United Community Bank - 10-Q quarterly report FY

 

 

 

See notes to Consolidated Financial Statements

See notes to Consolidated Financial Statements

See notes to Consolidated Financial Statements

See notes to Consolidated Financial Statements

Notes to Consolidated Financial Statements

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 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 2007 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.

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 September 30, 2008, approximately 1,385,000 additional awards could be granted under the plan. Through September 30, 2008, 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 nine months of 2008.

The weighted average fair value of stock options granted in the first nine months of 2008 and 2007 was $2.90 and $8.29, 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 2008 and 2007, expected volatility was determined using United’s historical monthly volatility over the period beginning in March of 2002 through the end of the last completed year. Compensation expense for stock options was $1,578,000 and $1,564,000 for the nine months ended September 30, 2008 and 2007, respectively, which was net of deferred tax benefits of $692,000 and $492,000, respectively. 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, net of any applicable tax benefit, 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 nine months ended September 30, 2008 and 2007 was $391,000 and $2,163,000, respectively.

The table below presents the activity in restricted stock awards for the first nine months of 2008.

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 nine months ended September 30, 2008 and 2007, compensation expense of $659,000 and $555,000, respectively, was recognized related to restricted stock awards. The total intrinsic value of the restricted stock was $1,184,000 at September 30, 2008.

As of September 30, 2008, there was $7.9 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 nine months ended September 30, 2008, was $3.6 million.

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 nine months ended September 30, 2008 and 2007, United issued 233,276 and 123,692 shares, respectively, and increased capital by $2.8 million and $3.6 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 September 30, 2008 and 2007, 116,567 and 66,366 shares, respectively, were issuable under the deferred compensation plan.

The following table sets forth the computation of basic and diluted earnings per share for the three months and nine months ended September 30, 2008 and 2007.

On January 1, 2008, United adopted Statement of Financial Accounting Standards No. 157, Fair Value Measurements (“SFAS No. 157”). SFAS No. 157 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. SFAS No. 157 applies to reported balances that are required or permitted to be measured at fair value under existing accounting pronouncements; accordingly, the standard does not require any new fair value measurements of reported balances.

SFAS No. 157 emphasizes that fair value is a market-based measurement, not an entity-specific measurement. Therefore, a fair value measurement should be determined based on the assumptions that market participants would use in pricing the asset or liability. As a basis for considering market participant assumptions in fair value measurements, SFAS No. 157 establishes a fair value hierarchy that distinguishes between market participant assumptions based on market data obtained from sources independent of the reporting entity (observable inputs that are classified within Levels 1 and 2 of the hierarchy) and the reporting entity’s own assumptions about market participant assumptions (unobservable inputs classified within Level 3 of the hierarchy).

Level 1  Valuation is based upon quoted prices (unadjusted) in active markets for identical assets or liabilities that United has the ability to access.

The following is a description of valuation methodologies used for assets and liabilities recorded at fair value.

Investment securities available-for-sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. Level 1 securities include those traded on an active exchange, such as the New York Stock Exchange, U.S. Treasury securities that are traded by dealers or brokers in active over-the-counter markets and money market funds. Level 2 securities include mortgage-backed securities issued by government sponsored entities, municipal bonds and corporate debt securities. Securities classified as Level 3 include asset-backed securities in less liquid markets.

Included in other assets in the consolidated balance sheet are assets related to employee deferred compensation plans. The assets associated with these plans are invested in mutual funds and classified as Level 1. Deferred compensation liabilities, also classified as Level 1, are carried at the fair value of the obligation to the employee, which mirrors the fair value of the invested assets and is included in other liabilities in the consolidated balance sheet.

Loans held for sale are carried at the lower of cost or market value. The fair value of loans held for sale is based on what secondary markets are currently offering for portfolios with similar characteristics. As such, United classifies loans subjected to nonrecurring fair value adjustments as Level 2.

United does not record loans at fair value on a recurring basis. However, from time to time, a loan is considered impaired and an allowance for loan losses is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Once a loan is identified as individually impaired, management measures impairment in accordance with SFAS 114, Accounting by Creditors for Impairment of a Loan, (SFAS 114). The fair value of impaired loans is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. At September 30, 2008, substantially all of the total impaired loans were evaluated based on the fair value of the collateral. In accordance with SFAS 157, impaired loans where an allowance is established based on the fair value of collateral require classification in the fair value hierarchy. When the fair value of the collateral is based on an observable market price or a current appraised value, United records the impaired loan as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, United records the impaired loan as nonrecurring Level 3.

Foreclosed assets are adjusted to fair value upon transfer of the loans to foreclosed assets. Subsequently, foreclosed assets are carried at the lower of carrying value or fair value. Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral. When the fair value of the collateral is based on an observable market price or a current appraised value, United records the foreclosed asset as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, United records the foreclosed asset as nonrecurring Level 3.

Goodwill and identified intangible assets are subject to impairment testing. United’s approach to testing goodwill for impairment is to compare the business unit’s carrying value to the implied fair value based on multiples of earnings and tangible book value for recently completed merger transactions. In the event the fair value is determined to be less than the carrying value, the asset is recorded at fair value as determined by the valuation model. As such, United classifies goodwill and other intangible assets subjected to nonrecurring fair value adjustments as Level 3.

Currently, United uses interest rate swaps and interest rate floors to manage its interest rate risk. The valuation of these instruments is determined using widely accepted valuation techniques including discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including interest rate curves and implied volatilities. The fair values of interest rate swaps are determined using the market standard methodology of netting the discounted future fixed cash receipts and the discounted expected variable cash payments. The variable cash payments are based on an expectation of future interest rates (forward curves) derived from observable market interest rate curves.

The fair values of interest rate options are determined using the market standard methodology of discounting the future expected cash receipts that would occur if variable interest rates fell below the strike rate of the floors. The variable interest rates used in the calculation of projected receipts on the floor are based on an expectation of future interest rates derived from observable market interest rate curves and volatilities. To comply with the provisions of SFAS No. 157, United incorporates credit valuation adjustments to appropriately reflect both its own nonperformance risk and the respective counterparty’s nonperformance risk in the fair value measurements. In adjusting the fair value of its derivative contracts for the effect of nonperformance risk, United has considered the effect of netting and any applicable credit enhancements, such as collateral postings, thresholds, mutual puts, and guarantees.

Although United has determined that the majority of the inputs used to value its derivatives fall within Level 2 of the fair value hierarchy, the credit valuation adjustments associated with its derivatives utilize Level 3 inputs, such as estimates of current credit spreads to evaluate the likelihood of default by itself and its counterparties. However, as of September 30, 2008, United has assessed the significance of the effect of the credit valuation adjustments on the overall valuation of its derivative positions and has determined that the credit valuation adjustments are not significant to the overall valuation of its derivatives. As a result, United has determined that its derivative valuations in their entirety are classified in Level 2 of the fair value hierarchy.

The table below presents United’s assets and liabilities measured at fair value on a recurring basis as of September 30, 2008, aggregated by the level in the fair value hierarchy within which those measurements fall.

United may be required, from time to time, to measure certain assets at fair value on a nonrecurring basis in accordance with U.S. Generally Accepted Accounting Principles. These include assets that are measured at the lower of cost or market that were recognized at fair value below cost at the end of the period. The table below presents United’s assets and liabilities measured at fair value on a nonrecurring basis as of September 30, 2008, aggregated by the level in the fair value hierarchy within which those measurements fall.

During the third quarter of 2008, United replaced its regular cash dividend with a stock dividend at a rate of 1 new share for every 130 shares owned. The stock dividend has been reflected in the financial statements as an issuance of stock with no proceeds rather than a stock split and therefore previously numbers of shares outstanding have not been adjusted. The amount of $40,000 shown in the equity statement as a reduction of capital related to the stock dividend is the amount of cash paid to shareholders for fractional shares.

On August 29, 2008, United Community Bank, United’s wholly-owned banking subsidiary, issued $30 million in subordinated debt which qualifies as Tier II capital under Risk-Based Capital rules. The unsecured subordinated debt accrues interest at three-month LIBOR plus 4.00% and matures on August 29, 2015. The subordinated debt is pre-payable at any time without penalty.

In February 2008, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position (“FSP”) FAS 140-3 Accounting for Transfers of Financial Assets and Repurchase Financing Transactions. This statement provides guidance regarding the accounting for a transfer of a financial asset and repurchase financing where the counterparties for both transactions are the same. In these circumstances, certain criteria must be met in order to not account for the transactions as a linked transaction. This FSP becomes effective for fiscal years and interim periods within those fiscal years, beginning on or after November 15, 2008. United does not anticipate that this FSP will have a material effect on United’s financial position, results of operations, or disclosures.

In February 2008, the FASB issued FSP FAS 157-1 Application of FASB Statement No. 157 to FASB Statement No. 13 and Other Accounting Pronouncements That Address Fair Value Measurements for Purposes of Lease Classification or Measurement under Statement 13 and FSP 157-2 Effective Date of FASB Statement No. 157. FSP FAS 157-1 excludes leases from the provisions of SFAS No. 157, unless the lease is valued under a transaction covered by Statement of Financial Accounting Standards No. 141(R) (SFAS No. 141). FSP FAS 157-2 delays implementation of SFAS No. 157 for nonfinancial assets and nonfinancial liabilities measured at fair value on a non-recurring basis until fiscal years beginning after November 15, 2008 and interim periods within those fiscal years. Because United does not have any leases which are subject to fair value accounting, and because United already discloses nonfinancial assets measured at fair value on a nonrecurring basis in the financial statements, United does not anticipate that these FSPs will have a material effect on United’s financial position, results of operations, or disclosures.

In March 2008, the FASB issued Statement of Financial Accounting Standards No. 161 (SFAS No. 161), Disclosures about Derivative Instruments and Hedging Activities. This statement requires an entity to provide enhanced disclosures about how and why an entity uses derivative instruments, how derivative instruments and related items are accounted for under SFAS 133, Accounting for Derivative Instruments and Hedging Activities (“SFAS 133”) and its related interpretations, and how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. This statement is intended to enhance the current disclosure framework in SFAS 133, by requiring the objectives for using derivative instruments be disclosed in terms of underlying risk and accounting designation. This statement becomes effective for fiscal years and interim periods beginning within those years after November 15, 2008. As this statement is related to disclosures only, United does not anticipate that adoption of this standard will have a material effect on United’s financial position or results of operations.

In September 2008, the FASB issued FASB Staff Positions FAS 133-1 (FSP FAS 133-1) and FIN 45-4, Disclosures about Credit Derivatives and Certain Guarantees: An Amendment of FASB Statement No. 133 and FASB Interpretation No. 45; and Clarification of the Effective Date of FASB Statement No. 161. This staff position details the proper disclosure and reporting for credit derivatives for both the party that assumes credit risk (seller) and the party that is protected by the credit derivative (buyer). The disclosures should include the nature, term, reasoning, and events and circumstances that would require the seller to perform under the derivative contract. This FSP is effective for reporting periods ending after November 15, 2008. United is not the buyer or seller on any credit derivatives at this time, and thus United does not anticipate that adoption of this staff position will have a material effect on United’s financial position or results of operations.

On October 10, 2008, the FASB issued FASB Staff Position FAS 157-3 (FSP FAS 157-3),Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active. This staff position addressed concerns among financial entities regarding assets trading in markets that were at one time active but have subsequently become inactive. Under FSP FAS 157-3, firms must take into account the facts and circumstances to determine whether the known trades in an inactive market are reflective of orderly transactions that are not forced liquidations or distressed sales. If the firm makes this determination, they can classify the assets as Level 3 of the fair value hierarchy and use an appropriate valuation approach relying to an extent on unobservable inputs, and thus following the appropriate disclosures associated with a recurring Level 3 asset. United’s current portfolio does not include any securities for which FSP FAS 157-3 would apply. Thus, FSP FAS 157-3 is not expected to have a material effect on United’s financial position, results of operations, or disclosures.

This Form 10-Q contains forward-looking statements regarding United Community Banks, Inc. (“United”), including, without limitation, statements relating to United’s expectations with respect to revenue, credit losses, levels of nonperforming assets, expenses, earnings and other measures of financial performance. Words such as “may”, “could”, “would”, “should”, “believes”, “expects”, “anticipates”, “estimates”, “intends”, “plans”, “targets” or similar expressions are intended to identify forward-looking statements. These forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties that are subject to change based on various factors (many of which are beyond United’s control). The following factors, among others, could cause United’s financial performance to differ materially from the expectations expressed in such forward-looking statements:

Additional information with respect to factors that may cause actual results to differ materially from those contemplated by suchforward-looking statements may also be included in other reports that United files with the Securities and Exchange Commission. United cautions that the foregoing list of factors is not exclusive and not to place undue reliance on forward-lookingstatements. United does not intend to update anyforward-looking statement, whether written or oral, relating to the matters discussed in this Form 10-Q.

The following discussion is intended to provide insight into the results of operations and financial condition of United and its subsidiaries and should be read in conjunction with the consolidated financial statements and accompanying notes.

United is a bank holding company registered with the Federal Reserve under the Bank Holding Company Act of 1956 that was incorporated under the laws of the state of Georgia in 1987 and commenced operations in 1988. At September 30, 2008, United had total consolidated assets of $8.1 billion, total loans of $5.8 billion, total deposits of $6.7 billion and stockholders’ equity of $816.9 million.

United’s activities are primarily conducted by its wholly owned Georgia banking subsidiary (the “Bank”) and Brintech, Inc., a consulting firm providing professional services to the financial services industry. The Bank operations are conducted under a community bank model that operates 27 “community banks” with local bank presidents and boards in north Georgia, the Atlanta metropolitan statistical area (“MSA”), the Gainesville MSA, coastal Georgia, western North Carolina, and east Tennessee.

Several significant events affecting the banking industry occurred during the third quarter of 2008, including the failure or near failure of several large financial institutions and the failure of Fannie Mae and Freddie Mac, two government sponsored enterprises or GSEs. These events led to serious concerns about the safety and soundness of the financial services industry that affected financial markets around the world. In response to the emerging crisis, on October 3, 2008, Congress passed and President Bush signed into law the Emergency Economic Stabilization Act of 2008 (The “Act”) which created a $700 billion Troubled Assets Relief Program (“TARP”) to purchase illiquid assets of troubled banks. The Act also raised the limits on FDIC insurance protection from $100,000 to $250,000 through the end of 2009. On October 14, the U.S. Treasury Department announced a voluntary capital purchase program that would allow the U.S. Treasury to purchase senior preferred shares in qualified financial institutions in an amount between 1% and 3% of the financial institutions’ risk-weighted assets.

United reported a net operating loss of $39.9 million for the third quarter of 2008, compared with net operating income of $22.5 million for the third quarter of 2007. Diluted operating loss per common share was $.84 for the third quarter of 2008, compared with diluted operating earnings per common share of $.46 for the third quarter of 2007. The loss in the third quarter of 2008 was due to a $76 million provision for loan losses and $10 million in writedowns and expenses on foreclosed properties that reflect the effect of further deterioration in credit conditions in United’s loan portfolio.

United reported a net operating loss of $16.7 million for the nine months ended September 30, 2008, compared with net operating income of $53.8 million for the nine months ended September 30, 2007. Diluted operating loss per common share was $.35 for the nine months ended September 30, 2008, compared with diluted operating earnings per common share of $1.36 for the nine months ended September 30, 2007.

Earnings decreased primarily as a result of a higher provision for loan losses related to the increase in charge-offs within the loan portfolio combined with margin compression due to an increase in non-performing assets, competitive deposit pricing and efforts to build liquidity. Housing sales remain at low levels, leaving a surplus of finished housing and lot inventory in our footprint, most notably in the Atlanta MSA. This decline in housing sales negatively affects both the cash flows of our residential construction and land development customers, and the demand for new land development loans.

Nonperforming assets increased to 2.20% of total assets as of September 30, 2008, compared to .77% as of September 30, 2007. This increase is a reflection of the downstream effects of declining home sales in the Atlanta MSA, which itself is indicative of the regional economic slowdown that is occurring in much of the Southeast. To date, the rise in nonperforming assets has been mostly confined to the residential construction and development portfolio and predominantly within the Atlanta MSA.

Fee revenue decreased $2.5 million, or 16%, from the third quarter of 2007. Although service charges and fees and brokerage fees remained near the same level as the third quarter of 2007, mortgage fees and consulting fees saw declines reflecting the slow housing market and a decline in demand for consulting services in the banking industry associated with earnings pressures. Other fee revenue was down from a year ago, primarily due to weak performance from bank owned life insurance assets and deferred compensation plan assets in the third quarter of 2008.

Operating expenses increased $8.8 million, or 18%, from the third quarter of 2007, primarily due to higher expenses associated with and writedowns on foreclosed real estate properties and higher FDIC insurance premiums.

The accounting and reporting policies of United are in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and conform to general practices within the banking industry. The more critical accounting and reporting policies include United’s accounting for the allowance for loan losses and accounting for intangible assets. In particular, United’s accounting policies related to allowance for loan losses and intangibles involve the use of estimates and require significant judgment to be made by management. Different assumptions in the application of these policies could result in material changes in United’s consolidated financial position or consolidated results of operations. See “Asset Quality and Risk Elements” herein for additional discussion of United’s accounting methodologies related to the allowance.

The presentation of United’s financial results herein include references to operating performance measures, which are measures of performance determined by methods other than GAAP. Management included non-GAAP performance measures because it believes they are useful for evaluating United’s operations and performance over periods of time. Also, United uses operating performance measures in managing and evaluating United’s business and intends to use them in discussions about United’s operations and performance.

Operating performance measures exclude the effect of a special $15 million fraud related provision for loan losses recorded in the second quarter of 2007 and an additional $3 million provision and $18 million in related charge-offs in the fourth quarter of 2007 involving lot loans in a failed real estate development near Spruce Pine, North Carolina. Management believes that the circumstances leading to the special provision and subsequent charge-offs were isolated, non-recurring events and do not reflect overall trends in United’s performance. Management also believes that these non-GAAP performance measures provide users of United’s financial information with a meaningful measure for assessing United’s financial results and credit trends and comparing financial results to prior periods.

A reconciliation of operating earnings measures to reported earnings measures using GAAP is presented below: