United Security Bancshares - 10-Q quarterly report FY

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

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 for the past 90 days.

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).

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

 

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.

 

See notes to consolidated financial statements

See notes to consolidated financial statements

The consolidated financial statements include the accounts of United Security Bancshares, and its wholly owned subsidiary United Security Bank (the “Bank”) and two bank subsidiaries, USB Investment Trust (the “REIT”) and United Security Emerging Capital Fund, (collectively the “Company” or “USB”). Intercompany accounts and transactions have been eliminated in consolidation.

These unaudited financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information on a basis consistent with the accounting policies reflected in the audited financial statements of the Company included in its Annual Report on Form 10-K for the year ended December 31, 2006. These interim financial statements do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of a normal recurring nature) considered necessary for a fair presentation have been included. Operating results for the interim periods presented are not necessarily indicative of the results that may be expected for any other interim period or for the year as a whole. Certain reclassifications have been made to the 2006 financial statements to conform to the classifications used in 2007. None of these reclassifications were material.

Following is a comparison of the amortized cost and approximate fair value of securities available for sale as of September 30, 2007 and December 31, 2006:

 

 

 

Included in other investment securities at September 30, 2007, is a short-term government securities mutual fund totaling $7.6 million, a CRA-qualified mortgage fund totaling $4.8 million, and a money-market mutual fund totaling $716,000. Included in other investment securities at December 31, 2006, is a short-term government securities mutual fund totaling $7.7 million, and a CRA-qualified mortgage fund totaling $4.8 million. The short-term government securities mutual fund invests in debt securities issued or guaranteed by the U.S. Government, its agencies or instrumentalities, with a maximum duration equal to that of a 3-year U.S. Treasury Note.

There were no realized gains or losses on sales or calls of available-for-sale securities during the nine months ended September 30, 2007 or September 30, 2006.

The following summarizes temporarily impaired investment securities at September 30, 2007:

 

Because the decline in market value is attributable to changes in market rates of interest rather than credit quality, and because the Company has the ability and intent to hold these investments until a recovery of fair value, which may be at maturity, the Company considers these investments to be temporarily impaired at September 30, 2007.

At September 30, 2007 and December 31, 2007, available-for-sale securities with an amortized cost of approximately $70.9 million and $70.9 million (fair value of $70.4 million and $69.7 million) were pledged as collateral for public funds, treasury tax and loan balances, and repurchase agreements.

Loans include the following:

There were no loans over 90 days past due and still accruing interest at September 30, 2007 or December 31, 2006. Nonaccrual loans totaled $17.1 million and $8.1 million at September 30, 2007 and December 31, 2006, respectively.

An analysis of changes in the allowance for credit losses is as follows:

The allowance for credit losses represents management's estimate of the risk inherent in the loan portfolio based on the current economic conditions, collateral values and economic prospects of the borrowers. The formula allowance for unfunded loan commitments totaling $609,000 at September 30, 2007 is carried in other liabilities. Significant changes in these estimates might be required in the event of a downturn in the economy and/or the real estate markets in the San Joaquin Valley, and the greater Oakhurst and East Madera County areas.

The following table summarizes the Company’s investment in loans for which impairment has been recognized for the periods presented:

 

 

 

At September 30, 2007, the Company had collateralized and uncollateralized lines of credit with the Federal Reserve Bank of San Francisco and other correspondent banks aggregating $385.4 million, as well as Federal Home Loan Bank (“FHLB”) lines of credit totaling $22.2 million. At September 30, 2007, the Company had total outstanding balances of $20.0 million drawn against its FHLB line of credit. Of the $20.0 million in FHLB borrowings outstanding at September 30, 2007, $10.0 million was in overnight borrowings, and the other $10.0 million consists of a two-year FHLB advance, at a fixed rate of 4.92%, and a maturity date of March 30, 2009.

The Company had collateralized and uncollateralized lines of credit with the Federal Reserve Bank of San Francisco and other correspondent banks aggregating $308.3 million, as well as Federal Home Loan Bank (“FHLB”) lines of credit totaling $28.0 million at December 31, 2006. At December 31, 2006, the Company had no advances on its lines of credit.

These lines of credit generally have interest rates tied to the Federal Funds rate or are indexed to short-term U.S. Treasury rates or LIBOR. FHLB advances are collateralized by all of the Company’s stock in the FHLB and certain qualifying mortgage loans. All lines of credit are on an “as available” basis and can be revoked by the grantor at any time.

 

The following table provides a reconciliation of the numerator and the denominator of the basic EPS computation with the numerator and the denominator of the diluted EPS computation:

 

Under the interest rate swap agreement, the Company receives a fixed rate and pays a variable rate based on the Prime Rate (“Prime”). The swap qualifies as a cash flow hedge under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”, as amended, and is designated as a hedge of the variability of cash flows the Company receives from certain variable-rate loans indexed to Prime. In accordance with SFAS No. 133, the swap agreement is measured at fair value and reported as an asset or liability on the consolidated balance sheet. The portion of the change in the fair value of the swap that is deemed effective in hedging the cash flows of the designated assets is recorded in accumulated other comprehensive income and reclassified into interest income when such cash flow occurs in the future. Any ineffectiveness resulting from the hedge is recorded as a gain or loss in the consolidated statement of income as part of noninterest income.

During August 2001, the Company’s Board of Directors approved a plan to repurchase, as conditions warrant, up to 280,000 shares (effectively 580,000 shares adjusted for 2-for-1 stock split in May 2006) of the Company’s common stock on the open market or in privately negotiated transactions. The duration of the program is open-ended and the timing of the purchases will depend on market conditions.

 

 

During the nine months ended September 30, 2007, 453,077 shares were repurchased at a total cost of $9.2 million and an average per share price of $20.20. Of the shares repurchased during 2007, 166,660 shares were repurchased under the 2004 plan at an average cost of $20.46 per shares, and 286,417 shares were repurchased under the 2007 plan at an average cost of $20.05 per shares.

 

 

On January 1, 2006 the Company adopted the disclosure provisions of Financial Accounting Standards Board (FASB) Statement No. 123 R, “Accounting for Share-Based Payments”. SFAS No. 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on the grant-date fair value of the award. The fair value is amortized over the requisite service period (generally the vesting period).

 

Included in salaries and employee benefits for the nine months ending September 30, 2007 and 2006 is $140,000 and $175,000 of share-based compensation, respectively. The related tax benefit on share-based compensation recorded in the provision for income taxes was not material to either quarter.

 

A summary of the Company’s options as of January 1, 2007 and changes during the nine months ended September 30, 2007 is presented below.

 

As of September 30, 2007 and 2006, there was $270,000 and $461,000, respectively, of total unrecognized compensation expense related to nonvested stock options. This cost is expected to be recognized over a weighted average period of approximately 1.25 years and 1.75 years, respectively. The Company received $510,000 and $310,000 in cash proceeds on options exercised during the nine months ended September 30, 2007 and 2006, respectively. No tax benefits were realized on stock options exercised during the nine months ended September 30, 2007, because all options exercised during the period were incentive stock options. Tax benefits realized on options exercised during the nine months ended September 30, 2006 totaled $201,000.

 

 

The Company determines fair value at grant date using the Black-Scholes-Merton pricing model that takes into account the stock price at the grant date, the exercise price, the expected life of the option, the volatility of the underlying stock and the expected dividend yield and the risk-free interest rate over the expected life of the option.

 

The weighted average assumptions used in the pricing model are noted in the table below. The expected term of options granted is derived using the simplified method, which is based upon the average period between vesting term and expiration term of the options. The risk free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of the grant. Expected volatility is based on the historical volatility of the Bank's stock over a period commensurate with the expected term of the options. The Company believes that historical volatility is indicative of expectations about its future volatility over the expected term of the options.

 

 

For options vested as of January 1, 2006 or granted after January 1, 2006, and valued in accordance with FAS 123R, the Company expenses the fair value of the option on a straight-line basis over the vesting period for each separately vesting portion of the award. The Company estimates forfeitures and only recognizes expense for those shares expected to vest. Based upon historical evidence, the Company has determined that because options are granted to a limited number of key employees rather than a broad segment of the employee base, expected forfeitures, if any, are not material.

 

 

The Black-Scholes-Merton option valuation model requires the input of highly subjective assumptions, including the expected life of the stock based award and stock price volatility. The assumptions listed about represent management's best estimates, but these estimates involve inherent uncertainties and the application of management judgment. As a result, if other assumptions had been used, the Company's recorded stock-based compensation expense could have been materially different from that previously reported by the Company. In addition, the Company is required to estimate the expected forfeiture rate and only recognize expense for those shares expected to vest. If the Company's actual forfeiture rate is materially different from the estimate, the share-based compensation expense could be materially different.

The Company and a subsidiary file income tax returns in the U.S federal jurisdiction, and several states within the U.S. There are no filings in foreign jurisdictions. The Company is not currently aware of any tax jurisdictions where the Company or any subsidiary is subject examination by federal, state, or local taxing authorities before 2001. The Internal Revenue Service (IRS) has not examined the Company’s or any subsidiaries federal tax returns since before 2001, and the Company currently is not aware of any examination planned or contemplated by the IRS. The California Franchise Tax Board (FTB) is currently examining the Company’s 2004 state tax return, and it is anticipated that the examination will be completed during the fourth quarter of 2007. There were no contingencies included in the financial statements at September 30, 2007 for the FTB’s examination of the Company’s 2004 tax state tax return.

During the second quarter of 2006, the FTB issued the Company a letter of proposed adjustments to, and assessments for, (as a result of examination of the tax years 2001 and 2002) certain tax benefits taken by the REIT during 2002. The Company continues to review the information available from the FTB and its financial advisors and believes that the Company's position has merit. The Company is pursing its tax claims and will defend its use of these entities and transactions. The Company will continue to assert its administrative protest and appeal rights pending the outcome of litigation by another taxpayer presently in process on the REIT issue in the Los Angeles Superior Court (City National v. Franchise Tax Board).

The Company has reviewed its REIT tax position as of January 1, 2007 (adoption date) and again at March 31, 2007, June 30, 2007, and September 30, 2007 in light of the adoption of FIN48. The Bank, with guidance from advisors believes that the case has merit with regard to points of law, and that the tax law at the time allowed for the deduction of the consent dividend. However, the Bank, with the concurrence of advisors, cannot conclude that it is “more than likely” (as defined in FIN48) that the Bank will prevail in its case with the FTB. As a result of the implementation of FIN48, the Company recognized approximately a $1.3 million increase in the liability for unrecognized tax benefits (included in other liabilities), which was accounted for as a reduction to the January 1, 2007 balance of retained earnings. The adjustment provided at adoption included penalties proposed by the FTB of $181,000 and interest totaling $210,000. During the nine months ended September 30, 2007, the Company recorded an additional $43,000 in interest liability pursuant to the provisions of FIN48. The Company had approximately $434,000 accrued for the payment of interest and penalties at September 30, 2007. Subsequent to the initial adoption of FIN48, it is the Company’s policy to recognize interest expense related to unrecognized tax benefits, and penalties, as a component tax expense. A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows (in 000’s):

 

 

 

 

The Company believes its adoption of SFAS No. 159 will have a positive impact on its ability to better manage the balance sheet and interest rate risks associated with this liability while potentially benefiting the net interest margin, net interest income, net income and earnings per common share in future periods. Specifically, the Company believes the election of fair value accounting for the junior subordinated debentures better reflects the true economic value of the debt instrument on the balance sheet. The Company’s junior subordinated debentures were issued in 2001 when the Trust Preferred Securities market was new and less liquid than today. As a result, subordinated debentures are available in the market at narrower spreads and lower issuing costs. With a higher-than-market spread to LIBOR, and remaining capitalized issuance costs of more than $400,000 on the balance sheet, the Company’s cost-basis of the subordinated debentures recorded on the balance sheet does not properly reflect the true opportunity costs to the Company.

 

The initial fair value measurement at adoption resulted in a $1,053,000 cumulative-effect adjustment to the opening balance of retained earnings at January 1, 2007. The adjustment resulted in an increase of $1,053,000 in the reported balance of the junior subordinated debentures, an increase in deferred tax assets of $443,000 and the corresponding reduction in retained earnings of $610,000. Under SFAS No. 159, this one-time charge to shareholders’ equity was not recognized in earnings. In addition to the fair value adjustment of the junior subordinated debentures recorded effective January 1, 2007, the Company also removed the remaining $405,000 in unamortized issuance costs of the debt instrument. The remaining issuance costs were removed in accordance with SFAS 159 effective January 1, 2007, with corresponding charges of $170,000 to deferred taxes and $235,000 to retained earnings.

 

As a requirement of electing early adoption of SFAS 159, the Company also adopted SFAS 157, “Fair Value Measurement” effective January 1, 2007. The Company utilized the guidelines of SFAS No. 157 to perform the fair value analysis on the junior subordinated debentures. In its analysis, the Company used a net-present-value approach based upon observable market rates of interest, over a term that considers the most advantageous market for the liability, and the most reasonable behavior of market participants.

 

The following table summarizes the effects of the adoption of SFAS No. 159 at both adoption date and September 30, 2007 (in 000’s) on the Company’s junior subordinated debentures. Changes in fair value (FV) for periods subsequent to adoption are recorded in current earnings. Pretax changes in fair value for the nine months ended September 30, 2007 totaled $2.2 million and are included as a gain in other noninterest income.

 

At June 30, 2007, the Company held junior subordinated debentures issued to capital trusts commonly known as "Trust Preferred securities.” The debt instrument was issued by the Company’s wholly-owned special purpose trust entity, USB Capital Trust I on July 25, 2001 in the amount of $15,000,000 with a thirty-year maturity, interest benchmarked at the 6-month-LIBOR rate (re-priced in January and July each year) plus 3.75%. The Company had the ability to redeem the debentures at its option. The prepayment provisions of the instrument allowed repayment after five years (July 25, 2006) with certain prepayment penalties. On July 25, 2007, the Company redeemed the $15.0 million in subordinated debentures plus accrued interest of $690,000 and a 6.15% prepayment penalty totaling $922,500. Concurrently, the Trust Preferred securities issued by Capital Trust I were redeemed. The prepayment penalty of $922,500 had previously been a component of the fair value adjustment for the junior subordinated debt at the initial adoption of SFAS No. 159, and as a result was recorded through retained earnings effective January 1, 2007.

 

During July 2007, the Company formed USB Capital Trust II, a wholly-owned special purpose entity, for the purpose of issuing Trust Preferred Securities. Like USB Capital Trust I formed in July 2001, USB Capital Trust II is a Variable Interest Entity (VIE) and will be considered a deconsolidated entity pursuant to FIN 46. On July 23, 2007 USB Capital Trust II issued $15 million in Trust Preferred securities. The securities have a thirty-year maturity and bear a floating rate of interest (repricing quarterly) of 1.29% over the three-month LIBOR rate (initial coupon rate of 6.65%). Interest will be paid quarterly. Concurrent with the issuance of the Trust Preferred securities, USB Capital Trust II used the proceeds of the Trust Preferred securities offering to purchase a like amount of junior subordinated debentures of the Company. The Company will pay interest on the junior subordinated debentures to USB Capital Trust II, which represents the sole source of dividend distributions to the holders of the Trust Preferred securities. The Company may redeem the junior subordinated debentures at anytime before October 2008 at a redemption price of 103.3, and thereafter each October as follows: 2008 at 102.64, 2009 at 101.98, 2010 at 101.32, 2011 at 100.66, and at par anytime after October 2012.

 

The fair value hierarchy under SFAS No. 157 prioritizes the inputs to valuation techniques used to measure fair value into three broad levels (Level 1, Level 2, and Level 3). Level 1 inputs are unadjusted quoted prices in active markets (as defined) for identical assets or liabilities that the reporting entity has the ability to access at the measurement date. Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. Level 3 inputs are unobservable inputs for the asset or liability, and reflect the reporting entity’s own assumptions about the assumptions that market participants would use in pricing the asset or liability (including assumptions about risk).

The Company performs fair value measurements on certain assets and liabilities as the result of the application of accounting guidelines and pronouncements that were relevant prior to the adoption of SFAS No. 157. Some fair value measurements, such as for available-for-sale securities and interest rate swaps are performed on a recurring basis, while others, such as impairment of goodwill and other intangibles, are performed on a nonrecurring basis.

The following tables summarize the Company’s assets and liabilities that were measured at fair value on a recurring basis during the period (in 000’s):

Available for sale securities are valued based upon open-market quotes obtained from reputable third-party brokers. Market pricing is based upon specific CUSIP identification for each individual security. Changes in fair market value are recorded in other comprehensive income as the securities are available for sale.

The fair value of interest rate swap contracts is based on the discounted net present value of the swap using third party dealer quotes. Changes in fair market value are recorded in other comprehensive income, and changes resulting from ineffectiveness are recorded in current earnings.

Fair value measurements for impaired loans are performed pursuant to SFAS No. 114, and are based upon either collateral values supported by appraisals, or observed market prices. The change in fair value of impaired assets that were valued based upon level three inputs was approximately $92,000 for the nine months ended September 30, 2007. This loss is not recorded directly as an adjustment to current earnings or comprehensive income, but rather as an adjustment component in determining the overall adequacy of the loan loss reserve. Such adjustments to the estimated fair value of impaired loans may result in increases or decreases to the provision for credit losses recorded in current earnings.

Upon adoption of SFAS No. 159 on January 1, 2007, the Company elected the fair value measurement option for all the Company’s pre-existing junior subordinated debentures, and subsequently for new junior subordinated debentures issued during July 2007 under USB Capital Trust II. The fair value of the debentures was determined based upon discounted cash flows utilizing observable market rates and credit characteristics for similar instruments. In its analysis, the Company used characteristics that distinguish market participants generally use, and considered factors specific to (a) the liability, (b) the principal (or most advantageous) market for the liability, and (c) market participants with whom the reporting entity would transact in that market. The adjustment for fair value at adoption was recorded as a cumulative-effect adjustment to the opening balance of retained earnings at January 1, 2007. Fair value adjustments subsequent to adoption are recorded in current earnings (see Notes 12 and 13 to the financial statements included herein in the Company’s 10-Q for September 30, 2007).

The following tables summarize the Company’s assets and liabilities that were measured at fair value on a nonrecurring basis during the period (in 000’s):

 

The Company completed its merger with Legacy Bank in February 2007 (see Note 15 to the financial statements included herein in the Company’s 10-Q for September 30, 2007). The merger transaction was accounted for using the purchase accounting method, and resulted in the purchase price being allocated to the assets acquired and liabilities assumed from Legacy Bank based on the fair value of those assets and liabilities. The allocations of purchase price based upon the fair market value of assets acquired and liabilities assumed is preliminary, but management does not believe that adjustments, if any, will be material. The fair value measurements for Legacy’s loan portfolio included certain market rate assumptions on segmented portions of the loan portfolio with similar credit characteristics, and credit risk assumptions specific to the individual loans within that portfolio. Available-for sale securities were valued based upon open-market quotes obtained from reputable third-party brokers. Legacy’s deposits were valued based upon anticipated net present cash flows related to Legacy’s deposit base, and resulted in a core deposit intangible (CDI) adjustment of $3.0 million carried as an asset on the Company’s balance sheet. Assumptions used to determine the CDI included anticipated costs of, and revenues generated by, those deposits, as well as the estimated life of the deposit base. Other assets and liabilities generally consist of short-term items including cash, overnight investments, and accrued interest receivable or payable, and as such, it was determined that carrying value approximated fair value.

The following tables provide a reconciliation of assets and liabilities at fair value using significant unobservable inputs (Level 3) on both a recurring (impaired loans) and nonrecurring (business combination) basis during the period (in 000’s):

 

On February 16, 2007, the Company acquired 100 percent of the outstanding common shares of Legacy Bank, N.A., located in Campbell, California. At merger, Legacy Bank’s one branch was merged with and into United Security Bank, a wholly owned subsidiary of the Company. The purchase of Legacy Bank provided the Company with an opportunity to expand its market area into Santa Clara County and to serve a loyal and growing small business niche and individual client base build by Legacy.

 

The aggregate purchase price for Legacy was $21.7 million, which included $171,000 in direct acquisition costs related to the merger. At the date of merger, Legacy Bank had 1,674,373 shares of common stock outstanding. Based upon an exchange rate of approximately .58 shares of the Company’s stock for each share of Legacy stock, Legacy shareholders received 976,411 shares of the Company’s common stock, amounting to consideration of approximately $12.86 per Legacy common share.

 

Legacy’s results of the operations have been included in the Company’s results beginning February 17, 2007.

 

During the second quarter of 2007, the Company re-evaluated the preliminary estimate of the core deposit intangible related to savings accounts acquired from Legacy and determined that the initial run-off of those deposits was faster than originally anticipated. As a result, the Company reduced the core deposits intangible by approximately $215,000 from the amount reported at March 31, 2007. Correspondingly, resultant goodwill was increased by that same $215,000.

 

The following summarizes the purchase and the resultant allocation to fair-market-value adjustments and goodwill:

 

 

The following condensed balance sheet summarizes the amount assigned for each major asset and liability category of Legacy at the merger date:

 

 

 

Core deposit intangibles totaling $3.0 million will be amortized for book purposes over an estimated life of approximately 7 years using the yield method. Core deposit intangibles will be reviewed for impairment on an annual basis.

 

Goodwill totaling $8.1 million will not be amortized for book purposes under current accounting guidelines. Because the merger was a tax-deferred stock-for-stock purchase, goodwill is not deductible for tax purposes. Goodwill will be reviewed for impairment on an annual basis.

In the Company's Form 10-K for the year ended December 31, 2006, a transition adjustment in the amount of $169,000 net of tax benefit of $112,000, was recognized as a component of the ending balance of Accumulated Other Comprehensive Income/(Loss) on the Company’s balance sheet as the result of the adoption of SFAS No. 158, “Employer’s Accounting for Defined Benefit Pension and Other Postretirement Plans”.

This adjustment was misapplied as a component of Comprehensive Income on the Company’s consolidated statement of income and comprehensive income for the year ended December 31, 2006. The table below reflects the effects of the misapplication of this adjustment at December 31, 2006.

The Company will correct the Other Comprehensive Income presentations in the Form 1O-K for the fiscal year ending December 31, 2007 to reflect the revised amounts shown above.

 

Other real estate owned (“OREO”), consisting of real estate acquired through foreclosure of collateral that secured loans, totaled $2.5 million at September 30, 2007. Subsequent to quarter-end, one OREO property carried at a value of $563,000 at September 30, 2007 was sold resulting in a pretax loss of $6,000. During October 2007, two nonaccrual loans totaling $ 6.3 million at September 30, 2007 were transferred to OREO. Accrued interest of approximately $866,000 on one nonaccrual loan with principal of $6.0 million was included in the transfer to OREO as an adjustment to the carrying value of the property. OREO was $9.1 million at October 31, 2007 after the transfers.

 

 

On February 16, 2007, the Company completed its merger of Legacy Bank, N.A. with and into United Security Bank, a wholly owned subsidiary of the Company. Legacy Bank which began operations in 2003 operated one banking office in Campbell, California serving small business and retail banking clients. With its small business and retail banking focus, Legacy Bank provides a unique opportunity for United Security Bank to serve a loyal and growing small business niche and individual client base in the San Jose area. Upon completion of the merger, Legacy Bank's branch office began operating as a branch office of United Security Bank. As of February 16, 2007 Legacy Bank had net assets of approximately of $8.6 million, including net loans of approximately $63 million and deposits of approximately $70 million.

 

The Company currently has eleven banking branches, which provide financial services in Fresno, Madera, Kern, and Santa Clara counties.

The following table summarizes the nine-month and year-to-date averages of the components of interest-bearing assets as a percentage of total interest-bearing assets, and the components of interest-bearing liabilities as a percentage of total interest-bearing liabilities:

 

With market rates of interest remaining level through much of 2007, then declining 50 basis points during mid-September 2007, the Company has begun to experience declines in its net interest margin. The Company’s net interest margin was 5.50% for the nine months ended September 30, 2007, as compared to 5.67% for the year ended December 31, 2006, and 5.66% for the nine months ended September 30, 2006. With approximately 63% of the loan portfolio in floating rate instruments at September 30, 2007, the effects of market rates continue to be realized almost immediately on loan yields. Loans yielded 9.28% during the nine months ended September 30, 2007, as compared to 9.13% for the year ended December 31, 2006, and 9.06% for the nine months ended September 30, 2006. Loan yield was enhanced during the first nine months of 2007, as a nonperforming loan was paid off during the quarter, providing an additional $902,000 in previously unrecognized interest income that would not have otherwise been recognized during the nine months ended September 30, 2007, and an enhancement to loan yield of approximately 21 basis points. The Company continues to experience pricing pressures on deposits, especially money market accounts and time deposits, as increased competition for deposits continues throughout the Company’s market area. The Company’s average cost of funds was 3.90% for the nine months ended September 30, 2007 as compared to 3.24% for the year ended December 31, 2006, and 3.10% for the nine months ended September 30, 2006.

Noninterest income continues to be driven by customer service fees, which totaled $3.5 million for the nine months ended September 30, 2007, representing on increase of $598,000 or 20.59% over the $2.9 million in customer service fees reported for the nine months ended September 30, 2006. Total noninterest income increased by $422 between the nine-month periods ended September 30, 2006 and September 30, 2007, primarily as the result of a $2.2 million gain recognized during the nine moths ended September 30, 2007 resulting from SFAS No. 159 fair value adjustments to the Company’s junior subordinated debt. Offsetting this were several reductions in noninterest income including, a nonrecurring $1.9 million gain on the sale of an investment in correspondent bank stock recognized during the first quarter of 2006, and a $1 million gain on the sale of the Company’s administrative headquarters during the third quarter of 2006, both of which did not occur again during 2007. Other noninterest income increased approximately $245,000 as the result of a number of items including increases in rental and OREO income experienced during the first nine months of 2007.

Noninterest expense increased approximately $1.4 million or 9.3% between the nine-month periods ended September 30, 2006 and September 30, 2007. Increases were experienced in salaries and employee benefits, occupancy expense, professional fees, and other general business expenses, as the Company continues to grow and seek qualified staff as part of its strategic plan. As part of noninterest expense, OREO expense actually declined by $1.7 million or 93.5% between the nine-month periods ended September 30, 2006 and September 30, 2007 as costs associated with an OREO property the Company was in the process of liquidating during 2006, were not again incurred during 2007.

The Company has maintained a strong balance sheet, with sustained loan growth and sound deposit growth. With the Legacy merger completed during February 2007, total assets have grown more than $124.7 million between December 31, 2006 and September 30, 2007, while net loans have grown $122.8 million, and deposits have grown $82.4 million during the nine months ended September 30, 2007. With increased loan growth, average loans comprised approximately 84% of overall average earning assets during the nine months ended September 30, 2007. In total, average core deposits, including NOW accounts, money market accounts, and savings accounts, continue to comprise a high percentage of total interest-bearing liabilities for the nine months ended September 30, 2007, although time deposits as a percentage of average deposits for the period have increased during 2007 as the Company has sought brokered deposits to fund continued loan demand. To further fund loan demand, the Company utilized its FHLB credit line during the first quarter of 2007, borrowing $10.0 million for a term of two years at a fixed rate of 4.92%.

 

For the nine months ended September 30, 2007, the Company reported net income of $10.6 million or $0.89 per share ($0.88 diluted) as compared to $10.4 million or $0.91 per share ($0.91 diluted) for the nine months ended September 30, 2006. The Company’s return on average assets was 1.87% for the nine-month-period ended September 30, 2007 as compared to 2.14% for the nine-month-period ended September 30, 2006. The Bank’s return on average equity was 17.43% for the nine months ended September 30, 2007 as compared to 22.12% for the same -month period of 2006.

 

Net interest income before provision for credit losses totaled $27.8 million for the nine months ended September 30, 2007, representing an increase of $3.3 million or 13.6% when compared to the $24.5 million reported for the same nine months of the previous year. The increase in net interest income between 2006 and 2007 is primarily the result of increased volumes in, and yields on, interest-earning assets, which more than offset increases in the Company’s cost of interest-bearing liabilities.

The Bank's net interest margin, as shown in Table 1, decreased to 5.50% at September 30, 2007 from 5.66% at September 30, 2006, a decrease of 16 basis point (100 basis points = 1%) between the two periods. Although the Company has experienced pricing pressures on loans over the past year, average market rates of interest increased between the nine-month periods ended September 30, 2006 and 2007. The prime rate averaged 8.23% for the nine months ended September 30, 2007 as compared to 7.86% for the comparative nine months of 2006. While yields on earning assets increased between the two periods presented, costs of interest-bearing liabilities increased more, increasing 80 basis points between the two nine-month periods.

Interest rates and Interest Differentials

Nine Months Ended September 30, 2007 and 2006