Wake Forest Bancshares, Inc - Recent Material Event
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PART I
FORWARD-LOOKING STATEMENTS
This document, including information incorporated by reference, contains, and future filings
by Wake Forest Bancshares, Inc. (the “Company”) on Form 10-QSB and Form 8-K and future oral and
written statements by the Company and its management may contain forward-looking statements about
the Company and its subsidiary which we believe are within the meaning of the Private Securities
Litigation Reform Act of 1995. These forward-looking statements include, without limitation,
statements with respect to anticipated future operating and financial performance, growth
opportunities, interest rates, cost savings and funding advantages expected or anticipated to be
realized by management. Words such as “may,” “could,” “should,” “would,” “believe,” “anticipate,”
“estimate,” “expect,” “intend,” “plan” and similar expressions are intended to identify these
forward-looking statements. Forward-looking statements by the Company and its management are based
on beliefs, plans, objectives, goals, expectations, anticipations, estimates and intentions of
management and are not guarantees of future performance. The Company disclaims any obligation to
update or revise any forward-looking statements based on the occurrence of future events, the
receipt of new information, or otherwise. The important factors we discuss below and elsewhere in
this document, as well as other factors discussed under the caption “Management’s Discussion and
Analysis of Financial Condition and Results of Operations” in our Annual Report to Shareholders
(attached to this document as Exhibit 13) and identified in our filings with the SEC and those
presented elsewhere by our management from time to time, could cause actual results to differ
materially from those indicated by the forward-looking statements made in this document:
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ITEM 1. DESCRIPTION OF BUSINESS
General
Wake Forest Bancshares, Inc. is a federally-chartered stock holding company for Wake Forest
Federal Savings & Loan Association (the “Association”), a federally-chartered stock savings and
loan association which conducts business from its one office located in Wake Forest, North
Carolina. The Company was formed on May 7, 1999 in connection with reorganization of the
Association into the “two tier” mutual holding company structure. The Company is a majority-owned
subsidiary of Wake Forest Bancorp, M.H.C., a federal mutual holding company (the “MHC”). The
Association was founded in 1922 as a building and loan association. In 1982, the Association
converted from a North Carolina chartered mutual savings and loan association to a
federally-chartered mutual savings and loan association. During fiscal year 1996, the Association
converted from a federally-chartered mutual savings and loan association to a federally-chartered
stock savings and loan association. The Association is the Company’s sole subsidiary. The
Association’s deposits are insured by the Deposit Insurance Fund of the Federal Deposit Insurance
Corporation (the “FDIC”) to the maximum extent permitted by law. At September 30, 2007, the
Company had total assets of $107.4 million, total deposits of $85.7 million and total stockholders’
equity of $20.2 million.
The Company conducts no business other than holding stock in the Association, investing
dividends received from the Association, repurchasing its common stock from time to time, and
distributing dividends on its common stock to its shareholders.
The primary focus of the Association is to provide financing for single family housing in its
market area of northern Wake County and southern Franklin County. The Association has concentrated
its lending activities on real estate loans secured by single family residential properties and
construction loans on primarily residential properties. To a lesser extent, the Association
invests in commercial real estate, land, multi-family residential and savings account loans. The
Association also invests its excess funds primarily in Federal Home Loan Bank (“FHLB”) stock,
Federal Home Loan Mortgage Corporation (“FHLMC”) stock, U.S. Treasury and Agency obligations, and
other short term interest-bearing deposits. The Association’s principal sources of funds are
deposits and principal and interest payments on loans. The principal source of income is interest
on loans and investment securities. The Association’s principal expenses are interest paid on
deposits and compensation and benefits.
The Association’s results of operations are dependent primarily on net interest income, which
is the difference between the interest income earned on its interest-earning assets, such as loans
and securities, and interest expense on its interest-bearing liabilities, such as deposits. The
Association also generates non-interest income such as service charges and other account fees, fees
from sale of loans in the secondary market, and gains from sale of investments. The Association’s
non-interest expenses primarily consist of compensation and benefits, occupancy expenses, data
processing fees and other operating expenses. The Association’s results of operations are also
significantly affected by general economic and competitive conditions (particularly changes in
market interest rates), government policies, changes in accounting standards and actions of
regulatory agencies. The Association exceeded all of its regulatory capital requirements at
September 30, 2007. See “Regulation — Federal Banking Regulation — Capital Requirements.”
The Association is primarily engaged in the business of attracting retail deposits from the
general public in the Association’s marketing area, and investing those deposits, together with
other sources of funds, primarily in loans secured by one- to four-family residential real estate
for retention in its loan portfolio. For further details, see below under “Lending Activities.”
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Market Area and Competition
The Association is a community-oriented savings institution which primarily gathers deposits
and originates one- to four-family residential mortgage loans and construction loans within its
market area. The Association’s market area for deposit gathering and lending is concentrated in
northern Wake County and southern Franklin County, North Carolina.
The Association’s market area has benefited from its close proximity to the “Research Triangle
Park” which includes the cities of Chapel Hill, Durham and Raleigh. The commuting distance from
the Research Triangle Park to the town of Wake Forest is approximately 15 miles. While most of the
commercial development within the Research Triangle Park has been in Durham County, most of the
residential development for the employees of the Research Triangle Park has taken place in Wake
County. Northern Wake County is expected to benefit from the continued expansion of this area.
Access to the Research Triangle Park is excellent due to the proximity of Interstate 540, which is
just south of Wake Forest. The driving time between Wake Forest and the Research Triangle Park is
about 20 minutes.
Currently, employment within the region varies, from a more high tech and service-oriented
industry near the Research Triangle Park to a more agricultural/manufacturing base further away
from the Research Triangle Park. The largest employers in the northern Wake County area include
Embarq, Novo-Nordisk, and Mallinckrodt.
The population of the Association’s market area has grown rapidly during the last decade and
is expected to continue its growth over the next ten years. Based on information provided by the
Wake Forest Chamber of Commerce, the town of Wake Forest’s population was 12,588 in 2000 and grew
77.34% to 22,324 in 2007. Residential households totaled 8,322 in Wake Forest in 2007. The median
and average household incomes in Wake Forest were $74,660 and $90,200, respectively, in 2007. Wake
County’s population was estimated at 817,000 in 2007 and Franklin County’s population was estimated
at 54,500 in 2005.
The Association faces substantial competition for both the deposits it accepts and the loans
it makes. Located within the Wake Forest area are branch offices of twelve other depository
institutions, ten of which are commercial banks and two are large credit unions. The Association
also encounters significant competition for deposits from commercial banks, savings banks, savings
and loan associations and credit unions located in the Raleigh-Durham area. Due to the
Association’s size relative to its competitors, the Association offers a more limited product line,
with an emphasis on product delivery and customer service. The Association competes for deposits
by offering a variety of customer services and deposit accounts at competitive interest rates. The
Association, as well as its competitors, is affected by general economic conditions, particularly
changes in market interest rates, real estate market values, government policies and regulatory
authorities’ actions. Changes in the ratio of the demand for loans relative to the availability of
credit may affect the level of competition from financial institutions which may have greater
resources than the Association, but which have not generally engaged in lending activities in the
Association’s market area in the past. Competition may also increase as a result of the lifting of
restrictions on the interstate operations of financial institutions. See “Regulation.”
Lending Activities
Loan Portfolio Composition. The Association’s loan portfolio consists primarily of
conventional one- to four-family first mortgage loans and construction loans. To a lesser extent,
the Association also makes multi-family residential loans, commercial real estate loans, land
loans, and loans secured by savings accounts at the Association.
The types of loans that the Association may originate are subject to federal and state laws
and regulations. Interest rates charged by the Association on loans are affected by the demand for
such loans, the supply of money available for lending purposes and the rates offered by
competitors. These factors are in turn affected by, among other things, economic conditions,
monetary policies of the federal government, including the Federal Reserve Board, and legislative
tax policies.
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The following table sets forth the composition of the Association’s mortgage and other loan
portfolios in dollar amounts and percentages at the dates indicated.
Loan Maturity. The following table shows the contractual maturity of the Association’s loans
at September 30, 2007. The table reflects the entire unpaid principal balance in the maturity
period that includes the final loan payment date and, accordingly, does not give effect to periodic
principal repayments or possible prepayments. Principal repayments and prepayments totaled $36.7
million and $42.6 million for the years ended September 30, 2007 and 2006, respectively.
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The following table sets forth the dollar amounts in each loan category at September 30, 2007
that are contractually due after September 30, 2008, and whether such loans have fixed interest
rates or adjustable interest rates.
Origination, Purchase, Sale and Servicing of Loans. The Association’s lending activities are
conducted through its office in Wake Forest, North Carolina. The Association originates both
adjustable-rate mortgage loans and fixed-rate mortgage loans. Adjustable-rate mortgage loans and
fixed-rate mortgage loans carry maximum amortizations of 30 years. The Association’s ability to
originate loans is dependent upon the relative customer demand for fixed-rate or adjustable-rate
mortgage loans, which is affected by the current and expected future levels of interest rates. The
Association currently holds for its portfolio all the adjustable rate loans it originates. The
Association has a correspondent lending program with a large national mortgage company and sells a
portion of its longer-term fixed rate residential mortgage loans in the secondary market. Loans
sold through the program are sold servicing released and typically will be 15 and 30 year
fixed-rate loans. The Association does not service loans for others and has no current plans to
begin such activities. From time to time, the Association purchases participations in mortgage
loans originated by other institutions or affordable housing consortiums. The determination to
purchase participations in specific loans or pools of loans is based upon criteria substantially
similar to the Association’s underwriting policies, which consider the financial condition of the
borrower, the location of the underlying property and the appraised value of the property, among
other factors.
One- to Four-Family Mortgage Lending. The Association offers both fixed-rate and
adjustable-rate mortgage loans, with amortizations of up to 30 years. These loans are secured by
one- to four-family residences, which generally are owner-occupied. Substantially all such loans
are secured by property located in northern Wake County and southern Franklin County, North
Carolina. Loan originations are generally obtained from existing or past customers and members of
the local communities. See “-Origination, Purchase, Sale and Servicing of Loans.”
At September 30, 2007, the Association’s total loans were $76.2 million, of which $25.5
million or 33.43% were one-to four-family residential mortgage loans. Of the one- to four-family
residential mortgage loans outstanding at September 30, 2007, 35.29%, or $9.0 million, were
fixed-rate loans and 64.71%, or $16.5 million, were adjustable-rate loans. The Association offers
three-, five-, and seven-year balloon loans, which are either called or modified based on the
Association’s interest rates currently in effect at the balloon date. These loans are similar to
adjustable rate loans in that the loans generally amortize over terms of up to 30 years but are not
indexed to any widely recognized rate, such as the one year U.S. Treasury securities rate, and do
not have interest rate caps or floors. Instead, the majority of such loans are modified at the
balloon date and the rate is adjusted to the Association’s current rate offered for similar loans
being originated on such dates. For purposes of the tabular presentations throughout this
document, such loans are considered to be adjustable. Such loans involve risks similar to more
traditional adjustable rate loans because the Association modifies the loan documents at the end of
the three-, five-, and seven-year terms to adjust for rates currently offered by the Association
for similar loans being originated on such dates. The loans are not generally underwritten again
at modification unless the Association is aware of collateral or ability-to-pay issues.
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In view of its operating strategy, the Association adheres to its Board approved underwriting
guidelines for loan origination, which, though prudent in approach to credit risk and evaluation of
collateral, allow management flexibility with respect to documentation of certain matters and
certain credit requirements. As a result, such underwriting guidelines in certain lending
situations are less rigid than comparable Federal National Mortgage Association (“Fannie Mae”) or
FHLMC underwriting guidelines. The Association’s loans are typically originated under terms,
conditions and documentation which permit them to be sold to U.S. government-sponsored enterprises
such as Fannie Mae or FHLMC. The Association sells certain residential loans in the secondary
market through a correspondent lending program which requires that the Association originate such
loans utilizing the standard secondary market underwriting requirements. Unless sold in the
secondary market, the Association’s policy is to originate one- to four-family residential mortgage
loans in amounts up to 80% of the lower of the appraised value or the selling price of the property
securing the loan unless private mortgage insurance is obtained. Mortgage loans originated by the
Association generally include due-on-sale clauses which provide the Association with the
contractual right to deem the loan immediately due and payable in the event the borrower transfers
ownership of the property without the Association’s consent. Due-on-sale clauses are an important
means of adjusting the rates on the Association’s fixed-rate mortgage loan portfolio and the
Association has generally exercised its rights under these clauses.
Construction Lending. The Association originates loans for construction to local real estate
contractors in its market area, generally with whom it has an established relationship and to
individuals for construction of one- to four-family residences. The Association’s construction
loans primarily have been made to finance the construction of one- to four-family residential
properties which will generally be owner-occupied. These loans are generally indexed to the prime
rate (“Prime”) with maturities of six to nine months, and allow for extensions with Board approval.
The Association’s policies provide that construction loans may be made in amounts up to 80% of the
appraised value of the property or the cost of construction, whichever is less, for construction of
one-to four-family residences. All construction loans are subject to the limitation on loans to
one borrower and the Association considers the location of the proposed construction in order to
avoid over-concentration in a single area. Prior to making a commitment to fund a construction
loan, the Association requires an independent appraisal of the property by a state-certified
appraiser if the requested amount exceeds $125,000. The Association’s Chairman of the Board
generally inspects each project at the commencement of construction and throughout the term of the
construction. Loan proceeds are disbursed in increments as construction progresses and as
inspections warrant based upon a percentage of completion. At September 30, 2007, the Association
had $23.8 million (net of undisbursed loan funds of $9.5 million) of residential construction loans
which amounted to 31.29% of the Association’s net loans outstanding. The largest residential
construction loan in the Association’s portfolio at September 30, 2007 was $818,300, is secured by
a single family residence under construction and is performing according to its terms.
Construction loans to individuals are typically made in connection with the granting of the
permanent loan on the property. Such loans convert to a fully amortizing adjustable- or fixed-rate
loan at the end of the construction term. In most cases, the Association requires that the closing
with respect to permanent financing occur simultaneously with the closing of any construction loan
to an individual.
The Association makes construction loans to local builders on either a pre-sold or speculative
(unsold) basis. However, the Association generally limits the number of unsold homes under
construction by its builders, with the amount dependent on the reputation of the builder, the
present exposure of the builder, the location of the property, the size of the loan and prior sales
of homes in the development. The Association estimates that approximately 70% of its construction
loans to builders are on a speculative basis.
The Association also originates construction loans on commercial properties. The underwriting
requirements are similar to those required for construction loans on residential properties.
However, the loan to value may not exceed 75% of the property’s appraised value, certain debt
service and income ratios are considered, and financial projections and business plans are
reviewed. At September 30, 2007, the Association had no commercial construction loans outstanding.
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Construction loans are generally considered to involve a higher degree of credit risk than
one- to four-family residential mortgage loans because circumstances outside the borrower’s control
may adversely affect the market value of the property. The Association has attempted to minimize
these risks by, among other things, limiting the extent of its construction lending as a proportion
of lending and by limiting its construction lending to primarily residential properties. In
addition, the Association has adopted underwriting guidelines which impose stringent loan-to-value,
debt service and other requirements for loans which are believed to involve higher elements of
credit risk, by limiting the geographic area in which the Association will do business to its
existing market and by working with builders with whom it has established relationships. It is
also the Association’s general policy to obtain personal guarantees from the principal of its
corporate borrowers on its construction loans.
Commercial Real Estate Mortgage Lending. The Association originates commercial real estate
mortgage loans that are generally secured by properties used for business purposes and retail
facilities, such as small office buildings, located in the Association’s market area as well as a
significant number of church loans. The Association’s underwriting procedures provide that
commercial real estate loans may be made in amounts up to the lesser of (i) 75% of the lesser of
the appraised value or purchase price of the property and (ii) the Association’s current loans to
one borrower limit. These loans are generally originated with amortization periods of up to 30
years with (i) a three-, five-, or seven-year balloon, or (ii) prime based loans. The
Association’s underwriting standards and procedures for these loans are similar to those applicable
to its construction lending, whereby the Association considers factors such as the borrower’s
expertise, credit history and profitability. At September 30, 2007, the Association’s commercial
real estate mortgage portfolio was $11.5 million, or 15.14% of total loans outstanding. The
largest commercial real estate loan in the Association’s portfolio at September 30, 2007 was $1.6
million and is secured by a local church.
Mortgage loans secured by commercial real estate properties are generally larger and involve a
greater degree of risk than one- to four-family residential mortgage loans. This risk is
attributable to the uncertain realization of projected income-producing cash flows which are
affected by vacancy rates, the ability to maintain rent levels against competitively-priced
properties and the ability to collect rent from tenants on a timely basis. Because payments on
loans secured by commercial real estate properties are often dependent on the successful operation
or management of the properties, repayment of such loans may be subject to a greater extent to
adverse conditions in the real estate market or the economy. The Association seeks to minimize
these risks through its underwriting standards, which require such loans to be qualified on the
basis of the property’s income and debt service ratio.
Equity Lines and Commercial Lines of Credit. The Association originates equity line loans on
one- to four- residential properties and line of credit loans on commercial real estate and
residential land. The Association’s underwriting policies require that equity line loans on one-
to four- residential properties be secured by real estate where the Association may or may not have
the first mortgage on the property. The equity line loans on one- to four- residential properties
may be made in amounts up to 80% of the appraised value or adjusted tax value of the property, and
take into consideration any outstanding first mortgage liens in determining the loan-to-value
ratio. Equity line loans are originated at Prime plus 1% and adjust for changes in prime thereafter
on the first day of the month following a change in Prime. The terms on the equity line loans on
one- to four- residential properties are for a period of 15 years. At September 30, 2007, the
Association’s equity line portfolio was $1.9 million, or 2.48% of total loans outstanding.
The risks associated with equity line loans on one- to four- residential properties are
generally similar to the risks associated with other forms of single-family residential lending due
to the loan to value limits placed on such loans. The lines are revolving and may or may not be
fully disbursed at any given time. The Association’s underwriting policies require that commercial
lines of credit be secured by real estate where the Association has a first mortgage position.
Commercial lines of credit are made in amounts up to 75% of the appraised value of developed real
estate or 65% of the appraised value of undeveloped land. Commercial lines of credit are made with
terms of between 3 and 30 years at generally prime plus 1%, with adjustments to Prime made on the
first day of the month following a change in Prime. The risks associated with lines of credit on
real estate are substantially the same as the risks described above on the Association’s other
forms of commercial real estate lending.
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Other Mortgage Lending. The Association also offers loans secured by land and multi-family
residences. Land loans generally consist of residential building lots for which the borrower
intends to ultimately construct residential properties, but may also include tracts purchased for
speculative purposes and a minor amount of farm land. Multi-family loans generally consist of
residential properties with more than four units, typically apartment complexes, in which the
Association has a participating interest through an affordable housing consortium. The Association
does not solicit such loans which do not constitute an active part of its business, and generally
offers such loans to accommodate its present customers or to fulfill commitments to affordable
housing consortiums. At September 30, 2007, the Association’s total land loan portfolio was $14.2
million or 18.70% of total loans outstanding and its multi-family loan portfolio was $354,100 or
0.46% of total loans outstanding.
The Association requires appraisals of all properties securing multi-family residential loans.
Appraisals are performed by an independent appraiser designated by the Association, all of which
are reviewed by management. The Association considers the quality and location of the real estate,
the credit of the borrower, the cash flow of the project and the quality of management involved
with the property.
The Association originates multi-family residential loans with both fixed and adjustable
interest rates which vary as to maturity. Such loans are typically income-producing investment
loans. Loan to value ratios on the Association’s multi-family residential loans are generally
limited to 75%. As part of the criteria for underwriting these loans, the Association’s general
policy is to obtain personal guarantees from the principals of its corporate borrowers.
Multi-family residential lending entails significant additional risks as compared with
single-family residential property lending. Such loans typically involve large loan balances to
single borrowers or groups of related borrowers. The payment experience on such loans is typically
dependent on the successful operation of the real estate project. The success of such projects is
sensitive to changes in supply and demand, conditions in the market for multi-family residential
properties as well as regional and economic conditions generally.
Savings Account Loans. The Association offers loans secured by savings accounts at the
Association. Interest rates charged on such loans are set at competitive rates, taking into
consideration the amount and term of the loan and are available in amounts up to 95% of the value
of the account. Savings account loans are reviewed and approved in conformity with standards
approved by the Association’s Board of Directors. At September 30, 2007, the Association’s savings
account loan portfolio totaled $143,200 or 0.19% of total loans outstanding.
Loan Approval Procedures and Authority. The Board of Directors establishes the lending
policies of the Association and reviews properties offered as security. The Board of Directors has
established the following lending authority: the lending officers may approve loans in amounts up
to $500,000 while loans above $500,000 require Board approval. The foregoing lending limits are
reviewed annually and, as needed, revised by the Board of Directors. The Board ratifies all loans
on a monthly basis.
For all loans originated by the Association, upon receipt of a completed loan application from
a prospective borrower, a credit report is ordered and certain other information is verified by an
independent credit reporting agency, and, if necessary, additional financial information is
required to be submitted by the borrower. An appraisal of any real estate intended to secure the
proposed loan is required, which appraisal currently is performed by an independent appraiser
designated and approved by the Association. Loans of up to $125,000 may be approved by the
Association’s loan officers using property tax values and drive-by appraisals. The Board annually
approves the independent appraisers used by the Association and approves the Association’s
appraisal policy. It is the Association’s policy to obtain title and hazard insurance on all real
estate loans. In connection with a borrower’s request for a renewal of a mortgage loan, the
Association evaluates the borrower’s ability to service the renewed loan applying an interest rate
that reflects prevailing market conditions. The current value of the underlying collateral
property is considered and the Association reserves the right to reappraise the property.
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Asset Quality
Non-Performing Loans. Loans are considered non-performing if they are in foreclosure or are
90 or more days delinquent. Management and the Board of Directors perform a monthly review of all
delinquent loans. The actions taken
by the Association with respect to delinquencies vary depending on the nature of the loan and
period of delinquency. The Association’s policies generally provide that delinquent mortgage loans
be reviewed and that a written late charge notice be mailed no later than the 30th day of
delinquency. The Association’s policies provide that telephone contact will be attempted to
ascertain the reasons for delinquency and the prospects of repayment. When contact is made with
the borrower at any time prior to foreclosure, the Association attempts to obtain full payment or
work out a repayment schedule with the borrower to avoid foreclosure. It is the Association’s
general policy to place all loans which are 90 days past due on nonaccrual status through the
establishment of a reserve for uncollected interest unless collectibility of all delinquent
interest is assured. Exceptions to placing a loan on non-accrual status are made when the loan
officer or management believe that no loss will be incurred on such loan. Any such exceptions are
reported to the Board of Directors on a monthly basis. Circumstances under which such an exception
may be granted include when the underlying property is being actively marketed for sales, when a
sales contract has been executed and is pending closing or when the Association and the borrower
are actively negotiating a work-out schedule and all such interest is considered collectible.
The Association, as part of its loan review process, including the decision whether to place a
loan on nonaccrual status, attempts to determine the underlying cause of the borrower’s delinquency
and ability to repay the loan. The Association has been able to take this approach because it is a
relatively small institution and its problem loans have been historically insignificant as a
percentage of the Association’s total loan portfolio. As the Association grows, it may be
necessary for the Association to take a more rigid approach and automatically place loans on
non-accrual status upon becoming 90 days or more past due and evaluate only those loans that
trigger certain mechanisms that might indicate that an exception is warranted. However, management
believes that its current approach keeps it better informed as to the progress of a problem loan
and its underlying difficulties and that its non-accrual policy results in an accurate depiction of
loans that are collectible or likely to result in a loss. There can be no assurances that the
Association will be able to maintain its problem loans at or below historical levels.
Non-Accrual and Other Past Due Loans. The following table sets forth information regarding
non-accrual loans, other past due loans and real estate owned. There were no troubled debt
restructurings at any of the dates presented below.
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Classified Assets. Federal regulations and the Association’s Classification of Assets Policy
require that the Association utilize an internal asset classification system as a means of
reporting problem and potential problem assets. The Association has incorporated the OTS internal
asset classifications as a part of its credit monitoring system. The Association currently
classifies problem and potential problem assets as “Special Mention,” “Substandard,” “Doubtful”
or “Loss” assets. An asset is considered “Substandard” if it is inadequately protected by the
current equity and paying capacity of the obligor or of the collateral pledged, if any.
“Substandard” assets include those characterized by the “distinct possibility” that the insured
institution will sustain “some loss” if the deficiencies are not corrected. Assets classified as
“Doubtful” have all of the weaknesses inherent in those classified “Substandard” with the added
characteristic that the weaknesses present make “collection or liquidation in full,” on the basis
of currently existing facts, conditions, and values, “highly questionable and improbable.” Assets
classified as “Loss” are those considered “uncollectible” and of such little value that their
continuance as assets without the establishment of a specific loss reserve is not warranted.
Assets which do not currently expose the insured institution to sufficient risk to warrant
classification in one of the aforementioned categories but possess weaknesses are required to be
designated “Special Mention.”
When an insured institution classifies one or more assets, or portions thereof, as Substandard
or Doubtful, it is required to establish an allowance for loan losses in an amount deemed prudent
by management. Allowance for loan losses represent loss allowances which have been established to
recognize the inherent risk associated with lending activities, but which, unlike specific
allowances, have not been allocated to particular problem assets. When an insured institution
classifies one or more assets, or proportions thereof, as “Loss,” it is required either to
establish a specific allowance for loan losses equal to 100% of the amount of the asset so
classified or to charge off such amount.
A savings institution’s determination as to the classification of its assets and the amount of
its allowance for loan losses is subject to review by the OTS, which can order the establishment of
additional allowances. The OTS, in conjunction with the other federal banking agencies, has
adopted an interagency policy statement on allowance for loan losses. The policy statement
provides guidance for financial institutions on both the responsibilities of management for the
assessment and establishment of adequate allowances and guidance for banking agency examiners to
use in determining the adequacy of valuation guidelines. Generally, the policy statement
recommends that institutions have effective systems and controls to identify, monitor and address
asset quality problems; that management has analyzed all significant factors that affect the
collectibility of the portfolio in a reasonable manner; and that management has established
acceptable allowance evaluation processes that meet the objectives set forth in the policy
statement.
While the Association believes that it has established an adequate allowance for loan losses,
there can be no assurance that regulators, in reviewing the Association’s loan portfolio as part of
a future regulatory examination, will not request the Association to materially increase its
allowance for loan losses, thereby negatively affecting the Association’s financial condition and
earnings at that time. Although management believes that adequate allowance for loan losses have
been established, actual losses are dependent upon future events and, as such, further additions to
the level of specific or allowance for loan losses may become necessary.
The Association’s management reviews and classifies the Association’s assets quarterly and
reports the results to the Association’s Board of Directors on a quarterly basis. The Association
classifies assets in accordance with the management guidelines described above. The Association
had $1,599,437 of assets classified as “Substandard” at September 30, 2007. The classified assets
include six residential loans from the same borrower totaling $595,650 and a foreclosed commercial
tract amounting to $1,003,800. The loans classified “Substandard” at September 30, 2007 were
comprised of two residential property loans totaling $115,450, three residential construction loans
totaling $455,100 from the same builder on partially completed homes, and one residential developed
lot loan totaling $25,100. The Association has established specific reserves on two of the
residential construction loans totaling $27,500. At this time, the Company believes that the fair
market value of all other properties is higher than the outstanding loan balances and no loss on
the ultimate disposition of these loans is expected. All of the loans classified as “Substandard”
have been placed on non-accrual status.
At September 30, 2007, the foreclosed commercial property consisted of a convenience store and
an adjacent tract of land, in total 3.81 acres located on a major highway outside of Wake Forest,
North Carolina. While the commercial property’s location is considered highly desirable, the
Company decided that an environmental assessment was necessary to properly market the tract due to
the historical uses of the property. As a result, site assessment reports were filed with various
state environmental agencies. Petroleum contamination and other trace elements consistent with
operating a gas station and a truck maintenance facility over an extended period of time were found
on parts of the property. The Company has obtained North Carolina Brownfields status (an
environmental program that assists in the re-development of contaminated sites) for the property
which should make the tract more attractive to prospective
developers. In addition, the Company obtained Trust Fund status for the site which will allow
certain environmental cost
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to be reimbursed. Although the Company does not currently believe the
contamination will have a significant detrimental effect on the potential development of the
property, the state environmental agencies are assisting the Company in determining the extent of
any required clean-up and ongoing monitoring steps that will be required. The Company has set
aside $185,000 at September 30, 2007 for such testing and clean-up activities. At this time, the
Company does not believe that the ongoing environmental costs will materially impact the value of
the property and no loss is expected on its ultimate sale. During 2007, the Company expensed
$100,800 in environmentally related cost for this property.
The Association also had four loans amounting to $1,388,650 classified as “Special Mention”.
The loans classified as “Special Mention” consists of a four loans on undeveloped residential
tracts in Franklin County from the same borrower.
Allowance for Loan Losses. The allowance for loan losses is established through a provision
for loan losses based on management’s evaluation of the risks inherent in the Association’s loan
portfolio and the general economy. The allowance for loan losses is maintained at an amount
management considers adequate to cover loan losses which are deemed probable and estimable. The
allowance is based upon a number of factors, including asset classifications, economic trends,
industry experience and trends, geographic and lending concentrations, estimated collateral values,
management’s assessment of the credit risk inherent in the portfolio, historical loan loss
experience, and the Association’s underwriting policies.
At September 30, 2007, the Association’s allowance for loan losses was $1,187,550, or 1.54% of
total loans, as compared to $1,042,500 or 1.34% of total loans at September 30, 2006. The
Association had non-performing loans of $595,650 and $666,350 at September 30, 2007 and September
30, 2006, respectively. The Association provided $165,000 in additional loan loss provisions
during 2007. During the current year, the Association charged off $19,950 of non-performing loans.
The Association provided $192,500 in additional loan loss provisions during 2006 and did not
charge off any loans during that period. This evaluation is inherently subjective as it requires
estimates that are susceptible to significant revisions as more information becomes available.
Various regulatory agencies, as an integral part of their examination process, periodically review
the Association’s allowance for loan losses. These agencies may require the Association to
establish additional valuation allowances, based on their judgments of the information available at
the time of the examination.
Real Estate Owned. Property acquired by the Association as a result of foreclosure on a
mortgage loan is classified as real estate owned (“REO”) and is initially recorded at the fair
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