UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
For the Quarterly Period Ended September 30, 2013
OR
Commission File Number: 0-20293
UNION FIRST MARKET BANKSHARES CORPORATION
(Exact name of registrant as specified in its charter)
1051 East Cary Street
Suite 1200
Richmond, Virginia 23219
(Address of principal executive offices) (Zip Code)
(804) 633-5031
(Registrant’s telephone number, including area code)
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.
Yesx No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes¨ No x
The number of shares of common stock outstanding as of November 4, 2013 was 24,923,908.
INDEX
PART I - FINANCIAL INFORMATIONItem 1 - Financial Statements
UNION FIRST MARKET BANKSHARES CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands, except share data)
See accompanying notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF INCOME
(Dollars in thousands, except per share amounts)
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Dollars in thousands)
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
NINE MONTHS ENDED SEPTEMBER 30, 2013 AND 2012
(Dollars in thousands, except share amounts)
(Unaudited)
CONSOLIDATED STATEMENTS OF CASH FLOWS
(1) See Note 5 "Borrowings" related to 2013 activity.
Notes to Consolidated Financial Statements (Unaudited)
September 30, 2013
The consolidated financial statements include the accounts of Union First Market Bankshares Corporation and its subsidiaries (collectively, the “Company”). Significant inter-company accounts and transactions have been eliminated in consolidation.
The unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and follow general practice within the banking industry. Accordingly, the unaudited consolidated financial statements do not include all the information and footnotes required by GAAP for complete financial statements. However, in the opinion of management, all adjustments (consisting only of normal recurring accruals) necessary for a fair presentation of the results of the interim periods presented have been made. The results of operations for the interim periods are not necessarily indicative of the results that may be expected for the full year.
These financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s 2012 Annual Report on Form 10-K. If needed, certain previously reported amounts have been reclassified to conform to current period presentation.
Recent Accounting Pronouncements
In December 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2011-11, “Balance Sheet (Topic 210) – Disclosures about Offsetting Assets and Liabilities.” This ASU requires entities to disclose both gross information and net information about both instruments and transactions eligible for offset in the balance sheet and instruments and transactions subject to an agreement similar to a master netting arrangement. An entity is required to apply the amendments for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods. An entity should provide the disclosures required by those amendments retrospectively for all comparative periods presented. The adoption of ASU 2011-11 did not have a material impact on the Company's consolidated financial statements.
In July 2012, the FASB issued ASU 2012-02, “Intangibles – Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment.” The amendments in this ASU apply to all entities that have indefinite-lived intangible assets, other than goodwill, reported in their financial statements. The amendments in this ASU provide an entity with the option to make a qualitative assessment about the likelihood that an indefinite-lived intangible asset is impaired to determine whether it should perform a quantitative impairment test. The amendments also enhance the consistency of impairment testing guidance among long-lived asset categories by permitting an entity to assess qualitative factors to determine whether it is necessary to calculate the asset’s fair value when testing an indefinite-lived intangible asset for impairment. The amendments are effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012. Early adoption is permitted. The adoption of ASU 2012-02 did not have a material impact on the Company's consolidated financial statements.
In January 2013, the FASB issued ASU 2013-01, “Balance Sheet (Topic 210): Clarifying the Scope of Disclosures about Offsetting Assets and Liabilities.” The amendments in this ASU clarify the scope for derivatives accounted for in accordance with Topic 815, Derivatives and Hedging, including bifurcated embedded derivatives, repurchase agreements and reverse repurchase agreements and securities borrowing and securities lending transactions that are either offset or subject to netting arrangements. An entity is required to apply the amendments for fiscal years, and interim periods within those years, beginning on or after January 1, 2013. The adoption of ASU 2013-01 did not have a material impact on the Company's consolidated financial statements.
In February 2013, the FASB issued ASU 2013-02, “Comprehensive Income (Topic 220): Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income.” The amendments in this ASU require an entity to present (either on the face of the statement where net income is presented or in the notes) the effects on the line items of net income of significant amounts reclassified out of accumulated other comprehensive income. In addition, the amendments require a cross-reference to other disclosures currently required for other reclassification items to be reclassified directly to net income in their entirety in the same reporting period. Companies should apply these amendments for fiscal years, and interim periods within those years, beginning on or after December 15, 2012. The Company has included the required disclosures from ASU 2013-02 in the consolidated financial statements.
In July 2013, the FASB issued ASU 2013-10, “Derivatives and Hedging (Topic 815): Inclusion of the Fed Funds Effective Swap Rate (or Overnight Index Swap Rate) as a Benchmark Interest Rate for Hedge Accounting Purposes.” The amendments in this ASU permit the Fed Funds Effective Swap Rate (also referred to as the Overnight Index Swap Rate) to be used as a U.S. benchmark interest rate for hedge accounting purposes under Topic 815, in addition to interest rates on direct Treasury obligations of the U.S. government and the London Interbank Offered Rate (“LIBOR”). The amendments also remove the restriction on using different benchmark rates for similar hedges. The amendments apply to all entities that elect to apply hedge accounting of the benchmark interest rate under Topic 815. The amendments are effective prospectively for qualifying new or redesignated hedging relationships entered into on or after July 17, 2013. The adoption of ASU 2013-10 did not have a material impact on the Company's consolidated financial statements.
In July 2013, the FASB issued ASU 2013-11, “Income Taxes (Topic 740): Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists.” The amendments in this ASU provide guidance on the financial statement presentation of an unrecognized tax benefit when a net operating loss carryforward, similar tax loss, or tax credit carryforward exists. An unrecognized tax benefit, or a portion of an unrecognized tax benefit, should be presented in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryforward, except as follows. To the extent a net operating loss carryforward, a similar tax loss, or a tax credit carryforward is not available at the reporting date under the tax law of the applicable jurisdiction to settle any additional income taxes that would result from the disallowance of a tax position or the tax law of the applicable jurisdiction does not require the entity to use, and the entity does not intend to use, the deferred tax asset for such purpose, the unrecognized tax benefit should be presented in the financial statements as a liability and should not be combined with deferred tax assets. The amendments in this ASU are effective for fiscal years, and interim periods within those years, beginning after December 15, 2013. Early adoption is permitted. The amendments should be applied prospectively to all unrecognized tax benefits that exist at the effective date. Retrospective application is permitted. The Company does not expect the adoption of ASU 2013-11 to have a material impact on its consolidated financial statements.
The amortized cost, gross unrealized gains and losses, and estimated fair values of investment securities as of September 30, 2013 and December 31, 2012 are summarized as follows (dollars in thousands):
Due to restrictions placed upon the Company’s common stock investment in the Federal Reserve Bank of Richmond and Federal Home Loan Bank of Atlanta (“FHLB”), these securities have been classified as restricted equity securities and carried at cost. These restricted securities are not subject to the investment security classifications and are included as a separate line item on the Company’s balance sheet. The FHLB requires Union First Market Bank (the “Bank”) to maintain stock in an amount equal to 4.5% of outstanding borrowings and a specific percentage of the Bank’s total assets. The Federal Reserve Bank of Richmond requires the Company to maintain stock with a par value equal to 6% of its outstanding capital. Restricted equity securities consist of Federal Reserve Bank stock in the amount of $6.8 million for both September 30, 2013 and December 31, 2012 and FHLB stock in the amount of $12.8 million and $13.9 million as of September 30, 2013 and December 31, 2012, respectively.
The following table shows the gross unrealized losses and fair value (in thousands) of the Company’s investments with unrealized losses that are not deemed to be other-than-temporarily impaired. These are aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position and are as follows:
As of September 30, 2013, there were $15.0 million, or 8 issues, of individual securities that had been in a continuous loss position for more than 12 months. Additionally, these securities had an unrealized loss of $402,000 and consisted of municipal obligations, mortgage-backed securities, and corporate bonds.
The following table presents the amortized cost and estimated fair value of securities as of September 30, 2013 and December 31, 2012, by contractual maturity (dollars in thousands). Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with, or without, call or prepayment penalties.
Securities with an amortized cost of $191.6 million and $183.7 million as of September 30, 2013 and December 31, 2012, respectively, were pledged to secure public deposits, repurchase agreements, and for other purposes.
During each quarter the Company conducts an assessment of the securities portfolio for other-than-temporary impairment (“OTTI”) consideration. The assessment considers factors such as external credit ratings, delinquency coverage ratios, market price, management’s judgment, expectations of future performance, and relevant industry research and analysis. An impairment is other-than-temporary if any of the following conditions exist: the entity intends to sell the security; it is more likely than not that the entity will be required to sell the security before recovery of its amortized cost basis; or the entity does not expect to recover the security’s entire amortized cost basis (even if the entity does not intend to sell). If a credit loss exists, but an entity does not intend to sell the impaired debt security and is not more likely than not to be required to sell before recovery, the impairment is other-than-temporary and should be separated into a credit portion to be recognized in earnings and the remaining amount relating to all other factors recognized as other comprehensive loss. Based on the assessment for the quarter ended September 30, 2013, and in accordance with the guidance, no OTTI was recognized.
Based on the assessment for the quarter ended September 30, 2011 and in accordance with the guidance, the Company determined that a single issuer Trust Preferred security incurred credit-related OTTI of $400,000, which was recognized in earnings for the quarter ended September 30, 2011. There is a possibility that the Company will sell the security before recovering all unamortized costs. The significant inputs the Company considered in determining the amount of the credit loss are as follows:
OTTI recognized for the periods presented is summarized as follow (dollars in thousands):
Loans are stated at their face amount, net of unearned income, and consist of the following at September 30, 2013 and December 31, 2012 (dollars in thousands):
The following table shows the aging of the Company’s loan portfolio, by class, at September 30, 2013 (dollars in thousands):
The following table shows the aging of the Company’s loan portfolio, by class, at December 31, 2012 (dollars in thousands):
Nonaccrual loans totaled $19.9 million, $26.2 million, and $32.2 million at September 30, 2013, December 31, 2012, and September 30, 2012, respectively. There were no nonaccrual loans excluded from impaired loan disclosure in 2013 or 2012. Loans past due 90 days or more and accruing interest totaled $7.3 million, $8.8 million, and $9.1 million at September 30, 2013, December 31, 2012, and September 30, 2012, respectively.
The following table shows purchased impaired commercial and consumer loan portfolios, by class and their delinquency status at September 30, 2013 (dollars in thousands):
The following table shows purchased impaired commercial and consumer loan portfolios, by class and their delinquency status at December 31, 2012 (dollars in thousands):
The Company measures the amount of impairment by evaluating loans either in their collective homogeneous pools or individually. The following table shows the Company’s impaired loans, by class, at September 30, 2013 (dollars in thousands):
The following table shows the Company’s impaired loans, by class, at December 31, 2012 (dollars in thousands):
The Company considers troubled debt restructurings (“TDRs”) to be impaired loans. A modification of a loan’s terms constitutes a TDR if the creditor grants a concession that it would not otherwise consider to the borrower for economic or legal reasons related to the borrower’s financial difficulties. Included in the impaired loan disclosures above are $47.9 million and $63.5 million of loans considered to be TDRs as of September 30, 2013 and December 31, 2012, respectively. All loans that are considered to be TDRs are evaluated for impairment in accordance with the Company’s allowance for loan loss methodology.
The following table provides a summary, by class, of modified loans that continue to accrue interest under the terms of the restructuring agreement, which are considered to be performing, and modified loans that have been placed in nonaccrual status, which are considered to be nonperforming, as of September 30, 2013 and December 31, 2012 (dollars in thousands):
The Company considers a default of a restructured loan to occur when the borrower is 90 days past due following the restructure or a foreclosure and repossession of the applicable collateral occurs. During the three months ended September 30, 2013 and 2012, the Company did not identify any restructured loans that went into default that had been restructured in the twelve-month period prior to the time of default. During the nine months ended September 30, 2013, the Company identified one loan that had been restructured in the prior twelve-month period and then went into default. This loan totaled approximately $43,000 and was a raw land and lot loan which was modified to an interest only loan with a market rate of interest. During the nine months ended September 30, 2012, the Company identified three restructured loans, totaling approximately $1.4 million that went into default that had been restructured in the twelve-month period prior to the time of default. All three loans had a term extension at a market rate.
The following table shows, by class and modification type, TDRs that occurred during the three and nine month periods ended September 30, 2013 (dollars in thousands):
The following table shows, by class and modification type, TDRs that occurred during the three month and nine month periods ended September 30, 2012 (dollars in thousands):
The following table shows the allowance for loan loss (“ALL”) activity, by portfolio segment, balances for allowance for credit losses, and loans based on impairment methodology for the nine months ended September 30, 2013. Allocation of a portion of the allowance to one category of loans does not preclude its availability to absorb losses in other categories (dollars in thousands):
The following table shows the allowance for loan loss activity, portfolio segment types, balances for allowance for loan losses, and loans based on impairment methodology for the year ended December 31, 2012. Allocation of a portion of the allowance to one category of loans does not preclude its availability to absorb losses in other categories (dollars in thousands):
The following table shows the allowance for loan loss activity, portfolio segment types, balances for allowance for loan losses, and loans based on impairment methodology for the nine months ended September 30, 2012. Allocation of a portion of the allowance to one category of loans does not preclude its availability to absorb losses in other categories (dollars in thousands):
The Company uses the past due status and trends as the primary credit quality indicator for the consumer loan portfolio segment while a risk rating system is utilized for commercial loans. Commercial loans are graded on a scale of 1 through 9. A general description of the characteristics of the risk grades follows:
The following table shows all loans, excluding purchased impaired loans, in the commercial portfolios by class with their related risk rating current as of September 30, 2013 (dollars in thousands):
The following table shows all loans, excluding purchased impaired loans, in the commercial portfolios by class with their related risk rating current as of December 31, 2012 (dollars in thousands):
The following table shows only purchased impaired loans in the commercial portfolios by class with their related risk rating and credit quality indicator information current as of September 30, 2013 (dollars in thousands):
The following table shows only purchased impaired loans in the commercial portfolios by class with their related risk rating and credit quality indicator information current as of December 31, 2012 (dollars in thousands):
Loans acquired are originally recorded at fair value, with certain loans being identified as impaired at the date of purchase. The fair values were determined based on the credit quality of the portfolio, expected future cash flows, and timing of those expected future cash flows.
The following shows changes in the Company’s acquired loan portfolio and accretable yield for the following periods (dollars in thousands):
The Company’s intangible assets consist of core deposits, trademarks, and goodwill arising from previous acquisitions. The Company has determined that core deposit intangibles and trademarks have a finite life and amortizes them over their estimated useful life. Core deposit intangible assets are being amortized over the period of expected benefit, which ranges from 4 to 14 years, using an accelerated method. The trademark intangible, acquired through previous acquisitions, was amortized over three years using the straight-line method. In accordance with Accounting Standards Codification (“ASC”) 350, Intangibles-Goodwill and Other (“ASC 350”), the Company reviews the carrying value of indefinite lived intangible assets at least annually or more frequently if certain impairment indicators exist. Based on the annual testing during the second quarter of each year and the absence of impairment indicators subsequent to the evaluation date, the Company has recorded no impairment charges to date for goodwill or intangible assets.
Information concerning intangible assets with a finite life is presented in the following table (dollars in thousands):
Amortization expense of core deposit intangibles for the three and nine months ended September 30, 2013 and 2012 totaled $921,000 and $2.9 million and $1.2 million and $3.7 million, respectively, and for the year ended December 31, 2012 was $4.9 million. Amortization expense of the trademark intangibles for the three and nine months ended September 30, 2013 and 2012 was $0 and $33,000 and $100,000 and $300,000, respectively, and for the year ended December 31, 2012 was $400,000. As of September 30, 2013, the estimated remaining amortization expense of core deposit intangibles is as follows (dollars in thousands):
Short-term Borrowings
Total short-term borrowings consist of securities sold under agreements to repurchase, which are secured transactions with customers and generally mature the day following the date sold. Also included in total short-term borrowings are federal funds purchased, which are secured overnight borrowings from other financial institutions, and short-term FHLB advances. Total short-term borrowings consist of the following as of September 30, 2013 and December 31, 2012 (dollars in thousands):
The Bank maintains federal funds lines with several correspondent banks; the remaining available balance was $88.0 million and $87.0 million at September 30, 2013 and December 31, 2012, respectively. The Company has certain restrictive covenants related to certain asset quality, capital, and profitability metrics associated with these lines and is considered to be in compliance with these covenants. Additionally, the Company had a collateral dependent line of credit with the FHLB of up to $808.4 million and $802.2 million at September 30, 2013 and December 31, 2012, respectively.
Long-term Borrowings
In connection with two bank acquisitions prior to 2006, the Company issued trust preferred capital notes to fund the cash portion of those acquisitions, collectively totaling $58.5 million. The trust preferred capital notes currently qualify for Tier 1 capital of the Company for regulatory purposes.
(1) reported as 'Other Assets' within the Consolidated Balance Sheets
As part of a prior acquisition, the Company assumed subordinated debt with terms of LIBOR plus 1.45% and a maturity date of April 2016. At September 30, 2013, the carrying value of the subordinated debt, net of the purchase accounting discount, was $16.2 million.
On August 23, 2012, the Company modified its fixed rate FHLB advances to floating rate advances which resulted in reducing the Company’s FHLB borrowing costs. In connection with this modification, the Company incurred a prepayment penalty of $19.6 million on the original advances, which is included as a component of long-term borrowings in the Company’s consolidated balance sheet. In accordance with ASC 470-50, Modifications and Extinguishments, the Company will amortize this prepayment penalty over the term of the modified advances using the effective rate method. The amortization expense is included as a component of interest expense on long-term borrowings in the Company’s consolidated income statement. Amortization expense for the three and nine months ended September 30, 2013 was $441,000 and $1.3 million, respectively, and $0 for both three and nine months ended September 30, 2012.
As of September 30, 2013, the advances from the FHLB consist of the following (dollars in thousands):
As of December 31, 2012, the advances from the FHLB consisted of the following (dollars in thousands):
The carrying value of the loans and securities pledged as collateral for FHLB advances totaled $1.1 billion and $1.0 billion as of September 30, 2013 and December 31, 2012, respectively.
As of September 30, 2013, the contractual maturities of long-term debt are as follows for the years ending (dollars in thousands):
Litigation Matters
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.
Litigation Relating to the StellarOne Acquisition
In a joint press release issued on June 10, 2013, the Company announced the signing of a definitive merger agreement for the acquisition of StellarOne Corporation (“StellarOne”). The Company expects to close the merger on or around January 1, 2014, subject to customary closing conditions, including shareholder approval. On June 14, 2013, Jaclyn Crescente, individually and on behalf of all other StellarOne shareholders, filed a class action complaint against StellarOne, its current directors, StellarOne Bank, and the Company, in the U.S. District Court for the Western District of Virginia, Charlottesville Division (Case No. 3:13-cv-00021-NKM). The complaint alleges that the StellarOne directors breached their fiduciary duties by approving the merger with the Company and that the Company aided and abetted in such breaches of duty. The complaint seeks, among other things, an order enjoining the defendants from proceeding with or consummating the merger, as well as other equitable relief and/or money damages in the event that the transaction is completed. StellarOne and the Company believe that the claims are without merit.
Financial Instruments with Off-Balance Sheet Risk
The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. The contractual amounts of these instruments reflect the extent of the Company’s involvement in particular classes of financial instruments.
The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit and letters of credit written is represented by the contractual amount of these instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. Unless noted otherwise, the Company does not require collateral or other security to support off-balance sheet financial instruments with credit risk.
Commitments to extend credit are agreements to lend to customers as long as there are no violations of any conditions established in the contracts. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Because many of the commitments may expire without being completely drawn upon, the total commitment amounts do not necessarily represent future cash requirements.
Letters of credit written are conditional commitments issued by the Company to guarantee the performance of customers to third parties. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers.
Union Mortgage Group, Inc., a wholly owned subsidiary of the Bank, uses rate lock commitments during the origination process and for loans held for sale. These commitments to sell loans are designed to mitigate the mortgage company’s exposure to fluctuations in interest rates in connection with rate lock commitments and loans held for sale. At September 30, 2013, the Company held approximately $1.9million of the loans available for sale in which the related rate lock commitment had expired; accordingly, a valuation adjustment of $120,000 was recorded to properly reflect the lower of cost or market value of these loans. This valuation adjustment was recorded within the mortgage segment; there was no valuation adjustment recorded in the prior year.
The following table presents the balances of commitments and contingencies (dollars in thousands):
(1) Includes unfunded overdraft protection.
The Company must maintain a reserve against its deposits in accordance with Regulation D of the Federal Reserve Act. For the final weekly reporting period in the periods ended September 30, 2013 and December 31, 2012, the aggregate amount of daily average required reserves was approximately $15.4 million and $14.2 million, respectively.
The Company has approximately $8.6 million in deposits in other financial institutions, of which $3.4 million serves as collateral for the trust swap further discussed in Note 7 “Derivatives.” The Dodd-Frank Act, which was signed into law on July 21, 2010, provided unlimited deposit insurance coverage for transaction accounts, but such provision expired on December 31, 2012. As of January 1, 2013, the deposit insurance coverage for transaction accounts is up to at least $250,000. The Company had approximately $4.5 million in deposits in other financial institutions that were uninsured at September 30, 2013. On an annual basis, the Company’s management evaluates the loss risk of its uninsured deposits in financial counter-parties.
For asset/liability management purposes, the Company uses interest rate swap agreements to hedge various exposures or to modify the interest rate characteristics of various balance sheet accounts. See Note 7 “Derivatives” in these “Notes to the Consolidated Financial Statements” for additional information.
Union Mortgage Group, Inc. has identified errors with respect to Truth in Lending Act disclosures made to certain customers during the period from November 2011 through August 2013 in connection with certain loans originated pursuant to insured loan programs administered by the United States Department of Agriculture and Federal Housing Administration. These disclosure errors understated to the borrowers the amount of mortgage insurance premiums that were required to be assessed over the life of the loans under guidelines enacted by these loan programs. The Company has, however, taken certain remedial action with respect to the affected borrowers to address the disclosure errors as permitted under applicable law. Virtually all of these loans were sold to third parties prior to the identification of the errors. Under the terms of the purchase agreements entered into in connection with the sale of such loans, amongst other remedies, these third parties have the right to require the Company to repurchase any such loans because of the errors. The Company is in the process of assessing whether these errors will have an impact on its financial statements and has concluded that not all of the relevant facts are available in order to reasonably estimate potential liability, if any. In the ordinary course of business, the Company records an indemnification reserve relating to mortgage loans previously sold based on historical statistics and loss rates. As of September 30, 2013 and December 31, 2012, the Company’s indemnification reserve was $564,000 and $446,000, respectively.
During the second quarter of 2010, the Company entered into an interest rate swap agreement (the “trust swap”) as part of the management of interest rate risk. The Company designated the trust swap as a cash flow hedge intended to protect against the variability of cash flows associated with the aforementioned Statutory Trust II preferred capital securities. The trust swap hedges the interest rate risk, wherein the Company receives interest of LIBOR from a counterparty and pays a fixed rate of 3.51% to the same counterparty calculated on a notional amount of $36.0 million. The term of the trust swap is six years with a fixed rate that started June 15, 2011. The trust swap was entered into with a counterparty that met the Company’s credit standards and the agreement contains collateral provisions protecting the at-risk party. The Company believes that the credit risk inherent in the contract is not significant. At September 30, 2013, the Company pledged $3.4 million of cash as collateral for the trust swap.
During the third quarter of 2013, the Company entered into eight interest rate swap agreements (the “prime loan swaps”) as part of the management of interest rate risk. The Company designated the prime loan swaps as cash flow hedges intended to protect the Company against the variability in the expected future cash flows on the designated variable rate loan products. The prime loan swaps hedge the underlying cash flows, wherein the Company receives a fixed interest rate ranging from 4.71% to 6.09% from counterparty and pays interest based on the Wall Street Journal prime index, with a spread of up to 1%, to the same counterparty calculated on a notional amount of $100.0 million. Four of the eight prime loan swaps contain floor rates ranging from 4.00% to 5.00%. The term of the prime loan swaps is six years with a fixed rate that started September 17, 2013. The prime loan swaps were entered into with a counterparty that met the Company’s credit standards and the agreement contains collateral provision protecting the at-risk party. The Company believes that the credit risk inherent in the contract is not significant. At September 30, 2013, the Company pledged securities with a market value of $5.8 million as collateral for the prime loan swaps.
Amounts receivable or payable are recognized as accrued under the terms of the agreements. In accordance with ASC 815, Derivatives and Hedging, the Company has designated the previously discussed derivatives as cash flow hedges, with the effective portions of the derivatives’ unrealized gains or losses recorded as a component of other comprehensive income. The ineffective portions of the unrealized gains or losses, if any, would be recorded in other expense. The Company has assessed the effectiveness of each hedging relationship by comparing the changes in cash flows on the designated hedged item. The Company’s cash flow hedges are deemed to be effective. At September 30, 2013, the fair value of the Company’s cash flow hedges was an unrealized loss of $2.7 million, the amount the Company would have expected to pay if the contract was terminated. The below asset and liability are recorded as a component of other comprehensive income recorded in the Company’s Consolidated Statements of Comprehensive Income.
Shown below is a summary of the derivatives designated as cash flow hedges at September 30, 2013 and December 31, 2012 (dollars in thousands):
*This receive rate is a weighted average rate for the 8 loan swaps that have a receive rate range from 4.71% to 6.09%. The pay rate is a weighted average rate taking into consideration the floor rates discussed above.
During the normal course of business, the Company enters into interest rate swap loan relationships (“loan swaps”) with borrowers to meet their financing needs. Upon entering into the loan swaps, the Company enters into offsetting positions with counterparties in order to minimize interest rate risk. These back-to-back loan swaps qualify as financial derivatives with fair values reported in other assets and other liabilities. Shown below is a summary regarding loan swap derivative activities at September 30, 2013 and December 31, 2012 (dollars in thousands):
The change in accumulated other comprehensive income (loss) for the three and nine months ended September 30, 2013 are summarized as follows, net of tax (dollars in thousands):
The change in accumulated other comprehensive income (loss) for the three and nine months ended September 30, 2012 are summarized as follows net of tax (dollars in thousands):
Reclassifications of unrealized gains (losses) on available-for-sale (“AFS”) securities are reported in the income statement as "Gains on securities transactions, net" with the corresponding income tax effect being reflected as a component of income tax expense. The Company reported gains of $5,000 and $47,000 for the three and nine months ended September 30, 2013, respectively, and a loss of $1,000 and a gain of $4,000 for the three and nine months ended September 30, 2012, respectively, related to gains/losses on the sale of securities. The tax effect of these transactions during the three and nine months ended September 30, 2013 and 2012 was $2,000 and $17,000 and $0 and $1,000, respectively, which were included as a component of income tax expense.
The Company follows ASC 820, Fair Value Measurements and Disclosures, (“ASC 820”) to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. This codification 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 willing market participants.
ASC 820 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 under ASC 820 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.
Derivative instruments
As discussed in Note 7 “Derivatives,” the Company records derivative instruments at fair value on a recurring basis. The Company utilizes derivative instruments as part of the management of interest rate risk to modify the repricing characteristics of certain portions of the Company’s interest-bearing assets and liabilities. The Company has contracted with a third party vendor to provide valuations for derivatives using standard valuation techniques and therefore classifies such valuations as Level 2. Third party valuations are validated by the Company using Bloomberg Valuation Service’s derivative pricing functions. The Company has considered counterparty credit risk in the valuation of its derivative assets and has considered its own credit risk in the valuation of its derivative liabilities.
Securities available for sale
Securities available for sale 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 (Level 2). If the inputs used to provide the evaluation for certain securities are unobservable and/or there is little, if any, market activity then the security would fall to the lowest level of the hierarchy (Level 3).
The Company’s investment portfolio is primarily valued using fair value measurements that are considered to be Level 2. The Company has contracted with a third party portfolio accounting service vendor for valuation of its securities portfolio. The vendor’s primary source for security valuation is Interactive Data Corporation (“IDC”), which evaluates securities based on market data. IDC utilizes evaluated pricing models that vary by asset class and include available trade, bid, and other market information. Generally, the methodology includes broker quotes, proprietary models, vast descriptive terms and conditions databases, as well as extensive quality control programs.
The vendor utilizes proprietary valuation matrices for valuing all municipals securities. The initial curves for determining the price, movement, and yield relationships within the municipal matrices are derived from industry benchmark curves or sourced from a municipal trading desk. The securities are further broken down according to issuer, credit support, state of issuance, and rating to incorporate additional spreads to the industry benchmark curves.
The Company uses Bloomberg Valuation Service, an independent information source that draws on quantitative models and market data contributed from over 4,000 market participants, to validate third party valuations. Any material differences between valuation sources are researched by further analyzing the various inputs that are utilized by each pricing source. No material differences were identified during our validation as of September 30, 2013 and December 31, 2012.
The carrying value of restricted Federal Reserve Bank of Richmond and FHLB stock approximates fair value based on the redemption provisions of each entity and is therefore excluded from the following table.
The following table presents the balances of financial assets and liabilities measured at fair value on a recurring basis at September 30, 2013 and December 31, 2012 (dollars in thousands):
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.
Loans held for sale
Loans held for sale are carried at the lower of cost or market value. These loans currently consist of residential loans originated for sale in the secondary market. Fair value is based on the price secondary markets are currently offering for similar loans using observable market data which is not materially different than cost due to the short duration between origination and sale (Level 2). As such, the Company records any fair value adjustments on a nonrecurring basis. Nonrecurring fair value adjustments of $363,000 and $0 were recorded on loans held for sale during the nine months ended September 30, 2013 and the year ended December 31, 2012, respectively. Gains and losses on the sale of loans are recorded within income from the mortgage segment on the Consolidated Statements of Income.
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 according to the contractual terms of the loan agreements will not be collected. The measurement of loss associated with impaired loans can be based on either the observable market price of the loan or the fair value of the collateral. Collateral dependent loans are reported at the fair value of the underlying collateral if repayment is solely from the underlying value of the collateral. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. The vast majority of the Company’s collateral is real estate. The value of real estate collateral is determined utilizing an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser using observable market data. When evaluating the fair value, management may discount the appraisal further if, based on their understanding of the market conditions, it is determined the collateral is further impaired below the appraised value (Level 3). The value of business equipment is based upon an outside appraisal, of one year or less, if deemed significant, or the net book value on the applicable business’s financial statements if not considered significant using observable market data. Likewise, values for inventory and accounts receivables collateral are based on financial statement balances or aging reports (Level 3). Collateral dependent impaired loans allocated to the allowance for loan losses are measured at fair value on a nonrecurring basis. Any fair value adjustments are recorded in the period incurred as provision for loan losses on the Consolidated Statements of Income.
Other real estate owned (“OREO”)
Fair values of OREO are carried at the lower of either carrying value or fair value less selling costs. Fair value is based upon independent market prices, appraised values of the collateral, or management’s estimation of the value of the collateral. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the foreclosed asset as Level 3 valuation. Total valuation expenses related to OREO properties for the nine months ended September 30, 2013 and September 30, 2012 were $491,000 and $0, respectively, and for the year ended December 31, 2012 were $301,000.
The following tables summarize the Company’s financial assets that were measured at fair value on a nonrecurring basis at September 30, 2013 and December 31, 2012 (dollars in thousands):
The following table displays quantitative information about Level 3 Fair Value Measurements for September 30, 2013 (dollars in thousands):
(1) A discount percentage (in addition to expected selling costs) is applied based on age of independent appraisals, current market conditions, and experience within the local market.
(2) The "Other" category of the impaired loans section from the table above consists of Other Commercial, Mortgage, Consumer Construction, HELOCs, and Other Consumer.
The following table displays quantitative information about Level 3 Fair Value Measurements for December 31, 2012 (dollars in thousands):
ASC 825, Financial Instruments, requires disclosure about fair value of financial instruments for interim periods and excludes certain financial instruments and all non-financial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented may not necessarily represent the underlying fair value of the Company.
Cash and cash equivalents
For those short-term instruments, the carrying amount is a reasonable estimate of fair value.
Loans
The fair value of performing loans is estimated by discounting expected future cash flows using a yield curve that is constructed by adding a loan spread to a market yield curve. Loan spreads are based on spreads currently observed in the market for loans of similar type and structure. Fair value for impaired loans and their respective level within the fair value hierarchy, are described in the previous disclosure related to fair value measurements of assets that are measured on a nonrecurring basis.
Deposits
The fair value of demand deposits, savings accounts, and certain money market deposits is the amount payable on demand at the reporting date. The fair value of certificates of deposit is estimated by discounting the future cash flows using the rates currently offered for deposits of similar remaining maturities.
Borrowings
The carrying value of the Company’s repurchase agreements is a reasonable estimate of fair value. Other borrowings are discounted using the current yield curve for the same type of borrowing. For borrowings with embedded optionality, a third party source is used to value the instrument. The Company validates all third party valuations for borrowings with optionality using Bloomberg’s derivative pricing functions.
Accrued interest
The carrying amounts of accrued interest approximate fair value.
Commitments to extend credit and standby letters of credit
The fair value of commitments is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair value of 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 counterparties at the reporting date. At September 30, 2013 and December 31, 2012, the fair value of loan commitments and standby letters of credit was immaterial.
The carrying values and estimated fair values of the Company’s financial instruments as of September 30, 2013 and December 31, 2012 are as follows (dollars in thousands):
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 values 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 and more likely to prepay in a falling 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 Company’s 2011 Stock Incentive Plan (the “2011 Plan”) provides for the granting of incentive stock options, non-statutory stock options, and nonvested stock awards to key employees of the Company and its subsidiaries. The 2011 Plan authorizes shares, which may be awarded to employees of the Company and its subsidiaries in the form of incentive stock options intended to comply with the requirements of Section 422 of the Internal Revenue Code of 1986 (“incentive stock options”), non-statutory stock options, and nonvested stock. Under the plan, the option price cannot be less than the fair market value of the stock on the grant date. A stock option’s maximum term is ten years from the date of grant and vests in equal annual installments of 20% over a five year vesting schedule. The Company issues new shares to satisfy stock-based awards. The following table summarizes the shares available in the plan as of September 30, 2013:
For the three month and nine month periods ended September 30, 2013 and 2012, respectively, the Company recognized stock-based compensation expense of approximately $297,000 and $622,000 ($236,000 and $505,000, net of tax), respectively, and $324,000 and $938,000 ($242,000 and $707,000, net of tax), respectively. These expenses were approximately $0.01 per common share for the quarter ended September 30, 2013, and approximately $0.02 for the nine months ended September 30, 2013. Stock based compensation expense was $0.01 and $0.04 for the three and nine month periods, respectively, ended September 30, 2012.
Stock Options
The following table summarizes the stock option activity for the nine months ended September 30, 2013:
The fair value of each stock option grant is estimated on the date of grant using the Black-Scholes option valuation model that uses the assumptions noted in the following table. No options have been granted since February of 2012:
(1) Calculated as the ratio of historical dividends paid per share of common stock to the stock price on the date of grant.
(2) Based on the average of the contractual life and vesting schedule for the respective option.
(3) Based on the monthly historical volatility of the Company’s stock price over the expected life of the options.
(4) Based upon the U.S. Treasury bill yield curve, for periods within the contractual life of the option, in effect at the time of grant.
The following table summarizes information concerning stock options issued to the Company’s employees that are vested or are expected to vest and stock options exercisable as of September 30, 2013:
Nonvested Stock
The 2011 Plan permits the granting of nonvested stock but are limited to one-third of the aggregate number of total awards granted. This equity component of compensation is divided between restricted (time-based) stock grants and performance-based stock grants. Generally, the restricted stock vests 50% on each of the third and fourth anniversaries from the date of the grant. The performance-based stock is subject to vesting based on achieving certain performance metrics; the grant of performance-based stock is subject to approval by the Company’s Compensation Committee in its sole discretion. The value of the nonvested stock awards was calculated by multiplying the fair market value of the Company’s common stock on grant date by the number of shares awarded. Employees have the right to vote the shares and to receive cash or stock dividends (restricted stock), if any, except for the nonvested stock under the performance-based component (performance stock).
The following table summarizes the nonvested stock activity for the nine months ended September 30, 2013:
The estimated unamortized compensation expense, net of estimated forfeitures, related to nonvested stock and stock options issued and outstanding as of September 30, 2013 that will be recognized in future periods is as follows (dollars in thousands):
Basic earnings per common share (“EPS”) was computed by dividing net income available to common stockholders by the weighted average number of common shares outstanding during the period. Diluted EPS is computed using the weighted average number of common shares outstanding during the period, including the effect of dilutive potential common shares outstanding attributable to stock awards. There were approximately 200,787and 594,946 shares underlying anti-dilutive stock awards as of September 30, 2013 and 2012, respectively.
The following is a reconcilement of the denominators of the basic and diluted EPS computations for the three and nine months ended September 30, 2013 and 2012 (dollars and shares in thousands, except per share amounts):
The Company has two reportable segments: a traditional full service community bank and a mortgage loan origination business. The community bank business for 2013 includes one subsidiary bank, which provides loan, deposit, investment, and trust services to retail and commercial customers throughout its 90 retail locations in Virginia. The mortgage segment includes one mortgage company, which provides a variety of mortgage loan products principally in Virginia, North Carolina, South Carolina, Maryland, and the Washington D.C. metro area. These loans are originated and sold primarily in the secondary market through purchase commitments from investors, which serves to mitigate the Company’s exposure to interest rate risk.
Profit and loss is measured by net income after taxes including realized gains and losses on the Company’s investment portfolio. The accounting policies of the reportable segments are the same as those described in the summary of significant accounting policies. Inter-segment transactions are recorded at cost and eliminated as part of the consolidation process.
Both of the Company’s reportable segments are service-based. The mortgage business is a fee-based business while the bank is driven principally by net interest income. The bank segment provides a distribution and referral network through its customers for the mortgage loan origination business. The mortgage segment offers a more limited referral network for the bank segment, due largely to the minimal degree of overlapping geographic markets.
The community bank segment provides the mortgage segment with the short-term funds needed to originate mortgage loans through a warehouse line of credit and charges the mortgage banking segment interest at the three month LIBOR rate plus 1.5%, floor of 2%. These transactions are eliminated in the consolidation process. A management fee for operations and administrative support services is charged to all subsidiaries and eliminated in the consolidated totals.
Information about reportable segments and reconciliation of such information to the consolidated financial statements for three and nine months ended September 30, 2013 and 2012 is as follows (dollars in thousands):
SEGMENT FINANCIAL INFORMATION
The following table presents the consolidated statement of income line “Other Operating Expenses” broken into greater detail for the three and nine months ended September 30, 2013 and 2012, respectively (dollars in thousands):
(1) OREO related costs include foreclosure related expenses, gains/losses on the sale of OREO, valuation reserves, and asset resolution related legal expenses.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders
Union First Market Bankshares Corporation
Richmond, Virginia
We have reviewed the accompanying consolidated balance sheets of Union First Market Bankshares Corporation and subsidiaries as of September 30, 2013 and 2012, and the related consolidated statements of income and comprehensive income for the three and nine month periods ended September 30, 2013 and 2012, and the related consolidated changes in stockholders' equity and cash flows for the nine month period ended September 30, 2013 and 2012. These consolidated financial statements are the responsibility of the Company's management.
We conducted our reviews in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures to financial data and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board, the objective of which is the expression of an opinion regarding the consolidated financial statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our reviews, we are not aware of any material modifications that should be made to the accompanying consolidated financial statements referred to above for them to be in conformity with U.S. generally accepted accounting principles.
We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board, the consolidated balance sheet of Union First Market Bankshares Corporation and subsidiaries as of December 31, 2012, and the related consolidated statements of income, comprehensive income, changes in stockholder's equity, and cash flows for the year then ended (not presented herein); and in our report dated March 13, 2013, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated balance sheet as of December 31, 2012, is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.
/s/ Yount, Hyde & Barbour, P.C.
Winchester, Virginia
November 7, 2013
ITEM 2 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Management’s discussion and analysis is presented to aid the reader in understanding and evaluating the financial condition and results of operations of Union First Market Bankshares Corporation and its subsidiaries (collectively, the “Company”). This discussion and analysis should be read with the consolidated financial statements, the notes to the financial statements, and the other financial data included in this report, as well as the Company’s Annual Report on Form 10-K and management’s discussion and analysis for the year ended December 31, 2012. Highlighted in the discussion are material changes from prior reporting periods and any identifiable trends affecting the Company. Results of operations for the three and nine month periods ended September 30, 2013 and 2012 are not necessarily indicative of results that may be attained for any other period. Amounts are rounded for presentation purposes while some of the percentages presented are computed based on unrounded amounts.
FORWARD-LOOKING STATEMENTS
Certain statements in this report may constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are statements that include projections, predictions, expectations, or beliefs about future events or results or otherwise are not statements of historical fact. Such statements are often characterized by the use of qualified words (and their derivatives) such as “expect,” “believe,” “estimate,” “plan,” “project,” “anticipate,” “intend,” “will,” or words of similar meaning or other statements concerning opinions or judgment of the Company and its management about future events. Although the Company believes that its expectations with respect to forward-looking statements are based upon reasonable assumptions within the bounds of its existing knowledge of its business and operations, there can be no assurance that actual results, performance, or achievements of the Company will not differ materially from any future results, performance, or achievements expressed or implied by such forward-looking statements. Actual future results and trends may differ materially from historical results or those anticipated depending on a variety of factors, including, but not limited to, the effects of and changes in: general economic and bank industry conditions, the interest rate environment, legislative and regulatory requirements, competitive pressures, new products and delivery systems, inflation, the stock and bond markets, accounting standards or interpretations of existing standards, technology, consumer spending and savings habits, and mergers and acquisitions, including merger integration risk in connection with the Company’s pending merger with StellarOne Corporation such as potential deposit attrition, higher than expected costs, customer loss and business disruption associated with the integration of StellarOne Corporation, including, without limitation, potential difficulties in maintaining relationships with key personnel and other integration related-matters. More information is available on the Company’s website, http://investors.bankatunion.comand on the Securities and Exchange Commission’s website, www.sec.gov. The information on the Company’s website is not a part of this Form 10-Q. The Company does not intend or assume any obligation to update or revise any forward-looking statements that may be made from time to time by or on behalf of the Company.
CRITICAL ACCOUNTING POLICIES
General
The accounting and reporting policies of the Company and its subsidiaries are in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and conform to general practices within the banking industry. The Company’s financial position and results of operations are affected by management’s application of accounting policies, including estimates, assumptions, and judgments made to arrive at the carrying value of assets and liabilities and amounts reported for revenues, expenses, and related disclosures. Different assumptions in the application of these policies could result in material changes in the Company’s consolidated financial position and/or results of operations.
The more critical accounting and reporting policies include the Company’s accounting for the allowance for loan losses, mergers and acquisitions, and goodwill and intangible assets. The Company’s accounting policies are fundamental to understanding the Company’s consolidated financial position and consolidated results of operations. Accordingly, the Company’s significant accounting policies are discussed in detail in Note 1 “Summary of Significant Accounting Policies” in the “Notes to the Consolidated Financial Statements” contained in Item 8 of the Form 10-K for the year ended December 31, 2012.
The following is a summary of the Company’s critical accounting policies that are highly dependent on estimates, assumptions, and judgments.
Allowance for Loan Losses (“ALL”)
The provision for loan losses charged to operations is an amount sufficient to bring the allowance for loan losses to an estimated balance that management considers adequate to absorb potential losses in the portfolio. Loans are charged against the allowance when management believes the collectability of the principal is unlikely. Recoveries of amounts previously charged-off are credited to the allowance. Management’s determination of the adequacy of the allowance is based on an evaluation of the composition of the loan portfolio, the value and adequacy of collateral, current economic conditions, historical loan loss experience, and other risk factors. Management believes that the allowance for loan losses is adequate. While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions, particularly those affecting real estate values. In addition, regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan losses. Such agencies may require the Company to make adjustments to the allowance based on their judgments about information available to them at the time of their examination.
The Company performs regular credit reviews of the loan portfolio to review the credit quality and adherence to its underwriting standards. The credit reviews consist of reviews by its Internal Audit group and reviews performed by an independent third party. Upon origination, each commercial loan is assigned a risk rating ranging from one to nine, with loans closer to one having less risk, and this risk rating scale is the Company’s primary credit quality indicator. Consumer loans are generally not risk rated; the primary credit quality indicator for this portfolio segment is delinquency status. The Company has various committees that review and ensure that the allowance for loan losses methodology is in accordance with GAAP and loss factors used appropriately reflect the risk characteristics of the loan portfolio.
The Company’s ALL consists of specific, general, and unallocated components.
Specific Reserve Component - The specific reserve component relates to impaired loans. A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Upon being identified as impaired, for loans not considered to be collateral dependent, an allowance is established when the discounted cash flows of the impaired loan are lower than the carrying value of that loan. Impaired loans under $500,000 are aggregated based on similar risk characteristics. The level of credit impairment within the pool(s) is determined based on historical loss factors for loans with similar risk characteristics, taking into consideration environmental factors specifically related to the underlying pool. The impairment of collateral dependent loans is measured based on the fair value of the underlying collateral (based on independent appraisals), less selling costs, compared to the carrying value of the loan. If the Company determines that the value of an impaired collateral dependent loan is less than the recorded investment in the loan, it either recognizes an impairment reserve as a specific component to be provided for in the allowance for loan losses or charge-off the deficiency if it is determined that such amount represents a confirmed loss. Typically, a loss is confirmed when the Company is moving towards foreclosure (or final disposition) of the underlying collateral or when there is a payment default of 180 days, whichever occurs first.
The Company obtains independent appraisals from a pre-approved list of independent, third party appraisal firms located in the market in which the collateral is located. The Company’s approved appraiser list is continuously maintained to ensure the list only includes such appraisers that have the experience, reputation, character, and knowledge of the respective real estate market. At a minimum, it is ascertained that the appraiser is currently licensed in the state in which the property is located, experienced in the appraisal of properties similar to the property being appraised, has knowledge of current real estate market conditions and financing trends, and is reputable. The Company’s internal Real Estate Valuation Group, which reports to the Risk and Compliance Group, performs either a technical or administrative review of all appraisals obtained. A technical review will ensure the overall quality of the appraisal, while an administrative review ensures that all of the required components of an appraisal are present. Generally, independent appraisals are updated every 12 to 24 months or as necessary. The Company’s impairment analysis documents the date of the appraisal used in the analysis, whether the officer preparing the report deems it current, and, if not, allows for internal valuation adjustments with justification. Adjustments to appraisals generally include discounts for continued market deterioration subsequent to the appraisal date. Any adjustments from the appraised value to carrying value are documented in the impairment analysis, which is reviewed and approved by senior credit administration officers and the Special Assets Loan Committee. External appraisals are the primary source to value collateral dependent loans; however, the Company may also utilize values obtained through broker price opinions or other valuations sources. These alternative sources of value are used only if deemed to be more representative of value based on updated information regarding collateral resolution. Impairment analyses are updated, reviewed, and approved on a quarterly basis at or near the end of each reporting period.
General Reserve Component - The general reserve component covers non-impaired loans and is derived from an estimate of credit losses adjusted for various environmental factors applicable to both commercial and consumer loan segments. The estimate of credit losses is a function of the product of net charge-off historical loss experience to the loan balance of the loan portfolio averaged during the preceding twelve quarters, as management has determined this to adequately reflect the losses inherent in the loan portfolio. The environmental factors consist of national, local, and portfolio characteristics and are applied to both the commercial and consumer segments. The following table shows the types of environmental factors management considers:
Unallocated Component – This component may be used to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio. Together, the specific, general, and any unallocated allowance for loan loss represents management’s estimate of losses inherent in the current loan portfolio. Though provisions for loan losses may be based on specific loans, the entire allowance for loan losses is available for any loan management deems necessary to charge-off. At September 30, 2013, there were no material amounts considered unallocated as part of the allowance for loan losses.
Impaired Loans
A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. A loan that is classified substandard or worse is considered impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent. The impaired loan policy is the same for each of the seven classes within the commercial portfolio segment.
For the consumer loan portfolio segment, large groups of smaller balance homogeneous loans are collectively evaluated for impairment. This evaluation subjects each of the Company’s homogenous pools to a historical loss factor derived from net charge-offs experienced over the preceding twelve quarters. The Company applies payments received on impaired loans to principal and interest based on the contractual terms until they are placed on nonaccrual status. All payments received are then applied to reduce the principal balance and recognition of interest income is terminated.
Mergers and Acquisitions
The Company’s merger and acquisition strategy focuses on high-growth areas with strong market demographics and targets organizations that have a comparable corporate culture, strong performance, and good asset quality, among other factors.
Business combinations are accounted for under Accounting Standards Codification (“ASC”) 805, Business Combinations, using the acquisition method of accounting. The acquisition method of accounting requires an acquirer to recognize the assets acquired and the liabilities assumed at the acquisition date measured at their fair values as of that date. To determine the fair values, the Company will continue to rely on third party valuations, such as appraisals, or internal valuations based on discounted cash flow analyses or other valuation techniques. Under the acquisition method of accounting, the Company will identify the acquirer and the closing date and apply applicable recognition principles and conditions. If they are necessary to implement its plan to exit an activity of an acquiree, costs that the Company expects, but is not obligated, to incur in the future are not liabilities at the acquisition date, nor are costs to terminate the employment of or relocate an acquiree’s employees. The Company does not recognize these costs as part of applying the acquisition method. Instead, the Company recognizes these costs as expenses in its post-combination financial statements in accordance with other applicable GAAP.
Acquisition-related costs are costs the Company incurs to effect a business combination. Those costs include advisory, legal, accounting, valuation, and other professional or consulting fees. Some other examples of acquisition-related costs to the Company include systems conversions, integration planning consultants, and advertising costs. The Company will account for acquisition-related costs as expenses in the periods in which the costs are incurred and the services are received, with one exception. The costs to issue debt or equity securities will be recognized in accordance with other applicable GAAP. These acquisition-related costs are included within the Consolidated Statements of Income classified within the noninterest expense caption.
Goodwill and Intangible Assets
The Company follows ASC 350, Goodwill and Other Intangible Assets, which prescribes the accounting for goodwill and intangible assets subsequent to initial recognition. The provisions of this guidance discontinued the amortization of goodwill and intangible assets with indefinite lives but require an impairment review at least annually and more frequently if certain impairment indicators are evident.
ABOUT UNION FIRST MARKET BANKSHARES CORPORATION
Headquartered in Richmond, Virginia, Union First Market Bankshares Corporation is the holding company for Union First Market Bank, which has 90 branches and more than 150 ATMs throughout Virginia. Non-bank affiliates of the holding company include: Union Investment Services, Inc., which provides full brokerage services; Union Mortgage Group, Inc., which provides a full line of mortgage products; and Union Insurance Group, LLC, which offers various lines of insurance products. Union First Market Bank also owns a non-controlling interest in Johnson Mortgage Company, LLC.
Additional information is available on the Company’s website at http://investors.bankatunion.com. The information contained on the Company’s website is not a part of this report. Shares of the Company’s common stock are traded on the NASDAQ Global Select Market under the symbol UBSH.
RESULTS OF OPERATIONS
Executive Overview
Third Quarter 2013 Compared to Third Quarter 2012
Third Quarter 2013 Compared to Second Quarter 2013
Year to Date 2013 Compared to 2012
(1)For a reconciliation of the non-GAAP measures operating earnings, ROA, ROE, EPS, and efficiency ratio, see “NON-GAAP MEASURES” included in this Item 2.
NET INTEREST INCOME
(1) Core net interest margin (FTE) excludes the impact of acquisition accounting accretion and amortization adjustments in net interest income.
On a linked quarter basis, tax-equivalent net interest income was $39.2 million, an increase of $476,000, or 1.2%, from the second quarter of 2013. The third quarter tax-equivalent net interest margin increased by 2 basis points to 4.20% from 4.18% in the previous quarter. The increase in net interest margin was principally attributable to the reduction in the cost of funds (4 bps) outpacing the decline in earning asset yields (2 bps). The increase in net interest income was driven by higher average loan balances, the decline in the cost of funds and the higher daycount in the current quarter. Loan yields continued to be negatively affected by the low interest rate environment as new and renewed loans were originated and repriced at lower rates. Yields on investment securities were largely unchanged for the quarter, as prepayment speeds in taxable securities slowed and a shift in mix from taxable securities to higher yielding tax-exempt securities continued. The cost of interest-bearing liabilities declined during the quarter largely driven by lower time deposit account balances.
For the three months ended September 30, 2013, tax-equivalent net interest income decreased $640,000, or 1.6%, when compared to the same period last year. The tax-equivalent net interest margin decreased by 11 basis points to 4.20% from 4.31% in the prior year. The decline in net interest margin was principally due to the continued decline in accretion on the acquired net earning assets (4 bps) and declines in earning asset yields exceeding the reduction in interest-bearing liabilities rates paid (7 bps). Lower earning asset interest income was principally due to lower yields on loans as new and renewed loans were originated and repriced at lower rates, faster prepayments on mortgage-backed securities, and cash flows from securities investments reinvested at lower yields. The decline in the cost of interest-bearing liabilities from the prior year’s third quarter was driven by a shift in mix from time deposits to demand deposits, reductions in deposit rates and lower wholesale borrowing costs.
The Company continues to believe that net interest margin will decline modestly over the next several quarters as decreases in earning asset yields are projected to outpace declines in interest-bearing liabilities rates.
For the nine months ended September 30, 2013, tax-equivalent net interest income was $116.9 million, a decrease of $1.4 million, or 1.2%, when compared to the same period last year. The tax-equivalent net interest margin decreased by 16 basis points to 4.20% from 4.36% in the prior year. The decline in the net interest margin was principally due to the continued decline in accretion on the acquired net earning assets (7 bps) and a decline in the yield on interest-earning assets that outpaced the reduction in the cost of interest-bearing liabilities (9 bps). Lower interest-earning asset income was principally due to lower yields on loans as new loans and renewed loans were originated and repriced at lower rates and declining investment securities yields driven by faster prepayments on mortgage-backed securities and cash flows from securities investments reinvested at lower yields.
The Volume Rate Analysis table below presents changes in interest income and interest expense and distinguishes between the changes related to increases or decreases in average outstanding balances of earning assets and interest-bearing liabilities (volume), and the changes related to increases or decreases in average interest rates on such assets and liabilities (rate). Changes attributable to both volume and rate have been allocated proportionally. Results, on a taxable equivalent basis, are as follows in this Volume Rate Analysis table for the three and nine months ended September 30, 2013 versus September 30, 2012 (dollars in thousands):
The Company’s fully taxable equivalent net interest margin includes the impact of acquisition accounting fair value adjustments. The 2013 and remaining estimated discount/premium and net accretion impact are reflected in the following table (dollars in thousands):
AVERAGE BALANCES, INCOME AND EXPENSES, YIELDS AND RATES (TAXABLE EQUIVALENT BASIS)
(1) Rates and yields are annualized and calculated from actual, not rounded amounts in thousands, which appear above.
(2) Interest income on securities includes $0 and $46 thousand for the three months ended September 30, 2013 and 2012 in accretion of the fair market value adjustments.
(3) Nonaccrual loans are included in average loans outstanding.
(4) Interest income on loans includes $471 thousand and $825 thousand for the three months ended September 30, 2013 and 2012 in accretion of the fair market value adjustments related to the acquisitions.
(5) Interest expense on certificates of deposits includes $2 thousand and $3 thousand for the three months ended September 30, 2013 and 2012 in accretion of the fair market value adjustments related to the acquisitions.
(6) Interest expense on borrowings includes $122 thousand for both the three months ended September 30, 2013 and 2012 in amortization of the fair market value adjustments related to acquisitions.
(7) Income and yields are reported on a taxable equivalent basis using the statutory federal corporate tax rate of 35%.
(8) Core net interest margin excludes purchase accounting adjustments and was 4.16% and 4.23% for the three months ended September 30, 2013 and 2012.
(2) Interest income on securities includes $15 thousand and $154 thousand for the nine months ended September 30, 2013 and 2012 in accretion of the fair market value adjustments.
(4) Interest income on loans includes $1.6 million and $3.0 million for the nine months ended September 30, 2013 and 2012 in accretion of the fair market value adjustments related to the acquisitions.
(5) Interest expense on certificates of deposits includes $5 thousand and $231 thousand for the nine months ended September 30, 2013 and 2012 in accretion of the fair market value adjustments related to the acquisitions.
(6) Interest expense on borrowings includes $367 thousand and $366 thousand for the nine months ended September 30, 2013 and 2012 in amortization of the fair market value adjustments related to acquisitions.
(8) Core net interest margin excludes purchase accounting adjustments and was 4.16% and 4.25% for the nine months ended September 30, 2013 and 2012.
NONINTEREST INCOME
On a linked quarter basis, noninterest income decreased $2.1 million, or 18.4%, to $9.2 million from $11.3 million in the second quarter. Excluding mortgage segment operations, noninterest income increased $524,000, or 7.7%. Service charges on deposit accounts increased $128,000 primarily related to higher overdraft and returned check fees. Other operating income increased $454,000, or 43.5%, related to income that was previously deferred and earned in the current quarter, a credit card service performance rebate, and receipt of insurance policy proceeds. Gains on sales of mortgage loans, net of commissions, decreased $2.6 million, or 55.8%, as rising mortgage interest rates led to gain on sale margin compression and declines in mortgage loan originations, which decreased by $79.3 million, or 26.6%, in the current quarter to $218.9 million from $298.2 million in the second quarter. Of the loan originations in the current quarter, 28.6% were refinances, which was down from 38.4% in the second quarter. Included in the current quarter gain on sale of mortgage loans was an increase of $246,000 in the indemnification reserve related to mortgage loans previously sold, resulting in a reduction in the gain.
For the quarter ended September 30, 2013, noninterest income decreased $1.3 million, or 12.2%, to $9.2 million from $10.5 million in the prior year’s third quarter. Excluding mortgage segment operations, noninterest income increased $1.5 million, or 24.9%, from the same period a year ago. Service charges on deposit accounts increased $252,000 primarily related to higher overdraft and returned check fees as well as service charges on savings accounts. Other service charges, commissions and fees increased $417,000 primarily due to higher net interchange fee income and fees on letters of credit. Losses on bank premises declined $302,000 due to the write down of a former branch location in the prior year. Other operating income increased $431,000, or 40.4%, related to income that was previously deferred and earned in the current quarter, a credit card service performance rebate, and receipt of insurance policy proceeds. Gains on sales of mortgage loans, net of commissions, decreased $2.7 million, or 56.7%, primarily due to lower loan origination volume and gain on sale margin compression due to rising mortgage interest rates. Mortgage loan originations decreased by $104.2 million, or 32.3%, in the current quarter to $218.9 million from $323.1 million in the third quarter of 2012. Included in the current quarter gain on sale of mortgage loans was an increase of $246,000 in the indemnification reserve related to mortgage loans previously sold, resulting in a reduction in the gain.
For the nine months ended September 30, 2013, noninterest income increased $1.1 million, or 3.8%, to $30.3 million, from $29.2 million a year ago. Excluding mortgage segment operations, noninterest income increased $2.0 million, or 11.2%, from the same period a year ago. Service charges on deposit accounts increased $450,000 primarily related to higher overdraft and returned check fees as well as service charges on savings accounts. Other account service charges and fees increased $1.1 million due to higher net interchange fee income, revenue on retail investment products, and fees on letters of credit. Other operating income increased $667,000 primarily related to increased income on bank owned life insurance and insurance related revenues. Conversely, gains on bank premises decreased $371,000 as the Company recorded a loss in the current year on the closure of bank premises coupled with gains in the prior year related to sale of bank premises. Gains on sales of mortgage loans, net of commissions, decreased $771,000 driven by lower gain on sale margins in 2013, partly due to reductions resulting from valuation reserves of $363,000 related to aged mortgage loans held-for-sale as well as an increase of $277,000 in the indemnification reserve related to mortgage loans previously sold.
NONINTEREST EXPENSE
NM - Not Meaningful
On a linked quarter basis, noninterest expense decreased $151,000, or 0.4%, to $34.1 million from $34.3 million when compared to the second quarter. Excluding mortgage segment operations and acquisition-related costs, noninterest expense increased $557,000, or 1.9%, compared to the second quarter. Other real estate owned (“OREO”) and credit-related costs increased $617,000 from the prior quarter due to valuation adjustments of $491,000, higher losses on the sales of OREO of $66,000, and increased credit-related legal fees of $108,000 in the current quarter. Salary-related expenses declined $496,000 primarily related to reduced levels of incentive compensation and seasonal payroll taxes in the current quarter and severance expense recorded in the prior quarter related to the relocation of Union Mortgage Group, Inc.’s headquarters to Richmond.
For the quarter ended September 30, 2013, noninterest expense increased $864,000, or 2.6%, to $34.1 million from $33.3 million for the third quarter of 2012. Excluding mortgage segment operations and acquisition-related costs, noninterest expense declined $278,000, or 0.9%, compared to the third quarter of 2012. Salaries and benefits expenses increased $300,000 primarily related to the costs associated with strategic investments in mortgage segment personnel in 2012 and 2013. OREO and credit-related costs increased $566,000, as the Company recorded valuation adjustments of $491,000 and incurred higher losses on the sales of OREO of $50,000 in the current quarter compared to the same quarter in 2012. These increases were partially offset by declines in occupancy expenses of $442,000 and furniture and equipment expenses of $144,000, primarily due to branch closures in 2012.
For the nine months ended September 30, 2013, noninterest expense increased $2.8 million, or 2.8%, to $101.9 million, from $99.1 million a year ago. Excluding mortgage segment operations and acquisition-related costs incurred in 2013, noninterest expense declined $1.9 million, or 2.2%, compared to the same period in 2012. Salaries and benefits expense increased $2.3 million due to costs associated with strategic investments in mortgage segment personnel in 2012 and 2013, severance expense recorded in the current year related to the relocation of Union Mortgage Group, Inc.’s headquarters to Richmond, group insurance cost increases, and management incentive payments related to higher earnings. Occupancy expenses decreased $562,000 and furniture and equipment expenses declined $190,000, primarily due to branch closures in 2012.
Community Bank Segment
On a linked quarter basis, the community bank segment’s net income was consistent with the second quarter at $9.2 million; excluding after-tax acquisition-related costs in the current and prior quarters of $471,000 and $919,000, respectively, net income decreased $436,000, or 4.3%. Net interest income was $37.5 million, an increase of $505,000, or 1.4%, from $37.0 million during the second quarter of 2013. The increase in net interest income was driven by higher average loan balances, the decline in the cost of funds and the higher day count in the current quarter. Loan yields continued to be negatively affected by the low interest rate environment as new and renewed loans were originated and repriced at lower rates. Yields on investment securities were largely unchanged for the quarter, as prepayment speeds in taxable securities slowed and a shift in mix from taxable securities to higher yielding tax-exempt securities continued. The cost of interest-bearing liabilities declined during the quarter largely driven by lower time deposit account balances. In addition, the Company increased its provision for loan losses by $800,000 during the quarter due to the impact of higher linked quarter net charge-offs on the historical loss factor.
Noninterest income increased $524,000, or 7.7%, to $7.3 million from $6.8 million in the second quarter, primarily related to an increase in other operating income of $454,000 related to income that was previously deferred and earned in the current quarter, a credit card service performance rebate, and receipt of insurance policy proceeds. Service charges on deposit accounts increased $128,000 primarily related to higher overdraft and returned check fees.
Noninterest expense increased $111,000, or 0.4%, to $29.9 million from $29.8 million when compared to the second quarter. Excluding acquisition-related expenses in the current and prior quarters of $473,000 and $919,000, respectively, noninterest expense increased $557,000, or 1.9%, from the prior quarter. The overall expense increase is primarily driven by higher OREO and credit-related costs of $584,000, as the Company incurred a valuation adjustment of $491,000 and higher losses on the sales of OREO.
For the three months ended September 30, 2013, the community bank segment’s net income of $9.2 million increased $414,000, or 4.7%, from the prior year’s third quarter; excluding after-tax acquisition-related costs of $471,000, net income increased $885,000, or 10.1%. Net interest income declined $963,000, or 2.5%, to $37.5 million due to a decline in earning asset yields exceeding the reduction in interest-bearing liabilities rates paid. Lower earning asset interest income was principally due to lower yields on loans as new and renewed loans were originated and repriced at lower rates, faster prepayments on mortgage-backed securities, and cash flows from securities investments reinvested at lower yields. The decline in the cost of interest-bearing liabilities from the prior year’s third quarter was driven by a shift in mix from time deposits to demand deposits, reductions in deposit rates and lower wholesale borrowing costs. In addition, the Company’s provision for loan losses was $600,000 lower than the same quarter of the prior year primarily due to continued improvement in asset quality.
Noninterest income increased $1.4 million, or 24.9%, to $7.3 million from $5.9 million in the prior year’s third quarter. Of this increase, service charges on deposit accounts increased $252,000 primarily related to higher overdraft and returned check fees as well as service charges on savings accounts, while other service charges, commissions and fees increased $417,000 primarily due to higher net interchange fee income and fees on letters of credit. Also contributing to the increase were lower losses on bank premises of $302,000 due to the write down of a former branch location in the prior year.
Noninterest expense increased $195,000, or 0.7%, to $29.9 million from $29.7 million when compared to the third quarter of 2012. Driving the increase were higher OREO and credit-related costs of $531,000, as the Company incurred a valuation adjustment of $491,000 and higher losses on the sales of OREO of $50,000 in the current quarter compared to the same quarter in 2012. These increases were partially offset by declines in occupancy expenses of $452,000 and furniture and equipment expenses of $190,000, primarily due to branch closures in 2012. Excluding acquisition-related expenses of $473,000 incurred in the third quarter of 2013, noninterest expense decreased $278,000, or 0.9%, from the same period in 2012.
For the nine months ended September 30, 2013, the community bank segment’s net income increased $2.7 million, or 11.3%, to $27.2 million when compared to the same period a year ago; excluding after-tax acquisition-related costs of $1.4 million in 2013, net income increased $4.1 million, or 17.0%. Net interest income decreased $2.6 million, or 2.3%, to $111.6 million when compared to the prior year. The decline in the net interest income was principally due to a decline in the yield on interest-earning assets that outpaced the reduction in the cost of interest-bearing liabilities. Lower interest-earning asset income was principally due to lower yields on loans as new loans and renewed loans were originated and repriced at lower rates and declining investment securities yields driven by faster prepayments on mortgage-backed securities and cash flows from securities investments reinvested at lower yields.In addition, the Company’s provision for loan losses was $4.1 million lower than the prior year primarily due to continued improvement in asset quality.
Noninterest income increased $2.0 million, or 11.2%, to $20.3 million, from $18.3 million a year ago. Of this increase, other account service charges and fees increased $1.1 million due to higher net interchange fee income, revenue on retail investment products, and fees on letters of credit. Other operating income increased $720,000 primarily related to increased income on bank owned life insurance and insurance related revenues. Service charges on deposit accounts increased $450,000 primarily related to higher overdraft and returned check fees as well as service charges on savings accounts. Partially offsetting these increases was a decrease in gains on bank premises of $371,000 as the Company recorded a loss in the current year on the closure of bank premises coupled with gains in the prior year related to the sale of bank premises.
Noninterest expense decreased $538,000, or 0.6%, to $89.2 million, from $89.8 million a year ago. Excluding acquisition-related expenses of $1.4 million in 2013, noninterest expense decreased $1.9 million, or 2.1%, from the prior year period. Occupancy expenses declined $775,000 largely related to lower rent and maintenance costs related to prior year branch closures, and amortization on acquired intangible assets declined $1.1 million.
MORTGAGE SEGMENT INFORMATION
On a linked quarter basis, the mortgage segment reported a net loss of $1.2 million for the third quarter compared to net income of $294,000 in the second quarter, representing a decrease of $1.5 million. Beginning in May 2013, rising mortgage interest rates have negatively affected mortgage loan origination volumes and gain on sale margins resulting in lower net gains on sales revenue. During the quarter, the mortgage segment experienced a decline in mortgage originations of $79.3 million, or 26.6%, from $298.2 million in the second quarter to $218.9 million. Refinanced volume decreased $51.9 million, or 45.3%, from $114.5 million, which represented 38.4% of total originations, in the prior quarter to $62.6 million, which represented 28.6% of total originations. As a result, gains on sales of mortgage loans sold, net of commission expenses, decreased $2.6 million, or 55.8%, to $2.1 million from $4.7 million in the second quarter. Included in the current quarter gain on sale of mortgage loans was a reduction resulting from a $246,000 increase in the indemnification reserve related to mortgage loans previously sold. Salaries and benefits expenses declined $522,000, primarily related to severance expenses incurred in the second quarter and lower current quarter salaries and overtime expenses due to management actions taken as a result of lower loan origination levels.
For the three months ended September 30, 2013, the mortgage segment reported a net loss of $1.2 million compared to net income of $859,000 for the same period last year, representing a decline of $2.1 million. Mortgage loan originations decreased by $104.2 million, or 32.3%, to $218.9 million from $323.1 million in the prior year driven by higher mortgage interest rates and lower refinanced loan demand. Refinanced volume decreased $123.5 million, or 66.4%, from $186.1 million, which represented 57.6% of total originations, in the third quarter of 2012 to $62.6 million, which represented 28.6% of total originations. During the current quarter, the Company recorded gains on the sale of mortgage loans, net of commission expenses, of $2.1 million, which were $2.7 million, or 56.7%, lower than the same period last year primarily due to lower loan origination volumes and gain on sale margin compression driven by the rise in mortgage loan interest rates in the current quarter. Included in the current quarter gain on sale of mortgage loans was a reduction resulting from a $246,000 increase in the indemnification reserve related to mortgage loans previously sold. Expenses increased $720,000, or 19.6%, over the same quarter last year primarily related to increases in contract labor of $245,000, loan-related expenses of $174,000, and legal and other professional fees of $110,000.
For the nine months ended September 30, 2013, the mortgage segment incurred a net loss of $761,000 compared to net income of $1.6 million during the same period last year, representing a decline of $2.3 million. Mortgage loan originations increased by $20.8 million, or 2.7%, to $785.2 million from $764.4 million during the same period last year due to the full year impact of the additional mortgage loan officers added in the first half of 2012. Gains on sales of mortgage loans, net of commission expenses, decreased $771,000, or 6.8%, driven by lower gain on sale margins in 2013, partly due to reductions resulting from valuation reserves of $363,000 related to aged mortgage loans held-for-sale as well as an increase of $277,000 in the indemnification reserve related to mortgage loans previously sold. Expenses increased by $3.5 million, or 35.6%, over the same period last year primarily due to increases in salary and benefit expenses of $2.3 million related to the costs associated with the addition of mortgage loan originators and support personnel in 2012, investments made in the current year to enhance the mortgage segment’s operating capabilities, and severance payments made in the second quarter related to the relocation of Union Mortgage Group, Inc.’s headquarters to Richmond. In addition, expenses increased due to higher mortgage branch rent expenses of $226,000, loan-related expenses of $356,000, and legal and other professional fees of $206,000.
While management is taking steps to recalibrate the mortgage segment’s cost structure to align with declining mortgage origination levels, in the near term, the return to profitability in the mortgage segment is dependent on increased mortgage production volumes and/or higher gain on sale margins from third quarter levels.
Income Taxes
The provision for income taxes is based upon the results of operations, adjusted for the effect of certain tax-exempt income and non-deductible expenses. In addition, certain items of income and expense are reported in different periods for financial reporting and tax return purposes. The tax effects of these temporary differences are recognized currently in the deferred income tax provision or benefit. Deferred tax assets or liabilities are computed based on the difference between the financial statement and income tax bases of assets and liabilities using the applicable enacted marginal tax rate.
The Company evaluates the likelihood that deferred tax assets will be recovered from future taxable income. If any such assets are not likely to be recovered, a valuation allowance must be recognized. The Company has determined that a valuation allowance is not required for deferred tax assets as of September 30, 2013. The assessment of the carrying value of deferred tax assets is based on certain assumptions. Changes in these assumptions could have a material impact on the Company’s financial statements.
The effective tax rate for the three and nine months ended September 30, 2013 and 2012 was 28.7% and 27.9%, and 29.2% and 28.6%, respectively.
BALANCE SHEET
At September 30, 2013, total assets were $4.0 billion, an increase of $18.9 million from September 30, 2012, and a decrease of $48.8 million from the year ended December 31, 2012. Total cash and cash equivalents were $75.1 million at September 30, 2013, an increase of $12.7 million from the same period last year, and a decrease of $7.8 million from December 31, 2012. Investment in securities declined $32.7 million, or 5.2%, from $622.1 million at September 30, 2012 to $589.4 million at September 30, 2013, and increased $4.1 million from December 31, 2012. Mortgage loans held for sale were $58.2 million, a decrease of $83.8 million from September 30, 2012, and a decline of $109.5 million from December 31, 2012.
At September 30, 2013, loans (net of unearned income) were $3.0 billion, an increase of $93.7 million, or 3.2%, from September 30, 2012, and an increase of $35.4 million from December 31, 2012. Average loans outstanding increased $123.5 million, or 4.3%, since September 30, 2012 and increased $103.6 million, or 3.6%, from December 31, 2012.
As of September 30, 2013, total deposits were $3.2 billion, an increase of $25.1 million, or 0.8%, when compared to September 30, 2012, and a decrease of $72.8 million, or 2.2%, from December 31, 2012. Year over year deposit growth was driven by increases in low cost deposit levels, which grew $92.9 million, while the drop in deposits since year end was driven by lower time deposit balances of $125.4 million, partially offset by an increase in low cost deposits of $51.3 million.
As of September 30, 2012, net short term borrowings declined $2.9 million, or 1.9% from September 30, 2012. From December 31, 2012, net short term borrowing increased $18.9 million, or 14.3%, primarily related to increased customer demand for repurchase agreements.
The Company’s capital ratios continued to be considered “well capitalized” for regulatory purposes. The Company’s ratio of total capital to risk-weighted assets was 14.40% and 15.00% on September 30, 2013 and 2012, respectively. The Company’s ratio of Tier 1 capital to risk-weighted assets was 13.13% and 13.44% at September 30, 2013 and 2012, respectively. The Company’s common equity to asset ratios at September 30, 2013 and 2012 were 10.72% and 11.00%, respectively, while its tangible common equity to tangible assets ratio was 9.09% and 9.27% at September 30, 2013 and 2012. During the first quarter, the Company entered into an agreement to purchase 500,000 shares of its common stock from Markel Corporation, the Company’s largest shareholder, for an aggregate purchase price of $9,500,000, or $19.00 per share. The repurchase was funded with cash on hand and the shares were retired. During the third quarter, the Company did not repurchase any shares. The Company is authorized to repurchase an additional 250,000 shares under its current repurchase program authorization, which expires December 31, 2013. Also, the Company paid a dividend of $0.14 per share during the current quarter, an increase of $0.01 from the prior quarter and an increase of $0.04 per share from the same quarter a year ago.
Securities
At September 30, 2013, the Company had total investments, in the amount of $609.0 million, or 15.0% of total assets, as compared to $606.1 million, or 14.8% of total assets, at December 31, 2012. The Company seeks to diversify its portfolio to minimize risk. It focuses on purchasing mortgage-backed securities for cash flow and reinvestment opportunities and securities issued by states and political subdivisions due to the tax benefits and the higher yield offered from these securities. All of the Company’s mortgage-backed securities are investment grade. The investment portfolio has a high percentage of municipals and mortgage-backed securities; therefore a higher taxable equivalent yield exists on the portfolio compared to its peers. The Company does not engage in structured derivative or hedging activities within the investment portfolio.
The table below sets forth a summary of the securities available for sale and restricted stock, at fair value for the following periods (dollars in thousands):
During each quarter and at year end, the Company conducts an assessment of the securities portfolio for other than temporary impairment (“OTTI”) consideration. The Company determined that a single issuer Trust Preferred security incurred credit-related OTTI of $400,000 during the year ended December 31, 2011; there is no remaining unrealized loss for this issue as of September 30, 2013. No OTTI was recognized in 2012 or during the nine months of 2013. The Company monitors the portfolio, which is subject to liquidity needs, market rate changes, and credit risk changes, to determine whether adjustments are needed. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
The following table summarizes the contractual maturity of securities available for sale at fair value and their weighted average yields as of September 30, 2013 (dollars in thousands):
As of September 30, 2013, the Company maintained a diversified municipal bond portfolio with approximately 71% of its holdings in general obligation issues and the remainder backed by revenue bonds. Issuances within the Commonwealth of Virginia represented 10% and issuances within the State of Texas represented 24% of the municipal portfolio; no other state had a concentration above 10%. Approximately 91% of municipal holdings are considered investment grade by Moody’s or Standard & Poor. The non-investment grade securities are principally insured Texas municipalities with no underlying rating. When purchasing municipal securities, the Company focuses on strong underlying ratings for general obligation issuers or bonds backed by essential service revenues.
Liquidity
Liquidity represents an institution’s ability to meet present and future financial obligations 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 banks, money market investments, federal funds sold, securities available for sale, loans held for sale, and loans maturing or re-pricing within one year. Additional sources of liquidity available to the Company include its capacity to borrow additional funds when necessary through federal funds lines with several correspondent banks, a line of credit with the FHLB, the purchase of brokered certificates of deposit, and a corporate line of credit with a large correspondent bank. Management considers the Company’s overall liquidity to be sufficient to satisfy its depositors’ requirements and to meet its customers’ credit needs.
As of September 30, 2013, cash, interest-bearing deposits in other banks, money market investments, federal funds sold, loans held for sale, investment securities, and loans that mature within one year totaled $1.1 billion, or 30.9%, of total earning assets. As of September 30, 2013, approximately $989.4 million, or 33.0%, of total loans are scheduled to mature within one year based on contractual maturity, adjusted for expected prepayments.
Loan Portfolio
Loans, net of unearned income, were $3.0 billion and $2.9 billion at September 30, 2013 and September 30, 2012, respectively. Loans secured by real estate continue to represent the Company’s largest category, comprising 83.7% of the total loan portfolio at September 30, 2013.
The following table presents the Company’s composition of loans, net of unearned income, in dollar amounts and as a percentage of total gross loans (dollars in thousands) as of:
The following table presents the remaining maturities, based on contractual maturity, by loan type and by rate type (variable or fixed), as of September 30, 2013 (dollars in thousands):
While the current economic environment is challenging, the Company remains committed to originating soundly underwritten loans to qualifying borrowers within its markets. The Company is focused on providing community-based financial services and discourages the origination of portfolio loans outside of its principal trade areas. As reflected in the loan table, at September 30, 2013, the largest component of the Company’s loan portfolio consisted of real estate loans, concentrated in commercial, construction, and residential 1-4 family. The risks attributable to these concentrations are mitigated by the Company’s credit underwriting and monitoring processes, including oversight by a centralized credit administration function and credit policy and risk management committee, as well as seasoned bankers focusing their lending to borrowers with proven track records in markets with which the Company is familiar. Union Mortgage Group, Inc. serves as a mortgage brokerage operation, selling the majority of its loan production in the secondary market or selling loans to meet Union First Market Bank’s current asset/liability management needs.
Asset Quality
Overview
During the third quarter, the Company continued to reduce the levels of impaired loans, troubled debt restructurings, and nonperforming assets, which were at their lowest levels since the fourth quarter of 2009. Additionally, total past due loans remained stable from the prior quarter and declined from the same quarter last year. Net charge-offs, the related ratio of net charge-offs to total loans, and the loan loss provision also decreased from the same quarter of the previous year but increased from the prior quarter due to the charge-off of loans specifically reserved for in prior periods. The allowance to nonperforming loans coverage ratio was at the highest level since the fourth quarter of 2008. The magnitude of any change in the real estate market and its impact on the Company is still largely dependent upon continued recovery of residential housing and commercial real estate and the pace at which the local economies in the Company’s operating markets improve.
Troubled Debt Restructurings (“TDRs”)
The total recorded investment in TDRs as of September 30, 2013 was $47.9 million, a decrease of $15.6 million, or 24.6%, from $63.5 million at December 31, 2012 and a decline of $15.9 million, or 24.9%, from $63.8 million at September 30, 2012. Of the $47.9 million of TDRs at September 30, 2013, $39.3 million, or 82.0%, were considered performing while the remaining $8.6 million were considered nonperforming. The decline in the TDR balance from December 31, 2012 is attributable to $11.9 million in net payments, $8.6 million being removed from TDR status, $1.6 million in transfers to OREO, and $1.6 million in charge-offs, partially offset by additions of $8.1 million. Loans removed from TDR status represent restructured loans with a market rate of interest at the time of the restructuring, which were performing in accordance with their modified terms for a consecutive twelve month period and that were no longer considered impaired. Loans removed from TDR status are collectively evaluated for impairment and due to the significant improvement in the expected future cash flows, these loans are grouped based on their primary risk characteristics, typically using the Company’s internal risk rating system as its primary credit quality indicator, and impairment is measured based on historical loss experience taking into consideration environmental factors. The significant majority of these loans have been subject to new credit decisions due to the improvement in the expected future cash flows, the financial condition of the borrower, and other factors considered during underwriting. The TDR activity during the quarter did not have a material impact on the Company’s allowance for loan losses, financial condition, or results of operations.
The following table provides a summary, by class and modification type, of modified loans that continue to accrue interest under the terms of the restructuring agreement, which are considered to be performing, and modified loans that have been placed in nonaccrual status, which are considered to be nonperforming, as of September 30, 2013 (dollars in thousands):
The following table provides a summary, by class and modification type, of modified loans that continue to accrue interest under the terms of the restructuring agreement, which are considered to be performing, and modified loans that have been placed in nonaccrual status, which are considered to be nonperforming, as of December 31, 2012 (dollars in thousands):
Nonperforming Assets
At September 30, 2013, nonperforming assets totaled $55.7 million, a decrease of $3.4 million, or 5.8%, at December 31, 2012 and a decline of $10.9 million, or 16.4%, from a year ago. In addition, NPAs as a percentage of total outstanding loans decreased 14 basis points to 1.85% in the current quarter from 1.99% at December 31, 2012 and declined 44 basis points from 2.29% a year earlier.
The following table shows a summary of assets quality balances and related ratios for periods presented (dollars in thousands):
Nonperforming assets at September 30, 2013 included $19.9 million in nonaccrual loans (excluding purchased impaired loans), a net decrease of $6.3 million, or 24.0%, from December 31, 2012 and a reduction of $12.3 million, or 38.2%, from September 30, 2012. The following table shows the activity in nonaccrual loans for the quarter ended (dollars in thousands):
The additions during the quarter were primarily related to commercial real estate loans. The reductions in nonaccrual loans during the third quarter of 2013 were primarily related to the commercial loan portfolio, particularly commercial construction and raw land loans.
The following table presents the composition of nonaccrual loans (excluding purchased impaired loans) and the coverage ratio, which is the allowance for loan losses expressed as a percentage of nonaccrual loans, at the quarter ended (dollars in thousands):
Nonperforming assets at September 30, 2013 also included $35.7 million in OREO, an increase of $2.9 million, or 8.8%, from December 31, 2012 and up $1.3 million, or 3.8%, from the prior year. The following table shows the activity in OREO for the quarter ended (dollars in thousands):
During the third quarter of 2013, the additions to OREO were principally related to residential real estate; sales from OREO were principally related to residential real estate and lots.
The following table presents the composition of the OREO portfolio at the quarter ended (dollars in thousands):
(1) Includes closed branch property and land previously held for branch sites.
Included in land development is $9.4 million related to a residential community in the Northern Neck region of Virginia, which includes developed residential lots, a golf course, and undeveloped land. Foreclosed properties were adjusted to their fair values at the time of each foreclosure and any losses were taken as loan charge-offs against the allowance for loan losses at that time. OREO asset balances are also evaluated at least quarterly by the subsidiary bank’s Special Asset Loan Committee and any necessary write downs to fair values are recorded as impairment.
Past Due Loans
At September 30, 2013, total accruing past due loans were $30.5 million, or 1.02% of total loans, a decrease from $32.4 million, or 1.09% of total loans, at December 31, 2012 and $39.0 million, or 1.34% of total loans, a year ago.
Charge-offs and delinquencies
For the quarter ended September 30, 2013, net charge-offs of loans were $2.3 million, or 0.30% on an annualized basis, compared to $1.1 million, or 0.14%, for the second quarter and $3.5 million, or 0.48%, for the same quarter last year. The increase in charge-offs from the prior quarter related to loans that were previously considered impaired and specifically reserved for in prior periods. Of the $2.3 million in net charge-offs in the current quarter, $1.8 million, or 78%, related to impaired loans specifically reserved for in the prior period. Net charge-offs in the current quarter included commercial loans of $1.7 million.
For the nine months ended September 30, 2013, net charge-offs of loans were $5.9 million, or 0.26% on an annualized basis, compared to $8.5 million, or 0.39% on an annualized basis, for the same period last year. Of the net charge-offs during the nine months ended September 30, 2013, $3.7 million were related to commercial loans.
Provision
The provision for loan losses for the current quarter was $1.8 million, an increase of $800,000 from the last quarter and a decrease of $600,000 from the same quarter a year ago. The increase in provision for loan losses in the current quarter compared to the prior quarter is driven by the impact of the increased linked quarter charge-offs on the historical loss factor. The provision to loans ratio for the quarter ended September 30, 2013 was 0.24% on an annualized basis compared to 0.13% last quarter and 0.33% the same quarter a year ago.
The provision for loan losses for the nine months ended September 30, 2013 was $4.9 million compared to $8.9 million for the nine months ended September 30, 2012. The decline in provision for loan losses in the current period compared to the last year is driven by improving asset quality and the impact of overall lower historical charge-off factors. The provision to loans ratio for the nine months ended September 30, 2013 was 0.22% on an annualized basis compared to 0.41% the same period a year ago.
Allowance for Loan Losses
The allowance for loan losses as a percentage of the total loan portfolio, adjusted for acquired loans (non-GAAP), was 1.30% at September 30, 2013, a decrease from 1.40% at December 31, 2012 and 1.66% at September 30, 2012. In acquisition accounting, there is no carryover of previously established allowance for loan losses. The allowance for loan losses as a percentage of the total loan portfolio was 1.13% at September 30, 2013, 1.18% at December 31, 2012, and 1.37% at September 30, 2012. The decrease in the allowance and related ratios was primarily attributable to the charge-off of impaired loans specifically reserved for in prior periods and improving credit quality metrics.
Impaired loans have declined from $155.4 million at December 31, 2012 and $177.9 million at September 30, 2012 to $119.2 million at September 30, 2013. The nonaccrual loan coverage ratio was at the highest level since the last quarter of 2008 at 169.9% at September 30, 2013, an increase from 133.2% at December 31, 2012 and 124.1% from the same quarter last year. The current level of the allowance for loan losses reflects specific reserves related to nonperforming loans, current risk ratings on loans, net charge-off activity, loan growth, delinquency trends, and other credit risk factors that the Company considers in assessing the adequacy of the allowance for loan losses.
The following table summarizes activity in the allowance for loan losses during the quarter ended (dollars in thousands):
The following table shows both an allocation of the allowance for loan losses among loan categories based upon the loan portfolio’s composition and the ratio of the related outstanding loan balances to total loans as of the period ended (dollars in thousands):
(1) The percent represents the loan balance divided by total loans.
As of September 30, 2013, total deposits were $3.2 billion, down $72.8 million, or 2.2%, from December 31, 2012 and up $25.1 million, or 0.8%, from September 30, 2012. Total interest-bearing deposits consist of NOW, money market, savings, and time deposit account balances. Total time deposit balances of $907.3 million accounted for 35.9% of total interest-bearing deposits at September 30, 2013. The Company continues to experience a shift from time deposits into lower cost transaction (demand deposits, NOW, money market, and savings) accounts. This shift is driven by the Company’s focus on acquiring low cost deposits and customer preference for liquidity in a historically low interest rate environment.
The community bank segment may also borrow additional funds by purchasing certificates of deposit through a nationally recognized network of financial institutions. The Company utilizes this funding source when rates are more favorable than other funding sources. As of September 30, 2013 and December 31, 2012, there were $0 and $10.2 million, respectively, purchased and included in certificates of deposit on the balance sheet. Maturities of time deposits as of September 30, 2013 are as follows (dollars in thousands):
Capital Resources
Capital resources represent funds, earned or obtained, over which financial institutions can exercise greater or longer 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 allow management to effectively leverage its capital to maximize return to shareholders.
The Board of Governors of the Federal Reserve System (the “Federal Reserve”) and the Federal Deposit Insurance Corporation (“FDIC”) have adopted capital guidelines to supplement the existing definitions of capital for regulatory purposes and to establish minimum capital standards. Specifically, the guidelines categorize assets and off-balance sheet items into four risk-weighted categories. The minimum ratio of qualifying total assets is 8.0%, of which 4.0% must be Tier 1 capital, consisting of common equity, retained earnings and a limited amount of perpetual preferred stock, less certain intangible items. The table below shows the Company exceeded the definition of “well capitalized” for regulatory purposes.
In connection with two bank acquisitions, prior to 2006, the Company issued trust preferred capital notes to fund the cash portion of those acquisitions, collectively totaling $58.5 million. The trust preferred capital notes currently qualify for Tier 1 capital of the Company for regulatory purposes.
The following table summarizes the Company’s regulatory capital and related ratios (dollars in thousands):
In June 2012, the Office of the Comptroller of the Currency, the Federal Reserve, and the FDIC proposed rules that would revise and replace the current capital rules to align with the Basel III capital standards and meet certain requirements of the Dodd-Frank Act. On July 2, 2013, the Federal Reserve approved revisions to its Basel III capital adequacy guidelines. The final rule requires the Company to comply with the following new minimum capital ratios, effective January 1, 2015: (1) a new common equity Tier 1 capital ratio of 4.5% of risk-weighted assets; (2) a Tier 1 capital ratio of 6% of risk-weighted assets (increased from the current requirement of 4%); (3) a total capital ratio of 8% of risk-weighted assets (unchanged from current requirement); and, (4) a leverage ratio of 4% of total assets.
Based on management’s interpretation and understanding of the new rules, the Company has evaluated the impact of the Basel III rule and expects the Company will continue to exceed the well capitalized minimum capital requirements based on the September 30, 2013 balance sheet composition.
NON-GAAP MEASURES
In reporting the results of September 30, 2013, the Company has provided supplemental performance measures on an operating or tangible basis. Operating measures exclude acquisition costs unrelated to the Company’s normal operations. The Company believes these measures are useful to investors as they exclude non-operating adjustments resulting from acquisition activity and allow investors to see the combined economic results of the organization. Tangible common equity is used in the calculation of certain capital and per share ratios. The Company believes tangible common equity and the related ratios are meaningful measures of capital adequacy because they provide a meaningful base for period-to-period and company-to-company comparisons, which the Company believes will assist investors in assessing the capital of the Company and its ability to absorb potential losses.
These measures are a supplement to GAAP used to prepare the Company’s financial statements and should not be viewed as a substitute for GAAP measures. In addition, the Company’s non-GAAP measures may not be comparable to non-GAAP measures of other companies.
The following table reconciles these non-GAAP measures from their respective GAAP basis measures for the periods ended (dollars in thousands, except share and per share amounts):
The allowance for loan losses as a percentage of the total loan portfolio includes net loans acquired in previous acquisitions. The Company believes the presentation of the allowance-to-legacy loan ratio (non-GAAP) is useful to investors because the acquired loans were recorded at a market discount (including credit valuation) with no allowance for loan losses carried over to the Company.
Acquired loans that have further deteriorated are included in the loan loss calculation of the allowance-to-legacy loan ratio. In order to present the allowance-to-legacy loan ratio, acquired loans with no additional credit deterioration beyond the original credit mark are adjusted out of the loan balance. The following table shows the allowance for loan losses as a percentage of the total loan portfolio, adjusted to remove acquired loans (dollars in thousands):
ITEM 3 – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk is the risk of loss arising from adverse changes in the fair value of financial instruments due to changes in interest rates, exchange rates, and equity prices. The Company’s market risk is composed primarily of interest rate risk. The Asset and Liability Management Committee (“ALCO”) of the Company is responsible for reviewing the interest rate sensitivity position of the Company and establishing policies to monitor and limit exposure to this risk. The Company’s Board of Directors reviews and approves the guidelines established by ALCO.
Interest rate risk is monitored through the use of three complementary modeling tools: static gap analysis, earnings simulation modeling, and economic value simulation (net present value estimation). Each of these models measures changes in a variety of interest rate scenarios. While each of the interest rate risk models has limitations, taken together they represent a reasonably comprehensive view of the magnitude of interest rate risk in the Company, the distribution of risk along the yield curve, the level of risk through time, and the amount of exposure to changes in certain interest rate relationships. Static gap, which measures aggregate re-pricing values, is less utilized because it does not effectively measure the options risk impact on the Company and is not addressed here. Earnings simulation and economic value models, which more effectively measure the cash flow and optionality impacts, are utilized by management on a regular basis and are explained below.
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 analyses, 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. Such assumptions are monitored by management and periodically adjusted as appropriate. 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 Company uses its simulation model to estimate earnings in rate environments where rates are instantaneously shocked up or down around a “most likely” rate scenario, based on implied forward rates. The analysis assesses the impact on net interest income over a 12 month time horizon after an immediate increase or “shock” in rates, of 100 basis points up to 300 basis points. The shock down 200 or 300 basis points analysis is not as meaningful as interest rates across most of the yield curve are at historic lows and cannot decrease another 200 or 300 basis points. The model, under all scenarios, does not drop the index below zero.
The following table represents the interest rate sensitivity on net interest income for the Company across the rate paths modeled for balances ended September 30, 2013 (dollars in thousands):
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 of equity is the economic value of all assets minus the economic value of all liabilities. The change in net economic value over different rate environments is an indication of the longer-term earnings capability of the balance sheet. The same assumptions are used in the economic value simulation as in the earnings simulation. The economic value simulation uses instantaneous rate shocks to the balance sheet.
The following chart reflects the estimated change in net economic value over different rate environments using economic value simulation for the balances at the period ended September 30, 2013 (dollars in thousands):
The shock down 200 or 300 basis points analysis is not as meaningful since interest rates across most of the yield curve are at historic lows and cannot decrease another 200 or 300 basis points. While management considers this scenario highly unlikely, the natural floor increases the Company’s sensitivity in rates down scenarios.
ITEM 4 – CONTROLS AND PROCEDURES
The Company maintains “disclosure controls and procedures,” as such term is defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”), that are designed to ensure that information required to be disclosed in reports that it files or submits under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. 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 assurance that the objectives of the disclosure controls and procedures are met. Additionally, in designing disclosure controls and procedures, management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. The design of any disclosure controls and procedures also is 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 future conditions.
Based on their evaluation as of the end of the period covered by this quarterly report on Form 10-Q, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that the disclosure controls and procedures were effective at the reasonable assurance level. There was no change in the internal control over financial reporting that occurred during the quarter ended September 30, 2013 that has materially affected, or is reasonably likely to materially affect, the 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 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.
In a joint press release issued on June 10, 2013, the Company announced the signing of a definitive merger agreement for the acquisition of StellarOne Corporation. The Company expects to close the merger on or around January 1, 2014, subject to customary closing conditions, including regulatory and shareholder approvals. On June 14, 2013, Jaclyn Crescente, individually and on behalf of all other StellarOne shareholders, filed a class action complaint against StellarOne, its current directors, StellarOne Bank and the Company, in the U.S. District Court for the Western District of Virginia, Charlottesville Division (Case No. 3:13-cv-00021-NKM). The complaint alleges that the StellarOne directors breached their fiduciary duties by approving the merger with the Company, and that the Company aided and abetted in such breaches of duty. The complaint seeks, among other things, an order enjoining the defendants from proceeding with or consummating the merger, as well as other equitable relief and/or money damages in the event that the transaction is completed. StellarOne and the Company believe that the claims are without merit.
ITEM 1A – RISK FACTORS
The following risk factors should be considered in addition to the risk factors disclosed in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012. Such factors relate to the Company’s pending merger with StellarOne Corporation.
Combining the Company and StellarOne may be more difficult, costly or time-consuming than the Company expects.
The success of the merger will depend, in part, on the Company’s ability to realize the anticipated benefits and cost savings from combining the businesses of the Company and StellarOne and to combine the businesses of the Company and StellarOne in a manner that permits growth opportunities and cost savings to be realized without materially disrupting the existing customer relationships of StellarOne or the Company or decreasing revenues due to loss of customers. However, to realize these anticipated benefits and cost savings, the Company must successfully combine the businesses of the Company and StellarOne. If the Company is not able to achieve these objectives, the anticipated benefits and cost savings of the merger may not be realized fully or at all or may take longer to realize than expected.
The Company and StellarOne have operated, and, until the completion of the merger, will continue to operate, independently. The success of the merger will depend, in part, on the Company’s ability to successfully combine the businesses of the Company and StellarOne. To realize these anticipated benefits, after the completion of the merger, the Company expects to integrate StellarOne’s business into its own. The integration process in the merger could result in the loss of key employees, the disruption of each party’s ongoing business, inconsistencies in standards, controls, procedures and policies that affect adversely either party’s ability to maintain relationships with customers and employees or achieve the anticipated benefits of the merger. The loss of key employees could adversely affect the Company’s ability to successfully conduct its business in the markets in which StellarOne now operates, which could have an adverse effect on the Company’s financial results and the value of its common stock. If the Company experiences difficulties with the integration process, the anticipated benefits of the merger may not be realized fully or at all, or may take longer to realize than expected. As with any merger of financial institutions, there also may be disruptions that cause the Company and StellarOne to lose customers or cause customers to withdraw their deposits from StellarOne’s or the Company’s banking subsidiaries, or other unintended consequences that could have a material adverse effect on the Company’s results of operations or financial condition after the merger. These integration matters could have an adverse effect on each of StellarOne and the Company during this transition period and for an undetermined period after consummation of the merger.
If the Company and StellarOne do not successfully integrate, the Company may not realize the expected benefits from the merger.
Integration in connection with a merger is sometimes difficult, and there is a risk that integrating the Company and StellarOne may take more time and resources than the Company expects. The Company’s ability to integrate StellarOne and its future success depend in large part on the ability of members of its Board of Directors and executive officers to work together effectively. After the merger, the Company will be governed by a Board of Directors comprised of 19 directors, of which 11 are current directors of the Company and eight are current directors of StellarOne.Additionally, after the merger, Dr. Raymond D. Smoot, Jr., current chairman of StellarOne’s Board of Directors, will serve as chairman of the Company’s Board of Directors and Ronald L. Hicks, the current chairman of the Company’s Board, will serve as vice chairman of the Company’s Board. Further, any current StellarOne directors who are not selected to serve on the Company’s Board of Directors will be offered a Board position with Union First Market Bank, the Company’s wholly owned subsidiary bank (the “Bank”) in connection with the subsidiary bank merger. Members of the Company’s executive management team are expected to remain in their current positions. Disagreements among Board members and executive management could arise in connection with integration issues, strategic considerations and other matters. As a result, there is a risk that the Company’s Board of Directors and executive officers may not be able to operate effectively, which would affect adversely the Company’s ability to integrate the operations of the Company and StellarOne successfully and the Company’s future operating results.
The Company may not be able to effectively integrate the operations of StellarOne Bank into Union First Market Bank.
The future operating performance of the Company and the Bank will depend, in part, on the success of the merger of the Bank and StellarOne Bank, which is expected to occur in May 2014. The success of the merger of the banks will, in turn, depend on a number of factors, including the Company’s ability to: (i) integrate the operations and branches of the Bank and StellarOne Bank; (ii) retain the deposits and customers of the Bank and StellarOne Bank; (iii) control the incremental increase in noninterest expense arising from the merger in a manner that enables the combined bank to improve its overall operating efficiencies; and (iv) retain and integrate the appropriate personnel of StellarOne Bank into the operations of the Bank, as well as reducing overlapping bank personnel. The integration of the Bank and StellarOne Bank following the subsidiary bank merger will require the dedication of the time and resources of the banks’ management, and may temporarily distract managements’ attention from the day-to-day business of the banks. If the Bank is unable to successfully integrate StellarOne Bank, the Bank may not be able to realize expected operating efficiencies and eliminate redundant costs.
The merger may distract management of the Company and StellarOne from their other responsibilities.
The merger could cause the respective management groups of the Company and StellarOne to focus their time and energies on matters related to the transaction that otherwise would be directed to their business and operations. Any such distraction on the part of either company’s management, if significant, could affect its ability to service existing business and develop new business and adversely affect the business and earnings of the Company or StellarOne before the merger, or the business and earnings of the Company after the merger.
Termination of the merger agreement could negatively impact the Company.
If the Agreement and Plan of Reorganization, dated as of June 9, 2013, between the Company and StellarOne (the “merger agreement”) is terminated, the Company’s business may be impacted adversely by the failure to pursue other beneficial opportunities due to the focus of management on the merger, without realizing any of the anticipated benefits of completing the merger. Additionally, if the merger agreement is terminated, the market price of the Company’s common stock could decline to the extent that the current market price reflects a market assumption that the merger will be completed. Furthermore, costs relating to the merger, such as legal, accounting and financial advisory fees, must be paid even if the merger is not completed. If the merger agreement is terminated under certain circumstances, the Company may be required to pay StellarOne a termination fee of $21.8 million.
The merger agreement limits the ability of the Company to pursue alternatives to the merger.
The merger agreement contains “no-shop” provisions that, subject to limited exceptions, limit the ability of the Company to discuss, facilitate or commit to competing third-party proposals to acquire all or a significant part of the Company. In addition, under certain circumstances, if the merger agreement is terminated and the Company, subject to certain restrictions, consummates a similar transaction other than the merger, the Company must pay to StellarOne a termination fee of $21.8 million. These provisions might discourage a potential competing acquiror that might have an interest in acquiring all or a significant part of the Company from considering or proposing the acquisition even if it were prepared to pay consideration the value of which is greater than the current per share market price of the Company.
The Company and StellarOne will be subject to business uncertainties and contractual restrictions while the merger is pending.
Uncertainty about the effect of the merger on employees and customers may have an adverse effect on the Company and StellarOne. These uncertainties may impair the Company’s and StellarOne’s ability to attract, retain and motivate key personnel until the merger is completed, and could cause customers and others that deal with the Company and StellarOne to seek to change existing business relationships with the Company and StellarOne. Retention of certain employees by the Company and StellarOne may be challenging while the merger is pending, as certain employees may experience uncertainty about their future roles with the Company or StellarOne. If key employees depart because of issues relating to the uncertainty and difficulty of integration or a desire not to remain with the Company or StellarOne, the Company’s or StellarOne’s business, or the business of the Company following the merger, could be harmed. In addition, subject to certain exceptions, the Company and StellarOne have each agreed to operate its business in the ordinary course prior to closing and refrain from taking certain specified actions until the merger occurs.
If the merger is not completed, the Company will have incurred substantial expenses without realizing the expected benefits of the merger.
The Company has incurred and will continue to incur substantial expenses in connection with the negotiation and completion of the transactions contemplated by the merger agreement, as well as the costs and expenses of filing, printing and mailing a joint proxy statement/prospectus and all filing and other fees paid to the Securities and Exchange Commission in connection with the merger. If the merger is not completed, the Company would have to recognize these expenses without realizing the expected benefits of the merger.
Pending litigation against StellarOne and the Company could result in an injunction preventing the completion of the merger or a judgment resulting in the payment of damages.
In connection with the merger, a purported StellarOne shareholder has filed a class action complaint against StellarOne, its current directors, StellarOne Bank and the Company. Among other remedies, the plaintiff seeks to enjoin the merger. The outcome of any such litigation is uncertain. If the case is not resolved, the lawsuit could prevent or delay completion of the merger and result in substantial costs to the Company and StellarOne, including any costs associated with the indemnification of directors and officers. The plaintiff and other potential shareholder plaintiffs may file additional lawsuits against the Company, StellarOne and/or the directors and officers of either company in connection with the merger. The defense or settlement of any lawsuit or claim that remains unresolved at the time the merger is completed may adversely affect the Company’s business, financial condition, results of operations and cash flows.
ITEM 2 – UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
(a) Sales of Unregistered Securities – None
(b) Use of Proceeds – Not Applicable
(c) Issuer Purchases of Securities
On February 28, 2013, the Company’s Board of Directors authorized a share repurchase program to purchase up to 750,000 shares of the Company’s common stock on the open market or in private transactions. The authorization permits management to repurchase the Company’s shares from time to time at management’s discretion. The repurchase program is authorized through December 31, 2013. No purchases of the Company’s common stock were made during the three month period ended September 30, 2013 by or on behalf of the Company or any affiliated purchaser. As of September 30, 2013, 250,000 shares remain available for repurchase under the share repurchase program.
ITEM 6 – EXHIBITS
The following exhibits are filed as part of this Form 10-Q and this list includes the Exhibit Index:
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.