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EX-32 - CERTIFICATIONS PURSUANT TO 18 U.S.C. SECTION 1350 - NORTH STATE BANCORPdex32.htm
EX-23 - CONSENT OF DIXON HUGHES PLLC - NORTH STATE BANCORPdex23.htm
EX-31.2 - CERTIFICATION PURSUANT TO RULE 13A-14(A) - NORTH STATE BANCORPdex312.htm
EX-31.1 - CERTIFICATION PURSUANT TO RULE 13A-14(A) - NORTH STATE BANCORPdex311.htm
Table of Contents

 

 

U.S. SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-K

Annual Report under Section 13 or 15(d) of the

Securities Exchange Act of 1934

For the Fiscal Year ended December 31, 2010

OR

Transition Report under Section 13 or 15(d) of the

Securities Exchange Act of 1934

For the Transition Period from ___________ to ___________

Commission File Number: 000-49898

 

 

North State Bancorp

(Exact name of registrant as specified in its charter)

 

North Carolina   65-1177289
(State or other jurisdiction of   (I.R.S. Employer
incorporation or organization)   Identification No.)

6204 Falls of the Neuse Road

Raleigh, North Carolina 27609

(Address of principal executive offices, including zip code)

(919) 787-9696

(Issuer’s telephone number)

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

Securities Registered under Section 12(g) of the Act:

 

Title of Each Class

 

Name of Each Exchange

On Which Registered

Common Stock, No Par Value   None

 

 

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

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

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

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 during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes  ¨    No  ¨

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

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

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 definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act:

 

Large accelerated filer   ¨    Accelerated filer   ¨
Non-accelerated filer   ¨  (Do not check if a smaller reporting company)    Smaller reporting company   x

The aggregate market value of the common stock held by non-affiliates was approximately $14.3 million as of June 30, 2010, based on the closing price of the common stock as quoted on the over-the-counter Bulletin Board on that day.

As of March 28, 2011, the registrant had outstanding 7,427,976 shares of Common Stock, no par value.

 

 

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant’s definitive proxy statement to be filed for its 2011 Annual Meeting of Shareholders to be held on June 2, 2011 to be filed with the Securities and Exchange Commission within 120 days of December 31, 2010 are incorporated by reference into Part III of this report.

 

 

 


Table of Contents

NORTH STATE BANCORP

ANNUAL REPORT ON FORM 10-K

Table of Contents

 

          Page  
   PART I   
Item 1.    Business      1   
Item 1A.    Risk Factors      8   
Item 1B.    Unresolved Staff Comments      16   
Item 2.    Properties      16   
Item 3.    Legal Proceedings      16   
Item 4.    Reserved      16   
   PART II   
Item 5.    Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities      16   
Item 6.    Selected Financial Data      18   
Item 7.    Management’s Discussion and Analysis of Financial Condition and Results of Operations      20   
Item 7A.    Quantitative and Qualitative Disclosures About Market Risk      47   
Item 8.    Financial Statements and Supplementary Data      48   
Item 9.    Changes in and Disagreements with Accountants on Accounting and Financial Disclosure      48   
Item 9A.    Controls and Procedures      48   
Item 9B.    Other Information      48   
   PART III   
Item 10.    Directors, Executive Officers and Corporate Governance      48   
Item 11.    Executive Compensation      49   
Item 12.    Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters      49   
Item 13.    Certain Relationships and Related Transactions, and Director Independence      49   
Item 14.    Principal Accountant Fees and Services      49   
   PART IV   
Item 15.    Exhibits and Financial Statement Schedules      50   


Table of Contents

NOTE REGARDING FORWARD-LOOKING STATEMENTS

Statements contained in this report, which are not historical facts, are forward-looking statements, as that term is defined in the Private Securities Litigation Reform Act of 1995. Amounts herein could vary as a result of market and other factors. Such forward-looking statements are subject to risks and uncertainties which could cause actual results to differ materially from those currently anticipated due to a number of factors, which include, but are not limited to, factors discussed in documents we file with the U.S. Securities and Exchange Commission from time to time. Such forward-looking statements may be identified by the use of such words as “believe,” “expect,” “anticipate,” “should,” “might,” “planned,” “estimated,” and “potential.” Examples of forward-looking statements include, but are not limited to, estimates with respect to our financial condition, expected or anticipated revenue, results of operations and business that are subject to various factors which could cause actual results to differ materially from these estimates. These factors include, but are not limited to: local, regional and national economies; substantial changes in financial markets; changes in real estate values and real estate markets; changes in interest rates; changes in legislation or regulation; our ability to manage growth; loss of deposits and loan demand to other savings and financial institutions; changes in accounting principles, policies, or guidelines; and other economic competitive, governmental, regulatory, and technological factors affecting our operations, pricing, products and services.

PART I

 

Item 1. Business.

Overview

We are a commercial bank holding company that was incorporated on June 5, 2002. We have one corporate subsidiary, North State Bank, which we acquired on June 28, 2002 as part of the Bank’s holding company reorganization. Our primary business is the ownership and operation of North State Bank. We also have three trust subsidiaries that we established to issue trust preferred securities.

North State Bank was incorporated under the laws of the State of North Carolina in May 2000 and opened for business on June 1, 2000. The Bank is not a member of the Federal Reserve System. Our main office and that of the Bank is located at 6204 Falls of the Neuse Road in north Raleigh, North Carolina. The Bank also operates offices at 4270 The Circle at North Hills, Raleigh, 2413 Blue Ridge Road in west Raleigh, 14091 New Falls of Neuse Road in the Wakefield area of north Raleigh, 835 Highway 70 West in Garner, North Carolina, 230 Fayetteville Street in downtown Raleigh and 1411 Commonwealth Drive, Wilmington, North Carolina. The term “we” in this report refers interchangeably to North State Bancorp and North State Bank.

We focus on serving the total banking needs of professional firms, professionals, property management companies, churches, non-profits and individuals who highly value a mutually beneficial banking relationship in the cities of Raleigh, Garner and Wilmington and the greater Wake County and New Hanover County market areas, by providing banking services including checking, savings and investment accounts; commercial, installment, mortgage, and personal loans; safe deposit boxes; savings bonds; wire transfer; and other associated services. We offered limited services in the Carteret County market area through a loan production office in Morehead City until April 2010 when we closed the office and combined its loan production with our Wilmington office. Although we have offered services specific to community association management firms throughout our history, we furthered our commitment to this industry in February 2009 by launching a new division, “CommunityPLUS”. This division is dedicated to serving the specialized needs of community association management firms. In November 2009 we sold our 5.6% interest in Beacon Title Agency, LLC, a title insurance agency, which we acquired in October 2007. Through the Bank’s subsidiary, North State Bank Financial Services, Inc., we offer wealth management and brokerage services. North State Bank Mortgage, a division of the Bank, began operations during February 2010 for the purpose of originating and selling single family, residential first mortgage loans.

Supervision and Regulation

Regulation of North State Bank

North State Bank is a North Carolina banking corporation whose deposits are insured by the Federal Deposit Insurance Corporation, or FDIC. As a commercial bank, we are subject to extensive regulation by the FDIC and the North Carolina Commissioner of Banks. The North Carolina Commissioner of Banks and the FDIC periodically examine our operations and require us to submit periodic reports regarding our financial condition and operations.

 

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We are subject to various state and federal laws and regulations that restrict or otherwise apply to our lending, deposit-taking and other business activities. Additionally, federal law generally prohibits us from engaging as principal in activities that are not permitted for national banks unless the FDIC determines that the activity would pose no significant risk to the deposit insurance fund, and we are, and continue to be, in compliance with all applicable capital standards. In addition, we generally are not able to acquire or retain equity investments of a type, or in an amount, that is not permissible for a national bank.

A bank must obtain the prior approval of the North Carolina Commissioner of Banks for any of the following events:

 

   

the merger with or purchase of substantially all the assets or assumption of liabilities of another financial institution;

 

   

the establishment of a branch office; and

 

   

the establishment or acquisition of a subsidiary corporation.

The North Carolina Commissioner of Banks or the FDIC may sanction any insured bank not operated in accordance with or not conforming to applicable regulations, policies, and directives. Proceedings may be instituted against an insured bank or any director, officer or employee of a bank that engages in unsafe and unsound practices, including the violation of applicable laws and regulations. The FDIC can terminate insurance of accounts of any insured bank not operated in accordance with or not conforming to its regulations, policies, and directives.

All FDIC-insured banks must maintain average daily reserves against their transaction accounts. Because required reserves must be maintained in the form of vault cash or in a non-interest-bearing account at a Federal Reserve Bank, the effect of the reserve requirement is to reduce the amount of the Bank’s interest-earning assets.

The Bank is subject to the provisions of Section 23A of the Federal Reserve Act. Section 23A places limits on the amount of certain transactions with affiliate entities. The total amount of the transactions by the Bank with a single affiliate is limited to 10% of the Bank’s capital and surplus and, for all affiliates, to 20% of the Bank’s capital and surplus. Each of the transactions among affiliates must also meet specified collateral requirements and must comply with other provisions of Section 23A designed to avoid transfers of low-quality assets between affiliates. The Bank also is subject to the provisions of Section 23B of the Federal Reserve Act which, among other things, prohibits transactions with affiliates that are subject to Section 23A unless the transactions are on terms substantially the same, or at least as favorable to the Bank or its subsidiaries, as those prevailing at the time for comparable transactions with nonaffiliated companies.

The USA Patriot Act of 2001 is intended to strengthen the ability of U.S. law enforcement and the intelligence community to work cohesively to combat terrorism on a variety of fronts. The Patriot Act contains sweeping anti-money laundering and financial transparency laws which require various regulations, including standards for verifying customer identification at account opening, and rules to promote cooperation among financial institutions, regulators, and law enforcement entities in identifying parties that may be involved in terrorism or money laundering. The Patriot Act requires financial institutions to adopt policies and procedures to combat money laundering, and it grants the Secretary of the Treasury broad authority to establish regulations and impose requirements and restrictions on financial institutions’ operations.

Community Reinvestment Act

We are subject to the provisions of the Community Reinvestment Act of 1977, which requires financial institutions to meet the credit needs of their local communities, including low and moderate income communities. In accordance with the Community Reinvestment Act, the FDIC periodically assesses our record of meeting the credit needs of our local communities by assigning one of the following ratings to our performance in that regard:

 

   

outstanding;

 

   

satisfactory;

 

   

needs to improve; or

 

   

substantial noncompliance.

In addition, the FDIC will strongly consider our performance under the Community Reinvestment Act as a factor upon any application by us for any of the following:

 

   

the establishment of a branch;

 

   

the relocation of a main office or branch; and

 

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the merger or consolidation with or the acquisition of assets or assumption of liabilities of an insured depository institution.

Capital Requirements

We must comply with the capital requirements imposed by the FDIC. Under the FDIC’s regulations, state-chartered, nonmember banks that receive the highest rating during the examination process have the following characteristics:

 

   

no anticipated or significant current growth;

 

   

well-diversified risk (including no undue interest rate risk exposure), excellent asset quality, high liquidity and good earnings; and

 

   

in general, are considered strong banking organizations.

The FDIC requires banks to maintain a minimum leverage ratio of 3% of Tier 1 capital, which is common stockholders’ equity less intangible assets, identified losses and other adjustments, to average total consolidated assets. The FDIC can require banks to maintain a ratio of 100 to 200 basis points above the stated minimum, and has generally set a minimum leverage ratio of not less than 4% for most banks.

To provide measurement of capital adequacy that is more sensitive to the individual risk profiles of financial institutions, the FDIC’s risk-based capital regulations provide that, in addition to maintaining their required leverage ratio, banks are expected to maintain a level of capital commensurate with risk profiles assigned to their assets. The regulations generally require a minimum ratio of Tier 1 capital to risk-weighted assets of 4%, and a minimum ratio of total capital to risk-weighted assets of 8%, of which at least one-half must be in the form of Tier 1 capital.

Dividends

The payment of any cash dividend is subject to the Bank’s board of directors’ evaluation of its operating results, financial condition, future growth plans, general business conditions, and to tax and other relevant considerations and regulatory limitations, including our minimum capital requirements. The Bank might not declare and pay any cash dividends, and if it were to do so, it might not continue to declare them or maintain them at the same level. As North State Bancorp owns all of the stock of North State Bank, any dividend declared would be paid to it.

In addition, statutory and regulatory restrictions apply to the payment of cash dividends on our common stock. Under North Carolina law applicable to banks, our directors may declare a cash dividend in an amount equal to our undivided profits, as they deem appropriate, subject to the limitation that the Bank’s capital surplus is at least 50% of its paid-in capital. Cash dividends may only be paid out of retained earnings. We cannot pay a cash dividend at any time that we are “undercapitalized” or insolvent, or when payment of the dividend would render us insolvent. Also, a FDIC-insured bank cannot pay a cash dividend while it is in default on any assessment due the FDIC.

Insurance Assessments

The FDIC insures our customers’ deposits. Under the Federal Deposit Insurance Reform Act of 2005, as amended (the “Reform Act”), the FDIC uses a risk-based assessment system to determine the amount of a bank’s deposit insurance assessment based on an evaluation of the probability that the deposit insurance fund will incur a loss with respect to that bank. The evaluation considers risks attributable to different categories and concentrations of the bank’s assets and liabilities and other factors the FDIC considers to be relevant, including information obtained from the bank’s federal and state banking regulators. The FDIC is responsible for maintaining the adequacy of the deposit insurance fund, and the amount paid by a bank for deposit insurance is influenced not only by the assessment of the risk it poses to the deposit insurance fund, but also by the adequacy of the insurance fund to cover the risk posed by all insured institutions.

The FDIC amended its risk-based assessment system for 2007 to implement authority granted by the Reform Act. 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. Risk Category I is the lowest risk category while Risk Category IV is the highest risk category. For 2009 and 2010, the Bank qualified for Risk Category I. For banks under $10 billion in total assets in Risk Category I, the 2009 and 2010 deposit assessment ranged from five to seven basis points of total qualified deposits. The actual assessment is dependent upon certain risk measures as defined in the final rule.

 

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In an effort to restore capitalization levels and to ensure the Deposit Insurance Fund will adequately cover projected losses from future bank failures, the FDIC, in late 2008, adopted a rule that alters the way in which it differentiates for risk in the risk-based assessment system and to revise deposit insurance assessment rates, including base assessment rates. For the first quarter of 2009 only, the FDIC increased all FDIC deposit assessment rates by seven basis points. These new rates range from 12 to 14 basis points for Risk Category I institutions to 50 basis points for Risk Category IV institutions. Under the FDIC’s restoration plan, the FDIC established new initial base assessment rates that are subject to adjustment as described below. Beginning April 1, 2009, the base assessment rates range from 12 to 14 basis points for Risk Category I institutions to 45 basis points for Category IV institutions. Changes in the risk-based assessment system include increasing premiums for institutions that rely on excessive amounts of brokered deposits, including CDARS, increasing premiums for excessive use of secured liabilities, including Federal Home Loan Bank advances, and lowering premiums for smaller institutions with very high capital levels.

In May 2009, the FDIC passed amendments to the restoration plan for the Deposit Insurance Fund. The amendment imposed a 20 basis point emergency special assessment on insured depository institutions as of June 30, 2009. The assessment was collected on September 30, 2009. On March 17, 2009, the FDIC adopted changes to the Temporary Liquidity Guarantee Program or TLGP which may provide for reduction of the emergency special assessment by up to four basis points. An interim rule proposed on February 27, 2009 would also permit the FDIC to impose an emergency special assessment after June 30, 2009, of up to 10 basis points if necessary to maintain public confidence in federal deposit insurance.

In late 2009, the Board of Directors of the FDIC adopted a rule to require insured institutions to prepay their estimated quarterly risk-based insurance deposit premiums for the fourth quarter of 2009 and for all of 2010, 2011 and 2012. The assessment rate was based on the third quarter of 2009 and assumed a 5% annual growth rate in deposits each year with a three-basis point increase in assessment rates effective on January 1, 2011. The entire assessment is accounted for as a prepaid expense on our consolidated balance sheet, as of December 30, 2009. For each quarter in 2010, we have expensed the portion of the prepaid expense applicable for each quarter and will continue to charge as an expense to our earnings the portion of the applicable prepaid expense for each quarter of 2011 and 2012. The results of the special assessment and increased regular assessments will continue to have a significant impact on our results of operations for 2011 and in the future.

The Dodd-Frank Wall Street Reform and Consumer Protection Act, passed in July 2010, also imposes additional assessments and costs with respect to deposits, requiring the FDIC to impose deposit insurance assessments based on total assets rather than total deposits. Based on rules passed pursuant to the Dodd-Frank Act, which rules become effective in April, 2011, the FDIC revised the deposit insurance assessment system to base assessments on the average total consolidated assets of the institution, rather than upon deposits payable in the U.S. as was previously the case. The FDIC also adopted a comprehensive, long-range “restoration” plan for the deposit insurance fund to ensure that the ratio of the fund’s reserves to insured deposits reaches 1.35 percent by 2020, as required by the Dodd-Frank Act. Based upon updated projections for the fund, the new restoration plan would forgo the uniform 3 basis point assessment rate increase previously scheduled to go into effect on January 1, 2011, and would keep the current rate schedule in effect. The FDIC’s rule also envisions eventually building the fund’s reserve ratio to 2.0 percent. Base assessment rates would adjust downward over time as the fund reached specified reserve levels. At this time, the ultimate effect of these legislative and regulatory developments, including the new assessment rules, cannot be predicted with any certainty.

See additional discussion in Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” FDIC insurance assessments could be further increased in the future if the FDIC finds it necessary to adequately maintain the Deposit Insurance Fund.

Insurance of an institution’s deposits may be terminated by the FDIC upon a finding that the institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC. Management of the Bank does not know of any practice, condition or violation that might lead to termination of the Bank’s deposit insurance.

Interstate Banking and Branching

Subject to state law, federal law permits adequately capitalized and managed bank holding companies to acquire control of a bank in any state. In addition, federal law permits banks to merge with banks located in other states and allows states to adopt legislation permitting out-of-state banks to open branch offices within that state’s borders. The North Carolina Reciprocal Interstate Banking Act permits banking organizations in any state with similar reciprocal legislation to acquire North Carolina banking organizations. In addition, subject to another state having similar laws, the North Carolina Interstate Branch Banking Act:

 

   

permits North Carolina banks and out-of-state banks to merge;

 

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authorizes North Carolina banks to establish or acquire branch offices in any other state; and

 

   

permits out-of-state banks to establish or acquire branch offices in North Carolina.

Prompt Corrective Action

The Federal Deposit Insurance Corporation Improvement Act of 1991 establishes a system of prompt corrective action to resolve the problems of undercapitalized institutions. Under this system, the federal banking regulators must rate supervised institutions on a basis of five capital categories. The federal banking regulators also must take certain mandatory supervisory actions and are authorized to take all other discretionary actions with respect to institutions in the three undercapitalized categories, the severity of which will depend upon the capital category in which the institution is placed. Generally, subject to narrow exception, the Federal Deposit Insurance Corporation Improvement Act requires the primary or appropriate banking regulator to appoint a receiver or conservator for an institution that is critically undercapitalized. The federal banking agencies have specified by regulation the relevant capital level for each category.

Under the Federal Deposit Insurance Corporation Improvement Act, the FDIC adopted regulations setting forth a five-tier scheme for measuring the capital adequacy of FDIC-insured commercial banks. Under the regulations, a bank is placed in one of the following capital categories:

 

   

Well Capitalized – a bank which has a total capital ratio of at least 10%, a Tier 1 capital ratio of at least 6%, and a Tier 1 leverage ratio of at least 5%;

 

   

Adequately Capitalized – a bank which has a total capital ratio of at least 8%, a Tier 1 capital ratio of at least 4%, and a Tier 1 leverage ratio of at least 4%;

 

   

Undercapitalized – a bank that has a total capital ratio of under 8%, a Tier 1 capital ratio of under 4%, or a Tier 1 leverage ratio of under 4%;

 

   

Significantly Undercapitalized – a bank that has a total capital ratio of under 6%, a Tier 1 capital ratio of under 3%, or a Tier 1 leverage ratio of under 3%; and

 

   

Critically Undercapitalized – a bank whose tangible equity is not greater than 2% of total tangible assets.

The regulations permit the FDIC to downgrade a bank to the next lower category if the FDIC determines after notice and opportunity for hearing or response that the bank is in an unsafe or unsound condition or that the bank has received and not corrected a less-than-satisfactory rating for any of the categories of asset quality, management, earnings, or liquidity in its most recent examination. Supervisory actions by the appropriate federal banking regulator depend upon an institution’s classification within the five categories.

The Federal Deposit Insurance Corporation Improvement Act generally prohibits a depository institution from making any capital distribution including payment of a cash dividend if the depository institution would thereafter be undercapitalized. Undercapitalized depository institutions are subject to restrictions on borrowing from the Federal Reserve System. In addition, undercapitalized depository institutions are subject to growth limitations and are required to submit capital restoration plans. If a depository institution fails to submit an acceptable plan, it is treated as if it is significantly undercapitalized.

Significantly undercapitalized depository institutions might be subject to a number of requirements and restrictions including orders to sell sufficient voting stock to become adequately capitalized, requirements to reduce total assets, and cessation of receipt of deposits from correspondent banks. Critically undercapitalized depository institutions are subject to appointment of a receiver or conservator.

Safety and Soundness Standards

The Federal Deposit Insurance Act requires the federal bank regulatory agencies to prescribe standards relating to internal controls, information systems and internal audit systems, loan documentation, credit underwriting, interest rate risk exposure, asset growth, asset quality, earnings, stock valuation, and compensation, fees and benefits, and such other operational and managerial standards as the agencies deem appropriate. The federal bank regulatory agencies have adopted a set of guidelines prescribing safety and soundness standards under the Federal Deposit Insurance Corporation Improvement Act. In general, the guidelines require appropriate systems and practices to identify and manage the risks and exposures specified in the guidelines. The guidelines prohibit excessive compensation as an unsafe and unsound practice and describe compensation as excessive when the amounts paid are

 

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unreasonable or disproportionate to the services performed by the executive officer, employee, director or principal shareholder. In addition, the agencies adopted regulations that authorize, but do not require, an agency to order an institution that has been given notice by an agency that is not satisfying any of such safety and soundness standards to submit a compliance plan. If, after being so notified, an institution fails to submit an acceptable compliance plan, the agency must issue an order directing action to correct the deficiency and may issue an order directing other actions of the types to which an undercapitalized institution is subject under the prompt correction action provisions of the Federal Deposit Insurance Corporation Improvement Act. If an institution fails to comply with such an order, the agency may seek to enforce such order in judicial proceedings and to impose civil money penalties.

Financial Modernization Legislation

The Gramm-Leach-Bliley Act of 1999 permits bank holding companies meeting management, capital and Community Reinvestment Act standards, and that register as a “financial holding company,” to engage in a broad range of non-banking activities, including insurance underwriting and investment banking. The Act allows insurance companies and other financial services companies to acquire banks and allows bank holding companies to acquire securities firms and mutual fund advisory companies. The Act requires appropriate safeguards if a bank holding company wishes to engage in any of these activities. The Act also contains extensive customer privacy protection provisions which require banks to adopt and implement policies and procedures for the protection of the financial privacy of their customers, including procedures that allow customers to elect that certain financial information not be disclosed to certain persons.

A bank holding company may become a financial holding company under the Gramm-Leach-Bliley Act if each of its subsidiary banks is “well capitalized” under the Federal Deposit Insurance Corporation Improvement Act prompt corrective action provisions, is well managed and has at least a satisfactory rating under the Community Reinvestment Act. In addition, the bank holding company must file a declaration with the Federal Reserve Board that the bank holding company wishes to become a financial holding company. A bank holding company that falls out of compliance with these requirements may be required to cease engaging in some of its activities. We registered as a financial holding company in September 2007 in order to invest in Beacon Title Agency, LLC, a title insurance agency, as a means to generate non-interest income. In November 2009, we sold our interest in Beacon Title Agency, LLC and terminated our financial holding company registration.

Regulation of North State Bancorp

As a bank holding company, we are subject to the supervision of, and to regular inspection by, the Board of Governors of the Federal Reserve System.

The Federal Reserve is authorized to adopt regulations affecting various aspects of bank holding companies. As a bank holding company, our activities, and those of companies which we control or in which we hold more than 5% of the voting stock, are limited to banking or managing or controlling banks or furnishing services to or performing services for our subsidiaries, or any other activity which the Federal Reserve determines to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. In making such determinations, the Federal Reserve is required to consider whether the performance of such activities by a bank holding company or its subsidiaries can reasonably be expected to produce benefits to the public such as greater convenience, increased competition or gains in efficiency that outweigh possible adverse effects, such as undue concentration of resources, decreased or unfair competition, conflicts of interest or unsound banking practices.

Generally, bank holding companies are required to obtain prior approval of the Federal Reserve to engage in any new activity not previously approved by the Federal Reserve or acquire more than 5% of any class of voting stock of any company. Bank holding companies also must obtain the prior approval of the Federal Reserve before acquiring more than 5% of any class of voting stock of any bank that is not already majority-owned by the bank holding company. Similarly, an entity seeking to acquire more than 5% of the voting securities of a bank holding company such as our company must first receive Federal Reserve approval.

Bank holding companies are required to give the Federal Reserve Board prior written notice of any purchase or redemption of outstanding equity securities if the gross consideration for the purchase or redemption, when combined with the net consideration paid for all such purchases or redemptions during the preceding 12 months, is equal to 10% or more of the holding company’s consolidated net worth. The Federal Reserve Board may disapprove such a purchase or redemption if it determines that the proposal would constitute an unsafe and unsound practice, or would violate any law, regulation, Federal Reserve Board order or directive, or any condition imposed by, or written agreement with, the Federal Reserve Board. Such notice and approval is not required for a bank holding company that would be treated as “well capitalized” under applicable regulations of the Federal Reserve Board, that has received a composite “1” or “2” rating at its most recent bank holding company inspection by the Federal Reserve Board, and that is not the subject of any unresolved supervisory issues.

 

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Bank holding companies are required to serve as a source of financial strength for their depository institution subsidiaries, and, if their depository institution subsidiaries become undercapitalized, bank holding companies may be required to guarantee the subsidiaries’ compliance with capital restoration plans filed with their bank regulators, subject to certain limits.

Bank holding companies must meet minimum capital requirements imposed by the Federal Reserve. These capital requirements are the same as those for banks imposed by the FDIC.

Dividends

As a bank holding company that does not, as an entity, currently engage in separate business activities of a material nature, our ability to pay cash dividends depends upon the cash dividends we receive from our subsidiary, North State Bank. At present, our only sources of income are cash dividends paid by the Bank. We must pay all of our operating expenses from funds we receive from the Bank. Therefore, shareholders may receive cash dividends from us only to the extent that funds are available after payment of our operating expenses and only in the event that the board decides to declare a dividend. In addition, the Federal Reserve Board generally prohibits bank holding companies from paying cash dividends except out of operating earnings where the prospective rate of earnings retention appears consistent with the bank holding company’s capital needs, asset quality and overall financial condition. To date, we have retained our earnings for use in the development of our business. As a relatively young bank holding company that expects to continue to expand its operations in Wake County, and other markets in North Carolina, we might or might not pay cash dividends on our common stock in the foreseeable future. We might not declare and pay any cash dividends, and if we were to do so, we might not continue to declare them or maintain them at the same level. We expect that, for the foreseeable future, any cash dividends paid by the Bank to us will likely be limited to amounts needed to pay any separate expenses or to make required payments on our debt obligations, including the interest payments on our junior subordinated debt.

Recent Legislation

On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act, or the Dodd-Frank Act, was signed into law. The Dodd-Frank Act implements far-reaching regulatory reform. Some of the more significant implications of the Dodd-Frank Act are summarized below:

 

   

Established centralized responsibility for consumer financial protection by creating a new agency, the Consumer Financial Protection Bureau, responsible for implementing, examining and enforcing compliance with federal consumer financial laws;

 

   

Established the same leverage and risk-based capital requirements that apply to insured depository institutions to most bank holding companies;

 

   

Required financial holding companies to be well-capitalized and well managed as of July 21, 2011; bank holding companies and banks must also be both well-capitalized and well managed in order to acquire banks located outside their home state;

 

   

Disallowed the ability of holding companies with more than $15 billion in assets to include trust preferred securities as Tier 1 capital; this provision will be applied over a three-year period beginning January 1, 2013;

 

   

Changed the assessment base for federal deposit insurance from the amount of insured deposits to consolidated assets less tangible capital;

 

   

Eliminated the ceiling on the size of the Deposit Insurance Fund and increased the floor on the size of the Deposit Insurance Fund;

 

   

Required implementation of corporate governance revisions, affecting areas such as executive compensation and proxy access by shareholders;

 

   

Repealed the federal prohibition on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts;

 

   

Amended the Electronic Fund Transfer Act to, among other things, give the Federal Reserve the authority to establish rules regarding interchange fees charged for electronic debit transactions by payment card issuers having assets over $10 billion and to enforce a new statutory requirement that such fees be reasonable and proportional to the actual cost of a transaction to the issuer; and

 

   

Increased the authority of the Federal Reserve to examine financial institutions including non-bank subsidiaries.

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 to financial institutions and consumers. Provisions in the legislation that affect the payment of interest on demand deposits are likely to increase the costs associated with deposits.

 

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The Dodd-Frank Act instituted significant changes to the overall regulatory framework for financial institutions including our company and the Bank. Many of the specific provisions of the Act have yet to be fully implemented, and the impact on us cannot be accurately predicted until regulations are enacted. The Dodd-Frank Act will likely cause a decline in certain revenues from consumer and mortgage products that are significant to our overall financial performance, and create additional compliance costs that we will incur.

Competition

The banking laws of North Carolina allow banks located in North Carolina to develop branches throughout the state. In addition, out-of-state institutions may open branches in North Carolina as well as acquire or merge with institutions located in North Carolina. As a result of such laws, banking in North Carolina is highly competitive.

We have six full-service banking offices located in Wake County and one full-service banking office in Wilmington, New Hanover County. These counties have numerous branches and corporate headquarters of money-center, super-regional, regional and statewide institutions, some of which have a major presence in Raleigh and Wilmington. In our market areas, we face competition from other banks, savings and loan associations, savings banks, credit unions, finance companies and major retail stores that offer competing financial services. Many of these competitors have greater resources, broader geographic coverage and higher lending limits than we do. We focus our efforts on selective customer groups including professional firms, professionals, churches, property management companies, non-profits and individuals who value a mutually beneficial banking relationship. We believe our efforts in attracting and keeping relationships with our chosen customers, helps to provide us with a competitive advantage. As of June 30, 2010, we held 2.86% and 1.29%, respectively, of deposits at bank offices in Wake and New Hanover County.

Employees

As of December 31, 2010, we had 118 full-time equivalent employees. We believe that our future success will depend in part on our continued ability to attract, hire, and retain qualified personnel. None of our employees are represented by a labor union. We have not experienced any work stoppages and consider our relations with our employees to be good.

Available Information

Our web site address is www.northstatebank.com. Information on our web site is not incorporated by reference herein. We make available free of charge through our web site our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission, or SEC.

 

Item 1A. Risk Factors

Ownership of shares of our securities involves certain risks. Holders of our securities and prospective investors in our securities should carefully consider the following risk factors and uncertainties described below together with all of the other information included and incorporated by reference in this report in evaluating an investment in our securities. If any of the risks and uncertainties discussed below actually occurs, our business, financial condition and results of operations could be materially adversely affected. In addition, other risks and uncertainties of which we are not currently aware, including those relating to the banking and financial services industries in general, or which we do not now believe are material, may cause earnings to be lower, or impair our future financial condition or results of operations. The value or market price of our common stock or any of our other securities could decline due to any of these identified or other risks, and you could lose all or part of your investment.

Risks Related to Our Business

Our Business May Be Adversely Affected by Conditions in the Financial Markets and Economic Conditions Generally.

The United States is still suffering the effects of the prolonged recession that began in 2007 and was officially declared over in June 2009. However, all indications show signs of a very slow recovery if not arguably the possibility of an ongoing recession. Business activity across a wide range of industries and regions remains greatly reduced compared to pre-2007 recession standards. Although there have been recent indications of increased consumer activity, local governments and many businesses are continuing to experience serious financial difficulty due to lower levels of consumer spending and the continued lack of liquidity in the credit markets. Unemployment has only declined slightly, remaining significantly higher than pre-recession levels with indications of continued high levels over the next several years. Since mid-2007 the financial services industry and the securities markets generally have been, and continue to be materially and adversely affected by significant declines in the values of nearly all asset classes and by a serious lack of liquidity and a lack of financing for many investors.

 

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Market conditions have also led to the failure or merger of a number of prominent financial institutions. In addition, declining asset values, defaults on mortgages and consumer loans, and the lack of market and investor confidence, as well as other factors, have all combined to cause rating agencies to lower credit ratings, and to otherwise increase the cost and decrease the availability of liquidity, despite very significant declines in Federal Reserve borrowing rates and other government actions.

Some banks and other lenders have suffered significant losses and have become reluctant to lend, even on a secured basis, due to the increased risk of default and the impact of reduced or declining asset values on the value of collateral. The foregoing has significantly weakened the strength and liquidity of some financial institutions. Since September 2008, the U.S. government, the Federal Reserve and other regulators have taken numerous steps to increase liquidity and to restore investor confidence, including significant investment in the equity of other banking organizations, but asset values generally have either continued to decline or remain low and access to liquidity continues to be very limited.

Our financial performance generally, and in particular the ability of our borrowers to pay interest on and repay principal of outstanding loans and the value of collateral securing those loans, is highly dependent upon the business environment in the markets where we operate in Wake and New Hanover counties, in North Carolina and in the United States as a whole.

Overall, during 2010, the business environment has continued to be adverse for many households and businesses in the United States. The business environment in North Carolina and the markets in which we operate has been less adverse than in the United States generally but remains weak and could deteriorate further. It is expected that the business environment in North Carolina and the United States will continue to be sluggish for the foreseeable future. There can be no assurance that these conditions will greatly improve in the near term. Such conditions could adversely affect the credit quality of our loans, the value of our investment securities, and our overall results of operations and financial condition.

The FDIC Deposit Insurance assessments that we are required to pay will increase, possibly materially, in the future, which would have an adverse affect on our earnings.

As a member institution of the FDIC, we are required to pay quarterly deposit insurance premium assessments to the FDIC. During the year ended December 31, 2010, we expensed $1.3 million in deposit insurance assessments and we paid $1.8 million in 2009. Due to the turmoil in 2008, 2009 and to a lesser extent in 2010 in the financial system, including the failure of several unaffiliated FDIC-insured depository institutions, the deposit insurance premium assessments paid by all banks have increased. Prior to 2009, banks paid anywhere from five basis points to 43 basis points for deposit insurance. The FDIC increased the assessment rate schedule by seven basis points (annualized) beginning on January 1, 2009. In May 2009, the FDIC passed amendments to the restoration plan for the Deposit Insurance Fund. This amendment imposed a five basis point emergency special assessment on insured depository institutions as of June 30, 2009. The assessment was collected on September 30, 2009. On March 17, 2009, the FDIC adopted changes to the Temporary Liquidity Guarantee Program, or TLGP, which may provide the possibility for reduction in the emergency special assessment by up to four basis points. An interim rule proposed on February 27, 2009 would also permit the FDIC to impose an emergency special assessment after June 30, 2009, of up to 10 basis points if necessary to maintain public confidence in federal deposit insurance. The FDIC also required insured institutions to prepay on December 30, 2009 their estimated quarterly risk-based insurance deposit premiums for the fourth quarter of 2009 and for all of 2010, 2011 and 2012. The assessment rate was based on the third quarter of 2009 and assumed a 5% annual growth rate in deposits each year with a three-basis point increase in assessment rates effective on January 1, 2011. The entire assessment is accounted for as a prepaid expense on our balance sheet, as of December 30, 2009. For each quarter in 2010, we have expensed the portion of the prepaid expense applicable for each quarter and will continue to charge as an expense to our earnings the portion of the applicable prepaid expense for each quarter of 2011 and 2012. The results of the special assessment and increased regular assessments will continue to have a significant impact on our results of operations for 2011 and in the future. Additional or increased assessments in the future also would impact our results of operations, perhaps significantly depending on the assessment.

The effects of the U.S. government’s plans to stabilize the financial system and the economy are unknown at this time.

In response to the 2008 – 2009 financial crisis affecting the financial markets and the banking system, the U.S. Congress on October 3, 2008 adopted the Emergency Economic Stabilization Act of 2008, or EESA, which established the Troubled Asset Relief Program, or TARP. Pursuant to the EESA, the Treasury was initially authorized to use $350 billion for the TARP. Of this amount, Treasury allocated $250 billion to the TARP Capital Purchase Program, or CPP. On January 15, 2009, the second $350 billion of TARP was released to the Treasury. The Secretary of the Treasury’s authority under TARP, which originally was set to expire on December 31, 2009, was extended to October 3, 2010. On February 17, 2009, the American Recovery and Reinvestment Act of 2009, or ARRA, was enacted as a sweeping economic recovery package intended to stimulate the economy and provide for extensive

 

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infrastructure, energy, health, and education needs. There can be no assurance as to the actual impact that EESA or its programs, including the CPP, and ARRA or its programs, will have on the national economy or financial markets. The failure of these significant legislative measures to help stabilize the financial markets and a continuation or worsening of current financial market conditions could materially and adversely affect our financial condition and results of operation.

Our profitability depends significantly on economic conditions in our market areas.

Our success depends to a large degree on the general economic conditions in Wake and New Hanover counties and adjoining markets. As of December 31, 2010, approximately 90.7% of our total loan portfolio was secured by real estate located in Wake and New Hanover Counties. The local economic conditions in these areas have a significant impact on the amount of loans that we make to our borrowers, the ability of our borrowers to repay these loans and the value of the collateral securing these loans. The recession affecting the nation as a whole began to affect North Carolina in the latter half of 2008. If the value of real estate in our market areas were to decline materially, a significant portion of our loan portfolio could become under collateralized despite our underwriting efforts to minimize risk, which could have a material adverse effect on us. A significant decline in general economic condition caused by the recession, unemployment and other factors beyond our control could impact our market areas, perhaps significantly, and could negatively affect our financial condition and performance. As an example, we increased our provision for loan losses in 2010 by $2.4 million, an increase of 41.8% over 2009. In addition, we charged off, net of recoveries, an aggregate of $6.7 million in loans in 2010, an increase of 92.3% from the aggregate amount charged off in 2009.

Our loan loss reserves may be insufficient.

We attempt to maintain an appropriate allowance for loan losses to provide for probable losses in our loan portfolio. We periodically determine the amount of the allowance based on consideration of several factors, including:

 

   

Historical loss rates through internal historical data;

 

   

Evaluation of general economic factors such as unemployment, inflation and interest rate environment;

 

   

Regulatory examination results and asset quality rating;

 

   

Regular reviews of loan delinquencies and overall loan portfolio quality; and

 

   

The levels of construction, development and non-owner occupied commercial real estate lending, the amount and quality of collateral, including guarantees, securing those loans and the levels of highly leveraged transactions.

There is no precise method of predicting credit losses, however, since any estimate of loan losses is necessarily subjective and the accuracy depends on the outcome of future events. Because a portion of our loan portfolio is relatively new due to rapid loan growth during the years 2006 through 2008, the current level of delinquencies and defaults may continue or increase in the future. If the economy continues to deteriorate, our borrowers could be negatively impacted which could result in higher charge-offs which could require us to increase our allowance for loan losses.

We make and hold in our loan portfolio a significant number of commercial real estate loans, including construction and development loans, which pose more credit and regulatory risk than other types of loans typically made by financial institutions.

At December 31, 2010, commercial real estate loans, including construction and development loans, comprised approximately 58.8% of our loan portfolio. The amount of commercial construction and development loans in our portfolio approximately doubled between 2007 and 2009, however, by the end of 2010 these loans had returned to near 2007 levels as we returned to our historic niche lending to our chosen customer groups with relationship deposit accounts while minimizing builder/developer lending activities. Real estate values are generally affected by changes in economic conditions, fluctuations in interest rates, the availability of loans to potential purchasers, changes in tax and other laws and acts of nature. Our concentration in commercial real estate exposes us to risk should the economy in our market areas continue to stagnate or further decline. Borrowers may not be able to make current payments on or repay commercial real estate loans and the value of the properties securing these loans may decline, which would reduce the security for these loans. A continuation of the stagnation or a further downturn in the real estate markets where we have loans could have a material adverse effect on our business, financial condition and results of operations. Further, banks’ concentration in commercial real estate loans have become a focal point of the federal banking regulators; our concentration in these loans subject us to adverse comment or action by our federal banking regulators, including the FDIC and the Federal Reserve.

 

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If we experience greater loan losses than anticipated, it would have an adverse effect on our net income.

While the risk of nonpayment of loans is inherent in banking, if we experience greater nonpayment levels than we anticipate, our earnings would be adversely impacted, which could adversely affect our overall financial condition. We cannot assure you that our monitoring procedures and policies will reduce certain lending risks or that our allowance for loan losses will be adequate to cover actual losses. In addition, as a result of the rapid growth in our loan portfolio between 2007 and 2008, loan losses may be greater than management’s estimates of the appropriate level for the allowance. Our net loan charge-offs in 2010 were $6.7 million and our provision for loan losses was $8.1 million, up 41.8% over the prior year. Loan losses can cause insolvency and failure of a financial institution. In addition, future provisions for loan losses could materially and adversely affect our profitability. Any loan losses will reduce our loan loss allowance. A reduction in our loan loss allowance may require an increase in our provision for loan losses, which would reduce our earnings.

Liquidity is essential to our business and we rely, in part, on external sources to finance a significant portion of our operations.

Liquidity is essential to our business. Our liquidity could be substantially negatively affected by our inability to attract sufficient deposits, access secured lending markets, brokered deposit markets or raise funding in the long-term or short-term capital markets. Factors that we cannot control, such as disruption of the financial markets or negative views about the financial services industry generally, could impair our ability to raise funding. In addition, our ability to raise funding could be impaired if the Federal Home Loan Bank or deposit brokers develop a negative perception of our long-term or short-term financial prospects. Such negative perceptions could be developed if we suffer a decline in the level of our business activity, regulatory authorities take significant action against us, or we discover employee misconduct or illegal activity, among other things. If we were unable to raise funds using the methods described above, we would likely need to liquidate unencumbered assets, such as our investment and loan portfolios, to meet maturing liabilities. We may be unable to sell some of our assets, or we may have to sell assets at a discount from market value, either of which could adversely affect our operations.

We may not be able to maintain and manage our growth, which may adversely affect our results of operations and financial condition and the value of our common stock.

Our strategy has been to increase the size of our company by opening new offices and pursuing business relationship opportunities within our chosen niches. We have grown rapidly since we began operations in 2000. We can provide no assurance that we will continue to be successful in increasing the volume of loans and deposits at acceptable risk levels and upon acceptable terms while managing the costs and implementation risks associated with our growth strategy. As anticipated, slower loan growth during 2010 coupled with higher loan charge-offs decreased loans by $22.3 million. We further anticipate continued slow growth in our volume of loans in 2011 as compared to our growth in previous years due to continued sluggish economic conditions and our focus on our historic customer groups. There can be no assurance that any further expansion will be profitable or that we will continue to be able to sustain our historic rate of growth, either through internal growth or through expansion in our existing markets or into new markets, or that we will be able to maintain capital sufficient to support our continued growth. If we grow too quickly, however, and are not able to control costs and maintain asset quality, rapid growth also could adversely affect our financial performance. There are considerable costs involved in opening new banking offices. New banking offices generally do not generate sufficient revenues to offset their costs until they have been in operation for at least a year or more. Also, we have no assurance these new or any future banking offices will be successful even after they are established.

Interest rate volatility could significantly harm our business.

Our results of operations may be significantly affected by the monetary and fiscal policies of the federal government and the regulatory policies of government authorities. A significant component of our earnings is our net interest income. Net interest income is the difference between income from interest-earning assets, such as loans, and the expense of interest-bearing liabilities, such as deposits and our borrowings. We may not be able to effectively manage changes in what we charge as interest on our earning assets and the expense we must pay on interest-bearing liabilities, which may significantly reduce our earnings. The Federal Reserve has made significant changes in interest rates during the last few years, and especially during 2008. The decline in market interest rates that occurred throughout 2008 and in particular in the fourth quarter of 2008 and the continued low rates in 2009 and 2010 negatively impacted our net interest income, net interest spread, net interest margin, and overall results of operations in those years. Since rates charged on loans often tend to react to market conditions faster than do rates paid on deposit accounts, these rate changes, especially decreasing rates, are expected to have a negative impact on our earnings until we can make appropriate adjustments in our deposit rates. Fluctuations in interest rates are not predicable or controllable and therefore there can be no assurances of our ability to continue to maintain a consistent positive spread between the interest earned on our earning assets and the interest paid on our interest-bearing liabilities. In addition, increases in interest rates could increase the interest we owe on our long-term debt which would have a negative effect on our results of operations.

 

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We rely heavily on the services of key personnel.

Larry D. Barbour, our president and chief executive officer, has substantial experience with our operations and has contributed significantly to our growth since our founding. The loss of the services of Mr. Barbour or of one or more members of our executive management team may have a material adverse effect on our operations. If Mr. Barbour or other members of our executive management team were no longer employed by us, our ability to implement our growth strategy could be impaired.

Our ability to retain and attract qualified employees is critical to the success of our business and the failure to do so may materially adversely affect our performance.

Our people are our most important resource and competition for qualified employees is intense. We may expand our banking network over the next several years, not just in our existing core market areas, but also in other community markets throughout central and eastern North Carolina and other contiguous markets. To expand into new markets successfully, we must identify and retain experienced key management members with local expertise and relationships in these markets. In order to attract and retain qualified employees, we must compensate such employees at market levels. Those levels have caused employee compensation to be our greatest noninterest expense as compensation is highly variable and moves with performance. If we are unable to continue to attract and retain qualified employees, or if compensation costs required to attract and retain employees become more expensive, our performance, including our competitive position, could be materially adversely affected.

We are subject to operational risk and an operational failure could materially adversely affect our businesses.

Operational risk refers to the risk of loss arising from inadequate or failed internal processes, people and/or systems. Operational risk also refers to the risk that external events, such as external changes (e.g., natural disasters, terrorist attacks and/or health epidemics), failures or frauds, will result in losses to our businesses.

Our business is highly dependent on our ability to process, on a daily basis, a large number of transactions and the transactions we process have become increasingly complex. We perform the functions required to operate our business either by ourselves or through agreements with third parties. We rely on the ability of our employees, our internal systems and systems at technology centers operated by third parties to process high numbers of transactions. In the event of a breakdown or improper operation of our own or our third-party’s systems or improper action by third parties or employees, we could suffer financial loss, impairment to our liquidity, a disruption of our businesses, regulatory sanctions and damage to our reputation.

In order to be profitable, we must compete successfully with other financial institutions which have greater resources and capabilities than we do.

The banking business in North Carolina in general and in Wake and New Hanover Counties in particular, in which we operate, is extremely competitive. Most of our competitors are larger and have greater resources than we do and have been in existence a longer period of time. We will have to overcome historical bank-customer relationships to attract customers away from our competition. We compete with other commercial banks, savings banks, thrifts, credit unions and securities brokerage firms.

Some of our competitors are not regulated as extensively as we are and, therefore, may have greater flexibility in competing for business. Some of these competitors are subject to similar regulation but have the advantages of larger established customer bases, higher lending limits, extensive branch networks, numerous automated teller machines, greater advertising-marketing budgets or other factors.

Our legal lending limit is determined by law and is based on our capital levels. The size of the loans that we offer to our customers may be less than the size of the loans that larger competitors are able to offer. This limit may affect our success in establishing relationships with the larger businesses in our markets.

 

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We are subject to extensive regulation that could limit or restrict our activities.

We operate in a highly regulated industry and are subject to examination, supervision, and comprehensive regulation by the North Carolina Office of the Commissioner of Banks, the FDIC, and the Federal Reserve Board. Our compliance with these regulations is costly and restricts certain of our current and possible future activities, including, investments, loans and interest rates charged, interest rates paid on deposits, locations of offices, payment of cash dividends, and mergers and acquisitions. We must also meet regulatory capital requirements. If we fail to meet these capital and other regulatory requirements, our financial condition, liquidity, and results of operations would be materially and adversely affected. Our failure to remain “well capitalized” and “well managed” for regulatory purposes could affect customer confidence, our ability to grow, the cost of our funds and FDIC insurance, our ability, should we decide, to pay cash dividends on our common stock, and our ability to make acquisitions. Further, a “critically undercapitalized” institution (even if it has a positive net worth) may not, beginning 60 days after becoming “critically undercapitalized,” make any payment of principal or interest on subordinated debt (subject to certain limited exceptions). Accordingly, if we were to become “critically undercapitalized,” we would generally be prohibited from making payments on the subordinated notes we issued in May and July 2008. In addition, “critically undercapitalized” institutions are subject to the appointment of a receiver or conservator with specified time frames. The regulators have discretion to impose additional restrictions on undercapitalized, significantly undercapitalized and critically undercapitalized institutions which could restrict our operations and our ability to make payments on our subordinated notes were we to fall under any undercapitalized category.

The Dodd-Frank Act will add to our compliance obligations and increase our cost of compliance, as well as likely adversely impact our revenues from consumer and mortgage products and could possibly adversely impact other parts of our business, financial condition and results of operations. Many provisions of the Act are subject to rulemaking and will take effect over several years, making it difficult for us to anticipate the overall financial impact on our business.

The laws and regulations applicable to the banking industry could change at any time, and we cannot predict the effects of these changes on our business and profitability. For example, new legislation or regulation could limit the manner in which we may conduct our business, including our ability to obtain financing, attract deposits, and make loans. Many of these regulations are intended to protect depositors, the public, and the FDIC, not shareholders. In addition, the burden imposed by these regulations may place us at a competitive disadvantage compared to competitors who are larger or who are less regulated. The laws, regulations, interpretations, and enforcement policies that apply to us have been subject to significant change in recent years, sometimes retroactively applied, and may change significantly in the future, including as part of the EESA. Any future legislation or regulation enacted into law could significantly alter the current regulatory scheme. Our cost of compliance with new legislation or regulation could adversely affect our ability to operate profitably.

Our growth or any future losses may require us to raise additional capital that may not be available when it is needed, or at all.

We are required by regulatory authorities to maintain adequate levels of capital to support our operations. We anticipate that our capital resources will satisfy our capital requirements for the foreseeable future. We may at some point, however, need to raise additional capital to support our continued growth, to offset operating losses, if any, or in response to regulatory changes. Our ability to raise additional capital, if needed, will depend in part on conditions in the capital markets at that time, which are outside our control, and on our financial performance. Accordingly, we may be unable to raise additional capital, if and when needed, on terms acceptable to us, or at all. If we cannot raise additional capital when needed, our ability to further expand our operations through internal growth and acquisitions could be materially impaired. In addition, if we issue additional equity capital, the interests of existing shareholders would be diluted.

Declines in value in investment securities held by us could require write-downs, which would reduce our earnings.

The securities in our investment portfolio primarily consist of U.S. Government securities and obligations of U.S. Government agencies as well as government-sponsored residential mortgage-backed securities, or MBSs, where mortgages are the underlying collateral. As a result of the national downturn in real estate markets and the rising mortgage delinquency and foreclosure rates, investors are increasingly concerned about these types of securities, which have negatively impacted the prices of such securities in the marketplace. The MBSs included in our investment portfolio are all agency-guaranteed with fixed rate mortgage securities underwritten and guaranteed by Freddie Mac (FHLMC) and Fannie Mae (FNMA) with Treasury funding commitment under the Treasury Senior Preferred Stock Purchase Agreement. We monitor the value of our investment portfolio regularly, including the ratings of securities in the portfolio and the dealer price quotes. Based upon these and other factors, the investment portfolio may experience impairment, which could harm our earnings and financial condition. If we were to conclude there were unrealized losses which were other than temporary, we would be required under U.S. generally accepted accounting principles, or GAAP, to reduce the carrying amount of the security to fair value and record a corresponding charge to earnings, which would also reduce our regulatory

 

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capital and negatively impact our capital ratios. These negative impacts could significantly impair our ability to borrow funds under credit arrangements, as well as various material depository arrangements and relationships. Temporary impairments on available for sale securities also reduce our book value per share as the changes in the value reduce shareholders’ equity. Currently, all of our available for sale securities in our investment portfolio are rated AAA by the three major rating agencies.

We are subject to security and operational risks relating to the use of our technology that could damage our reputation and business.

Security breaches in our internet banking activities could expose us to possible liability and damage our reputation. Any compromise of our security also could deter customers from using our internet banking services that involve the transmission of confidential information. We rely on standard internet security systems to provide the security and authentication necessary to effect secure transmission of data and access to bank informational systems. These precautions may not protect our systems from compromises or breaches of our security measures that could result in damage to our reputation and business. Additionally, we outsource our data processing to a third party. If our third party provider encounters difficulties or if we have difficulty in communicating with such a third party, it will significantly affect our ability to adequately process and account for customer transactions, which would significantly affect our business operations.

Volatile and illiquid financial markets resulting from a significant event in the market may hinder our ability to increase or maintain our current liquidity position.

Financial concerns in broad based financial sectors such as mortgage banking or home building may result in a volatile and illiquid bond market and may reduce or eliminate our ability to pledge certain types of assets to increase or maintain our liquidity position. A decline in our liquidity position may hinder our ability to grow the balance sheet through internally generated loan growth or otherwise.

Changes in the federal or state tax laws may negatively impact our financial performance.

We are subject to changes in tax law that could increase the effective tax rate payable to the state or federal government. These changes may be retroactive to previous periods and, as a result, could negatively affect our current and future financial performance.

Changes in accounting standards or interpretation of new or existing standards could materially affect our financial results.

From time to time the Financial Accounting Standards Board, or FASB, and the SEC change accounting regulations and reporting standards that govern the preparation of our consolidated financial statements. In addition, the FASB, the SEC, bank regulators and our outside independent auditors may revise their previous interpretations regarding existing accounting regulations and the application of these accounting standards. Revisions to these interpretations are beyond our control and may have a material impact on our results of operations.

Acts or threats of terrorism and political or military actions taken by the United States or other governments could adversely affect general economic or industry conditions.

Geopolitical conditions might affect our earnings. Acts or threats of terrorism and political or military actions taken by the United States or other governments in response to terrorism, or similar activity, could adversely affect general economic or industry conditions.

Unpredictable catastrophic events could have a material adverse effect on our operations.

The occurrence of catastrophic events such as hurricanes, earthquakes, pandemic disease, floods, other severe weather, fires or other catastrophes could adversely affect our financial condition or results of operations. Unpredictable natural and other disasters could have an adverse effect on us in that such events could materially disrupt our operations or the ability or willingness of our customers to access the financial services offered by us. The incidence and severity of catastrophes are inherently unpredictable. Although we carry insurance to mitigate our exposure to certain catastrophic events, these events could nevertheless reduce our earnings and cause volatility in our financial results for any fiscal quarter or year and have a material adverse effect on our financial condition and results of operations.

 

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Risks Related to Owning Our Common Stock

We have implemented anti-takeover devices that could make it more difficult for another company to acquire us, even though such an acquisition may increase shareholder value.

If we were to be acquired by another company, our shareholders may receive a premium for their shares. However, provisions in our articles of incorporation and bylaws could make it difficult for anyone to acquire us. Our articles of incorporation require a supermajority vote of two-thirds of our outstanding common stock in order to affect a sale or merger of our company that has not been approved by our board of directors. Our articles of incorporation also provide for “blank check” preferred stock, which allows our board of directors, without shareholder approval, to issue preferred shares with rights and preferences superior to those of our common stock, including superior rights on voting and to cash dividends and liquidation proceeds. In addition, our articles of incorporation permit our board to consider constituents other than our shareholders in deciding on a merger or sale of the company. These constituents are our employees, depositors, customers, creditors and the communities in which we conduct business. This provision also allows the board to consider the competence, experience and integrity of any proposed acquirer as well as the prospects of success of any merger or sale proposal. All of these provisions may make a merger or sale of our company more difficult or prevent a merger or sale altogether even if the merger or sale is supported by our shareholders and would provide them a premium for their shares.

Our bylaws divide the board of directors into three classes of directors serving staggered three-year terms with approximately one-third of the board of directors elected at each annual meeting of shareholders. The classification of directors makes it more difficult for shareholders to change the composition of the board of directors. As a result, at least two annual meetings of shareholders would be required for the shareholders to change a majority of the directors, whether or not a change in the board of directors would be beneficial and whether or not a majority of shareholders believe that such a change would be desirable. Consequently, a takeover attempt may prove difficult, and shareholders may not realize the highest possible price for their shares.

Our common stock is quoted on the Over-the-Counter Bulletin Board and is not quoted on a stock exchange, the trading volume is low and the sale of a substantial amount of our common stock in the public market could depress the price of our common stock.

Our common stock is not traded on a national stock exchange, such as the NASDAQ. It is only quoted on the Over-the-Counter Bulletin Board. Consequently, our common stock is not as liquid as most stocks traded on an exchange. In addition, the average daily trading volume of our shares as quoted on the Over-the-Counter Bulletin Board for all trading days in 2010 on which there were trades in our stock, were approximately 641 shares, which means our stock is thinly traded. Thinly traded stock can be more volatile than stock trading on an exchange. We cannot predict the extent to which an active public market for our common stock will develop or be sustained. Since mid-2008, the stock market has experienced an unprecedented level of price and volume volatility, and market prices for the stock of many companies have experienced wide price fluctuations that have not necessarily been related to their operating performance. Therefore, our shareholders may not be able to sell their shares at the volumes, prices, or times that they desire. We cannot predict the effect, if any, that future sales of our common stock in the market, or availability of shares of our common stock for sale in the market, will have on the market price of our common stock. We therefore can give no assurance that sales of substantial amounts of our common stock in the market, or the potential for large amounts of sales in the market, would not cause the price of our common stock to decline or impair our ability to raise capital through sales of our common stock.

We have never paid cash dividends and may not ever pay cash dividends.

We have never paid cash dividends on our common stock and may never do so. Consequently, any returns on an investment in our common stock in the foreseeable future will have to come from an increase in the value of the stock itself. As noted above, the lack of an active trading market for our common stock could make it difficult to sell shares of our common stock. The payment of cash dividends would be dependent on our operations, capital levels and needs and other factors.

Our securities are not FDIC insured.

None of our securities, including our common stock, is a savings or deposit account or other obligation of North State Bank, and none is insured by the FDIC or any other governmental agency and our securities are subject to investment risk, including the possible loss of principal.

 

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The holders of our junior subordinated debentures have rights that are senior to those of our common shareholders.

We have supported our past growth in part through the issuance of trust preferred securities from three special purpose trusts and an accompanying sale of an aggregate of $15.5 million junior subordinated debentures to these trusts. Payments of the principal and interest on the preferred securities of the trusts are conditionally guaranteed by us. Further, the accompanying junior subordinated debentures that we issued to the trusts are senior to our shares of common stock. As a result, we must make payments on the junior subordinated debentures before any cash dividends can be paid on our common stock and, in the event of our bankruptcy, dissolution or liquidation, the holder of the junior subordinated debentures must be satisfied before any distributions can be made on our common stock. We have the right to defer distributions on the junior subordinated debentures (and the related trust preferred securities) for up to five years, during which time no cash dividends may be paid on our common stock.

 

Item 1B. Unresolved Staff Comments

None.

 

Item 2. Properties.

Our headquarters and our main office are located in north Raleigh, North Carolina, where we occupy approximately 22,635 square feet of office space in a stand-alone building which we own. We have an operations center in north Raleigh that consists of approximately 9,773 square feet of office space under a lease extending through April 2017. Beginning in May 2008, we added another 1,756 square feet under lease in the same building. We have an office in North Hills Raleigh where we occupy approximately 12,000 square feet of office space under a lease extending through March 2015. We own an office in west Raleigh that consists of approximately 10,000 square feet, approximately 5,200 square feet of which we occupy and the remainder of which is under tenant lease. We have an office in Garner, North Carolina, where we own a building that has approximately 5,000 square feet of office space. We own an office in the Wakefield area of Raleigh, which has approximately 10,000 square feet of office space. We have an office in Wilmington where we occupy the entire first floor, approximately 9,440 square feet of office space, in a stand-alone building under lease. This lease runs through December 31, 2022. We moved our downtown Raleigh office in August 2010 where we lease 4,300 square feet of office space on the first floor. This lease runs through June 2020. We continue to lease approximately 3,700 square feet of office space in downtown Raleigh which is currently unoccupied. The rent expense on the unoccupied space is reimbursed monthly by our new landlord until the lease expires at the end of October 2011.

 

Item 3. Legal Proceedings.

From time to time, we are party to various legal proceedings or claims, either asserted or unasserted, which arise in the ordinary course of business. Although the ultimate outcome of these matters cannot be determined until final resolution of the matter, we do not believe that the resolution of any of these matters will have a material effect upon our financial condition or results of operations in any interim or annual period.

 

Item 4. Reserved.

PART II

 

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

Stock Information

Our common stock is not traded on any exchange. Our stock is listed on the Over-the-Counter Bulletin Board under the symbol “NSBC.OB.” Set forth below for each quarter in 2010 and 2009 is information on the high and low bid and asked prices of our common stock as reported on the Over-the-Counter Bulletin Board.

 

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     High      Low  

Fiscal Year Ended December 31, 2010

     

January 1 through March 31, 2010

   $ 5.00       $ 3.90   

April 1 through June 30, 2010

     4.50         3.50   

July 1 through September 30, 2010

     4.40         3.58   

October 1 through December 31, 2010

     4.25         2.75   

Fiscal Year Ended December 31, 2009

     

January 1 through March 31, 2009

   $ 8.00       $ 5.45   

April 1 through June 30, 2009

     6.50         4.75   

July 1 through September 30, 2009

     7.99         5.10   

October 1 through December 31, 2009

     6.95         2.76   

As of March 17, 2011, there were approximately 538 shareholders of record. We estimate that there were approximately 1,078 beneficial owners on March 17, 2011.

Dividends

To date, we have not paid any cash dividends. Our ability to pay cash dividends is dependent on the earnings of our subsidiary, North State Bank. Pursuant to the order of the North Carolina Commissioner of Banks approving the organization of North State Bank in 2000, North State Bank could not pay cash dividends for its first three years of operation. In the future, we expect that any earnings will be used for the development of our business as we seek to expand our operations in North Carolina. Subject to these restrictions, the Board of Directors will consider the payment of cash dividends when it is deemed prudent to do so. Further, our ability to declare and pay cash dividends depends upon, among other things, restrictions imposed by the reserve and capital requirements of North Carolina and federal law, our income and fiscal condition, tax considerations, and general business conditions. Therefore, we might or might not pay cash dividends on our common stock in the foreseeable future, and it is possible we might never pay cash dividends.

On March 17, 2004, our trust subsidiary issued preferred securities in a private placement. On December 15, 2005 and on November 28, 2007, our second and third trust subsidiaries, respectively, issued preferred securities in a private placement. In each instance, we, in turn, issued $5.0 million unsecured subordinated debentures to each trust to serve as the income source for the trust’s payment of interest on its preferred securities. Pursuant to the terms of the indentures that govern our debentures, we are prohibited from paying cash dividends on our stock in the event we are in default on the terms of the debentures or the indentures.

Equity Compensation Plans

Set forth below is information on our equity compensation plans as of December 31, 2010.

 

Plan Category

   Number of securities
to be issued
upon exercise of
outstanding options,
warrants and rights
     Weighted-average
exercise  price of
outstanding options,
warrants and rights
     Number of  securities
remaining available for
future issuance under
equity compensation plans
 

Equity compensation

plans approved by our

shareholders

     140,498       $ 8.51         497,498   

Equity compensation plans not approved by our shareholders

     —           —           —     
                          

Total

     140,498       $ 8.51         497,498   

Our equity compensation plans consist of the 2000 Stock Option Plan for Employees, the 2000 Stock Option Plan for Non-Employee Directors and the 2003 Stock Plan, all of which were approved by our shareholders. The 2003 Stock Plan replaced the two prior plans. We do not have any equity compensation plans or arrangements that have not been approved by our shareholders.

 

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Comparison of Cumulative Total Return

The following graph compares the cumulative total shareholder return on our common stock over the five-year period ended December 31, 2010, with the cumulative total return for the same period on the Russell 2000 Index, the SNL $500M—$1B and SNL Bank Pink Banks Index. The graph assumes that at the beginning of the period indicated $100 was invested in our common stock and the stock of the companies comprising the Russell 2000 Index, the SNL $500M—$1B and SNL Bank Pink Sheets Index, and that all dividends, if any, were reinvested. Prices are based on quotations for our common stock on the Over-the-Counter Bulletin Board.

LOGO

 

      Period Ending  

Index

   12/31/05      12/31/06      12/31/07      12/31/08      12/31/09      12/31/10  

North State Bancorp

     100.00         165.89         132.20         72.58         44.07         36.39   

Russell 2000

     100.00         118.37         116.51         77.15         98.11         124.46   

SNL Bank $500M-$1B

     100.00         113.73         91.14         58.40         55.62         60.72   

SNL Bank Pink

     100.00         109.49         99.37         71.28         60.58         62.46   

 

Item 6. Selected Financial Data.

The following table sets forth selected consolidated financial information for our company as of and for the years ended December 31, 2010, 2009, 2008, 2007 and 2006. The data has been derived from our audited consolidated financial statements. The consolidated financial statements as of December 31, 2010 and 2009 and for the years ended December 31, 2010, 2009 and 2008 and the independent registered public accounting firm’s report thereon are included elsewhere in this report. The following should also be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in Item 7 of this report.

 

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     As of or for the Year Ended December 31,  
     2010     2009     2008     2007     2006  
     (Dollars in thousands, except per share data)  

Operating Data:

          

Total interest income

   $ 30,962      $ 33,440      $ 36,075      $ 32,738      $ 26,412   

Total interest expense

     7,488        11,846        15,817        15,439        11,587   
                                        

Net interest income

     23,474        21,594        20,258        17,299        14,825   

Provision for loan losses

     8,095        5,710        2,755        1,339        69   
                                        

Net interest income after provision for loan losses

     15,379        15,884        17,503        15,960        14,756   

Noninterest income

     4,476        1,168        1,226        1,121        1,174   

Noninterest expense

     18,036        15,137        14,809        12,033        10,743   
                                        

Income before income taxes

     1,819        1,915        3,920        5,048        5,187   

Provision for income taxes

     795        817        1,555        1,953        1,915   
                                        

Net income

   $ 1,024      $ 1,098      $ 2,365      $ 3,095      $ 3,272   
                                        

Per Share Data: (1)

          

Earnings per share - basic

   $ 0.14      $ 0.15      $ 0.33      $ 0.45      $ 0.49   

Earnings per share - diluted

     0.14        0.15        0.32        0.42        0.46   

Market price:

          

High

     5.00        8.00        14.35        21.75        16.66   

Low

     2.75        2.76        5.25        12.00        9.55   

Close

     3.51        4.25        7.00        12.75        16.00   

Tangible book value

     5.03        5.02        4.96        4.52        3.90   

Weighted average shares outstanding:

          

Basic

     7,363,618        7,179,744        7,158,545        6,917,365        6,617,228   

Diluted

     7,389,397        7,316,292        7,356,364        7,301,377        7,162,121   

Selected Year-End Balance Sheet Data:

          

Total assets

   $ 633,865      $ 679,429      $ 687,581      $ 547,520      $ 455,477   

Loans - held for sale

     51,472        —          —          —          —     

Loans

     499,523        521,809        546,357        469,228        345,943   

Allowance for loan losses

     9,935        8,581        6,376        5,020        3,983   

Deposits

     562,748        606,888        612,678        457,310        402,078   

Short-term borrowings

     3,615        6,103        7,782        37,886        10,670   

Long-term debt

     27,269        27,290        27,311        16,332        11,196   

Shareholders’ equity

     37,502        36,166        35,546        31,557        26,597   

Selected Average Balances:

          

Total assets

   $ 656,006      $ 695,908      $ 594,532      $ 472,827      $ 398,097   

Loans - held for sale

     30,726        —          —          —          —     

Loans

     510,000        541,576        520,075        393,927        316,620   

Total interest-earning assets

     613,103        658,549        571,615        454,005        382,899   

Deposits

     582,154        618,242        512,855        412,125        349,070   

Short-term borrowings

     5,804        9,236        16,130        14,681        10,784   

Long-term debt

     27,271        27,291        26,927        11,666        11,205   

Total interest-bearing liabilities

     500,302        563,999        476,414        349,144        284,504   

Shareholders’ equity

     37,896        36,974        34,526        29,219        23,944   

Selected Performance Ratios:

          

Return on average assets

     0.16     0.16     0.40     0.65     0.82

Return on average equity

     2.70     2.97     6.85     10.59     13.67

Net interest spread (4)

     3.55     2.98     2.99     2.79     2.83

Net interest margin (4)

     3.83     3.28     3.54     3.81     3.87

Noninterest income to total revenue

     16.01     5.13     5.71     6.09     7.34

Noninterest income to average assets

     0.68     0.17     0.21     0.24     0.29

Noninterest expense to average assets

     2.75     2.18     2.49     2.54     2.70

Efficiency ratio

     64.53     66.50     68.83     65.33     67.15

Asset Quality Ratios:

          

Nonaccrual loans to period-end loans

     2.30     3.61     0.93     0.66     0.11

Allowance for loan losses to period-end loans

     1.99     1.64     1.17     1.07     1.15

Ratio of allowance for loan losses to nonaccrual loans

     0.86 x        0.46 x        1.26 x        1.62 x        10.03 x   

Nonperforming assets to total assets

     2.65     3.26     1.07     0.57     0.09

Net charge-offs/(recoveries) to average loans

     1.32     0.65     0.27     0.08     -0.07

 

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     As of or for the Year Ended December 31,  
     2010     2009     2008     2007     2006  
     (Dollars in thousands, except per share data)  

Capital Ratios (2):

          

Total risk-based capital

     12.99     12.64     11.99     10.32     10.21

Tier 1 risk-based capital

     9.64     9.34     8.85     9.25     9.09

Leverage ratio

     8.04     7.31     7.39     8.50     7.58

Equity to assets ratio

     5.92     5.32     5.17     5.76     5.84

Average equity to average assets

     5.78     5.31     5.81     6.18     6.01

Other Data (3):

          

Number of banking offices

     7        8        8        7        6   

Number of full time equivalent employees

     118        96        100        99        75   

 

(1) Adjusted for the 3-for-2 stock splits in 2007 and 2006.
(2) Capital ratios are for bank only.
(3) Includes one loan production office for the years 2009, 2008, 2007, and 2006.
(4) Excludes average nonaccrual loans in the calculation for the years 2010, 2009 and 2008.

 

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Management’s Discussion and Analysis

The following discussion and analysis is presented to assist in understanding our consolidated financial condition and results of operations for the years ended December 31, 2010 and 2009. You should read this discussion and the related financial data in conjunction with the information set forth under Item 1A “Risk Factors,” and our audited consolidated financial statements and the related footnotes, which are included elsewhere in Item 8 in this report. Because we have no operations and our only significant business is the ownership of North State Bank, the following discussion concerns primarily the business of the Bank. However, for ease of reading and because the financial statements are presented on a consolidated basis, this discussion makes no distinction between our company and the Bank unless otherwise noted.

Recent Market Developments in the Banking Industry

Although recent news indicates the recession ended in June of 2009, the economy continues to experience reduced business activity as a result of the prolonged recession which began in 2007. Although there has been some stability in real estate prices in some areas, in others declines continue due to falling real estate prices on homes and commercial real estate, a continued high level of unemployment as well as continued increases in foreclosures.

Our financial performance generally, and in particular the ability of our borrowing customers to pay interest on and repay principal of outstanding loans and the value of collateral securing those loans, is highly dependent upon the business environment in the markets where we operate in Wake and New Hanover Counties, in North Carolina. Due to the state of the economy in our market areas and the resultant potential impact on our loan portfolio, we continue to closely monitor our loan portfolio, nonperforming assets and allowance for loan losses. See the discussions on “Provision for Loan Losses” and “Allowance for Loan Losses and Asset Quality.” The business environment in North Carolina and the markets in which we operate may continue to see some deterioration for the foreseeable future which could continue to adversely impact our earnings in the future.

The resulting effects of the deep and prolonged recession on the real estate market and economy could adversely affect the credit quality of our loans and our overall results of operations and financial condition in the future. Further, the U.S. government’s response to the recession and the financial crisis could significantly impact our operations, including the recent and potential imposition of new laws and regulations and regulatory assessments.

The FDIC required insured institutions to prepay on December 30, 2009 their estimated quarterly risk-based insurance deposit premiums for the fourth quarter of 2009 and for all of 2010, 2011 and 2012. The assessment rate was based on the third quarter of 2009 and assumed a 5% annual growth rate in deposits each year with a three-basis point increase in assessment rates effective on January 1, 2011. The $4.9 million assessment we paid was accounted for as a prepaid expense on our balance sheet, as of December 30, 2009. Our earnings for the year ended December 31, 2010 include the applicable portion of the prepaid expense for the period. We generally are unable to control the amount of premiums that we are required to pay for FDIC insurance. Additional bank or financial institution failures may require payment of even higher FDIC premiums than the recently increased levels. Any future changes in the calculation or assessment of FDIC insurance premiums may have a material adverse effect on our results of operations and financial condition.

 

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In response to the financial crisis affecting the banking system and financial markets and going concern threats to investment banks and other financial institutions, the U.S. Government adopted in the fourth quarter of 2008 the Emergency Economic Stabilization Act, or EESA, and authorized the Department of the Treasury to establish the Troubled Asset Relief Program, or TARP, to purchase equity stakes in a wide variety of banks and thrifts through TARP’s Capital Purchase Program, or CPP. After careful and complete evaluation, our Board of Directors chose not to participate in the CPP. Also, the FDIC adopted the Temporary Liquidity Guarantee Program, or TLGP, as an initiative to counter the system-wide crisis in the nation’s financial sector. We elected to participate in the TLGP, in part, through full FDIC insurance coverage of all non-interest bearing deposit transaction accounts regardless of dollar amount. The Dodd-Frank Wall Street Reform and Consumer Protection Act, enacted in August 2010, permanently sets the deposit insurance limit for banks at $250,000 which was scheduled to expire December 31, 2013. We also elected to participate in the Transaction Account Guarantee, or TAG, program which was recently extended for an additional six months through December 31, 2010 and also provides for an additional extension of the program, without further rulemaking, for a period of time not to exceed December 31, 2011. Under TAG, customers of participating insured depository institutions are provided full coverage on qualifying transaction accounts. The rule requires that interest rates on qualifying NOW accounts be reduced to .25%. On November 9, 2010 the FDIC issued a final rule implementing Section 343 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Section 343 provides unlimited deposit insurance for noninterest-bearing transaction accounts from December 31, 2010 through December 31, 2012. This rule is similar to the FDIC’s TAG program and is set to replace the TAG program once that program expires at the end of 2010. Initially Section 343 excluded low interest bearing Negotiable Order of Withdrawal, or NOW, accounts, and Interest on Lawyers Trust Account, or IOLTA. These accounts under Section 343 would be insured under the general insurance rules up to the standard maximum insurance amount of $250,000. During February 2011, Section 343 was modified to provide unlimited FDIC coverage to IOLTA accounts through December 31, 2010. We will continue to monitor and evaluate the Dodd-Frank Act and its effect on our bank and the banking industry in general.

Description of Business

We are a commercial bank holding company that was incorporated on June 5, 2002. We have one subsidiary, North State Bank, which we acquired on June 28, 2002 as part of our bank holding company reorganization. In March 2004, we established a subsidiary trust, North State Statutory Trust I, which we refer to as Trust I, to issue trust preferred securities. In December 2005, we established a second subsidiary trust, North State Statutory Trust II, which we refer to as Trust II and in November 2007 we established a third subsidiary trust, North State Statutory Trust III, which we refer to as Trust III. Our only business is the ownership and operation of North State Bank and its three subsidiary trusts.

North State Bank is a North Carolina chartered banking corporation. The Bank, which offers a full array of commercial and retail banking services, opened for business on June 1, 2000. Through the Bank, we currently operate six full-service banking offices located in Raleigh and Garner, North Carolina and one full-service banking office located in Wilmington, North Carolina. Our principal customers consist of professional firms, professionals, churches, property management companies, non-profits and individuals who value a mutually beneficial banking relationship. The Bank has a subsidiary, North State Financial Services, Inc., which offers brokerage services and wealth management. In February 2010, we acquired the operations of a Raleigh-based mortgage lender, Affiliated Mortgage, LLC, creating North State Bank Mortgage, or NSB Mortgage, as a division of the Bank for the purpose of originating and selling single-family residential first mortgages.

Financial Condition at December 31, 2010 and 2009

Overview

Total assets as of December 31, 2010 were $633.9 million, a decrease of $45.6 million or 6.7% over December 31, 2009. The decrease in assets is primarily due to a decrease in our loan portfolio. Our loan portfolio decreased $22.3 million to $499.5 million from $521.8 million as of December 31, 2009. Our loan portfolio continues to decline from 2008 levels primarily due to lower loan demand, higher levels of loan charge-offs and transfers to foreclosed assets. Other interest-earning deposits with banks and certificates of deposits invested in other insured banking institutions decreased $7.1 million and $50.0 million, respectively, from December 31, 2009. Funds from these accounts were reinvested into the loan pipeline of NSB Mortgage, our new mortgage division. Emphasis on building core deposits coupled with lower loan demand provided the opportunity to reduce non-traditional funding sources and jumbo certificates of deposit throughout the year. Overall our deposits were down $44.1 million or 7.3% to $562.7 million as of December 31, 2010, compared to total deposits of $606.9 million as of December 31, 2009 due to the elimination or decrease in nontraditional deposit funds.

We continue to utilize our Federal Reserve account for our overnight excess funds. Our interest-earning deposits with banks as of December 31, 2010 included $42.4 million in excess overnight funds in our Federal Reserve account and $1.5 million held at correspondent banks compared to $49.9 million and $1.1 million, respectively, as of December 31, 2009. Certificates of deposit with federally insured banking institutions decreased $50.0 million to $198,000 as of December 31, 2010. These certificates of deposit are fully insured by the FDIC with an average remaining maturity of less than one month as of December 31, 2010. Excess funds from our Federal Reserve account and maturing certificates of deposit were primarily re-deployed into our mortgage loan pipeline.

 

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Substantially all of our investments are accounted for as available for sale and are presented at their fair market value. Our available for sale investment portfolio decreased $14.2 million to $9.2 million as of December 31, 2010. As part of our investment portfolio management, we strategically sold $21.0 million of our U.S. Treasury notes and Government-sponsored residential mortgage-backed securities for gains of $741,000 during 2010. Maturities were $17.1 million during the year. Proceeds from these sales and maturities were in part utilized by our mortgage loan pipeline as well as for new purchases of U.S. Treasury notes and Government-sponsored residential mortgage-backed securities. We own $250,000 in corporate bonds that are accounted for as held to maturity and are carried at book value.

Our portfolio loans decreased to $499.5 million as of December 31, 2010 compared to $521.8 million as of December 31, 2009. The decline in the loan portfolio reflects a higher level of loan payoffs over new loan volume, $6.7 million of net loan charge-offs and transfers to foreclosed assets of $9.2 million. New loan demand remains slow due to the continued effects of the recession coupled with our strategic focus on lending to our targeted customer groups. Our loan portfolio continues to represent our largest earning asset component at 78.8% of total assets. With our new mortgage division, NSB Mortgage, we also originate single-family, residential first mortgage loans that have been approved for purchase by secondary investors and are sold in the secondary market. As of December 31, 2010, mortgage loans held for sale were $51.5 million.

The allowance for loan losses was $9.9 million as of December 31, 2010 compared to $8.6 million as of December 31, 2009, representing 1.99% and 1.64% of loans outstanding, respectively, at each balance sheet date. The allowance is increased by provisions charged to operations and reduced by loans charged off, net of recoveries. The level of the allowance relative to gross loans increased primarily due to higher charge-off and other risk factors applied to the loan portfolio as of December 31, 2010 over the prior year-end. We established the allowance for loan losses at a level management considers adequate to provide for probable loan losses based on our assessment of our loan portfolio as of December 31, 2010. We monitor the allowance monthly.

Our premises and equipment remained substantially unchanged from year-end 2009 at $14.8 million. Foreclosed assets increased to $5.3 million as of December 31, 2010 from $3.3 million as of December 31, 2009, reflecting $9.2 million of additional properties, sales of foreclosed properties of $6.0 million, capital expenditures on foreclosed properties of $169,000 and valuation adjustments on foreclosed properties of $1.1 million during the year ended December 31, 2010. Additional discussion regarding foreclosed assets is included in the section “Allowance for Loan Losses and Asset Quality.”

As of December 31, 2010 our deposits were $562.7 million, a decrease of $44.1 million from $606.9 million as of December 31, 2009, substantially in non-relationship deposits. Traditional core deposits grew $24.9 million providing the opportunity to eliminate in January 2010 all of the $20.1 million of wholesale brokered certificates of deposit included on our balance sheet at December 31, 2009. In addition, non-relationship, non-brokered internet deposits, which are certificates of deposit issued by means of an internet subscription service, were reduced to $5.2 million as of December 31, 2010, down $28.3 million from December 31, 2009. Our core deposit growth is a result of our efforts to seek opportunities to develop banking relationships with our targeted customer groups throughout all our markets in general and through the success of our property management division “CommunityPLUS.” As of December 31, 2010, deposits in this division represented approximately 35.6% of our total deposits, up from 24.7% of total deposits as of December 31, 1009 and 18.4% as of December 31, 2008.

Improvement in our deposit mix also resulted from our efforts to strengthen our relationship deposits. Noninterest-bearing demand deposits and low-cost interest-bearing transaction accounts increased to 20.9% and 44.5%, respectively, of total deposits as of December 31, 2010 compared to 17.3% and 38.3%, respectively, as of December 31, 2009. Simultaneously, higher costing time deposits declined to 34.6% of total deposits compared to 44.4% for the prior year period. In total, our core deposits continued to increase, up $24.9 million to $437.8 million from $412.9 million as of December 31, 2009, representing 77.8% compared to 68.0%, respectively, of our total deposits as of December 31, 2010 and December 31, 2009. As noted above, our “CommunityPLUS” division, dedicated to growing deposits specifically in the property management industry, was a key factor to our core deposit growth, increasing approximately $50.7 million to $200.4 million as of December 31, 2010 compared to $149.7 million as of December 31, 2009.

Short-term borrowings of $3.6 million as of December 31, 2010 consisted entirely of securities sold under repurchase agreements, down $2.5 million from December 31, 2009. We utilize short-term borrowings to support our balance sheet management, however our strong core deposit growth during 2010 reduced the need for this funding source. Long-term borrowings were essentially unchanged from December 31, 2009 at $27.3 million, consisting primarily of $11.0 million of subordinated notes and $15.5 million in junior subordinated debentures.

Total shareholders’ equity increased $1.3 million to $37.5 million as of December 31, 2010. The increase was primarily provided by net income of $1.0 million and the conversion of 229,463 stock options held by directors and employees into common stock which contributed $671,000 to our total shareholders’ equity. Other comprehensive income components decreased shareholders’ equity as of December 31, 2010 by $459,000.

 

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Investments

Our investment portfolio primarily consists of U.S. Treasury notes and U.S. Government agency securities, including residential mortgage-backed securities, or MBSs. The MBSs consist of fixed-rate mortgage securities underwritten and guaranteed by Freddie Mac (FHLMC) and Fannie Mae (FNMA) with Treasury funding commitment under the EESA. Currently, all of our available for sale securities in our investment portfolio are rated AAA by the three major rating agencies. We continue to have no holdings in Fannie Mae or Freddie Mac preferred stock and no holdings in non-agency mortgage-backed securities. Most all of the securities held in our investment portfolio are available for sale. In addition to economic and market conditions, our overall management strategy for our investment portfolio is determined by, among other factors, loan demand, deposit mix, liquidity and collateral needs, our interest rate risk position and the overall structure of our balance sheet.

Available for sale securities are reported at fair value and consist of debt instruments not classified as trading securities or as held to maturity securities. Unrealized holding gains and losses on available for sale securities are reported, net of related tax effect, in other comprehensive income. Gains and losses on the sale of available for sale securities are determined using the specific-identification method. Premiums and discounts are recognized in interest income using the interest method over the period to maturity. During 2010 we strategically sold $21.0 million of our U.S. Treasury notes and Government-sponsored residential mortgage-backed securities for gains of $741,000 during 2010. Maturities were $17.1 million during the year. Proceeds from these sales and maturities were in part utilized by our mortgage loan pipeline as well as for $24.0 million in new purchases of U.S. Treasury notes and Government-sponsored residential mortgage-backed securities. As of December 31, 2010 we own $250,000 in corporate bonds that are accounted for as held to maturity and are carried at book value. During 2008, the Bank purchased $750,000 of corporate bonds accounted for as held to maturity and are carried at book value. During June 2010, $500,000 of the corporate bonds were transferred for collateral on a community reinvestment loan. Declines in the fair value of individual held to maturity and available for sale securities below their cost that are other than temporary would result in permanent write-downs of the individual securities to their fair value. If we do not intend to sell the security prior to recovery and it is more likely than not we will not be required to sell the impaired security prior to recovery, the credit loss portion of the impairment is recognized in earnings and the remaining impairment is recognized in other comprehensive income. Otherwise, the full impairment loss is recognized in earnings. The classification of securities is generally determined at the date of purchase.

The tables below present information on our investment portfolio at the dates indicated.

 

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     As of December 31, 2010  
     Amortized
cost
     Gross
unrealized
gains
     Gross
unrealized
losses
     Fair
value
 
             
             
     (Dollars in thousands)  

Securities available for sale:

           

U. S. government securities and obligations of U.S. government agencies

   $ 5,500       $ —         $ —         $ 5,500   

Government-sponsored residential mortgage-backed securities

     3,829         28         123         3,734   
                                   

Total securities available for sale

   $ 9,329       $ 28       $ 123       $ 9,234   
                                   

Securities held to maturity:

           

Corporate securities

   $ 250       $ —         $ 39         211   
                                   

Total securities held to maturity

   $ 250       $ —         $ 39       $ 211   
                                   
     As of December 31, 2009  
     Amortized
cost
     Gross
unrealized
gains
     Gross
unrealized
losses
     Fair
value
 
             
             
     (Dollars in thousands)  

Securities available for sale:

           

Government-sponsored residential mortgage-backed securities

   $ 22,745       $ 686       $ 33       $ 23,398   
                                   

Total securities available for sale

   $ 22,745       $ 686       $ 33       $ 23,398   
                                   

Securities held to maturity:

           

Corporate securities

   $ 750       $ —         $ 57         693   
                                   

Total securities held to maturity

   $ 750       $ —         $ 57       $ 693   
                                   
     As of December 31, 2008  
     Amortized
cost
     Gross
unrealized
gains
     Gross
unrealized
losses
     Fair
value
 
             
             
     (Dollars in thousands)  

Securities available for sale:

           

U. S. government securities and obligations of U.S. government agencies

   $ 15,271       $ 573       $ —         $ 15,844   

State and municipal securities

     1,434         10         1         1,443   

Government-sponsored residential mortgage-backed securities

     18,721         407         9         19,119   
                                   

Total securities available for sale

   $ 35,426       $ 990       $ 10       $ 36,406   
                                   

Securities held to maturity:

           

Corporate securities

   $ 750       $ —         $ 14       $ 736   
                                   

Total securities held to maturity

   $ 750       $ —         $ 14       $ 736   
                                   

The amortized cost, fair value and weighted average yield of securities available for sale at December 31, 2010 by contractual maturity are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

 

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     As of December 31, 2010  
     Amortized
Cost
     Fair
Value
     Weighted
Average
Yield
 
          
          
     (Dollars in thousands)         

Securities available for sale:

        

U. S. government securities and obligations of U.S. government agencies

        

Due within one year

   $ 5,500       $ 5,500         0.12
                    
     5,500         5,500         0.12
                    

Government-sponsored residential mortgage-backed securities

        

Due within one year

     195         200         4.72

Due after one but within five years

     440         458         4.38

Due after ten years

     3,194         3,076         2.70
                    
     3,829         3,734         2.99
                    

Total Securities available for sale:

        

Due within one year

   $ 5,695       $ 5,700         0.28

Due after one but within five years

     440         458         4.38

Due after ten years

     3,194         3,076         2.70
                    
   $ 9,329       $ 9,234         1.30
                    

Securities held to maturity:

        

Corporate securities

        

Due after five but within ten years

   $ 250       $ 211         4.26
                    
   $ 250       $ 211         4.26
                    

Loan Portfolio

Our loan policies and procedures establish the basic guidelines governing lending operations. Generally, the guidelines address the type of loans that we seek, target markets, underwriting and collateral requirements, terms, interest rate and yield considerations and compliance with laws and regulations. The policies are reviewed and approved at least annually by the board of directors. Responsibility for loan review, underwriting, compliance and document monitoring resides with the chief credit officer and his staff and are responsible for loan processing and approval. All loans and credit lines are subject to approval procedures and amount limitations. Depending upon the loan requested, approval may be granted by the individual commercial banker, our credit administration officers or, for the largest relationships, the loan committee of our Board of Directors. Any loan exposure in the aggregate greater than $3 million requires the approval of the loan committee. All individual loan authorities are reviewed and approved annually by the chief credit officer, chief executive officer and the loan committee.

Our current loan portfolio includes loans provided to customers outside our established groups such as builders and developers in the residential and commercial real-estate industry. We transitioned our lending strategy beginning in late 2008 back to our original objective to lend to specific customer groups that we originally defined and set out to provide unique and competitive service choosing customers such as professional firms, professionals, property management companies, non-profits, churches and individuals seeking a mutually beneficial banking relationship. Throughout 2010, loan growth continued to slow and decline due to the continued downturn in the economy and our re-focus on lending to relationship customers within our targeted customer groups. Over 90.0% of our loan portfolio is secured by real estate. Our loan portfolio consists of commercial and residential real estate loans including construction and land development, business loans and loans to individuals. Our current long-term strategy is to minimize activities in construction and land development lending in the future.

Our loan portfolio as of December 31, 2010 was $499.5 million, a decrease of $22.3 million from $521.8 million, as of December 31, 2009. Our New Hanover County market experienced a reduction of $10.4 million in loans from December 31, 2009, $4.6 million of which was due to loans charged off. Loans in this market area represent approximately 13.2% of total loans outstanding as of December 31, 2010. The prolonged effects of the recession have continued to affect market conditions in the New Hanover market and increasingly more during 2010 within the Wake County market. Both markets are still experiencing deterioration in real estate market conditions and significantly reduced business activity as a whole. The ability of our borrowers to pay interest on and repay principal of outstanding loans and the value of collateral securing those loans is highly dependent upon the business environment in the markets where we operate in Wake and New Hanover counties, in North Carolina.

 

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The following table is a summary of our loans outstanding by major category for the total Bank, New Hanover County and Wake County.

 

     December 31, 2010     New Hanover County
December 31, 2010
    Wake County
December 31, 2010
 
     Amount     % of
Total
Loans
    Amount     % of
Total Bank
Loans
    Amount     % of
Total Bank
Loans
 
     (Dollars in thousands)  

Real estate loans:

            

Construction, land development and other land loans

   $ 133,194        26.6   $ 27,612        5.5   $ 105,582        21.1

Farmland

     3,254        0.7     —          —          3,254        0.7

One to four family residential

     98,450        19.7     11,902        2.4     86,548        17.3

Multifamily residential

     6,618        1.3     1,204        0.2     5,414        1.1

Non-farm nonresidential

     211,732        42.4     19,331        3.9     192,401        38.5
                                                
     453,248        90.7     60,049        12.0     393,199        78.7

Non-real estate loans:

            

Commercial and industrial

     42,884        8.6     5,113        1.0     37,771        7.5

Consumer and other

     3,644        0.7     777        0.2     2,867        0.6
                                                
     46,528        9.3     5,890        1.2     40,638        8.1
                                                
     499,776        100.0     65,939        13.2     433,837        86.8

Unamortized net deferred loan fees

     (253       (37       (216  
                              

Total loans

   $ 499,523        $ 65,902        $ 433,621     
                              

Commercial real-estate construction and land development loans decreased approximately $33.1 million from December 31, 2009 as construction projects were paid off or completed and moved to longer-term commercial real-estate-secured loans which increased $31.4 million over December 31, 2009. Combined, commercial real-estate remains the largest component of our loan portfolio comprising approximately 58.9% and 56.6%, respectively, of the loan portfolio as of December 31, 2010 and 2009. Commercial loans secured by real estate are principally secured by owner-occupied buildings including professional practices, office, and church properties; and single family rental properties, residential building lots, commercially-zoned land and residential homes. Properties securing these loans are located primarily within our markets of Wake and New Hanover County, North Carolina. During the year 2010 our variable rate loan portfolio averaged approximately 33.6% of our total average loans, up slightly from 32.3% during 2009. The prime interest rate remained at 3.25% throughout the year 2010. Our concentration in commercial real estate exposes us to more credit and regulatory risk than other types of loans.

As of December 31, 2010, real-estate-secured one-to-four family construction, residential loans and home equity lines of credit, combined, represented 29.9% of the loan portfolio at $149.5 million, down from 32.2% or $167.8 million as of December 31, 2009. These loans are typically secured by the primary residence of the borrower and the combined loan-to-value ratio is usually 90% or less. Non-real estate secured commercial and industrial loans declined minimally by $2.8 million to 8.6% from 8.7% of the loan portfolio as of December 31, 2010 and December 31, 2009, respectively. Installment and other consumer loans to individuals decreased $1.3 million from December 31, 2009 and remains at less than one percent of the loan portfolio outstanding. We do not service loans for other financial institutions. We have no foreign loans and we do not engage in lease financing or loan financing in highly leveraged transactions used for buyouts, acquisitions and recapitalizations.

Through NSB Mortgage we originate single-family, residential first mortgage loans that have been approved for purchase by secondary investors and are sold in the secondary market. As of December 31, 2010, mortgage loans held for sale were $51.5 million. Prior to February 2010, we on occasion originated and retained a small number of mortgage loans in our loan portfolio. We continue to have no exposure to subprime loans in our loan portfolio including our newly formed NSB Mortgage division which offers only traditional mortgage products underwritten to Freddie Mac guidelines.

The table below presents information on our loan portfolio by major category at the dates indicated.

 

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Table of Contents
     As of December 31,  
     2010     2009     2008     2007     2006  
     Amount     % of
Total
Loans
    Amount     % of
Total
Loans
    Amount     % of
Total
Loans
    Amount     % of
Total
Loans
    Amount     % of
Total
Loans
 
     (Dollars in thousands)  

Real estate loans:

                    

Construction, land development and other land loans

   $ 133,194        26.7   $ 174,764        33.5   $ 177,979        32.6   $ 132,254        28.2   $ 70,273        20.3

Farmland

     3,254        0.7     2,398        0.5     2,510        0.5     2,634        0.6     1,578        0.5

One to four family residential

     98,450        19.6     108,229        20.7     105,869        19.4     86,262        18.4     63,474        18.3

Multifamily residential

     6,618        1.3     5,713        1.1     5,993        1.1     4,753        1.0     7,977        2.3

Non-farm nonresidential

     211,732        42.4     180,284        34.5     190,950        34.8     183,951        39.1     149,861        43.3
                                                                                
     453,248        90.7     471,388        90.3     483,301        88.4     409,854        87.3     293,163        84.7

Non-real estate loans:

                    

Commercial and industrial

     42,884        8.6     45,713        8.7     57,306        10.5     53,052        11.3     46,168        13.3

Consumer and other

     3,644        0.7     4,986        1.0     6,166        1.1     6,703        1.4     6,853        2.0
                                                                                
     46,528        9.3     50,699        9.7     63,472        11.6     59,755        12.7     53,021        15.3
                                                                                
     499,776        100.0     522,087        100.0     546,773        100.0     469,609        100.0     346,184        100.0

Unamortized net deferred loan fees

     (253       (278       (416       (381       (261  
                                                  

Total loans

   $ 499,523        $ 521,809        $ 546,357        $ 469,228        $ 345,923     
                                                  

The table below presents as of December 31, 2010 (i) the aggregate maturities of loans in the named categories of our loan portfolio and (ii) the aggregate amounts of such loans, by variable and fixed rates.

 

     As of December 31, 2010  
     Due within
one year
    Due after one
year but within 5
    Due after
five years
    Total  
     Amount      Yield     Amount      Yield     Amount      Yield     Amount      Yield  
     (Dollars in thousands)  

Variable rate loans:

                    

Real estate - construction

   $ 14,561         4.63   $ 21,784         4.41   $ 3,854         5.00   $ 40,199         4.57

Real estate - commercial

     52,423         4.34     28,659         3.83     3,353         3.97     84,435         4.15

Commercial and industrial loans

     16,531         4.32     2,070         4.19     704         3.95     19,305         4.29

Installment loans

     335         3.87     39         3.75     93         3.75     467         3.84

Equity lines

     3,015         3.18     27,783         3.57     470         4.10     31,268         3.54
                                            

Total at variable rates

     86,865         4.34     80,335         3.91     8,474         4.44     175,674         4.15
                                            

Fixed rate loans:

                    

Real estate - construction

     9,681         5.97     36,281         6.52     12,350         6.57     58,312         6.41

Real estate - residential

     1,801         5.69     13,119         6.12     12,959         5.66     27,879         5.86

Real estate - commercial

     51,688         6.16     124,302         6.36     19,101         6.48     195,091         6.32

Commercial and industrial loans

     7,102         6.38     17,932         6.43     3,337         6.16     28,371         6.01

Installment loans

     1,338         5.40     698         6.56     668         7.61     2,704         5.81
                                            

Total at fixed rates

     71,610         6.13     192,332         6.38     48,415         6.28     312,357         6.26
                                            

Subtotal

     158,475         5.15     272,667         5.65     56,889         6.00     488,031         5.50

Nonaccrual loans

     11,492           —             —             11,492      
                                            

Loans, gross

   $ 169,967         $ 272,667         $ 56,889         $ 499,523      
                                            

The above table is based on contractual scheduled maturities. Early repayment of loans or renewals at maturity is not considered in this table. Demand loans and loans having no stated schedule of repayments and no stated maturity are reported as due in one year or less.

Asset Quality and the Allowance for Loan Losses

We prepare our consolidated financial statements on the accrual basis of accounting, including the recognition of interest income on our loan portfolio, unless a loan is placed on a non-accrual basis. We generally place loans on a non-accrual basis when a loan becomes 90 days past due and/or in management’s opinion the borrower may be unable to meet payments as they become due. Amounts received on non-accrual loans generally are applied first to principal and then to interest only after all principal has been collected. Restructured loans considered troubled debt restructurings, or TDRs, occur when for economic or legal reasons related to the borrower’s financial difficulties, a concession is granted to the borrower that would not otherwise be considered, including the reduction of interest rates below a rate otherwise available to that borrower or the forgiveness of interest or principal due to the borrower’s weakened financial condition. Interest on restructured loans is accrued at the restructured rate when it is anticipated that no loss of

 

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original principal will occur. Potential problem loans are loans that are currently performing in accordance with the original terms of the loan and are not a component of nonperforming assets but are closely monitored as a result of information regarding possible credit problems of the related borrowers. The $1.2 million potential problem loans as of December 31, 2010 consisted of approximately $522,000 of commercial real estate construction loans in our New Hanover County market, approximately $461,000 of non-real estate commercial and industrial loans located within our Wake County market and approximately $200,000 of residential real estate primarily located within our Wake County market. Our nonperforming assets as of December 31, 2010 were comprised of $11.5 million in nonaccrual loans and foreclosed assets of $5.3 million. Included in the nonaccrual loans were $520,000 loans considered TDRs. Not included in nonperforming assets as of December 31, 2010, were $131,000 of accruing loans past due 90 days or more, accruing potential problem loans of $1.2 million and accruing TDRs of $11.7 million. Concessions we have granted to customers experiencing cash flow difficulties resulting in a TDR includes reduction in interest rate, forgiveness of interest or modification of payment terms.

We have increased our level of review and monitoring of our real estate secured loans due to the weakened real estate market and the substantial portion of our loan portfolio consisting of real-estate-secured construction and real-estate-secured residential and commercial loans. We began increasing our credit administration staff in early 2007 to assist in the management and review of our growing loan portfolio, particularly real estate loans, and higher levels of nonperforming assets.

Nonaccrual loans have declined to $11.5 million or 2.30% of period-end loans as of December 31, 2010, from $18.8 million or 3.61% of period-end loans as of December 31, 2009. Primarily due to charge-offs and transfers to foreclosed assets, nonaccrual loans have declined throughout 2010, from $17.2 million as of March 31, 2010, to $15.6 million as of June 30, 2010 and $13.5 million as of September 30, 2010. This trend however, could reverse as the continued effects of the prolonged recession could cause continued reduction in business activity in the markets we serve, which could result in higher nonaccrual loans in the future. Our borrowers tied to the residential and commercial real estate industry continue to be impacted from the recession. Specifically, those involved in residential real estate may have restricted or more pressure on cash-flows due to seasonality in real estate sales and consequently our levels of past due and nonaccrual loans could increase during this time. Our 2010 trend of nonaccrual loans mirrored this real estate sales cycle during 2010.

The table below presents for the dates indicated information regarding our non-performing assets.

 

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Table of Contents
     As of December 31,  
     2010     2009     2008     2007     2006  
     (Dollars in thousands)  

Nonaccrual loans

   $ 10,972      $ 17,009      $ 5,057      $ 3,103      $ 397   

Restructured and nonaccrual loans

     520        1,839        —          —          —     
                                        

Total nonaccrual loans

     11,492        18,848        5,057        3,103        397   

Foreclosed assets

     5,296        3,271        2,276        —          —     
                                        

Total nonperforming assets

   $ 16,788      $ 22,119      $ 7,333      $ 3,103      $ 397   
                                        

Accruing loans past due 90 days or more

   $ 131      $ 200      $ —        $ 492      $ —     

Restructured accruing loans

     11,741        —          —          —          —     

Potential problem loans

     1,184        1,433        3,494        327        242   

Allowance for loan losses

     9,935        8,581        6,376        5,020        3,983   

Nonaccrual loans to period end loans

     2.30     3.61     0.93     0.66     0.11

Allowance for loan losses to period end loans

     1.99     1.64     1.17     1.07     1.15

Nonperforming assets to loans and foreclosed assets

     5.65     4.21     1.34     0.66     0.11

Nonperforming assets to total assets

     4.50     3.26     1.07     0.57     0.09

Ratio of allowance for loan losses to nonaccrual (x)

     0.86 x        0.46 x        1.26 x        1.62 x        10.03 x   
     As of December 31,  
     2010     2009     2008     2007     2006  
     (Dollars in thousands)  

Nonaccrual loans by major category:

          

Real estate loans:

          

Construction, land development and other land loans

   $ 6,931      $ 14,484      $ 4,223      $ 133      $ —     

One to four family residential

     2,697        1,738        16        —          —     

Non-farm nonresidential

     255        2,152        480        1,958        —     

Non-real estate loans:

          

Commercial and industrial

     1,598        438        288        1,012        397   

Consumer and other

     11        36        50        —          —     
                                        

Total nonaccrual loans

   $ 11,492      $ 18,848      $ 5,057      $ 3,103      $ 397   
                                        

Foreclosed assets by major category:

          

Construction, land development and other land

   $ 2,297      $ 1,647      $ 210      $ —        $ —     

One to four family residential

     1,131        —          —          —          —     

Non-farm nonresidential

     1,868        1,624        2,066        —          —     
                                        

Total foreclosed assets

   $ 5,296      $ 3,271      $ 2,276      $ —        $ —     
                                        

As of December 31, 2010, 86.0% of our nonaccrual loans were real-estate secured with 10.5% represented within our New Hanover County market. Real-estate secured construction and land development loans comprised 60.3% of nonaccrual loans, all of which were represented in our Wake County market. Non-real estate commercial and industrial and consumer loans comprised 14.0% of which 2.1% were represented in our New Hanover market. In total, $1.4 million or 12.6% of the $11.5 million nonaccrual loans as of December 31, 2010 were in our New Hanover County market area with the remaining 87.4% represented throughout our offices in Wake County.

An aggregate of $7.6 million of the nonaccrual loans as of December 31, 2010 is attributable to nine borrowers with an average loan balance of approximately $448,000 for various construction, commercial real estate and one-to-four family real estate and commercial and industrial loans, all of which are located in our Wake County market areas. The average loan exposure for these borrowers is approximately $ 846,000 with the largest exposure to any one borrower included in our nonaccrual loans at $1.8 million. Each specific loan in these customer relationships was analyzed for impairment and our management concluded specific impairment reserves aggregating $1.1 million on these loans were necessary in addition to $464,000 of partial charge-offs. Our impairment analysis of the remaining $3.9 million of nonaccrual loans consisted of 32 loans to 22 borrowers with an average loan balance of less than $122,000. These loans were also analyzed for impairment resulting in additional impairment reserves of $1.0 million. Included in the above nonaccrual loans are six residential real estate loans or commercial non-real estate loans totaling $520,000 which were restructured

 

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to forgive all accrued interest due to financial difficulties of the borrower. The restructured loans remain on nonaccrual status as of December 31, 2010. See Note D to our consolidated financial statements for additional detail regarding loans, nonaccrual loans and credit quality.

The following table is a summary of our nonaccrual loans by major category for the total Bank, New Hanover County and Wake County as of December 31, 2010.

 

     Total Bank     New Hanover County     Wake County  
     December 31, 2010     December 31, 2010     December 31, 2010  
     Amount      % of Total
Nonaccrual
Loans
    Amount      % of Total
Bank Nonaccrual
Loans
    Amount      % of Total
Bank Nonaccrual
Loans
 
                  (Dollars in thousands)               

Real estate loans:

               

Construction, land development and other land loans

   $ 6,931         60.3   $ —           —        $ 6,931         60.3

One to four family residential

     2,697         23.5     1,004         8.8     1,693         14.7

Non-farm nonresidential

     255         2.2     200         1.7     54         0.5
                                                   
     9,883         86.0     1,204         10.5     8,678         75.5

Non-real estate loans:

               

Commercial and industrial

     1,598         13.9     231         2.0     1,368         11.9

Consumer and other

     11         0.1     11         0.1     —           —     
                                             
     1,609         14.0     242         2.1     1,368         11.9
                                                   

Total nonaccrual loans

   $ 11,492         100.0   $ 1,446         12.6   $ 10,046         87.4
                                 

As of December 31, 2010, we also identified and evaluated $1.2 million of potential problem loans, primarily as a result of information regarding possible, although not probable, credit problems of the related borrowers. These loans were performing in accordance with the original terms of the loans as of December 31, 2010. Management considered these loans in assessing the adequacy of our allowance for loan losses. These loans were represented by four individual loans and borrowers with an average loan balance under $300,000. Approximately $723,000 of these potential problem loans are secured by real estate and the remainder are secured with receivables, equipment or are unsecured.

As of December 31, 2009, the recorded investment in loans that management considered impaired totaled $18.8 million including $1.8 million in restructured loans. Impaired loans of $17.1 million had a corresponding allowance of $2.6 million. There was no corresponding allowance with the remaining $1.7 million of loan balances analyzed for impairment after recording approximately $437,000 in related charge-offs. We also identified $1.4 million of potential problem loans as of December 31, 2009 of which $264,000 were charged-off during 2010, $705,000 are on nonaccrual status and $176,000 continue to be classified as a potential problem loans as of December 31, 2010. The remaining December 31, 2009 potential problem loans have been paid off during 2010 or are currently performing at year end 2010.

Foreclosed assets of $5.3 million as of December 31, 2010 consisted of 31 properties acquired through foreclosure of which approximately 43.4% or $2.3 million of the properties represented residential or commercial construction or land development properties. Approximately 21.4% or $1.1 million represented one-to-four family residential properties and approximately 35.3% or $1.9 million represented commercial real estate properties. The largest of these properties in terms of dollar value is $623,000 in commercial real estate located in our New Hanover County market area.

Assets acquired through, or in lieu of, foreclosure are held for sale and are initially recorded at fair value less cost to sell at the date of foreclosure, establishing a new cost basis. Subsequent to foreclosure, the initial recorded value may be reduced by additional valuation allowances which are charged to earnings if the estimated fair value of the property less estimated costs to sell declines below the initial recorded value. Approximately 73.4% of the foreclosed real estate properties as of December 31, 2010 were in the New Hanover market area. Due to the continued downturn in real estate for this market as well as increased deterioration in the Wake County real estate market, the foreclosed properties underwent periodic revaluations throughout 2010, resulting in additional valuation losses on various foreclosed properties of $1.1 million. These write-downs are in our consolidated statements of operations included in this report. During the year 2010, sales of 30 foreclosed properties with a carrying value of approximately $6.2 million were sold net of selling costs for $6.0 million resulting in net losses of $183,000. Fair value of foreclosed assets is based on recent appraisals or discounted collateral values for properties for which recent appraisals were not available. After review of these foreclosed assets, we believe the fair values, less estimated costs to sell, equal their current carrying value as of December 31, 2010. Foreclosed assets as of December 31, 2009 consisted of 16 properties totaling $3.3 million with the largest dollar value of $1.6 million representing a commercial building acquired from the settlement of a loan attributable to a single-practice physician who died unexpectedly. The property was sold in March 2010 at approximately its carrying value and is included in the 2010 sales of foreclosed property discussed above.

 

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The following table presents for the dates indicated, information about foreclosed assets.

 

     Year Ended December 31,  
     2010     2009     2008  
     (Dollars in thousands)  

Foreclosed assets beginning of year

   $ 3,271      $ 2,276      $ —     

Loans transferred to foreclosed assets

     9,183        2,376        2,276   

Expenditures on foreclosed assets

     169        135        —     

Proceeds from sales, net of selling expenses

     (5,996     (781     —     

Net loss on sale of foreclosed assets

     (183     (38     —     
                        
     6,444        3,968        2,276   

Valuation allowance for foreclosed assets

     (1,148     (697     —     
                        

Foreclosed assets end of year

   $ 5,296      $ 3,271      $ 2,276   
                        

Our allowance for loan losses is maintained at a level that our management considers adequate to provide for probable loan losses based on our assessment of various factors affecting our loan portfolio, including a review of problem loans, business conditions and loss experience and an overall evaluation of the quality of the underlying collateral.

Management evaluates the adequacy of our allowance for loan losses on a monthly basis. The evaluation of the allowance for loan losses is divided into two components. A general reserve allowance is calculated on the current loan portfolio for the homogeneous or general pool of loans and a separate reserve is determined for loans that are individually analyzed for impairment. In evaluating the allowance for loan losses, we prepare on a monthly basis an analysis of our current homogeneous group of loans using historical loss rates, other identified factors, and data from our loan portfolio. Beginning in the fourth quarter of 2009, we adopted a factor methodology to apply a charge-off rate to our performing loan portfolio. This methodology utilizes three components to determine factors to apply to this section of our loan loss model which is subdivided by nine categories of loans. The factors applied to the nine loan categories include charge-off history, current impairments and management’s judgment. The charge-off history review results in a determination by loan category of where our charge-offs have historically occurred which allows us to determine a risk factor for the historical charge-off risk of each given loan category. We review the current impairments by loan category as we consider these as a predictor of future charge-offs to determine a risk factor for each given loan category. Management’s determination of the charge-off history and current impairments determines a range of factors for each loan category. The individual ranges from charge-off history and current impairments are added together to arrive at a final factor range. Management then uses its judgment based on internal and external items to determine the final factor. An estimated reserve allowance for the performing portfolio is then calculated from the final risk factors for each category of loan applied to the five-year weighted average annual charge-off rate.

We also have identified seven qualitative factors that are considered indicators of changes in the level of risk of loss inherent in our loan portfolio. These factors consider the risk of payment performance, overall portfolio quality (utilizing weighted average risk rating), general economic factors such as unemployment, delinquency and charge-off rates, regulatory examination results, interest rate environment, levels of highly leveraged transactions (as defined in Section 365.2 of the FDIC regulations) and levels of construction, development and non-owner occupied commercial real estate lending. These factors are examined for trends and the risk that they represent to our loan portfolio. Each of these factors is assigned a level of risk and this risk factor is applied to only the general pool of loans to calculate the appropriate allowance.

In addition to the general reserve, all loans risk rated “substandard”, “doubtful” and “loss” are reviewed for probable losses and if management determines a loan to be impaired it is removed from its homogeneous group and individually analyzed for impairment. A loan is considered impaired when it is considered probable that all amounts due under the contractual terms of the loan will not be collected when due. We have established policies and procedures for identifying loans that should be considered for impairment such as credit risk reviews, a watch list, delinquency monitoring and specific market, product and concentration reviews. Other groups of loans may be selected for impairment review. For loans determined to be impaired, the specific allowance is based on the present value of expected cash flows or the fair value of the collateral or the loan’s observable market price. Using the combined data gathered during this monthly evaluation process, the model calculates an estimated reserve amount.

While we believe that our management uses the best information available to determine the allowance for loan losses, unforeseen market conditions could result in adjustments to the allowance for loan losses, and net income could be significantly affected, if circumstances differ substantially from the assumptions used in making the final determination. Because these factors and management’s assumptions are subject to change, the allocation is not necessarily indicative of future loan portfolio performance. Also, as an important component of their periodic examination process, regulatory agencies review our allowance for loan losses and may require additional provisions for estimated losses based on judgments that differ from those of management.

 

 

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The table below provides information on our allocation of our allowance for loan losses among various loan categories for the dates presented.

 

     As of December 31,  
     2010     2009     2008     2007     2006  
     Amount      % of Total
Loans (1)
    Amount      % of Total
Loans (1)
    Amount      % of Total
Loans (1)
    Amount (2)      % of Total
Loans (1)
    Amount (2)      % of Total
Loans (1)
 
     (Dollars in thousands)  

Real estate loans:

                         

Construction, land development and other land loans

   $ 3,744         26.7   $ 4,357         33.5   $ 1,953         32.6   $ 1,414         28.2   $ 809         20.3

Farmland

     27         0.7     19         0.5     10         0.5     28         0.6     18         0.5

One to four family residential

     2,339         19.7     1,276         20.7     1,019         19.4     922         18.4     730         18.3

Multifamily residential

     55         1.3     46         1.1     22         1.1     51         1.0     92         2.3

Non-farm nonresidential

     2,382         42.4     1,958         34.5     1,288         34.9     1,966         39.2     1,724         43.3

Non-real estate loans:

                         

Commercial and industrial

     1,354         8.6     870         8.8     2,005         10.5     567         11.3     531         13.3

Consumer and other

     34         0.6     55         0.9     79         1.0     72         1.3     79         2.0
                                                                                     
   $ 9,935         100.0   $ 8,581         100.0   $ 6,376         100.0   $ 5,020         100.0   $ 3,983         100.0
                                                                                     

 

(1) Represents the percent of total loans outstanding by loan type. This allowance for loan and lease losses is calculated on an approximate basis and is not necessarily indicative of future losses.
(2) Represents an estimated allocation of the allowance for loan losses based on loans outstanding in each category as a percent of total loans outstanding.

The table below presents information regarding the changes in our allowance for loan losses as of or for the years indicated.

 

     As of or for the Year Ended December 31,  
     2010     2009     2008     2007     2006  
     (Dollars in thousands)  

Loan outstanding at the end of the year

   $ 499,523      $ 521,809      $ 546,357      $ 469,228      $ 345,943   
                                        

Average loans outstanding during the year

   $ 510,000      $ 541,576      $ 520,075      $ 393,927      $ 316,620   
                                        

Allowance for loan losses at beginning of year

   $ 8,581      $ 6,376      $ 5,020      $ 3,983      $ 3,679   

Provision for loan losses

     8,095        5,710        2,755        1,339        69   
                                        
     16,676        12,086        7,775        5,322        3,748   
                                        

Loans charged off:

          

Real estate loans:

          

Construction, land development and other land loans

     4,445        1,694        123        —          —     

One to four family residential

     765        896        148        —          —     

Non-farm nonresidential

     364        178        45        —          —     

Non-real estate loans:

          

Commercial and industrial

     1,224        636        805        299        —     

Consumer and other

     34        106        284        3        5   
                                        

Total charge-offs

     6,832        3,510        1,405        302        5   

Recoveries of loans previously charged off:

          

Real estate loans:

          

Construction, land development and other land loans

     68        —          —          —          —     

One to four family residential

     7        1        —          —          230   

Non-farm nonresidential

     10        —          —          —          —     

Non-real estate loans:

          

Commercial and industrial

     6        4        6        —          2   

Consumer and other

     —          —          —          —          8   
                                        

Total recoveries

     91        5        6        —          240   

Net charge-offs/(recoveries)

     6,741        3,505        1,399        302        (235
                                        

Allowance for loan losses at end of year

   $ 9,935      $ 8,581      $ 6,376      $ 5,020      $ 3,983   
                                        

Ratios:

          

Nonaccrual loans to period-end loans

     2.30     3.61     0.93     0.66     0.11

Allowance for loan losses as a percent of loans at end of year

     1.99     1.64     1.17     1.07     1.15

Net charge-offs/(recoveries) as a percent of average loans

     1.32     0.65     0.27     0.08     -0.07

As of December 31, 2010, the allowance for loan losses was $9.9 million, $1.4 million above the prior year-end. The general reserve as of December 31, 2010 increased by approximately $2.3 million over the prior year-end primarily due to overall higher charge-off and other risk factors applied to the general non-impaired pool of loans. A decline of $22.3 million of loans outstanding

 

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decreased the general reserve by approximately $343,000. Including reserves for potential problem loans, the specific reserve allocated to impaired loans was down $642,000 from December 31, 2009 due to charge-offs on impaired loans. We provided for probable losses through specific impairment reserve allowances of $2.1 million on $6.5 million of non-performing loans. Our allowance for loan loss model also provided approximately $147,000 of reserves for $637,000 of potential problem loans. Detail regarding impaired and potential problem loans is discussed above. As a result, the increase in the level of the allowance relative to gross loans resulted primarily from the increase in charge-off and other risk factors applied to our general non-impaired pool of loans. Risk factors are examined for trends and the risk that they represent to our loan portfolio and have increased overall due to changes in general economic trends such as payment performance, loan delinquency and charge-off rates, unemployment and changes in risk ratings. As a percent of loans outstanding the allowance for loans losses increased 35 basis points to 1.99% as of December 31, 2010 compared to 1.64% as of December 31, 2009.

Our loan loss allowance is increased by provisions charged to operations and reduced by loans charged off, net of recoveries. Net charge-offs were $6.7 million for the year-ended December 31, 2010, $3.2 million higher than the $3.5 million of net charge-offs for the prior year. Approximately $5.5 million or 81.4% of the loans charged off during 2010 were for real estate secured loans of which construction and land development loans represented $4.4 million. A substantial portion, $4.0 million or 60.1% of the real estate secured charge-offs were located in our New Hanover County market. The real-estate secured net charge-offs were comprised of $3.9 million one-to-four family construction and residential loans and $1.6 million commercial construction and real-estate secured loans. Additional information regarding our allowance for loan losses and loan loss experience is presented in Notes D and E to our consolidated financial statements included in this report. If the economy continues to languish or deteriorate, our borrowers could be negatively impacted which could result in continued increased charge-offs and non-performing loans, which could require us to increase our allowance for loan losses.

The following table is a summary of our net charge-offs as of December 31, 2010 by major category for the total Bank, New Hanover County and Wake County.

 

     Net Charge-off Composition as of December 31, 2010  
     Total Bank
December 31, 2010
    New Hanover County
December 31, 2010
    Wake County
December 31, 2010
 
     Amount      % of
Net
Charge-offs
    Amount      % of
Total Bank Net
Charge-offs
    Amount      % of
Total Bank Net
Charge-offs
 
                  (Dollars in thousands)               

Net charge-offs, real estate loans:

               

Construction, land development and other land loans

   $ 4,377         65.0   $ 3,325         49.3   $ 1,052         15.6

One to four family residential

     758         11.1     483         7.1     274         4.1

Non-farm nonresidential

     354         5.3     240         3.6     114         1.7
                                                   
     5,489         81.4     4,048         60.0     1,440         21.4

Net charge-offs, non-real estate loans:

               

Commercial and industrial

     1,218         18.1     513         7.6     706         10.5

Consumer and other

     34         0.5     24         0.4     10         0.1
                                                   
     1,252         18.6     537         8.0     716         10.6
                                                   

Total net charge-offs

   $ 6,741         100.0   $ 4,585         68.0   $ 2,156         32.0
                                 

Deposits

Our deposits are the primary source of our funds for our portfolio loans, mortgage pipeline and investments. Our deposit strategy is to obtain deposit funds from within our market areas through relationship banking wherein we do not lend to a customer without a deposit relationship. We believe that the great majority of our deposits are from individuals and entities located in our market areas with an increasing concentration of deposits from our “Community PLUS” division where we have deposit relationships with property management customers located within and outside of our market areas. As of December 31, 2010, deposits from our “Community PLUS” division represented approximately 35.6% of our total deposits.

Our decision to slow loan growth coupled with our success at building and retaining deposit relationships provided the opportunity to substantially reduce non-traditional internet deposits during 2010 and eliminate completely generally more volatile wholesale brokered certificates of deposit in January 2010.

In total, our deposits decreased $44.1 million to $562.7 million as of December 31, 2010 from $606.9 million as of December 31, 2009 predominately in non-traditional funding sources. Traditional core deposits generally include noninterest-bearing demand deposits, interest-bearing transaction accounts, which are savings, money market and interest checking accounts as well as relationship-oriented certificates of deposit less than $100,000. These relationship-oriented core deposits increased $24.6 million to $437.8 million from $412.9 million as of December 31, 2009, representing 77.8% compared to 68.0%, respectively, of our total deposits as of December 31, 2010 and 2009.

 

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In addition to reducing our reliance on non-core deposits, our efforts to focus on maintaining and developing our core deposit relationships has also benefited our deposit mix as well. Non-interest bearing deposits increased $12.9 million, or 12.3%, to $117.8 million as of December 31, 2010 over $104.9 million as of December 31, 2009. Interest-bearing transaction deposits grew to $250.5 million as of December 31, 2010, an increase of $17.8 million or 7.6% over December 31, 2009. Deposit funds in non-interest bearing and money market and interest checking accounts from our “CommunityPLUS” division contributed approximately $9.7 million and $22.9 million, respectively, of the increases in these deposit funds. Overall, noninterest-bearing demand deposits have increased to 20.9% of total deposits as of December 31, 2010 compared to 17.3% as of December 31, 2009. Similarly, interest-bearing transaction deposits have increased to 44.5% of total deposits compared to 38.3% for the 2009 period.

Conversely, time deposits decreased to 34.6% of total deposits as of December 31, 2010 compared to 44.4% as of December 31, 2009. The decline in these deposits were, for the most part, intentional as part of our strategic decision to reduce or eliminate non-relationship time deposits. Time deposits overall declined to $194.4 million, a decrease of $74.8 million or 27.8% from $269.3 million as of December 31, 2009. Non-core wholesale brokered certificates of deposit were eliminated entirely in January 2010, a decrease of $20.1 million from year-end 2009. Non-brokered internet deposits, which are non-core certificates of deposit issued by means of an internet subscription service, were reduced to $5.2 million as of December 31, 2010, a decrease of $28.3 million or 84.5% from $33.4 million as of year-end 2009. Also, strategic decisions regarding profitability and/or non-relationship accounts, led to the intentional reduction in generally more volatile time deposits over $100,000. Excluding internet deposits, time deposits over $100,000 decreased $25.1 million or 21.2% to $93.7 million as of December 31, 2010. Time deposits through participation in the Certificate of Deposit Account Registry Service, or CDARS, program increased $4.5 million to $26.1 million as of December 3, 2010 from $21.6 million as of December 31, 2009. The CDARS program provides full FDIC insurance on deposit balances greater than posted FDIC limits by exchanging larger depository relationships with other CDARS members. Traditional core time deposits less than $100,000 declined $5.9 million to $69.5 million from $74.4 million as of December 31, 2009. We did experience growth in core time deposits through our “CommunityPLUS” division which grew to approximately $52.9 million, an increase of $18.1 million or 52.1% over the prior year-end.

Continued success in eliminating non-core and generally more volatile deposits such as internet deposits and time deposits to single service customers will continue to be a priority in the future while we maintain our focus on growing traditional core deposits with our customers with whom we aim to obtain the customers’ primary borrowing and deposit relationship as well as our continued success through our property management division “CommunityPLUS”.

The table below presents information on our average deposits for the years presented.

 

     For the Year Ended December 31,  
     2010     2009     2008  
     Average
Amount
     Average
Rate
    Average
Amount
     Average
Rate
    Average
Amount
     Average
Rate
 
     (Dollars in thousands)  

Savings, NOW and money market

   $ 242,359         0.85   $ 229,016         0.90   $ 212,885         2.18

Time deposits over $100,000

     110,325         2.20     141,852         2.98     98,494         4.59

Other time deposits

     114,543         1.79     156,604         2.83     121,978         3.96
                                 

Total interest-bearing deposits

     467,227         1.40     527,472         2.04     433,357         3.23

Noninterest-bearing deposits

     114,927           90,770           79,498      
                                 

Total deposits

   $ 582,154         1.12   $ 618,242         1.74   $ 512,855         2.73
                                 

 

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The following table presents the amounts and maturities of deposits with balances of $100,000 or more:

 

As of December 31, 2010

      
(Dollars in thousands)       

Remaining maturity:

  

Less than three months

   $ 24,159   

Three to six months

     9,915   

Six to twelve months

     35,451   

Over twelve months

     29,308   
        

Total

   $ 98,833   
        

Borrowings

Securities sold under agreements to repurchase generally mature within one to four days from the transaction date and are collateralized by U.S. Government Agency obligations. These repurchase agreements are classified as short-term borrowings in the accompanying balance sheets. As of December, 31, 2010, we had available lines of credit totaling approximately $163.7 million with various financial institutions and the Federal Reserve for borrowing on a short-term basis. These lines are subject to annual renewals with varying interest rates. We had no outstanding borrowings on these lines of credit as of December 31, 2010 except a long-term FHLB advance for approximately $804,000, maturing in 2025.

The following table sets forth certain information regarding our short-term borrowings for the periods indicated.

 

     For the Year Ended December 31,  
     2010     2009     2008  
     (Dollars in thousands)  

Short-term borrowings:

      

Repurchase agreements and federal funds purchased

      

Balance outstanding at end of period

   $ 3,615      $ 6,103      $ 7,782   

Maximum amount outstanding at any month end during the period

     7,444        16,754        22,342   

Average balance outstanding

     5,803        9,236        11,089   

Weighted-average interest rate during the period

     0.33     0.36     1.94

Weighted-average interest rate at end of period

     0.11     0.36     0.37

Federal Home Loan Bank advances - < 1Yr

      

Balance outstanding at end of period

   $ —        $ —        $ —     

Maximum amount outstanding at any month end during the period

     —          —          23,000   

Average balance outstanding

     —          —          5,041   

Weighted-average interest rate during the period

     —          —          2.80

Weighted-average interest rate at end of period

     —          —          —     

Total Short-term borrowings:

      

Balance outstanding at end of period

   $ 3,615      $ 6,103      $ 7,782   

Maximum amount outstanding at any month end during the period

     7,444        16,754        31,988   

Average balance outstanding

     5,803        9,236        16,130   

Weighted-average interest rate during the period

     0.33     0.36     2.21

Weighted-average interest rate at end of period

     0.11     0.05     0.05

 

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Long-term trust preferred securities and related junior subordinated debentures outstanding as well as subordinated notes are included in long-term borrowings in the accompanying balance sheets. Long-term borrowings as of December 31, 2010 are as follows:

 

     As of December 31,  
     2010      2009  
     (Dollars in thousands)  

Long-term borrowings

  

FHLB advances

   $ 804       $ 825   

Subordinated debentures

     11,000         11,000   

Junior subordinated debentures

     15,465         15,465   
                 
   $ 27,269       $ 27,290   
                 

Results of Operations For the Years Ended December 31, 2010 and 2009

Overview. The prolonged effects of the recession on real estate and business activity in the markets we serve and the overall economy in general continue to restrain our overall results of operations compared to pre-recession results. Net income for the year ended December 31, 2010 was $1.0 million compared to $1.1 million for the year ended December 31, 2009, a decrease of $74,000 or 6.7%. Diluted net income per share of common stock was $0.14 in 2010 compared to $0.15 in 2009. The decrease in earnings can be directly attributed to a higher provision for loan losses and increases in expenses related to foreclosed assets. The increase in loan loss provision was as a result of increased loan charge-offs, additional reserves on impaired loans and increases in risk factors to the loan portfolio in general. Additional foreclosed properties and continued deterioration in real-estate prices resulted in higher operating expenses related to foreclosed properties as well as additional write-downs on re-valuations and losses on sales of foreclosed properties during the year. The overall decrease in earnings was minimized through favorable changes in deposit mix, mortgage income generated from our new mortgage division and the continuation of several cost savings initiatives such as the temporary suspension to our company’s 401(k) match, fees to our corporate board members, the elimination of incentive bonuses and merit increases for the year and other cost savings in general. For the year ended 2010 return on average assets remained at 0.16% while return on average equity declined to 2.70% from 2.97% for 2009.

Net Interest Income. Interest income for the year ended December 31, 2010 decreased $2.5 million or 7.4% over the prior year period while for the same period interest expense decreased $4.4 million or 36.8% resulting in an increase of $1.9 million in net interest income for the year. Net interest income was $23.5 million for the year ended December 31, 2010 compared to $21.6 million for the year ended December 31, 2009, up 8.7%. Our focus on developing and maintaining our core deposit relationships while simultaneously reducing non-core deposits brought beneficial changes to our deposit mix with a corresponding decrease in interest expense. The favorable change in deposit mix was the primary factor for the increase in net interest income coupled with the redeployment of lower yielding interest-earning deposits into higher yielding mortgage loans held for sale.

Interest income is affected by changes in the mix and volume of average-earning assets, interest rates and also by the level of loans on nonaccrual status. Interest income for the year ended December 31, 2010 was $31.0 million compared to $33.4 million for the prior year, a decrease of $2.5 million. The overall decrease in interest income over the prior year was attributable to a decrease in volume of our average-earning assets, primarily loans, lower yields as well as the effect of a higher level of average nonaccrual loans over the prior year. Our loan portfolio, our highest yielding asset, declined $33.8 million on average from 2009, effectively reducing interest income by approximately $2.0 million. Lower loan yields effectively decreased interest income by approximately $1.0 million. In addition a higher average of nonaccrual loans resulted in additional lost interest income of approximately $171,000 over the prior year. Mortgage loans held for sale averaged $30.7 million for the year 2010 providing additional income of $1.5 million, offsetting declines in other lower-yielding interest-earning assets including investments and certificates of deposits with banks. The yield on mortgage loans held for sale averaged 4.79% compared to 2.94%, and .89%, respectively, for available for sale investments and other interest-earning deposits and certificates of deposit.

Our intentional change in deposit mix and repricing of time deposits at lower rates, were the primary factors for the overall decrease in interest expense. Interest expense for the year ended December 31, 2010 was $7.5 million compared to $11.8 million for the prior year, a $4.4 million decrease. Average time deposits decreased $73.6 million from the previous year primarily in non-core wholesale brokered, internet and single-service certificates of deposit. These higher-costing and generally more volatile deposits were replaced with lower costing interest checking, money market and non-interest-bearing transaction deposits which grew in total an average of $37.5 million, of which $24.2 million were in non-interest-bearing demand deposits. The decrease in average time deposits decreased interest expense by approximately $1.8 million while lower interest rates as a result of repricing reduced total interest expense by approximately $2.4 million. Interest expense on average short-term and long-term borrowings decreased $14,000 and $157,000, respectively, over the prior year due substantially to lower interest rates on these borrowings.

The yield on our earning assets averaged 5.05% during 2010 compared to 5.08% during 2009. During the same period, the cost of our interest-bearing liabilities averaged 1.50% compared to 2.10%. Overall our net interest margin, excluding average nonaccrual loans, increased 55 basis points to 3.83% during 2010 compared to 3.28% during 2009.

Provision for Loan Losses. The provision for loan losses increased $2.4 million or 41.8% to $8.1 million for the year ended December 31, 2010, compared with $5.7 million for the prior year. Provisions for loan losses are charged to income to bring the allowance for loan losses to a level considered appropriate by our management. The increase in the provision for year 2010 is

 

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principally in response to higher charge-offs, additional reserves for impaired loans and overall increases to risk factors to the general reserve. Net charge-offs increased to $6.7 million or 1.32% of average loans for the year ended December 31, 2010 compared to $3.5 million or .65% of average loans the year ended December 31, 2009. The allowance for loan losses was $9.9 million as of December 31, 2010 and $8.6 million as of December 31, 2009, representing 1.99% and 1.64%, respectively, of loans outstanding as of December 31, 2010 and 2009. See “Asset Quality and the Allowance For Loan Losses” above for more detail.

Non-interest Income. For the year ended December 31, 2010, non-interest income increased $3.3 million or over 283% over the prior year primarily due to fee income from our new mortgage division. Fees from mortgage operations were $2.6 million for the year ended 2010 resulting from a high volume of mortgage loan refinances due to lower interest rates. Included in non-interest income for 2010 and 2009 are security gains from our available for sale portfolio of $741,000 and $464,000, respectively. During 2009, non-interest income includes the loss from the write-off of our stock investment in our lead correspondent bank of $134,000. Fees from annuity sales and other fees generated from our wealth management services division provided $439,000 in non-interest income, up $323,000 or 277.0% over the prior year period. We restructured, and hired a new wealth management director for our wealth management services division during the second quarter of 2010 and expect fees generated from this division as well as fees from our new mortgage division to be key sources of noninterest income in the future. Service charges and fees on deposit accounts and merchant and other loan fees were $402,000 and $114,000, respectively, for 2010 compared to $432,000 and $136,000, respectively for 2009. As a percentage of average assets, non-interest income increased to .68% for the year 2010 compared to .17% for the year 2009.

Non-interest Expense. Non-interest expense includes salaries and benefits paid to employees, occupancy and equipment expenses and all other operating costs. Total non-interest expense for the year ended December 31, 2010 increased $2.9 million or 19.2% to $18.0 million from $15.1 million for the prior year period. The increase is primarily attributable to substantially higher net costs related to foreclosed assets, up $780,000, over the prior year period as well as additional personnel costs attributable to our new mortgage division. We continued expense reducing initiatives during 2010 which began in early 2009 in an effort to partially offset unexpected expenses, particularly higher asset quality related costs due to the current and anticipated economic environment. We plan to re-instate fees paid to our corporate board early in 2011 which had been suspended for the past two years. Presently other than corporate board fees we do not anticipate re-instatement of other cost saving initiatives such as incentive bonuses and merit increases or 401k matching contributions in the near future until our asset quality related expenses return to historically low levels.

Salaries and other personnel expense represent our largest expense category at $8.4 million for the year ended December 31, 2010, up $2.0 million or 30.6% from $6.4 million for the year ended December 31, 2009. Approximately $1.9 million of the increase was attributable to our new mortgage division. A high level of mortgage loan refinancing activity throughout the year generated increased personnel costs through commissions paid to mortgage loan originators as well as additional costs for support personnel within this division. Personnel expense within our wealth management services division is also primarily fee driven. Significantly higher fee income resulted in higher commission expense, up approximately $230,000 over the prior year. We continued to temporarily suspend 401k matching benefits, incentive bonuses as well as merit increases as part of the cost savings initiatives we began in 2009. Expense for 401k matching contributions decreased $108,000 from the prior year as these benefits were not suspended until May 2009. As a percentage of average assets, personnel expense increased to 1.28% for the year 2010 compared to .92% for the year 2009.

Occupancy and equipment costs remained substantially unchanged increasing $16,000 to $2.8 million for the year ended December 31, 2010 from the same period last year. Other non-interest expenses increased $913,000 or 15.3% over the prior year period primarily due to increased expenses related to foreclosed assets. Subsequent to foreclosure, valuations are periodically performed on the properties. Due to continued downturn in the New Hanover County and increasingly in the Wake County real estate markets, revaluations of foreclosed properties resulted in valuation losses of $1.1 million for the year ended December 31, 2010, up $451,000 or 64.7% over the prior year. In addition to the valuation write-downs, net losses on sales of foreclosed assets for the period were $183,000 compared to $38,000 for the prior year. General costs on foreclosed properties net of rental income received were $256,000, up $184,000 or 255.6% over 2009 due to a higher number of foreclosed properties maintained during the year. As a percent of average assets, net foreclosed asset costs were .24% for the year ended December 31, 2010 compared to .12% for the prior year period. FDIC insurance premiums were down $420,000 for 2010 from the prior year. The decrease is due to a lower deposit base as well as the inclusion in the prior year period of an emergency special assessment levied against all banks in June 2009 in addition to a higher base assessment. Additional discussion regarding increased insurance assessments is presented in Item 1. Business “Supervision and Regulation-Insurance Assessments.” Our outsourced services expense is related to data processing and other services for our customers’ accounts. These services are primarily volume driven and increase as we add new offices and products with corresponding increases in loan, deposit and other customer-based accounts. In total, outsourced data processing fees were up $266,000 over the prior year, primarily due to outsourced software services to our customers of our “CommunityPLUS” division. Professional fees were up $59,000 over the prior year for legal, audit and tax services and shareholder communications due primarily to higher annual meeting expense, the acquisition of our new mortgage loan division and employment contracts. There were no other significant changes in other noninterest expenses. Including additional net costs related to foreclosed assets and additional personnel expense as a result of our new mortgage division, our non-interest expense as a percent of average assets was 2.75% for the year ended December 31, 2010 compared to 2.18% for the prior year.

Income Taxes. We recorded $795,000 in income tax expense for the year ended December 31, 2010 and $817,000 for the year ended December 31, 2009. Income tax expense as a percentage of pretax income was 43.7% for 2010 and 42.7% for 2009. The effective tax rate was higher in 2010 primarily due to fewer permanent tax differences compared to the prior year. Management has evaluated our tax positions and has concluded that we have no uncertain tax positions.

 

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Results of Operations For the Years Ended December 31, 2009 and 2008

Overview. For the year ended December 31, 2009, our net income was $1.1 million compared to $2.4 million for the year ended December 31, 2008, a decrease of $1.3 million or 53.6%. Diluted net income per share of common stock was $0.15 in 2009 and $0.32 in 2008. The decrease in earnings was primarily attributable to: additional provision for loan losses due to higher levels of impaired loans and increases in risk factors to the loan portfolio in general; significantly higher FDIC assessments in general plus a one-time special assessment levied against all banks in June 2009; losses on the re-valuation and sales of foreclosed assets; operating expenses related to foreclosed assets; and the impact of a $13.8 million increase in nonaccrual loans that required the reversal of recognized interest income at the time of placement on nonaccrual status and loss of future interest income. The overall decrease in earnings was minimized through several cost savings initiatives as well as savings from shifts in deposits; expense reducing initiatives such as the temporary suspension to our company’s 401(k) match, fees to our corporate board members, the elimination of incentive bonuses and merit increases for the year and other cost savings in general; and a change in deposit mix, specifically a higher level of non-interest bearing accounts.

As of December 31, 2009 compared to the prior year, net interest income increased $1.3 million, provision for loan losses increased $3.0 million, noninterest income decreased $692,000 and noninterest expense decreased $306,000. Return on average assets was 0.16% in 2009 versus 0.40% in 2008 and .65% in 2007 while return on average equity was 2.97%, 6.85% and 10.59% for the years ended December 31, 2009, 2008 and 2007, respectively.

Net Interest Income. Net interest income was $21.6 million for the year ended December 31, 2009, an increase of $1.3 million or 6.6% over the year ended December 31, 2008. The increase in net interest income was attributable to overall growth in average interest-earning assets which helped to offset declines in yields; a change in deposit mix; and the impact of the lower interest rate environment on our funding costs. Interest income for the year ended December 31, 2009 decreased $2.6 million or 7.3% over the prior year period while interest expense for the same period decreased $4.0 million or 25.1%.

The overall decrease in interest income over the prior year was primarily due to lower yields on our average earning assets as well as the effect of a substantially higher level of nonaccrual loans over the prior year. The Wall Street Journal prime rate for the year ended December 31, 2009 averaged 184 basis points lower than in 2008. Comparatively, yields on our average interest-earning assets were 129 basis points lower. The lower yields on our average interest-earning assets reduced interest income approximately $4.9 million. Combined with the effect of lower yields, a higher level of loans where interest accrual was discontinued also resulted in lower interest income. Nonaccrual loans increased to $18.8 million as of December 31, 2009 compared to $5.1 million as of December 31, 2008, representing an approximate $704,000 loss in interest income for the year. Average earning asset growth, primarily loans and certificates of deposits with banks, provided approximately $2.3 million of additional interest income. A significant portion of the increase in average earning assets, $49.0 million and $34.9 million, respectively, was in lower yielding earning assets consisting of certificates of deposit with banks and other interest-earning deposits with banks with average yields of approximately 1.76% and 0.25%, respectively. The loan portfolio, our highest yielding asset with an average yield of 5.77%, grew on average $21.5 million over the prior year with most of the growth occurring during the first half of the year. Overall, total interest income decreased $2.6 million.

As with interest income, lower interest rates were the primary factor for the overall decrease in interest expense. Total interest expense decreased $4.0 million from the previous year. Lower interest rates as a result of repricing our interest-bearing deposits to reflect market conditions reduced total interest expense by approximately $7.0 million. Growth in average interest-bearing deposits of $94.1 million, primarily time deposits over $100,000, increased total interest expense by approximately $3.1 million for the year ended December 31, 2009 compared to the prior year. Interest expense on average short-term and long-term borrowings decreased $323,000 and $393,000, respectively, over the prior year primarily due to lower interest rates on these borrowings as they repriced in the declining rate environment and a decrease of $6.9 million in average short-term borrowings.

Other factors affecting our net interest income for the year 2009 include the effect of our average earning assets volume outpacing our average interest-bearing liabilities and an increase in average noninterest-bearing demand deposits. Non-interest-bearing deposits increased to $90.8 million, an increase of $11.3 million over the year 2008. These deposit funds declined on average $9.8 million during 2008 due to a requirement of the North Carolina State Bar for our attorney trust account customers to transition from noninterest-bearing demand deposit accounts to interest-bearing checking accounts by the end of June 30, 2008. The increase in 2009 was in large part due to our “CommunityPlus” division which provided on average an increase of approximately $14.1 million in these funds for the year.

The average yield on our earning assets during 2009 was 4.98% compared to 6.27% during 2008, down 129 basis points. During the same period, the average cost of our interest-bearing liabilities decreased by 122 basis points to 2.10% for the year 2009. The yield and rate decreases primarily reflect rate declines, principally changes to the prime lending rate. For the year 2009, the national prime lending rate averaged 184 basis points lower than the prior year. The national prime lending rate remained at 3.25% for the year 2009. Overall our net interest margin declined 30 basis points to 3.22% during 2009 compared to 3.52% during 2008.

 

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Provision for Loan Losses. The provision for loan losses increased $3.0 million or 107.3% to $5.7 million for the year ended December 31, 2009, compared with $2.8 million for the prior year. Provisions for loan losses are charged to income to bring the allowance for loan losses to a level considered appropriate by our management. The increase in the provision for year 2009 is principally in response to an increase in impaired loans and overall increases to risk factors to the general reserve. Net charge-offs were $3.5 million or .65% of average loans and $1.4 million or .27% of average loans, respectively, for the years ended December 31, 2009 and 2008. The allowance for loan losses was $8.6 million as of December 31, 2009 and $6.4 million as of December 31, 2008, representing 1.64% and 1.17%, respectively, of loans outstanding as of December 31, 2009 and 2008. See “Asset Quality and the Allowance For Loan Losses” above for more detail.

Non-interest Income. For the year ended December 31, 2009, our non-interest income remained substantially unchanged at $1.2 million, down $58,000 from the corresponding prior year. Included in non-interest income for 2009 are net security gains of $464,000 from our available for sale portfolio and the loss from the write-off of our stock investment in our lead correspondent bank of $134,000. Excluding net security gains and stock investment loss, non-interest income decreased $388,000 to $838,000, compared to $1.2 million for the corresponding prior year. Service charges and fees on deposit accounts were substantially unchanged from the prior year at $432,000 compared to $428,000 for the year 2008. Merchant and other loan fees were down $384,000 due to decreased new loan and modified loan activity. We began efforts at the beginning of 2008 to dissolve our mortgage operations by the end of June 2008, resulting in a decrease in mortgage operation fees of $72,000 from the prior year. Fees from annuity sales and other fees generated from wealth management services provided $117,000 in non-interest income, down $51,000 over the prior year period. As a percentage of average assets, non-interest income decreased to .17% for the year 2009 compared to .21% for the year 2008. In late 2009, we sold our 5.6% equity interest in a title insurance agency at a gain of $18,000.

Non-interest Expense. Non-interest expense includes salaries and benefits paid to employees, occupancy and equipment expenses and all other operating costs. Total non-interest expense, including $1.4 million in increased FDIC insurance premiums in 2009, increased $328,000 to $15.1 million for the year ended December 31, 2009 compared to $14.8 million for the year ended December 31, 2008. In addition to higher FDIC premiums, net cost of foreclosed assets was $807,000 for the year ended December 31, 2009 compared to $5,000 for the prior year. Cost savings initiatives we began early in 2009 partially offset increasingly higher regulatory assessments, specifically FDIC insurance premiums, as well as higher costs related to foreclosed assets and any other unexpected changes due to the current economic environment. In the aggregate, total non-interest expense, including FDIC insurance premiums and higher foreclosed asset costs, as a percentage of average total assets decreased to 2.18% for the year 2009 compared to 2.49% for year 2008. FDIC insurance premiums represented .25% and .07%, respectively, of average total assets for the years ended December 31, 2009 and 2008. Net foreclosed asset costs represented .12% and 0%, respectively of average assets for the same periods.

Salaries and other personnel expense represent our largest expense category at $6.4 million for the year 2009, down $1.7 million from $8.1 million for the year 2008. Full time equivalent employees were down four employees from the prior year period due to organizational consolidations. Our efforts to reduce noninterest expense provided much of the decrease in overall personnel expense. For the year ended December 31, 2009 compared to 2008, incentive and other payroll bonuses decreased approximately $192,000, 401(k) retirement expense was down $216,000 while salaries and other related benefits and costs decreased approximately $655,000. The remaining decrease in overall personnel expense is primarily the result of higher per loan origination cost adjustments implemented in late 2008, increasing the amount of deferred personnel-related origination costs on new and modified loans. As a percentage of average assets, personnel expense decreased to .92% for the year 2009 compared to 1.37% for the year 2008.

Occupancy and equipment costs increased $249,000 to $2.8 million for the year ended December 31, 2009 compared to the prior year. The increase reflects additional depreciation and other occupancy costs on our new multi-story building for our north Raleigh banking office and new corporate offices which opened on June 8, 2009.

Other non-interest expenses increased $1.1 million over the prior year primarily due to increased regulatory expenses. FDIC insurance assessments increased $1.4 million or 346.0% over the prior year due to higher regulatory rate requirements. The FDIC increased the base assessment insurance premiums and also imposed a special assessment of five basis points that was levied against all banks in June 2009. Additional discussion regarding increased insurance assessments is presented in Item 1. Business “Supervision and Regulation-Insurance Assessments.” Our outsourced services expense is related to data processing and other services for our customers’ accounts. These services are primarily volume driven and increase as we add new offices and products with corresponding increases in loan, deposit and other customer-based accounts. Additional costs for 2009 include outsourced software services for our customers in the “CommunityPLUS” division, approximately $285,000 for the year ended December 31, 2009. In total, outsourced data processing fees were up $346,000 over the prior year. Fees for directors were down $182,000 compared to the prior year as a result of a decision to suspend corporate director fees for 2009. An increased emphasis on reducing other noninterest expense wherever possible resulted in decreases in postage, printing and office supplies of $49,000, advertising and promotion expense of $195,000 and donations of $56,000. Net expenses related to foreclosed assets added $802,000, of which $697,000 were valuation write-downs, non-interest expense over the prior year. There were no other significant changes in other noninterest expenses.

 

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Income Taxes. We recorded $817,000 in income tax expense for the year ended December 31, 2009 and $1.6 million for the year ended December 31, 2008. Income tax expense as a percentage of pretax income was 42.7% for 2009 and 39.7% for 2008. The effective tax rate was higher in 2009 primarily due to fewer permanent tax differences compared to the prior year. Management has evaluated our tax positions and has concluded that we have no uncertain tax positions.

Net Interest Income

Like most financial institutions, the primary component of our earnings is net interest income. Net interest income is the difference between interest income, principally from loan and investment securities portfolios, and interest expense, principally on customer deposits and borrowings. Changes in net interest income result from changes in volume, spread and margin. For this purpose, volume refers to the average dollar level of interest-earning assets and interest-bearing liabilities, spread refers to the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities, and margin refers to net interest income divided by average interest-earning assets and is influenced by the level and relative mix of interest-earning assets and interest-bearing liabilities, as well as levels of non-interest-bearing liabilities. The following table sets forth, for the periods indicated, information with regard to average balances of assets and liabilities, as well as the total dollar amounts of interest income from interest-earning assets and interest expense on interest-bearing liabilities, resultant yields or costs, net interest income, net interest spread, net interest margin and ratio of average interest-earning assets to average interest-bearing liabilities. Non-accrual loans are excluded in determining average loans outstanding. Accretion of net deferred loan fees is included in interest income in the table below.

 

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    Year Ended December 31, 2010     Year Ended December 31, 2009     Year Ended December 31, 2008  
    Average
Balance
    Interest     Average
Rate
    Average
Balance
    Interest     Average
Rate
    Average
Balance
    Interest     Average
Rate
 
    (Dollars in thoursands)  

Interest-earning assets:

                 

Loans (1)

  $ 494,706      $ 28,288        5.72   $ 528,476      $ 31,257        5.91   $ 516,288      $ 34,318        6.65

Loans held for sale

    30,726        1,472        4.79     —          —          —          —          —          —     

Investment securities available for sale

    19,970        587        2.94     25,725        1,113        4.33     29,492        1,349        4.57

Investment securities held to maturity

    420        16        3.81     750        38        5.07     285        20        7.02

Other interest-earning assets

    67,281        599        0.89     103,598        1,032        1.00     25,550        388        1.52
                                                     

Total interest-earning assets

    613,103        30,962        5.05     658,549        33,440        5.08     571,615        36,075        6.31
                                   

Other assets

    42,903            37,359            22,917       
                                   

Total assets

  $ 656,006          $ 695,908          $ 594,532       
                                   

Interest-bearing liabilities:

                 

Deposits:

                 

Savings, NOW and money market

  $ 242,359        2,066        0.85   $ 229,016        2,062        0.90   $ 212,885        4,644        2.18

Time deposits over $100,000

    110,325        2,431        2.20     141,852        4,234        2.98     98,494        4,520        4.59

Other time deposits

    114,543        2,051        1.79     156,604        4,439        2.83     121,978        4,826        3.96

Borrowings:

                 

Short-term borrowings

    5,804        19        0.33     9,236        33        0.36     16,130        356        2.21

Long-term debt

    27,271        921        3.38     27,291        1,078        3.95     26,927        1,471        5.46
                                                     

Total interest-bearing liabilities

    500,302        7,488        1.50     563,999        11,846        2.10     476,414        15,817        3.32
                                                     

Noninterest-bearing deposits

    114,927            90,770            79,498       

Other liabilities

    2,881            4,165            4,094       

Shareholders’ equity

    37,896            36,974            34,526       
                                   

Total liabilities and shareholders’ equity

  $ 656,006          $ 695,908          $ 594,532       
                                   

Net interest income and interest rate spread

    $ 23,474        3.55     $ 21,594        2.98     $ 20,258        2.99
                                                     

Net interest margin

        3.83