UNITED STATESSECURITIES AND EXCHANGE COMMISSION
FORM 10-Q
x Quarterly Report pursuant to Section 13 or 15(d) of the Securities and Exchange Act of 1934.
For the quarterly period ended September 30, 2004
o Transition Report pursuant to Section 13 or 15(d) of the Securities and Exchange Act of 1934.
For the transition period from to
Commission file number 0-30533
TEXAS CAPITAL BANCSHARES, INC.
214/932-6600(Registrant’s telephone number,including area code)
N/A(Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report)
Indicate by checkmark whether the issuer (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
Indicate by checkmark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No o
APPLICABLE ONLY TO CORPORATE ISSUERS:
On October 31, 2004, the number of shares set forth below was outstanding with respect to each of the issuer’s classes of common stock:
Texas Capital Bancshares, Inc.Form 10-QQuarter Ended September 30, 2004
Index
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ITEM 1. FINANCIAL STATEMENTS
See accompanying notes to consolidated financial statements.
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[Continued from above table, first column(s) repeated]
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(1) ACCOUNTING POLICIES
Basis of Presentation
The accounting and reporting policies of Texas Capital Bancshares, Inc. (the “Company”) conform to accounting principles generally accepted in the United States and to generally accepted practices within the banking industry. The Consolidated Financial Statements of the Company include the accounts of the Company and its subsidiary, Texas Capital Bank, National Association (the “Bank”). Certain prior period balances have been reclassified to conform with the current period presentation.
The consolidated interim financial statements have been prepared without audit. Certain information and footnote disclosures presented in accordance with accounting principles generally accepted in the United States have been condensed or omitted. In the opinion of management, the interim financial statements include all normal and recurring adjustments and the disclosures made are adequate to make interim financial information not misleading.
Stock-based Compensation
At September 30, 2004, the Company had a stock-based employee compensation plan. The Company accounts for the plan under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. No stock-based employee compensation cost for options is reflected in net income, as all options granted under the plan had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation,to stock-based employee compensation.
The fair value of these options was estimated at the date of grant using a Black-Scholes value option pricing model with the following weighted average assumptions used for 2004 and 2003, respectively: a risk free interest rate of 3.63% and 3.05%, a dividend yield of 0%, a volatility factor of .288 and .091, and an estimated life of five years.
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(1) ACCOUNTING POLICIES (continued)
The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company’s employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.
(2) EARNINGS PER SHARE
The following table presents the computation of basic and diluted earnings per share (dollars in thousands except share and per share data):
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(3) FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK
The Bank 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. These financial instruments include commitments to extend credit and standby letters of credit which involve varying degrees of credit risk in excess of the amount recognized in the consolidated balance sheets. The Bank’s exposure to credit loss in the event of non-performance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of these instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. The amount of collateral obtained, if deemed necessary, is based on management’s credit evaluation of the borrower.
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer’s credit-worthiness on a case-by-case basis.
Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.
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QUARTERLY FINANCIAL SUMMARY – UNAUDITEDConsolidated Daily Average Balances, Average Yields and Rates(Dollars in thousands except per share data)
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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Forward Looking Statements
Statements and financial analysis contained in this document that are not historical facts are forward looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward looking statements describe our future plans, strategies and expectations and are based on certain assumptions. As a result, these forward looking statements involve substantial risks and uncertainties, many of which are beyond our control. The important factors that could cause actual results to differ materially from the forward looking statements include the following:
For a more complete discussion of important factors that could cause results to differ materially from the forward looking statements included in this Report, including the factors listed above, see the discussion in our Annual Report on Form 10-K for the year ending December 31, 2003 under the caption “Investment Considerations”.
We have no obligation to update or revise any forward looking statements as a result of new information or future events. In light of these assumptions, risks and uncertainties, the events discussed in any forward looking statements in this quarterly report might not occur.
Results of Operations
Summary of Performance
The Company recorded net income of $5.2 million, or $.20 per diluted common share, for the third quarter of 2004 compared to $3.3 million, or $.14 per diluted common share, for the third quarter of 2003. Return on average equity was 11.25% and return on average assets was .85% for the third quarter of 2004 compared to 9.05% and .64%, respectively, for the third quarter of 2003.
The increase in net income and improvement in return on assets in 2004 are attributed to growth in net interest income, which came from continued earning asset growth, as well as an improvement in net interest margin. Net interest income for the third quarter of 2004 increased by $6.0 million, or 45%, from $13.4 million to $19.4 million over the third quarter of 2003. The increase in net interest income was due to an increase in average earning assets of $372.7 million, or 19%, with a 61 basis point increase in net interest margin.
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Non-interest income increased $951,000, or 38%, compared to the third quarter of 2003. The Company benefited from growth in fees related to wealth management, and gain on sale of mortgage loans, which is related to our residential mortgage lending division that was started in the third quarter of 2003.
Non-interest expense increased $4.1 million, or 39%, compared to the third quarter of 2003. The increase is primarily related to a $3.1 million increase in salaries and employee benefits to $8.9 million from $5.8 million. The increase related to general business growth, staffing for the new Houston office and the start-up of the residential mortgage lending division.
Non-GAAP Financial Measure
During the quarter ended June 30, 2003, net income included the impact of reversing our deferred tax asset valuation allowance of $5.9 million, $6.3 million in penalties related to unwinding repurchase agreements prior to maturity and approximately $250,000 in separation expense related to the resignation of a senior officer. For the nine months ended September 30, 2003, adjusted income, or income per share excluding the impact of reversing the valuation allowance, unwinding penalties and separation expense would have been $0.39, on a diluted basis. Adjusted income per share, or income per share excluding the impact of reversing the valuation allowance, unwinding penalties and separation expense for the nine months ended September 30, 2003 is a non-GAAP financial measure. As disclosed in our second quarter and third quarter 2003 Form 10Q’s, management believes that this non-GAAP financial measure is useful to investors and to management because they provide additional information that more closely reflects our intrinsic operating performance and growth. Reversal of the entire valuation allowance was based on our assessment of our ability to generate earnings to allow the deferred tax assets to be realized which is supported by our current earnings trends. We unwound certain repurchase agreements, incurring the unwinding penalties, in order to take advantage of historical lows in interest rates, which had decreased on similar repurchase agreements by approximately 1.4% since the time we entered into the original repurchase agreements. Although we have experienced employee separations in the past, this was the first separation with an executive who had entered into an employee agreement with us. We currently have only four other employees with employment agreements. Since we have not had any reversals of valuation allowances, unwinding penalties or separation expenses related to employees who have employment agreements in our operating history, we believe that this non-GAAP financial measure is useful to investors and to management to understand the development of our income per share results since our formation and to help in comparing our intrinsic operating performance in different periods. Management also uses this measure internally to evaluate our performance and manage our operations. This measurement should not be regarded as a replacement for corresponding GAAP measures, including net income.
The following table reconciles income per share excluding the impact of reversing the valuation allowance, unwinding penalties, and separation expense to income per share, which is the most directly comparable financial measure presented in accordance with GAAP.
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Reconciliation of GAAP to income per share, excluding the impact of reversing the valuation allowance, unwinding penalties, and separation expense.
Net Interest Income
Net interest income was $19.4 million for the third quarter of 2004, compared to $13.4 million for the third quarter of 2003. The increase was due to an increase in average earning assets of $372.7 million as compared to the third quarter of 2003 and a 61 basis point increase in net interest margin. The increase in average earning assets included a $329.5 million increase in average loans held for investment and a $149.1 million increase in average securities offset by a $101.2 million decrease in loans held for sale. For the quarter ended September 30, 2004, average net loans and securities represented 65% and 35%, respectively, of average earning assets compared to 66% and 34% in the same quarter of 2003. While we continue to apply prudent lending standards, loan growth in the third quarter of 2004 in our core loan portfolio (excluding loans held for sale) totaled $121.1 million. Our securities percentage has increased as we have continued to use additional securities to increase our earnings and improve our return on equity by taking advantage of market spreads.
Average interest bearing liabilities increased $312.1 million from the third quarter of 2003, which included a $222.4 million increase in interest bearing deposits and a $89.7 million increase in other borrowings. The increase in average borrowings was primarily related to funding of the increase in investment securities. The average cost of interest bearing liabilities increased from 1.85% for the three months ended September 30, 2003 to 1.97% for the same period of 2004, reflecting the increase in market interest rates.
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Net interest income was $53.3 million for the first nine months of 2004, compared to $37.8 million for the same period of 2003. The increase was due to an increase in average earning assets of $363.6 million as compared to 2003 and a 48 basis point increase in net interest margin. The increase in average earning assets included a $278.5 million increase in average loans held for investment and a $169.0 million increase in average securities. For the nine months ended September 30, 2004, average net loans and securities represented 64% and 36%, respectively, of average earning assets compared to 65% and 34% in the same period of 2003.
Average interest bearing liabilities increased $288.5 million from the third quarter of 2003, which included a $187.0 million increase in interest bearing deposits and a $97.8 million increase in other borrowings. The increase in average borrowings was primarily related to funding of the increase in investment securities. The average cost of interest bearing liabilities decreased from 2.12% for the nine months ended September 30, 2003 to 1.81% for the same period of 2004, reflecting the reduction in market interest rates.
TABLE 1 — VOLUME/RATE ANALYSIS(In thousands)
Net interest margin, the ratio of net interest income to average earning assets, was 3.37% for the third quarter of 2004 compared to 2.76% for the third quarter of 2003. The increase was due primarily to a 70 basis point increase in the yield on earning assets offset by a 12 basis point increase in the cost of interest bearing liabilities.
Non-interest Income
Non-interest income increased $951,000 in the third quarter of 2004 compared to the same quarter of 2003. Trust fee income increased $132,000 due to continued growth of trust assets in 2003 and 2004. Gain on sale of mortgage loans totaled $1.1 million and relates to our residential mortgage lending division that was started in the third quarter of 2003. Offsetting these increases was a decrease in mortgage warehouse fees. Mortgage warehouse fees totaled $241,000 for the third quarter of 2004, compared to $545,000 for the third quarter of 2003. The decrease was due to more normalized production levels in 2004 as compared to a peak in production during the second and third quarters of 2003 as overall refinancings reached record levels. Also, there was a decrease in BOLI income related to an annual adjustment in earning rates.
Non-interest income, excluding gain on sale of securities, increased $1.9 during the nine months ended September 30, 2004 to $9.9 million compared to $8.0 million during the same period of 2003. Trust fee income increased $436,000 due to continued growth of trust assets in 2003 and 2004. Gain on sale of mortgage loans totaled $2.3 million and relates to our newly created residential mortgage lending division. Offsetting these increases were decreases in cash processing fees and mortgage warehouse fees. Cash processing fees were $386,000 lower in the first nine months of 2004 compared to the same period of 2003. These fees were related
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to a special project that occurred in the first quarter of 2002, 2003 and 2004. 2004 fees are lower than 2003 fees due to smaller participation and more competitive pricing. Mortgage warehouse fees totaled $753,000 for the first nine months of 2004, compared to $1.2 million for the same period of 2003. The decrease was due to more normalized production levels in 2004 as compared to a peak in production during the second and third quarters of 2003 as overall refinancings reached record levels.
While management expects continued growth in non-interest income, the future rate of growth could be affected by increased competition from nationwide and regional financial institutions. In order to achieve continued growth in non-interest income, we may need to introduce new products or enter into new markets. Any new product introduction or new market entry would likely place additional demands on capital and managerial resources.
TABLE 2 – NON-INTEREST INCOME(In thousands)
Non-interest Expense
Non-interest expense for the third quarter of 2004 increased $4.1 million, or 39%, to $14.6 million from $10.5 million, and is primarily related to a $3.1 million increase in salaries and employee benefits to $8.9 million from $5.8 million. The increase in salaries and employee benefits resulted from an increase in the total number of employees related to general business growth, staffing for the new Houston office and the start-up of the residential mortgage lending division. Of the increase, approximately $828,000 is related to commissions in the residential mortgage lending division and represents a variable component of compensation expense directly related to residential loan production, sales and gains on the sale of mortgage loans reflected in non-interest income.
Advertising expense increased $89,000, or 42%. Advertising expense for the three months ended September 30, 2004 included $41,000 of direct marketing and branding and $261,000 for the purchase of miles related to the American Airlines AAdvantage® program, compared to $37,000 of direct marketing and branding and $176,000 for the purchase of miles during the same period for 2003.
Net occupancy expense for the three months ended September 30, 2004 increased by $178,000, or 14%, compared to the same quarter in 2003 and is related to our continued business growth, the new Houston office and the start-up of the residential mortgage lending division. Legal and professional expense for the three months ended September 30, 2004 increased $11,000 or 1% compared to the same quarter in 2003. Communications and data processing expense for the three months ended September 30, 2004 remained consistent compared to the same quarter in 2003, with a slight decrease of $3,000 or 0.4%.
Non-interest expense for the first nine months of 2004 increased $4.6 million, or 13%, to $41.4 million from $36.8 million during the same period in 2003 and is primarily related to an $8.0 million increase in salaries and employee benefits to $25.0 million from $17.0 million. The increase in salaries and employee benefits resulted from an increase in the total number of employees related to general business growth, staffing for the new Houston office and the start-up of the residential mortgage lending division. Of the increase, approximately
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$1.7 million is related to commissions in the residential mortgage lending division and represents a variable component of compensation expense directly related to residential loan production, sales and gains on the sale of mortgage loans reflected in non-interest income.
Advertising expense increased $278,000, or 46%. Advertising expense for the nine months ended September 30, 2004 included $101,000 of direct marketing and branding and $782,000 for the purchase of miles related to the American Airlines AAdvantage® program, compared to $99,000 of direct marketing and branding and $506,000 for the purchase of miles during the same period for 2003.
Net occupancy expense for the nine months ended September 30, 2004 increased by $467,000, or 13%, compared to the same period in 2003 and is related to our continued business growth, the new Houston office and the start-up of the residential mortgage lending division. Legal and professional expense for the nine months ended September 30, 2004 increased $74,000 or 3% compared to the same period in 2003. Communications and data processing expense for the nine months ended September 30, 2004 increased $395,000 or 18% compared to the same period in 2003 due to continued growth and costs associated with our system conversion.
TABLE 3 – NON-INTEREST EXPENSE(In thousands)
Analysis of Financial Condition
The aggregate loan portfolio at September 30, 2004 increased $253.7 million from December 31, 2003 to $1.6 billion. Commercial loans increased $138.5 million and real estate loans increased $42.5 million. Construction loans and consumer loans increased $77.0 million and $165,000, respectively, and leases decreased $2.7 million.
TABLE 4 – LOANS(In thousands)
We continue to lend primarily in Texas. As of September 30, 2004, a substantial majority of the principal amount of the loans in our portfolio was to businesses and individuals in Texas. This geographic concentration subjects the loan portfolio to the general economic conditions within this area. We originate substantially all of
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the loans in our portfolio, except in certain instances we have purchased individual leases and loan and lease pools (primarily commercial and industrial equipment and vehicles), as well as selected loan participations and USDA government guaranteed loans.
Summary of Loan Loss Experience
The reserve for loan losses, which is available to absorb losses inherent in the loan portfolio, totaled $18.7 million at September 30, 2004, $17.7 million at December 31, 2003 and $17.3 million at September 30, 2003. This represents 1.26%, 1.44% and 1.53% of loans held for investment (net of unearned income) at September 30, 2004, December 31, 2003 and September 30, 2003, respectively.
The provision for loan losses is a charge to earnings to maintain the reserve for loan losses at a level consistent with management’s assessment of the loan portfolio in light of current economic conditions and market trends. The Company recorded a provision of $375,000 for the quarter ended September 2004 and $475,000 for the same quarter in 2003. These provisions were made to reflect management’s assessment of the risk of loan losses specifically including the significant growth in outstanding loans during each of these periods.
The reserve for loan losses is comprised of allocated reserves for impaired loans and potential losses in the portfolio at the balance sheet date, but not yet identified with specific loans. We regularly evaluate our reserve for loan losses to maintain an adequate level to absorb potential loan losses in the loan portfolio. Factors contributing to the determination of allocated reserves include the credit worthiness of the borrower, changes in the value of pledged collateral, and general economic conditions. All loans and commitments rated substandard or worse and greater than $1,000,000 are reviewed and a specific allocation is assigned based on the potential loss which may be realized from those loans. For purposes of determining the general reserve, the portfolio is segregated by product types to recognize differing risk profiles among categories, and then further segregated by credit grades. Credit grades are assigned to all loans greater than $50,000. Each credit grade is assigned a risk factor, or reserve allocation percentage. These risk factors are multiplied by the outstanding principal balance and risk-weighted by product type to calculate the required reserve. A similar process is employed to calculate that portion of the required reserve assigned to unfunded loan commitments.
The reserve allocation percentages assigned to each credit grade have been developed based on an analysis of the Company’s historical loss rates and historical loss rates within the banking industry and our markets, adjusted for certain qualitative factors. Qualitative adjustments for such things as general economic conditions, changes in credit policies and lending standards, and changes in the trend and severity of problem loans, can cause the estimation of future losses to differ from past experience. The unallocated portion of the general reserve is intended to cover exposure to additional uncertainty and considers industry trends. In addition, the reserve considers the results of reviews performed by independent third party reviewers as reflected in their confirmations of assigned credit grades within the portfolio.
The methodology used in the periodic review of reserve adequacy, which is performed at least quarterly, is designed to be dynamic and responsive to changes in portfolio credit quality and potential for future credit losses. The changes are reflected in the general reserve and in specific reserves as the collectibility of larger classified loans is continuously recalculated with new information. Historical loss ratios are closely monitored for our portfolio and the industry. Currently, the review of reserve adequacy is performed by executive management and presented to our board of directors for their review, consideration and ratification on a quarterly basis.
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TABLE 5 – SUMMARY OF LOAN LOSS EXPERIENCE(In thousands)
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Non-performing Assets
Non-performing assets include non-accrual loans and leases, accruing loans 90 or more days past due, restructured loans, and other repossessed assets. The table below summarizes our non-accrual loans by type:
At September 30, 2004, we had $117,000 in loans past due 90 days and still accruing interest. At September 30, 2004, we had $318,000 in other repossessed assets.
Generally, we place loans on non-accrual when there is a clear indication that the borrower’s cash flow may not be sufficient to meet payments as they become due, which is generally when a loan is 90 days past due. When a loan is placed on non-accrual status, all previously accrued and unpaid interest is reversed. Interest income is subsequently recognized on a cash basis as long as the remaining unpaid principal amount of the loan is deemed to be fully collectible. If collectibility is questionable, then cash payments are applied to principal. As of September 30, 2004, approximately $4.0 million of our non-accrual loans were earning on a cash basis.
A loan is considered impaired when, based on current information and events, it is probable that we will be unable to collect all amounts due (both principal and interest) according to the terms of the loan agreement. Reserves on impaired loans are measured based on the present value of the expected future cash flows discounted at the loan’s effective interest rate or the fair value of the underlying collateral.
Securities Portfolio
Securities are identified as either held-to-maturity or available-for-sale based upon various factors, including asset/liability management strategies, liquidity and profitability objectives, and regulatory requirements. Held-to-maturity securities are carried at cost, adjusted for amortization of premiums or accretion of discounts. Available-for-sale securities are securities that may be sold prior to maturity based upon asset/liability management decisions. Securities identified as available-for-sale are carried at fair value. Unrealized gains or losses on available-for-sale securities are recorded as accumulated other comprehensive income in stockholders’ equity. Amortization of premiums or accretion of discounts on mortgage-backed securities is periodically adjusted for estimated prepayments.
Our unrealized gain on the securities portfolio value increased from a gain of $5.0 million, which represented .65% of the amortized cost at December 31, 2003, to a gain of $8.3 million, which represented 1.02% of the amortized cost at September 30, 2004.
The following table discloses, as of September 30, 2004, our investment securities that have been in a continuous unrealized loss position for less than 12 months and those that have been in a continuous unrealized loss position for 12 or more months (in thousands):
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We believe the investment securities in the table above are within ranges customary for the banking industry. The number of investment positions in this unrealized loss position totals 30. We do not believe these unrealized losses are “other than temporary” as (1) we have the ability and intent to hold the investments to maturity, or a period of time sufficient to allow for a recovery in market value; (2) it is not probable that we will be unable to collect the amounts contractually due; and (3) no decision to dispose of the investments were made prior to the date of issuance of this report. The unrealized losses noted are interest rate related due to rising rates at September 30, 2004 in relation to previous rates in mid-2003. We have not identified any issues related to the ultimate repayment of principal as a result of credit concerns on these securities.
Liquidity and Capital Resources
In general terms, liquidity is a measurement of our ability to meet our cash needs. Our objective in managing our liquidity is to maintain our ability to meet loan commitments, purchase securities or repay deposits and other liabilities in accordance with their terms, without an adverse impact on our current or future earnings. Our liquidity strategy is guided by policies, which are formulated and monitored by our senior management and our Balance Sheet Management Committee (BSMC), and which take into account the marketability of assets, the sources and stability of funding and the level of unfunded commitments. We regularly evaluate all of our various funding sources with an emphasis on accessibility, stability, reliability and cost-effectiveness. For the year ended December 31, 2003 and for the nine months ended September 30, 2004, our principal source of funding has been our customer deposits, supplemented by our short-term and long-term borrowings, primarily from securities sold under repurchase agreements and federal funds purchased from our downstream correspondent bank relationships (which consist of banks that are considered to be smaller than our bank).
Since early 2001, our liquidity needs have primarily been fulfilled through growth in our core customer deposits. Our goal is to obtain as much of our funding as possible from deposits of these core customers, which as of September 30, 2004, comprised $1,582.6 million, or 96.2%, of total deposits. These deposits are generated principally through development of long-term relationships with customers and stockholders and our retail network which is mainly through BankDirect, our internet banking facility.
In addition to deposits from our core customers, we also have access to incremental deposits through brokered retail certificates of deposit, or CDs. As of September 30, 2004, brokered retail CDs comprised $62.3 million, or 3.8%, of total deposits. Our dependence on retail brokered CDs is limited by our internal funding guidelines, which as of September 30, 2004, limited borrowing from this source to 15% of total fundings.
Additionally, we have borrowing sources available to supplement deposits and meet our funding needs. These borrowing sources include federal funds purchased from our downstream correspondent bank relationships (which consist of banks that are smaller than our bank) and from our upstream correspondent bank relationships (which consist of banks that are larger than our bank), securities sold under repurchase agreements, treasury, tax and loan notes, and advances from the Federal Home Loan Bank, or FHLB. As of September 30, 2004, our borrowings consisted of a total of $467.4 million of securities sold under repurchase agreements, $96.3 million of downstream federal funds purchased, $50.0 million of upstream federal funds purchased, $11.2 million from customer repurchase agreements, and $3.2 million of treasury, tax and loan notes. Credit availability from the FHLB is based on our bank’s financial and operating condition and borrowing collateral we hold with the FHLB. At September 30, 2004, we had $25 million in overnight borrowings from the FHLB. Our unused FHLB borrowing capacity at September 30, 2004 was approximately $149.0 million. As of September 30, 2004, we had unused upstream federal fund lines available from commercial banks of approximately $89.1 million. During the nine months ended September 30, 2004, our average other borrowings from these sources were $604.5 million or 28.6% of average total fundings, which is well within our internal funding guidelines,
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which limit our dependence on borrowing sources to 35% of total fundings. The maximum amount of borrowed funds outstanding at any month-end during the first nine months of 2004 was $653.2 million, or 28.8%, of total fundings.
As of September 30, 2004, our significant fixed and determinable contractual obligations to third parties were as follows:
The contractual amount of our financial instruments with off-balance sheet risk expiring by period at September 30, 2004 is presented below:
Due to the nature of our unfunded loan commitments, including unfunded lines of credit, the amounts presented in the table above do not necessarily represent amounts that we anticipate funding in the periods presented above.
Our equity capital averaged $178.9 million for the nine months ended September 30, 2004 as compared to $134.0 million for the same period in 2003. This increase reflects our retention of net earnings during this period and the proceeds from the initial public offering of our common stock which was consummated in August 2003. We have not paid any cash dividends on our common stock since we commenced operations and have no plans to do so in the near future.
TABLE 6 – CAPITAL RATIOS
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Critical Accounting Policies
The Securities and Exchange Commission (SEC) recently issued guidance for the disclosure of “critical accounting policies”. The SEC defines “critical accounting policies” as those that are most important to the presentation of a company’s financial condition and results, and require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain.
We follow financial accounting and reporting policies that are in accordance with accounting principles generally accepted in the United States. The more significant of these policies are summarized in Note 1 to the consolidated financial statements in our Annual Report on Form 10K for the year ended December 31, 2003 filed with the SEC. Not all these significant accounting policies require management to make difficult, subjective, or complex judgments. However, the policies noted below could be deemed to meet the SEC’s definition of critical accounting policies.
Management considers the policies related to the allowance for loan losses as the most critical to the financial statement presentation. The total allowance for loan losses includes activity related to allowances calculated in accordance with Statement of Financial Accounting Standards (SFAS) No. 114,Accounting by Creditors for Impairment of a Loan, and SFAS No. 5, Accounting for Contingencies. The allowance for loan losses is established through a provision for loan losses charged to current earnings. The amount maintained in the allowance reflects management’s continuing evaluation of the loan losses inherent in the loan portfolio. The allowance for loan losses is comprised of specific reserves assigned to certain classified loans and general reserves. Factors contributing to the determination of specific reserves include the credit-worthiness of the borrower, and more specifically, changes in the expected future receipt of principal and interest payments and/or in the value of pledged collateral. A reserve is recorded when the carrying amount of the loan exceeds the discounted estimated cash flows using the loan’s initial effective interest rate or the fair value of the collateral for certain collateral dependent loans. For purposes of determining the general reserve, the portfolio is segregated by product types in order to recognize differing risk profiles among categories, and then further segregated by credit grades. See “Summary of Loan Loss Experience” for further discussion of the risk factors considered by management in establishing the allowance for loan losses.
Management considers the policies related to income taxes to be critical to the financial statement presentation. The Company utilizes the liability method in accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based upon the difference between the values of the assets and liabilities as reflected in the financial statements and their related tax basis using enacted tax rates in effect for the year in which the differences are expected to be recovered or settled. As changes in tax law or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. A valuation reserve is provided against deferred tax assets unless it is more likely than not that such deferred tax assets will be realized. In 2003, as a result of a reassessment of our ability to generate sufficient earnings to allow the utilization of our deferred tax assets, we believed it was more likely than not that the deferred tax assets will be realized. Accordingly, in compliance with SFAS No. 109, we reversed the valuation allowance and certain related tax reserves during the period.
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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk is a broad term for the risk of economic loss due to adverse changes in the fair value of a financial instrument. These changes may be the result of various factors, including interest rates, foreign exchange rates, commodity prices, or equity prices. Additionally, the financial instruments subject to market risk can be classified either as held for trading purposes or held for other than trading.
The Company is subject to market risk primarily through the effect of changes in interest rates on its portfolio of assets held for purposes other than trading. The effect of other changes, such as foreign exchange rates, commodity prices, and/or equity prices do not pose significant market risk to the Company.
The responsibility for managing market risk rests with the BSMC, which operates under policy guidelines established by our board of directors. The negative acceptable variation in net interest revenue due to a 200 basis point increase or decrease in interest rates is generally limited by these guidelines to +/- 10%. These guidelines also establish maximum levels for short-term borrowings, short-term assets, and public and brokered deposits. They also establish minimum levels for unpledged assets, among other things. Compliance with these guidelines is the ongoing responsibility of the BSMC, with exceptions reported to the full board of directors on a quarterly basis.
Interest Rate Risk Management
We perform a sensitivity analysis to identify interest rate risk exposure on net interest income. We quantify and measure interest rate risk exposure using a model to dynamically simulate the effect of changes in net interest income relative to changes in interest rates and account balances over the next 12 months based on three interest rate scenarios. These are a “most likely” rate scenario and two “shock test” scenarios.
The “most likely” rate scenario is based on the consensus forecast of future interest rates published by independent sources. These forecasts incorporate future spot rates and relevant spreads of instruments that are actively traded in the open market. The Federal Reserve’s Federal Funds target affects short-term borrowing; the prime lending rate and the London Inter Bank Offering Rate are the basis for most of our variable-rate loan pricing.
The 10-year mortgage rate is also monitored because of its effect on prepayment speeds for mortgage-backed securities. These are our primary interest rate exposures. We are currently not using derivatives to manage our interest rate exposure.
The two “shock test” scenarios assume a sustained parallel 200 basis point increase or decrease, respectively, in interest rates. As short-term rates have continued to fall since 2001 we could not assume interest rate changes of 200 basis points as the results of the decreasing rates scenario would be negative rates. Therefore, our “shock test” scenarios with respect to decreases in rates now assume a decrease of 100 basis points in the current interest rate environment. We will continue to evaluate these scenarios as interest rates change, until short-term rates rise above 2.0%.
Our interest rate risk exposure model incorporates assumptions regarding the level of interest rate or balance changes on indeterminable maturity deposits (demand deposits, interest bearing transaction accounts and savings accounts) for a given level of market rate changes. These assumptions have been developed through a combination of historical analysis and future expected pricing behavior. Changes in prepayment behavior of mortgage-backed securities, residential, and commercial mortgage loans in each rate environment are captured using industry estimates of prepayment speeds for various coupon segments of the portfolio. The impact of planned growth and new business activities is factored into the simulation model.
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This modeling indicated interest rate sensitivity is as follows:
TABLE 7 – INTEREST RATE SENSITIVITY(Dollars in thousands)
The simulations used to manage market risk are based on numerous assumptions regarding the effect of changes in interest rates on the timing and extent of repricing characteristics, future cash flows, and customer behavior. These assumptions are inherently uncertain and, as a result, the model cannot precisely estimate net interest income or precisely predict the impact of higher or lower interest rates on net interest income. Actual results will differ from simulated results due to timing, magnitude and frequency of interest rate changes as well as changes in market conditions and management strategies, among other factors.
ITEM 4. CONTROLS AND PROCEDURES
Our management, including our chief executive officer and chief financial officer have evaluated our disclosure controls and procedures as of September 30, 2004 and concluded that those disclosure controls and procedures are effective. There have been no changes in our internal controls or in other factors known to us that could significantly affect these controls subsequent to their evaluation, nor any corrective actions with regard to significant deficiencies and material weaknesses. While we believe that our existing disclosure controls and procedures have been effective to accomplish these objectives, we intend to continue to examine, refine and formalize our disclosure controls and procedures and to monitor ongoing developments in this area.
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PART II — OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
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SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
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EXHIBIT INDEX
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