Atlantic Union Bankshares - 10-K annual report

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2002

Commission file number: 0-20293

UNION BANKSHARES CORPORATION

(Exact name of registrant as specified in its charter)

212 North Main Street, P.O. Box 446, Bowling Green, Virginia 22427

(Address or principal executive offices) (Zip code)

(804) 633-5031

(Registrant’s telephone number including area code)

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

None

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

Common Stock, $2 par value

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 is an accelerated filer (as defined in Rule 12b – 2 of the Act). Yes  x  No  ¨

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

The aggregate market value of voting stock held by non-affiliates of the registrant as of February 21, 2003 was $174,363,576.

The number of shares of common stock outstanding as of February 21, 2003 was 7,589,524.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant’s definitive proxy statement to be used in conjunction with the registrant’s 2003 Annual Meeting of Shareholders are incorporated into Part III of this Form 10-K.

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UNION BANKSHARES CORPORATION

FORM 10-K

INDEX

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PART I

Item 1.—Business

GENERAL

Union Bankshares Corporation (the “Company”) is a multi-bank holding company organized under Virginia law and registered under the Bank Holding Company Act of 1956. The Company is headquartered in Bowling Green, Virginia. The Company is committed to the delivery of financial services through its four affiliated community banks (the “Community Banks”) and two non-bank financial services affiliates:

The Company was formed in connection with the July 1993 merger of Northern Neck Bankshares Corporation and Union Bancorp, Inc. into Union Bankshares Corporation. On September 1, 1996, King George State Bank and on July 1, 1998, Rappahannock National Bank became wholly-owned subsidiaries of the Company. On February 22, 1999, the Bank of Williamsburg began business as a newly organized bank. In June 1999, after the retirement of its president, King George State Bank was merged into Union Bank & Trust Company (“Union Bank”) and ceased to be a subsidiary bank.

Each of the Community Banks is a full service retail commercial bank offering consumers and businesses a wide range of banking and related financial services, including checking, savings, certificates of deposit and other depository services, and loans for commercial, industrial, residential mortgage and consumer purposes. The Community Banks also issue credit cards and can deliver automated teller machine services through the use of reciprocally shared ATMs in the major ATM networks. All of the Community Banks offer Internet banking access for banking services and online bill payment for both consumers and commercial companies.

The Company principally serves, through its Community Banks, the Virginia counties of Caroline, Hanover, James City, King George, King William, Spotsylvania, Stafford, Richmond, Westmoreland, Essex, Lancaster and Northumberland, and the Cities of Williamsburg, Newport News and Fredericksburg, Virginia. In January 2002, the Bank of Williamsburg opened a loan production office servicing Newport News and converted it to a full service branch in May 2002. In August 2002, Union Bank opened a loan production office in the Manassas area (Prince William County) and anticipates opening a loan production office in the Greater Richmond market (Western Henrico County) in early 2003. Through its Community Banks, the Company operated 31 branches in its primary trade area at December 31, 2002.

Union Investment Services has provided securities, brokerage and investment advisory services since its formation in February 1993. It is a full service investment company handling all aspects of wealth management including stocks, bonds, annuities, mutual funds and financial planning.

On February 11, 1999, the Company acquired CMK Corporation t/a “Mortgage Capital Investors,” a mortgage loan brokerage company headquartered in Springfield, Virginia, by merger of CMK

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Corporation into Mortgage Capital Investors, Inc., a wholly owned subsidiary of Union Bank (“MCI”). MCI has seven offices located in Virginia (3), Maryland (3) and South Carolina (1), and is also licensed to do business in Washington, D.C. MCI provides a variety of mortgage products to customers in those states. The mortgage loans originated by MCI are generally sold in the secondary market through purchase agreements with institutional investors. MCI also offers insurance services to its customers through a joint venture with an insurance agency.

Union Bankshares Corporation had assets of $1.116 billion, deposits of $897.6 million and stockholders’ equity of $105.5 million at December 31, 2002. The Community Banks range in asset size from $40.9 to $766.7 million at December 31, 2002.

SEGMENTS

The Company has two reportable segments: traditional full service community banks and a mortgage loan origination business, each as described above. See Note 17 in the Notes to Consolidated Financial Statements contained in Item 8, Financial Statement and Supplementary Data, of this Form 10-K and Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, of this Form 10-K, for certain financial and other information about each of the Company’s operating segments.

ACQUISITION PROGRAM

The Company looks to expand its market area and increase its market share through internal growth, de novo expansion and strategic acquisitions. In 2002, the Company, through two of its Community Banks, opened two loan production offices as a means to enter new markets in Virginia: Newport News and Manassas. The Newport News location received regulatory approval in May 2002 to become a full service branch.

EMPLOYEES

As of December 31, 2003 the Company had 471 employees, including executive officers, loan and other banking officers, branch personnel, operations personnel and others. None of the Company’s employees is represented by a union or covered under a collective bargaining agreement. Management of the Company considers their employee relations to be excellent.

COMPETITION

The Company experiences strong competition in all aspects of its business. In its market area, the Company competes with large national and regional financial institutions, savings and loans and other independent community banks, as well as credit unions, consumer finance companies, mortgage companies, loan productions offices, mutual funds and life insurance companies. Competition has increasingly come from out-of-state banks through their acquisitions of Virginia-based banks. Competition for deposits and loans is affected by factors such as interest rates offered, the number and location of branches and types of products offered, as well as the reputation of the institution. The Company’s non-bank financial services affiliates also operate in highly competitive environments.

Union Bankshares Corporation is the second largest independent bank holding company headquartered in Virginia, after the announced acquisition of First Virginia Bank by BB&T Corp. The Company’s Community Banks generally have a strong market share within the markets they serve, but due to the significant presence of out of state banks and the Company’s absence in many Virginia markets, the Company’s deposit market share in Virginia is only .69% of the total banking deposits in Virginia.

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SUPERVISION AND REGULATION

Bank holding companies and banks are extensively regulated under both federal and state law. The following description briefly addresses certain provisions of federal and state laws and certain regulations and proposed regulations and the potential impact of such provisions on the Company and the Community Banks. To the extent statutory or regulatory provisions or proposals are described herein, the description is qualified in its entirety by reference to the particular statutory or regulatory provisions or proposals.

Bank Holding Companies

As a bank holding company registered under the Bank Holding Company Act of 1956 (the “BHCA”), the Company is subject to regulation by the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”). The Federal Reserve Board has jurisdiction under the BHCA to approve any bank or non-bank acquisition, merger or consolidation proposed by a bank holding company. The BHCA generally limits the activities of a bank holding company and its subsidiaries to that of banking, managing or controlling banks, or any other activity that is so closely related to banking or to managing or controlling banks as to be a proper incident thereto.

Since September 1995, the BHCA has permitted bank holding companies from any state to acquire banks and bank holding companies located in any other state, subject to certain conditions, including nationwide and state imposed concentration limits. Banks are also able to branch across state lines, provided certain conditions are met, including that applicable state law must expressly permit such interstate branching. Virginia has adopted legislation that permits branching across state lines, provided there is reciprocity with the state in which the out-of-state bank is based.

There are a number of obligations and restrictions imposed on bank holding companies and their depository institution subsidiaries by federal law and regulatory policy that are designed to reduce potential loss exposure to the depositors of such depository institutions and to the Federal Deposit Insurance Corporation (the “FDIC”) insurance funds in the event the depository institution becomes in danger of default or is in default. For example, under a policy of the Federal Reserve Board with respect to bank holding company operations, a bank holding company is required to serve as a source of financial strength to its subsidiary depository institutions and to commit resources to support such institutions in circumstances where it might not do so absent such policy. In addition, the “cross-guarantee” provisions of federal law require insured depository institutions under common control to reimburse the FDIC for any loss suffered or reasonably anticipated by either the Savings Association Insurance Fund (“SAIF”) or the Bank Insurance Fund (“BIF”) as a result of the default of a commonly controlled insured depository institution in danger of default. The FDIC may decline to enforce the cross-guarantee provisions if it determines that a waiver is in the best interest of the SAIF or the BIF or both. The FDIC’s claim for damages is superior to claims of stockholders of the insured depository institution or its holding company but is subordinate to claims of depositors, secured creditors and holders of subordinated debt (other than affiliates) of the commonly controlled insured depository institutions.

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

The Company is registered under the bank holding company laws of Virginia. Accordingly, the Company and the Community Banks (other than Rappahannock National Bank, which is federally regulated) are subject to regulation and supervision by the State Corporation Commission of Virginia (the “SCC”).

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Capital Requirements

The Federal Reserve Board, the Office of the Comptroller of the Currency (the “OCC”) and the FDIC have issued substantially similar risk-based and leverage capital guidelines applicable to United States banking organizations. In addition, those regulatory agencies may from time to time require that a banking organization maintain capital above the minimum levels because of its financial condition or actual or anticipated growth. Under the risk-based capital requirements of these federal bank regulatory agencies, the Company and each of the Subsidiary Banks are required to maintain a minimum ratio of total capital to risk-weighted assets of at least 8%. At least half of the total capital is required to be “Tier 1 capital”, which consists principally of common and certain qualifying preferred shareholders’ equity, less certain intangibles and other adjustments. The remainder (“Tier 2 capital”) consists of a limited amount of subordinated and other qualifying debt (including certain hybrid capital instruments) and a limited amount of the general loan loss allowance. The Tier 1 and total capital to risk-weighted asset ratios of the Company as of December 31, 2002 were 11.05% and 12.15%, respectively, exceeding the minimum requirements.

In addition, each of the federal regulatory agencies has established a minimum leverage capital ratio (Tier 1 capital to average tangible assets) (“Tier 1 leverage ratio”). These guidelines provide for a minimum Tier 1 leverage ratio of 4% for banks and bank holding companies that meet certain specified criteria, including that they have the highest regulatory examination rating and are not contemplating significant growth or expansion. The Tier 1 leverage ratio of the Company as of December 31, 2002, was 8.49%, which is above the minimum requirements. The guidelines also provide that banking organizations experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels, without significant reliance on intangible assets.

Limits on Dividends and Other Payments

The Company is a legal entity, separate and distinct from its subsidiary institutions. A significant portion of the revenues of the Company result from dividends paid to it by the Community Banks. There are various legal limitations applicable to the payment of dividends by the Community Banks to the Company, as well as the payment of dividends by the Company to its respective shareholders.

Under federal law, the Community Banks may not, subject to certain limited exceptions, make loans or extensions of credit to, or investments in the securities of, the Company or take securities of the Company as collateral for loans to any borrower. The Community Banks are also subject to collateral security requirements for any loans or extensions of credit permitted by such exceptions.

The Community Banks are subject to various statutory restrictions on their ability to pay dividends to the Company. Under the current supervisory practices of the Community Banks’ regulatory agencies, prior approval from those agencies is required if cash dividends declared in any given year exceed net income for that year plus retained net profits of the two preceding years. The payment of dividends by the Community Banks or the Company may also be limited by other factors, such as requirements to maintain capital above regulatory guidelines. Bank regulatory agencies have the authority to prohibit the Community Banks or the Company from engaging in an unsafe or unsound practice in conducting their business. The payment of dividends, depending on the financial condition of the Community Banks, or the Company, could be deemed to constitute such an unsafe or unsound practice.

Under the FDIA, insured depository institutions such as the Community Banks are prohibited from making capital distributions, including the payment of dividends, if, after making such distribution,

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the institution would become “undercapitalized” (as such term is used in the statute). Based on the Community Banks’ current financial condition, the Company does not expect that this provision will have any impact on its ability to obtain dividends from the Community Banks.

In addition to dividends it receives from the Community Banks, the Company receives management fees from its affiliated companies for various services provided to them including: data processing, item processing, customer accounting, financial accounting, human resources, funds management, credit administration, sales and marketing, collections, facilities management, call center and internal audit. These fees are charged to each subsidiary based upon various specific allocation methods measuring the usage of such services by that subsidiary. The fees are eliminated in the consolidation process.

The Community Banks

The Community Banks are supervised and regularly examined by the Federal Reserve Board and the SCC, and in the case of Rappahannock National Bank, the OCC. The various laws and regulations administered by the regulatory agencies affect corporate practices, such as the payment of dividends, incurring debt and acquisition of financial institutions and other companies, and affect business practices, such as the payment of interest on deposits, the charging of interest on loans, types of business conducted and location of offices.

The Community Banks are also subject to the requirements of the Community Reinvestment Act (the “CRA”). The CRA imposes on financial institutions an affirmative and ongoing obligation to meet the credit needs of the local communities, including low- and moderate-income neighborhoods, consistent with the safe and sound operation of those institutions. Each financial institution’s efforts in meeting community credit needs currently are evaluated as part of the examination process pursuant to twelve assessment factors. These factors also are considered in evaluating mergers, acquisitions and applications to open a branch or facility.

As institutions with deposits insured by the BIF, the Community Banks also are subject to insurance assessments imposed by the FDIC. There is a base assessment for all institutions. In addition, the FDIC has implemented a risk-based assessment schedule, imposing assessments ranging from zero to 0.27% of an institution’s average assessment base. The actual assessment to be paid by each BIF member is based on the institution’s assessment risk classification, which is determined based on whether the institution is considered “well capitalized,” “adequately capitalized” or “undercapitalized,” as such terms have been defined in applicable federal regulations, and whether such institution is considered by its supervisory agency to be financially sound or to have supervisory concerns. In 2002, the Company paid only the base assessment rate through the Community Banks which amounted to $134,713 in deposit insurance premiums.

Other Safety and Soundness Regulations

The federal banking agencies have broad powers under current federal law to make prompt corrective action to resolve problems of insured depository institutions. The extent of these powers depends upon whether the institutions in question are “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” or “critically undercapitalized.” All such terms are defined under uniform regulations defining such capital levels issued by each of the federal banking agencies.

The Gramm-Leach-Bliley Act of 1999

The Gramm-Leach-Bliley Act of 1999 (“GLBA”) was signed into law on November 12, 1999. The main purpose of GLBA is to permit greater affiliations within the financial services industry, primarily

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banking, securities and insurance. The provisions of GLBA that are believed to be of most significance to the Company are discussed below.

GLBA repealed sections 20 and 32 of the Glass-Steagall Act, which separated commercial banking from investment banking, and substantially amends the BHCA, which limited the ability of bank holding companies to engage in the securities and insurance businesses. To achieve this purpose, GLBA created a new type of company, the “financial holding company.” A financial holding company may engage in or acquire companies that engage in a broad range of financial services, including

A bank holding company may elect to become a financial holding company only if all of its depository institution subsidiaries are well-capitalized, well-managed and have at least a satisfactory CRA rating. For various reasons, the Company has not elected to be treated as a financial holding company.

GLBA establishes a system of functional regulation under which the federal banking agencies regulate the banking activities of financial holding companies and banks’ financial subsidiaries, the Securities and Exchange Commission regulate their securities activities and state insurance regulators will regulate their insurance activities.

GLBA and certain regulations issued by federal banking agencies also provide protection against the transfer and use by financial institutions of consumers nonpublic personal information. A financial institution must provide to its customers, at the beginning of the customer relationship and annually thereafter, the institution’s policies and procedures regarding the handling of customers’ nonpublic personal financial information. The privacy provisions generally prohibit a financial institution from providing a customer’s personal financial information to unaffiliated third parties unless the institution discloses to the customer that the information may be so provided and the customer is given the opportunity to opt out of such disclosure.

Neither the provisions of GLBA nor the act’s implementing regulations have had a material impact on the Company’s or the Community Banks’ regulatory capital ratios (as discussed above) or ability to continue to operate in a safe and sound manner.

SEC Filings

The Company files annual, quarterly and other reports under the Securities Exchange Act of 1934 with the Securities and Exchange Commission. These reports are posted and are available at the Company’s website, ubsh.com.

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Item 2.—Properties

The Company, through its subsidiaries, owns or leases buildings that are used in the normal course of business. The main office is located at 212 N. Main Street, Bowling Green, Virginia, in a building owned by the Company. The Company’s subsidiaries own or lease various other offices in the counties and cities in which they operate. See the Notes to Consolidated Financial Statements contained in Item 8, Financial Statement and Supplementary Data, of this Form 10-K for information with respect to the amounts at which bank premises and equipment are carried and commitments under long-term leases.

Unless otherwise indicated, the properties below are owned by the Company and its subsidiaries as of December 31, 2002.

Locations

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Item 3.—Legal Proceedings

In the ordinary course of its operations, the Company and its subsidiaries are parties to various legal proceedings. Based on the information presently available, and after consultation with legal counsel, management believes that the ultimate outcome in such proceedings, in the aggregate, will not have a material adverse effect on the business or the financial condition or results of operations of the Company.

Item 4.—Submission of Matters to a Vote of Security Holders

No matters were submitted to a vote of security holders during the fourth quarter of the year ended December 31, 2002.

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PART II

Item 5.—Market for Registrant’s Common Equity and Related Stockholder Matters

Union Bankshares Corporation’s common stock is traded on the Nasdaq National Market under the symbol “UBSH”. The Company’s common stock began trading on the Nasdaq National Market in October 1993.

There were 7,579,707 shares of the Company’s common stock outstanding at the close of business on December 31, 2002, which were held by 2,255 shareholders of record. The closing price of the Company’s stock on December 31, 2002 was $27.25 per share as compared to $16.24 on December 31, 2001.

The following table summarizes the high and low sales prices and dividends declared for the two years ended December 31, 2002.

Restrictions on the ability of the Community Banks to transfer funds to the Company at December 31, 2002, are set forth in Note 16 of the Notes to the Consolidated Financial Statements contained in Item 8, Financial Statements and Supplementary Data, of this Form 10-K. A discussion of certain limitations on the ability of the Community Banks to pay dividends to the Company and the ability of the Company to pay dividends on its common stock, is set forth in Part I, Business, of this Form 10-K under the headings “Supervision and Regulation—Limits on Dividends and Other Payments” and “—The Community Banks”.

The dividend amount on the Company’s common stock is established by the Board of Directors semi-annually and dividends are typically paid on May 1^st and November 1^st of each year. In making its decision on the payment of dividends on the Company’s common stock, the Board considers operating results, financial condition, capital adequacy, regulatory requirements, shareholder returns and other factors.

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Item 6.—Selected Financial Data

The following table sets forth selected financial data for the Company for the last five years.

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

The following discussion provides information about the major components of the results of operations and financial condition, liquidity and capital resources of Union Bankshares Corporation and its subsidiaries. This discussion and analysis should be read in conjunction with the Consolidated Financial Statements and the Notes to the Consolidated Financial Statements presented in Item 8, Financial Statements and Supplementary Data, of this Form 10-K.

CRITICAL ACCOUNTING POLICIES

General

The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). The financial information contained within the statements is, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. The Company uses historical loss factors as one factor in determining the inherent loss that may be present in its loan portfolio. Actual losses could differ significantly from the historical factors that are used. The fair value of the investment portfolio is based on period end valuations but changes daily with the market. In addition, GAAP itself may change from one previously acceptable method to another method. Although the economics of these transactions would be the same, the timing of events that would impact these transactions could change.

Allowance for Loan Losses

The allowance for loan losses is an estimate of the losses that may be sustained in the loan portfolio. The allowance is based on two basic principles of accounting: (i) Statement of Financial Accounting Standard (“SFAS”) No. 5, Accounting for Contingencies, which requires that losses be accrued when they are probable of occurring and estimatable and (ii) SFAS No. 114, Accounting by Creditors for Impairment of a Loan, which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance.

The Company’s allowance for loan losses model has three basic components: the formula allowance, the specific allowance and a calculation for unfunded loans. Each of these components is determined based upon estimates that can and do change when actual events occur. These estimates are reevaluated at least quarterly as part of a review of the adequacy of the allowance for loan loss. The allowance formula uses historical losses and current economic and business conditions in developing estimated loss factors as an indicator of future losses for various loan classifications; as a result, the estimated losses could differ from the losses incurred in the future. The specific allowance uses various techniques such as historical loss information, expected cash flows and fair market value of collateral to arrive at an estimate of losses. The use of these values is inherently subjective and actual losses could be greater or less than the estimates. The allowance calculation for unfunded loans uses historical factors to determine the losses that are attributable to these loans. Management periodically reassesses the approach taken in these estimates in order to enhance the process.

Goodwill and Intangibles

In June 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard (SFAS) No. 141, Business Combinations and SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 141 requires that the purchase method of accounting be used for all business

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combinations initiated after June 30, 2001. Additionally, it further clarifies the criteria for the initial recognition and measurement of intangible assets separate from goodwill. SFAS No. 142 is effective for fiscal years beginning after December 15, 2001 and prescribes the accounting for goodwill and intangible assets subsequent to initial recognition. The provisions of SFAS No. 142 discontinue the amortization of goodwill and intangible assets with indefinite lives. Instead, these assets will be subject to at least an annual impairment review, and more frequently if certain impairment indicators are in evidence. SFAS No. 142 also requires that reporting units be identified for the purpose of assessing potential future impairments of goodwill.

The Company adopted SFAS No. 142 on January 1, 2002. Goodwill is included in other assets and totaled $864,000 at December 31, 2002 and 2001. The goodwill is no longer amortized, but instead tested for impairment at least annually. Based on the testing, there were no impairment charges for 2002. Application of the nonamortization provisions of the Statement resulted in additional net income of $82,500 for the year ended December 31, 2002.

Core deposit intangibles are included in other assets and are being amortized on a straight-line basis over the period of expected benefit, which ranges from 10 to 15 years. Core deposits, net of amortization amounted to $5,500,000 and $6,093,000 at December 31, 2002 and 2001, respectively. The Company adopted SFAS 147 on January 1, 2002 and determined that the core deposit intangible will continue to be amortized over the estimated useful life.

OVERVIEW

Union Bankshares Corporation’s net income for 2002 totaled $14.5 million or $1.92 per share on a basic and $1.90 on a diluted basis, up 24.2% from $11.7 million or $1.55 per share on a basic and diluted basis for 2001. Profitability as measured by return on average assets (ROA) for 2002 was 1.41% as compared to 1.27% a year earlier, while return on average equity (ROE) for 2002 was 14.91% as compared to 13.55% in 2001. Core profitability continued to improve as net interest income increased by 22.6% and noninterest income was up 9.0%.

Union Bankshares Corporation’s financial performance in 2002 was significantly influenced by the effect of lower interest rates on both the community bank segment and the mortgage banking segment. Net income for the community bank segment was $12.9 million, an increase of $2.4 million, or 22.7% over 2001. In 2002, reductions in interest rates resulted in a slight decline in interest income while the repricing of deposits and the reduction of rates on other borrowings combined to decrease interest expense and increase net interest income. Net interest income increased $7.0 million or 21.6%, resulting in the highest net interest margin in several years. Noninterest income in the community bank segment grew modestly in 2002 at 3.0%. Service charges and fees, the primary component of noninterest income, increased 8.1% in 2002. Noninterest expense in this sector increased 10.3% while assets grew by over 13.5%. This ability to grow on a stable cost platform has allowed the Company to realize efficiencies from both internal growth and expansion opportunities.

The decline in mortgage interest rates in 2002 stimulated mortgage loan originations and enhanced the financial performance of the Company’s mortgage banking segment. Mortgage loan originations in 2002 totaled $385 million and the gains on the sales of those loans totaled $10.1 million, a 13.9% increase over 2001. Net income for the mortgage banking segment was $1.6 million, an improvement of $400,000 over $1.2 million in 2001. This improvement was largely the result of increased volume but continued expense controls resulted in a decrease of $135,000 in noninterest expense excluding salaries and benefits. Refinanced mortgages represented 42% of the mortgage segment’s loan production for the year as compared to 30% in 2001. The Company continues to focus on developing and maintaining relationships with builders and realtors to generate loan referrals, to provide a more steady source of origination volume in a more stable rate environment.

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Assets grew to $1.116 billion at December 31, 2002, up 13.5% from $983.1 million a year ago. Loans grew to $714.8 million, up 19.1% over year-end 2001 totals reflecting growth in our loan production in all entities. Deposits increased to $897.6 million at December 31, 2002 from $784.1 million at December 31, 2001, a 14.5% increase. The Company’s capital position grew by 18.6%, from $89.0 million at December 31, 2001 to $105.5 million a year later and remains strong at 9.5% of total assets.

NET INTEREST INCOME

Net interest income, which represents the principal source of earnings for the Company is the amount by which interest income exceeds interest expense. The net interest margin is net interest income expressed as a percentage of interest-earning assets. Changes in the volume and mix of interest-earning assets and interest-bearing liabilities, as well as their respective yields and rates, have a significant impact on the level of net interest income, the net interest margin and net income.

Various world and national events over the last two years, including the terrorist attacks and corporate scandals, have contributed to economic uncertainty that appears likely to continue into 2003. This prolonged period of economic weakness resulted in interest rate cuts by the Federal Reserve Board that reduced interest rates by 475 basis points in 2001 and an additional 50 basis points in 2002. Although the Company has not seen significant weakening in the economies of the markets it serves, the impact of the interest rate reductions has had a significant impact. During 2002 the Company benefited from the maturity of higher-rate certificates of deposit issued in prior years that were renewed at significantly lower interest rates. The impact of changes in rates on certificates of deposit resulted in a reduction in interest expense of over $6.2 million in 2002. During the same timeframe, lower interest rates resulted in loan prepayments and repricings that reduced interest income on loans by $6.2 million. However, increased loan volumes offset much of that decline, contributing $5.6 million in additional interest income. (see Volume and Rate Analysis table).

During 2002, net interest income, on a taxable equivalent basis, which reflects the tax benefits of nontaxable interest income, totaled $43.3 million, an increase of 20.8% from $35.9 million in 2001. The Company’s net interest margin increased to 4.49% in 2002, as compared to 4.17% in 2001. The yield on earning assets decreased to 7.04% from 7.94% in 2001 while the cost of interest-bearing liabilities decreased from 4.42% in 2001 to 3.05% in 2002. Average interest-bearing liabilities increased by $72.8 million, or 9.9% while average earning assets grew by $104.7 million, or 12.2%. In 2002, deposits increased through both internal growth and the addition of two new branches, which brought $13.9 million in deposits. Many investors left the stock market and chose to maintain their liquidity in bank deposits, which is reflected in the rapid growth in interest-bearing transaction accounts and demand deposit balances. While the margin increased on a year-to-year basis, some compression was seen in the fourth quarter as asset repricing and prepayments accelerated. The majority of the repricing of higher-rate certificates of deposit was completed in 2002. The Company anticipates that interest rates will begin to rise in the second half of 2003 and that in a rising rate environment the net interest margin will improve. However, should interest rates remain at their current levels for an extended time period, the Company would expect additional declines in the yields on investments and loans and would cause the net interest margin to gradually decline over the next several quarters.

During 2001, net interest income, on a taxable equivalent basis totaled $35.9 million, an increase of 4.9% from $34.2 million in 2000. The Company’s net interest margin declined to 4.17% in 2001, as compared to 4.23% in 2000. The yield on earning assets decreased to 7.94% from 8.39% in 2000 while the cost of interest-bearing liabilities decreased to 4.42% in 2001 from 4.80% in 2000. Average interest-bearing liabilities increased by $35.3 million, or 5.0% while average earning assets grew by $53.1 million, or 6.6%.

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The following table shows interest income on earning assets and related average yields, as well as interest expense on interest-bearing liabilities and related average rates paid for the periods indicated.

The following table summarizes changes in net interest income attributable to changes in the volume of interest-bearing assets and liabilities compared to changes in interest rates. Nonaccrual loans are included in average loans outstanding.

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VOLUME AND RATE ANALYSIS* (TAXABLE EQUIVALENT BASIS)

INTEREST SENSITIVITY

An important element of earnings performance and the maintenance of sufficient liquidity is proper management of the interest sensitivity gap. The interest sensitivity gap is the difference between interest sensitive assets and interest sensitive liabilities in a specific time interval. This gap can be managed by repricing assets or liabilities, which are variable rate instruments, by replacing an asset or liability at maturity or by adjusting the interest rate during the life of the asset or liability. Matching the amounts of assets and liabilities maturing in the same time interval helps to hedge interest rate risk and to minimize the impact of rising or falling interest rates on net interest income.

The Company determines the overall magnitude of interest sensitivity risk and then formulates policies governing asset generation and pricing, funding sources and pricing, and off-balance sheet commitments. These decisions are based on management’s expectations regarding future interest rate movements, the state of the national and regional economy, and other financial and business risk factors. The Company uses computer simulations to measure the effect of various interest rate scenarios on net interest income. This modeling reflects interest rate changes and the related impact on net interest income and net income over specified time horizons.

At December 31, 2002, the Company had $168.1 million more assets than liabilities subject to repricing within one year and was, therefore, in an asset-sensitive position. An asset-sensitive Company generally will be impacted favorably by increasing interest rates while a liability-sensitive company’s net interest margin and net interest income generally will be impacted favorably by declining interest rates. At December 31, 2001, the Company had $148.3 million more liabilities than assets subject to repricing within one year.

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Although the gap report shows the Company to be asset-sensitive, computer simulation shows the Company’s net interest income tends to increase when interest rates rise and fall when interest rates decline. The explanation for this is that interest rate changes affect bank products differently. For example, if the prime rate changes by 1.00% (100 basis points or bps), the change on certificates of deposit may only be 0.75% (75 bps), while other interest bearing deposit accounts may only change 0.10% (10 bps). Also, despite their fixed terms, loan products are often refinanced as rates decline but rarely refinanced as rates rise. In 2002, with slightly declining rates, the market stayed in a more normal curve. Liabilities repriced early in the year while assets repriced throughout the year resulting in an increase in net interest income.

EARNINGS SIMULATION ANALYSIS

Management uses simulation analysis to measure the sensitivity of net interest income to changes in interest rates. The model calculates an earnings estimate based on current and projected balances and rates. This method is subject to the accuracy of the assumptions that underlie the process, but it provides a better analysis of the sensitivity of earnings to changes in interest rates than other analysis such as the static gap analysis discussed above.

Assumptions used in the model are derived from historical trends and management’s outlook and include loan and deposit growth rates and projected yields and rates. All maturities, calls and prepayments in the securities portfolio are assumed to be reinvested in like instruments. Mortgage loans and mortgage backed securities prepayment assumptions are based on industry estimates of prepayment speeds for portfolios with similar coupon ranges and seasoning. Different interest rate scenarios and yield curves are used to measure the sensitivity of earnings to changing interest rates. Interest rates on different asset and liability accounts move differently when the prime rate changes and are reflected in the different rate scenarios.

The following table represents the interest rate sensitivity on net interest income for the Company using different rate scenarios:

ECONOMIC VALUE SIMULATION

Economic value simulation is used to calculate the estimated fair value of assets and liabilities over different interest rate environments. Economic values are calculated based on discounted cash flow analysis. The net economic value is the economic value of all assets minus the market value of all liabilities. The change in net economic value over different rate environments is an indication of the larger term repricing risk in the balance sheet. The same assumptions are used in the economic value simulation as in the earnings simulation. The following chart reflects the change in net economic value over different rate environments:

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NONINTEREST INCOME

Noninterest income increased by 9.0% from $16.1 million in 2001 to $17.5 million in 2002. This increase is primarily due to a $1.2 million increase in gains on sales of loans, which rose from $8.9 million in 2001 to $10.1 million in 2002. The growth in mortgage originations, stimulated by low mortgage interest rates, led to this increase. Service charges on deposits rose 11.5% from $3.7 million to $4.1 million. Other service charges, commissions and fee income were up slightly from $2.5 million in 2001 to $2.6 million as ATM fees continued to grow while brokerage commissions were slowed by the down stock market. A securities loss of $159,000 represents a $284,000 change from gains of $125,000 a year ago. This was partially offset by gains on the sale of other real estate and fixed assets as a result of sales of a former branch site and several nonperforming asset properties. In addition, other operating income was down from $906,000 in 2001 to $800,000 in 2002. This decline was principally the result of a decrease in the earnings rate on bank owned life insurance.

In 2001, noninterest income increased by 34.0% from $12.0 million in 2000 to $16.1 million in 2001. This increase was primarily attributable to a $3.3 million increase in gains on sales of loans, which increased from $5.5 million in 2000 to $8.9 million in 2001 as mortgage originations increased. In addition, other operating income was up from $498,000 in 2000 to $906,000 in 2001. The rise was principally the result of increases in the cash surrender value of bank owned life insurance. Other service charges, commissions and fee income were up $325,000 from $2.2 million in 2000 to $2.5 million as brokerage fees and ATM fees continued to grow. Service charges on deposits rose slightly from $3.6 million to $3.7 million.

In the third quarter of 2000, the Company restructured its securities portfolio, selling lower-yielding securities to invest in higher-yielding instruments and resulting in a loss of $1.1 million. In the same quarter, the Company completed the termination of its defined benefit plan resulting in a $1.1 million gain. In connection with the termination of the defined benefit plan, the Company redirected a portion of the expense of the prior plan to enhance the existing compensation of employees to be more competitive with the market. The net impact of these two nonrecurring transactions on noninterest income was minimal.

NONINTEREST EXPENSES

Noninterest expenses totaled $35.9 million in 2002, an increase of $3.5 million versus $32.4 million in 2001. Salaries and benefits were $21.3 million in 2002, up $2.2 million or 11.6% compared to $19.1 million in 2001. The increase in mortgage loan originations and gains on loan sales within the mortgage segment resulted in an increase of $1.1 million in salaries and benefits of which $572,000 was commission compensation. The community bank segment’s salaries and benefits were up $1.1 million year-to-year. This was the result of two new branches, a loan production office in Manassas, Virginia, higher group insurance, some increased support staffing and normal increases. Occupancy expenses were $2.3 million, up $139,000 over $2.2 million in 2001. Equipment expense was down slightly at $2.7 million versus $2.9 million in 2001. Other operating expense was $9.5 million up $1.2 million compared to $8.3 million in 2001. This was the result of increases in operating expense, marketing, other taxes and other expenses rose. Much of these increased costs were related to the new

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locations, new product advertising, Centennial celebrations at two of the Company’s Community Banks and operating costs and core deposit expenses.

Noninterest expenses totaled $32.4 million in 2001, flat versus $32.4 million in 2000. Salaries and benefits were $19.1 million in 2001, up $373,000 or 2.0% compared to $18.7 million in 2000. The increase in mortgage loan production and gains on loan sales within the mortgage segment resulted in an increase of $1.2 million in commission compensation but this was largely offset by a decrease in salaries of $700,000. This reflects reductions in staffing related to the closing of mortgages offices and severance payments in 2000. The community bank segment’s salaries and benefits expenses were flat year-to-year. Occupancy expenses were $2.2 million, down $121,000 over $2.3 million in 2000. Equipment expense was down slightly at $2.9 million versus $3.0 million in 2000. Other operating expense was $8.3 million down slightly compared to $8.4 million in 2000. This was the result of professional fees being down while marketing, other taxes and other expenses rose. Much of these cost efficiencies are attributable to the consolidation of virtually all back office functions and the Company’s investment in technology.

LOAN PORTFOLIO

Loans, net of unearned income, totaled $714.8 million at December 31, 2002, an increase of 19.1% over $600.2 million at December 31, 2001. Loans secured by real estate represent the Company’s largest category, comprising 72.2% of the total loan portfolio at December 31, 2002. Of this total, 1-4 family residential loans, not including home equity lines, comprised 26.6% of the total loan portfolio at December 31, 2002, down slightly from 28.2% in 2001. Loans secured by commercial real estate comprised 28.0% of the total loan portfolio at December 31, 2002, as compared to 25.8% in 2001, and consist of income producing properties, as well as commercial and industrial loans where real estate constitutes a secondary source of collateral. Real estate construction loans accounted for 11.9% of total loans outstanding at December 31, 2002. The Company’s charge-off rate for all loans secured by real estate has historically been low.

LOAN PORTFOLIO

The Company’s consumer loan portfolio, its second largest category, consists principally of installment loans. Total loans to individuals for household, family and other personal expenditures

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totaled 14.3% of total loans at December 31, 2002, down from 15.8% in 2001. The increased competition for automobile loans including zero percent financing by automobile companies continued to impact this portfolio significantly in 2002. Commercial loans, secured by non-real estate business assets comprised 11.0% of total loans at the end of 2002, a slight decrease from 11.8% at the end of 2001. Loans to the agricultural industry totaled less than 1.0% of the loan portfolio in each of the last five years.

REMAINING MATURITIES OF SELECTED LOANS

Loans, net of unearned income, totaled $600.2 million at December 31, 2001, an increase of 3.3% over $580.8 million at December 31, 2000, fueled largely by commercial real estate and commercial loan growth.

The Company is focused on providing community-based financial services and discourages the origination of portfolio loans outside of its principal trade area. The Company maintains a policy not to originate or purchase loans to foreign entities or loans classified by regulators as highly leveraged transactions. To manage the growth of the real estate loans in the loan portfolio, facilitate asset/liability management and generate additional fee income, the Company sells a portion of conforming first mortgage residential real estate loans to the secondary market as they are originated. Mortgage Capital Investors, Inc. serves as a mortgage brokerage operation, selling the majority of its loan production in the secondary market or selling loans to the affiliated banks that meet the banks’ current asset/liability management needs. This venture has provided the banks’ customers with enhanced mortgage products and the Company with improved efficiencies through the consolidation of this function.

ASSET QUALITY—ALLOWANCE/PROVISION FOR LOAN LOSSES

The allowance for loan losses represents management’s estimate of the amount adequate to provide for potential losses inherent in the loan portfolio. Among other factors, management considers the Company’s historical loss experience, the size and composition of the loan portfolio, the value and adequacy of collateral and guarantors, non-performing credits and current and anticipated economic conditions. There are additional risks of future loan losses, which cannot be precisely quantified nor attributed to particular loans or classes of loans. Because those risks include general economic trends as well as conditions affecting individual borrowers, the allowance for loan losses is an estimate. The allowance is also subject to regulatory examinations and determination as to adequacy, which may take into account such factors as the methodology used to calculate the allowance and size of the allowance in comparison to peer companies identified by regulatory agencies.

Management maintains a list of loans which have a potential weakness that may need special attention. This list is used to monitor such loans and is used in the determination of the sufficiency of the Company’s allowance for loan losses. As of December 31, 2002, the allowance for loan losses was $9.2 million or 1.28% of total loans as compared to $7.3 million, or 1.22% in 2001. The provision for loan losses was $2.9 million in 2002 and $2.1 million in 2001.

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The allowance for loan losses as of December 31, 2001 was $7.3 million or 1.22% of total loans as compared to $7.4 million, or 1.27% in 2000. The provision for loan losses in both 2001 and 2000 was $2.1 million.

ALLOWANCE FOR LOAN LOSSES