UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2018

COMMISSION FILE NUMBER: 0-22955

 

BAY BANKS OF VIRGINIA, INC.

(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

 

1801 BAYBERRY COURT, SUITE 101

RICHMOND, VIRGINIA 23226

(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)

(804) 325-3775

(REGISTRANT’S TELEPHONE NUMBER, INCLUDING AREA CODE)

N/A

(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    ☐  no

Indicate by check mark whether the registrant has submitted electronically, every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).    ☒  yes    ☐  no

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definition of “large accelerated filer,” “accelerated filer”, “smaller reporting company”, and “emerging growth company” in Rule 12b-2 of the Exchange Act.

 

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.  ☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    ☐  yes    ☒  no

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: 13,248,716 shares of common stock on November 2, 2018.

 

 

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FORM 10-Q

For the interim period ending September 30, 2018

INDEX

 

 

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PART I – FINANCIAL INFORMATION

BAY BANKS OF VIRGINIA, INC.

CONSOLIDATED BALANCE SHEETS

 

 

See Notes to Consolidated Financial Statements.

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BAY BANKS OF VIRGINIA, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)

 

 

See Notes to Consolidated Financial Statements.

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BAY BANKS OF VIRGINIA, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(unaudited)

 

 

See Notes to Consolidated Financial Statements.

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BAY BANKS OF VIRGINIA, INC.

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

(unaudited)

 

 

See Notes to Consolidated Financial Statements.

 

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BAY BANKS OF VIRGINIA, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

 

 

See Notes to Consolidated Financial Statements.

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Notes to Consolidated Financial Statements (Unaudited)

Note 1: Basis of Presentation

Bay Banks of Virginia, Inc. (the “Company”) is the holding company for Virginia Commonwealth Bank, formerly known as Bank of Lancaster (the “Bank” or “VCB”), for VCB Financial Group, Inc., formerly known as Bay Trust Company (“VCBFG”), and for Steptoes Holdings, LLC (“Steptoes Holdings”). The consolidated financial statements of the Company include the accounts of Bay Banks of Virginia, Inc., the Bank, VCBFG, and Steptoes Holdings.

On April 1, 2017, the Company completed the merger with Virginia BanCorp Inc., which is further discussed in Note 3, and as such, the consolidated financial statements presented herein reflect the combined operations of the business combination since the effective time of the merger.

In August 2017, the Company completed a private placement of 3,783,784 shares of common stock at an offering price of $9.25 per share to certain existing shareholders, institutional investors, and other accredited investors. Proceeds from the offering, net of offering expenses, were $32.9 million.

The accounting and reporting policies of the Company conform to accounting principles generally accepted in the United States of America (“GAAP”) and to the general practices within the banking industry. In management’s opinion, all adjustments, consisting only of normal recurring adjustments necessary for a fair presentation of the consolidated financial statements, have been included. The results of operations for the interim periods are not necessarily indicative of the results to be expected for the full year or for any other interim periods. These consolidated financial statements should be read in conjunction with the consolidated financial statements and notes to the consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017.

Certain amounts presented in the consolidated financial statements of prior periods have been reclassified to conform to current year presentations. The reclassifications had no effect on net income, net income per share, or shareholders’ equity as previously reported. All dollar amounts included in the tables in these notes are in thousands, except per share data, unless otherwise stated.

Note 2: Amendments to the Accounting Standards Codification

In March 2017, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2017-09, Compensation – Stock Compensation (Accounting Standards Codification (“ASC”) 718). The amendments in this ASU provide guidance about which changes to the terms or conditions of a share-based payment award require an entity to account for modifications in Topic 718. An entity should account for the effects of a modification unless all the following are met: (1) The fair value (or calculated value or intrinsic value, if such an alternative measurement method is used) of the modified award is the same as the fair value (or calculated value or intrinsic value, if such an alternative measurement method is used) of the original award immediately before the original award is modified. If the modification does not affect any of the inputs to the valuation technique that the entity uses to value the award, the entity is not required to estimate the value immediately before and after the modification; (2) The vesting conditions of the modified award are the same as the vesting conditions of the original award immediately before the original award is modified; and (3) The classification of the modified award as an equity instrument or a liability instrument is the same as the classification of the original award immediately before the original award is modified. The current disclosure requirements in ASC 718 apply regardless of whether an entity is required to apply modification accounting under the amendments in this ASU. This ASC was effective for annual periods and interim periods beginning after December 15, 2017. Early adoption is permitted. The Company adopted this ASC in the first quarter of 2018. The adoption did not have a material effect on the Company’s financial statements.

In March 2017, the FASB issued ASU 2017-08, Receivables - Nonrefundable Fees and Other Costs (ASC 310-20), Premium Amortization on Purchased Callable Debt Securities. The amendments in this ASU shorten the amortization period for certain callable debt securities purchased at a premium. Upon adoption of the standard, premiums on these qualifying callable debt securities will be amortized to the earliest call date. Discounts on purchased debt securities will continue to be accreted to maturity. The amendments are effective for fiscal years beginning after December 15, 2018 and interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period. Upon transition, entities should apply the guidance on a modified retrospective basis, with a cumulative-effect adjustment to retained earnings as of the beginning of the period of adoption and provide the disclosures required for a change in accounting principle. The Company early adopted this ASU, and the adoption did not have a material effect on its consolidated financial statements.

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In March 2017, the FASB issued ASU 2017-07, Compensation – Retirement Benefits (ASC 715): Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost. This ASU intends to improve the presentation of net periodic pension cost and net periodic postretirement benefit costs in the income statement and to narrow the amounts eligible for capitalization in assets. This ASU is effective for fiscal years beginning after December 15, 2017. The Company adopted this ASU in the first quarter of 2018. The adoption did not have a material effect on the Company’s financial statements.

In January 2017, the FASB issued ASU 2017-04, Intangibles—Goodwill and Other (ASC 350): Simplifying the Test for Goodwill Impairment. This ASU simplifies accounting for goodwill impairments by eliminating step two (the implied fair value to carrying value of goodwill) from the existing goodwill impairment test. A goodwill impairment will now be the amount by which a reporting unit’s carrying value exceeds its fair value. The effective date and transition requirements for the technical corrections will be effective for the Company for reporting periods beginning after December 15, 2019. Early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. The Company early adopted this ASU, and the adoption did not have a material effect on the Company’s financial statements.

In June 2016, the FASB issued ASU 2016-13, Financial Instruments – Credit Losses (ASC 326), which is new guidance for the accounting for credit losses on instruments within its scope. It introduces a new model for current expected credit losses (“CECL”), which will apply to financial assets subject to credit losses and measured at amortized cost and certain off-balance sheet credit exposures. This will include loans, held-to-maturity debt securities, loan commitments, financial guarantees, net investments in leases, reinsurance, and trade receivables. The CECL model requires an entity to estimate the credit losses expected over the life of an exposure (or pool of exposures). The estimate of expected credit losses should consider historical information, current information, and reasonable and supportable forecasts, including estimates of prepayments. In addition, this ASC will replace the current available-for-sale debt securities other-than-temporary impairment model with an estimate of expected credit losses only when the fair value falls below the amortized cost of the asset. Credit losses on available-for-sale debt securities will be limited to the difference between the security’s amortized cost basis and its fair value. The available-for-sale debt security model will also require the use of an allowance to record estimated credit losses and subsequent recoveries. The ASU also addresses purchased financial assets with credit deterioration. Disclosure requirements are expanded regarding an entity’s assumptions, models, and methods for estimating the allowance for loan losses. This ASU is effective for interim and annual reporting periods beginning after December 15, 2019. The Company has formed an implementation group, which is evaluating the effect that this ASU will have on its consolidated financial statements. During the third quarter of 2018, the work group reviewed various CECL software tools and vendors, and subsequent to the end of the quarter, the Company selected a third party vendor and model to support the requirements of the standard and to assist in implementation.

In February 2016, the FASB issued ASU 2016-02, Leases (ASC 842). This ASC increases transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and requiring more disclosures related to leasing transactions. This ASC is effective for the fiscal years beginning after December 15, 2018, with early adoption permitted. The Company has several lease agreements, such as for office space, which are currently considered operating leases and not recognized on its balance sheet. The Company expects the new guidance to require these lease agreements to be recognized on its balance sheet as a right-to-use asset with a corresponding liability. The Company is currently taking inventory of its lease agreements and accumulating the data needed to implement the new standard. However, the Company does not expect the new standard to have a material effect on its financial statements.

In January 2016, the FASB issued ASU 2016-01, Financial Instruments – Overall (ASC 825-10), which requires equity investments, other than those accounted for using the equity method, to be measured at fair value through earnings. There will no longer be an available-for-sale classification measured (changes in fair value reported in other comprehensive income) for equity securities with readily determinable fair values. The cost method is also eliminated for equity instruments without a readily determinable fair value. For these investments, companies can elect to record the investment at cost, less impairment, plus or minus subsequent adjustments for observable price changes. This election only applies to equity investments that do not qualify for the net asset value practical expedient. Public companies will be required to use the exit price when measuring the fair value of financial instruments measured at amortized cost for disclosure purposes. In addition, this ASC requires financial assets and financial liabilities to be presented separately in the notes to the financial statements, grouped by measurement category and form of financial asset. The classification and measurement guidance is effective for periods beginning after December 15, 2017. The Company’s primary available-for sale investments are debt securities and are therefore not included in the scope of this ASU. However, the Company is subject to certain disclosure requirements of the standard and engaged a third party to assist with the measurement of exit prices of its financial instruments, including its loans receivables, deposits, and borrowings and adopted this standard in the first quarter of 2018. The adoption of this ASC did not have a material effect on the Company’s financial statements, other than the fair value disclosures in Note 11.

In May 2014, the FASB issued ASC 2014-09, Revenue from Contracts with Customers (ASC 606). The amendments in this ASU modify the guidance companies use to recognize revenue from contracts with customers for transfers of goods or services and transfers of nonfinancial assets, unless those contracts are within the scope of other standards. The ASC requires that entities apply a specific method to recognize revenue reflecting the consideration expected from customers in exchange for the transfer of goods and

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services. The guidance also requires new qualitative and quantitative disclosures, including information about contract balances and performance obligations. Entities are also required to disclose significant judgments and changes in judgments for determining the satisfaction of performance obligations. Subsequent to the issuance of this ASC, the FASB issued targeted updates to clarify specific implementation issues including ASU 2016-08, Principal versus Agent Considerations (Reporting Revenue Gross versus Net), ASU 2016-10, Identifying Performance Obligations and Licensing, ASU 2016-12, Narrow-Scope Improvements and Practical Expedients, and ASU 2016-20, Technical Corrections and Improvements to Topic 606, Revenue from Contracts with Customers. For financial reporting purposes, the standard allows for either full retrospective adoption, meaning the standard is applied to all of the periods presented, or modified retrospective adoptions, meaning the standard is applied only to the most current period presented in the financial statements with the cumulative effect on initially applying the standard being recognized at the date of initial application. The effective date for this ASC was for annual reporting periods beginning after December 15, 2017. The Company’s primary source of revenue is interest income from loans and investments and loan fees. As these items are outside the scope of the standard, this income was not affected by this ASC. The Company reviewed other sources of income including fiduciary fees, secondary market lending fees, and other deposit account fees against the requirements of the standard and concluded no changes in the accounting methods were necessary. These sources of revenue are recognized in income when the Company’s performance obligation is completed, which generally is when the transaction occurs for transaction related fees or when the asset is transferred on the sale of loans. The Company also completed its evaluation of certain costs related to these revenue streams to determine whether such costs should be presented as expenses or contra-revenue (i.e., gross versus net). Based on its evaluation, the Company determined that the classification of certain debit and credit card related costs should change (i.e., costs should be presented net of related revenues). This classification was made to both revenue and expense for the quarters and year to date periods ended September 30, 2018 and 2017, reported as interchange fees, net on the consolidated statements of operations.

Note 3: Business Combination

On April 1, 2017, the Company and Virginia BanCorp Inc. (“Virginia BanCorp”), a bank holding company conducting substantially all of its operations through its subsidiary, Virginia Commonwealth Bank, completed a merger pursuant to the Agreement and Plan of Merger, dated as of November 2, 2016, by and between the Company and Virginia BanCorp (the “Merger”). The Company is the surviving corporation in the Merger, and the former shareholders of Virginia BanCorp received 1.178 shares of the Company’s common stock for each share of Virginia BanCorp common stock they owned immediately prior to the merger, for a total issuance of 4,586,221 shares of the Company’s common stock valued at approximately $42.2 million at the time of closing. As of the completion of the Merger, the Company’s legacy shareholders owned approximately 51% of the outstanding common stock of the Company, and Virginia BanCorp’s former shareholders owned approximately 49% of the outstanding common stock of the Company. After the Merger of Virginia BanCorp with and into the Company, Virginia BanCorp’s subsidiary bank was merged with and into Bank of Lancaster, a wholly owned subsidiary of the Company, and immediately thereafter Bank of Lancaster changed its name to Virginia Commonwealth Bank.

The Merger was accounted for using the acquisition method of accounting in accordance with ASC 805, Business Combinations. Under this method, the assets and liabilities of Virginia BanCorp were recorded at their respective fair values as of April 1, 2017. Determining the fair value of assets and liabilities, particularly for the loan portfolio, is a complex process involving significant judgment regarding methods and assumptions used to calculate the estimated fair values. As a result, the Company recognized goodwill of $7.6 million in connection with the Merger, none of which is deductible for income tax purposes.

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The following table details the total consideration paid by the Company, in connection with the acquisition of Virginia BanCorp, the fair value of the assets acquired and liabilities assumed, and the resulting goodwill.

 

 

Pro Forma Financial Information

The table below illustrates the unaudited pro forma revenue and net income of the combined entities had the acquisition taken place on January 1, 2017. The unaudited combined pro forma revenue and net income combines the historical results of Virginia BanCorp with the Company’s consolidated statements of operations for the period noted, and while certain adjustments were made for the estimated effect of certain fair value adjustments and other acquisition-related activity, they are not indicative of what would have occurred had the acquisition actually taken place on January 1, 2017. Merger-related expenses of $1.1 million were included in the Company’s actual consolidated statements of operations for the nine months ended September 30, 2017, but were excluded from the unaudited pro forma information below. Operational cost savings and other efficiencies expected to be achieved by the Company due to the Merger are also not reflected in the unaudited pro forma amounts.

 

 

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Impact of Certain Acquisition Accounting Adjustments

The net effect of the amortization and accretion of premiums and discounts associated with the Company’s acquisition accounting adjustments to assets acquired and liabilities assumed from Virginia BanCorp had the following effect on the consolidated statements of operations for the periods presented.

 

 

Note 4: Securities

The aggregate amortized costs and fair values of available-for-sale securities as of the dates stated were as follows.

 

 

Securities with fair values of $18.3 million and $19.4 million were pledged as collateral for securities sold under repurchase agreements as of September 30, 2018 and December 31, 2017, respectively. As of September 30, 2018 and December 31, 2017, all the securities pledged for repurchase agreements were state and municipal obligations. All the repurchase agreements had remaining contractual maturities that were overnight and continuous. Securities sold under repurchase agreements were $6.1 million and $9.5 million as of September 30, 2018 and December 31, 2017, respectively, and are included in liabilities on the consolidated balance sheets. The securities pledged to each agreement are reviewed daily and can be changed at the option of the Bank with minimal risk of loss due to fair value changes.

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Securities in an unrealized loss position at September 30, 2018 and December 31, 2017, by period of the unrealized loss, are shown below. The unrealized loss positions were primarily related to interest rate movements and not the credit quality of the issuers. All agency securities and state and municipal securities are investment grade or better, and their losses are considered temporary. Management does not intend to sell nor expect to be required to sell these securities, and all amortized cost bases are expected to be recovered. Securities with unrealized loss positions at September 30, 2018 included 56 U.S. government agencies, 49 state and municipal obligations, and 2 corporate bonds. Securities with unrealized loss positions at December 31, 2017 included 36 U.S. government agencies, 34 state and municipal obligations, and one corporate bond.

The following tables provide additional information on these securities as of the dates stated.

 

 

 

The following table presents the amortized cost and fair value by contractual maturity of securities available for sale as of the dates stated. Expected maturities may differ from contractual maturities, as issuers may have the right to call or prepay obligations with or without call or prepayment penalties.

 

 

Restricted Securities

The Company’s investment in Federal Home Loan Bank of Atlanta (“FHLB”) stock totaled $4.3 million and $3.7 million at September 30, 2018 and December 31, 2017, respectively. The Company also had an investment in Federal Reserve Bank of Richmond (“FRB”) stock, which totaled $2.3 million at September 30, 2018 and $1.9 million at December 31, 2017. The investments in both FHLB and FRB stock are required investments related to the Bank’s membership in the FHLB and FRB. These securities do not have a readily determinable fair value as their ownership is restricted, and they lack an active market for trading. Additionally, per charter provisions related to the FHLB and FRB stock, all repurchase transactions of such stock must occur at par. Accordingly, these securities are carried at cost and are periodically evaluated for impairment.

Note 5: Loans

Loans are reported at their recorded investment, which is the outstanding principal balance net of any unearned income, such as deferred fees and costs, charge-offs, and acquisition accounting adjustments (discounts) on acquired loans. Interest on loans is recognized over the term of the loan and is calculated using the interest method on principal amounts outstanding. Loan origination fees and certain direct origination costs are deferred and recognized as an adjustment of the related loan yield over the contractual term of the loan, adjusted for early pay-offs, where applicable.

All interest accrued but not collected for loans that are placed on nonaccrual or charged off are reversed against interest income at the time the loan is classified as nonaccrual. Any subsequent interest received on these loans is recognized as interest income on the cash

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basis until the loan qualifies to return to accrual status. Generally, a loan is returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured, or it becomes well-secured and in the process of collection.

The following is a summary of the balances of loans as of the dates stated.

 

 

The recorded investment for past due and nonaccruing loans is shown in the following tables as of the dates stated. A loan past due 90 days or more is generally placed on nonaccrual unless it is both well secured and in the process of collection. Loans presented below as 90 days or more past due and still accruing include purchased credit-impaired (“PCI”) loans.

 

 

 

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The following tables include an aging analysis, based upon contractual terms, of the recorded investment of PCI loans as of the dates stated, included in the tables above.

 

 

 

Note 6: Allowance for Loan Losses

The allowance for loan losses (“ALL”) reflects management’s judgment of probable loan losses inherent in the loan portfolio at the balance sheet date. Management uses a disciplined process and methodology to establish the ALL each quarter. To determine the total ALL, the Company estimates the reserves needed for each homogenous segment and class of the loan portfolio, and for any loans analyzed individually for impairment. Depending on the nature of each segment and class, considerations include historical loss experience, adverse situations that may affect a borrower’s ability to repay, credit scores, past due history, estimated value of any underlying collateral, prevailing local and national economic conditions, and internal policies and procedures, including credit risk management and underwriting. This evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as conditions change.

The ALL consists of specific, general, and unallocated components. The specific component is determined by identifying impaired loans (as described below) then evaluating those meeting certain criteria to calculate the amount of impairment. Impaired loans measured for impairment generally include (1) any loan risk rated Special Mention or worse where the borrower has filed for bankruptcy; and (2) all loans risk rated Substandard or worse with balances of $400 thousand or more; and (3) all loans classified as a troubled debt restructuring (“TDR”). A specific allowance is held when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component of the ALL is the result of the collective evaluation of any loans not identified as impaired or evaluated as impaired and are grouped into segments and classes. Historical loss experience is calculated and applied to each segment or class, as well as adjustments for qualitative factors. Qualitative factors include changes in local and national economic indicators, such as unemployment rates, interest rates, gross domestic product growth, and real estate market trends; the level of past due and nonaccrual loans; risk ratings on individual loans; strength of credit policies and procedures; loan officer experience; borrower credit scores; and other intrinsic risks related to the types and geographic locations of loans. These qualitative adjustments reflect management’s judgment of risks inherent in the segments. An unallocated component is maintained, if needed, to cover uncertainties that could affect management’s estimate of probable losses. Changes in the allowance for loan losses and the related provision expense can materially affect net income.

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Loans Evaluated for Impairment

The following table shows loans evaluated for impairment individually and collectively by segment as of the dates stated.

 

 

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The following tables show an analysis of the change in the ALL by segment for the periods presented.

 

 

Purchased Credit-Impaired Loans

The following table presents the changes in the accretable yield for PCI loans for the period presented.

 

Internal Risk Rating Grades

All loans in the Company’s loan portfolio, with the exception of purchased consumer loans, are risk rated using loan risk grading software that employs a variety of algorithms based on detailed account characteristics to include borrower’s payment history on a total relationship basis as well as loan to value exposure. For non-homogenous loans, management reviews these resulting grade

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assignments and makes adjustments to the final grade where appropriate based on an assessment of additional external information that may affect a particular loan. For purchased consumer loans, a loan is rated “substandard” when it is 90 days or more past due; otherwise, the loan is graded “pass”.

  Risk rating categories are as follows:

Pass – Borrower is strong or sound and collateral securing the loan, if any, is adequate.

Watch – Borrower exhibits some signs of financial stress but is generally believed to be a satisfactory customer and collateral, if any, may be in excess of 90% of the loan balance.

Special Mention – Adverse trends in the borrower’s financial position are evident and warrant management’s close attention. Any collateral may not be fully adequate to secure the loan balance.

Substandard – A loan in this category has a well-defined weakness in the primary repayment source that jeopardizes the timely collection of the debt. There is a distinct possibility that a loss may result if the weakness is not corrected.

Doubtful – Default has already occurred and it is likely that foreclosure or repossession procedures have begun or will begin in the near future. Weaknesses make collection or liquidation in full, based on currently existing information, highly questionable and improbable.

Loss – Uncollectible and of such little value that continuance as a bankable asset is not warranted.

The following tables show the risk rating of loans as of the dates stated.

 

 

 

Impaired Loans

The following table shows the Company’s recorded investment and the borrowers’ unpaid principal balances for impaired loans, excluding PCI loans, with the associated ALL amount, if applicable, as of the dates stated.

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The following table shows the average recorded investment and interest income recognized for impaired loans, excluding PCI loans, for the periods presented.

 

 

The following table presents a reconciliation of nonaccrual loans to impaired loans as of the dates stated.

 

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Troubled Debt Restructuring

For economic or legal reasons related to a borrower’s financial condition, management may grant a concession to a borrower that it would not otherwise consider. In cases where borrowers are granted new terms that provide for a reduction of either interest or principal or an extension of the maturity date at a stated interest rate lower than the current market rate for new debt with similar risks, the related loan is classified as a troubled debt restructuring. Management strives to identify borrowers in financial difficulty early and may work with them to modify their loan to more affordable terms before their loan reaches nonaccrual status. These modified terms may include rate reductions, principal forgiveness, payment forbearance, and other actions intended to minimize the economic loss to the Company.

Loans modified as TDRs are considered impaired and are individually evaluated for impairment for the ALL. The following table presents, by segment, information related to loans modified as TDRs for the periods presented.

 

 

 

 

No loans designated as TDRs subsequently defaulted in the first nine months of 2018 or 2017.

The following table presents a roll forward of accruing and nonaccruing TDRs for the period presented.

 

 

Note 7: Other Real Estate Owned, net

The following table presents the carrying value of properties included in other real estate owned (“OREO”) as of the dates stated.

 

 

There were no residential loans in the process of foreclosure as of September 30, 2018.

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Note 8: Earnings per share

The following table shows the weighted average number of shares used in computing earnings per share and the effect on the weighted average number of shares of dilutive potential common stock. Basic earnings per share amounts are computed by dividing the net income (the numerator) by the weighted average number of common shares outstanding (the denominator). Diluted earnings per share amounts assume the conversion, exercise, or issuance of all potential common stock instruments, unless the effect is to reduce the loss or increase the earnings per common share. For both computations, the weighted average number of employee stock ownership plan (“ESOP”) shares not committed to be released to participant accounts purchased by the ESOP are not assumed to be outstanding. The weighted average ESOP shares excluded from the computation were 147,383 and 154,376 for the three and nine months ended September 30, 2018, respectively. The weighted average ESOP shares excluded from the computation were 136,376 and 104,510 for the three and nine months ended September 30, 2017, respectively. For the three months ended September 30, 2018 and 2017, options on 88,784 and 11,258 shares, respectively, were not included in computing diluted earnings per share because their effects would have been anti-dilutive. For the nine months ended September 30, 2018 and 2017, options on 88,784 and 21,258 shares, respectively, were not included in computing diluted earnings per share because their effects would have been anti-dilutive.

 

 

Note 9: Employee Benefit Plans

The Company has a non-contributory, cash balance pension plan for employees who were vested in the plan as of December 31, 2012, when it was frozen (i.e., curtailed). Each participant’s account balance grows based on monthly interest credits.

The Company also sponsored a post-retirement benefit plan covering retirees who were age 55 with 10 years of service or age 65 with five years of service prior to March 1, 2018, when the plan was curtailed. The Company recognized a gain on the curtailment of the post-retirement plan of $352 thousand at March 1, 2018, which is included in the consolidated statements of operations for the nine months ended September 30, 2018. The post-retirement benefit plan provides coverage toward a retiree’s eligible medical and life insurance benefits expenses. The plan is unfunded and funded as benefits are paid.

Note 10: Borrowings

FHLB Borrowings

As of September 30, 2018 and December 31, 2017, the Bank had $80.0 million and $70.0 million, respectively, of outstanding FHLB borrowings, consisting of three and two advances, respectively. Advances on the FHLB lines are secured by a blanket lien on qualified one-to-four family real estate, commercial real estate, and multifamily residential loans. Immediate available credit, as of September 30, 2018, was $150.1 million against a total line of credit of $245.1 million.

Further information regarding the three advances outstanding as of September 30, 2018 are shown in the following table.

 

 

Subordinated Notes

On May 28, 2015, the Company entered into a purchase agreement with 29 accredited investors under which the Company issued an aggregate of $7.0 million of subordinated notes (the “notes”) to the accredited investors. The notes have a maturity date of May 28,

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2025 and bear interest, payable on the first of March and September of each year, at a fixed interest rate of 6.50% per year. The notes are not convertible into common stock or preferred stock and are not callable by the holders. The Company has the right to redeem the notes, in whole or in part, without premium or penalty, at any interest payment date on or after May 28, 2020, but in all cases in a principal amount with integral multiples of $1,000, plus interest accrued and unpaid through the date of redemption. If an event of default occurs, such as the bankruptcy of the Company, the holder of a note may declare the principal amount of the notes to be due and immediately payable. The notes are unsecured, subordinated obligations of the Company and rank junior in right of payment to the Company’s existing and future senior indebtedness. The notes qualify as Tier 2 capital for regulatory reporting. The aggregate carrying value of the notes, including capitalized debt issuance costs, was $6.9 million at both September 30, 2018 and December 31, 2017. For the three and nine months ended September 30, 2018 and 2017, the effective interest rate on the notes was 6.85% and 6.87%, respectively.

ESOP Debt

The aggregate carrying value of debt secured by shares of Company stock, issued and outstanding, in the Company’s ESOP was $1.0 million at September 30, 2018 and $1.1 million at December 31, 2017 and was included in other liabilities on the consolidated balance sheets. The debt is comprised of five fixed rate-amortizing notes, four of which carry an interest rate of 3.25% and one that carries an interest rate of 4.50% with maturity dates ranging from March 1, 2019 to December 31, 2027. Shares that collateralize these loans are not allocated to ESOP participants’ accounts.

Note 11: Fair Value Measurements

The Company uses fair value to record certain assets and liabilities and to determine fair value disclosures. Authoritative accounting guidance clarifies that fair value of certain assets and liabilities is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value also assumes that the reporting entity would sell the asset or transfer the liability in the principal or most advantageous market.

Authoritative accounting guidance specifies a hierarchy of valuation techniques based on whether the inputs to those valuation techniques are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Company’s market assumptions. The three levels of the fair value hierarchy based on these two types of inputs are as follows:

 

 

The following describes the valuation techniques used by the Company to measure certain financial assets and liabilities recorded at fair value on a recurring basis in the financial statements:

Available-for-sale securities: Available-for-sale securities are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted market prices, when available (Level 1). If quoted market prices are not available, fair values are measured utilizing independent valuation techniques of identical or similar securities for which significant assumptions are derived primarily from or corroborated by observable market data. Third-party vendors compile prices from various sources and may determine the fair value of identical or similar securities by using pricing models that consider observable market data (Level 2). In certain cases, where there is limited activity or less transparency around inputs to the valuation, securities are classified within Level 3 of the valuation hierarchy. The Company engages a third party to determine the fair value of its available-for-sale securities.

Mortgage servicing rights (“MSR”): The Company currently owns MSRs from two loan portfolios, one serviced for Fannie Mae (“FNMA”) and one serviced for Freddie Mac (“FHLMC”). The MSRs for the portfolios serviced for FNMA and FHLMC are recorded at fair value on a recurring basis, with changes in fair value recorded in the results of operations.

A third-party model is used to determine fair value, which establishes pools of performing loans, calculates cash flows for each pool, and applies a discount rate to each pool. Loans are segregated into 12 pools based on each loan’s term and seasoning (age). All loans have fixed interest rates. Cash flows are then estimated by utilizing assumed service costs and prepayment speeds. Monthly service costs were assumed to be $6.50 per loan as of September 30, 2018 and as of December 31, 2017. Prepayment speeds are determined primarily based on the average interest rate of the loans in each pool. The prepayment scale used is the Public Securities Association (“PSA”) model, where “100% PSA” means prepayments are zero in the first month, then increase by 0.2% of the loan balance each month until reaching 6.0% in month 30. Thereafter, the 100% PSA model assumes an annual prepayment of 6.0% of the remaining

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loan balance. The average PSA speed assumption in the fair value model is 128% and 150% as of September 30, 2018 and December 31, 2017, respectively. A discount rate of 12.5% and 13.0% was then applied to each pool as of September 30, 2018 and as of December 31, 2017, respectively. The discount rate is intended to represent the estimated market yield for the highest quality grade of comparable servicing. MSRs are classified as Level 3.

The following table presents the balances of financial assets and liabilities measured at fair value on a recurring basis as of the dates stated.

 

 

 

The reconciliation of items using Level 3 inputs is as follows.

 

Certain assets are measured at fair value on a nonrecurring basis in accordance with GAAP. Adjustments to the fair value of these assets usually result from the application of lower-of-cost-or-market accounting or write-downs of individual assets.

The following describes the valuation techniques used by the Company to measure certain assets recorded at fair value on a nonrecurring basis in the financial statements:

Impaired Loans: Loans are designated as impaired when, in the judgment of management based on current information and events, it is probable that all amounts due will not be collected according to the contractual terms of the loan agreement. The measurement of loss associated with impaired loans can be based on either the discounted cash flows of the loan or the fair value of the collateral, if any, less estimated costs to sell. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. Any given loan may have multiple types of collateral; however, the vast majority of the Company’s collateral is real estate. The value of real estate collateral is generally determined utilizing a market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the Company using observable market data (Level 2). However, if the collateral value is significantly adjusted due to differences in the comparable properties, or is discounted by the Company because of lack of marketability, then the fair value is considered Level 3. The value of business equipment is based upon an outside appraisal if deemed significant, or the net book value on the applicable business’ financial statements if not considered significant. Likewise, values for inventory and accounts receivables collateral are based on financial statement balances or aging reports (Level 3). Fair value adjustments are recorded in the period incurred as provision for loan losses on the consolidated statements of operations.

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Other Real Estate Owned: OREO is measured at fair value less estimated costs to sell, based on an appraisal conducted by an independent, licensed appraiser. If the collateral value is significantly adjusted due to differences in the comparable properties, or is discounted by the Company because of lack of marketability, then the fair value is considered Level 3. Fair value adjustments, if any, are recorded in the period incurred and included in other noninterest expense on the consolidated statements of operations.

The following table summarizes the Company’s assets that were measured at fair value on a non-recurring basis as of the dates stated.

 

 

 

The following tables display quantitative information about Level 3 Fair Value Measurements as of the dates stated.

 

 

 

In the first quarter of 2018, the Company adopted ASU 2016-01, Financial Instruments – Overall (Subtopic 825-10), which requires public companies to use the exit price when measuring fair value of financial instruments measured at amortized cost. The Company engaged a third party to assist with the prospective measurement of the fair value of certain assets and liabilities measured on a nonrecurring basis. The fair values as of September 30, 2018 below were calculated using the exit prices, as promulgated by this standard, while the fair values as of December 31, 2017 were calculated using a discounted cash flows method or other methods; therefore, the tables below are not comparable.

 

The carrying values of cash and due from banks, interest-bearing deposits, certificates of deposit, federal funds sold or purchased, accrued interest receivable, loans held for sale, and noninterest-bearing and interest-bearing deposits are payable on demand or are of such short duration that carrying value approximates market value.

The carrying value of restricted securities approximates fair value based on the redemption provisions of the issuer.

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The fair value of performing loans is estimated by discounting the future cash flows using two sets of data sources. First, recent originations, occurring over the prior twelve months, were evaluated, and second, market data showing originations over the prior three months was evaluated. The selected rate was the greater of the two sources. For all loans other than a selective consumer loan portfolio, credit loss severity rates were calculated using the probability of default and the loss given default percentages derived from market data. For the consumer loan portfolio, historical delinquency data was obtained by the servicer of the portfolio. The fair value of impaired loans is measured as described within the Impaired Loans section of this note. The fair value of loans does consider the lack of liquidity and uncertainty in the market that might affect the valuation.

Time deposits are presented at estimated fair value by discounting the future cash flows using recent issuance rates over the prior three months and a market rate analysis of recent offering rates.

The fair value of the Company’s subordinated notes is estimated by utilizing recent issuance rates for subordinated debt offerings of similar issuer size.

The fair value of the FHLB advances is estimated by discounting the future cash flows using current interest rates offered for similar advances.

The fair value of commitments to extend credit is estimated using the fees currently charged to enter similar agreements, taking into account the remaining terms of the agreements and the present credit worthiness of the counter parties. For fixed rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair value of standby letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counter parties at the reporting date. At September 30, 2018 and December 31, 2017, the fair value of loan commitments and standby letters of credit was immaterial, and therefore not included in the table below.

 

The Company assumes interest rate risk (the risk that general interest rate levels will change) as a result of its normal operations. As a result, the fair value of the Company’s financial instruments will change when interest rate levels change and that change may be either favorable or unfavorable to the Company. Management attempts to match maturities of assets and liabilities to the extent believed necessary to minimize interest rate risk. However, borrowers with fixed rate obligations are less likely to prepay in a rising rate environment. Conversely, depositors who are receiving fixed rates are more likely to withdraw funds before maturity in a rising rate environment and less likely to do so in a falling rate environment. Management monitors rates and maturities of assets and liabilities and attempts to minimize interest rate risk by adjusting terms of new loans and deposits and by investing in securities with terms that mitigate the Company’s overall interest rate risk.

The following tables summarize the Company’s financial assets and liabilities at carrying values and estimated fair values on a nonrecurring basis as of the dates stated.

 

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Note 12: Changes in Accumulated Other Comprehensive Income (Loss)

The components of accumulated other comprehensive income (loss), net of taxes, are shown in the following tables for the periods presented.

 

 

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion is intended to assist in understanding the results of operations and the financial condition of Bay Banks of Virginia, Inc. (the “Company”). This discussion should be read in conjunction with the consolidated financial statements and the notes thereto included in Item 1 of this Form 10-Q and in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017 (the “2017 Form 10-K”).

STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

This report contains statements concerning the Company’s expectations, plans, objectives, future financial performance, and other statements that are not historical facts. These statements may constitute “forward-looking statements” as defined by federal securities laws. These statements may address issues that involve estimates and assumptions made by management, risks and uncertainties, and actual results could differ materially from historical results or those anticipated by such statements. These forward-looking statements include statements about the Company’s plans, obligations, expectations and intentions, and other statements that are not historical facts. Words such as “anticipates,” “believes,” “intends,” “should,” “expects,” “will,” and variations of similar expressions are intended to identify forward-looking statements. Factors that could have a material adverse effect on the operations and future prospects of the Company include, but are not limited to: changes in interest rates, general economic conditions, the legislative/regulatory climate, monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury and the Board of Governors of the Federal Reserve System; the quality or composition of the loan or investment portfolios; demand for loan products; deposit flows; competition; expansion activities; demand for financial services in the Company’s market area; accounting principles, policies, and guidelines; changes in banking, tax, and other laws and regulations and interpretations or guidance thereunder; and other factors detailed in the Company’s publicly filed documents, including the factors described in Item 1A., “Risk Factors,” in the 2017 Form 10-K. These risks and uncertainties should be considered in evaluating the forward-looking statements contained herein, and readers are cautioned not to place undue reliance on such statements, which speak only as of the date they are made.

EXECUTIVE SUMMARY

MERGER WITH VIRGINIA BANCORP

On April 1, 2017, the Company and Virginia BanCorp, Inc. (“Virginia BanCorp”) completed a merger pursuant to the Agreement and Plan of Merger, dated as of November 2, 2016, by and between the Company and Virginia BanCorp (the “Merger”). Pursuant to the Merger, the Company acquired approximately $329.1 million in assets, including $266.1 million of loans, and assumed approximately $294.5 million in liabilities as of April 1, 2017. Merger related costs incurred by the Company were $363 thousand and $1.1 million for the first nine months of 2018 and 2017, respectively.

The financial information for the periods ended September 30, 2017 and September 30, 2018 presented herein reflects the combined operations of the business combination since the effective time of the Merger, April 1, 2017.

All dollar amounts included in the tables of this discussion are in thousands, except per share data, unless otherwise stated.

GENERAL

The principal source of earnings for the Company is net interest income. Net interest income is the amount by which interest income exceeds interest expense. Net interest margin is net interest income expressed as a percentage of average interest-earning assets. Changes in the volume and/or mix of interest-earning assets and interest-bearing liabilities, the associated yields and rates, the level of noninterest-bearing deposits, and the volume of nonperforming assets have an effect on net interest income, net interest margin, and net income.

OVERVIEW OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

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RESULTS OF OPERATIONS

NET INTEREST INCOME AND NET INTEREST MARGIN

Loans acquired in the Merger were discounted to estimated fair value (for credit losses and interest rates) as of the effective date of the Merger. A portion of the acquisition accounting adjustments (discounts) to record the acquired loans at estimated fair value is being recognized (accreted) into interest income over the estimated remaining life of the loans for those loans that were deemed to be, as of the Merger date, purchased performing and over the period of expected cash flows from the loans that were deemed to be purchased credit-impaired (“PCI”). The amount of accretion income recognized within a period is based on many factors, including among other factors, loan prepayments and curtailments; therefore, amounts recognized are subject to volatility.

A time deposit (certificate of deposit) fair value adjustment was also recorded as of the Merger date, which represents a premium over the value of the contractual repayments of fixed-maturity deposits using prevailing market interest rates for similar term deposits. The resulting fair value adjustment is being amortized into interest expense on a level-yield basis over the weighted average remaining life of the acquired time deposit portfolio.

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The following table presents average interest-earning assets and interest-bearing liabilities, tax-equivalent yields on such assets and rates (costs) paid on such liabilities, net interest margin, and net interest spread, as of and for the periods stated. Yields and costs are annualized.

 

 

 

Interest income for the three months ended September 30, 2018, on a taxable-equivalent basis, was $10.9 million, an increase of $1.3 million from the third quarter of 2017, primarily driven by higher average interest-earning assets of $929.1 million in the 2018 period compared to $867.9 million in the 2017 period, an increase of $61.3 million. This increase in average interest-earning assets was primarily attributable to organic loan growth in the 2018 period and higher yields on loans and securities due to the increasing interest rate environment, partially offset by lower accretion of loan discounts in the 2018 period of $357 thousand compared to $409 thousand in the 2017 period.

Interest expense for the three months ended September 30, 2018 was $2.6 million, an increase of $905 thousand from the third quarter of 2017, primarily driven by higher average interest-bearing liabilities of $762.0 million in the 2018 period compared to

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$715.9 million in the 2017 period, an increase of $46.1 million. This increase in average interest-bearing liabilities was primarily attributable to organic retail deposit growth, particularly time and money market deposits. Contributing to the increase in interest expense in the third quarter of 2018 compared to the third quarter of 2017 were higher costs of deposits (1.19% and 0.83% for the third quarters of 2018 and 2017, respectively) due to heightened competition for deposits in the Company’s markets and promotional deposit products as the Company expands in the Hampton Roads market. In addition, higher rates were paid on Federal Home Loan Bank of Atlanta (“FHLB”) advances (2.48% and 1.53% for the third quarters of 2018 and 2017, respectively) due to the increasing interest rate environment.

Due to the changes in interest income and interest expense discussed above, net interest income for the three months ended September 30, 2018, on a taxable-equivalent basis, was $8.3 million, an increase of $441 thousand from the third quarter of 2017.

 

Net interest margin was 3.57% and 3.62% for the three months ended September 30, 2018 and 2017, respectively. This decrease is primarily attributable to the increase in funding costs, as noted above, and lower accretion of fair value adjustments (discounts) on acquired loans ($357 thousand and $409 thousand for 2018 and 2017, respectively) and the amortization of fair value adjustments (premium) on time deposits ($40 thousand and $103 thousand for 2018 and 2017, respectively). Excluding the acquisition accounting adjustments on loans and time deposits, net interest margin was 3.40% in the 2018 period compared to 3.39% in the 2017 period.

 

The following table presents average interest-earning assets and interest-bearing liabilities, tax-equivalent yields on such assets and rates (costs) paid on such liabilities, and net interest margin, as of and for the periods stated. Yields and costs are annualized.

 

 

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Interest income for the nine months ended September 30, 2018, on a taxable-equivalent basis, was $32.2 million, an increase of $8.8 million from the first nine months of 2017, primarily driven by higher average interest-earning assets of $916.2 million in the 2018 period compared to $692.4 million in the 2017 period, an increase of $223.8 million. This increase in average interest-earning assets was primarily attributable to organic loan growth and interest-earning assets acquired in the Merger included from the effective date of the Merger. Also contributing to the increase in interest income in the first nine months of 2018 compared to the first nine months of 2017 were higher yields on loans due to the increasing interest rate environment and higher accretion of discounts on acquired loans of $1.4 million in the 2018 period compared to $860 thousand in the 2017 period.

Interest expense for the nine months ended September 30, 2018 was $7.0 million, an increase of $2.9 million from the first nine months of 2017, primarily driven by higher average interest-bearing liabilities of $752.5 million in the 2018 period compared to $582.7 million in the 2017 period, an increase of $169.8 million. This increase in average interest-bearing liabilities was primarily attributable to organic deposit growth and liabilities assumed in the Merger included from the effective date of the Merger. Contributing to the increase in interest expense in the first nine months of 2018 compared to the first nine months of 2017 was higher rates paid on deposits (1.08% and 0.80% for the first nine months of 2018 and 2017, respectively) due to heightened competition for deposits, as mentioned above. In addition, higher rates were paid on FHLB advances (2.24% and 1.41% for the first nine months of 2018 and 2017, respectively) due to the increasing interest rate environment.

Due to the changes in interest income and interest expense discussed above, net interest income for the nine months ended September 30, 2018, on a taxable-equivalent basis, was $25.2 million, an increase of $5.9 million from the first nine months of 2017.

Net interest margin was 3.67% and 3.72% for the nine months ended September 30, 2018 and 2017, respectively. This decrease is primarily attributable to higher funding costs, partially offset by the effects of accretion of discounts on acquired loans and higher yields on loans. Excluding the acquisition accounting adjustments on loans and time deposits, net interest margin was 3.44% in the 2018 period compared to 3.51% in the 2017 period.

The following table presents the effect of acquisition accounting adjustments (accretion of loan discounts and amortization of time deposits) on net interest margin for the periods stated:

 

PROVISION FOR LOAN LOSSES

Provision for loan losses was $509 thousand for the three months ended September 30, 2018, while the provision for loan losses was $1.1 million in the same period of 2017. Provision for loan losses was $481 thousand for the nine months ended September 30, 2018, while provision for loan losses for the first nine months of 2017 was $1.8 million. Provision for loan losses in the third quarter of 2018 was primarily attributable to an increase of approximately $52.7 million of gross loans in the quarter, while the provision in the third quarter of 2017 includes reserves for a select portfolio of consumer loans. The provision for loan losses for the first nine months of 2018 included a benefit of $580 thousand to correct for an overstatement recorded in the Company’s year-end 2017 allowance for loan losses for acquired loans, as reported in the Company’s Form 10-Q for the second quarter of 2018.

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NONINTEREST INCOME

The following tables present a summary of noninterest income and the dollar and percentage change for the periods presented. Noninterest income for the nine months ended September 30, 2017 included the operations of Virginia BanCorp since the effective date of the Merger.  

 

Non-deposit product income increased $39 thousand in the third quarter of 2018 compared to the third quarter of 2017 due to higher commissions from the wealth management business of the Company’s wholly-owned subsidiary, VCB Financial Group, Inc. (“VCBFG”). This increase was offset by lower income from fiduciary activities from the trust and estate administration business of VCBFG of $66 thousand. Net gains on disposition of other assets was primarily attributable to the sale of a former branch building and land in the third quarter of 2018.

Noninterest income in the nine months ended September 30, 2018 included a gain of $352 thousand on the curtailment of the Company’s post-retirement benefit plan effective March 1, 2018. Non-deposit product income increased by $258 thousand in the 2018 period compared to the 2017 period due to higher wealth management commissions earned by VCBFG. Additionally, secondary market lending income increased $170 thousand in the 2018 period compared to the 2018 period due to higher sales volume of originated residential mortgages sold to governmental agencies and other third-party buyers.

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NONINTEREST EXPENSE

The following tables present a summary of noninterest expense and the dollar and percentage change for the periods presented. Noninterest expenses for the nine months ended September 30, 2017 included the operations of Virginia BanCorp from the effective date of the Merger.  

 

 

Noninterest expenses increased $812 thousand in the third quarter of 2018 compared to the third quarter of 2017, primarily due to higher salaries and benefits (greater number of full-time equivalents) and higher data processing expenses. There were no merger related expenses reported in the three months ended September 30, 2018. In the third quarter of 2018, the Company announced initiatives and other anticipated reductions to decrease noninterest expenses. The benefits of these items are reflected in data processing, consulting, and salaries and employee benefits expenses in the third quarter of 2018. The decrease in other expense is primarily due to a $172 thousand benefit recorded in the third quarter of 2018 to correct for an overstatement of other expense in 2017 related to contributions to employee stock ownership plans (ESOP).

Higher noninterest expenses in the first nine months of 2018 were primarily due to higher personnel costs (greater number of full-time equivalents) and higher consulting, audit and accounting, and legal fees, due to various regulatory and corporate activities in the 2018

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period. Expenses associated with the succession of the Company’s Chief Financial Officer and fees incurred in the first nine months of 2018 in the completion of the Company’s 2017 year-end reporting were approximately $1.2 million. Expenses associated with these items are primarily recorded in consulting, audit and accounting, and legal.

The table below presents the income tax expense and effective tax rate for the periods presented.

 

Lower effective tax rates in the 2018 periods reflected the Tax Cuts and Jobs Act of 2017 enacted in December 2017, which reduced the federal corporate marginal income tax rate from 34% to 21%, effective January 1, 2018.

ASSET QUALITY

Loans charged-off during the third quarter of 2018, net of recoveries, totaled $335 thousand compared to $396 thousand for the third quarter of 2017. This resulted in a slight decrease in the annualized net charge-off ratio to 0.17% for the third quarter of 2018 compared to 0.22% for the third quarter of 2017. For the nine months ended September 30, 2018, the annualized net charge off ratio was 0.12% compared to 0.18% for the nine months ended September 30, 2017.

The ratio of allowance for loan losses (“ALL”) to gross loans was 0.85% as of September 30, 2018 compared to 1.01% as of December 31, 2017. The decline in the ratio of ALL to gross loans is primarily due to the overstatement in the ALL at year-end 2017, as previously discussed, and the reduction in historical loss factors as older periods are released from the calculation. Gross loans is inclusive of loans acquired in the Merger, which were recorded at fair value as of the date of the Merger.

The following table presents certain asset quality measures as of the dates stated.

FINANCIAL CONDITION

Total assets increased by $56.9 million to $1.03 billion as of September 30, 2018 from $970.6 million as of December 31, 2017, primarily due to organic loan growth in the first nine months of 2018. Cash, including federal funds sold and interest-bearing deposits, was $22.7 million and $58.3 million as of September 30, 2018 and December 31, 2017, respectively.

The following tables present information about the Company’s securities portfolio on a taxable-equivalent basis as of the dates stated. The increase in fair value of $4.1 million since year-end 2017 in the available-for-sale securities portfolio was primarily attributable to approximately $9.7 million of purchases of available-for-sale securities, partially offset by principal amortization and an increase in unrealized losses of $1.9 million, primarily due to an increase in interest rates. As of September 30, 2018 and December 31, 2017, available-for-sale securities represented 7.9% of total assets.

 

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During the nine months ended September 30, 2018, gross loans increased by $87.8 million, or 11.5% (over 15% annualized), since December 31, 2017. Excluding the pay down of approximately $50 million in the first nine months of 2018 of purchased portfolio loans, including those acquired in the Merger, gross loan growth on an annualized basis was approximately 24%. The largest components of this increase were a $30.0 million increase in commercial and industrial loans, a $28.7 million increase in construction, land, and land development loans, a $27.6 million increase in commercial mortgages, and a $23.9 million increase in residential first mortgages, partially offset by a $14.6 million decline in consumer loans, primarily the decline in balances of certain portfolios of consumer loans acquired in the Merger and in the second and third quarters of 2017.

The following table presents the Company’s composition of loans in dollar amounts and as a percentage of total loans as of the dates stated.

Allowance for loan losses decreased by $483 thousand since December 31, 2017 to $7.3 million as of September 30, 2018, primarily due to charge-offs (net of recoveries) and the correction in the second quarter of 2018 of an amount recorded in the Company’s year-end 2017 allowance for loan losses, as previously noted.

The following table presents the Company’s allowance for loan losses by loan type and the percent of loans in each category to total loans as of the dates stated.

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Other real estate owned, net as of September 30, 2018 was $3.7 million, consisting of 25 individual properties (18 of which were land lots), compared to $4.3 million in OREO (29 properties) as of December 31, 2017, or a $621 thousand decline. This decline was primarily attributable to the sale of two properties ($2.3 million carrying amount) in the first quarter of 2018 resulting in a net gain of approximately $257 thousand.

As of September 30, 2018, total deposits were $809.1 million compared to $761.8 million at year-end 2017, a $47.3 million (or 8.3% annualized) increase. The increase was primarily due to an increase of $30.9 million in savings and interest-bearing demand deposits and a $10.8 million increase in time deposits.

Maturities of large denomination time deposits (equal to or greater than $100 thousand) as of September 30, 2018 are presented in the following table.

As of September 30, 2018, the Company had two fixed rate FHLB advances totaling $70.0 million and one variable rate FHLB advance of $10.0 million outstanding. As of December 31, 2017, the Company had one fixed rate FHLB advance of $60.0 million and one variable rate FHLB advance of $10.0 million outstanding. The following table summarizes the period-end balance, highest month balance, average balance, and weighted average rate paid as of and for the periods presented.

 

LIQUIDITY

Liquidity represents an institution’s ability to meet present and future financial obligations (such as commitments to fund loans or meet depositors’ requirements) through either the sale or maturity of existing assets or the acquisition of additional funds through liability management. Liquid assets include cash, interest-bearing deposits with other banks, federal funds sold, and investments and loans maturing within one year. The Company’s ability to obtain deposits and purchase funds at favorable rates are major factors for liquidity. Management believes that the Company maintains overall liquidity that is sufficient to satisfy its depositors’ requirements and its customers’ credit needs.

At September 30, 2018, cash and cash equivalents totaled $22.5 million, investment securities maturing in one year or less totaled $2.4 million and loans maturing in one year or less totaled $176.9 million. This resulted in a liquidity ratio as of September 30, 2018 of 19.6% compared to 14.7% as of December 31, 2017. The Company determines this ratio by dividing the sum of cash and cash equivalents, and investment securities and loans maturing in one year or less by total assets. The Bank has formal liquidity management plans, which includes periodic evaluation of cash flow projections.

The Company has a line of credit with the FHLB of $245.1 million, with $150.1 million available as of September 30, 2018 and federal funds lines of credit with correspondent banks totaling $24.5 million. Federal funds lines of credit can be cancelled at any time by the correspondent bank.

As of September 30, 2018, the Company was not aware of any other known trends, events, or uncertainties that have or are reasonably likely to have a material effect on liquidity.

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CAPITAL RESOURCES

Capital resources represent funds, earned or obtained, over which a financial institution can exercise greater long-term control in comparison with deposits and borrowed funds. The adequacy of the Company’s capital is reviewed by management on an ongoing basis with reference to size, composition, and quality of the Company’s resources, and consistency with regulatory requirements and industry standards. Management seeks to maintain a capital structure that will assure an adequate level of capital to support anticipated asset growth and to absorb potential losses, yet allows management to effectively leverage its capital to maximize return to shareholders. The Company’s capital, also known as shareholders’ equity, is comprised primarily of outstanding common stock and retained earnings.

Capital resources are primarily affected by net income and net unrealized gains or losses on available-for-sale securities (net of tax). The available-for-sale securities portfolio is reported at fair value with unrealized gains or losses, net of taxes, recognized as accumulated other comprehensive income (loss) on the Company’s consolidated balance sheets. Another factor affecting accumulated other comprehensive income (loss) is changes in the fair value of the Company’s pension and post-retirement benefit plans and changes in said plan obligations. Shareholders’ equity before accumulated other comprehensive loss was $119.2 million as of September 30, 2018 compared to $115.7 million as of December 31, 2017. The increase of $3.5 million was primarily attributable to net income of $3.1 million for the nine months ended September 30, 2018. Accumulated other comprehensive loss increased by $1.5 million from December 31, 2017 to September 30, 2018, primarily due to an increase in unrealized net losses (net of tax) in the available-for-sale securities portfolio, primarily due to an increasing interest rate environment.

Book value per share of the Company’s common stock, including accumulated other comprehensive loss, increased to $8.80 as of September 30, 2018 from $8.68 as of December 31, 2017.

The Bank is subject to minimum regulatory capital ratios as defined by the Board of Governors of the Federal Reserve System (the “Federal Reserve”). As of September 30, 2018, the Bank’s capital ratios continue to be in excess of regulatory minimums and the Bank was well-capitalized by these guidelines.

In July 2013, the Federal Reserve issued final rules that made changes to its capital rules to align them with the Basel III regulatory capital framework and meet certain requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Effective January 1, 2015, the final rules require the Bank to comply with the following minimum capital ratios: (i) a new Common Equity Tier 1 capital ratio of 4.5% of risk-weighted assets; (ii) a Tier 1 capital ratio of 6.0% of risk-weighted assets (increased from the prior requirement of 4.0%); (iii) a total capital ratio of 8.0% of risk-weighted assets (unchanged from the prior requirement); and (iv) a leverage ratio of 4.0% of total assets (unchanged from the prior requirement). The following additional capital requirements related to the capital conservation buffer are being phased in over a four-year period, which began on January 1, 2016. When fully phased in on January 1, 2019, the rules will require the Bank to maintain (i) a minimum ratio of Common Equity Tier 1 to risk-weighted assets of at least 4.5%, plus a 2.5% “capital conservation buffer” (which is added to the 4.5% Common Equity Tier 1 ratio as that buffer is phased in, effectively resulting in a minimum ratio of Common Equity Tier 1 to risk-weighted assets of at least 7.0% upon full implementation), (ii) a minimum ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus the 2.5% capital conservation buffer (which is added to the 6.0% Tier 1 capital ratio as that buffer is phased in, effectively resulting in a minimum Tier 1 capital ratio of 8.5% upon full implementation), (iii) a minimum ratio of total capital to risk-weighted assets of at least 8.0%, plus the 2.5% capital conservation buffer (which is added to the 8.0% total capital ratio as that buffer is phased in, effectively resulting in a minimum total capital ratio of 10.5% upon full implementation), and (iv) a minimum leverage ratio of 4.0%, calculated as the ratio of Tier 1 capital to average assets. The capital conservation buffer requirement is being phased in as of January 1, 2016, at 0.625% of risk-weighted assets, increasing by the same amount each year until fully implemented at 2.5% on January 1, 2019. The capital conservation buffer is designed to absorb losses during periods of economic stress. Banking institutions with a ratio of Common Equity Tier 1 to risk-weighted assets above the minimum but below the conservation buffer will face constraints on dividends, equity repurchases, and compensation based on the amount of the shortfall.

The following table presents capital ratios for the Bank, minimum capital ratios required, and ratios defined as “well-capitalized” by the Bank’s regulators as of the dates stated.

 

 

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OFF BALANCE SHEET COMMITMENTS

In the normal course of business, the Company offers various financial products to its customers to meet their credit and liquidity needs. These instruments may involve elements of liquidity, credit and interest rate risk in excess of the amount recognized in the Company’s consolidated balance sheets. The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit and standby-letters of credit is represented by the contractual amount of these instruments. Subject to its normal credit standards and risk monitoring procedures, the Company makes contractual commitments to extend credit. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments may expire without being completely drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Conditional commitments are issued by the Company in the form of performance stand-by letters of credit, which guarantee the performance of a customer to a third party. The credit risk of issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.

The following table presents the Company’s off balance sheet commitments as of the dates stated.

 

CONTRACTUAL OBLIGATIONS

There have been no material changes outside the ordinary course of business to the contractual obligations disclosed in the Company’s 2017 Form 10-K.

RECENT ACCOUNTING PRONOUNCEMENTS

Refer to Note 2, Amendments to the Accounting Standards Codification, in the Notes to the Consolidated Financial Statements contained in Item 1 of this report, for information related to the adoption of new amendments to the Accounting Standards Codification.

ITEM 3.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Not required.

ITEM 4.CONTROLS AND PROCEDURES

EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES

As of the end of the period to which this report relates, the Company has carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Rule 13a-14 of the Securities Exchange Act of 1934 (the “Exchange Act”). In designing and evaluating its disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that objectives of the disclosure controls and procedures are met. The design of any disclosure controls and procedures is also based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential conditions.

Based upon this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are not effective to ensure that material information is recorded, processed, summarized and reported by the Company on a timely basis in order to comply with the Company’s disclosure obligations under the Exchange Act and the rules and regulations promulgated under it. The aforementioned officers based this conclusion on the fact that the Company had material weaknesses as described in its 2017 Form 10-K, which were not fully remediated and tested as of September 30, 2018.

Remediation Status

Management, with oversight from the Audit Committee, is committed to remediating the material weaknesses which existed as of December 31, 2017 and have not been fully remediated as of September 30, 2018, and is actively engaged in the implementation of a remediation plan, including the actions detailed in the 2017 Form 10-K, to ensure that controls contributing to these material weaknesses are designed appropriately and will operate effectively. In the first quarter of 2018, the Company hired a new Chief Financial Officer and Controller with substantial experience in financial reporting under the Exchange Act and in the requirements to implement appropriate changes in internal controls in areas of the findings of control deficiencies.

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In the second and third quarters of 2018, management designed and implemented internal controls that address and remediate a substantial number of the control deficiencies that culminated in material weaknesses as of December 31, 2017. As of the end of the quarterly period ended September 30, 2018, management has not fully tested the operating effectiveness of these controls.

CHANGES IN INTERNAL CONTROLS OVER FINANCIAL REPORTING

Except as noted in the preceding section, there was no change to the Company’s internal control over financial reporting during the three months ended September 30, 2018 that 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

In the ordinary course of its operations, the Company is a party to various legal proceedings. Based upon information currently available, management believes that such legal proceedings, in the aggregate, will not have a material adverse effect on the business, financial condition, or results of operations of the Company.

ITEM 1A.RISK FACTORS

There have been no material changes to the risk factors disclosed in the 2017 Form 10-K.

ITEM 2.UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

None to report.

ITEM 3.DEFAULTS UPON SENIOR SECURITIES

None to report.

ITEM 4.MINE SAFETY DISCLOSURES

Not applicable.

ITEM 5.OTHER INFORMATION

None to report.

 

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ITEM 6.EXHIBITS

 

 

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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.

 

 

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