UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

 

 

 

Form 10-K

 

 

Commission file number: 000-49976

 

 

 

 

ALLIANCE BANKSHARES CORPORATION
(Exact name of registrant as specified in its charter)

 

 

 

 

 

14200 Park Meadow Drive, Suite 200 South, Chantilly, Virginia 20151

(Address of principal executive offices) (Zip Code)

 

(703) 814-7200

 

(Registrant’s telephone number, including area code)

 

 

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

Securities registered pursuant to Section 12(g) of the Act:

None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act.  Yes o     No þ

 

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

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No þ

 

The aggregate market value of Alliance Bankshares Corporation common stock held by non-affiliates as of June 30, 2010 was $12,854,316 based on the closing sale price of $2.69 per common share.

 

The number of shares of common stock outstanding as of March 28, 2011 was 5,108,219.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the registrant’s definitive proxy statement for the registrant’s 2011 Annual Meeting of Shareholders (the “2011 Proxy Statement”) are incorporated by reference into Part III of this report.

 

 

TABLE OF CONTENTS

 

 

 

GENERAL

 

Alliance Bankshares Corporation (Bankshares or Company) is a single-bank holding company that was incorporated under Virginia law in 2002. Bankshares conducts substantially all of its operations through its subsidiaries. Our banking subsidiary, Alliance Bank Corporation (the Bank or Bank) is state-chartered in Virginia and is a member of the Federal Reserve System. In addition to the Bank, Bankshares has another subsidiary, Alliance Virginia Capital Trust I (Trust), a Delaware statutory trust that was formed in connection with the issuance of trust preferred capital securities in June of 2003.

 

The Bank is a state-chartered commercial bank that was incorporated in Virginia and opened for business on November 16, 1998 and has continuously offered banking products and services to surrounding communities since that date. The Bank has six full service banking facilities. The Bank places special emphasis on serving the needs of individuals, small and medium size businesses and professional concerns in the greater Washington, D.C. Metropolitan region. We use the internet to offer online account access, bill payment and commercial cash management. In addition, certain loan and deposit products may be offered from time to time on our website, as well as at our numerous physical locations. Currently, the Bank executes its business via two key business lines: Commercial Banking and Retail Banking. The business unit formerly known as Private Client Services is now referred to as Title and Escrow Services and is part the of Commercial Banking business line.

 

In March 2001, the Bank formed Alliance Home Funding, LLC (AHF). AHF is a wholly-owned mortgage banking subsidiary of the Bank and originated residential mortgages for subsequent sale. AHF did not maintain the servicing rights on mortgages sold. On December 27, 2006, Bankshares announced it would no longer offer mortgage banking operations via AHF. AHF remains a subsidiary of the Bank but is inactive. Alliance Bank Mortgage Division (ABMD) was created in 2007 as a division within the Bank. From time to time, ABMD offered mortgage banking products and services to Bank clients and some additional third party clients. In early 2010, ABMD had minimal operational activity. As of December 31, 2010, this division within the Bank was inactive.

 

On November 15, 2005, the Bank formed Alliance Insurance Agency (AIA) through the acquisition of Danaher Insurance Agency. AIA was a wholly-owned subsidiary of the Bank and sold a wide array of insurance and financial products. In 2006 and 2007, AIA acquired two additional insurance agencies. The combined AIA operations offered insurance products in the Alliance trade area. On December 29, 2009, the Bank sold AIA and no longer offers insurance products. The effects of the discontinued business operation are shown separately in the consolidated financial statements.

 

EMPLOYEES

 

As of December 31, 2010, Bankshares and its subsidiaries had a total of 62 full-time employees. Bankshares considers relations with its employees to be reasonable and effective. None of our employees are covered by any collective bargaining agreements.

 

COMPETITION

 

Bankshares faces significant competition for loans and deposits including title and escrow deposits. Competition comes from other commercial banks, savings and loan associations, savings banks, mortgage bankers, broker/dealers, investment advisors and other institutions. We emphasize specialized customer service and advanced technology, establishing long-term customer relationships and building customer loyalty by providing products and services designed to address the specific needs of our customers.

 

The severe economic downturn experienced over the past few years has increased the competition to attract valuable clients. In addition, the changing complexion of local community banks and migration of bankers within the region is creating greater competitive pressure on the Bank. Our customer service team, relationship managers

and senior bankers remain focused on delivering high touch, high quality service along with competitive products to meet or exceed the needs of our clients within our targeted market niches.

 

It is possible that current and future governmental regulatory and economic initiatives could further impact the competitive landscape in the Bank’s markets. Because federal regulation of financial institutions changes regularly and is the subject of constant legislative debate, we cannot foresee how federal regulation of financial institutions may change in the future.

 

Lending Activities

 

Credit Risk Management.  Our credit management vision is based on the belief that a sound shared credit culture within the Bank, the application of well-designed policies and procedures, and a long term view are the ingredients that will result in superior asset quality and consistent and acceptable growth. Our business model contains key assumptions that superior asset quality and consistent, acceptable profitability are significant drivers to maximizing shareholder value. We will not sacrifice asset quality to meet growth objectives, nor permit opportunities to lead to concentrations of risk that are inappropriate or contain excessive risk. The economic slowdown that developed into a deep recession has had a negative impact on our short term performance. As positive economic and business factors emerge, we still remain true to our core business values and maintain a diligent focus on asset quality. We employ a number of business processes to manage risk in our loan portfolio. These include the loan underwriting and approval process, our exposure management process, loan management and the independent loan review. While no set of processes or procedures can eliminate the possibility of loss, we believe that each of these processes contributes to the quality of our risk management activities.

 

Loan Underwriting and Approval Process.  Loan requests are developed by our relationship managers who work directly with our customers. Relationship managers are responsible for understanding the request and will make an evaluation to ensure that the request is consistent with our underwriting standards and risk tolerance. Depending on the complexity of the transaction, additional support is provided by a credit analyst who provides an independent analysis of the financial strength of the borrower and the underlying credit-worthiness of the transaction.

 

We utilize both a signature system and a committee system for approving loans. Relationship managers are given credit authority commensurate with their experience and demonstrated knowledge and ability. The maximum individual authority of any relationship manager is $250,000. Loans from $250,000 to $1.0 million require an approval or a second signature of the Director of Commercial Banking, Chief Credit Officer, or President.

 

Loans in excess of $1.0 million are considered by our management loan committee, which consists of the senior relationship managers, the President and the Chief Credit Officer. Relationships with total requirements of $2.5 million or greater require approval by our Loan Committee of the Board of Directors. In determining the actual level of required approval, all direct and indirect extensions of credit to the borrower are considered.

 

Exposure Management Process.  We utilize a 10-point rating system for our commercial and real estate credit exposures. The vast majority of our loans falls into the middle range of risk ratings and carry what we consider to be ordinary and manageable business risk. A risk rating is assigned during the underwriting process and is confirmed through the approval process. This risk rating influences our decision about the overall acceptability of the loan given our overall portfolio risk and also may influence our decision regarding the sale of a participation in the loan. As part of the systematic evaluation of our loan portfolio, when a loan risk rating increases to a 7 or above (special mention, substandard, doubtful or loss) it is considered for impairment analysis. As part of this process, our credit management team also prepares an analysis of all loans determined to be impaired. The watch list, impaired loans, nonaccrual loans and Other Real Estate Owned (OREO) inventory is presented to our Directors at our monthly Board meetings.

 

Portfolio diversification and business strategy are key components of our process. On a monthly basis, our Board reviews the total portfolio by lending type. Exposure ranges are established at least annually and are reviewed monthly as a percentage of risk-based capital for each lending type. Business strategies are considered and adjusted based on current portfolio amounts and our perceptions of the market. A number of factors are considered which result in strategies to expand, attract, maintain, shrink or disengage categories within our portfolio. At the present

time, our business plan continues to call for shrinking our exposure to certain construction categories and land loans. In addition, we evaluated the risk profile of certain of our residential real estate categories, in particular Home Equity or HELOC products, and determined more restrictive underwriting standards remain appropriate.

 

The Board-approved exposure ranges developed by us reflect our desire to build an appropriately diversified loan portfolio. We consider market opportunities, the overall risk in our existing loans, and our expectations for future economic conditions and how they together may impact our portfolio. We then establish guidelines for what we believe are appropriate amounts in each category of loans. The guidelines are reviewed frequently for changing market conditions and the desire to adjust the Bank’s risk profile.

 

The Board of Governors of the Federal Reserve System (the Federal Reserve) has published commercial real estate guidelines for all institutions that are a function of regulatory capital. The guidelines are commonly referred to as the 100% / 300% guidelines. These guidelines call for enhanced management and risk controls for real estate lending when exposures are in excess of the suggested regulatory guidelines. Our current exposure ranges have been established with reference to these guidelines relating to commercial real estate lending, as well as our view of real estate related lending in the current economic environment.

 

Participations are also a part of our risk exposure management process. We seek participants even for loans that we find acceptable and within our policy guidelines in order to spread the risk and maintain the capacity to handle future requests from the same borrower. From time to time, we may also purchase participations from institutions we believe share our commitment to strong underwriting standards. In general, management will attempt to operate the Bank as a net seller of loan participations.

 

Loan Management.  Commercial and real estate loans require a high degree of attention to monitor changes in cash flows and collateral values. The primary responsibility for ensuring that loans are being handled in accordance with their terms and conditions rests with the relationship manager, supported by a credit analysis department and a loan operations group. We obtain and review regular financial reports from our borrowers to evaluate operating performance and identify early warning signs of increasing risk. Our culture encourages the early reporting of problems so that they can be addressed in a timely and manageable manner. Identification of increased risk results in an increased risk rating, more frequent management review and possible remediation to include requiring additional collateral or identification of alternate sources of repayment. When feasible, we also seek to increase the interest rates to reflect the higher risk and provide an incentive for borrowers to explore all alternative financing sources. Adversely rated credits are reviewed monthly with the Bank’s Board of Directors.

 

Management of construction loans includes regular on-site inspections by Bank-engaged inspectors to ensure that advances are supported by work completed. Regular title updates are obtained to protect against intervening liens. A regular evaluation is done to ensure that there is sufficient loan availability remaining to complete a project. Information regarding current sales and/or leasing is documented by relationship managers.

 

Commercial real estate loans are generally managed on a monthly basis based on receipt of regular principal and interest payments. Operating statements and updated leasing information are collected at least annually. This information is analyzed to determine the ongoing soundness of the credit. Our general practice is to perform a site visit at least annually to visually inspect our collateral.

 

Smaller consumer and business loans, most of which require monthly payments of principal and interest, are managed primarily based on their payment record. As long as monthly payments are made in a timely manner, we spend only a nominal amount of time to oversee the portfolio. Past due reports are reviewed on a weekly basis and appropriate action is determined based on the level of delinquency and the collateral supporting the credits.

 

Starting in late 2007, we undertook a variety of real estate lending studies. These studies focused on products and loan types that appear to have caused risk within our lending portfolio as well as certain loan types that we view as having higher degrees of risk in the current economic environment. The results of the studies have led to elimination of certain loan products such as higher loan-to-value (or LTV) HELOC loans, tighter lending standards and a change in our credit risk appetite for certain lending products.

 

We continue to perform these types of studies as we see micro and macro trends that we believe could adversely impact our loan portfolio. In addition, we periodically perform deeper analysis of certain segments of the

loan portfolio. The information is used by management to assess the current and expected risk profile of the loan portfolio. As conditions change, we modify our tactical approach to extending credit and consider more strategic changes as necessary. We believe market conditions related to certain real estate lending segments remain challenging and we believe our current lending standards for new loan originations reflect current market conditions.

 

Independent Loan Review.  At least annually, we employ the services of an independent company to assess our lending operations. The outside review firm evaluates our underwriting processes to ensure that we are performing an appropriate level of due diligence by independently selecting a sample of loans for review. Each loan that is chosen as part of the sample has the bank-assigned risk rating evaluated. The quality of individual loans is evaluated to ensure that we have fairly described the risks inherent in the specific transaction. The review team is directed to evaluate whether we are administering loans in accordance with our policies and procedures. An evaluation is performed on our remediation plan used to identify problem loans. The reviewer evaluates the adequacy of specific reserve allocations on impaired credits and the appropriateness of the process and documentation of our overall allowance for loan losses.

 

We report the results of the independent loan review activities to the Audit Committee of the Board of Directors and to the Bank’s Board of Directors. We consider any process improvement recommendations from the independent loan review team and address each recommendation with a suggested action plan. We are not aware of any material differences in the evaluation of individual loans between management, the Bank’s Board of Directors and the independent company regarding specific loans, loan policies or credit administration.

 

Lending Limit.  At December 31, 2010, our legal lending limit for loans to one borrower was $6.4 million. As part of our risk management strategy, we maintain internal “house” limits below our legal lending limit. Our current house limit is 80% of our legal lending limit, or $5.1 million. However, to minimize client concentration risk and transactional risk, we prefer not to extend credit beyond the $2.0 million to $3.0 million dollar range. When we receive customer requests in excess of our house or legal lending limit, we evaluate the credit risk under our normal guidelines. Incremental loans amounts exceeding house policy or legal lending limits of approved transactions are sold as participations and funded by other banks. This practice allows us to serve our clients’ business needs as they arise and reduces our risk exposure and operate within the regulatory requirements.

 

COMMERCIAL BANKING LINE OF BUSINESS

 

We categorize our loans into five general classifications: Commercial Real Estate, Real Estate Construction, Residential Real Estate, Commercial Business and Consumer. Further segmentation of each classification by collateral type is included in our internal management reports and in information provided to the Board of Directors on a monthly basis.

 

Loan Portfolio.  As part of our normal business activities, we are engaged in making loans to a broad range of customers, including small businesses and middle market companies, professionals, home builders, commercial real estate developers, commercial real estate investors, consumers and others in our market area. We generally define our market area as Northern Virginia and the surrounding jurisdictions in the Washington, D.C. metropolitan area (including areas as far south as Fredericksburg, Virginia). The loan portfolio decreased 7.5% during 2010 as management continued to reduce construction and land related lending, adversely risk rated credits and our residential subordinate lending exposures (both HELOC and closed-end second trust loans) as circumstances allowed. Our loan portfolio balance at December 31, 2010 was $332.3 million compared to $359.4 million at December 31, 2009.

 

Commercial Real Estate Lending.  As of December 31, 2010, commercial real estate loans were $146.2 million or 44.0% of the loan portfolio, compared to $153.3 million or 42.7% of the portfolio as of December 31, 2009. The decreased loan volume reflects the effect of the current economic environment evidenced by the lack of customer demand in the commercial real estate market in the greater Washington, D.C. metropolitan area. In addition, substantially all loans require regular monthly amortization of principal, resulting in a natural reduction in the portfolio. These loans are typically secured by first trusts on office, retail, warehouse, commercial condominiums or industrial space. These loans are generally divided into two categories: loans to commercial entities that will occupy

most or all of the property (described as “owner-occupied”) and loans for income producing properties held by investors.

 

In the case of owner-occupied loans, the Bank is usually the primary provider of financial services for the company and/or the principals. This allows us to further monitor the quality of the ongoing cash flow available to service the loans. While these loans are real estate secured, we believe that, as a portfolio, these loans are less subject to the normal real estate cycles because the underlying businesses are owned by the borrowers who will not seek alternative rental space in times of market over-supply.

 

Commercial real estate loans made on income producing properties are made on generally the same terms and conditions as owner-occupied loans. Underwriting guidelines generally require borrowers to contribute cash equity that results in an 80% or less loan-to-value ratio on owner-occupied properties and a 75% or less loan-to-value ratio on investment properties. Exceptions to these guidelines are infrequent and are justified based on other credit factors.

 

Loans in this category (owner occupied and investment properties) are generally amortizing over 15-25 year periods and carry adjustable rates which reset every 1 to 5 years, indexed against like-maturity treasury instruments.

 

Real Estate Construction Lending.  The real estate construction portfolio was $43.0 million or 13% of the portfolio as of December 31, 2010, down slightly from the $50.1 million, or 14%, as of December 31, 2009. This category consists of three distinct product offerings: loans for the acquisition, development and construction of commercial properties; loans for the acquisition, development and construction of residential properties; and construction loans to individuals for their own primary residences or second homes.

 

Our commercial construction segment generally contains projects where we expect to make a long term commercial mortgage loan upon successful completion of the project. We also have customers who build commercial condominium units which will be sold to smaller end users. These end loans are also attractive to us as they can lead to full service relationships with small business owners. Demand for the financing of new projects has been extremely limited over the past two years as developers have delayed or cancelled projects due to market uncertainties. Our underwriting requirements in the current market include substantial pre-leasing or pre-sales, higher levels of equity and more substantial borrower liquidity levels.

 

After substantial decreases in 2008 and 2009, we experienced a slight increase in our residential construction portfolio during 2010. Residential home builders who are delivering 1 to 10 single family units per year have been one of our primary customer segments. We advance money for the purchase of lots and also provide funds for construction. When practical, we limit the number of speculative units that a builder can finance at any particular time. Our construction loan monitoring process includes a complete appraisal, periodic site inspections by a third party, regular interaction by the relationship managers and administrative oversight of the funds utilized in construction to ensure that construction is progressing as planned and that there are always sufficient funds available in the loan to complete the project. In addition to evaluating the financial capacity of the borrower, we also require equity in each transaction that puts us in a range of 70-75% loan-to-value on an “as completed” basis. Substantially all the loans in this category carry a floating rate of interest tied to the Wall Street Journal (WSJ) prime rate with appropriate minimum contractual rates.

 

The smallest segment of residential construction loans are to borrowers who have engaged a contractor to build their primary residence. These loans are underwritten against stringent lending standards, requiring meaningful cash equity, strong income resulting in conservative debt-to income ratios, and impeccable credit standing. We further require that the borrower engage a qualified contractor to complete the project. While we expect that repayment will likely come from subsequent financing obtained in the traditional mortgage markets, we underwrite these loans assuming we will convert the loan into a portfolio mortgage. We manage the loan during the construction period essentially the same as if the borrower was a builder.

 

Residential Real Estate Lending.  The residential real estate portfolio was $110.9 million or 33.4% of the portfolio as of December 31, 2010, up slightly from $110.4 million or 30.7% of the portfolio as of December 31, 2009. This category consists of five distinct product offerings: open end home equity loans, which are loans secured by secondary financing on residential real estate (HELOCs); closed end amortizing second mortgages; bridge loans to commercial entities who acquire and remodel properties; first mortgage loans secured by 1-4 family properties

held as income or investment properties; and portfolio first mortgage loans on primary or secondary 1-4 family residences.

 

The Bank has been an active HELOC lender since its inception. This historically attractive portfolio has experienced some challenges since 2008 as a result of a combination of factors: loss of value in the property securing the loans, a lack of marketability of residential properties, and the impact of loss of income/employment of individuals in our market. We have adjusted and tightened our underwriting standards on new credits to limit loan-to-value ratios to 75% or less and to require higher credit scores and more appropriate debt service ratios. Substantially all of these loans are priced at or above the WSJ prime rate and float on a daily basis. Originations subsequent to January 2008 often carry interest rate floors. While our loans generally have a revolving period of 15 years followed by a 15 year amortization (30 years total), our experience is that, similar to first mortgages, the actual expected maturity of an individual loan is much shorter.

 

The HELOC portfolio was a source of losses over the past few years. We had, and continue to have, a number of customers whose personal incomes were directly impacted by the significant downturn in the economy and residential real estate market. We cannot predict when this cycle will change. However, we believe our active risk management analysis and early intervention will minimize our future losses.

 

Our closed-end second trust portfolio results primarily from the conversion of existing HELOCs. This generally involves eliminating any unused availability, fixing the interest rate at current market rates for similar credits, and amortizing the unpaid balance over 15 to 30 years based on the borrower’s capacity to service the debt. We believe our current underwriting standards are conservative and reflect the realities of today’s current real estate market.

 

We have a group of customers who are active in the acquisition and remodeling of existing 1-4 family residential properties. These “bridge” loans, secured by first deeds of trust, are generally made under annually reviewed lines of credit which outline the terms and conditions of each individual advance. Each advance generally has a maturity of less than 1 year and carries a floating rate of interest tied to the WSJ prime rate with contractual minimum rates and transaction fees. Advance rates are based on the lower of cost or “as is” market value and are generally limited to 80% or less of the appraised value. Our customers buy these properties in the ordinary course of their business either directly from owners or as part of a foreclosure process. They then invest their own money to restore the property to a fully marketable condition. These loans in many respects are similar to regular residential construction loans but without some of the related risks.

 

We also have clients who invest in 1-4 family properties for rental income purposes. Loans that support these investment activities are underwritten based on appropriate loan-to-value ratios, identified cash flows and assignment of rents, as well as the financial capacity of the sponsors. Loans in this category generally carry rates which re-set every 3 to 5 years and require monthly amortization.

 

The final group in this category is loans secured by first trusts on 1-4 family primary residences. While we do not actively market this product, there are times when business circumstances justify making such a loan for our regular portfolio. These situations include loans to individuals who for one reason or another do not find mortgage products in the market to fit their needs and who maintain substantial non-lending relationships with us that make these loans attractive to us. The maximum loan-to-value ratio in these loans is generally 80%, with most at lower advance rates. These loans either have an expected maturity of 5 years or less or carry interest rates that adjust with Treasury rates. Loans in this category are generally amortized over 30 years or less.

 

Commercial Business Lending.  Our commercial business lending category consists of general business credit in the form of lines of credit, revolving credit facilities, term loans, equipment loans, stand-by letters of credit and other credit needs experienced by small and medium sized businesses. These loans are written for any sound business purpose including the financing of business equipment, meeting general working capital needs, or supporting business expansion. Commercial loans generally are secured by business assets, carry the personal guarantees of the principals and have either floating rates tied to the WSJ prime rate or are fixed for 3 to 7 year periods. Our customers come from a wide variety of businesses, including government contractors, professional services, building trades and retail. Commercial business loans represented 8.3% of the loan portfolio or $27.5 million at December 31, 2010, a decrease from $40.6 million at December 31, 2009, which was 11.3%

of the portfolio. The major factor in the decline is the very severe economic recession that continues to impact the local economy. We experienced lower borrowings by commercial customers who were also affected by the economic conditions leading to a general contraction in their needs for credit. In the long-term, we expect growth in this loan category as the economy improves.

 

Consumer Lending.  This category constitutes the smallest part of our loan portfolio. These loans are small personal lines of credit and term loans. Loans are both secured (deposit accounts, brokerage accounts, automobiles, etc.) and unsecured and carry either fixed or floating rates. Our marketing of these products is generally reactive in nature, responding to requests that come to us primarily from the principals and/or employees of our commercial customers. The balance as of December 31, 2010 was $4.7 million compared to $4.9 million as of December 31, 2009.

 

Traditional Mortgage Banking.  In December 2006, we made the strategic decision to exit our stand alone mortgage banking operation (AHF). In 2009 and 2008, we offered mortgage banking products through a small team of Bank employees that formed the Alliance Bank Mortgage Division (ABMD). In early 2010, we made the decision to eliminate the ABMD mortgage staffing. In 2010, we had minor level of income which was related to selling the remaining loans that had been originated by ABMD. ABMD remains inactive as of December 31, 2010.

 

COMMERCIAL BANKING LINE OF BUSINESS

 

Deposit Activities and Other Services.  Deposits and repurchase agreements are the key sources of our funding. We offer a broad array of deposit products that include demand, NOW, money market, savings accounts and certificates of deposit. In addition to deposit products, we offer customer repurchase agreements (repos). We typically see repos used by commercial business customers as part of active cash management programs. We pay competitive interest rates on the interest bearing deposits to garner our share of the market. As a relationship-oriented bank, we also seek to obtain deposit relationships with our loan clients.

 

Our strategic plan is to continue our focus on specialized customer services executed via the Title and Escrow Services Department. This department serves entrepreneurs, professionals and small business owners that include title and mortgage loan closing companies, which represent a substantial percentage of our non-interest bearing deposits. Through the use of proprietary software, enhanced customer service, and a package of electronic banking tools, we are able to deliver an array of services that are very attractive and affordable for title insurance agencies, many of which maintain significant account balances with us. Our business strategy includes expanding the number of customers in this market segment by continuing to provide the highest quality customer service and the latest technology devoted to this industry. This remains a highly competitive sector of the market.

 

In 2008, in order to leverage our strategic approach to client deposit services, we created a framework of products to enter the community homeowners’ association management (HOA) arena. Since our entry into this market segment, we have been working with clients to establish products and services that meet the market need. At this point in time this deposit business line is still developing as a funding source for the Company.

 

We have traditionally offered investment and wealth management products to our clients. In mid-2010, we assessed our product offerings, delivery channel and market penetration. The review indicated certain resources should be reallocated more effectively within the Company. Consequently, in late third quarter of 2010, we transitioned these investment and wealth management clients to another unaffiliated wealth management company.

 

WHOLESALE FUNDING

 

As our overall asset liability management process dictates, we may become more or less competitive in our deposit terms and interest rate structure. Consequently, we may use brokered deposits to augment the Bank’s funding position. The wholesale nature of brokered deposits makes gathering specific quantities or duration of deposits an efficient process. In 2008, as the real estate economy declined and we experienced outflows of non-interest bearing deposits, we used wholesale or brokered deposits to supplement our overall funding position. We continue to utilize brokered deposits to extend the duration of liabilities as part of our asset liability management strategies. We are a member of the Federal Home Loan Bank of Atlanta (FHLB) and we utilize the short-term and long-term advances as part of our funding strategy.

RETAIL BANKING LINE OF BUSINESS

 

We offer traditional retail loan and deposit products for our clients via our six bank business center locations: Fair Lakes, Annandale, the city of Manassas Park, Reston, Ballston and Tyson’s Corner. The locations have the characteristics of a traditional retail branch, (e.g. tellers, ATM, customer service representative and a branch manager), and we view the retail operation as a tool to execute our core commercial and business strategies. In 2010, we migrated our commercial and real estate relationship managers to offices within the branch network. This action was designed to fully support the market trade areas and our tactical approach to business development.

 

We recognize the cost to develop and implement a large retail presence; therefore, our business strategy calls for a limited number of strategically placed business centers in the greater Washington, D.C. metropolitan area.

 

FDIC Insurance of Deposit Accounts

 

The deposits of the Bank are insured by the Federal Deposit Insurance Corporation (the FDIC) up to the limits set forth under applicable law. For additional information regarding federal deposit insurance, please see our discussion in Part I, Item 1 of this Annual Report on Form 10-K under the heading “Supervision and Regulation — Insurance of Accounts, Assessments and Regulation by the FDIC.”

 

DISCONTINUED OPERATIONS — INSURANCE AGENCIES

 

AIA was formed on November 15, 2005 with the acquisition of Danaher Insurance Agency. AIA acquired two wholly owned subsidiaries subsequent to its formation: on December 14, 2006, Alliance/Battlefield Insurance Agency, LLC (Battlefield), and on April 5, 2007, the Fredericksburg Insurance Group (FIG). On December 29, 2009, the Bank entered into and closed on a Stock Purchase Agreement to sell AIA. As of the closing date, the Bank is no longer involved in the sale of insurance related products.

 

SUPERVISION AND REGULATION

 

General

 

Bank holding companies and banks are extensively regulated under both federal and state law. The following summary briefly describes the more significant provisions of currently applicable federal and state laws and certain regulations and the potential impact of such provisions on Bankshares and the Bank. This summary is not complete, and we refer you to the particular statutory or regulatory provisions or proposals for more information. Because federal regulation of financial institutions changes regularly and is the subject of constant legislative debate, we cannot forecast how federal regulation of financial institutions may change in the future and affect Bankshares’ and the Bank’s operations.

 

Regulation of Bankshares

 

Bankshares must file annual, quarterly and other reports with the Securities and Exchange Commission (SEC). Bankshares is directly affected by the corporate responsibility and accounting reform legislation signed into law on July 30, 2002, known as the Sarbanes-Oxley Act of 2002 (the SOX Act), and the related rules and regulations. The SOX Act includes provisions that, among other things, require that periodic reports containing financial statements that are filed with the SEC be accompanied by chief executive officer and chief financial officer certifications as to the accuracy and compliance with law; additional disclosure requirements and corporate governance and other related rules.

 

When enacted in 2002, Section 404(a) of the SOX Act required public companies to include in their annual reports on Form 10-K an assessment from management of the effectiveness of the company’s internal control over financial reporting, and Section 404(b) of the SOX Act required the company’s auditor to attest to and report on management’s assessment. From 2002 through 2010, the SEC had delayed implementation of Section 404(b) of the SOX Act for public companies with a public float below $75 million (i.e. companies that are smaller reporting companies or non-accelerated filers). In July 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) permanently exempted smaller reporting companies and non-accelerated filers from

Section 404(b) of the SOX Act, and the SEC made conforming amendments to certain of its rules and forms in September 2010.

 

Our management’s report on internal control over financial reporting is contained in Item 9A herein. Bankshares has expended considerable time and money in complying with the SOX Act and expects to continue to incur additional expenses in the future.

 

Bank Holding Company Act

 

As a bank holding company, Bankshares is subject to regulation under the Bank Holding Company Act of 1956, as amended (the BHCA), and the examination and reporting requirements of the Board of Governors of the Federal Reserve. As a state-chartered commercial bank, the Bank and its subsidiaries are also subject to regulation, supervision and examination by the Virginia State Corporation Commission’s Bureau of Financial Institutions (the Bureau) and regulation, supervision and examination by the Federal Reserve.

 

The BHCA generally limits the activities of a bank holding company and its subsidiaries to that of banking, managing or controlling banks, or any other activity that is closely related to banking or to managing or controlling banks. Since September 1995, the BHCA has permitted bank holding companies from any state to acquire banks and bank holding companies located in any other state, subject to certain conditions, including nationwide and state imposed concentration limits. Banks also are able to branch across state lines, provided certain conditions are met, including that applicable state laws expressly permit such interstate branching. Virginia permits branching across state lines, provided there is reciprocity with the state in which the out-of-state bank is based. Similarly, approval of the Virginia Bureau of Financial Institutions is required for certain acquisitions of other banks and bank holding companies. The Federal Reserve has jurisdiction to approve any bank or non-bank acquisition, merger or consolidation proposed by a bank holding company.

 

The Federal Reserve requires a bank holding company to act as a source of financial strength and to take measures to preserve and protect its bank subsidiaries. Bankshares would be compelled by the Federal Reserve to invest additional capital in the event the Bank experiences significant loan losses, earnings shortfalls or rapid balance sheet growth.

 

Federal law and regulatory policy impose a number of obligations and restrictions on bank holding companies and their depository institution subsidiaries to reduce potential loss exposure to the depositors and to the Federal Deposit Insurance Corporation (the FDIC) insurance funds. For example, a bank holding company must commit resources to support its subsidiary depository institutions. In addition, insured depository institutions under common control must reimburse the FDIC for any loss suffered or reasonably anticipated by the Deposit Insurance Fund (DIF) as a result of the default of a commonly controlled insured depository institution. The FDIC may decline to enforce the provisions if it determines that a waiver is in the best interest of the DIF. An FDIC claim for damage is superior to claims of stockholders of an insured depository institution or its holding company but is subordinate to claims of depositors, secured creditors and holders of subordinated debt, other than affiliates, of the commonly controlled insured depository institution.

 

The Federal Deposit Insurance Act (the FDIA) provides that amounts received from the liquidation or other resolution of any insured depository institution must be distributed, after payment of secured claims, to pay the deposit liabilities of the institution before payment of any other general creditor or stockholder. This provision would give depositors a preference over general and subordinated creditors and stockholders if a receiver is appointed to distribute the assets of the Bank.

 

Restrictions on Extensions of Credit and Investment in the Stock of Bankshares or its Subsidiaries

 

Subsidiary banks of a bank holding company are subject to certain restrictions imposed by the Federal Reserve Act on any extensions of credit to the bank holding company or any of its subsidiaries, or investments in the stock or other securities thereof, and on the taking of such stock or securities as collateral for loans to any borrower. Further, a holding company and any subsidiary bank are prohibited from engaging in certain tie-in arrangements in connection with the extension of credit. A subsidiary bank may not extend credit, lease or sell property, or furnish any services, or fix or vary the consideration for any of the foregoing, on the condition that: (a) the customer obtain

or provide some additional credit, property or services from or to such bank other than a loan, discount, deposit or trust service; (b) the customer obtain or provide some additional credit, property or service from or to a holding company or any other subsidiary of a holding company; or (c) the customer not obtain some other credit, property or service from competitors, except for reasonable requirements to assure the soundness of credit extended.

 

Capital Requirements

 

The Federal Reserve Board and the FDIC have issued substantially similar risk-based and leverage capital guidelines applicable to banking organizations they supervise. Under the risk-based capital requirements of these federal bank regulatory agencies, Bankshares and the Bank are required to maintain a minimum ratio of total capital to risk-weighted assets of at least 8% and a minimum ratio of Tier 1 capital to risk-weighted assets of at least 4%. At least half of the total capital must be Tier 1 capital, which includes common equity, retained earnings and qualifying perpetual preferred stock, less certain intangibles and other adjustments. The remainder may consist of Tier 2 capital, such as a limited amount of subordinated and other qualifying debt (including certain hybrid capital instruments), other qualifying preferred stock and a limited amount of the general loan loss allowance. At December 31, 2010, the total capital to risk-weighted asset ratio of Bankshares was 12.9% and the ratio of the Bank was 12.8%. At December 31, 2010, the Tier 1 capital to risk-weighted asset ratio was 11.6% for Bankshares and 11.5% for the Bank.

 

In addition, each of the federal regulatory agencies has established leverage capital ratio guidelines for banking organizations. These guidelines provide for a minimum Tier l leverage ratio of 4.0% for banks and bank holding companies. At December 31, 2010, the Tier l leverage ratio was 7.5 percent for Bankshares and 7.4% for the Bank. The guidelines also provide that banking organizations experiencing internal growth or making acquisitions must maintain capital positions substantially above the minimum supervisory levels, without significant reliance on intangible assets.

 

In December 2010, the Basel Committee on Banking Supervision (the Basel Committee) released its final framework for strengthening international capital and liquidity regulation, now officially identified by the Basel Committee as “Basel III.” Basel III, when implemented by the U.S. banking agencies and fully phased-in, will require bank holding companies and their bank subsidiaries to maintain substantially more capital, with a greater emphasis on common equity. Implementation is presently scheduled to be phased in between 2014 and 2019, although it is possible that implementation may be delayed as a result of multiple factors including the current condition of the banking industry within the U.S. and abroad.

 

The Basel III final capital framework, among other things, (i) introduces as a new capital measure “Common Equity Tier 1” (CET1), (ii) specifies that Tier 1 capital consists of CET1 and “Additional Tier 1 capital” instruments meeting specified requirements, (iii) defines CET1 narrowly by requiring that most adjustments to regulatory capital measures be made to CET1 and not to the other components of capital and (iv) expands the scope of the adjustments as compared to existing regulations.

 

When fully phased in on January 1, 2019, Basel III requires banks to maintain (i) as a newly adopted international standard, a minimum ratio of CET1 to risk-weighted assets of at least 4.5%, plus a 2.5% “capital conservation buffer” (which is added to the 4.5% CET1 ratio as that buffer is phased in, effectively resulting in a minimum ratio of CET1 to risk-weighted assets of at least 7%), (ii) a minimum ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus the capital conservation buffer (which is added to the 6.0% Tier 1 capital ratio as that buffer is phased in, effectively resulting in a minimum Tier 1 capital ratio of 8.5% upon full implementation), (iii) a minimum ratio of Total (that is, Tier 1 plus Tier 2) capital to risk-weighted assets of at least 8.0%, plus the capital conservation buffer (which is added to the 8.0% total capital ratio as that buffer is phased in, effectively resulting in a minimum total capital ratio of 10.5% upon full implementation) and (iv) as a newly adopted international standard, a minimum leverage ratio of 3%, calculated as the ratio of Tier 1 capital to balance sheet exposures plus certain off-balance sheet exposures (computed as the average for each quarter of the month-end ratios for the quarter).

 

Basel III also provides for a “countercyclical capital buffer,” generally to be imposed when national regulators determine that excess aggregate credit growth becomes associated with a buildup of systemic risk, that would be a

CET1 add-on to the capital conservation buffer in the range of 0% to 2.5% when fully implemented (potentially resulting in total buffers of between 2.5% and 5%).

 

The aforementioned capital conservation buffer is designed to absorb losses during periods of economic stress. Banking institutions with a ratio of CET1 to risk-weighted assets above the minimum but below the conservation buffer (or below the combined capital conservation buffer and countercyclical capital buffer, when the latter is applied) will face constraints on dividends, equity repurchases and compensation based on the amount of the shortfall.

 

The implementation of the Basel III final framework will commence January 1, 2013. On that date, banking institutions will be required to meet the following minimum capital ratios:

 

 

The Basel III final framework provides for a number of new deductions from and adjustments to CET1. These include, for example, the requirement that mortgage servicing rights, deferred tax assets dependent upon future taxable income and significant investments in non-consolidated financial entities be deducted from CET1 to the extent that any one such category exceeds 10% of CET1 or all such categories in the aggregate exceed 15% of CET1.

 

Implementation of the deductions and other adjustments to CET1 will begin on January 1, 2014 and will be phased-in over a five-year period (20% per year). The implementation of the capital conservation buffer will begin on January 1, 2016 at 0.625% and be phased in over a four-year period (increasing by that amount on each subsequent January 1, until it reaches 2.5% on January 1, 2019).

 

The U.S. banking agencies have indicated informally that they expect to propose regulations implementing Basel III in mid-2011 with final adoption of implementing regulations in mid-2012. Notwithstanding its release of the Basel III framework as a final framework, the Basel Committee is considering further amendments to Basel III, including the imposition of additional capital surcharges on globally systemically important financial institutions. In addition to Basel III, the Dodd-Frank Act requires or permits the federal banking agencies to adopt regulations affecting banking institutions’ capital requirements in a number of respects, including potentially more stringent capital requirements for systemically important financial institutions.

 

Accordingly, the regulations ultimately applicable to Bankshares may be substantially different from the Basel III final framework as published in December 2010. Requirements to maintain higher levels of capital or to maintain higher levels of liquid assets could adversely impact the Bankshares’ net income and return on equity.

 

Payment of Dividends

 

As a bank holding company, Bankshares is a separate legal entity from the Bank. Virtually all of Bankshares’ income results from dividends paid to it by the Bank. Both Bankshares and the Bank are subject to laws and regulations that limit the payment of dividends, including requirements to maintain capital at or above regulatory minimums. Banking regulators have indicated that Virginia banking organizations should generally pay dividends only (1) from net undivided profits of the bank, after providing for all expenses, losses, interest and taxes accrued or due by the bank and (2) if the prospective rate of earnings retention appears consistent with the organization’s capital needs, asset quality and overall financial position. In addition, the Federal Deposit Insurance Act prohibits insured depository institutions such as the Bank from making capital distributions, including the payment of dividends, if, after making such distribution, the institution would become undercapitalized as defined in the statute.

The Dodd-Frank Act

 

On July 21, 2010, financial regulatory reform legislation entitled the “Dodd-Frank Wall Street Reform and Consumer Protection Act” (the Dodd-Frank Act) was signed into law. The Dodd-Frank Act implements far-reaching changes across the financial regulatory landscape, including provisions that, among other things, will:

 

 

Many aspects of the Dodd-Frank Act are subject to rulemaking and will take effect over several years, making it difficult to anticipate the overall financial impact on Bankshares, its subsidiaries, its customers or the financial industry more generally. Provisions in the legislation that affect the payment of interest on demand deposits and interchange fees are likely to increase the costs associated with deposits as well as place limitations on certain revenues those deposits may generate. Provisions in the legislation that revoke the Tier 1 capital treatment of trust preferred securities and otherwise require revisions to the capital requirements of Bankshares and the Bank could require Bankshares and the Bank to seek other sources of capital in the future. Some of the rules that have been proposed and, in some cases, adopted to comply with the Dodd-Frank Act’s mandates are discussed further below.

Incentive Compensation

 

In June 2010, the Federal Reserve, the Office of the Comptroller of the Currency and the FDIC issued a comprehensive final guidance on incentive compensation intended to ensure that the incentive compensation policies of banking organizations do not undermine the safety and soundness of such organizations by encouraging excessive risk-taking. The guidance, which covers all employees that have the ability to materially affect the risk profile of an organization, either individually or as part of a group, is based upon the key principles that a banking organization’s incentive compensation arrangements should (i) provide incentives that do not encourage risk-taking beyond the organization’s ability to effectively identify and manage risks, (ii) be compatible with effective internal controls and risk management, and (iii) be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors.

 

The Federal Reserve will review, as part of the regular, risk-focused examination process, the incentive compensation arrangements of banking organizations, such as Bankshares, that are not “large, complex banking organizations.” These reviews will be tailored to each organization based on the scope and complexity of the organization’s activities and the prevalence of incentive compensation arrangements. The findings of the supervisory initiatives will be included in reports of examination. Deficiencies will be incorporated into the organization’s supervisory ratings, which can affect the organization’s ability to make acquisitions and take other actions. Enforcement actions may be taken against a banking organization if its incentive compensation arrangements, or related risk-management control or governance processes, pose a risk to the organization’s safety and soundness and the organization is not taking prompt and effective measures to correct the deficiencies.

 

Prompt Corrective Action

 

The federal banking agencies have broad powers under current federal law to take prompt corrective action to resolve problems of insured depository institutions. The extent of these powers depends upon whether the institution in question is “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” or “critically undercapitalized” under the risk-based and leverage capital guidelines discussed above. These terms are defined under uniform regulations issued by each of the federal banking agencies regulating these institutions. An insured depository institution which is less than adequately capitalized must adopt an acceptable capital restoration plan, is subject to increased regulatory oversight and is increasingly restricted in the scope of its permissible activities. As of December 31, 2010, Bankshares was considered “well capitalized.”

 

Gramm Leach Bliley Act of 1999

 

The Gramm Leach Bliley Act (the GLB Act) allows a bank holding company or other company to declare and certify its status as a financial holding company, which will allow it to engage in activities that are financial in nature, that are incidental to such activities, or are complementary to such activities. The GLB Act enumerates certain activities that are deemed financial in nature, such as underwriting insurance or acting as an insurance principal, agent or broker, underwriting, dealing in or making markets in securities, and engaging in merchant banking under certain restrictions. It also authorizes the Federal Reserve to determine by regulation what other activities are financial in nature, or incidental or complementary thereto.

 

In order for a bank holding company to qualify as a financial holding company, all of its depository subsidiaries must be “well capitalized” and well managed, and must meet their Community Reinvestment Act of 1977 (CRA) obligations. The bank holding company also must declare its intention to become a financial holding company to the Federal Reserve and certify that it meets the requirements. Although Bankshares could qualify to be a financial holding company, Bankshares does not currently contemplate seeking to become a financial holding company until it identifies significant specific benefits from doing so.

 

The GLB Act also imposes customer privacy requirements on financial institutions. Financial institutions generally are prohibited from disclosing customer information to non-affiliated third parties, unless the customer has been given the opportunity to object and has not objected to such disclosure. Financial institutions must disclose their specific privacy policies to their customers annually. Upon making such disclosure, there is no specific restriction on financial institutions disclosing customer information to affiliated parties. Financial institutions must comply with state law, however, if it protects customer privacy more fully than federal law.

The cumulative effect of the GLB Act and other recent bank legislation has caused us to strengthen our staff to handle the procedures required by this additional regulation. The increased staff and operational costs have impacted the Bank and Bankshares’ profitability.

 

Regulation of Alliance Bank

 

The Bank is a Virginia chartered commercial bank and a member of the Federal Reserve System. Its deposit accounts are insured by the Deposit Insurance Fund (DIF) of the FDIC up to the maximum legal limits of the FDIC and it is subject to regulation, supervision and regular examination by the Bureau and the Federal Reserve. The regulations of these various agencies govern most aspects of the Bank’s business, including required reserves against deposits, loans, investments, mergers and acquisitions, borrowings, dividends, location and number of branch offices. The laws and regulations governing the Bank generally have been promulgated to protect depositors and the deposit insurance funds, and not for the purpose of protecting shareholders.

 

Insurance of Accounts, Assessments and Regulation by the FDIC

 

The Bank’s deposits are insured up to applicable limits by the DIF of the FDIC. The FDIC amended its risk-based assessment system in 2007 to implement authority granted by the Federal Deposit Insurance Reform Act of 2005 (FDIRA). Under the revised system, insured institutions are assigned to one of four risk categories based on supervisory evaluations, regulatory capital levels and certain other factors. An institution’s assessment rate depends upon the category to which it is assigned. Unlike the other categories, Risk Category I, which contains the least risky depository institutions, contains further risk differentiation based on the FDIC’s analysis of financial ratios, examination component ratings and other information. Assessment rates are determined by the FDIC and, for calendar year 2008, assessments ranged from five to 43 basis points of each institution’s deposit assessment base. Due to losses incurred by the DIF in 2008 from failed institutions, and anticipated future losses, the FDIC adopted an across the board seven basis point increase in the assessment range for the first quarter of 2009. The FDIC made further refinements to its risk-based assessment that became effective April 1, 2009, and effectively made the range seven to 77.5 basis points. The FDIC may adjust rates uniformly from one quarter to the next, except that no single adjustment can exceed three basis points.

 

The Emergency Economic Stabilization Act of 2008 temporarily raised the basic limit on federal deposit insurance coverage from $100,000 to $250,000 per depositor. The legislation originally provided that the basic deposit insurance limit would return to $100,000 after December 31, 2009. The legislation did not change coverage for retirement accounts, which continues to be $250,000. In July 2010, the Dodd-Frank Act made permanent the $250,000 limit for federal deposit insurance.

 

In November 2008, the FDIC adopted a final rule implementing the Temporary Liquidity Guarantee Program (TLGP) because of disruptions in the credit markets, particularly the interbank lending market, which reduced banks’ liquidity and impaired their ability to lend. The goal of the TLGP is to decrease the cost of bank funding so that bank lending to consumers and businesses will normalize. The TLGP is industry funded and does not rely on the DIF to achieve its goals. The TLGP consists of two components: a temporary guarantee of certain newly-issued senior unsecured debt (the Debt Guarantee Program) and a temporary unlimited guarantee of funds in noninterest-bearing transaction accounts at FDIC-insured institutions (the Transaction Account Guarantee Program). The Bank is participating in both of these programs and will be required to pay assessments associated with the TLGP as follows:

 

 

In May 2009, the FDIC adopted a final rule imposing a five basis point special assessment on each insured depository institution’s assets minus Tier 1 capital as of June 30, 2009. The assessment was part of the FDIC’s efforts to rebuild the DIF and help maintain public confidence in the banking system. The Bank was assessed $299,000, all of which was expensed in 2009.

 

In November 2009, the FDIC adopted a final rule requiring insured depository institutions to prepay their estimated quarterly risk-based assessments for the fourth quarter of 2009, and for all of 2010, 2011 and 2012, on December 31, 2009, along with each institution’s risk-based deposit insurance assessment for the third quarter of 2009. The prepayment was based on an institution’s assessment rate and assessment base for the third quarter of 2009, assuming a five percent annual growth in deposits each year. While the FDIC plan would maintain current assessment rates through 2010, effective January 1, 2011, the rates would increase by three basis points across the board. The FDIC has elected to forgo this increase under a new DIF restoration plan adopted in October 2010 as discussed below. On December 30, 2009, the Bank prepaid $5.4 million of FDIC assessments.

 

In October 2010, the FDIC adopted a new DIF restoration plan to ensure that the fund reserve ratio reaches 1.35 percent by September 30, 2020, as required by the Dodd-Frank Act. Under the new restoration plan, the FDIC will forego the uniform three-basis point increase in initial assessment rates scheduled to take place on January 1, 2011 and maintain the current schedule of assessment rates for all depository institutions. At least semi-annually, the FDIC will update its loss and income projections for the fund and, if needed, will increase or decrease assessment rates, following notice-and-comment rulemaking if required.

 

In November 2010 and January 2011, the FDIC issued final rules to implement provisions of the Dodd-Frank Act and other federal legislation that provide for temporary unlimited coverage for noninterest-bearing transaction accounts beginning January 1, 2011 and continuing through December 2012. For purposes of this extension, the definition of noninterest-bearing transaction accounts excludes negotiable order of withdraw consumer checking accounts (NOW accounts) but includes Interest on Lawyer Trust Accounts (IOLTAs). The extended program is not optional and will no longer be funded by separate premiums.

 

In February 2011, the FDIC approved a final rule that changes the assessment base from domestic deposits to average consolidated total assets minus average tangible equity (defined as Tier 1 capital); adopts a new large-bank pricing assessment scheme; and sets a target size for the DIF. The changes will go into effect beginning with the second quarter of 2011 and will be payable at the end of September 2011. The rule, as mandated by the Dodd-Frank Act, finalizes a target size for the DIF at 2 percent of insured deposits. It also implements a lower assessment rate schedule when the fund reaches 1.15% and, in lieu of dividends, provides for a lower rate schedule when the reserve ratio reaches 2% and 2.5%.

 

Monetary and Fiscal Policy Effects on Interest Rates

 

Banking is a business that depends on interest rate differentials. In general, the difference between the interest paid by the Bank on its deposits and its other borrowings and the interest received by it on loans extended to its customers and securities held in its trading or investment portfolios, constitute the major portion of the Bank’s earnings. Thus, our earnings and growth are subjected to the influence of economic conditions both domestic and foreign, and also to the monetary and fiscal policies of the United States and its agencies, particularly the Federal Reserve, which regulates the supply of money through various means including open market dealings in United States government securities. The nature and timing of changes in such policies, and their potential impact on the Bank and Bankshares, cannot be predicted.

 

Interstate Banking and Branching

 

The federal banking agencies are authorized to approve interstate bank merger transactions without regard to whether the transaction is prohibited by the law of any state, unless the home state of one of the banks has opted out of the interstate bank merger provisions of the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the Riegle-Neal Act) or by adopting a law after the date of enactment of the Riegle-Neal Act and prior to

June 1, 1997, that applies equally to all out-of-state banks and expressly prohibits merger transactions involving out-of-state banks. Interstate acquisitions of branches are permitted only if the law of the state in which the branch is located permits such acquisitions. Such interstate bank mergers and branch acquisitions are also subject to the nationwide and statewide insured deposit concentration limitations described in the Riegle-Neal Act.

 

All banks located in Virginia are authorized to branch statewide. Accordingly, a bank located anywhere in Virginia has the ability, subject to regulatory approval, to establish branch facilities near any of our facilities and within the Bank’s market area. Applicable Virginia statutes permit regulatory authorities to approve de novo branching in Virginia by institutions located in states that would permit Virginia institutions to branch on a de novo basis into those states. Prior to the enactment of the Dodd-Frank Act, national and state-chartered banks were generally permitted to branch across state lines by merging with banks in other states if allowed by the applicable states’ laws. However, interstate branching is now permitted for all national and state-chartered banks as a result of the Dodd-Frank Act, provided that a state bank chartered by the state in which the branch is to be located would also be permitted to establish a branch, thus effectively giving out of state banks parity with in state banks with respect to de novo branching.

 

Regulatory Enforcement Authority

 

Federal banking law grants substantial enforcement powers to federal banking regulators. This enforcement authority includes, among other things, the ability to assess civil money penalties, to issue cease and desist or removal orders and to initiate injunctive actions against banking organizations and institution-affiliated parties. In general, these enforcement actions may be initiated for violations of laws and regulations and unsafe or unsound practices. Other actions or inactions may provide the basis for enforcement action, including misleading or untimely reports filed with regulatory authorities.

 

Transactions with Affiliates

 

Transactions between banks and their affiliates are governed by Sections 23A and 23B of the Federal Reserve Act. An affiliate of a bank is any bank or entity that controls, is controlled by or is under common control with such bank. Generally, Section 23A(a) limits the extent to which a bank or its subsidiaries may engage in “covered transactions” with any one affiliate to an amount equal to 10% of such institution’s capital stock and surplus, and maintain an aggregate limit on all such transactions with affiliates to an amount equal to 20% of such capital stock and surplus, and (b) requires that all such transactions be on terms substantially the same, or at least as favorable, to the bank as those provided to a nonaffiliate. The term “covered transaction” includes the making of loans, purchase of assets, issuance of a guarantee, asset repurchase agreements and similar other types of transactions. Section 23B applies to “covered transactions” as well as sales of assets and payments of money to an affiliate. These transactions must also be conducted on terms substantially the same, or at least as favorable, to the bank as those provided to nonaffiliates.

 

Community Reinvestment Act (CRA)

 

The CRA encourages each insured depository institution covered by the act to help meet the credit needs of the communities in which it operates. The CRA requires that each federal financial supervisory agency assess the record of each covered depository institution helping to meet the credit needs of its entire community, including low-and-moderate income neighborhoods, consistent with safe and sound operations; an agency will take that record into account when deciding whether to approve an institution’s application for a deposit facility.

 

The Bank received a satisfactory CRA rating from the Federal Reserve Bank of Richmond following the Bank’s last CRA compliance review. An institution classified in this group has a satisfactory record of ascertaining and helping to meet the credit needs of its entire delineated community, including low- and moderate-income neighborhoods, in a manner consistent with its resources and capabilities.

 

Loans to Insiders

 

The Federal Reserve Act and related regulations impose specific restrictions on loans to directors, executive officers and principal shareholder of banks. Under Section 22(h) of the Federal Reserve Act, any loan to a director,

an executive officer or to a principal shareholder of a bank, or to entities controlled by any of the foregoing, may not exceed, together with all outstanding loans to such persons or entities controlled by such person, the bank’s loan to one borrower limit. For purposes of Section 22 of the Federal Reserve Act, the Dodd-Frank Act has included in the concept of “loans to an insider” other extensions of credit including repurchase agreements, derivative transactions, and securities lending or borrowing transactions. Loans in the aggregate to insiders of the related interest as a class may not exceed two times the bank’s unimpaired capital and unimpaired surplus until the bank’s total assets equal or exceed $100 million, at which time the aggregate is limited to the bank’s unimpaired capital and unimpaired surplus. Section 22(h) also prohibits loans above amounts prescribed by the appropriate federal banking agency to directors, executive officers, and principal shareholders of a bank or bank holding company, and to entities controlled by such persons, unless such loans are approved in advance by a majority of the board of directors of the bank with any “interested” director not participating in the voting. The loan amount, which includes all other outstanding loans to such person, as to which such prior board of director approval is required, is the greater of $25,000 or 5% of capital and surplus (up to $500,000). Section 22(h) requires that loans to directors, executive officers and principal shareholders be made on terms and with underwriting standards that are substantially the same as those offered in comparable transactions to other persons. Further, section 402 of the Sarbanes-Oxley Act of 2002, with certain exceptions; prohibit loans to directors and executive officers.

 

Other Regulations

 

Bankshares maintains a compliance department to ensure it is in compliance with consumer protection laws and regulations.

 

Bank Secrecy Act (BSA).  Under the Bank Secrecy Act, a financial institution is required to have systems in place to detect certain transactions, based on the size and nature of the transaction. Financial institutions are generally required to report cash transactions involving more than $10,000 to the Treasury. In addition, financial institutions are required to file suspicious activity reports for transactions that involve more than $5,000 and /or which the financial institution knows, suspects or has reason to suspect, involves illegal funds, is designed to evade the requirements of the BSA or has no lawful purpose.

 

USA Patriot Act.  The USA Patriot Act, which became effective on October 26, 2001, amends the Bank Secrecy Act and is intended to facilitate information sharing among governmental entities and financial institutions for the purpose of combating terrorism and money laundering. Among other provisions, the USA Patriot Act permits financial institutions, upon providing notice to the Treasury, to share information with one another in order to better identify and report to the federal government activities that may involve money laundering or terrorists’ activities. The USA Patriot Act is considered a significant banking law in terms of information disclosure regarding certain customer transactions. Certain provisions of the USA Patriot Act impose the obligation to establish anti-money laundering programs, including the development of a customer identification program, and the screening of all customers against any government lists of known or suspected terrorists. Although it does create a reporting obligation and there is a cost of compliance, the USA Patriot Act does not materially affect the Bank’s products, services or other business activities.

 

Reporting Terrorist Activities.  The Federal Bureau of Investigation (FBI) has sent, and will send, banking regulatory agencies lists of the names of persons suspected of involvement in terrorist activities. The Bank has been requested, and will be requested, to search its records for any relationships or transactions with persons on those lists. If the Bank finds any relationships or transactions, it must file a suspicious activity report with the Treasury and contact the FBI.

 

The Office of Foreign Assets Control (OFAC), which is a division of the Treasury, is responsible for helping to insure that United States entities do not engage in transactions with “enemies” of the United States, as defined by various Executive Orders and Acts of Congress. OFAC sends banking regulatory agencies lists of names of persons and organizations suspected of aiding, harboring or engaging in terrorist acts. If the Bank finds a name on any transaction, account or wire transfer that is on an OFAC list, it must freeze such account, file a suspicious activity report with the Treasury and notify the FBI. The Bank has appointed an OFAC compliance officer to oversee the inspection of its accounts and the filing of any notifications. The Bank actively checks high-risk areas such as new accounts, wire transfers and customer files. The Bank performs these checks utilizing software that is updated each

time a modification is made to the lists of Specially Designated Nationals and Blocked Persons provided by OFAC and other agencies.

 

Interagency Appraisal and Evaluation Guidelines.  In December 2010, the Federal Reserve Board, the Office of the Comptroller of the Currency and the FDIC, jointly with other federal regulatory agencies, issued the Interagency Appraisal and Evaluation Guidelines. This guidance, which updates guidance originally issued in 1994, sets forth the minimum regulatory standards for appraisals. The guidance incorporates previous regulatory issuances affecting appraisals, addresses advances in information technology used in collateral evaluation, and clarifies standards for use of analytical methods and technological tools in developing evaluations. The guidance also requires institutions to use strong internal controls to ensure reliable appraisals and evaluations and to monitor and periodically update valuations of collateral for existing real estate loans and transactions.

 

Future Regulatory Uncertainty

 

Legislative Initiatives.  From time to time, various legislative and regulatory initiatives are introduced in Congress and state legislatures, as well as by regulatory agencies. Such initiatives may include proposals to expand or contract the powers of bank holding companies and depository institutions or proposals to substantially change the financial institution regulatory system. Such initiatives may change banking statutes and the operating environment for Bankshares and the Bank in substantial and unpredictable ways. It is difficult to determine the ultimate effect that any potential legislation, if enacted, or implementing regulations with respect thereto, would have, upon the financial condition or results of our operations or the operations of Bankshares or the Bank. A change in statute, regulations or regulatory policies applicable to us or the Bank could have a material effect on the financial condition, results of operations or business of Bankshares and the Bank.

 

INTERNET ACCESS TO CORPORATE DOCUMENTS

 

Information about Bankshares can be found on the Bank’s website at www.alliancebankva.com. Under “Documents/SEC Filings” in the Investor Relations section of the website, Bankshares posts its annual reports, quarterly reports, current reports, definitive proxy materials and any amendments to those reports as soon as reasonably practicable after they are electronically filed with or furnished to the SEC. All such filings are available free of charge.

 

 

Our credit risk management approach or processes can impact our results.  We have a disciplined approach to credit allocation. In the event our risk processes indicate a business strategy towards or away from a certain loan type, we may create a concentration of credit which could be positively or negatively impacted by economic factors. Our credit risk management approach is dependent on our personnel accurately and adequately identifying current and inherent risks in loan transactions and loan products. Although we believe our credit risk management approach is appropriate, the failure to accurately identify risks in loan transactions could negatively affect our financial condition and performance.

 

Our focus on commercial and real estate loans may increase the risk of credit losses, which would negatively affect our financial results.  We offer a variety of loans including commercial lines of credit, commercial term loans, real estate, construction, home equity, consumer and other loans. Many of our loans are secured by real estate (both residential and commercial) in the greater Washington, D.C. metropolitan area. A continued downturn in this real estate market, such as further deterioration in the value of this collateral, or in the local or national economy and job markets, could adversely affect our customers’ ability to pay these loans, which in turn could adversely affect us. Risk of loan defaults and foreclosures are unavoidable in the banking industry, and we try to limit our exposure to this risk by monitoring our extensions of credit carefully. We cannot fully eliminate credit risk, and as a result credit losses may occur in the future.

 

If our allowance for loan losses becomes inadequate, our results of operations may be adversely affected.  We maintain an allowance for loan losses that we believe is adequate to absorb any potential losses in our loan portfolio. Through a periodic review and consideration of the loan portfolio, management determines the amount of the allowance for loan losses by considering general market conditions, credit quality of the loan portfolio and

performance of our customers relative to their financial obligations with us. The amount of future losses is susceptible to changes in economic, operating and other conditions, including changes in interest rates that may be beyond our control, and these future losses may exceed our current estimates. Although we believe the allowance for loan losses is adequate to absorb probable losses in our loan portfolio, we cannot predict such losses or provide assurance that our allowance will be adequate in the future. Excessive loan losses could have a material adverse impact on our financial performance.

 

Federal and state regulators, as an integral part of their supervisory function, periodically review our allowance for loan losses. These regulatory agencies may require us to increase our provision for loan losses or to recognize further loan charge-offs based upon their judgments, which may be different from ours. Any increase in the allowance for loan losses required by these regulatory agencies could have a negative effect on our financial condition and results of operations.

 

If the value of real estate in our market areas was to decline materially, a significant portion of our loan portfolio could become under-collateralized, which could have a material adverse effect on our asset quality, capital structure and profitability.  As of December 31, 2010, a significant portion of our loan portfolio is comprised of loans secured by either commercial real estate or 1-4 family residential properties. In the majority of these loans, real estate was the primary collateral component. In some cases, and out of an abundance of caution, we take real estate as security for a loan even when it is not the primary component of collateral. The real estate collateral that provides the primary or an alternate source of repayment in the event of default may deteriorate in value during the term of the loan as a result of changes in economic conditions, fluctuations in interest rates and the availability of loans to potential purchasers, changes in tax and other laws and acts of nature. If we are required to liquidate the collateral securing a loan to satisfy the debt during a period of reduced real estate values, which we have seen and continue to experience, our earnings and capital could be adversely affected. We are subject to increased lending risks in the form of loan defaults as a result of the high concentration of real estate lending in our loan portfolio should the real estate market in Virginia and our market area maintain its downward turn. Continued weakness of the real estate market in our primary market areas could have an adverse effect on the demand for new loans, the ability of borrowers to repay outstanding loans, the value of real estate and other collateral securing the loans and the value of real estate owned by us. If real estate values decline further, it is also more likely that we would be required to increase our allowance for loan losses, which could adversely affect our financial condition and results of operations.

 

If we need additional capital in the future to achieve or maintain our targeted regulatory capital levels, we may not be able to obtain it on terms that are favorable. This could negatively affect our performance and the value of our common stock. Our business strategy calls for balance sheet repositioning and loan growth while maintaining an adequate capital buffer above the “well capitalized” status. If our balance sheet composition and risk profile changes, we may need to expand the acceptable range of the capital buffer above our current targeted levels. Our ability to raise capital through the sale of additional securities will depend primarily upon our financial condition and the condition of financial markets at that time. We may not be able to obtain additional capital in the amounts needed or on terms satisfactory to us or to our shareholders.

 

The Basel III capital requirements may require us to maintain higher levels of capital, which could reduce our profitability.  The recent adoption of Basel III targets higher levels of base capital, certain capital buffers and a migration toward common equity as the key source of regulatory capital. Although the new capital requirements are phased in over the next decade and may change substantially before final implementation, Basel III signals a growing effort by domestic and international bank regulatory agencies to require financial institutions, including depository institutions, to maintain higher levels of capital. The direction of the Basel III implementation activities or other regulatory viewpoints could require additional capital to support our business risk profile prior to final implementation of the Basel III standards. If Bankshares and the Bank are required to maintain higher levels of capital, Bankshares and the Bank may have fewer opportunities to invest capital into interest-earning assets, which could limit the profitable business operations available to Bankshares and the Bank and adversely impact our financial condition and results of operations.

 

We have been effective in a specific market niche, which creates an industry concentration.  We have made a special effort to obtain deposits from title and mortgage loan closing companies. These are monies held for short

periods of time by title and mortgage loan closing companies pending the disbursement of funds in mortgage loan or mortgage loan refinancing transactions. The balances on deposit with us from these depositors tend to fluctuate greatly during any given month, depending on transaction scheduling and overall market conditions. These balances represent a substantial portion of our non-interest bearing deposits, which creates a real estate industry concentration. These deposits are subject to seasonal and cyclical market fluctuations and are particularly sensitive to slower real estate markets. In order to meet the withdrawal needs of these customers, we monitor our liquidity, investment securities and lines of credit on a constant basis. The attractive nature of this deposit base or market niche has generated substantial banking competition for this type of client. Because of this industry concentration in our deposits, we are exposed to liquidity and concentration risks attendant to changes in real estate markets, which could adversely impact our overall performance.

 

We depend on the services of key personnel, and a loss of any of those personnel could disrupt our operations and result in reduced earnings.  We are a customer focused and relationship driven organization. Our growth and success has been in large part driven by the personal customer relationships maintained by our executives. Although we have entered into employment contracts with our executive officers, we cannot offer any assurance that they and other key employees will remain employed by us. The recent departure of a senior executive responsible for the title and escrow line of business could have an impact on the Bank’s key business lines if customers and accounts with which the senior executive maintained close relationships were to end their business relationships with the Company in the future. The loss of services of key employees or client relationship managers could reduce the number of quality accounts maintained at the Bank, which could have a material adverse effect on our operations and possibly result in reduced revenues and earnings.

 

The success of our future recruiting and employee retention efforts will impact our ability to execute our business strategy.  Our business strategy will require us to continue to attract, hire, motivate and retain skilled personnel to develop new customer relationships as well as new financial products and services. Many experienced banking professionals employed by our competitors are covered by agreements not to compete or solicit their existing customers if they were to leave their current employment. These agreements make the recruitment of these professionals more difficult in a competitive labor market. In light of the presently competitive labor market, we cannot assure you that we will be successful in attracting, hiring, motivating or retaining qualified and high-performing, experienced banking professionals. In addition, we are deploying resources to attract additional relationship officers and staff personnel, but cannot guarantee that this investment of money and management time will be successful. The success of our recruiting efforts may impact our ability to execute our business strategy and our future profitability.

 

Liquidity risk could impair our ability to fund operations and jeopardize our financial condition, results of operations and cash flows.  Liquidity is essential to our business. Our ability to implement our business strategy will depend on our ability to obtain funding for loan originations, working capital and other general corporate purposes. An inability to raise funds through deposits, borrowing, and securities sold under repurchase agreements, the sale of loans and other sources could have a substantial negative effect on our liquidity. We do not anticipate that our retail and commercial deposits will be fully sufficient to meet our funding needs in the foreseeable future. We therefore rely on deposits obtained through intermediaries, FHLB advances, securities sold under agreements to repurchase and other wholesale funding sources to obtain the funds necessary to implement our growth strategy.

 

Our access to funding sources in amounts adequate to finance our activities or on terms which are acceptable to us could be impaired by factors that affect us specifically or the financial services industry or economy in general, including a decrease in the level of our business activity as a result of a downturn in the markets in which our loans are concentrated or adverse regulatory action against us. Our ability to borrow could also be impaired by factors that are not specific to us, such as a disruption in the financial markets or negative views and expectations about the prospects for the financial services industry in light of the recent turmoil faced by banking organizations and the continued deterioration in credit markets. To the extent we are not successful in obtaining such funding, we will be unable to implement our strategy as planned which could have a material adverse effect on our financial condition, result of operations and cash flows.

 

Difficult market conditions have adversely affected our industry.  Dramatic declines in the housing market over the past few years, with falling home prices and increasing foreclosures, unemployment and under-

employment, have negatively impacted the credit performance of real estate related loans and resulted in significant write-downs of asset values by financial institutions. Reflecting concern about the stability of the financial markets generally and the strength of counterparties, many lenders and institutional investors have reduced or ceased providing funding to borrowers, including to other financial institutions. This market turmoil and tightening of credit have led to an increased level of commercial and consumer delinquencies, lack of consumer confidence, increased market volatility and widespread reduction of business activity generally. The resulting economic pressures on consumers and lack of confidence in the financial markets have adversely affected our business and results of operations. Market developments may affect consumer confidence levels and may cause adverse changes in payment patterns, causing increases in delinquencies and default rates, which may impact our charge-offs and provision for credit losses. A worsening of these conditions would likely exacerbate the adverse effects of these difficult market conditions on us and others in the financial institutions industry.

 

Our future success is dependent on our ability to compete effectively in the highly competitive banking industry.  The Northern Virginia and the greater Washington, D.C. metropolitan area in which we operate is considered highly attractive from an economic and demographic viewpoint, and is therefore a highly competitive banking market. Our future growth and success will depend on our ability to compete effectively in this highly competitive financial services environment. We compete for loans, deposits, and investment dollars with numerous large, regional and national banks and other community banking institutions, as well as other kinds of financial institutions and enterprises, such as securities firms, insurance companies, savings associations, credit unions, and private lenders. Many competitors offer products and services we do not offer and many have substantially greater resources, name recognition and market presence that benefit them in attracting business. In addition, some competitors may be able to price loans and deposits more aggressively than we do. Some of the financial services organizations with which we compete are not subject to the same degree of regulation as is imposed on bank holding companies and federally insured state-chartered banks, national banks and federal savings institutions. As a result, these nonbank competitors have certain advantages over us in accessing funding and in providing various services. The differences in resources and regulations may make it harder for us to compete profitably, reduce the rates that we can earn on loans and investments, increase the rates we must offer on deposits and other funds, and adversely affect our overall financial condition and earnings.

 

The Dodd-Frank Act could increase our regulatory compliance burden and associated costs, place restrictions on certain products and services, and limit our future capital raising strategies.  A wide range of regulatory initiatives directed at the financial services industry have been proposed in recent months. One of those initiatives, the Dodd-Frank Act, was signed into law on July 21, 2010. The Dodd-Frank Act represents a sweeping overhaul of the financial services industry within the United States and mandates significant changes in the financial regulatory landscape that will impact all financial institutions, including the Company. The Dodd-Frank Act will likely increase our regulatory compliance burden and may have a material adverse effect on us, by increasing the costs associated with our regulatory examinations and compliance measures. The federal regulatory agencies, and particularly bank regulatory agencies, are given significant discretion in drafting the Dodd-Frank Act’s implementing rules and regulations and, consequently, many of the details and much of the impact of the Dodd-Frank Act will depend on the final implementing rules and regulations. Accordingly, it remains too early to fully assess the impact of the Dodd-Frank Act and subsequent regulatory rulemaking processes on our business, financial condition or results of operations.

 

Among the Dodd-Frank Act’s significant regulatory changes, the Dodd-Frank Act creates a new financial consumer protection agency that could impose new regulations on us and include its examiners in our routine regulatory examinations conducted by the FDIC, which could increase our regulatory compliance burden and costs and restrict the financial products and services we can offer to our customers. This agency, named the Consumer Financial Protection Bureau, may reshape the consumer financial laws through rulemaking and enforcement of the Dodd-Frank Act’s prohibitions against unfair, deceptive and abusive business practices, which may directly impact the business operations of financial institutions offering consumer financial products or services, including the Company. This agency’s broad rulemaking authority includes identifying practices or acts that are unfair, deceptive or abusive in connection with any consumer financial transaction or consumer financial product or service. Although the Consumer Financial Protection Bureau has jurisdiction over banks with $10 billion or greater in assets, rules, regulations and policies issued by the Bureau may also apply to the Company or its subsidiaries by

virtue of the adoption of such policies and best practices by the Federal Reserve and FDIC. The costs and limitations related to this additional regulatory agency and the limitations and restrictions that will be placed upon the Company with respect to its consumer product and service offerings have yet to be determined. However, these costs, limitations and restrictions may produce significant, material effects on our business, financial condition and results of operations

 

The Dodd-Frank Act also increases regulatory supervision and examination of bank holding companies and their banking and non-banking subsidiaries, which could increase our regulatory compliance burden and costs and restrict our ability to generate revenues from non-banking operations. The Dodd-Frank Act imposes more stringent capital requirements on bank holding companies, which could limit our future capital strategies. The Dodd-Frank Act also increases regulation of derivatives and hedging transactions, which could limit our ability to enter into, or increase the costs associated with, interest rate hedging transactions.

 

Trading in our common stock has been relatively inactive. As a result, stockholders may not be able to quickly and easily sell their common stock, particularly in large quantities.  Although our common stock is listed on the NASDAQ Capital Market and a number of broker- dealers offer to make a market in our common stock on a regular basis, the trading volume of our common stock to date has been limited, averaging approximately 2,746 shares per trading day during the year ended December 31, 2010. There can be no assurance that a continuously active and liquid market for our common stock will develop or, even if such a market did develop, could be maintained. As result, shareholders may find it difficult to sell a significant number of shares at the prevailing market price, which would make it difficult for our shareholders to liquidate their investment in our common stock.

 

Our deposit insurance premiums could be substantially higher in the future, which could have an adverse impact on our financial condition or results of operations.  Market conditions have affected the DIF of the FDIC and reduced the ratio of the insurance reserve to insured deposits. As a result, insured depository institutions may be required to pay significantly higher premiums or additional special assessments. If we are required to pay significantly higher deposit insurance premiums or special assessments, our results of operations and financial condition could be materially adversely impacted.

 

Under current FDIC regulations, each insured depository institution is subject to a risk-based assessment system and, depending on its assigned risk category, is assessed insurance premiums based on the amount of deposits held. On February 7, 2011, the FDIC adopted final rules that are effective April 1, 2011 to implement changes to the deposit insurance assessment rules that were required by the Dodd-Frank Act. In particular, the definition of an institution’s deposit insurance assessment base will change from total deposits to total assets less tangible equity, and the new initial base assessment rates range from 5 to 35 basis points depending on risk category. As under the current FDIC regulations, following the effectiveness of the FDIC’s new deposit insurance assessment rules, a depository institution with a higher assigned risk category will be assessed insurance premiums based on a higher base assessment rate, and thus will pay higher deposit insurance premiums, than the rates applicable to and premiums paid by a similarly situated depository institution with a lower assigned risk category. If the risk category of the Bank ever declines, the Bank’s base deposit insurance assessment rate could increase. If the Bank’s base deposit insurance assessment rate increases, the Company could be required to pay increased FDIC deposit insurance premiums that could have an adverse impact on our financial condition or results of operations.

 

Deterioration in the soundness of other financial institutions could adversely affect us.  Our ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial services institutions are interrelated as a result of trading, clearing, counterparty or other relationships, and we routinely execute transactions with counterparties in the financial industry, including brokers and dealers, commercial banks, and other institutional clients. As a result, defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry generally, could exacerbate the market-wide liquidity crisis and could lead to losses or defaults by us or by other institutions. There is no assurance that any such losses would not materially adversely affect our results of operations.

 

Declines in asset values may result in impairment charges and adversely affect the value of our investments, financial performance, and capital.  We maintain an investment portfolio that includes, but is not limited to, government sponsored entity securities, mortgage- backed securities and municipal securities. The market value

may be affected by factors other than the underlying performance of the issuer or composition of the bonds themselves, such as ratings downgrades, adverse changes in business climate, and a lack of liquidity for resales of certain investment securities. We periodically, but not less than quarterly, evaluate investments and other assets for impairment indicators. We may be required to record additional impairment charges if our investments suffer a decline in value that is considered other-than-temporary. If we determine that a significant impairment has occurred, we would be required to charge against earnings the credit-related portion on the other-than-temporary impairment, which could have a material adverse effect on our results of operations in the periods in which the write-offs occur.

 

Our adoption of Fair Value Option (FVO) accounting could result in income statement volatility.  In 2007, we adopted the provisions of ASC 820-10 and account for certain assets and liabilities on a fair value basis. Our objective in adopting the accounting standard was to provide the reader of the financial statements a more realistic view of our balance sheet and the market values of investments and wholesale liabilities. If our matching of assets and liabilities is not precisely achieved for business or economic reasons, more income statement volatility may occur.

 

Unexpected losses in future reporting periods may require us to establish a valuation allowance against our deferred tax assets.  We evaluate our deferred tax assets for recoverability based on all available evidence. This process involves significant management judgment about assumptions that are subject to change from period to period based on changes in tax laws or variances between our future projected operating performance and our actual results. We are required to establish a valuation allowance for deferred tax assets if we determine, based on available evidence at the time the determination is made, that it is more likely than not that some portion or all of the deferred tax assets will not be realized. In determining the “more likely than not” criterion, we evaluate all positive and negative available evidence as of the end of each reporting period. The realization of the deferred tax assets ultimately depends on the existence of sufficient taxable income in either the carryback or carryforward periods under applicable tax laws. Such a charge could have a material adverse effect on our results of operations, financial condition, and capital position.

 

Our business is subject to interest rate risk and variations in interest rates may negatively affect our financial performance.  The majority of our assets and liabilities are monetary in nature and subject us to significant risk from changes in interest rates. Fluctuations in interest rates are not predictable or controllable. Like most financial institutions, changes in interest rates can impact our net interest income, which is the difference between interest earned from interest-earning assets, such as loans and investment securities, and interest paid on interest-bearing liabilities, such as deposits and borrowings, as well as the valuation of our assets and liabilities. We expect that we will periodically experience “gaps” in the interest rate sensitivities of our assets and liabilities, meaning that either our interest-bearing liabilities will be more sensitive to changes in market interest rates than our interest-earning assets or vice versa. In either event, if market interest rates should move contrary to our position, this “gap” will negatively impact our earnings. Many factors impact interest rates, including governmental monetary policies, inflation, recession, changes in unemployment, the money supply, and international disorder and instability in domestic and foreign markets.

 

An increase in interest rates may, among other things, reduce the demand for loans and our ability to originate loans. A decrease in the general level of interest rates may affect us through, among other things, increased prepayments on our loan and mortgage-backed securities portfolios and increased competition for deposits. Accordingly, changes in the level of market interest rates affect our net yield on interest-earning assets, loan origination volume, loan and mortgage-backed securities portfolios, and our overall results. Although our asset liability management strategy is designed to control our risk from changes in market interest rates, it may not be able to prevent changes in interest rates from having a material adverse effect on our results of operations and financial condition.

 

Failure to maintain an effective system of internal control over financial reporting may not allow us to be able to report our financial results on a timely basis with the desired degree of accuracy.  The requirements of Section 404 of the SOX Act and SEC rules and regulations require an annual management report on our internal controls over financial reporting, including, among other matters, management’s assessment of the effectiveness of our internal control over financial reporting. If we fail to maintain an effective system of internal control over financial reporting, we may not be able to report our financial results with the desired degree of accuracy or to prevent fraud.

 

Bankshares has no unresolved comments from the SEC staff.

 

 

We typically lease our branch and office locations. Our business model seeks to minimize the level of investment in buildings and facilities; thus we have not purchased any branch, production office or business office locations. In securing space, we are generally responsible for build out costs, furniture and fixtures, computers, telephones and bank-specific equipment such as vaults, alarms and ATMs. In the next three years, four of our branch leases will expire. As part of our routine facilities management process we review the performance of these specific locations and the surrounding branch trade area. The evaluation could lead to relocation of certain branch sites prior to the lease expiration or at the expiration of the lease.

 

The following table highlights our facilities:

 

 

 

 

We believe that all of our properties are maintained in good operating condition and are suitable and adequate for our operational needs.

 

 

There are no material pending legal proceedings to which Bankshares or any of its subsidiaries is a party or to which the property of Bankshares or any of its subsidiaries is subject to at December 31, 2010. Bankshares previously reported on Bankshares’ Form 8-K filed with the SEC on February 4, 2011, that certain litigation with Frank H. Grace, III, a former executive officer, was resolved in January 2011.

 

 

 

Our common stock is listed for quotation on the NASDAQ Capital Market (formerly called the NASDAQ SmallCap Market) on the NASDAQ Stock Market System under the symbol ABVA. As of March 21, 2011, we had 5,108,219 shares of common stock issued and outstanding, held by approximately 334 shareholders of record and the closing price of our common stock was $5.08.

 

The high and low sales prices per share for our common stock for each quarter for the two years ended December 31, 2010, as reported by the NASDAQ Stock Market, are shown in the table below. During these periods, we did not issue any cash dividends.

 

 

Dividend Policy

 

Payment of dividends is at the discretion of Bankshares’ Board of Directors and is subject to various federal and state regulatory limitations. As a business strategy, we have elected to retain all earnings to support current and future growth. From time to time, we will consider a stock split in the form of a stock dividend in lieu of paying cash dividends. Our most recent stock split in the form of a 15% stock dividend was distributed to shareholders on June 30, 2006.

 

Issuer Purchases of Equity Securities

 

No repurchases of equity securities occurred in 2010 or 2009.

 

 

 

 

 

The following discussion is intended to assist in understanding and evaluating the financial condition and results of operations of Alliance Bankshares Corporation (Bankshares), Alliance Bank Corporation (Bank), Alliance Bank Mortgage Division (ABMD) and Alliance Home Funding (AHF), on a consolidated basis. This discussion and analysis should be read in conjunction with Bankshares’ consolidated financial statements and related notes included in Item 8 of this Annual Report on Form 10-K.

 

FORWARD-LOOKING STATEMENTS

 

Some of the matters discussed below and elsewhere in this report include forward-looking statements. These forward-looking statements include statements regarding profitability, liquidity, adequacy of the allowance for loan losses, interest rate sensitivity, market risk and financial and other goals. Forward-looking statements often use words such as “believe,” “expect,” “plan,” “may,” “will,” “should,” “project,” “contemplate,” “anticipate,” “forecast,” “intend” or other words of similar meaning. Forward-looking statements in this report may include, but are not limited to, statements regarding profitability, liquidity, the Bankshares’ loan portfolio, allowance for loan losses and provision for loan losses, trends regarding net charge-offs, trends regarding levels of nonperforming assets, interest rates and yields, interest rate sensitivity, market risk, regulatory developments, capital requirements, business strategy and other goals or objectives.

 

You can also identify them by the fact that they do not relate strictly to historical or current facts. The forward-looking statements we use in this report are subject to significant risks, assumptions and uncertainties, including among other things, the following important factors that could affect the actual outcome of future events:

 

 

 

In addition, our business and financial performance could be impacted as the financial industry restructures in the current environment, both by changes in the creditworthiness and performance of our counterparties and by changes in the regulatory and competitive landscape. Additionally, other risks that could cause actual results to differ from predicted results are set forth in Item 1A of this Annual Report on Form 10-K.

 

Because of these and other uncertainties, our actual results and performance may be materially different from results indicated by these forward-looking statements. In addition, our past results of operations are not necessarily indicative of future performance.

 

We caution you that the above list of important factors is not exclusive. These forward-looking statements are made as of the date of this report, and we may not undertake steps to update these forward-looking statements to reflect the impact of any circumstances or events that arise after the date the forward-looking statements are made.

 

2010 Performance Highlights

 

 

 

Executive Overview

 

Balance Sheet

 

December 31, 2010 compared to December 31, 2009.  Total assets were $538.5 million as of December 31, 2010, a decrease of $37.8 million from the December 31, 2009 level of $576.3 million. As of year-end 2010, total loans were $332.3 million, trading securities were $2.1 million and investment securities were $135.9 million. The remaining balance of the earning assets were overnight federal funds sold of $17.9 million and restricted stocks of $6.4 million. These earning assets amounted to $494.5 million or 91.8% of total assets at year end 2010, as compared to $523.1 million or 90.8% of total assets as of year-end 2009.

 

The allowance for loan losses was $5.3 million or 1.59% of loans outstanding as of December 31, 2010. This compares to $5.6 million or 1.56% of loans outstanding as of December 31, 2009. (The ratios exclude loans held for sale.) Non-performing assets totaled $9.4 million as of December 31, 2010, compared to non-performing assets of $13.5 million as of December 31, 2009. Impaired loans and nonaccruals amounted to $4.3 million as of December 31, 2010; in addition the specific allocation of the allowance for loan losses related to these loans was $873 thousand as of December 31, 2010. Impaired and nonaccrual loans as of December 31, 2009 were $5.6 million; we provided a specific allocation of $1.5 million of the allowance for loan losses on these loans.

 

Total deposits amounted to $406.9 million as of December 31, 2010, a decrease of $25.0 million from the December 31, 2009 level of $431.9 million. Total demand deposits were $124.6 million as of December 31, 2010 compared to $92.8 million as of year end 2009. Demand deposits represent 30.6% of total deposits as of December 31, 2010, compared to 21.5% as of December 31, 2009.

 

We use customer repurchase agreements (repos) and wholesale funding from the Federal Home Loan Bank of Atlanta (FHLB) to support the asset growth of the organization. As of December 31, 2010, there were $43.1 million of customer repos outstanding or $5.4 million more than were outstanding at the end of 2009. As of December 31, 2010, the organization had $41.2 million in FHLB long term advances outstanding, compared to $50.8 million as of December 31, 2009. The longer term FHLB advances are used as part of our overall balance sheet management strategy.

 

In June 2003, we issued $10.0 million in Trust Preferred Capital Notes through a statutory business trust. As of December 31, 2010 and December 31, 2009, the full $10.0 million was considered Tier 1 regulatory capital. The Trust Preferred Capital Notes accrue interest at a rate of 3 month LIBOR plus 315 basis points. Under provisions of the Trust Preferred Capital Notes documents, Bankshares has elected to defer the cash payments due on various quarterly installment due dates.

 

Total stockholders’ equity was $33.7 million as of December 31, 2010 and $33.1 million as of December 31, 2009. The change from the 2009 level is primarily related to the net income of $705 thousand. Book value per share increased to $6.60 as of December 31, 2010 from $6.49 as of December 31, 2009.

 

December 31, 2009 compared to December 31, 2008.  Total assets were $576.3 million as of December 31, 2009, an increase of $3.5 million over the December 31, 2008 level of $572.8 million. As of year end 2009, total loans were $359.4 million, loans held for sale were $2.0 million, trading securities were $7.5 million and investments were $151.3 million. The remaining balance of the earning assets was overnight federal funds sold

of $3.0 million. These earning assets amounted to $523.1 million or 90.8% of total assets at year end 2009, as compared to $528.7 million or 92.3% of total assets as of year end 2008.

 

The allowance for loan losses was $5.6 million or 1.56% of loans outstanding as of December 31, 2009. This compares to $5.8 million or 1.57% of loans outstanding as of December 31, 2008. (The ratios exclude loans held for sale.) Non-performing assets totaled $13.5 million as of December 31, 2009, compared to non-performing assets of $16.6 million as of December 31, 2008. Impaired loans and nonaccruals amounted to $5.6 million as of December 31, 2009; in addition the specific allocation of the allowance for loan losses related to these loans was $1.5 million as of December 31, 2009. Impaired and nonaccrual loans as of December 31, 2008 were $4.9 million; we provided a specific allocation of $1.1 million of the allowance for loan losses on these loans.

 

Total deposits amounted to $431.9 million as of December 31, 2009, an increase of $3.2 million from the December 31, 2008 level of $428.7 million. Total demand deposits were $92.8 million as of December 31, 2009 compared to $75.4 million as of year end 2008. Demand deposits represented 21.5% of total deposits as of December 31, 2009, compared to 17.6% as of December 31, 2008.

 

We use customer repurchase agreements (repos) and wholesale funding from the FHLB to support the asset growth of the organization. As of December 31, 2009, there were $37.7 million of customer repos outstanding or $12.4 million more than were outstanding at the end of 2008. As of December 31, 2009, the organization had $50.8 million in FHLB long term advances outstanding, compared to $51.4 million as of December 31, 2008. The longer term FHLB advances are used as part of our overall balance sheet management strategy.

 

Total stockholders’ equity was $33.1 million as of December 31, 2009 and $37.2 million as of December 31, 2008. The change from the 2008 level is primarily related to the net loss of $4.4 million. Book value per share decreased to $6.49 as of December 31, 2009 from $7.28 as of December 31, 2008. Tangible book value per share increased to $6.49 as of December 31, 2009 from $6.12 as of December 31, 2008.

 

On December 29, 2009, the Bank sold AIA. As of September 30, 2009, the Bank had goodwill of $3.6 million and intangibles of $2.0 million associated with AIA. The Bank recognized $455 thousand as a loss on the sale and closing costs of $816 thousand for a total loss on sale of $1.3 million. The full financial effect of the discontinued operations was a net loss of $671 thousand. The Board and management felt the sale was appropriate in light of future earnings prospects, the economy and regulatory capital needs of the Bank. The sale eliminated all of the goodwill and intangibles which are deductions from regulatory capital.

 

Critical Accounting Policies

 

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

 

Allowance for Loan Losses.  The allowance for loan losses is an estimate of the losses that may be sustained in our loan portfolio. The allowance is based on two basic principles of accounting: (1) ASC 450-10-05, Contingencies (formerly SFAS No. 5, Accounting for Contingencies), which requires that losses be accrued when they are probable of occurring and estimable, and (2) ASC 310-10-35, Receivables (formerly SFAS No. 114, Accounting by Creditors for Impairment of a Loan), which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance. The allowance for loan losses has two basic components: the general allowance and the specific allowance.

 

The general allowance is developed following the accounting principles contained in ASC 450-10-05 (formerly SFAS No. 5, Accounting for Contingencies) and represents the largest component of the total allowance.

It is determined by aggregating un-criticized loans and unimpaired loans by loan type based on common purpose, collateral, repayment source or other credit characteristics and then applying factors which in the judgment of management represent the expected losses over the life of the loans. In determining those factors, we consider the following: (1) delinquencies and overall risk ratings, (2) loss history, (3) trends in volume and terms of loans, (4) effects of changes in lending policy, (5) the experience and depth of the borrowers’ management, (6) national and local economic trends, (7) concentrations of credit by individual credit size and by class of loans, (8) quality of loan review system and (9) the effect of external factors (e.g., competition and regulatory requirements).

 

ASC 310-10-35, Receivables (formerly SFAS No. 114, Accounting by Creditors for Impairment of a Loan) is the basis upon which we determine specific reserves on individual loans which comprise the specific allowance. Specific loans to be evaluated for impairment are identified based on the borrower’s loan size and the loan’s risk rating, collateral position and payment history. If it is determined that it is likely that the Bank will not receive full payment in a timely manner, the loan is determined to be impaired. Each such identified loan is then evaluated to determine the amount of reserve that is appropriate based on ASC 310-10-35. This standard also requires that losses be accrued based on the differences between the value of collateral, present value of expected future cash flows or values that are observable in the secondary market and the loan balance.

 

Goodwill.  Bankshares adopted ASC 350-20, Intangibles — Goodwill and Other (formerly SFAS No. 142, Goodwill and Other Intangible Assets), effective January 1, 2002. Accordingly, goodwill is no longer subject to amortization over its estimated useful life, but is subject to at least an annual assessment for impairment by applying a fair value based test. Goodwill related to the AIA acquisitions was tested for impairment on an annual basis or more frequently if events or circumstances warranted. For the year ended December 31, 2008, Bankshares tested the goodwill carrying value. Based upon the results of the testing, Bankshares concluded that there was impairment during 2008. We recorded an impairment charge of $300 thousand in 2008.

 

Under ASC 350-20, acquired intangible assets are separately recognized if the benefit of the asset can be sold, transferred, licensed, rented, or exchanged, and amortized over its useful life. The costs of other intangible assets, based on independent valuation and/or internal valuations, are amortized over their estimated lives.

 

On December 29, 2009, the Bank entered into and closed on a stock purchase agreement to sell the insurance agencies, which eliminated the goodwill and intangible assets carried on our books.

 

Share-Based Compensation.  In December 2004, the FASB issued ASC 718-10, Stock Compensation (formerly SFAS No. 123R, Share-Based Payment). ASC 718-10 requires companies to recognize the cost of employee services received in exchange for awards of equity instruments, such as stock options and nonvested shares, based on the fair value of those awards at the date of grant. Compensation cost has been measured using the Black-Scholes model to estimate fair value of an award on the grant date and is recognized over the service period, which is usually the vesting period.

 

Deferred Tax Asset.  Bankshares routinely evaluates the likelihood of the recognition of deferred tax assets. The analysis is used to determine if a valuation allowance for deferred tax assets is necessary. Our analysis reviews various forms of positive and negative evidence in determining whether a valuation allowance is necessary and if so to what degree a valuation allowance is warranted.

 

We considered positive evidence such as 2010 financial results, previous earnings patterns, the recent history of loan charge-offs, nonperforming assets, OREO expenses, multiyear business projections and the potential realization of NOL carry forwards within the prescribed time periods. We considered several different economic scenarios in evaluating whether the projected income in future periods was sufficient to recover the NOL over the prescribed period. In addition, we considered tax planning strategies that would impact the timing and extent of taxable income. The projected performance metrics over the period of NOL recognition indicates that it is more likely than not that Bankshares will have sufficient taxable income to recognize the deferred tax assets as of December 31, 2010. Therefore, Bankshares has concluded that a valuation allowance for deferred tax assets is not necessary as of December 31, 2010.

Results of Operations

 

2010 compared to 2009.  For the year ended December 31, 2010, net income amounted to $705 thousand, compared to net loss of ($4.4) million for 2009. Basic and diluted net income (loss) per common share was $0.14 in 2010 and ($0.86) in 2009. Earnings (loss) per share from continuing operations was $0.14 at December 31, 2010 compared to ($0.73) at December 31, 2009. Return on average equity was 1.89% in 2010 compared to (12.23%) in 2009. Return on average assets was 0.13% in 2010 compared to (0.74%) in 2009. The net interest margin was 3.79% in 2010 which compares to 2.89% in 2009. The key drivers of our improved net income in 2010 were an improved net interest margin, reduced credit and OREO related costs, reduced operating expenses, and gains on sale of investment securities.

 

2009 compared to 2008.  For the year ended December 31, 2009, net loss amounted to ($4.4) million, compared to net loss of ($9.0) million for 2008. Loss per common share, basic was ($0.86) in 2009 and ($1.77) in 2008. Loss per common share, diluted was ($0.86) in 2009 and ($1.77) in 2008. Return on average equity was (12.23)% in 2009 compared to (21.29)% in 2008. Return on average assets was (0.74)% in 2009 compared to (1.63)% in 2008. The net interest margin was 2.89% in 2009 which compares to 2.52% in 2008. The key drivers of our net loss in 2009 relate to OREO expense in the amount of $2.4 million and provision for loan losses of $3.0 million.

 

Interest Income and Expense

 

Net interest income (on a fully taxable equivalent basis) was $19.4 million in 2010 or $3.5 million higher than the 2009 level of $15.9 million. The cost of interest bearing liabilities amounted to $7.9 million in 2010 compared to $12.6 million in 2009. This $4.7 million year-over-year reduction in the cost of interest-bearing liabilities completely offset the $1.2 million decline in earnings from our asset base, and was driven by declines in the rates paid by the Company on each category of interest-bearing liabilities.

 

The following table illustrates average balances of total interest earning assets and total interest bearing liabilities for the periods indicated, showing the average distribution of assets, liabilities, stockholders’ equity and related income, expense and corresponding weighted average yields and rates. The average balances used in these tables and other statistical data were calculated using daily average balances.

Average Balances, Interest Income and Expense and Average Yield and Rates⁽¹⁾

 

 

 

 

Our net interest margin was 3.79% for the year ended December 31, 2010, compared to 2.89% for 2009. The net interest income earned, on a fully taxable equivalent basis, was $19.4 million in 2010 compared to $15.9 million in 2009, an increase of 22.0%. The improvement in net interest margin, which was a key driver in improvement of our net income, was due to a substantial decline in interest expense.

 

Average loan balances were $344.7 million for the year ended December 31, 2010, compared to $361.0 million for 2009. This is a decrease of $16.3 million, or 4.5%. The related interest income from loans was $20.5 million in

2010, a decrease of $630 thousand from the 2009 level of $21.1 million. The average yield on loans increased to 5.94% in 2010, an increase of 9 basis points compared to the same period in 2009.

 

Trading securities averaged $3.3 million for the year ended December 31, 2010 compared to $39.4 million for the year ended December 31, 2009. As part of our strategic management of the balance sheet, we took proactive steps to reduce the size of the trading portfolio, including selling our entire SBA securities portfolio in 2009. In 2010, we continued our strategy to liquidate our trading assets when economically feasible or when market conditions improve. As of December 31, 2010, we held only three trading asset positions amounting to $2.1 million. Trading securities interest income for the year ended December 31, 2010 was $214 thousand compared to $1.5 million for the same period in 2009. The average yield on trading securities increased to 6.49% in 2010, an increase of 272 basis points compared to the same period in 2009.

 

Investment securities averaged $146.6 million for the year ended December 31, 2010 compared to $125.0 million for the year ended December 31, 2009. Investment securities income was $6.6 million on a fully taxable equivalent basis for the year ended December 31, 2010 and $5.9 million for the year ended December 31, 2009. The average tax equivalent yields on investment securities for the year ended December 31, 2010 and 2009 were 4.49% and 4.71% respectively. In 2010, we actively added investment securities to the balance sheet. The securities added to the balance sheet provide positive returns on excess liquidity generated by the Bank’s operations, including by the Bank’s deposit gathering initiatives, and are an attractive alternative to the very low yields received from federal funds sold.

 

A certain portion of the Bank’s excess liquidity is invested in federal funds sold. For the year ended December 31, 2010, federal funds sold contributed $64 thousand of interest income, compared to $56 thousand for the same period in 2009.

 

Average interest-bearing liabilities (deposits and purchased funds) were $418.8 million in 2010, which was $43.0 million less than the 2009 level of $461.8 million. Interest expense for all interest-bearing liabilities amounted to $7.9 million for the year ended December 31, 2010, a $4.7 million decrease from the 2009 level of $12.6 million. The average cost of interest-bearing liabilities for the year ended December 31, 2010 was 1.89% or 84 basis points lower than the 2009 level of 2.73%. The declining and low interest environment allowed for market competitive repricing of certain core deposit products in 2010. Additionally, the brokered certificate of deposit portfolio benefited from the lower interest rate environment as well. Average time deposits were $233.2 million, a decrease of $53.1 million over the 2009 level of $286.3 million. Average FHLB advances were $54.3 million in 2010 or $3.2 million higher than the 2009 average of $51.1 million. Average other borrowings were $55.2 million as of December 31, 2010, a decrease of $244 thousand from the 2009 level of $55.4 million. Other borrowings are principally comprised of customer repurchase agreements and federal funds purchased.

 

Non-interest bearing demand deposit balances averaged $100.4 million as of the year ended December 31, 2010, or $4.1 million more than the year ended December 31, 2009 balance of 96.3 million. These balances are subject to seasonal changes.

The following table describes the impact on our interest income and expense resulting from changes in average balances and average rates for the periods indicated. The change in interest income due to both volume and rate has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each.

 

 

Bankshares realized significant benefits to its net interest income from the repricing and maturities of certain deposit and wholesale funding instruments during the year ended December 31, 2010.

 

Loan Portfolio

 

In its lending activities, Bankshares seeks to develop substantial relationships with clients whose business and individual banking needs will grow with the Bank. The company has made significant efforts to be responsive to the lending needs in the markets served, while maintaining sound asset quality and credit practices. We grant credit to commercial markets, commercial real estate, real estate construction, and residential real estate and consumer loans in the normal course of business. The loan portfolio net of discounts and fees was $332.3 million as of December 31, 2010 or $27.1 million lower than the December 31, 2009 level of $359.4 million.

 

The following tables summarize the composition of the loan portfolio by dollar amount and each segment as a percentage of the total loan portfolio as of the dates indicated:

 

 

Substantially all loans are initially underwritten based on identifiable cash flows and supported by appropriate advance rates on collateral which is independently valued. Commercial loans are generally secured by accounts receivable, equipment and business assets. Commercial real estate is secured by income producing properties of all types. Real estate construction loans are supported by projects which generally require an appropriate level of pre-sales or pre-leasing. Generally, all commercial and real estate loans have full recourse to the owners and/or sponsors. Residential real estate is secured by first or second trusts on both owner-occupied and investor-owned residential properties.

 

As noted in the table above loans secured by various types of real estate constitute a significant portion of total loans. Commercial real estate loans represent the largest dollar exposure. Substantially all of these loans are secured by properties in the Metropolitan Washington, D.C. area with the heaviest concentration in Northern Virginia and Fairfax County in particular. Risk is managed through diversification by sub-market, property type, and loan size. Risk is further managed by seeking investment property loans with multiple tenants and by emphasizing owner-occupied loans. The average loan size in this portfolio is $658 thousand as of December 31, 2010.

 

The table also shows a substantial reduction in the real estate construction portion of the portfolio. This reflects the results of management’s efforts to de-emphasize this type of lending. New originations in this segment are being underwritten in the context of current market conditions and are particularly focused in sub-markets which appear to be the strongest in the region. Legacy loans, particularly in the land portion of this portfolio, have been largely converted to amortizing loans with regular principal and interest payments. We expect to see further reductions in our land exposure offset by potential increases in certain residential construction activities as market conditions improve.

 

Loans secured by residential real estate have grown in aggregate. This reflects substantial growth in our 1-4 family first trust loans partially offset by the reductions in our 1-4 family subordinate trust loans (HELOCs and closed-end 2^nd mortgages). All loans in both categories represent loans underwritten by us (we do not purchase loans in this portfolio) to customers with whom we have direct contact in the local communities we serve. We believe that our underwriting criteria reflect current market conditions. The portfolio of first mortgage loans had an average size per housing unit of $321 thousand as of December 31, 2010. Our subordinate trust loans averaged $99 thousand per property as of December 31, 2010. While we recognize that the Metropolitan Washington, D.C. residential real estate market is in a nascent recovery, we believe our current underwriting standards, our emphasis on serving the sub-markets we know, the granularity of our portfolio, and our continued reduction of our subordinate trust portfolio represent appropriate risk management for this portfolio.

The following table presents the maturities or repricing periods of selected loans outstanding at December 31, 2010:

 

 

Asset Quality

 

We segregate loans meeting the criteria for special mention, substandard, doubtful and loss from non-classified, or pass rated, loans. We review the characteristics of each rating at least annually, generally during the first quarter of each year. The characteristics of these ratings are as follows:

 

Pass and watch rated loans (risk ratings 1 to 6) are to persons or business entities with an acceptable financial condition, appropriate collateral margins, appropriate cash flow to service the existing loans, and an appropriate leverage ratio. The borrower has paid all obligations as agreed and it is expected that the borrower will maintain this type of payment history. When necessary, acceptable personal guarantors support the loan.

 

Special mention loans (risk rating 7) have a specific defined weakness in the borrower’s operations and/or the borrower’s ability to generate positive cash flow on a sustained basis. The borrower’s recent payment history is characterized by late payments. Bankshares’ risk exposure to special mention loans is mitigated by collateral supporting the loan. The collateral is considered to be well-managed, well maintained, accessible and readily marketable.

 

Substandard loans (risk rating 8) are considered to have specific and well-defined weaknesses that jeopardize the viability of Bankshares’ credit extension. The payment history for the loan has been inconsistent and the expected or projected primary repayment source may be inadequate to service the loan. The estimated net liquidation value of the collateral pledged and/or ability of the personal guarantors to pay the loan may not adequately protect Bankshares. There is a distinct possibility that Bankshares will sustain some loss if the deficiencies associated with the loan are not corrected in the near term. A substandard loan would not automatically meet our definition of an impaired loan unless the loan is significantly past due and the borrower’s performance and financial condition provide evidence that it is probable that Bankshares will be unable to collect all amounts due

 

Substandard non-accrual loans have the same characteristics as substandard loans. However these loans have a non-accrual classification most frequently because the borrower’s principal or interest payments are 90 days or more past due.

 

Doubtful rated loans (risk rating 9) have all the weakness inherent in a loan that is classified as substandard but with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. The possibility of loss related to doubtful rated loans is extremely high.

 

Loss (risk rating 10) rated loans are not considered collectible under normal circumstances and there is no realistic expectation for any future payment on the loan. Loss rated loans are fully charged off.

 

The table below presents the Company’s loan portfolio by risk rating classification and loan portfolio segment as of December 31, 2010.

 

 

 

 

As part of our normal credit risk management practices, we regularly monitor the payment performance of our borrowers. Substantially all loans require some form of payment on a monthly basis, with a high percentage requiring regular amortization of principal. However, certain HELOCs, Commercial and Industrial lines of credit and construction loans generally require only monthly interest payments.

 

When payments are 90 days or more in arrears or when we determine that it is no longer prudent to recognize current interest income on a loan, we classify the loan as non-accrual. From time to time a loan may be past due for 90 days or more but it is in process of collection and thus warrants remaining on accrual status. As of December 31, 2010, we evaluated a residential real estate construction loan with a principal value of $256 thousand loan that was more than 90 days past due and determined that it should remain on accrual status. In early 2011, interest payments were brought current on this loan. In addition, the loan was fully repaid in the first quarter of 2011.

The following table sets forth the aging and non-accrual loans by class as of December 31, 2010: