United Community Bank - 10-Q quarterly report FY

United Community Banks, Inc.

 

Notes to Consolidated Financial Statements

 

Note 1 – Accounting Policies

 

          The accounting and financial reporting policies of United Community Banks, Inc. (“United”) and its subsidiaries conform to accounting principles generally accepted in the United States of America (“GAAP”) and general banking industry practices. The accompanying interim consolidated financial statements have not been audited. All material intercompany balances and transactions have been eliminated. A more detailed description of United’s accounting policies is included in the 2008 annual report filed on Form 10-K.

 

          In management’s opinion, all accounting adjustments necessary to accurately reflect the financial position and results of operations on the accompanying financial statements have been made. These adjustments are normal and recurring accruals considered necessary for a fair and accurate presentation. The results for interim periods are not necessarily indicative of results for the full year or any other interim periods.

 

          Statement of Financial Accounting Standards No. 161, Disclosures about Derivative Instruments and Hedging Activities, an amendment of FASB Statement No. 133 (“SFAS 161”), amends and expands the disclosure requirements of Financial Accounting Standards Board (“FASB”) Statement No. 133,Accounting for Derivative Instruments and Hedging Activities (“SFAS 133”) with the intent to provide users of financial statements with an enhanced understanding of: (1) how and why an entity uses derivative instruments, (2) how derivative instruments and related hedged items are accounted for under SFAS 133 and its related interpretations, and (3) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. SFAS 161 requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about the fair value of and gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative instruments.

 

          As required by SFAS 133, United records all derivatives on the balance sheet at fair value. The accounting for changes in the fair value of derivatives depends on the intended use of the derivative, whether United has elected to designate a derivative in a hedging relationship and apply hedge accounting and whether the hedging relationship has satisfied the criteria necessary to apply hedge accounting. Derivatives designated and qualifying as a hedge of the exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges. Derivatives designated and qualifying as a hedge of the exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges. Derivatives may also be designated as hedges of the foreign currency exposure of a net investment in a foreign operation. Hedge accounting generally provides for the matching of the timing of gain or loss recognition on the hedging instrument with the recognition of the changes in the fair value of the hedged asset or liability that are attributable to the hedged risk in a fair value hedge or the earnings effect of the hedged forecasted transactions in a cash flow hedge. United may enter into derivative contracts that are intended to economically hedge certain of its risks, even though hedge accounting does not apply or United elects not to apply hedge accounting under SFAS 133.

 

          Foreclosed property is initially recorded at fair value, less cost to sell. If the fair value, less cost to sell at the time of foreclosure, is less than the loan balance, the deficiency is charged against the allowance for loan losses. If the fair value, less cost to sell, of the foreclosed property decreases during the holding period, a valuation allowance is established with a charge to operating expenses. When the foreclosed property is sold, a gain or loss is recognized on the sale for the difference between the sales proceeds and the carrying amount of the property. Financed sales of foreclosed property are accounted for in accordance with Statement of Financial Accounting Standards No. 66, Accounting for Sales of Real Estate (“SFAS 66”).

 

Note 2 – Federally Assisted Acquisition of Southern Community Bank

 

          On June 19, 2009, United Community Bank (“UCB”) purchased substantially all the assets and assumed substantially all the liabilities of Southern Community Bank (“SCB”) from the Federal Deposit Insurance Corporation (“FDIC”), as Receiver of SCB. SCB operated five commercial banking branches on the south side of Atlanta in Fayetteville, Peachtree City, Locust Grove and Newnan, Georgia. The FDIC took SCB under receivership upon SCB’s closure by the Georgia Department of Banking and Finance at the close of business June 19, 2009. UCB submitted a bid for the acquisition of SCB with the FDIC on June 16, 2009. The transaction resulted in a cash payment of $31 million from the FDIC to UCB. Further, UCB and the FDIC entered loss sharing agreements regarding future losses incurred on loans and foreclosed loan collateral existing at June 19, 2009. Under the terms of the loss sharing agreements, the FDIC will absorb 80 percent of losses and share 80 percent of loss recoveries on the first $109 million of losses and, absorb 95 percent of losses and share in 95 percent of loss recoveries on losses exceeding $109 million. The term for loss sharing on residential real estate loans is ten years, while the term for loss sharing on all other loans is five years.

 

          The SCB acquisition was accounted for under the purchase method of accounting in accordance with the FASB’s Statement of Financial Accounting Standards No. 141(R) Business Combinations (“SFAS 141(R)”). The statement of net assets acquired as of June 19, 2009 and the resulting gain from acquisition are presented in the following table.

 

Statement of net assets acquired (at estimated fair values)

 

          The purchased assets and assumed liabilities were recorded at their respective acquisition date fair values, and identifiable intangible assets were recorded at fair value. Fair values are preliminary and subject to refinement for up to one year after the closing date of a merger as information relative to closing date fair values become available. A gain totaling $11.4 million resulted from the acquisition and is included as a component of fee revenue on the consolidated statement of income. The amount of the gain is equal to the amount by which the fair value of assets purchased exceeded the fair value of liabilities assumed. The results of operations of SCB for the period of June 19, 2009 to June 30, 2009 are included in the consolidated financial statements. SCB’s results of operations prior to the acquisition are not included in United’s consolidated statement of income.

 

          United made significant estimates and exercised significant judgment in accounting for the acquisition of SCB. Management engaged an independent third party to assist in determining the value of SCB’s loans. United also recorded an identifiable intangible asset representing the value of the core deposit customer base of SCB. In determining the value of the identifiable intangible asset, United estimated average lives of depository accounts, future interest rate levels, the cost of servicing various depository products, and other significant items. Management used quoted market prices and observable data to determine the fair value of investment securities. The fair values of FHLB advances, certificates of deposit and other borrowings which were purchased and assumed from SCB were determined based on discounted cash flows at current rates for similar instruments.

 

          Purchased loans acquired in a business combination are recorded at estimated fair value on their purchase date. The carryover of the related allowance for loan losses is prohibited. Purchased loans are accounted for under American Institute of Certified Public Accountants Statement of Position 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer (“SOP 03-3”), when the loans have evidence of credit deterioration since origination and it is probable at the date of acquisition that United will not collect all contractually required principal and interest payments. Evidence of credit quality deterioration as of the purchase date may include statistics such as past due and nonaccrual status. Generally, acquired loans that meet United’s definition of nonaccrual status fall within the scope of SOP 03-3. The difference between contractually required payments at acquisition and the cash flows expected to be collected at acquisition is referred to as the non-accretable difference which is deducted from the carrying amount of loans. Subsequent decreases to the expected cash flows will generally result in a provision for loan losses. Subsequent increases in cash flows result in a reversal of the provision for loan losses to the extent of prior charges or a reversal of the non-accretable difference with a positive impact on interest revenue. Further, any excess of cash flows expected at acquisition over the estimated fair value is referred to as the accretable yield and is recognized into interest revenue over the remaining life of the loan when there is reasonable expectation about the amount and timing of such cash flows.

 

          Loans, foreclosed property and the estimated FDIC reimbursement resulting from the loss share agreements with the FDIC are reported as “covered assets” in the consolidated balance sheet. The table below shows the components of covered assets at June 30, 2009.

 

          Covered loans are initially recorded at fair value at the acquisition date. Subsequent decreases in the amount expected to be collected results in a provision for loan losses and an increase in the estimated FDIC reimbursement, with any estimated net loss impacting earnings. Covered foreclosed property is initially recorded at its estimated fair value.

 

          On the acquisition date, the preliminary estimate of the contractually required payments receivable for all SOP 03-3 loans acquired was $70.8 million, the cash flows expected to be collected were $24.5 million including interest, and the estimated fair value of the loans was $23.6 million. These amounts were determined based upon the estimated remaining life of the underlying loans, which include the effects of estimated prepayments. At June 30, 2009, a majority of these loans were valued based on the liquidation value of the underlying collateral, because the expected cash flows are primarily based on the liquidation of the underlying collateral and the timing and amount of the cash flows could not be reasonably estimated. Because of the short time period between the closing of the transaction and June 30, 2009, certain amounts related to the SOP 03-3 loans are preliminary estimates and adjustments in future quarters may occur.

 

Note 3 – Stock-Based Compensation

 

          United has an equity compensation plan that allows for grants of incentive stock options, nonqualified stock options, restricted stock awards (also referred to as “nonvested stock” awards), stock awards, performance share awards or stock appreciation rights. Options granted under the plan can have an exercise price no less than the fair market value of the underlying stock at the date of grant. The general terms of the plan include a vesting period (usually four years) with an exercisable period not to exceed ten years. Certain option and restricted stock awards provide for accelerated vesting if there is a change in control (as defined in the plan). As of June 30, 2009, approximately 954,000 additional awards could be granted under the plan. Through June 30, 2009, only incentive stock options, nonqualified stock options and restricted stock awards and units had been granted under the plan.

 

          The following table shows stock option activity for the first six months of 2009.

 

          The weighted average fair value of stock options granted in the second quarter of 2009 and 2008 was $2.88 and $2.93, respectively. The fair value of each option granted was estimated on the date of grant using the Black-Scholes model. Because United’s option plan has not been in place long enough to gather sufficient information about exercise patterns to establish an expected life, United uses the formula provided by the Securities and Exchange Commission in Staff Accounting Bulletin No. 107 to determine the expected life of options.

 

          The weighted average assumptions used to determine the fair value of stock options are presented in the table below.

 

          United’s stock trading history began in March of 2002 when United listed on the Nasdaq National Market. For 2009 expected volatility was determined using United’s historical monthly volatility for the seventy five months ended December 31, 2008. Seventy five months was chosen to correspond to the expected life of 6.25 years. For 2008, expected volatility was determined using United’s historical monthly volatility over the period beginning in March of 2002 through the end of 2007. Compensation expense for stock options was $1.4 million and $1.5 million for the six months ended June 30, 2009 and 2008, respectively. Deferred tax benefits of $498,000 and $445,000, respectively, were included in the determination of income tax (benefit) expense for the six-month periods ended June 30, 2009 and 2008. The amount of compensation expense for both periods was determined based on the fair value of the options at the time of grant, multiplied by the number of options granted that were expected to vest, which was then amortized over the vesting period. The forfeiture rate for options is estimated to be approximately 3% per year. The total intrinsic value of options exercised during the six months ended June 30, 2009 and 2008 was $840 and $277,000.

 

          The table below presents the activity in restricted stock awards for the first six months of 2009.

 

          Compensation expense for restricted stock is based on the fair value of restricted stock awards at the time of grant, which is equal to the value of United’s common stock on the date of grant. The value of restricted stock grants that are expected to vest is amortized into expense over the vesting period. For the six months ended June 30, 2009 and 2008, compensation expense of $433,000 and $441,000, respectively, was recognized related to restricted stock awards. The total intrinsic value of the restricted stock was $1.0 million at June 30, 2009.

 

          As of June 30, 2009, there was $6.9 million of unrecognized compensation cost related to nonvested stock options and restricted stock awards granted under the plan. That cost is expected to be recognized over a weighted-average period of 1.4 years. The aggregate grant date fair value of options and restricted stock awards that vested during the six months ended June 30, 2009, was $3.5 million.

 

Note 4 – Common Stock Issued / Common Stock Issuable

 

          United provides a Dividend Reinvestment and Share Purchase Plan (“DRIP”) to its shareholders. Under the DRIP, shareholders of record can voluntarily reinvest all or a portion of their cash dividends into shares of United’s common stock, as well as purchase additional stock through the plan with cash. United’s 401(k) retirement plan regularly purchases shares of United’s common stock directly from United. In addition, United has an Employee Stock Purchase Program (“ESPP”) that allows eligible employees to purchase shares of common stock at a 5% discount, with no commission charges. For the six months ended June 30, 2009 and 2008, United issued 167,873 and 113,047 shares, respectively, and increased capital by $974,000 and $1.6 million, respectively, through these programs.

 

          United offers its common stock as an investment option in its deferred compensation plan. The common stock component of the deferred compensation plan is accounted for as an equity instrument and is reflected in the consolidated financial statements as common stock issuable. At June 30, 2009 and 2008 182,041 and 105,579 shares, respectively, were issuable under the deferred compensation plan.

Note 5 – Securities Available for Sale

 

          The cost basis, unrealized gains and losses, and fair value of securities available for sale at June 30, 2009, December 31, 2008 and June 30, 2008 are presented below (in thousands):

 

          The following table summarizes securities in an unrealized loss position as of June 30, 2009, December 31, 2008 and June 30, 2008 (in thousands):

 

          Management believes that there were no unrealized losses as of June 30, 2009, December 31, 2008 and June 30, 2008 that represented an other-than-temporary impairment. Unrealized losses were primarily attributable to changes in interest rates, and United has both the intent and ability to hold the securities for a time necessary to recover the amortized cost.

 

          The amortized cost and fair value of the investment securities at June 30, 2009, by contractual maturity, are presented in the following table (in thousands). Expected maturities may differ from contractual maturities because issuers and borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

 

          The following table summarizes securities sales activity for the three month and six month periods ended June 30, 2009 and 2008 (in thousands):

 

         During the second quarter of 2009, United recognized an impairment loss of $744,000 on an equity investment in Silverton Bank, a financial institution that failed during the quarter. The impairment loss represents the full amount of United’s investment in Silverton.

 

Note 6 – Earnings Per Share

 

 

Note 7 – Subsequent Events

 

          United performed an evaluation of subsequent events through August 7, 2009, the date upon which United’s quarterly report on Form 10-Q was filed with the Securities and Exchange Commission. No subsequent events were identified that would have required a change to the financial statements or disclosure in the notes to the financial statements.

 

Note 8 – Assets and Liabilities Measured at Fair Value

 

Assets and Liabilities Measured at Fair Value on a Recurring Basis

 

          The table below presents United’s assets and liabilities measured at fair value on a recurring basis as of June 30, 2009, aggregated by the level in the fair value hierarchy within which those measurements fall.