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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

 

FORM 10-Q

 

(Mark one)

 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
  For the quarterly period ended March 31, 2012

 

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
  For the transition period from ______________ to _____________

 

Commission file number: 1-35085

 

 

FRANKLIN FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

Virginia   27-4132729
(State or other jurisdiction   (I.R.S. Employer Identification No.)
of incorporation or organization)    
4501 Cox Road, Glen Allen, VA 23060
(Address of principal executive offices, including zip code)
(804) 967-7000
(Registrant’s telephone number, including area code)
Not applicable
(Former name, former address and former fiscal year, if changed since last report)

 

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

 

Indicate by check mark 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 shorter period that the registrant was reported to submit and post such files). Yes x No ¨

 

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

 

Large accelerated filer ¨ Accelerated Filer x Non-accelerated filer ¨ Smaller reporting company ¨

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes ¨ No x

 

14,302,838 shares of the registrant’s common stock, par value $0.01 per share, were outstanding at May 1, 2012.

 
 

 

 

Franklin Financial Corporation

 

Form 10-Q

 

Table of Contents

Part I. Financial Information Page No.  
     
Item 1. Financial Statements  
     
  Consolidated Balance Sheets at March 31, 2012 (unaudited) and September 30, 2011 2
     
  Consolidated Income Statements for the Three and Six Months Ended March 31, 2012 and 2011 (unaudited) 3
     
  Consolidated Statements of Comprehensive Income and Changes in Stockholders’ Equity for the Six Months Ended March 31, 2012 and 2011 (unaudited) 4
     
  Consolidated Statements of Cash Flows for the Six Months Ended March 31, 2012 and 2011 (unaudited) 5
     
  Notes to the Unaudited Consolidated Financial Statements 6
     
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations Operations 29
     
Item 3. Quantitative and Qualitative Disclosures About Market Risk 45
     
Item 4. Controls and Procedures 45
     
Part II. Other Information  
     
Item 1. Legal Proceedings 46
     
Item 1A. Risk Factors 46
     
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 46
     
Item 3. Defaults Upon Senior Securities 46
     
Item 4. Mine Safety Disclosures 46
     
Item 5. Other Information 46
     
Item 6. Exhibits 46
     
Signatures   

 

 

1
 

  

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

 

FRANKLIN FINANCIAL CORPORATION AND SUBSIDIARIES

Consolidated Balance Sheets

(Dollars in thousands, except per share amounts)  March 31, 2012   September 30, 2011 
Assets  (unaudited)     
Cash and cash equivalents:        
Cash and due from banks  $17,851   $4,366 
Interest-bearing deposits in other banks   84,314    72,955 
Money market investments   33,831    38,428 
Total cash and cash equivalents   135,996    115,749 
           
Securities available for sale   404,659    396,809 
Securities held to maturity   22,975    25,517 
           
Loans, net of deferred loan fees   468,243    493,047 
Less allowance for loan losses   11,206    14,624 
Net loans   457,037    478,423 
           
Loans held for sale   1,953    922 
Federal Home Loan Bank stock   10,637    11,014 
Office properties and equipment, net   6,243    6,287 
Real estate owned   8,831    8,627 
Accrued interest receivable:          
Loans   2,124    2,339 
Mortgage-backed securities and collateralized mortgage obligations   719    761 
Other investment securities   1,756    1,801 
Total accrued interest receivable   4,599    4,901 
           
Cash surrender value of bank-owned life insurance   32,356    31,714 
Prepaid expenses and other assets   14,584    17,014 
Total assets  $1,099,870   $1,096,977 
           
Liabilities and Stockholders’ Equity          
Deposits:          
Savings deposits  $263,679   $265,192 
Time deposits   374,264    383,562 
Total deposits   637,943    648,754 
           
Federal Home Loan Bank borrowings   190,000    190,000 
Advance payments by borrowers for property taxes and insurance   2,386    2,335 
Accrued expenses and other liabilities   6,636    6,330 
Total liabilities   836,965    847,419 
           
Commitments and contingencies (see note 8)          
           
Stockholders’ equity:          
Preferred stock, $0.01 par value: 10,000,000 shares authorized, no shares
     issued or outstanding
   -    - 
Common stock: $0.01 par value; 75,000,000 shares authorized; 14,302,838
     shares issued and outstanding
   143    143 
Additional paid-in capital   142,967    142,882 
Unearned ESOP shares   (10,728)   (11,082)
Undistributed stock-based deferral plan shares: 252,215 shares   (2,533)   (2,533)
Retained earnings   130,053    125,770 
Accumulated other comprehensive (loss) income   3,003    (5,622)
Total stockholders’ equity   262,905    249,558 
Total liabilities and stockholders’ equity  $1,099,870   $1,096,977 

 

The accompanying notes are an integral part of these consolidated financial statements.

2
 

 

FRANKLIN FINANCIAL CORPORATION AND SUBSIDIARIES

Consolidated Income Statements

Three and Six Months Ended March 31, 2012 and 2011 (Unaudited)

 

 

   Three Months Ended March 31,   Six Months Ended March 31, 
 (Dollars in thousands, except per share amounts)  2012   2011   2012   2011 
Interest and dividend income:                
Interest and fees on loans  $7,730   $7,800   $15,616   $15,983 
Interest on deposits in other banks   30    33    53    77 
Interest and dividends on securities:                    
Taxable   3,185    3,250    6,641    6,472 
Nontaxable   72    79    144    159 
Total interest and dividend income   11,017    11,162    22,454    22,691 
Interest expense:                    
Interest on deposits   1,944    2,672    4,010    5,437 
Interest on borrowings   2,287    2,266    4,603    4,582 
Total interest expense   4,231    4,938    8,613    10,019 
Net interest income   6,786    6,224    13,841    12,672 
Provision for loan losses   (298)   290    (152)   712 
Net interest income after provision for loan losses   7,084    5,934    13,993    11,960 
Noninterest (expense) income:                    
Service charges on deposit accounts   16    12    24    20 
Other service charges and fees   108    91    614    153 
Gains on sales of loans held for sale   63    65    141    216 
Gains on sales of securities, net   -    364    -    264 
Gains (losses) on sales of other real estate owned   428    (46)   625    54 
Impairment of securities, net:                    
Impairment of securities   (935)   (490)   (2,879)   (786)
Less: Impairment recognized in other comprehensive income   (64)   (108)   (553)   (105)
Net impairment reflected in earnings   (871)   (382)   (2,326)   (681)
Increase in cash surrender value of bank-owned life insurance   319    316    642    636 
Other operating income   125    146    225    270 
Total noninterest (expense) income   188    566    (55)   932 
Other noninterest expenses:                    
Personnel expense   2,050    1,997    4,078    3,890 
Occupancy expense   228    207    440    408 
Equipment expense   232    221    458    446 
Advertising expense   51    32    110    72 
Federal deposit insurance premiums   203    272    411    518 
Other operating expenses   848    1,439    1,669    2,284 
Total other noninterest expenses   3,612    4,168    7,166    7,618 
Income before provision for income taxes   3,660    2,332    6,772    5,274 
Federal and state income tax expense   1,152    597    2,489    1,504 
Net income  $2,508   $1,735   $4,283   $3,770 
                     
Basic net income per common share  $0.19    N/A   $0.32    N/A 
                     
Diluted net income per common share  $0.19    N/A   $0.32    N/A 

 

The accompanying notes are an integral part of these consolidated financial statements.

3
 

 

FRANKLIN FINANCIAL CORPORATION AND SUBSIDIARIES

Consolidated Statements of Comprehensive Income and Changes in Stockholders’ Equity

Six Months Ended March 31, 2012 and 2011 (Unaudited)

 

(Dollars in thousands)  Common Stock   Additional Paid-in Capital   Unearned ESOP Shares   Undistributed Stock-Based Deferral Plan Shares   Retained Earnings   Accumulated Other Comprehensive Income (Loss)   Total Stockholders’ Equity 
Balance at September 30, 2010  $-   $-   $-   $-   $124,339   $2,430   $126,769 
Net income   -    -    -    -    3,770    -    3,770 
Other comprehensive income:                                   
Net unrealized holding losses arising during the period, net of income tax benefit of $1,199   -    -    -    -    -    (516)   (516)
                                    
Reclassification adjustment for gains included in net income, net of income tax expense of $81   -    -    -    -    -    (132)   (132)
                                    
Other-than-temporary impairment of held-to-maturity securities related to factors other than credit, net of amortization, net of income tax expense of $15   -    -    -    -    -    25    25 
                                    
Amortization of previously recognized other-than-temporary impairment of available-for-sale securities related to factors other than credit, net of income tax expense of $261   -    -    -    -    -    426    426 
                                    
Comprehensive income                                 3,573 
Balance at March 31, 2011  $-   $-   $-   $-   $128,109   $2,233   $130,342 
                                    
Balance at September 30, 2011  $143   $142,882   $(11,082)  $(2,533)  $125,770   $(5,622)  $249,558 
ESOP shares allocated   -    68    354    -    -    -    422 
Stock-based compensation expense        17    -    -    -    -    17 
Net income   -    -    -    -    4,283    -    4,283 
Other comprehensive income (loss):                                   
Net unrealized holding gains arising during the period, net of income tax expense of $515   -    -    -    -    -    6,766    6,766 
                                    
Reclassification adjustment for losses included in net income, net of income tax benefit of $261   -    -    -    -    -    1,938    1,938 
                                    
Other-than-temporary impairment of held-to-maturity securities related to factors other than credit, net of amortization, net of income tax benefit of $157   -    -    -    -    -    (257)   (257)
                                    
Amortization of previously recognized other-than-temporary impairment of available-for-sale securities related to factors other than credit, net of income tax expense of $109   -    -    -    -    -    178    178 
                                    
Comprehensive income                                 12,908 
Balance at March 31, 2012  $143   $142,967   $(10,728)  $(2,533)  $130,053   $3,003   $262,905 

 

The accompanying notes are an integral part of these consolidated financial statements.

4
 

 

FRANKLIN FINANCIAL CORPORATION AND SUBSIDIARIES

Consolidated Statements of Cash Flows

Six Months Ended March 31, 2012 and 2011 (Unaudited)

 

   2012   2011 
 (Dollars in thousands)        
Cash Flows From Operating Activities        
Net income  $4,283   $3,770 
Adjustments to reconcile net income to net cash and cash          
equivalents provided by operating activities:          
Depreciation and amortization   414    350 
Provision for loan losses   (152)   712 
Impairment charges on other real estate owned   -    781 
Gains on sales of securities available for sale, net   -    (264)
Impairment charge on securities   2,326    681 
Loss on sales or disposal of office properties and equipment, net   13    1 
Gains on sales of other real estate owned, net   (625)   (54)
Net amortization on securities   1,204    767 
Originations of loans held for sale   (7,730)   (8,559)
Sales and principal payments on loans held for sale   6,572    11,091 
ESOP compensation expense   422    - 
Stock-based compensation expense   17    - 
Changes in assets and liabilities:          
Accrued interest receivable   302    (291)
Cash surrender value of bank-owned life insurance   (642)   (636)
Prepaid expenses and other assets   1,704    (2,339)
Advance payments by borrowers for property taxes and insurance   51    108 
Accrued expenses and other liabilities   751    861 
Net cash and cash equivalents provided by operating activities   8,910    6,979 
Cash Flows From Investing Activities          
Net redemptions of Federal Home Loan Bank stock   377    471 
Proceeds from maturities, calls and paydowns of securities available for sale   68,464    54,269 
Proceeds from sales of securities available for sale   4,225    12,173 
Purchases of securities available for sale   (74,459)   (134,455)
Proceeds from maturities and paydowns of securities held to maturity   2,283    4,260 
Net decrease (increase) in loans   21,488    (4,235)
Purchases of office properties and equipment   (361)   (277)
Capitalized improvements of real estate owned   -    (46)
Proceeds from sales of real estate owned   131    1,030 
Net cash and cash equivalents provided (used) by investing activities   22,148    (66,810)
Cash Flows From Financing Activities          
Net (decrease) increase in savings deposits   (1,513)   10,813 
Net (decrease) increase in time deposits   (9,298)   21,170 
Net increase in stock order funds   -    242,377 
Net cash and cash equivalents (used) provided by financing activities   (10,811)   274,360 
Net increase in cash and cash equivalents   20,247    214,529 
Cash and cash equivalents at beginning of period   115,749    97,909 
Cash and cash equivalents at end of period  $135,996   $312,438 
           
Supplemental disclosures of cash flow information          
Cash payments for interest  $8,573   $9,981 
Cash payments for income taxes  $1,504   $1,400 
Supplemental schedule of noncash investing and financing activities          
Unrealized gains (losses) on securities available for sale  $9,765   $(1,241)
Transfer of loans to other real estate owned, net  $448   $2,439 
Sales of other real estate owned financed by the Bank  $395   $- 

.

The accompanying notes are an integral part of these consolidated financial statements.

5
 

 

FRANKLIN FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Unaudited Consolidated Financial Statements

March 31, 2012

 

Note 1. Nature of Business and Summary of Significant Accounting Policies

 

Organization and Description of Business -- Franklin Financial Corporation (“Franklin Financial”), a Virginia corporation, is the holding company for Franklin Federal Savings Bank (the “Bank”), a federally chartered capital stock savings bank engaged in the business of attracting retail deposits from the general public and originating both owner and non-owner-occupied one-to four-family loans as well as multi-family loans, nonresidential real estate loans, construction loans, land and land development loans, and non-mortgage commercial loans. The Bank has two wholly owned subsidiaries, Franklin Service Corporation, which provides trustee services on loans originated by the Bank, and Reality Holdings LLC, which, through its subsidiaries, holds and manages foreclosed properties purchased from the Bank. The interim consolidated financial statements presented in this report include the unaudited financial information of Franklin Financial and subsidiaries on a consolidated basis. The Company (as defined below) operates as one segment.

 

These interim consolidated financial statements do not contain all necessary disclosures required by accounting principles generally accepted in the United States of America (“GAAP”) for complete financial statements and, therefore, should be read in conjunction with the audited consolidated financial statements and the notes thereto included in the Company’s Annual Report on Form 10-K for the year ended September 30, 2011 (“2011 Form 10-K”).  These interim consolidated financial statements include all normal and recurring adjustments that management believes are necessary in order to conform to GAAP.  The results for the three and six months ended March 31, 2012 are not necessarily indicative of the results that may be expected for the year ending September 30, 2012 or any other future period. The consolidated balance sheet as of September 30, 2011 was derived from the Company’s audited annual consolidated financial statements in the 2011 Form 10-K.

 

Principles of Consolidation -- The consolidated financial statements include the accounts of Franklin Financial, the Bank, Franklin Service Corporation, and Reality Holdings LLC and its subsidiaries (collectively, the “Company”). All significant intercompany transactions and balances have been eliminated in consolidation. The accounting and reporting policies of the Company conform to GAAP.

 

Use of Estimates -- Management of the Company has made a number of estimates and assumptions relating to the reporting of assets and liabilities and the disclosure of contingent assets and liabilities to prepare these consolidated financial statements in conformity with GAAP. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the allowance for loan losses, the projected benefit obligation for the defined benefit pension plan, the valuation of deferred taxes, and the analysis of securities for other-than-temporary impairment.

 

Loans -- Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off are reported at their outstanding principal balance adjusted for any charge-offs and net of the allowance for loan losses and any deferred fees or costs. Loan origination fees and certain direct loan origination costs are deferred and recognized over the contractual lives of the related loans as an adjustment of the loans’ yields using the level-yield method on a loan-by-loan basis.

 

Loans are placed on nonaccrual status when they are three monthly payments or more past due unless management believes, based on individual facts, that the delay in payment is temporary and that the borrower will be able to bring past due amounts current and remain current. All interest accrued but not collected for loans that are placed on non-accrual status is reversed against interest income. Any payments made on these loans while on non-accrual status are accounted for on a cash-basis until the loan qualifies for return to accrual status or is subsequently charged-off. Loans are returned to accrual status when the principal and interest amounts due are brought current and management believes that the borrowers will be able to continue to make required contractual payments.

 

Allowance for Loan Losses -- The allowance for loan losses is maintained at an amount estimated to be sufficient to absorb probable principal losses, net of principal recoveries (including recovery of collateral), inherent in the existing loan portfolio. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. The allowance for loan losses consists of specific and general components.

6
 

 

The specific component relates to loans identified as impaired. The Company determines and recognizes impairment of certain loans when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Loans that experience insignificant delays and payment shortfalls generally are not classified as impaired. An impaired loan is measured at net realizable value, which is equal to present value less estimated costs to sell. The present value is estimated using expected future cash flows discounted at the loan’s effective interest rate, the loan’s observable market price, or the fair value of the collateral, if the loan is collateral dependent.

 

The general component covers loans not identified for specific allowances and is based on historical loss experience adjusted for various qualitative factors. The allowance for loan losses is increased by provisions for loan losses and decreased by charge-offs (net of recoveries). In estimating the allowance, management segregates its portfolio by loan type and credit grading. Management’s periodic determination of the allowance for loan losses is based on consideration of various factors, including the Company’s past loan loss experience, current delinquency status and loan performance statistics, industry loan loss statistics, periodic loan evaluations, real estate value trends in the Company’s primary lending areas, regulatory requirements, and current economic conditions. The delinquency status of loans is computed based on the contractual terms of the loans.

 

Management’s estimate of the adequacy of the allowance is subject to evaluation and adjustment by the Bank’s regulators. Management believes that the current allowance for loan losses is a reasonable estimate of known and inherent losses in the loan portfolio.

 

Stock-Based Compensation -- The Company issues restricted stock and stock options under the Franklin Financial Corporation 2012 Equity Incentive Plan to key officers and outside directors. In accordance with the requirements of ASC 718, Compensation – Stock Compensation, the Company has adopted a fair value based method of accounting for employee stock compensation plans, whereby compensation cost is measured as of the grant date based on the fair value of the award and is recognized over the vesting period.

 

Income Taxes -- Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss, capital loss, and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to be in effect for the year in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in earnings in the period that includes the enactment date. Valuation allowances are established when necessary to reduce deferred tax assets to the amount deemed more likely than not to be realized in future periods. It is the Company’s policy to provide for uncertain tax positions and the related interest and penalties based upon management’s assessment of whether a tax benefit is more likely than not to be sustained upon examination by tax authorities. Any interest and penalties assessed on tax positions are recognized in income tax expense.

 

Reclassifications -- Certain reclassifications have been made to the financial statements of prior periods to conform to the current period presentation. Net income, earnings per share, and stockholders’ equity previously reported were not affected by these reclassifications.

 

Concentrations of Credit Risk -- Most of the Company’s activities are with customers in Virginia with primary geographic focus in the Richmond metropolitan area, which includes the city of Richmond and surrounding counties. Securities and loans also represent concentrations of credit risk and are discussed in note 2 “Securities” and note 3 “Loans” in the notes to the unaudited consolidated financial statements. Although the Company believes its underwriting standards are conservative, the nature of the Company’s portfolio of construction loans, land and land development loans, and income-producing nonresidential real estate loans and multi-family loans results in a smaller number of higher-balance loans. As a result, the default of loans in these portfolio segments may result in more significant losses to the Company.

7
 

 

Recent Accounting Pronouncements

 

In May 2011, the FASB issued Accounting Standards Update (ASU) No. 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. This ASU represents the converged guidance of the FASB and the International Accounting Standards Board (the “Boards”) on fair value measurement. The collective efforts of the Boards and their staffs, reflected in ASU 2011-04, have resulted in common requirements for measuring fair value and for disclosing information about fair value measurements, including a consistent meaning of the term “fair value.” The Boards have concluded the common requirements will result in greater comparability of fair value measurements presented and disclosed in financial statements prepared in accordance with GAAP and International Financial Reporting Standards. The amendments to the Codification in ASU 2011-04 are to be applied prospectively. For public entities, the amendments are effective during interim and annual periods beginning after December 15, 2011. See note 9 of the notes to the unaudited consolidated financial statements for disclosures about fair value measurements.

 

In June 2011, the FASB issued Accounting Standards Update (ASU) No. 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income. This ASU amends the Codification to allow an entity the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In both choices, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income. ASU 2011-05 eliminates the option to present the components of other comprehensive income as part of the statement of changes in stockholders' equity. The amendments to the Codification in ASU 2011-05 do not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income. ASU 2011-05 should be applied retrospectively. For public entities, the amendments are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. The Company is evaluating the impact of ASU 2011-05 on the presentation of its consolidated financial statements.

 

In December 2011, the FASB issued Accounting Standards Update (ASU) No. 2011-11: Disclosures about Offsetting Assets and Liabilities. The eligibility criteria for offsetting are different in International Financial Reporting Standards (“IFRS”) and GAAP. Offsetting, otherwise known as netting, is the presentation of assets and liabilities as a single net amount in the statement of financial position (balance sheet). Unlike IFRS, GAAP allows companies the option to present net in their balance sheets derivatives that are subject to a legally enforceable netting arrangement with the same party where rights of set-off are only available in the event of default or bankruptcy. To allow investors to better compare financial statements prepared in accordance with IFRS or GAAP, the Boards have issued common disclosure requirements related to offsetting arrangements in ASU No. 2011-11. The amendments to the Codification in this ASU require an entity to disclose information about offsetting and related arrangements to enable users of its financial statements to understand the effect of those arrangements on its financial position. An entity is required to apply the amendments for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods. An entity should provide the disclosures required by those amendments retrospectively for all comparative periods presented. The Company is evaluating the impact of ASU No. 2011-11 on its consolidated financial statements.

 

In December 2011, the FASB issued Accounting Standards Update (ASU) No. 2011-12: Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05. The amendments to the Codification in ASU No. 2011-12 are effective at the same time as the amendments in ASU No. 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income (discussed above), so that entities will not be required to comply with the presentation requirements in ASU No. 2011-05 that ASU No. 2011-12 is deferring. In order to defer only those changes in ASU No. 2011-05 that relate to the presentation of reclassification adjustments, the paragraphs in ASU No. 2011-12 supersede certain pending paragraphs in ASU No. 2011-05. The amendments are being made to allow the FASB time to redeliberate whether to present on the face of the financial statements the effects of reclassifications out of accumulated other comprehensive income on the components of net income and other comprehensive income for all periods presented. While the FASB is considering the operational concerns about the presentation requirements for reclassification adjustments and the needs of financial statement users for additional information about reclassification adjustments, entities should continue to report reclassifications out of accumulated other comprehensive income consistent with the presentation requirements in effect before ASU No. 2011-05. All other requirements in ASU No. 2011-05 are not affected by ASU No. 2011-12, including the requirement to report comprehensive income either in a single continuous financial statement or in two separate but consecutive financial statements. Public entities should apply these requirements for fiscal years, and interim periods within those years, beginning after December 15, 2011. The Company is evaluating the impact of ASU No. 2011-12 on its consolidated financial statements.

8
 

 

Note 2. Securities

 

The amortized cost, gross unrealized gains and losses, and estimated fair value of securities at March 31, 2012 and September 30, 2011 are summarized as follows:

 

 

   March 31, 2012 
(Dollars in thousands)  Adjusted amortized cost   OTTI recognized in AOCI   Amortized cost   Gross unrealized gains   Gross unrealized losses   Estimated fair value 
Available for sale:    
States and political subdivisions  $12,655   $-   $12,655   $907   $-    13,562 
Agency mortgage-backed securities   29,039    -    29,039    1,041    11    30,069 
Agency collateralized mortgage                              
obligations   206,639    -    206,639    2,041    408    208,272 
Corporate equity securities   27,224    -    27,224    2,782    2,408    27,598 
Corporate debt securities   118,167    942    119,109    6,377    328    125,158 
     Total  $393,724   $942   $394,666   $13,148   $3,155    404,659 

 

   September 30, 2011 
(Dollars in thousands)  Adjusted amortized cost   OTTI recognized in AOCI   Amortized cost   Gross unrealized gains   Gross unrealized losses   Estimated fair value 
Available for sale:    
U.S. government and agency securities  $7,500   $-   $7,500   $1   $-   $7,501 
States and political subdivisions   18,143    -    18,143    765    735    18,173 
Agency mortgage-backed securities   23,561    -    23,561    1,259    25    24,795 
Agency collateralized mortgage                              
obligations   207,123    -    207,123    2,497    917    208,703 
Corporate equity securities   28,735    -    28,735    442    7,504    21,673 
Corporate debt securities   110,289    1,230    111,519    5,854    1,409    115,964 
     Total  $395,351   $1,230   $396,581   $10,818   $10,590   $396,809 

 

   March 31, 2012 
 (Dollars in thousands)  Adjusted amortized cost   OTTI recognized in AOCI   Amortized cost   Gross unrealized gains   Gross unrealized losses   Estimated fair value 
Held to maturity:                        
   Agency mortgage-backed securities  $5,123   $-   $5,123   $177   $-   $5,300 
   Agency collateralized mortgage                              
     obligations   5,944    -    5,944    595    1    6,538 
   Non-agency collateralized                              
     mortgage obligations   11,908    1,250    13,158    936    3,529    10,565 
Total  $22,975   $1,250   $24,225   $1,708   $3,530   $22,403 

 

9
 

 

   September 30, 2011 
(Dollars in thousands)  Adjusted amortized cost   OTTI recognized in AOCI   Amortized cost   Gross unrealized gains   Gross unrealized losses   Estimated fair value 
Held to maturity:    
   Agency mortgage-backed securities  $5,512   $-   $5,512   $187   $-   $5,699 
   Agency collateralized mortgage                              
     obligations   6,552    -    6,552    835    1    7,386 
   Non-agency collateralized                              
     mortgage obligations   13,453    835    14,288    908    5,033    10,163 
     Total  $25,517   $835   $26,352   $1,930   $5,034   $23,248 

 

 

The amortized cost and estimated fair value of securities at March 31, 2012, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to prepay obligations with or without prepayment penalties.

 

   Available for sale   Held to maturity 
   Amortized   Estimated fair   Amortized   Estimated fair 
 (Dollars in thousands)  cost   value   cost   value 
Non-mortgage debt securities:                
Due in one year or less  $17,226   $17,642   $-   $- 
Due after one year through five years   54,996    57,429    -    - 
Due after five years through ten years   25,520    27,578    -    - 
Due after ten years   34,022    36,071    -    - 
 Total non-mortgage debt securities   131,764    138,720    -    - 
                     
Mortgage-backed securities   29,039    30,069    5,123    5,300 
Collateralized mortgage obligations   206,639    208,272    19,102    17,103 
Corporate equity securities   27,224    27,598    -    - 
   Total securities  $394,666   $404,659   $24,225   $22,403 

 

The following tables present information regarding temporarily impaired securities as of March 31, 2012 and September 30, 2011:

 

   March 31, 2012 
   Less Than 12 Months   12 Months or Longer   Total 
   Estimated   Gross   Estimated   Gross   Estimated   Gross 
   fair   unrealized   fair   unrealized   fair   unrealized 
 (Dollars in thousands)  value   losses   value   losses   value   losses 
Available for sale:                        
Agency mortgage-backed securities  $3,428   $11   $-   $-   $3,428   $11 
Agency collateralized mortgage obligations   42,237    408    -    -    42,237    408 
Corporate equity securities   6,902    2,408    -    -    6,902    2,408 
Corporate debt securities   16,796    256    1,928    72    18,724    328 
Total available for sale   69,363    3,083    1,928    72    71,291    3,155 
                               
Held to maturity:                              
Agency collateralized mortgage obligations   -    -    109    1    109    1 
Non-agency collateralized mortgage obligations   236    17    8,045    3,512    8,281    3,529 
Total held to maturity   236    17    8,154    3,513    8,390    3,530 
                               
Total temporarily impaired securities  $69,599   $3,100   $10,082   $3,585   $79,681   $6,685 

 

10
 

 

   September 30, 2011 
   Less Than 12 Months   12 Months or Longer   Total 
 (Dollars in thousands)  Estimated fair
value
   Gross unrealized losses   Estimated fair
value
   Gross unrealized losses   Estimated fair
value
   Gross unrealized losses 
Available for sale:                        
States and political subdivisions  $1,715   $735   $-   $-   $1,715   $735 
Agency mortgage-backed securities   4,592    25    -    -    4,592    25 
Agency collateralized mortgage obligations   50,933    901    3,097    16    54,030    917 
Corporate equity securities   17,982    7,504    -    -    17,982    7,504 
Corporate debt securities   17,816    1,191    11,783    218    29,599    1,409 
Total available for sale   93,038    10,356    14,880    234    107,918    10,590 
                               
Held to maturity:                              
Agency collateralized mortgage obligations   -    -    116    1    116    1 
Non-agency collateralized mortgage obligations   845    259    7,530    4,774    8,375    5,033 
Total held to maturity   845    259    7,646    4,775    8,491    5,034 
                               
Total temporarily impaired securities  $93,883   $10,615   $22,526   $5,009   $116,409   $15,624 

 

The Company’s securities portfolio consists of investments in various debt and equity securities as permitted by regulations of the Office of the Comptroller of the Currency (“OCC”) and the Federal Reserve Board (“FRB”), including mortgage-backed securities, collateralized mortgage obligations, government agency bonds, state and local government obligations, corporate debt obligations, and common stock of various companies.

 

During the three and six months ended March 31, 2012 the Company recognized no gains or losses on sales of securities available for sale. During the three months ended March 31, 2011, the Company recognized gross gains on sales of securities available for sale of $605,000 and gross losses of $241,000. During the six months ended March 31, 2011, the Company recognized gross gains on sales of securities available for sale of $705,000 and gross losses of $441,000.

 

The Company performs an other-than-temporary impairment analysis of the securities portfolio on a quarterly basis. The determination of whether a security is other-than-temporarily impaired is highly subjective and requires a significant amount of judgment. In evaluating for other-than-temporary impairment, management considers the duration and severity of declines in fair value, the financial condition of the issuers of each security, as well as whether it is more likely than not that the Company will be required to sell these securities prior to recovery, which may be maturity, based on market conditions and cash flow requirements. In performing its analysis for debt securities, the Company’s consideration of the financial condition of the issuer of each security was focused on the issuer’s ability to continue to perform on its debt obligations, including any concerns about the issuer’s ability to continue as a going concern. In performing its analysis for equity securities, the Company’s analysis of the financial condition of the issuer of each security included the issuer’s economic outlook, distressed capital raises, large write-downs causing dilution of capital, distressed dividend cuts, discontinuation of significant segments, replacement of key executives, and the existence of a pattern of significant operating losses. In addition to the financial condition of each issuer, the Company considered the severity and duration of impairments and the likelihood that the fair value of securities would recover over a reasonable time horizon.

 

The Company recognized total impairment charges on debt and equity securities in earnings of $871,000 and $382,000 during the three months ended March 31, 2012 and 2011, respectively, and $2.3 million and $681,000 for the six months ended March 31, 2012 and 2011, respectively.

11
 

 

The table below provides a cumulative rollforward of credit losses recognized in earnings for debt securities for which a portion of OTTI is recognized in AOCI:

 

(Dollars in thousands)    
Balance of credit losses at September 30, 2011  $79 
Additions for credit losses on securities not previously recognized   16 
Additional credit losses on securities previously recognized as impaired   47 
Reductions for increases in expected cash flows   (80)
Balance of credit losses at March 31, 2012  $62 

 

To determine the amount of other-than-temporary impairment losses that are related to credit versus the portion related to other factors, management compares the current period estimate of future cash flows to the prior period estimated future cash flows, both discounted at each security’s yield at purchase. Any other-than-temporary impairment recognized in excess of the difference of these two values is deemed to be related to factors other than credit.

 

Unrealized losses in the remainder of the Company’s portfolio of collateralized mortgage obligations, mortgage-backed securities, securities of states and political subdivisions, and corporate debt securities were related to sixty-six securities and were caused by increases in market interest rates, spread volatility, or other factors that management deems to be temporary; and because management believes that it is not more likely than not that the Company will be required to sell these securities prior to maturity or a full recovery of the amortized cost, the Company does not consider these securities to be other-than-temporarily impaired.

 

Unrealized losses in the remainder of the Company’s portfolio of equity securities were related to eleven securities and were considered temporary. Each of these securities has been in an unrealized loss position for fewer than twelve months, and because management believes that it is not more likely than not that the Company will be required to sell these equity positions for a reasonable period of time sufficient for a recovery of fair value, the Company does not consider these equity securities to be other-than-temporarily impaired.

 

The Company pledges certain securities as collateral for its FHLB borrowings. Securities collateralizing FHLB borrowings had a carrying value of $240.6 million at March 31, 2012 compared to $262.1 million at September 30, 2011.

 

Note 3. Loans

 

Loans held for investment at March 31, 2012 and September 30, 2011 are summarized as follows:

 

   March 31,   September 30, 
(Dollars in thousands)  2012   2011 
Loans        
One-to four-family  $110,998   $114,947 
Multi-family   80,129    79,106 
Nonresidential   199,029    190,747 
Construction   30,444    43,992 
Land and land development   50,323    67,049 
Other   554    650 
     Total loans   471,477    496,491 
           
Deferred loan fees   3,234    3,444 
     Loans, net of deferred loan fees   468,243    493,047 
           
Allowance for loan losses   11,206    14,624 
      Net loans  $457,037   $478,423 

 

The Company pledges certain loans as collateral for its FHLB borrowings. Loans collateralizing FHLB borrowings had a carrying value of $276.8 million at March 31, 2012 compared to $252.9 million at September 30, 2011.

12
 

 

Note 4. Allowance for Loan Losses

 

The allowance for loan losses is maintained at a level considered adequate to provide for our estimate of probable credit losses inherent in the loan portfolio. The allowance is increased by provisions charged to operating expense and reduced by net charge-offs. While the Company uses the best information available to make its evaluation, future adjustments may be necessary if there are significant changes in conditions.

 

The allowance is comprised of two components: (1) a general allowance related to loans both collectively and individually evaluated and (2) a specific allowance related to loans individually evaluated and identified as impaired. A summary of the methodology the Company employs on a quarterly basis related to each of these components to estimate the allowance for loan losses is as follows.

 

Credit Rating Process

 

As discussed in note 1 above, the Company's methodology for estimating the allowance for loan losses incorporates the results of periodic loan evaluations for certain non-homogeneous loans, including non-homogenous loans in lending relationships greater than $2.0 million and any individual loan greater than $1.0 million. The Company's loan grading system analyzes various risk characteristics of each loan type when considering loan quality, including loan-to-value ratios, current real estate market conditions, location and appearance of properties, income and net worth of any guarantors, and rental stability and cash flows of income-producing nonresidential real estate loans and multi-family loans. The credit rating process results in one of the following classifications for each loan in order of increasingly adverse classification: Excellent, Good, Satisfactory, Watch List, Special Mention, Substandard, and Impaired. The Company continually monitors the credit quality of loans in the portfolio through communications with borrowers as well as review of delinquency and other reports that provide information about credit quality. Credit ratings are updated at least annually with more frequent updates performed for problem loans or when management becomes aware of circumstances related to a particular loan that could materially impact the loan’s credit rating. Management maintains a classified loan list consisting of watch list loans along with loans rated special mention or lower that is reviewed on a monthly basis by the Company’s Internal Asset Review Committee.

 

General Allowance

 

To determine the general allowance, the Company segregates loans by portfolio segment as defined by loan type. Loans within each segment are then further segregated by credit rating. The Company determines a base reserve rate for each portfolio segment by calculating the average charge-off rate for each segment over a historical time period determined by management, typically one to three years. The base reserve rate is then adjusted based on qualitative factors that management believes could result in future loan losses differing from historical experience. Such qualitative factors can include delinquency rates, loan-to-value ratios, and local economic and real estate conditions. The base reserve rate plus these qualitative adjustments results in a total reserve rate for each portfolio segment. A multiple of the total reserve rate for each segment is then applied to the balance of loans in each segment based on credit rating. Loans rated Excellent have no associated allowance. No loans were rated Excellent at March 31, 2012 or September 30, 2011. Loans rated Good are multiplied by 10% of the total reserve rate, Satisfactory loans are multiplied by 100% of the total reserve rate, and loans rated Watch List, Special Mention, and Substandard are multiplied by 150%, 200%, and 300% of the total reserve rate, respectively. This tiered structure is used by the Company to account for a higher probability of loss for loans with increasingly adverse credit ratings.

 

Specific Allowance for Impaired Loans

 

Impaired loans include loans identified as impaired through our credit rating system as well as loans modified in a troubled debt restructuring. Loans are identified as impaired when management believes, based on current information and events, it is probable that the Company will be unable to collect all amounts due in accordance with the contractual terms of the underlying loan agreement. Once a loan is identified as impaired, management determines a specific allowance by comparing the outstanding loan balance to net realizable value, which is equal to fair value less estimated costs to sell. The amount of any allowance recognized is the amount by which the loan balance exceeds the net realizable value. If the net realizable value exceeds the loan balance, no allowance is recorded. The fair value of impaired loans is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows. Of the $34.5 million of loans classified as impaired at March 31, 2012, $34.4 million were considered “collateral dependent” and evaluated using the fair value of collateral method and $44,000 were evaluated using discounted estimated cash flows. See note 9 for further discussion of the Company's method for estimating fair value on impaired loans.

13
 

 

Activity in the allowance for loan losses by portfolio segment is summarized as follows:

 

(Dollars in thousands)  One-to four-family   Multi-family   Non-residential   Construction   Land and land development   Other   Total 
 Balance, September 30, 2011  $1,324   $1,357   $3,146   $1,724   $7,064   $9   $14,624 
 Provision   403    (96)   (445)   (155)   144    (3)   (152)
 Recoveries   3    -    -    3    -    -    6 
 Charge-offs   (68)   -    -    (8)   (3,196)   -    (3,272)
 Balance, March 31, 2012  $1,662   $1,261   $2,701   $1,564   $4,012   $6   $11,206 

 

(Dollars in thousands)  One-to four-family   Multi-family   Non-residential   Construction   Land and land development   Other   Total 
                             
 Balance, September 30, 2010  $1,260   $1,177   $2,888   $2,700   $5,372   $22   $13,419 
 Provision   454    977    583    236    (1,526)   (12)   712 
 Recoveries   1    -    -    23    -    -    24 
 Charge-offs   (464)   -    -    (933)   (836)   -    (2,233)
 Balance, March 31, 2011  $1,251   $2,154   $3,471   $2,026   $3,010   $10   $11,922 

 

During the three and six months ended March 31, 2012, the Company recorded net charge-offs of $245,000 and $3.3 million, respectively, compared to net charge-offs of $15,000 and $2.2 million, respectively, in the three and six months ended March 31, 2011. As a result of continued concerns regarding the valuations of collateral for land and land development loans, the Company recorded a provision for loan losses of $144,000 in the six months ended March 31, 2012 for the portfolio of land and land development loans. The Company also recorded a provision for loan losses of $403,000 for its portfolio of one-to four-family loans due to an increase in historical charge-offs and nonaccrual loans in the Company’s portfolio of non-owner-occupied one-to four-family loans. These provisions were more than offset by decreases in the allowances for the Company’s multi-family, nonresidential, and construction loan portfolios. These decreases were partially the result of improving credit quality combined with decreased loan balances in the construction loan portfolio.

 

Details of the allowance for loan losses by portfolio segment and impairment methodology at March 31, 2012 and September 30, 2011 are as follows:

 

   March 31, 2012 
   General Allowance   Specific Allowance               Allowance as 
(Dollars in thousands)  Balance   Allowance   Balance   Allowance   Total Balance   Total Allowance   Coverage   % of total allowance 
One-to four-family  $106,659   $1,256   $4,339   $406   $110,998   $1,662    1.50%   14.8%
Multi-family   67,422    1,063    12,707    198    80,129    1,261    1.57    11.3 
Nonresidential   194,702    2,701    4,327    -    199,029    2,701    1.36    24.1 
Construction   30,319    1,564    125    -    30,444    1,564    5.14    14.0 
Land and land development   37,352    4,012    12,971    -    50,323    4,012    7.97    35.8 
Other   554    6    -    -    554    6    1.00    - 
Total allowance  $437,008   $10,602   $34,469   $604   $471,477   $11,206    2.38    100.0%

 

14
 

 

   September 30, 2011 
   General Allowance   Specific Allowance               Allowance as 
(Dollars in thousands)  Balance   Allowance   Balance   Allowance   Total Balance   Total Allowance   Coverage   % of total allowance 
One-to four-family  $110,047   $1,192   $4,900   $132   $114,947   $1,324    1.15%   9.1%
Multi-family   66,347    1,145    12,759    212    79,106    1,357    1.71    9.2 
Nonresidential   180,895    3,146    9,852    -    190,747    3,146    1.65    21.5 
Construction   43,903    1,697    89    27    43,992    1,724    3.92    11.8 
Land and land development   40,500    4,070    26,549    2,994    67,049    7,064    10.54    48.3 
Other   650    9    -    -    650    9    1.40    0.1 
Total allowance  $442,342   $11,259   $54,149   $3,365   $496,491   $14,624    2.95    100.0%

 

Details regarding classified loans and impaired loans at March 31, 2012 and September 30, 2011 are as follows:

 

   March 31,   September 30, 
(Dollars in thousands)  2012   2011 
Special mention        
One-to four-family  $4,803   $5,372 
Nonresidential   5,506    - 
Construction   2,083    3,142 
Land and land development   11,694    7,944 
Total special mention loans   24,086    16,458 
           
Substandard          
One-to four-family   4,120    4,347 
Multi-family   251    253 
Nonresidential   3,140    3,156 
Construction   166    166 
Land and land development   7,621    623 
Total substandard loans   15,298    8,545 
           
Impaired          
One-to four-family   4,339    4,900 
Multi-family   12,707    12,759 
Nonresidential   4,327    9,852 
Construction   125    89 
Land and land development   12,971    26,549 
Total impaired loans   34,469    54,149 
           
Total rated loans  $73,853   $79,152 

 

The increase in special mention and substandard loans at March 31, 2012 compared to September 30, 2011 was primarily the result of the reclassification of certain loans classified as impaired at September 30, 2011 to special mention or substandard.

 

Included in impaired loans are troubled debt restructurings of $6.2 million and $10.6 million at March 31, 2012 and September 30, 2011, respectively, that had related allowance balances of $0 and $239,000, respectively.

 

Troubled Debt Restructurings

 

During the six months ended March 31, 2012, the Company modified four loans in troubled debt restructurings, including one construction loan, one nonresidential loan, and two land and land development loans. The restructuring of the construction loan involved the reduction in the loan’s interest rate floor and monthly principal payment requirement to accommodate cash flow difficulties being experienced by the borrower. The specific allowance determined for this loan through a discounted cash flows analysis was not material. This loan remained on accrual status as the borrower was current at March 31, 2012. The nonresidential loan modification consisted of further principal payment reductions and an extension of the call date on a loan previously recognized as a troubled debt restructuring. This loan was returned to accrual status during the six months ended March 31, 2012 as it had remained current on restructured payment requirements for over six months, and the Company believes that the borrower has the intent and ability to keep the loan current. The two land and land development loans restructured share the same collateral and had been previously identified as impaired loans. These loans have matured, and the restructurings consisted of forbearance agreements extending the maturity dates of the loans in order to provide the developers more time to sell the collateral. Interest recognized on a cash basis on restructured loans was not material for the three and six months ended March 31, 2012.

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During the six months ended March 31, 2011, the Company modified three loans in troubled debt restructurings, including one land and land development loan with an outstanding balance of $760,000, one construction loan with an outstanding balance of $90,000, and one nonresidential loan with a balance of $5.5 million. The restructuring of the land and land development loan consisted of a reduction in the monthly principal payment requirement to accommodate cash flow difficulties being experienced by the borrower. Interest recognized on a cash basis on restructured loans was not material for the three and six months ended March 31, 2011.

 

Loans and the related allowance for loan losses summarized by loan type and credit rating at March 31, 2012 are as follows:

 

 (Dollars in thousands)  Total   Good   Satisfactory   Watch List   Special Mention   Substandard   Impaired   Not Rated 
Loans                                
One-to four-family(1)  $110,998   $104   $25,177   $1,449   $3,860   $1,820   $4,339   $74,249 
Multi-family   80,129    20,681    39,036    2,043    -    251    12,707    5,411 
Nonresidential   199,029    86,765    92,963    470    5,506    3,140    4,327    5,858 
Construction   30,444    -    16,811    517    2,083    166    125    10,742 
Land and land development   50,323    -    17,015    -    11,694    7,621    12,971    1,022 
Other   554    -    -    -    -    -    -    554 
Total loans  $471,477   $107,550   $191,002   $4,479   $23,143   $12,998   $34,469   $97,836 

 

(Dollars in thousands)  Total   Good   Satisfactory   Watch List   Special Mention   Substandard   Impaired   Not Rated 
Allowance for loan losses                                
One-to four-family(1)  $1,662   $-   $428   $37   $131   $93   $406   $567 
Multi-family   1,261    43    824    65    -    16    198    115 
Nonresidential   2,701    182    1,952    15    231    198    -    123 
Construction   1,564    -    797    37    198    24    -    508 
Land and land development   4,012    -    1,062    -    1,459    1,427    -    64 
Other   6    -    -    -    -    -    -    6 
    Total allowance for loans losses  $11,206   $225   $5,063   $154   $2,019   $1,758   $604   $1,383 
_________________________
(1)Owner-occupied one-to four-family loans are considered “Not Rated” in the calculation of the allowance for loan losses.

 

Details regarding the delinquency status of the Company’s loan portfolio at March 31, 2012 are as follows:

 

(Dollars in thousands)  Total   Current   31-60 Days   61-90 Days   91-120 Days   121-150 Days   151-180 Days   180+ Days 
One-to four-family  $110,998   $102,451   $1,656   $597   $338   $469   $313   $5,174 
Multi-family   80,129    73,787    251    -    -    -    -    6,091 
Nonresidential   199,029    194,232    -    2,537    -    -    -    2,260 
Construction   30,444    30,197    -    -    -    -    81    166 
Land and land development   50,323    34,865    4,056    -    20    -    1,322    10,060 
Other   554    554    -    -    -    -    -    - 
Total  $471,477   $436,086   $5,963   $3,134   $358   $469   $1,716   $23,751 

 

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The following is a summary of information pertaining to impaired and non-accrual loans at March 31, 2012 and September 30, 2011:

 

   March 31, 2012   September 30, 2011 
(Dollars in thousands)   Amount   Allowance   Amount   Allowance 
Impaired loans with a specific allowance                
One-to four-family  $4,339   $406   $2,328   $132 
Multi-family   1,251    198    1,265    212 
Construction   -    -    90    27 
Land and land development   -    -    9,879    2,994 
Total impaired loans with a specific allowance  $5,590   $604   $13,562   $3,365 
                     
Impaired loans for which no specific allowance                    
is necessary                    
One-to four-family  $-   $-   $2,572   $- 
Multi-family   11,456    -    11,494    - 
Nonresidential   4,327    -    9,852    - 
Construction   125    -    -    - 
Land and land development   12,971    -    16,669    - 
Total impaired loans for which no specific                    
allowance is necessary  $28,879   $-   $40,587   $- 

 

 

(Dollars in thousands)  March 31,
2012
   September 30, 2011 
Nonaccrual loans        
One-to four-family  $9,356   $9,879 
Multi-family   6,091    6,103 
Nonresidential   7,037    12,572 
Construction   247    255 
Land and land development   13,235    13,396 
Total non-accrual loans  $35,966   $42,205 

 

There were no loans past due ninety days or more and accruing at March 31, 2012 or September 30, 2011. The weighted average balance of impaired loans was $34.9 million and $36.7 million for the three months ended March 31, 2012 and 2011, respectively, and $45.2 million and $29.4 million for the six months ended March 31, 2012 and 2011, respectively. Accrued interest on impaired loans was not material at March 31, 2012 or September 30, 2011. Interest recognized on a cash basis on impaired loans was $347,000 and $229,000 for the three months ended March 31, 2012 and 2011, respectively, and $493,000 and $398,000 for the six months ended March 31, 2012 and 2011, respectively. Interest recognized on a cash basis on nonaccrual loans, including loans classified as impaired, was $482,000 and $423,000 for the three months ended March 31, 2012 and 2011, respectively, and $821,000 and $788,000 for the six months ended March 31, 2012 and 2011, respectively.

 

Note 5. Real Estate Owned

 

Real estate owned at March 31, 2012 and September 30, 2011 is summarized as follows:

 

   March 31,   September 30, 
(Dollars in thousands)   2012   2011 
Real estate owned        
Real estate held for sale  $1,831   $1,545 
Real estate held for development and sale   7,000    7,082 
Total real estate owned  $8,831   $8,627 

 

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During the six months ended March 31, 2012, the Company sold real estate owned totaling $345,000. The Company recognized net gains on sales of real estate owned of $428,000 and $625,000 for the three and six months ended March 31, 2012, respectively, compared with net losses of $46,000 for the three months ended March 31, 2011 and net gains of $54,000 for the six months ended March 31, 2011. Gains on sales for the three months and six months ended March 31, 2012 included the recognition of $358,000 in gains on properties sold in previous periods that had been deferred in accordance with GAAP because financing was provided by the Company and the sales did not meet either initial or continuing investment criteria to qualify for gain recognition. The total of such deferred gains recognized and included in gains on sales for the six months ended March 31, 2012 was $502,000. At March 31, 2012, the Company had deferred gains on sales of real estate owned of $327,000 compared to $771,000 at September 30, 2011. No impairment charges on real estate owned were recognized for the three or six months ended March 31, 2012 compared with impairment charges of $781,000 for the three and six months ended March 31, 2011.

 

Note 6. Earnings per Share

 

Basic earnings per share are computed by dividing income available to common stockholders by the weighted average number of common shares outstanding for the period. The Company had no dilutive potential common shares for the three and six months ended March 31, 2012. Because the mutual to stock conversion was not completed until April 27, 2011, earnings per share data is not presented for the three or six months ended March 31, 2011.

 

   Three months ended   Six months ended 
(Amounts in thousands, except per share data)  March 31, 2012   March 31, 2012 
Numerator:        
Net income available to common stockholders  $2,508   $4,283 
Denominator:          
Weighted-average common shares outstanding   13,223    13,214 
Effect of dilutive securities   -    - 
Weighted-average common shares outstanding - assuming dilution   13,223    13,214 
Earnings per common share  $0.19   $0.32 
Earnings per common share - assuming dilution  $0.19   $0.32 

 

Note 7. Employee Benefit Plans

 

Pension Plan

 

The Bank has a noncontributory defined benefit pension plan (the “Pension Plan”) for substantially all of the Bank’s employees who were employed on or before July 31, 2011. The Bank froze the Pension Plan to new participants effective August 1, 2011, and, therefore, employees hired after July 31, 2011 are not eligible to participate in the Pension Plan. Retirement benefits under this plan are generally based on the employee’s years of service and compensation during the five consecutive years of highest compensation in the ten years immediately preceding retirement.

 

The Pension Plan assets are held in a trust fund by the plan trustee. The trust agreement under which assets of the Pension Plan are held is a part of the Virginia Bankers Association Master Defined Benefit Pension Plan (the
“Plan”). The Plan’s administrative trustee is appointed by the board of directors of the Virginia Bankers Association Benefits Corporation. At March 31, 2012, Reliance Trust Company was investment manager for the Plan. Contributions are made to the Pension Plan, at management’s discretion, subject to meeting minimum funding requirements, up to the maximum amount allowed under the Employee Retirement Income Security Act of 1974 (ERISA), based upon the actuarially determined amount necessary for meeting plan obligations. Contributions are intended to provide not only for benefits attributed to service to date, but also for benefits expected to be earned by employees in the future.

 

The Company uses a September 30 measurement date for the Pension Plan.

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Components of net periodic benefit cost for the three and six months ended March 31, 2012 and 2011 are as follows:

 

   Three months ended March 31,   Six months ended March 31, 
(Dollars in thousands)  2012   2011   2012   2011 
Service cost  $150   $143   $301   $286 
Interest cost   166    162    332    324 
Expected return on plan assets   (203)   (218)   (406)   (435)
Recognized net actuarial loss   58    16    115    32 
Net periodic benefit cost  $171   $103   $342   $207 

 

The net periodic benefit cost is included in personnel expense in the consolidated income statements.

 

Equity Incentive Plan

 

On February 21, 2012, the Company adopted the Franklin Financial Corporation 2012 Equity Incentive Plan (the “2012 Equity Incentive Plan”), which provides for awards of restricted stock and stock options to key officers and outside directors. The cost of the 2012 Equity Incentive Plan is based on the fair value of restricted stock and stock option awards on their grant date.

 

The vesting of the restricted stock awards is contingent upon service, performance, and market criteria. Performance criteria consist of the achievement of certain benchmarks regarding tangible book value per share, while market conditions consist of provisions that allow for partial vesting of shares in the event that certain share price targets are met even if performance criteria are not fully met. The fair value of restricted stock is determined based upon management’s assumptions regarding the achievement of performance and market conditions stipulated for each award. For awards with performance conditions, fair value is based upon the price of the Company’s stock on the grant date. For awards with both performance and market conditions, fair value is based on a Monte Carlo analysis incorporating the closing price of the Company’s stock on the grant date along with assumptions related to the Company’s stock price given the achievement of certain performance criteria. Restricted stock awards may not be disposed of or transferred during the vesting period but carry with them the right to receive dividends. The cost of restricted stock awards will be recognized using the graded-vesting method over the five-year vesting period during which participants are required to provide services in exchange for the awards.

 

The vesting of stock options is contingent only upon meeting service conditions. The fair value of stock options is estimated using a Black-Scholes option pricing model using assumptions for dividend yield, stock price volatility, risk-free interest rate, and option terms. These assumptions are based on judgments regarding future events, are subjective in nature, and cannot be determined with precision. Since stock option awards contain only service conditions, management has elected to recognize the cost of stock option awards on a straight-line basis over the five-year vesting period during which participants are required to provide services in exchange for the awards.

 

Shares of common stock issued under the 2012 Equity Incentive Plan may be authorized unissued shares or, in the case of restricted stock awards, may be shares repurchased on the open market. The maximum number of shares that may be awarded under the plan is 2,002,398, including 1,430,284 for option exercises and 572,114 restricted stock shares. Share-based compensation related to stock options and restricted stock recognized for the three and six months ended March 31, 2012 was $17,000, and the related income tax benefit was $7,000.

 

The table below presents stock option activity for the six months ended March 31, 2012:

 

(Dollars in thousands, except per share amounts)  Options   Weighted-average exercise price   Remaining contractual life (years)   Aggregate intrinsic value 
Options outstanding at September 30, 2011   -    N/A    N/A    N/A 
Granted   1,152,000   $13.42    10.0   $12 
Exercised   -    -    -    - 
Forfeited   -    -    -    - 
Expired   -    -    -    - 
Options outstanding at March 31, 2012   1,152,000   $13.42    10.0   $12 

 

Expected volatility – Based on the historical volatility of the Company’s stock.

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Risk-free interest rate – Based on the U.S. Treasury yield curve and the expected life of the options at the time of grant.

 

Expected dividends – The Company has not declared a dividend, and therefore no dividends are assumed.

 

Expected life – Based on a weighted-average of the five-year vesting period and the 10-year contractual term of the stock option plan.

 

Grant price for the stock options – Based on the closing price of the Company’s stock on the grant date.

 

The fair value of the Company’s stock option grants in 2012 was determined using the Black-Scholes option pricing formula, which resulted in a fair value of $3.76 per option. The following assumptions were used in the formula:

 

Expected volatility   24.39%
Risk-free interest rate   1.43%
Expected dividends   0.00%
Expected life (in years)   6.5 
Grant price for the stock options  $13.42 

 

At March 31, 2012, the Company had $2.9 million of unrecognized compensation expense related to 778,443 stock options expected to vest. No shares were vested as of March 31, 2012. The table below presents information about stock options expected to vest over the five-year vesting period at March 31, 2012:

 

(Dollars in thousands, except per share amounts)    
Options expected to vest at period end   778,443 
Weighted-average exercise price  $13.42 
Remaining contractual life (years)   10.0 
Aggregate intrinsic value  $8 

 

The table below presents restricted stock award activity for the six months ended March 31, 2012:

 

   Restricted stock awards   Weighted-average grant date fair value 
Non-vested at September 30, 2011   -    N/A 
Granted   464,500   $13.42 
Vested   -    - 
Forfeited   -    - 
Non-vested at March 31, 2012   464,500   $13.42 

 

At March 31, 2012, unrecognized compensation expense adjusted for expected forfeitures was $4.2 million related to 313,797 shares of restricted stock expected to vest. The weighted-average period over which compensation cost related to non-vested awards is expected to be recognized was 5.0 years at March 31, 2012.

 

Employee Stock Ownership Plan

 

In connection with the Company’s stock conversion completed in April 2011, the Bank established an employee stock ownership plan (“ESOP”) for the benefit of all of its eligible employees. Employees at the date of conversion and employees of the Bank hired after the conversion who have been credited with at least 1,000 hours of service during a 12-month period and who have attained age 21 are eligible to participate in the ESOP. It is anticipated that the Bank will make contributions to the ESOP in amounts necessary to amortize the ESOP loan payable to Franklin Financial over a period of 20 years.

 

Unearned ESOP shares are shown as a reduction of stockholders’ equity. Dividends on unearned ESOP shares, if paid, will be considered to be compensation expense. The Company will recognize compensation cost equal to the fair value of the ESOP shares during the periods in which they become committed to be released. To the extent that the fair value of the Company’s ESOP shares differs from the cost of such shares, the differential will be recognized in stockholders’ equity. The Company will receive a tax deduction equal to the cost of the shares released. As the ESOP is internally leveraged, the loan receivable by Franklin Financial from the ESOP is not reported as an asset nor is the debt of the ESOP shown as a liability in the consolidated financial statements.

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Compensation expense related to the ESOP for the three and six months ended March 31, 2012 was $186,000 and $424,000, respectively. The fair value of unearned ESOP shares, using the closing quoted market price per share of the Company’s stock, was $14.4 million at March 31, 2012. A summary of ESOP share allocation for the six months ended March 31, 2012 is as follows:

 

Shares allocated at September 30, 2011   35,987 
Shares allocated during the period   35,449 
Shares distributed during the period   - 
Allocated shares held by the ESOP trust at March 31, 2012   71,436 
Unearned shares at March 31, 2012   1,072,791 
Total ESOP shares   1,144,227 

 

Stock-Based Deferral Plan

 

In connection with the Company’s stock conversion completed in April 2011, the Company adopted a stock-based deferral plan whereby certain officers and directors could use funds from previously existing nonqualified deferred compensation plans to invest in stock of the Company. The Company established a trust to hold shares purchased through the stock-based deferral plan, and the trust purchased 245,783 shares in the conversion and 6,432 thereafter. The trust qualifies as a rabbi trust that will be settled upon the retirement of participating officers and directors through the distribution of shares held by the trust. As a result, shares held by the trust are accounted for in a manner similar to treasury stock, and the deferred compensation balance is recorded as a component of additional paid-in capital on the Company’s consolidated balance sheet in accordance with GAAP.

 

Note 8. Financial Instruments with Off-Balance-Sheet Risk

 

The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet its investment and funding needs and the financing needs of its customers. These financial instruments include commitments to extend credit, commitments to sell loans, and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized or disclosed in the consolidated financial statements. The contractual or notional amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments.

 

The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual or notional amount of those instruments. The Company uses the same credit and collateral policies in making commitments to extend credit and standby letters of credit as it does for on-balance-sheet instruments.

 

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee by the customer. Since some commitments may expire without being funded, the commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer’s creditworthiness on a case-by-case basis. The total amount of loan commitments was $98.9 million and $55.7 million at March 31, 2012 and September 30, 2011, respectively.

 

Standby letters of credit written are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. The credit risk and recourse provisions involved in issuing letters of credit are essentially the same as those involved in extending loans to customers, and the estimated fair value of these letters of credit, which is included in accrued expenses and other liabilities, was not material at March 31, 2012 and September 30, 2011, respectively. The amount of standby letters of credit was $344,000 and $1.0 million at March 31, 2012 and September 30, 2011, respectively. The Company believes that the likelihood of having to perform on standby letters of credit is remote based on the financial condition of the guarantors and the Company’s historical experience.

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At March 31, 2012, the Company had rate lock commitments to originate mortgage loans amounting to $101,000 and mortgage loans held for sale of $2.0 million compared to $3.8 million and $922,000, respectively, at September 30, 2011. At March 31, 2012, the Company had corresponding commitments outstanding of $2.1 million to sell loans on a best-efforts basis compared to $4.7 million at September 30, 2011. These commitments to sell loans are designed to eliminate the Company’s exposure to fluctuations in interest rates in connection with rate lock commitments and loans held for sale.

 

Note 9. Fair Value Measurements

 

The fair value of a financial instrument is the current amount that would be exchanged between willing parties in an orderly market, other than in a forced liquidation. Fair value is best determined based on quoted market prices. In cases where quoted market prices are not available or quoted prices are reflective of a disorderly market, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instruments. The Codification (Section 825-10-50) excludes certain financial instruments and all non-financial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented may not necessarily represent the underlying fair value of the Company.

 

Under current fair value guidance, the Company groups assets and liabilities at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. An adjustment to the pricing method used within either Level 1 or Level 2 inputs could generate a fair value measurement that effectively falls in a lower level in the hierarchy. These levels are:

 

Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

 

Level 2: Significant other observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, and other inputs that are observable or can be corroborated by observable market data.

 

Level 3: Valuations for assets and liabilities that are derived from other valuation methodologies, including option pricing models, discounted cash flow models and similar techniques, and not based on market exchange, dealer, or broker traded transactions. Level 3 valuations incorporate certain assumptions and projections in determining the fair value assigned to such assets or liabilities.

 

The following is a description of valuation methodologies used for assets and liabilities recorded at fair value. The determination of where an asset or liability falls in the hierarchy requires significant judgment. The Company evaluates its hierarchy disclosures each quarter and, based on various factors, it is possible that an asset or liability may be classified differently from quarter to quarter. However, the Company expects that changes in classifications between levels will be rare.

 

Securities available for sale: Securities available-for-sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using a combination of methods, including model pricing based on spreads obtained from new market issues of similar securities, dealer quotes, and trade prices. Level 1 securities include common equity securities traded on nationally recognized securities exchanges. Level 2 securities include mortgage-backed securities and collateralized mortgage obligations issued by government sponsored entities, municipal bonds, and corporate debt securities.

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Securities held to maturity: Securities held-to-maturity are recorded at fair value on a non-recurring basis. A held-to-maturity security’s amortized cost is adjusted only in the event that a decline in fair value is deemed to be other-than-temporary. At March 31, 2012, certain held-to-maturity securities were deemed to be other-than-temporarily impaired. These securities are classified as Level 3 securities and were written down to fair value at the balance sheet date determined by discounting estimated future cash flows. Management believes that classification and valuation of these securities, consisting of private-label asset-backed securities, as Level 3 assets was necessary as the market for such securities severely contracted beginning in 2008 and became and has remained inactive since that time. While the market for highly-rated private-label securities with low delinquency levels and high subordination saw significant price improvement beginning in the second half of fiscal 2010, the market for securities similar to those recognized as other-than-temporarily impaired, which had low ratings, high delinquency levels, and low subordination levels, remained inactive. As a result, management does not believe that quoted prices on similar assets were representative of fair value as there were few transactions, and transactions were often executed at distressed prices. Management estimates and discounts future cash flows based on a combination of observable and unobservable inputs, including a security’s subordination percentage, projected delinquency rates, and estimated loss severity given default. These estimates are discounted using observable current market rates for securities with similar credit quality.

 

Loans held for sale: The fair value of loans held for sale is determined using quoted secondary-market prices. If the fair value of a loan is below its carrying value, a lower-of-cost-or-market adjustment is made to reduce the basis of the loan. If fair value exceeds carrying value, no adjustment is made. As such, the Company classifies loans held for sale as Level 2 assets and makes fair value adjustments on a non-recurring basis.

 

Impaired loans: The Company does not record loans at fair value on a recurring basis. However, from time to time, a loan is considered impaired and, if necessary, a specific allowance for loan losses is established. Loans for which it is probable that payment of principal and interest will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Once a loan is identified as individually impaired, management writes the loan down to net realizable value, which is equal to fair value less estimated costs to sell, if the loan balance exceeds net realizable value. The fair value of impaired loans is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value, or discounted cash flows. Those impaired loans not requiring a specific allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. For loans deemed to be “collateral dependent,” fair value is estimated using the appraised value of the related collateral. At the time the loan is identified as impaired, the Company determines if an updated appraisal is needed and orders an appraisal if necessary. Subsequent to the initial measurement of impairment, management considers the need to order updated appraisals each quarter if changes in market conditions lead management to believe that the value of the collateral may have changed materially. Impaired loans where a specific allowance is established based on the fair value of collateral require classification in the fair value hierarchy. When the fair value of the collateral is based on an observable market price or an appraised value less than one year old estimated utilizing information gathered from an active market, the Company classifies the impaired loan as a Level 2 asset. When an appraised value is not available, is greater than one year old, or if management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company classifies the impaired loan as a Level 3 asset. Additionally, if the fair value of an impaired loan is determined using an appraisal less than one year old that utilizes information gathered from an inactive market or contains material adjustments based upon unobservable market data, the Company classifies the impaired loan as a Level 3 asset. Impaired loans evaluated using discounted estimated cash flows are classified as Level 3 assets.

 

Real estate owned: Real estate owned (“REO”) is adjusted to net realizable value, which is equal to fair value less costs to sell, upon foreclosure. Subsequently, REO is adjusted on a non-recurring basis to the lower of carrying value or net realizable value. Fair value is based upon independent market prices, appraised values of the collateral, or management’s estimation of the value of the REO. When the fair value of REO is based on an observable market price or an appraised value less than one year old estimated utilizing information gathered from an active market, the Company classifies the REO as a Level 2 asset. When an appraised value is not available, is greater than one year old, or if management determines the fair value of the REO is further impaired below the appraised value and there is no observable market price, the Company classifies the REO as a Level 3 asset. Additionally, if the fair value of the REO is determined using an appraisal less than one year old that utilizes information gathered from an inactive market or contains material adjustments based upon unobservable market data, the Company classifies the REO as a Level 3 asset.

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Assets measured at fair value on a recurring basis as of March 31, 2012 are summarized below:

 

   Total   Level 1   Level 2   Level 3 
Securities available for sale                
States and political subdivisions  $13,562   $-   $11,798   $1,764 
Agency mortgage-backed securities   30,069    -    30,069    - 
Agency collateralized mortgage obligations   208,272    -    208,272    - 
Corporate equity securities   27,598    27,598    -    - 
Corporate debt securities   125,158    -    120,292    4,866 
Total assets at fair value  $404,659   $27,598   $370,431   $6,630 

 

A rollforward of securities classified as Level 3 measured at fair value on a recurring basis from the prior year end is as follows:

 

Balance of Level 3 assets measured on a recurring basis at September 30, 2011  $6,685 
Principal payments in period   (93)
Accretion (amortization) of premiums or discounts   (14)
Other-than-temporary impairment charges included in noninterest income   (686)
Increase (decrease) in unrealized gains or losses included in accumulated other comprehensive income   738 
Balance of Level 3 assets measured on a recurring basis at March 31, 2012  $6,630 

 

Level 3 securities measured at fair value on a recurring basis at March 31, 2012 consist of one municipal bond and one corporate debt security for which the Company was not able to obtain dealer quotes due to lack of trading activity. These two securities are measured at fair value based on a combination of the observable market prices of similar securities based on their trading activity and broker quotes. Price estimates are then adjusted for liquidity discounts necessary to account for the lack of trading activity for each security. Changes in the liquidity discount applied could result in significantly higher or lower fair value measurements. During the three months ended March 31, 2012, the Company recognized an other-than-temporary impairment charge on the municipal bond of $686,000, which is included in noninterest income (expense) in the income statement.

 

The Company may be required, from time to time, to measure certain assets at fair value on a non-recurring basis in accordance with GAAP. These include assets that are measured at the lower of cost or market that were recognized at fair value below cost at the end of the period, including held-to-maturity securities, impaired loans, and real estate owned. Held-to-maturity securities are measured at fair value in a period in which an other-than-temporary impairment charge is recognized. Impaired loans are measured at fair value when a change in the value of the underlying collateral or a change in the present value of estimated future cash flows result in a change in the specific allowance for such a loan. Real estate owned is measured at fair value in the period of foreclosure or in a period in which a change in net realizable value results in an impairment charge.

 

Assets measured at fair value on a non-recurring basis as of March 31, 2012 are included in the table below:

 

   Total   Level 1   Level 2   Level 3 
Non-agency collateralized mortgage obligations  $547   $-   $-   $547 
Impaired loans                    
One-to four-family   3,933    -    3,933    - 
Real estate owned   555    -    555    - 
Total assets at fair value  $5,035   $-   $4,488   $547 

 

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In estimating the fair value of non-agency collateralized mortgage obligations (“CMOs”), the Company performs a discounted cash flow analysis that uses certain unobservable inputs, including delinquency and loss severity rates for the collateral underlying each security, cash flow estimates obtained from a third-party service, and the discount rate applied. Since there is no readily-available discount rate for each individual security, the Company begins with the rate of a seven-year corporate bond (which management believes mirrors the expected remaining life of these securities) with a credit rating of B as of the balance sheet date. The Company applies this rate as the discount rate on non-agency CMOs rated as “investment grade” (i.e. BBB or better) by the major rating agencies and applies multiples of this rate to non-agency CMO’s of lower credit quality. For securities rated between BB+ and B-, the Company applies this rate times a factor of two; for securities rated between CCC+ and C-, the Company applies this rates times a factor of three; and for securities rate below C-, the Company applies this rate times a factor of four. The following table provides information about unobservable inputs used in the valuation of non-agency CMOs at March 31, 2012:

 

   Range   Weighted Average
Delinquency rate   0.00% – 72.87%    18.32%
Loss severity   17.81% – 79.19%    46.50%
Discount rate   6.56% – 26.25%    19.63%

 

The following methods and assumptions were used to estimate fair value of other classes of financial instruments:

 

Cash and cash equivalents: The carrying amount is a reasonable estimate of fair value.

 

Loans held for investment: The fair value of loans held for investment is determined by discounting the future cash flows using the rates currently offered for loans of similar remaining maturities. Estimates of future cash flows are based upon current account balances, contractual maturities, prepayment assumptions, and repricing schedules.

 

Federal Home Loan Bank stock: The carrying amount of restricted stock approximates the fair value based on the redemption provisions.

 

Accrued interest receivable: The carrying amount is a reasonable estimate of fair value.

 

Deposits: The carrying values of passbook savings, money market savings, and money market checking accounts are reasonable estimates of fair value. The fair value of fixed-maturity certificates of deposit is determined by discounting the future cash flows using the rates currently offered for deposits of similar remaining maturities.

 

FHLB borrowings: The fair values of FHLB borrowings are determined by discounting the future cash flows using rates currently offered for borrowings with similar terms.

 

Accrued interest payable: The carrying amount is a reasonable estimate of fair value.

 

Advance payments by borrowers for property taxes and insurance: The carrying amount is a reasonable estimate of fair value.

 

Commitments to extend credit: The fair value of commitments is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The majority of the Company’s commitments to extend credit carry current interest rates if converted to loans.

 

Standby letters of credit: The fair value of standby letters of credit is based on fees the Company would have to pay to have another entity assume its obligation under the outstanding arrangement.

 

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The estimated fair values of the Company’s financial instruments, as well as their classifications in the fair value hierarchy, at March 31, 2012 and September 30, 2011 are as follows:

 

   March 31, 2012 
   Total   Level 1   Level 2   Level 3 
   Carrying   Fair   Carrying   Fair   Carrying   Fair   Carrying   Fair 
 (Dollars in thousands)  Value   Value   Value   Value   Value   Value   Value   Value 
Financial assets:                                
Cash and cash equivalents  $135,996   $135,996   $135,996   $135,996   $-   $-   $-   $- 
Securities available for sale   404,659    404,659    27,598    27,598    370,431    370,431    6,630    6,630 
Securities held to maturity   22,975    22,403    -    -    11,067    11,840    11,908    10,563 
Net loans   457,037    475,026    -    -    -    -    457,037    475,026 
Loans held for sale   1,953    1,953    -    -    1,953    1,953    -    - 
FHLB stock   10,637    10,637    10,637    10,637    -    -    -    - 
Accrued interest receivable   4,599    4,599    4,592    4,592    -    -    -    - 
                                         
Financial liabilities:                                        
Deposits   637,943    642,841    -    -    637,943    642,841    -    - 
FHLB borrowings   190,000    221,636    -    -    190,000    221,636    -    - 
Accrued interest payable   922    922    922    922    -    -    -    - 
Advance payments by borrowers for taxes and insurance   2,386    2,386    2,386    2,386    -    -    -    - 
                                         
Off-balance-sheet financial instruments:                                        
Commitments to extend credit   98,949    -    -    -    -    -    98,949    - 
Standby letters of credit   344    4    -    -    -    -    344    4 

 

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   September 30, 2011 
   Total   Level 1   Level 2   Level 3 
   Carrying   Fair   Carrying   Fair   Carrying   Fair   Carrying   Fair 
 (Dollars in thousands)  Value   Value   Value   Value   Value   Value   Value   Value 
Financial assets:                                
Cash and cash equivalents  $115,749   $115,749   $115,749   $115,749   $-   $-   $-   $- 
Securities available for sale   396,809    396,809    21,673    21,673    368,451    368,451    6,685    6,685 
Securities held to maturity   25,517    23,248    -    -    12,064    13,085    13,453    10,163 
Net loans   478,423    497,084    -    -    -    -    478,423    497,084 
Loans held for sale   922    922    -    -    922    922    -    - 
FHLB stock   11,014    11,014    11,014    11,014    -    -    -    - 
Accrued interest receivable   4,901    4,901    4,901    4,901    -    -    -    - 
                                         
Financial liabilities:                                        
Deposits   648,754    655,790    -    -    648,754    655,790    -    - 
FHLB borrowings   190,000    223,240    -    -    190,000    223,240    -    - 
Accrued interest payable   904    904    904    904    -    -    -    - 
Advance payments by borrowers for taxes and insurance   2,335    2,335    2,335    2,335    -    -    -    - 
                                         
Off-balance-sheet financial instruments:                                        
Commitments to extend credit   55,702    -    -    -    -    -    55,702    - 
Standby letters of credit   1,015    3    -    -    -    -    1,015    3 

 

Note 10. Subsequent Events

 

FHLB Advance Restructurings

 

Subsequent to March 31, 2012, the Company exchanged six FHLB borrowings totaling $120.0 million for new advances of the same amount. In connection with these exchanges, the Company paid prepayment penalties totaling $12.1 million. The new advances were not considered to be substantially different from the original advances in accordance with ASC 470-50, Debt – Modifications and Exchanges, and as a result the prepayment penalties will be treated as a discount on the new debt and amortized over the life of the new advances as an adjustment to rate. Details regarding these exchanges are as follows (dollars in thousands):

 

Terms of Original Advance Terms of New Advance  Advance
Amount
  Prepayment
Penalty
   Effective
Rate of
New
Advance
     
Interest payable monthly at a fixed rate of 3.49%, principal due and payable on December 5, 2013 Interest payable quarterly at a fixed rate of 1.30%, principal due and payable on April 25, 2017  $ 10,000  $476    2.25%     
                     
Interest payable monthly at a fixed rate of 3.44%, principal due and payable on December 10, 2013 Interest payable quarterly at a fixed rate of 1.05%, principal due and payable on April 25, 2016    10,000   470    2.23%     
                     
Interest payable quarterly at a fixed rate of 3.72%, principal due and payable on June 9, 2015 Interest payable quarterly at a fixed rate of 3.04%, principal due and payable on May 4, 2018    25,000   *    3.04%     
                     
Interest payable quarterly at a fixed rate of 5.58%, principal due and payable on May 16, 2016 Interest payable quarterly at a fixed rate of 4.31%, principal due and payable on May 8, 2022    25,000   *    4.31%     
                     
Interest payable monthly at a fixed rate of 5.36%, principal due and payable on November 1, 2016 Interest payable quarterly at a fixed rate of 2.28%, principal due and payable on May 4, 2021    25,000   4,710    4.41%     
                     
Interest payable monthly at a fixed rate of 5.85%, principal due and payable on September 17, 2018 Interest payable quarterly at a fixed rate of 3.69%, principal due and payable on May 3, 2032    25,000   6,411    5.03%     
                     
   $120,000 $12,067          

*The prepayment penalty is embedded in the rate for the new advance.

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Stock Repurchase Program

 

On May 3, 2012, the Board of Directors approved a stock repurchase program whereby the Company may repurchase up to 5%, or 715,141 shares, of its outstanding common stock either on the open market or through private transactions until October 31, 2012. Purchases will be conducted through an SEC Rule 10b5-1 repurchase plan with Sandler O’Neill & Partners, L.P. (“Sandler”) whereby Sandler will, from time to time and in accordance with Rule 10b-18 of the Securities Exchange Act of 1934, as amended, act as agent for the Company in purchasing shares based upon the parameters of the Rule 10b5-1 repurchase plan. The Rule 10b5-1 repurchase plan allows the Company to repurchase its shares during periods when it would normally not be active in the market due to its internal trading blackout period.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Safe Harbor Statement for Forward-Looking Statements

 

This report may contain forward-looking statements within the meaning of the federal securities laws. These statements are not historical facts; rather they are statements based on our current expectations regarding our business strategies and their intended results and our future performance. Forward-looking statements are preceded by terms such as “expects,” “believes,” “anticipates,” “intends” and similar expressions. Forward-looking statements are not guarantees of future performance. Numerous risks and uncertainties could cause or contribute to our actual results, performance and achievements being materially different from those expressed or implied by the forward-looking statements. These forward-looking statements are subject to significant risks and uncertainties. Actual results may differ materially from those contemplated by the forward-looking statements due to, among others, the following factors:

 

general economic conditions, either internationally, nationally, or in our primary market area, that are worse than expected;
a continued decline in real estate values;
changes in the interest rate environment that reduce our interest margins or reduce the fair value of financial instruments;
increased competitive pressures among financial services companies;
changes in consumer spending, borrowing and savings habits;
legislative, regulatory or supervisory changes that adversely affect our business;
adverse changes in the securities markets; and
changes in accounting policies and practices, as may be adopted by the bank regulatory agencies, the Financial Accounting Standards Board or the Public Company Accounting Oversight Board.

 

Additional factors that may affect our results are discussed in the Company’s Annual Report on Form 10-K for the year ended September 30, 2011 under Item 1A titled “Risk Factors.” These factors should be considered in evaluating the forward-looking statements and undue reliance should not be placed on such statements. Except as required by applicable law or regulation, we assume no obligation and disclaim any obligation to update any forward-looking statements.

 

Critical Accounting Policies

 

We consider accounting policies involving significant judgments and assumptions by management that have, or could have, a material impact on the carrying value of certain assets or on income to be critical accounting policies.

 

Allowance for Loan Losses. The allowance for loan losses is the amount estimated by management as necessary to cover losses inherent in the loan portfolio at the balance sheet date. The allowance is established through the provision for loan losses, which is charged to income. Determining the amount of the allowance for loan losses necessarily involves a high degree of judgment. Among the material estimates required to establish the allowance are: the likelihood of default; the loss exposure at default; the amount and timing of future cash flows on impaired loans; the value of collateral; and the determination of loss factors to be applied to the various elements of the portfolio. All of these estimates are susceptible to significant change. Management reviews the level of the allowance at least quarterly and establishes the provision for loan losses based upon an evaluation of the portfolio, past loss experience, current economic conditions and other factors related to the collectability of the loan portfolio. Although we believe that we use the best information available to establish the allowance for loan losses, future adjustments to the allowance may be necessary if economic or other conditions differ substantially from the assumptions used in making the evaluation. In addition, our regulator, as an integral part of its examination process, periodically reviews our allowance for loan losses and may require us to recognize adjustments to the allowance based on its judgments about information available to it at the time of its examination. A large loss could deplete the allowance and require increased provisions to replenish the allowance, which would adversely affect earnings. See note 4 of the notes to the unaudited consolidated financial statements.

29
 

 

Other-Than-Temporary Impairment. Investment securities are reviewed at each quarter to determine whether the fair value is below the current amortized cost. When the fair value of any of our investment securities has declined below its amortized cost, management is required to assess whether the decline is other than temporary. In making this assessment, we consider such factors as the type of investment, the length of time and extent to which the fair value has been below the carrying value, the financial condition and near-term prospects of the issuer, and our intent and ability to hold the investment long enough to allow for any anticipated recovery. The decision to record a write-down, its amount and the period in which it is recorded could change if management’s assessment of the above factors were different. We do not record impairment write-downs on debt securities when impairment is due to changes in interest rates, since we have the intent and ability to realize the full value of the investments by holding them to maturity. Quoted market value is considered to be fair value for actively traded securities. For illiquid and thinly traded securities where market quotes are not available, we use discounted cash flows to determine fair value. Additional information regarding our accounting for investment securities is included in note 2 of the notes to the unaudited consolidated financial statements.

 

Income Taxes. Management makes estimates and judgments to calculate certain tax liabilities and to determine the recoverability of certain deferred tax assets, which arise from temporary differences between the tax and financial statement recognition of revenues and expenses. The Company also estimates a valuation allowance for deferred tax assets if, based on the available evidence, it is more likely than not that some portion or all of the recorded deferred tax assets will not be realized in future periods. These estimates and judgments are inherently subjective.

 

In evaluating the recoverability of deferred tax assets, management considers all available positive and negative evidence, including past operating results, recent cumulative losses – both capital and operating – and the forecast of future taxable income – also both capital and operating. In determining future taxable income, management makes assumptions for the amount of taxable income, the reversal of temporary differences and the implementation of feasible and prudent tax planning strategies. These assumptions require judgments about future taxable income and are consistent with the plans and estimates to manage the Company’s business. Any reduction in estimated future taxable income may require the Company to record a valuation allowance against deferred tax assets. An increase in the valuation allowance would result in additional income tax expense in the period and could have a significant impact on future earnings.

 

Pension Plan. The Company has a noncontributory, defined benefit pension plan. This plan is accounted for under the provisions of ASC Topic 715: Compensation-Retirement Benefits, which requires an employer to recognize the overfunded or underfunded status of a defined benefit postretirement plan as an asset or liability in its statement of financial position and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. The funded status of a benefit plan is measured as the difference between plan assets at fair value and the benefit obligation. For a pension plan, the benefit obligation is the projected benefit obligation. ASC Topic 715 also requires an employer to measure the funded status of a plan as of the date of its year-end statement of financial position. Management must make certain estimates and assumptions when determining the projected benefit obligation. These estimates and assumptions include the expected return on plan assets, the rate of compensation increases over time, and the appropriate discount rate to be used in determining the present value of the obligation.

 

Comparison of Financial Condition at March 31, 2012 and September 30, 2011

 

Assets. Total assets at March 31, 2012 were $1,099.9 million, an increase of $2.9 million, or 0.3%, from total assets of $1,097.0 million at September 30, 2011.

 

Cash and cash equivalents increased $20.3 million to $136.0 million at March 31, 2012 compared to $115.7 million at September 30, 2011, an increase of 17.5%. Securities increased $5.3 million, or 1.3%, to $427.6 million at March 31, 2012 compared to $422.3 million at September 30, 2011. The increase in securities included the purchase of $66.3 million of agency CMOs and $8.2 million of corporate bonds and a $9.8 million increase in net unrealized gains on securities available-for-sale, partially offset by other-than-temporary impairment charges of $2.9 million, $63.2 million of normal principal payments on securities, $7.5 million of maturities of agency securities, and $4.2 million of sales of municipal bonds.

30
 

 

The Company did not purchase any corporate equity securities during the six months ended March 31, 2012. However, at its February 22, 2012 meeting, the Board of Directors partially lifted the moratorium on the purchase of equity securities by the Company by revising the Investment Policy to allow selected purchases of the common stocks of Virginia-based community banking institutions. Any such purchases must be recommended by the Investment Committee and approved in advance by the Board. The Company plans to make strategic investments in larger, consistently-profitable Virginia-based community banking institutions whose stocks generally have trading volumes equal to or greater than the Company’s and whose franchises are deemed attractive in connection with the anticipated consolidation of the community banking industry in Virginia. The lifting of the moratorium does not change the Company’s longer-term goal of gradually reducing its common stock investments, but, in the intermediate term, reductions will be made in investments in larger cap entities, and investments in Virginia-based community banking institution stocks may increase.

 

Total loans, excluding loans held for sale, decreased $25.0 million, or 5.0%, to $471.5 million at March 31, 2012 compared to $496.5 million at September 30, 2011. The decrease was the result of several significant loan prepayments as well as charge-offs of $3.3 million. One- to four-family loans declined $3.9 million, construction loans declined $13.5 million, land and land development loans declined $16.7 million, and other loans declined $96,000. These declines were partially offset by increases in multi-family loans of $1.0 million and nonresidential loans of $8.3 million.

 

Liabilities. Total liabilities at March 31, 2012 were $837.0 million compared to $847.4 million at September 30, 2011, a decrease of $10.4 million, or 1.2%, as a result of a $9.3 million decrease in certificates of deposit as several large deposits matured and were not renewed at current low rates and a $1.5 million decrease in money market checking and money market savings accounts. Changes in other liability categories were not significant, including FHLB borrowings, which were unchanged at $190.0 million at March 31, 2012 and September 30, 2011.

 

Stockholders’ equity. Stockholders’ equity was $262.9 million at March 31, 2012, an increase of $13.3 million, or 5.3%, from September 30, 2011. The increase was the result of net income held in retained earnings of $4.3 million and a $8.7 million increase in accumulated other comprehensive income caused primarily by a net increase in the estimated fair value of our portfolio of available-for-sale securities.

 

Comparison of Operating Results for the Three Months Ended March 31, 2012 and March 31, 2011

 

General. We had net income of $2.5 million for the three months ended March 31, 2012 compared to $1.7 million for the three months ended March 31, 2011, an increase of $773,000, or 44.6%. The increase was the net result of a $562,000 increase in net interest income, a $588,000 decrease in the provision for loan losses, a $489,000 increase in other-than-temporary impairment charges on securities included in earnings, a $364,000 decline in gains on sales of securities, a $474,000 increase in gains on sales of other real estate owned, a $556,000 decrease in other noninterest expenses, and a $555,000 increase in income tax expense.

 

Net Interest Income. Net interest income increased $562,000, or 9.0%, to $6.8 million in the quarter ended March 31, 2012 from $6.2 million in the quarter ended March 31, 2011. The increase in net interest income resulted from investing the funds received in the mutual-to-stock conversion completed in April 2011 and a decline in rates paid on deposits.

 

Total interest and dividend income decreased $145,000, or 1.3%, to $11.0 million for the quarter ended March 31, 2012 from $11.2 million for the quarter ended March 31, 2011. Interest income on loans decreased $70,000 from the comparable quarter in the prior year as an 11 basis point increase in the overall yield was more than offset by a decrease of $16.8 million in the average balance of loans for the three months ended March 31, 2012 compared to the comparable quarter in the prior year. The average balance of nonresidential loans increased $5.0 million while the yield declined 8 basis points for the three months ended March 31, 2012 compared to the three months ended March 31, 2011. The average balance of multi-family loans increased $1.2 million while the yield declined 40 basis points for the three months ended March 31, 2012 compared to the three months ended March 31, 2011. These increases in average balances were more than offset by a $10.4 million decline in the average balance of one- to four-family loans, a $5.7 million decline in the average balance of construction loans, and a $6.6 million decline in the average balance of land and land development loans. The yields on one- to four-family and land and land development loans increased 17 basis points and 106 basis points, respectively, while the yield on construction loans declined 5 basis points. Rates on one- to four-family loans increased because of a higher concentration of investment property loans, which have higher yields. Rates on land and land development loans were positively affected in the quarter ended March 31, 2012 by collections on nonaccrual loans and by rate floors.

31
 

 

Interest and dividend income on investment securities decreased $80,000, or 2.4%, as a $76.0 million increase in the average balance of investment securities for the three months ended March 31, 2012 compared to the comparable quarter in the prior year was more than offset by a 75 basis point decline in yield. The decrease was due primarily to a $58,000 decline in interest income on MBS for the three months ended March 31, 2012 compared to the comparable quarter in the prior year due to an 81 basis point decline in yield and only a $465,000 increase in the average balance. Additionally, an increase in the average balance of CMOs of $90.5 million was more than offset by a 122 basis point decline in yield and resulted in a decrease in interest income of $40,000 for the three months ended March 31, 2012 compared to the three months ended March 31, 2011. The Company has significantly increased its investment in short-term CMOs to meet regulatory qualified thrift lender requirements, to better position the Company for rising interest rates, and to manage the proceeds from the Company’s stock conversion until the funds can be effectively deployed into new loan opportunities. Partially offsetting the foregoing decreases was a $57,000 increase in interest income on corporate debt securities.

 

Total interest expense decreased $707,000, or 14.3%, to $4.2 million for the quarter ended March 31, 2012 from $4.9 million for the three months ended March 31, 2011. The decline was the result of a $728,000 decrease in deposit costs partially offset by a $21,000 increase in FHLB borrowings costs for the three months ended March 31, 2012 compared to the three months ended March 31, 2011. The average balance of interest-bearing deposits decreased $34.9 million due to a decrease in average certificates of deposit of $25.9 million along with a $9.0 million decrease in money market savings and money market checking accounts. The Company has not been aggressive in deposit pricing since its mutual to stock conversion because of the large amount of cash raised in the conversion. The average interest rate paid on deposits decreased 39 basis points as a result of the lower interest rate environment for deposits in the quarter ended March 31, 2012 compared to the comparable period in the prior year.

 

Provision for Loan Losses. The provision for loan losses decreased $588,000 to a credit provision of $298,000 for the three months ended March 31, 2012 compared to a provision expense of $290,000 for the three months ended March 31, 2011. The decrease in the provision reflects a combination of a decrease in the balance of loans outstanding as well as lower nonperforming loans and a leveling-off of problem loans in certain portfolios for the most recent quarter compared to the three months ended March 31, 2011. The Company recorded provisions of $126,000 and $196,000 in the nonresidential and construction loan portfolios, respectively, for the three months ended March 31, 2012. The increase in the provision for the nonresidential portfolio was the result of a $12.2 million increase in loan balances, while the provision for the construction portfolio reflects changes in loan ratings that offset a decline in loan balances of $8.0 million. The Company recorded credit provisions for the one- to four-family, multi-family, and land and land development loan portfolios totaling $618,000, partially as a result of declining loan balances and partially due to improving credit quality. Net loan charge-offs were $245,000 for the quarter ended March 31, 2012 compared to $14,000 for the quarter ended March 31, 2011. The overall allowance rate declined 8 basis points at March 31, 2012 to 2.38% of total loans from 2.46% of total loans at December 31, 2011. See note 4 of the notes to the unaudited consolidated financial statements for a discussion of our methodology for estimating the allowance for loan losses.

 

Noninterest Income

 

The following table presents the components of noninterest income and the percentage change in each for the periods indicated:

 

   Three Months Ended March 31,   Increase (Decrease) 
(Dollars in thousands)  2012   2011   % 
Service charges on deposit accounts  $16   $12    38.2%
Other service charges and fees   108    91    18.9 
Gains on sales of loans held for sale   63    65    (3.4)
Gains on sales of securities, net   -    364    (100.0)
Gains (losses) on sales of other real estate owned   428    (46)   NM 
Impairment of securities   (935)   (490)   90.8 
    Impairment recognized in OCI   (64)   (108)   (41.2)
    Net impairment reflected in earnings   (871)   (382)   128.1 
Increase in cash surrender value of bank-owned               
life insurance   319    316    1.2 
Other operating income   125    146    (14.7)
Total noninterest income  $188   $566    (66.8)

  

32
 

 

Gains, Losses, and Impairment Charges on Securities. Other-than-temporary-impairment charges on securities reflected in earnings increased $489,000 to $871,000 for the three months ended March 31, 2012 compared to $382,000 for the quarter ended March 31, 2011. Impairment charges reflected in earnings consisted of $719,000 in charges on debt securities and $152,000 on equity securities for the three months ended March 31, 2012 compared to $330,000 on debt securities and $52,000 on equity securities in the three months ended March 31, 2011. Impairment charges for the three months ended March 31, 2012 primarily related to the impairment of the Company’s investment in an auction-rate municipal bond backed by student loans. This bond was downgraded in the most recent quarter and has been experiencing deterioration in the underlying pool of student loans. Additionally, as shown in the table above, the Company had no gains on sales of securities in the quarter ended March 31, 2012 compared to net gains of $364,000 in the quarter ended March 31, 2011.

 

Noninterest Income, Excluding Gains, Losses, and Impairment Charges on Securities. Total other noninterest income excluding gains, losses, and impairment charges on securities increased $475,000, or 81.4%, for the three months ended March 31, 2012 compared to the three months ended March 31, 2011, primarily as a result of $428,000 in net gains on sales of real estate owned in the three months ended March 31, 2012 compared to net losses on sale of $46,000 in the comparable period in the prior year.

 

Noninterest Expense.

 

The following table presents the components of noninterest expense and the percentage change for the periods indicated:

   Three Months Ended March 31,   Increase (Decrease) 
 (Dollars in thousands)  2012   2011   % 
Personnel expense  $2,050   $1,997    2.6%
Occupancy expense   228    207    10.2 
Equipment expense   232    221    4.8 
Advertising expense   51    32    57.8 
Federal deposit insurance premiums   203    272    (25.2)
Other operating expenses   848    1,439    (41.1)
Total other noninterest expenses  $3,612   $4,168    (13.3)

 

Total noninterest expenses decreased $556,000, or 13.3%, to $3.6 million for the three months ended March 31, 2012 compared to $4.2 million for the three months ended March 31, 2011. The decrease in noninterest expenses was due primarily to a $781,000 decrease in impairment charges on real estate owned, partially offset by a $183,000 increase in other operating expenses related to increases in regulatory and compliance costs associated with being a publicly-traded company. Federal deposit insurance premiums decreased $69,000 because of the improved credit risk rating of the Bank.

 

Income Tax Expense. Income tax expense was $1.2 million for the three months ended March 31, 2012 compared to $597,000 for the three months ended March 31, 2011. The effective income tax rate for the three months ended March 31, 2012 was 31.5% compared to an effective income tax rate of 25.6% for the three months ended March 31, 2011.

 

Comparison of Operating Results for the Six Months Ended March 31, 2012 and March 31, 2011

 

General. We had net income of $4.3 million for the six months ended March 31, 2012 compared to $3.8 million for the six months ended March 31, 2011, an increase of $513,000, or 13.6%. The increase was the net result of a $1.2 million increase in net interest income, an $864,000 decrease in the provision for loan losses, a $1.6 million increase in other-than-temporary impairment charges on securities included in earnings, a $461,000 increase in other service charges and fees, a $264,000 decrease in gains on sales of securities, a $571,000 increase in gains on sales of other real estate owned, a $452,000 decrease in other noninterest expenses, and a $985,000 increase in income tax expense.

33
 

 

Net Interest Income. Net interest income increased $1.2 million, or 9.2%, to $13.9 million in the six months ended March 31, 2012 from $12.7 million in the six months ended March 31, 2011. The increase in net interest income resulted from investing the funds received in the mutual-to-stock conversion completed in April 2011 and a decline in rates paid on deposits.

 

Total interest and dividend income decreased $237,000, or 1.0%, to $22.5 million for the six months ended March 31, 2012 from $22.7 million for the six months ended March 31, 2011. Interest income on loans decreased $367,000 as loan yields declined in all categories except for land and land development loans and other loans. The yield on loans decreased 2 basis points while the average balance decreased $11.2 million for the six months ended March 31, 2012 compared to the comparable period in the prior year. The average balance on multi-family and nonresidential loans increased $1.2 million and $10.4 million, respectively, while yields on such loans declined 21 basis points and 3 basis points, respectively, for the six months ended March 31, 2012 compared to the six months ended March 31, 2011. These increases in average balances were more than offset by a $12.5 million decline in the average balance of one- to four-family loans, a $4.0 million decline in the average balance of construction loans, and a $5.0 million decline in the average balance of land and land development loans. The yields on one- to four-family and construction loans declined 5 basis points and 26 basis points, respectively, due both to prepayments of higher yielding loans and more competitive market pricing of new and renewing loans, while the yield on land and land development loans increased 26 basis points. Rates on land and land development loans were positively affected in the six months ended March 31, 2012 by collections on nonaccrual loans and by rate floors.

 

Interest and dividend income on investment securities increased $134,000, or 2.0%, as a $96.3 million increase in the average balance of investment securities for the six months ended March 31, 2012 compared to the comparable period in the prior year more than offset a 77 basis point decline in yield. The increase was due to a $111.6 million increase in the average balance of CMOs that more than offset a 130 basis point decline in yield and resulted in an increase in interest income of $183,000 for the six months ended March 31, 2012 compared to the six months ended March 31, 2011. The Company has significantly increased its investment in short-term CMOs to meet regulatory qualified thrift lender requirements, to better position the Company for rising interest rates, and to manage the proceeds from the Company’s stock conversion until the funds can be effectively deployed into new loan opportunities. Additionally, interest income on corporate bonds increased $169,000 as an increase in yield of 42 basis points more than offset a $3.4 million decline in the average balance for the six months ended March 31, 2012 compared to the comparable period in the prior year. These increases were partially offset by a decrease in interest income on MBSs of $175,000 for the six months ended March 31, 2012 compared to the comparable period in the prior year due to an 87 basis point decline in yield and a $2.2 million decline in the average balance.

 

Total interest expense decreased $1.4 million, or 14.0%, to $8.6 million for the six months ended March 31, 2012 from $10.0 million for the six months ended March 31, 2011. The decline was the result of a $1.4 million decrease in deposit costs. The average balance of interest-bearing deposits decreased $17.4 million due to a decrease in average certificates of deposit of $11.1 million along with a $6.3 million decrease in money market savings and money market checking accounts. The average interest rate paid on deposits decreased 41 basis points as a result of the lower interest rate environment for deposits in the six months ended March 31, 2012.

 

Provision for Loan Losses. The provision for loan losses decreased $864,000 to a credit provision of $152,000 for the six months ended March 31, 2012 compared to a provision expense of $712,000 for the six months ended March 31, 2011. The decrease in the provision reflects a combination of a decrease in the balance of loans outstanding as well as lower nonperforming loans and a leveling-off of problem loans in certain portfolios for the six months ended March 31, 2012 compared to the six months ended March 31, 2011. The Company recorded provisions of $403,000 and $144,000 in the one-to four-family and land and land development loan portfolios, respectively. The provision for the one-to four-family portfolio was the result of an increase in nonperforming non-owner-occupied loans, while the provision for the land and land development portfolio reflects management’s continued concerns regarding collateral valuations in this portfolio. The Company recorded credit provisions for the multi-family, nonresidential, and construction loan portfolios totaling $696,000, partially as a result of declining loan balances and partially due to improving credit quality in the Company’s nonresidential and construction loan portfolios. Net loan charge-offs were $3.3 million for the six months ended March 31, 2012 compared to $2.2 million for the six months ended March 31, 2011. The overall allowance rate declined 57 basis points at March 31, 2012 to 2.38% of total loans from 2.95% of total loans at September 30, 2011. See note 4 of the notes to the unaudited consolidated financial statements for a discussion of our methodology for estimating the allowance for loan losses.

34
 

 

Noninterest Income

 

The following table presents the components of noninterest income and the percentage change in each for the periods indicated:

 

   Six months Ended March 31,   Increase (Decrease) 
(Dollars in thousands)  2012   2011   % 
Service charges on deposit accounts  $24   $20    19.3%
Other service charges and fees   614    153    302.4 
Gains on sales of loans held for sale   141    216    (34.7)
Gains on sales of securities, net   -    264    (100.0)
Gains on sales of other real estate owned   625    54    NM 
Impairment of securities   (2,879)   (786)   266.1 
    Impairment recognized in OCI   (553)   (105)   425.7 
    Net impairment reflected in earnings   (2,326)   (681)   241.5 
Increase in cash surrender value of bank-owned               
life insurance   642    636    1.0 
Other operating income   225    270    (17.0)
Total noninterest income (expense)  $(55)  $932    (105.9)

 

Gains, Losses, and Impairment Charges on Securities. Other-than-temporary-impairment charges on securities reflected in earnings increased $1.6 million to $2.3 million for the six months ended March 31, 2012 compared to $681,000 for the six months ended March 31, 2011. Impairment charges reflected in earnings consisted of $815,000 in charges on debt securities and $1.5 million on equity securities for the six months ended March 31, 2012 compared to $629,000 on debt securities and $52,000 on equity securities in the six months ended March 31, 2011. Debt impairment charges for the six months ended March 31, 2012 related primarily to the Company’s investment in an auction-rate municipal bond backed by student loans that was downgraded in the three months ended March 31, 2012 and is experiencing deteriorating collateral quality. Equity impairment charges for the six months ended March 31, 2012 primarily related to the impairment of the Company’s investment in one Virginia-based community bank with a price trend that raises significant concern about the ability of the stock price to return to the Company’s cost basis in a reasonable period of time. Additionally, as shown in the table above, the Company had no gains on sales of securities in the six months ended March 31, 2012 compared to gains of $264,000 in the six months ended March 31, 2011.

 

Noninterest Income, Excluding Gains, Losses, and Impairment Charges on Securities. Total other noninterest income excluding gains, losses, and impairment charges on securities increased $922,000, or 68.3%, for the six months ended March 31, 2012 compared to the six months ended March 31, 2011, primarily as a result of a $461,000 increase in other service charges and fees and a $571,000 increase in gains on sales of other real estate owned. The increase in other service charges and fees was the result of fees received in connection with the prepayment of several large loans due either to refinancing or the sale of the underlying collateral, which totaled $509,000 in the six months ended March 31, 2012 compared to $13,000 in the comparable six months in the prior year.

35
 

 

Noninterest Expense.

 

The following table presents the components of noninterest expense and the percentage change for the periods indicated:

   Six months Ended March 31,   Increase (Decrease) 
 (Dollars in thousands)  2012   2011   % 
Personnel expense  $4,078   $3,890    4.8%
Occupancy expense   440    408    7.9 
Equipment expense   458    446    2.6 
Advertising expense   110    72    52.3 
Federal deposit insurance premiums   411    518    (20.7)
Other operating expenses   1,669    2,284    (26.9)
Total other noninterest expenses  $7,166   $7,618    (5.9)

 

Total noninterest expenses decreased $452,000, or 5.9%, to $7.2 million for the six months ended March 31, 2012 compared to $7.6 million for the six months ended March 31, 2011. The decrease in noninterest expenses was due primarily to a $107,000 decrease in federal deposit insurance premiums and a $615,000 decrease in other operating expenses. The decrease in other operating expenses was due to no impairment charges on real estate owned for the six months ended March 31, 2012 compared to impairment charges of $781,000 for the six months ended March 31, 2011. These decreases were partially offset by an $188,000 increase in personnel expense caused by a $424,000 increase in expenses related to the Company’s ESOP and a $136,000 increase in pension plan expenses partially offset by a $312,000 decrease in deferred compensation plan expenses and a $56,000 decrease in salary expenses.

 

Income Tax Expense. Income tax expense was $2.5 million for the six months ended March 31, 2012 compared to $1.5 million for the six months ended March 31, 2011. The effective income tax rate for the six months ended March 31, 2012 was 36.8% compared to an effective income tax rate of 28.5% for the six months ended March 31, 2011. The increase in the effective tax rate is due primarily to the $1.5 million impairment loss on equity securities. Losses on equity securities are capital losses and can be utilized for tax purposes to offset capital gains. Because the Company is in a capital loss carryforward position and unable to utilize the capital loss, no related tax benefit was allowed for the six months ended March 31, 2012.

36
 

Average Balances, Interest and Dividend Income and Interest Expense, Yields and Rates

 

The following table presents information regarding average balances of assets and liabilities, the total dollar amounts of interest income and dividends from average interest-earning assets, the total dollar amounts of interest expense on average interest-bearing liabilities, and the resulting average yields and costs. The yields and costs for the periods indicated are derived by dividing annualized income or expense by the average daily balances of assets or liabilities, respectively, for the periods presented. Non-accrual loans are included in average loan balances only. Loan fees are included in interest income on loans and are not material.

 

   For the Three Months Ended March 31, 
   2012   2011 
(Dollars in thousands)  Average Balance   Interest and Dividends   Yield/ Cost   Average Balance   Interest and Dividends   Yield/ Cost 
Assets:                        
Interest-earning assets:                        
Loans:                        
One-to four-family  $110,646   $1,955    7.11%  $121,089   $2,072    6.94%
Multi-family   78,914    1,290    6.57    77,756    1,337    6.97 
Nonresidential   188,268    3,155    6.74    183,264    3,080    6.82 
Construction   35,909    451    5.05    41,572    523    5.10 
Land and land development   61,984    867    5.63    68,624    773    4.57 
Other   571    12    8.45    809    15    7.52 
Total loans   476,292    7,730    6.53    493,114    7,800    6.42 
Securities:                              
Collateralized mortgage obligations   243,757    1,125    1.86    153,237    1,165    3.08 
Mortgage-backed securities   32,116    237    2.97    31,651    295    3.78 
States and political subdivisions   13,730    186    5.45    18,738    210    4.55 
U. S. government agencies   825    4    1.95    10,303    25    0.98 
Corporate equity securities   25,194    77    1.23    24,829    72    1.18 
Corporate debt securities   121,894    1,595    5.26    122,884    1,538    5.07 
Total securities   437,516    3,224    2.96    361,642    3,305    3.71 
Investment in FHLB stock   10,637    33    1.29    12,071    24    0.81 
Other interest-earning assets   94,360    30    0.12    66,642    33    0.21 
Total interest-earning assets   1,018,805    11,017    4.35    933,469    11,162    4.85 
Allowance for loan losses   (11,930)             (12,098)          
Noninterest-earning assets   80,304              91,999           
Total assets  $1,087,179             $1,013,370           
Liabilities and stockholders’ equity:                              
Interest-bearing liabilities:                              
Deposits:                              
Money market savings  $221,418    255    0.46   $227,218    515    0.92 
Money market checking   43,362    51    0.47    46,586    108    0.94 
Certificates of deposit   364,113    1,638    1.81    390,036    2,049    2.13 
Total deposits   628,893    1,944    1.24    663,840    2,672    1.63 
FHLB borrowings   190,000    2,287    4.84    190,000    2,266    4.84 
Total interest-bearing liabilities   818,893    4,231    2.08    853,840    4,938    2.35 
Noninterest bearing liabilities   10,012              28,178           
Total liabilities   828,905              882,018           
Stockholders’ equity   258,274              131,352           
Total liabilities and stockholders’ equity  $1,087,179             $1,013,370           
Net interest income       $6,786             $6,224      
Interest rate spread(1)             2.27%             2.50%
Net interest margin(2)             2.68%             2.70%
Average interest-earning assets to
average interest-bearing liabilities
             124.41%             109.33%
                               
(1)Interest rate spread represents the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities.
(2)Net interest margin represents net interest income as a percentage of average interest-earning assets.

 

37
 

 

   For the Six Months Ended March 31, 
   2012   2011 
(Dollars in thousands)  Average Balance   Interest and Dividends   Yield/ Cost   Average Balance   Interest and Dividends   Yield/ Cost 
Assets:                        
Interest-earning assets:                        
Loans:                        
One-to four-family  $111,257   $3,920    7.05%  $123,798   $4,384    7.10%
Multi-family   78,394    2,591    6.61    77,179    2,624    6.82 
Nonresidential   188,867    6,432    6.81    178,427    6,082    6.84 
Construction   37,776    948    5.02    41,815    1,100    5.28 
Land and land development   64,353    1,700    5.28    69,323    1,736    5.02 
Other   598    25    8.36    1,925    57    5.94 
Total loans   481,245    15,616    6.49    492,467    15,983    6.51 
Securities:                              
Collateralized mortgage obligations   252,549    2,476    1.96    140,972    2,293    3.26 
Mortgage-backed securities   30,858    466    3.02    33,059    641    3.89 
States and political subdivisions   15,307    376    4.91    19,598    429    4.39 
U. S. government agencies   2,485    18    1.45    8,630    38    0.88 
Corporate equity securities   24,195    185    1.53    23,382    155    1.33 
Corporate debt securities   119,761    3,207    5.36    123,192    3,038    4.94 
Total securities   445,155    6,728    3.02    348,833    6,594    3.79 
Investment in FHLB stock   10,742    57    1.04    12,197    37    0.61 
Other interest-earning assets   88,425    53    0.12    68,250    77    0.23 
Total interest-earning assets   1,025,567    22,454    4.38    921,747    22,691    4.94 
Allowance for loan losses   (13,482)             (12,457)          
Noninterest-earning assets   80,075              83,122           
Total assets  $1,092,160             $992,412           
Liabilities and stockholders’ equity:                              
Interest-bearing liabilities:                              
Deposits:                              
Money market savings  $221,670    510    0.46   $226,077    1,026    0.91 
Money market checking   43,194    103    0.48    45,066    212    0.94 
Certificates of deposit   370,734    3,397    1.83    381,872    4,199    2.21 
Total deposits   635,598    4,010    1.26    653,015    5,437    1.67 
FHLB borrowings   190,000    4,603    4.85    190,000    4,582    4.84 
Total interest-bearing liabilities   825,598    8,613    2.09    843,015    10,019    2.38 
Noninterest bearing liabilities   10,772              19,803           
Total liabilities   836,370              862,818           
Stockholders’ equity   255,790              129,594           
Total liabilities and stockholders’ equity  $1,092,160             $992,412           
Net interest income       $13,841             $12,672      
Interest rate spread(1)             2.29%             2.56%
Net interest margin(2)             2.69%             2.76%
Average interest-earning assets to
average interest-bearing liabilities
             124.22%             109.34%
                               
(1)Interest rate spread represents the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities.
(2)Net interest margin represents net interest income as a percentage of average interest-earning assets.

 

38
 

 

Rate/Volume Analysis 

 

The following table sets forth the effects of changing rates and volumes on our net interest income. The rate column shows the effects attributable to changes in rate (changes in rate multiplied by prior volume). The volume column shows the effects attributable to changes in volume (changes in volume multiplied by prior rate). The net column represents the sum of the prior columns. The net changes attributable to the combined impact of both rate and volume have been allocated proportionately to the changes due to volume and the changes due to rate.

 

   Three Months Ended March 31, 2012 Compared to Three Months Ended March 31, 2011   Six Months Ended March 31, 2012 Compared to Six Months Ended
March 31, 2011
 
   Increase (Decrease)
Due to:
       Increase (Decrease)
Due to:
     
(Dollars in thousands)  Volume   Rate   Net   Volume   Rate   Net 
Interest income:                        
Loans  $(1,003)  $933   $(70)  $(324)  $(43)  $(367)
Securities   2,573    (2,654)   (81)   3,172    (3,038)   134 
Investment in FHLB stock   (17)   26    9    (13)   33    20 
Other interest earning assets   51    (54)   (3)   48    (72)   (24)
        Total   1,604    (1,749)   (145)   2,883    (3,120)   (237)
Interest expense:                              
Deposits:                              
Money market savings   (13)   (247)   (260)   (20)   (496)   (516)
Money market checking   (7)   (50)   (57)   (8)   (101)   (109)
Certificates of deposit   (132)   (279)   (411)   (186)   (616)   (802)
FHLB borrowings   -    21    21    -    21    21 
        Total   (152)   (555)   (707)   (214)   (1,192)   (1,406)
Increase (decrease) in net interest income  $1,756   $(1,194)  $562   $3,097   $(1,928)  $1,169 

 

Asset Quality

 

Nonperforming Assets (NPAs)

 

At March 31, 2012, nonperforming assets totaled $44.8 million, a decrease of $6.0 million from $50.8 million at September 30, 2011. Our level of NPAs remains elevated over historical experience as a result of stresses in real estate markets, which are largely a result of the broader and extended economic slowdown. While we intend to actively work to reduce our NPAs, these levels of nonperforming assets are likely to remain elevated in the near term as problem loans work to resolution, which may be foreclosure.

 

Nonperforming assets at March 31, 2012 included $36.0 million in nonperforming loans (NPLs) as summarized in the table below. The following table reflects the balances and changes from the prior quarter:

 

 (Dollars in thousands)  March 31, 2012   December 31, 2011   Change 
Nonaccrual loans:            
One-to four-family  $9,356   $10,479   $(1,123)
Multi-family   6,091    6,095    (4)
Nonresidential   7,037    7,051    (14)
Construction   247    247    - 
Land and land development   13,235    13,827    (592)
     Total   35,966    37,699    (1,733)
                
Accruing loans past due 90 days or more   -    -    - 
Total nonperforming loans  $35,966   $37,699   $(1,733)

 

39
 

 

At March 31, 2012, the allowance for loan losses as a percentage of total loans was 2.38% compared to 2.95% at September 30, 2011. While management believes there are signs of stabilization in the local economy and real estate markets, it continues to believe that the market for large-tract land developments in the Richmond MSA is significantly stressed, and, as a result, the Company partially charged-off certain land and land development loans during the first fiscal quarter that had specific reserves at September 30, 2011. Additionally, management increased the allowance for loan losses for the remainder of loans in this portfolio, resulting in an allowance of 10.7% at March 31, 2012 for land and land development loans analyzed as part of the general allowance. See note 4 of the notes to the unaudited consolidated financial statements for further analysis of the allowance for loan losses.

 

The following table sets forth selected asset quality data and ratios for the dates indicated:

 

 (Dollars in thousands)  March 31,
2012
   September 30, 2011 
Nonperforming loans  $35,966   $42,205 
Real estate owned   8,831    8,627 
        Total nonperforming assets  $44,797   $50,832 
           
Allowance for loan losses  $11,206   $14,624 
Total loans  $471,477   $496,491 
           
Ratios          
Allowance as a percentage of total loans   2.38%   2.95%
Allowance as a percentage of nonperforming loans   31.16%   34.65%
Total nonperforming loans to total loans   7.63%   8.50%
Total nonperforming loans to total assets   3.27%   3.85%
Total nonperforming assets to total assets   4.07%   4.63%

 

At March 31, 2012, nonaccrual loans were primarily comprised of the following:

 

Land and land development loans:
   
-One loan on several hundred acres of undeveloped land in central Virginia proposed for a residential development within a planned unit development. This loan had a balance of $4.9 million and was classified as impaired at March 31, 2012. The collateral was valued at $11.0 million based upon a September 2011 appraisal, and a specific allowance calculation on this loan resulted in no allowance at March 31, 2012 due to sufficient collateral.
   
-One loan on several hundred acres of undeveloped land in central Virginia proposed for multi-use development within a planned unit development. This loan is a participation loan with two other banks, each having a one-third interest. The balance of the Company’s portion of this loan was $4.1 million and was classified as impaired at March 31, 2012. The collateral was valued at $13.8 million (of which $4.6 million is attributable to the Company) based upon an August 2011 appraisal, and a specific allowance calculation on this loan resulted in no allowance at March 31, 2012 due to sufficient collateral.
   
-One loan on 60 single-family lots and approximately 60 acres of developed land in central Virginia. The loan is a participation loan with another bank and was 151 – 180 days delinquent at March 31, 2012. Our participation interest is 62%, and our balance on this loan was $1.3 million at March 31, 2012. A specific allowance calculation on this loan resulted in no allowance at March 31, 2012 due to sufficient collateral. Fifty-three of these lots were foreclosed on by the lead participant subsequent to March 31, 2012.
   
-Two loans on adjoining single-family residential developments in central Virginia with a combined balance of $1.8 million at March 31, 2012. These loans are participations with five other banks, and the Company’s participation percentage on each loan is 23.6%. During the three months ended March 31, 2012, the Company bought out one of the original loan participants, resulting in a 5% increase in the its participation percentage on each loan. While these loans were current at March 31, 2012, they were identified as impaired due to significant deterioration of the value of the underlying collateral. A May 2011 appraisal indicated a value of $8.5 million for the development, $2.0 million of which was attributable to the Company’s participation interest. A specific allowance calculation on this loan resulted in no allowance at March 31, 2012 due to sufficient collateral.

 

40
 

Nonresidential real estate loans:
   
-One loan on a strip shopping center in northern Virginia with four available out-parcel sites. The shopping center, which is 30% leased, is within one mile of a major regional shopping center. The loan is a participation with three other banks, and our participation portion is approximately 32%. Our balance at March 31, 2012 was $2.3 million. This loan was modified in a troubled debt restructuring during the year ended March 31, 2011. Based upon a December 2011 appraisal valuing the collateral at $8.3 million (of which $2.7 million is attributable to the Company), no specific allowance was necessary at March 31, 2012 due to sufficient collateral. The loan was over 180 days delinquent at March 31, 2012.
   
-One loan secured by a day care center and twenty-six developed lots in central Virginia. This loan had a balance of $2.1 million and was 61 – 90 days delinquent at March 31, 2012. The collateral for this loan was valued at $2.7 million based on a June 2011 appraisal of the day care center and the lots. We have two other loans to entities controlled by the guarantor on this loan as described below in the section regarding nonaccrual one-to four-family loans. A specific allowance calculation on this loan resulted in no allowance at March 31, 2012 due to sufficient collateral.
   
-One loan on an exhibition hall in central Virginia that was current at March 31, 2012. The loan is a participation with two other banks, and our participation portion is approximately 32%. Our balance at March 31, 2012 was $2.7 million. During the quarter ended March 31, 2012, the borrower negotiated a three-year extension of the loan at a market interest rate that instituted principal amortization and, as part of the extension, the borrower provided additional collateral adjacent to the exhibition hall. An appraisal dated August 2011of the exhibition hall and additional collateral values the properties at $3.5 million. The loan is not considered impaired due to the financial strength of the guarantor.
   
Multifamily
   
-One loan on an apartment complex in central Virginia that had a balance of $6.1 million and was over 180 days delinquent at March 31, 2012. Based upon current occupancy, the apartment complex does not generate enough cash to service the debt and requires support from the guarantor. The apartment complex is valued at $14.1 million based upon a February 2012 appraisal. This loan was considered impaired at March 31, 2012, but no specific allowance was necessary due to sufficient collateral. The Company has two other loans on this property totaling $5.4 million that were rated substandard at March 31, 2012 and are discussed below in substandard loans other than nonperforming loans.
   
One-to four-family
   
-Fifty loans on one-to four-family residential properties in central Virginia to multiple borrowers with an aggregate balance of $5.0 million at March 31, 2012.
   
-Two loans outstanding to separate entities controlled by the same guarantor totaling $4.3 million secured by twenty-two non-owner-occupied one-to four-family homes, almost all of which were rented at March 31, 2012. These loans were over 180 days delinquent at March 31, 2012 because the rental cash flows from the properties were not sufficient to fully cover debt service. A specific allowance calculation on these loans resulted in a specific allowance of $406,000 at March 31, 2012 based on February 2012 appraisals.
   

The following table shows the aggregate amounts of our classified and criticized loans and securities at the dates indicated in accordance with regulatory classification definitions.

 

(Dollars in thousands)  March 31, 2012   September 30, 2011 
Loans        
Special mention  $24,086   $16,458 
Substandard   49,767    62,694 
Total criticized loans   73,853    79,152 
           
Securities          
Substandard   14,546    13,563 
Doubtful   2,718    3,002 
Total classified securities   17,264    16,565 
  Total criticized assets  $91,117   $95,717 

 

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At March 31, 2012, substandard loans, other than nonperforming loans, were comprised primarily of the following:

 

-Two additional loans on the apartment complex in central Virginia discussed above under nonaccrual multi-family loans totaling $5.4 million. Based upon current occupancy, the apartment complex does not generate enough cash to service the debt and requires support from the guarantor. The apartment complex is valued at $14.1 million based upon a February 2012 appraisal.
   
-One loan on a 64-unit apartment complex in central Virginia with a balance of $1.3 million at March 31, 2012. The apartment complex does not generate enough cash to service the debt and requires support from the guarantor. This loan was identified as impaired at March 31, 2012 and had a specific allowance of $200,000 based on a May 2011 appraisal of the apartment complex indicating a value of $1.2 million.
   
-Two loans maturing in May 2012 secured by several hundred acres of undeveloped land in central Virginia. The loans had a combined balance of $3.0 million at March 31, 2012, and both loans were current. The borrower on one of the loans, with a balance of $2.5 million, declared bankruptcy in December 2009. An appraisal dated January 2007 valued the collateral at $9.9 million. A new appraisal has been ordered in connection with the maturing of the loans.
   
-One loan secured by several hundred acres of partially-developed residential land in central Virginia. The property is zoned for 110 potential lots. The “as-is” value of the collateral based on an April 2008 appraisal is $8.2 million, and the Company’s loan balance at March 31, 2012 was $4.0 million. The loan was current at March 31, 2012 and, to date, has received support from the guarantors as needed.

 

Liquidity and Capital Resources

 

Liquidity

 

Liquidity is the ability to meet current and future financial obligations of a short-term and long-term nature. Our primary sources of funds consist of deposit inflows, loan repayments, maturities and sales of securities and borrowings from the FHLB. While maturities and scheduled amortization of loans and securities are predictable sources of funds, deposit flows, calls of investment securities and borrowed funds, and prepayments on loans and mortgage-backed securities and collateralized mortgage obligations are greatly influenced by general interest rates, economic conditions and competition.

 

Our most liquid assets are cash and cash equivalents and securities classified as available-for-sale. The levels of these assets depend on our operating, financing, lending and investing activities during any given period. At March 31, 2012, cash and cash equivalents totaled $136.0 million. In addition, at March 31, 2012, we had the ability to borrow a total of approximately $178.3 million in additional funds from the FHLB. Additionally, we established a borrowing arrangement with the Federal Reserve Bank of Richmond, although no borrowings have occurred and no assets have been pledged to date. We intend to use corporate bonds as collateral for this arrangement and had unpledged corporate bonds with an estimated fair value of $125.2 million at March 31, 2012.

 

At March 31, 2012, we had $98.9 million in loan commitments outstanding, which included $62.9 million in undisbursed loans. Certificates of deposit due within one year of March 31, 2012 totaled $220.7 million. The large percentage of certificates of deposit that mature within one year reflects customers’ hesitancy to invest their funds for long periods. If these maturing deposits are not renewed, we will be required to seek other sources of funds, including other certificates of deposit and borrowings. Depending on market conditions, we may be required to pay higher rates on such deposits or other borrowings than we currently pay on the certificates of deposit. Management believes, however, based on past experience that a significant portion of our certificates of deposit will be renewed. We have the ability to attract and retain deposits by adjusting the interest rates offered.

 

In addition, we believe that our branch network, which is presently comprised of eight full-service retail banking offices located throughout our primary market area, and the general cash flows from our existing lending and investment activities, will afford us sufficient long-term liquidity.

42
 

 

Regulatory Capital

 

The Bank is subject to various regulatory capital requirements administered by the Office of the Comptroller of the Currency (“OCC”). Failure to meet minimum capital requirements can initiate certain mandatory and possible discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company's consolidated financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. In addition, the Bank is required to notify the OCC before paying dividends to Franklin Financial.

 

The regulations require that savings institutions meet three capital requirements: a core capital requirement, a tangible capital requirement, and a risk-based capital requirement. The Tier 1 capital regulations require a savings institution to maintain Tier 1 capital of not less than 4% of adjusted total assets. The tangible capital regulations require savings institutions to maintain tangible capital of not less than 1.5% of adjusted total assets. The risk-based capital regulations require savings institutions to maintain capital of not less than 8% of risk-weighted assets.

 

At March 31, 2012, the Bank had regulatory capital in excess of that required under each requirement and was classified as a “well capitalized” institution as determined by the OCC. There are no conditions or events that management believes have changed the Bank’s classification. As a savings and loan holding company regulated by the Federal Reserve Board (“FRB”), Franklin Financial is not currently subject to any separate regulatory capital requirements. The Dodd-Frank Act, however, requires the FRB to promulgate consolidated capital requirements for depository institution holding companies that are no less stringent, both quantitatively and in terms of components of capital, than those applicable to institutions themselves. There is a five-year transition period before the capital requirements will apply to savings and loan holding companies. The following table reflects the level of required capital and actual capital of the Bank at March 31, 2012 and September 30, 2011:

 

   Actual   Amount required to be "adequately capitalized"   Amount required to be "well capitalized" 
(Dollars in thousands)  Amount   Percentage   Amount   Percentage   Amount   Percentage 
March 31, 2012                        
Tier 1 capital  $170,500    16.73%  $40,766    4.00%  $51,343    5.00%
(to adjusted tangible assets)                              
                               
Tier 1 risk-based capital   170,500    24.95    27,330    4.00    40,995    6.00 
(to risk weighted assets)                              
                               
Tangible capital   170,500    16.73    15,287    1.50    15,287    1.50 
(to adjusted tangible assets)                              
                               
Risk-based capital   179,074    26.21    54,660    8.00    68,325    10.00 
(to risk weighted assets)                              

 

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   Actual   Amount required to be "adequately capitalized"   Amount required to be "well capitalized" 
(Dollars in thousands)  Amount   Percentage   Amount   Percentage   Amount   Percentage 
September 30, 2011                        
Tier 1 capital  $164,347    16.07%  $40,915    4.00%  $51,490    5.00%
(to adjusted tangible assets)                              
                               
Tier 1 risk-based capital   164, 347    23.81    27,605    4.00    41,408    6.00 
(to risk weighted assets)                              
                               
Tangible capital   164, 347    16.07    15,343    1.50    15,343    1.50 
(to adjusted tangible assets)                              
                               
Risk-based capital   173,006    25.07    55,211    8.00    69,013    10.00 
(to risk weighted assets)                              

 

There were no dividends declared by the Bank to Franklin Financial in the six months ended March 31, 2012.

 

The following is a reconciliation of the Bank’s GAAP capital to regulatory capital at March 31, 2012 and September 30, 2011 (dollars in thousands):

 

   March 31, 2012 
(Dollars in thousands)  Tier 1 capital   Tier 1 risk-based capital   Tangible capital   Risk-based capital 
GAAP capital  $175,656   $175,656   $175,656   $175,656 
Accumulated gains on certain available-                    
for-sale securities   (5,144)   (5,144)   (5,144)   (5,144)
Disallowed deferred tax assets   (2,572)   (2,572)   (2,572)   (2,572)
Pension plan   2,560    2,560    2,560    2,560 
General allowance for loan losses   -    -    -    8,574 
Regulatory capital – computed  $170,500   $170,500   $170,500   $179,074 

 

   September 30, 2011 
(Dollars in thousands)  Tier 1 capital   Tier 1 risk-based capital   Tangible capital   Risk-based capital 
GAAP capital  $168,711   $168,711   $168,711   $168,711 
Accumulated gains on certain available-                    
for-sale securities   (4,002)   (4,002)   (4,002)   (4,002)
Disallowed deferred tax assets   (2,922)   (2,922)   (2,922)   (2,922)
Pension plan   2,560    2,560    2,560    2,560 
General allowance for loan losses   -    -    -    8,659 
Regulatory capital – computed  $164,347   $164,347   $164,347   $173,006 

 

Off-Balance Sheet Arrangements

 

In the normal course of operations, we engage in a variety of financial transactions that, in accordance with generally accepted accounting principles, are not recorded in our financial statements. These transactions involve, to varying degrees, elements of credit, interest rate and liquidity risk. Such transactions are used primarily to manage customers’ requests for funding and take the form of loan commitments and lines of credit.

 

For the year ended September 30, 2011 and the six months ended March 31, 2012, we engaged in no off-balance sheet transactions reasonably likely to have a material effect on our consolidated financial condition, results of operations or cash flows.

44
 

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

 

Interest Rate Sensitivity Analysis

 

Management uses an interest rate sensitivity analysis to review our level of interest rate risk. This analysis measures interest rate risk by computing changes in the present value of our cash flows from assets, liabilities and off-balance sheet items in the event of a range of assumed changes in market interest rates. The present value of equity is equal to the market value of assets minus the market value of liabilities, with adjustments made for off-balance sheet items. This analysis assesses the risk of loss in market risk sensitive instruments in the event of a sudden and sustained 100 to 300 basis point increase or a 100 basis point decrease in market interest rates with no effect given to any future steps that management might take to counter the impact of that interest rate movement. The following table presents the change in the present value of Franklin Federal’s equity at March 31, 2012 that would occur in the event of an immediate change in interest rates based on management assumptions. The table does not include the effect of approximately $69.0 million of investable assets held by Franklin Financial Corporation at March 31, 2012.

 

    Present Value of Equity 
Change in   Market         
Basis Points   Value   $ Change   % Change 
    (Dollars in thousands) 
 300   $151,389   $(27,660)   (15.4)%
 200    161,090    (17,959)   (10.0)
 100    168,964    (10,085)   (5.6)
 0    179,049    -    - 
 -100    176,027    (3,022)   (1.7)

 

Using the same assumptions as above, the sensitivity of our projected net interest income for the twelve months ending March 31, 2013 is as follows:

 

    Projected Net Interest Income 
Change in   Net Interest         
Basis Points   Income   $ Change   % Change 
    (Dollars in thousands) 
 300   $23,384   $(2,775)   (10.6)%
 200    24,524    (1,635)   (6.3)
 100    25,518    (641)   (2.5)
 0    26,159    -    - 
 -100    24,320    (1,839)   (7.0)

 

Assumptions made by management relate to interest rates, loan prepayment rates, deposit decay rates, and the market values of certain assets under differing interest rate scenarios, among others. As with any method of measuring interest rate risk, certain shortcomings are inherent in the method of analysis presented in the foregoing table. For example, although certain assets and liabilities may have similar maturities or periods to repricing, they may react in different degrees to changes in market interest rates. Also, the interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market rates. Additionally, certain assets have features, such as rate caps or floors, that restrict changes in interest rates on a short-term basis and over the life of the asset. Further, in the event of a change in interest rates, expected rates of prepayments on loans and early withdrawals from certificates could deviate significantly from those assumed in calculating the table.

 

Item 4. Controls and Procedures

 

The Company’s management has carried out an evaluation, under the supervision and with the participation of the Company’s principal executive officer and principal financial officer, of the effectiveness of the Company’s “disclosure controls and procedures,” as such term is defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Based on this evaluation, the Company’s principal executive officer and principal financial officer concluded that, as of the end of the period covered by this report, the Company’s disclosure controls and procedures were effective for the purpose of ensuring that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act (1) is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms, and (2) is accumulated and communicated to the Company’s management, including its principal executive and principal financial officers, as appropriate, to allow timely decisions regarding required disclosure.

45
 

 

In addition, based on that evaluation, there has been no change in the Company’s internal control over financial reporting that occurred during the Company’s last fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

PART II. OTHER INFORMATION

 

Item 1. Legal Proceedings

 

We are not involved in any pending legal proceedings other than routine legal proceedings occurring in the ordinary course of business. Our management believes that such routine legal proceedings, in the aggregate, are immaterial to our consolidated financial condition and results of operations.

 

Item 1A. Risk Factors

 

For information regarding the Company’s risk factors, see “Risk Factors” in the Company’s Annual Report filed on Form 10-K for the year ended September 30, 2011. As of March 31, 2012, the risk factors of the Company have not changed materially from those disclosed in the Form 10-K.

 

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

 

Not applicable.

 

Item 3. Defaults Upon Senior Securities

 

Not applicable.

 

Item 4. Mine Safety Disclosures

 

Not applicable.

 

Item 5. Other Information

 

Not applicable.

 

Item 6. Exhibits

 

  3.1 Articles of Incorporation of Franklin Financial Corporation (1)
  3.2 Bylaws of Franklin Financial Corporation (2)
  4.0 Form of Common Stock Certificate of Franklin Financial Corporation (3)
  31.1 Rule 13a-14(a) Certification of Chief Executive Officer
  31.2 Rule 13a-14(a) Certification of Chief Financial Officer
  32 Section 1350 Certifications
  101 The following materials from the Franklin Financial Corporation Quarterly Report on Form 10-Q for the quarter ended March 31, 2012 are formatted in Extensible Business Reporting Language (XBRL): (i) the Consolidated Balance Sheets; (ii) the Consolidated Income Statements;  (iii) the Consolidated Statements of Cash Flows; (iv) the Consolidated Statements of Comprehensive Income and Changes in Stockholders’ Equity; and (v) related notes.

_______________

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  (1)   Incorporated herein by reference to Exhibit 3.1 of pre-effective amendment No. 1 to the Company’s Registration Statement on Form S-1 (File No. 333-171108), filed with the Securities and Exchange Commission on January 28, 2011.
  (2)   Incorporated herein by reference to Exhibit 3.2 of pre-effective amendment No. 1 to the Company’s Registration Statement on Form S-1 (File No. 333-171108), filed with the Securities and Exchange Commission on January 28, 2011.
  (3)   Incorporated herein by reference to Exhibit 4.0 to the Company’s Registration Statement on Form S-1 (File No. 333-171108), as amended, initially filed with the Securities and Exchange Commission on December 10, 2010.

 

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SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

 

  FRANKLIN FINANCIAL CORPORATION
                                 Registrant
     
     
May 8, 2012 By: /s/ Richard T. Wheeler, Jr.
    Richard T. Wheeler, Jr.
    Chairman, President and Chief Executive Officer
     (Principal Executive Officer)
     
     
     
May 8, 2012 By: /s/ Donald F. Marker
    Donald F. Marker
    Vice President, Chief Financial Officer and Secretary/Treasurer
     (Principal Financial and Accounting Officer)