial Statements and Supplementary Data, in this Form 10-K.

CRITICAL ACCOUNTING POLICIES

GENERAL. The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). The financial information contained within our statements is, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. We use historical loss factors as one factor in determining the inherent loss that may be present in our loan portfolio. Actual losses could differ significantly from the historical factors that we use. In addition, GAAP itself may change from one previously acceptable method to another method. Although the economics of our transactions would be the same, the timing of events that would impact our transactions could change.

ALLOWANCE FOR LOAN LOSSES. The allowance for loan losses is an estimate of the losses that may be sustained in our loan portfolio. The allowance is based on two basic principles of accounting: (1) Statement of Financial Accounting Standards (“SFAS”) No. 5, Accounting for Contingencies, which requires that losses be accrued when they are probable of occurring and estimable and (2) SFAS No. 114, Accounting by Creditors for Impairment of a Loan, which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance. The use of these values is inherently subjective and our actual losses could be greater or less than the estimates.

The allowance for loan losses is increased by charges to income and decreased by charge-offs (net of recoveries). Management’s periodic evaluation of the adequacy of the allowance is based on past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, the estimated value of any underlying collateral, and current economic conditions.

OVERVIEW

2004 Compared to 2003

Bay Banks of Virginia, Inc. recorded earnings for 2004 of $2,181,360, or $.93 per share basic and $.93 per share on a diluted basis, as compared to 2003 earnings of $2,013,185 and $.87 per share basic and $.86 per share on a diluted basis. This is an increase in net income of 8.4% as compared to year end 2003. Net interest income for 2004 increased to $9,774,657, up 14.1% as compared to $8,562,995 for 2003. Non-interest income for 2004, before net securities gains, decreased to $2,543,569 as compared to 2003 non-interest income, before net securities gains, of $2,588,894, a decrease of 1.7%. Non-interest expenses increased to $9,322,862, up 9.2% over 2003 non-interest expenses of $8,536,017.

Performance as measured by the Company’s return on average assets (“ROA”) was .73% for the year ended December 31, 2004 compared to .72% for 2003. Performance as measured by return on average equity (“ROE”) was 8.55% for the year ended December 31, 2004, compared to 7.92% for 2003.

2003 Compared to 2002

Earnings for the Company were $2,013,185 for 2003, down 12.5% as compared to 2002 earnings of $2,301,401. The 2003 basic earnings per share were $.87 and diluted earnings per share were $.86, as compared to 2002 basic earnings per share of $1.00 and diluted earnings per share of $.99. Net interest income was $8,562,995 for 2003 as compared to $8,753,103 for 2002, a decrease of 2.2%. Non-interest income before net securities gains for 2003 was $2,588,894, up 23.9% over 2002 non-interest income before net securities gains of $2,088,624. Non-interest expenses for 2003 were $8,536,017, up 18.5% as compared to 2002 non-interest expenses of $7,202,587.

10

Table of Contents

Performance as measured by the Company’s ROA was .72% for the year ended December 31, 2003, compared to .91% for 2002. Performance as measured by ROE was 7.92% for the year ended December 31, 2003, compared to 9.72% for 2002.

Return on Equity and Assets

RESULTS OF OPERATIONS

Net Interest Income

The principal source of earnings for the Company is net interest income. Net interest income is the amount by which interest income exceeds interest expense. The net interest margin is net interest income expressed as a percentage of interest earning assets. Changes in the volume and mix of interest earning assets and interest bearing liabilities, the associated yields and rates, and the volume of non-performing assets have a significant impact on net interest income, the net interest margin, and net income.

Net interest income, on a fully tax equivalent basis which reflects the tax benefits of nontaxable interest income, was $10.2 million in 2004, $9.0 million in 2003 and $9.1 million in 2002. This represents an increase in net interest income of 13.5% for 2004 as compared to 2003 and a nominal decrease of 1.3% for 2003 compared to 2002. The interest rate spread on average earning assets and liabilities was 3.37%, 3.24% and 3.56 % for 2004, 2003, and 2002 respectively.

The Company’s net interest margin increased to 3.67 % for 2004 as compared to 3.53% for 2003. The net interest margin was 3.93% for 2002. The yield on earning assets decreased to 5.22% for 2004 as compared to 5.41% and 6.27% for years 2003 and 2002, respectively. The cost of interest bearing liabilities decreased to 1.85% for 2004 as compared to 2.17% and 2.71% for years 2003 and 2002, respectively. Average earning assets increased 9.4% to $277.5 million for 2004 as compared to $253.6 million for 2003. Average earning assets were $230.7 million for 2002. Average interest bearing liabilities increased 6.2% to $233.5 million at year end 2004 as compared to $220.0 million at year end 2003. Average interest bearing liabilities were $199.2 million at year end 2002.

11

Table of Contents

Average Balances, Income and Expenses, Yields and Rates

Years Ended December 31,

(Fully taxable equivalent basis)

Notes:

The Company’s balance sheet expanded at a rate of 4.4% during 2004 with year end loans increasing by 13.2% and year end deposits increasing by 1.9% as compared to year end 2003 balances. Loan growth was primarily composed of single family residential loans with adjustment periods of one, three, or five years and variable rate commercial loans that are re-priced with adjustments in the prime rate. Deposit growth was primarily in savings, non-interest bearing and interest bearing transaction accounts. Interest bearing transaction accounts generally re-price slowly and at the discretion of Company management. The result was that the Company shifted its interest rate sensitivity position from liability sensitive to slightly asset sensitive. Being asset sensitive is favorable in a rising rate environment because assets will re-price faster than liabilities. The Company began to realize the benefit of asset sensitivity as short term interest rates began to increase during the second half of 2004.

During 2003, the Company experienced significant re-pricing of its loan portfolio due to record levels of loan refinancing. The yield on total earning assets declined to 5.41% in 2003 from 6.27% in 2002, a reduction of 13.7%. Refinancing continued through the first quarter of 2004, but to a much lesser extent than during 2003. Nevertheless, the impact of refinancing and a flattening yield curve further compressed the yield on total interest earning assets to 5.22% in 2004 from 5.41% in 2003, a reduction of 3.5%.

Downward pressure on the earning asset yield was slowed through increases in loan offering rates and by culling low-yielding bonds within the investment portfolio. The market place continues to experience significant sales of existing homes and new construction. The Company has remained competitive in its loan pricing, but has systematically been able to increase loan offering rates as the marketplace allows.

During 2004, the Company was able to reduce interest expense through increases in balances of non-interest bearing deposits and re-pricing of time and other deposits. Deposits grew by less than 2% as compared to 2003, however, the mix of deposits changed dramatically. Non-interest bearing deposits grew by 13.4% as compared to year end 2003 and savings and interest bearing deposit accounts grew by 6.2%. This growth in

12

Table of Contents

deposits allowed the Company to reduce its total yield on deposits to 1.89% from 2.19% for the prior year. Coupled with controlling the pressure on asset yields and increased loan volume, this provided an additional $1.2 million in net interest income.

Volume and Rate Analysis of Changes in Net Interest Income

Notes:

Interest Sensitivity

Earnings performance and the maintenance of sufficient liquidity depend heavily on efficient management of the interest sensitivity gap. The interest sensitivity gap is the difference between interest sensitive assets and interest sensitive liabilities in a specific time interval. The interest sensitivity gap can be managed by re-pricing assets or liabilities, which are variable rate instruments, by replacing an asset or liability at maturity or by adjusting the interest rate during the life of the asset or liability. By matching the volume of assets and liabilities that mature in the same time interval, the Company can insulate against interest rate risk and minimize the impact of rising or falling rates.

The Company employs a variety of measurement techniques to identify and manage its exposure to changing interest rates and subsequent changes in liquidity. The Company utilizes a simulation model that estimates interest income volatility and interest rate risk. In addition, the Company utilizes an Asset Liability Committee (the “ALCO”) composed of appointed members from management and the Board of Directors. Through the use of simulation, the ALCO estimates the overall magnitude of interest rate risk and then formulates policy with which to manage asset growth and pricing, funding sources and pricing, and off-balance sheet commitments. These decisions are based on management’s expectations regarding future interest rate movements, economic conditions both locally and nationally, and other business and risk factors.

Earnings Simulation Analysis

The Company employs a simulation model that captures the impact of changing interest rates on the interest income received and interest expense paid on all assets and liabilities reflected on the balance sheet. The method is subject to the accuracy of the assumptions that underlie the process, but it provides a valuable analysis of the sensitivity of earnings to changes in interest rates.

13

Table of Contents

The following table reflects the interest rate sensitivity, at twenty-four months, on net interest income for the Company using different rate scenarios.

Unlike most industrial companies, virtually all of the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates have a more significant impact on a financial institution’s performance than do general levels of inflation. Interest rates do not necessarily move in the same magnitude as the prices of goods and services. Another impact of inflation is on non-interest expenses, which tend to rise during periods of general inflation. The values of real estate held as collateral by the Company for loans and foreclosed property could be affected by inflation or changing prices due to market conditions.

Management believes the most significant impact on financial results is the Company’s ability to react to changes in interest rates. Management attempts to maintain a favorable position between rate-sensitive assets and rate-sensitive liabilities in order to protect against wide interest rate fluctuations.

Economic Value of Equity Simulation

Economic value of equity simulation is used to calculate the estimated fair value of assets and liabilities over different interest rate environments. Economic values are calculated based on discounted cash flow analysis with the net economic value of equity being the fair value of all assets minus the fair value of all liabilities. The change in economic value over varying rate environments is an indication of long term interest rate sensitivity of the balance sheet. The following chart reflects the change in the economic value of equity over varying rate environments:

Non-Interest Income

Total non-interest income decreased to $2.8 million in 2004 as compared to $3.0 million in 2003, a reduction of 5.7%. Non-interest income in 2002 was $2.1 million. The decrease in non-interest income was due to declines in secondary market lending fees, gains on sale of other real estate, and other income. For 2004, secondary market lending fees totaled $184 thousand as compared to $363 thousand for 2003. Gains on sale of other real estate were $14 thousand as compared to $192 thousand for the prior year, and other income was $127 thousand as compared to $151 for the prior year.

Income improved in fiduciary income, service charges on deposit accounts, and other service charges. Fiduciary income increased to $665 thousand from $622 for 2003, service charges on deposits increased to $669 thousand from $599 thousand, and other service charges increased to $885 thousand from $663 thousand.

The two most significantly declining non-interest income items were secondary market lending fees and gains on sale of other real estate. Secondary market lending fees declined during 2004 due to the ability of the Company’s subsidiary bank to remain competitively priced to loan rates offered in the secondary market. These loans are sold into the secondary market with servicing released. As noted above, loan growth was strong for the Company during 2004 and there was less demand for secondary market products as a result. Gains on sale of other real estate are dependent upon the volume and nature of the properties that the Company buys back through foreclosure. During 2004, the number and value of foreclosed properties was lower than 2003 which resulted in fewer income dollars from the sale of those foreclosed properties.

14

Table of Contents

Non-Interest Expense

During 2004, total non-interest expenses increased 9.2% to $9.3 million from $8.5 million in 2003 and $7.2 million in 2002. Non-interest expenses are composed of salaries and benefits, occupancy expense, state bank franchise tax, Visa Program expense, telephone expense and other operating expenses.

Salary and benefit expense continues to be the major component of non-interest expenses. Salary and benefits expense increased 16.8% to $5.1 million in 2004, as compared to $4.4 million in 2003 and $3.6 million in 2002. The benefits component for 2004 increased 10.2% over 2003. If the effects of SFAS No. 91 loan origination setup credits, which reduce salary expense, are removed, salary and benefit expense for 2004 increased only 8.4% over 2003.

Occupancy expense increased 3.2% to $1.4 million during 2004 as compared to 2003. Occupancy expense was $884 thousand for 2002 State bank franchise tax expense declined 5.0% to $202 thousand as compared to $212 thousand for 2003. Expenses related to the Visa Program increased by 14.2% to $422 thousand as compared to $369 thousand for 2003. Telephone expense declined 10.3% to $167 thousand as compared to $187 thousand for 2003. Other expense declined by 0.8% to $2.0 million as compared to 2003.

Management continues its program of identifying variable expenses that can be reduced or eliminated. Net of salary and benefit expense, non-interest expenses increased by $50 thousand, or 1.2% during 2004, as compared to 2003.

Income Taxes

Income tax expense in 2004 was $760 thousand, $661 thousand in 2003 and $870 thousand in 2002. Income tax expense corresponds to an effective rate of 25.8%, 24.7% and 27.4% for the three years ended December 31, 2004, 2003, and 2002, respectively. Note 12 to the Consolidated Financial Statements provide a reconciliation between the amounts of income tax expense computed using the federal statutory income tax rate and actual income tax expense. Also included in Note 12 to the Consolidated Financial Statements is information regarding deferred taxes for 2004, 2003, and 2002.

Loans

Loan production remained strong during 2004 as new loan volumes were only marginally impacted by loan prepayments. During 2004, as shown below, loans increased by 13.3% to $214.1 million as compared to 2003 balances of $189.0 million. Loans secured by real estate represent the largest category, comprising 84.7% of the loan portfolio at December 31, 2004. Of these balances, 1-4 family residential, not including home equity lines, was 48.0% of total loans, down from 54.7% at year end 2003. Commercial loan balances decreased 13.3% to $21.5 million from $24.8 million at year end 2003. Commercial loan balances were 10.1% of total loans at year end 2004 as compared to 13.1% at year end 2003. Consumer installment loans decreased 6.2% to $9.9 million from $10.6 million at year end 2003.

Types of Loans

Notes:

Deferred loan costs and fees not included.

Allowance for loan losses not included.