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EX-32.1 - VSB BANCORP INCex32_1.htm
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EX-31.1 - VSB BANCORP INCex31_1.htm
UNITED STATES
SECURITY AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20849
 
FORM 10-Q
 
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
  FOR THE QUARTER ENDED SEPTEMBER 30, 2010
   
o
TRANSITION REPORT PURSUANT TO SECTION 13 OF THE EXCHANGE ACT FOR THE TRANSITION PERIOD
 
COMMISSION FILE NUMBER 0-50237
 
VSB Bancorp, Inc.
(Exact name of registrant as specified in its charter)
 
New York
(State or other jurisdiction of incorporation or organization)
 
11 - 3680128
(I. R. S. Employer Identification No.)
 
4142 Hylan Boulevard, Staten Island, New York 10308
(Address of principal executive offices)
 
(718) 979-1100
Registrant’s telephone number
 
Common Stock
(Title of Class)
 
Indicate by check mark whether the registrant (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 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 o
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes o No o
 
Indicate by check mark whether the registrant is a large accelerated filer, a non-accelerated filer or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
Large Accelerated Filer o
 
Accelerated Filer o
 
Non-Accelerated Filer o
 
Smaller Reporting Company x
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act):
Yes o No x
 
Par Value: $0.0001 Class of Common Stock
 
The Registrant had 1,831,185 common shares outstanding as of November 5, 2010.

 
 

 
 
CROSS REFERENCE INDEX
 
     
Page
  PART I    
       
 
4
   
5
   
6
   
7
   
8 to 19
       
 
19 to 32
 
32
       
   
       
Item 1 Legal Proceedings  
33
     
Signature Page  
34
     
  Exhibit 31.1, 31.2, 32.1, 32.2  
35 to 38
 
 
2

 

Forward-Looking Statements
 
When used in this periodic report, or in any written or oral statement made by us or our officers, directors or employees, the words and phrases “will result,” “expect,” “will continue,” “anticipate,” “estimate,” “project,” or similar terms are intended to identify “forward-looking statements.” A variety of factors could cause our actual results and experiences to differ materially from the anticipated results or other expectations expressed in any forward-looking statements. Some of the risks and uncertainties that may affect our operations, performance, development and results, the interest rate sensitivity of our assets and liabilities, and the adequacy of our loan loss allowance, include, but are not limited to:
 
 
!
deterioration in local, regional, national or global economic conditions which could result in, among other things, an increase in loan delinquencies, a decrease in property values, or a change in the real estate turnover rate;
 
!
changes in market interest rates or changes in the speed at which market interest rates change;
 
!
changes in laws and regulations affecting the financial service industry;
 
!
changes in the public’s perception of financial institutions in general and banks in particular;
 
!
changes in competition; and
 
!
changes in consumer preferences by our customers or the customers of our business borrowers.
 
Please do not place undue reliance on any forward-looking statement, which speaks only as of the date made. There are many factors, including those described above, that could affect our future business activities or financial performance and could cause our actual future results or circumstances to differ materially from those we anticipate or project. We do not undertake any obligation to update any forward-looking statement after it is made.
 
 
3

 
 
VSB Bancorp, Inc.
(unaudited)

   
September 30,
   
December 31,
 
   
2010
   
2009
 
             
Assets:
           
Cash and due from banks
  $ 48,172,249     $ 39,716,919  
Investment securities, available for sale
    111,825,511       113,912,404  
Loans receivable
    78,991,268       78,834,156  
Allowance for loan loss
    (1,246,245 )     (1,063,454 )
Loans receivable, net
    77,745,023       77,770,702  
Bank premises and equipment, net
    2,815,726       3,204,063  
Accrued interest receivable
    613,366       722,228  
Other assets
    1,485,615       1,673,556  
Total assets
  $ 242,657,490     $ 236,999,872  
Liabilities and stockholders’ equity:
               
Liabilities:
               
Deposits:
               
Demand and checking
  $ 70,380,356     $ 70,372,448  
NOW
    36,535,651       32,501,930  
Money market
    25,787,453       28,124,315  
Savings
    15,213,703       15,001,936  
Time
    65,466,728       64,669,128  
Total deposits
    213,383,891       210,669,757  
Escrow deposits
    355,811       316,329  
Accounts payable and accrued expenses
    2,450,261       1,529,837  
Total liabilities
    216,189,963       212,515,923  
                 
Stockholders’ equity:
               
Common stock ($.0001 par value, 3,000,000 shares authorized, 1,989,509 issued, 1,840,200 outstanding at September 30, 2010 and 1,945,134 issued, 1,762,191 outstanding at December 31, 2009)
    199       195  
Additional paid in capital
    9,211,286       9,317,719  
Retained earnings
    17,192,444       16,112,741  
Treasury stock, at cost (149,309 shares at September 30, 2010 and 182,943 shares at December 31, 2009)
    (1,466,575 )     (1,840,249 )
Unearned Employee Stock Ownership Plan shares
    (605,863 )     (732,672 )
Accumulated other comprehensive income, net of taxes of $1,801,357 and $1,371,416, respectively
    2,136,036       1,626,215  
Total stockholders’ equity
    26,467,527       24,483,949  
                 
Total liabilities and stockholders’ equity
  $ 242,657,490     $ 236,999,872  
 
See notes to consolidated financial statements.
 
 
4

 
 
VSB Bancorp, Inc.
(unaudited)
 
   
Three months
   
Three months
   
Nine months
   
Nine months
 
   
ended
   
ended
   
ended
   
ended
 
   
Sep. 30, 2010
   
Sep. 30, 2009
   
Sep. 30, 2010
   
Sep. 30, 2009
 
Interest and dividend income:
                       
Loans receivable
  $ 1,492,206     $ 1,360,529     $ 4,333,693     $ 4,014,424  
Investment securities
    1,089,101       1,252,213       3,375,355       3,949,499  
Other interest earning assets
    16,709       11,199       39,599       21,633  
Total interest income
    2,598,016       2,623,941       7,748,647       7,985,556  
Interest expense:
                               
NOW
    42,915       37,685       123,515       100,458  
Money market
    58,250       63,044       183,754       186,499  
Savings
    11,978       12,186       35,567       38,507  
Time
    136,333       202,074       444,343       733,391  
Total interest expense
    249,476       314,989       787,179       1,058,855  
                                 
Net interest income
    2,348,540       2,308,952       6,961,468       6,926,701  
Provision for loan loss
    15,000       75,000       125,000       450,000  
Net interest income after provision for loan loss
    2,333,540       2,233,952       6,836,468       6,476,701  
Non-interest income:
                               
Loan fees
    18,383       19,359       37,238       69,883  
Service charges on deposits
    559,728       528,203       1,651,448       1,612,252  
Net rental income
    14,950       13,965       41,199       38,049  
Other income
    42,814       35,557       129,175       105,152  
Total non-interest income
    635,875       597,084       1,859,060       1,825,336  
Non-interest expenses:
                               
Salaries and benefits
    1,018,505       920,478       2,972,763       2,744,206  
Occupancy expenses
    358,718       372,965       1,084,114       1,125,288  
Legal expense
    53,443       47,164       230,224       181,660  
Professional fees
    68,000       78,000       194,850       230,500  
Computer expense
    66,020       70,046       198,572       207,742  
Directors’ fees
    59,475       55,500       179,000       167,275  
FDIC and NYSBD assessments
    105,000       102,000       304,000       279,000  
Other expenses
    305,864       303,661       948,558       939,279  
Total non-interest expenses
    2,035,025       1,949,814       6,112,081       5,874,950  
Income before income taxes
    934,390       881,222       2,583,447       2,427,087  
Provision/(benefit) for income taxes:
                               
Current
    453,982       407,432       1,241,092       1,283,635  
Deferred
    (26,453 )     (679 )     (59,104 )     (163,365 )
Total provision for income taxes
    427,529       406,753       1,181,988       1,120,270  
Net income
  $ 506,861     $ 474,469     $ 1,401,459     $ 1,306,817  
Earnings per share:
                               
Basic
  $ 0.28     $ 0.26     $ 0.79     $ 0.72  
Diluted
  $ 0.28     $ 0.26     $ 0.79     $ 0.72  
Comprehensive income
  $ 611,445     $ 989,054     $ 1,911,280     $ 2,727,125  
Book value per common share
  $ 14.38     $ 13.69     $ 14.38     $ 13.69  

See notes to consolidated financial statements.
 
 
5

 
 
VSB Bancorp, Inc.
Year Ended December 31, 2009 and Nine Months Ended September 30, 2010
(unaudited)

   
Number of
                                 
Accumulated
       
   
Common
         
Additional
         
Treasury
   
Unearned
   
Other
   
Total
 
   
Shares
   
Common
   
Paid-In
   
Retained
   
Stock,
   
ESOP
   
Comprehensive
   
Stockholders’
 
   
Outstanding
   
Stock
   
Capital
   
Earnings
   
at cost
   
Shares
   
Income
   
Equity
 
                                                 
Balance at January 1, 2009
    1,882,461     $ 192     $ 9,200,010     $ 14,714,143     $ (395,891 )   $ (901,750 )   $ 587,063     $ 23,203,767  
                                                                 
Exercise of stock option, including tax benefit
    21,250       3       118,624                                       118,627  
Stock-based compensation
                    1,278                                       1,278  
Amortization of earned portion of ESOP common stock
                                            169,078               169,078  
Amortization of cost over fair value - ESOP
                    (2,193 )                                     (2,193 )
Cash dividends declared ($0.24 per share)
                            (423,679 )                             (423,679 )
Purchase of treasury stock, at cost
    (141,520 )                             (1,444,358 )                     (1,444,358 )
Comprehensive income:
                                                               
Net income
                            1,822,277                               1,822,277  
Other comprehensive income, net:
                                                               
Change in unrealized gain on securities available for sale, net of tax effects
     —        —        —        —        —        —        1,039,152        1,039,152  
Total comprehensive income
                                                             2,861,429  
                                                                 
Balance at December 31, 2009
    1,762,191     $ 195     $ 9,317,719     $ 16,112,741     $ (1,840,249 )   $ (732,672 )   $ 1,626,215     $ 24,483,949  
                                                                 
Exercise of stock option, including tax benefit
    44,375       4       292,207                                       292,211  
Stock-based compensation
                    47,183                                       47,183  
Amortization of earned portion of ESOP common stock
                                            126,809               126,809  
Amortization of cost over fair value - ESOP
                    (50,237 )                                     (50,237 )
Cash dividends declared ($0.18 per share)
                            (321,756 )                             (321,756 )
Purchase of treasury stock, at cost
    (1,866 )                             (21,912 )                     (21,912 )
Contribution to RRP Trust from treasury shares
    35,500               (395,586 )             395,586                        
Comprehensive income:
                                                               
Net income
                            1,401,459                               1,401,459  
Other comprehensive income, net:
                                                               
Change in unrealized gain on securities available for sale, net of tax effects
                                        509,821       509,821  
Total comprehensive income
                                                            1,911,280  
                                                                 
Balance at September 30, 2010
    1,840,200     $ 199     $ 9,211,286     $ 17,192,444     $ (1,466,575 )   $ (605,863 )   $ 2,136,036     $ 26,467,527  

See notes to consolidated financial statements.
 
 
6

 
 
VSB Bancorp, Inc.
(unaudited)

   
Three months
   
Three months
   
Nine months
   
Nine months
 
   
ended
   
ended
   
ended
   
ended
 
   
Sep. 30, 2010
   
Sep. 30, 2009
   
Sep. 30, 2010
   
Sep. 30, 2009
 
CASH FLOWS FROM OPERATING ACTIVITIES:
                       
Net income
  $ 506,861     $ 474,469     $ 1,401,459     $ 1,306,817  
Adjustments to reconcile net income to net cash provided by operating activities
                               
Depreciation and amortization
    147,390       163,910       449,156       502,691  
Accretion of income, net of amortization of premium
    12,478       (1,422 )     21,753       (15,943 )
ESOP compensation expense
    25,085       26,521       76,572       68,695  
Stock-based compensation expense
    23,789       320       47,183       959  
Provision for loan losses
    15,000       75,000       125,000       450,000  
(Increase)/decrease in prepaid and other assets
    (8,578 )     38,838       187,941       321,247  
Decrease in accrued interest receivable
    5,965       5,475       108,862       18,012  
Increase in deferred income taxes
    (26,453 )     (679 )     (59,104 )     (163,365 )
Increase in accrued expenses and other liabilities
    428,232       8,596       549,588       263,632  
Net cash provided by operating activities
    1,129,769       791,028       2,908,410       2,752,745  
                                 
CASH FLOWS FROM INVESTING ACTIVITIES:
                               
Net change in loan receivable
    (1,629,610 )     (3,444,888 )     (21,852 )     (6,883,891 )
Proceeds from repayment of investment securities, available for sale
    8,838,964       10,362,372       27,560,762       28,711,718  
Purchases of investment securities, available for sale
    (9,167,708 )     (10,638,412 )     (24,633,330 )     (22,414,623 )
Purchases of premises and equipment
    (12,548 )     (54,439 )     (60,819 )     (158,613 )
Net cash (used in)/provided by investing activities
    (1,970,902 )     (3,775,367 )     2,844,761       (745,409 )
                                 
CASH FLOWS FROM FINANCING ACTIVITIES:
                               
Net increase in deposits
    (12,340,815 )     2,743,593       2,753,616       14,457,743  
Exercise of stock options
                292,211       118,627  
Purchase of treasury stock, at cost
    (5,566 )           (21,912 )     (462,972 )
Cash dividends paid
    (109,093 )     (108,286 )     (321,756 )     (323,438 )
Net cash (used in)/provided by financing activities
    (12,455,474 )     2,635,307       2,702,159       13,789,960  
                                 
NET (DECREASE)/INCREASE IN CASH AND CASH EQUIVALENTS
    (13,296,607 )     (349,032 )     8,455,330       15,797,296  
                                 
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD
    61,468,856       37,386,551       39,716,919       21,240,223  
                                 
CASH AND CASH EQUIVALENTS, END OF PERIOD
  $ 48,172,249     $ 37,037,519     $ 48,172,249     $ 37,037,519  
                                 
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
                               
Cash paid during the period for:
                               
Interest
  $ 249,231     $ 305,803     $ 816,435     $ 1,187,914  
Taxes
  $ 633,463     $ 343,542     $ 1,347,868     $ 869,394  
 
See notes to consolidated financial statements.
 
 
7

 
 
VSB BANCORP, INC.
 

 
1.      GENERAL
 
VSB Bancorp, Inc. (referred to using terms such as “we,” “us,” or the “Company”) is the holding company for Victory State Bank (the “Bank”), a New York chartered commercial bank. Our primary business is owning all of the issued and outstanding stock of the Bank. Our common stock is listed on the NASDAQ Global Market. We trade under the symbol “VSBN”.
 
Through the Bank, the Company is primarily engaged in the business of commercial banking, and to a lesser extent retail banking. The Bank gathers deposits from individuals and businesses primarily in Staten Island, New York and makes loans throughout that community. Therefore, the Company’s exposure to credit risk is significantly affected by changes in the local Staten Island economic and real estate markets. The Bank invests funds that are not used for lending primarily in government securities, mortgage backed securities and collateralized mortgage obligations. Customer deposits are insured, up to the applicable limit, by the Federal Deposit Insurance Corporation (“FDIC”). The Bank is supervised by the New York State Banking Department and the FDIC.
 
2.      SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
The following is a description of the significant accounting and reporting policies followed in preparing and presenting the accompanying consolidated financial statements. These policies conform with accounting principles generally accepted in the United States of America (“GAAP”).
 
Principles of Consolidation - The consolidated financial statements of the Company include the accounts of the Company, including its subsidiary Victory State Bank. All significant inter-company accounts and transactions between the Company and Bank have been eliminated in consolidation.
 
Use of Estimates - The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the amounts of revenues and expenses during the reporting period. Actual results can differ from those estimates. The allowance for loan losses, prepayment estimates on the mortgage-backed securities and Collateralized Mortgage Obligation portfolios, contingencies and fair values of financial instruments are particularly subject to change.
 
Reclassifications – Some items in the prior year financial statements were reclassified to conform to the current presentation.
 
Cash and Cash Equivalents – Cash and cash equivalents consists of cash on hand, due from banks and interest-bearing deposits. Net cash flows are reported for customer loan and deposit transactions and interest-bearing deposits with original maturities of 90 days or less. Regulation D of the Board of Governors of the Federal Reserve System requires that Victory State Bank maintain interest-bearing deposits or cash on hand as reserves against its demand deposits. The amount of reserves which Victory State Bank is required to maintain depends upon its level of transaction accounts. During the fourteen day period from September 23, 2010 through October 6, 2010, Victory State Bank was required to maintain reserves, after deducting vault cash, of $4,370,000. Reserves are required to be maintained on a fourteen day basis, so, from time to time, Victory State Bank may use available cash reserves on a day to day basis, so long as the fourteen day average reserves satisfy Regulation D requirements. Victory State Bank is required to report transaction account levels to the Federal Reserve on a weekly basis.
 
 
8

 
 
Interest-bearing bank balances – Interest-bearing bank balances mature overnight and are carried at cost.
 
Investment Securities, Available for Sale - Investment securities, available for sale, are to be held for an unspecified period of time and include securities that management intends to use as part of its asset/liability strategy. These securities may be sold in response to changes in interest rates, prepayments or other factors and are carried at estimated fair value. Gains or losses on the sale of such securities are determined by the specific identification method. Interest income includes amortization of purchase premium and accretion of purchase discount. Premiums and discounts are recognized in interest income using a method that approximates the level yield method without anticipating prepayments, except for mortgage-backed securities where prepayments are estimated. Unrealized holding gains or losses, net of deferred income taxes, are excluded from earnings and reported as other comprehensive income in a separate component of stockholders’ equity until realized. For debt securities with other than temporary impairment (OTTI) that management does not intend to sell or expect to be required to sell, the amount of impairment is split into two components as follows: 1) OTTI related to credit loss, which must be recognized in the income statement and 2) OTTI related to other factors, which is recognized in other comprehensive income. The credit loss is defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis.
 
The Company invests primarily in agency Collateralized Mortgage-Backed Obligations (“CMOs”) with estimated average lives primarily under 4.5 years and Mortgage-Backed Securities. These securities are primarily issued by the Federal National Mortgage Association (“FNMA”), the Government National Mortgage Association (“GNMA”) or the Federal Home Loan Mortgage Corporation (“FHLMC”) and are primarily comprised of mortgage pools guaranteed by FNMA, GNMA or FHLMC. The Company also invests in whole loan CMOs, all of which are AAA rated. These securities expose the Company to risks such as interest rate, prepayment and credit risk and thus pay a higher rate of return than comparable treasury issues.
 
Loans Receivable - Loans receivable, that management has the intent and ability to hold for the foreseeable future or until maturity or payoff, are stated at unpaid principal balances, adjusted for deferred net origination and commitment fees and the allowance for loan losses. Interest income on loans is credited as earned.
 
It is the policy of the Company to provide a valuation allowance for probable incurred losses on loans based on the Company’s past loan loss experience, known and inherent risks in the portfolio, adverse situations which may affect the borrower’s ability to repay, estimated value of underlying collateral and current economic conditions in the Company’s lending area. The allowance is increased by provisions for loan losses charged to earnings and is reduced by charge-offs, net of recoveries. While management uses available information to estimate losses on loans, future additions to the allowance may be necessary based upon the expected growth of the loan portfolio and any changes in economic conditions beyond management’s control. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank’s allowance for loan losses. Such agencies may require the Bank to recognize additions to the allowance based on judgments different from those of management. Management believes, based upon all relevant and available information, that the allowance for loan losses is appropriate.
 
The Company has a policy that all loans 90 days past due are placed on non-accrual status. It is the Company’s policy to cease the accrual of interest on loans to borrowers past due less than 90 days where a probable loss is estimated and to reverse out of income all interest that is due. The Company applies payments received on non-accrual loans to the outstanding principal balance due before applying any amount to interest, until the loan is restored to an accruing status. On a limited basis, the Company may apply a payment to interest on a non-accrual loan if there is no impairment or no estimated loss on this asset. The Company continues to accrue interest on construction loans that are 90 days past contractual maturity date if the loan is expected to be paid in full in the next 60 days and all interest is paid up to date.
 
Loan origination fees and certain direct loan origination costs are deferred and the net amount recognized over the contractual loan terms using the level-yield method, adjusted for periodic prepayments in certain circumstances.
 
 
9

 
 
The Company considers a loan to be impaired when, based on current information, it is probable that the Company will be unable to collect all principal and interest payments due according to the contractual terms of the loan agreement. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Impairment is measured on a loan by loan basis for commercial and construction loans. Impaired loans are measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate or, as a practical expedient, at the loan’s observable market price or the fair value of the collateral. The fair value of the collateral, as reduced by costs to sell, is utilized if a loan is collateral dependent. Loans with modified terms that the Company would not normally consider, and for which the borrower is experiencing financial difficulties, are considered troubled debt restructurings and classified as impaired. Large groups of smaller balance homogeneous loans, such as consumer loans and residential loans, are collectively evaluated for impairment.
 
Long-Lived Assets - The Company periodically evaluates the recoverability of long-lived assets, such as premises and equipment, to ensure the carrying value has not been impaired. In performing the review for recoverability, the Company would estimate the future cash flows expected to result from the use of the asset. If the sum of the expected future cash flows is less than the carrying amount an impairment will be recognized. The Company reports these assets at the lower of the carrying value or fair value.
 
Premises and Equipment - Premises, leasehold improvements, and furniture and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization are accumulated by the straight-line method over the estimated useful lives of the respective assets, which range from three to fifteen years. Leasehold improvements are amortized at the lesser of their useful life or the term of the lease.
 
Federal Home Loan Bank (FHLB) Stock - The Bank is a member of the FHLB system. Members are required to own a certain amount of stock based on the level of borrowings and other factors, and may invest in additional amounts. FHLB stock is carried at cost, classified as a restricted security, and periodically evaluated for impairment. Because this stock is viewed as a long term investment, impairment is based on ultimate recovery of par value, which is the price the Bank pays for the FHLB Stock. Both cash and stock dividends are reported as income.
 
Income Taxes - The Company utilizes the liability method to account for income taxes. Under this method, deferred tax assets and liabilities are determined on differences between financial reporting and the tax bases of assets and liabilities and are measured using the enacted tax rates and laws expected to be in effect when the differences are expected to reverse. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. As such, a tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded.
 
The Company recognizes interest and/or penalties related to income tax matters in income tax expense.
 
Financial Instruments - In the ordinary course of business, the Company has entered into off-balance sheet financial instruments, primarily consisting of commitments to extend credit.
 
Basic and Diluted Net Income Per Common Share - The Company has stock compensation awards with non-forfeitable dividend rights which are considered participating securities. As such, earnings per share is computed using the two-class method. Basic earnings per common share is computed by dividing net income allocated to common stock by the weighted average number of common shares outstanding during the period which excludes the participating securities. Diluted earnings per common share includes the dilutive effect of additional potential common shares from stock-based compensation plans, but excludes awards considered participating securities. Earnings and dividends per share are restated for all stock splits and stock dividends through the date of issuance of the financial statements.
 
 
10

 
 
Basic net income per share of common stock is based on 1,772,566 shares and 1,809,218 shares, the weighted average number of common shares outstanding for the three months ended September 30, 2010 and 2009, respectively. Diluted net income per share of common stock is based on 1,772,635 and 1,828,638, the weighted average number of common shares outstanding plus potentially dilutive common shares for the three months ended September 30, 2010 and 2009, respectively. The weighted average number of potentially dilutive common shares excluded in calculating diluted net income per common share due to the anti-dilutive effect is 36,876 and 36,082 shares for the three months ended September 30, 2010 and 2009, respectively. Common stock equivalents were calculated using the treasury stock method.
 
Basic net income per share of common stock is based on 1,754,466 shares and 1,803,281 shares, the weighted average number of common shares outstanding for the nine months ended September 30, 2010 and 2009, respectively. Diluted net income per share of common stock is based on 1,754,633 and 1,820,612, the weighted average number of common shares outstanding plus potentially dilutive common shares for the nine months ended September 30, 2010 and 2009, respectively. The weighted average number of potentially dilutive common shares excluded in calculating diluted net income per common share due to the anti-dilutive effect is 34,677 and 54,094 shares for the nine months ended September 30, 2010 and 2009, respectively. Common stock equivalents were calculated using the treasury stock method.
 
The reconciliation of the numerators and the denominators of the basic and diluted per share computations for the three and nine months ended September 30, are as follows:
 
Reconciliation of EPS
           
   
Three months ended
   
Three months ended
 
   
September 30, 2010
   
September 30, 2009
 
Basic
           
Distributed earnings allocated to common stock
  $ 106,354     $ 108,553  
Undistributed earnings allocated to common sock
    390,555       365,916  
Net earnings allocated to common stock
  $ 496,909     $ 474,469  
                 
Weighted common shares outstanding including participating securities
    1,808,066       1,809,218  
Less: Participating securities
    (35,500 )      
Weighted average shares
    1,772,566       1,809,218  
                 
Basic EPS
  $ 0.28     $ 0.26  
                 
Diluted
               
Net earnings allocated to common stock
  $ 496,909     $ 474,469  
                 
Weighted average shares for basic
    1,772,566       1,809,218  
Dilutive effects of:
               
Stock Options
    69       19,420  
Unvested shares not considered particpating securtities
           
      1,772,635       1,828,638  
                 
Diluted EPS
  $ 0.28     $ 0.26  
 
 
11

 
 
Reconciliation of EPS
           
   
Nine months ended
   
Nine months ended
 
   
September 30, 2010
   
September 30, 2009
 
Basic
           
Distributed earnings allocated to common stock
  $ 315,804     $ 324,591  
Undistributed earnings allocated to common sock
    1,071,135       982,226  
Net earnings allocated to common stock
  $ 1,386,939     $ 1,306,817  
                 
Weighted common shares outstanding including participating securities
    1,774,343       1,803,281  
Less: Participating securities
    (19,877 )      
Weighted average shares
    1,754,466       1,803,281  
                 
Basic EPS
  $ 0.79     $ 0.72  
                 
Diluted
               
Net earnings allocated to common stock
  $ 1,386,939     $ 1,306,817  
                 
Weighted average shares for basic
    1,754,466       1,803,281  
Dilutive effects of:
               
Stock Options
    167       17,331  
Unvested shares not considered particpating securtities
           
      1,754,633       1,820,612  
                 
Diluted EPS
  $ 0.79     $ 0.72  
 
Net earnings allocated to common stock for the period is distributed earnings during the period, such as dividends on common shares outstanding, plus a proportional amount of retained income for the period based on restricted shares granted but unvested compared to the total common shares outstanding.
 
Stock Based Compensation - The Company records compensation expense for stock options provided to employees in return for employment service. The cost is measured at the fair value of the options when granted, and this cost is expensed over the employment service period, which is normally the vesting period of the options.
 
Employee Stock Ownership Plan (“ESOP”) - The cost of shares issued to the ESOP, but not yet allocated to participants, is shown as a reduction of stockholders’ equity. Compensation expense is based on the market price of shares as they are committed to be released to participant accounts. Cash dividends on allocated ESOP shares reduce retained earnings; cash dividends on unearned ESOP shares reduce debt and accrued interest.
 
Stock Repurchase ProgramsOn September 8, 2008, the Company announced that its Board of Directors had authorized a Rule 10b5-1 stock repurchase program for the repurchase of up to 100,000 shares of the Company’s common stock. On April 21, 2009, the Company announced that its Board of Directors had authorized a second Rule 10b5-1 stock repurchase program for the repurchase of up to an additional 100,000 shares of the Company’s common stock. At September 30, 2010, the Company had repurchased a total of 184,809 shares of its common stock under these stock repurchase programs. Stock repurchases under the program have and will be accounted for using the cost method, in which the Company will reflect the entire cost of repurchased shares as a separate reduction of stockholders’ equity on its balance sheet.
 
Retention and Recognition Plan – At the April 27, 2010 Annual Meeting, the stockholders of VSB Bancorp, Inc. approved the adoption of the 2010 Retention and Recognition Plan (the “RRP”). The RRP authorizes the award of up to 50,000 shares of our common stock to directors, officers and employees. In conjunction with the approval the RRP, stockholders approved the award of 4,000 shares of stock to each of our eight directors who have at least five years of service. The director awards will vest over five years, with 20% vesting annually for each of the first five years after the award is made, subject to acceleration and forfeiture. On June 8, 2010, an additional 3,500 shares of stock were awarded to the President and CEO of the Company, which will vest over a 65 month period, with 20% vesting annually for each of the first five years starting in November 2011, subject to acceleration and forfeiture. The recipient of an award will not be required to make any payment to receive the award or the stock covered by the award. As of September 30, 2010, 35,500 shares of the RRP have been awarded. The Company recognizes compensation expense for the shares awarded under the RRP gradually as the shares vest, based upon the market price of the shares on the date of the award. For the nine months ended September 30, 2010, the Company recognized $39,138 of compensation expense related to the shares awarded. The income tax benefit resulting from this expense was $15,655. As of September 30, 2010, there was approximately $356,448 of unrecognized compensation costs related to the shares awarded. These costs are expected to be recognized over the next 4.50 years.
 
 
12

 
 
A summary of the status of the Company’s nonvested plan shares as of September 30, 2010 is as follows:
 
For the Nine Months Ended September 30, 2010:
       
         
Weighted Average
 
   
Shares
   
Grant Date Share Value
 
             
Non vested at beginning of period
        $  
Granted
    35,500       11.46  
Vested
             
Non vested at end of period
    35,500     $ 11.46  
 
Comprehensive Income - Comprehensive income consists of net income and other comprehensive income. Other comprehensive income includes unrealized gains and losses, net of taxes, on securities available for sale which are also recognized as separate components of equity.
 
Recently-Adopted Accounting Standards - In June 2009, the FASB amended previous guidance relating to transfers of financial assets and eliminated the concept of a qualifying special purpose entity. This guidance must be applied as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period and for interim and annual reporting periods thereafter. This guidance must be applied to transfers occurring on or after the effective date. Additionally, on and after the effective date, the concept of a qualifying special-purpose entity is no longer relevant for accounting purposes. Therefore, formerly qualifying special-purpose entities should be evaluated for consolidation by reporting entities on and after the effective date in accordance with the applicable consolidation guidance. The disclosure provisions were also amended and apply to transfers that occurred both before and after the effective date of this guidance. The adoption of this standard did not have a material effect on the Company’s results of operations or financial position.
 
In June 2009, the FASB amended guidance for consolidation of variable interest entity guidance by replacing the quantitative-based risks and rewards calculation for determining which enterprise, if any, has a controlling financial interest in a variable interest entity with an approach focused on identifying which enterprise has the power to direct the activities of a variable interest entity that most significantly impact the entity’s economic performance and (1) the obligation to absorb losses of the entity or (2) the right to receive benefits from the entity. Additional disclosures about an enterprise’s involvement in variable interest entities are also required. This guidance is effective as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period, and for interim and annual reporting periods thereafter. Early adoption is prohibited. The adoption of this standard did not have a material effect on the Company’s results of operations or financial position.
 
 
13

 
 
Recently Issued but Not Yet Effective Standards - In January 2010, the FASB issued guidance to improve disclosure requirements related to fair value measurements and disclosures. The guidance requires that a reporting entity should disclose separately the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements and describe the reasons for the transfers and that activity in Level 3 should be presented on a gross basis rather than one net number for information about purchases, issuances, and settlements. The guidance also requires that a reporting entity should provide fair value measurement disclosures for each class of assets and liabilities and about the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements. This guidance is effective for interim and annual reporting periods beginning after December 31, 2009 except for the roll forward of activity in Level 3 which is effective for interim and annual reporting periods beginning after December 31, 2010. Adopting this pronouncement did not have a material effect on the results of operations or financial condition of the Company.
 
In July 2010, the FASB issued an Accounting Standards Update (“ASU”), “Receivables: Disclosure about the Credit Quality of Financing Receivables and the Allowance for Credit Losses”. The objective of this ASU is for an entity to provide disclosures that facilitate financial statement users’ evaluation of the nature of credit risk inherent in the entity’s portfolio of financing receivables, how that risk is analyzed and assessed in arriving at the allowance for credit losses, and the changes and reasons for those changes in the allowance for credit losses. An entity should provide disclosures on a disaggregated basis on two defined levels: (1) portfolio segment; and (2) class of financing receivable. The ASU makes changes to existing disclosure requirements and includes additional disclosure requirements about financing receivables, including credit quality indicators of financing receivables at the end of the reporting period by class of financing receivables, the aging of past due financing receivables at the end of the reporting period by class of financing receivables, and the nature and extent of troubled debt restructurings that occurred during the period by class of financing receivables and their effect on the allowance for credit losses. For public entities, the disclosures as of the end of a reporting period are effective for interim and annual reporting periods ending on or after December 15, 2010. The disclosures about activity that occurs during a reporting period are effective for interim and annual reporting periods beginning on or after December 15, 2010. The adoption is disclosure related only and the Company expects that adoption will have no impact on the results of operations.
 
3.      INVESTMENT SECURITIES, AVAILABLE FOR SALE
 
The following table summarizes the amortized cost and fair value of the available-for-sale investment securities portfolio at September 30, 2010 and December 31, 2009 and the corresponding amounts of unrealized gains and losses therein:
 
      September 30, 2010        
   
Amortized
   
Unrealized
   
Unrealized
   
Fair
 
   
Cost
   
Gains
   
Losses
   
Value
 
                         
FNMA MBS - Residential
  $ 3,669,895     $ 167,949     $     $ 3,837,844  
GNMA MBS - Residential
    1,110,260       74,506             1,184,766  
Whole Loan MBS - Residential
    1,476,804       42,910             1,519,714  
Collateralized mortgage obligations
    101,631,159       3,652,028             105,283,187  
    $ 107,888,118     $ 3,937,393     $     $ 111,825,511  
 
 
14

 

      December 31, 2009        
   
Amortized
   
Unrealized
   
Unrealized
   
Fair
 
   
Cost
   
Gains
   
Losses
   
Value
 
                         
FNMA MBS - Residential
  $ 4,855,213     $ 185,607     $     $ 5,040,820  
GNMA MBS - Residential
    1,265,428       55,812             1,321,240  
Whole Loan MBS - Residential
    1,860,603       15,135       (18,845 )     1,856,893  
Collateralized mortgage obligations
    102,933,529       3,085,224       (325,302 )     105,693,451  
    $ 110,914,773     $ 3,341,778     $ (344,147 )   $ 113,912,404  
 
There were no sales of investment securities for the nine months ended September 30, 2010 and the year ended December 31, 2009.
 
The amortized cost and fair value of the investment securities portfolio are shown by expected maturity. Expected maturities may differ from contractual maturities, especially for collateralized mortgage obligations, if borrowers have the right to call or prepay obligations with or without call or prepayment penalties.
 
   
September 30, 2010
 
Securities, Available for Sale
 
Amortized
   
Fair
 
Expected Maturity
 
Cost
   
Value
 
Less than one year
  $ 644,248     $ 655,337  
Due after one year through five years
    2,046,552       2,085,394  
Due after five years through ten years
    32,449,412       34,059,004  
Due after ten years
    72,747,906       75,025,776  
    $ 107,888,118     $ 111,825,511  
 
At September 30, 2010, there were no investment securities with an unrealized loss. The following table summarizes the investment securities with unrealized losses at December 31, 2009 by aggregated major security type and length of time in a continuous unrealized loss position:
 
December 31, 2009
 
Less than 12 months
   
More than 12 months
    Total
   
Fair
   
Unrealized
   
Fair
   
Unrealized
   
Fair
   
Unrealized
 
   
Value
   
Loss
   
Value
   
Loss
   
Value
   
Loss
 
                                     
FNMA MBS
  $     $     $     $     $     $  
GNMA MBS
                                   
Whole Loan MBS
                433,666       (18,845 )     433,666       (18,845 )
Collateralized mortgage obligations
    10,036,242       (280,961 )     1,750,950       (44,341 )     11,787,192       (325,302 )
    $ 10,036,242     $ (280,961 )   $ 2,184,616     $ (63,186 )   $ 12,220,858     $ (344,147 )
 
The Company evaluates securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation. Consideration is given to the length of time and the extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer, and the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. In analyzing an issuer’s financial condition, the Company may consider whether the securities are issued by the federal government or its agencies, whether downgrades by bond rating agencies have occurred, and the results of reviews of the issuer’s financial condition.
 
 
15

 
 
Securities pledged had a carrying amount of $55,267,480 and $54,199,477 at September 30, 2010 and December 31, 2009, respectively and were pledged to secure public deposits and balances in excess of the deposit insurance limit on certain customer accounts.
 
4.      FAIR VALUE OF FINANCIAL INSTRUMENTS
 
The following disclosure of the estimated fair value of financial instruments is made in accordance with the requirements of FASB ASC 820, “Financial Instruments”. The estimated fair value amounts have been determined by the Company using available market information and appropriate valuation methodologies. However, considerable judgment is necessarily required to interpret market data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts.
 
The following methods and assumptions were used by the Company in estimating fair values of financial instruments:
 
Interest-bearing Bank Balances – Interest-bearing bank balances mature within one year and are carried at cost which are estimated to be reasonably close to fair value.
 
Money Market Investments – The fair value of these securities approximates their carrying value due to the relatively short time to maturity
 
Investment Securities, Available For Sale – The estimated fair value of these securities is determined by using available market information and appropriate valuation methodologies. The estimates presented herein are not necessarily indicative of the amounts that the Company could realize in a current market exchange.
 
Loans Receivable - The fair value of commercial and construction loans are approximated by the carrying value as the loans are tied directly to the Prime Rate and are subject to change on a daily basis. The fair value of the remainder of the portfolio is determined by discounting the future cash flows of the loans using the appropriate discount rate.
 
Other Financial Assets - The fair value of these assets, principally accrued interest receivable, approximates their carrying value due to their short maturity.
 
Non-Interest Bearing and Interest Bearing Deposits - The fair value disclosed for non-interest bearing deposits is equal to the amount payable on demand at the reporting date. The fair value of interest bearing deposits is based upon the current rates for instruments of the same remaining maturity. Interest bearing deposits with a maturity of greater than one year are estimated using a discounted cash flow approach that applies interest rates currently being offered.
 
Other Liabilities - The estimated fair value of other liabilities, which primarily include accrued interest payable, approximates their carrying amount.
 
 
16

 
 
The carrying amounts and estimated fair values of financial instruments, at September 30, 2010 and December 31, 2009 are as follows:
 
   
September 30, 2010
   
December 31, 2009
 
   
Carrying
   
Fair
   
Carrying
   
Fair
 
   
Amount
   
Value
   
Amount
   
Value
 
Financial Assets:
                       
Cash and cash equivalents
  $ 48,172,249     $ 48,172,249     $ 39,716,919     $ 39,716,919  
Investment securities, available for sale
    111,825,511       111,825,511       113,912,404       113,912,404  
Loans receivable
    77,745,023       78,474,967       77,770,702       78,515,058  
Other financial assets
    613,366       613,366       722,228       722,228  
Total Financial Assets
  $ 238,356,149     $ 239,086,093     $ 232,122,253     $ 232,866,609  
Financial Liabilities:
                               
Non-interest bearing deposits
  $ 70,736,167     $ 70,736,167     $ 70,688,777     $ 70,688,777  
Interest bearing deposits
    143,003,535       142,947,399       140,297,309       140,258,492  
Other liabilities
    19,116       19,116       45,695       45,695  
Total Financial Liabilities
  $ 213,758,818     $ 213,702,682     $ 211,031,781     $ 210,992,964  
 
ASC 825 establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:

 
Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.
   
 
Level 2: Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.
   
 
Level 3: Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing and asset or liability.
 
The fair value of securities available for sale are determined by obtaining quoted prices on nationally recognized securities exchanges (Level 1 inputs) or matrix pricing, which is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities (Level 2 inputs).
 
   
Fair Value Measurements at September 30, 2010 Using
 
               
Significant
       
         
Quoted Prices in
   
Other
   
Significant
 
         
Active Markets for
   
Observable
   
Unobservable
 
   
September 30,
   
Identical Assets
   
Inputs
   
Inputs
 
   
2010
   
(Level 1)
   
(Level 2)
   
(Level 3)
 
Assets:
                       
FNMA MBS - Residential
  $ 3,837,844     $     $ 3,837,844     $  
GNMA MBS - Residential
    1,184,766             1,184,766        
Whole Loan MBS - Residential
    1,519,714             1,519,714        
Collateralized mortgage obligations
    105,283,187             105,283,187        
Total Available for sale Securities
  $ 111,825,511     $     $ 111,825,511     $  
 
 
17

 
 
   
Fair Value Measurements at December 31, 2009 Using
 
               
Significant
       
         
Quoted Prices in
   
Other
   
Significant
 
         
Active Markets for
   
Observable
   
Unobservable
 
   
December 31,
   
Identical Assets
   
Inputs
   
Inputs
 
   
2009
   
(Level 1)
   
(Level 2)
   
(Level 3)
 
Assets:
                       
FNMA MBS - Residential
  $ 5,040,820     $     $ 5,040,820     $  
GNMA MBS - Residential
    1,321,240             1,321,240        
Whole Loan MBS - Residential
    1,856,893             1,856,893        
Collateralized mortgage obligations
    105,693,451             105,693,451        
Total Available for sale Securities
  $ 113,912,404     $     $ 113,912,404     $  
 
Certain financial assets and financial liabilities are measured at fair value on a nonrecurring basis, that is, the instruments are not measured at fair value on an ongoing basis but are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment).
 
Assets and Liabilities Measured on a Non-Recurring Basis

Assets and liabilities measured at fair value on a non-recurring basis are summarized below:

Impaired loans are reported at the fair value of the underlying collateral if repayment is expected solely from the collateral. Collateral values are estimated using Level 3 inputs based on internally customized discounting criteria and updated appraisals when received.
 
   
Fair Value Measurements at September 30, 2010 Using
 
               
Significant
       
         
Quoted Prices in
   
Other
   
Significant
 
         
Active Markets for
   
Observable
   
Unobservable
 
   
September 30,
   
Identical Assets
   
Inputs
   
Inputs
 
   
2010
   
(Level 1)
   
(Level 2)
   
(Level 3)
 
Assets:
                       
Impaired loans
  $ 381,264     $     $     $ 381,264  
 
   
Fair Value Measurements at December 31, 2009 Using
 
               
Significant
       
         
Quoted Prices in
   
Other
   
Significant
 
         
Active Markets for
   
Observable
   
Unobservable
 
   
December 31,
   
Identical Assets
   
Inputs
   
Inputs
 
   
2009
   
(Level 1)
   
(Level 2)
   
(Level 3)
 
Assets:
                       
Impaired loans
  $ 43,505     $     $     $ 43,505  
 
As of September 30, 2010, we had one impaired loan with a specific reserve that was collateral dependent. Collateral dependent impaired loans, which are measured for impairment using the fair value of the collateral, had a carrying amount of $396,996, with a valuation allowance of $15,732, causing an additional provision for loan losses of $15,000 for the period.
 
 
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As of December 31, 2009, we had one impaired loan with a specific reserve that was collateral dependent. Collateral dependent impaired loans, which are measured for impairment using the fair value of the collateral, had a carrying amount of $43,505.
 
 
Financial Condition at September 30, 2010
 
Total assets were $242,657,490 at September 30, 2010, an increase of $5,657,618 or, 2.4%, from December 31, 2009. The increase resulted from the investment of funds available to us as the result of an increase in deposits and retained earnings. The deposit increase was caused generally by our efforts to grow our franchise and specifically by the deposit increases at our branch offices. We invested these funds primarily in cash and cash equivalents. The principal changes resulting in the net increase in assets can be summarized as follows:
 
 
a $8,455,330 net increase in cash and cash equivalents, partially offset by
 
a $2,086,893 net decrease in investment securities available for sale and
 
a $388,337 net decrease in bank premises and equipment.
 
In addition to these changes in major asset categories, we also experienced changes in other asset categories due to normal fluctuations in operations. We had a slight increase in gross loans receivable but a slight decrease in net loans receivable because we increased our allowance for loan losses.
 
Our deposits (including escrow deposits) were $213,739,702 at September 30, 2010, an increase of $2,753,616 or 1.31%, from December 31, 2009 as a result of our active solicitation of retail deposits to increase funds for investment. The increase in deposits resulted from increases of $4,033,721 in NOW accounts, $797,600 in time deposits, $211,767 in savings accounts, $39,482 in escrow deposits and $7,908 in non-interest demand deposits, partially offset by a decrease of $2,336,862 in money market accounts. Our other liabilities were $2,450,261 at September 30, 2010, an increase of $920,424 or 60.2%, from December 31, 2009 primarily due to an increase in our deferred tax liability caused by the deferred tax effect of our FAS115 adjustment on investment securities.
 
Total stockholders’ equity was $26,467,527 at September 30, 2010, an increase of $1,983,578 or 8.10%, from December 31, 2009. The increase reflected: (i) $1,079,703 net increase in retained earnings due to net income of $1,401,459 for the nine months ended September 30, 2010 partially offset by $321,756 of dividends paid in 2010; (ii) an increase in the net unrealized gain on securities available for sale of $509,821 reflecting the positive effect of low market interest rates on the fair value of our securities portfolio; (iii) a $292,211 increase due to the exercise by officers and directors of options to purchase 44,375 shares of common stock; and (iv) a reduction of $126,809 in Unearned ESOP shares reflecting the gradual payment of the loan we made to fund the ESOP’s purchase of our stock. The initial implementation of the RRP resulted in a $395,586 reduction in additional paid in capital and a corresponding reduction in Treasury shares, with no net change in stockholders’ equity. Additionally, there was a $21,912 increase in Treasury shares representing the cost of 1,866 shares of common stock we repurchased in the second quarter and third quarter of 2010 under our Company’s previously announced stock repurchase plans.
 
The unrealized gain on securities available for sale is excluded from the calculation of regulatory capital. Management does not anticipate selling securities in this portfolio, but changes in market interest rates or in the demand for funds may change management’s plans with respect to the securities portfolio. If there is a material increase in interest rates, the market value of the available for sale portfolio may decline. Management believes that the principal and interest payments on this portfolio, combined with the existing liquidity, will be sufficient to fund loan growth and potential deposit outflow.
 
 
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The Dodd-Frank Wall Street Reform and Consumer Protection Law
 
On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Law was adopted. It has been described as the greatest legislative change in the supervision of financial institutions since the 1930s. Its effect on Victory State Bank and VSB Bancorp, Inc. cannot now be judged with certainty because the law requires over 200 regulatory rulemakings and over 50 agency studies. However, we believe that the following areas, among others, will be or may be significant to our future operations:
 
 
1.
The law exempts smaller reporting companies filing with the Securities and Exchange Commission, such as our company, from the internal controls attestation rules of Section 404(b) of the Sarbanes-Oxley Act. Thus far, we have incurred expenses to prepare for compliance but we have not been governed by Section 404(b) due to temporary SEC extensions of the compliance deadline. The permanent exemption means that we will not be required to incur the expense of actual compliance as long as we continue to qualify as a smaller reporting company.
     
 
2.
Securities brokers may not vote shares held in “street name” unless they receive instructions from their customers on the election of directors, executive compensation or any other significant matter, as determined by the SEC. This may increase our costs of holding annual stockholder meetings if it becomes necessary for us to retain the services of a proxy solicitor to increase shareholder participation in our meetings or to obtain approval of matters that the Board presents to stockholders.
     
 
3.
At least every three years, we will be required to submit to our stockholders, for a non-binding vote, our executive compensation. Depending upon SEC implementing regulations, this requirement may increase the cost of holding some stockholder meetings. The law also requires that the SEC implement other requirements for enhanced compensation disclosures.
     
 
4.
The law includes a number of changes to expand FDIC insurance coverage, as well as changes to the premiums banks must pay for insurance coverage, and the requirements applicable to the reserve ratio (the ratio of the deposit insurance fund to the amount of insured deposits). One important change is that, in the future, deposit insurance premiums we pay will be based upon total assets minus tangible capital, rather than based upon deposits. Since we do not use material borrowings to provide funds for asset growth, and we do not have material intangible assets that are excluded from capital such as goodwill, we anticipate that our share of the total deposit premiums to be collected may decrease as the result of this change. However, other factors, such as required replenishment of the current reserve fund, which has a negative reserve ratio and which must be increased to 1.35% of total insured deposits in the next ten years, as well as future failures of banks that may further deplete the fund, may result in an increase in our future deposit insurance premium. The FDIC must provide an offset for smaller banks negating the adverse effect of requiring a reserve ratio in excess of 1.15%, but reaching even the 1.15% ratio may require additional burdens on smaller banks. The overall increase in premiums may more than offset the effect of the change from a deposit-based to an asset-based premium structure.
     
 
5.
The law increases the amount of each customer’s deposits that are subject to FDIC insurance. The general limit has been permanently increased from $100,000 to $250,000. In addition, non-interest bearing transaction accounts will be fully insured, without limit, from December 31, 2010 to January 1, 2013.
     
 
6.
The law repeals the prohibition on paying interest on demand deposit accounts, effective in July 2011. Interest-free demand deposits represent a substantial portion of our deposit base. Once the prohibition on paying interest on such deposits becomes effective, competitive pressures may require that we offer interest checking accounts to businesses in order to retain deposits. That could have a direct adverse effect on our cost of funds. Although current market interest rates are very low, and such deposits are unlikely to carry high rates of interest, an increase in market interest rates could result in significant additional costs in order to maintain the level of such deposits.
 
 
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7.
The law makes interstate branching by banks much easier than in the past. We have no plans to branch outside New York State, but the law may facilitate out of state banks branching into our market area, thus increasing competition.
     
 
8.
The law creates a new federal agency – the Bureau of Consumer Financial Protection – which will have substantial authority to regulate consumer financial transactions. Our loans are primarily made to businesses rather than individual consumers, so the bureau will not have a direct effect on many of our loan transactions. However, the bureau also has authority to regulate other non-loan consumer transactions, such as deposits and electronic banking transactions. The implementation of new consumer regulations may increase our operating costs in a manner we cannot predict until regulations are adopted.
 
The Current Economic Turmoil
 
The economy in the United States, including the economy in Staten Island, was and may still be in a recession. Although some analysts report that the economy is recovering, the extent and speed of the recovery is far from clear and some analysts predict a darker road ahead. There is substantial stress on many financial institutions and financial products. The federal government has intervened by making hundreds of billions of dollars in capital contributions to the banking industry. We draw a substantial portion of our customer base from local businesses, especially those in the building trades and related industries. Our customers have been adversely affected by the economic downturn, and if adverse conditions in the local economy continue, it will become more difficult for us to conduct prudent and profitable business in our community.
 
Making permanent residential mortgage loans is not a material part of our business, and our investments in mortgage-backed securities and collateralized mortgage obligations have been made with a view towards avoiding the types of securities that are backed by low quality mortgage-related assets. However, one of the primary focuses of our local business is receiving deposits from, and making loans to, businesses involved in the construction and building trades industry on Staten Island. Construction loans represented a significant component of our loan portfolio, reaching 39.8% of total loans at year end 2005. As we monitored the economy and the strength of the local construction industry, we elected to reduce our portfolio of construction loans. By September 30, 2010, the percentage had declined to 8.3%. However, developers and builders provide not only a source of loans, but they also provide us with deposits and other business. If the weakness in the economy continues or worsens, then that could have a substantial adverse effect on our customers and potential customers, making it more difficult for us to find satisfactory loan opportunities and low-cost deposits. This could compel us to invest in lower yielding securities instead of higher-yielding loans and could also reduce low cost funding sources such as checking accounts and require that we replace them with higher cost deposits such as time deposits. Either or both of those shifts could reduce our net income.
 
Changes in FDIC Assessment Rates
 
In the past two years, there have been many failures and near-failures among financial institutions. The number of FDIC-insured banks that have failed has increased, and the FDIC insurance fund reserve ratio, representing the ratio of the fund to the level of insured deposits, has declined due to losses caused by bank failures. As a result, the FDIC has increased its deposit insurance premiums on remaining institutions, including well-capitalized institutions like Victory State Bank, in order to replenish the insurance fund. If bank failures continue to occur, and more so if the level of failures increases, the FDIC insurance fund will further decline, and the FDIC is likely to continue to impose higher premiums on healthy banks. Thus, despite the prudent steps we may take to avoid the mistakes made by other banks, our costs of operations may increase as a result of those mistakes by others.
 
 
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Our FDIC regular insurance premium was $96,359 in the third quarter of 2010 compared to $68,901 in the third quarter of 2009 (excluding the $101,950 special assessment described below), an increase of 39.9%. In contrast, the level of deposits, on which the FDIC insurance premium is based, increased only 13.6%. The FDIC is currently in the process of reviewing its deposit insurance premium assessment rates to reach and maintain the required ratio of reserve funds to total deposits. The FDIC has recently rescinded its plan to increase all deposit insurance rates by an additional 3 basis points beginning in 2011. Our Bank, even though we are in the lowest regulatory risk category, will be subject to an assessment rate between seven (7) and twelve (12) basis points per annum, which is higher than the assessment rate in 2008 of from five (5) to seven (7) basis points. The FDIC continues to have the right to increase these rates by 3 basis points without following mandatory federal rule making procedures. The FDIC also imposed a special assessment in 2009 on all FDIC-insured banks equal to 5 basis points on total assets minus Tier 1 capital. Our special assessment amounted to $101,950. The increase in the assessment rate and the special assessment significantly increased our deposit insurance expense in 2009.
 
Despite the deposit insurance premium increase and the special assessment, the fund created to pay the cost of resolving failed banks currently has a negative balance. The FDIC has recently published estimates that the losses to the fund from 2010 through 2014 will be $52 billion instead of the previous estimate of $60 billion. As a result, the FDIC rescinded the 3 basis point increase scheduled to take effect in 2011. However, if these estimates turn out to be incorrect, and the losses to the insurance fund increase, the FDIC could increase insurance premiums and thereby increase our non-interest expense.
 
Possible Adverse Effects on Our Net Income Due to Fluctuations in Market Rates
 
Our principal source of income is the difference between the interest income we earn on interest-earning assets, such as loans and securities, and our cost of funds, principally interest paid on deposits. These rates of interest change from time to time, depending upon a number of factors, including general market interest rates. However, the frequency of the changes varies among different types of assets and liabilities. For example, for a five-year loan with an interest rate based upon the prime rate, the interest rate may change every time the prime rate changes. In contrast, the rate of interest we pay on a five-year certificate of deposit adjusts only every five years, based upon changes in market interest rates.
 
In general, the interest rates we pay on deposits adjust more slowly than the interest rates we earn on loans because our loan portfolio consists primarily of loans with interest rates that fluctuate based upon the prime rate. In contrast, although many of our deposit categories have interest rates that could adjust immediately, such as interest checking accounts and savings accounts, changes in the interest rates on those accounts are at our discretion. Thus, the rates on those accounts, as well as the rates we pay on certificates of deposit, tend to adjust more slowly. As a result, the declines in market interest rates that occurred through the end of 2008 initially had an adverse effect on our net income because the yields we earn on our loans declined more rapidly than our cost of funds. However, many of our prime-based loans have minimum interest rates, or floors, below which the interest rate does not decline despite further decreases in the prime rate. As our loans reached their interest rate floors, our loan yields stabilized while our deposit costs continued to decline. This had a positive effect on our net interest income.
 
When market interest rates begin increasing, which we expect will occur at some point in the future, we anticipate an initial adverse effect on our net income. We anticipate that this will occur because our deposit rates should begin to rise, while loan yields remain relatively steady until the prime rate increases sufficiently that our loans begin to reprice above their interest rate floors. For most of our prime-rate based loans, this will not occur until the prime rate increases above 6%. Once our loan rates exceed the interest rate floors, increases in market interest rates should increase our net interest income because our cost of deposits should probably increase more slowly than the yields on our loans. However, customer preferences and competitive pressures may negate this positive effect because customers may choose to move funds into higher-earning deposit types as higher interest rates make them more attractive, or competitors offer premium rates to attract deposits. We also have a substantial portfolio of investment securities with fixed rates of interest, most of which are mortgage-backed securities with an estimated average life of not more than 5 years.
 
 
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Results of Operations for the Three Months Ended September 30, 2010 and September 30, 2009
 
Our results of operations depend primarily on net interest income, which is the difference between the income we earn on our loan and investment portfolios and our cost of funds, consisting primarily of interest we pay on customer deposits. Our operating expenses principally consist of employee compensation and benefits, occupancy expenses, professional fees, advertising and marketing expenses and other general and administrative expenses. Our results of operations are significantly affected by general economic and competitive conditions, particularly changes in market interest rates, government policies and actions of regulatory authorities.
 
General. We had net income of $506,861 for the quarter ended September 30, 2010, compared to net income of $474,469 for the comparable quarter in 2009. The principal categories which make up the 2010 net income are:
 
 
Interest income of $2,598,016
 
Reduced by interest expense of $249,476
 
Reduced by a provision for loan losses of $15,000
 
Increased by non-interest income of $635,875
 
Reduced by non-interest expense of $2,035,025
 
Reduced by income tax expense of $427,529
 
We discuss each of these categories individually and the reasons for the differences between the quarters ended September 30, 2010 and 2009 in the following paragraphs.
 
Interest Income. Interest income was $2,598,016 for the quarter ended September 30, 2010, compared to $2,623,941 for the quarter ended September 30, 2009, a decrease of $25,925, or 1.0%. There were two principal reasons for the decline. First, a $1.5 million decrease in average balance in investment securities between the periods coupled with a decline in market interest rates, were the principal causes of a $163,112 decline in interest income on investment securities. Second, an increase in the average balance of other interest-earning assets shifted our asset mix toward our lowest interest-earning asset category due to our decision to become more liquid to provide increased flexibility in the event of an interest rate increase. On the positive side, interest income on loans increased by $131,677 as the average balance of loans increased between the periods.
 
We had an $8,282,235 increase in average balance and a 5 basis point decrease in the average yield on loans from the quarter ended September 30, 2009 to the quarter ended September 30, 2010. The increase in the average balance was the result of our efforts to increase our loan portfolio. Our average non-performing loans increased by $4.8 million, for the quarter ending September 30, 2010 from the same period in 2009, hampering an increase in our average loan yield. The interest rate floors on our loans have helped to stabilize interest income from the loan portfolio, but these floors will have the effect of limiting increases in our income until the prime rate rises above 6%.
 
We experienced a 51 basis point decrease in the average yield on our investment securities portfolio, from 4.26% to 3.75%, due to the purchase of new investment securities at lower market rates than the yields on the principal paydowns we received. The average balance of our investment portfolio decreased by $1,544,698, or 1.32%, between the periods. The investment securities portfolio represented 73.8% of average non-loan interest earning assets in the 2010 period compared to 74.5% in the 2009 period as we deliberately limited our investment of available funds in investment securities due to the low yields available to us and our desire to avoid locking in those low yields for long periods while maintaining flexibility when interest rates eventually increase.
 
 
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The average yield on other interest earning assets (principally overnight investments) increased 5 basis points from 0.11% for the quarter ended September 30, 2009 to 0.16% for the quarter ended September 30, 2010 and we had an increase in average balance of other interest earning assets of $839,877 from the quarter ended September 30, 2009 to the quarter ended September 30, 2010. This increase in average balance occurred because we chose to invest the excess proceeds from our deposit growth into overnight investments to increase our liquidity in a volatile market and to help establish a buffer for when market interest rates begin to rise.
 
Interest Expense. Interest expense was $249,476 for the quarter ended September 30, 2010, compared to $314,989 for the quarter ended September 30, 2009, a decrease of $66,513 or 20.8%. The decrease was primarily the result of a reduction in the rates we paid on deposits, principally on time deposits, reflecting a 43 basis point decrease in the cost of time deposits between the periods, due to the continuing low market interest rates. With market rates remaining at very low levels, customer time deposits continue to be renewed or replaced with new deposits at lower rates. As a result, our average cost of funds, excluding the effect of interest-free demand deposits, decreased to 0.68% from 0.91% between the periods.
 
Net Interest Income Before Provision for Loan Losses. Net interest income before the provision for loan losses was $2,348,540 for the quarter ended September 30, 2010, an increase of $39,588, or 1.7% over the $2,308,952 in the comparable 2009 period. The increase was primarily because the reduction in our cost of funds was greater than the reduction in our interest income when comparing the quarter ended September 30, 2010 to the same period ended 2009. Our interest rate spread increased 7 basis points to 3.69% for the quarter ended September 30, 2010 from 3.62% in the same period of 2009. The spread between the periods increased because the drop in the yield on our interest earning assets was smaller than the reduction in the cost of funds, primarily due to the $8.3 million increase in average loans, our highest yielding asset.
 
Our net interest margin decreased to 3.95% for the quarter ended September 30, 2010 from 3.98% in the same period of 2009. The interest rate margin decreased when we reinvested the proceeds from payments on investment securities at lower rates because of the decline in market interest rates and also because other interest earning assets (principally overnight investments) were a larger percentage of the asset mix. The margin is higher than the spread because it takes into account the effect of interest free demand deposits and capital. However, the average margin declined slightly while the spread increased slightly because interest free funds are less valuable when market interest rates are low and we are able to invest those funds in lower average yielding assets. In addition, we shifted more marginal, excess funds not needed to fund loans into overnight investments rather than purchasing investment securities so that we are positioned to better address an increase in market interest rates that many experts are predicting will occur in the foreseeable future.
 
Provision for Loan Losses. We took a provision for loan losses of $15,000 for the quarter ended September 30, 2010 compared to a provision for loan losses of $75,000 for the quarter ended September 30, 2009. The $60,000 decrease in the provision was due to our evaluation of our loan portfolio and the low level of charge-offs in the 2010 period. A number of factors justified the reduction. Although we experienced an increase in non-performing loans from $1,755,994 at September 30, 2009 to $6,459,626 at September 30, 2010, most of those loans are secured by real estate. We individually evaluated the non-performing mortgage loans based primarily upon updated appraisals and we determined that the level of our allowance was appropriate to address inherent losses. In addition, we had recoveries (which are added back to the allowance for loan losses) of $23,484 in the third quarter of 2010. We are aggressively collecting charged-off loans in an effort to recover the amounts charged off whenever we believe that collection efforts are likely to be fruitful. Overall, our allowance for loan losses increased from $1,024,025 or 1.40% of total loans, at September 30, 2009 to $1,246,245 or 1.57% of total loans, at September 30, 2010.
 
The provision for loan losses in any period depends upon the amount necessary to bring the allowance for loan losses to the level management believes is appropriate, after taking into account charge offs and recoveries. Our allowance for loan losses is based on management’s evaluation of the risks inherent in our loan portfolio and the general economy. Management periodically evaluates both broad categories of performing loans and problem loans individually to assess the appropriate level of the allowance.
 
 
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Although management uses available information to assess the appropriateness of the allowance on a quarterly basis in consultation with outside advisors and the board of directors, changes in national or local economic conditions, the circumstances of individual borrowers, or other factors, may change, increasing the level of problem loans and requiring an increase in the level of the allowance. The allowance for loan losses represented 1.57% of total loans at September 30, 2010, compared to 1.41% at September 30, 2009. There can be no assurance that a higher level, or a higher provision for loan losses, will not be necessary in the future.
 
Non-interest Income. Non-interest income was $635,875 for the quarter ended September 30, 2010, compared to $597,084 during the same period last year. The $38,791, or 6.5%, increase in non-interest income was a direct result of normal fluctuations in retail banking transactions and the fees derived from them, such as insufficient funds fees, in 2010 coupled with the general effect that higher average assets and deposits can be expected to generate higher bank fees. Loan fees decreased as an increase in non-accrual loans during the 2010 period required that we reverse the accrual of late fees on those loans.
 
Non-interest Expense. Non-interest expense was $2,035,025 for the quarter ended September 30, 2010, compared to $1,949,814 for the quarter ended September 30, 2009, an increase of $85,211 or 4.4%. The principal shifts in the individual categories were:
 
 
a $98,027 increase in salaries and benefits as a result of new hires, higher benefit costs and normal raises for existing employees;
 
a $14,247 decrease in occupancy expenses primarily due to the retirement of certain fixed assets.
 
In addition to these changes, we also experienced changes in the various other non-interest expenses categories due to normal fluctuations in operations.
 
Income Tax Expense. Income tax expense was $427,529 for the quarter ended September 30, 2010, compared to income tax expense of $406,753 for the same period ended 2009. The increase in income tax expense was due to the $53,168 increase in income before taxes in the 2010 period. Our effective tax rate for the quarter ended September 30, 2010 was 45.8% and for the quarter ended September 30, 2009 was 46.2%.
 
Results of Operations for the Nine Months Ended September 30, 2010 and September 30, 2009
 
Our results of operations depend primarily on net interest income, which is the difference between the income we earn on our loan and investment portfolios and our cost of funds, consisting primarily of interest we pay on customer deposits. Our operating expenses principally consist of employee compensation and benefits, occupancy expenses, professional fees, advertising and marketing expenses and other general and administrative expenses. Our results of operations are significantly affected by general economic and competitive conditions, particularly changes in market interest rates, government policies and actions of regulatory authorities.
 
General. We had net income of $1,401,459 for the nine months ended September 30, 2010, compared to net income of $1,306,817 for the comparable period in 2009. The principal categories which make up the 2010 net income are:
 
 
Interest income of $7,748,647
 
Reduced by interest expense of $787,179
 
Reduced by a provision for loan losses of $125,000
 
Increased by non-interest income of $1,859,060
 
Reduced by non-interest expense of $6,112,081
 
Reduced by income tax expense of $1,181,988
 
 
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We discuss each of these categories individually and the reasons for the differences between the nine months ended September 30, 2010 and 2009 in the following paragraphs.
 
Interest Income. Interest income was $7,748,647 for the nine months ended September 30, 2010, compared to $7,985,556 for the nine months ended September 30, 2009, a decrease of $236,909, or 3.0%. There were two principal reasons for the decline. First, a $4.9 million decrease in average balance in investment securities between the periods, coupled with a decline in market interest rates, were the principal causes of a $574,144 decline in interest income on investment securities. Second, an increase in the average balance of other interest-earning assets shifted our asset mix toward our lowest interest-earning asset category due to our decision to become more liquid to provide increased flexibility in the event of an interest rate increase. On the positive side, interest income on loans increased by $319,269 as the average balance of loans increased between the periods due to our efforts to increase our loan portfolio.
 
The average balance of loans, our highest-yielding asset category, increased $9,427,468 from the nine months ended September 30, 2009 to the nine months ended September 30, 2010 due to management’s efforts to increase our loan portfolio. The positive effect of the increase in average balance was partially offset by a 30 basis point drop in our average loan yield due to the continued low market interest rate conditions and a higher level of recovery of non-accrual interest income, $164,708 for the first nine months in 2009, compared to $16,439 in the same period in 2010. The interest rate floors on our loans have helped to stabilize interest income from the loan portfolio, but these floors will have the effect of limiting increases in our income until the prime rate rises above 6%.
 
We experienced a 48 basis point decrease in the average yield on our investment securities portfolio, from 4.41% to 3.93%, due to the purchase of new investment securities at lower market rates than the yields on the principal paydowns we received. The average balance of our investment portfolio decreased by $4,922,071 or 4.11%, between the periods. The investment securities portfolio represented 75.2% of average non-loan interest earning assets in the 2010 period compared to 80.9% in the 2009 period as we deliberately limited our investment of available funds in investment securities due to the low yields available to us in the nine months ended September 30, 2010 and our desire to avoid locking in those low yields for long periods.
 
The average yield on other interest earning assets (principally overnight investments) increased 4 basis points from 0.10% for the nine months ended September 30, 2009 to 0.14% for the nine months ended September 30, 2010 and we had an increase in average balance of other interest earning assets of $9,654,967 from the nine months ended September 30, 2009 to the nine months ended September 30, 2010. This increase in average balance occurred because we chose to invest the excess proceeds from our deposit growth into overnight investments and Federal Reserve term deposits as a tool to increase our liquidity in a volatile market and to help establish a buffer for when market interest rates begin to rise.
 
Interest Expense. Interest expense was $787,179 for the nine months ended September 30, 2010, compared to $1,058,855 for the nine months ended September 30, 2009, a decrease of $271,676 or 25.7%. The decrease was primarily the result of a reduction in the rates we paid on deposits, principally on time deposits, reflecting a 55 basis point decrease in the cost of time deposits between the periods, due to continuing low market interest rates. As a result, our average cost of funds, excluding the effect of interest-free demand deposits, decreased to 0.73% from 1.06% between the periods.
 
Net Interest Income Before Provision for Loan Losses. Net interest income before the provision for loan losses was $6,961,468 for the nine months ended September 30, 2010, an increase of $34,767, or 0.50%, from $6,926,701 in the comparable 2009 period. The small increase was due to the $236,909 decrease in interest income partially offset by the positive effect of the reduction in our cost of funds of 32 basis points. The $236,909 decrease in interest income was due to the decline in the average yield on interest earning assets of 41 basis points from the nine months ended September 30, 2009 to the nine months ended September 30, 2010. The effect of lower yields was partially offset by the $14,160,364 increase in average earning assets in the 2010 period as we increased interest earning assets by invested funds obtained from our efforts to grow deposits. Our interest rate spread decreased 8 basis points to 3.74% for the nine months ended September 30, 2010 from 3.82% in the same period of 2009. The spread declined because our lowest yielding assets, overnight investments, were a larger percentage of the earning asset mix in 2010 and the overall yield on interest earning assets decreased faster than the reduction in our cost of funds.
 
 
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Our net interest margin decreased to 4.01% for the nine months ended September 30, 2010 from 4.23% in the same period of 2009. The interest rate margin decreased when we invested the proceeds from payments on investment securities at lower rates because of the decline in market interest rates and also because other interest earning assets (principally overnight investments) were a larger percentage of the asset mix. The margin is higher than the spread because it takes into account the effect of interest free demand deposits and capital. However, the average margin declined more rapidly than the spread because we shifted more marginal, excess funds not needed to fund loans into overnight investments rather than purchasing investment securities to position ourselves to better address an increase in market interest rates that many experts are predicting will occur in the foreseeable future.
 
Provision for Loan Losses. We took a provision for loan losses of $125,000 for the nine months ended September 30, 2010 compared to a provision for loan losses of $450,000 for the nine months ended September 30, 2009. The $325,000 decrease in the provision was due to our evaluation of our loan portfolio and substantially lower level of charge-offs in the 2010 period. Charge-offs totaled $22,712 for the nine months ended September 30, 2010 as compared to $467,336 in the same period in 2009 while we had recoveries of $80,503 in the first nine months of 2010 compared to recoveries of $53,485 during the first nine months of 2009. We are aggressively collecting charged-off loans in an effort to recover the amounts charged off whenever we believe that collection efforts are likely to be fruitful. Although we experienced an increase in non-performing loans from $1,755,994 at September 30, 2009 to $6,459,626 at September 30, 2010, most of those loans are secured by real estate. We individually evaluated the non-performing mortgage loans based primarily upon updated appraisals and we determined that the level of our allowance was appropriate to address inherent losses. Overall, our allowance for loan losses increased from $1,024,025, or 1.40% of total loans at September 30, 2009 to $1,246,245, or 1.57% of total loans, at September 30, 2010.
 
The provision for loan losses in any period depends upon the amount necessary to bring the allowance for loan losses to the level management believes is appropriate, after taking into account charge offs and recoveries. Our allowance for loan losses is based on management’s evaluation of the risks inherent in our loan portfolio and the general economy. Management periodically evaluates both broad categories of performing loans and problem loans individually to assess the appropriate level of the allowance.
 
Although management uses available information to assess the appropriateness of the allowance on a quarterly basis in consultation with outside advisors and the board of directors, changes in national or local economic conditions, the circumstances of individual borrowers, or other factors, may change, increasing the level of problem loans and requiring an increase in the level of the allowance. The allowance for loan losses represented 1.57% of total loans at September 30, 2010 compared to 1.41% at September 30, 2009. There can be no assurance that a higher level, or a higher provision for loan losses, will not be necessary in the future.
 
Non-interest Income. Non-interest income was $1,859,060 for the nine months ended September 30, 2010, compared to $1,825,336 during the same period last year. The $33,724, or 1.9%, increase in non-interest income was a direct result of normal fluctuations in retail banking transactions and the fees derived from them, such as insufficient funds fees, in 2010. Loan fees decreased as an increase in non-accrual loans during the 2010 period required that we reverse the accrual of late fees on those loans.
 
 
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Non-interest Expense. Non-interest expense was $6,112,081 for the nine months ended September 30, 2010, compared to $5,874,950 for the nine months ended September 30, 2009, an increase of $237,131 or 4.0%. The principal shifts in the individual categories were:
 
 
a $228,557 increase in salaries and benefits as a result of new hires, higher related benefit costs, including the costs of the recently adopted stock plans, and increased salary and benefits due to normal raises;
 
a $48,564 increase in legal expense primarily due to increased collection costs;
 
a $25,000 increase in FDIC and NYSBD assessments due to an increase in the FDIC assessment rate and assessment base over the prior year;
 
a $41,174 decrease in occupancy expenses due to the full depreciation of certain fixed assets; and
 
a $35,650 decrease in professional fees due to the costs involved with the hiring of key staff in 2009 period.
 
In addition to these changes, we also experienced changes in the various other non-interest expenses categories due to normal fluctuations in operations.
 
Income Tax Expense. Income tax expense was $1,181,988 for the nine months ended September 30, 2010, compared to income tax expense of $1,120,270 for the same period ended 2009. The increase in income tax expense was due to the $156,360 increase in income before income taxes in the 2010 period. Our effective tax rate for the nine months ended September 30, 2010 was 45.8% and for the nine months ended September 30, 2009 was 46.2%.
 
 
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VSB Bancorp, Inc.
Consolidated Average Balance Sheets
(unaudited)
 
    Three    
Three
    Nine     Nine  
    Months Ended     Months Ended     Months Ended     Months Ended  
    Sep. 30, 2010     Sep. 30, 2009     Sep. 30, 2010     Sep. 30, 2009  
   
Average
       
Yield/
   
Average
         
Yield/
   
Average
         
Yield/
   
Average
         
Yield/
 
   
Balance
 
Interest
   
Cost
   
Balance
   
Interest
   
Cost
   
Balance
   
Interest
   
Cost